Cost Function is identifying the specific relationship between Total Cost of Production and Total Output of the Firm.
Cost function is given by,
C = f (y)
where,
C = total cost of production (dependent variable)
y = total output of the firm (independent variable)
where both the variables are positively related.
Therefore we observe that if the manager is interested to increase the target in output, the firm must have the capacity to make higher cost of production.
From the cost function concept, we get cost analysis. In the cost analysis we explain the nature and behavior of different cost of production with the help of different cost curves.
The different types of cost productions are –
(1) Total cost of production
(2) Fixed cost of production
(3) Variable cost of production
(4) Marginal cost of production
(5) Average cost of production
(6) Incremental cost of production
(7) Opportunity cost of production
The nature and behavior of the above stated costing components are explained as follows:
(1) Total cost of production
Total cost of production is the total expenditure which the manager is making for getting total output in a particular financial year. If the output is zero still manager has to make some initial expenditures for the employment of fixed factors of production and therefore Total Cost of Production can never be zero. However, with increase in target in output total cost of production goes on increasing.
(2) Fixed cost of production
Fixed cost of production is the expenditure which the manager is making for the employment of fixed factors of production, i.e., purchase of land, construction of building, purchase of essential machinery, employment of minimum skilled labour and finally expenditure for infrastructure development. These expenditure are completely independent of the level of output. Therefore if the output is zero total fixed cost of production remains constant.
(3) Variable cost of production
This expenditure is completely dependent on the level of output. This expenditure is for the employment of variable factors of production, i.e., purchase of raw materials, employment of labor on contract basis and permanent basis and purchase of new technology into the existing production process. If output is zero total variable cost is also zero however if we increase in target of output total variable cost goes on increasing.
(4) Marginal cost of production
The marginal cost of production is additional expenditure which the manager is making for getting one more additional unit of the product in the market. Therefore marginal cost of production is the rate at which total cost of production goes on increasing with the increase in output of the firm. It is observed that initially a manager is facing increase in return to scale and therefore in this situation marginal cost of production gets a downward trend. Then the manager is facing constant return to scale for which marginal cost of production becomes constant. Then the manager is facing diminishing return to scale and in this situation we observe that marginal cost of production gets an increasing trend.
(5) Average cost of production
Average cost of production is known as per unit cost of production.
Average Cost = (total cost of production) / (total output)
The behavior of average cost of production can be analysed as (A) behavior of short run average cost of production, (B) behavior of long run average cost of production.
(A) Behavior of Short Run Average Cost of Production
The significance of average cost is that it is accepted as efficiency parameter. Higher the efficiency of management, lower will be per unit cost of production. Therefore the manager is always interested to get maximum output as lowest per unit cost of production.
It is observed that total cost of production is divided into two parts, i.e., total fixed cost of production and total variable cost of production.
Therefore,
Total cost of production = (total fixed cost of production) + (total variable cost of production)
Therefore we get that,
Average cost = (total cost of production) / (total output) = [(total fixed cost of production) / (total output)] / [(total variable cost of production) / (total output)] = (average fixed cost of production) + (average variable cost of production)
In the short run nature and behavior of average cost of production is determined by the trends of average fixed cost of production and average variable cost of production.
(B) Behavior of Long Run Average Cost of Production
Long run is the summation of short run. In long run the manager is always interested to get the target in output always at lowest per unit cost of production, as we know that average cost of production is accepted as efficiency parameter of manager.
(6) Incremental cost of production
Incremental cost of production is additional liability which is going to be imposed on the management due to acceptance of a new strategy and rejection of the existing strategy.
Therefore,
Incremental cost of production = (total cost of production of the proposed strategy) – (total cost of production of the existing strategy)
The manager must understand whether the firm is in a position to accept the additional liability which will be imposed on the firm due to acceptance of proposed strategy.
The principle is that higher the amount of incremental cost of production, lower will be the preference for the strategy. Therefore the manager will select the strategy which is having least amount of incremental cost of production. Therefore it is observed that incremental cost of production is an important costing parameter in the decision making process of the management.
(7) Opportunity cost of production
Opportunity cost of production is the amount of sacrifice which the manger is going to make every year for accepting a new strategy and rejecting the alternative existing strategy.
For example let us consider there are two strategies of production X and Y which are available to the manager. From the implementation of strategy X the manager gets annual profit of Rs. 20,000. From the implementation of strategy Y, the manager gets annual profit of Rs. 30,000. Now it is observed that due to the existing socio-economic conditions, the manager has to continue the business with the strategy X and manager can’t accept strategy Y. in this situation,
Opportunity cost = Rs. (30,000 – 20,000) = Rs. 10,000 annual profit
This amount of profit every year the manger is making sacrifice due to the acceptance of strategy X and rejection of strategy Y. the principle is that higher the amount of opportunity cost of production, lower will be the preference of that strategy. Hence opportunity cost of production plays an important role in the decision making process of the management.