Fixed cost
Fixed costs ( T.F.C):- Fixed costs are expenses on factors of production which do not change with the level of output. In other words, fixed costs are costs incurred by the firm regardless of the level of out put and they are incurred even when the firm produces zero output.
Fixed costs are expenses whose total does not change in proportion to the activity of a business, within the relevant time period or scale of production. For example, a retailer must pay rent and utility bills irrespective of sales to be considered part of fixed costs, but treated differently. Unit fixed costs decline with volume, following a rectangular hyperbola as the inverse of the volume of production.
Variable costs by contrast change in relation to the activity of a business such as sales or production volume. In the example of the retailer, variable costs may primarily be composed of inventory (goods purchased for sale), and the cost of goods is therefore almost entirely variable. In manufacturing, direct material costs are an example of a variable cost.
Along with variable costs, fixed costs make up one of the two components of total cost. In the most simple production function, total cost is equal to fixed costs plus variable costs.
In microeconomics and business, the difference between fixed costs and variable costs (and the related terms average cost and marginal cost) is crucial, as each will influence production decisions for profit maximization differently. In the most simple cases, fixed costs do not affect production decisions, because they cannot be changed, and management will choose to produce if sales prices are above the cost of each additional unit (marginal cost).
Fixed costs should not be confused with sunk costs. From a pure economics perspective, fixed costs may not be fixed in the sense of invariate; they may change, but are fixed in relation to the quantity of production for the relevant time period. For example, a company may have unexpected and unpredictable expenses unrelated to production, and these would not be considered part of variable costs.
It is important to understand that fixed costs are "fixed" only within a certain range of activity or over a certain period of time. If enough time passes, all costs become variable. Similarly, not all indirect costs are fixed costs; for example, advertising expenses are indirect costs that are variable over a slightly longer time frame, as they may not be subject to change in the short term, but may be easily adjustable over a longer time frame.
In accounting terminology, fixed costs will broadly include all costs (expenses) which are not included in cost of goods sold, and variable costs are those captured in costs of goods sold. The implicit assumption required to make the equivalence between the accounting and economics terminology is that the accounting period is equal to the period in which fixed costs do not vary in relation to production. In practice, this equivalence does not always hold and depending on the period under consideration by management, some overhead expenses (such as sales, general and administrative expenses) can be adjusted by management, and the specific allocation of each expense to each category will be decided under cost accounting.
In business planning and management accounting, usage of the terms fixed costs, variable costs and others will often differ from usage in economics, and may depend on the intended use. For example, costs may be segregated into per unit costs (costs of goods sold), fixed costs per period, and variable costs as a proportion of revenue. Capital expenditures will usually be allocated separately, and depending on the purpose, a portion may be regularly allocated to expenses as depreciation and amortization and seen as a fixed cost per period, or the entire amount may be considered upfront fixed costs.
Total Cost ( T.C): It is the summation of all the expenses incurred on fixed factors ( TFC) plus all the expenses on variable factors ( T.V.C). Therefore, T. C = T.F.C + T.V.C
Total cost (TC), Total fixed cost ( TFC) and Total variable cost ( TVC) curves.
Per unit costs of production.
Per Unit or average cost of production are obtained from the above types of costs and therefore include the following:
Average fixed cost ( AFC) :- is the total fixed cost per unit of output produced. It is obtained by dividing the total fixed cost ( TFC) by the total output ( Q)
Therefore, AFC = TFC
Q
Average fixed cost often diminishes with an increase in output. As such the average fixed cost curve is down ward sloping, from left to right.
Figure 2.23. Average fixed cost curve
Average variable Cost ( AVC):- It is the total variable Cost (TVC) per unit of output ( Q)produced. It is obtained by dividing the TVC by the total output (Q)
Hence , AVC = TVC
Q
The AVC first falls as output increases but after reaching a certain minimum point , it starts to rise. It is U-shaped.
Figure 2.24. Average variable cost curve
Average total cost ( ATC):- Is the total cost per unit output. It is obtained by dividing total cost ( TC) by total output.(Q)
Therefore ATC = TC
Q
Average total cost also first falls but eventually starts to rise , as output increases. ATC curve is U-shaped
Figure 2.25. Average Total cost curve
Note: T.C = TFC+TVC. This also implies that ATC= AFC+AVC. Hence while ATC and AVC curves are both U-shaped, ATC curve lies above AVC curve.
Marginal cost (MC). This is the additional cost incurred by a firm in producing an extra unit of output. It is therefore the addition to total cost (TC) occurring from the production of one extra unit of output.
It is obtained by dividing the difference in total cost resulting from producing one extra unit (êTC) by the difference in total output (êQ)
Hence MC= êTC
ê Q , where,
êTC = change in total cost (difference)
êQ = change in total output.
Note: MC first falls as output increases up to a minimum point and eventually begins to rise. MC curve is also U-Shaped.
Figure 2.26 Marginal cost curve.
Relationship between ATC, AFC, AVC and MC
Note:
All ATC, AVC and MC first decline as output increases but eventually start to rise as output increases.
Diagrammatically the three ( ATC, AVC, MC) are U -shaped.
AVC tends to equal ATC as output increases. The gap between ATC and AVC tends to narrow as output increases because ATC keeps on falling slowly.
AVC reaches its minimum before ATC i.e AVC falls faster than ATC.
MC is equal to ATC when ATC is at its minimum i.e the MC curve cuts the ATC curve when ATC is at its lowest point.
AFC declines continuously because as output increases, the fixed cost is being spread over a widening level of output. The AFC curve falls continuously but does not touch the X axis.
When MC is below AVC, AVC will be falling and when MC is above AVC, AVC will be increasing.
When MC is below ATC, ATC is falling and when it is above ATC, ATC is rising.
AFC and AVC curves are below ATC curve because ATC includes both AFC and AVC.
Fixed costs are expenses whose total does not change in proportion to the activity of a business, within the relevant time period or scale of production. For example, a retailer must pay rent and utility bills irrespective of sales to be considered part of fixed costs, but treated differently. Unit fixed costs decline with volume, following a rectangular hyperbola as the inverse of the volume of production.
Variable costs by contrast change in relation to the activity of a business such as sales or production volume. In the example of the retailer, variable costs may primarily be composed of inventory (goods purchased for sale), and the cost of goods is therefore almost entirely variable. In manufacturing, direct material costs are an example of a variable cost.
Along with variable costs, fixed costs make up one of the two components of total cost. In the most simple production function, total cost is equal to fixed costs plus variable costs.
In microeconomics and business, the difference between fixed costs and variable costs (and the related terms average cost and marginal cost) is crucial, as each will influence production decisions for profit maximization differently. In the most simple cases, fixed costs do not affect production decisions, because they cannot be changed, and management will choose to produce if sales prices are above the cost of each additional unit (marginal cost).
Fixed costs should not be confused with sunk costs. From a pure economics perspective, fixed costs may not be fixed in the sense of invariate; they may change, but are fixed in relation to the quantity of production for the relevant time period. For example, a company may have unexpected and unpredictable expenses unrelated to production, and these would not be considered part of variable costs.
It is important to understand that fixed costs are "fixed" only within a certain range of activity or over a certain period of time. If enough time passes, all costs become variable. Similarly, not all indirect costs are fixed costs; for example, advertising expenses are indirect costs that are variable over a slightly longer time frame, as they may not be subject to change in the short term, but may be easily adjustable over a longer time frame.
In accounting terminology, fixed costs will broadly include all costs (expenses) which are not included in cost of goods sold, and variable costs are those captured in costs of goods sold. The implicit assumption required to make the equivalence between the accounting and economics terminology is that the accounting period is equal to the period in which fixed costs do not vary in relation to production. In practice, this equivalence does not always hold and depending on the period under consideration by management, some overhead expenses (such as sales, general and administrative expenses) can be adjusted by management, and the specific allocation of each expense to each category will be decided under cost accounting.
In business planning and management accounting, usage of the terms fixed costs, variable costs and others will often differ from usage in economics, and may depend on the intended use. For example, costs may be segregated into per unit costs (costs of goods sold), fixed costs per period, and variable costs as a proportion of revenue. Capital expenditures will usually be allocated separately, and depending on the purpose, a portion may be regularly allocated to expenses as depreciation and amortization and seen as a fixed cost per period, or the entire amount may be considered upfront fixed costs.
Total Cost ( T.C): It is the summation of all the expenses incurred on fixed factors ( TFC) plus all the expenses on variable factors ( T.V.C). Therefore, T. C = T.F.C + T.V.C
Total cost (TC), Total fixed cost ( TFC) and Total variable cost ( TVC) curves.
Per unit costs of production.
Per Unit or average cost of production are obtained from the above types of costs and therefore include the following:
Average fixed cost ( AFC) :- is the total fixed cost per unit of output produced. It is obtained by dividing the total fixed cost ( TFC) by the total output ( Q)
Therefore, AFC = TFC
Q
Average fixed cost often diminishes with an increase in output. As such the average fixed cost curve is down ward sloping, from left to right.
Figure 2.23. Average fixed cost curve
Average variable Cost ( AVC):- It is the total variable Cost (TVC) per unit of output ( Q)produced. It is obtained by dividing the TVC by the total output (Q)
Hence , AVC = TVC
Q
The AVC first falls as output increases but after reaching a certain minimum point , it starts to rise. It is U-shaped.
Figure 2.24. Average variable cost curve
Average total cost ( ATC):- Is the total cost per unit output. It is obtained by dividing total cost ( TC) by total output.(Q)
Therefore ATC = TC
Q
Average total cost also first falls but eventually starts to rise , as output increases. ATC curve is U-shaped
Figure 2.25. Average Total cost curve
Note: T.C = TFC+TVC. This also implies that ATC= AFC+AVC. Hence while ATC and AVC curves are both U-shaped, ATC curve lies above AVC curve.
Marginal cost (MC). This is the additional cost incurred by a firm in producing an extra unit of output. It is therefore the addition to total cost (TC) occurring from the production of one extra unit of output.
It is obtained by dividing the difference in total cost resulting from producing one extra unit (êTC) by the difference in total output (êQ)
Hence MC= êTC
ê Q , where,
êTC = change in total cost (difference)
êQ = change in total output.
Note: MC first falls as output increases up to a minimum point and eventually begins to rise. MC curve is also U-Shaped.
Figure 2.26 Marginal cost curve.
Relationship between ATC, AFC, AVC and MC
Note:
All ATC, AVC and MC first decline as output increases but eventually start to rise as output increases.
Diagrammatically the three ( ATC, AVC, MC) are U -shaped.
AVC tends to equal ATC as output increases. The gap between ATC and AVC tends to narrow as output increases because ATC keeps on falling slowly.
AVC reaches its minimum before ATC i.e AVC falls faster than ATC.
MC is equal to ATC when ATC is at its minimum i.e the MC curve cuts the ATC curve when ATC is at its lowest point.
AFC declines continuously because as output increases, the fixed cost is being spread over a widening level of output. The AFC curve falls continuously but does not touch the X axis.
When MC is below AVC, AVC will be falling and when MC is above AVC, AVC will be increasing.
When MC is below ATC, ATC is falling and when it is above ATC, ATC is rising.
AFC and AVC curves are below ATC curve because ATC includes both AFC and AVC.
TABLE 2.21 Costs in the short run
|
OUTPUTQ |
TFC |
TVC |
TC |
AFC |
AVC |
ATC |
MC |
|
0 |
60 |
- |
60 |
k |
- |
k |
k |
|
1 |
60 |
50 |
110 |
60 |
50 |
110 |
50 |
|
2 |
60 |
80 |
140 |
30 |
40 |
70 |
30 |
|
3 |
60 |
105 |
165 |
20 |
35 |
55 |
25 |
|
4 |
60 |
125 |
180 |
15 |
3`.3 |
45 |
15 |
|
5 |
60 |
150 |
210 |
12 |
30 |
40 |
30 |
|
6 |
60 |
180 |
240 |
10 |
30 |
40 |
30 |
|
7 |
60 |
220 |
280 |
8.6 |
31.4 |
40 |
40 |
|
8 |
60 |
280 |
350 |
7.5 |
35 |
43.8 |
70 |
|
9 |
60 |
370 |
430 |
6.7 |
41.1 |
47.8 |
80 |
|
10 |
60 |
520 |
580 |
6 |
52 |
58 |
150 |