Meaning of Cost of Production.

Cost is analyzed from the producer’s point of view. Cost estimates are made in terms of money.
Cost calculations are indispensable for management decisions.

In the production process, a producer employs different factor inputs. These factor inputs are to
be compensated by the producer for the services in the production of a commodity. The
compensation is the cost. The value of inputs required in the production of a commodity
determines its cost of output. Cost of production refers to the total money expenses (Both
explicit and implicit) incurred by the producer in the process of transforming inputs into
outputs. In short, it refers total money expenses incurred to produce a particular quantity of
output by the producer. The knowledge of various concepts of costs, cost-output relationship etc.
occupies a prominent place in cost analysis.

Managerial Uses Of Cost Analysis

A detailed study of cost analysis is very useful for managerial decisions. It helps the management

1. To find the most profitable rate of operation of the firm.

2. To determine the optimum quantity of output to be produced and supplied.

3. To determine in advance the cost of business operations.

4. To locate weak points in production management to minimize costs.

5. To fix the price of the product.

6. To decide what sales channel to use.

7. To have a clear understanding of alternative plans and the right costs involved in them.

8. To have clarity about the various cost concepts.

9. To decide and determine the very existence of a firm in the production field.

10. To regulate the number of firms engaged in production.

11. To decide about the method of cost estimation or calculations.

12. To find out decision making costs by re-classifications of elements, reprising of input factors
etc, so as to fit the relevant costs into management planning, choice etc.

Different Kinds Of Cost Concepts.

1. Money Cost and Real Cost

When cost is expressed in terms of money, it is called as money cost It relates to money
outlays by a firm on various factor inputs to produce a commodity. In a monetary economy,
all kinds of cost estimations and calculations are made in terms of money only. .Hence, the
knowledge of money cost is of great importance in economics. Exact measurement of money
cost is possible.

When cost is expressed in terms of physical or mental efforts put in by a person in the
making of a product, it is called as real cost. It refers to the physical, mental or psychological
efforts, the exertions, sacrifices, the pains, the discomforts, displeasures and inconveniences
which various members of the society have to undergo to produce a commodity. It is a subjective
And relative concept and hence exact measurement is not possible.

2. Implicit or Imputed Costs and Explicit Costs

Explicit costs are those costs which are in the nature of contractual payments and are paid
by an entrepreneur to the factors of production [excluding himself] in the form of rent,
wages, interest and profits, utility expenses, and payments for raw materials etc. They can
be estimated and calculated exactly and recorded in the books of accounts.

Implicit or imputed costs are implied costs. They do not take the form of cash outlays and as
such do not appear in the books of accounts. They are the earnings of owner-employed
resources. For example, the factor inputs owned by the entrepreneur himself like capital can be
utilized by himself or can be supplied to others for a contractual sum if he himself does not
utilize them in the business. It is to be remembered that the total cost is a sum of both implicit
and explicit costs.

3. Actual costs and Opportunity Costs

Actual costs are also called as outlay costs, absolute costs and acquisition costs. They are those
costs that involve financial expenditures at some time and hence are recorded in the books of
accounts. They are the actual expenses incurred for producing or acquiring a commodity or
service by a firm. For example, wages paid to workers, expenses on raw materials, power, fuel
and other types of inputs. They can be exactly calculated and accounted without any difficulty.

Opportunity cost of a good or service is measured in terms of revenue which could have
been earned by employing that good or service in some other alternative uses. In other
words, opportunity cost of anything is the cost of displaced alternatives or costs of sacrificed
alternatives. It implies that opportunity cost of anything is the alternative that has been
foregone. Hence, they are also called as alternative costs. Opportunity cost represents only
sacrificed alternatives. Hence, they can never be exactly measured and recorded in the books of
accounts.

The knowledge of opportunity cost is of great importance to management decision. They help in
taking a decision among alternatives. While taking a decision among several alternatives, a
manager selects the best one which is more profitable or beneficial by sacrificing other
alternatives. For example, a firm may decide to buy a computer which can do the work of 10
laborers. If the cost of buying a computer is much lower than that of the total wages to be paid to
the workers over a period of time, it will be a wise decision. On the other hand, if the total wage
bill is much lower than that of the cost of computer, it is better to employ workers instead of
buying a computer. Thus, a firm has to take a number of decisions almost daily.

4. Direct costs and indirect costs

Direct costs are those costs which can be specifically attributed to a particular product, a
department, or a process of production. For example, expenses on raw materials, fuel, wages
to workers, salary to a divisional manager etc are direct costs. On the other hand, indirect costs
are those costs, which are not traceable to any one unit of operation. They cannot be attributed to
a product, a department or a process. For example, expenses incurred on electricity bill, water
bill, telephone bill, administrative expeneses etc.

5. Past and future costs.

Past costs are those costs which are spent in the previous periods. On the other hand, future costs
are those which are to be spent. in the future. Past helps in taking decisions for future.

6. Marginal and Incremental costs

Marginal cost refers to the cost incurred on the production of another or one more unit .It
implies additional cost incurred to produce an additional unit of output It has nothing to do
with fixed cost and is always associated with variable cost.

Incremental cost on the other hand refers to the costs involved in the production of a batch or
group of output. They are the added costs due to a change in the level or nature of business
activity. For example, cost involved in the setting up of a new sales depot in another city or cost
involved in the production of another 100 extra units.

7. Fixed costs and variable costs.

Fixed costs are those costs which do not vary with either expansion or contraction in
output. They remain constant irrespective of the level of output. They are positive even if
there is no production. They are also called as supplementary or over head costs.

On the other hand, variable costs are those costs which directly and proportionately increase
or decrease with the level of output produced. They are also called as prime costs or direct
costs.
8. Accounting costs and economic costs.

Accounting costs are those costs which are already incurred on the production of a
particular commodity. It includes only the acquisition costs. They are the actual costs involved
in the making of a commodity. On the other hand, economic costs are those costs that are to be
incurred by an entrepreneur on various alternative programs. It involves the application of
opportunity costs in decision making.

Determinants Of Costs

Cost behavior is the result of many factors and forces. But it is very difficult to determine in
general the factors influencing the cost as they widely differ from firm to firm and even industry
to industry. However, economists have given some factors considering them as general
determinants of costs. They have enough importance in modern business set up and decision
making process. The following factors deserve our attention in this connection.

1. Technology

Modern technology leads to optimum utilization of resources, avoid all kinds of wastages, saving
of time, reduction in production costs and resulting in higher output. On the other hand, primitive
technology would lead to higher production costs.

2. Rate of output: (the degree of utilization of the plant and machinery)

Complete and effective utilization of all kinds of plants and equipments would reduce production
costs and under utilization of existing plants and equipments would lead to higher production
costs.

3.Size of Plant and scale of production

Generally speaking big companies with huge plants and machineries organize production on
large scale basis and enjoy the economies of scale which reduce the cost per unit.

4. Prices of input factors

Higher market prices of various factor inputs result in higher cost of production and vice-versa.

5. Efficiency of factors of production and the management

Higher productivity and efficiency of factors of production would lead to lower production costs
and vice-versa.

6. Stability of output
Stability in production would lead to optimum utilization of the existing capacity of plants and
equipments. It also brings savings of various kinds of hidden costs of interruption and learning
leading to higher output and reduction in production costs.

7. Law of returns

Increasing returns would reduce cost of production and diminishing returns increase cost.

8. Time period

In the short run, cost will be relatively high and in the long run, it will be low as it is possible to
make all kinds of adjustments and readjustments in production process.

Thus, many factors influence cost of production of a firm.

Learn short – run and long – run cost functions

Cost and output are correlated. Cost output relations play an important role in almost all business
decisions. It throws light on cost minimization or profit maximization and optimization of
output. The relation between the cost and output is technically described as the “COST
FUNCTION”. The significance of cost-output relationship is so great that in economic analysis
the cost function usually refers to the relationship between cost and rate of output alone and we
assume that all other independent variables are kept constant. Mathematically speaking TC = f
(Q) where TC = Total cost and Q stands for output produced.

However, cost function depends on three important variables.

1 Production function

If a firm is able to produce higher output with a little quantity of inputs, in that case, the cost
function becomes cheaper and vice-versa.

2. The market prices of inputs

If market prices of different factor inputs are high in that case, cost function becomes higher and
vice-versa.

3. Period of time

Cost function becomes cheaper in the long run and it would be relatively costlier in the short run.

Types of cost function.

Generally speaking there are two types of cost functions.

1. Short run cost function.

 2. Long run cost function.

Cost-Output Relation Ship And Cost Curves In The Short-Run. ¼br />

It is interesting to note that the relationship between the cost and output is different at two
different periods of time i.e. short-run and long run. Generally speaking, cost of production will
be relatively higher in the short-run when compared to the long run. This is because a producer
will get enough time to make all kinds of adjustments in the productive process in the long run
than in the short run. When cost and output relationship is represented with the help of diagrams,
we get short run and long run cost curves of the firm. Now we shall make a detailed study of cost
out put relations both in the short-run as well as in the long run.

MEANING OF SHORT RUN

Short-run is a period of time in which only the variable factors can be varied while fixed
factors like plant, machinery etc remains constant. Hence, the plant capacity is fixed in the
short run. The total number of firms in an industry will remain the same. Time is insufficient
either for the entry of new firms or exit of the old firms. If a firm wants to produce greater
quantities of output, it can do so only by employing more units of variable factors or by having
additional shifts, or by having over time work for the existing labor force or by intensive
utilization of existing stock of capital assets etc. Hence, short run is defined as a period where
adjustments to changed conditions are only partial.

The short run cost function relates to the short run production function. It implies two sets of
input components – (a) fixed inputs and (b) variable inputs. Fixed inputs are unalterable. They
remain unchanged over a period of time. On the other hand, variable factors are changed to vary
the output in the short run. Thus, in the short period some inputs are fixed in amount and a firm
can expand or contract its output only by changing the amounts of other variable inputs. The
cost-output relationship in the short run refers to a particular set of conditions where the scale of
operation is limited by the fixed plant and equipment. Hence, the costs of the firm in the short
run are divided into fixed cost and variable costs. We shall study these two concepts of costs in
some detail

1. Fixed costs

These costs are incurred on fixed factors like land, buildings, equipments, plants, superior
type of labor, top management etc.
Fixed costs in the short run remain constant because the firm does not change the size of
plant and the amount of fixed factors employed. Fixed costs do not vary with either
expansion or contraction in output. These costs are to be incurred by a firm even output is
zero. Even if the firm close down its operation for some time temporarily in the short run, but
remains in business, these costs have to be borne by it. Hence, these costs are independent of
output and are referred to as unavoidable contractual cost.

Prof. Marshall called fixed costs as supplementary costs. They include such items as contractual
rent payment, interest on capital borrowed, insurance premiums, depreciation and maintenance
allowances, administrative expenses like manager’s salary or salary of the permanent staff,
property and business taxes, license fees, etc. They are called as over-head costs because these
costs are to be incurred whether there is production or not. These costs are to be distributed on
each unit of output produced by a firm. Hence, they are called as indirect costs.

2. Variable costs

The cost corresponding to variable factors are discussed as variable costs. These costs are
incurred on raw materials, ordinary labor, transport, power, fuel, water etc, which directly
vary in the short run. Variable costs directly and proportionately increase or decrease with the
level of output. If a firm shuts down for some time in the short run; then it will not use the
variable factors of production and will not therefore incur any variable costs. Variable costs are
incurred only when some amount of output is produced. Total variable costs increase with
increase in the level of production and vice-versa. Prof. Marshall called variable costs as prime
costs or direct costs because the volume of output produced by a firm depends directly upon
them.

It is clear from the above description that production costs consist of both fixed as well as
variable costs. The difference between the two is meaningful and relevant only in the short run.
In the long run all costs become variable because all factors of production become adjustable and
variable in the long run.

However, the distinction between fixed and variable costs is very significant in the short run
because it influences the average cost behavior of the firm. In the short run, even if a firm wants
to close down its operation but wants to remain in business, it will have to incur fixed costs but it
must cover at least its variable costs.

Cost-output relationship and nature and behavior of cost curves in the short run

In order to study the relationship between the level of output and corresponding cost of
production, we have to prepare the cost schedule of the firm. A cost-schedule is a statement of
a variation in costs resulting from variations in the levels of output. It shows the response
of cost to changes in output. A hypothetical cost schedule of a firm has been represented in the
following table.

Output in Units TFC TVC TC AFC AVC AC MC

0 360 – 360 – – – –
1 360 180 540 360 180 540 180
2 360 240 600 180 120 300 60
3 360 270 630 120 90 210 30
4 360 315 675 90 78.75 168.75 45
5 360 420 780 72 84 156 105
6 360 630 990 60 105 165 210
On the basis of the above cost schedule, we can analyse the relationship between changes in the
level of output and cost of production. If we represent the relationship between the two in a
geometrical manner, we get different types of cost curves in the short run. In the short run,
generally we study the following kinds of cost concepts and cost curves.

1. Total fixed cost (TFC)

TFC refers to total money expenses incurred on fixed inputs like plant, machinery, tools &
equipments in the short run. Total fixed cost corresponds to the fixed inputs in the short run
production function. TFC remains the same at all levels of output in the short run. It is the same
when output is nil. It indicates that whatever may be the quantity of output, whether 1 to 6 units,
TFC remain constant. The TFC curve is horizontal and parallel to OX-axis, showing that it is
constant regardless of out put per unit of time. TFC starts from a point on Y-axis indicating that
the total fixed cost will be incurred even if the output is zero. In our example, Rs 300-00 is TFC.
It is obtained by summing up the product or quantities of the fixed factors multiplied by their
respective unit price.

2. Total variable cost (TVC)

TVC refers to total money expenses incurred on the variable factors inputs like raw
materials, power, fuel, water, transport and communication etc, in the short run. Total
variable cost corresponds to variable inputs in the short run production function. It is obtained by
summing up the production of quantities of variable inputs multiplied by their prices. The
formula to calculate TVC is as follows. TVC = TC-TFC. TVC = f (Q) i.e. TVC is an increasing
function of out put. In other words TVC varies with output. It is nil, if there is no production.
Thus, it is a direct cost of output. TVC rises sharply in the beginning, gradually in the middle and
sharply at the end in accordance with the law of variable proportion. The law of variable
proportion explains that in the beginning to obtain a given quantity of output, relative variation in
factors needed are in less proportion, but after a point when the diminishing returns operate,
variable factors are to be employed in a larger proportion to increase the same level of output.

TVC curve slope upwards from left to right. TVC curve rises as output is expanded. When out
put is Zero, TVC also will be zero. Hence, the TVC curve starts from the origin.
3. Total cost (TC)

The total cost refers to the aggregate money expenditure incurred by a firm to produce a
given quantity of output. The total cost is measured in relation to the production function by
multiplying the factor prices with their quantities. TC = f (Q) which means that the T.C. varies
with the output. Theoretically speaking TC includes all kinds of money costs, both explicit and
implicit cost. Normal profit is included in the total cost as it is an implicit cost. It includes fixed
as well as variable costs. Hence, TC = TFC +TVC.

TC varies in the same proportion as TVC. In other words, a variation in TC is the result of
variation in TVC since TFC is always constant in the short run.

The total cost curve is rising upwards from left to right. In our example the TC curve starts form
Rs. 300-00 because even if there is no output, TFC is a positive amount. TC and TVC have same
shape because an increase in output increases them both by the same amount since TFC is
constant. TC curve is derived by adding up vertically the TVC and TFC curves. The vertical
distance between TVC curve and TC curve is equal to TFC and is constant throughout because
TFC is constant.

4. Average fixed cost (AFC)

Average fixed cost is the fixed cost per unit of output. When TFC is divided by total units
of out put AFC is obtained, Thus, AFC = TFC/Q

AFC and output have inverse relationship. It is higher at smaller level and lower at the higher
levels of output in a given plant. The reason is simple to understand. Since AFC = TFC/Q, it is a
pure mathematical result that the numerator remaining unchanged, the increasing denominator
causes diminishing product. Hence, TFC spreads over each unit of out put with the increase in
output. Consequently, AFC diminishes continuously. This relationship between output and fixed
cost is universal for all types of business concerns.

The AFC curve has a negative slope. The curve slopes downwards throughout the length. The
AFC curve goes very nearer to X axis, but never touches axis. Graphically it will fall steeply in
the beginning, gently in middle and tend to become parallel to OX-axis. Mathematically
speaking as output increases, AFC diminishes. But AFC will never become zero because the
TFC is a positive amount. AFC will never fall below a minimum amount because in the short
run, plant capacity is fixed and output cannot be enlarged to an unlimited extent.

5. Average variable cost: (AVC)

The average variable cost is variable cost per unit of output. AVC can be computed by
dividing the TVC by total units of output. Thus AVC = TVC/Q. The AVC will come down in
the beginning and then rise as more units of output are produced with a given plant. This is
because as we add more units of variable factors in a fixed plant, the efficiency of the inputs first
increases and then it decreases.

The AVC curve is a U-shaped cost curve. It has three phases. Page 198 ( B.A)
a. Decreasing phase

In the first phase from A to B, AVC declines, As output expands, AVC declines because when
we add more quantity of variable factors to a given quantity of fixed factors, output increases
more efficiently and more than proportionately due to the operation of increasing returns.

b. Constant phase

In the II phase, i.e. at B, AVC reaches its minimum point. When the proportion of both fixed and
variable factors are the most ideal, the output will be the optimum. Once the firm operates at its
normal full capacity, output reaches its zenith and as such AVC will become the minimum.

c. Increasing phase

In the III phase, from B to C, AVC rises when once the normal capacity is crossed, the AVC
rises sharply. This is because additional units of variables factors will not result in more than
proportionate output. Hence, greater output may be obtained but at much greater AVC. The old
proverb “Too many cooks spoil the broth” aptly applies to this III stage. It is clear that as long as
increasing returns operate, AVC falls and when diminishing returns set in, AVC tends to
increase.

6. Average total cost (ATC) or Average cost (AC)

Ac refers to cost per unit of output. AC is also known as the unit cost since it is the cost per
unit of output produced. AC is the sum of AFC and AVC. Average total cost or average cost is
obtained by dividing the total cost by total output produced. AC = TC/Q Also AC is the sum of
AFC and AVC.

In the short run AC curve also tends to be U-shaped. The combined influence of AFC and AVC
curves will shape the nature of AC curve.
 As we observe, average fixed cost begin to fall with an increase in output while average variable
costs come down and rise. As long as the falling effect of AFC is much more than the rising
effect of AVC, the AC tends to fall. At this stage, increasing returns and economies of scale
operate and complete utilization of resources force the AC to fall.

When the firm produces the optimum output, AC becomes minimum. This is called as least –
cost output level. Again, at the point where the rise in AVC exactly counter balances the fall in
AFC, the balancing effect causes AC to remain constant.

In the third stage when the rise in average variable cost is more than drop in AFC, then the AC
shows a rise, When output is expanded beyond the optimum level of output, diminishing returns
set in and diseconomies of scale starts operating. At this stage, the indivisible factors are used in
wrong proportions. Thus, AC starts rising in the third stage.

The short run AC curve is also called as “Plant curve”. It indicates the optimum utilization of a
given plant or optimum plant capacity.

7. Marginal Cost (MC)

Marginal cost may be defined as the net addition to the total cost as one more unit of
output is produced. In other words, it implies additional cost incurred to produce an
additional unit. For example, if it costs Rs. 100 to produce 50 units of a commodity and Rs. 105
to produce 51 units, then MC would be Rs. 5. It is obtained by calculating the change in total
costs as a result of a change in the total output. Also MC is the rate at which total cost changes
with output. Hence,

It is necessary to note that MC is independent of TFC and it is directly related to TVC as we

calculate the cost of producing only one unit. In the short run, the MC curve also tends to be U-
shaped.

The shape of the MC curve is determined by the laws of returns. If MC is falling, production will
be under the conditions of increasing returns and if MC is rising, production will be subject of
diminishing returns.

The table indicates the relationship between AC & MC

Difference in Rs.
Output in Units TC in Rs. AC in Rs.
MC
1 150 150 –
2 190 95 40
3 220 73.3 30
4 236 59 16
5 270 54 34
6 324 54 54
7 415 59.3 91
8 580 72.2 165

Relation between AC and MC

From the diagram it is clear that:

1. Both MC and AC fall at a certain range of output and rise afterwards.

2. When AC falls, MC also falls but at certain range of output MC tends to rise even though
AC continues to fall. However, MC would be less than AC. This is because MC is
attributed to a single unit where as in case of AC, the decreasing AC is distributed over
all the units of output produced.
3. So long as AC is falling, MC is less than AC. Hence, MC curve lies below AC curve. It
indicates that fall in MC is more than the fall in AC. MC reaches its minimum point
before AC reaches its minimum.
4. When AC is rising, after the point of intersection, MC will be greater than AC. This is
because in case of MC, the increasing MC is attributed to a single unit, where as in case
of AC, the increasing AC is distributed over all the output produced.
5. So long as the AC is rising, MC is greater and AC. Hence, AC curve lies to the left side
of the MC curve. It indicates that rise in MC is more than the rise in AC.
6. MC curve cuts the AC curve at the minimum point of the AC curve. This is because,
when MC decreases, it pulls AC down and when MC increases, it pushes AC up. When
AC is at its minimum, it is neither being pulled down or being pushed up by the MC.
Thus, When AC is minimum, MC = AC. The point of intersection indicates the least cost
combination point or the optimum position of the firm. At output Q the firm is working at
its “Optimum Capacity” with lowest AC. Beyond Q, there is scope for “Maximum
Capacity” with rising cost.

Cost Output Relationship In The Long Run

Long run is defined as a period of time where adjustments to changed conditions are
complete.

It is actually a period during which the quantities of all factors, variable as well as fixed factors
can be adjusted. Hence, there are no fixed costs in the long run. In the short run, a firm has to
carry on its production within the existing plant capacity, but in the long run it is not tied up to a
particular plant capacity. If demand for the product increases, it can expand output by enlarging
its plant capacity. It can construct new buildings or hire them, install new machines, employ
administrative and other permanent staff. It can make use of the existing as well as new staff in
the most efficient way and there is lot of scope for making indivisible factors to become divisible
factors. On the other hand, if demand for the product declines, a firm can cut down its production
permanently. The size of the plant can also be reduced and other expenditure can be minimized.
Hence, production cost comes down to a greater extent in the long run.

As all costs are variable in the long run, the total of these costs is total cost of production. Hence,
the distinction between fixed and variables costs in the total cost of production will
disappear in the long run. In the long run only the average total cost is important and
considered in taking long term output decisions.

Long run average cost is the long run total cost divided by the level of output. In brief, it is the
per unit cost of production of different levels of output by changing the size of the plant or scale
of production.

The long run cost – output relationship is explained by drawing a long run cost curve through
short – run curves as the long period is made up of many short – periods as the day is made up of
24 hours and a week is made out of 7 days. This curve explains how costs will change when the
scale of production is varied.

The long run -cost curves are influenced by the laws of return to scale as against the short run
cost curves which are subject to the working of law of variable proportions.

In the short run the firm is tied with a given plant and as such the scale of operation remains
constant. There will be only one AC curve to represent one fixed scale of output in the short run.
In the long run as it is possible to alter the scale of production, one can have as many AC curves
as there are changes in the scale of operations.
In order to derive LAC curve, one has to draw a number of SAC curves, each curve representing
a particular scale of output. The LAC curve will be tangential to the entire family of SAC cures.
It means that it will touch each SAC curve at its minimum point.

Production cost difference in the short run and long run

In the diagram, the LAC curve is drawn on the basis of three possible plant sizes.
Consequently, we have three different SAC curves – SAC1, SAC2 and SAC3. They represent
three different scales of output. For output OM3 the AC will be L2M2 in the short run as well as
the long run.

When output is to be expanded to OM3, it can be obtained at a higher average cost of

production. K3, M3 is the short run AC because, scale of production would remain constant in
the short run. But the same output of OM3 can be produced at a lower AC of L3M3 in the long
run since the scale of production can be modified according to the requirements. The distance
between K3L3 represent difference between the cost of production in the short run and long run.

Similarly, when output is contracted to OM1 in the short run, K1M1 will become the short run
AC and L1M1 will be the long run AC. Hence, K1L1 indicates the differences between short run
and long run cost of production. If we join points L1, L2 and L3 we get LAC curve.

Important features of long run AC curves

1. Tangent curve

Different SAC curves represent different operational capacities of different plants in the short
run. LAC curve is locus of all these points of tangency. The SAC curve can never cut a LAC
curve though they are tangential to each other. This implies that for any given level of output, no
SAC curve can ever be below the LAC curve. Hence, SAC cannot be lower than the LAC in the
ling run. Thus, LAC curve is tangential to various SAC curves.

2. Envelope curve

It is known as Envelope curve because it envelopes a group of SAC curves appropriate to

different levels of output.

3. Flatter U-shaped or dish-shaped curve.

The LAC curve is also U shaped or dish shaped cost curve. But It is less pronounced and much
flatter in nature. LAC gradually falls and rises due to economies and diseconomies of scale.

4. Planning curve.

The LAC cure is described as the Planning Curve of the firm because it represents the least cost
of producing each possible level of output. This helps in producing optimum level of output at
the minimum LAC. This is possible when the entrepreneur is selecting the optimum scale plant.
Optimum scale plant is that size where the minimum point of SAC is tangent to the minimum
point of LAC.

5. Minimum point of LAC curve should be always lower than the minimum point of SAC
curve.

This is because LAC can never be higher than SAC or SAC can never be lower than LAC. The
LAC curve will touch the optimum plant SAC curve at its minimum point.

A rational entrepreneur would select the optimum scale plant. Optimum scale plant is that size at
which SAC is tangent to LAC, such that both the curves have the minimum point of tangency. In
the diagram, OM2 is regarded as the optimum scale of output, as it has the least per unit cost. At
OM2 output LAC = SAC.

LAC curve will be tangent to SAC curves lying to the left of the optimum scale or right side of
the optimum scale. But at these points of tangency, neither LAC is minimum nor will SAC be
minimum. SAC curves are either rising or falling indicating a higher cost

Managerial Use of LAC

The study of LAC is of greater importance in managerial decision making process.

1. It helps the management in the determination of the best size of the plant to be
constructed.
2. The LAC curve helps a firm to decide the size of the plant to be adopted for producing
the given output. For outputs less than cost lowering combination at the optimum scale
i.e., when the firm is working subject to increasing returns to scale, it is more economical
to under use a slightly large plant operating at less than its minimum cost – output than to
 over use smaller unit. Conversely, at output beyond the optimum level, that is when the
firm experience decreasing return to scale, it is more economical to over use a slightly
smaller plant than to under use a slightly larger one. Thus, it explains why it is more
economical to over use a slightly small plant rather than to under use a large plant.
3. LAC is used to show how a firm determines the optimum size of the plant. An optimum
size of plant is one that helps in best utilization of resources in the most economical
manner.

COST OF PRODUCTION: FORMULAS