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SubjectFree lesson

Cost concepts

ClassNotes Team 4 MIN READUPDATED 4 JUL 2026

Economics SSS 2 First Term

WEEK 6

Cost concepts

Performance Objectives

Student should be able to:

  1. Understand basic cost concepts (Total, Average, Fixed, Variable and Marginal costs).
  2. Explain the short-run and long-run costs
  3. Distinguish between economists and accountants view of costs.

Content

Definition of cost of production

Cost of production refers to the total price paid for resources used to manufacture a product or create a service to sell to consumers including raw materials, labour and overhead. Cost of production can also be related to all the rewards due to factors of production, which include rent for land, wage and salary for labour, interest for capital and profits to the entrepreneur.

Basic cost concepts

  1. Fixed cost (FC): Fixed cost also called overhead cost or unavoidable cost may be defined as a cost that does not vary with the level of output. It simply means the cost of an entrepreneur which does not change with change of output. Examples of fixed cost are the cost of buildings, land and plant and machinery. Fixed cost can be calculated by this formula: FC= TC-VC
  2. Variable cost (VC): Variable cost, also called direct cost, may be defined as the cost of production which varies directly with the level of output. Variable cost may increase as more of output is produced or decrease as less output is produced. Examples of variable cost are; costs of raw materials, labour, fuel etc. variable cost can be calculated by this formula: VC= TC-FC
  3. Total cost (TC): This may be defined as the total sum of fixed and variable cost incurred by an enterprise in the production of a particular commodity. Total cost can be calculated with this formula: TC= FC+VC or TC= ATC×Q
  4. Average cost or Average Total cost (ATC): Average cost refers to the cost per unit of output or the total cost of production of a commodity incurred by an enterprise divided by the number of units of output. Average cost is calculated by this formula: AC= Total cost(TC) ÷ Total output(TQ) or ATC= AFC+AVC
  5. Average variable cost (AVC): This may be defined as the cost per unit of the variable cost of output. As the production increases, average variable cost may rise or fall. It is calculated by this formula: AVC=TVC÷TQ or ATC-AFC
  6. Average fixed cost (AFC): This may be defined as the fixed cost of producing a unit of output. Average fixed cost is obtained by dividing fixed cost (FC) by the number of units of output as reflected in this formula: AFC= TFC÷ Unit of output(Q) or ATC- AVC
  7. Marginal cost (MC): This may be defined as the extra cost of increasing output by one more unit. Alternatively, marginal cost is the cost difference in producing an additional unit of a commodity. It can be calculated using this formula: MC= Changes in TC ÷ Changes in output

Short-run and Long-run costs

Short-run cost: The short-run cost may be defined as that period in which some of the firm’s productive factors like building, capital, equipment and costs are fixed and some are variable. To be in production during the period of the short run, the firm must be able to cover its variable costs.

Long-run cost: The long-run cost is periods in which all factor input in a production process are variable. While the short-run decisions deal with the operation of existing production capacity, the long run is a planning period towards which an entrepreneur makes his plans and chooses the plant size that is best for his operations.

It is recommended that when a firm’s average cost is greater than its price, the firm should stay open in the short run if price is greater than AVC. Such firm should shut down in the long run. This is because any further production will add to losses in the long run.

Distinction between an economist’s an accountant’s views on cost

The economist’s view of cost is quite different from the way an accountant views it.

The economist views cost in terms of opportunity cost, that is, the forgone alternative, namely how an individual can sacrifice one thing to obtain another. The money spent on a commodity is not what bothers the economist but the alternative commodity that is left un-bought to purchase that commodity.

On the other hand, the accountant views cost in terms of the amount of money spent to have a commodity. Alternatively, the accountant view cost in terms of actual payment made, which is referred to in Economics as money cost.

In summary, an economist views cost in terms of opportunity cost, while an accountant views cost in terms of actual money spent.