The firm's average costs are equal. The concept of average cost
The purpose of creating a business - opening a company, building a plant with the subsequent release of planned products - is to make a profit. But increasing personal income requires considerable costs, not only moral, but also financial. All monetary expenses aimed at producing any good are called costs in economics. To work without losses, you need to know the optimal volume of goods/services and the amount of money spent to produce them. To do this, average and marginal costs are calculated.
Average costs
With an increase in the volume of production, the costs that depend on it grow: raw materials, wages of key workers, electricity and others. They are called variables and have different dependencies for different quantities of goods/services produced. At the beginning of production, when the volumes of goods produced are small, variable costs are significant. As production increases, costs decrease due to economies of scale. However, there are expenses that an entrepreneur bears even with zero production of goods. Such costs are called fixed: utilities, rent, salaries of administrative staff.
Total costs are the sum of all costs for a specific volume of goods produced. But to understand the economic costs invested in the process of creating a unit of goods, it is customary to turn to average costs. That is, the quotient of total costs to output volume is equal to the value of average costs.
Marginal cost
Knowing the value of the funds spent on the sale of one unit of good, it cannot be argued that an increase in output by another 1 unit will be accompanied by an increase in total costs, in an amount equal to the value of average costs. For example, to produce 6 cupcakes, you need to invest 1200 rubles. It’s easy to immediately calculate that the cost of one cupcake should be at least 200 rubles. This value is equal to average costs. But this does not mean that preparing another pastry will cost 200 rubles more. Therefore, to determine the optimal volume of production, it is necessary to know how much money will be required to invest in order to increase output by one unit of the good.
Economists come to the aid of the firm’s marginal costs, which help them see the increase in total costs associated with the creation of an additional unit of goods/services.
Calculation
MC - this designation in economics has marginal costs. They are equal to the quotient of the increase in total expenses to the increase in volume. Since the increase in total costs in the short term is caused by an increase in average variable costs, the formula can look like: MC = ΔTC/Δvolume = Δaverage variable costs/Δvolume.
If the values of gross costs corresponding to each unit of production are known, then marginal costs are calculated as the difference between adjacent two values of total costs.
Relationship between marginal and average costs
Economic decisions on conducting business activities must be made after marginal analysis, which is based on marginal comparisons. That is, the comparison of alternative solutions and determination of their effectiveness occurs by assessing the incremental costs.
Average and marginal costs are interrelated, and changes in one relative to the other are the reason for adjusting the volume of output. For example, if marginal costs are less than average costs, then it makes sense to increase output. It is worth stopping the increase in production volume in the case when marginal costs are higher than average.
The equilibrium situation will be in which marginal costs are equal to the minimum value of average costs. That is, there is no point in further increasing production, since additional costs will increase.
Schedule
The presented graph shows the company's costs, where ATC, AFC, AVC are the average total, fixed and variable costs, respectively. The marginal cost curve is denoted MC. It has a convex shape towards the x-axis and at minimum points intersects the curves of average variables and total costs.
Based on the behavior of average fixed costs (AFC) on the graph, we can conclude that increasing the scale of production leads to their reduction; as mentioned earlier, there is an effect of economies of scale. The difference between ATC and AVC reflects the amount of fixed costs; it is constantly decreasing due to the approach of AFC to the x-axis.
Point P, characterizing a certain volume of product output, corresponds to the equilibrium state of the enterprise on the market. If you continue to increase volume, then costs will need to be covered by profits as they begin to increase sharply. Therefore, the company should settle on the volume at point P.
Marginal Revenue
One of the approaches to calculating production efficiency is to compare marginal costs with marginal revenue, which is equal to the increase in funds from each additional unit of goods sold. However, the expansion of production is not always associated with an increase in profits, because the dynamics of costs are not proportional to volume and with an increase in supply, demand and, accordingly, the price decrease.
A firm's marginal cost is equal to the price of the good minus marginal revenue (MR). If marginal cost is lower than marginal revenue, then production can be expanded, otherwise it must be curtailed. By comparing the values of marginal costs and income, for each value of output, it is possible to determine the points of minimum costs and maximum profit.
Profit maximization
How to determine the optimal production size to maximize profits? This can be done by comparing marginal revenue (MR) and marginal cost (MC).
Each new product produced adds marginal revenue to total income, but at the same time increases total costs by marginal cost. Any unit of output whose marginal revenue exceeds its marginal cost should be produced because the firm will receive more revenue from selling that unit than it will add to costs. Production is profitable as long as MR > MC, but as output increases, rising marginal costs due to the law of diminishing returns will make production unprofitable because they will begin to exceed marginal revenue.
Thus, if MR > MC, then production needs to be expanded if MR< МС, то его надо сокращать, а при MR = МС достигается равновесие фирмы (максимум прибыли).
Features when using the rule of equality of limit values:
- The condition MC = MR can be used to maximize profit in the case when the cost of the good is higher than the minimum value of average variable costs. If the price is lower, the company does not achieve its goal.
- Under conditions of pure competition, when neither buyers nor sellers can influence the formation of the cost of a good, marginal revenue is equivalent to the price of a unit of goods. This implies the equality: P = MC, in which marginal costs and marginal price are the same.
Graphical representation of a firm's equilibrium
Under pure competition, where price equals marginal revenue, the graph looks like this.
Marginal costs, the curve of which intersects the line parallel to the x-axis, characterizing the price of the good and marginal income, form a point showing the optimal sales volume.
In practice, there are times when doing business when an entrepreneur should think not about maximizing profits, but minimizing losses. This happens when the price of a good decreases. Stopping production is not the best option since fixed costs must be paid. If the price is less than the minimum value of gross average costs, but exceeds the value of the average variables, then the decision must be based on the output of goods in the volume obtained at the intersection of the marginal values (income and costs).
If the price of a product in a purely competitive market has fallen below the firm's variable costs, then management must take the responsible step of temporarily stopping the sale of goods until the cost of an identical good rises in the next period. This will trigger an increase in demand due to a decrease in supply. An example is agricultural firms that sell products in the autumn-winter period, and not immediately after harvest.
Costs in the long run
The time interval during which changes in the production capacity of an enterprise can occur is called the long-term period. The firm's strategy must include cost analysis for the future. In the long time frame, long-term average and marginal costs are also considered.
With the expansion of production capacity, there is a decrease in average costs and an increase in volumes up to a certain point, then costs per unit of output begin to increase. This phenomenon is called economies of scale.
The long-run marginal cost of an enterprise shows the change in all costs due to an increase in output. The average and marginal cost curves relate to each other over time in a similar way to the short-term period. The main strategy in the long run is the same - it is determining production volumes by means of the equality MC = MR.
The goal of most business entities is to make a profit from the sale of goods and provision of services. However, in order to sell a product, you must first purchase it from another company or produce it yourself. In both cases, the matter does not come without costs.
Costs are the cost of resources consumed in the production process (in particular, materials, raw materials, worker labor, etc.). In other words, these are all economic resources that were used to produce certain goods, expressed in a single monetary equivalent.
Costs that form the cost of the final product, services provided or work performed in a certain period and can be reliably estimated constitute production costs.
Classification of costs
The growing unprofitability of business entities in various industries indicates the need to improve the efficiency of cost management. To manage them rationally, enterprise costs are classified according to various criteria.
Each manufacturer, due to limited resources in the course of its activities, is faced with the need to compare several alternatives and settle on one of them. This choice is permanent. Costs play a key role in solving this problem. They allow you to estimate the cost of production of a particular product. The part of costs that depends on a particular option is taken into account. These costs are called relevant. They are the ones that management takes into account to make the best decision. In contrast, irrelevant costs do not depend on the chosen alternative and will be incurred by the enterprise in any case.
In management accounting, sunk costs are also identified. Their value cannot be affected by any of the decisions made.
For the purpose of effective management, incremental and marginal costs are calculated. The company bears the first costs when releasing an unplanned batch of products. The costs that a company incurs in producing one additional unit of product are called marginal.
The enterprise's costs are planned taking into account the expected production volumes, norms and limits. They relate to the planned cost of production. However, there are also unplanned costs that arise in reality. An example would be marriage.
Depending on whether the amount of costs incurred varies with output volumes, they are classified into fixed and variable production costs.
Fixed costs
The peculiarity of the former is that they do not change over a short period of time. If an enterprise decides to increase or, on the contrary, reduce production, such costs remain at the same level. Fixed costs are rent for production premises, warehouses, retail outlets; salaries of administrative employees; costs of maintaining buildings, in particular utilities. However, it must be taken into account that only the amount of total costs for the entire output is constant. Costs calculated per unit of production will decrease in direct proportion to the increase in production volumes. This is a pattern.
Variable production costs
As soon as a business entity begins to produce products, variable costs arise. Their main share is formed by used working capital. While fixed costs remain relatively stable for the enterprise, variable costs directly depend on output volumes. The larger the production volumes, the higher the costs.
Composition of variable costs
Variable production costs include the cost of materials and raw materials. During their planning, standards for material consumption relative to a unit of finished product are used for calculation.
The next variable cost item is labor costs. These include the salaries of the main personnel involved in production, support employees, foremen, technologists, as well as service personnel (loaders, cleaners). In addition to the basic salary, bonuses, compensation and incentive amounts, as well as wages for workers who are not on the main staff are taken into account here.
In addition to materials and raw materials, most business entities incur costs for the purchase of auxiliary materials, semi-finished products, spare parts, components and fuel, without which in most cases the production process is impossible.
Classification of variable costs
As noted earlier, the amount of variable costs depends on the volume of products produced. However, these indicators do not always change in equal proportions. Based on the nature of the dependence of costs on the quantity of products produced, they are classified into progressive, digressive and proportional.
According to the method of including variable costs in the cost of production, they are divided into direct and indirect. If the former are immediately transferred to the cost of the released good, then the latter are distributed among various types of products. For this purpose, a distribution base is selected. This could be the cost of raw materials or the salaries of key workers. Indirect production costs are represented by administrative and management costs, costs for staff development, social services and production infrastructure.
For effective management, total and average variable production costs are calculated. To determine the last indicator, the total cost is divided by the number of products produced.
Gross production costs of the enterprise
In order to assess the profitability of production of a particular product, an enterprise needs to calculate gross (total) costs. In the short term, they are formed by a combination of variable and fixed costs. If, for some reason, the enterprise does not produce products, then the gross costs are equal to constant ones. As production volumes increase during business activities, total costs increase by the amount of variables depending on the number of products manufactured.
Of great importance in economic practice is the classification of costs depending on their relationship with the volume of production.
In the short run, some resources remain unchanged, while others change to increase or decrease total output.
In accordance with this, all production costs are divided into permanent And variables. In this case, it is necessary to distinguish between costs for the entire volume output - full (total, total) production costs and production costs units products – average (unit) costs.
Enterprise costs for the entire output volume
Permanent(F.C.) are costs that do not depend on the volume of output ( Q) and arise even when production has not yet begun. Thus, even before production begins, the enterprise should have at its disposal such factors as buildings, machines, and equipment. In the short term, fixed costs are depreciation, rent, security costs, and property taxes.
Variables(V.C.) – production costs, which vary depending on the volume of output. These include: main and auxiliary materials, workers’ wages, transportation costs, electricity costs for production purposes, etc.
Aggregate(TC) costs are the sum of fixed and variable costs:
TC = FC + VC.
The relationship between production volume and the level of production costs is described using the corresponding curves (Fig. 1).
Since fixed costs do not depend on production volume, the fixed cost curve ( F.C.) is represented by a horizontal line.
Variables ( V.C.) and cumulative ( TC) production costs increase along with an increase in output, but the growth rate of these costs is not the same. Starting from zero, as production increases, they initially grow very quickly, then as production increases, their growth rate slows down, they grow more slowly as production increases. Subsequently, however, when the law of diminishing returns comes into play, variable and total costs begin to outpace production growth.
Average (unit) production costs
Average constants costs ( A.F.C.) – fixed costs per unit of production:
AFC = FC: Q.
As production volume increases, fixed costs are distributed over more products, so that average fixed costs decrease as production volume increases.
Average variables costs ( AVC) – variable costs per unit of production:
AVC = VC: Q.
Rice. 1. Cumulative, variable and constant curves
production costs
As production volume increases, average variable costs first fall, reach their minimum, and then, under the influence of the law of diminishing returns, begin to rise.
Average cumulative costs ( ATC) – total costs per unit of production:
ATC = TC: Q.
Dynamics of averages total costs reflects the dynamics of average fixed and variable costs. While both are decreasing, the average total costs are falling, but when, as production volume increases, the growth of variable costs begins to outpace the fall in fixed costs, the average total costs begin to rise.
Widely used in economic analysis marginal cost(MS) – increase in costs as a result of producing one additional unit of product:
MS =Δ TC: Δ Q, or MS =Δ TCn –Δ TCn–1.
Marginal cost shows how much it would cost the firm to increase output per unit. Marginal costs have a decisive influence on the firm's choice of production volume, because it is precisely the indicator that the firm can influence.
As in the case of total costs, the dependence of average and marginal production costs on production volume is described by the curves of the corresponding indicators. The family of average and marginal production costs is presented in Fig.
Analysis of average and marginal cost curves shows, What:
− when marginal costs are less than average variable and average total ( MS< ABC And ATS), the production of each additional unit of output reduces average variable and average total costs;
− when marginal costs are greater than average variable and average total ( MS> ABC And ATS), the production of each new unit of output increases average variable and average total costs;
− when marginal costs are equal to average variable and average total, average variable and average total costs minimal.
Rice. 2. Limit (MC) and average (constant – AFC) curves
variable - AVC, total - ATC) costs
Production costs in the short term are divided into constant and variable.
Fixed costs (TFC) are costs of production that are independent of the firm's output and must be paid even if the firm produces nothing. Associated with the very existence of the company and depend on the amount of constant resources and the corresponding prices of these resources. These include: salaries of senior executives, interest on loans, depreciation, rental space, cost of equity capital and insurance payments.
Variable costs (TVC) are those costs, the value of which varies depending on the volume of output; this is the sum of the company's expenses on variable resources used in the production process: wages of production personnel, materials, payments for electricity and fuel, transportation costs. Variable costs increase as production volume increases.
Total (total) costs (TC) – represent the sum of fixed and variable costs: TC=TFC+TVC. At zero output, variable costs are equal to zero, and total costs are equal to fixed costs. After the start of production, variable costs begin to increase in the short term, causing an increase in total costs.
The nature of the total (TC) and total variable cost (TVC) curves is explained by the principles of increasing and diminishing returns. As returns increase, the TVC and TC curves grow to a decreasing degree, and as returns begin to fall, costs increase to an increasing degree. Therefore, to compare and determine production efficiency, average production costs are calculated.
Knowing the average production costs, it is possible to determine the profitability of producing a given quantity of products.
Average production costs are the costs per unit of output produced. Average costs, in turn, are divided into average fixed, average variable and average total.
Average Fixed Cost (AFC) – represents the fixed cost per unit of output. AFC=TFC/Q, where Q is the quantity of products produced. Since fixed costs do not vary with output, average fixed costs fall as the quantity sold increases. Therefore, the AFC curve continuously decreases as production increases, but does not cross the output axis.
Average variable costs (AVC) – represent variable costs per unit of production: AVC=TVC/Q. Average variable costs are subject to the principles of increasing and decreasing returns to factors of production. The AVC curve has an arcuate shape. Under the influence of the principle of increasing returns, average variable costs initially fall, but, having reached a certain point, begin to increase under the influence of the principle of diminishing returns.
There is an inverse relationship between variable production costs and the average product of a variable factor of production. If the variable resource is labor (L), then average variable costs are wages per unit of output: AVC=w*L/Q (where w is the wage rate). Average product of labor APL = output volume per unit of factor used Q/L: APL=Q/L. Result: AVC=w*(1/APL).
Average total cost (ATC) is the cost per unit of output produced. They can be calculated in two ways: by dividing total costs by the number of products produced, or by adding average fixed and average variable costs. The AC (ATC) curve has an arcuate shape like average variable costs, but exceeds it by the amount of average fixed costs. As output increases, the distance between AC and AVC decreases due to a faster decline in AFC, but never reaches the AVC curve. The AC curve continues to fall after a release in which AVC is minimal because AFC's continued decline more than offsets weak AVC growth. However, with further production growth, the increase in AVC begins to exceed the decrease in AFC, and the AC curve turns upward. The minimum point of the AC curve determines the most efficient and productive level of production in the short term.
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Economic and accounting costs.
In economics costs most often referred to as losses that a manufacturer (entrepreneur, firm) is forced to bear in connection with the implementation of economic activities. This could be: the cost of money and time for organizing production and acquiring resources, loss of income or product from missed opportunities; costs of collecting information, concluding contracts, promoting goods to the market, preserving goods, etc. When choosing among different resources and technologies, a rational manufacturer strives for minimal costs, so he chooses the most productive and cheapest resources.
The production costs of any product can be represented as a set of physical or cost units of resources expended in its production. If we express the value of all these resources in monetary units, we obtain the cost expression of the costs of producing a given product. This approach will not be wrong, but it seems to leave unanswered the question of how the value of these resources will be determined for the subject, which will determine this or that line of his behavior. The economist's task is to choose the best option for using resources.
Costs in the economy are directly related to the denial of the possibility of producing alternative goods and services. This means that the cost of any resource is equal to its cost, or value, given the best possible use of it.
It is necessary to distinguish between external and internal costs.
External or explicit costs– these are cash expenses for paying for resources owned by other companies (payment for raw materials, fuel, wages, etc.). These costs, as a rule, are taken into account by an accountant, reflected in the financial statements and are therefore called accounting.
At the same time, the company can use its own resources. In this case, costs are also inevitable.
Internal costs – These are the costs of using the firm's own resources that do not take the form of cash payments.
These costs are equal to the cash payments that the firm could receive for its own resources if it chose the best option for using them.
Economists consider all external and internal payments as costs, including the latter and normal profit.
Normal, or zero, profit - this is the minimum fee necessary to maintain the entrepreneur's interest in the chosen activity. This is the minimum payment for the risk of working in a given area of the economy, and in each industry it is assessed differently. It is called normal for its similarity to other incomes, reflecting the contribution of a resource to production. Zero - because in essence it is not a profit, representing a part of the total production costs.
Example. You are the owner of a small store. You purchased goods worth 100 million rubles. If accounting costs for the month amounted to 500 thousand rubles, then to them you must add lost rent (let’s say 200 thousand rubles), lost interest (let’s say you could put 100 million rubles in the bank at 10% per annum, and receive approximately 900 thousand rubles) and a minimum risk fee (let’s say it is equal to 600 thousand rubles). Then the economic costs will be
500 + 200 + 900 + 600 = 2200 thousand rubles.
Production costs in the short term, their dynamics.
The production costs that a firm incurs in producing products depend on the possibility of changing the amount of all employed resources. Some types of costs can be changed quite quickly (labor, fuel, etc.), others require some time for this.
Based on this, short-term and long-term periods are distinguished.
Short term – This is the period of time during which a firm can change production volume only due to variable costs, while production capacity remains unchanged. For example, hire additional workers, purchase more raw materials, use equipment more intensively, etc. It follows that in the short run costs can be either constant or variable.
Fixed costs (F.C.) - These are costs whose value does not depend on the volume of production.
Fixed costs are associated with the very existence of the firm and must be paid even if the firm does not produce anything. These include: rental payments, deductions for depreciation of buildings and equipment, insurance premiums, interest on loans, and labor costs for management personnel.
Variable costs (V.C.) - These are costs, the value of which changes depending on changes in production volume.
With zero output they are absent. These include: costs of raw materials, fuel, energy, most labor resources, transport services, etc. The firm can control these costs by changing production volume.
Total production costs (TC) – This is the sum of fixed and variable costs for the entire volume of output.
TC = total fixed costs (TFC) + total variable costs (TVC).
There are also average and marginal costs.
Average costs – This is the cost per unit of production. Average short-term costs are divided into average fixed, average variable and average total.
Average fixed costs (A.F.C.) are calculated by dividing total fixed costs by the number of products produced.
Average variable costs (AVC) are calculated by dividing total variable costs by the number of products produced.
Average Total Cost (ATC) are calculated using the formula
ATS = TS / Q or ATS = AFC + AVC
To understand the behavior of a firm, the category of marginal costs is very important.
Marginal cost (MC)– These are additional costs associated with producing one more unit of output. They can be calculated using the formula:
MS =∆ TC / ∆ Qwhere ∆Q= 1
In other words, marginal cost is the partial derivative of the total cost function.
Marginal costs make it possible for a firm to determine whether it is advisable to increase production of goods. To do this, compare marginal costs with marginal revenue. If marginal costs are less than the marginal revenue received from sales of this unit of product, then production can be expanded.
As production volumes change, costs change. Graphical representation of cost curves reveals some important patterns.
Fixed costs, given their independence from production volumes, do not change.
Variable costs are zero when there is no output; they increase as output increases. Moreover, at first the growth rate of variable costs is high, then it slows down, but upon reaching a certain level of production, it increases again. This nature of the dynamics of variable costs is explained by the laws of increasing and diminishing returns.
Gross costs are equal to fixed costs when output is zero, and as production increases, the gross cost curve follows the shape of the variable cost curve.
Average fixed costs will continuously decrease following the growth of production volumes. This is because fixed costs are spread over more units of production.
The average variable cost curve is U-shaped.
The average total cost curve also has this shape, which is explained by the relationship between the dynamics of AVC and AFC.
The dynamics of marginal costs are also determined by the law of increasing and diminishing returns.
The MC curve intersects the AVC and AC curves at the points of the minimum value of each of them. This dependence of the limit and average values has a mathematical basis.
