Any firm in business incurs costs. The costs for a firm are vital for its production. Costs come in various forms. For the firm to compete effectively and still remain in business, it must meet its objectives which are mainly maximizing profits and minimizing costs. This paper examines the various costs of a firm and how they affect the firm's production capabilities.
The monetary value that is used in the production process is what is referred to as costs. Costs are incurred whenever output of a firm is realized. They are necessary for the realization of revenue. In this connection, costs are very useful in the calculation of the profit of a firm. Costs are broken down into the following categories;
Opportunity costs: these are costs of the best priority that is foregone. It is always hard for an outsider to determine the best forgone alternative.
Discretionary costs: these are costs that are used in the strategic goals of production e.g. advertising costs etc
These are the main costs of production. They are divided into the following:
Fixed costs: these are costs that do not vary over some time, thus they do not show any response to the levels of production. These costs are literary "fixed." Fixed costs are borne by a company whether it is making profit or losses or whether the firm is manufacturing or not. Such costs include costs like: rent of offices or premises. Relating to the Sparkling Automotive Company balance sheet, fixed costs are administrative expenses (3000), depreciation (1600), maintenance (8700), etc.
Mixed costs: these are costs or expenses that are comprised of two parts; the fixed and the variable parts. The two components of the cost are inseparable forming the mixed cost. The fixed part of the mixed costs does not change over some time while the variable component of the mixed cost changes over time. These costs could be fixed over some period of short time but they jump or shift with increase in time. An example is the annual auto-mobile operating expenses. Mixed costs are found as below: Y=c+bz where Y- total cost, c-fixed cost, b- variable cost per unit and z-number of activities in units. The analysis of mixed costs entails the analysis of the various fixed and variable cost s in the mixed (accounting coach 2010). Basing on the SAC's balance sheet, the company's operating expenses form the mixed costs, this is because they have a fixed costs (maintenance costs) and a variable costs (factory supplies).
Variables costs: unlike the fixed costs, these costs do vary over time. With increased production, these costs do vary either increase or decrease. With no production, variable costs are zero. Example is the cost of raw materials used in production. In our example of SAC, variable costs include labor cost (6000), factory salaries (12500), raw materials (33710), selling expenses (1560) etc. total variable costs = selling expenses + cost of raw materials + factory salaries + labor costs + factory utilities + direct labor + maintenance costs
Economies of scale: this is an economic situation in which the total cost of production reduces with an increase in output. There is a less than proportionate rise in total costs.
Dis-economies of scale: this is the opposite of economies of scale. In this situation, the total costs of production always rise with increased in the output of the firm.
Constant return to scale: this is an economic situation in which the total production output of a firm equal the total costs that the firm uses as inputs. Thus the firm realizes a constant productivity.
The production costs of a firm can either rise or decrease. This could be due to either increase in the price of raw materials used as inputs or the increase in the quantity of inputs. Thus for a given organization to realize economies of scale it must either reduce the quantity of inputs with increased output or lower the prices paid for the inputs (possess good negotiation power).
Total costs and average costs
The total costs of a firm are the sum total of total fixed costs and the total variable costs.
Average total costs: they can be broken down into average fixed costs and average variable costs.
Average fixed costs: are found by dividing the total fixed costs with the total output of the firm. The average fixed costs of a firm decreases with the increase in output of the firm. AFc=Fc/X where AFc-average Fixed costs, X- output and F-fixed costs. From SAC's balance sheet average fixed costs can be calculated as:
Average variable costs: these are found by dividing the total variable costs with the total output of the firm. With an increase in output average variable costs decrease up to a certain point then they start o rise. This is usually explained by the fixed factor of production in the short run. AVc=VC/X=VC where AVc-average variable costs, VC- variable costs and X- output.
Average total costs: this is found by dividing all the total costs with output of the firm. They can also be found by adding together the average fixed costs and the average variable costs. ATc=AFc+AVc =AFc+AVC.
Basing on the SAC's balance sheet;
Costs and operation of a firm and pricing of its output
The costs of a firm will determine the capability of the firm meeting its objective of costs minimization during the production. A firm will always seek to operate with that level of raw materials that make it maximize its profit. That required level is provided by the break even point. The break-even analysis provides the required relationship between the total revenue and the total costs. It shows the profitable sales volume required by the firm. It is found by dividing fixed costs with (per unit profit - per unit variable costs). At the break even point, total costs of a firm are equal to it's the firm's total generated revenue. By the analysis of the break even point, the firm's management can know the bets way to increasing profitability either by increasing the product price, lowering fixed or variable costs.
Increase in output
When a firm increases output, its revenue levels will increase. The increase in output has the following implications on the costs of a firm:
Fixed costs: fixed costs do not increase with an increase in output. Therefore an increase in output will leave the total fixed costs unchanged. Contrary, an increase in output will result in reduced average fixed costs. This is because the average fixed costs are found by dividing the total fixed costs by the total output.
Average costs: average costs depend on the volume of the firm's input. Average costs increases with increased inputs and reduce with reduced inputs. Increased output of a firm which eventually result in the increased profitability of a firm, will translate into increased average costs if the raw material's volume was increased. Increased revenue will also increase total average costs when the prices of raw materials are increased otherwise; the increase in the revenue of the firm translates into reduced average variable costs with low input prices and reduced inputs.
On the other hand, an increase in the revenue of the firm reduces the average variable costs of the firm.
This paper analyzes the various costs of a firm. A firm incurs costs for it to produce. The cots incurred by the firm are categorized into fixed variable and mixed costs. For a firm to realize it profit maximization objective, it must minimize costs at all times. An increase in the revenue of the company reduces average fixed cost and average variable costs.
- Accounting coach, (2010). "What are mixed costs?" Retrieved on February 28, 2010 from: http://blog.accountingcoach.com/mixed-costs-fixed-costs-variable-costs/
- Pearsoned, (2010). "Cost behavior chapter 1." Retrieved on February 28, 2010 from: http://vig.pearsoned.co.uk/catalog/uploads/MANA_C01.pdf
- Economics web institute, (2010). "costs." retrieved on February 28, 2010 from: http://www.economicswebinstitute.org/glossary/costs.htm