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Cost Analysis: Types of Costs and Short Run and Long Run Cost Curves

If you run a business, “cost” is much more than the bill you pay. Cost analysis helps a manager answer practical questions: What does each unit really cost? Should we produce more? When should we shut down? In this guide, we first look at the main types of costs (using a bakery example and a numerical schedule), and then see how costs behave when a firm has little time to adjust (short run) and when it has plenty of time (long run).

1. Types of costs

1. Money cost (nominal cost) and real cost

Money cost is the total money spent to produce a good: wages, rent, raw materials and so on. Real cost refers to the efforts, sacrifices and sufferings involved, for instance the strain of long working hours. In business decisions, money cost is used most often.

2. Explicit and implicit costs

• Explicit costs are actual cash payments to outsiders: wages, rent, electricity, flour, butter.
• Implicit costs are the value of the owner’s own resources used in the business, with no cash paid. If the baker uses her own shop, the rent she could have earned by renting it out is an implicit cost. The salary she could have earned elsewhere is another.

Accountants usually count only explicit costs. Economists count both, which is why economic profit = revenue − (explicit + implicit costs).

3. Opportunity cost

Opportunity cost is the value of the next best alternative given up. If you spend a Saturday running a stall instead of working a ₹1,500 shift elsewhere, your opportunity cost of the stall day is ₹1,500, even if you pay nothing out of pocket. It is the most important idea in economics, because every choice has a trade-off.

4. Fixed, variable and total costs

• Total fixed cost (TFC): costs that do not change with output in the short run: rent, insurance, salaries of permanent staff, loan EMI. Even if the bakery bakes nothing, these remain.
• Total variable cost (TVC): costs that change with output: flour, sugar, packaging, power for baking, daily wages. If output is zero, TVC is zero.
• Total cost (TC): TC = TFC + TVC.

5. Average and marginal costs

• Average fixed cost (AFC) = TFC ÷ Q. It keeps falling as output rises (the “spreading the overhead” effect).
• Average variable cost (AVC) = TVC ÷ Q.
• Average cost (AC or ATC) = TC ÷ Q = AFC + AVC.
• Marginal cost (MC) = change in TC when output rises by one unit. It tells you the cost of making one more.

A numerical example

Assume total fixed cost is ₹60.

Notice two things: AFC keeps falling, and MC first falls and then rises. When MC is below AC, AC falls; when MC is above AC, AC rises.

6. Sunk cost

A sunk cost is money already spent and cannot be recovered, such as the money spent on a failed advertising campaign. A good rule: sunk costs should not affect future decisions. What matters is the extra cost and extra benefit from here onwards.

7. Other useful classifications

• Private cost vs social cost: private cost is borne by the firm; social cost includes harm to society, such as pollution from a factory.
• Historical vs replacement cost: historical cost is the price originally paid; replacement cost is what it would cost to buy the same asset today.
• Direct vs indirect cost: direct costs can be traced to a product (flour for bread); indirect costs are shared (the factory manager’s salary).
• Controllable vs uncontrollable cost: managers can influence some costs but not others, such as government taxes.

2. Short run and long run cost

Costs behave differently depending on how much time a firm has to adjust. In a week, a restaurant cannot build a new kitchen. In five years, it can. This difference between the “short run” and the “long run” is the heart of short run and long run cost analysis.

Short-run costs

In the short run, at least one factor (like plant size) is fixed. So, costs are split into fixed and variable costs. The main short-run curves are:

• SAC (short-run average cost): U-shaped.
• AVC (average variable cost): also U-shaped.
• AFC (average fixed cost): a falling curve that never touches zero.
• SMC (short-run marginal cost): also U-shaped, rising faster than the average curves.

Why is the SAC curve U-shaped?

The U shape comes from the law of variable proportions. At low output, the fixed factor is under-used, so adding variable inputs lifts productivity and average cost falls. After the best combination is reached, diminishing returns appear, so extra output costs more and average cost rises. Also, AFC keeps falling, which helps at first, but in the end the rising AVC wins.

Relationships between the curves

• MC cuts both AVC and SAC at their lowest points.
• When MC is below average cost, average cost falls. When MC is above it, average cost rises.
• The gap between SAC and AVC is AFC, and it gets smaller as output grows.

Think of cricket averages: if your latest score (marginal) is lower than your batting average, the average drops; if the score is higher, the average rises. Marginal and average costs behave the same way.

Long-run costs

In the long run, all factors are variable. A firm can choose any plant size. There are no fixed costs, only variable costs. The main curves are the long-run average cost (LAC) and long-run marginal cost (LMC) curves.

The LAC curve: the “envelope”

For each plant size, there is a different short-run average cost curve (SAC1, SAC2, SAC3 and so on). The long-run average cost curve is drawn by joining the lowest cost possible for every level of output across those short-run curves. Because it wraps around them from below, it is called the envelope curve or the planning curve. A firm uses it to choose the plant size that gives the lowest cost for its planned output.

Why is the LAC curve U-shaped?

The long-run U-shape is caused by returns to scale and the economies and diseconomies of scale, not by the law of variable proportions.

• Economies of scale (falling LAC): specialisation, bulk buying, cheaper finance, better machinery and spreading of overheads.
• Constant returns (flat portion): the firm has reached its best size.
• Diseconomies of scale (rising LAC): management problems, communication delays, labour issues and bureaucracy.

Internal and external economies

• Internal economies arise inside the firm because of its own growth, such as a big firm buying raw materials at a discount.
• External economies come from the growth of the industry or area, for example when many garment units cluster in a city and a skilled workforce, suppliers and transport develop around them.

Short run vs long run costs at a glance

Real example

A mobile-phone assembly company has one factory. This year it can only add more shifts or workers (short run). Over the next few years, it can build a second plant, install automated lines or move to a bigger site (long run). Each new plant size has its own cost curve, and the company picks the plant that lowers its cost for the expected demand.

Read next (Part 3): Objectives of a Firm: The Profit Maximization Model and the Economist’s Theory of the Firm