COST THEORY: PRINCIPLES, APPLICATIONS AND EXAMPLES - DUDAS - 2025

The cost theory is used by economists to provide a framework of understanding about how businesses and individuals allocate their resources to keep costs low and profits high. Costs are very important in making business decisions.

The cost of production provides a floor for the determination of prices. It helps managers make the right decisions, such as what price to quote, whether or not to place a particular order to purchase supplies, whether to withdraw or add a product to the existing product line, and so on.

Generally, costs refer to the expenses incurred by a company in the production process. In economics, cost is used in a broader sense; in this case the costs include the value assigned to the entrepreneur's own resources, as well as the owner-manager's salary.

Principles of the theory

If you want to open a manufacturing plant to make products, you need to spend money. After the entrepreneur of this plant invests the money to manufacture the goods, that cash is no longer available for anything else.

Examples of costs are industrial facilities, workers, and machines used in the production process. The theory of costs offers a guide so that companies can know the value that allows them to establish the level of production with which they obtain the greatest profit at the lowest cost.

Cost theory uses different cost measures or indicators, such as fixed and variable. Fixed costs (CF) do not vary with the quantity of goods produced (CBP). An example of a fixed cost would be the rental of a premises.

Variable costs (CV) change depending on the quantity produced. For example, if increasing production requires hiring additional workers, then the wages of these workers are variable costs.

The resulting sum of fixed costs and variable costs is the total cost (TC) of a company.

CT = CF + CV

Other cost indicators

The cost theory has other indicators:

Average cost total (CPT)

The total cost divided by the quantity of goods produced. CPT = CT / CBP

Marginal cost (CM)

The increase in total cost resulting from increasing production by one unit. CM = CT _{CBP + 1} - CT _CBP

Charts are often used to explain cost theory to help companies make the best decision about their level of production.

An average total cost curve is in the shape of a U, showing how average total cost decreases as production increases and then increases as marginal cost increases.

The total average cost decreases initially because, as production increases, the average cost is spread over a greater number of units produced. Eventually, the marginal cost grows with the increase in production, which increases the total average cost.

The objective of a company is to reach its maximum profitability (R), which is equivalent to subtracting its total cost from its total income (IT). R = IT - CT

It is important to determine the level of production that generates the highest level of profit or profitability. This implies paying attention to marginal cost, as well as marginal revenue (MR): the increase in income that arises from an increase in production. IM = IT _{CBP + 1} - IT _CBP.

Under cost theory, as long as marginal revenue exceeds marginal cost, increased production will increase profitability.

Applications

Cost theory is applied in a large number of accounting and managerial decisions in business management:

Breakeven analysis

Technique used to evaluate the relationship between costs, sales and operating profitability of a company at various levels of production.

Degree of operating leverage

Instrument that assesses the effect of a percentage change in sales or production on profitability in the operation of a company.

Business risk analysis

It is the variability or uncertainty inherent in the operating profit of a company.

Economies of scope

Economies that exist when the cost of producing two (or more) products by the same company is less than the cost of producing these same products separately by different companies.

Contribution analysis

It is the existing margin between sales income and variable costs. In other words, it is the profit or loss of a company without taking into account fixed costs.

Engineering cost techniques

Functional evaluation methods that combine the lower costs of labor, equipment and raw materials required to produce different levels of production. Use only industrial engineering information.

Operating lever

Determine the use of assets with fixed costs (for example, with depreciation) in an effort to increase profitability.

Example

The cost theory is used to explain the selling price of a good, calculating how much it costs to produce it.

Suppose a particular car has a sales price of $ 10,000. The cost theory would explain this market value by pointing out that the producer had to spend:

- $ 5,000 on the motor.

- $ 2000 in metal and plastic for the frame.

- $ 1000 in glass for the windshield and windows.

- $ 500 for tires.

- $ 500 for the labor and depreciation of the machinery needed to assemble the vehicle.

- $ 500 in other expenses that do not directly affect production, such as premises rent and administrative salaries.

The variable cost of production of $ 9,000 allows for a healthy operating return of $ 1,000 on invested capital.

The cost theory indicates that if the final price were less than $ 10,000 (say $ 8,900), producers would have no incentive to stay in car production.

Some of them would leave the industry and invest their financial capital elsewhere. The exodus would reduce the supply of cars, raising their price until it once again made sense for producers to make cars.

On the other hand, if the price of a car were significantly more than $ 10,000 (say, $ 13,000), then the "rate of profit" in this industry would be much higher than in other companies of comparable risk. Investors would focus on car production, increasing supply and lowering prices.

Cost theory provides a coherent explanation of how a market economy works. Prices actually have a strong correlation with the costs of production of the various goods and services.

The cost theory gives a plausible mechanism to explain this phenomenon. The development of the theory of costs has been a definite advance in economics.

References

1. Smriti Chand (2018). Cost Theory: Introduction, Concepts, Theories and Elasticity. Taken from: yourarticlelibrary.com
2. Shane Hall (2017). Cost Theory in Economics. Taken from: bizfluent.com
3. Robert P. Murphy (2011). Problems with the cost theory of value. Mises Institute. Taken from: mises.org
4. Quizlet inc. (2018). Applications of Cost Theory. Taken from: quizlet.com
5. J Chavez (2018). Cost Theory. Economy. Unit 2. Taken from: sites.google.com
6. Marysergia Peña (2018). Cost Theory. Unit IV. University of the Andes. Faculty of economics and social sciences. Taken from: webdelprofesor.ula.ve