GOLDEN STARS MONTESSORI ACADEMYSUBJECT: ECONOMICS
CLASS: S S 1
TOPIC: COST CONCEPTS: MEANING AND TYPES (FIXED, VARIABLE, TOTAL, MARGINAL, AND AVERAGE)
In everyday language, when we talk about "cost," we usually mean the price tag on an item. However, in Economics, Cost of Production refers to the total expenditure incurred by a business firm in the process of producing goods or services. It includes the money spent on raw materials, labor, rent, electricity, and machinery.
Understanding cost is vital because every producer aims to maximize profit. Since Profit = Total Revenue - Total Cost, a producer must deeply understand their costs to make informed decisions about how much to produce and what price to charge. In the Nigerian context, whether you are running a small "Pure Water" factory or a large cement plant, managing costs is the difference between business survival and failure.
Fixed costs, also known as "Overhead Costs" or "Supplementary Costs," are expenses that do not change with the level of output. Whether a factory produces 1,000 bags of flour or zero bags, these costs remain the same in the short run.
Detailed Example: Imagine you rent a shop in Balogun Market for ₦200,000 a year to sell shoes. If you sell 500 pairs of shoes, your rent is ₦200,000. If you travel for a month and sell zero shoes, you still owe the landlord ₦200,000. Other examples include the cost of heavy machinery, permanent staff salaries, and insurance premiums.
Variable costs, or "Prime Costs," are expenses that change directly with the volume of production. If you produce more, these costs increase; if you produce nothing, these costs are zero.
Detailed Example: Consider a tailor sewing school uniforms. The cost of fabric (material), thread, and buttons are variable costs. If the tailor sews 10 uniforms, they buy a certain amount of fabric. If they sew 100 uniforms, they must buy ten times more fabric. If they don't sew any uniforms, they don't spend money on fabric.
Total Cost is the sum of Fixed Cost and Variable Cost at a specific level of output. It represents the total amount of money spent to produce a certain quantity of goods.
The Formula:
Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC)
Example: If a baker pays ₦50,000 for shop rent (FC) and spends ₦30,000 on flour and sugar (VC) to make 100 loaves of bread, the Total Cost is ₦80,000.
Average Cost, also called "Unit Cost," is the cost of producing a single unit of a product. It is calculated by dividing the Total Cost by the number of units produced (Quantity).
The Formula:
Average Cost (AC) = Total Cost (TC) / Total Quantity (Q)
Why it matters: A business must know its Average Cost to set a selling price. If it costs ₦800 to make one loaf of bread (Average Cost), the baker must sell it for more than ₦800 to make a profit.
Marginal Cost is the extra cost incurred by producing one additional unit of a product. It helps producers decide whether it is profitable to increase production by just one more unit.
The Formula:
Marginal Cost (MC) = Change in Total Cost / Change in Quantity
(Or: TC of 'n' units - TC of 'n-1' units)
Detailed Example: If it costs ₦1,000 to produce 10 bags of sachet water and ₦1,080 to produce 11 bags, the Marginal Cost of the 11th bag is ₦80.
Let’s look at how a small business calculates these costs using a Cost Schedule.
| Quantity (Q) | Fixed Cost (FC) | Variable Cost (VC) | Total Cost (TC) | Average Cost (AC) | Marginal Cost (MC) |
|---|---|---|---|---|---|
| 0 | 100 | 0 | 100 | - | - |
| 1 | 100 | 50 | 150 | 150 | 50 |
| 2 | 100 | 80 | 180 | 90 | 30 |
| 3 | 100 | 120 | 220 | 73.3 | 40 |
Step-by-Step Guide to the Table:
Objective: To identify and calculate production costs for a hypothetical or real small-scale snack business.
Materials Needed:
Procedure:
Exercise A: Categorization Task Classify the following as either Fixed Cost (FC) or Variable Cost (VC) for a Barbing Salon:
Exercise B: Problem Solving A local shoe manufacturer has a Fixed Cost of ₦10,000. When he produces 5 pairs of shoes, his Variable Cost is ₦15,000.