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Production and Cost Relationships - Essay Example

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This paper explores the relationship between costs in production. Utilizing numerical example and graphical representations, this paper provides a simplistic view of different costs incurred by a firm. In more detail, this paper first turns in identifying the major goal of a firm-that is profit maximization and offers solution in term of cost minimization…
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Production and Cost Relationships
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Download file to see previous pages Profit is measured as the difference between the revenue generated deducted with the costs incurred. Thus, in order to maximize profits, the company could either ensure that it is generating the highest revenue possible by increasing price and quantity demanded or minimize the costs that it incurs (Pindyck and Rubinfeld 2005). This paper will focus on the latter. The following chapters will look at the relationship of average cost, marginal cost, and marginal product in the aim of helping a business organization attain its goal of profit maximization.
In the course of its operation, a business organization incurs various costs in order to ensure that products are designed, manufactured, and distributed to customers (Cepeda 2005). In order to understand average total cost, it is best to have a comprehension of what comprises the total cost that a business organization faces. In general, the company is faced with two different costs which make up its total cost namely fixed cost and variable cost (Brue and McConnell 2005). Fixed cost, as the name implies is fixed and does not vary with the level of production. An example of fixed cost is the payment for rent of production plant or retailing store. On the other hand, variable costs are those costs which changes when the quantity of production is changed (Cepeda 2005). Examples of these are the cost of materials and labor which are needed in the production of one unit of a product. The sum of the total fixed cost and the total variable cost is the total cost. Dividing the total cost with the number of quantity produced by the business organization will yield the average total cost (Brue and McConnell 2005).
Table 1. Numerical Example for Average Total Cost
Total Fixed Cost
Total Variable Cost
Total Cost
Average Total Cost

In order to illustrate fixed cost, it is best to come up with a numerical example. Suppose that a company manufactures figurines and incurs fixed cost as follows in a month: $200 for building rent; $300 for administrative expense; and $100 for utilities. On the hand, it incurs the following variable cost per unit: $10 direct material and $15 direct labor. The company's production capacity is 300 units per month. Table 1 shows the company's variable cost and fixed cost at each level of quantity produced. On the other hand, Figure 1 shows the short run average total cost curve. It should be noted that as the quantity produced is increased, ATC declines because of economies of scale, managerial specialization, and use of more efficient labor.
Figure 1. ATC Curve in the Short-run

However, in the long run, ATC curve will begin to inflect because of the diseconomies of scale as production expands further (Pindyck and Rubinfeld 2005). Thus, the long run ATC curve will tend to slope downward at first and begin to ...Download file to see next pagesRead More
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