FIXED COSTS

Fixed costs are those costs that cannot be varied during the period in question, for example, rates and taxes. The table below shows the expected fixed and variable costs that will be incurred by a company buying a number of identical warehouses to store it's products.

FIXED AND VARIABLE COSTS FOR A NUMBER OF WAREHOUSES

NUMBER TOTAL FIXED COST‘000 TOTAL VARIABLE COST‘000 TOTAL COST
'000
1 50 30 80
2 50 37 87
3 50 43 93
4 50 50 100
5 50 60 110
6 50 72 122
7 50 87 137
8 50 106 156
9 50 131 181
10 50 161 211

The degree to which an input is fixed depends on the period because in the long run, few services are completely fixed as cost curves and equilibrium positions vary during that period. The variable costs are shown in column 3 and the total of the variable and fixed costs in column 4.

Although it is possible to compare total cost figures and total revenue figures to determine the most profitable option for the company, it is more instructive to work with average and marginal costs.

In general, the average variable, average total and marginal cost curves are all versions of the corresponding variable, total and marginal product curves and demonstrate the same economic relationships. For example, when the average product is increasing, average cost is decreasing and when marginal product is increasing, marginal cost is decreasing. In economic terms both illustrate increasing returns to scale that is, movement towards more and more efficient use of variable and fixed costs.

The diagram below shows typical average and marginal cost curves. They reveal much about the nature of the costs that face a firm. For example, the marginal cost curve cuts the average cost curve from below at the lowest point on the average cost curve. As long as the cost of producing one additional unit is lower than the average cost, the production of an additional unit will lower the average cost.

TYPICAL MARGINAL COST CURVES



It follows that the output of an operating, profit maximising firm will be no less than the output at which marginal costs = average variable cost. The marginal cost curve is a mirror image of the marginal product curve.

TABLE

DEVELOPER'S CONSTRUCTION COST TABLE FOR COTTAGES

VARIABLE INPUT
(LABOUR) 		$ VALUE OF VARIABLE INPUT
(LABOUR) ‘000 		$ VALUE OF FIXED INPUT
(MAN’MENT) ‘000 		TOTAL INPUT
(TOTAL COST)
‘000 		COMMODITY
(HOUSES)
5 150 180 330 1
11 200 180 380 2
17 255 180 435 3
23 310 180 490 4
30 370 180 550 5
37 430 180 610 6
45 495 180 675 7
55 565 180 745 8
66 640 180 820 9

The table below shows the cost data for a construction company producing cottages and is analyzed into marginal costs.

From the table it can be seen that if the firm believes if it can sell it's houses for $55 000 it will produce 3 houses, if they can sell for $60 000 it will produce 6 houses, and for $75 000; 9 houses. As the potential selling price increases, output will increase until marginal cost = the new marginal revenue (price). A "purely" competitive market is assumed and only 1 fixed and 1 variable input whereas in practice there may be many.

CONSTRUCTION COST TABLE

QUANTITY

(HOUSES)

AVERAGE COST

(COST PER HOUSE) ‘000

MARGINAL

COST

‘000

1

330

50

2

190

55

3

145

55

4

122.5

60

5

110

60

6

101.7

65

7

96.4

70

8

93.1

75

9

91.1




The general relationship between the costs are shown in the diagram above showing average and marginal curves.

Valuers using the cost approach estimate the cost of constructing a similar property (replacement cost new) and then adjust for "demand side influences" by subtracting an amount for depreciation. Market prices above replacement cost new would cause potential buyers to build themselves (opportunity cost) and if prices are well below, potential builders would buy instead.

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