Theory of Costs: Principles, Applications and Examples

Economists use the cost theory to provide a framework for understanding how companies and individuals allocate their resources in order 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 correct decisions, such as what price to quote, whether or not to place a particular order to buy supplies, whether to withdraw or add a product to the existing product line, and so on.

Cost theory

In general, the costs refer to the expenses incurred by a company in the production process. In the field of 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.


  • 1 Principles of theory
    • 1.1 Other cost indicators
  • 2 Applications
    • 2.1 Breakeven analysis
    • 2.2 Degree of operating leverage
    • 2.3 Business risk analysis
    • 2.4 Scope Economies
    • 2.5 Contribution analysis
    • 2.6 Engineering cost techniques
    • 2.7 Operating lever
  • 3 Example
  • 4 References

Principles of theory

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

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

Cost theory uses different measures or cost 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 rent of a place.

Variable costs (CV) change according to the quantity produced. For example, if to increase production it is necessary to hire additional workers, then the wages of these workers are variable costs.

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

CT = CF + CV

Cost theory 1

Other cost indicators

Cost theory has other indicators:

Total average cost (CPT)

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

Marginal cost (CM)

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

Graphs are often used to explain cost theory and thus enable companies to make the best decision about their level of production.

A curve of the total average cost takes the form of a U, which shows how the total average cost decreases as production increases and then increases as the marginal cost increases.

The total average cost decreases at the beginning because, to the extent that production increases, the average cost is distributed in a greater number of units produced. Eventually, the marginal cost grows due to the increase in production, which increases the total average cost.

Cost theory 2

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 generating the highest level of profit or profitability. This implies paying attention to the marginal cost, as well as marginal income (IM): the increase in income that arises from an increase in production. IM = IT CBP + 1 - ITEM CBP.

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


The theory of costs is applied in a large number of accounting and management 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 profits of a company.

Scope Economies

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 margin between sales income and variable costs. Put another way, it is the profit or loss of a company without taking into account the 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

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


Cost theory is used to explain the sale price of a good, calculating how much it costs to produce it.

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

- $ 5000 in the engine.

- 2000 $ in metal and plastic for the frame.

- $ 1000 in glass for the windshield and windows.

- $ 500 for the tires.

- $ 500 for the work and depreciation of the machinery necessary to assemble the vehicle.

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

The variable production cost of $ 9,000 allows for a healthy operating return of $ 1000 of the capital invested.

The cost theory indicates that if the final price were less than $ 10,000 (say, $ 8900), the producers would have no incentive to remain in automobile 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 once again it made sense for producers to make cars.

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

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

Cost theory gives a plausible mechanism to explain this phenomenon. The development of cost theory has been a definite advance in economic science.


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

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