During the process of production, a number of factors (both fixed and variable) join hands. These factors are available only at a price. Expenses incurred on the factors of production are known as the cost of production, or in short, the cost. On the other hand, the producer receives payments from the sale of the goods produced. Such sale proceeds are referred to as revenue in Economics.
The aim of the producer is to maximise its profit. Since profit is the difference between revenue and cost, profit maximisation amounts to maximisation of difference between revenue and cost, by increasing the former and lowering the latter.
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While the level of revenue is primarily determined by the market factors, the cost can be brought down either by producing the optimum level of output using the least cost combination of inputs or by increasing factor productivities or by improving the organisational efficiency.
A profit maximising firm needs to monitor revenue and cost continuously. Thus, the concepts of cost and revenue are very important in the price theory. They exhibit not only the profits or losses earned by the firm, but also help in price and output determination.
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A rational producer chooses the production decision through the cost and revenue analysis. In this chapter, the theory of costs is explained. This chapter is concerned with the measurement of economic efficiency, i.e., the use of inputs in terms of costs, rather than in physical terms (technological efficiency).
Cost of production provides the floor to pricing. It helps managers to take correct decisions, like which price to quote, whether to place a particular order for inputs or not, whether to abandon or add a product to the existing product line, whether to expand or contract production, whether or not to use idle capacity, whether to buy or manufacture a product and so on. Decisions about payment of tax, bonus, dividend, choice of technology, sales promotion channels, etc., also involve computations of costs.
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Production function as such does not reveal anything about the economic aspect of costs and prices. Once prices of factor inputs are known, the technological relationships (in physical units) implied by the production function can be used to derive the cost functions. Hence, the theory of costs is restatement of the theory of production in monetary terms.