The total cost function helps companies assess profitability by adding fixed and variable costs. Long-run total cost divided by units produced results in long-run average cost, essential for mapping costs and economic returns. Graphs show constant, increasing, and decreasing returns.
The total cost function is an economic measure that helps a company assess its profitability. Similar to accounting rules, total costs are the sum of total fixed costs and total variable costs. A business can determine its profitability by subtracting total costs from total revenue, leaving a total economic profit. The total cost function provides graphs that come from various formulas, providing pictorial references for evaluating a company’s increasing or decreasing returns. Economists or corporate finance analysts typically provide this information for a company.
The basic formula for the total cost function is that total cost is equal to fixed costs plus X times variable costs. X represents the number of units that a company produces in a given period of time. A company can plug in different values to X to find the best variable costs for the total cost formula. Total cost charts derived from this formula come from dividing long-run total cost, another name for total cost in economics, by X, resulting in a long-run average cost. This is essential for mapping costs and economic returns.
Economists and corporate finance analysts tend to plot a company’s long-run total costs or long-run average costs. The calculations are often quite technical, resulting in an analysis that is beyond the scope of this article. However, the direction of the lines on the chart is the most important thing in this analysis. The company may keep a record of the charts for trend analysis or comparative review. Outside of the company, these charts are meaningless to external stakeholders.
The first graph in the total cost function rises from the bottom left to the right up in a right angle graph. The result of this graph is that a company is earning constant returns from operations. This also occurs when a company has a straight line on the graph, where long-run average cost and long-run marginal cost are equal. Again, constant returns are possible under these conditions. These two boxes are common in business.
When long-run total cost slopes slightly up and to the right, a firm experiences increasing returns. The slope of the line is often a smooth increase over a longer period of time. Increasing returns also occur when a firm’s long-run average cost and long-run marginal cost start on the left of the graph, drop significantly, and then move to the right in a smooth decline. These are also important charts in terms of economic analysis and total cost function.
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