Theory of the Firm 2

(iii) Total costs

Total cost is the sum of all costs incurred in the production at a given level of output i.e. the sum of fixed and variable costs.

Total cost = Fixed costs+ variable costs.

- As output increases total costs will also increase.


NOTE: It has been assumed that semi-variable costs are part of fixed and variable costs.

(iv) Direct and indirect costs

Costs can be classified according to the way they affect the product.

They can either be direct or indirect costs.

a) Direct costs

These are costs that can be physically traced to the final product/process.


i) Raw materials i.e. all the materials that can be physically traced to the final product.

ii) Direct labour i.e. wages for those factory employees directly engaged in the manufacture of the product e.g. wages for machine operators,packers,mixers,assemblers e.t.c.

iii) Packing materials used.

iv) Direct expenses i.e. expenses which are directly allocated to a particular unit of goods being made.e.g maintenance costs of machines and equipment, designs and drawings, hire for special tools or equipment for a particular production.

- These costs are also known as prime costs. They are usually variable costs.

Indirect costs (factory overheads)

These are costs which cannot be traced or directly identified in the final product i.e. they cannot be attributed to any specific output.

They also include the costs that appear in such small quantities that their effects are negligible.


i) Payment for stationary and other items such as lubricating oil, small tools, telephone use, cleaning and transport for employees.

ii) Wages and salaries for managers, supervisers, store keepers, clerks and watchmen.

iii) Payment for rent, land lease, insurance, advertising,warehousing and audit fees.

iv)Payment for the power used in the production process.

Indirect costs are also known as overheads. They are usually fixed costs.

Average costs

- Average costs refer to costs per unit output
-It is determined by dividing the total of a particular cost by the total output at each level of output.(They are also known as unit costs).

Types of Average costs

i) Average fixed costs

ii) Average variable costs

iii) Average total costs

a) Average fixed costs; (AFC)

Average fixed cost (AFC) is the total fixed cost at each level of output divided by the total output at that level.

AFC=Total fixed costs

Total units produced

Output (units) Fixed costs (sh) Average fixed costs (AFC)
200 200
100 200 2
200 200 1
300 200
400 200
500 200

b) Average variable costs (AVC)

AVC refers to total variable costs at each level divided by the total units of output produced at that level.

Average variable costs (AVC)=Total variable costs
Total units produced
Output (units) Variable costs (sh) AVC
100 200 2
200 400 2
300 600 2
400 800 2
500 1000 2

c) Average Total Costs (ATC/AC)

Average total cost (ATC) is divided by;

i) Dividing the sum of fixed and variable costs (total costs) by the total units produced.i.e

ATC=fixed costs variable costs
Total units produced

ii) Adding average fixed costs (AFC) and average variable cost (AVC)


Output (units) Total cost ATC
100 400 4
200 600 3
300 800
400 1000 2.5
500 1200 2.4
Output (units) Average fixed
costs (AFC) (sh)
Average v costs ATC=AFC+AVC

100 2 2 4
200 1 2 3
300 0.66 2 2.66
400 0.5 2 2.5
500 0.4 2 2.4


The marginal cost is the change in total cost (ATC) which results from a unit change in output.

Marginal cost is the cost of producing one extra unit of output
E.g. when total costs increase from sh.300 to sh.350 when an additional unit is produced, then MC=sh.50

Location of the Firm

Location; is the site or place from which the business operations/firm would be established.

The management has to make appropriate decisions concerning the location of the firm since a good location would lead to success
while a bad location would lead to failure of the business enterprise.

Factors determining the location of the firm

a. Raw materials

The availability of raw materials is one of the factors that determine the location of firms.

Firms should be located near the source of raw material when:

(i) The raw materials are heavy and bulky so that costs of transporting them to far distances would be too high.

(ii) The raw materials are perishable

Advantages of locating firm near source of raw materials:

- Transport cost of raw materials is minimized

- production process can run uninterrupted because of constant supply of raw materials thus continuous production

- storage cost of the raw material will be minimized

- It is easier for the firm to select the quality of raw materials required.

- Easier to get fresh raw materials/undamaged raw materials

b. Labour (Human Resources)

This is divided into 3 categories; semi-skilled and unskilled labour
- Labour intensive firms must be located in areas where there is both abundant.

labour force and appropriate labour force.

- Firms requiring labour of any kind maybe located in the urban centres because in such areas labour is in plentiful supply.

- Agricultural processing firms are found in the rural areas.

- Location of the firms near the source of labour reduces the cost of transporting labour force to factories and also reduces time wasting in transporting labour from far.

c. Market

A firm may be located near the market for its products to cut down on production costs .i.e to avoid the costs involved in transportation of the
finished products.

Reasons locating near markets

- where the finished product is more bulky or more difficult than the raw materials, then the industry would be located near the market e.g. blocks and bricks used in building will be manufactured near the place where they are required than the source of raw materials because the finished product is more delicate to transport and is susceptible to damage.

- it reduces the cost of transporting the products to the market.

- To minimize the damage of the final product

- where the finished product is perishable or fragile, the industry should be located near the market to avoid breackages or spoilage.

Examples are commodities like milk or bread which usually go bad very quickly and therefore need to be consumed immediately they are produced.

d. Transport and Communication

Efficient transport is the lifeline of modern businesses.

Firms will choose those locations that have well-developed transport facilities such as roads, railway lines, seaports and airports because;

i) They require constant supplies of raw materials

ii) They need to distribute/send out finished products to different destinations

iii) They need to be in contact with other business associates like suppliers, customers and competitors.

Poorly developed transport facilities may lead to:

- High transportation costs especially where raw materials or the finished products are bulky.

- Delays in receiving the raw materials and distributing the finished products.

- Where communication network is poor, business people will not be able to give or get information in time.

e. Power and Water Supply

Fuel and power are required to run machines and ensures smooth operation for the business.

Water is required for cleaning, cooling and even as a raw material.

They are therefore strong factors in determining the location of a firm i.e. firms that require a lot of power and water need to be located where there is adequate supply of these factors.

f. Government policy

The government may formulate policies that may have implications on the location of the firms, especially with regard to physical planning. Such planning may be aimed at checking rural-urban migration, environmental degradation or for strategic concerns.

Theory of the Firm 1 | Theory of the Firm 2 |
Theory of the Firm 3 | Theory of the Firm 4 |
Theory of the Firm 5 | Theory of the Firm 6 |

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