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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 company can determine its profitability by subtracting total costs from total revenue, leaving total economic profit. The total cost function provides charts that come from various formulas, providing pictorial references for assessing a company’s increasing or decreasing returns. Economists or corporate finance analysts usually provide this information for a business.
The basic formula for the total cost function is total cost equals fixed costs plus X times the variable costs. X represents the number of units a company produces in a given time period. A company can plug different values into X in order to find the best variable costs for the total cost formula. The total cost charts derived from this formula come from dividing long-run total cost — another name for total cost in economics — by X, which results in long-term average cost. This is essential to charting economic costs and returns.
Economists and corporate finance analysts tend to chart either a company’s long-run total costs or long-run average costs. The calculations are often quite technical, resulting in analysis that is beyond the scope of this article. The direction of the lines on the chart, however, is what is most important in this analysis. A record of the charts may be kept by the company to perform a trend analysis or comparison review. Outside of the company, these charts are fairly meaningless to external stakeholders.
The first chart in the total cost function rises from the bottom left to the upward right on a right-angle chart. The result from this graph is that a company is earning constant returns from operations. This also occurs when a company has a straight line on the chart, where long-run average cost and long-run marginal cost are equal. Again, constant returns are possible under these conditions. These two charts are common in business.
When long-run total cost slopes upward slightly and to the right, a company experiences increasing returns. The slope of the line is often a gentle increase over a longer period of time. Increasing returns also occur when a company’s long-run average cost and long-run marginal cost start at the left of the chart, go down significantly, and then move to the right at a gentle decrease. These are also important charts in terms of economic analysis and total cost function.