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Cost Analysis and Cost Analysis and EstimationEstimation
What Makes Cost Analysis Difficult?
Link Between Accounting and Economic Valuations Accounting and economic costs often
differ. Historical Versus Current Costs
Historical cost is the actual cash outlay. Current cost is the present cost of
previously acquired items. Replacement Cost
Cost of replacing productive capacity using current technology.
Opportunity Cost
Opportunity Cost Concept Opportunity cost is foregone value. Reflects second-best use.
Explicit and Implicit Costs Explicit costs are cash expenses. Implicit costs are noncash
expenses.
Incremental and Sunk Costs in Decision Analysis
Incremental Cost Incremental cost is the change in cost tied
to a managerial decision. Incremental cost can involve multiple units
of output. Marginal cost involves a single unit of output.
Sunk Cost Irreversible expenses incurred previously. Sunk costs are irrelevant to present
decisions.
Short-run and Long-run Costs
How Is the Operating Period Defined? At least one input is fixed in the short
run. All inputs are variable in the long run.
Fixed and Variable Costs Fixed cost is a short-run concept. All costs are variable in the long run.
Short-run Cost Curves
Short-run Cost Categories Total Cost = Fixed Cost + Variable
Cost For averages, ATC = AFC + AVC Marginal Cost, MC = ∂TC/∂Q
Short-run Cost Relations Short-run cost curves show minimum
cost in a given production environment.
Short Run Cost GraphsShort Run Cost Graphs
AFC
Q
Q
1.
2. AVC
3.
Q
AFC
AVC
ATC
MC
MC intersects lowest point of AVC and lowest point of ATC.
When MC < AVC, AVC declinesWhen MC > AVC, AVC rises
Relationships Among Cost & Relationships Among Cost & Production FunctionsProduction Functions
AP & AVC are inversely AP & AVC are inversely related.related. (ex: one input) (ex: one input)
AVC = WL /Q = W/ (Q/L) = AVC = WL /Q = W/ (Q/L) = W/ APW/ APLL
As APAs APL L rises, AVC fallsrises, AVC falls
MP and MC are inversely MP and MC are inversely relatedrelated
MC = dTC/dQ = W dL/dQ = MC = dTC/dQ = W dL/dQ = W / (dQ/dL) = W / MPW / (dQ/dL) = W / MPLL
As MPAs MPLL declines, MC rises declines, MC rises
prod. functions
cost functions
MPL
L
MC
AP
AVC
Q
Q
cost
Long-run Cost Curves
Economies of Scale Long-run cost curves show
minimum cost in an ideal environment.
Long Run Cost FunctionsLong Run Cost Functions All inputs are variable All inputs are variable
(can adjust) in the long (can adjust) in the long run.run.
LAC is long run average LAC is long run average costcost ENVELOPE of SAC curvesENVELOPE of SAC curves
LMC is flatter than LMC is flatter than SMC curves.SMC curves.
The optimal plant size for The optimal plant size for a given output Qa given output Q2 2 is plant is plant size 2. (A SR concept.)size 2. (A SR concept.)
However, the optimal However, the optimal plant size occurs at Qplant size occurs at Q33, , which is the lowest cost which is the lowest cost point overall. (A LR point overall. (A LR concept.)concept.) Q
LAC
LMCSAC2
SMC2
Q2 Q3
Long Run Cost Function (LAC) Long Run Cost Function (LAC) Envelope of SAC curvesEnvelope of SAC curves
Cost Elasticity and Economies of Scale
Cost elasticity is εC = ∂C/C ÷ ∂Q/Q. εC < 1 means falling AC,
increasing returns. εC = 1 means constant AC
constant returns. εC > 1 means rising AC,
decreasing returns.
Long-run Average Costs
Economists think that the LAC is U-Economists think that the LAC is U-shapedshaped
Downward section due to:Downward section due to: Product-level economiesProduct-level economies which include which include
specialization and learning curve effects.specialization and learning curve effects. Plant-level economiesPlant-level economies, such as economies in , such as economies in
overhead, required reserves, investment, or overhead, required reserves, investment, or interactions among products (economies of interactions among products (economies of scope).scope).
Firm-level economiesFirm-level economies which are economies in which are economies in distribution and transportation of a distribution and transportation of a geographically dispersed firm, or economies in geographically dispersed firm, or economies in marketing, sales promotion, or R&D of multi-marketing, sales promotion, or R&D of multi-product firms.product firms.
CRS region
MES Max ES
DRS
LAC
Flat section of the LACFlat section of the LAC Displays constant returns to scaleDisplays constant returns to scale The minimum efficient scale (MES) is the smallest The minimum efficient scale (MES) is the smallest
scale at which minimum per unit costs are attained.scale at which minimum per unit costs are attained. Upward rising section of LAC is due to:Upward rising section of LAC is due to:
Diseconomies of scale. These include Diseconomies of scale. These include transportation costs, imperfections in the labor transportation costs, imperfections in the labor market, and problems of coordination and control market, and problems of coordination and control by management.by management.
The maximum efficient scale (Max ES) is the largest The maximum efficient scale (Max ES) is the largest scale before which unit costs begin to rise.scale before which unit costs begin to rise.
Modern business management offers techniques to Modern business management offers techniques to avoid diseconomies of scale through profit centers, avoid diseconomies of scale through profit centers, transfer pricing, and tying incentives to transfer pricing, and tying incentives to performance.performance.
Economies of Scope Economies of Scope Concept
Scope economies are cost advantages that stem from producing multiple outputs.
Big scope economies explain the popularity of multi-product firms.
Without scope economies, firms specialize. Exploiting Scope Economies
Scope economics often shape competitive strategy for new products.
Cost-volume-profit Analysis
Cost-volume-profit Charts Cost-volume-profit analysis shows
effects of varying scale. Breakeven analysis shows zero profit
points of cost coverage.