Session 1- COSTS

8/3/2019 Session 1- COSTS

http://slidepdf.com/reader/full/session-1-costs 1/22

WHAT ARE THE COSTS ¶ RELEVANT· TO

MANAGERIAL DECISION MAKING??

AN UNDERSTANDING OF THEINTERACTION OF BUSINESSES AND

MARKETS, AND OPTIMALMANAGERIAL DECISION-MAKING

Costs of Production



Manager¶s objectiv e

yMAXIMIZING PROFITS ???

y What is Profit ??

y What are the other factors ?



y Profits = TR ± TC

y TR = price/unit * quantity

y TC = cost/unit * quantity



Nature of costs

y EXPLICIT COSTS ( ACCOUNTING COSTS) -

y actual exp. «to hire, rent, or purchase inputs««w ages, rent of equipment and building,

price of capital, price of R M, and intermediate products [ FC, VC, MC, AC, SR & LR costs]

y IMPLICIT COSTS-

y v alue of inputs owned & used by the firm«.eg., salary that the entrepreneur could earn in his bestalternativ e employment«



Accounting & Economic Profits«

y In accounting, onl y explicit costs or actual expenditures are considered«

y In economics, both explicit and implicit/ opportunity costs are taken into account«i.e., for managerialdecision making, economic or opportunity costs are the relevant costs..



EXA MPLE-inv entory v aluation

y A firm purchased R M for Rs.100/-

y But price of R M f alls to Rs.60/-

y Suppose that the firm has to take a decisionregarding the use of this R M for mak ing a product«

y The accountant v alues this R M al w a ys at Rs.100/-, its historical cost..

y So any re v enue from the product which is less than100 ma y be considered µUnprofitable¶



W hat are the rele v ant costs(ECONOMIC COSTS)for managerial decision mak ing??

y For the firm Rs. 100/-spent on R M is already sunk «

y W hat matters is onl y the current replacement cost-Rs.60/-!!!

y Hence, the decision to produce the product or not would be on the basis of Rs.60/- and not Rs.100/- ..

y So any price of the product > or = 60 would beprofitable!!



One simple ruleOne simple rule

If a course of action generatespositive Economic ProfiT

Do it



A man who needs to think about hisA man who needs to think about hiscosts..costs..



10

Some numbers«.Some numbers«.

General Motors

Disaggregated Automotive Income Data, 2003

(all data is extracted primarily from 10-K 2003)

Per car sold Per car sold

Net Revenues (from Manufactured products) in $ billions 150.0 17,442 112.7 20,719

Total units sold (millions) 8.6 5.44

Costs ($ billions) 155.8 $18,112 116.4 $21,401

Global Total GM North America Only

R evenue per car Cost per car



Executive meetingExecutive meeting

Do we produce the Chevy Malibu thismonth?

What is the benefit? The cost?

What decision maximizes our economicprofit?



Make Car or Not?Make Car or Not?

Make car? End of month: R evenue ± Cost = -$682

What if we don¶t make the car?

What do things look like at theend of the month?



13

Cost numbers«.Cost numbers«.

Costs, per car $21,252

Materials, Utilities, Parts etc. 11,149

Labor 4,868

Jobs Bank 147

Miscellaneous 2,069

Depreciation 1,140

R&D 912

Warranty expense 613 Interest Expense 324

Net Tax Expense (income) 31



14

If we don¶t produce..If we don¶t produce..

Costs, per car $21,252 Incur Cost?


Labor 4,868

Jobs Bank 147

SG&A 2,069

Depreciation 1,140

R&D 912

Warranty expense 613

Interest Expense 324


Costs incurred, if don't produce



15Source: Harris, 1/7/2012 15



16




Labor 4,868

Jobs Bank 147

SG&A 2,069

Depreciation 1,140

R&D 912




Costs incurred, if don't produce ~90%



17




Labor 4,868

Jobs Bank 147

SG&A 2,069

Depreciation 1,140

R&D 912




Costs incurred, if don't produce ~90%

Industry experts estimated that around 90% of Industry experts estimated that around 90% of costs are unavoidable in the short run in this case.costs are unavoidable in the short run in this case.



18Make Car (this month) or Not?Make Car (this month) or Not? Make car? End of month:

R evenue ± Cost = -$682 Don¶t make the car?

What do things look like at the end of themonth?

R evenue ± Cost = 0 ± 0.9*21,252

= -19,261

What is the profit maximizing decision?



19Sunk CostsSunk Costs

Make the Chevy Malibu if the avoidable costs are less than the price per car.

The unavoidable costs are irrelevant tothis decision.

Unavoidable costs are SUNK. That is, the firm incurs these in either

event. If we took them into account, would make

the wrong choice.

Ignore sunk costs!!



20Opportunity CostOpportunity Cost

What if there is more than one possibleuse of resources? What if the sameavoidable costs could be incurred whenmaking a car that brings in greater

revenue?

The economic cost of making a Malibuincludes the maximum lost value of using

the resources for any other opportunity.

This is the Opportunity Cost, and shouldbe included in decision-making.



21Economic ProfitEconomic Profit

Economic profit is revenue lessavoidable cost, where avoidablecost includes opportunity cost and

ignores sunk costs.

If economic profit from an action

is greater than zero, take theaction!!



22Produce this year?Produce this year?

Some costs which are unavoidableand hence sunk this month maybecome as ³unsunk´ and relevant

in a longer-term decision.

If cannot make positive economicprofit over time, get out of thebusiness!!

Documents

Session 1- COSTS