Cost Analysis and Estimation

What Makes Cost Analysis Difficult?

Link Between Accounting and Economic Valuations

Historical Versus Current Costs

Accounting and economic costs often differ.

Replacement Cost

Historical cost is the actual cash outlay. Current cost is the present cost of previously acquired items. 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 Graphs

1.
AFC
Q

MC ATC

3.

AVC

AFC
Q MC intersects lowest point of AVC and lowest point of ATC. When MC < AVC, AVC declines When MC > AVC, AVC rises

2.

AVC

Relationships Among Cost & Production Functions

AP & AVC are inversely related. (ex: one input) AVC = WL /Q = W/ (Q/L) = W/ APL

prod. functions
AP

MPL

As APL rises, AVC falls

cost
AVC MC

MP and MC are inversely related MC = dTC/dQ = W dL/dQ = W / (dQ/dL) = W / MPL

cost functions Q

As MPL declines, MC rises

Long-run Cost Curves

Economies of Scale Long-run cost curves show minimum cost in an ideal environment.

Long Run Cost Functions

All inputs are variable (can adjust) in the long run. LAC is long run average cost

SMC2

SAC2 LMC

LMC is flatter than SMC curves.

ENVELOPE of SAC curves

The optimal plant size for a given output Q2 is plant size 2. (A SR concept.) However, the optimal plant size occurs at Q3, which is the lowest cost point overall. (A LR concept.)

LAC

Q2

Q3

Long Run Cost Function (LAC) Envelope of SAC curves

Cost Elasticity and Economies of Scale

Cost elasticity is C = C/C Q/Q.

C < 1 means falling AC, increasing returns. C = 1 means constant AC constant returns. C > 1 means rising AC, decreasing returns.

Long-run Average Costs

Economists think that the LAC is Ushaped

Downward section due to:

Product-level economies which include specialization

and learning curve effects. Plant-level economies, such as economies in overhead, required reserves, investment, or interactions among products (economies of scope). Firm-level economies which are economies in distribution and transportation of a geographically dispersed firm, or economies in marketing, sales promotion, or R&D of multi-product firms.

LAC
CRS region

Flat section of the LAC

DRS

MES Max ES Displays constant returns to scale The minimum efficient scale (MES) is the smallest scale at which minimum per unit costs are attained.

Upward rising section of LAC is due to:

Diseconomies of scale. These include transportation costs, imperfections in the labor market, and problems of coordination and control by management. The maximum efficient scale (Max ES) is the largest scale before which unit costs begin to rise. Modern business management offers techniques to avoid diseconomies of scale through profit centers, transfer pricing, and tying incentives to

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.
Scope economics often shape competitive strategy for new products.

Exploiting Scope Economies

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.