CHAPTER 8 Cost Analysis  The opportunity cost of the owner’s time is

 Economic cost refers to the cost of attracting a measured by the most attractive salary offer that
resource from its next best alternative use (the the owner could have received by applying his or
opportunity cost concept). her talents, skills, and experience in the
 Managers seeking to make the most efficient use of management of a similar (but second-best) business
resources to maximize value must be concerned owned by someone else.
with both short-run and long-run opportunity costs.  Similarly, the opportunity cost of the capital is
 Short-run cost output relationships help managers measured by the profit or return that could have
to plan for the most profitable level of output, given been received if the owner had chosen to employ
the capital resources that are immediately capital in his or her second-best (alternative)
available. investment of comparable risk.
 Long-run cost-output relationships involve  Economic profit is defined as the difference
between total revenues and these total economic
attracting additional capital to expand or contract
costs, implicit opportunity costs as well as explicit
the plant size and change the scale of operations. outlays:
 Achieving minimum efficient scale is often the key Economic profit = Total revenues − Explicit costs − Implicit costs
to a successful operations strategy.  When one recognizes that such first-best and
second-best uses change over time, it becomes
THE MEANING AND MEASUREMENT OF COST
clear that the historical outlay of funds to obtain a
 In its most elementary form, cost simply refers to
resource at an earlier date (the accounting cost
the sacrifice incurred whenever an exchange or
basis) may not be the appropriate measure of
transformation of resources takes place.
opportunity cost in a decision problem today.
 This association between forgone opportunities and
 Opportunity costs. The value of a resource in its
economic cost applies in all circumstances.
next best alternative use. Opportunity cost
 However, the appropriate manner to measure costs
represents the return or compensation that must
is a function of the purpose for which the cost
be forgone as the result of the decision to employ
information is to be used.
the resource in a given economic activity.
Accounting versus Economic Costs
 Accountants have been primarily concerned with Three Contrasts between Accounting and
identifying highly stable and predictable costs for
Economic Costs
Depreciation Cost Measurement
financial reporting purposes.
 The production of a good or service typically
 As a result, they define and measure cost by the
requires the use of licenses and plant and
known certain historical outlay of funds.
equipment.
 Thus, the price paid for commodity or service
 As these capital assets are used, their service life is
inputs, expressed in dollars, is one measure of the
expended, and the assets wear out or become
accounting cost.
obsolete.
 Similarly, the interest paid to bondholders or
 Depreciation is a loss of asset value.
lending institutions is used to measure the
 Unfortunately, it is often difficult, if not impossible,
accounting cost of funds to the borrower.
to determine the exact service life of a capital asset
 Economists, on the other hand, have been mainly
and the future changes in its market value.
concerned with measuring costs for decision-
 Some assets are unique (patents); others are not
making purposes.
traded in liquid resale markets (plants); and still
 The objective is to determine the present and
others are rendered obsolete with little
future costs of resources associated with various
predictability (computers).
alternative courses of action.
 To overcome these measurement problems with
 Such an objective requires a consideration of the
economic depreciation cost, accountants have
opportunities forgone (or sacrificed) whenever a
adopted certain procedures for allocating a portion
resource is used in a given course of action.
of the acquisition cost of an asset to each
 So, although both the accounting cost and the
accounting time period, and in turn to each unit of
economic cost of a product will include such explicit
output that is produced within that time period.
costs as labor, raw materials, supplies, rent,
 This allocation is typically done by one of several
interest, and utilities, economists will also include
arbitrary methods of assigning a portion of the
the implicit opportunity costs of time and capital
historical cost to each year of the service life.
that the owner-manager has invested in the
 Capital assets. A durable input that depreciates
enterprise.
with use, time, and obsolescence.
Inventory Valuation
 Whenever materials are stored in inventory for a
period of time before being used in the production
process, the accounting and economic costs may
differ if the market price of these materials has
changed from the original purchase price.
 The accounting cost is equal to the actual
acquisition cost, whereas the economic cost is equal
to the current replacement cost.
 As the following example illustrates, the use of the
acquisition cost can lead to incorrect production
decisions.
Sunk Cost of Underutilized Facilities
 sunk costs should not be considered relevant costs
because such costs are unavoidable, independent of
the course of action chosen.
 Sunk cost. A cost incurred regardless of the
alternative action chosen in a decision-making
problem.
Conclusions
1. Costs can be measured in different ways, depending
on the purpose for which the cost figures are to be
used.
2. The costs appropriate for financial reporting
purposes are not always appropriate for decision-
making purposes.
 Typically, changes and modifications have to be
made to reflect the opportunity costs of the
various alternative actions that can be chosen in
a given decision problem.
 The relevant cost in economic decision making
is the opportunity cost of the resources rather
than the historical outlay of funds required to
obtain the resources.
3. Sunk costs, which are incurred regardless of the
alternative action chosen, should seldom be
considered in making operating decisions.
SHORT-RUN COST FUNCTIONS
 In addition to measuring the costs of producing a
given quantity of output, economists are also
concerned with determining the behavior of costs
when output is varied over a range of possible
values.
 The relationship between cost and output is
expressed in terms of a cost function: a schedule,
graph, or mathematical relationship showing the
minimum achievable cost of producing various
quantities of output.
 The discussion in Chapter 7 concerning the inputs
used in the production process distinguished
between fixed and variable inputs.
 A fixed input was defined as an input that is
required in the production process, but whose
quantity used in the process is constant over a given
period of time regardless of the level of output
produced.
 Short-run questions relate to a situation in which
one or more of the inputs to the production process
are fixed.
 Long-run questions relate to a situation in which all
inputs are variable; that is, no restrictions are
imposed on the amount of a resource that can be
employed in the production process.
 The length of time required to vary all the inputs
can be as long as a decade (e.g., in shipbuilding). In
other cases, the long-run may be just a few weeks
 The total cost of producing a given quantity of
output is equal to the sum of the costs of each of
the inputs used in the production process.
 In discussing short-run cost functions, it is useful to
classify costs as either fixed or variable costs.
 Fixed costs represent the costs of all the inputs to
the production process that are fixed or constant
over the short run.
 Variable costs consist of the costs of all the variable
inputs to the production process. Whereas variable
costs may not change in direct proportion to the
quantity of output produced, they will increase (or
decrease) in some manner as output is increased
(or decreased).
 Cost function. A mathematical model, schedule, or
graph that shows the cost (such as total, average, or
marginal cost) of producing various quantities of
output.
 Fixed costs. The costs of inputs to the production
process that are constant over the short run.
 Variable costs. The costs of the variable inputs to
the production process.
Average and Marginal Cost Functions
 Once the total cost function is determined, one can
then derive the average and marginal cost
functions.
 The average fixed cost AFC, average variable cost
AVC, and average total cost ATC are equal to the
respective fixed, variable, and total costs divided by
the quantity of output produced:
 Technically, the ratio ΔTC/ΔQ represents the
incremental cost associated with a discrete change
in output by more than one unit rather than the
marginal cost associated with one additional unit of
output.
 Marginal cost is defined as the incremental
increase in total cost that results from a one-unit
increase in output, and is calculated as
 The average total cost curve in Figure 8.2, which is
equal to the sum of the vertical heights of the
average fixed and average variable cost curves,
initially declines and subsequently begins rising
beyond a particular level of output.
 At Q = 55 the average total cost curve is at its
minimum value.
 As discussed in the previous chapter, specialization
in the use of the variable inputs initially results in
increasing returns and declining marginal costs and
average variable costs.
 Eventually, however, the gains from specialization
are overwhelmed by crowding effects, diminishing
marginal returns set in, and then marginal and
average variable costs begin increasing as shown in
Figure 8.3.
 This reasoning is used to explain the U-shaped
pattern of the short-run ATC, AVC, and MC curves in
Figures 8.2 and 8.3 and indeed in all short-run
average cost structures.
LONG-RUN COST FUNCTIONS
 Over the long-run planning horizon, using the
available production methods and technology, the
firm can choose the plant size, types and sizes of
equipment, labor skills, and raw materials that,
when combined, yield the lowest cost of producing
the desired amount of output.
 Once the optimum combination of inputs is chosen
to produce the desired level of output at least cost,
some of these inputs (plant and equipment)
become fixed in the short run.
 If demand increases unexpectedly and the firm
wishes to produce not Q1, as planned, but rather
Q2 as shown in Figure 8.3, it may have little choice
but to lay on additional variable inputs such as
overtime labor and expedite the rush-order delivery
of supplies to meet its production goals.
 Not surprisingly, such arrangements are expensive,
and short-run average cost will temporarily rise to B
at C02.
 Should this demand persist, a larger fixed input
investment in plant and equipment is warranted.
 Then, unit cost can be reduced from C02 to C2.
 Associated with the larger fixed input investment is
another short-run average cost function SAC2.
 Several of these other short-run average cost
functions (SRAC3, SRAC4) are shown in Figure 8.3.
 The long-run average cost function consists of the
lower boundary or envelope of all these short-run
curves.
 No other combination of inputs exists for producing
each level of output Q at an average cost below the
cost that is indicated by the LRAC curve.
Optimal Capacity Utilization: Three Concepts
 To assess capacity utilization, assume the firm has
been producing Q1 units of output using a plant of
size “1,” having a short-run average cost curve of
SAC1.
 The average cost of producing Q1 units is therefore
C1, and Q1 is the optimal output for the plant size
represented by SAC1.
 Optimal output for a given plant size is a short-run
concept of capacity utilization.
 Suppose that the firm now wishes to expand output
to Q2.
 What will the average cost be of producing this
higher volume of output? In the short run, as we
saw earlier, the average cost would be C02.
 However, in the long run, it would be possible for
the firm to build a plant of size “2,” having a short-
run average cost curve of SAC2.
 With this larger plant, the average cost of producing
Q2 units of output would be only C2.
 Thus, because the firm has more options available
to it in the long run, average total cost of any given
output generally can be reduced.
 SAC2 represents the optimal plant size for a given
output rate Q2.
 Should demand then collapse, even a company like
Toyota may be stuck with excess manufacturing
capacity and find it wishes to cut output back to the
original level Q1, despite the much higher unit costs
at point A.
 However, as the business cycle recovers, if the firm
can execute a marketing plan to sell still more
output, a still more efficient allocation of resources
is available.
 Only when optimal output increases to Q3, where
the firm will build the universally least cost optimal
plant size represented by SAC3, will further
opportunities for cost reduction cease.
 This concept of optimal capacity utilization applies
to the long run, given the technology in place at this
plant.
 Short-run average total cost with underutilization of
capacity at Point A or overutilization of capacity at
Point B in Figure 8.3 is always higher than the
 minimum average total cost in the long run (LRAC)
fundamentally because the production manager can
vary plant and equipment in the long run, matching
capacity to his or her output requirements .
 Optimal output for a given plant size. Output
rate that results in lowest average total cost for a
given plant size.
 Optimal plant size for a given output rate.
Plant size that results in lowest average total cost
for a given output.
 Optimal plant size. Plant size that achieves
minimum long-run average total cost.
ECONOMIES AND DISECONOMIES OF SCALE
 The long-run average total cost LRAC function is
hypothesized to decline as the flow rate of
throughput rises over the lower range of operations
scale and is hypothesized to remain flat or rise over
the higher range of scale.
 Declining long-run average total cost reflects
internal economies of scale at one of three levels:
the product level, the multiproduct plant level, or
the firm level of operations.
Product-Level Internal Economies of Scale
 A number of different sources of declining cost are
associated with producing one product (say, PCs) at
a higher rate of throughput per day.
 Special-purpose equipment, which is more efficient
in performing a limited set of operations, can be
substituted for less efficient general-purpose
equipment.
 Likewise, the production process can be broken
down into a series of smaller tasks, and workers can
be assigned to the tasks for which they are most
qualified.
 Workers are then able to acquire additional
proficiency through higher repetition of the tasks to
which they are assigned.
 In manufacturing, a related phenomenon called the
learning curve effect has often been observed
whereby the amount of labor input required to
produce another unit of output decreases as the
cumulative volume of output rises (e.g., during long
production runs of 767 airframes at Boeing).
 The learning curve principle was first applied in
airframe manufacturing, shipbuilding, and appliance
manufacturing.
 Learning curve effects and volume discounts in
purchasing inputs (so-called external economies of
scale) are easily distinguished from internal
economies of scale because they depend upon
cumulative volume of output no matter how small
the production throughput rate per time period.
 As such, they may well be associated with no
change in the scale of operations whatsoever; the
firm simply buys large volumes of input at one time.
 The learning curve relationship is usually expressed
as a constant percentage by which the amount of
an input (or cost) per unit of output is reduced each
time production is doubled.

This learning curve relationship plotted in Figure 8.4
can be expressed algebraically as follows:
C = aQb
 where C is the input cost of the Qth unit of output,
Q is consecutive units of output produced, a is the
theoretical (or actual) input cost of the first unit of
output, and b is the rate of reduction in input cost
per unit of output.
 Because the learning curve is downward sloping,
the value of b is normally negative.
 Taking logarithms of both sides of Equation 8.11
yields
log C = log a + b log Q
 Regression analysis can then be used to estimate
the parameters b and log a in order to forecast
costs at various cumulative volumes.
 Internal economies of scale. Declining long run
average costs as the rate of output for a product,
plant, or firm is increased.
 Learning curve effect. Declining unit cost runs
attributable to greater cumulative volume.
 Volume discount. Reduced variable cost
attributable to larger purchase orders.
The Percentage of Learning
 The percentage of learning, which is defined as the
proportion by which an input (or its associated cost)
is reduced when output is doubled, can be
estimated as follows:
 where C1 is the input (or cost) for the Q1 unit of output
and C2 is the cost for the Q2 = 2Q1 unit of output.
Plant-Level Internal Economies of Scale
 Sources of scale economies at the plant level
include capital investment, overhead, and required
reserves of maintenance parts and personnel.
 With respect to capital investment, capital costs
tend to increase less than proportionately with the
productive capacity of a plant, particularly in
process-type industries.
 Another source of plant-level scale economies is
overhead costs, which include such administrative
costs as management salaries and paperwork
documentation associated with regulatory
compliance.
 Overhead costs can be spread over a higher volume
of throughput in a larger plant or facility, thus
reducing average costs per unit.
Firm-Level Internal Economies of Scale
 In addition to product-level and plant-level
economies of scale, other scale economies are
associated with the overall size of the multi plant
firm. One possible source of firm-level scale
economies is in distribution.
 For example, multiplant operations may permit a
larger firm to maintain geographically dispersed
plants.
 Delivery costs are often lower for a geographically
dispersed operation compared with a single (larger)
plant. Another possible source of scale economies
to the firm is in raising capital funds.
 Because flotation costs increase less than
proportionately with the size of the security (stock
or bond) issue, average flotation costs per dollar of
funds raised is smaller for larger firms.
 Similar scale economies also exist in marketing and
sales promotion.
 These scale economies can take such forms as (1)
quantity discounts in securing advertising media
space and time, or (2) the ability of the large firm to
spread the fixed costs of advertising each period
over greater throughput. In addition, the large firm
may be able to achieve a relatively greater degree
of brand recognition and brand loyalty for any given
level of sales promotion expenditures.
Diseconomies of Scale
 Rising long-run average costs at higher rates of
throughput are attributed to diseconomies of scale.
 A primary source of diseconomies of scale
associated with an individual production plant is
transportation costs.
 Another possible source of plant diseconomies is
labor requirements; higher wage rates or costly
worker recruiting and relocation programs may be
required to attract the necessary personnel.
 Finally, large-scale plants are often inflexible
operations designed for long production runs of one
product, based often on forecasts of what the
target market wanted in the past.
 Diseconomies of scale at the firm level result from
problems of coordination and control encountered
by management as the scale of operations is
increased.
 First, the size of management staffs and their
associated salary costs may rise more than
proportionately as the scale of the firm is increased.
 Also, less direct and observable costs may occur,
such as the losses arising from delayed or faulty
decisions and weakened or distorted managerial
incentives.
 Diseconomies of scale. Rising long-run average
costs as the level of output is increased.
The Overall Effects of Scale Economies and
Diseconomies
 For some industries, such as textile and furniture
manufacturing, long-run average costs for the firm
remain constant over a wide range of output once
scale economies are exhausted.
 In such cases, many plant sizes are consistent with
least-cost production, as shown in Figure 8.5. In
other industries (e.g., engine block casting), long-
run average costs rise at large scale.
 The possible presence of both economies and
diseconomies of scale leads to the hypothesized
long-run average cost function for a typical
manufacturing firm being U-shaped with a flat
middle area.
 Up to some minimum efficient scale (MES), that is,
the smallest scale at which minimum long-run
average total costs are attained, economies of scale
are present.
 In most industries, it is possible to increase the size
of the firm beyond this MES without incurring
diseconomies of scale.
 Over this extended middle-scale range, average
costs per unit are relatively constant.
 However, expansion beyond the maximum efficient
scale eventually will result in problems of
inflexibility, lack of managerial coordination, and
rising long-run average total costs.
 Minimum efficient scale (MES). The smallest scale
at which minimum costs per unit are attained.
SUMMARY
 Cost is defined as the sacrifice incurred whenever
an exchange or transformation of resources takes
place.
 Different approaches are used in measuring costs,
depending on the purposes for which the
information is to be used.
 For financial reporting purposes, the historical
outlay of funds is usually the appropriate measure
of cost, whereas for decision making purposes, it is
often appropriate to measure cost in terms of the
opportunities forgone or sacrificed.
 A cost function is a schedule, graph, or
mathematical relationship showing the minimum
achievable cost (such as total, average, or marginal
cost) of producing various quantities of output.
 Short-run total costs are equal to the sum of fixed
and variable costs.
 Marginal cost is defined as the incremental increase
in total cost that results from a one-unit increase in
output.
 The short-run average variable and marginal cost
functions of economic theory are hypothesized to
 be U-shaped, first falling and then rising as output is
increased.
 Falling short-run unit costs are attributed to the
gains available from specialization in the use of
capital and labor.
 Rising short-run unit costs are attributed to
diminishing returns in production.
 The theoretical long-run average cost function is
often found to be L-shaped due to the frequent
presence of scale economies and frequent absence
of scale diseconomies.
 Economies of scale are attributed primarily to
specialization and other features of the production
process or the factor markets, whereas
diseconomies of scale are attributed primarily to
problems of coordination and inflexibility in large-
scale organizations.
 Volume discounts in purchasing inputs and learning
curve effects, both of which result from a larger
cumulative volume of output, can be distinguished
from scale effects, which depend on the firm’s rate
of production throughput per time period.
 Learning curve advantages often, therefore, arise in
small-scale plants able to make long production
runs.
 Minimum efficient scale is achieved by a rate of
output sufficient to reduce long-run average total
cost to the minimum possible level.
 Smaller rates of output imply smaller plant sizes to
reduce unit cost, albeit to higher levels than would
be possible if a firm’s business plan could support
minimum efficient scale production.