Cost Analysis

Chapter 8
Cost Analysis
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in
whole or in part.
The Importance of Cost Analysis
» Managers seek to make the most efficient
use of resources to maximize value, at the
lowest possible cost.
» The advantages once assigned to being a
large firm (economies of scale and scope)
have not provided the advantages of
flexibility and agility found in some smaller
companies.
» Cost analysis is helpful in the task of finding
the lowest cost methods to produce goods
and services.
whole or in part. 2
Managerial Challenge: General Motors
• In 2009, Toyota became the top selling auto brand in
North America; but, GM was still the largest car
company.
• With high labor rates, low-cost competitors, and
market contraction in 2008, GM had to look for cost
saving methods of production.
• By 2010, North America’s auto sale rebounded 20
percent.
• Government-assigned bailouts, gave collective
bargaining right to General Motors to hire “tier two”
laborers at half pay, which helped increase its
profitability.
whole or in part. 3
Meaning and Measurement of Cost
• There are many cost concepts used in business.
• Measurement of cost is a function of the purpose for which
the cost information is used.
• Accounting vs. Economic Cost
•Accounting costs involve explicit historical costs.
•Economic costs are based on making decisions. These costs
can be both implicit and explicit (labor, rent, supplies etc.).
•A chief example is that economic costs include the opportunity
costs (value of next best alternative use) of owner-supplied
resources, such as time and money, which are implicit costs.
•Economic Profit = Total Revenues - Explicit Costs - Implicit Costs
•Implicit costs make economic profit lower than accounting
profit.
whole or in part. 4
Three Contrasts between Accounting &
Economic Cost:
1. Depreciation Cost Measurement: Accounting
depreciation cost (e.g., straight-line depreciation)
tends to be different from economic depreciation
cost.
• Economic depreciation cost considers opportunity
cost; accounting depreciation cost considers historical
cost.
2. Inventory Valuation: Accounting valuation
depends on its acquisition cost.
• Economists view the cost of inventory as the cost of
replacement.
whole or in part. 5
3. Sunk Cost of Underutilized Facilities: Empty
space may appear to have "no cost”
• Economists view its alternative use (e.g.,
rental value) as its opportunity cost.
• Sunk Costs – already paid for, or there
already exists a contractual obligation to
pay
whole or in part. 6
SHORT-RUN COST FUNCTIONS
• TC = FC + VC total cost (TC) is the sum of Fixed Cost

(FC) and Variable Cost (VC)
2. AFC = FC/Q average fixed cost is FC divided by Q
3. AVC = VC/Q average variable cost is VC divided by Q
4. ATC = TTC/Q = AFC + AVC average total cost is the

sum of AFC and AVC.
5. MC = ΔTTC/ΔQ = ∂ (TTC)/ ∂ Q marginal cost is the

cost of the last item whole orproduced
in part. 7
Figure 8.1
• TFC is $150
• Adding TFC to
TVC is an
upward shift of
cost to make
TTC
• An S-shaped
TVC gives an
S-shaped TTC
whole or in part. 8
Figure 8.1
• MC intersects lowest point of AVC and lowest point of

• ATC.
• When MC < AVC, AVC declines When MC > AVC, AVC
rises
whole or in part. 9
Suppose we have the equation:
TTC = 100 + 60Q -3Q2 + 0.10Q3
• What is TFC?
• 100 • Notice TTC is cubic or
S-shaped.
• Not a function of Q
• Notice the MC is quadratic,
• What is TVC? which is U-shaped.
• TVC = 60Q -3Q2 + .1Q3
• Notice also that TVC is
• What is MC? quadratic, which also
• MC = d(TVC)/dQ = U-shaped.
60 - 6Q + .3Q2
whole or in part. 10
Long-Run Cost Functions
•All inputs are variable in the long run.
•LRAC is long-run average cost

• Envelope of SRAC curves
Long-Run Cost Function (LRAC) Envelope
of SRAC curves
Figure 8.3
• The optimal plant size for a given output Q2 is SATC2. (a SR concept)
• However, the optimal plant size occurs at Q3, which is the lowest cost
point overall. (a LR concept)
Economies and Diseconomies of Scale
1. Product-level Internal Economies of Scale
involves declining cost associated with a product, as a firm
increases production or throughput per day due to volume
discounts, specialization, mass customization , and learning
curve effects.
• Mass customization is designed to standardize at least
some of the production processes associated with fulfilling
customer orders.
• Lee’s customers can choose their own back-pocket
stitching and the number of prior stone washings at a mall
kiosk. Lee assembles the custom order from stockpiles of
subassemblies.
• Economies offered in the mass production of items helps
to offset the expense whole of individually designed products. 13
or in part.
Learning Curve Relationship
• Workers and management become more
efficient with experience.
• The cost of production declines as the
cumulative volume of output increases.
• Functionally, the learning curve relationship
can be written C = a·Qb, where C is the input
cost of the Qth unit, which is a function of
consecutive units of output produced.
• Taking the (natural) logarithm of both sides,
we get: log C = log a + b·log Q
Learning Curve Relationship
Figure 8.4: Learning Curve: Arithmetic Scale
Percentage of Learning
• The proportion by which costs are reduced

through DOUBLING output is estimated as
follows:
L = (C2/C1)·100%
• where C1 is the input or cost for the Q1 unit
of output and C2 is the input or cost for the
Q2 unit of output (and Q2 = 2•Q1).
• If the percentage of learning, L = 82%, then
input costs decline 18% as output doubles.
Economies and Diseconomies of Scale
2. Plant-level Internal Economies of Scale
involves producing several products at the
same plant. These include economies in
overhead, required reserves, investment, or
interactions among products (economies of
scope).
3. Firm-level Internal Economies of Scale occur
in firms with several plants. These include
economies in distribution and transportation
of a geographically dispersed firm, or
economies in marketing, sales promotion. 17
whole or in part.
Diseconomies of Scale
• Rising long-run average costs with an
increase in output
• Sources include transportation costs,
inflexible operations designed for long
production runs, and problems of
coordination and control by
management.
Figure 8.5: U-shaped LRAC
• Flat section of the LRAC

• Displays constant returns to scale
• The minimum efficient scale (MES) is the smallest scale at which
minimum long-run average total costs are attained.
• The maximum efficient scale (Max ES) is the largest scale before which
unit
© 2014 Cengage costs
Learning. All begin to rise.
Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in
Auto Production: Minimum Efficient Scale
• At Ford, cars made from
aluminum has a minimum
efficient size of 50,000
units (A)
Figure 8.6
• Cars made from steel has a
MES of 300,000 units (C)
• Hence, Ford can change its
products faster if it uses
aluminum, even if 10%
more costly.

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Chapter 8

• TC = FC + VC total cost (TC) is the sum of Fixed Cost

2. AFC = FC/Q average fixed cost is FC divided by Q

3. AVC = VC/Q average variable cost is VC divided by Q

4. ATC = TTC/Q = AFC + AVC average total cost is the

5. MC = ΔTTC/ΔQ = ∂ (TTC)/ ∂ Q marginal cost is the

• MC intersects lowest point of AVC and lowest point of

•LRAC is long-run average cost

• The optimal plant size for a given output Q2 is SATC2. (a SR concept)

• The proportion by which costs are reduced

• Flat section of the LRAC

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