Costs & Extent Decisions

By: Dr. Shirley Catley-Rinoza

Institute of Accounts, Business, & Finance
Far Eastern University, Manila

Learning Objectives: Students should be able to :

• Understand the impact of costs to the business
• Comprehend how different costs relate to each other
• Determine the most profitable output in terms of costs and revenue
• Apply cost analysis in managerial decisions
•
Outline:
• Review on Production Costs
• Marginal Costs
• Marginal Revenue
• Relationships Between Costs
• Extent Decisions
• Marginal Analysis
• Costs & Revenue
• Fixed Costs (FC) – costs that remain constant throughout the production period
• Variable Costs (VC) – costs that change with the output level
• Total Cost (TC) – the sum of all fixed costs & variable costs employed
• Average Cost or Average Total Cost (ATC) – cost of producing each unit, obtained by
dividing total cost by total output (Q).
• The total cost increases by an amount equal to the variable cost.
• The average cost will increase or decrease due to the change in variable cost, but it does
not inform about the most profitable output level ; whether to increase or decrease the
output in relation to profit.

Marginal Cost and Marginal Revenue – provide the information for extent decisions
• Marginal Cost – the additional cost for producing one more unit
• Marginal Revenue – the additional revenue for producing one more unit
• Marginal Cost & Marginal Revenue
• Marginal Cost (MC) = Change in Total Cost divided by change in Total Output
• MC = change in TC/ change in Q
• Marginal Revenue (MR) = Change in Total Revenue divided by change in Total Output (Q)
• MR = change in TR/change in Q
• Calculating for the Marginal Revenue
 Costs & Extent Decisions
By: Dr. Shirley Catley-Rinoza
Institute of Accounts, Business, & Finance
Far Eastern University, Manila

Comparing Marginal Cost and Marginal Revenue

• Relationships Among MC, ATC & AVC

Initially, both ATC and AVC are high, but with

Increasing output, are declining because these
costs are spread over larger outputs. Their
decline
Is due to the lower MC. Both ATC & AVC start to
rise as MC gets higher than them because of the
diminishing marginal returns; which implies that
the additional units are costlier to produce.
low marginal costs of production first pull down
average costs and then higher marginal costs
pull them up.

2 categories of decisions:
• All-or-none decisions
• the manager chooses either to do something or not. Some examples are whether or
not to enter a new market, whether or not to adopt a new technology, and whether
or not to eliminate a product line. The rule for making an all-or-none decision is
simple--if the benefit exceeds the cost, do it!
• Extent Decisions
• requires the manager not only to choose whether or not to do something, but also
to decide the extent of that activity. Examples are how many units of product to
produce, what to spend on advertising, and how many employees to hire.
• (https://www.swlearning.com/mba_primer/product/economics/less2/e24.htm)
 Costs & Extent Decisions
By: Dr. Shirley Catley-Rinoza
Institute of Accounts, Business, & Finance
Far Eastern University, Manila

Extent Decisions
• Decisions involving “how much” and “how many” Questions
• Production decisions at the marginal:
• how many more? How much more? To increase profit
• When confronted with extent choices, the manager can use the principle of maximum net
advantage, which states that, to get the most net gain, you must choose the quantity at
which marginal benefit is equal to marginal cost. For example, if it costs a hotel $25,000 to
have 100 guests and $25,020 for 101 guests, the marginal cost of the one additional guest
is $20 ($25,020 - $25,000).
• If the marginal benefit of one additional guest is greater than its additional cost, then it
pays to increase the accommodation beyond 100 guests, but stop accommodating more
when its MR=MC
• Sell more if MR > MC; sell less if MR < MC. If MR = MC, you are selling the right amount
(maximizing profit!).
• An incentive compensation scheme that increases marginal revenue or reduces marginal
cost will increase effort. Fixed fees have no effects on effort.

(http://www.swlearning.com/mba_primer/product/economics/less2/e24.htm)
Froeb, et.al.Managerial Economics.5th ed. 2018 Cengage Learning
• Marginal Analysis
• Memorial Hospital
• the MC of a delivery was $3,000
• The MR was $5,000
• Therefore, MR>MC so the hospital was not delivering enough babies
• Increase the deliveries up to that point when MR=MC
• TV Ad cost to get one more customer :
• MCTV is $50, If the marginal revenue (MR) generated by this customer is greater than $50,
do more advertising.

Marginal Analysis
• Competing Strategies: Telephone ads or TV ads
Estimated MCPH = $100= ($10,000 / 100)
• So, to get one more customer costs $50 for TV and $100 for phone
MCPH > MCTV so shift ad dollars from phone to TV
• Pay to Performance: flat rate or incentive pay?
• A consulting firm COO received a flat salary of $75,000
• After learning about the benefits of incentive pay
in class, the CEO changed COO compensation to
$50K + (1/3)* (Profits-$150K)
• Profits increased 74% to $1.2 M
Costs & Extent Decisions
By: Dr. Shirley Catley-Rinoza
Institute of Accounts, Business, & Finance
Far Eastern University, Manila
• Compensation increased $75Kg$177K

• Supplemental lessons on Costs

• Watch this videoclips for the basic calculations on costs -
https://courses.lumenlearning.com/wm-microeconomics/chapter/average-costs-and-
curves/
• Watch this videoclip for the explanation on the relationship between average total cost
and marginal cost -
• https://www.youtube.com/watch?v=C3m9FC3T3vw
• References:
• https://courses.lumenlearning.com/wm-microeconomics/chapter/average-costs-and-
curves/
• https://opentextbc.ca/principlesofeconomics/chapter/7-2-the-structure-of-costs-in-the-
short-run/
• https://www.swlearning.com/mba_primer/product/economics/less2/e24.htm
• Froeb, et.al.Managerial Economics. 5th ed. 2018 Cengage Learning