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Dr.

Karim Kobeissi

Chapter 6: Cost Analysis

C o s t - D e fi n i t i o n
Sum of the inputs may
multiplied
respective

by
prices

their
and

added together give the


money

value

of

the

inputs, that is the cost of


production.

What Makes Cost Analysis Difficult?

Cost analysis is madedifficult by the


effects

of

unforeseen

inflation,

unpredictable changes in technology,


and the dynamic nature of input and
output market.

Why Cost Analysis is Important?


You may have heard the phrase "if they had just done
a simple cost-benefit analysis" used in critiquing
a decision. There are different types of costs with
different impacts on a decision. Understanding the
different types of costs and their impacts will help us
make better decisions, and hopefully help us avoid
being asked why we didn't use a cost-benefit analysis.

The Different Types of Cost


Historical Vs Current Costs
Historical Cost is the actual cash outlay (acquisition

cost adjusted for depreciation and, in some cases,


damages).
Current

Cost

is the present cost of previously

acquired items.

For example, Computers cost much

less todaythan they did just a few years age.


Therefore, current cost for such items is determined
by what is referred to as a replacementcost which is
defined as the cost of duplicating these items by using
the current technology.

The Different Types of Cost ( c o n )


Explicit Vs Implicit Costs
Explicit Costs are defined as the out of pocket money.
Implicit Costs are noncash expenses. An example of an
implicit cost is theopportunity costof a sole proprietor working
in his/her own business. For example, Gina works as a sole
proprietor and her business reported anet income(revenuesexpenses) of $30,000 for the year. Since a sole proprietor does
not receive a salary, there is no explicit cost reported for Gina's
work in her business. However, if Gina is foregoing a salary of
$40,000 from another company, that is an implicit cost for her
business. After considering this implicit cost, Gina is losing
$10,000 by working in her proprietorship.

The Different Types of Cost ( c o n )


Sunk Vs Incremental Costs
Sunk costs , also known as fixed costs, are
irreversible expenses incurred previously. They are
irrelevant to present decisions. For example, if
you decide to have your employees work three shifts
instead of two, your rent should stay the same.
Incremental cost, also known as variable cost, is
the change in cost tied to a managerial
present decision. For example, If you pay your
employees hourly and you need them to work more
hours, your labor costs will increase incrementally.
N.B. Incremental cost can involve multiple units of
output.
Marginal cost involves a single unit of output.

Sunk Costs
In the 1970's Lockhead spent $ 1
billion
developing a new airplane (Tristar).
After
sinking the money, it was clear that
the venture was not going to be a
success.
Lockhead went to its creditors, and
asked
for more money, saying, We have to

Sunk Costs
Some of the creditors said, Why put
in
more money, since there is no way we
can

Who
right?

was

Sunk Costs
Answer: Both arguments are wrong.
The billion dollar initial investment is
a sunk cost that is irrelevant to
the decision.

We

should

extra

compare
revenue

the
of

Dont cry over spilt


milk

Sunk Costs
In the long run, Some fixed costs
remain sunk while others might not
be.
For example, In the long run, you can
sell your factory and exit the industry
if the profits remain negative.

The Different Types of Cost ( c o n )


Short-run Vs Long-run Costs
In the short run, at least one input (e.g. factory size) is fixed.
The short run cost is the cost of production at variousproduction
(output) levels for a specific plant size and a given operating
environment The short run cost function for a particular factory
is the relationship between output and cost; i.e., the cost that is
incurred (Yi) in producing various levels of output (Xi). There for
total short-run cost(TC) can be classified into fixed cost FC
(stays constant no matter what level of output; e.g., rent) and
variable cost VC - (vary with the level of output ; e.g., power
bills):

TC = FC + VC.

Short Run Cost Table

The Short-run Cost Curves Show Minimum Cost in a


Given Production Environment

The Different Types of Cost ( c o n )

- In the long run, costs are all variable. This means that even
capital (e.g., plant) can be altered. Output level can be
changed by changing both capital and labor. We say that
changing the amount of capital that a producer uses is
changing

its"scale.

By changing scale in the long run, a firm can


choose which short run average total cost curve
it wants to have Choose the IDEAL factory for
producing

that

level

of

output

(Quantity

Long Run Average Total Cost


(LRATC)
TheLong
Run
Average
Total
Cost
(LRATC)curve of a firm shows the minimum
average total cost at which a firm can produce
any given level of output in the long run (when
all inputs are variables).
In the long run, a firm will use the level of capital
(or other inputs that are fixed in the short run)
that can produce a given level of output at the
lowest possible average cost. Consequently, the
LRATC curve is theenvelopeof the short run
average total cost (SRATC) curves, where each
SRATC curve is defined by a specific quantity of
capital (or other fixed input).

a producer could select between (each corresponding


specific plant), and then draw another curve containing all of
the new curve is called the long run average total cost
(LRATC) that shows the minimum cost in an
environment.

to a
these,
curve
ideal

Average Cost Per Unit

QD
Plant Optimal
Size with

Qi

The Different Types of Cost ( c o n )

The long run cost function shows


the

cost

various

of

production

plant

sizes

operating
reflects

the

conditions.
economies

at
and
It
and

diseconomies of scale which are


a helpful guide for decisions-

Economies of Scale
ECONOMIES

OF

SCALE

(increasing returns to scale) Exist when long-run average


total cost (LRATC) decrease
as production increase.
This cost decrease is mainly
dueto labor specialization,
commercial,

financial

managerial advantages, and


applying better technology.

Constant Returns to Scale (CRTS)


CONSTANT RETURNS TO
SCALE - Exist when long
run

average

total

cost

(LRATC) do not change as


production increases.

It is shown by the flat


portion of the LRATC
curve.

Minimum Efficient Scale (MES)

Minimum Efficient Scale (MES)

The point at which the increase


in the scale of production yields
no significant unit cost benefits.
MES is the lowest point where
the plant (or firm) can produce
such that its long run average
cost is minimum.

Diseconomies of Scale
DISECONOMIES OF SCALE
-

Exist

when

long-run

average total cost (LRATC)


increase

as

production

increase.
This cost decrease is mainly
dueto

administrative

disadvantage of large scale


when the firm size expand
beyond the optimal size.

S h a p e o f t h e L RATC C u r v e
The shape of the LRATC curve is important not only because of its
implications for plant scale decision but also because of its effects on the
potential level of competition especially when it declines in some
industries. Competition in the industry is most vigorous when MES
is small in absolute terms.
(U) Shape LRATC Industry With Strong Competition:
Industries with low fixed costs.

(L) Shaped LRATC - Industry With Weak Competition:


Industries with high fixed costs.

Cost Volume Profit Analysis


A- Profit Maximization Analysis
B- Breakeven Analysis

A- Profit Maximization Analysis

Assume that (X) company has the following:


Operations centralized at single plant initially
Estimated demand is given by P = 940 - 0.02Q
Estimated marginal revenu (derived equation) MR = 940 0.04Q
Cost structure is given by TC = 250,000 + 40Q + 0.01Q 2
1) Compute Maximum Profit Activity Level (Q*)
2) Compute (P*)
3) Compute Maximum Profit
4) Compute the quantity for which the short run average cost is
minimum (QCM)
1- The profit maximizing activity level (Q*) with centralized production
occurs when MR - MC = 0 MR = MC Or MC = derivative (TC) = 0.02
Q + 40 940 0.04Q = 0.02 Q + 40 0.06 Q = 900 Q* = 15000
Units.
2- Q* = 15000 P* = 940 - 0.02Q = 640 $
3- Maximum Profit = TR - TC = [(P* . Q*) - TC] = (15000 X 640) - [250000
+(40 X15000) +[0.01 X (15000)2 ]] = 6500000 $
4- Minimum cost occurs when AC = MC (TC / Q) = MC
250,000/Q + 40 + 0.01Q = 0.02 Q + 40 (QCM) = 5000 Units.

B- Breakeven Analysis

Thebreak-even
point
is
thepointat which total revenue
(P. X) and total cost (F + V.X) are
equal. It represents the number
of units produced and sold (X)
needed to make the total cost
equal to the total revenue:
P.X = F + V.X
X = F / (P-V)
Where:
V= Variable cost per unit
F= Fixed costs
P = Price of unit sold