Chapter 08

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.
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 Americas 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.
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.
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.
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.
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 = TTC/Q = (TTC)/Q marginal cost is the cost
of the last item produced
whole or in part.
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.
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.
SUPPOSE WE HAVE THE EQUATION:

TTC = 100 + 60Q -3Q2 + 0.10Q3
What is TFC?
Notice TTC is cubic or

100
S-shaped.
Not a function of Q
Notice the MC is
What is TVC?
quadratic, which is U TVC = 60Q -3Q2
shaped.
+ .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
whole or in part.
11
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)
2014
However,
the optimal plant size occurs at Q3,accessible
which
is
Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly
website, in
whole or in part.
12
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.
Lees 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 of individually designed products.
whole or in part.
13
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 = aQb,
where C is the input cost of the Q th unit,
which is a function of consecutive units of
output produced.
Taking the (natural) logarithm of both
sides, we get: log C = log a + blog Q
whole or in part.
14
LEARNING CURVE RELATIONSHIP

Figure 8.4: Learning Curve: Arithmetic Scale
whole or in part.
15
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 = 2Q1).
If the percentage of learning, L = 82%,
then input costs decline 18% as output
doubles.
whole or in part.
16
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.
whole or in part.
17
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.
whole or in part.
18
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 costs begin to rise.
whole or in part.
19
AUTO PRODUCTION: MINIMUM EFFICIENT

SCALE
Figure 8.6
At Ford, cars made

from aluminum has a
minimum efficient
size of 50,000 units
(A)
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.
whole or in part.
20

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CHAPTER 8

THE IMPORTANCE OF COST

MANAGERIAL CHALLENGE: GENERAL

MEANING AND MEASUREMENT

There are many cost concepts used in business.

Accounting vs. Economic Cost

THREE CONTRASTS BETWEEN

2. Inventory Valuation: Accounting

3. Sunk Cost of Underutilized

SHORT-RUN COST FUNCTIONS

MC intersects lowest point of AVC and lowest point of

SUPPOSE WE HAVE THE EQUATION:

Notice TTC is cubic or

LONG-RUN COST FUNCTIONS

LONG-RUN COST FUNCTION (LRAC)

The optimal plant size for a given output Q2 is SATC2. (a

ECONOMIES AND DISECONOMIES OF

LEARNING CURVE RELATIONSHIP

LEARNING CURVE RELATIONSHIP

ECONOMIES AND DISECONOMIES

Rising long-run average costs

FIGURE 8.5: U-SHAPED LRAC

Flat section of the LRAC

AUTO PRODUCTION: MINIMUM EFFICIENT

At Ford, cars made

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