Ch.

9 – Application
of Cost Theory
Managerial Economics Applications Strategy and
Tactics p. 275

Slide 1
 Applications of
Cost Theory
Chapter 9
Topics in this Chapter include:
• Estimation of Cost Functions using regressions
» Short run -- various methods including polynomial
functions
» Long run -- various methods including
• Engineering cost techniques
• Survivor techniques
• Break-even analysis and operating leverage
• Risk assessment
2005 South-Western Publishing Slide 2
 Cost Function
• A schedule, graph, • To accept an order
or mathematical offered at a specific
relationship price, the firm
showing total, needs to know the
average, and variable and direct
marginal cost of fixed costs the
producing various order entails.
quantities of output.

Slide 3
 Short Run Cost-Output
Relationships
• Typically use TIME SERIES data for a plant or
for firm, regression estimation is possible.
• Typically use a functional form that “fits” the
presumed shape. cubic is S-shaped
• For TC, often CUBIC or backward S-shaped

• For AC, often QUADRATIC

quadratic is U-shaped or arch shaped.

Slide 4
What Went Wrong
With Boeing?
• Airbus and Boeing both produce large capacity
passenger jets
• Boeing built each 747 to order, one at a time, rather
than using a common platform
» Airbus began to take away Boeing’s market share through
its lower costs.
• As Boeing shifted to mass production techniques,
cost fell, but the price was still below its marginal
cost for wide-body planes
Slide 5
 Estimating LR Cost Relationships
• Use a CROSS AC
SECTION of firms
» SR costs usually LAC
uses a time series
• Assume that firms
are near their
lowest average cost
for each output
Q
Slide 6
 Economies of Scale vs
Economies of Scope
• Economies of Scale • Economies of
refer to the cost advantage Scope occur
experienced by a firm
whenever inputs
when it increases its level
of output. It arises due to can be shared in the
the inverse relationship production of
between per-unit fixed cost different products
and the quantity produced.
The greater the quantity of
output produced, the lower
the per-unit fixed cost.
Slide 7
 Engineering Cost Approach
• Engineering Cost Techniques offer an alternative to fitting
lines through historical data points using regression analysis.
• It uses knowledge about the efficiency of machinery.
• Some processes have pronounced economies of scale,
whereas other processes (including the costs of raw materials)
do not have economies of scale.
• Size and volume are mathematically related, leading to
engineering relationships. Large warehouses tend to be
cheaper than small ones per cubic foot of space.

Slide 8
 Survivor Technique
• The Survivor Technique examines what size of
firms are tending to succeed over time, and what
sizes are declining.
• This is a sort of Darwinian survival test for firm
size.
• Presently many banks are merging, leading one to
conclude that small size offers disadvantages at
this time.
• Dry cleaners are not particularly growing in
average size, however.
Slide 9
 Break-even Analysis
• We can have multiple B/E (break-
Total even) points with non-linear costs &
Cost revenues.
• If linear total cost and total revenue:
» Total Revenue TR = P x Q
Total » Total Cost TC = F + (V x Q)
Revenue • where V is Average Variable
Cost per Unit
• F is Fixed Cost
• Q is Output or units
Q • P is selling Price per Unit
B/E B/E • cost-volume-profit analysis
Slide 10
 The Break-even Quantity: Q B/E
• At break-even: TR = TC
» So, P•Q = F + V•Q TR
• Q B/E = F / ( P - V) = F/CM
» where CONTRIBUTION
MARGIN is: CM = ( P - V)
PROBLEM: As a garage TC
contractor, find Q B/E
if: P = $9,000 per garage
V = $7,000 per garage
& F = $40,000 per year
B/E Q
Slide 11
Answer: Q = 40,000/(2,000)= 40/2 = 20
garages at the break-even point.

Break-even Sales Volume

• Amount of sales revenues that
breaks even or where Total Ex: At Q = 20,
Revenue equals Total Costs B/E Sales Volume is
• P•Q B/E = P•[F/(P-V)] $9,000•20 =
$180,000 Sales Volume
= F / [ 1 - V/P ]

Variable Cost Ratio

Slide 12
 Limitations of Break Even and
Contribution Margin
• Assumes that Costs • Assumes that
can be classified selling price,
into fixed and variable and fixed
variable costs costs are known at
• Assumes constant each level of output
product mix • Operating costs is
matched with
resulting revenues
is the same period
Slide 13
 Target Profit Output

 Quantity needed to attain a target

profit
 If is the target profit, Q target 
= [ F + ] / (P-V)
Suppose want to attain $50,000 profit, then,

Q target  = ($40,000 + $50,000)/$2,000

= $90,000/$2,000 = 45 garages
Slide 14
Degree of Operating Leverage (DOL)
or Operating Profit Elasticity

• DOL = E
» sensitivity of operating profit or Earnings
Before Interest and Taxes (EBIT) to changes
in output
• Operating  = TR-TC = (P-v)•Q - F
• Hence, DOL = (P-v)•Q / [(P-v)•Q - F]

DOL is a measure of the importance of Fixed Cost

or Business Risk to fluctuations in output
Slide 15
 Suppose the Contractor Builds 45
Garages, what is the D.O.L?
• DOL = (9000-7000) • 45 .
{(9000-7000)•45 - 40000}
= 90,000 / 50,000 = 1.8
• A 1% INCREASE in Q  1.8% INCREASE
in operating profit.
• At the break-even point, DOL is INFINITE.
» A small change in Q increase EBIT by
astronomically large percentage rates

Slide 16
 Operating Profit and the Business Cycle

peak EBIT =
operating
profit
Output

Trough TIME
recession 2. EBIT tends to
1. EBIT is more volatile collapse late in
that output over cycle recessions
Slide 17
Review Question 1

Slide 18
 Answer to Question 1
• Since Break Even = Fixed costs / (Price –
Variable cost)
a. BE will increase since the contribution margin
(Price less Variable Costs) will decrease
b. BE will increase since labor is part of Fixed
Costs
c. BE will increase since the requirement entails
additional fixed costs

Slide 19
Review Question 2

Slide 20
 Answer to Question 2
• Fixed Costs = 12,000,000 which is 60% of
Total Costs since Variable Costs is 40% of
Total Costs
• Total Costs = 12,000,000 / .60 = 30,000,000
• Total Costs = Break-Even Sales Volume
• BE Sales Volume = 30,000,000

Slide 21