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. 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 = DTTC/DQ =  (TTC)/ Q marginal cost is the cost of the

last item produced
whole or 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-
• Not a function of Q shaped.
• 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 U-
• MC = d(TVC)/dQ = 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
© 2014 overall.
Cengage Learning. All (a LR
Rights concept)
Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in
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 of individually designed products.
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.
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
costs begin to rise.
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 08

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CHAPTER 8

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

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

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

5. MC = DTTC/DQ =  (TTC)/ Q marginal cost is the cost of 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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