Cost analysis

Dr. Mohsina Hayat

Costs
• A firm’s total cost of producing a given level of output is the
opportunity cost of the owners
• Everything they must give up in order to produce that amount of output

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The Nature of Costs
• Explicit Costs
• Accounting Costs
• arise from transactions in which the firm purchases
inputs or the services of inputs from other parties
• Economic Costs
• Implicit Costs
• Explicit cost
• Alternative or Opportunity Costs

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Explicit vs. Implicit Costs
• Types of costs
• Explicit (involving actual payments)
• Money actually paid out for the use of inputs

• Implicit (no money changes hands)

• The cost of inputs for which there is no direct money payment

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The Irrelevance of Sunk Costs
• Sunk cost is one that already has been paid, or must be paid,
regardless of any future action being considered
• Should not be considered when making decisions
• Even a future payment can be sunk
• If an unavoidable commitment to pay it has already been made

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 Short-Run Cost
Total fixed cost (TFC) – the cost incurred by the firm that does
not depend on how much output it produces
Total variable cost (TVC) – the cost incurred by the firm that
depends on how much output it produces
Total cost (TC) – the sum of total fixed and total variable cost
at each output level
Marginal cost (MC) – the change in total cost that results from
a one-unit change in output
Average fixed cost (AFC) – total fixed cost divided by the
amount of output
Average variable cost (AVC) – total variable cost divided by the
amount of output
Average total cost (ATC) – total cost divided by the output
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Short-Run Cost Functions
Total Cost = TC = f(Q)
Total Fixed Cost = TFC
Total Variable Cost = TVC
TC = TFC + TVC
Average Total Cost = ATC = TC/Q
Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
Marginal Cost = TC/Q = TVC/Q

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 Short-Run Cost Functions
  TC = 60 +10Q
TC
TC

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Short-Run Cost Functions

Q TFC TVC TC AFC AVC ATC MC

0 $60 $0 $60 - - - -
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55

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 Behind Cost Relationships

• The shape of the TVC curve

is determined by the shape
of the TP curve, which in
turn reflects diminishing
marginal returns.

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Short-Run Cost Curves

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Relationship between different measure of
cost
• Over the range of output AFC and AVC fall, AC also falls
• When AFC falls but AVC increases, change in AC depends
on the rate of change in AFC and AVC.
1. if decrease in AFC > increase in AVC, then AC falls,
2. if decrease in AFC = increase in AVC, AC remains
constant and
3. If decrease in AFC < increase in AVC, then AC increases
AC and MC
• The marginal product curve of the variable input generally rises and then falls,
attributable to the law of diminishing marginal returns.
• As a result, the MC curve will first fall and then rise
• The average product curve rises, reaches a maximum, and then falls, due to the law of
diminishing marginal productivity.
• The average product curve rises, reaches a maximum, and then falls, due to the law of
diminishing marginal productivity.
• When MC falls, AC also fall, over a certain range of output. When MC is falling, the rate
of fall in MC > AC,
• because while MC is attributed to a single marginal unit, AC is distributed over the entire
output.
• Therefore, AC decrease at lower rate than MC.
• When MC increase , AC also increase but at a lower rate for the
reason given in
• Range of output over which the relationship does not exist.
• Over this range of output over, MC begins to increase while AC
continues to decrease. reason is
• When MC starts increasing, it increases at a relatively lower rate that is
sufficient only to reduce the rate of decrease in AC- not not sufficient to push
the AC up.
• MC curve intersects AC curve at its minimum.
• AC continues to decrease, MC begins to rise at the same level of
output. Therefore , they are bound to intersect.
• When AC is at it minimum, it is neither increasing nor decreasing, it is
constant. When AC is constant, AC = MC. That is the point of
intersection.
 Marginal-Average Relationships

When marginal cost is below average (total or variable) cost,

average cost will decline.
When marginal cost is above average cost, average cost rises.
When average cost is at a minimum, marginal cost is equal to
average cost.

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 Geometry of Cost Curves

© 2010 Pearson Addison-Wesley

 Output optimization in the short-run
 
Level of output is optimized at the level of production at the
level of production at which AC =MC.

A
A + 5 + 2Q
MC = 5 + 4Q
AC = MC
+ 5 + 2Q = 5 + 4Q
Q = 10

© 2010 Pearson Addison-Wesley

 Long-Run Cost Curves

LAC curve is also known as the Envelope curve or planning curve as it serve as a guide to the
entrepreneur in his plans to expand production.
LAC relate to return to scale
© 2010 Pearson Addison-Wesley
Economies of Scale and Diseconomies of
Scale
• Economies of scale – a situation in which a firm can increase its
output more than proportionally to its total input cost
• Diseconomies of scale – a situation in which a firm’s output increases
less than proportionally to its total input cost
Long-Run Cost Curves

Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/Q
Long-Run Marginal Cost = LMC = LTC/Q
 Derivation of Long-Run Cost Curves

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 Relationship Between Long-Run and Short-Run Average Cost Curves

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Optimum plant size and long run cost curves

Optimum size of a firm is one which ensures the most efficient utilization of resources.
Optimum size of the firm is one that minimizes the LAC.
Given the state of technology over time, a firm aiming to minimize its average cost over time must choose
a plant that the most efficient utilization of the resources.
The learning curve

A learning curve is a concept that graphically depicts the relationship between the cost and
output over a defined period of time, normally to represent the repetitive task of an employee
or worker. The learning curve was first described by psychologist Hermann Ebbinghaus in 1885
and is used as a way to measure production efficiency and to forecast costs.
learning curve is downward sloping in the beginning with a flat slope toward the end, with the
cost per unit depicted on the Y-axis and total output on the X-axis. As learning increases, it
decreases the cost per unit of output initially before flattening out, as it becomes harder to
increase the efficiencies gained through learning.
Benefits of Using the Learning Curve
The learning curve does a good job of depicting the cost per unit of output over time. Companies know how much an
employee earns per hour and can derive the cost of producing a single unit of output based on the amount of hours
needed. A well-placed employee who is set up for success should decrease the company's costs per unit of output
over time. Businesses can use the learning curve to conduct production planning, cost forecasting and logistic
schedules.
The slope of the learning curve represents the rate in which learning translates into cost savings for a company. The
steeper the slope, the higher the cost savings per unit of output. This standard learning curve is known as the 80%
learning curve. It shows that for every doubling of a company's output, the cost of the new output is 80% of the prior
output. As output increases, it becomes harder and harder to double a company's previous output, depicted using
the slope of the curve, which means cost savings slow over time
Break-even analysis: Profit Contribution
analysis
Profit Contribution analysis/ cost-volume profit analysis
It is a relationship between total cost, total revenue , total profit
and loss over the whole range of output
Break even analysis under Linear cost & revenue functions
TC = 100+10Q
TR = 15Q
P = 40
TFC = 200
AVC = 5
QBE = 40
Cost-Volume-Profit Analysis

  Total Revenue = TR = (P)(Q)

Total Cost = TC = TFC + (AVC)(Q)
Breakeven Volume TR = TC
(P)(Q) = TFC + (AVC)(Q)

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Cost-Volume-Profit Analysis
 break even analysis chart used to measure the Contribution made by business activity towards covering
fixed costs.
Profit volume analysis
PV =

BEP (sales Value) =

PV ratio is not only helpful in finding the break-even point but it can be used for making a choice of the
product.
If there is no time constraint, the choice should always be for a product that have a higher PV ratio

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e.g.
• Suppose two products A and B involve the following variable cost and
price
• PV ratio for A =50% and for each machine PV ratio = 50/2 = 25%
• PV ratio or B = 40%

Product A B
Selling price per unit 2 2.5
Variable cost per unit 1 1.5
Machine hour per unit 2 1.0
Margin safety
•  The margin of safety is given by the difference between the sales at
break-even point and actual sales.
• Margin of safety =
• Margin of safety =
• Margin of safety =
• Where Sa = actual sales and Sb = sales at BEP
• Margin of safety can be increased by increasing the selling price,
provided the sale is not seriously affected. When ddd for product is
inelastic
 Empirical Estimation
Functional Form for Short-Run Cost Functions

Theoretical Form Linear Approximation

TVC  aQ  bQ 2  cQ 3 TVC  a  bQ

TVC a
AVC   a  bQ  cQ 2
AVC   b
Q Q

MC  a  2bQ  3cQ 2 MC  b

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 Minimizing Costs Internationally
• Foreign Sourcing of Inputs
• New International Economies of Scale
• Immigration of Skilled Labor
• Brain Drain

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