COSTS OF PRODUCTION

What are the costs ‘ Relevant’ to Managerial

Decision Making??
An understanding of the interaction of
businesses and markets, and optimal
managerial decision-making
MANAGER’S OBJECTIVE

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MAXIMIZING
PROFITS ???

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 What is Profit ??

 What are the other factors ?

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 01/11/22
 Profits = TR – TC

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 TR = price/unit * quantity

 TC = cost/unit * quantity

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NATURE OF COSTS

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 EXPLICIT COSTS ( ACCOUNTING COSTS) -
 actual exp. …to hire, rent, or purchase

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inputs……wages, rent of equipment and
building, price of capital, price of RM, and
intermediate products [ FC, VC, MC, AC, SR
& LR costs]
 IMPLICIT COSTS-

 value of inputs owned & used by the

firm….eg., salary that the entrepreneur could
earn in his best alternative employment…
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ACCOUNTING & ECONOMIC
PROFITS…

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 In accounting, only explicit costs or actual
expenditures are considered…

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 In economics, both explicit and implicit/
opportunity costs are taken into account…
i.e., for managerial decision making,
economic or opportunity costs are the
relevant costs..

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EXAMPLE-INVENTORY VALUATION

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 A firm purchased RM for Rs.100/-

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 But price of RM falls to Rs.60/-
 Suppose that the firm has to take a decision
regarding the use of this RM for making a
product…
 The accountant values this RM always at
Rs.100/-, its historical cost..
 So any revenue from the product which is
less than 100 may be considered
‘Unprofitable’ 6
WHAT ARE THE RELEVANT
COSTS(ECONOMIC COSTS) C
FOR MANAGERIAL DECISION MAKING??

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 For the firm Rs. 100/-spent on RM is already
sunk…
 What matters is only the current

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replacement cost- Rs.60/-!!!

 Hence, the decision to produce the product

or not would be on the basis of Rs.60/- and
not Rs.100/- ..

 So any price of the product > or = 60

would be {profitable???!!}
 [See chapter 7 page 288]
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ONE SIMPLE RULE

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If a course of action
generates positive

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Economic ProfiT

Do it

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A MAN WHO NEEDS TO THINK
ABOUT HIS COSTS..

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SOME NUMBERS….

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General Motors
Disaggregated Automotive Income Data, 2003
(all data is extracted primarily from 10-K 2003) Global Total GM North America Only
Per car sold Per car sold
Net Revenues (from Manufactured products) in $ billions 150.0 17,442 112.7 20,719
Total units sold (millions) 8.6 5.44
Costs ($ billions) 155.8 $18,112 116.4 $21,401

Revenue per car Cost per car

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EXECUTIVE MEETING

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 Do we produce the Chevy Malibu this
month?

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 What is the benefit? The cost?

 What decision maximizes our

economic profit?
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MAKE CAR OR NOT?

01/11/22
 Make car? End of month:
 Revenue – Cost = -$682

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 What if we don’t make the
car?

 What do things look like at

the end of the month?
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COST NUMBERS….

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Costs, per car $21,252
Materials, Utilities, Parts etc. 11,149

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Labor 4,868
Jobs Bank 147
Miscellaneous 2,069
Depreciation 1,140
R&D 912
Warranty expense 613
Interest Expense 324
Net Tax Expense (income) 31

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IF WE DON’T
PRODUCE..

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Costs, per car $21,252 Incur Cost?
Materials, Utilities, Parts etc. 11,149

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Labor 4,868
Jobs Bank 147
SG&A 2,069
Depreciation 1,140
R&D 912
Warranty expense 613
Interest Expense 324
Net Tax Expense (income) 31
Costs incurred, if don't produce

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01/11/22 Rajkishan Nair IGSM 2015
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Source: Harris, 01/11/22

IF WE DON’T
PRODUCE..

01/11/22
Costs, per car $21,252 Incur Cost?
Materials, Utilities, Parts etc. 11,149

Rajkishan Nair IGSM 2015

Labor 4,868
Jobs Bank 147
SG&A 2,069
Depreciation 1,140
R&D 912
Warranty expense 613
Interest Expense 324
Net Tax Expense (income) 31
Costs incurred, if don't produce
~90
%

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IF WE DON’T
PRODUCE..

01/11/22
Costs, per car $21,252 Incur Cost?
Materials, Utilities, Parts etc. 11,149

Rajkishan Nair IGSM 2015

Labor 4,868
Jobs Bank 147
SG&A 2,069
Depreciation 1,140
R&D 912
Warranty expense 613
Interest Expense 324
Net Tax Expense (income) 31
Costs incurred, if don't produce
~90
%
Industry experts estimated that around 90% of 17
costs are unavoidable in the short run in this case.
MAKE CAR (THIS MONTH) OR NOT?
 Make car? End of month:

01/11/22
 Revenue – Cost = -$682
 Don’t make the car?

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 What do things look like at the end of the month?
 Revenue – Cost = 0 – 0.9*21,252
= -19,261
 What is the profit maximizing decision?

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SUNK COSTS
 Make the Chevy Malibu if the avoidable

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costs are less than the price per car.
 The unavoidable costs are irrelevant to this
decision.

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 Unavoidable costs are SUNK.
 That is, the firm incurs these in either
event.
 If we took them into account, would make
the wrong choice.

Ignore sunk costs!!

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OPPORTUNITY COST
 What if there is more than one possible

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use of resources? What if the same
avoidable costs could be incurred when

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making a car that brings in greater
revenue?^

 The economic cost of making a Malibu

includes the maximum lost value of using
the resources for any other opportunity.

 Thisis the Opportunity Cost, and should

be included in decision-making. 20
ECONOMIC PROFIT
 Economic profit is revenue less

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avoidable cost, where avoidable

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cost includes opportunity cost and
ignores sunk costs.

 Ifeconomic profit from an action

is greater than zero, take the
action!!
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PRODUCE THIS
YEAR?
 Some costs which are unavoidable

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and hence sunk this month may

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become as “unsunk” and relevant
in a longer-term decision.

 If
you cannot make positive
economic profit over time, get out
of the business!!
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