Managerial Economics: Chapter 6

Cost Analysis
CONTENTS
• Relevant Costs

• The Cost of Production

• Returns to Scale and Scope

• Cost Analysis and Optimal Decisions

COST ANALYSIS

– is the bedrock on which many managerial

decisions are grounded. Reckoning costs

accurately is essential to determining a firm’s
current level of profitability.
RELEVANT COSTS
- A continuing theme of previous chapters is that
optimal decision making depends crucially on a
comparison of relevant alternatives. Roughly speaking,
the manager must consider the relevant pros and cons of
one alternative versus another. Only relevant costs are
those that differ across alternative courses of action.
RELEVANT COSTS

• Opportunity Costs and Economic Profits

• Fixed and Sunk Costs

Opportunity Costs and Economic Profits
Opportunity Cost - the concept of opportunity cost

focuses explicitly on a comparison of relative pros

and cons. The opportunity cost associated with
choosing a particular decision is measured by the
benefits forgone in the next-best alternative.
Examples:

• What is the opportunity cost of pursuing an MBA degree and

giving up your 5 year working in business?

• What is the opportunity cost of choosing to invest in

Company A which provides a return of 6% in 1 year and
rejecting Company B that provides a return of 10% in 1 year?
Economic Profit
Accounting profit is Economic profit is the
the difference difference between
between revenues revenues and all
obtained and expenses economic costs (explicit
and implicit), including
incurred.
opportunity costs.
Example:
An owner of a lumber store reported the following financials for last year. If the owner closed the
store, he would be working at Home Depot earning $80,000 a year and be able to rent the store’s
property (building and land) for $50,000 a year.

Revenue: $1,000,000 Accounting profit?

Staff wages: $300,000 Acct. profit = Revenue - Explicit Costs
Utilities: $10,000 $1,000,000 – 300,000 – 10,000 – 20,000 – 500,000 = $170,000
Insurance: $20,000 Economic profit?
Supplies: $500,000 Economic profit = Revenue – Explicit Cost – Implicit Cost
$1,000,000 – 300,000 – 10,000 – 20,000 – 500,000 – 80,000 – 50,000 = $40,000

Explicit Cost – a cost that involves spending money

Implicit Cost – a non-monetary opportunity cost associated with the owner’s time and the resources owned by
the firm.

Accounting profit is always greater than economic profit

Fixed and Sunk Costs
Fixed Costs are elements of cost that do not vary with the level
of output.

Common fixed business costs: rental lease or mortgage

payments, salaries, insurance payments, property taxes,
interest expenses, depreciation, and some utilities.
Fixed and Sunk Costs
Sunk Costs

- costs that already has been incurred and cannot be recovered.

- money that has already been spent and cannot be recovered.

Examples: Research & development costs, advertising costs,

cost of specialized equipment.
The Cost of Production

Short-Run Costs – in the short run, capital is

a fixed input and labor is the sole variable
input.
The Cost of Production

Variable costs represent the firm’s expenditures on

variable inputs.
The Cost of Production

Average total cost (or simply average cost) is total cost

divided by the total quantity of output.
The Cost of Production

Marginal cost is the addition to total cost that results

from increasing output by one unit.
The Cost of Production

Long-Run Costs - In the long run, the firm can freely

vary all of its inputs. In other words, there are no fixed
inputs or fixed costs; all costs are variable.
The Cost of Production
• Constant returns of scale

• Increasing returns to scale or equivalently,

economies of scale

• Finally, decreasing returns to scale

Returns to Scale and Scope
Returns to Scale – directly determine the shape of long-run average
cost.
Returns to Scale and Scope
Economies of scope - a production process exhibits
economies of scope when the cost of producing multiple
goods is less than the aggregate cost of producing each
item separately.
Cost Analysis and Optimal Decisions
- knowledge off the firm’s relevant cost is essential for
determining sound managerial decision.

a. We consider decisions concerning a single products.

b. We examine decision for multi product firms.

Single Product
- the firm sets it’s optimal output where marginal revenue equals
marginal cost.
Single Product
- the firm sets it’s optimal output where marginal revenue equals
marginal cost.
The Shut-Down Rule
The shutdown rule states that a firm should continue operations as long
as the price (average revenue) is able to cover average variable costs.
Multiple Products
- producing, involving, or offering more than one product it’s part of the
work that you go through when you go from a single-product company,
which is what Apple has largely been, to a multiproduct company.

The firm’s output rule for multiple goods can be stated in two parts:

1. Each good should be produce if and only if it makes a positive

contribution to the firm’s fixed cost.

2. In the long run, the firm should be continue operation if, and only if, it
makes a positive economic profits.