Cost Analysis Chapter 7 The Importance of Cost

Cost Analysis Chapter 7 The Importance of Cost Analysis » Managers seek to produce the highest quality products at the lowest possible cost. » Firms that are satisfied with the status quo find that competitors arise that produce at lower costs and drive them out of business. » 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 lower cost methods to produce goods and services. 2005 South-Western Publishing Slide 1

Managerial Challenge: US Airways • US Airways created in mergers with Allegheny, Mohawk, Lake Central, Pacific Southwest and Piedmont Airways. • Mostly in the East, with high cost but high yields (most seats were filled). • But, this situation invites entry by competitors by Continental or others. • The key to US Airways’ survival lays in managing its high cost. Slide 2

Meaning and Measurement of Cost There a number of cost concepts in business. • Opportunity Cost – value of next best alternative use. • Explicit vs. Implicit Cost – actual prices paid vs. opportunity cost of owner -supplied resources. Slide 3

Accounting vs Economic Cost • Accounting costs involve explicit historical costs. They attempt to use the same rules for different firms, so we can compare firm performance. • Economic costs are based on making decisions. These costs can be both implicit and explicit. » A chief example is that economic costs include the opportunity costs of owner-supplied resources such as time and money, which are implicit costs. » Economic Profit = Total Revenues - Explicit Costs Implicit Costs » Both explicit and implicit costs make economic profit lower than accounting profit Slide 4

• Depreciation Cost Measurement. Accounting depreciation (e. g. , straight-line depreciation) tends to have little relationship to the actual loss of value » To an economist, the actual loss of value is the true cost of using machinery. • Inventory Valuation. Accounting valuation depends on its acquisition cost » Economists view the cost of inventory as the cost of replacement. • Unutilized Facilities. Empty space may appear to have "no cost” » Economists view its alternative use (e. g. , rental value) as its opportunity cost. Slide 5

• Sunk Costs -- already paid for, or • • there already exists a contractual obligation to pay Incremental Cost - - extra cost of implementing a decision = TC of a decision Marginal Cost -- cost of last unit produced = TC/ Q SHORT RUN COST FUNCTIONS 1. TC = FC + VC fixed & variable costs 2. ATC = AFC + AVC = FC/Q + VC/Q Slide 6

Short Run Cost Graphs MC ATC 3. 1. AFC Q 2. AVC AFC Q MC intersects lowest point AVC of AVC and lowest point of ATC. When MC < AVC, AVC declines Q When MC > AVC, AVC rises Slide 7

Relationships Among Cost & Production Functions • AP & AVC are inversely related. (ex: one input) • AVC = WL /Q = W/ (Q/L) = W/ APL Q prod. functions AP » As APL rises, AVC falls • MP and MC are inversely related • MC = d. TC/d. Q = W d. L/d. Q = W / (d. Q/d. L) = W / MPL » As MPL declines, MC rises MPL cost AVC L MC cost functions Q (Figure 8. 3 on page 358) Slide 8

Problem Let there be a cubic VC function: VC =. 5 Q 3 - 10 Q 2 + 150 Q 1. find AVC from the VC function above. 2. find minimum variable cost output from AVC. 3. and find MC from the VC function A 1: AVC =. 5 Q 2 -10 Q + 150 (divide by Q) A 2: Minimum AVC is where d. AVC/d. Q = 0 d. AVC / d. Q = Q - 10 = 0 Q = 10, so AVC = 100 @ Q = 10 A 3: MC= d. VC/d. Q= 1. 5 Q 2 - 20 Q + 150 Slide 9

Long Run Cost Functions • All inputs are variable in the long run • LAC is long run average cost SMC 2 SAC 2 LMC » ENVELOPE of SAC curves • LMC is FLATTER than SMC curves • The optimal plant size for a given output Q 2 is plant size 2. (A SR concept. ) • However, the optimal plant size occurs at Q 3, which is the lowest cost point overall. (A LR concept. ) LAC Q 2 Q 3 Q Slide 10

Long Run Cost Function (LAC) Envelope of SAC curves Ave Cost SAC-small capital SAC-med. capital SAC-big capital LAC--Envelope of SRAC curves Figure 8. 4 on page 360 Q Slide 11

Economists think that the LAC is U-shaped • Downward section due to: » Product-level economies which include specialization and learning curve effects. » Plant-level economies, such as economies in overhead, required reserves, investment, or interactions among products (economies of scope). » Firm-level economies which are economies in distribution and transportation of a geographically dispersed firm, or economies in marketing, sales promotion, or R&D of multi-product firms. Slide 12

LAC • Flat section of the LAC CRS region DRS » Displaces constant returns to scale MES Max ES » The minimum efficient scale (MES) is the smallest scale at which minimum per unit costs are attained. • Upward rising section of LAC is due to: » diseconomies of scale. These include transportation costs, imperfections in the labor market, and problems of coordination and control by management. » The maximum efficient scale (Max ES) is the largest scale before which unit costs begin to rise. » Modern business management offers techniques to avoid diseconomies of scale through profit centers, transfer pricing, and tying incentives to performance. Slide 13

Problem Q Suppose we have the following info: TC = 200 + 5 Q -. 4 Q 2 +. 001 Q 3 MC = 5 -. 8 Q +. 003 Q 2 1. 2. 3. 4. FIND fixed cost FIND AVC function FIND AVC at Q = 10 If FC rises $500, what happens to the average variable cost function? Slide 14

TC = 200 + 5 Q -. 4 Q 2 +. 001 Q 3 MC = 5 -. 8 Q +. 003 Q 2 1. FIND fixed cost Answer: FC = 200, the intercept in the TC curve. 2. FIND AVC function Answer: VC = 5 Q -. 4 Q 2 +. 001 Q 3 So AVC = 5 -. 4 Q +. 001 Q 2 (Divide VC by Q) 3. FIND AVC at Q = 10. Answer: Substitute Q = 10 into the AV C function. AVC = 5 -. 4(10) +. 001(102) = 4 – 4 +. 1 = 1. 1. 4. If FC rises $500, what happens to the average variable cost function? Answer: No change, since AVC does not include fixed cost. Slide 15