What is Cost?

Cost is the monetary value that a company has spent in order to produce something.

Sellers point of view

Buyers point of view

What Makes Cost Analysis Difficult?

Link Between Accounting and Economic Valuations
Accounting and economic costs often differ.

Historical Cost
When costs are calculated for a firms income tax returns, the law requires use of the actual amount spent to purchase the labor, raw materials, and

capital equipment used in production.

Current cost
Current cost is the amount that must be paid under prevailing market conditions. Current cost is influenced by market conditions measured by the number of buyers and sellers, the present state of technology, inflation, and so on.

Replacement Cost

Replacement cost, the cost of duplicating productive capability using current technology. For example, the value of used personal computers tends to fall by 30 to 40 percent per year.

Opportunity Cost
Opportunity Cost Concept
Opportunity cost is foregone value. Reflects second-best use.

Explicit and Implicit Costs

Explicit costs are cash expenses. Implicit costs are noncash expenses.

Incremental and Sunk Costs in Decision Analysis

Incremental Cost
Incremental cost is the change in cost tied to a managerial decision. Incremental cost can involve multiple units of output. Marginal cost involves a single unit of output.

Sunk Cost
Irreversible expenses incurred previously. Sunk costs are irrelevant to present decisions.

Short-run and Long-run Costs

How Is the Operating Period Defined?
At least one input is fixed in the short run. All inputs are variable in the long run.
Two basic cost functions are used in managerial decision making: short-run cost functions, used for day-to-

day operating decisions, and long-run cost functions, used

for long-range planning.

Fixed and Variable Costs

Fixed costs do not vary with output. These costs include interest

expenses, rent on leased plant and equipment, depreciation charges

associated with the passage of time, property taxes, and salaries for employees not laid off during periods of reduced activity. Variable costs fluctuate with output. Expenses for raw materials, depreciation associated with the use of equipment, the variable portion of utility charges, some labor costs, and sales commissions

are all examples of variable expenses.

Short-run Cost Curves

Short-run Cost Categories

Short-run Cost Relations

Short-run cost curves show minimum cost in a given production environment

Long-run Cost Curves

Economies of Scale
Long-run cost curves show minimum cost in an ideal environment. Labor specialization often gives rise to economies of scale. Labor productivity can be higher in large firms, where individuals are hired to perform specific tasks. This can reduce unit costs for large-scale operations.

Cost Elasticity and Economies of Scale

Cost elasticity is

C = C/C Q/Q.

C < 1 means falling AC, increasing returns.

C = 1 means constant AC constant returns. C > 1 means rising AC, decreasing returns.

Long-Run Average Costs

Short-run cost curves relate costs and output for a specific

scale of plant. Long-run cost curves identify the optimal scale

of plant for each production level. Long-run average cost

(LRAC) curves can be thought of as an envelope of short-run

average cost (SRAC) curves.

Long-run Average Costs

Minimum Efficient Scale

Competitive Implications of Minimum Efficient Scale
MES is the minimum point on the LRAC curve.

Competition is most vigorous when:

MES is small in absolute terms.
MES is a small share of industry output. Disadvantage to less than MES scale is modest.

Transportation Costs and MES

Terminal, line-haul and inventory costs can be important. High transport costs reduce MES impact.

Firm Size and Plant Size

Multi-plant Economies and Diseconomies of Scale
Multi-plant economies are cost advantages from operating several plants. Multi-plant diseconomies are cost disadvantages from operating several plants.

Economics of Multi-plant Operation: an Example

Plant Size and Flexibility

Learning Curves
Learning Curve Concept
Learning causes an inward shift in the LRAC curve. Learning curve advantages are often mistaken for economies of scale effects.

Learning Curve Example Strategic Implications of the Learning Curve Concept When learning results in 20% to 30% cost savings, it becomes a key part of competitive strategy.

Economies of Scope
Economies of Scope Concept
Scope economies are cost advantages that stem from producing multiple outputs. Big scope economies explain the popularity of multi-product firms. Without scope economies, firms specialize.

Exploiting Scope Economies

Scope economics often shape competitive strategy for new
products.

Cost-volume-profit Analysis
Cost-volume-profit Charts
Cost-volume-profit analysis shows effects of varying scale. Breakeven analysis shows zero profit points of cost coverage.

Degree of Operating Leverage

DOL=Q(P-AVC)/[Q(P-AVC)-TFC] DOL is the elasticity of profit with respect to output.