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By Mark Hirschey

Cost Analysis and Estimation

Chapter 9

Chapter 9 OVERVIEW

What Makes Cost Analysis Difficult Opportunity Cost Incremental and Sunk Costs in Decision Analysis Short-run and Long-run Costs Short-run Cost Curves Long-run Cost Curves Minimum Efficient Scale Firm Size and Plant Size Learning Curves Economies of Scope Cost-volume-profit Analysis


historical cost current cost replacement cost opportunity cost explicit cost implicit cost incremental cost profit contribution sunk cost cost function short-run cost functions long-run cost functions short run long run planning curves

operating curves fixed cost variable cost short-run cost curve long-run cost curve economies of scale cost elasticity capacity minimum efficient scale multiplant economies of scale multiplant diseconomies of scale learning curve economies of scope cost-volume-profit analysis breakeven quantity

What Makes Cost Analysis Difficult?

Link Between Accounting and Economic Valuations

Historical Versus Current Costs

Accounting and economic costs often differ.

Replacement Cost

Historical cost is the actual cash outlay. Current cost is the present cost of previously acquired items. Cost of replacing productive capacity using current technology.

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.

Fixed and Variable Costs

Fixed cost is a short-run concept. All costs are variable in the long run.

Short-run Cost Curves

Short-run Cost Categories

Total Cost = Fixed Cost + Variable Cost For averages, ATC = AFC + AVC Marginal Cost, MC = TC/Q

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.

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

Minimum Efficient Scale

Competitive Implications of Minimum Efficient Scale

MES is the minimum point on the LRAC curve. MES is small in absolute terms. MES is a small share of industry output. Disadvantage to less than MES scale is modest.

Competition is most vigorous when:

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 Curve Example Strategic Implications of the Learning Curve Concept

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

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.
Scope economics often shape competitive strategy for new products.

Exploiting Scope Economies

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.