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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

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What is Cost?Cost is the monetary value that a company has spent in

order to produce something.

Sellers point of viewBuyers point of view

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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.

Current cost

Replacement CostReplacement 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.

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Opportunity Cost

Opportunity Cost ConceptOpportunity cost is foregone value.

Reflects second-best use.

Explicit and Implicit CostsExplicit costs are cash expenses.

Implicit costs are noncash expenses.

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Incremental and Sunk Costs in Decision Analysis

Incremental Cost Incremental cost is the change in cost tied to amanagerial decision.

Incremental cost can involve multiple units ofoutput.

Marginal cost involves a single unit of output.

Sunk Cost Irreversible expenses incurred previously.

Sunk costs are irrelevant to present decisions.

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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.

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Fixed and Variable CostsFixed 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.

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Long-run Cost Curves

Economies of ScaleLong-run cost curves show minimum cost inan ideal environment. Labor specializationoften gives rise to economies of scale. Laborproductivity can be higher in large firms,

where individuals are hired to performspecific tasks. This can reduce unit costs forlarge-scale operations.

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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.

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Long-run Average Costs

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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.

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Transportation Costs and MES

Terminal, line-haul and inventory costs can be important.

High transport costs reduce MES impact.

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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 severalplants.

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Economics of Multi-plantOperation: an Example

Plant Size and Flexibility

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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.

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Economies of Scope

Economies of Scope Concept

Scope economies are cost advantages that stem from producing multipleoutputs.

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.

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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.

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Degree of Operating Leverage

DOL=Q(P-AVC)/[Q(P-AVC)-TFC]

DOL is the elasticity of profit with respect to output.

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