BUSINESS ECONOMICS

Session 6: COST ANALYSIS - I

1. 1.1 Pre-Work Introduction In the production analysis, as discussed earlier, the firms decision making relates to how much output to produce based on the behaviour of Total Product (TP), Average Product (AP) and Marginal Product (MP), given a capacity / scale of operation. These output decisions also

correspond to input use decisions that are based on input productivity and their prices. As such,
MP3 MPn MP1 MP2 = = .. = P1 P2 P3 Pn

Given the above basis, increasing supply or output in the short run (i.e. under a given production capacity) and in the long run (i.e. creating additional capacity) have varying cost implications. The focus of this session is to understand cost implications of supply decisions in the short run. Any production decision involves cost. Firms must pay for the inputs (both tangible and intangible) they use. Therefore, in defining their production strategies, firms try to reduce unnecessary costs as they in turn reduce their profits. For example, for taking decisions such as these, firms have to continuously weigh available alternatives and opt for the most efficient ones: Is it cheaper to hire a new worker or to pay overtime? To open a new factory or expand an old one? To invest in new machinery at home or relocate production abroad?

1.2

Cost Concepts Before we take up the cost analysis of production decisions, an understanding of the basic cost concepts is necessary. In the Accounting framework, generally, only the explicit expenditure incurred is considered as cost. Thus, with respect to production, actual expenditure incurred by the firms towards wages, rent or purchase of inputs will be considered as costs of production. However, there could be other resources/inputs used by the firm for which explicit expenditures may not have been incurred. For example, an architect / consultant may be operating from self owned house instead of a separate office. expenditure on office space rental. In this case, there is no explicit Similarly, we could also have

situations where entrepreneurs could have invested their own savings (instead of borrowing) or may not be taking monthly salaries as wages. In these cases, as there is no explicit expenditure incurred, these costs will not be included in the cost of supply of a product. However, in the economic framework, the above inputs are resources that could have been used in the production and supply of products. Since these inputs have alternate uses (eg: house could have been rented out; savings could have earned interest, if invested in financial instruments, entrepreneur could have earned salary, if employed elsewhere), the cost of using these resources can be imputed from the possible alternate uses. This approach of imputing costs for inputs on which no explicit expenditure is incurred is referred to as Opportunity cost principle. business. For example, if an entrepreneur engaged in cookie

Thus, under this framework the total costs for producing a product i.e. Explicit costs + Implicit costs = Total cost will be the basis for taking

production decisions. In this way, a business firm is able to estimate the true cost of producing a product. Thus, in our analysis the Total Cost (TC) would now include both explicit and implicit costs.

1.3

Normal

vs

Supernormal profits

By definition, profits are the difference between Total Revenue earned and Total Cost incurred. In our analysis, we have two approaches in viewing profits. First, when the difference between TR & TC is zero, then the business firm will be earning only Normal profits. Why?

Production takes place when factor inputs are employed.

In

economic analysis, four broad categories of factor inputs are identified, namely, Land, Labour, Capital and Entrepreneurship. The returns to each of these factor inputs are as follows: Land : rent Labour : wages Capital : interest Entrepreneurship : profits. Since in production analysis, entrepreneurship or management is considered as production input, the returns to the same i.e. the profits are taken as a cost parameter.

In other words, returns to the entrepreneur (i.e. profits) are included in cost calculations. Second, when the difference between Total Revenue and Total Cost is positive then the firm would be earning supernormal profits. In other words, the business firm is earning more than two normal rates of return on the inputs used in the production process.

Putting together the above profit concepts, the implications of business firms profit maximization would entail maximizing supernormal profits. 1.4 Case let: Gopal Banerjee & Co. Trading and Profit and Loss Account for the Year Ending December 1994. Dr. To opening stock To purchase To inward parcel postage To gross profit To salaries & wage To advertisement To boxes & wrappings To office supplies & postage To light & power To insurance, taxes & repairs of building To telephone To depreciation To interest on borrowings To misc. expenses To net profit Cr. 50,000 By sale 5.50.000 By closing stock 5,000 90,000 6,95,000 25,000 By gross profit 5,000 3,000 1,000 3,000 7,000 2,000 5,000 10,000 7,000 22,000 Rs. 90,000 6,35,000 60,000

90,000

Rs. 90,000

The above statement was given to a business economist for his comments. On enquiry, Sri Gopal Banerjee supplied the following additional information:

a)

Upto the year 1988, he worked as a manager of another jewellery shop where he was getting a salary of Rs. 600 per month. Since then he left the service and started his own retain shop.

b)

The building in which the retail shop is housed, is a two-storey airconditioned building owned by Sri Gopal Banerjee himself. The building is located in such a market place that it can readily be let out any time for Rs. 800 per month.

c)

Sri Banerjee has invested his own capital of the order of Rs. 2,00,000. If borrowed, it would have been obtained at a 9 per cent interest per annum.

The business economist made certain adjustments and thereby a fresh calculation, which showed that Sri Gopal Banerjee was actually running the business at a net loss of Rs. 12,800 per annum. On being told so, Sri Banerjee was surprised and argued: a) Impossible; I am working for profits and not for salary. I dont actually draw any salary from the business. b) c) I have got my own building. I do not pay any rent. I have invested my own money. I do not pay any interest. In fact, I have worked hard to put this business in a position where there is no need for borrowing money I think, it is creditable that a businessman here is free from any debt to banks and moneylenders. d) If I am saving some money by way of employing my own labour, own building and own money, how can I incur loss? Net loss; Unbelievable! Discussion Questions: 1. 2. What is the problem? Do your agree with Sri Gopal Banerjee? In particular, Sri Banerjee fails to understand the way, the net loss (or Rs. 12,800) figures is derived. Prepare a small table which would help him to understand this derivation. And, if necessary, explain.

3.

Discuss the conditions under which profits and super normal profits can be earned.

Source: (M. Adhikary, Managerial Economics) 2. 2.1 Post Work Learning Objective (i) (ii) (i) 2.2 2.2.1 to define and examine economic cost of inputs to develop cost output relationship framework for business decisions to derive firms supply curve in the short run

Summary Economic cost of inputs A business firms production function indicates how much of each input is required for producing various amounts of the product (Q). In determining the cost of producing the product, a business firm should be able to determine the true cost of the inputs used. A firm may be using both owned and purchased inputs in the production activity. While explicit expenditure is incurred for the

purchased inputs, costs have to be imputed for owned inputs based on opportunity cost principle.

The opportunity cost of an input may not be equal to the historical cost. Assume, a TV is bought for Rs. 10,000. Two months later prices fall to Rs. 8,000. In this case, Rs. 10,000 is the historical cost and Rs. 8,000 is the current opportunity cost of TV. In managerial decision making, current opportunity cost reflects the true value of the input used.

Since all resources/inputs used are scarce and have alternate uses, cost implications of production decisions, take into account the economic costs of production which covers both the explicit and implicit costs.

2.2.2

Cost output relationship framework Since the cost of all factor inputs are accounted for while defining Total Costs, normal profits i.e. the returns to entrepreneurship are included in the cost of production. For profit maximization, production decisions aim to maximize supernormal profits. In the short run, the cost determinants are the output (Q) to be produced and the quantum of inputs used. This would imply that as Q increases, Total Costs (TC) also rise. And, since fixed and variable inputs are used, correspondingly and Total Variable Costs (TVC). The increase in TC, TFC and TVC is not the same over the output range. Therefore, the cost implications of output decisions are based on Average Costs (AC), Average Fixed Cost (AFC) and Average Variable Cost (AVC). Average cost relationships are derived from the underlying average productivity of inputs, i.e. AFC, AVC, are inversely related to the average productivity of factor inputs. Output corresponding to we have, Total Fixed Costs (TFC)

minimum AC is defined as cost efficient output. A firm may decide to produce on the rising part of the AC curve under rising output price conditions. Similarly, a firm may decide to operate

on the falling part of the AC curve under declining output price conditions. This is referred to Excess capacity. 2.2.3 Firms supply curve The MC curve above the AVC represents the supply curve of the firm. The upward sloping MC curve reflects the incremental costs associated with increasing output (Q). If the market price corresponds to the firms MC curve above AC curve, then the firm would be earning supernormal profits. If the market price corresponds to the firms MC curve above the AVC, a firm will be minimizing the loss as a part of the fixed costs are recovered. 2.3 Readings 1. 2. 2.4 Handout 4: Opportunity Cost and the Supply of goods Text Book: Chapter 8

Learning Activities 1. Kevin Coughlin, a lawyer working for a large firm and earning $60,000 per year, is contemplating setting up his own law practice. He estimates that renting an office would cost $10,000 per year, hiring a legal secretary would cost $20,000 per year, renting the required office equipment would cost $15,000 per year, and purchasing the required supplies, paying for electricity, telephone, and so forth would cost another $5,000. The lawyer estimated that his total revenues for the year would be $100,000, and he is indifferent between keeping his present occupation with the large

law firm and opening his own law office. (a) How much would be the explicit costs of the lawyer for running his own law and office for the year? (b) How much would the accounting costs be? The

implicit costs? The economic costs? (c) Should the lawyer go ahead and start his own practice? 2. Indicate whether each of the following involves an upward or downward shift in the average cost curve or, instead, involves a leftward or rightward movement along a given curve. Also indicate whether each will have an increasing, or uncertain effect on the level of average cost. A. B. C. D. E. 3. A rise in wage rates A decline in output An energy-saving technical change A fall in interest rates An increase in learning or experience

Airway Express has an evening flight from Los Angeles to New York with an average of 80 passengers and a return flight the next afternoon with an average of 50 passengers. The plane makes no other trip. The charge for the plane remaining in New York

overnight is $1,200 and would be zero in Los Angeles. The airline is contemplating eliminating the night flight out of Los Angeles and replacing it with a morning flight. The estimated number of

passengers is 70 in the morning flight and 50 in the return afternoon flight. The one-way ticket for any flight is $200. The operating cost of the plane for each flight is $11,000. The fixed costs for the plane are $3,000 per day whether it flies or not. (a) Should the airline replace its night flight from Los Angeles with a morning flight? (b) Should the airline remain in business?