The Analysis of Costs

1. The Economic Role of

Costs
=The (opportunity) cost of
producing the item indicates
the desire of consumers for
other goods.
Economic Role of Costs
=The demand for a product
indicates the intensity of
consumers desires for an
item.
Opportunity costs
The value of the other products that the resources
used in production could have produced at their
next best alternative
Historical costs
The amount the firm actually paid for a particular
input
Explicit and
Implicit Costs
=Costs may be either explicit or
implicit.

EExplicit costs result when a
monetary payment is made.
EImplicit costs involve resources
owned by the firm and dont
involve a monetary payment.
Ee.g.: Time spent by owner running
the firm or the normal rate of return
on the owners financial investment
(opportunity cost of equity capital).
Explicit vs. implicit costs
=Explicit costs include the ordinary items that
an accountant would include as the firms
expenses

=Implicit costs include opportunity costs of
resources owned and used by the firms owner
Total Cost:
Total
Cost
=
explicit costs implicit costs
+
Accounting and
Economic Profit
=Economic profit is total revenues
minus total costs (including all
opportunity costs).
=Economic profit only occurs when the
rate of return is above the normal rate
of return (the opportunity cost of
capital).
EFirms earning zero economic profit are
earning exactly the market (normal)
rate of return.
=Accounting profit is total revenue
minus expenses of firm over a
designated time period.

Accounting and
Economic Profit
EOften excludes implicit costs
such the opportunity cost of
equity capital.
EAccounting profit is generally
greater than economic profit
The Nature of Costs and
Profits
=ACCOUNTING PROFITS: Total Revenue
(TR) - Total Costs (TC)
=ECONOMIC PROFITS: Total Revenue -
(Explicit Costs + Implicit Costs)
=OPPORTUNITY COST OF CAPITAL:
Implicit Return that must be paid to
investors to induce them to supply capital
to the firm
The (Un)Profitable Ethnic
Restaurant
Total Revenue $800,000
- Cost of Goods Sold
Direct Labor $300,000
Direct Materials $200,000
- Explicit Indirect Costs
Administration $ 80,000
Overheads $100,000
Interest/Depreciation $ 40,000
-----------
Accounting Profit $ 80,000
- Implicit Costs
Interest Foregone(10%on$500,000) $ 50,000
Wages Foregone $ 60,000
-----------
Economic Profit(Loss) ($30,000)
1. What are implicit costs? Do implicit costs
contribute to the opportunity cost of production?
Should an implicit cost be counted as cost? Give 3
examples of implicit costs. Why do economists
consider normal returns to capital as a cost?
Questions for Thought:
2. How does economic profit differ from accounting
profit? If a firm is making zero economic profit,
does this indicate that it is about to go out of
business? What does economic profit indicate?
3. What is shirking? If the managers of a firm are
attempting to maximize the profits of the firm, will
they have an incentive to limit shirking? How might
they go about doing so?

3. Short and Long Run
=In the short run, output can
only be altered by changing
the usage of variable
resources such as labor and
raw materials.
Short Run
=The short run is a period of
time so short that the firms
level of plant and heavy
equipment (capital) is fixed.
Long Run
=The long run is a period of
time sufficient for the firm to
alter all factors of production.
=In the long run, firms can
enter and exit the industry.
=The actual short run and long
run differs by industry

2. Output and Costs
In the Short Run
Short run
A period of time so short that the firm cannot alter
the quantity of some of its inputs

=Typically plant and equipment are fixed inputs
in the short run
=Fixed inputs determine the scale of the firms
operation
Three concepts of total
tosts
=Total fixed costs = FC
=Total variable costs = VC
=Total costs = FC + VC

EExamples: insurance premiums,
property taxes, opportunity cost
of fixed assets.
Total Fixed Costs
=Total Fixed Costs (TFC) are costs
that remain unchanged in the short
run when output is altered.
EDecline as output expands.
Average Fixed Costs
=Average Fixed Costs (AFC) are
fixed costs per unit (i.e,
TFC/output).
Variable Costs
=Total Variable Costs (TVC) are the
sum of costs that rise as output
expands.
EExamples: cost of labor and raw
material.
=Average Variable Costs (AVC) are
variable costs per unit (i.e,
TVC/output).
Total Cost
=Total Cost (TC) = Total Fixed
Cost + Total Variable Cost
=Average Total Cost (ATC) =
Average Fixed Cost + Average
Variable Cost
EMC will decline initially, reach a
minimum, and then rise.
Marginal Cost
=Marginal Cost (MC) is the increase
in total cost associated with a one-
unit increase in production.
Q
p
Average Total Costs will be a U-shaped curve
since AFC will be high for small rates of output
and MC will be high as the plants production
capacity ( q ) is approached.
Q
p
Marginal Costs will rise sharply as the plants
production capacity ( q ) is approached.
Q
p Average Fixed Costs will be high for small rates
of output (as they are divided across few units),
but they will always decline as output expands
(as they are divided across more units).
Short-Run Cost Curves
ATC
MC
AFC
q
q
Shape of ATC Curve
=The ATC curve is U-shaped.
EATC is high for an underutilized
plant because AFC is high.
EATC is high for an over-utilized
plant because MC is high.
OUTPUT FC VC TC
0 2000 0 2000
1 2000 100 2100
2 2000 180 2180
3 2000 280 2280
4 2000 392 2392
5 2000 510 2510
6 2000 650 2650
7 2000 800 2800
8 2000 960 2960
9 2000 1140 3140
10 2000 1340 3340
11 2000 1560 3560
12 2000 2160 4160
Fixed, variable, and total costs
Media Corp.
Fixed, Variable, and Total Costs --
Media Corp.
0
1000
2000
3000
4000
5000
0 5 10 15
Units of Output
d
o
l
l
a
r
s
FC
VC
TC
Average and marginal costs
Media Corp.
OUTPUT AFC AVC ATC MC
0
1 2000.0 100.0 2100.0 100
2 1000.0 90.0 1090.0 80
3 666.7 93.3 760.0 100
4 500.0 98.0 598.0 112
5 400.0 102.0 502.0 118
6 333.3 108.3 441.7 140
7 285.7 114.3 400.0 150
8 250.0 120.0 370.0 160
9 222.2 126.7 348.9 180
10 200.0 134.0 334.0 200
11 181.8 141.8 323.6 220
12 166.7 180.0 346.7 600
Average and marginal costs
Media Corp.
0
500
1000
1500
2000
0 2 4 6 8 10 12
Units of output
$
$
$
AFC
AVC
ATC
MC
Diminishing Returns
and Cost Curves
=If a firm faces diminishing returns,
MC will rise with additional output.

EAs MC continues to rise, it will
eventually exceed ATC and raise
ATC.
EBefore that point, MC is below
ATC and is bringing down ATC
TFC
TC
TVC








0








Total
Costs
4 2
Here we graph the general shape of the
firms short-run total cost curves.
50
100
150
200
6 8
50
10
TC TVC TFC
Output
per day
1
2
3
4
5
6
7
8
9
10
0
15
25
34
42
52
64
79
98
122
152
Note that total fixed costs are flat and
remain the same for 0 units or 11 units.
Output
Total Costs Curves
=
+
11
202
50
50
50
50
50
50
50
50
50
50
50
50
65
75
84
92
102
114
129
148
172
202
252
12
250
Note that total variable costs increase as
more variable inputs are utilized.
As total costs are the combination of
TVC and TFC, they are everywhere
positive and increase sharply with output
AFC









0








Cost
per unit
4 2
To understand the relationship between
the average and marginal curves, we
calculate each of the average curves
from the total curves and then introduce
the marginal curve.
6 8
50
10
AFC TFC
Output
per day
1
2
3
4
5
6
7
8
9
10
----
$ 50.00
$ 25.00
$ 16.67
$ 12.50
$ 10.00
$ 8.33
$ 6.25
$ 5.56
$ 5.00
Output
=
/
11
$ 4.55
50
50
50
50
50
50
50
50
50
50
50
12
The average fixed cost curve (AFC) is
the total fixed cost (TFC) divided by the
output level. It is high for a few units,
and becomes small as output increases.
20
40
60
80
$ 7.14
Average and
Marginal Cost Curves
AVC
AFC









0








Cost
per unit
4 2 6 8 10
AVC
Output
per day
1
2
3
4
5
6
7
8
9
10
----
$ 15.00
$ 12.50
$ 11.33
$ 10.50
$ 10.40
$ 10.67
$ 12.25
$ 13.56
$ 15.20
=
/
11
$ 18.36
12
The average variable cost curve (AVC)
is the total variable cost (TVC) divided
by the output level. It is higher either
for a few or lot of units and has some
minimal point between the two where,
when graphed later, marginal costs
(MC) will cross it.
20
40
60
80
$ 11.29
TVC
0
15
25
34
42
52
64
79
98
122
152
202
Average and
Marginal Cost Curves
Output
MC
AVC
AFC
















Cost
per unit
4 2 6 8 10
MC
Output
1
1
1
1
1
1
1
1
1
1
$ 15.00
$ 10.00
$ 9.00
$ 8.00
$ 10.00
$ 12.00
$ 19.00
$ 24.00
$ 30.00
=
/
1 $ 50.00
12
20
40
60
80
$ 15.00
TC
50
65
75
84
92
102
114
129
148
172
202
252
Note that MC starts low and increases as
output increases. It also crosses AVC at
its minimum point.
TC
10
9
8
10
12
15
50
19
24
30
15
To calculate the marginal costs curve
(MC) we must take the change in the TC
curve ( TC) and divide that by the
change in output ( Output). Our
increments for increasing output here
are to increase by 1 ( 1).
I mportant Note :
MC always crosses AVC
at its minimum point.
Average and
Marginal Cost Curves
Output
MC
AVC
AFC









0








Cost
per unit
4 2 6 8 10
ATC
Output
per day
1
2
3
4
5
6
7
8
9
10
----
$ 65.00
$ 37.50
$ 28.00
$ 23.00
$ 20.40
$ 19.00
$ 18.50
$ 19.11
$ 20.20
=
/
11
$ 22.91
12
Note that when the output is low, ATC is
high because AFC is very high. Also,
ATC is high when output is large as MC
becomes large when output is high.
20
40
60
80
$ 18.43
TC
50
65
75
84
92
102
114
129
148
172
202
252
These two relationships explain why the
ATC curve has its distinct U - shape.
Lastly we graph the average total cost
curve (ATC) as TC divided by the output.
Note: MC crosses ATC at its minimum.
ATC
I mportant Note :
MC always crosses ATC
at its minimum point.
Average and
Marginal Cost Curves
Output

3. Output and Costs
In the Long Run
Long Run ATC
=The long-run ATC shows the
minimum average cost of
producing each output level when
a firm is able to choose plant size.
Cost
per unit
Output Level
LRATC
Planning Curve
The ATC curve for the firm will depend upon the size
of the plant that is operating.
Representative Short-run
Average Cost Curves
If, as here, the cost per unit varies according to the size
of the facility, then a Long Run Average Total Cost
(LRATC) can be mapped out as the surface of all the
minimum points possible at all the possible degrees of scale.
Economies of Scale
=Economies of Scale: Reductions in
per unit costs as output (plant
size) expands can occur for three
reasons.

EMass production
ESpecialization
EImprovements in production as
a result of experience
EBureaucratic inefficiencies may
result as size expands.
Diseconomies of
Scale
=Diseconomies of Scale: increases in
per unit costs as output (plant
size) expands can occur

Constant Returns to
Scale
=Constant Returns to Scale:
Unit costs that are constant as
plant size is changed.
demonstrating
Diseconomies of Scale meaning that a further expansion in plant
size leads to higher levels of cost.
Cost
per unit
Output Level
LRATC
Different Types of LRATC
Often the LRATC will have segments that represent either
Economies of scale, constant returns to scale, or even
diseconomies of scale.
Below, the LRATC represented has a downward sloping segment
demonstrating Economies of Scale for that range of output,
meaning that an further expansion in plant size can reduce
per unit cost up to output level q.
There is also a upward sloping segment,
q
Economies of Scale Diseconomies of Scale
Plant of
Ideal Size
Cost
per unit
Output Level
LRATC
demonstrating Diseconomies of Scale,
Different Types of LRATC
Below, the LRATC represented has a downward sloping segment
demonstrating Economies of Scale for that range of output,
an upward sloping segment,
q
1

Economies
of Scale
Diseconomies
of Scale
q
2

Constant Returns
to Scale
Plant of
Ideal Size
and a flat segment, demonstrating Constant Returns to Scale.
Constant Returns to Scale suggests that the ideal plant size would
be one of any size that delivers between q
1
and q
2
. Increases in
plant size from q
1
to any point below or including q
2
would
result in neither a reduction nor an increase in the per unit costs
of production due to scale.
Cost
per unit
Output
Level
LRATC
Different Types of LRATC
Below, the LRATC represented has a downward sloping segment
demonstrating Economies of Scale for the entire range of output,
which implies that the most efficient size plant available would
be the largest one possible.
q
Economies of Scale
Plant of
Ideal Size
Long-run cost functions
=Often considered to be the firms planning horizon
=Describes alternative scales of operation when all
inputs are variable
Quantity of output
Average
cost
Long-run average cost function
Shows the minimum cost per unit of producing each output
level when any scale of operation is available
Quantity of output
Average
cost
SR average cost
functions
LR average cost
Key steps:
Cost estimation process
Definition of costs
Correction for price level changes
Relating cost to output
Matching time periods
Controlling product, technology, and plant
Length of period and sample size
Minimum efficient scale
The smallest output at which long-run average
cost is a minimum.
Quantity of output
Average
cost
Q
mes

The Survivor Technique
=Classify the firms in an industry by size and
compute the percentage of industry output
coming from each size class at various times
=If the share of one class diminishes over time,
it is assumed to be inefficient
=These firms are then operating below
minimum efficient scale
Economies of Scope
Exist when the cost of producing two (or more)
products jointly is less than the cost of
producing each one alone.

S = C(Q
1
) + C(Q
2
) - C(Q
1
+ Q
2
)
C(Q
1
+ Q
2
)

6. What Factors Cause
the Firms Cost Curves
to Shift?
Cost Curve Shifters
=Prices of resources
=Taxes
=Regulations
=Technology
Cost
per unit
Output Level
Higher Resource Prices and
Cost
If resource prices increase, the cost of production
increases and thus the ATC and the MC move
upward simultaneously.
ATC
1

MC
1

ATC
2

MC
2


5. The Economic Way of
Thinking about Costs
Sunk Costs
=Sunk Costs are historical costs
associated with past decisions that
cant be changed.
ESunk costs may provide
information, but are not
relevant to current choices.
ECurrent choices should be made
on current and future costs and
benefits.
Cost and Supply
=In the short run, when making
supply decisions, the marginal
cost of producing additional
units is the relevant cost
consideration
=In the long run, the average
total cost is vital to the supply
decision
1. If a firm maximizes profit, it must minimize the
cost of producing the profit-maximum output.
Is this statement true or false? Explain your
answer.
Questions for Thought:
2. Draw a U-shaped short-run ATC curve for a firm.
Construct the accompanying MC and AVC curves.
3. Firms that make a profit have increased the
value of the resources they used; their actions
created wealth. In contrast, the actions of firms
that make losses reduce wealth. The discovery
and undertaking of profit-making opportunities
are key ingredients of economic progress.
Evaluate this statement.
Special Topics in Cost:
Breakeven Analysis
=BE Analysis involves the short run and is used
when there are fixed costs that need to be
covered
=BE Analysis reveals the relationship between
profits, variable costs, fixed costs and volume
=It is useful tool for analyzing the financial
characteristics of alternative production systems
Special Topics: BE
Analysis (cont.)
=It focuses on how total costs and profits
vary with volume of output as the firm
operates in a more mechanized or
automated manner and thus substitutes
fixed costs for variable costs
Break-even Analysis
Quantity of output
Dollars
Total Revenue
Total Cost
Loss
Profit
Determining the Break-
even Point
=The BE Point is given by the intersection of the
total cost line with the total revenue line, that is,
where total revenues cover total costs. At BE
pt., TR = TFC + TVC
or PxQ = TFC + AVCxQ
or (P-AVC)Q = TFC
or Qbe = TFC/(P-AVC)

The Break-even Point
(cont.)
=Thus, if P = $50 per unit
and AVC= $25 per unit
and TFC = $100,000
then, Qbe = 100,000/(50-25)
= 4,000 units
=The fixed costs that must be recovered
from the sales dollar after the deduction
of variable costs determines Qbe
Operating Leverage
=Operating Leverage (OL) reflects the
extent to which fixed production facilities,
as opposed to variable factors of
production are used in operations
=The Degree of Operating Leverage (DOL)
at a particular level of output is simply the
percentage change in profits over the
percentage change in output/sales that
produces that change in profits
Operating Leverage (cont.)
=DOL is an elasticity concept, and can be
called the operating leverage elasticity of
profits
= DOL = % Profits/ % Output
= ( Profits/ Q) (Q/Profits)
= [Q(P-AVC)]/[Q(P-AVC)-TFC]
=The further actual output is from Qbe, the
lower is the DOL
Operating Leverage (cont.)
=The greater the ratio of price to variable costs
per unit, the greater the absolute sensitivity of
profits to volume changes and the greater the
degree of operating leverage for all levels of
output
=The firm having the greater total fixed cost will
have the higher DOL
=The DOL can be used as an indicator of risk
Operating Leverage (cont.)
DOL for Two Firms
Firm A Firm B
Price = $10.00 Price = $10.00
AVC= $5.00 AVC= $2.00
TFC= $1,000 TFC= $4,000
-----------------------------------------------------------------------------------------------------------
-----
Rate of Output Profit DOL
Firm A Firm B Firm A Firm B
0 -$1,000 -$4,000 0 0
200 0 -$2,400 Undefined -0.67
500 $1,500 0 1.67 Undefined
1,000 $4,000 $4,000 1.25 2.00
1,500 $6,500 $8,000 1.15 1.50
2,000 $9,000 $12,000 1.11 1.33
Operating Leverage (cont.)
=Characteristics of the example:
EDOLs are 0 are a zero output rate and negative until
a breakeven rate of output is reached
EWhen the firm is incurring losses, DOL is not
meaningful because it suggests that profit falls as
output increases, which is not the case
EWhen profits are earned, a negative DOL is
maeningful
Operating Leverage (cont.)
=Characteristics of the example (cont.)
EA DOL when positive profits are being earned means
that output has increased beyond that rate that
maximizes profit
EDOL is greatest for smaller output rates around Qbe
and declines as output moves away from Qbe
EAt the same rate of output, DOL is always higher for
Firm B than A because of its higher fixed costs vs.
variable costs (risk)
Profit Contribution
Analysis
=The difference between price and average
variable costs (P-AVC) is defined as profit
contribution. At outputs below Qbe, profit
contribution is used to cover fixed costs
and afterwards, it is a direct contributor to
profit
=Profit Contribution Analysis allows a
manager to find the output rate that
covers TFC & earn a required profit
Profit Contribution
Analysis (cont.)
=Thus, the required rate of profit can be
expressed by the equation,
Required Profit = PQ-AVC(Q)-TFC
so that the output necessary is given by
Q = (TFC+Required Profit)/(P-AVC)
=Breakeven Analysis is a specific case of
Profit Contribution Analysis when the
Required Profit is equal to zero
Margin of Profitability
=A third measure of current profitability is a firms
Margin of Profitability (MOP)
=MOP is the ratio of economic profit to total fixed
cost
=It is measured as MOP = (Qa-Qbe)/Qbe
=MOP is a measure of the amount of production
in excess of breakeven and shows the cushion
available to the manager before Qbe is reached
Managerial Uses of BE
Analysis
=It provides management a good deal of
information about the operating and
business risks of the company. Given an
approximate B.E. Point, management can
relate fluctuations in expected future
volume to this point and ascertain the
stability of profits - knowledge that may
be useful to determine the ability of the
firm to service debt
Managerial Uses of BE
Analysis (cont.)
=It is important when the acquisition of
assets is planned. The expected future
trend and stability of volume, together
with the ratio of expected price to
expected AVC, will bear heavily on the
decision to increase fixed costs
=It is useful in pricing decisions since it
tells the effect on profits of changes in
prices and costs
Limitations of BE Analysis
= Assumes constant P and AVC irrespective of volume, when sales volume
may very often influence P and AVC
= Assumes that TFC remains fixed over the entire volume range, when in fact
this range may be limited by the immediate physical capacity of the firm
and TFC may be a step function as volume changes
= It ignores the problem in practice of classifying some costs that are
partially fixed and partially variable, that is, semi-variable costs, e.g. rent,
insurance etc. with discounts
= It is based on one-product analysis and not very suited to multiple-product
analysis where there is a major problem of allocating common costs
= Acoounting information used for BE analysis is based on historical costs
which are not stable over time and which do not reflect the forward-looking
nature of managerial decisions
= It is short-run analysis and not suitable for long-range planning