MANAGERIAL ECONOMICS

12th Edition

By Mark Hirschey

Cost Analysis and Estimation

Chapter 8

Chapter 8 OVERVIEW

Economic and Accounting Costs Role of Time in Cost Analysis 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

Chapter 8 KEY CONCEPTS

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 degree of operating leverage

Economic and Accounting Costs

Historical Versus Current Costs

Historical cost is the actual cash outlay. Current cost is the present cost of previously acquired items. Foregone value associated with current rather than next-best use of an asset. Replacement cost is expense of replacing productive capacity using current technology.
Explicit costs are cash expenses. Implicit costs are noncash expenses.

Opportunity Costs

Explicit and Implicit Costs

Role of Time in Cost 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.

How Is the Operating Period Defined?

Short

Run Versus Long Run

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

Long-run

total cost curves show minimum total cost in an ideal environment. Economies of Scale

Increasing returns to scale imply falling average costs. Constant returns to scale implies constant average costs. Decreasing returns to scale implies rising average costs.

Cost Elasticities and Economies of Scale

Cost

elasticity measures the percentage change in cost following a one percent change in output.

C = C/C Q/Q.

Cost

elasticity measures returns to scale.

C < 1 means increasing returns (falling AC).. C = 1 means constant returns (constant AC). C > 1 means decreasing returns (rising AC).

Minimum Efficient Scale

Minimum

Efficient Scale

MES is the corner point on an L-shaped LRAC curve. MES is the minimum point on an U-shaped LRAC curve.

Competition

is most vigorous when:

MES is small in absolute terms. MES is a small share of industry output. Cost disadvantage to small scale is modest.

Transportation Costs and MES

Transportation

Costs

Terminal charges are the cost of loading and unloading freight. Line-haul costs are expenses of moving goods, e.g., gas. Inventory costs are shipping costs tied to time in transit.

High

transport costs reduce MES impact.

Location near customers can offset scale disadvantages.

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 coordination costs from operating several plants. Big plants can offer lower AC. Smaller plants can make it easier to add and /or subtract capacity.

Plant Size and Flexibility

Learning Curves
Learning

Curve Concept

Learning causes an inward shift in the LRAC curve due to better production knowledge. Learning is often mistaken for scale economies.

Strategic

Implications of the Learning Curve Concept

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