MANAGERIAL

th
ECONOMICS 11 Edition
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
 Chapter 9
KEY CONCEPTS
 historical cost  operating curves fixed cost
 current cost  variable cost
 replacement cost  short-run cost curve
 opportunity cost  long-run cost curve
 explicit cost  economies of scale
 implicit cost  cost elasticity
 incremental cost  capacity
 profit contribution  minimum efficient scale
 sunk cost  multiplant economies of scale
 cost function  multiplant diseconomies of scale
 short-run cost functions  learning curve
 long-run cost functions  economies of scope
 short run  cost-volume-profit analysis
 long run  breakeven quantity
 planning curves
 What Makes Cost Analysis
Difficult?
 Link Between Accounting and Economic
Valuations
 Accounting and economic costs often differ.
 Historical Versus Current Costs
 Historical cost is the actual cash outlay.
 Current cost is the present cost of previously
acquired items.
 Replacement Cost
 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 εC = ∂C/C ÷ ∂Q/Q.
 εC < 1 means falling AC, increasing
returns.
 εC = 1 means constant AC constant
returns.
 εC > 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.
 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.
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 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.
 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=Q(P-AVC)/[Q(P-AVC)-TFC]
 DOL is the elasticity of profit with respect to
output.