The Cost of Production & Managerial Decision Making

Topics to be Discussed

WHAT? Relationship between Production and Costs Measuring Cost: Which Costs Matter? Cost in the Short Run Cost in the Long Run

Topics to be Discussed

Short-Run Cost Curves Long-Run Cost Curves Plant Size and Economies of Scale Plant Size and Diseconomies of Scale Economies of Scope Breakeven Analysis Estimating and Predicting Costs

Why Cost Analysis is important?

Costs play in determining the profitability of the firm Conventional accounting statements do not always present the information needed for effective managerial decisions Understand various cost concepts Understand concepts of economies of scale and scope and apply them to business strategy

Introduction

The production technology measures the relationship between input and output. (Q =f (K, L, R) ) Given the production technology, managers must choose how to produce a product with minimum cost Why outsourcing?

Introduction

To determine the optimal level of output and the input combinations, we must know costs of production. We know Total cost C=w (L) + r (K) Various cost concepts

Measuring Cost: Which Costs Matter?

Economic Cost vs. Accounting Cost Economic Cost vs. Accounting Cost

Accounting Cost
Eg.

Actual expenses plus depreciation charges for capital equipment are explicit costs

These

Economic Cost (explicit + implicit costs)

Cost So

to a firm of utilizing economic resources in production, including opportunity cost (implicit costs) economic costs include both explicit and implicit costs

Measuring Cost: Which Costs Matter?

Opportunity Cost Opportunity costs refer to the value of the inputs owned and used by the firm in its own production activity.

In measuring production costs, the firm must include the opportunity costs of all inputs, whether purchased or owned by the firm. Profit = Total Revenue Total Cost Accounting Profit Vs Economic Profit Accounting Profit = Total Revenue Explicit costs Economic Profit = Total Revenue (Explicit + implicit cost)

Measuring Cost: Which Costs Matter?

An Example for opportunity cost

A firm owns its own building and pays no rent for office space Does this mean the cost of office space is zero?

NO! There is also Cost of Being Your Own Boss

Private Costs and Social Costs Any example for social cost? How to estimate social costs?

Measuring Cost: Which Costs Matter?

Fixed, Variable Costs and Total Costs Fixed, Variable Costs and Total Costs

Total output is a function of variable inputs and fixed inputs. (Q=f (K, L,R,Land) Therefore, the total cost of production equals the fixed cost (the cost of the fixed inputs) plus the variable cost (the cost of the variable inputs), or

TC = FC + VC

Measuring Cost: Which Costs Matter?

Fixed and Variable Costs Fixed and Variable Costs Fixed Cost
Does Cost

not vary with the level of output

paid by a firm that is in business regardless of the level of output cost must be paid even if output is zero

Fixed

Variable Cost
Cost

that varies as output varies

Example?

A Firms Short-Run Costs

Rate of Fixed Output Cost (FC) Variable Cost (VC) Total Cost (TC) Marginal Cost (MC) Average Fixed Cost (AFC) Average Variable Cost (AVC) Average Cost (AC)

0 1 2 3 4 5 6 7 8 9 10 11

50 50 50 50 50 50 50 50 50 50 50 50

0 50 78 98 112 130 150 175 204 242 300 385

50 100 128 148 162 180 200 225 254 292 350 435

--50 28 20 14 18 20 25 29 38 58 85

--50 25 16.7 12.5 10 8.3 7.1 6.3 5.6 5 4.5

--50 39 32.7 28 26 25 25 25.5 26.9 30 35

--100 64 49.3 40.5 36 33.3 32.1 31.8 32.4 35 39.5

Cost in the Short Run

Marginal

Cost (MC) is the cost of expanding output by one unit. Since fixed cost have no impact on marginal cost, it can be written as:

V C TC M C= = Q Q

Cost in the Short-Run

TC=3+4Q (what is MC?) Average Fixed Cost is Total Fixed cost divided by the quantity of output produced

AFC= TFC/Q

Average Variable Cost is Total Variable Cost divided by the quantity of output produced AVC= TVC/Q

Cost in the Short Run

Average

Cost (AC) is the cost per unit of output, or average fixed cost (AFC) plus average variable cost (AVC). TFC TVC ATC = + Q Q

Cost in the Short Run

That

is,

TC ATC = AFC + AVC or Q

Cost in the Short Run

The Determinants of Short-Run Cost

The

relationship between the production function and cost can be exemplified by either increasing marginal returns and decreasing cost or decreasing marginal returns and increasing cost.

Cost in the Short Run

The Determinants of Short-Run Cost

Increasing With

marginal returns and decreasing cost

increasing marginal returns, output is increasing relative to input and variable cost and total cost will fall relative to output. marginal returns and increasing cost

Diminishing With

decreasing marginal returns, output is decreasing relative to input and variable cost and total cost will rise relative to output.

Cost in the Short Run

Consequently (see the table):

MC

decreases initially with increasing marginal returns

0 through 4 units of output

MC

increases with decreasing marginal returns (due to law of diminishing marginal returns)

5 through 11 units of output

A Firms Short-Run Costs (Rs)

Rate of Fixed Output Cost (FC) Variable Cost (VC) Total Cost (TC) Marginal Cost (MC) Average Fixed Cost (AFC) Average Variable Cost (AVC) Average Total Cost (ATC)

0 1 2 3 4 5 6 7 8 9 10 11

50 50 50 50 50 50 50 50 50 50 50 50

0 50 78 98 112 130 150 175 204 242 300 385

50 100 128 148 162 180 200 225 254 292 350 435

--50 28 20 14 18 20 25 29 38 58 85

--50 25 16.7 12.5 10 8.3 7.1 6.3 5.6 5 4.5

--50 39 32.7 28 26 25 25 25.5 26.9 30 35

--100 64 49.3 40.5 36 33.3 32.1 31.8 32.4 35 39.5

Cost Curves for a Firm

(Rs.per year)

Cost 400

Total cost is the vertical sum of FC and VC.

TC VC
Variable cost increases with production and the rate varies with increasing & decreasing returns.

300

200

100 50
0 1 2 3 4 5 6 7 8 9

Fixed cost does n vary with output FC

10 11 12 13 Output

Cost Curves for a Firm

Cost
(Rs per unit)

100

MC
75

50

AC AVC

25

AFC
0 1 2 3 4 5 6 7 8 9 10 11 Output (units/yr.)

Cost in the Long Run

firms expansion path shows the minimum cost combinations of labor (L) and capital (K) at each level of output.

A Firms Expansion Path

Capital per year 150 Rs3000 Isocost Line
The expansion path illustrates the least-cost combinations of labor and capital that can be used to produce each level of output in the long-run.

100 75

Rs2000 Isocost Line

Expansion Path C B

50 A 25 50 100 150
200 Unit Isoquant 300 Unit Isoquant

200

300

Labor per year

A Firms Long-Run Total Cost Curve

Cost per Year Expansion Path 3000 F

E 2000

1000

100

200

300

Output, Units/yr

Long-Run Cost Curves and Returns to Scale

Long-Run Average Cost (LAC)

Constant

Returns to Scale

If input is doubled, output will double and average cost is constant at all levels of output.

Long-Run Cost Curves and Returns to Scale

Long-Run Average Cost (LAC)

Increasing

Returns to Scale

If input is doubled, output will more than double and average cost decreases at all levels of output.

Long-Run Cost Curves and Returns to Scale

Long-Run Average Cost (LAC)

Decreasing

Returns to Scale

If input is doubled, the increase in output is less than twice as large and average cost increases with output.

Long-Run Cost Curves and Returns to Scale

Long-Run Average Cost (LAC)

In

the long-run: Firms experience increasing and decreasing returns to scale and therefore long-run average cost is U shaped.

Long-Run Average and Marginal Cost

Cost (Rs per unit of output

LMC LAC

Output

Economies of Scale

Economies of Scale are technological or organisational advantages that accrue to the firm as it increases output in the long run. Economies of scale reduces long run average costs.(Declining portion of LAC curve)

Economies of Scale

Economies of Scale
Economies

of Scale occur when increase in output is greater than the increase in inputs. to advancing technological devt and mass production, there will be reduction in the production costs and prices

Due

Eg: Computer, other consumer electronics etc.

Economies of Scale

At higher scales of operation, more specialised and productive machinery can be used. There are financial reasons for economies of scale Bulk purchase advantage, bank loans at lower interest rates, decreasing costs in advertisement and promotional activities

Economies of Scale

Economies of scale due to International trade in inputs Outsourcing accounts for more than one third of total manufacturing costs by Japanses firms, saving them more than 20 % of production costs. Opening of production facilities abroad Globalisation and new economies of scale

Diseconomies of Scale
Diseconomies

of Scale

Increase in output is less than the increase in inputs. Diseconomies of scale are organisational disadvantage that the firm encounters as it increases output in the long run. Diseconomies of scale increase long run average costs (Increasing portion of LAC Curve)

Measuring Economies of Scale

Measuring Economies of Scale by estimating Cost-Output Elasticity

Ec = Cost output elasticity = % in cost from a 1 increase % in output

Cost Output Elasticity

Cost

Elasticity is the percentage change in long run total cost from a 1 per cent change in output

Measuring Economies of Scale

Measuring Economies of Scale The cost elasticity reflects the presence of either economies of scale or diseconomies of scale Ec= percentage change in LTC Percentage change in Q

Measuring Economies of Scale

Ec=

LTC . Q

(Q2 +Q1) (LTC2 + LTC1)

Where LTC is Long run Total Cost Q is output

Measuring Economies of Scale

Q1 is initial output and Q2 is New level of output

LTC1 is long run total cost in the initial period

LTC2 is long run total cost for new level of output

Measuring Economies of Scale

Ec <1 means LTC increases by a smaller percentage than the percentage increase in output (E of Scale) Ec =1 means LTC changes by the same percentage as the percentage change in output (CRS) Ec >1 means LTC increases by a larger percentage than the percentage increase in output (DES)

Measuring Economies of Scale

Ec < 1 means Economies of Scale Ec = 1 means constant returns to scale Ec > 1 means diseconomies of scale

Economies of Scope
If

total cost of production is lower when two products (services) are produced together than when they are produced separately. of scope occur when the average cost of undertaking two or more activities together is less than the sum of the costs of each activity separately.

Economies

Economies of Scope

Examples:
Automobile

company--cars and trucks and research

University--Teaching A

firm that produces a second product in order to use the by-products

What are the advantages of joint production?

Consider

an automobile company producing cars and tractors

Economies of Scope

Advantages 1) Both use capital and labor. 2) The firms share management resources. 3) Both use the same labor skills and type of machinery.

Economies of Scope

Observations
There

is no direct relationship between economies of scope and economies of scale.

May experience economies of scope and diseconomies of scale May have economies of scale and not have economies of scope

Economies of Scope

Degree of Economies of Scope measures the savings in cost and can be written:

C(X) + C (Y ) C ( X , Y ) SC = C( X ,Y )
C(X) C(Y)

is the cost of producing X is the cost of producing Y

C(X,Y)

is the joint cost of producing both products

Example

The ABC Corporation produces 1000 wood cabinets and 500 wood desks per year, the total cost being $30000. If the firm produced 1000 wood cabinets only, the cost would be $23000. If the firm produced 500 wood desks only, the cost would be $ 11,000.
(a) Calculate the degree of economies of Scope (b) Why do economies of scope exist?

Example

S= (23000+11000-30000)/30000=0.13

Example

CX =$2000 CY =$3000 C (X, Y) = $4000 SC= ($2000+$3000 ) ($4000)

($4000)

=$1000/$4000 =0.25 Approx..25 % saving in cost

Economies of Scope

Interpretation:

If

Savings in Cost > 0 -- Economies of scope Savings in Cost < 0 -- Diseconomies of scope

If

Estimating and Predicting Cost

Estimates of future costs can be obtained from a cost function, which relates the cost of production to the level of output and other variables that the firm can control. Suppose we wanted to derive the total cost curve for automobile production. Either using time series data or cross section data on variables we can estimate cost functions and predict for future.

Estimating and Predicting Cost

Difficulties in Measuring Cost 1) Output data may represent an aggregate of different type of products. 2) Cost data may not include opportunity cost. 3) Allocating cost to a particular product may be difficult when there is joint products.

Break-even Analysis

Most useful for managerial decision making A firm is at break even when revenue of the firm is equal to its cost TR = TC No profit, No loss

How to calculate Breakeven point Quantity?

Break-even Analysis
Qb

= TFC/ (P-AVC) = Total Fixed Cost

TFC P=

Price of product Average Variable Cost

AVC=

Break-even Analysis

Suppose a firm producing a product that has fixed cost per month Rs. 60,000, Average Variable Cost of production is Rs.3.60, Price of Product is Rs.6 per one. What is the breakeven output ? TFC/ (P- AVC) 60,000/ (6.0 3.60) = 25,000 units

Summary

Cost functions relate the cost of production to the level of output of the firm. Managers, investors, and economists must take into account the opportunity cost associated with the use of the firms resources. Firms are faced with both fixed and variable costs in the short-run.

Summary

When there is a single variable input, as in the short run, the presence of diminishing returns determines the shape of the cost curves. In the long run, all inputs to the production process are variable. The shape of long run average cost curve is determined by whether firm experiences IRS, CRS or DRS

Summary

The firms expansion path describes how its cost-minimizing input choices vary as the scale or output of its operation increases. A firm enjoys economies of scale when it can double its output at less than twice the cost.

Summary

Economies of scope exist when the joint output of a single firm is greater than the output that could be achieved by two different firms each producing a single output.

Thank you