Cost Analysis

Topics for discussion

     

Total Revenue and Total Cost Opportunity Cost Total and Average Fixed Costs Total and Average Variable Costs Total and Marginal Cost Shape of the Curves

A Firms Total Revenue and Total Cost



Total Revenue The amount that the firm receives for the sale of its output. Total Cost The amount that the firm pays to buy inputs.
Profit is the firms total revenue minus its total cost.

Profit = Total revenue - Total cost

Explicit and Implicit Costs



Costs may be either explicit or implicit.

Total Cost

= explicit costs + implicit costs

Explicit costs result when a monetary payment is made. Implicit costs involve resources owned by the firm that do not involve a monetary payment.


Examples:
time spent by owner running the firm the foregone normal rate of return on the owners financial investment

Accounting and Economic Profit



Economic profit is total revenues minus total costs Accounting profit is total revenue minus the expenses of the firm over a time period.

Accounting versus Economic Profit

Total Revenue Sales (groceries) Costs (Explicit) Groceries (wholesale) Taxes Advertising Labor (employees) Total (explicit) costs 170,000 76,000 10000 2,000 12,000 100,000 Additional (implicit) costs Interest (personal investment) Rent (owner's building) Salary (owner's labor) Total (implicit) costs Total Explicit and Implicit costs: Accounting Profit:


7,000 18,000 50,000 75,000 175,000 -5,000

70,000

Economic Profit:

To calculate accounting profit, subtract the explicit costs from total revenue. To calculate economic profit, subtract both the explicit and implicit costs from total revenue.

Economic Profit vs. Accounting Profit



Accounting profit = TR - TC (explicit, accounting costs) Most of the time, when the word "profit" is used, we are referring to accounting profits Accounting profits are important to managers, shareholders, govt. (for taxes), etc.

However, managerial decisions should not be based only on accounting profits, but should always include the more comprehensive concept of "economic profits." Economic Profits = TR - TC (explicit accounting costs + implicit costs, including OC). Managerial decisions should always be based on Economic Profits, not accounting profits.

Opportunity Cost


The opportunity cost is the value of the most valuable good or service forgone. Example:
Should we go to a movie or study for next weeks test. Should we get MBA or professional training or begin work right after college. Should we invest our money in stock market or invest in new business.

Sunk Costs


Sunk Costs : are similar to FC, in that they

represent costs that do NOT play a relevant role in managerial decisions.

 

Sunk cost = an expense that:  a) has already been incurred, and  b) cannot be recovered. Example: You paid $120,000 for your house, and now the most you can get is $100,000 It is often difficult to ignore sunk costs, they can often incorrectly sneak into decision making.

Sunk Costs


Example: A firm spends $20m on R&D for a new product over many years. Now an additional $10m is needed to complete a prototype. Should the firm consider the original $20m investment?
No, because it is a sunk cost and cannot be recovered whether the firm markets the new product or not. The firm should look only at the product's current expected future revenue compared to the current marginal (incremental) additional costs of bringing the product to the market.

Sunk Costs


For example, if the current expected revenue is $15m compared to the $10m cost, then the firm should continue with the project, even though the expected loss will be $15m $30m = -$15m. If they consider the sunk cost of $20m and abandon the project, the loss be even greater, -$20m.

Categories of Cost

Fixed Costs


Fixed costs are those costs that do not vary with the quantity of output produced. Costs of a firms fixed inputs Remain constant as output changes Example: Interest payment on borrowed capital and rental expenditure on leased plant and equipment.

Variable Costs


Variable costs are those costs that do change as the firm alters the quantity of output produced. Costs of a firms variable inputs Change with output Example: Payments for raw material, fuel, excise taxes etc.

Total and Average Fixed Costs



Total Fixed Costs (TFC): costs that remain unchanged in the short run when output is altered Examples:  insurance premiums  property taxes  the opportunity cost of fixed assets Average Fixed Costs (AFC): Fixed costs per unit (i.e. TFC / output). decline as output expands

Total and Average Variable Costs



Total Variable Costs (TVC): sum of costs that increase as output expands Examples:  cost of labor  raw materials Average Variable Costs (AVC): variable costs per unit (i.e. TVC / output)

Average Costs
F ix e d c o s t FC AFC= = Q u a n tity Q V a ria b le c o s t V C AV C= = Q u a n tity Q T o ta l c o s t TC ATC= = Q u a n tity Q

Marginal Cost
Marginal cost (MC) measures the amount total cost rises when the firm increases production by one unit.  Marginal cost helps answer the following question: How much does it cost to produce an additional unit of output?


Marginal Cost


Marginal Cost (MC)

Increase in total cost from producing one more unit or output

MC !

TC Q

MC curve is U-shaped
When MPL rises, MC falls When MPL falls, MC rises. MPL rises and then falls, MC will fall and then rise.

Marginal Cost


the increase in Total Cost associated with a one-unit increase in production Typically, MC will decline initially, reach a minimum, and then rise. SMC = PL / MPL, where PL = wage per hour, and MPL = marginal product of labor. SMC will go DOWN if either MPL goes UP, or PL goes DOWN. SMC will go UP if either MPL goes DOWN, or PL goes UP

Marginal Cost (MC):

Example
 

 

Firm's SR Cost Function, C = f (Q): C = $270 + (30 Q + .3 Q2) FC VC where Q is thousands of units and C are thousands of dollars. Dividing all terms by Q, we have ATC: ATC = (270 / Q ) + (30 + .3Q) AFC AVC
As Q increases, AFC steadily decreases and AVC rises. At low levels of Q, AFC dominates; at high levels of Q, AVC dominates, and the combination of the two effects explains the U-shaped ATC.

SMC = d TC / d Q = 30 + .6Q


MC rises as Q increases.

SR Relationship Between Production andTotal Cost



Add marginal cost to the table

Input (L) 0 1 2 3 4 5 6 7 8 9

Q 0 1,000 3,000 6,000 8,000 9,000 9,500 9,850 10,000 9,850

MP 1,000 2,000 3,000 2,000 1,000 500 350 150 -150

TVC (wL) 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500

MC 0.50 0.25 0.17 0.25 0.50 1.00 1.43 3.33

SR Relationship Between Production and Cost



Observe that:
When MP is increasing, MC is decreasing. When MP is decreasing, MC is increasing.

Total Input (L) 0 1 2 3 4 5 6 7 8 9

Q 0 1,000 3,000 6,000 8,000 9,000 9,500 9,850 10,000 9,850

MP 1,000 2,000 3,000 2,000 1,000 500 350 150 -150

TVC (wL) 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500

MC 0.50 0.25 0.17 0.25 0.50 1.00 1.43 3.33

Short-Run Cost Curves

P

TFC
Q

Total Fixed Costs: do not vary with output; hence, they are the same whether output is set to 100,000 units or 0.

Average Fixed Costs: will be high for small rates of output (as total fixed costs are divided by few units), but will always decline with output (as total fixed costs are divided by more and more units).

AFC
Q

Short-Run Cost Curves

P

MC

Marginal Costs: rise sharply as the plants production capacity (q) is approached.

q Q ATC
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 Q

Output and Costs In the Short Run

Shape of the ATC Curve



The ATC curve is U-shaped.

ATC is high for an underutilized plant because AFC is high. ATC is high for an over-utilized plant because MC is high.

Short Run Total Cost Curves

total fixed costs are flat Total they are constant at all output levels. costs total variable costs increase as more variable inputs are utilized. 200 As total costs are the combination of TVC and TFC, they are everywhere positive and increase sharply with output
150 Output per day

TC TVC

TFC + TVC = TC
50 50 50 50 50 50 0 25 42 64 98 152 50 75 92 114 148 202
100

0 2 4 6 8 10

TFC
50 Output 2 4 6 8 10

Short Run Cost Curves

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. 60
Cost per unit

40

TFC
50 50 50 50 50 50 50

Output per day

= AFC
---50.00 25.00 12.50 8.33 6.25 5.00
20

0 1 2 4 6 8 10

AFC
Output

10

Short Run Cost Curves

The average variable cost curve (AVC) is the total variable cost (TVC) divided Cost by the output level. It is higher either per unit for a few or a lot of units and has some minimal point between the two where, when graphed later, marginal costs (MC) 60 will cross.

TVC
0 15 25 42 64 98 152

Output per day

= AVC
---15.00 12.50 10.50 10.67 12.25 15.20

40

0 1 2 4 6 8 10

20

AVC AFC
Output

10

Short Run Cost Curves

To calculate the marginal cost curve (MC) we take the change in TC ((TC) and divide that by the change in output. Our increments for increasing output here are 1 ( 1). MC starts low and increases as output increases. It also crosses AVC at its minimum point.
Cost per unit 60

MC
40 MC always crosses AVC at its minimum point.

TC
50 65 75 84 92 102 114 129 148 172 202

(TC ( Output MC =
15 10 8 12 19 30 1 1 1 1 1 1 15.00 10.00 8.00 12.00 19.00 30.00

AVC
20

AFC
Output

10

Short Run Cost Curves

The average total cost curve (ATC) is simply TC divided by the output. When output is low, ATC is high because AFC is high. Also, ATC is high when output is large as MC grows large when output is high. These two relationships explain the distinct Ushape of the ATC curve.
Cost per unit 60

MC
MC always crosses ATC at its minimum point. 40

TC
50 65 75 92 114 148 202

Output per day

= ATC
---65.00 37.50 23.00 19.00 18.50 20.20

0 1 2 4 6 8 10

ATC
20

AVC AFC
Output

10

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.

Planning Curve


The ATC curve for the firm will depend upon the size of the plant.


If the cost per unit varies according to the size of the facility, then a Long Run Average Total Cost curve (LRATC) can be mapped out as the surface of all the minimum points possible at all the possible degrees of scale.
Cost per unit

Representative short-run Average Cost curves

LRATC
Output level

Economies of Scale


As output (plant size) is increased, per-unit costs will follow one of three possibilities:
Economies of Scale: Reductions in per unit costs as output expands. Three reasons:
  

mass production specialization improvements in production as a result of experience

Diseconomies of Scale: increases in per unit costs as output expands Constant Returns to Scale: unit costs are constant as output expands

Economies Of Scope


Most firms produce a variety of goods and services, e.g. banks, Proctor and Gamble, General Mills, Walt Disney, etc. In the production of various products, there may likely be Economies of Scope, which are the potential efficiencies and cost advantages of producing closely related goods or services.
For example, Coca-Cola has economies of scope in the production of various beverages: different soft drinks, juices, sports drinks, iced tea, spring water, etc. A Bank has economies of scope providing various financial services and products such as mutual funds, checking and savings accounts, loans, insurance, etc.

Economies Of Scope


Economies of Scope (SC) exist when joint production of multiple goods is less than the aggregate cost of producing each item separately, measured as: SC = C (Q1) + C (Q2) - C (Q1, Q2) C (Q1) + C (Q2) where:
  

C (Q1) = cost of producing Q1 alone C (Q2) = cost of producing Q2 alone C (Q1, Q2) = cost of jointly producing Q1 and Q2

Economies Of Scope


For example: Suppose that joint production of Q1 and Q2 is $17m. Producing each good separately would be $12m for Q1 and $8m for Q2, for a total of $20m. In other words, the firm saves $3m with joint production. Or: SC = $20m - $17m = .15 or 15%. $20m
This means that the firm saves 15% with joint production ($20m to $17m = -15% cost savings)

Economies Of Scope


Sources of Economies of Scope

Shared activities between Q1 and Q2. Coca-Cola can use the same bottling equipment and machinery to produce many different beverage lines Transfer of skills between Q1 and Q2. Coca-Cola can use its expertise in soft drink production for other beverages, like orange juice, bottled iced tea, bottled water, etc Consolidated sales, ordering, and delivery. CocaCola can use the same sales force for all of its beverage lines, and can consolidate shipments of beverages

Economies Of Scope
Consolidated advertising. Proctor and Gamble can advertise all products simultaneously Multiple outputs from a single input. Cattle producers selling both beef and hides. Airline providing both passenger and freight services Micromarketing. General Mills can produce 20 different breakfast cereals, Proctor and Gamble can produce 20 different kinds of shampoo. Coke can produce 20 different types of soft drinks, etc

Different Types of LRATC

LRATC often have segments that represent: economies of scale, constant returns to scale, or diseconomies of scale. The LRATC represented below has a downward sloping segment demonstrating economies of scale for that range of output meaning that an expansion of plant size can reduce per unit cost up to output level q. There is also an upward sloping segment, demonstrating diseconomies of scale meaning that an expansion in plant size beyond output level q leads to higher per unit costs.
Cost per unit Economies of Scale Diseconomies of Scale

Plant of ideal size

LRATC
Output level

 The LRATC below has a downward sloping segment demonstrating economies of scale, an upward sloping segment, demonstrating diseconomies of scale, and a flat segment, demonstrating constant returns to Scale. The flat region of the LRATC curve between q1 and q2 represents constant returns to scale. Any of the plant sizes in this region would be ideal because they minimize per unit costs.
Cost per unit Economies of scale Constant returns to scale Plant of ideal size Diseconomies of scale

Different Types of LRATC

LRATC
q1 q2
Output level

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.
Cost per unit Economies of scale

Plant of ideal size

LRATC q
Output level

Learning Curve


Learning curve concept summarizes the inverse relationship between cumulative production and ATC. As cumulative production increases, ATC declines because of increased productivity gains, increased efficiency gains from learning and experience.

Learning Curve


Sources of learning:
Worker skills increase over time, as they learn the production process and become more efficient over time. Trial-and-error and experimentation with different methods of production result in increased efficiency/productivity over time. Equipment can be redesigned and improved with experience, as engineers learn how to produce more efficiently. Research and development result in continual improvements in production efficiency.

Learning Curve


Examples of the Learning Curve

When VCRs first came out in early 1980s, they sold for $2000. Over time, learning resulted in prices less than $100, with significant improvements in quality, durability, features, reliability, etc. Ball point pens were originally $12.50 in 1945, or about $125 in today's dollars! Hand held calculators, introduced in early 1970s, fell from $1000 to $10 over the decade

Learning Curve


Using the Learning Curve

The firm's goal is to maximize LR profits, and can use the learning curve concept to guide decision making

By aggressively cutting price initially, the firm gains on two dimensions

gains market share with the new product, establishes "first mover advantage," lower prices mean more sales, which allows the firm to work down the learning curve faster