cost analysis presentation

8/4/2019 Cost Analysis Presentation

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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


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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


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Accounting and Economic Profit

Economic profitis total revenues minus totalcosts

Accounting profitis total revenue minus theexpenses of the firm over a time period.


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Accounting versus Economic Profit

Costs (Explicit)

Groceries (wholesale) 76,000

Taxes 10000

Advertising 2,000

Accounting Profit: 70,000

Additional (implicit) costs

Interest (personal investment) 7,000

Rent (owner's building) 18,000

Economic Profit: -5,000

Total Revenue

Sales (groceries) 170,000

Labor (employees) 12,000

Total (explicit) costs 100,000

Salary (owner's labor) 50,000

Total (implicit) costs 75,000

Total Explicit andImplicit costs: 175,000

To calculate accounting profit, subtract the explicit costs fromtotal revenue.

To calculate economic profit, subtract both the explicitand implicit costs from total revenue.


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Economic Profit vs.Accounting

Profit Accounting profit = TR - TC (explicit,

accounting costs)

Most of the time,when the word "profit" isused, we are referring to accounting profits

Accounting profits are important to managers,shareholders, govt. (for taxes), etc.


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However, managerial decisions should not bebased only on accounting profits, but shouldalways include the more comprehensiveconcept of"economic profits."

Economic Profits = TR - TC (explicitaccounting costs + implicit costs, including

OC). Managerial decisions should always bebased on Economic Profits,notaccountingprofits.


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Sunk Costs

Sunk Costs : are similar to FC, in that theyrepresent 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, andnow the most you can get is $100,000

It is often difficult to ignore sunk costs, they canoften incorrectly sneak into decision making.


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Sunk Costs Example: A firm spends $20m on R&D for a

new product over many years. Now anadditional $10m is needed to complete aprototype. Should the firm consider the

original $20m investment? No, because it is a sunk cost and cannot be

recovered whether the firm markets the newproduct or not. The firm should look only at

the product's current expected future revenuecompared to the current marginal(incremental) additional costs of bringing theproduct to the market.


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Sunk Costs

For example, if the current expected revenueis $15m compared to the $10m cost, then thefirm should continue with the project, even

though the expected loss will be $15m -$30m = -$15m. If they consider the sunkcost of $20m and abandon the project, the

loss be even greater, -$20m.


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Categories of Cost


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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.


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Total and Average Fixed Costs

Total Fixed Costs (TFC):costs that remain unchanged in the shortrun 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


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Average Costs

F i x e d c o s t F CA F C = =Q u a n t i t y Q

V a r i a b l e c o s t V CA V C = =

Q u a n t i t y Q

T o t a l c o s t T CA T C = =

Q u a n t i t y Q


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Marginal Cost

Marginal Cost (MC)

Increase in total cost from producing one moreunit or output

QTCMC !

MC curve is U-shaped

When MPL rises, MC fallsWhen MPL falls, MC rises.

MPL rises and then falls, MC will fall and then rise.


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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 arethousands 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 levelsof Q, AVC dominates, and the combination of the two

effects explains the U-shaped ATC.


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SMC = d TC / d Q = 30 + .6Q MC rises as Q increases.


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SR Relationship Between

Production and Cost Add

marginal

cost to thetable

Total

Input

(L) Q MP

TVC

(wL) MC

0 0 0

1 1,000 1,000 500 0.502 3,000 2,000 1,000 0.25

3 6,000 3,000 1,500 0.17

4 8,000 2,000 2,000 0.25

5 9,000 1,000 2,500 0.50

6 9,500 500 3,000 1.00

7 9,850 350 3,500 1.43

8 10,000 150 4,000 3.33

9 9,850 -150 4,500


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Q

P

Average FixedCosts:will be high for small rates ofoutput (as total fixed costs aredivided by few units), but willalways decline with output (astotal fixed costs are divided

by more and more units).

Total FixedCosts:do not vary with output;hence, they are the samewhether output is set to100,000 units or 0.

Q

P

AFC

TFC

Short-Run Cost Curves


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Q

P

Average Total Costs:

will be a U-shaped curve sinceAFCwill be high for small ratesof output andMCwill be highas the plants productioncapacity (q) is approached.

Marginal Costs:rise sharply as the plants

production capacity (q) isapproached.

Q

P

MC

qATC

q

Short-Run Cost Curves


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Output and Costs

In the Short Run


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Shape of the ATC Curve The ATCcurve is U-shaped.

ATCis high for an underutilized plantbecause AFC is high.

ATCis high for an over-utilized plantbecause MC is high.


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TFC

TCTVC

0

Totalcosts

42

50

100

150

200

6 8 10

TCTVCTFCOutput

per day

2

468

10

0

25

426498

152

total fixe

dcosts are flat they are constant at all output levels.

Output

=+

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50

50

75

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202

total variable costs increase asmore variable inputs are utilized.

As total costs are the combination ofTVCand TFC, they are everywherepositive and increase sharply with output

Short Run Total Cost Curves


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AFC

Costper unit

42 6 8 10Output

20

40

60

AVCTVCOutput

per day=/

AVC

012

468

10

----

15.0012.50

10.5010.6712.2515.20

01525

426498

152

The average variable cost curve (AVC)

is the total variable cost (TVC) dividedby the output level. It is higher eitherfor a few or a lot of units and has someminimal point between the two where,when graphed later, marginal costs (MC)will cross.

Short Run Cost Curves


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ATCTCOutput

per day=/

0

1

2468

10

----

65.00

37.5023.0019.0018.50

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When output is low, ATCis highbecause AFCis high. Also, ATCishigh when output is large asMCgrows large when output is high.

50

65

7592

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202

These two relationships explain the

distinct Ushape of the ATCcurve.

The average total cost curve (ATC)

is simply TCdivided by the output.

ATC

MCalways crossesATCat its minimum point.

Short Run Cost Curves

AFC

Costper unit

42 6 8 10Output

20

40

60

AVC

MC


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Output and Costs

In the Long Run


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Costper unit

Output level

LRATC

Planning Curve The ATCcurve for the firm will depend upon the size of the plant.

Representative short-runAverage Costcurves

If the cost per unit varies according to the size of thefacility, then a Long Run Average Total Costcurve(LRATC) can be mapped out as the surface of all theminimum points possible at all the possible degrees ofscale.


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Economies OfScope

Most firms produce a variety of goods andservices, e.g. banks, Proctor and Gamble,General Mills, Walt Disney, etc.

In the production of various products, there may

likely be Economies ofScope, which are thepotential efficiencies and cost advantages ofproducing 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 Bankhas economies of scope providing various financialservices and products such as mutual funds, checkingand savings accounts, loans, insurance, etc.


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Economies OfScope

For example: Suppose that joint productionof Q1 and Q2 is $17m. Producing each goodseparately would be $12m for Q1 and $8m forQ2, for a total of $20m. In other words, thefirm saves $3m with joint production. Or:

SC = $20m - $17m = .15 or 15%.$20m

This means that the firm saves 15% with jointproduction ($20m to $17m = -15% cost savings)


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Economies OfScope

Sources of Economies ofScope Shared activities between Q1 and Q2. Coca-Cola

can use the same bottling equipment andmachinery to produce many different beverage

lines Transfer of skills between Q1 and Q2. Coca-Cola

can use its expertise in soft drink production forother beverages, like orange juice, bottled iced

tea, bottled water, etc Consolidated sales, ordering, and delivery. Coca-

Cola can use the same sales force for all of itsbeverage lines, and can consolidate shipments of

beverages


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Costper unit

Output level

LRATCoften have segments that represent: economies ofscale, constant returns to scale, ordiseconomies of scale.

The LRATCrepresented below has a downward slopingsegment demonstrating economies of scale for that rangeof output meaning that an expansion of plant size canreduce per unit cost up to output level q.

There is also an upward sloping segment, demonstrating

diseconomies of scale meaning that an expansion in plantsize beyond output level q leads to higher per unit costs.

q

Economies of Scale Diseconomies of Scale

Different Types of LRATC

LRATCPlant ofideal size


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The LRATCbelow has a downward sloping segmentdemonstrating economies of scale, an upward sloping

segment, demonstrating diseconomies of scale, and a flatsegment, demonstrating constant returns to Scale.

Costper unit

Output levelq1 q2

Economiesof scale

Diseconomiesof scale

Constant returnsto scale

The flat region of the LRATCcurve between q1 and q2represents constant returns to scale. Any of the plantsizes in this region would be ideal because they minimize

per unit costs.


LRATC

Plant ofideal size


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Costper unit

Output level

LRATC

Below, the LRATCrepresented has a downward sloping

segment demonstratingEconomies of Scale for the entirerange of output, which implies that the most efficient sizeplant available would be the largest one possible.

q

Economies of scale

Plant ofideal size



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LearningCurve

Learning curve concept summarizes theinverse relationship between cumulativeproduction and ATC.

As cumulative production increases, ATCdeclines because of increased productivitygains, increased efficiency gains from

learning and experience.


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LearningCurve

Sources of learning: Worker skills increase over time, as they learn the

production process and become more efficientover time.

Trial-and-error and experimentation with differentmethods of production result in increasedefficiency/productivity over time. Equipment canbe redesigned and improved with experience, as

engineers learn how to produce moreefficiently. Research and development result incontinual improvements in production efficiency.


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cost analysis presentation

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