cost theory and estimation
DESCRIPTION
Production and Cost Analysis for Managerial EconomicsTRANSCRIPT
![Page 1: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/1.jpg)
Cost Theory and Estimation
An important consideration in decision making
![Page 2: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/2.jpg)
Cost Theory and Estimation
Nature of Costs
Short-Run Cost Functions
Long-Run Cost Curves
Learning Curves
Cost-Volume-Profit Analysis
The New Economies of Scale
Supply-Chain Management
Empirical Estimation of Cost Functions
![Page 3: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/3.jpg)
Nature of Costs • What is relevant?
![Page 4: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/4.jpg)
A cost is relevant if it is
affected by a
management decision
• Opportunity cost
• Marginal cost
• Incremental cost
• Sunk cost http://article.wn.com/view/2014/06/24/Three_Graphs_that_Show_the_Chinese_Mobile_Technology_Revolut/
![Page 5: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/5.jpg)
https://mrski-apecon-2008.wikispaces.com/Chapter+13+Emily+K
RevenueRevenue
Total
Opportunity
Costs
![Page 6: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/6.jpg)
Explicit Costs
• The actual expenditures of the firm
• Accounting costs
![Page 7: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/7.jpg)
Implicit Costs
• Value of the inputs owned
and used by the firm
• Economic costs
• Cost that does not require the
firm to give up money, but
rather opportunity
![Page 8: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/8.jpg)
Nature of Costs
Implicit costs
https://mrski-apecon-2008.wikispaces.com/Chapter+13+Emily+K
![Page 9: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/9.jpg)
The opportunity cost associated with choosing a particular decision is measured by the benefits foregone in the next-best alternative
![Page 10: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/10.jpg)
Consider this…
Management Fees
Miscellaneous revenues
Less:
Office rent
Other office expenses
Staff wages (excluding self)
Profit
Php140,000
12,000
-36,000
-18,000
-24,000
74,000
Management Fees
Miscellaneous revenues
Less:
Office rent
Other office expenses
Staff wages (excluding self)
Interest rate @ 8%
Current value at job
Profit (Loss)
Php140,000
12,000
36,000
18,000
24,000
6,400
56,000
11,600
![Page 11: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/11.jpg)
Consider this…
Management Fees
Miscellaneous revenues
Less:
Office rent
Other office expenses
Staff wages (excluding self)
Profit
Php140,000
12,000
-36,000
-18,000
-24,000
74,000
Management Fees
Miscellaneous revenues
Less:
Office rent
Other office expenses
Staff wages (excluding self)
Interest rate @ 8%
Current value at job
Profit (Loss)
Php140,000
12,000
36,000
18,000
24,000
6,400
80,000
(12,400)
![Page 12: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/12.jpg)
The sunk cost is an expense that has already been incurred and cannot be recovered
![Page 13: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/13.jpg)
Nature of Costs Incremental costs are associated with
a choice and therefore only ever
include forward-looking costs
sunk costs not included
Marginal costs refer to the cost to
produce one more unit of product or
service.
Marginal and Incremental
costs are used to help
management evaluate
different potential future
courses of action
![Page 14: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/14.jpg)
Cost functions • Factors that determine costs
![Page 15: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/15.jpg)
Short-Run
• Some of the firm’s
inputs are fixed
• Cost curves are
operating curves
TC = TFC + TVC
![Page 16: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/16.jpg)
Short-Run(per-unit)
• ATC = TC/Q
• AVC = TVC/Q
• AFC = TFC/Q
= ATC - AVC
• MC = ΔTC/ΔQ
= ΔTVC/ ΔQ
AFC
![Page 17: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/17.jpg)
Table 7-1 Short-Run total and Per-Unit Cost Schedules
Ch.7 Cost Theory and Estimation, Salvatore. P.283
Q TFC TVC TC AFC AVC ATC MC
0 $60 $0 $60 -- -- -- --
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
![Page 18: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/18.jpg)
0 1 2 3 4 5
TFC $60 60 60 60 60 60
TVC $0 20 30 45 80 135
TC $60 80 90 105 140 195
$0
$50
$100
$150
$200
$250
![Page 19: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/19.jpg)
1 2 3 4 5
AFC -- $60 30 20 15 12
AVC -- $20 15 15 20 27
ATC -- $80 45 35 35 39
MC -- $20 10 15 35 55
$0
$10
$20
$30
$40
$50
$60
$70
$80
$90
![Page 20: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/20.jpg)
1 2 3 4 5
AFC -- $60 30 20 15 12
AVC -- $20 15 15 20 27
ATC -- $80 45 35 35 39
MC -- $20 10 15 35 55
$0
$10
$20
$30
$40
$50
$60
$70
$80
$90
AVC, ATC, and MC are
U-shaped
AFC continues to decline as
output increases
MC curve reaches its
minimum before intercepting
AVC and ATC curves at their
lowest points
![Page 21: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/21.jpg)
Q1Q2 Q3
(1) AVC first declines, reaches a minimum
at Q2, and rises thereafter
• AVC at its minimum, MC = AVC
(2) ATC first declines, reaches a minimum
at Q3, and rises thereafter
• ATC at its minimum, MC = ATC
(3) MC first declines, reaches a minimum at
Q1, and rises thereafter
• MC equals both AVC and ATC at
their minimum values
• MC lies below AVC and ATC over
the range for which these curves
decline, but lies above them when
they are rising
![Page 22: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/22.jpg)
Q TFC TVC TC AFC AVC ATC MC
0 $60 $0 $60 -- -- -- --
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
AVC = TVC = wL = w = w
Q Q Q/L APL
AVC
TVC
Q
w
L
APL
– average variable cost
– total variable cost
– output level
– wage rate
– quantity of labor used
– average physical product of labor
![Page 23: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/23.jpg)
Q TFC TVC TC AFC AVC ATC MC
0 $60 $0 $60 -- -- -- --
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
MC = ΔTVC = Δ(wL) = w(ΔL) = w = w aΔQ ΔQ ΔQ ΔQ/ΔL MPL
MPL – marginal product of labor
![Page 24: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/24.jpg)
Long-Run
• All inputs are variable
• Cost curves are
planning curves
LAC = LTCQ
![Page 25: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/25.jpg)
![Page 26: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/26.jpg)
LAC = LTC
Q
LMC = ΔLTC
ΔQ
• The U-shape of the LAC curve depends on
increasing, constant, and decreasing returns to
scale
• The relationship of the LMC-LTC is the same as the
short-run MC-ATC.
![Page 27: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/27.jpg)
Relationship of Long-Run and
Short-Run Average Cost Curves
• Long-Run average cost curve shows
the minimum average cost of
producing any given level of output
• LAC curve is the tangent line to
each of the short-run average
curves
![Page 28: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/28.jpg)
Returns to Scale
Constant returns to scale
Increasing returns to scale
Decreasing returns to scale INPUT OUTPUT
INPUT OUTPUT
INPUT OUTPUT
![Page 29: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/29.jpg)
Returns to Scale
Constant returns to scale
Increasing returns to scale
Decreasing returns to scale
INPUT OUTPUT
INPUT OUTPUT
INPUT OUTPUT
![Page 30: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/30.jpg)
![Page 31: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/31.jpg)
![Page 32: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/32.jpg)
![Page 33: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/33.jpg)
Minimum Efficient Scale (MES)
•The lowest output at
which minimum
average cost can be
achieved
•Important in determining
how many firms a
particular market can
support
![Page 34: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/34.jpg)
Economies of
Scope
• The cost of
producing multiple
goods is less than
the aggregate cost
of producing each
item separately
• An important source
of economies of
scope is transferable
know-how
![Page 35: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/35.jpg)
Learning Curves
• As firms gain experience in the
production of a commodity or
service, their average cost of
production usually declines
• from many experiences gained
• used to forecast needs for
personnel, machinery, raw
materials and for scheduling
production
![Page 36: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/36.jpg)
![Page 37: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/37.jpg)
Cost-Volume-Profit
Analysis
• Breaking it even
and then some
![Page 38: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/38.jpg)
Cost-Volume-Profit Analysis(CVP Analysis / breakeven analysis)
Examines the relationship among total revenue, total costs, and total profits of the firm at various levels of output
TR = (P)(Q)
TC = TFC + (AVC)(Q)
TR=TC
![Page 39: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/39.jpg)
![Page 40: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/40.jpg)
QB = TFC .
P-AVC
Solve:
(P)(QB) – (AVC)(QB) = TFC
(QB)(P-AVC) = TFC
Q
TR = (P)(Q)TC = TFC + (AVC)(Q)TR=TC(P) (QB) = TFC + (AVC) (QB)
![Page 41: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/41.jpg)
QB = TFC .
P-AVC
Q
TFC = $200
P = $10
AVC = $5
Solve:
QB = $200 .
$10-$5
QB = 40
Contribution margin per unit
• Portion of the selling price
that can be applied to
cover fixed costs and
provide for profits
![Page 42: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/42.jpg)
QT = TFC + πT .
P-AVC
Q
TFC = $200
P = $10
AVC = $5
Solve:
QT = $200 + $100 .
$10-$5
QT = 60
![Page 43: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/43.jpg)
Operating Leverage (OL)
Refers to the ratio of the firms total fixed costs to total variable costs
Higher ratio = more leveraged
= profits are more sensitive to changes in output or sales
𝐷𝑂𝐿 =%∆𝜋
%∆𝑄=
∆𝜋/𝜋
∆𝑄/𝑄=
∆𝜋
∆𝑄.𝑄
𝜋
DOL – degree of operating leverage
![Page 44: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/44.jpg)
Q
FC = $200
FC’ = $300
AVC = $5
AVC’ = $3.33
QB’ = 45
TC’ has a higher DOL
than TC and therefore
a higher QB
![Page 45: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/45.jpg)
𝐷𝑂𝐿 =60($10 − $5)
60 $10 − $5 − $200=$300
$100= 3
Given:
Increase in output from 60 to 70 units
Find:
DOL with TC
![Page 46: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/46.jpg)
𝐷𝑂𝐿 =60($10 − $5)
60 $10 − $5 − $200=$300
$100= 3
𝐷𝑂𝐿′ =60($10 − $3.33)
60 $10 − $3.33 − $300≅$400
$100= 4
The degree of operating leverage (DOL)
increases as the firm becomes more
leveraged or capital intensive
![Page 47: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/47.jpg)
New Economies of ScaleMinimizing costs internationally
International trade in inputs
Foreign sourcing of inputs - requirement to remain competitive
New international economies of scale
Firms must constantly explore sources of cheaper inputs and
overseas production
Product development, purchasing, production, demand
management, order fulfillment
Immigration of skilled labor
![Page 48: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/48.jpg)
Logistics or supply-chain management
Merging at the corporate level of the purchasing, transportation,
warehousing, distribution and customer services functions rather than
dealing with them separately at division levels
Development of new and much faster algorithms that greatly facilitate the
solution of complex logistic problems
Growing use of just-in-time inventory management
Increasing trend toward globalization of production and distribution
![Page 49: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/49.jpg)
Empirical Estimation
of Cost Functions
• Planning for the long
haul
![Page 50: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/50.jpg)
Empirical Estimation
Data Collection Issues
Opportunity costs must be extracted from accounting cost data
Costs must be apportioned among products
Costs must be matched to output over time
Costs must be corrected for inflation
𝐶 = 𝑓(𝑄, 𝑋1, 𝑋2, … , 𝑋𝑛)
![Page 51: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/51.jpg)
Empirical EstimationFunctional Form for Short-Run Cost Functions
Theoretical Form
𝑀𝐶 = 𝑎 + 2𝑏𝑄 + 3cQ2
![Page 52: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/52.jpg)
![Page 53: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/53.jpg)
Empirical EstimationFunctional Form for Short-Run Cost Functions
Linear Approximation
![Page 54: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/54.jpg)
![Page 55: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/55.jpg)
Empirical EstimationEfficiency of Operation in Estimating the LAC curve
![Page 56: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/56.jpg)
Architecture of Ideal Firm
Core Competencies
Outsourcing of Non-Core Tasks
Learning Organization
Efficiency and Flexibility
Location Near Markets
Agility in Responding to Market Forces
![Page 57: Cost Theory and Estimation](https://reader034.vdocuments.net/reader034/viewer/2022042506/55785649d8b42a2f6a8b529a/html5/thumbnails/57.jpg)
References
Salvatore, D. (2007). Managerial Economics In A Global Economy (Sixth ed.). New York: Oxford
University Press.
Samuelson, W. F., & Marks, S. G. (2010). Managerial Economics (Sixth ed.). New Jersey: John
Wiley & Sons, Inc.
Thomas, C. R., & Maurice, S. (2011). Managerial Economics Foundations of Business Analysis
and Strategy (Tenth ed.). New York: McGraw-Hill Co.
*Web site sources for other graphs