Download - 12 theory of cost and estimation
Cost Theory and Estimation
An important consideration in decision making
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
Nature of Costs • What is relevant?
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/
https://mrski-apecon-2008.wikispaces.com/Chapter+13+Emily+K
RevenueRevenue
Total
Opportunity
Costs
Explicit Costs
• The actual expenditures of the firm
• Accounting costs
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
Nature of Costs
Implicit costs
https://mrski-apecon-2008.wikispaces.com/Chapter+13+Emily+K
The opportunity cost associated with choosing a particular decision is measured by the benefits foregone in the next-best alternative
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
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)
The sunk cost is an expense that has already been incurred and cannot be recovered
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
Cost functions • Factors that determine costs
Short-Run
• Some of the firm’s
inputs are fixed
• Cost curves are
operating curves
TC = TFC + TVC
Short-Run(per-unit)
• ATC = TC/Q
• AVC = TVC/Q
• AFC = TFC/Q
= ATC - AVC
• MC = ΔTC/ΔQ
= ΔTVC/ ΔQ
AFC
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
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
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
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
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
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
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
Long-Run
• All inputs are variable
• Cost curves are
planning curves
LAC = LTCQ
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.
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
Returns to Scale
Constant returns to scale
Increasing returns to scale
Decreasing returns to scale INPUT OUTPUT
INPUT OUTPUT
INPUT OUTPUT
Returns to Scale
Constant returns to scale
Increasing returns to scale
Decreasing returns to scale
INPUT OUTPUT
INPUT OUTPUT
INPUT OUTPUT
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
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
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
Cost-Volume-Profit
Analysis
• Breaking it even
and then some
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
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)
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
QT = TFC + πT .
P-AVC
Q
TFC = $200
P = $10
AVC = $5
Solve:
QT = $200 + $100 .
$10-$5
QT = 60
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
Q
FC = $200
FC’ = $300
AVC = $5
AVC’ = $3.33
QB’ = 45
TC’ has a higher DOL
than TC and therefore
a higher QB
𝐷𝑂𝐿 =60($10 − $5)
60 $10 − $5 − $200=$300
$100= 3
Given:
Increase in output from 60 to 70 units
Find:
DOL with TC
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
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
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
Empirical Estimation
of Cost Functions
• Planning for the long
haul
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)
Empirical EstimationFunctional Form for Short-Run Cost Functions
Theoretical Form
𝑀𝐶 = 𝑎 + 2𝑏𝑄 + 3cQ2
Empirical EstimationFunctional Form for Short-Run Cost Functions
Linear Approximation
Empirical EstimationEfficiency of Operation in Estimating the LAC curve
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
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