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Ch. 8 - Cost Analysis: Managerial Economics Applications Strategy and Tactics P. 275

The document provides an overview of cost analysis concepts for managers. It discusses the importance of cost analysis for producing goods at low costs and remaining competitive. It then defines key cost concepts like fixed costs, variable costs, average costs, marginal costs, and how they relate. It provides examples of short-run and long-run cost curves and functions. Finally, it discusses factors that influence the shapes of average and marginal cost curves in the short and long-run.

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William DC Rivera
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943 views20 pages

Ch. 8 - Cost Analysis: Managerial Economics Applications Strategy and Tactics P. 275

The document provides an overview of cost analysis concepts for managers. It discusses the importance of cost analysis for producing goods at low costs and remaining competitive. It then defines key cost concepts like fixed costs, variable costs, average costs, marginal costs, and how they relate. It provides examples of short-run and long-run cost curves and functions. Finally, it discusses factors that influence the shapes of average and marginal cost curves in the short and long-run.

Uploaded by

William DC Rivera
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Ch.

8 – Cost Analysis
Managerial Economics Applications Strategy and
Tactics p. 275

Slide 1
Cost Analysis
Chapter 8
The Importance of Cost Analysis
» Managers seek to produce the highest quality
products at the lowest possible cost.
» Firms that are satisfied with the status quo find that
competitors arise that produce at lower costs and
drive them out of business.
» The advantages once assigned to being a large firm
(economies of scale and scope) have not provided
the advantages of flexibility and agility found in
some smaller companies.
» Cost analysis is helpful in the task of finding lower
cost methods to produce goods and services.
2005 South-Western Publishing Slide 2
Managerial Challenge:
US Airways
• US Airways created in mergers with
Allegheny, Mohawk, Lake Central, Pacific
Southwest and Piedmont Airways.
• Mostly in the East, with high cost but high
yields (most seats were filled).
• But, this situation invites entry by
competitors by Continental or others.
• The key to US Airways’ survival lays in
managing its high cost.
Slide 3
Meaning and Measurement of Cost

There a number of cost concepts in business.


• Opportunity Cost – value of next best
alternative use.
• Explicit vs. Implicit Cost – actual
prices paid vs. opportunity cost of
owner-supplied resources.

Slide 4
Accounting vs Economic Cost
• Accounting costs involve explicit historical costs.
They attempt to use the same rules for different firms,
so we can compare firm performance.
• Economic costs are based on making decisions.
These costs can be both implicit and explicit.
» A chief example is that economic costs include the
opportunity costs of owner-supplied resources such as time
and money, which are implicit costs.
» Economic Profit = Total Revenues - Explicit Costs -
Implicit Costs
» Both explicit and implicit costs make economic profit
lower than accounting profit

Slide 5
• Depreciation Cost Measurement. Accounting
depreciation (e.g., straight-line depreciation) tends to
have little relationship to the actual loss of value
» To an economist, the actual loss of value is the true
cost of using machinery.
• Inventory Valuation. Accounting valuation depends on
its acquisition cost
» Economists view the cost of inventory as the cost of
replacement.
• Unutilized Facilities. Empty space may appear to have
"no cost”
» Economists view its alternative use (e.g., rental value)
as its opportunity cost.
Slide 6
• Sunk Costs -- already paid for, or there
already exists a contractual obligation to pay
• Incremental Cost - - extra cost of
implementing a decision =  TC of a decision
• Marginal Cost -- cost of last unit
produced =  TC/Q

SHORT RUN COST FUNCTIONS

1. TC = FC + VC or fixed + variable costs

2. ATC = AFC + AVC = FC/Q + VC/Q

Slide 7
Short Run Cost Graphs MC
ATC
1. 3. AVC

AFC AFC
Q Q
MC intersects lowest point
2. AVC
of AVC and lowest point of
ATC.

When MC < AVC, AVC declines


Q When MC > AVC, AVC rises
Slide 8
Relationships Among Cost & Production Functions

• AP & AVC are inversely Q


related. (ex: one input) prod. functions

• AVC = WL /Q = W/ (Q/L) =
AP
W/ APL
» As APL rises, AVC falls MPL
cost L
• MP and MC are inversely AVC MC
related
• MC = dTC/dQ = W dL/dQ =
W / (dQ/dL) = W / MPL cost functions

» As MPL declines, MC rises Q


(Figure 8.3 on page 358)
Slide 9
Problem
Let there be a cubic VC function:
VC = .5 Q3 - 10 Q2 + 150 Q
1. find AVC from the VC function above.
2. find minimum variable cost output from AVC.
3. and find MC from the VC function
A1: AVC = .5 Q 2 -10 Q + 150 (divide by Q)
A2: Minimum AVC is where dAVC/dQ = 0
dAVC / dQ = Q - 10 = 0
Q = 10, so AVC = 100 @ Q = 10
A3: MC= dVC/dQ= 1.5 Q2 - 20 Q + 150
Slide 10
Long Run Cost Functions
• All inputs are variable in the
SMC2
long run
• LAC is long run average cost
» ENVELOPE of SAC curves SAC2 LMC
• LMC is FLATTER than
SMC curves
• The optimal plant size for a
given output Q2 is plant size 2. LAC
(A SR concept.)
• However, the optimal plant
size occurs at Q3, which is the
lowest cost point overall. (A
Q2 Q3 Q
LR concept.) Slide 11
Long Run Cost Function (LAC)
Envelope of SAC curves
Ave Cost SAC-small capital
SAC-med. capital

SAC-big capital

LAC--Envelope
of SRAC curves

Figure 8.4 on page 360 Q


Slide 12
Economists think that the
LAC is U-shaped
• Downward section due to:
» Product-level economies which include
specialization and learning curve effects.
» Plant-level economies, such as economies in
overhead, required reserves, investment, or
interactions among products (economies of scope).
» Firm-level economies which are economies in
distribution and transportation of a geographically
dispersed firm, or economies in marketing, sales
promotion, or R&D of multi-product firms.

Slide 13
LAC
CRS region
• Flat section of the LAC DRS
» Displaces constant returns to scale MES Max ES
» The minimum efficient scale (MES) is the smallest scale at which
minimum per unit costs are attained.
• Upward rising section of LAC is due to:
» diseconomies of scale. These include transportation costs,
imperfections in the labor market, and problems of coordination and
control by management.
» The maximum efficient scale (Max ES) is the largest scale before
which unit costs begin to rise.
» Modern business management offers techniques to avoid
diseconomies of scale through profit centers, transfer pricing, and
tying incentives to performance.
Slide 14
Review Problem/Questions

Slide 15
Problem 1
Q Suppose we have the following info:
TC = 200 + 5Q - .4Q2 + .001Q3
MC = 5 - .8Q + .003 Q2
1. FIND fixed cost
2. FIND AVC function
3. FIND AVC at Q = 10
4. If FC rises $500, what happens to
the average variable cost function?
Slide 16
Problem 2

Slide 17
Answers

Slide 18
TC = 200 + 5Q - .4Q2 + .001Q3
MC = 5 - .8Q + .003 Q2
1. FIND fixed cost
Answer: FC = 200, the intercept in the TC curve.
2. FIND AVC function
Answer: VC = 5Q - .4Q2 + .001Q3
So AVC = 5 - .4Q + .001Q2 (Divide VC by Q)
3. FIND AVC at Q = 10.
Answer: Substitute Q = 10 into the AV C function.
AVC = 5 - .4(10) + .001(102) = 4 – 4 + .1 = 1.1.
4. If FC rises $500, what happens to the average variable
cost function?
Answer: No change, since AVC does not include fixed
cost.
Slide 19
Answer P2
a. 5,000,000 – 4,500,000 – 40,000 – 400,000
= 60,000
b. 5,000,000 – 4,500,000 – 60,000 – 400,000
-30,000 – [(4M-3M) * .10]
= -90,000

Slide 20

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