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The Analysis of Costs

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1. The Economic Role ofCosts

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The (opportunity) cost ofproducing the item indicates

the desire of consumers forother goods.

Economic Role of Costs

The demand for a productindicates the intensity ofconsumers desires for anitem.

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Opportunity costs

The value of the other products that the resourcesused in production could have produced at their

next best alternative

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Historical costs

The amount the firm actually paid for a particularinput

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Explicit andImplicit Costs

Costs may be either explicit orimplicit.

Explicit costs result when a

monetary payment is made.Implicit costs involve resources

owned by the firm and dontinvolve a monetary payment.

e.g.: Time spent by owner runningthe firm or the normal rate of returnon the owners financial investment(opportunity cost of equity capital) .

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Explicit vs. implicit costs

Explicit costs include the ordinary items thatan accountant would include as the firms

expenses

Implicit costs include opportunity costs of

resources owned and used by the firms owner

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Total Cost:TotalCost = explicit costs implicit costs+

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Accounting andEconomic Profit

Economic profit is total revenuesminus total costs (including allopportunity costs).Economic profit only occurs when therate of return is above the normal rateof return (the opportunity cost ofcapital) .

Firms earning zero economic profit areearning exactly the market (normal)

rate of return.

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Accounting profit is total revenueminus expenses of firm over a

designated time period.

Accounting andEconomic Profit

Often excludes implicit costssuch the opportunity cost ofequity capital.

Accounting profit is generallygreater than economic profit

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The Nature of Costs andProfits

ACCOUNTING PROFITS : Total Revenue(TR) - Total Costs (TC)

ECONOMIC PROFITS : Total Revenue -(Explicit Costs + Implicit Costs)OPPORTUNITY COST OF CAPITAL :Implicit Return that must be paid toinvestors to induce them to supply capitalto the firm

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The (Un)Profitable EthnicRestaurant

Total Revenue $800,000- Cost of Goods Sold

Direct Labor $300,000Direct Materials $200,000

- Explicit Indirect Costs Administration $ 80,000Overheads $100,000Interest/Depreciation $ 40,000

----------- Accounting Profit $ 80,000

- Implicit CostsInterest Foregone(10%on$500,000) $ 50,000Wages Foregone $ 60,000

-----------Economic Profit(Loss) ($30,000)

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1. What are implicit costs? Do implicit costscontribute to the opportunity cost of production?Should an implicit cost be counted as cost? Give 3

examples of implicit costs. Why do economistsconsider normal returns to capital as a cost?

Questions for Thought:

2. How does economic profit differ from accountingprofit? If a firm is making zero economic profit,does this indicate that it is about to go out ofbusiness? What does economic profit indicate?

3. What is shirking? If the managers of a firm areattempting to maximize the profits of the firm, will

they have an incentive to limit shirking? How mightthey go about doing so?

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3. Short and Long Run

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In the short run, output canonly be altered by changingthe usage of variableresources such as labor andraw materials.

Short Run

The short run is a period oftime so short that the firmslevel of plant and heavyequipment (capital) is fixed.

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Long Run

The long run is a period oftime sufficient for the firm toalter all factors of production.In the long run, firms canenter and exit the industry.The actual short run and longrun differs by industry

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2. Output and Costs

In the Short Run

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Short run

A period of time so short that the firm cannot alterthe quantity of some of its inputs

Typically plant and equipment are fixed inputs in the short run

Fixed inputs determine the scale of the firmsoperation

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Three concepts of totaltosts

Total fixed costs = FC

Total variable costs = VCTotal costs = FC + VC

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Examples: insurance premiums,property taxes, opportunity costof fixed assets.

Total Fixed Costs

Total Fixed Costs (TFC) are coststhat remain unchanged in the shortrun when output is altered.

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Decline as output expands.

Average Fixed Costs

Average Fixed Costs (AFC) arefixed costs per unit (i.e,TFC/output).

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Variable Costs

Total Variable Costs (TVC) are thesum of costs that rise as outputexpands.

Examples: cost of labor and rawmaterial.

Average Variable Costs (AVC) are

variable costs per unit (i.e,TVC/output).

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Total Cost

Total Cost (TC) = Total FixedCost + Total Variable Cost

Average Total Cost (ATC) = Average Fixed Cost + Average Variable Cost

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MC will decline initially, reach aminimum, and then rise.

Marginal Cost

Marginal Cost (MC) is the increasein total cost associated with a one-unit increase in production.

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Q

p

Average Total Costs will be a U-shaped curvesince AFC will be high for small rates of outputand MC will be high as the plants production capacity ( q ) is approached.

Q

p

M arginal Costs will rise sharply as the plants production capacity ( q ) is approached.

Q

p Average F ixed Costs will be high for small ratesof output (as they are divided across few units),

but they will always decline as output expands(as they are divided across more units).

Short-Run Cost Curves

ATC

MC

AFC

q

q

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Shape of ATC Curve

The ATC curve is U-shaped. ATC is high for an underutilizedplant because AFC is high. ATC is high for an over-utilizedplant because MC is high.

Fi d i bl d l

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OUTPUT FC VC TC

0 2000 0 2000

1 2000 100 2100

2 2000 180 2180

3 2000 280 2280

4 2000 392 2392

5 2000 510 2510

6 2000 650 2650

7 2000 800 2800

8 2000 960 29609 2000 1140 3140

10 2000 1340 3340

11 2000 1560 3560

12 2000 2160 4160

Fixed, variable, and total costsMedia Corp.

Fi d V i bl d T t l C t

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Fixed, Variable, and Total Costs --Media Corp.

0

1000

2000

3000

40005000

0 5 10 15

Units of Output

d o l

l a r s FC

VCTC

A d i l t

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Average and marginal costsMedia Corp.

OUTPUT AFC AVC ATC MC

0

1 2000.0 100.0 2100.0 100

2 1000.0 90.0 1090.0 80

3 666.7 93.3 760.0 100

4 500.0 98.0 598.0 112

5 400.0 102.0 502.0 118

6 333.3 108.3 441.7 140

7 285.7 114.3 400.0 150

8 250.0 120.0 370.0 160

9 222.2 126.7 348.9 180

10 200.0 134.0 334.0 200

11 181.8 141.8 323.6 220

12 166.7 180.0 346.7 600

A g d gi l t

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Average and marginal costsMedia Corp.

0

5001000

15002000

0 2 4 6 8 10 12

Units of output

$ $ $ AFC

AVC

ATC

MC

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Diminishing Returnsand Cost Curves

If a firm faces diminishing returns,MC will rise with additional output.

As MC continues to rise, it willeventually exceed ATC and raise

ATC.Before that point, MC is below

ATC and is bringing down ATC

H h h l h f h

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TF C

TC

TVC

0

TotalCosts

42

Here we graph the general shape of thefirms short -run total cost curves.

50

100

150

200

6 8

50

10

TCTVCTFCOutput per day

123456789

10

01525344252647998

122152

Note that total fixed costs are flat andremain the same for 0 units or 11 units.

Output

Total Costs Curves

= +

11 202

5050505050505050505050

5065758492

102114129148172202252

12

250 Note that total variable costs increase as

more variable inputs are utilized. As total costs are the combination ofTVC and TFC, they are everywhere

positive and increase sharply with output

T d t d th l ti hi b t d

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AF C

0

Cost per unit

42

To understand the relationship betweenthe average and marginal curves, wecalculate each of the average curvesfrom the total curves and then introducethe marginal curve.

6 8

50

10

AFCTFC Output per day

123456789

10

----$ 50.00$ 25.00$ 16.67$ 12.50$ 10.00$ 8.33

$ 6.25$ 5.56$ 5.00

Output

= /

11 $ 4.55

5050505050505050505050

12

The average fixed cost curve ( AFC ) isthe total fixed cost ( TFC ) divided by theoutput level. It is high for a few units,and becomes small as output increases.

20

40

60

80

$ 7.14

verage andMarginal Cost Curves

g d

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AVC

AF C

0

Cost per unit

42 6 8 10

AVCOutput per day

123456789

10

----$ 15.00$ 12.50$ 11.33$ 10.50$ 10.40$ 10.67

$ 12.25$ 13.56$ 15.20

= /

11 $ 18.3612

The average variable cost curve ( AVC )is the total variable cost ( TVC ) divided

by the output level. It is higher either

for a few or lot of units and has someminimal point between the two where,when graphed later, marginal costs(MC) will cross it.

20

40

60

80

$ 11.29

TVC0

1525344252647998

122152202


Output

To calculate the marginal costs curve

verage and

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M C

AVC

AF C

Cost per unit

42 6 8 10

MCOutput

1111111111

$ 15.00$ 10.00$ 9.00$ 8.00$ 10.00$ 12.00

$ 19.00$ 24.00$ 30.00

= /

1 $ 50.00 12

20

40

60

80

$ 15.00

TC5065758492

102114129148172202252

Note that MC starts low and increases asoutput increases. It also crosses AVC atits minimum point.

TC

1098

101215

50

192430

15

To calculate the marginal costs curve (MC) we must take the change in the TC curve ( TC) and divide that by thechange in output ( Output). Ourincrements for increasing output here

are to increase by 1 ( 1). I mpor tant Note : M C always crosses AVC at its minimum point.


Output

Lastly we graph the average total cost verage and

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M C

AVC

AF C

0

Cost per unit

42 6 8 10

ATCOutput per day

123456789

10

----$ 65.00$ 37.50$ 28.00$ 23.00$ 20.40$ 19.00

$ 18.50$ 19.11$ 20.20

= /

11 $ 22.9112

Note that when the output is low, ATC ishigh because AFC is very high. Also,

ATC is high when output is large as MC

becomes large when output is high.

20

40

60

80

$ 18.43

TC5065758492

102114129148172202252

These two relationships explain why the ATC curve has its distinct U - shape.

Lastly we graph the average total costcurve (ATC) as TC divided by the output.

Note: MC crosses ATC at its minimum.

ATC

I mportant Note : M C always crosses ATC at its minimum point.


Output

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3. Output and Costs

In the Long Run

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Long Run ATC

The long-run ATC shows theminimum average cost ofproducing each output level whena firm is able to choose plant size.

Planning Curve

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Cost per unit

Output Level

LRATC

Planning Curve

The ATC curve for the firm will depend upon the sizeof the plant that is operating.

Representative Short-runAverage Cost Curves

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

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Economies of Scale

Economies of Scale : Reductions inper unit costs as output (plantsize) expands can occur for three

reasons.Mass productionSpecialization

Improvements in production asa result of experience

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Bureaucratic inefficiencies mayresult as size expands.

Diseconomies ofScale

Diseconomies of Scale : increases inper unit costs as output (plantsize) expands can occur

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Constant Returns toScale

Constant Returns to Scale :Unit costs that are constant asplant size is changed.

Different Types of LRATC

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demonstrating Diseconomies of Scale meaning that a further expansion in plant

size leads to higher levels of cost.Cost per unit

Output Level

LRATC

Different Types of LRATC Often the LRATC will have segments that represent either

Economies of scale , constant returns to scale , or evendiseconomies of scale .

Below, the LRATC represented has a downward sloping segmentdemonstrating Economies of Scale for that range of output,meaning that an further expansion in plant size can reduce

per unit cost up to output level q. There is also a upward sloping segment,

q

Economies of Scale Diseconomies of Scale

Plant of Ideal Size

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Cost per unit

Output Level

LRATC


Below, the LRATC represented has a downward sloping segmentdemonstrating Economies of Scale for the entire range of output,which implies that the most efficient size plant available would

be the largest one possible.

q

Economies of Scale

Plant of Ideal Size

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Long-run cost functions

Often considered to be the firms planning horizon Describes alternative scales of operation when allinputs are variable

Quantity of output

Averagecost

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Long-run average cost function

Shows the minimum cost per unit of producing each outputlevel when any scale of operation is available

Quantity of output

Averagecost

SR average costfunctions

LR average cost

Key steps:

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Key steps:Cost estimation process

Definition of costs Correction for price level changes

Relating cost to output Matching time periods Controlling product, technology, and plant Length of period and sample size

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Minimum efficient scale

The smallest output at which long-run averagecost is a minimum.

Quantity of output

Averagecost

Qmes

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The Survivor Technique

Classify the firms in an industry by size andcompute the percentage of industry output

coming from each size class at various timesIf the share of one class diminishes over time,it is assumed to be inefficient

These firms are then operating belowminimum efficient scale

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Economies of Scope

Exist when the cost of producing two (or more) products jointly is less than the cost of

producing each one alone.

S = C(Q 1) + C(Q 2) - C(Q 1+ Q 2)C(Q 1+ Q 2)

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6. What Factors Cause

the Firms Cost Curves

to Shift?

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Cost Curve Shifters

Prices of resources

TaxesRegulationsTechnology

Higher Resource Prices andCost

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Cost per unit

Output Level

g Cost

If resource prices increase, the cost of productionincreases and thus the ATC and the MC moveupward simultaneously.

ATC 1 MC 1

ATC 2 MC 2

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5. The Economic Way of

Thinking about Costs

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Sunk Costs

Sunk Costs are historical costsassociated with past decisions thatcant be changed.

Sunk costs may provideinformation, but are notrelevant to current choices.

Current choices should be madeon current and future costs andbenefits.

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Cost and Supply

In the short run, when makingsupply decisions, the marginalcost of producing additionalunits is the relevant costconsideration

In the long run, the average

total cost is vital to the supplydecision

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1. If a firm maximizes profit, it must minimize thecost of producing the profit- maximum output.Is this statement true or false? Explain youranswer.

Questions for Thought:

2. Draw a U-shaped short-run ATC curve for a firm.Construct the accompanying MC and AVC curves.

3. Firms that make a profit have increased thevalue of the resources they used; their actionscreated wealth. In contrast, the actions of firmsthat make losses reduce wealth. The discoveryand undertaking of profit-making opportunitiesare key ingredients of economic progress. Evaluate this statement.

Special Topics in Cost:

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Special Topics in Cost:Breakeven Analysis

BE Analysis involves the short run and is usedwhen there are fixed costs that need to becoveredBE Analysis reveals the relationship betweenprofits, variable costs, fixed costs and volumeIt is useful tool for analyzing the financial

characteristics of alternative production systems

Special Topics: BE

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Special Topics: BEAnalysis (cont.)

It focuses on how total costs and profitsvary with volume of output as the firm

operates in a more mechanized orautomated manner and thus substitutesfixed costs for variable costs

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Break-even Analysis

Quantity of output

DollarsTotal Revenue

Total Cost

Loss

Profit

Determining the Break

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Determining the Break-even Point

The BE Point is given by the intersection of thetotal cost line with the total revenue line, that is,where total revenues cover total costs. At BEpt., TR = TFC + TVCor PxQ = TFC + AVCxQor (P-AVC)Q = TFC

or Qbe = TFC/(P-AVC)

The Break even Point

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The Break-even Point(cont.)

Thus, if P = $50 per unitand AVC= $25 per unit

and TFC = $100,000then, Qbe = 100,000/(50-25)= 4,000 units

The fixed costs that must be recoveredfrom the sales dollar after the deductionof variable costs determines Qbe

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Operating Leverage

Operating Leverage (OL) reflects theextent to which fixed production facilities,as opposed to variable factors ofproduction are used in operationsThe Degree of Operating Leverage (DOL) at a particular level of output is simply the

percentage change in profits over thepercentage change in output/sales thatproduces that change in profits

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Operating Leverage (cont.)

DOL is an elasticity concept, and can becalled the operating leverage elasticity ofprofits DOL = % Profits/ % Output

= ( Profits/ Q) (Q/Profits)= [Q(P-AVC)]/[Q(P-AVC)-TFC]

The further actual output is from Qbe, thelower is the DOL

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The greater the ratio of price to variable costsper unit, the greater the absolute sensitivity ofprofits to volume changes and the greater thedegree of operating leverage for all levels ofoutputThe firm having the greater total fixed cost will

have the higher DOLThe DOL can be used as an indicator of risk

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DOL for Two FirmsFirm A Firm BPrice = $10.00 Price = $10.00

AVC= $5.00 AVC= $2.00

TFC= $1,000 TFC= $4,000-----------------------------------------------------------------------------------------------------------

-----Rate of Output Profit DOL

Firm A Firm B Firm A Firm B0 -$1,000 -$4,000 0 0

200 0 -$2,400 Undefined -0.67500 $1,500 0 1.67 Undefined

1,000 $4,000 $4,000 1.25 2.001,500 $6,500 $8,000 1.15 1.502,000 $9,000 $12,000 1.11 1.33

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Characteristics of the example:DOLs are 0 are a zero output rate and negative untila breakeven rate of output is reachedWhen the firm is incurring losses, DOL is notmeaningful because it suggests that profit falls asoutput increases, which is not the caseWhen profits are earned, a negative DOL ismaeningful

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Characteristics of the example (cont.) A DOL when positive profits are being earned meansthat output has increased beyond that rate thatmaximizes profitDOL is greatest for smaller output rates around Qbeand declines as output moves away from Qbe At the same rate of output, DOL is always higher forFirm B than A because of its higher fixed costs vs.variable costs (risk)

Profit Contribution

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Profit ContributionAnalysis

The difference between price and averagevariable costs (P-AVC) is defined as profitcontribution . At outputs below Qbe, profitcontribution is used to cover fixed costsand afterwards, it is a direct contributor toprofit

Profit Contribution Analysis allows amanager to find the output rate thatcovers TFC & earn a required profit

Profit Contribution

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Profit ContributionAnalysis (cont.)

Thus, the required rate of profit can beexpressed by the equation,Required Profit = PQ-AVC(Q)-TFCso that the output necessary is given byQ = (TFC+Required Profit)/(P-AVC)Breakeven Analysis is a specific case ofProfit Contribution Analysis when theRequired Profit is equal to zero

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Margin of Profitability

A third measure of current profitability is a firmsMargin of Profitability (MOP)MOP is the ratio of economic profit to total fixedcostIt is measured as MOP = (Qa-Qbe)/QbeMOP is a measure of the amount of productionin excess of breakeven and shows the cushionavailable to the manager before Qbe is reached

Managerial Uses of BE

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Managerial Uses of BEAnalysis

It provides management a good deal ofinformation about the operating andbusiness risks of the company. Given anapproximate B.E. Point, management canrelate fluctuations in expected futurevolume to this point and ascertain the

stability of profits - knowledge that maybe useful to determine the ability of thefirm to service debt

Managerial Uses of BE

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Managerial Uses of BEAnalysis (cont.)

It is important when the acquisition ofassets is planned. The expected futuretrend and stability of volume, togetherwith the ratio of expected price toexpected AVC, will bear heavily on thedecision to increase fixed costs

It is useful in pricing decisions since ittells the effect on profits of changes inprices and costs

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Limitations of BE Analysis

Assumes constant P and AVC irrespective of volume, when sales volumemay very often influence P and AVC

Assumes that TFC remains fixed over the entire volume range, when in factthis range may be limited by the immediate physical capacity of the firmand TFC may be a step function as volume changesIt ignores the problem in practice of classifying some costs that arepartially fixed and partially variable, that is, semi-variable costs, e.g. rent,insurance etc. with discountsIt is based on one-product analysis and not very suited to multiple-productanalysis where there is a major problem of allocating common costs

Acoounting information used for BE analysis is based on historical costswhich are not stable over time and which do not reflect the forward-lookingnature of managerial decisionsIt is short-run analysis and not suitable for long-range planning

cost ppt1

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