Lecture five © copyright ： qinwang 2013 [email protected] SHUFE school of international business.

Lecture five

© copyright ： qinwang [email protected]  

SHUFE  school of international business

Cost analysis

• Cost definition Accounting cost and opportunity cost Explicit vs. Implicit Cost Incremental cost and Sunk cost Fixed cost and variable cost

• Cost analysis

Accounting cost is historical cost/business cost, The total amount of money expended (wages, interests, raw materials, depreciation, utilities … ) in an business process. It is money paid out the past and recorded in

journal entries and ledgers.

Accounting cost

value of next best alternative use. (the forgone benefits that could be received from that alternative use); the most valuable forgone alternative.

A resource has n usages ， the revenue from each usage is R1 ， R2 ，…， Rn 。 the resource is used in usage i, its opportunity cost is opportunity cost =Max{ R1 ， R2 ，… Ri -1 ， Ri+1 …R

n}

Opportunity cost

Example: $100000 can be invested in the following: save in the bank, interest return is $4000 ； buy bonds ， bond income $10000 ； invest in stocks ， revenue is $12000 。 the money saves in bank, opportunity cost is $12000. The money buys bonds, opportunity cost is $12000. The money invests in stocks, opportunity cost is $10000.

Accounting cost and opportunity cost

A and B each set up an Fast Food Restaurant in the same district. The Scale of the restaurant is similar. A use his own house and 50000 yuan(cash); B spent 20000/year to rent the house and 50000 loan from the bank. Interest rate is 10%. They manage the restaurant themselves. The right is their profit sheet (half a year), Which one is better?

A B

operating income

150000 150000

Operating cost

95000 112000

Material costs

70000 70000

Depreciation/H

8000 --

wages 15000 15000

Interest --- 5000

Depreciation/E

2000 2000

Rent for H --- 20000

Gross profit 55000 38000

Accounting profit & Economic profit

Economic profit = Total revenue Explicit costs –Implicit costs

Example: opportunity costs at Bentley Clothing Store

Accounting cost and opportunity cost: depreciation measurement Capital assets: a durable input that depreciates

with use, time and onbsolescence

A machine, is purchased for 10000, and is expected to have a 10-year life; straight-line method of depreciation is 1000;but Current market value:8000;Value after one year:6800 Economist’s Depreciation: 8000-6800=1200

Accounting cost and opportunity cost: Inventory valuation Firm A and firm B uses steel 1000Kg/year. Firm A use steel inventory which price is1000yuan/kg; Firm B’s steel is bought now at the price of 1200yuan/kg 。 the two firms accounting cost and opportunity cost?

Firm A ： accounting cost=1000100=100000yuan

opportunity cost =1200100=120000yuan

Firm B ： accounting cost=1200100=120000yuan opportunity cost =1200100=120000yuan

Opportunity cost1. Equity Fund( private house)2. Manage the company yourself 3. Useless equipment

Incremental Cost and Sunk cost

Incremental cost: the overall change that a company

experiences by producing one additional unit of good

Sunk cost: A cost incurred regardless of the

alternative action chosen in a decision-making problem

Firm B is putting a bid in a project, the following is the budget:

Pre prepare- expense 200000 Fixed cost (must pay whether win the bid or not) Variable cost （ pay after winning the bid

200000 500000

Total cost Profi t（33%）

900000 300000

Bid price 1200000

Firm B asks for 1200000 yuan ， but the contract-issuing party only wants to give 600000 yuan, what should firm B do?

unit ： yuan

Example

Economies and diseconomies of scale

Economies of scale Declining long-run average costs as the

rate of output for a product, plant, or firm is increased.

Internal economies of scale Learning curve effect External economy of scale

Long-Run Average & Marginal Cost Curves

Product-lever economics A number of different sources of scale economies are

associated with producing larger volumes of a single product

Plant-level economics Sources of scale economies at the plant level include

capital investment, overhead, and required reserves of maintenance parts and personnel.

Firm-level economics Scale economies are associated with the overall size

of the firm, aften can only be realized by large multiproduct multi-plant firm.

The overall effects of scale economies and diseconomies

Minimum efficient scale (MES) The smallest scale at which minimum

costs per unit are attained.

Discussion: scale economics in the traditional cable industry

The industrT: Telephone landlines, traditional cable TV and electric utilities

cost

Economies of scope

Economies of scope Economies that exist whenever the cost

of producing two (or more) products jointly by one plant or firm is less than the cost of producing these products separately by different plants or firms.

Discussion: strategy under economies of scale and economics of scope

Specialization strategy Horizontal integration Vertical integration

Diversification strategy Related diversification strategy Unrelated diversification strategy

Engineering cost techniques

A method of estimating cost functions by deriving the least-cost conbination of labor, capital equipment and raw materials required to produce carious levels of output, using only industrial engineering information

The survivor technique

A method of estimating cost functions from the shares of industry output coming from each size class over time. Size classes whose shares of industry output are increasing (decreasing) over time are presumed to be relatively efficient (inefficient) and have lower (higher) average cost.

Profit analysis

Contribution analysis

Break-even analysis

contribution （ added profit ） = incremental payoff –incremental cost

contribution margin per unit = incremental payoff per unit-incremental cost per unit = price – variable cost per unit

if ： contribution>0, accept; otherwise, give up .

Contribution analysis

Application of incremental cost

Apply for decision in short-run If there are many programs, choose the

one with biggest contribution (other conditions are the same) 。

The firm have three products: X 、 Y 、 Z. should it continue the product Z ？

Exampl1: continue dog product ？

product X Y ZTotal revenue 150000 100000 50000Direct cost 60000 50000 35000Indirect cost 60000 40000 20000Gross profit 30000 10000 -5000

The firm now produce product A and want to add a new product B or C. fixed expense of the firm is 50000 yuan/month, which one to be chose?

Example 2： choose B or C

product A B C

Sales (month)

20000 10000 50000

Price (yuan) 5 10 3

Variable cost per unit(yuan)

2 5.4 2

1. the relationship of production, cost and profit 2.count break-even point 3.confirm margin of safety margin of safety is the surplus of sales and break-even point. The bigger of margin of safety, the more safety of the business is.

Break-even analysis

Revenue curve

Cost curve

cost

productivity

Profitzone

Loss zone

0

Fixed cost

Variable cost

Break-even point

Total cost

Total revenue

Sales

HT Q=sales ； P=price ； F=fixed cost/u ； V=variable cost/u ； =profit

（ 1） break-even point ：

（ 2） production with target profit

（ 3） total profit ：

VP

FQ

VP

FQ

FQVP ）（

Revenue curve

Cost curve

cost

productivity

Profitzone

Loss zone

0

Break-even point

Revenue curve

Cost curve

cost

productivity

Profitzone

Loss zone

0

Break-even point

Revenue curve

Cost curve

cost

productivity

Profitzone

Loss zone

0

Fixed cost

Variable cost

Break-even point

Margin of safety

Total cost

Total revenue

Sales

margin of safety =sales- breakeven point

Margin of safety rate=margin of safety sales

Margin of safety and margin of safety rate ：

Operating leverage

Operating leverage describes the substitution of fixed element and variable element.

For example: if invest in technology and equipment increases, fixed cost rises but variable cost may fall, operating leverage will be changed.

Operating leverage: DOL ＝ /Q.Q/ (demand elasticity of profit) ：

DOL ＝ [Q(P-AVC)]/[Q(P-AVC)-TFC]

If the firm invest more in equipment, that means large fixed cost and low variable cost, then the DOL of the firm is high. The firm must sell more, otherwise it will be in loss.

Firm A is an travel agency and organized a tour to city A. the tour is about 10 days. Firm A afford for fare, board and lodging. The following is related data ：

Fixed cost （yuan）

discount salary others total

1200 2400 400 4000

Example ：

（ 1 ） If charge for 600 yuan to every traveler, how many traveler will clear its cost ？ If the charge is 700 yuan ， how many traveler ？（ 2 ） If charge for 600 yuan per people ， the number of traveler is about 50 people ； if charge for 700 yuan ， the number of traveler is about 40 ， calculate the margin of safety, margin of safety rate and the profit when charge fee is 600 yuan or 700 yuan.（ 3 ） If firm’s target profit is 1000 yuan ， charge is 600 yuan per people, how many traveler will realize the goal ？ If charge for 700 yuan ， how many traveler ？

Variable cost （yuan）

board and lodging per people other variable cost per people total

475 25 500

Example: GE’s fixed cost and capacity

In 1988, GE announced to cut its capacity to adapt to the temporal market. Until 1991, GE closed 10 lines that means GE reduce its fixed cost about $12.5-13 billion. GE once used two way to balance the contradiction of capacity and demand:

I: to produce all products and try to sell them at low price or high coupon( in 1988, GE spent $3.3 billion to stimulate consumer ）；II: reduce production (under capacity) as to slow the process line or cancel shift.

New strategy: GE would give full use to its capacity—works 5day/week， two shift/day. When demand is over the capacity, GE would ask the worker to work overtime or add an extra shift to increase production. It was the strategy that Ford abided by. Ford adjust its capacity to low demand in stead of the high capacity, because Ford did not want to fire employee at low demand. Actually, both GE and Ford try to balance the choice: to reduce fixed cost at troughs and increase variable cost at peak in the business cycle.