chap8 cost analysis

8/6/2019 Chap8 Cost Analysis

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Slide 1

Cost Analysis The Importance of Cost Analysis

Managers seek to produce the highest quality productsat the lowest possible cost.

Firms that are satisfied with the status quo find thatcompetitors arise that produce at lower costs and drivethem 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 somesmaller companies.

Cost analysis is helpful in the task of finding lower costmethods to produce goods and services.


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Slide 2

U.S Airways US Airways was created through 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.


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Slide 3

Accounting vs Economic Cost Accounting costs involve explicit(or money) costs. They

attempt to use the same rules for different firms, so we cancompare firm performance.

Economic costs are based on making decisions. These costscan be both implicit and explicit.

A chief example is that economic costs include theopportunity costs of owner-supplied resources such as timeand money, which are implicit costs.

Economic Profit = Total Revenue - Explicit Costs - Implicit Costs

Implicit costs make economic profit lower than accountingprofit


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Slide 4

Meaning and Measurement of Cost

There a number of cost concepts in

business.

Opportunity Cost value of next best

alternative use.

Explicitvs.ImplicitCost actual prices

paid vs. opportunity cost of owner-suppliedresources.


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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.


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Slide 6

Sunk Costs -- already paid for, or there alreadyexists a contractual obligation to pay.

Incremental Cost -- extra cost of implementing adecision = TC of a decision

Marginal Cost -- cost of last unit produced i.e.,TC/Q

SHORT RUN COST FUNCTIONS 1. TC = FC + VC fixed & variable costs

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


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Slide 7

Short Run Cost Graphs

AFC

Q

Q

1.

2. AVC

3.

Q

AFC

AVC

ATC

MC

MC intersects lowest point

of AVC and lowest point ofATC.

When MC < AVC, AVC declines

When MC > AVC, AVC rises


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Slide 9

Suppose that Variable Cost is cubic:

VC = .5 Q3 - 10 Q2 + 150 Q

1. Find AVC from the VC function above.2. Find minimum variable cost output from AVC.3. Find MC from the VC function

A1:AVC = .5 Q 2 -10 Q + 150 (divide by Q)

A2: Minimum AVC is where dAVC/dQ = 0dAVC / dQ = Q - 10 = 0

Q = 10, so AVC = 100 @ Q = 10

A3: MC= dVC/dQ= 1.5 Q2 - 20 Q + 150

Try this


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Slide 10

All inputs are variable (canadjust) in the long run.

LAC is long run averagecost

ENVELOPE of SAC curves LMC is flatter than

SMC curves. The optimal plant size for a

given output Q2 is plant size

2. (A SR concept.) However, the optimal plant

size occurs at Q3, which isthe lowest cost point overall.(A LR concept.)

Q

LAC

LMCSAC2

SMC2

Q2

Q3

Long Run Cost Functions


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Slide 11

Long Run Cost Function (LAC)

Envelope of SAC curves


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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 indistribution and transportation of a geographically

dispersed firm, or economies in marketing, sales

promotion, or R&D of multi-product firms.


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Slide 13

CRS region

MES Max ES

DRS

LAC

Flat section of the LAC Displays constant returns to scale

The minimum efficient scale (MES) is the smallestscale at which minimum per unit costs are attained.

Upward rising section of LAC is due to: Diseconomies of scale. These include transportationcosts, imperfections in the labor market, and problemsof 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.


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Slide 14

International Variation in

Dealing with Firm Size General Motors was divided into several division:

Chevy, Buick, Cadillac, Fisher Body, and a fewothers to have each compete with each other, yethave the advantage of large size.

But the Japanese use hundreds of individualcompanies.

Matsushita Electric has 161 consolidated units

Hitachi Ltd has 660 companies Large firms must find ways to avoid diseconomies

of scale but take advantage of their larger size.


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Slide 15

At Ford, cars madefrom aluminum has aminimum efficient size

of 50,000 (pt A)

Cars made from steelhas a MES of 300,000(pt C)

Hence, Ford can changeits products faster if ituses aluminum, even if10% more costly.

Figure 8.9 page 322

50,000 300,000

MES aluminum MES steel

B

AC

Auto Production: Minimum Efficient

Scale


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Slide 16

Q Suppose we have the following info:

TC = 200 + 5Q - .4Q2 + .001Q3

MC = 5 - .8Q + .003 Q2

1. Find FC

2. Find AVC function

3. Find AVC at Q = 104. If FC rises to $500, what happens to

the average variable cost function?

Try this


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Slide 17

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 to $500, what happens to the average variable

cost function?

Answer:No change, since AVC does not include

fixed cost.

We know:

chap8 cost analysis

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