12 theory of cost and estimation
- 1. Cost Theory and Estimation An important consideration in decision making
- 2. 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
- 3. Nature of Costs • What is relevant?
- 4. 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/
- 6. Explicit Costs • The actual expenditures of the firm • Accounting costs
- 7. 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
- 8. Nature of Costs Implicit costs https://mrski-apecon-2008.wikispaces.com/Chapter+13+Emily+K
- 9. The opportunity cost associated with choosing a particular decision is measured by the benefits foregone in the next- best alternative
- 10. 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
- 11. 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)
- 12. The sunk cost is an expense that has already been incurred and cannot be recovered
- 13. 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
- 14. Cost functions • Factors that determine costs
- 15. Short-Run • Some of the firm’s inputs are fixed • Cost curves are operating curves TC = TFC + TVC
- 16. Short-Run (per-unit) • ATC = TC/Q • AVC = TVC/Q • AFC = TFC/Q = ATC - AVC • MC = ΔTC/ΔQ = ΔTVC/ ΔQ AFC
- 17. 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
- 18. 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
- 19. 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
- 20. 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
- 21. Q1 Q2 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
- 22. 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
- 23. 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 a ΔQ ΔQ ΔQ ΔQ/ΔL MPL MPL – marginal product of labor
- 24. Long-Run • All inputs are variable • Cost curves are planning curves LAC = LTC Q
- 26. 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.
- 27. 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
- 28. Returns to Scale Constant returns to scale Increasing returns to scale Decreasing returns to scale INPUT OUTPUT INPUT OUTPUT INPUT OUTPUT
- 29. Returns to Scale Constant returns to scale Increasing returns to scale Decreasing returns to scale INPUT OUTPUT INPUT OUTPUT INPUT OUTPUT
- 33. 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
- 34. 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
- 35. 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
- 37. Cost-Volume-Profit Analysis • Breaking it even and then some
- 38. 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
- 40. 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)
- 41. 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
- 42. QT = TFC + πT . P-AVC Q TFC = $200 P = $10 AVC = $5 Solve: QT = $200 + $100 . $10-$5 QT = 60
- 43. 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
- 44. Q FC = $200 FC’ = $300 AVC = $5 AVC’ = $3.33 QB’ = 45 TC’ has a higher DOL than TC and therefore a higher QB
- 45. 𝐷𝑂𝐿 = 60($10 − $5) 60 $10 − $5 − $200 = $300 $100 = 3 Given: Increase in output from 60 to 70 units Find: DOL with TC
- 46. 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
- 47. New Economies of Scale Minimizing 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
- 48. 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
- 49. Empirical Estimation of Cost Functions • Planning for the long haul
- 50. 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)
- 51. Empirical Estimation Functional Form for Short-Run Cost Functions Theoretical Form 𝑀𝐶 = 𝑎 + 2𝑏𝑄 + 3cQ2
- 53. Empirical Estimation Functional Form for Short-Run Cost Functions Linear Approximation
- 55. Empirical Estimation Efficiency of Operation in Estimating the LAC curve
- 56. 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
- 57. 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