Chapter 7
The Theory
and
d Estimation
i
i
of Cost
Chapter Outline
Importance of cost in managerial decisions
Definition
f
and
d use off costs in economic analysis
l
Relationship between production and cost
Short run cost function
Short-run
Long-run cost function
Learning curve
Economies of scope and scale
Supply chain management
Ways companies have cut costs to remain
competitive
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7-2
Learning Objectives
Define the cost function and the difference between
the short and long run
Distinguish between economic cost and accounting
cost
Explain how the concept of relevant cost is used in
economic analysis
Define total, variable, average and fixed cost
Explain the linkage between the production and
cost function
Provide reasons for the existence of economies of
scale and scope
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7-3
Importance of Cost
a age a Decisions
ec s o s
in Managerial
Ways to contain or cut costs popular during
the
h past decade
d
d
Most common: reduce number of people on the
payroll
Consolidation of shared services
Outsourcing components of the business
Mergers
g
and consolidation (usually
(
y with a
reduction in employees)
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7-4
Definition and Use of
Cost in Economic
Cos
co o c Analysis
a ys s
Relevant cost: a cost that is affected by a
management decision
d
Historical cost: cost incurred at the time of
procurement
Opportunity cost: amount or subjective
value
l
that
th t is
i forgone
f
in
i choosing
h
i
one
activity over the next best alternative
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7-5
Definition and Use of
Cost in Economic
Cos
co o c Analysis
a ys s
Incremental cost: varies with the range of
options available
l bl in the
h d
decision
Sunk cost: does not vary in accordance with
decision alternatives
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Relationship Between
oduc o a
and
d Cos
Cost
Production
Cost function is simply the production
f
function
expressed
d in monetary rather
h than
h
physical units
We assume the firm is a price taker in the
input market
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7-7
Relationship Between
oduc o a
and
d Cos
Cost
Production
Total variable cost (TVC) = the cost
associated
d with
h the
h variable
bl input, ffound
d by
b
multiplying the number of units by the unit
price
Marginal cost (MC) = the rate of change
in total variable cost
TVC
W
MC =
=
Q
MP
The law of diminishing returns implies that MC
will eventually
y increase
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7-8
Relationship Between
oduc o a
and
d Cos
Cost
Production
Plotting TP and TVC
illustrates
ll
that
h they
h
are mirror images of
each other
When TP increases
at an increasing
rate TVC increases
rate,
at a decreasing rate
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7-9
Short-run Cost Function
Short-run cost function assumptions:
the firm employs two inputs, labor and capital
the firm operates in a short-run production
period where labor is variable, capital is fixed
the firm produces a single product
the firm employs a fixed level of technology
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7-10
Short-run Cost Function
More short run cost function assumptions.
the firm operates at every level of output in the
mostt efficient
ffi i t way
the firm operates in perfectly competitive input
markets and must pay for its inputs at a given
market rate (it is a price taker)
the short-run production function is affected by
th law
the
l
off diminishing
di i i hi
returns
t
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7-11
Short-run Cost Function
Standard variables in the short-run cost
function:
Quantity (Q) is the amount of output that a firm
can produce in the short run
Total fixed cost (TFC) is the total cost of using
the fixed input, capital (K)
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7-12
Short-run Cost Function
Standard variables in the short-run cost
function:
Total variable cost (TVC) is the total cost of using
the variable input, labor (L)
Total cost (TC) is the total cost of using all the
firms inputs,
TC = TFC + TVC
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7-13
Short-run Cost Function
Standard variables in the short-run cost
function:
Average fixed cost (AFC) is the average per-unit
cost of using the fixed input K
AFC = TFC/Q
Average variable cost (AVC) is the average perunit cost of using the variable input L
AVC = TVC/Q
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7-14
Short-run Cost Function
Standard variables in the short-run cost
function:
Average total cost (AC) is the average per-unit
cost of all the firms inputs
AC = AFC + AVC = TC/Q
Marginal cost (MC) is the change in a firms total
cost (or total variable cost) resulting from a unit
change in output
MC = DTC/DQ = DTVC/DQ
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Short-run Cost Function
Graphical example of the cost variables
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7-16
Short-run Cost Function
Important observations
AFC declines steadily
when MC = AVC, AVC is at a minimum
when MC < AVC, AVC is falling
when MC > AVC,
AVC AVC is rising
The same three rules apply for average cost (AC)
as for AVC
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7-17
Short-run Cost Function
Two critical relationships:
Productivity and cost are inversely related.
The marginal
g
cost p
pulls average
g either up
p or
down depending on if it is above or below
average.
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7-18
Short-run Cost Function
A reduction in the firms fixed cost would
cause the
h average cost line
l
to shift
hf
downward
A reduction in the firms variable cost would
cause all three cost lines (AC
(AC, AVC,
AVC MC) to
shift downward.
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7-19
Short-run Cost Function
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7-20
Short-run Cost Function
Alternative specifications of the Total Cost
f
function
(relating
( l
totall cost and
d output))
cubic relationship:
as output increases, total cost first increases at a
decreasing
g rate, then increases at an increasing
g rate
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7-21
Short-run Cost Function
Alternative specifications of the Total Cost
f
function
(relating
( l
totall cost and
d output))
quadratic relationship: as output increases, total
cost increases at an increasing rate
linear relationship: as output increases, total cost
increases at a constant rate
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7-22
Long-run Cost Function
In the long run, all inputs to a firms
production
d
ffunction may be
b changed
h
d
Because there are no fixed inputs, there are no
fixed costs
firms
s long run marginal cost pertains to
The firm
returns to scale
In general, at first firms achieve increasing
returns to scale, then as they mature they have
constant returns, then they may experience
decreasing returns to scale
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7-23
Long-run Cost Function
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Long-run Cost Function
When a firm experiences increasing returns
to scale:
l
a proportional increase in all inputs increases
output by a greater proportion
as output increases by some percentage, total
cost of production increases by some lesser
percentage
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7-25
Long-run Cost Function
Economies of scale: situation where a
f
firms
long-run
l
average cost (LRAC)
(
)d
declines
l
as output increases
Diseconomies of scale: situation where a
firms LRAC increases as output increases
In
I general,
l the
th LRAC curve is
i u-shaped.
h
d
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7-26
Long-run Cost Function
Reasons for long-run economies of scale:
specialization of labor and capital
prices of inputs may fall with volume discounts in
firms purchasing
use of capital equipment with better priceperformance ratios
larger firms may be able to raise funds in capital
markets at a lower cost
larger firms may be able to spread out
promotional costs
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7-27
Long-run Cost Function
In long run, the firm can choose any level of
capacity
Once it commits to a level of capacity,
capacity at least one
of the inputs must be fixed. This then becomes a
short-run problem.
The LRAC curve is an envelope of SRAC curves, and
outlines the lowest per
per-unit
unit costs the firm will incur
over a range of output.
Learning Curve
Learning curve: line showing the
relationship
l
h b
between llabor
b cost and
d
additional units of output
A downward slope indicates additional cost per
unit declines as the level of output increases
because workers improve with practice.
The production process also improves as
engineers and other development personnel gain
more experience.
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Learning Curve
Learning curve: measured in terms of percentage
decrease in additional labor cost as output increases
Yx = Kxn
Yx
K
= units of factor or cost to produce the xth unit
= factor units or cost to produce the Kth
(usually first) unit
x
= product unit (the xth unit)
n
= log S/log 2
p p
parameter
S
= slope
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7-32
Economies of Scope
Economies of scope: reduction of a firms
unit cost by
b producing
d
two or more goods
d or
services jointly rather than separately
Closely related to economies of scale
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7-33
Supply Chain Management
Supply chain management (SCM):
efforts
ff
by
b a firm
f
to improve efficiencies
ff
through each link of a firms supply chain
from supplier to customer
transaction costs are incurred by using resources
outside the firm
coordination costs arise because of uncertainty
y
and complexity of tasks
information costs arise to properly coordinate
activities between the firm and its suppliers
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Supply Chain Management
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Supply Chain Management
Ways to develop better supplier
relationships
l
h
strategic alliance: firm and outside supplier join
together in some sharing of resources
competitive tension: firm uses two or more
suppliers, thereby helping the firm keep its
purchase prices under control
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7-36
Ways Companies Cut
Costs
Cos
s to
o Remain
e a Competitive
Co pe
e
the strategic use of cost
reduction in cost of materials
using
g information technology
gy to reduce
costs
reduction of process costs
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7-37
Ways Companies Cut
Costs
Cos
s to
o Remain
e a Competitive
Co pe
e
relocation to lower-wage countries or
regions
mergers, consolidation, and subsequent
downsizing
layoffs and plant closings
reductions in fixed assets
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7-38
Global Application
Discussion example: Li & Fung
Is this
h the
h model
d l off a global
l b lb
business?
Operating in 40 countries around the world
Outsourcing the entire supply chain
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7-39
Summary
Virtually all management decisions must
consider
d the
h impact on costs.
The short run cost function has fixed costs,
i th
in
the llong run, all
ll costs
t are variable.
i bl
The law of diminishing returns also affects
costs.
costs
Firms may experience economies of scope
and scale and benefit by the learning curve.
curve
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7-40
