F.  Cost Theory and Estimation

1.  Cost concepts

a.  Opportunity cost

• What is foregone when taking an action

b.  Explicit costs

• Actual expenditures made

c.  Implicit costs

•  Value of inputs owned  and used by firm

• Measured by the opportunity cost

d.  Economic costs

• Includes both explicit and implicit costs 

e.  Accounting costs

• Includes only explicit costs

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f.  Marginal cost

• Change in total cost due to a 1-unit increase in output

g.  Incremental cost

• Change in total cost from implementing a decision

h.  Relevant costs

• Costs that should be considered when making decisions

i.  Sunk costs

• Expense already incurred, can't be recovered

• Should be ignored when making decisions

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2.  Short-run cost functions

• Some inputs fixed in the short run

a.  Total costs

(1)  Total fixed costs (TFC)

• Costs that remain constant as output changes

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(2)  Total variable costs (TVC) - costs that change as output changes

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(3)  Total cost (TC) - all costs

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b.  Per unit costs

(1) Average fixed cost (AFC)

AFC = TFC / Q

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(2) Average variable cost (AVC)

AVC = TVC / Q

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(3) Average total cost (ATC)

ATC = TC / Q

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(4) Marginal cost (MC)

MC = ΔTC / ΔQ

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3.  Long-run cost curves

• All inputs are variable in the long run

a.  Long-run total cost

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b.  Long-run average and marginal cost

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4.  Plant size and economies of scale

• Economies of scale - output grows proportionately more than inputs => average cost declines

• Diseconomies of scale - output grows proportionately less than inputs => average cost increases

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a.  Reasons for economies of scale

(1) Greater specialization possible

(2) More specialized machinery can be used

(3) Physical properties

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(4) Fewer supervisors needed per unit of output

(5) Fewer spare parts needed per unit of output

(6) Smaller inventory needed per unit of output

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(7)  Volume discounts in the purchase of inputs

(8)  More favorable credit terms for larger companies

(9) Economies of scale in advertising and promotion

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b.  Reason for decreasing returns to scale

• More difficult to manage firm

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5.  Learning curves

• Costs usually decrease as firms gain more experience in producing a product

• Average cost decreases as cumulative output increases

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6.  International considerations and supply chain management

• Big increase in foreign sourcing of inputs - buying of inputs and components from overseas

• More firms with production facilities in many countries

• Immigration of skilled labor into the U.S. - primarily in technical fields

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a.  International economies of scale

• Reduce costs by internationalizing different aspects of a firm's operation

(1) Product development

• Design core product for world economy, allow variations for local markets

(2) Purchasing

• Buy raw materials, parts, and components globally instead of just locally

(3) Production

• Coordinate  production in low-cost manufacturing countries with final assembly near markets

(4)  Demand management

• Forecast and manage demand on a global basis

(5) Order fulfillment

• Reduce costs by shipping products from plants closest to customers

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b.  Supply chain management

• Also referred to a logistics

• Merge at the corporate level purchasing, transportation, warehousing, distribution, and customer services

• Reasons for growth:

(1) Better technology allows better management of activities

(2) Growing use of just-in-time inventory management

• Requires greater coordination of activities

(3) Increased globalization of production and distribution

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7.  Cost-volume profit analysis

• Also called breakeven analysis

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a.  Breakeven level of output

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b.  Target level of profit

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c.  Operating leverage

• Degree of operating leverage (DOL) - measures responsiveness of profits to changes in output

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