MANAGERIAL DECISION MAKING

E.  Cost Analysis

1.  Concepts

a.  Relevant costs

• Costs that differ across alternative courses of action

b.  Opportunity costs

• Benefits foregone in next-best alternative

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c.  Profit

• Accounting profit = revenue - cost

• Economic profit = revenue - all costs (including opportunity cost)

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d.  Normal return

• Return required to compensate suppliers of capital for bearing risk of an investment

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e.  Fixed costs

• Don't vary with level of output

• Should be ignored when making decisions

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f.  Sunk costs

• Expense already incurred, can't be recovered

• Should be ignored when making decisions

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2.  Returns to scale

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a.  Declining average cost

• Capital intensive production

• Specialization

• Technology relationships

• Fixed expenses

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b.  Constant average cost

• Production process can be easily replicated

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c.  Increasing average cost

• Problems with organization and control in large firms

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d.  Minimum efficient scale

• Lowest output at which average cost is at a minimum

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3.  Economies of scope

• Less costly to produce multiple goods together than separately

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Due to:

• Multiple product production process

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• By-products in production process

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• Underutilization of inputs

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• Transferable knowledge or experience

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• Consumption of complementary goods

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• Use of common inputs to produce differentiated products

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4.  Learning curve

• Average cost decreases as cumulative output increases, due to learning

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