C.  Cost Analysis

1.  Cost functions

Shows the relationship between costs and output produced

a.  Fixed vs. variable costs

Variable costs - change with level of output

Ex. - Wages, cost of raw materials, energy costs

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Fixed costs - don't vary with output

Ex. - Rent, interest on loans, marketing expenditures

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Semifixed costs - fixed over certain range, variable over others

Ex. - Trucks

Q = 0 - 5000 => 1 truck

Q = 5001 - 10000 => 2 trucks

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Ex. - Salaried employees, administrative expenditures

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• May depend on time frame - many costs fixed in short run

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b.  Total cost

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c.  Average costs

AC = average cost = TC / Q

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d.  Marginal cost (MC)

MC = ΔTC / ΔQ

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e.  Relationship between average and marginal costs

If MC > AC, AC is increasing

If MC < AC, AC is decreasing

If MC = AC, AC is at a minimum

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2.  Short-run vs. long-run costs

Short-run - firm cannot change size of production facilities

Long-run - firm can adjust plant size, employ alternative technologies

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Short-run - used to determine day-to-day operational decisions

Long-run - used for planning purposes

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3.  Sunk vs. avoidable costs

Sunk costs - costs incurred no matter what decision is made

Avoidable costs - costs can be avoided if certain choices made

Ex. - Unsold products, some capital expenditures

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Some fixed costs are not sunk costs

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Ex. - Capital that can be transferred to other uses

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4.  Profitability

a.  Economic vs. accounting costs

Opportunity cost - cost of foregone alternatives

Ex. - Foregone wages, return on capital assets

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Accounting costs - only look at costs explicitly incurred

Economic costs - include opportunity cost along with accounting costs

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Ex. - Quit job to start a business

Salary at former job = $200,000

Wages of employees = $300,000

Expenses for supplies and raw materials = $550,000

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Accounting costs = $300,000 + $550,000 = $850,000

Economic costs = $850,000 + $200,000 = $1,050,000

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b.  Economic vs. accounting profit

Accounting profit (π) = total revenue - accounting costs

Economic profit (π) =  total revenue - economic costs

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Ex. - Quit job to start a business

TR = $1,000,000

Accounting π = $1,000,000 - $850,000 = $150,000

Economic π = $1,000,000 - $1,050,000 = -$50,000

Ex. - McDonald's, 2002

Accounting π = $2,113 million

Economic π = -$124 million

Opportunity cost = $2,237 million

Total assets = $23,970.5 million

Implied rate of return for alternative use of assets = 9.33%