Cost Analysis andCost Analysis and
What Makes Cost Analysis
Link Between Accounting and Economic
Accounting and economic costs often differ.
Historical Versus Current Costs
Historical cost is the actual cash outlay.
Current cost is the present cost of previously
Cost of replacing productive capacity using
Opportunity Cost Concept
Opportunity cost is foregone value.
Reflects second-best use.
Explicit and Implicit Costs
Explicit costs are cash expenses.
Implicit costs are noncash expenses.
Incremental and Sunk Costs in
Incremental cost is the change in cost tied to
a managerial decision.
Incremental cost can involve multiple units of
Marginal cost involves a single unit of output.
Irreversible expenses incurred previously.
Sunk costs are irrelevant to present decisions.
Short-run and Long-run Costs
How Is the Operating Period Defined?
At least one input is fixed in the short
All inputs are variable in the long run.
Fixed and Variable Costs
Fixed cost is a short-run concept.
All costs are variable in the long run.
Short-run Cost Curves
Short-run Cost Categories
Total Cost = Fixed Cost + Variable Cost
For averages, ATC = AFC + AVC
Marginal Cost, MC = ∂TC/∂Q
Short-run Cost Relations
Short-run cost curves show minimum
cost in a given production environment.
Short Run Cost GraphsShort Run Cost Graphs
MC intersects lowest point
of AVC and lowest point of
When MC < AVC, AVC declines
When MC > AVC, AVC rises
Relationships Among Cost &Relationships Among Cost &
Production FunctionsProduction Functions
AP & AVC are inverselyAP & AVC are inversely
related.related. (ex: one input)(ex: one input)
AVC = WL /Q = W/ (Q/L) = W/AVC = WL /Q = W/ (Q/L) = W/
As APAs APLL rises, AVC fallsrises, AVC falls
MP and MC are inverselyMP and MC are inversely
MC = dTC/dQ = W dL/dQ = W /MC = dTC/dQ = W dL/dQ = W /
(dQ/dL) = W / MP(dQ/dL) = W / MPLL
As MPAs MPLL declines, MC risesdeclines, MC rises
Long-run Cost Curves
Economies of Scale
Long-run cost curves show minimum
cost in an ideal environment.
Long Run Cost FunctionsLong Run Cost Functions
All inputs are variableAll inputs are variable
(can adjust) in the long(can adjust) in the long
LAC is long run averageLAC is long run average
ENVELOPE of SAC curvesENVELOPE of SAC curves
LMC is flatter thanLMC is flatter than
SMC curves.SMC curves.
The optimal plant size forThe optimal plant size for
a given output Qa given output Q22 is plantis plant
size 2. (A SR concept.)size 2. (A SR concept.)
However, the optimalHowever, the optimal
plant size occurs at Qplant size occurs at Q33,,
which is the lowest costwhich is the lowest cost
point overall. (A LRpoint overall. (A LR
Long Run Cost Function (LAC)Long Run Cost Function (LAC)
Envelope of SAC curvesEnvelope of SAC curves
Cost Elasticity and Economies
Cost elasticity is εC = ∂C/C ÷ ∂Q/Q.
εC < 1 means falling AC, increasing
εC = 1 means constant AC constant
εC > 1 means rising AC, decreasing
Economists think that the LAC is U-Economists think that the LAC is U-
Downward section due to:Downward section due to:
Product-level economiesProduct-level economies which include specializationwhich include specialization
and learning curve effects.and learning curve effects.
Plant-level economiesPlant-level economies, such as economies in, such as economies in
overhead, required reserves, investment, oroverhead, required reserves, investment, or
interactions among products (economies of scope).interactions among products (economies of scope).
Firm-level economiesFirm-level economies which are economies inwhich are economies in
distribution and transportation of a geographicallydistribution and transportation of a geographically
dispersed firm, or economies in marketing, salesdispersed firm, or economies in marketing, sales
promotion, or R&D of multi-product firms.promotion, or R&D of multi-product firms.
Flat section of the LACFlat section of the LAC
Displays constant returns to scaleDisplays constant returns to scale
The minimum efficient scale (MES) is the smallestThe minimum efficient scale (MES) is the smallest
scale at which minimum per unit costs arescale at which minimum per unit costs are
Upward rising section of LAC is due to:Upward rising section of LAC is due to:
Diseconomies of scale. These includeDiseconomies of scale. These include
transportation costs, imperfections in the labortransportation costs, imperfections in the labor
market, and problems of coordination and controlmarket, and problems of coordination and control
by management.by management.
The maximum efficient scale (Max ES) is theThe maximum efficient scale (Max ES) is the
largest scale before which unit costs begin to rise.largest scale before which unit costs begin to rise.
Modern business management offers techniquesModern business management offers techniques
to avoid diseconomies of scale through profitto avoid diseconomies of scale through profit
centers, transfer pricing, and tying incentives tocenters, transfer pricing, and tying incentives to
Economies of Scope
Economies of Scope Concept
Scope economies are cost advantages that
stem from producing multiple outputs.
Big scope economies explain the popularity of
Without scope economies, firms specialize.
Exploiting Scope Economies
Scope economics often shape competitive
strategy for new products.
Cost-volume-profit analysis shows effects of
Breakeven analysis shows zero profit points
of cost coverage.