Cost theory


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Cost theory

  1. 1. Understanding of Cost Theory& its connection to Cost Accounting Gunel Poladova Date 021007
  2. 2. Cost Object <ul><li>A cost object-is any activity for which a separate measurement of costs is desired . Cost of a product, cost of rendering a service to a bank customer or hospital patient, or indeed anything for which one wants to measure the cost of recourses used. </li></ul>
  3. 3. Impicit&Explicit costs <ul><li>Implicit cost-Input costs that do not require an outlay of money by the firm </li></ul><ul><li>(Horace is skilled by computer could earn $100 per hour working as programmer, for every hour he works at his pizza factory he gives up $100 income and this forgone income is also part of his costs ) </li></ul><ul><li>Explicit cost-Input cost that require an outlay of money by the firm </li></ul>
  4. 4. Economists& Accountants analyse of the cost <ul><li>Economists are interested in studying how the firm make production and pricing decisions </li></ul><ul><li>Theses decisions are based on both explicit and implicit costs </li></ul><ul><li>Accountants have the job of keeping track of money that flows into and out of firms.They count explicit cost and often ignore implicit cost </li></ul>
  5. 5. Economists& Accountants analyse of the cost <ul><li>When Horace gives up the opportunity to earn money as computer programmer his accountant will not count this as a cost of his pizza business .Because no money flows out the business to pay for this cost, it never shows in financial statements </li></ul>
  6. 6. Economists& Accountants analyse of the cost <ul><li>An Economist however will count the foregone </li></ul><ul><li>Income as a cost because it will affect the decisions that Horace makes in his pizza business </li></ul><ul><li>If his wage as computer programmer rises from $ 100 to $ 500 per hour he might decide that running his pizza business is too costly and choose to shut down the factory to become a full-time programmer </li></ul>
  7. 7. The cost of Capital as an Opportunity Cost <ul><li>Horace used $300 000 of his savings to buy his pizza factory from his previous owner. If Horace had instead left this money deposited in a saving accounts that pays an interest rate pf 5 per cent he would have earned $ 15 000 a year in interest income. To own his business he has given up $ 15 000 a year in interest income. This foregone $ 15 000 one of the implicit costs of his business </li></ul>
  8. 8. The cost of Capital as an Opportunity Cost <ul><li>The Economist views the $ 15 000 in interest </li></ul><ul><li>Income that Horace gives up every year as cost of their business even though it is implicit cost </li></ul><ul><li>Accountant will not show this & 15 000 as cost because no money flows out of the business to pay for it </li></ul>
  9. 9. The cost of Capital as an Opportunity Cost <ul><li>Horace did not have the entire & 300 000 to buy the factory but instead he used $ 100 000 from his own savings and borrowed $ 200 000 from a bank at an interest rate of 5 per cent. Horaces accountant will count the $ 10 000 that they paid on bank loan every year as a cost </li></ul><ul><li>According to economist view the opportunity cost of owning business is still $ 15 000 </li></ul>
  10. 10. The cost of Capital as an Opportunity Cost <ul><li>The opportunity cost equals the interest on the bank loan (an explicit cost $ 10 000) plus the forgone interest on savings (an implicit cost of $ 5000) </li></ul>
  11. 11. Economic&Accounting profit <ul><li>Economic profit as the firms total revenue minus all the opportunity costs (exp&impl) of producing the goods and services sold Accounting profit as the firms total revenue minus only the firms explicit costs </li></ul><ul><li>For a business to be profitable from an economists standpoint , total revenue must cover all the opportunity costs,both expl&impl </li></ul>
  12. 12. Economic&Accounting profit <ul><li>Economic profit-total revenue minus total cost, including both explicit&implicit cost </li></ul><ul><li>Accounting profit – total revenue minus total explicit cost </li></ul>
  13. 13. <ul><li>An Economist Views An Accountant Views </li></ul>Economic&Accounting profit Economic Profit Implicit costs Explicit costs Accounting profit Explicit costs Revenue Revenue Total opportunity Cost
  14. 14. <ul><li>Farmer MacDonald gives bagpipe lessons for $ 20 an hour. One days he spends 10 hours planting $ 100 worth of seeds on his farm. What opportunity cost has he incurred? </li></ul><ul><li>What cost would his account measure? </li></ul><ul><li>If these seeds will yield $ 200 worth of crops does old Mac Donald earn an accounting profit? Does he earn an economic profit? </li></ul>Quick Quiz
  15. 15. Production Function <ul><li>Number Output Marginal Cost Cost Total Cost of </li></ul><ul><li>of workers quantity product of of inputs </li></ul><ul><li>pizzas of labour factory workers (cost factory&work) </li></ul><ul><li>0 0 30 0 30 </li></ul><ul><li>1 50 50 30 10 40 </li></ul><ul><li>2 90 40 30 20 50 </li></ul><ul><li>3 120 30 30 30 60 </li></ul><ul><li>4 14o 10 30 40 70 </li></ul><ul><li>5 150 30 50 80 </li></ul>
  16. 16. Production Function <ul><li>Production function </li></ul>Number of workers Quantity of output Number of workers hired
  17. 17. The Production Function <ul><li>Relationship between the quantity of input (workers) and quantity of output Production Function </li></ul><ul><li>The marginal product of any input in the production process is the increase in in the quantity of output obtained from one additional unit of that input </li></ul><ul><li>The Diminishing Marginal Product the property whereby the marginal product of an input declines as the quantity of the input increase </li></ul>
  18. 18. Production Function <ul><li>The number of workers increase , the Marginal product declines. </li></ul><ul><li>At first only a few workers hired and they have easy access to kitchen equipment.As the number of workers increases additional workers have to share equipment and work in more crowded conditions. </li></ul><ul><li>More and more workers are hired each additional worker contributes less to the production of the pizza </li></ul>
  19. 19. Total Cost Curve
  20. 20. Production Function& Total Cost Curve <ul><li>The Total Cost Curve gets steeper as the amount produced rises, whereas the production function gets flatter as production rises. </li></ul><ul><li>This changes in slope occur for the same reason </li></ul><ul><li>High production means that kitchen is crowded, each additional worker adds less to production </li></ul><ul><li>Kitchen is crowded producing an additional pizza requires a lot of additional labor is thus very costly </li></ul><ul><li>Therefore, when the quantity produced is large, the total cost curve is relatively steep </li></ul>
  21. 21. <ul><li>If farmer Jones plants no seeds on his farm, he gets no harvest. If he plants 1 bag of seeds he gets 3 tones of wheat. If he plants 2 bags he gets 6 tones. A bag of seeds cost $ 100 and seeds are his only cost. Use this data to graph the farmers production function and Total Cost Curve. </li></ul>Quick Quiz
  22. 22. Average and Marginal Cost <ul><li>How much does it cost to make the typical unit? </li></ul><ul><li>How much does it cost to increase production </li></ul><ul><li>of 1 more unit? </li></ul>
  23. 23. Cost Terms <ul><li>Fixed& Variable Cost </li></ul><ul><li>Direct& Indirect Costs </li></ul><ul><li>Period& Product Costs </li></ul><ul><li>Cost behavior in relation to volume of ativity </li></ul><ul><li>Relevant and irrelevant costs </li></ul><ul><li>Avoidable and unavoidable cots </li></ul><ul><li>Sunk Costs </li></ul><ul><li>Opportunity Costs </li></ul><ul><li>Incremental and marginal costs </li></ul>
  24. 24. Fixed& Variable Cost <ul><li>Fixed Cost do not vary with quantity of output produced. They are incurred even if the firm produces nothing t all. </li></ul><ul><li>Rent </li></ul><ul><li>Salary worker s </li></ul><ul><li>Variable Cost change as the firm alters the quantity of output produced </li></ul><ul><li>Sugar </li></ul><ul><li>Paper cups </li></ul><ul><li>A firms total Cost-is the sum fixed and variable costs </li></ul>