Implicit Costs Webpub at Allegheny

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Implicit Costs Webpub at Allegheny Powered By Docstoc
					                                Cost Analysis
                                   Chapter 8
  The Importance of Cost Analysis
    » Managers seek to produce the highest quality
      products at the lowest possible cost.
    » Firms that are satisfied with the status quo find that
      competitors arise that produce at lower costs and
      drive them out of business.
    » The advantages once assigned to being a large firm
      (economies of scale and scope) have not provided
      the advantages of flexibility and agility found in
      some smaller companies.
    » Cost analysis is helpful in the task of finding lower
      cost methods to produce goods and services.
2008 Thomson * South-Western                             Slide 1
     Managerial Challenge:
        US Airways
• US Airways was created through mergers
  with Allegheny, Mohawk, Lake Central,
  Pacific Southwest and Piedmont Airways.
• Mostly in the East, with high cost but high
  yields (most seats were filled).
• But, this situation invites entry by
  competitors by Continental or others.
• The key to US Airways’ survival lays in
  managing its high cost.                       Slide 2
  Accounting vs Economic Cost
• Accounting costs involve explicit historical
  costs. They attempt to use the same rules for
  different firms, so we can compare firm
• Economic costs are based on making decisions.
  These costs can be both implicit and explicit.
  » A chief example is that economic costs include the
    opportunity costs of owner-supplied resources such as
    time and money, which are implicit costs.
  Economic Profit = Total Revenues - Explicit Costs - Implicit Costs
  » Implicit costs make economic profit lower than
    accounting profit
                                                                  Slide 3
Meaning and Measurement of Cost

  There a number of cost concepts in business.
• Opportunity Cost – value of next best
  alternative use.
• Explicit vs. Implicit Cost – actual
  prices paid vs. opportunity cost of
  owner-supplied resources.

                                             Slide 4
• Depreciation Cost Measurement. Accounting
  depreciation (e.g., straight-line depreciation) tends to
  have little relationship to the actual loss of value
   » To an economist, the actual loss of value is the true
      cost of using machinery.
• Inventory Valuation. Accounting valuation depends on
  its acquisition cost
   » Economists view the cost of inventory as the cost of
• Unutilized Facilities. Empty space may appear to have
  "no cost”
   » Economists view its alternative use (e.g., rental value)
      as its opportunity cost.
                                                       Slide 5
• Sunk Costs -- already paid for, or
    there already exists a contractual obligation to
•   Incremental Cost - - extra cost of
     implementing a decision =  TC of a
•   Marginal Cost -- cost of last unit
    produced =  TC/Q


    1.    TC = FC + VC fixed & variable costs

    2.    ATC = AFC + AVC = FC/Q + VC/Q
                                                   Slide 6
Short Run Cost Graphs
 1.               3.                     AVC

            AFC                      AFC
              Q                        Q
                MC intersects lowest point
 2.         AVC
                of AVC and lowest point of

                When MC < AVC, AVC declines
              Q When MC > AVC, AVC rises
                                       Slide 7
 Relationships Among Cost & Production Functions

• AP & AVC are inversely               Q
  related. (ex: one input)                              prod. functions

• AVC = WL /Q = W/ (Q/L) =                                      AP
  W/ APL
  » As APL rises, AVC falls                                     MPL
                                cost                             L
• MP and MC are inversely                   AVC                 MC
• MC = dTC/dQ = W dL/dQ =
  W / (dQ/dL) = W / MPL                                    cost functions

  » As MPL declines, MC rises                                           Q
                                           (Figure 8.3 on page 311)
                                                                  Slide 8
   Suppose that Variable Cost is cubic:
         VC = .5 Q3 - 10 Q2 + 150 Q
  1.   find AVC from the VC function above.
  2.   find minimum variable cost output from AVC.
  3.   and find MC from the VC function
A1: AVC = .5 Q 2 -10 Q + 150 (divide by Q)
A2: Minimum AVC is where dAVC/dQ = 0
                  dAVC / dQ = Q - 10 = 0
                  Q = 10, so AVC = 100 @ Q = 10
A3: MC= dVC/dQ= 1.5 Q2 - 20 Q + 150
                                                     Slide 9
         Long Run Cost Functions
• All inputs are variable in the
  long run
• LAC is long run average cost
   » ENVELOPE of SAC curves
                                                 SAC2 LMC
• LMC is FLATTER than
  SMC curves
• The optimal plant size for a
  given output Q2 is plant size 2.                     LAC
  (A SR concept.)
• However, the optimal plant
  size occurs at Q3, which is the
  lowest cost point overall. (A
  LR concept.)                       Q2           Q3   Q
                                                           Slide 10
     Long Run Cost Function (LAC)
         Envelope of SAC curves
Ave Cost
                        SAC-small capital
                                   SAC-med. capital

                                        SAC-big capital

                                 of SRAC curves

               Figure 8.4 on page 313         Q
                                                  Slide 11
       Economists think that the
           LAC is U-shaped
• Downward section due to:
  » Product-level economies which include
    specialization and learning curve effects.
  » Plant-level economies, such as economies in
    overhead, required reserves, investment, or
    interactions among products (economies of scope).
  » Firm-level economies which are economies in
    distribution and transportation of a geographically
    dispersed firm, or economies in marketing, sales
    promotion, or R&D of multi-product firms.

                                                      Slide 12
                                                  CRS region
• Flat section of the LAC                                             DRS
  » Displays constant returns to scale     MES               Max ES
  » The minimum efficient scale (MES) is the smallest scale at which
    minimum per unit costs are attained.

• Upward rising section of LAC is due to:
  » diseconomies of scale. These include transportation costs,
    imperfections in the labor market, and problems of coordination and
    control by management.
  » The maximum efficient scale (Max ES) is the largest scale before
    which unit costs begin to rise.
  » Modern business management offers techniques to avoid
    diseconomies of scale through profit centers, transfer pricing, and
    tying incentives to performance.
                                                                 Slide 13
  International Variation in
   Dealing with Firm Size
• General Motors was divided into several division:
  Chevy, Buick, Cadillac, Fisher Body, and a few others
  to have each compete with each other, yet have the
  advantage of large size.
• But the Japanese use hundreds of individual
• Matsushita Electric has 161 consolidated units
• Hitachi Ltd has 660 companies
• Large firms must find ways to avoid diseconomies of
  scale but take advantage of their larger size.
                                                   Slide 14
         Auto Production:
   Minimum Efficient Scale
                         • At Ford, cars made
                           from aluminum has a
Figure 8.9 page 322
                           minimum efficient size
                           of 50,000 (pt A)
   B                     • Cars made from steel
                           has a MES of 300,000
                           (pt C)
  A                      • Hence, Ford can change
                  C        its products faster if it
                           uses aluminum, even if
50,000       300,000       10% more costly.
MES aluminum MES steel                         Slide 15
Q Suppose we have the following info:
       TC = 200 + 5Q - .4Q2 + .001Q3
       MC =       5 - .8Q + .003 Q2
  1.   FIND fixed cost
  2.   FIND AVC function
  3.   FIND AVC at Q = 10
  4.   If FC rises $500, what happens to
       the average variable cost function?
                                             Slide 16
                     TC = 200 + 5Q - .4Q2 + .001Q3
            We know:
                     MC =       5 - .8Q + .003 Q2
1. FIND fixed cost
  Answer: FC = 200, the intercept in the TC curve.
2. FIND AVC function
  Answer: VC = 5Q - .4Q2 + .001Q3
    So AVC = 5 - .4Q + .001Q2 (Divide VC by Q)
3. FIND AVC at Q = 10.
  Answer: Substitute Q = 10 into the AV C function.
   AVC = 5 - .4(10) + .001(102) = 4 – 4 + .1 = 1.1.
4. If FC rises to $500, what happens to the average variable
    cost function?
  Answer: No change, since AVC does not include
   fixed cost.
                                                       Slide 17

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