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THEORY OF COSTS

The Theory and Estimation of Cost


The Importance of Cost in Managerial Decisions The Definition and Use of Cost in Economic Analysis The Relationship Between Production and Cost The Short Run Cost Function The Long Run Cost Function The Learning Curve Economies of Scope Economies of Scale: the Short Run Versus the Long Run Supply Chain Management Ways Companies Have Cut Costs to Remain Competitive

Learning Objectives

Define the cost function and explain the difference between a short-run and a long-run cost function. Explain the linkages between the production function and the cost function. Distinguish between economic cost and accounting cost. Explain how the concept of relevant cost is used in the economic analysis of cost. Define short-run total cost, short-run variable cost, and total fixed cost and explain their relationship to each other.

Learning Objectives
Define average cost, average variable cost, and average fixed cost and explain their relationship to each other in the short run. Do the same for average cost and average variable cost in the long run. Compare and contrast the short-run cost function and the long-run cost function and explain why economies of scale is considered to be a long-run phenomenon. Provide at least four reasons for the existence of economies of scale.

The Importance of Cost in Managerial Decisions

Ways to contain or cut costs over the past decade


Most

common: reduce number of people on the payroll Outsourcing components of the business Merge, consolidate, then reduce headcount

The Definition and Use of Cost in Economic Analysis

Relevant cost: a cost that is affected by a management decision. Historical cost: cost incurred at the time of procurement. Opportunity cost: amount or subjective value that is forgone in choosing one activity over the next best alternative. Incremental cost: varies with the range of options available in the decision. Sunk cost: does not vary in accordance with decision alternatives.

The Relationship Between Production and Cost

Cost function is simply the production function expressed in monetary rather than physical units. Assume the firm is a price taker in the input market.

The Relationship Between Production and Cost


Total Variable Cost (TVC): the cost associated with the variable input, determined by multiplying the number of units by the unit price. Marginal Cost (MC): the rate of change in total variable cost. TVC W

MC

MP

The law of diminishing returns implies that MC will eventually increase

The Relationship Between Production and Cost

Plotting TP and TVC illustrates that they are mirror images of each other. When TP increases at an increasing rate, TVC increases at a decreasing rate.

The Short-Run Cost Function

For simplicity the following assumptions are made:


The firm employs two inputs, labor and capital. The firm operates in a short-run production period where labor is variable, capital is fixed. The firm uses the inputs to produce a single product. The firm operates with a fixed level of technology. The firm operates at every level of output in the most efficient way. The firm operates in perfectly competitive input markets and must pay for its inputs at a given market rate. It is a price taker in the input markets. The short-run production function is affected by the law of diminishing returns.

The Short-Run Cost Function

Standard variables in the short-run cost function:


Quantity

(Q): the amount of output that a firm can produce in the short run. Total fixed cost (TFC): the total cost of using the fixed input, capital (K) Total variable cost (TVC): the total cost of using the variable input, labor (L) Total cost (TC): the total cost of using all the firms inputs, L and K. TC = TFC + TVC

The Short-Run Cost Function

Standard variables in the short-run cost function:


Average fixed cost (AFC): the average per-unit cost of using the fixed input K. AFC = TFC/Q Average variable cost (AVC): the average per-unit cost of using the variable input L. AVC = TVC/Q Average total cost (AC) is the average per-unit cost of using all the firms inputs. AC = AFC + AVC = TC/Q Marginal cost (MC): the change in a firms total cost (or total variable cost) resulting from a unit change in output. MC = TC/Q = TVC/Q

The Short-Run Cost Function

Graphical example of the cost variables

The Short-Run Cost Function

Important Observations
AFC

declines steadily over the range of production. When MC = AVC, AVC is at a minimum. When MC < AVC, AVC is falling. When MC > AVC, AVC is rising. The same three rules apply for average cost (AC) as for AVC.

The Short-Run Cost Function

A reduction in the firms fixed cost would cause the average cost line to shift downward. A reduction in the firms variable cost would cause all three cost lines (AC, AVC, MC) to shift.

The Short-Run Cost Function

Alternative specifications of the Total Cost function


Most
As

commonly: specified as a cubic relationship between total cost and output


output increases, total cost first increases at a decreasing rate, then increases at an increasing rate.

Quadratic
As

relationship

output increases, total cost increases at an increasing rate.

Linear
As

relationship

output increases, total cost increases at a constant rate.

The Long-Run Cost Function


In the long run, all inputs to a firms production function may be changed. Because there are no fixed inputs, there are no fixed costs. The firms long run marginal cost pertains to returns to scale.

First,

increasing returns to scale. As firms mature, they achieve constant returns, then ultimately decreasing returns to scale.

The Long-Run Cost Function

When a firm experiences increasing returns to scale:


A

proportional increase in all inputs increases output by a greater proportion. As output increases by some percentage, total cost of production increases by some lesser percentage.

The Long-Run Cost Function

Economies of Scale: situation where a firms long-run average cost (LRAC) declines as output increases. Diseconomies of Scale: situation where a firms LRAC increases as output increases. In general, the LRAC curve is u-shaped.

The Long-Run Cost Function

Reasons for long-run economies


Specialization

in the use of labor and capital. Prices of inputs may fall as the firm realizes volume discounts in its purchasing. Use of capital equipment with better priceperformance ratios. Larger firms may be able to raise funds in capital markets at a lower cost than smaller firms. Larger firms may be able to spread out promotional costs.

The Long-Run Cost Function

Reasons for Diseconomies of Scale


Scale

of production becomes so large that it affects the total market demand for inputs, so input prices rise. Transportation costs tend to rise as production grows.
Handling

expenses, insurance, security, and inventory costs affect transportation costs.

The Long-Run Cost Function

In long run, the firm can choose any level of capacity. Once it commits to a level of capacity, at least one of the inputs must be fixed. This then becomes a short-run problem. The LRAC curve is an envelope of SRAC curves, and outlines the lowest per-unit costs the firm will incur over a range of output.

The Learning Curve


Learning Curve: line showing the relationship between labor cost and additional units of output. Downward slope indicates additional cost per unit declines as the level of output increases because workers improve with practice. Measured in terms of percentage decrease in additional labor cost as output doubles.
Yx = Kxn

Yx = Units of factor or cost to produce the xth unit K = Factor units or cost to produce the Kth (usually first) unit x = Product unit (the xth unit) n = log S/log 2 S = Slope parameter

Economies of Scope

Economies of Scope: reduction of a firms unit cost by producing two or more goods or services jointly rather than separately. Closely related to economies of scale.

Supply Chain Management

Supply Chain Management (SCM): efforts by a firm to improve efficiencies through each link of a firms supply chain from supplier to customer. Includes all internal and external activities required to fulfill a customers demand. Transaction costs are incurred by using resources outside the firm. Coordination costs arise because of uncertainty and complexity of tasks. Information costs arise because information is essential to the proper coordination of activities between the firm and its suppliers.

Supply Chain Management

Ways to develop better supplier relationships


Strategic

alliance: firm and outside supplier join together in some sharing of resources. Competitive tension: firm uses two or more suppliers, thereby helping the firm keep its purchase prices under control.

Ways Companies Have Cut Costs to Remain Competitive

The Strategic Use of Cost Reduction in Cost of Materials Using Information Technology to Reduce Costs Reduction of Process Costs Relocation to Lower-Wage Countries or Regions Mergers, Consolidation, and Subsequent Downsizing Layoffs and Plant Closings