Cost Analysis and Estimation

What Makes Cost Analysis Difficult?

Link Between Accounting and Economic Valuations
Accounting and economic costs often differ. a/c wd use only cash payments for cost of production vs remuneration to all factors of production. Historical cost is the actual cash outlay. Current cost is the present cost of previously acquired items. Cost of replacing productive capacity using current technology.

Historical Versus Current Costs

Replacement Cost

Opportunity Cost
The income that would have been received if the input had been used in its most profitable alternative use. The value of the product not produced because an input was used for another purpose. An economic concept not an accounting concept.
As economic decision-makers, we assume costs include opportunity costs.

Opportunity Cost
Opportunity Cost Concept
Opportunity cost is foregone value. Reflects second-best use.

Explicit and Implicit Costs

Explicit costs are cash expenses. Out pocket expenditure. Implicit costs are noncash expenses and not directly incurred.

Incremental and Sunk Costs in Decision Analysis

Incremental Cost
Incremental cost is the change in cost tied to a managerial decision. Incremental cost can involve multiple units of output.
Marginal cost involves a single unit of output.

Sunk Cost
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 run. 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. 276 prob

Important Fixed Costs

Total fixed cost (TFC):
All costs associated with the fixed input.

Average fixed cost per unit of output:

AFC = TFC Output

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Variable Costs
Can be increased or decreased by the manager. Variable costs will increase as production increases. Total Variable cost (TVC) is the summation of the individual variable costs. VC = (the quantity of the input) X (the inputs price).
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 Variable costs exist in the short-run and long-run:

In fact, all costs are considered to be variable costs in the long run.

Variable Costs

Variable versus Fixed, some examples:

Fertilizer is a variable cost until it has been purchased and applied. Labor and cash rent contracts have to be considered fixed costs during the duration of the contract. Irrigation water is generally variable, but can have a fixed component.
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Important Variable Costs

Total variable cost (TVC):
All costs associated with the variable input.

Average variable cost per unit of output:

AVC = TVC Output

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Total Cost
The sum of total fixed costs and total variable costs:
TC = TFC + TVC

In the short run TC will only increase as TVC increases.

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Average Total Cost

Average total cost per unit of output:

AFC + AVC ATC = TC Output

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Marginal Cost
The additional cost incurred from producing an additional unit of output: MC = TC Output MC = TVC Output

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Typical Total Cost Curves

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Typical Total Cost Curves

TFC is constant and unaffected by output level. TVC is always increasing:
First at a decreasing rate. Then at an increasing rate.

TC is parallel to TVC:
TC is higher than TVC by a distance equal to TFC.

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Typical Average & Marginal Cost Curves

AFC is always declining at a decreasing rate. ATC and AVC decline at first, reach a minimum, then increase at higher levels of output. The difference between ATC and AVC is equal to AFC. MC is generally increasing. MC crosses ATC and AVC at their minimum point.
If MC is below the average value: Average value will be decreasing. If MC is above the average value: Average value will be increasing. 16

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 Total and Per-Unit Cost Schedules

1 2 3 4 5 6 7 8

Qty. of out put (Units)

Total Fixed costs($)

Total Variable costs($)

Total Costs($)

Average Fixed cost ($)

Average Variable cost ($)

Average Total Cost($)

Marginal cost ($)

TFC

TVC

TC

AFC

AVC

AC

MC

60

60

60

20

80

60

20

80

20

60

30

90

30

15

45

10

60

45

105

20

15

35

15

60

80

140

15

20

35

35

60

135

195

12

27

39

55

Cont..

Here per unit cost schedule is plotted. Note that MC is plotted between the various levels of output.

We see that AFC curve falls continuously, while the AVC,ATC,and MC curves curves first fall and then rise(ie, they are U shaped)
Reason the AVC curve is U shaped: with labour as the only variable input in the short, TVC for any output level (Q) equals the given wage rate (w) times the quantity of labour (L) used. Then, TVC wL w w

AVC= --- = --- = --- = --- = w x 1/ APL

Q/L APL

With w constant and from our knowledge that APL or Q/L usually rises first , reaches a maximum, and then falls, it follows that AVC curve first falls, reaches a minimum, and then rises.thus , the AVC curve is the monetised mirror image or reciprocal of the APL curve. Since the AVC curve is U-shaped, the ATC curve is also U-shaped.

T The U-shape of MC curve can be similarly explained as follows. h dTVC d(wL) w(dL) w w e = ------- = ------ = -------- = -------- = ------ = w x 1/MPL MC
dQ dQ dQ dQ / dL MPL

Since the marginal product of labour (MPL) first rises, reaches a maximum, and then falls, it follows that the MC curve first falls, T
reaches a minimum, and then rises. Thus, the rising portion of the MC curve reflects the operation of the law of diminishing returns.

Cost function.
Linear Quadratic Cubic Linear[TC=a+bQ a is TFC and bQ is TVC] AFC=TFC/Q=a/Q AVC=TVC/Q=b ATC=TC/Q=a+bq/Q

Cont
Quadratic TC=a+Bq+Cq2

There is an imp. Relationship between the firms SATC and LAC curves. Each SATC curve represents the plant to be used to produce a particular level of output at minimum cost. The LAC curve is then tangent to these SATC curves and shows the the minimum cost of producing each level of output. Eg., The lowest LAC(of $30t) to produce two units of output results when the firm operates plant 1 at point B on its SATC1 curve. The lowest LAC(of $20t) to produce four units of output results when the firm operates plant 2 at point D on its SATC2 curve. Four units of output could also be produced by the firm operating plant1 at point D* on its SATC1 curve. However, this would not represent the lowest cost of producing 4Q in the long run. Other points on the LAC curve are similarly obtained. Thus, the LAC curve shows the minimum perunit cost of producing any level of output when the firm can build any desired scale of plant. Note that the LAC to produce 3Q is the same for plant 1 and plant 2 (point C).