CHAPTER 8 Cost Analysis  The opportunity cost of the owner’s time is

 Economic cost refers to the cost of attracting a measured by the most attractive salary offer that
resource from its next best alternative use (the the owner could have received by applying his or
opportunity cost concept). her talents, skills, and experience in the
 Managers seeking to make the most efficient use of management of a similar (but second-best) business
resources to maximize value must be concerned owned by someone else.
with both short-run and long-run opportunity costs.  Similarly, the opportunity cost of the capital is
 Short-run cost output relationships help managers measured by the profit or return that could have
to plan for the most profitable level of output, given been received if the owner had chosen to employ
the capital resources that are immediately capital in his or her second-best (alternative)
available. investment of comparable risk.
 Long-run cost-output relationships involve  Economic profit is defined as the difference
between total revenues and these total economic
attracting additional capital to expand or contract
costs, implicit opportunity costs as well as explicit
the plant size and change the scale of operations. outlays:
 Achieving minimum efficient scale is often the key Economic profit = Total revenues − Explicit costs − Implicit costs
to a successful operations strategy.  When one recognizes that such first-best and
second-best uses change over time, it becomes
THE MEANING AND MEASUREMENT OF COST
clear that the historical outlay of funds to obtain a
 In its most elementary form, cost simply refers to
resource at an earlier date (the accounting cost
the sacrifice incurred whenever an exchange or
basis) may not be the appropriate measure of
transformation of resources takes place.
opportunity cost in a decision problem today.
 This association between forgone opportunities and
 Opportunity costs. The value of a resource in its
economic cost applies in all circumstances.
next best alternative use. Opportunity cost
 However, the appropriate manner to measure costs
represents the return or compensation that must
is a function of the purpose for which the cost
be forgone as the result of the decision to employ
information is to be used.
the resource in a given economic activity.
Accounting versus Economic Costs
 Accountants have been primarily concerned with Three Contrasts between Accounting and
identifying highly stable and predictable costs for
Economic Costs
Depreciation Cost Measurement
financial reporting purposes.
 The production of a good or service typically
 As a result, they define and measure cost by the
requires the use of licenses and plant and
known certain historical outlay of funds.
equipment.
 Thus, the price paid for commodity or service
 As these capital assets are used, their service life is
inputs, expressed in dollars, is one measure of the
expended, and the assets wear out or become
accounting cost.
obsolete.
 Similarly, the interest paid to bondholders or
 Depreciation is a loss of asset value.
lending institutions is used to measure the
 Unfortunately, it is often difficult, if not impossible,
accounting cost of funds to the borrower.
to determine the exact service life of a capital asset
 Economists, on the other hand, have been mainly
and the future changes in its market value.
concerned with measuring costs for decision-
 Some assets are unique (patents); others are not
making purposes.
traded in liquid resale markets (plants); and still
 The objective is to determine the present and
others are rendered obsolete with little
future costs of resources associated with various
predictability (computers).
alternative courses of action.
 To overcome these measurement problems with
 Such an objective requires a consideration of the
economic depreciation cost, accountants have
opportunities forgone (or sacrificed) whenever a
adopted certain procedures for allocating a portion
resource is used in a given course of action.
of the acquisition cost of an asset to each
 So, although both the accounting cost and the
accounting time period, and in turn to each unit of
economic cost of a product will include such explicit
output that is produced within that time period.
costs as labor, raw materials, supplies, rent,
 This allocation is typically done by one of several
interest, and utilities, economists will also include
arbitrary methods of assigning a portion of the
the implicit opportunity costs of time and capital
historical cost to each year of the service life.
that the owner-manager has invested in the
 Capital assets. A durable input that depreciates
enterprise.
with use, time, and obsolescence.
Inventory Valuation quantity used in the process is constant over a given
 Whenever materials are stored in inventory for a period of time regardless of the level of output
period of time before being used in the production produced.
process, the accounting and economic costs may  Short-run questions relate to a situation in which
differ if the market price of these materials has one or more of the inputs to the production process
changed from the original purchase price. are fixed.
 The accounting cost is equal to the actual  Long-run questions relate to a situation in which all
acquisition cost, whereas the economic cost is equal inputs are variable; that is, no restrictions are
to the current replacement cost. imposed on the amount of a resource that can be
 As the following example illustrates, the use of the employed in the production process.
acquisition cost can lead to incorrect production  The length of time required to vary all the inputs
decisions. can be as long as a decade (e.g., in shipbuilding). In
other cases, the long-run may be just a few weeks
Sunk Cost of Underutilized Facilities  The total cost of producing a given quantity of
 sunk costs should not be considered relevant costs output is equal to the sum of the costs of each of
because such costs are unavoidable, independent of the inputs used in the production process.
the course of action chosen.  In discussing short-run cost functions, it is useful to
 Sunk cost. A cost incurred regardless of the classify costs as either fixed or variable costs.
alternative action chosen in a decision-making  Fixed costs represent the costs of all the inputs to
problem. the production process that are fixed or constant
over the short run.
Conclusions
 Variable costs consist of the costs of all the variable
1. Costs can be measured in different ways, depending
inputs to the production process. Whereas variable
on the purpose for which the cost figures are to be
costs may not change in direct proportion to the
used.
quantity of output produced, they will increase (or
2. The costs appropriate for financial reporting
decrease) in some manner as output is increased
purposes are not always appropriate for decision-
(or decreased).
making purposes.
 Cost function. A mathematical model, schedule, or
 Typically, changes and modifications have to be
graph that shows the cost (such as total, average, or
made to reflect the opportunity costs of the
marginal cost) of producing various quantities of
various alternative actions that can be chosen in
output.
a given decision problem.
 The relevant cost in economic decision making  Fixed costs. The costs of inputs to the production
is the opportunity cost of the resources rather process that are constant over the short run.
than the historical outlay of funds required to  Variable costs. The costs of the variable inputs to
obtain the resources. the production process.
3. Sunk costs, which are incurred regardless of the
Average and Marginal Cost Functions
alternative action chosen, should seldom be
 Once the total cost function is determined, one can
considered in making operating decisions.
then derive the average and marginal cost
SHORT-RUN COST FUNCTIONS functions.
 In addition to measuring the costs of producing a  The average fixed cost AFC, average variable cost
given quantity of output, economists are also AVC, and average total cost ATC are equal to the
concerned with determining the behavior of costs respective fixed, variable, and total costs divided by
when output is varied over a range of possible the quantity of output produced:
values.
 The relationship between cost and output is
expressed in terms of a cost function: a schedule,
graph, or mathematical relationship showing the
minimum achievable cost of producing various
quantities of output.
 The discussion in Chapter 7 concerning the inputs  Technically, the ratio ΔTC/ΔQ represents the
used in the production process distinguished incremental cost associated with a discrete change
between fixed and variable inputs. in output by more than one unit rather than the
 A fixed input was defined as an input that is marginal cost associated with one additional unit of
required in the production process, but whose output.
 Marginal cost is defined as the incremental  Associated with the larger fixed input investment is
increase in total cost that results from a one-unit another short-run average cost function SAC2.
increase in output, and is calculated as  Several of these other short-run average cost
functions (SRAC3, SRAC4) are shown in Figure 8.3.
 The long-run average cost function consists of the
lower boundary or envelope of all these short-run
curves.
 No other combination of inputs exists for producing
each level of output Q at an average cost below the
cost that is indicated by the LRAC curve.

Optimal Capacity Utilization: Three Concepts

 The average total cost curve in Figure 8.2, which is
equal to the sum of the vertical heights of the  To assess capacity utilization, assume the firm has
average fixed and average variable cost curves, been producing Q1 units of output using a plant of
initially declines and subsequently begins rising size “1,” having a short-run average cost curve of
beyond a particular level of output. SAC1.
 At Q = 55 the average total cost curve is at its  The average cost of producing Q1 units is therefore
minimum value. C1, and Q1 is the optimal output for the plant size
represented by SAC1.
 As discussed in the previous chapter, specialization
in the use of the variable inputs initially results in  Optimal output for a given plant size is a short-run
increasing returns and declining marginal costs and concept of capacity utilization.
average variable costs.  Suppose that the firm now wishes to expand output
 Eventually, however, the gains from specialization to Q2.
are overwhelmed by crowding effects, diminishing  What will the average cost be of producing this
marginal returns set in, and then marginal and higher volume of output? In the short run, as we
average variable costs begin increasing as shown in saw earlier, the average cost would be C02.
Figure 8.3.  However, in the long run, it would be possible for
 This reasoning is used to explain the U-shaped the firm to build a plant of size “2,” having a short-
pattern of the short-run ATC, AVC, and MC curves in run average cost curve of SAC2.
Figures 8.2 and 8.3 and indeed in all short-run  With this larger plant, the average cost of producing
average cost structures. Q2 units of output would be only C2.
 Thus, because the firm has more options available
LONG-RUN COST FUNCTIONS to it in the long run, average total cost of any given
 Over the long-run planning horizon, using the output generally can be reduced.
available production methods and technology, the  SAC2 represents the optimal plant size for a given
firm can choose the plant size, types and sizes of output rate Q2.
equipment, labor skills, and raw materials that,  Should demand then collapse, even a company like
when combined, yield the lowest cost of producing Toyota may be stuck with excess manufacturing
the desired amount of output. capacity and find it wishes to cut output back to the
 Once the optimum combination of inputs is chosen original level Q1, despite the much higher unit costs
to produce the desired level of output at least cost, at point A.
some of these inputs (plant and equipment)  However, as the business cycle recovers, if the firm
become fixed in the short run. can execute a marketing plan to sell still more
 If demand increases unexpectedly and the firm output, a still more efficient allocation of resources
wishes to produce not Q1, as planned, but rather is available.
Q2 as shown in Figure 8.3, it may have little choice  Only when optimal output increases to Q3, where
but to lay on additional variable inputs such as the firm will build the universally least cost optimal
overtime labor and expedite the rush-order delivery plant size represented by SAC3, will further
of supplies to meet its production goals. opportunities for cost reduction cease.
 Not surprisingly, such arrangements are expensive,  This concept of optimal capacity utilization applies
and short-run average cost will temporarily rise to B to the long run, given the technology in place at this
at C02. plant.
 Should this demand persist, a larger fixed input  Short-run average total cost with underutilization of
investment in plant and equipment is warranted. capacity at Point A or overutilization of capacity at
 Then, unit cost can be reduced from C02 to C2. Point B in Figure 8.3 is always higher than the
 minimum average total cost in the long run (LRAC)  As such, they may well be associated with no
fundamentally because the production manager can change in the scale of operations whatsoever; the
vary plant and equipment in the long run, matching firm simply buys large volumes of input at one time.
capacity to his or her output requirements .  The learning curve relationship is usually expressed
 Optimal output for a given plant size. Output as a constant percentage by which the amount of
rate that results in lowest average total cost for a an input (or cost) per unit of output is reduced each
given plant size. time production is doubled.

 Optimal plant size for a given output rate. This learning curve relationship plotted in Figure 8.4
can be expressed algebraically as follows:
Plant size that results in lowest average total cost
C = aQb
for a given output.  where C is the input cost of the Qth unit of output,
 Optimal plant size. Plant size that achieves Q is consecutive units of output produced, a is the
minimum long-run average total cost. theoretical (or actual) input cost of the first unit of
output, and b is the rate of reduction in input cost
ECONOMIES AND DISECONOMIES OF SCALE per unit of output.
 Because the learning curve is downward sloping,
 The long-run average total cost LRAC function is
the value of b is normally negative.
hypothesized to decline as the flow rate of
 Taking logarithms of both sides of Equation 8.11
throughput rises over the lower range of operations yields
scale and is hypothesized to remain flat or rise over log C = log a + b log Q
the higher range of scale.  Regression analysis can then be used to estimate
 Declining long-run average total cost reflects the parameters b and log a in order to forecast
internal economies of scale at one of three levels: costs at various cumulative volumes.
the product level, the multiproduct plant level, or  Internal economies of scale. Declining long run
the firm level of operations. average costs as the rate of output for a product,
plant, or firm is increased.
Product-Level Internal Economies of Scale
 Learning curve effect. Declining unit cost runs
 A number of different sources of declining cost are
attributable to greater cumulative volume.
associated with producing one product (say, PCs) at
 Volume discount. Reduced variable cost
a higher rate of throughput per day.
attributable to larger purchase orders.
 Special-purpose equipment, which is more efficient
in performing a limited set of operations, can be The Percentage of Learning
substituted for less efficient general-purpose
 The percentage of learning, which is defined as the
equipment.
proportion by which an input (or its associated cost)
 Likewise, the production process can be broken is reduced when output is doubled, can be
down into a series of smaller tasks, and workers can estimated as follows:
be assigned to the tasks for which they are most
qualified.
 Workers are then able to acquire additional
 where C1 is the input (or cost) for the Q1 unit of output
proficiency through higher repetition of the tasks to
and C2 is the cost for the Q2 = 2Q1 unit of output.
which they are assigned.
 In manufacturing, a related phenomenon called the Plant-Level Internal Economies of Scale
learning curve effect has often been observed  Sources of scale economies at the plant level
whereby the amount of labor input required to include capital investment, overhead, and required
produce another unit of output decreases as the reserves of maintenance parts and personnel.
cumulative volume of output rises (e.g., during long  With respect to capital investment, capital costs
production runs of 767 airframes at Boeing). tend to increase less than proportionately with the
 The learning curve principle was first applied in productive capacity of a plant, particularly in
airframe manufacturing, shipbuilding, and appliance process-type industries.
manufacturing.  Another source of plant-level scale economies is
 Learning curve effects and volume discounts in overhead costs, which include such administrative
purchasing inputs (so-called external economies of costs as management salaries and paperwork
scale) are easily distinguished from internal documentation associated with regulatory
economies of scale because they depend upon compliance.
cumulative volume of output no matter how small  Overhead costs can be spread over a higher volume
the production throughput rate per time period. of throughput in a larger plant or facility, thus
reducing average costs per unit.
Firm-Level Internal Economies of Scale The Overall Effects of Scale Economies and
 In addition to product-level and plant-level Diseconomies
economies of scale, other scale economies are  For some industries, such as textile and furniture
associated with the overall size of the multi plant manufacturing, long-run average costs for the firm
firm. One possible source of firm-level scale remain constant over a wide range of output once
economies is in distribution. scale economies are exhausted.
 For example, multiplant operations may permit a  In such cases, many plant sizes are consistent with
larger firm to maintain geographically dispersed least-cost production, as shown in Figure 8.5. In
plants. other industries (e.g., engine block casting), long-
 Delivery costs are often lower for a geographically run average costs rise at large scale.
dispersed operation compared with a single (larger)  The possible presence of both economies and
plant. Another possible source of scale economies diseconomies of scale leads to the hypothesized
to the firm is in raising capital funds. long-run average cost function for a typical
 Because flotation costs increase less than manufacturing firm being U-shaped with a flat
proportionately with the size of the security (stock middle area.
or bond) issue, average flotation costs per dollar of  Up to some minimum efficient scale (MES), that is,
funds raised is smaller for larger firms. the smallest scale at which minimum long-run
 Similar scale economies also exist in marketing and average total costs are attained, economies of scale
sales promotion. are present.
 These scale economies can take such forms as (1)  In most industries, it is possible to increase the size
quantity discounts in securing advertising media of the firm beyond this MES without incurring
space and time, or (2) the ability of the large firm to diseconomies of scale.
spread the fixed costs of advertising each period  Over this extended middle-scale range, average
over greater throughput. In addition, the large firm costs per unit are relatively constant.
may be able to achieve a relatively greater degree  However, expansion beyond the maximum efficient
of brand recognition and brand loyalty for any given scale eventually will result in problems of
level of sales promotion expenditures. inflexibility, lack of managerial coordination, and
rising long-run average total costs.
Diseconomies of Scale
 Minimum efficient scale (MES). The smallest scale
 Rising long-run average costs at higher rates of
at which minimum costs per unit are attained.
throughput are attributed to diseconomies of scale.
 A primary source of diseconomies of scale SUMMARY
associated with an individual production plant is  Cost is defined as the sacrifice incurred whenever
transportation costs. an exchange or transformation of resources takes
 Another possible source of plant diseconomies is place.
labor requirements; higher wage rates or costly  Different approaches are used in measuring costs,
worker recruiting and relocation programs may be depending on the purposes for which the
required to attract the necessary personnel. information is to be used.
 Finally, large-scale plants are often inflexible  For financial reporting purposes, the historical
operations designed for long production runs of one outlay of funds is usually the appropriate measure
product, based often on forecasts of what the of cost, whereas for decision making purposes, it is
target market wanted in the past. often appropriate to measure cost in terms of the
 Diseconomies of scale at the firm level result from opportunities forgone or sacrificed.
problems of coordination and control encountered  A cost function is a schedule, graph, or
by management as the scale of operations is mathematical relationship showing the minimum
increased. achievable cost (such as total, average, or marginal
 First, the size of management staffs and their cost) of producing various quantities of output.
associated salary costs may rise more than  Short-run total costs are equal to the sum of fixed
proportionately as the scale of the firm is increased. and variable costs.
 Also, less direct and observable costs may occur,  Marginal cost is defined as the incremental increase
such as the losses arising from delayed or faulty in total cost that results from a one-unit increase in
decisions and weakened or distorted managerial output.
incentives.  The short-run average variable and marginal cost
 Diseconomies of scale. Rising long-run average functions of economic theory are hypothesized to
costs as the level of output is increased.
 be U-shaped, first falling and then rising as output is
increased.
 Falling short-run unit costs are attributed to the
gains available from specialization in the use of
capital and labor.
 Rising short-run unit costs are attributed to
diminishing returns in production.
 The theoretical long-run average cost function is
often found to be L-shaped due to the frequent
presence of scale economies and frequent absence
of scale diseconomies.
 Economies of scale are attributed primarily to
specialization and other features of the production
process or the factor markets, whereas
diseconomies of scale are attributed primarily to
problems of coordination and inflexibility in large-
scale organizations.
 Volume discounts in purchasing inputs and learning
curve effects, both of which result from a larger
cumulative volume of output, can be distinguished
from scale effects, which depend on the firm’s rate
of production throughput per time period.
 Learning curve advantages often, therefore, arise in
small-scale plants able to make long production
runs.
 Minimum efficient scale is achieved by a rate of
output sufficient to reduce long-run average total
cost to the minimum possible level.
 Smaller rates of output imply smaller plant sizes to
reduce unit cost, albeit to higher levels than would
be possible if a firm’s business plan could support
minimum efficient scale production.