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Managerial Economics Applications, Strategies and Tactics, 14e

James R. McGuigan

R. Charles Moyer

Frederick H. deB. Harris

© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

PART III – PRODUCTION AND COST

Chapter 8 –

Cost Analysis

Chapter 8 – Cost Analysis Overview

THE MEANING AND MEASUREMENT OF COST

SHORT-RUN COST AND PRODUCT FUNCTIONS

LONG-RUN COST FUNCTIONS

ECONOMIES AND DISECONOMIES OF SCALE

Ch 8 – The Meaning and Measurement of Cost Accounting versus Economic Costs (1 of 2)

Accountants have been primarily concerned with identifying highly stable and predictable costs for financial reporting purposes

As a result, they define and measure cost by the known certain historical outlay of funds

The price paid for commodity or service inputs, in USD, is one measure of the accounting cost

Interest paid to bondholders or lending institutions is used to measure the accounting cost of funds to the borrower

Ch 8 – The Meaning and Measurement of Cost Accounting versus Economic Costs (2 of 2)

Economists, on the other hand, have been mainly concerned with measuring costs for decision-making purposes

That objective is different

Opportunity costs: The value of a resource in its next-bet alternative use

Opportunity cost represents the return or compensation that must be foregone as the result of the decision to employ the resource in a given economic activity

Economic profit is defined:

Ch 8 – The Meaning and Measurement of Cost Three Contrasts between Accounting & Economic Costs (1 of 3)

Depreciation Cost Measurement – The production of a good of service typically requires the use of plant and equipment

Capital assets: A durable input that depreciates with use, time and obsolescence

Depreciation is a loss of asset value, but it is difficult or impossible to determine the exact service life of a capital asset and future changes in its market value

As a result, accountants have adopted standard allocation procedures for assigning a portion of the acquisition cost of an asset to each accounting time period, and to each unit of output produced within that time period

Table 8.1 – Profitability of Bentley Clothing Store

Ch 8 – The Meaning and Measurement of Cost Three Contrasts between Accounting & Economic Costs (2 of 3)

Inventory Valuation– When materials are stored in inventory before being used, the accounting and economic costs may differ if the market price of the materials has changed

The accounting cost is equal to the actual acquisition cost

The economic cost is equal to the current replacement cost

Sunk cost – A cost incurred regardless of the alternative action chosen in a decision-making problem

Sunk Cost of Underutilized Facilities – As shown in Table 8.3, a savings results from accepting an offer for less than the firm’s cost

Table 8.2 – Effect of Inventory Valuation Methods on Measured Profit – Westside Plumbing & Heating Co.

Table 8.3 – Warehouse Rental Decision – Dunbar Manufacturing Company

Ch 8 – The Meaning and Measurement of Cost Three Contrasts between Accounting & Economic Costs (3 of 3)

Conclusions–

1. Costs can be measured indifferent ways, depending on the purpose for which the cost figures are to be used

2. The costs appropriate for financial reporting purposes are not always appropriate for decision-making purposes. The relevant cost in economic decision making is the opportunity cost of the resources rather than the historical outlay of funds required to obtain the resources

Ch 8 – Short-Run Cost and Product Functions (1 of 3)

Fixed costs – The costs of inputs to the production process that are constant over the short run

Variable input costs – The costs of the variable inputs to the production process

Average and Marginal Cost Functions

Ch 8 – Short-Run Cost and Product Functions (2 of 3)

Marginal cost – The incremental increase in total variable cot that results from a one-unit increase in output

Table 8.4 – Production Function – Deep Creek Mining Company

Figure 8.1 – Foreign Exchange (FX) Rates: The Value of the U.S. Dollar against Several Major Currencies

Table 8.5 – Short-run Cost Functions – Deep Creek Mining Company

Ch 8 – Short-Run Cost and Product Functions (3 of 3)

Figure 8.2 – Short-Run Average & Marginal Cost Functions – Deep Creek Mining Company

Figure 8.3 – Long-Run & Short-Run Average Cost Functions

Ch 8 – Long-Run Cost Functions (1 of 1)

In long-run planning, the firm chooses the optimum combination of inputs to produce the desired level of output at least cost, and some of these inputs become fixed

In the short run, if demand increases unexpectedly, the firm may have little choice but to add additional variable inputs

Should this demand persist, a larger fixed input investment in plant and equipment is warranted, and then unit cost can be reduced

See Figure 8.3

Ch 8 – Long-Run Cost Functions Optimal Capacity Utilization: Three Concepts (1 of 1)

Optimal output for a given plant size – Output rate that results in lowest average total cost for a given plant size

Optimal plant size for a given output rate – Plant size that results in lowest average total cost for a given output

Optimal plant size – Plant size that achieves minimum long-run average total cost

Ch 8 – Economies and Diseconomies of Scale (1 of 1)

Product Level Internal Economies of Scale

Internal economies of scale - Declining long-run average costs as the rate of output for a product, plant, or firm is increased

Learning curve effect – Declining unit cost attributable to greater cumulative from longer production runs

Volume discount – Reduced variable cost attributable to larger purchase orders

Figure 8.4 – Learning Curve: Arithmetic Scale

Ch 8 – Economies and Diseconomies of Scale The Percentage of Learning (1 of 1)

Plant-Level Internal Economies of Scale

Sources of scale economies at the plant level include capital investment, overhead, and required reserves of maintenance parts and personnel

Firm-Level Internal Economies of Scale

One possible source is in distribution; multi-plant operations may permit a larger firm to maintain geographically dispersed plants, lowering delivery costs

Diseconomies of Scale

Diseconomies of scale - Rising long-run average total costs as the level of output is increased

Ch 8 – Economies and Diseconomies of Scale The Overall Effects of Scale Economies and Diseconomies (1 of 2)

For some industries, long-run average total costs for the firm remain constant over a wide range of output once scale economies are exhausted; For others, long-run average total costs rise at a large scale

The possible presence of both economies and diseconomies of scale leas to the hypothesized long-run average cost function for a typical manufacturing firm being U-shaped with a flat middle area

See Figure 8.5

Figure 8.5 – Long-Run average Cost Function and Scale Economies

Ch 8 – Economies and Diseconomies of Scale The Overall Effects of Scale Economies and Diseconomies (2 of 2)

Minimum efficient scale (MES) - The smallest scale at which minimum costs per unit are attained

Up to some MES, the smallest scale at which minimum long-run average total cost are attained, economies of scale are present

In most industries, it is possible to increase the size of the firm beyond this MES without incurring diseconomies of scale

But expansion beyond the maximum efficient scale eventually will result in problems in inflexibility, lack of managerial coordination, and rising long-run average total costs

Figure 8.6 – Minimum Efficient Scale (MES) in Autos