The theory and estimation of costs

1. The theory and estimation of costs Chapter 7

2. Importance of cost in managerial decisions • Cost has become very important in recent years as increasing competitive pressures, changing technology and customer demand have made it harder for firms to achieve high profit margins. These have let firms to outsourcing and relocation of manufacturing facilities to lower wage countries. For ex. Nike. • Firms in order to cut costs and remain competitive, entered mergers, consolidations. For ex. BP and Mobil

3. Cost concepts • Relevant costs • Any cost is considered relevant if it is affected by a management decision • A) Historical vs replacement cost • According to the principle of relevant cost, the firm should use replacement cost. • B) opportunity cost vs out-of-pocket cost • Opportunity cost is one of the most important and useful concept in economical analysis. It is often referred as indirect cost or implicit cost. While referring to out-of-pocket cost as direct cost. • C) sunk vs incremental cost • Such cost is the cost that does not vary with decision alternatives. Incremental cost is the cost that varies with the range of options available in a decision.

4. Relationship between production and costs • This is expressed for a SR case when one input is used at a given wage rate. (see table) • Input L Q TVC(LW) MC

5. Short run cost function • Lets specify the model with the use of L and K. • L is variable input and K is fixed input. • Firm operates in perfectly competitive labor market. Thus wage is given. • Before specifying the cost function, lets look at the following table: • Insert table and figures here

6. Alternative cost functions • A) cubic: TC=a +bQ-cQ2+dQ3 • Insert figures here • B) quadratic: TC=a +bQ+cQ2 • Insert figures here • C) Linear: TC=a +bQ • Insert figures here

7. Long run cost function and economies of scale • In the long run all inputs are variable. • As output increases, total cost increases, but not at a constant rate. • Long run cost function shows the same behavior of production function. First increasing return to scale then decreasing return to scale. • In a long run, average cost curve is illustrated as below: • Insert figure here

8. Factors affecting economies of scale and diseconomies of scale For economies of scale • Specialization in use of labor and capital • Indivisible nature of capital equipment • Productive capacity of capital rising faster purchase price • Economies in maintaining inventory of past • Discounts from bulk purchases • Lower cost of raising capital funds • Management efficiencies

9. Reasons for diseconomies of scale • Disproportionate rise in transportation costs • Input market imperfections (wage driven up) • Management coordination and control problem • Disproportionate rise in staff and indirect labor