Cost Analysis and Estimation

Chapter 8
 Cost in Managerial Decisions
 Costs become more important as higher profit
margins are harder to achieve as a result of
 increasing competition
 changing technology
 customer demand
 Firms look for ways to cut costs in their
production processes by:
 restructuring and downsizing
 outsourcing
 merging and consolidating
 Definition of Cost
 For reporting purposes, “cost” is defined
within the domain of the accounting
department.
 For decision making purposes, “cost” is
defined based on the concept of relevancy.
 A cost is relevant if it is affected by a
management decision. That is, a relevant
cost changes as a result of the decision
made by the management.
 Historical vs Replacement Cost
 E.g. You are an olive oil producer and you
currently hold an inventory of 3 tons of
olives.
 The historical cost of the olives inventory is
TL30,000.

 The current market value of the olives is

TL45,000.

 When you price your olive oil today, which

cost is relevant?
 The relevant cost is the current market value
(the replacement cost):
 You will have to replace your olives inventory at
the new price
 Alternatively, you could sell the olives
inventory instead of using it in production:
 You could earn TL45,000 from this sale.
 Hence, by using the olives in production, you
are forgoing the opportunity to receive the
TL45,000.

 Historical cost of the olives is irrelevant for

the production decision.
 Opportunity Cost vs
Out-of-Pocket Cost
 Opportunity cost is very important in
managerial decision making because it
highlights the consequences of making
choices under conditions of scarcity.
 Opportunity cost is the amount or value
forgone in choosing one activity over
the next best alternative.
 It is considered to be an implicit or
indirect cost.
 An implicit cost can be contrasted with an
explicit or direct cost that represents an out-
of-pocket expense.
 In the example of olives, the replacement cost
of TL45,000 is the opportunity cost of using the
olives in production instead of selling them in
the market.
 If the you need additional olives for
production and purchases them from the
market, the expense associated with this
purchase would be the out-of-pocket cost.
 Sunk vs Incremental Cost
 Incremental cost is the cost that varies with
the range of options available in a decision.
 It is also called the “escapable” cost. If a
cost can be avoided when the decision is not
made, then it is escapable and is an
incremental cost.
 An incremental cost is incurred only if the
decision is made and an alternative is chosen.
 Sunk vs Incremental Cost
 Sunk cost is the cost that does not
change in accordance with the decision
alternatives. The sunk cost is the same
no matter which alternative you choose.
 Sunk cost is an “inescapable” cost.
 It is a cost that is incurred whether or
not there is any decision to be made
about alternatives.
 Suppose your firm hires a consultant to advise on
the economics of changing the location of your
retail business from Armada to Panora. You will
decide to switch only if your profits increase by
TL20,000 or more.

 You pay the consultant TL10,000 for the services.

 The consultant recommends that by switching
over to Panora, your firm would make a profit of
TL25,000 over and above what it could make at
Armada.
 Should your firm switch to Panora?
 Yes! The consultant’s fee of TL10,000 is a sunk
cost; it has been incurred regardless of your
decision.
  $750,000 - $550,000 = $200,000 is the sunk cost since
whether the firm produces or sells, the firm has already
paid $750,000 for these chips and the difference
between the replacement value and the historical value
is a sunk cost.
 $200,000 of sunk cost is an irrelevant cost for the
decision about production.
 If technology changes and the chips in the
inventory become obsolete, then the market value
of the chips will be zero.
 In this case, all of the historical cost of $750,000 is
the sunk cost to the firm.
 Costs and Profits
 The economist’s concept of profit differs from
that of the accountant.
 In both cases,
profit = revenues - costs
 Economic cost  Accounting cost

 Accounting cost = out-of-pocket costs + depreciation

 Economic cost = Accounting cost + Opportunity cost

 Economic Profit
 E.g. The manager of a small
supermarket wants to open and operate
her own store. She will leave her
current job and use TL50,000 of her
savings for this business venture. Her
current salary is TL45,000 and her
TL50,000 savings are currently earning

10% interest in a savings deposit.

 Accounting and Economic Costs
Related to Opening Her Own Store
TL
Cost of goods sold 300,000
General and administrative expenses 150,000
TL
Total accounting cost 450,000

Forgone salary for being a store manager 45,000

Forgone interest earnings from savings (at 10% interest) 5,000

TL
Total opportunity cost 50,000
TL
Total economic cost (total accounting cost plus total opportunity cost) 500,000
 Normal and Economic Profit
Normal Economic Economic
Profit Profit Loss
TL TL TL
Revenue 500,000 550,000 480,000
Accounting cost 450,000 450,000 450,000
Opportunity cost 50,000 50,000 50,000
TL TL TL
Profit 0 50,000 – 20,000

Accounting profit Accounting profit Accounting profit

TL TL TL
of 50,000 equals of 100,000 of 30,000 is less
the opportunity exceeds the than the
TL
cost of 50,000 opportunity cost of opportunity cost of
TL TL
50,000 50,000
 Normal and Economic Profit
 The point of normal profit would be the
economic break-even for the firm.
 Economic break-even indicates that the firm’s
revenue is sufficient to cover both its out-of-
pocket expense and its opportunity cost.
 A normal profit does not mean no profit.
 Total economic cost includes the opportunity cost
of all resources used.
 The return on capital is included as a cost since it
represents the opportunity cost of using the
capital in the current alternative.
 The Relationship Between
Production and Cost
 The cost function is the production
function expressed in monetary rather
than physical units.
 Assumptions about the short-run
production function also apply to the
short-run cost function.
 In addition, for the cost function we assume that
the firm is a “price taker” in the input market.
Therefore, it can use as many or as few inputs as it
desires as long as it pays the going market price
for them.
 In the input market, the resources are still scarce.
However, any given firm is so small in comparison
with the whole market that the firm can use as
many units of input as it desires if it pays the going
market price for inputs.
 An Example Production Process

Total Input (L) Q TVC (L x $500) MP (Q / L) MC (TVC / Q)

0 0 0
1 1,000 500 1,000 0.50
2 3,000 1,000 2,000 0.25
3 6,000 1,500 3,000 0.16
4 8,000 2,000 2,000 0.25
5 9,000 2,500 1,000 0.50
6 9,500 3,000 500 1.00
7 9,850 3,500 350 1.42
8 10,000 4,000 150 3.33
9 9,850 4,500 -150 -3.33
 When the total product (Q) increases at an
increasing rate, total variable cost (TVC)
increases at a decreasing rate.

 When the total product (Q) increases at a

decreasing rate, total variable cost (TVC)
increases at an increasing rate.

 Total variable cost is a mirror image of total

product.
 When the firm’s marginal product is
increasing, its marginal cost of production
is decreasing.

 When the firm’s marginal product is

decreasing (when the law of diminishing
returns takes affect), its marginal cost is
increasing.
Total, Average, and Marginal Cost
 total cost = total fixed cost + total variable cost
TC = TFC + TVC

 average cost = average fixed cost + average variable cost

TC / Q = TFC / Q + TVC / Q
AC = AFC + AVC

 marginal cost = marginal fixed cost + marginal variable cost

MC = TFC / Q + TVC / Q
MC = MVC
 The Short Run Cost Function
 Two inputs: labor (L) and capital (K)
 Short-run production period
 A single product
 A given level of technology
 Price taker for the price of inputs
 The firm is operating most efficiently at all levels
of output.
 Underlying production function is affected by the
law of diminishing marginal returns
 Total Total Average Average Average
Fixed Variable Total Fixed Variable Total Marginal
Quantity Cost Cost Cost Cost Cost Cost Cost
(Q) (TFC) (TVC) (TC) (AFC) (AVC) (AC) (MC)
0 100 0.00 100.00
1 100 55.70 155.70 100.00 55.70 155.70 55.70
2 100 105.60 205.60 50.00 52.80 102.80 49.90
3 100 153.90 253.90 33.33 51.30 84.63 48.30
4 100 204.80 304.80 25.00 51.20 76.20 50.90
5 100 262.50 362.50 20.00 52.50 72.50 57.70
6 100 331.20 431.20 16.67 55.20 71.87 68.70
7 100 415.10 515.10 14.29 59.30 73.59 83.90
8 100 518.40 618.40 12.50 64.80 77.30 103.30
9 100 645.30 745.30 11.11 71.70 82.81 126.90
10 100 800.00 900.00 10.00 80.00 90.00 154.70
11 100 986.70 1,086.70 9.09 89.70 98.79 186.70
12 100 1,209.60 1,309.60 8.33 100.80 109.13 222.90
 Average fixed cost declines steadily over the range of
production.
 Average variable cost declines at first but starts to
increase after 4 units.
 Average total cost also declines at first but starts to
increase after 4 units.
 Marginal cost declines and then starts to increase once
the third unit of output is produced.
 When MC < AVC, AVC is falling.
 When MC > AVC, AVC is rising.
 When MC = AVC, AVC is at its minimum.
 The Long Run Cost Function
 In the long run, all inputs to a firm’s
production function may be changed.
 There are no fixed inputs and thus
there are no fixed costs.
 Decisions regarding long-run cost of
operations are considered to be part of
the management’s planning horizon.
 Total Total Average Average Average
Fixed Variable Total Fixed Variable Total Marginal
Quantity Cost Cost Cost Cost Cost Cost Cost
(Q) (TFC) (TVC) (TC) (AFC) (AVC) (AC) (MC)
0 100 0.00 100.00
1 100 55.70 155.70 100.00 55.70 155.70 55.70
2 100 105.60 205.60 50.00 52.80 102.80 49.90
3 100 153.90 253.90 33.33 51.30 84.63 48.30
4 100 204.80 304.80 25.00 51.20 76.20 50.90
5 100 262.50 362.50 20.00 52.50 72.50 57.70
6 100 331.20 431.20 16.67 55.20 71.87 68.70
7 100 415.10 515.10 14.29 59.30 73.59 83.90
8 100 518.40 618.40 12.50 64.80 77.30 103.30
9 100 645.30 745.30 11.11 71.70 82.81 126.90
10 100 800.00 900.00 10.00 80.00 90.00 154.70
11 100 986.70 1,086.70 9.09 89.70 98.79 186.70
12 100 1,209.60 1,309.60 8.33 100.80 109.13 222.90
 7
LRMC
6
5
4 LRAC
3
2

1
0
0 10000 20000 30000 40000 50000 60000 70000

The long-run cost function exhibits the same pattern of behavior

as the short-run cost function.
 Similarity Between Short-Run
and Long-Run Cost Functions
 The reason the short-run cost function
exhibits the “decreasing-increasing”
pattern is the law of diminishing
marginal returns.
 The reason the long-run cost function
exhibits the “decreasing-increasing”
pattern is increasing-decreasing returns
to scale.
 Economies of Scale
 If a firm’s long-run average cost declines
as output increases, the firm is
experiencing economies of scale.
 The primary reason for economies of scale
is the underlying returns to scale in the
firm’s long-run production function.
 The returns to scale and economies /
diseconomies of scale are mirror images of
each other.
$/TL

LRAC

Q
economies constant returns diseconomies
of scale to scale of scale
(neither economies
nor diseconomies)
 Possible Reasons for
Economies of Scale
 Specialization in the use of labor and capital
 Indivisible nature of many types of capital
equipment
 Productive capacity of capital equipment rising
faster than purchase price
 Economies in maintaining inventory of
replacement parts and maintenance personnel
 Discounts from bulk purchases
 Lower cost of raising capital funds
 Spreading of promotional and research and
development costs
 Management efficiencies (line and staff)
 Possible Reasons for
Diseconomies of Scale

 Disproportionate rise in transportation

costs
 Input market imperfections (e.g. wage
rates driven up)
 Management coordination and control
problems
 Disproportionate rise in staff and indirect
labor
 The Envelope Curve
 The LRAC curve can be represented as
a combination of SRAC curves
corresponding to each level of scale
(capacity) along the LRAC.
 This acknowledges the fact that once a
firm commits itself to a certain level of
capacity, it must consider at least one
of the inputs fixed as it varies the rest.
$/TL

SRAC8
SRAC1
SRAC
SRAC2 7

SRAC3 SRAC6 v
v
SRAC4
v SRAC5 v
v v
v

Q
Q*

economies of scale diseconomies of scale

 The firm’s LRAC curve is the envelope
of the various SRAC curves.
 Short-run average cost curves for the
larger plants are positioned to the right
of the curves for smaller ones.
 Plants with larger capacities are greatly
influenced by economies or
diseconomies of scale.
 As a result of economies of scale, SRAC2 is
positioned below and to the right of SRAC1.
 The minimum point of SRAC2 is lower than that
for SRAC1.
 As a result of diseconomies of scale, SRAC6 is
positioned above and to the right of SRAC5.
 The minimum point of SRAC6 is higher than that
for SRAC5.
 Asterisks mark the minimum points on the
SRACs.
 The asterisk for Plant 2’s minimum SRAC depicts
a level above the average cost that would be
incurred by Plant 3 in the short-run for a
comparable level of production.
 The envelope curve shows that over certain
ranges of output, a firm is better off operating a
larger plant.
 The Learning Curve
 A line showing the relationship between
labor cost and additional units of output.
 Downward slope of the learning curve
indicates that the additional cost per unit
declines as the level of output increases
because workers improve with practice.
 The reduction in cost from this particular
source of improvement is referred to as the
learning curve effect.
 The learning curve effect is measured by the
percentage decrease in additional labor
cost each time the output doubles.
 Learning rate is given by the following
formula:
 AC2 
learning rate  1   x 100
 AC1 
 This is the rate at which average cost falls as
cumulative output doubles.
unit
labor
cost

cumulative output
over time
From C to B, learning effect
From B to A, economies of scale effect
 Economies of Scope

 The reduction in a firm’s unit cost that

results from producing two or more
goods jointly rather than separately.
 Sharing certain aspects of the
production process, the firm is able to
decrease its unit cost.
 COST-VOLUME-PROFIT ANALYSIS
Break-Even Analysis
 Break-even volume is the sales level for
which total revenue equals total cost.
 After the break-even level, revenues start to
exceed costs and profits start to build up.
 The critical question is whether the sales
volume will reach and surpass the break-even
level.
TL/$
TC

TR

Q1 Q2 Q


There are two break-even sales levels.

The profits are positive between these two quantities.
 TC
TL/$ TR

Q1 Q2 Q


There are two break-even sales levels.

The profits are positive between these two quantities.
TL/$ TR

TC

Q* Q

There is a single break-even sales level.

The profits are positive after this quantity.
Applications of Break-Even
Analysis

BE analysis is very useful when decisions

need to be made about the price and quantity
levels of a proposed product.
 TL/$ TR2

TR1

TC1

TC2

Q1 Q2 Q3 Q4 Q

Q4 : initial break-even volume

Q3 : break-even after costs decrease and revenues are constant
Q2 : break-even after revenues increase and costs are constant
Q1 : break-even after revenues increase and costs decrease
Algebraic Calculation of Break-Even
 Break-even occurs where total revenues are
equal to total costs:

P x Q = AVC x Q + FC
total total variable total
revenue cost fixed
cost
Q (P – AVC) = FC
Q  FC
P - AVC
Q  FC
CM where CM is the
contribution margin.
In a multi-product firm, each product may be required to attain a
specific profit target to maintain its place in the product mix.

Break-even analysis can be used to find the sales volume at

which this profit target will be reached.

Since the profit target is a constant monetary figure in TL or $, it

can be added to the fixed-cost figure to represent the total TL or $
amount that must be obtained through contributions from each unit
sold.

Q FC  π
CM
This calculation will give the sales volume necessary to cover the
fixed costs and to attain the desired target profit.
 Break-even analysis is useful where a product
may be manufactured under two or more
technologies of production.

E.g. A firm is considering three alternative

methods of manufacturing for a product.
The market price for the product is
established at $4.00 per unit.

Alternative 1 : FC = $20,000 AVC = $2.00 / unit

Alternative 2 : FC = $45,000 AVC = $1.00 / unit
Alternative 3 : FC = $70,000 AVC = $0.50 / unit
  Assume that the decision maker’s estimate of
sales volume exhibit the following distribution:
Expected Alternative Alternative Alternative
Sales Level 1 2 3
10,000 Break-even -15,000 -35,000
15,000 10,000 Break-even -22,500
20,000 20,000 15,000 Break-even
30,000 40,000 45,000 35,000
40,000 60,000 75,000 70,000
50,000 80,000 105,000 105,000
60,000 100,000 135,000 140,000

The profitability figures under different sales scenarios

indicate that Alternative 1 is the most suitable choice since its
break-even point is at the low end of this distribution.