Managerial Economics
Applications, Strategies and Tactics, 14e
James R. McGuigan
R. Charles Moyer
Frederick H. deB. Harris
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PART III – PRODUCTION AND COST
Chapter 8 –
Cost Analysis
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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
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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
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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:
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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
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Table 8.1 – Profitability of Bentley Clothing Store
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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
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Table 8.2 – Effect of Inventory Valuation Methods on
Measured Profit – Westside Plumbing & Heating Co.
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Table 8.3 – Warehouse Rental Decision –
Dunbar Manufacturing Company
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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
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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
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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
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Table 8.4 – Production Function –
Deep Creek Mining Company
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Figure 8.1 – Foreign Exchange (FX) Rates: The Value of the
U.S. Dollar against Several Major Currencies
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Table 8.5 – Short-run Cost Functions –
Deep Creek Mining Company
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Ch 8 – Short-Run Cost and Product Functions
(3 of 3)
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Figure 8.2 – Short-Run Average & Marginal Cost Functions
– Deep Creek Mining Company
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Figure 8.3 – Long-Run & Short-Run Average Cost Functions
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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
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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
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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
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Figure 8.4 – Learning Curve: Arithmetic Scale
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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
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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
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Figure 8.5 – Long-Run average Cost Function and Scale
Economies
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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
•
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Figure 8.6 – Minimum Efficient Scale (MES) in Autos
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