UNIT VI

The Theory and

Estimation of Cost
Overview
Definition and use of cost
Relating production and cost
Short run and long run cost
Economies of scope and scale
Breakeven analysis
Supply chain management
Ways companies have cut costs to
remain competitive
Learning objectives
define the cost function

distinguish between economic cost and

accounting cost

explain how the concept of relevant cost is

used

understand total, variable, average and

fixed cost
Learning objectives

Distinguish between short-run and long-

run cost

Provide reasons for the existence of

economies of scale

Concept and applications of Break Even

Analysis
The theory of cost, together with the principles of demand and
production, constitutes three of the basic areas of managerial
economics.

Profit can only be determined by comparing the revenue with the

cost of production.

In this chapter we will discuss those principle of cost theory which

are integral to decisions about optimal price and output rates.

First we will discuss different economic concept of cost.

 he Economic Concept of Cost :

he term cost has different meanings in different context.

. Opportunity Cost :

Opportunity cost of any decision is the value of the next best

lternative that must be forgone.

. Explicit and Implicit Costs :

xplicit costs are those costs that involve an actual payment to

he other parties.

mplicit costs represent the value of forgone opportunities but do

ot involve an actual payment.
3. Marginal, Incremental and Sunk Costs :

Marginal cost refers to the change in the total cost associated

with a one-unit change output.

Incremental cost refers to the total additional cost of implementing

a managerial decision.

Sunk costs are expenditures that have been made in the past or
that must be paid in the future as part of a contractual agreement.
Or, it is the cost that has been incurred and cannot be reversed.

4. The Cost of Long-Lived Assets :

The cost of long-lived assets is calculated by deducting

depreciation from its original cost.
Production and Cost :

A cost function relates cost to the rate of output. The basis for
cost function is the production function and the prices of inputs.

Thus the minimum cost of a given rate of outputs found by

multiplying the efficient rate of each input by their respective
prices and summing the costs.

Thus, it can be written as:

C=rK+wL

in this case, the value of K and L is determined after calculating

the expansion path.
Short-Run Cost Function :

In the short-run, at least one factor of production is fixed and cost

of that input is defined as fixed cost.

The total obligations of the firm per time-period for all fixed inputs
are called as “total fixed cost (TFC)”.

The total obligations of the firm per time-period for all variable
inputs are called as “total variable cost (TVC)”.

Total cost is the sum of these two costs, as

TC = TFC + TVC

These functions relate an output rate to the total cost of production.

Functions that indicate the cost per unit of output can also be
determined.

These functions are useful in decision making than total cost

functions because cost per unit of output must be compared
with the market price of that product.

These functions can be calculated as:

AVERAGE TOTAL COST : AC = TC / Q

AVERAGE VARIABLE COST : AVC = TVC / Q

AVERAGE FIXED COST : AFC = TFC / Q

MARGINAL COST : MC = ∆ TC / ∆Q
Now consider a firm is operating with 10 units of capital @ Rs100
and wage rate is also Rs100 per unit.

Input Rate Rate of TFC TVC TC

Capital Labor Output
10 0 0 1000 0 1000
10 2.00 1 1000 200 1200
10 3.67 2 1000 367 1367
10 5.10 3 1000 510 1510
10 6.77 4 1000 677 1677
10 8.77 5 1000 877 1877
10 11.27 6 1000 1127 2127
10 14.60 7 1000 1460 2460
10 24.60 8 1000 2460 3460
 If we plot these total cost functions, we get:

4000

3000
TFC
Cost

2000 TVC

1000 TC

0
1 2 3 4 5 6 7 8 9
Rate of Output
Now Consider the per unit cost function:

Output AFC AVC AC MC

0 …… ….. …… ……..
1 1000 200 1200 200
2 500 184 684 167
3 333 170 503 143
4 250 169 419 167
5 200 175 375 200
6 167 188 355 250
7 143 209 351 333
8 125 307 432 1000
 If we plot these per unit cost function we get:

1400
1200
1000
AVC ……..
Cost per unit

800
AC …….
600
MC …….
400
200
0
0 5 10
Rate of Output
Thus, it is true of all marginal and average functions, as long as
marginal cost is below the average cost curve, the average
function will decline.

When marginal is above average, the average cost curve will rise.

This implies that marginal cost intersects both the average total
cost (AC) and average variable cost (AVC) functions at the
minimum point of the average curves.

Long-Run Cost Curves :

Firms operate in the short-run but plan in the long-run.

At any point of time, the firm has one or more fixed factors of
production. Therefore, production decisions must be made based
on short-run cost curves.
Importance of cost
in managerial decisions
 Ways to contain or cut costs popular
during the past decade

 most common: reduce number of people

on the payroll

 outsourcing components of the business

 merge, consolidate, then reduce

headcount
Definition and use of cost in
economic analysis
 Relevant cost: a cost that is affected by a
management decision
 Historical cost: cost incurred at the time of
procurement
 Opportunity cost: amount or subjective
value that is forgone in choosing one
activity over the next best alternative
 Incremental cost: total additional cost of
implementing managerial decision.
 Sunk cost: does not vary in accordance
with decision alternatives
Relationship between
production and cost

 Cost function is simply the production

function expressed in monetary rather
than physical units

We assume the firm is a ‘price taker’ in

the input market
Relationship between
production and cost
 Total variable cost (TVC) = the cost
associated with the variable input, found by
multiplying the number of units by the unit
price

 Marginal cost (MC) = the rate of change in

total variable cost
TVC W
MC  
Q MP
The law of diminishing returns (Chapter 6)
implies that MC will eventually increase
Relationship between
production and cost
Plotting TP and TVC
illustrates that they
are mirror images of
each other

When TP increases at
an increasing rate,
TVC increases at a
decreasing rate
Short-run cost function
 For simplicity use the following assumptions:
 the firm employs two inputs, labor and capital
 the firm operates in a short-run production
period where labor is variable, capital is fixed
 the firm produces a single product
 the firm employs a fixed level of technology
 the firm operates at every level of output in
the most efficient way
 the firm operates in perfectly competitive input
markets and must pay for its inputs at a given
market rate (it is a ‘price taker’)
 the short-run production function is affected by
the law of diminishing returns
Short-run cost function
 Standard variables in the short-run cost
function:

Quantity (Q) is the amount of output that

a firm can produce in the short run

Total fixed cost (TFC) is the total cost of

using the fixed input, capital (K)
Short-run cost function
 Standard variables in the short-run cost
function:

Total variable cost (TVC) is the total cost

of using the variable input, labor (L)

Total cost (TC) is the total cost of using

all the firm’s inputs,
TC = TFC + TVC
Short-run cost function
 Standard variables in the short-run cost
function:

Average fixed cost (AFC) is the average

per-unit cost of using the fixed input K
AFC = TFC/Q
Average variable cost (AVC) is the
average per-unit cost of using the
variable input L
AVC = TVC/Q
Short-run cost function
 Standard variables in the short-run cost
function:

Average total cost (AC) is the average

per-unit cost of all the firm’s inputs
AC = AFC + AVC = TC/Q
Marginal cost (MC) is the change in a
firm’s total cost (or total variable cost)
resulting from a unit change in output
MC = TC/Q = TVC/Q
Short-run cost function
 Graphical example of the cost variables
Short-run cost function
 Important observations

 AFC declines steadily

 when MC = AVC, AVC is at a minimum
 when MC < AVC, AVC is falling
 when MC > AVC, AVC is rising

The same three rules apply for average

cost (AC) as for AVC
Short-run cost function
 A reduction in the firm’s fixed cost would
cause the average cost line to shift
downward

A reduction in the firm’s variable cost

would cause all three cost lines (AC, AVC,
MC) to shift
Short-run cost function
 Alternative specifications of the Total Cost
function (relating total cost and output)

 cubic relationship

TC = a + bQ – cQ2 + dQ3

 as output increases, total cost first

increases at a decreasing rate, then
increases at an increasing rate
Short-run cost function
 Alternative specifications of the Total Cost
function (relating total cost and output)
 quadratic relationship
TC = a + bQ + cQ2
 as output increases, total cost
increases at an increasing rate
 linear relationship
TC = a + bQ
 as output increases, total cost
increases at a constant rate
1 2
Long-run cost function
 In the long run, all inputs to a firm’s
production function may be changed

 because there are no fixed inputs,

there are no fixed costs
 the firm’s long run marginal cost
pertains to returns to scale
 at first increasing returns to scale, then
as firms mature they achieve constant
returns, then ultimately decreasing returns
to scale
Long-run cost function
 When a firm experiences increasing
returns to scale:

 a proportional increase in all inputs

increases output by a greater proportion

 as output increases by some

percentage, total cost of production
increases by some lesser percentage
Long-run cost function
 Economies of scale: situation where a
firm’s long-run average cost (LRAC)
declines as output increases

 Diseconomies of scale: situation where

a firm’s LRAC increases as output
increases

 In general, the LRAC curve is u-shaped.

Long-run cost function
 Reasons for long-run economies

 specialization of labor and capital

 prices of inputs may fall with volume
discounts in firm’s purchasing
 use of capital equipment with better
price-performance ratios
 larger firms may be able to raise funds
in capital markets at a lower cost
 larger firms may be able to spread out
promotional costs
Long-run cost function
 Reasons for diseconomies of scale

 Scale of production becomes so large

that it affects the total market demand
for inputs, so input prices rise
 Management coordination and control
problems
 Disproportionate rise in staff and
indirect labor
Chapter Seven 43
Long-run average cost curve as the
envelope of short-run average cost

In long run, the firm can choose any level of

capacity

Once it commits to a level of capacity, at least

one of the inputs must be fixed. This then
becomes a short-run problem

The LRAC curve is an envelope of SRAC curves,

and outlines the lowest per-unit costs the firm
will incur over a range of output
Learning curve
Learning curve is a line showing the
relationship between labor cost and additional
units of output.

Downward slope indicates 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 often referred to as
the learning curve effect.
Learning curve
Specifically a learning curve is measured
in terms of percentage decrease in
additional labor cost each time output
doubles.

Thus for an “80 percent” learning curve,

each time the output doubles, the cost of
producing the next increment of output
decreases to 80 percent of the previous
level (i.e. declines by 20 percent).
There is a mathematical formula for
determining the pattern of reduction in
labor cost based on a selected percentage
decline
Yx = Kxn
Yx = units of factor or cost to
produce the xth unit
K = factor units or cost to produce
the Kth (usually first) unit
x = product unit (the xth unit)
n = log S/log 2
S = slope parameter
Economies of scope
 Economies of scope: reduction of a
firm’s unit cost by producing two or more
goods or services jointly rather than
separately

Closely related to economies of scale

Chapter Seven 51
Breakeven Analysis OR Profit
Contribution Analysis OR Cost-
Volume-Profit Analysis

It examines the relationship among the

total revenue, total cost andtotal profits of
the firm at various levels of output.

It is used to determine the sales volume

required for the firm tobreak even and the
total profits and losses at other sales
levels.
52
 The difference between price and average
variable cost (P-AVC)is defined as profit
contribution.
That is, revenue on the sales of a unit of
output after variable costs are covered
represents a contribution towards profits.

At low rates of output, the firm may be

losing money because fixed costs have
not yet been covered by the profit
contribution.

Chapter Seven 53
Thus, at low rate of output, profit contribution is
used to cover fixed costs. After fixed costs are
covered, the firm will start earning profit.

A manager may want to know the output rate

necessary to cover all fixed costs to earn required
profit of say πR.

Assume both price and variable cost per unit of

output are constant, then profit will be shown as:

54
 πR = PQ – [ (Q . AVC) + FC ]
where PQ is the total revenue and FC is
the total fixed cost OR
Q = FC + πR
P – AVC
……….. (1)
Thus equation (1) gives a relation that can
be used to determine the rate of output
necessary to generate a specified rate of
profit.
A special case of this equation is where the
required economic profit is zero, that is πR =
0. This output rate is called as the
breakeven point of the firm.
Chapter Seven 55
The breakeven rate of output, Qe, is given by
the equation:

Qe = FC
P - AVC ……… (2)

Suppose, the FC = Rs10000, P = Rs20 and

AVC = Rs15, then break even rate of output
will be

Qe = 10000 / (20 – 15) = 2000 units

56
This can be shown as:

57
If the assumptions of constant price and
average variable cost are relaxed, breakeven
analysis can still be applied, although the key
relationship (total revenue and total variable
cost) will not be linear functions of output.

This can be shown as:

58
Chapter Seven 59
Operating Leverage :

It refers to the ratio of the firm’s total fixed cost to total variable
cost.

The higher is the ratio, the more leveraged the firm is said to be.

Leverage can be analyzed using the concept of “profit elasticity

(Eπ) or degree of operating leverage (DOL)”, which is defined
as the percentage change in profit associated with a 1 percentage
change in unit sales or rate of output. That is

Eπ = % change in profit
% change in unit sales
Or
Eπ = ∆π / π = ∆π . Q …….. (1)
∆Q / Q ∆Q π

For infinitesimally small changes in Q, the profit

elasticity is
Eπ = dπ . Q …………… (2)
dQ π

If the price of output is constant regardless of the rate of output,

profit elasticity depends on three variables: the rate of output, the
level of total fixed costs, and variable costs per unit of output.
This can be calculated from the equation of profit as:

π = PQ – (AVC)(Q) – TFC …….. (3)

and change in profit is :
∆π = P(∆Q) – (AVC)(∆Q) ………(4)

Substituting the value of equation 3 & 4 into 1, we get

Eπ = [P(∆Q) – (AVC)(∆Q)] / [PQ – (AVC)(Q) – TFC] .. (5)

∆Q / Q

On simplifying the equation it yields

Eπ = . Q(P – AVC) . ……….. (6)

Q(P – AVC) – TFC
On analyzing the 6th equation, it is clear that for two firms with
equal prices, rates of output and variable costs per unit, the firm
having greater total fixed costs (TFC) will have the higher profit
elasticity.

Thus with a small change in TFC the profit will change by greater
amount.

But the other aspect of having higher TFC is the firm’s break
even level will increase.

As the firm become more leveraged, its total fixed costs rise but
its total variable costs fall and because of higher overhead costs
the breakeven output of the firm will increase, as shown as:
There is usually a trade-off between risk and return.

Greater the return is usually associated with higher risk.

Thus a management decision to become more leveraged is

effectively a decision to accept greater risk for the chance to earn
higher profit.
Supply chain management
 Supply chain management (SCM):
efforts by a firm to improve efficiencies
through each link of a firm’s supply chain
from supplier to customer

• transaction costs are incurred by using

resources outside the firm
• coordination costs arise because of
uncertainty and complexity of tasks
• information costs arise to properly
coordinate activities between the firm and
its suppliers
Chapter Seven 66
Supply chain management
 Ways to develop better supplier
relationships

 strategic alliance: firm and outside

supplier join together in some sharing
of resources
 competitive tension: firm uses two or
more suppliers, thereby helping the firm
keep its purchase prices under control

Chapter Seven 67
Ways companies cut
costs to remain competitive
 the strategic use of cost
 reduction in cost of materials
 using information technology to reduce
costs
 reduction of process costs
 relocation to lower-wage countries or
regions
 mergers, consolidation, and subsequent
downsizing
 layoffs and plant closings

Chapter Seven 68
Global application
 Example: manufacturing chemicals in
China

 labor content relatively low

 high use of equipment and raw

materials
 noncost reasons for outsourcing

Chapter Seven 69