Chapter The Theory and Estimation of Cost Chapter Outline • • • • • • • • • Importance of cost in managerial decisions Definition and use of costs in economic analysis Relationship between production and cost Short-run cost function Long-run cost function Learning curve Economies of scope and scale Supply chain management Ways companies have cut costs to remain competitive Copyright ©2014 Pearson Education, Inc All rights reserved 7-2 Learning Objectives • Define the cost function and the difference between the short and long run • Distinguish between economic cost and accounting cost • Explain how the concept of relevant cost is used in economic analysis • Define total, variable, average and fixed cost • Explain the linkage between the production and cost function • Provide reasons for the existence of economies of scale and scope Copyright ©2014 Pearson Education, Inc All rights reserved 7-3 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 Consolidation of shared services Outsourcing components of the business Mergers and consolidation (usually with a reduction in employees) Copyright ©2014 Pearson Education, Inc All rights reserved 7-4 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 Copyright ©2014 Pearson Education, Inc All rights reserved 7-5 Definition and Use of Cost in Economic Analysis • Incremental cost: varies with the range of options available in the decision • Sunk cost: does not vary in accordance with decision alternatives Copyright ©2014 Pearson Education, Inc All rights reserved 7-6 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 Copyright ©2014 Pearson Education, Inc All rights reserved 7-7 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 implies that MC will eventually increase Copyright ©2014 Pearson Education, Inc All rights reserved 7-8 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 Copyright ©2014 Pearson Education, Inc All rights reserved 7-9 Short-run Cost Function • Short-run cost function assumptions: – – the firm employs two inputs, labor and capital – – the firm produces a single product the firm operates in a short-run production period where labor is variable, capital is fixed the firm employs a fixed level of technology Copyright ©2014 Pearson Education, Inc All rights reserved 7-10 Long-run Cost Function • Economies of scale: situation where a firm’s longrun 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 Copyright ©2014 Pearson Education, Inc All rights reserved 7-26 Long-run Cost Function • Reasons for long-run economies of scale: – – – – – 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 Copyright ©2014 Pearson Education, Inc All rights reserved 7-27 Long-run Cost Function • Reasons for diseconomies of scale: – Scale of production is not optimal for the total market demand – Transportation costs tend to rise as production grows, due to handling expenses, insurance, security, and inventory costs Copyright ©2014 Pearson Education, Inc All rights reserved 7-28 Long-run Cost Function • 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 Copyright ©2014 Pearson Education, Inc All rights reserved 7-29 Long-run Cost Function Copyright ©2014 Pearson Education, Inc All rights reserved 7-30 Learning Curve • Learning curve: line showing the relationship between labor cost and additional units of output – A downward slope indicates additional cost per unit declines as the level of output – The production process also improves as engineers and other development increases because workers improve with practice personnel gain more experience Copyright ©2014 Pearson Education, Inc All rights reserved 7-31 Learning Curve • Learning curve: measured in terms of percentage decrease in additional labor cost as output increases Y = Kxn x 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 S = slope parameter Copyright ©2014 Pearson Education, Inc All rights reserved 7-32 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 Copyright ©2014 Pearson Education, Inc All rights reserved 7-33 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 Copyright ©2014 Pearson Education, Inc All rights reserved 7-34 Supply Chain Management Copyright ©2014 Pearson Education, Inc All rights reserved 7-35 Supply Chain Management • Ways to develop better supplier relationships – strategic alliance: firm and outside supplier join together in some sharing of – competitive tension: firm uses two or more suppliers, thereby helping the firm keep resources its purchase prices under control Copyright ©2014 Pearson Education, Inc All rights reserved 7-36 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 Copyright ©2014 Pearson Education, Inc All rights reserved 7-37 Ways Companies Cut Costs to Remain Competitive • relocation to lower-wage countries or regions • mergers, consolidation, and subsequent downsizing • layoffs and plant closings • reductions in fixed assets Copyright ©2014 Pearson Education, Inc All rights reserved 7-38 Global Application • Discussion example: Li & Fung Is this the model of a global business? – – Operating in 40 countries around the world Outsourcing the entire supply chain Copyright ©2014 Pearson Education, Inc All rights reserved 7-39 Summary • Virtually all management decisions must consider the impact on costs • The short run cost function has fixed costs, in the long run, all costs are variable • The law of diminishing returns also affects costs • Firms may experience economies of scope and scale and benefit by the learning curve Copyright ©2014 Pearson Education, Inc All rights reserved 7-40 .. .Chapter Outline • • • • • • • • • Importance of cost in managerial decisions Definition and use of costs in economic analysis Relationship between production and cost Short-run... the cost function and the difference between the short and long run • Distinguish between economic cost and accounting cost • Explain how the concept of relevant cost is used in economic analysis... Define total, variable, average and fixed cost • Explain the linkage between the production and cost function • Provide reasons for the existence of economies of scale and scope Copyright ©2014 Pearson