# Cost Theory and Estimation EC611--Managerial Economics

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1 Cost Theory and Estimation EC611--Managerial Economics Dr. Savvas C Savvides, European University Cyprus

2 The Nature of Costs Accounting cost actual payments made by a firm in a period Opportunity cost amount lost by not using a resource in its best alternative use Supernormal profit profit over and above the return earned at the market rate of interest Economists include opportunity cost in a firm s total costs Managerial Economics DR. SAVVAS C SAVVIDES 2

3 Accounting vs. Economic Profits Cynthia s Economic Profit Calculation Total Revenue 100,000 Total Opportunity Costs Wages 9,600 Consumables 50,000 Overheads 3,000 Bank interest paid 2,000 TOTAL EXPLICIT COSTS 64,600 ACCOUNTING PROFITS 35,400 Cynthia s wages forgone 6,000 Cynthia s interest foregone 1,000 Normal profits 15,000 TOTAL IMPLICIT COSTS 22,000 TOTAL COSTS 86,600 ECONOMIC PROFITS 13,400 Managerial Economics DR. SAVVAS C SAVVIDES 3

4 Short-Run Cost Functions TC = TFC + TVC Average Total Cost = ATC = TC/Q Average Fixed Cost = AFC = TFC/Q Average Variable Cost = AVC = TVC/Q ATC = AFC + AVC Marginal Cost = TC/ Q = TVC/ Q Managerial Economics DR. SAVVAS C SAVVIDES 4

5 Short-Run Cost Functions Q TFC TVC TC AFC AVC ATC MC 0 \$60 \$0 \$ \$60 \$20 \$80 \$ Managerial Economics DR. SAVVAS C SAVVIDES 5

6 Managerial Economics DR. SAVVAS C SAVVIDES 6

7 Average and Marginal Costs AC, MC When MC=AC AC is minimum MC AC When MC<AC AC falls When MC>AC AC rises Output Managerial Economics DR. SAVVAS C SAVVIDES 7

8 Long-Run Cost Curves Long-Run Total Cost = LTC = f(q) Long-Run Average Cost = LAC = LTC/Q Long-Run Marginal Cost = LMC = LTC/ Q Managerial Economics DR. SAVVAS C SAVVIDES 8

9 Derivation of Long-Run Cost Curves Managerial Economics DR. SAVVAS C SAVVIDES 9

10 Relationship Between Long-Run and Short-Run Average Cost Curves Managerial Economics DR. SAVVAS C SAVVIDES 10

11 Relationship between Production and Costs Managerial Economics DR. SAVVAS C SAVVIDES 11

12 Returns to Scale and LR-ATC Managerial Economics DR. SAVVAS C SAVVIDES 12

13 Reasons for Economies of Scale Specialization: As a firm s scale of operations increases, there are more opportunities for developing specialization in the use of inputs as well. This reduces unit costs Dimensional Factors / Indivisibilities: As the scale of operations increase, firms are able to economize on certain inputs which do not have to be employed in the same proportion as the scale of operations has increased. This is true especially of certain fixed costs (large capacity machinery, a large telephone electronic switchboard, etc) or head office overhead expenses (marketing, accounting managerial staff). Managerial Economics DR. SAVVAS C SAVVIDES 13

14 Innovations and Global Competitiveness Product Innovation Process Innovation Product Cycle Model Just-In-Time Production System Competitive Benchmarking Computer-Aided Design (CAD) Computer-Aided Manufacturing (CAM) Managerial Economics DR. SAVVAS C SAVVIDES 14

15 Learning Curves Average Cost of Unit Q = C = aq b Estimation Form: log C = log a + b Log Q Managerial Economics DR. SAVVAS C SAVVIDES 15

16 Strategic Cost Minimization Cost Leadership EasyJet, Ryan Air Reduction in materials costs Process Re-engineering Use of IT to reduce costs Enterprise Resource Planning (ERP) integration of CRM, SCM, Sales & Marketing and Accounting functions Foreign Sourcing of Inputs (Asia) Relocation to Lower-cost countries (SE Asia, E. Europe) M & A and Downsizing New International Economies of Scale Layoffs and Plant closings Managerial Economics DR. SAVVAS C SAVVIDES 16

17 New Management Tools Benchmarking: finding out what processes or techniques excellent firms use and adopt & adapt Total Quality Management: the constant improvements in product quality and processes to deliver consistently superior service and value to customers Reengineering: seeks to completely reorganize the firm (processes, departments, entire firm). Radically redesigning processes to achieve significant gains in speed, quality, service, profitability The Learning Organization: continuous learning both on the individual level as well as on the collective level. It is based on five ingredients: a new mental model - achieve personal mastery develop system thinking develop shared vision strive for team learning Managerial Economics DR. SAVVAS C SAVVIDES 17

18 Architecture of Ideal Firm Core Competencies Outsourcing of Non-Core Tasks Learning Organization Efficiency and Flexibility Location Near Markets Agility in Responding to Market Forces Managerial Economics DR. SAVVAS C SAVVIDES 18

19 Cost-Volume-Profit Analysis (Break-Even Analysis) Total Revenue = TR = (P)(Q) Total Cost = TC = TFC + (AVC)(Q) Breakeven Volume TR = TC (P)(Q) = TFC + (AVC)(Q) Q BE = TFC/(P - AVC) Managerial Economics DR. SAVVAS C SAVVIDES 19

20 Cost-Volume-Profit Analysis P = 10 TFC = 200 AVC = 5 Q BE =TFC/(P - AVC) =200/(10-5) = 40 Managerial Economics DR. SAVVAS C SAVVIDES 20

21 Operating Leverage Operating Leverage = TFC/TVC Degree of Operating Leverage = DOL DOL % π QP ( AVC) = = % Q Q( P AVC) TFC Managerial Economics DR. SAVVAS C SAVVIDES 21

22 Operating Leverage TC has a higher DOL than TC and therefore a higher Q BE Managerial Economics DR. SAVVAS C SAVVIDES 22

23 Uses of Break-Even Analysis BE analysis can help in the following business situations / decisions: New Product development: BE can determine the level of Q for the firm to achieve profitability Expansion of Operations: Increasing sales would also increase the level of FC and VC Modernization and Automation Projects: Fixed investments increase in order to lower VC (especially labor) BE analysis can help Managerial Economics DR. SAVVAS C SAVVIDES 23

24 Empirical Estimation Data Collection Issues Opportunity Costs Must be Extracted from Accounting Cost Data Costs Must be Apportioned Among Products Costs Must be Matched to Output Over Time Costs Must be Corrected for Inflation Managerial Economics DR. SAVVAS C SAVVIDES 24

25 Empirical Estimation Functional Form for Short-Run Cost Functions Theoretical Form 2 3 TVC = aq + bq + cq Linear Approximation TVC = a + bq TVC AVC = = a + bq + cq Q 2 AVC a = + Q b MC = a+ 2bQ+ 3cQ 2 MC = b Managerial Economics DR. SAVVAS C SAVVIDES 25

26 Empirical Estimation Theoretical Form Linear Approximation Managerial Economics DR. SAVVAS C SAVVIDES 26

27 Empirical Estimation Long-Run Cost Curves Cross-Sectional Regression Analysis Engineering Method Survival Technique Managerial Economics DR. SAVVAS C SAVVIDES 27

28 Empirical Estimation Actual LAC versus empirically estimated LAC Managerial Economics DR. SAVVAS C SAVVIDES 28

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