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OVERVIEW
What Makes Cost Analysis Difficult
Opportunity Cost
Incremental and Sunk Costs in Decision Analysis
Short-run and Long-run Costs Short-run Cost Curves
Long-run Cost Curves
Minimum Efficient Scale
Firm Size and Plant Size
Learning Curves
Economies of Scope
Cost-volume-profit Analysis
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What is Cost?Cost is the monetary value that a company has spent in
order to produce something.
Sellers point of viewBuyers point of view
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Current cost is the amount that must be paid under prevailing market
conditions. Current cost is influenced by market conditions measured by the
number of buyers and sellers, the present state of technology, inflation, and
so on.
Current cost
Replacement CostReplacement cost, the cost of duplicating productive capability using current
technology.For example, the value of used personal computers tends to fall by 30 to 40
percent per year.
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Opportunity Cost
Opportunity Cost ConceptOpportunity cost is foregone value.
Reflects second-best use.
Explicit and Implicit CostsExplicit costs are cash expenses.
Implicit costs are noncash expenses.
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Incremental and Sunk Costs in Decision Analysis
Incremental Cost Incremental cost is the change in cost tied to amanagerial decision.
Incremental cost can involve multiple units ofoutput.
Marginal cost involves a single unit of output.
Sunk Cost Irreversible expenses incurred previously.
Sunk costs are irrelevant to present decisions.
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Short-run and Long-run Costs
How Is the Operating Period Defined?At least one input is fixed in the short run.
All inputs are variable in the long run.
Two basic cost functions are used in managerial
decision making: short-run cost functions, used for day-to-
day operating decisions, and long-run cost functions, used
for long-range planning.
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Fixed and Variable CostsFixed costs do not vary with output. These costs include interest
expenses, rent on leased plant and equipment, depreciation charges
associated with the passage of time, property taxes, and salaries for
employees not laid off during periods of reduced activity.
Variable costs fluctuate with output. Expenses for raw materials,
depreciation associated with the use of equipment, the variable
portion of utility charges, some labor costs, and sales commissions
are all examples of variable expenses.
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Long-run Cost Curves
Economies of ScaleLong-run cost curves show minimum cost inan ideal environment. Labor specializationoften gives rise to economies of scale. Laborproductivity can be higher in large firms,
where individuals are hired to performspecific tasks. This can reduce unit costs forlarge-scale operations.
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Cost Elasticity and Economies of Scale
Cost elasticity is C= C/C Q/Q.
C < 1 means falling AC, increasing returns.
C = 1 means constant AC constant returns.
C> 1 means rising AC, decreasing returns.
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Long-run Average Costs
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Minimum Efficient Scale
Competitive Implications of Minimum Efficient Scale
MES is the minimum point on the LRAC curve.
Competition is most vigorous when:
MES is small in absolute terms.
MES is a small share of industry output.
Disadvantage to less than MES scale is modest.
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Transportation Costs and MES
Terminal, line-haul and inventory costs can be important.
High transport costs reduce MES impact.
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Firm Size and Plant Size
Multi-plant Economies and Diseconomies of Scale
Multi-plant economies are cost advantages from operating several plants.
Multi-plant diseconomies are cost disadvantages from operating severalplants.
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Economics of Multi-plantOperation: an Example
Plant Size and Flexibility
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Learning Curves
Learning Curve Concept Learning causes an inward shift in the LRAC curve.
Learning curve advantages are often mistaken for economies of scale effects.
Learning Curve Example
Strategic Implications of the Learning Curve Concept When learning results in 20% to 30% cost savings, it becomes a key part of
competitive strategy.
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Economies of Scope
Economies of Scope Concept
Scope economies are cost advantages that stem from producing multipleoutputs.
Big scope economies explain the popularity of multi-product firms.
Without scope economies, firms specialize. Exploiting Scope Economies
Scope economics often shape competitive strategy for new products.
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Cost-volume-profit Analysis
Cost-volume-profit Charts
Cost-volume-profit analysis shows effects of varying scale.
Breakeven analysis shows zero profit points of cost coverage.
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Degree of Operating Leverage
DOL=Q(P-AVC)/[Q(P-AVC)-TFC]
DOL is the elasticity of profit with respect to output.
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