engineering economics "cost concepts

Cost concepts

A cost is incurred when a firm uses a resource for some purpose

Costs are assembled into meaningful groups called cost pools (e.g., by type of cost or source)

Any factor that has the effect of changing the level of total cost is called a cost driver

A cost object is any product, service, customer, activity, or organizational unit to which costs are assigned for some management purpose

Basic Definitions

Cost Function Cost is the function of output c=f(X) C=f(X, T, ,K)

WHEREC=TOTAL COSTX=outputT=technologyK=price of factors = FIXED FACTORS(S)

Determinants Of Cost(1) Rate of output (i.e., utilization of fixed plant) (2) Size of plant (3) Prices of input factors (materials and labour) (4) Technology (5) Stability of output (6) Efficiency (of management as well as labour)

Elements of cost

MATERIAL

LABOUR

EXPENSES

What Makes Cost Analysis Difficult?

Link Between Accounting and Economic Valuations Accounting and economic costs often

differ. Most of the cost are uncontrollable Demand varies

Fixed CostDoes not vary with the output

Average Fixed costAVC = TFC / No. of units (Fixed cost per Unit)

Variable CostCost that varies directly with the output

VC

Output

Cost

Average Variable Cost

AVC = TVC / No.of Units (Variable cost per unit)

Output

Cost

AVC

Total Cost

TC = TFC + TVC

TVC

Output

Cost

TC

TFC

Opportunity Cost Value foregone while choosing the next best

alternative The income that would have been received if

the input had been used in its most profitable alternative use

It denotes the real cost of using an input Economic concept of cost

Incremental, Marginal and Sunk Costs

Incremental Cost Incremental cost is the change in cost

tied to a managerial decision. Fixed cost and variable cost changes

Marginal cost Additional cost of producing one

additional unit of output Only the variable cost changes

Shut down & Abandonment Costs

Shutdown cost – Expenses of temporary closure

Abandonment cost – Expenses of permanent closure

Is an expenditure that cannot be recovered Sunk costs are irrelevant to present decisions.

Sunk Cost

Avoidable and Unavoidable cost

Cost that can be avoided by eliminating a product or department is avoidable and that which cannot be, is unavoidable.

Ex. – Rent of factory is unavoidable if a product is discontinued

Historical, Current and Replacement Cost

Historical Versus Current Costs Historical cost is the actual cash outlay. Current cost is the present cost of

previously acquired items. Replacement Cost

Cost of replacing productive capacity using current technology.

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.

Fixed and Variable Costs Fixed cost is a short-run concept. All costs are variable in the long run.

Cost Concepts Total Fixed Costs (TFC)

The summation of all fixed and sunk costs to production.

Total Variable Costs (TVC) The summation of all variable costs to

production. Total Costs (TC)

The summation of total fixed and total variable costs.

TC=TFC+TVC

Cost Concepts Average Fixed Costs (AFC)

The total fixed costs divided by output. Average Variable Costs (AVC)

The total variable costs divided by output. Average Total Costs (ATC)

The total costs divided by output. The summation of average fixed costs and

average variable costs, i.e., ATC=AFC+AVC.

Cost Concepts

Marginal Costs The change in total costs divided by the

change in output. TC/Y

The change in total variable costs divided by the change in output. TVC/Y

Marginal Cost

How can marginal cost equal both the change in total cost divided by the change in output and the change in total variable cost divided by the change in output when variable costs are not equal to total costs? Short answer: fixed costs do not change.

Marginal Cost Cont. We want to show that MC = TVC/Y when

TVC TC. We know that TC = TFC + TVC This implies that TC = (TFC + TVC) This implies that TC = TFC + TVC We know that TFC = 0 Hence, TC = TVC Divide the previous by Y, we obtain TC/Y = TVC/Y MC = TVC/Y

Marginal Cost

AVC = TVC / No.of Units (Variable cost per unit)

Output

Cost MC

Graphical Representation of Cost Concepts

$

Y

ATC

MC

AVC

AFC

Typical Average & Marginal Cost Curves

AFC is always declining at a decreasing rate.

ATC and AVC decline at first, reach a minimum, then increase at higher levels of output.

The difference between ATC and AVC is equal to AFC.

MC is generally increasing.

MC crosses ATC and AVC at their minimum point.

If MC is below the average value: Average value will be

decreasing. If MC is above the average

value: Average value will be

increasing.

MC will meet AVC and ATC from below at the corresponding minimum point of each. Why?

As output increases AFC goes to zero. As output increases, AVC and ATC get

closer to each other.

Long-Run cost curves

Nothing is fixed – everything is variable.

The long run average cost curve is called as the envelope curve

Example of Cost Concepts

O/p

TFC TVC TC AFC AVC ATC MC

10

30

48

65

81

96

108

116

120

117

1000

1000

1000

1000

1000

1000

1000

1000

1000

1000

1000

1600

2000

2200

2600

3200

4000

5000

6200

7600

2000

2600

3000

3200

3600

4200

5000

6000

7200

8600

100

33.33

20.83

15.38

12.35

10.42

9.26

8.62

8.33

8.55

100

53.33

41.67

33.85

32.10

33.33

37.04

43.10

51.67

64.96

200

86.67

62.50

49.23

45.45

43.75

46.30

51.72

60.00

73.51

30

22.22

11.76

25

40

66.67

125

300

-466.67

X

10

16

20

22

26

32

40

50

62

76

MATERIAL

Direct: traceable to one particular process, job or product – identified with each unit of product

Example: manufacturing an apparel Cloth, collar, buttons, cufflinks, thread Primary packing material (e.g., carton,

wrapping, cardboard, boxes, etc.) Fuel, lubricating oil etc for operating &

maintenance of machine Small tools Materials used for repairs & maintenance

LABOUR

Inspectors Supervisors Internal transport staff Storekeeper, maintenance staff

EXPENSES

Expenses leading to a job or contract Traveling expenses for negotiation Special pattern, design Special tools for executing the contract

Rent Insurance Canteen, hospital, power , lighting,

maintenance

Types of Costs Variable Costs

These costs exist only if production occurs. E.g., fuel for tractor, seed, etc.

Fixed Costs These cost exist whether production occurs or

not. In the long-run there are no fixed costs. Can be both cash and non-cash expenses. E.g., depreciation on tractors and buildings, etc.

Types of Costs Cont.

Sunk Costs Is an expenditure that cannot be

recovered. In essence, it becomes part of fixed

costs. E.g., pre-harvest costs.

Long-Run Average Costs The long run average cost (LRAC) curve is

the envelope of the short run average cost curves when the size of the operation is allowed to increase or decrease.

Note that a short run average cost curve exists for every possible farm size, as defined by the amount of fixed input available.

Long-Run Average Costs Cont.

In a competitive market, the long run optimal production will occur at the lowest point on the LRAC, i.e., economic profits are driven to zero.

Size in the Long-Run

A measure of size in the long run between output and costs as farm size increases (EOS) is the following: EOS = percent change in costs divided

by percent change in output value

Size in the Long-Run Cont. If this ratio of EOS is less than one, then

there are decreasing costs to expanding production, i.e., increasing returns to size.

If this ratio is equal to one, then there are constant costs to expanding production, i.e., constant returns to size.

If this ratio is greater than one, then there are increasing costs to expanding production, i.e., decreasing returns to size.

Economies of Size This exists when the LRAC is decreasing. Also known as increasing returns to size. Usually occurs because of full utilization of

capital (tractors and buildings) and labor. Also occurs because of discount pricing for

buying in bulk and selling price benefits for selling large quantities.

Diseconomies of Size This exists when the LRAC is increasing. Also known as decreasing returns to size. Usually occurs because a lack of

managerial skills. Also occurs because travel time increases

as farm increases. Livestock: disease control and manure disposal. Crops: geographical distance away from each

other.

Revenue Concepts Revenue (TR) is defined as the output

price (py) multiplied by the quantity (Y).

Average revenue (AR) equals total revenue divided by output (Y), i.e., TR/Y, which equals py.

Marginal Revenue is the change in total revenue divided by the change in output, i.e., TR/Y.

Short-Run Decision Making

In the short-run, there are many ways to choose how to produce. Maximize output. Utility maximization of the manager. Profit maximization.

Profit () is defined as total revenue minus total cost, i.e., = TR – TC.

Short-Run Decision Making Cont. When examining output, we want to

set our production level where MR = MC when MR > AVC in the short-run. If MR AVC, we would want to shut

down. Why?

If we can not set MR exactly equal to MC, we want to produce at a level where MR is as close as possible to MC, where MR > MC.

Intuition for Setting MR = MC

Suppose MR < MC. This implies that by producing more

output, you have a greater addition of cost than you do revenue. Hence you would not make the change.

Intuition for Setting MR = MC Suppose MR > MC. This implies that by producing

more output, you have a greater addition of revenue than you do cost. Hence you would make the change.

You would stop increasing output at the point where the trade-off in additional revenue is just equal to the trade-off in additional costs.

Why Shutdown WhenMR < AVC

If MR < AVC, this implies that you are not bringing in enough revenue from each unit produced to cover your variable costs.

Hence you could minimize your loss if you were to shutdown.

Why Produce When ATC > MR > AVC When MR < ATC, the company is making a

loss. Why would it produce?

Since the firm is making something above and beyond its variable cost, it can put some of that revenue towards fixed cost. This implies that it minimizes its loss by

producing.

Profit Scenario Graphically

$

Y

ATC

MC

AVC

AFC

MR = py

Profit

ATC

Yprofit

Loss Minimizing Graphically

$

Y

ATC

MC

AVC

AFC

Loss

ATC

Yloss

MR = py

Shutdown Decision Graphically

$

Y

ATC

MC

AVC

AFC

Loss = A + B

ATC

Yloss

MR = py

A

B

If we did not produce: loss = B

Production Rules for the Long-Run

To maximize profits, the farmer should produce when selling price is greater than ATC at the production level where MC = MR.

To minimize losses, the farmer should not produce when selling price is less than ATC, i.e., shutdown the business.

Note on Cost Concepts

The producer’s supply curve is the part of the MC curve that is above the shutdown point.

Short-Run & Long-Run “Time concepts” rather than fixed

periods. Short-run:

One or more production input is fixed: Increasing cropland?

One crop or livestock production cycle. Long-run:

The quantity of all necessary production inputs can be changed.

Expand or acquire additional inputs.

Fixed Costs Result from owning a fixed input or

resource. Incurred even if the resource isn’t

used. Don’t change as the level of

production changes (in the short run). Exist only in the short run. Not under the control of the manager

in the short run. The only way to avoid fixed costs is to

sell the item.

Fixed Costs(DIRTI – 5)

1. Depreciation2. Interest3. Rent4. Taxes

(property)5. Insurance

Cash

Noncash

Important Fixed Costs Total fixed cost (TFC):

All costs associated with the fixed input.

Average fixed cost per unit of output:

AFC = TFC Output

Variable Costs

Can be increased or decreased by the manager.

Variable costs will increase as production increases.

Total Variable cost (TVC) is the summation of the individual variable costs.

VC = (the quantity of the input) X (the input’s price).

Variable Costs Variable costs exist in the short-

run and long-run: In fact, all costs are considered to

be variable costs in the long run. Variable versus Fixed, some

examples: Fertilizer is a variable cost until it has

been purchased and applied. Labor and cash rent contracts have to

be considered fixed costs during the duration of the contract.

Irrigation water is generally variable, but can have a fixed component.

Important Variable Costs Total variable cost (TVC):

All costs associated with the variable input.

Average variable cost per unit of output:

AVC = TVC Output

Total Cost

The sum of total fixed costs and total variable costs:

TC = TFC + TVC

In the short run TC will only increase as TVC increases.

Average Total Cost Average total cost per unit of

output:

AFC + AVC

ATC = TC Output

Marginal Cost The additional cost incurred from

producing an additional unit of output:

MC = TC Output

MC = TVC Output

Typical Total Cost Curves

Typical Total Cost Curves(selected attributes)

TFC is constant and unaffected by output level.

TVC is always increasing: First at a decreasing rate. Then at an increasing rate.

TC is parallel to TVC: TC is higher than TVC by a distance

equal to TFC.

Typical Average & Marginal Cost Curves

Stocking Rate Problem

Production Rules for the Short-Run

If expected selling price > minimum ATC (which implies TR > TC): A profit can be made.

Maximize profit by producing where: MR = MC

Production Rules for the Short-Run

If expected selling price < minimum ATC but > minimum AVC: (which implies TR > TVC but < TC) A loss cannot be avoided. Minimize loss by producing where

MR = MC. The loss will be between 0 and TFC.

Production Rules for the Short-Run

If expected selling price < minimum AVC (which implies TR < TVC): A loss cannot be avoided. Minimize loss by not producing. The loss will be equal to TFC.

Short Run Production Decisions

Production Rules for the Long-Run

If selling price > ATC (or TR > TC): Continue to produce. Maximize profit by producing

where MR = MC.

Production Rules for the Long-Run

If selling price < ATC (or TR < TC): There will be a continual loss. Sell the fixed assets to eliminate

fixed costs. Reinvest money in a more

profitable alternative.

Farm Size in the Short-Run

Possible Size-Cost Relations

Economies of Size Increasing returns to size. LRAC curve is decreasing. Economies of size result from:

Full utilization of labor, machinery, buildings.

Ability to afford specialized labor and machinery and new technology.

Price discounts for volume purchasing of inputs.

Price advantages when selling large amounts of output.

Long-Run Average Cost Curve(Economies of Size)

Diseconomies of Size

Decreasing returns to size. LRAC curve begins to increase. Diseconomies of size result from:

Lack of sufficient managerial skill. Need to hire, train, supervise, and

coordinate larger labor force. Dispersion over a larger

geographical area. Disease control, waste disposal.

Long-Run Average Cost Curve(Diseconomies of size)