cost analysis presentation
TRANSCRIPT
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Topics for discussion
Total Revenue and Total Cost
Opportunity Cost
Total and Average Fixed Costs
Total and Average Variable Costs
Total and Marginal Cost
Shape of the Curves
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A Firms Total Revenue and Total Cost
Total Revenue The amount that the firm receives for the sale of its output.
Total Cost The amount that the firm pays to buy inputs.
Profit is the firms total revenue minus its total cost.
Profit = Total revenue - Total cost
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Accounting and Economic Profit
Economic profitis total revenues minus totalcosts
Accounting profitis total revenue minus theexpenses of the firm over a time period.
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Accounting versus Economic Profit
Costs (Explicit)
Groceries (wholesale) 76,000
Taxes 10000
Advertising 2,000
Accounting Profit: 70,000
Additional (implicit) costs
Interest (personal investment) 7,000
Rent (owner's building) 18,000
Economic Profit: -5,000
Total Revenue
Sales (groceries) 170,000
Labor (employees) 12,000
Total (explicit) costs 100,000
Salary (owner's labor) 50,000
Total (implicit) costs 75,000
Total Explicit andImplicit costs: 175,000
To calculate accounting profit, subtract the explicit costs fromtotal revenue.
To calculate economic profit, subtract both the explicitand implicit costs from total revenue.
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Economic Profit vs.Accounting
Profit Accounting profit = TR - TC (explicit,
accounting costs)
Most of the time,when the word "profit" isused, we are referring to accounting profits
Accounting profits are important to managers,shareholders, govt. (for taxes), etc.
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However, managerial decisions should not bebased only on accounting profits, but shouldalways include the more comprehensiveconcept of"economic profits."
Economic Profits = TR - TC (explicitaccounting costs + implicit costs, including
OC). Managerial decisions should always bebased on Economic Profits,notaccountingprofits.
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Sunk Costs
Sunk Costs : are similar to FC, in that theyrepresent costs that do NOT play a relevant
role in managerial decisions. Sunk cost = an expense that:
a) has already been incurred, and b) cannot be recovered.
Example: You paid $120,000 for your house, andnow the most you can get is $100,000
It is often difficult to ignore sunk costs, they canoften incorrectly sneak into decision making.
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Sunk Costs Example: A firm spends $20m on R&D for a
new product over many years. Now anadditional $10m is needed to complete aprototype. Should the firm consider the
original $20m investment? No, because it is a sunk cost and cannot be
recovered whether the firm markets the newproduct or not. The firm should look only at
the product's current expected future revenuecompared to the current marginal(incremental) additional costs of bringing theproduct to the market.
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Sunk Costs
For example, if the current expected revenueis $15m compared to the $10m cost, then thefirm should continue with the project, even
though the expected loss will be $15m -$30m = -$15m. If they consider the sunkcost of $20m and abandon the project, the
loss be even greater, -$20m.
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Categories of Cost
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Fixed Costs Fixed costs are those costs that do not
vary with the quantity of output produced.
Costs of a firms fixed inputs
Remain constant as output changes Example: Interest payment on borrowed
capital and rental expenditure on leased
plant and equipment.
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Total and Average Fixed Costs
Total Fixed Costs (TFC):costs that remain unchanged in the shortrun when output is altered
Examples:
insurance premiums
property taxes
the opportunity cost of fixed assets
Average Fixed Costs (AFC):Fixed costs per unit (i.e. TFC / output).
decline as output expands
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Average Costs
F i x e d c o s t F CA F C = =Q u a n t i t y Q
V a r i a b l e c o s t V CA V C = =
Q u a n t i t y Q
T o t a l c o s t T CA T C = =
Q u a n t i t y Q
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Marginal Cost
Marginal Cost (MC)
Increase in total cost from producing one moreunit or output
QTCMC !
MC curve is U-shaped
When MPL rises, MC fallsWhen MPL falls, MC rises.
MPL rises and then falls, MC will fall and then rise.
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Example
Firm's SR Cost Function, C = f (Q): C = $270 + (30 Q + .3 Q2)
FC VC
where Q is thousands of units and C arethousands of dollars.
Dividing all terms by Q, we have ATC:
ATC = (270 / Q ) + (30 + .3Q)
AFC AVC As Q increases, AFC steadily decreases and AVC
rises. At low levels of Q,AFC dominates; at high levelsof Q, AVC dominates, and the combination of the two
effects explains the U-shaped ATC.
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SMC = d TC / d Q = 30 + .6Q MC rises as Q increases.
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SR Relationship Between
Production and Cost Add
marginal
cost to thetable
Total
Input
(L) Q MP
TVC
(wL) MC
0 0 0
1 1,000 1,000 500 0.502 3,000 2,000 1,000 0.25
3 6,000 3,000 1,500 0.17
4 8,000 2,000 2,000 0.25
5 9,000 1,000 2,500 0.50
6 9,500 500 3,000 1.00
7 9,850 350 3,500 1.43
8 10,000 150 4,000 3.33
9 9,850 -150 4,500
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Q
P
Average FixedCosts:will be high for small rates ofoutput (as total fixed costs aredivided by few units), but willalways decline with output (astotal fixed costs are divided
by more and more units).
Total FixedCosts:do not vary with output;hence, they are the samewhether output is set to100,000 units or 0.
Q
P
AFC
TFC
Short-Run Cost Curves
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Q
P
Average Total Costs:
will be a U-shaped curve sinceAFCwill be high for small ratesof output andMCwill be highas the plants productioncapacity (q) is approached.
Marginal Costs:rise sharply as the plants
production capacity (q) isapproached.
Q
P
MC
qATC
q
Short-Run Cost Curves
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Output and Costs
In the Short Run
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Shape of the ATC Curve The ATCcurve is U-shaped.
ATCis high for an underutilized plantbecause AFC is high.
ATCis high for an over-utilized plantbecause MC is high.
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TFC
TCTVC
0
Totalcosts
42
50
100
150
200
6 8 10
TCTVCTFCOutput
per day
2
468
10
0
25
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152
total fixe
dcosts are flat they are constant at all output levels.
Output
=+
50
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50
50
75
92114148
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total variable costs increase asmore variable inputs are utilized.
As total costs are the combination ofTVCand TFC, they are everywherepositive and increase sharply with output
Short Run Total Cost Curves
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AFC
Costper unit
42 6 8 10Output
20
40
60
AVCTVCOutput
per day=/
AVC
012
468
10
----
15.0012.50
10.5010.6712.2515.20
01525
426498
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The average variable cost curve (AVC)
is the total variable cost (TVC) dividedby the output level. It is higher eitherfor a few or a lot of units and has someminimal point between the two where,when graphed later, marginal costs (MC)will cross.
Short Run Cost Curves
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ATCTCOutput
per day=/
0
1
2468
10
----
65.00
37.5023.0019.0018.50
20.20
When output is low, ATCis highbecause AFCis high. Also, ATCishigh when output is large asMCgrows large when output is high.
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65
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These two relationships explain the
distinct Ushape of the ATCcurve.
The average total cost curve (ATC)
is simply TCdivided by the output.
ATC
MCalways crossesATCat its minimum point.
Short Run Cost Curves
AFC
Costper unit
42 6 8 10Output
20
40
60
AVC
MC
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Output and Costs
In the Long Run
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Costper unit
Output level
LRATC
Planning Curve The ATCcurve for the firm will depend upon the size of the plant.
Representative short-runAverage Costcurves
If the cost per unit varies according to the size of thefacility, then a Long Run Average Total Costcurve(LRATC) can be mapped out as the surface of all theminimum points possible at all the possible degrees ofscale.
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Economies OfScope
Most firms produce a variety of goods andservices, e.g. banks, Proctor and Gamble,General Mills, Walt Disney, etc.
In the production of various products, there may
likely be Economies ofScope, which are thepotential efficiencies and cost advantages ofproducing closely related goods or services.
For example, Coca-Cola has economies of scope in the
production of various beverages: different soft drinks,juices, sports drinks, iced tea, spring water, etc. A Bankhas economies of scope providing various financialservices and products such as mutual funds, checkingand savings accounts, loans, insurance, etc.
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Economies OfScope
For example: Suppose that joint productionof Q1 and Q2 is $17m. Producing each goodseparately would be $12m for Q1 and $8m forQ2, for a total of $20m. In other words, thefirm saves $3m with joint production. Or:
SC = $20m - $17m = .15 or 15%.$20m
This means that the firm saves 15% with jointproduction ($20m to $17m = -15% cost savings)
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Economies OfScope
Sources of Economies ofScope Shared activities between Q1 and Q2. Coca-Cola
can use the same bottling equipment andmachinery to produce many different beverage
lines Transfer of skills between Q1 and Q2. Coca-Cola
can use its expertise in soft drink production forother beverages, like orange juice, bottled iced
tea, bottled water, etc Consolidated sales, ordering, and delivery. Coca-
Cola can use the same sales force for all of itsbeverage lines, and can consolidate shipments of
beverages
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Costper unit
Output level
LRATCoften have segments that represent: economies ofscale, constant returns to scale, ordiseconomies of scale.
The LRATCrepresented below has a downward slopingsegment demonstrating economies of scale for that rangeof output meaning that an expansion of plant size canreduce per unit cost up to output level q.
There is also an upward sloping segment, demonstrating
diseconomies of scale meaning that an expansion in plantsize beyond output level q leads to higher per unit costs.
q
Economies of Scale Diseconomies of Scale
Different Types of LRATC
LRATCPlant ofideal size
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The LRATCbelow has a downward sloping segmentdemonstrating economies of scale, an upward sloping
segment, demonstrating diseconomies of scale, and a flatsegment, demonstrating constant returns to Scale.
Costper unit
Output levelq1 q2
Economiesof scale
Diseconomiesof scale
Constant returnsto scale
The flat region of the LRATCcurve between q1 and q2represents constant returns to scale. Any of the plantsizes in this region would be ideal because they minimize
per unit costs.
Different Types of LRATC
LRATC
Plant ofideal size
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Costper unit
Output level
LRATC
Below, the LRATCrepresented has a downward sloping
segment demonstratingEconomies of Scale for the entirerange of output, which implies that the most efficient sizeplant available would be the largest one possible.
q
Economies of scale
Plant ofideal size
Different Types of LRATC
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LearningCurve
Learning curve concept summarizes theinverse relationship between cumulativeproduction and ATC.
As cumulative production increases, ATCdeclines because of increased productivitygains, increased efficiency gains from
learning and experience.
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LearningCurve
Sources of learning: Worker skills increase over time, as they learn the
production process and become more efficientover time.
Trial-and-error and experimentation with differentmethods of production result in increasedefficiency/productivity over time. Equipment canbe redesigned and improved with experience, as
engineers learn how to produce moreefficiently. Research and development result incontinual improvements in production efficiency.
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