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Cost theory 214

more uncertain than a decision to switch suppliers, or invest in new

machinery, or close a plant.

Just as with production theory, the distinction between short run and long

run is an important one. In the short run, managers are concerned with

determining the optimal level of output to produce from a given plant size

or plant sizes, for a multiplant firm!, and then planning production accord"ingly, in terms of the optimal input of the variable factor, scheduling and so on.

In the long run, all inputs are variable so the most fundamental decision the

firm has to ma#e is the scale at which to operate. $he optimal scale is the one

that is the most efficient, in economic terms, for producing a given output.

Cost analysis is made comple% because there are many different definitions

and concepts of cost, and it is not always straightforward to determine which

costs to use and how to measure them in a particular situation. $he focus here

is on the relevant costs for decision"ma#ing. In order to clarify this aspect

the following four distinctions are important.

&.1.2 '%plicit and implicit costs

'%plicit costs can be considered as e%penses or out"of " poc# et costs r ent, r aw

materials, fuel, wages!( they are normally recorded in a firm)s accounts.

*owever , the economic cost of using a resource is its opportunity cost, which

is the cost of forgoing the ne%t most profitable use of the resource, or the benefit

that could be obtained from the ne%t"best use. $his involves both e%plicit and

implicit costs. +et us ta#e the e%ample of a student considering underta#ing

an -( the r elevant costs can be classified as either e%plicit costs or implicit

costs.

'%plicit costs include fees, boo#s, accommodation, food, transportation,

rec" reation and entertainment and so on. /ot all of these may be directly

related to doing an -, the last category for e%ample, so they can be

regarded as inci" dental costs. oney still has to be made available to pay

these costs.

Implicit costs are non"cash costs, li#e the salary that could have been

earned, leisure time forgone if wor# re0uired on the - e%ceeds the hours

of salar ied wor#!, and interest forgone on assets which have to be used to pay- e% penses.

1pportunity costs would include elements of both, but are not simply the

sum of the two( for e%ample, accommodation is not an opportunity cost if the

student would be in the same accommodation whether they were doing

the - or not. 1pportunity costs should be used for decision"ma#ing pur"

poses, meaning ma#ing the fundamental decision whether to do the - or

not. $hese costs then have to be compared with the e%pected benefits, mone"

tary and non"monetary, of underta#ing an - programme. $his does not

mean that the other costs are unimportant( they are still relevant in cash

planning.

&.1. *istorical and current costs

*istorical costs represent actual cash outlay and this is what accountants record

and measure. $his means measuring costs in historical terms, at the time they

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Cost theory 213

were incurred. lthough this is relevant for ta% purposes it may not reflect the

current costs.

Current costs refer to the amount that would be paid for an item under

pr esent mar#et conditions. ften current costs e%ceed historical costs,

particularly with inflation. In some situations, for e%ample I$ e0uipment,

current costs tend to be below historical costs because of rapid improvementsin technology. In this case the item being costed may no longer be available,

and the appropriate cost is the replacement cost. $his is the cost of

duplicating the productive capability of the item using current technology.

4 eplacement cost is the relevant cost f or decision"ma#ing. $he following

e%ample illustrates this principle.

ssume that Clearglass Conservatories is offered a contract to build a

con" servatory at a property, at a price of 5&6,666. $he labour costs are 546,666

and the materials necessary to complete the 7ob are already in inventory,

valued at the historical cost of 513,666. If the 7ob is accepted, Clearglass, asan ongoing concern, will have to replace the materials, but the price of these

has risen, so the current cost is 522,666. If Clearglass uses historical cost to cost

the 7ob they will accept it, e%pecting to ma#e a profit of 53,666. $hey should,

however, re7ect it since they will really ma#e a loss of 52,666. $his can be seen

more clearly if we consider what happens if they accept the 7ob and then

restore their inventory to the previous level. $hey will end up receiving

5&6,666 and paying out 5&2,666 546,666 for labour and 522,666 for materials!,

thus losing 52,666.

&.1.4 8un# and incremental costs

8un# costs are costs that do not vary according to different decisions. n e%ample

was given earlier in the case of the - student)s accommodation( the accom"

modation cost was the same whether or not the student did the -. ften

these costs refer to outlays that have already occurred at the time of decision"

ma#ing, li#e the cost of mar#et research conducted before deciding whether to

launch a new product.

Incremental costs refer to changes in costs caused by a particular decision.

9sing the same e%ample, if the student would have to pay 54,666 for yearly

accommodation doing a salaried 7ob and 5&,666 for accommodation to do the

-, the incremental cost associated with the decision to do the - would

be 52,666 assuming simplistically that there are no other costs or benefits

related to the differences in accommodation!. Incremental costs are the rele"

vant costs for decision"ma#ing.

&.1.3 :rivate and social costs

:rivate costs refer to costs that accrue directly to the individuals performing a

particular activity, in other words they are internal costs. ;or private firms

these are the only costs that are relevant, unless there are ethical consider"

ations see Chapter 12!.

8ocial costs also include e%ternal costs that are passed on to other parties,

and are often difficult to value. ;or e%ample, motorists cause pollution

and

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Cost theory 21&

congestion which affect many other people this is the economic 7ustification

for fuel duties, which are an attempt to internalize these e%ternalities, as seen

in Chapter 12!. $herefore when a resource li#e oil or petrol is used there are

both internal and e%ternal costs. $he social costs are the sum of the two,

meaning the total cost to society of using a resource being careful not to

double"count any duties!. 8ocial costs are relevant for public policy decision"ma#ing. In this situation the techni0ue of cost"benefit analysis is often

used. *owever, since we are largely concerned with managerial decision"

ma#ing, social costs and cost"benefit analysis will not be e%amined here.

&.1.& 4elevant costs for decision"ma#ing

;or private firms it has been shown above that it is the opportunity costs, the

replacement costs and the incremental costs that are relevant. $hese concepts

are all illustrated in the following case study.

Case study &.1< -rewster oofing

r -rewster operates a roofing company in +ondon

and has been as#ed by the local government

authority of erton to repair the roofs of several of

their properties damaged in a recent storm. $he 7ob

must be completed during the ne%t four wee#s

twenty wor#ing days!, and erton has offered

51&,666 for the 7ob. r -rewster has estimated that

the 7ob re0uir es seventy"five wor# days, but he can

only use his regular three wor#ers for the 7ob

because it is a very busy period for the industry as a

whole. ;ortunately,

r -rewster)s son, =ill, can ta#e time off from his

regular 7ob paying 5>6 per day! to help complete

the wor#. r -rewster has estimated that, for his

regular employees, the cost per wor# day is 5136. $his

consists of a wage of 5166 which is only paid if the

employee is wor#ing! and 536 in contributions to

the government which are paid annually regardless

of how many days the em ployees wor# !.

-rewster oofing has all the e0uipment necessary

for the 7ob and has some of the materials available in

inventory. $he materials cost 53,666 originally, but

these costs have since increased by an average of 3

per cent. dditional materials costing 5,666 are also

re0uired.

r -rewster has costed the 7ob as follows<

evenue 51&,666Costs+abour 5?,666

aterials 5>,666$otal costs 51@,666:rofit 51,666!

n the basis of the above analysis r -rewster re7ects

the 7ob.

Auestions

1 :repare a revised cost estimate for the 7ob, ta#ing

into account opportunity costs, replacement costs

and incremental costs. ssume that r -rewster

considers the 7ob from the viewpoint of a family business, including himself and his son together.

2 dvise r -rewster regarding whether he should

accept the 7ob, stating any assumptions involved in

your analysis.

&.1.@ 8ummary of cost concepts

8everal points emerge from the above discussion of costs<

1 $here is not always a right and a wrong way to use cost concepts. $he rightcosts for decision"ma#ing are not the right costs for estimating ta% liability

and vice versa.

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2 anagers must be very careful in using cost information prepared by

accountants, since it has been collected and categorized for different

purposes.

$he determination of costs is not always purely ob7ective( this is particularly

true of implicit costs, where a considerable degree of 7udgement is often

re0uired.

&.2 8hort"run cost behaviour

anagers want to #now the nature of the cost functions pertaining to their

firm for the following reasons<

1 $o ma#e pricing decisions B this aspect is considered in Chapters > and 16.

2 $o determine the appropriate levels of other factors in the mar#eting mi% B this is considered in Chapters ? and 16.

$o forecast and plan for the costs and input levels associated with a given

level of output.

&.2.1 Classification of costs

It was seen in Chapter 3 that the short run in economic terms is defined as

the period during which at least one factor of production is fi%ed and others

are variable. $his leads to a further classification of costs, into fi%ed costs

and variable costs.;i%ed costs are related to the fi%ed factors and do not vary with output in the

short run. '%amples are rent, insurance, interest payments, and depreciation

if estimated on a time basis!. $hese costs may vary in the short run, for

e%ample if the interest rate rises, but not because of a change in output.

;i%ed costs have to be paid even if output is zero for any period, for e%ample

when there is a stri#e.

ariable costs are related to the variable factors and vary directly with output.

$his was assumed in some of the analysis in Chapter , for e%ample in $able .4

relating price changes to profit. '%amples of variable costs are raw materials,wages, depreciation related to the use of e0uipment, and some fuel costs.

In practice a clear distinction between fi%ed and variable costs is not always

possible( some costs, li#e fuel above, may have fi%ed and variable elements.

1ther costs, li#e administrative salaries, may be fi%ed over a certain output

range, but if output e%ceeds the range an increase in staff may be re0uired,

thus increasing costs.

&.2.2 $ypes of unit cost

anagers are often more interested in units costs than in total costs, for the

following reasons<

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