MANAGERIAL
th
ECONOMICS 11 Edition
By
Mark Hirschey
Cost Analysis and
Estimation
Chapter 9
Chapter 9
OVERVIEW
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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
Chapter 9
KEY CONCEPTS
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historical cost
current cost
replacement cost
opportunity cost
explicit cost
implicit cost
incremental cost
profit contribution
sunk cost
cost function
short-run cost functions
long-run cost functions
short run
long run
planning curves
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operating curves fixed cost
variable cost
short-run cost curve
long-run cost curve
economies of scale
cost elasticity
capacity
minimum efficient scale
multiplant economies of scale
multiplant diseconomies of scale
learning curve
economies of scope
cost-volume-profit analysis
breakeven quantity
What Makes Cost Analysis
Difficult?
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Link Between Accounting and Economic
Valuations
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Historical Versus Current Costs
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Accounting and economic costs often differ.
Historical cost is the actual cash outlay.
Current cost is the present cost of previously
acquired items.
Replacement Cost
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Cost of replacing productive capacity using
current technology.
Opportunity Cost
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Opportunity Cost Concept
Opportunity cost is foregone value.
 Reflects second-best use.
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Explicit and Implicit Costs
Explicit costs are cash expenses.
 Implicit costs are noncash expenses.
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Incremental and Sunk Costs in
Decision Analysis
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Incremental Cost
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Incremental cost is the change in cost tied to
a managerial decision.
Incremental cost can involve multiple units of
output.
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Marginal cost involves a single unit of output.
Sunk Cost
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Irreversible expenses incurred previously.
Sunk costs are irrelevant to present decisions.
Short-run and Long-run Costs
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How Is the Operating Period Defined?
At least one input is fixed in the short
run.
 All inputs are variable in the long run.
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Fixed and Variable Costs
Fixed cost is a short-run concept.
 All costs are variable in the long run.
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Short-run Cost Curves
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Short-run Cost Categories
Total Cost = Fixed Cost + Variable Cost
 For averages, ATC = AFC + AVC
 Marginal Cost, MC = ∂TC/∂Q
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Short-run Cost Relations
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Short-run cost curves show minimum
cost in a given production environment.
Long-run Cost Curves
Economies of Scale
 Long-run cost curves show minimum
cost in an ideal environment.
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Cost Elasticity and Economies
of Scale
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Cost elasticity is εC = ∂C/C ÷ ∂Q/Q.
εC < 1 means falling AC, increasing
returns.
 εC = 1 means constant AC constant
returns.
 εC > 1 means rising AC, decreasing
returns.
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Long-run Average Costs
Minimum Efficient Scale
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Competitive Implications of Minimum
Efficient Scale
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MES is the minimum point on the LRAC curve.
Competition is most vigorous when:
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MES is small in absolute terms.
MES is a small share of industry output.
Disadvantage to less than MES scale is
modest.
Transportation Costs and MES
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Terminal, line-haul and inventory costs can be
important.
High transport costs reduce MES impact.
Firm Size and Plant Size
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Multi-plant Economies and Diseconomies
of Scale
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Multi-plant economies are cost advantages
from operating several plants.
Multi-plant diseconomies are cost
disadvantages from operating several plants.
Economics of Multi-plant
Operation: an Example
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Plant Size and Flexibility
Learning Curves
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Learning Curve Concept
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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
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When learning results in 20% to 30% cost
savings, it becomes a key part of competitive
strategy.
Economies of Scope
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Economies of Scope Concept
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Scope economies are cost advantages that
stem from producing multiple outputs.
Big scope economies explain the popularity of
multi-product firms.
Without scope economies, firms specialize.
Exploiting Scope Economies
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Scope economics often shape competitive
strategy for new products.
Cost-volume-profit Analysis
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Cost-volume-profit Charts
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Cost-volume-profit analysis shows effects of
varying scale.
Breakeven analysis shows zero profit points of
cost coverage.
Degree of Operating Leverage
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DOL=Q(P-AVC)/[Q(P-AVC)-TFC]
DOL is the elasticity of profit with respect to
output.