COST THEORY AND ANALYSIS To get on top of their task, managers have to have a good concept of costs and

how these costs will vary as output changes. This topic examines how economists define costs, which is different from the accounting definition, so that it can be a useful concept for business decision making. The topic concludes with a discussion of the estimation of cost curves and a brief examination of three extensions of cost theory (profit contribution analysis, break-even analysis, and operating leverage) for priceoutput decision making. Accounting versus Economic Costs Costs in any Income Statement (or Statement of Financial Performance or Profit and Loss Statement) reflect the accountant's concept of costs and are underpinned by accrual accounting, which emphasiss acquisition costs (generally historical costs). According to economists, historical costs are not necessarily appropriate for making business decisions. They advocate the use of opportunity costs because they measure the actual costs of the resources. The opportunity cost of an activity (e.g., building an office building) is the payoff (in this case, it is measured by the revenue generated) associated with the best alternative activity (e.g., building 10 houses) that is forgone. Since accountants and economists have different views on the treatment of costs, the accounting costs of an activity may not correspond to its economic costs. Short-Run Cost In the short run, technology is constant, i.e. f ( ) discussed in Topic 4, and at least one input is fixed (usually capital K). The cost incurred by a fixed input is known as fixed cost (FC) while the cost incurred by a variable input is known as variable cost (VC). The short-run total cost (TC) of production is the sum of fixed and variable costs, TC = FC + VC Students should aware that . . If there is no production in the short run, the fixed cost is still incurred to the firm and TC = FC. . The line dividing fixed and variable costs is often fuzzy. Some costs may be semi-fixed. For example, all the Lorries of a transport firm carry up to two tons. The costs of lorries is fixed within the intervals (0,2), (2, 4), (4,6), so on and so forth, but is variable between these intervals. Average Costs Average fixed cost (AFC) is total fixed cost divided by output, i.e. AFC = FC Q Average variable cost (AVC) is total variable cost divided by output, i.e. AVC(Q) = VC(Q) Q Therefore, average total cost (ATC) is the sum of average fixed cost and average variable cost, i.e. ATC(Q) = AFC + AVC(Q) Marginal Cost Marginal cost (MC) is the addition to total cost attributable to the addition of one unit to output, i.e. MC = DTC DQ Short-Run Total Cost Functions

Recall that the firm's objective is to minimize cost given the required output and the input prices. Once the optimal amount of variable inputs is determined, the short-run total cost associated with the required output is known. Therefore, it is the convention to write the short-run total cost function as a function of output. In doing so, the shortrun total cost function is able to measure the lowest possible total cost of producing different levels of output given the fixed input. TC(Q) = FC + VC(Q) A specific short-run total cost function describes the exact relationship between output and costs. The specific short-run total cost function that gives us regular U-shaped AC, AVC, and MC curves is a cubic function of output: TC(Q) =aQ3 + bQ2 + cQ + d, where a, c, d > 0, b < 0 and b2 < 3ac. Note that .. The cubic function is a 'S-shaped' function. .. The AFC is a rectangular hyperbola regardless of the specification of the TC curve. Examples: TC = 0.1Q3 - 3Q2 + 60Q + 100 TC = 0.5Q3 - 2Q2 + 111Q + 1000 Long-Run Cost Recall that the definition of the long run is a period of time of such length that all inputs are variable. However, you should not forget that it is more important to treat the long run as a planning horizon. Relationship between short run and long run cost curves If Q1 is the planned output level, then the smaller factory with SAC1 is selected. Once the plant size is selected, in this case SAC1, the firm has to operate at point A on SAC1 in the short run. If output increases to Q2, its cost increases slightly from CA to CG. Note that the firm can lowers its cost by operating at point H of the larger factory (with SAC2) and lowers its production cost to CH. The long-run average cost curve (LAC) is the envelope curve, tracing the lower boundary of all short-run cost curves, e.g., AJH in Figure 5.1. The limiting case of a LAC with infinite number of SAC's also turns out to be a U-shaped curve, see Figure 5.2. Note that LMC stands for long-run marginal cost curve and it cuts the LAC at its minimum. Economies of Scale Economies of scale refers to the ability of a firm to perform an activity at a lower unit cost (i.e., AC) when it is performed on a larger scale at a particular point of time. Economies of scale are more likely to occur in capital-intensive production process where standardisation is possible. Categories of Economies of Scale There are three types of economies of scale: Inter-plant single-product (or firm-specific) economies of scale Intra-plant single-product (or plant-specific) economies of scale Product-specific economies of scale We can discuss the first and the second type of economies of scale together; interplant applies to LAC while intra-plant applies to SAC.

When the LAC is declining (LAC > LMC), we say that the firm is experiencing inter-plant economies of scale or positive inter-plant economies of scale.

When the LAC is flattening out, (LAC = LMC), we say that the firm is experiencing inter-plant constant economies of scale. When the LAC is rising (LAC < LMC), we say that the firm is experiencing inter-plant diseconomies of scale or inter-plant negative economies of scale. The degree of inter-plant economies or diseconomies of scale is measured by the ratios: This analysis can be applied to a single plant (i.e. a single SAC) to examine the intraplant or plant-specific economies of scale. Suppose the firm produces more than one product in its facility. The analysis applied to inter-plant and intra-plant economies of scale is not applicable. The singleproduct economies of scale cannot be simply extended to measure product-specific economies of scale. The economies of scale of the i-th product in a joint production involve the calculation of average incremental cost (AICi) and the marginal cost of the i-th product MCi). Conceptually, the product-specific economies of scale of the i-th product is measured by Si where Compare this equation with those of the inter-plant and intra-plant economies of scale measures. Minimum Efficiency Scale (MES) and Optimal Production such that it has a flat bottom and form a 'L-shaped' curve, Point A indicates the minimum efficiency scale (MSE), which indicates the smallest scale of production at which minimum costs per unit are attained. Point B is the maximum efficiency scale that indicates the scale of production where inefficiency sets in both points are determined by the technology available to the industry. Theoretically, the optimal scale of production should occur between MES and maximum efficiency scale. Practically, the optimal scale of production is jointly determined by economies of scale and the extent of the market. Learning Curves Learning can also affect the cost structure of a product; workers and managers improve their performance on specific tasks as they gain experience in production. The first evidence of learning was documented in the 1930s in the airframe industry where the unit labour costs in airframe production declined with cumulative output. Suppose the cost for the first q1 unit of a new product is AVC1, as shown in the first panel of Figure 5.4. As the workers and managers gain experience, cost of output decline to, say, AVC2 for the second Q1 unit. We can plot the two sets of numbers to yield the learning curve for doubling output. Theoretically, a learning curve is expressed as a power function: AVCQ = aQb Where AVCQ is the cost of producing Q-th unit of output, a is the cost of producing the first unit of output and -1 < b < 0 is the experience elasticity of cost reduction. The experience elasticity of cost reduction measures the percentage change in AVC for every one per cent increase in cumulative output. The magnitude of learning benefits is often expressed in term of a progress ratio (r), which is defined as the ratio of average costs as cumulative output doubled: Note that r = 1 implies no learning, and 0 < r < 1 implies learning. Differences Between Economies of Scale and Learning Here are the differences:

Economies of scale refer to the ability to perform an activity at a lower unit cost, i.e. AC, when it is performed on a larger scale at a particular point of time. .. Learning refers to the reductions in unit variable cost, i.e. AVC, due to accumulating experience on the organization of production and production technique over time. Economies of scale are more likely to occur in capital-intensive production processes where standardization is possible while learning is more likely to occur in labour-intensive processes. However, the two can occur at the same time. Economies of Scope Economies of scope are most prevalent in the joint production of different variants of the same basic product (e.g., different variants of the same model of passenger car). The concept is developed in the early 1980s and economies of scope is said to present whenever it is less costly to produce two products jointly than it is to produce them separately. The degree of scope economies ( ) for a two-product case is given by the ratio: SC = C(x) + C(y) - C (x,y) C(x,y) Where C(x) is the cost of producing product X, C(y) is the cost of producing product Y, and C(x,y) is the cost of producing both products jointly. When 0 < SC < 1, there is the presence of economies of scope. Applications of Cost Theory Cost functions are essential to effective business decision making about prices and output. There are three extensions worth mentioning: Profit contribution analysis Break-even or cost-volume-profit analysis .. Operating leverage Profit contribution analysis examines the contribution of additional sales to gross operating profits. Break-even analysis focuses on the calculation of the output level that gives zero profit. Operating leverage examines the effect of the use of fixed assets in production process on the output elasticity of profit. Profit Contribution and Break-even Analysis The difference between price (p) and AVC is defined as profit contribution margin (PCM): PCM = p - AVC At low rates of output, profit contribution may not even cover fixed costs. Only after fixed costs are covered (i.e. breakeven), that the firm is earning a profit. Technically, we can examine the two analyses together. The profit equation is written as: p = TR - TC = pQ - [(AVC Q) + FC] = PCM Q - FC Suppose the firm has a required profit (pR) level to attain, the required output (QR) is:

QR = FC + pR PCM For a given PCM, the higher the required profit, the higher the required output. That is, required profit and required output are positively related. Similarly, given the required profit, the required output and PCM are negatively related. To calculate the break-even output, set pR = 0, and Qb = FC PCM Operating Leverage A firm is said to be highly leveraged if fixed costs are large relative to variable costs, which in turn implies that changes in profit are highly responsive to changes in output. High operating leverage usually occurs when the production process is highly capital intensive. A firm's degree of operating leverage (DOL) is defined as: DOL = PCM Q PCM Q - FC Note that the larger the FC, the smaller is the denominator and the higher the value of DOL. This means that a highly leveraged firm has a large break-even output because DOL = Q = Q Q - Qb Q FC PCM Estimation of Cost Functions The estimation of short-run and long-run cost functions involves different techniques. The usual procedure of estimating a short-run cost function of a particular plant at a particular point of time is to estimate the following cubic function using the costoutput data collected: TC(Q) = aQ3 + bQ2 + cQ2 + d with MC(Q) = 3aQ2 + 2bQ + c And ATC(Q) = aQ2 + bQ + c + dQ-1 As for the estimation of a long-run cost function, one can estimate the same cubic function using the cost-output data of a plant over time provided that the scale has changed sufficiently. The problem with this procedure is that the time period is probably long enough for production technology and input prices to have changed as well. Therefore, a better method is to use cross-sectional cost-output data collected on a sample of various-sized plants (employing the same production technology) at a given point of time to mimic the various SAC's. Some economists advocate the use of survivor technique to estimate the LAC of an industry. This approach, though simple to follow, has its shortcomings. It does not yield the entire LAC curve. It only helps to estimate the efficient plant size (for same cost structure and homogenous product) or a range of efficient plant sizes (for different cost structures and differentiated products) of an industry.

CAPITAL BUDGETING The process of determining whether or not projects such as building a new plant or investing in a long-term venture are worthwhile. Popular methods of capital budgeting include net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF), and payback period. Capital Budgeting is the process by which the firm decides which long-term investments to make. Capital Budgeting projects, i.e., potential long-term investments, are expected to generate cash flows over several years. The decision to accept or reject a Capital Budgeting project depends on an analysis of the cash flows generated by the project and its cost. The following three Capital Budgeting decision rules will be presented: A Capital Budgeting decision rule should satisfy the following criteria: . Must consider all of the project's cash flows. . Must consider the Time Value of Money . Must always lead to the correct decision when choosing among Mutually Exclusive Projects. Of these three, only the Net Present Value and Internal Rate of Return decision rules consider all of the project's cash flows and the Time Value of Money. As we shall see, only the Net Present Value decision rule will always lead to the correct decision when choosing among Mutually Exclusive Projects. This is because the Net Present Value and Internal Rate of Return decision rules differ with respect to their Reinvestment Rate Assumptions. The Net Present Value decision rule implicitly assumes that the project's cash flows can be reinvested at the firm's Cost of Capital, whereas, the Internal Rate of Return decision rule implicitly assumes that the cash flows can be reinvested at the projects IRR. Since each project is likely to have a different IRR, the assumption underlying the Net Present Value decision rule is more reasonable.