Managerial Economics Week 5 PDF

Managerial Cost concepts: Economics Week 5 (Sept. 2 to 8, 2024) I. Cost concepts: fixed, variable, and marginal costs. II. Cost-output relationships and economies of scale. I. Cost concepts: fixed, variable, and marginal costs. The total cost of a business is composed of fixed costs and...

Managerial Cost concepts: Economics Week 5 (Sept. 2 to 8, 2024) I. Cost concepts: fixed, variable, and marginal costs. II. Cost-output relationships and economies of scale. I. Cost concepts: fixed, variable, and marginal costs. The total cost of a business is composed of fixed costs and variable costs. Fixed costs and variable costs affect the marginal cost of production only if variable costs exist. The marginal cost of production is calculated by dividing the change in the total cost by a one-unit change in the production output level. The calculation determines the cost of production for one more unit of the good. It is useful in measuring the point at which a business can achieve economies of scale.  Marginal cost of production refers to the additional cost of producing just one more unit. Fixed costs do not affect the marginal cost of production since they do not typically vary with additional units. Variable costs, however, tend to increase with expanded capacity, adding to marginal cost due to the law of diminishing marginal returns. Fixed Cost vs. Variable Cost A fixed cost is a cost that remains constant; it does not change with the output level of goods and services. It is an operating expense of a business, but it is independent of business activity. An example of fixed cost is a rent payment. If a company pays $5,000 in rent per month, it remains the same even if there is no output for the month. A variable cost is dependent on the production output level of goods and services. Unlike a fixed cost, a variable cost is always fluctuating. This cost rises as the production output level rises and decreases as the production output level decreases.  For example, say a company owns a manufacturing plant and produces toys. The electricity bill varies as the production output level of toys varies. If no toys are produced, the company spends less on the electricity bill. If the production output of toys increases, the cost of the electricity increases. Marginal Cost of Production The marginal cost of production is an economics and managerial accounting concept most often used among manufacturers as a means of isolating an optimum production level. Manufacturers often examine the cost of adding one more unit to their production schedules. At a certain level of production, the benefit of producing one additional unit and generating revenue from that item will bring the overall cost of producing the product line down. The key to optimizing manufacturing costs is to find that point or level as quickly as possible.  Marginal cost of production includes all of the costs that vary with that level of production. For example, if a company needs to build an entirely new factory in order to produce more goods, the cost of building the factory is a marginal cost. The amount of marginal cost varies according to the volume of the goods being produced. A company with greater variable costs compared to fixed costs shows a more consistent per-unit cost and, therefore, a more consistent gross margin, operating margin, and profit margin. A company with greater fixed costs compared to variable costs may achieve higher margins as production increases since revenues increase but the costs will not. However, the margins may also reduce if production decreases. Marginal cost benefits The marginal cost of production is important to businesses when they conduct a financial analysis and include these potential benefits: 1. Assists in concentrating resources where excess marginal revenue over marginal costs are at its highest. 2. Allows for increased and decreased costs of production, which helps a company evaluate how much they pay to produce more items. 3. Helps determine when a company can achieve cost advantages through more efficient production to optimize overall operations. 4. May decrease the overall cost of making a product line. 5. Indicates whether companies should continue additional production or increase prices depending on any losses incurred. How to calculate marginal cost Before you calculate marginal cost, you should understand change in costs and change in quantity: 1. Change in costs: During production, costs may increase or decrease. This will likely occur when manufacturing needs to increase or decrease output volume. For example, if production requires two more workers to be hired to meet the output volume, then a change in costs would occur. The change in costs is determined by subtracting production costs accrued during the first output run from production costs in the next output run. 2. Change in quantity: The amount of product can increase or decrease at various points in production, and the quantities should be sufficient in order to evaluate significant changes in cost. For example, if 3,000 pairs of shoes were made in an initial production run but 10,000 more need to be made, you could calculate the change in quantity by deducting the number of shoes made in the first run from the volume of output in the second. Marginal cost formula The formula for calculating marginal cost is as follows: Marginal cost = Change in costs / Change in quantity II. Cost-output relationships and economies of scale. The cost-output relationship plays an important role in determining the optimum level of production. Knowledge of the cost-output relation helps the manager in cost control, profit prediction, pricing, promotion etc. The relation between cost and its determinants is technically described as the cost function. Where; C= Cost (Unit or total cost) S= Size of plant/scale of production O= Output level P= Prices of inputs T= Technology  Considering the period the cost function can be classified as (1) short-run cost function and (2) long-run cost function. In economics theory, the short-run is defined as that period during which the physical capacity of the firm is fixed and the output can be increased only by using the existing capacity allows to bring changes in output by physical capacity of the firm. 1. Cost-Output Relationship in the Short-Run The cost concepts made use of in the cost behavior are Total cost, Average cost, and Marginal cost. Total cost is the actual money spent to produce a particular quantity of output. Total Cost is the summation of Fixed Costs and Variable Costs. TC=TFC+TVC Up to a certain level of production Total Fixed Cost i.e., the cost of plant, building, equipment etc, remains fixed. But the Total Variable Cost i.e., the cost of labor, raw materials etc., vary with the variation in output. Average cost is the total cost per unit. It can be found out as follows.  AC=TC/Q The total of Average Fixed Cost (TFC/Q) keep coming down as the production is increased and Average Variable Cost (TVC/Q) will remain constant at any level of output. Marginal Cost is the addition to the total cost due to the production of an additional unit of product. It can be arrived at by dividing the change in total cost by the change in total output. 2. Cost-output Relationship in the Long-Run Long run is a period, during which all inputs are variable including the one, which are fixes in the short-run. In the long run a firm can change its output according to its demand. Over a long period, the size of the plant can be changed, unwanted buildings can be sold staff can be increased or reduced. The long run enables the firms to expand and scale of their operation by bringing or purchasing larger quantities of all the inputs. Thus in the long run all factors become variable. The long-run cost-output relations therefore imply the relationship between the total cost and the total output. In the long-run cost-output relationship is influenced by the law of returns to scale.  In the long run a firm has a number of alternatives in regards to the scale of operations. For each scale of production or plant size, the firm has an appropriate short-run average cost curves. The short-run average cost (SAC) curve applies to only one plant whereas the long-run average cost (LAC) curve takes in to consideration many plants. The long-run cost-output relationship is shown graphically with the help of “LCA’ curve.  To draw on ‘LAC’ curve we have to start with a number of ‘SAC’ curves. In the above figure it is assumed that technologically there are only three sizes of plants — small, medium and large, ‘SAC’, for the small size, ‘SAC2’ for the medium size plant and ‘SAC3’ for the large size plant. If the firm wants to produce ‘OP’ units of output, it will choose the smallest plant. For an output beyond ‘OQ’ the firm wills optimum for medium size plant. It does not mean that the OQ production is not possible with small plant. Rather it implies that cost of production will be more with small plant compared to the medium plant. Economies of scale Economies of scale are cost advantages realized by companies when production becomes more efficient. Companies can achieve economies of scale by increasing production while lowering per-unit production costs. Costs can be both fixed and variable.  Economies of scale are cost advantages that companies experience when production becomes efficient. This occurs when production rises at a rate faster than costs, with costs then being spread over a larger amount of goods. A business's size is related to whether it can achieve an economy of scale—larger companies will have more cost savings and higher production levels. Economies of scale can be both internal and external; internal economies are caused by factors within a single company, while external factors affect the entire industry.  The size of the business generally matters when it comes to economies of scale. The larger the business, the more the cost savings. Economies of scale can be both internal and external. Internal economies of scale are based on management decisions, while external ones have to do with outside factors. Internal functions include accounting, information technology, and marketing, which are also considered operational efficiencies and synergies.  Economies of scale are an important concept for any business in any industry and represent the cost-savings and competitive advantages larger businesses have over smaller ones. Most consumers don't understand why a smaller business charges more for a similar product sold by a larger company. That's because the cost per unit depends on how much the company produces. Internal vs. External Economies of Scale As mentioned above, there are two different types of economies of scale. Internal economies of scale: Originate within the company, due to changes in how that company functions or produces goods External economies of scale: Based on factors that affect the entire industry, rather than a single company Internal Economies of Scale Internal economies of scale happen when a company cuts costs internally, so they're unique to that particular firm. This may be the result of the sheer size of a company or because of decisions from the firm's management. There are different kinds of internal economies of scale. These include: 1. Technical: large-scale machines or production processes that increase productivity 2. Purchasing: discounts on cost due to purchasing in bulk 3. Managerial: employing specialists to oversee and improve different parts of the production process 4. Risk-Bearing: spreading risks out across multiple investors 5. Financial: higher creditworthiness, which increases access to capital and more favorable interest rates 6. Marketing: more advertising power spread out across a larger market, as well as a position in the market to negotiate External Economies of Scale External economies of scale, on the other hand, are achieved because of external factors, or factors that affect an entire industry. That means no one company controls costs on its own. These occur when there is a highly skilled labor pool, subsidies and/or tax reductions, and partnerships and joint ventures—anything that can cut down on costs to many companies in a specific industry. Performance Task #