Cost Analysis PDF

COST 1  Cost In a business firm cost are half of the picture, the other half is sales/total revenue. The most important equation of any business firm 2  Fixed Cost Stay the same no matter how much output c...

COST 1  Cost In a business firm cost are half of the picture, the other half is sales/total revenue. The most important equation of any business firm 2  Fixed Cost Stay the same no matter how much output changes. Sometimes called sunk costs because once you’ve obligated yourself to pay them, that money 2 TYPES: has been sunk into your firm. Variable Cost Varies with output. When output rises, variable costs rise; when output falls, variable costs fall. 3  Fixed Cost examples: Rent Insurance premiums Salaries of employees Property taxes Interest payments 2 TYPES: Depreciation allowances on plant and equipment Variable Cost examples: Wages (if you cut back output, you lay off some of these people) Fuel (when output changes, you vary your fuel bill) Raw materials 4 Some costs can have a component or part that is fixed and part that is variable Examples: ▪ Electricity ▪ Phone Bill 5 Total Cost ▪ Sum of fixed cost and variable cost. ▪ The increase in total cost is due to the increase in variable cost. 6 Total Cost OUTPUT FIXED VARIABLE TOTAL COST COST COST 1 1,000 400 1,400 2 1,000 700 1,700 3 1,000 1,100 2,100 4 1,000 1,700 2,700 5 1,000 2,700 3,700 6 1,000 4,500 5,500 7 1,000 7,500 8,500 7  Marginal Cost ▪ The cost of producing one additional unit of output. OUTPUT FIXED VARIABLE TOTAL MARGINAL COST COST COST COST 1 1,000 400 1,400 400 2 1,000 700 1,700 300 3 1,000 1,100 2,100 400 4 1,000 1,700 2,700 600 5 1,000 2,700 3,700 1,000 6 1,000 4,500 5,500 1,800 7 1,000 7,500 8,500 3,000 8 The Short Run & The Long Run The present time is always the short run 9  Short Run Length of time it takes all fixed costs to become variable costs 10  Long Run ▪ Is the time at which all costs become variable costs. ▪ It never exists except in theory. You never really reach it. 11 Toward the end of the short run… You decide whether you’re going to stay in business or go out of it. 12 Average Cost 13  You’re interested in selling hot dogs at the beach. There are dozens of other hot dog vendors, each of whom charges $1.50 for each hotdog. You add up all your costs, including the rent for a cart, CASE STUDY ingredients, etc. Your total cost is $250 and you expect to sell 200 hot dogs a day. ▪ How much is your average cost per hotdog? ▪ It’s $1.25. So, you’d make a 0.25¢ profit on each hotdog. ▪ If your TC came to $300? ▪ AC= $1.50. you will not have profit. 14  Average Fixed Cost Gets progressively smaller as output rises because we are Output (Q) FC AFC dividing larger and larger and larger… outputs 1 1,000 1,000 (denominator) into Fixed Costs (numerator) that stays 2 500 the same. 3 333.33 4 250 5 200 15  Average Variable Cost It declines for a while as output increases. Eventually, Output (Q) VC AVC however, AVC will level off and begin to rise. 1 500 500 2 800 400 3 970 323.33 4 1,050 262.5 5 1,500 300 16  Average Total Cost Like AVC, ATC declines with output for a while but Output (Q) TC ATC eventually levels off and then begins to rise. 1 1,500 1,500 2 1,800 900 3 1,970 656.67 4 2,050 512.5 5 3,400 680 17 Output FC VC TC MC AFC AVC ATC 1 1,000 500 1,500 500 1,000 500 1,500 2 800 1,800 300 500 400 900 3 1,000 2,000 200 333.33 333.33 666.67 4 1,300 2,300 300 250 325 575 5 1,700 2,700 400 200 340 540 6 2,400 3,400 700 166.67 400 566.67 18 19 ▪ IDEAL IMAGE 20  The Production Function and the Law of Diminishing Returns 21 ▪ A business owner tries to keep their costs down by getting the maximum output from using the best combination of the factors of production (L, La, k, E) by using different production function. 22 Production Function Is the relationship between the maximum amounts of output a firm can produce and various quantities of inputs. 23 What would be the maximum number of workers you would hire? Number of Total Output Marginal Workers Output 0 0 0 1 2 2 2 5 3 3 9 4 4 12 3 5 14 2 6 15 1 7 15 0 8 14 -1 9 11 -3 24 25 26 Law of Diminishing Returns ▪ As successive units of a variable resource are added to a fixed set of resources, beyond some point, the extra, or marginal product attribute to each additional unit of the variable resource will decline. 27 Example: Farming the same size of land with increasing number of workers 28  Economies of Scale Economies of mass production ▪ Large scale enterprise is expected to be more efficient than small ones. ▪ Economies of being advantaged. ▪ Spreading fixed cost ▪ Adam Smith’s Pin Theory 29  Economies of Scale Large scale enterprise is expected to be more efficient than small ones. ▪ A wholesaler has much lower prices than a retailer 30  Economies of Scale Economies of being advantaged. ▪ Brand name becomes a household name 31  Economies of Scale Spreading fixed cost ▪ As you produce more goods, your fixed costs are spread out over a greater amount of production, reducing the unit cost of each product. 32  Economies of Scale Adam Smith’s Pin Theory ▪ Specialization ▪ Division of Labor Worker 2: Worker 4: Worker 6: Raw Straightens Sharpens Packages Material Wire Wire Wire Worker 1: Worker 3: Worker 5: Draws Wire Cuts Wire Adds Head 33 Diseconomies of Scale Inefficiencies that become endemic in large firms. 34 Decision Making 35  Operate It will yield the highest possible profits. If it is losing money, it will operate at that output at which Short Run losses are minimized Shut Down Its output is zero but there is still fixed cost 36 A firm will operate in the short run when total revenue exceeds variable costs. TR>VC A firm will shut down when variable costs exceeds total revenue TRTC, it will stay in business. If the firm’s TR