COST ANALYSIS. Semester II 2010/11

Transcription

1 COST ANALYSIS Semester II 2010/11

2 A function that defines the minimum possible cost of producing each output level when variable factors are employed in the cost minimizing manner

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4 Historical cost: The prices that were actually paid for resources used in the production process. Explicit cost: Payments made to the suppliers of goods and services. There are two types; direct or prime cost (direct traceable cost) and indirect overhead cost (common costs i.e. cannot be traced to any unit of output). Implicit cost: It is not considered, expect for depreciation

5 EXAMPLE $ Sales 2,000 Less: Expenses 1,000 Accounting profit $1,000

6 Replacement cost: The price of replacing a resource used in the production process. Explicit cost: Payments made to the suppliers of goods and services. There are two types; direct or prime cost (direct traceable cost) and indirect overhead cost (common costs i.e. cannot be traced to any unit of output). Implicit cost: Determines whether a certain business decision should or should not be taken. For example, opportunity cost.

7 It is the monetary return that would have been possible from the best alternative course of action and compare it with the monetary return on the proposed course of action. For example, you can invest $10,000 in your business and receive a return of $1,00 (10%) or invest in the open market and receive $1,400 (14%). The opportunity cost is $1,400 $1,000 = $400

8 EXAMPLE $ Sales 2,000 Less Expenses 1,000 Accounting profit $1,000 Less opportunity cost 400 Economic profit $600

9 It is a period of time within which at least one of the input is fixed while others are variable. Output can only be changed by varying the quantities of the variable inputs, for example labour. The classification of resources into fixed and variable in the short run makes it possible to specify a short run cost function.

10 Cost $ TFC Output

11 Returns to variable input measure the productivity of the variable inputs. There are four possible situations regarding the productivity behaviour of the variable inputs. These are: 1constant; 2decreasing; 3increasing; and 4increasing followed by decreasing.

12 Cost ($) TC TFC TVC Output

13 Cost ($) TC TFC TVC Output

14 Cost ($) TC TVC TFC Output

15 TC TVC Cost ($) TFC Output

16 Total cost (TC) is total fixed cost (TFC) Total Variable Cost (TVC) TC = TFC + TVC plus TFC = TC TVC TVC = TC TFC

17 Average fixed cost (AFC): equals to TFC divided by output (Q); TFC/Q. Average variable cost (AVC): equals to TVC divided by Q; TVC/Q. Average cost (AC): equals to TC divided by Q; TC/Q. Marginal cost (MC): equals to the change in TC divided by the change in Q; TC/ Q or the change in TVC divided by the change in Q TVC/ Q

18 Table TI Output TFC ($) TVC ($) TC ($) AFC ($) AVC ($) AC ($) MC ($)

19 $ 0 AFC Q

20 $ MC AC AVC 0 Q

21 SAMPLE Given: Q = Q; calculate the following: TFC; TVC; AFC; AVC; AC; and MC

22 SOLUTION TFC = TC TVC = Q 45Q TFC = $500 TVC = TC TVC = Q 500 TVC = 45Q AFC = TFC/Q = 500/Q

23 Solution (continued) AVC = TVC/Q = 45Q/Q = $45 AC = TC/Q = 500/Q + 45Q/Q = 500/Q + 45 MC = TVC/ Q = (1)45Q 1 1 = $45

24 From Figure CVI, the following is noted: MC = AVC and MC = AC; AVC and AC are at their minimum points. Based on these findings, the following conclusions can be drawn: 1 AVC is decreasing when MC is less than AVC, also when MC is greater than AVC, AVC is increasing; and 2 AC is decreasing when MC is less than AC, also when MC is greater than AC, AC is increasing.

25 1 AC is at a minimum: AC = MC or Find the first derivative of AC and let it equal to zero i.e. AC/ Q = 0 2 AVC is at a minimum: AVC = MC or Find the first derivative of AVC and let it equal to zero i.e. AVC/ Q = 0 3 MC is at a minimum: Find the first derivative of MC and let it equal to zero i.e. MC/ Q = 0

26 Planning is an integral part of management. The planning process, sometimes, involve the appraisal of special nonrecurring decisions/ projections. A nonrecurring decision or special project usually requires a firm to make special changes to its current activity. For example special order, produce in house, outsourced and discontinue a product. Evaluation of a special project is based on cost concepts which fall under the heading of incremental analysis. There are two components to incremental analysis: incremental revenue and incremental cost. The difference is contribution and on the strength of the contribution a course of action is taken.

27 $ P 5 P 4 MC AC AVC P 3 P 2 P 1 Q 1 Q 2 Q 3 Q 4 Q 5 Quantity

28 From Figure CVII P < AVC; discontinue to minimize loss. P = AVC; no difference to continue or discontinue. P > AVC or (P <AC); continue in the short run, however, if this situation does not change in the long run, discontinue the business. P = AC; earn normal profit. P > AC; earn economic profit.

29 In this presentation, we first compared the cost analyses of accountants and economists. We then discussed the relationship between the rate of output and the level of cost. In the short run cost functions, we discussed four possible scenarios regarding returns to variable inputs: constant, decreasing, increasing and increasing followed by decreasing. We also examined incremental analysis and shutdown analysis (briefly).