Cost Theory: Concepts and Equations

Cost Theory concepts, equations, and examples.

INTRODUCTION

• Costs for decision-making
• Explicit and implicit costs
• Historical and current costs
• Sunk and incremental costs

Use Implicit, Current and Incremental Costs.

EXPLICIT COSTS – expenses or out-of-pocket costs (rent, raw materials, fuel, wages); normally recorded in a firm’s accounts.

However, the economic cost of using a resource is its opportunity cost, which is the cost of forgoing the next most profitable use of the resource, or the benefit that could be obtained from the next-best use involves both explicit and implicit costs.

Student considering undertaking an MBA; the relevant costs can be classified as follows:

a) Explicit Costs

fees, books, accommodation, food, transportation, recreation and entertainment etc. Not all of these may be directly related to doing an MBA, incidental costs. Money still has to made available to pay these costs.

b) Implicit Costs

noncash costs, like the salary that could have been earned, leisure time foregone (if work required on the MBA exceeds time of salaried work), and interest foregone on assets which have to be used to pay MBA expenses.

Opportunity costs would include elements of both, but are not simply the sum of the two; for example, accommodation is not an opportunity cost if the student would be in the same accommodation whether they were doing the MBA or not. Opportunity costs should be used for decision-making.

HISTORICAL AND CURRENT COSTS

(a) Historical Costs

These represent actual cash outlay and this is what accountants record and measure. This means measuring costs in historical terms, at the time they were incurred. Although this is relevant for tax purposes it may not reflect the current costs.

 

(b) Current Costs

These refer to the amount that would be paid for an item under present market conditions, often the replacement cost

SUNK AND INCREMENTAL COSTS

(a) Sunk Costs

These are costs that do not vary according to different decisions. An example was given earlier in the case of the MBA student’s accommodation; the accommodation cost was the same whether or not the student did the MBA. Often these costs refer to outlays that have already occurred at the time of decision-making.

(b) Incremental Costs

These refer to changes in costs caused by a particular decision. if the student would have to pay £6,000 for yearly accommodation doing a salaried job and £9,000 for accommodation to do the MBA, the incremental cost associated with the decision to do the MBA is £3,000.

SHORT RUN

a) CLASSIFICATION OF COSTS

FIXED COSTS – costs of using fixed factors: rent, insurance, interest, depreciation. Do not vary with output.

VARIABLE COSTS – costs of using variable factors: raw materials, labour, fuel. Vary directly with output.

b) UNIT COST

PURPOSE

• Comparison with price to determine profit
• Efficiency

c) TYPES OF UNIT COST

• Average fixed cost (AFC) = FC/Q
• Average variable cost (AVC) = VC/Q
• Average total cost (ATC) = TC/Q = AFC + AVC
• Marginal cost (MC) = ΔC/ ΔQ

d) RELATIONSHIPS WITH OUTPUT

• AFC – falls as output rises because FC becomes spread over a larger output
• MC – falls at start as output rises because of increasing returns and then starts to rise because of diminishing returns
• AVC – same as above
• ATC – same as above because it is the sum of AFC and AVC
• Note: MC intersects both AVC and ATC at their minimum points.

f) EFFICIENCY – where ATC is at a minimum – compromise between spreading FC and getting diminishing returns.

LONG RUN

a) NATURE

• All costs are variable – no fixed factors
• Unit costs affected by EOS and DOS: Cost advantages and disadvantages of being bigger
• Internal and external
• EOS = ASPECTS OF INCREASING SIZE OR SCALE THAT LEAD TO FALLING LR UNIT COSTS
• DOS = ASPECTS OF INCREASING SIZE OR SCALE THAT LEAD TO RISING LR UNIT COSTS

b) ECONOMIES OF SCALE

• Technical – increased specialisation and indivisibilities
• Managerial – larger firms can employ more specialised managers
• Marketing – buying in bulk, discounts
• Financial – easier and cheaper to borrow or raise funds

c) DISECONOMIES OF SCALE

• Technical – lower morale, problems of interdependence of operations
• Managerial – problems of communications, leading to lack of control and coordination

d) RETURNS TO SCALE

• IRTS: EOS > DOS: falling unit costs in LR: mass manufacturing, utilities
• CRTS: EOS = DOS: constant unit costs in LR: general retailing
• DRTS: EOS

  Some industries combine all 3 shapes at different ranges of output

  A PROBLEM-SOLVING APPROACH

  Five useful EQUATIONS:

  • C = a + bQ, a = FC, b = AVC = MC
  • R = PQ with P constant
  • PROFIT = R – C
  • BEO = FC/(P – AVC)
  • PCPU = P – AVC

  You need to solve in CORRECT SEQUENCE.

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