Chapter 7 :

The Theory of
Estimation of Cost
SG 4 Business Economics – SLEMBA BPOM 01
Group Member :
1. Andina Liestyanti
2. Dyah Meita Retno Murti
3. Edi Priyo Yunianto
4. Imam Luqman Hakim
5. Jazari Alfaridi
6. Perdhana Ari Sudewo
7. Rahma Yulianti
 • The best decisions related to business strategy
can be taken by paying attention to the efficiency
and effectiveness of the use of company costs,
especially those related to costs that are relevant
and irrelevant to be issued.
The • Over this past decade, companies recognize that
they still require people to run their operations.
Importance of So the idea is not to reduce labor as much as it is
to optimize labor by reconfiguring where the labor
Cost in being used is located and how it is organized
Managerial • More companies trying to cut costs by :
reducing their assets (often referred to in
Decisions the popular press as an “asset-light”
strategy)
to merge and consolidate
• Achieve the minimal average cost (fixed cost and
variable cost) to achieve maximum output (Q)
 Both economists and managerial or cost accountants use the concept of
relevant cost when analyzing business problems and recommending
solutions. A cost is considered to be relevant if it is affected by a management
decision. Any cost not affected by a decision is considered irrelevant.
1. Historical Versus Replacement Cost
a. Historical cost, occurs during procurement or production
b. Replacement cost, which is required when replacing inventory, or
The Definition following cost developments after procurement
According to relevant cost principle, the firm should use the amount that
has an impact on the alternatives being considered
and Use of 2. Opportunity Cost Versus Out-of-Pocket Cost
a. Opportunity cost, the cost when we decide to choose one thing and
Cost in miss another opportunity. Used in decision making from a strategic
point of view with a broader perspective.

Economic b. Out-of-pocket costs (often called accounting costs), which are costs
incurred by the company. Used in decision making with
consideration of the company's financial condition, whether it is over
Analysis or not.
On occasion, economists refer to opportunity cost as indirect cost or
implicit cost, and refer to out-of-pocket cost as direct cost or explicit cost.
4. Sunk Versus Incremental Cost
a. Incremental cost, which is the cost that varies with the various
options available in a decision
b. Sunk cost, the cost that must be incurred by the company because
of the decrease in inventory value over time
The Relationship Between Production and Cost
• In the production process, costs are needed, especially in variable input in the production
process. Costs are influenced by total production and input prices
• The formula used in the analysis of the relationship between production and cost:
MC = ΔTVC / ΔQ (if no fix cost) or MC = ΔTC / ΔQ
MC = Marginal Cost
MP = Marginal Product
TVC = Total Variable Cost
Q = Output (Total Production)
TC = Total Cost
L = Input (Variable Cost)
W = Wage Rate
• MP = ΔQ/ΔL
• Relationship between MC dan MP
Assumption: 40-hour work week and
the weekly wage rate (W) is $500
When MP is increasing, its MC of production is decreasing, vise versa
The Relationship Between Production and Cost
• The cost function used in economic analysis is
simply the production function expressed in
monetary rather than physical units.
• Furthermore, all the limiting assumptions used in
specifying the short-run production function apply
to the short-run cost function.
• The only additional assumption needed to
determine the short-run economic cost function
pertains to the prices of the inputs used in the
production process

When the total product (Q) increases at an increasing rate,

total variable cost (TVC) increases at a decreasing rate. When
Q increases at a decreasing rate, TVC increases at an
increasing rate. Plotting these numbers on a graph makes it
quite apparent that total variable cost is a “mirror image” of
total product
The Short-Run Cost
Function
• Quantity (Q ): The amount of output that a firm can produce in the short run.
(Total product is also used in reference to this amount.)
• Total fixed cost (TFC): The total cost of using the fixed input K.
• Total variable cost (TVC): The total cost of using the variable input L.
• Total cost (TC): The total cost of using all the firm’s inputs (in this case, L
and K).
• Average fixed cost (AFC): The average or per-unit cost of using the fixed
input K.
• Average variable cost (AVC): The average or per-unit cost of using the
variable input L.
• Average total cost (AC): The average or per-unit cost of using all the firm’s
inputs.
• Marginal cost (MC): The change in a firm’s total cost (or, for that matter, its
total variable cost) resulting from a unit change in output.
 The assumptions for Table 7.2 above :
The Short-Run 1. The firm employs two inputs, labor and capital.
Cost Function 2. The firm operates in a short-run production period. Labor is its variable input, and
capital is its fixed input.
3. The firm uses the inputs to make a single product.
4. In producing the output, the firm operates at a given level of technology. (Recall
that in our discussion of the short-run production function, we assumed the firm
uses state-of-the-art technology in the production process. The same holds when
we talk about short run cost.)
5. The firm operates at every level of output in the most efficient way.
6. The firm operates in perfectly competitive input markets and must therefore pay
for its inputs at some given market rate. In other words, it is a price taker in the
input markets.
7. The firm’s underlying short-run production function is affected by the law of
diminishing returns.
The Short-Run Cost Function Figure 7.2 (b)
Figure 7.2 (a)
• Output increases from 0 to 12
• Total fixed cost, as expected, remains constant at $100 over the range
of output.
• Total variable cost increases at a decreasing rate, but when the fourth
unit of output is produced, it starts to increase at an increasing rate.
The same is true for total cost.
Figure 7.2 (b)
• When marginal cost is equal to average variable cost, the latter measure is
at its minimum point. (This occurs at 4 units of output.)
• When marginal cost is equal to average cost, average cost is at its
minimum point. (This occurs at 6 units of output.)
• As long as marginal cost is below average variable cost, average variable
cost declines as output increases. However, when marginal cost exceeds
average variable cost, average variable cost starts to increase. The same
relationship holds between marginal cost and average total cost
The Short-Run Cost Function
Increasing Cost Efficiency in the Short
Run
• AC_min -> input which is used most
efficiently in a particular production function
• Assumes the firm is already operating as
best it can with state-of-the-art technology,
the only possibility to reduce cost in the
short run is for the inputs to decrease in
price. Graph a, changes in input prices will
shift the cost curve. If the fixed input costs
are reduced (e.g., rental payments), the AC
will shift downward. AVC and MC are not
affected.
• Graph b, changes in input prices will shift
the cost function. If the variable input costs
decrease (e.g., a reduction in wage rates
or raw materials costs), then MC <AVC
and AC will shift downward. Minimum MC′
and AVC′ occur at the same output levels
as MC and AVC, but minimum AC′ occurs
at a larger output level than AC.
The Long-Run Cost Function
The Relationship Between Long-Run Production and Long-Run Cost
• All costs of production are variable, there are no fixed cost
• Exercise for analysis of long run production and long rung cost

As output increases, total cost increases, but not at a constant rate. The rate of change of the
long-run total cost function is called the marginal cost (long-run marginal cost). In looking at
the long-run marginal cost column in Table 7.3 and Figure 7.5, we see that this measure at
first decreases, then is constant, and finally increases over the range of the output.
The Long-Run Cost
Function
The hypothesize is that a firm’s long-run production function
may at first exhibit increasing returns, then constant returns,
and finally decreasing returns to scale expect a firm’s
long-run cost to change in a reciprocal fashion

When a firm experiences increasing returns to scale, an

increase in all its inputs by some proportion results in an
increase in its output by some greater proportion. Assuming
constant input prices over time, this means that if the firm’s
output increases by some percentage, its total cost of
production increases by some lesser percentage

Figure 7.6 the reciprocal behavior of long-run cost and

long-run production
 The Long-Run Cost Function
Short-Run Vs Long-Run Fungtions

Although the long-run cost function appears to exhibit the same pattern of behavior as the short-run cost function,
the reasons for their respective patterns are entirely unrelated. The short-run cost function is affected by increasing
and diminishing returns to individual factors, a phenomenon that is assumed to take effect when at least one of the
inputs is held constant, and the long-run function is affected by increasing and decreasing returns to scale, a
phenomenon assumed to take effect when all the firm’s inputs are allowed to vary
Economies of Scale
Figure 7.8 illustrates a typical U-shaped average cost curve reflecting the different
types of scale economies that a firm might experience in the long run
Observe long-run average cost from Table 7.3. This variable is the key indicator of
a phenomenon called economies of scale (or increasing returns to scale [IRTS]).
If a firm’s long-run average cost declines as output increases, the firm is said to be
experiencing economies of scale. The smallest output where minimum LRAC is
achieved is called minimum efficient scale (MES or MinES)
If long-run average cost increases as output increases, this is a sign of
diseconomies of scale (or decreasing returns to scale [DRTS]). The largest output
level for which minimum LRAC is achieved, called maximum efficient scale
(MaxES).
There is no special term to describe the situation in which a firm’s long-run average
cost remains constant as output increases or decreases. We say that such a firm
experiences efficient scale (or constant returns to scale [CRTS]) over a range of
outputs.
The Long-Run Average Cost Curve as the
Envelope of Short-Run Average Cost
• Once a firm commits itself to a certain level of capacity, it must consider at least one
of the inputs fixed as it varies the rest. In terms of production cost, this means that
once a capacity level is decided on, the firm must work with a short-run cost function
• The points labeled a through f represent the levels of output and average cost
shown in Table 7.3
• Short-run average cost (SRAC) curves for the larger plants are positioned to the
right of the curves for smaller ones, indicating greater production capacity. But,
plants with larger capacities are greatly influenced by economies and diseconomies
of scale. Because of the impact of economies of scale, plant B’s SRAC curve is
positioned below and to the right of plant A’s, so the minimum point of B’s SRAC
curve is lower than that for A. The same can be said for plant C and D.
• Because of the impact of diseconomies of scale, plant E’s SRAC curve is positioned
above and to the right of D’s, and the same can be said for plant F
• The minimum SRAC points for all the plants are marked with asterisks.
• The asterisk marking plant B’s minimum short-run average cost depicts a level
above the average cost that would be incurred by plant C in the short run for a
comparable level of production. If a firm wants to produce between 20,000 and
30,000 units of output per month, it would be better off using the manufacturing
capacity provided by plant C than to try to increase the usage of the smaller plant B.
We can see that the firm’s long-run average cost curve
is actually the envelope of the various short-run average
cost curves. As the number of choices of plant size
approaches infinity, the envelope becomes a
continuous version.
The Long-Run Cost Function
Using Long-Run Average Cost as a Decision-Making Tool: The Importance of
Coordinating Production Plans with Market Forecasts
Long-run cost analysis can help
for picking the best level of
long-run capacity on the market
forecasters. Certainly, optimal
long-run production decisions
require a balanced contribution
from both the engineers and the
marketing people.

Because diseconomies of scale take effect when plant E is used, plant D is

appropriate for output levels on the downward-sloping (from c to d) and
upward-sloping part of its SRAC (from d to e) Figure 7.9

The penalty for selecting the inappropriate level of capacity is the incurrence of
unnecessary cost, whether the actual demand turns out to be above or below the
range used as a basis for the firm’s decision on long-run production capacity. In
Figure 7.11, we can see that if the firm had decided to build plant B and the demand
turned out to be 25,000, it would lose on a per-unit basis the amount depicted by the
arrow. If demand were such that it required the firm to produce only 5,000 units per
month, the firm would suffer a similar type of loss
 • Learning Curve: line showing the relationship between labor cost
and additional units of output.
• Downward slope indicates additional cost per unit declines as the
level of output increases because workers improve with practice.

The • Measured in terms of percentage decrease in additional labor

cost as output doubles.
Yx = Kxn
Learning Yx = Units of factor or cost to produce the xth unit

Curve unit
K = Factor units or cost to produce the Kth (usually first)

x = Product unit (the xth unit)

n = log S/log 2
S = Slope parameter
The Learning Curve
Although the learning curve is expressed in terms of the
marginal cost of production, the impact of improving with
practice can also be seen in terms of the decline in
average cost. Table 7.6 also shows the cumulative labor
cost and the cumulative average labor cost of producing
various levels of output. As can be seen, the average
labor cost also decreases, although not as sharply as the
marginal labor cost. In any case, the learning curve effect
clearly has an impact on the short-run cost presented
earlier. In particular, the learning curve effect causes the
short-run average cost curve to shift downward. This is
shown in Figure 7.13.
The Learning Curve
• The use of learning curve in
driving down the cost frequently
cited by Japanese
• The particular use of learning
curve involve accelerating
production experience through
aggressive price cutting measures
• The price cuts add sales and give
the production faster
 • Economies of Scope: reduction of a
firm’s unit cost by producing two or
Economies of more goods or services jointly rather
Scope than separately.
• Closely related to economies of scale.
Supply Chain Management

• Supply Chain Management (SCM): efforts by a firm to improve efficiencies through each link of a
firm’s supply chain from supplier to customer.
• Includes all internal and external activities required to fulfill a customer’s demand.
• Transaction costs are incurred by using resources outside the firm.
• Coordination costs arise because of uncertainty and complexity of tasks.
• Information costs arise because information is essential to the proper coordination of activities
between the firm and its suppliers.
• Ways to develop better supplier relationships
• Strategic alliance: firm and outside supplier join together in some sharing of resources.
• Competitive tension: firm uses two or more suppliers, thereby helping the firm keep its purchase
prices under control.
Examples of • The Strategic Use of Cost
Ways • Reduction in Cost of Materials
Companies • Using Information Technology to Reduce
Costs
Have Cut • Reduction of Process Costs
Costs • Relocation to Lower-Wage Countries or
to Remain Regions
• Mergers, Consolidation, and Subsequent
Competitive Downsizing
• Layoffs and Plant Closings