Chapter 4: Cost Analysis

Contents
• Different cost concepts
• The Concept of Opportunity cost
• Explicit and Implicit Costs
• Sunk Costs
• Short-Run Cost Analysis
• Long-Run Cost Analysis
• Optimal Plant Size
• Scale and Scope Economies
• A Firm’s Break-Even Volume and Operating Leverage: A simple Analysis
Chapter 4: Cost Analysis

Different cost concepts

Opportunity cost
𝐴𝑚𝑜𝑢𝑛𝑡 sacrificed
• Opportunity cost: the benefit lost when one alternative is selected over another. Opp. cost = 𝐴𝑚𝑜𝑢𝑛𝑡 𝑔𝑎𝑖𝑛𝑒𝑑

Explicit and Implicit Costs

• Explicit cost: out-of-pocket costs/actual Birr payment made
• Implicit costs: opportunity cost of resource firms own. Example, owner could earn Birr 12, 000 as Nurse,
implicitly foregone to run a firm. Economic (opportunity) costs include explicit cost and implicit costs.

Sunk Costs
• Cost incurred by past decision, can`t be undone, Irrelevant for decision making
• Example: marketing campaign expenses, research and development expense, training expense
Chapter 4: Cost Analysis

Short – run cost analysis

• Total cost of production (TC) is divided into two parts, total fixed cost (TFC) and
total variable cost (TVC), 𝑇𝐶=𝑇𝐹𝐶+𝑇𝑉𝐶
• In short run, at least one inputs is fixed in supply & its price constitutes the fixed cost.
• Fixed cost is defined as that cost which does not vary with the output.
• Example: depreciation of machinery or building
• Variable cost is the cost that varies with the quantity of output produced.
• Example: cost of labor, cost of raw material, running expenses.
Chapter 4: Cost Analysis
Short – run cost analysis
Fixed cost Variable cost
Chapter 4: Cost Analysis

Total fixed cost

Total cost
Costs based on
Total Variable cost
Short
production
Average fixed cost
run cost
period
Average cost Average variable
cost
Marginal cost
Long run total cost
Long run Long run Average cost
cost Long run marginal cost
Chapter 4: Cost Analysis

Short – Run Cost Analysis Short Run Cost Curves

Short run cost functions

• 𝑻𝑪 = 𝒇 𝑸 = 𝑻𝑭𝑪 + 𝑻𝑽𝑪
𝑻𝑪 𝑻𝑭𝑪 𝑻𝑽𝑪
• 𝑨𝑪 = = + = 𝑨𝑭𝑪 + 𝑨𝑽𝑪
𝑸 𝑸 𝑸
• 𝑨𝑭𝑪 = 𝑻𝑭𝑪/𝑸
• 𝑨𝑽𝑪 = 𝑻𝑽𝑪/𝑸
• 𝑴𝑪 = ∆𝑻𝑪/∆𝑸
Chapter 4: Cost Analysis

Short – run cost analysis

Example 1: fill the missing data.
Q TFC TVC TC AFC AVC AC MC
0 60 -
1 60 20
2 60 43
3 60 48
4 60 67
5 60 90
6 60 132
Chapter 4: Cost Analysis

Long – run cost analysis

• In the long run all inputs are variables
• A firm attempts to maximize long run profits by selecting a short run production technology (or
scale of plant) that minimizes cost.
• The firm has to very carefully decide the short run plant size it wants to build on the basis of the
future demand of the product, developments in technology and changes in the price of inputs
• The LAC shows the average cost of production when all factors are in variable supply.
• The LAC curve is derived from the short run AC (SAC) curves.
• The firm has infinite methods of production available in the LR, each represented by a d/t plant
size.
• Each plant size is represented by a different SAC curve.
 Chapter 4: Cost Analysis

Long – run cost analysis

• For 𝑄 < 𝑂3, LAC curve is tangent to Optimal plant size

the SAC curves to the left of their
minimum points.
• For 𝑄 > 𝑂3, LAC is tangent to the
SAC curves to the right of their
minimum points.
• At 𝑄 = 𝑂3, LAC is tangent to SAC3
at its minimum point, E. Point E is
minimum point of LAC curve also.
• The plant size whose costs are
denoted by SAC3 is called the
optimum scale of plant
Chapter 4: Cost Analysis

Economies of scale and scope

Economies of scale
• Economies of scale are the cost advantages that a business can exploit by
expanding their scale of production in the long run.
• It is classified into internal economies and external economies.
Economies of scope
• It is the cost advantage due to the production of two or more distinct
products, using the same operation
Chapter 4: Cost Analysis

A Firm’s Break-Even Volume and Operating Leverage: A

simple Analysis

A Firm’s Break-Even Volume

• It is the level of sales that causes profits to equal zero.
• It is the unit sales required for earnings before interest and taxes (EBIT) to be
equal to zero. This point is often referred to as the operating breakeven point.
𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
• The break even quantity is given by 𝑄 =
𝑝𝑟𝑖𝑐𝑒−𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡
Chapter 4: Cost Analysis

A Firm’s Operating Leverage

• Operational leverage is a measure of the degree
to which a firm or project can increase operating
income by increasing revenue.
𝐐(𝐏−𝐕)
• 𝐃𝐎𝐋 =
𝐐 𝐏−𝐕 −𝐅
where, Q is number of unit, P is the price
per unit, V is the variable cost per unit and F is fixed costs.
(𝑻𝑹−𝑽𝑨𝑹𝑰𝑨𝑩𝑳𝑬 𝑪𝑶𝑺𝑻𝑺)/𝑻𝑹
• 𝑫𝑶𝑳 =
(𝑻𝑹−𝑽𝑨𝑹𝑰𝑨𝑩𝑳𝑬 𝑪𝑶𝑺𝑻𝑺−𝑭𝑰𝑿𝑬𝑫 𝑪𝑶𝑺𝑻)/𝑻𝑹
Chapter 4: Cost Analysis

A Firm’s Operating Leverage

• Example: Dega Bottled Water purifying company sells 10,000 product
units at an average price of Birr 50. The variable cost per unit is Birr 12, while
the total fixed costs are Birr 100,000. The management of Dega Bottled Water
purifying company wanted to determine the company’s current degree of
operating leverage. What is the company’s DOL?
• Solution: DOL = 1.357
• The DOL indicates that every 1% change in the company’s sales
will change the company’s operating income by 1.357%.
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The End