ESTIMATION OF COST FUNCTION

MANU NAIR ROLL NO : 23 MBA (FT), SEM: 1 S.M.S , CUSAT

COST FUNCTION

Cost function expresses the relationship between cost and cost determining factors. In mathematical form, it is expressed as, C=f (S,O,P,T,E)

DETERMINANTS OF COST FUNCTION

The main determinants of a cost function are:

Plant size Output level prices of inputs used in production nature of technology managerial efficiency

INFLUENCE OF EACH FACTORS ON COST

Plant Size Plant size is an important variable in determining cost The scale of operations or plant size and the unit cost are inversely related. Such a relationship gives downward slope of cost function depending upon the different sizes of plants taken into account.

Output Level Output level and total cost are positively related. As the total cost increases with increase in output and total cost decreases with decrease in output This is because increased production requires increased use of raw materials, labour, etc.

Price of Input

Changes in input prices influence cost, depending on the relative usage of the inputs and relative changes in their prices. the cost of production varies directly with the prices of production.

Technology: Technology is a significant factor in determining cost. improvement in technology increases production leading to increase in productivity and decrease in production cost. cost varies inversely with technological progress.

Managerial efficiency

More the managerial efficiency less the cost of production. Managerial efficiency is inversely related to cost of production

ESTIMATION OF COST FUNCTION

Three most important and commonly used method for measurement of cost function are:

Accounting Method Engineering Method Econometric Method

ACCOUNTING METHOD
The cost-output relationship is estimated by classifying the total cost into fixed, variable and semi-variable costs. fixed, variable and semi-variable costs all are determined on the basis of inspection and experience Total cost, Average cost and marginal cost for each level of output can then be obtained through simple arithmetic procedure.

Drawbacks: Detailed breakdown of accounts kept on same basis over a period of years. Experience with wide range of fluctuations in output rate to come up with accurate estimates.

ENGINEERING METHOD
Based directly on the physical relationship of inputs to output and uses the price of inputs to determine costs. What will be cost behaviour in future on basis of capacity of equipments, modified by experience with manpower requisites and efficiency factors, with past cost behaviour.

Note: This method is more relevant in short run. Useful when old data are difficult to be found. This method requires a sound understanding of engineering and a detailed sampling of the different processes under controlled conditions.

ECONOMETRIC METHOD
Cost function are estimated on basis of statistical analysis. uses multiple correlation analysis to find the functional relation between changes in cost and cost determinants. It picks the fixed cost element in cost components and shows whether the marginal cost is constant or variable with changes in cost determinants.

Most scientific method. Very expensive Time consuming

LONG RUN COST FUNCTION

Long run cost functions are used in planning firms investment decisions

To determine the extent of economies and diseconomies of the scale in order to select optimal plant size.

SHORT RUN COST FUNCTION

Short run cost function are estimated to help managers to determine optimal pricing policies for the company.

Used to determine marginal cost of producing additional units of output.

Estimation of Long-Run Cost Functions

Techniques used:

Regression Analysis
Engineering cost method Survivor Technique

Regression Analysis in L-R Cost Estimation

Mostly with cross-sectional data

Pluses:

since data comes from different firms, quantity of output can vary over relatively wide ranges.
All data from same point of time, so technology will not change Do not have to regard price changes

Regression Analysis in L-R Cost Estimation Contd

Minuses:
Interregional cost differences

All firms not necessarily operating at optimal level of technology

Cost may be recorded differently in different firms Different companies may pay their cost factor differently

Engineering Cost Method

Based on understanding of inputs and outputs and their relationship

In this approach, the analysis begins with an engineering production function: optimal production input combinations for producing any given level of production is identified. Cost can be obtained by multiplying each level of input usage by current price of input and summing over the inputs.

Engineering Cost Method Contd

Pluses:
technology held constant no problem with inflation (current input prices) Less error from measurement

Minuses:
cost estimation are normative only direct output costs are estimated often made based on pilot plant operations, not actual production.

Survivor Technique
This method, suggested by G.Stigler, bases its findings on the change in the proportion of total industry output produced by firms of different size categories.
Look at company size that is successful in an industry!

Used for deciding optimal plant size.

Survivor Technique Continued

Pluses:
Simple Avoids unreliable data

Minuses:
No help in measuring cost for planning purposes Just tell which company size appears to be more efficient Implicitly assume that the industry is highly competitive, so survival and prosperity are solely a function of efficient use of resources, not the market power or erection of barriers of entry.

Shapes of Short Run Cost Functions

Cubic cost function:

A cubic cost function represents the normal theoretical cost function, which exhibits both decreasing marginal and average costs and increasing marginal and average cost.

Cubic Cost Functions continued

TC = a + bQ - cQ + dQ AC = a/Q + b - cQ + dQ MC = b - 2cQ + 3dQ

CUBIC COST FUNCTIONS

TC

QUADRATIC COST FUNCTION

If data does not fit to a cubic cost function, we can try to fit it in a quadratic one. Quadratic cost function: TC= a + bQ + cQ AC = a/Q + b + cQ MC = b + 2cQ

Linear Cost Function

Also a linear total cost function can be fitted. Then the three functions get the following form
TC = a + bQ AC = a/Q + b MC = b

CONCLUSION
In order to make rational policies regarding cost in an organization, one should know the relation between cost and cost determining factors. For this empirical analysis of cost function is required.