The Nature of Costs Analysis for a Garage Business

By:
•The Nature of
Costs
Joseph Oloba
jose.oloba@gmail.com
joloba@livingstone.ac.ug
+256785552288
+256700552288

Case Review:
• A garage business had an old car that it bought
several months ago. The car needed a replacement
engine before it can be driven.
• It is possible to buy a reconditioned engine for £300.
It would take seven hours for the engine to be fitted
by a mechanic who is paid £12 an hour.
• At present the garage is short of work, but the
owners are reluctant to lay off any mechanics or
even to cut down their basic working week, because
skilled labour is difficult to find and an upturn in
repair work is expected soon.
• The garage paid £3,000 to buy the car. Without the
engine it could be sold for an estimated £3,500.
• What is the minimum price at which the garage
should sell the car with a reconditioned engine
fitted?

A definition of Cost:
• Cost may be deﬁned as the amount of
resources, usually measured in monetary
terms, sacriﬁced to achieve a particular
objective.
• The objective might be to retain a car, to buy
a particular house, to make a particular
product, or to render a particular service.
• Cost means the amount of expenditure
(actual or notional) incurred on, or
attributable to, a given thing.

Cost Accounting = Costing + Cost Reporting + Cost Control.
 COST ACCOUNTING: The Institute of Cost and Management Accountant, England (ICMA) has
defined Cost Accounting as – “the process of accounting for the costs from the point at which
expenditure incurred, to the establishment of its ultimate relationship with cost centers and cost
units. In its widest sense, it embraces the preparation of statistical data, the application of cost
control methods and the ascertainment of the profitability of activities carried out or planned”.
 Cost accounting is concerned with recording, classifying and summarizing costs for
determination of costs of products or services, planning, controlling and reducing such costs and
furnishing of information to management for decision making
Cost Accounting:

Product Cost Information:
• External parties—stockholders, creditors, and
regulators
• For investment and credit decisions
• Complies with GAAP
• Enterprise focus
• Internal parties
• Planning, controlling, and decision making
• Evaluating performance
• Includes upstream and downstream costs
• Disaggregated

Nature of Costs:
• There are accounting costs which an entrepreneur
takes into account in making payments to the
various factors of production.
• Explicit costs are the payments to outside suppliers
of inputs.”
• Implicit costs are the imputed value of the
entrepreneur’s own resources and services.
• According to Salvatore, “Implicit costs are the value
of owned inputs used by the firm in its own
production process.”

Entrepreneurial Costs:
• Owners of the firm are entitled to the
difference between revenue and costs
which is generally called (accounting)
profit.
• However, if they incur opportunity costs
for their time or other resources supplied
to the firm, these should be considered a
cost of the firm.
7

From Production to Cost:
 Production concepts examine the amount of
input(s) needed to produce a given output.
 Cost concepts examine the cost of the inputs
needed to produce a given output.
 Thus cost concepts combine production
concepts with input prices.

Short-Run Cost Measures:
 Fixed cost (F): production expense that does not vary
with output.
 Variable cost (VC): production expense that changes
with quantity of output produced.
 Total cost (C):
C = VC + F

Average Cost Concepts:
 Average fixed cost:
AFC = F /q
 Average variable cost:
AVC = VC /q
 Average (total) cost:
AC = C/q = AFC + AVC

Marginal Cost:
 Marginal cost, MC, is the cost of producing the last
unit
 MC is the change in cost, C, when output changes
by q
 That is, MC = C/q

Sunk Fixed Cost:
 We usually assume fixed cost is sunk, i.e., expenditure that
cannot be recovered.
 The opportunity cost of capital is zero
 because you can't get this expenditure back no matter what you do.
 So ignore it when making decisions
 Example: walk out of a bad movie early, regardless of what
you paid to attend
 Otherwise, fixed cost is called avoidable.

Long-Run Costs:
 A firm adjusts all its inputs so its cost of
production is as low as possible.
 If capital and other variable costs can be
varied, LR fixed costs equal zero (F = 0).
 Thus LR total cost = LR variable cost:
C = VC

Value Chain:
• Research and
Development
• Product Design
• Supply
• Production
• Marketing
• Distribution
• Customer
Service
Communicate strategy to all members of the value
chain.
 A set of value-adding functions and
processes that converts inputs into
products or services

Components of the Value Chain:

Balanced Scorecard
Perspectives:
• Learning and Growth
• Use the organization’s intellectual capital to adapt to
changing customer needs or to influence new customers’
needs and expectations through product or service
innovations
• Internal Business
• Things to do well to meet customer needs and
expectations
• Customer Value
• How well the organization is doing relative to important
customer criteria
• Financial
• Address stockholders/stakeholders concerns about
profitability and organizational growth

Balanced Scorecard
Measures:
•Short-term and long-
term
•Internal and external
•Financial and
nonfinancial

Nature of costs:
In the production process many fixed and variable factors
are used.
1. Total Variable Costs – Those expenses of production
which change with the change in the firm’s output.
Larger outputs require larger inputs of labour, raw
materials, power, fuel etc.
2. Total Fixed Costs – These are supplementary costs and
are those costs of production which do not change with
the change in productivity. They are rent and interest
payments, depreciation charges, wages and salaries of
permanent staffs etc.

Nature of costs:
The Cost function
• The cost function expresses a functional relationship
amidst total cost and factors that determine it.
• Usually the factors that determine total cost of
production (C) of a firm are the productivity (Q), the
level of technology (T), the prices of factors (Pt) and
the fixed factors (F).
It is expressed as follows.
• C = f (Q, T, Pf, F)

Nature of costs:
The Traditional Theory of Costs
• The traditional theory of costs analyses the behaviour of cost curves in
the shortrun and long run and arrives at the conclusion that both the
short run and long run cost curves are U shaped but the long run cost
curves are flatter than the short run cost curves.
• TC = TFC + TVC
• Total Costs – These are those expenses incurred by a firm in
producing a given quantity or a commodity. They include payments for
rent, interest, wages, taxes and expenses on raw materials, electricity,
water, advertising etc.
• Total Fixed Cost – These costs of production that do not change with
output. They are independent of the level of output.
• Total Variable Costs – These costs of production that change directly
with productivity. They rise when output increases and fall when
output declines.

Nature of costs:
• Short run average costs – In the short run analysis of the firm average
costs are more important than total costs. The units of productivity
that a firm produces do not cost the same amount to the firm.
• Short run average variable Costs – These are equal total variable
costs at each level of output divided by the number of units produced.
SAVC = TVC / Q.
• Short Run Average Total Costs – These are the average costs of
producing any given output. They are arrived at by dividing the total
costs at each level of output by the number of units produced. The
shape of these curves is U shaped. SAC or SAVC = TC / Q = (TFC / Q)
+ TVC / Q = AFC + AVC
• Short run Marginal Cost – A fundamental concept for the
determination of the exact level of output of a firm is the marginal
cost. Marginal Cost is the addition to total cost by producing an
additional unit of output.

Nature of costs:
• The LAC falls or rises more slowly than the SAC curve because in the
long run all costs become variable and few are fixed.
• The plant and equipment can be worked fully and more efficiently so
that both the average variable costs are lower in the long run than in
the short run.
• That is why the LAC curve is flatter than the SAC curve.
• In the short run, the market cost is related to both the fixed and
variable costs.
• As a result the SMC curve falls and rises more swiftly than the LMC
curve.
• It first calls and is below the LAC curve.
• Then it rises and cuts the LAC curve at its lowest point E and is above
the latter throughout its length

Nature of costs:
• Cost = amount of resources, usually measured in monetary
terms, sacrificed to achieve a particular objective.
Relevant and irrelevant costs
• l Relevant costs must – relate to the objective being pursued by
the business – differ from one possible decision outcome to the
next.
• l Relevant costs therefore include – opportunity costs –
differential future outlay costs.
• Irrelevant costs therefore include – all past (or sunk) costs – all
committed costs – non-differential outlay costs.
• Qualitative factors of decisions l Financial/economic decisions
almost inevitably have qualitative aspects that ﬁnancial
analysis cannot really handle, despite their importance.

Building-Block Concepts
of Costing Systems:
Cost object
Direct costs
of a cost object
Indirect costs
of a cost object

of Costing Systems:
Cost Assignment
Direct
Costs
Indirect
Costs
Cost Tracing
Cost Allocation
Cost
Object

of Costing Systems:
Cost pool
Cost allocation base

Costing Systems:
Actual costing is a system that uses actual costs
to determine the cost of individual jobs.
It allocates indirect costs based on the actual
indirect-cost rate(s) times the actual quantity
of the cost-allocation base(s).

Costing Systems:
Normal costing is a method that allocates
indirect costs based on the budgeted
indirect-cost rate(s) times the actual
quantity of the cost allocation base(s).

Normal Costing:
Assume that the manufacturing company budgets
$60,000 for total manufacturing overhead costs
and 2,400 machine-hours.
What is the budgeted indirect-cost rate?
$60,000 ÷ 2,400 = $25 per hour
How much indirect cost was allocated to Job 650?
500 machine-hours × $25 = $12,500

Normal Costing:
What is the cost of Job 650 under normal costing?
Direct materials $50,000
Direct labor 19,000
Factory overhead 12,500
Total $81,500

Cost Classification – On the
Basis of:
• Nature
• Function
• Direct & indirect
• Variability
• Controllability
• Normality
• Financial accounting classification
• Time
• Planning and control
• Managerial decision making

Cost Effects of $10 Tax:
 This tax affects variable but not fixed cost
 After-tax (a) cost = before-tax (b) cost + 10q:
Ca = Cb + 10q
 At every quantity, AVC, AC, and MC curves shift up by
$10:
AVCa = AVCb + $10
ACa = ACb + $10
MCa = MCb + $10

On the Basis of Nature:
 Materials
 Labour
 Expenses

On the Basis of Function:
Manufacturing costs
Commercial costs – ADM and S&D Costs
Direct costs
Indirect costs
On the Basis of Direct and Indirect:

On the Basis of Variability:
 Fixed costs
 Variable costs
 Semi variable costs

On the Basis of Controllability:
 Controllable costs
 Uncontrollable costs
Normal costs
Abnormal costs
On the Basis of Normality:

On the Basis of Financial
Accounts:
 Capital costs
 Revenue costs
 Deferred revenue costs

On the Basis of Time:
 Historical costs
 Pre determined costs
Budgeted costs
Standard costs
On the Basis of Planning and Control:

On the Basis of Managerial Decision
Making:
Marginal costs
Out of pocket
costs
Sunk costs
Imputed costs
Opportunity costs
Replacement
costs
Avoidable costs
Unavoidable
costs
Relevant and
irrelevant costs
Differential costs

Terms in Cost Accounting:
Cost unit
 Cost centre
 Cost estimation
 Cost ascertainment
 Cost allocation
 Cost apportionment
 Cost reduction
 Cost control

Methods of Costing:
 Job costing
 Contract costing
 Batch costing
 Process costing
Unit costing
 Operating costing
 Operation costing
 Multiple costing

Types of Costing:
Uniform costing
Marginal costing
Standard
costing
Historical
costing
Direct costing
Absorption
costing

Calculation of various cost:
Direct Materials
Opening stock of materials
Add Purchases of materials
Less Closing stock of materials
(a) Materials consumed
Direct Wages
Direct Expenses ------ ------
PRIME COST
Add Factory Overheads
Factory rent, rates, taxes Fuel-power and water Lighting and Heating Indirect wages Depreciation, Repairs
Salaries of Works Manager etc. Indirect Materials
Drawing office and works office expenses Depreciation on factory land and building Less Scrap value
Defective work
Add Work in progress (opening)
Less Work in progress (closing) ------
WORKS COST
Add Office/Administration overheads
Office rent, insurance, lighting, cleaning
Office salaries, telephone, law and audit expenses
General Manager’s salary
Printing and stationery
Maintenance, repairs, upkeep of office bldg
Bank charges and miscellaneous expenses ------
COST OF PRODUCTION
Add Opening stock of finished goods
Less Closing stock of finished goods ------
COST OF GOODS SOLD
Add Selling and Distribution Overheads
Showroom expenses, salesmen’s salaries
& commission, bad debts, discounts, warehouse rent, carriage outwards, advertising, delivery expenses, samples and free gifts etc.
COST OF SALES
Add Net Profit or deduct net loss: ------ SALES ------

Basic Concepts of Costs:
• An opportunity cost can be deﬁned as the value in
monetary terms of being deprived of the next best
opportunity in order to pursue the particular objective.
• Opportunity cost is the cost of a good or service as
measured by the alternative uses that are foregone by
producing the good or service.
• If 15 bicycles could be produced with the materials used to
produce an automobile, the opportunity cost of the
automobile is 15 bicycles.
• The price of a good or service often may reflect its
opportunity cost.
• An outlay cost is an amount of money that will have to
be spent to achieve that objective.

MBA = = massive bonuses
absent:
• MBA = = massive bonuses absent By 2008, the slowdown in business in the City (of
London) had an effect on the level of recruitment on MBA (Master of Business
Administration) courses.
• When business in the City is booming, many of the people who might be attracted to
undertake an MBA feel that the cost of doing so is too great.
• When financial markets slow down, the demand for MBA courses tends to pick up.
• According to Professor Alan Morrison of the Said Business School, University of
Oxford, when city bonuses fall, ‘the opportunity cost of doing an MBA is reduced’.
Source: Tieman, R., ‘Demand hots up despite cool market’,
Financial Times, 16 June 2008.

Basic Concepts of Costs:
• Accounting cost is the concept that goods or services cost
what was paid for them.
• Accounting costs–the costs that appear on firm
accounting statements –are explicit costs that have
incurred in the past. –Since these costs are used to pay
taxes and to assess the financial health of the firm to
outsiders
• Economic cost is the amount required to keep a resource
in its present use; the amount that it would be worth in
its next best alternative use.
• Economic costs are the sum of the explicit and implicit
opportunity costs. –Includes all the decision-relevant
costs. –Usually forward-looking. –May not be objectively
verifiable.

Labor Costs:
• Like accountants, economists regard the
payments to labor as an explicit cost.
• Labor services (worker-hours) are
purchased at an hourly wage rate (w):
The cost of hiring one worker for one
hour.
• The wage rate is assumed to be the
amount workers would receive in their
next best alternative employment.
49

Capital Costs:
• While accountants usually calculate capital
costs by applying some depreciation rule to the
historical price of the machine, economists
view this amount as a sunk cost.
• A sunk cost is an expenditure that once made
cannot be recovered.
• These costs do not focus on foregone
opportunities.
50

Capital Costs:
• Economists consider the cost of a machine to
be the amount someone else would be willing
to pay for its use.
• The cost of capital services (machine-hours) is
the rental rate (v) which is the cost of hiring
one machine for one hour.
• This is an implicit cost if the machine is owned
by the firm.
51

Element of cost:
•Cost object
•Cost
•Cost unit
•Cost centre
•Profit centre

Cost object:
• It is an activity or item or operation
for which a separate measurement of
costs is desired
• E.g. the cost of operating the
personnel department of a company,
the cost of a repair fob, and the cost
for control
53

Cost:
•It is the amount of expenditure
incurred on a specific cost
object
•Total cost = quantity used *
cost per unit (unit cost)
54

Cost unit:
•It is a quantitative unit of
product or service in which
costs are ascertained, e.g. cost
per table made, cost per metre
of cloth
55

Cost centre:
• It is a location or function of an
organisation in respect of which costs
are ascertained
• E.g. the rent, rates and maintenance
of buildings; the wages and salaries of
strorekeepers
56

Profit centre:
•It is location or function where
managers are accountable for
sales revenues and expenses
•E.g. division of a company that
is responsible for the sales of
products
57

Cost classification:
• Direct cost
• Indirect cost (overhead)
58
Element of cost
Materials Labour Expenses
Direct Indirect Direct Indirect Direct Indirect

Direct cost:
• Cost that can be identified specifically
with or traced to a given cost object
• The direct costs consist of the following
three elements:
• Direct materials
• Direct labour
• Direct expenses
59

Indirect cost (overhead):
• Cost that cannot be identified specifically
with or traced to a given cost object
• They are identified with cost centres as
overheads
oIndirect materials
oIndirect labour
oIndirect expenses
60

The substance from which the finished product is
made is known as material.
(a) DIRECT MATERIAL: is one which can be directly
or easily identified in the product Eg: Timber in
furniture, Cloth in dress, etc.
(b) INDIRECT MATERIAL: one which cannot be easily
identified in the product.
Material:

Examples of Indirect Material:
• At factory level – lubricants, oil,
consumables, etc.
• At office level – Printing & stationery,
Brooms, Dusters, etc.
• At selling & dist. level – Packing
materials, printing & stationery, etc.

The human effort required to convert the materials
into finished product is called labour.
(a) DIRECT LABOUR: is one which can be conveniently identified
or attributed wholly to a particular job, product or process.
Eg:wages paid to carpenter, fees paid to tailor,etc.
(b) INDIRECT LABOUR: is one which cannot be conveniently
identified or attributed wholly to a particular job, product or
process.
Labour:

Examples of Indirect Labour:
• At factory level – foremen’s salary,
works manager’s salary, gate keeper’s
salary,etc
• At office level – Accountant’s salary,
GM’s salary, Manager’s salary, etc.
• At selling and dist.level – salesmen
salaries, Logistics manager salary, etc.

are those expenses other than materials and labour.
DIRECT EXPENSES: are those expenses which can be
directly allocated to particular job, process or
product. Eg : Excise duty, royalty, special hire
charges,etc.
INDIRECT EXPENSES: are those expenses which
cannot be directly allocated to particular job, process
or product.
Other Expenses:

Examples of other expenses:
•At factory level – factory rent,
factory insurance, lighting, etc.
•At office level – office rent, office
insurance, office lighting, etc.
•At sales & dist.level – advertising,
show room expenses like rent,
insurance, etc.

Cost accumulation:
•Prime cost = direct materials + direct labour + direct expenses
•Production cost = Prime cost + factory overhead
OR
= Direct materials + Conversion cost
*Conversion cost is the production cost of converting raw materials into
finished product
•Total cost = Prime cost + Overheads (admin, selling,distribution cost)
OR
= Production cost + period cost (administrative, selling,
distribution and finance
cost)
•Period cost is treated as expenses and matched against sales for
calculating
profit, e.g. office rental

Cost coding:
• A code is a system of symbols designed to
be applied to a classified set of items to
give a brief, accurate reference,
facilitating entry, collation and analysis
• Coding is important in modern
computerised accounting systems for
catergories various composite accounting
items
68

Reasons:
•To reducing error owing
to descriptions
•Enable easy recalling
•Reduce computer file size
as a code
69

Cost behavior:
•Costs can be classified into
variable, fixed, semi-variable,
or step-costs according to how
they behave with respect of
changes in activity levels
70

Variable cost:
•It increases or decreases in
direct proportion to levels of
activity, but the unit variable
cost remains constant
•E.g. cost of food served in a
restaurant
71

Fixed cost:
•Total fixed cost remains constant
over a relevant range of activity
level but unit fixed cost falls with
an increase in activity volume
72

Semi-variable cost:
•It processes characteristics
of both fixed and variable
cost
•It increases or decreases
with activity level but not
in direct proportion
73

Step cost:
• It remains constant for a range of
activity levels, then, on further
increase in activity, the cost jumps to
a new level and remains constant over
a certain range until the next jump
occurs
74

Cost for stock valuation:
•Unexpired and expired cost
•Product and period cost
75

Unexpired cost:
• Unexpired costs are the resources that
have been acquired and are expected
to contribute to the future revenue
• They will be recorded as assets in
current period
• They will be charged as expenses
when they have been consumed in the
generation of revenue
76

Expired costs:
•Expired costs are the
expenses attributable to the
generation of revenue in the
current period
77

Product cost:
• Product cost are related to the goods
purchased or produced for resale
• If the products are sold, the product cost will
be included in the cost of goods sold and
recorded as expenses in current period
• If the products are unsold, the product costs
will be included in the closing stock and
recorded as assets in the balance sheet
78

Period cost:
• Period cost related to the operation of
a business
• They are treated as fixed cost and
charged as expenses when they are
incurred
• They should not be included in the
stock valuation
79

Cost Curves:
• A firm’s expansion path shows how minimum-
cost input use increases when the level of
output expands.
• With this it is possible to develop the
relationship between output levels and total
input costs.
• These cost curves are fundamental to the
theory of supply.
80

Cost Curves:
• Figure 6.3 shows four possible shapes for cost
curves.
• In Panel a, output and required input use is
proportional which means doubling of output
requires doubling of inputs. This is the case
when the production function exhibits
constant returns to scale.
81

FIGURE 6.3: Possible Shapes of the Total Cost
Curve:
82
Total
cost
TC
Quantity
per week
(a) Constant Returns to Scale
0

Cost Curves:
• Panels b and c reflect the cases of decreasing and
increasing returns to scale, respectively.
• With decreasing returns to scale the cost curve is
convex, while the it is concave with increasing
returns to scale.
• Decreasing returns to scale indicate considerable
cost advantages from large scale operations.

Total
cost
TC
Quantity
per week
0
Total
cost
TC
Quantity
per week
(b) Decreasing Returns to Scale
0
Total
cost TC
Quantity
per week
(c) Increasing Returns to Scale
0
FIGURE 6.3:
Possible Shapes of the Total Cost Curve:

Cost Curves:
• Panel d reflects the case where there are
increasing returns to scale followed by
decreasing returns to scale.
• This might arise because internal co-
ordination and control by managers is initially
underutilized, but becomes more difficult at
high levels of output.
• This suggests an optimal scale of output.

Total
cost
TC
Quantity
per week
0
Total
cost
TC
Quantity
per week
0
Total
cost TC
Quantity
per week
0
Total
cost
TC
Quantity
per week
(d) Optimal Scale
0
FIGURE 6.3:
Possible Shapes of the Total Cost Curve:

Average Costs:
• Average cost is total cost divided by output;
a common measure of cost per unit.
• If the total cost of producing 25 units is
$100, the average cost would be
q
TC
AC costAverage
4$
25
100$
AC

Marginal Cost:
• The additional cost of producing one more
unit of output is marginal cost.
• If the cost of producing 24 units is $98 and
the cost of producing 25 units is $100, the
marginal cost of the 25th unit is $2.
qinChange
TCinChange
costMarginal  MC

Marginal Cost Curves:
• Marginal costs are reflected by the
slope of the total cost curve.
• The constant returns to scale total
cost curve shown in Panel a of Figure
6.3 has a constant slope, so the
marginal cost is constant as shown by
the horizontal marginal cost curve in
Panel a of Figure 6.4.

AC, MC
AC, MC
Quantity
per week
0
FIGURE 6.4:
Average and Marginal Cost Curves:

•With decreasing returns to scale,
the total cost curve is convex
(Panel b of Figure 6.3).
•This means that marginal costs
are increasing which is shown by
the positively sloped marginal cost
curve in Panel b of Figure 6.4.

AC, MC
AC, MC
Quantity
per week
0
AC, MC
AC
MC
Quantity
per week
0
FIGURE 6.4:

•Increasing returns to scale results
in a concave total cost curve (Panel
c of Figure 6.3).
•This causes the marginal costs to
decrease as output increases as
shown in the negatively sloped
marginal cost curve in Panel c of
Figure 6.4.

AC, MC
AC, MC
Quantity
per week
0
AC, MC
AC
AC
MC
MC
Quantity
per week
0
AC, MC
Quantity
per week
0
FIGURE 6.4:

• When the total cost curve is first concave
followed by convex as shown in Panel d of
Figure 6.3, marginal costs initially decrease
but eventually increase.
• Thus, the marginal cost curve is first
negatively sloped followed by a positively
sloped curve as shown in Panel d of Figure 6.4.

AC, MC
AC, MC
Quantity
per week
0
AC, MC
AC
AC
AC
MC
MC
MC
Quantity
per week
0
AC, MC
Quantity
per week
0
AC, MC
Quantity
per week
(d) Optimal Scale
0 q*
FIGURE 6.4:

Average Cost Curves:
• If a firm produces only one unit of output,
marginal cost would be the same as
average cost
• Thus, the graph of the average cost curve
begins at the point where the marginal
cost curve intersects the vertical axis.

• For the constant returns to scale case,
marginal cost never varies from its initial
level, so average cost must stay the same
as well.
• Thus, the average cost curve are the same
horizontal line as shown in Panel a of
Figure 6.4.
98

• With convex total costs and increasing
marginal costs, average costs also rise as
shown in Panel b of Figure 6.4.
• Because the first few units are produced
at low marginal costs, average costs will
always b less than marginal cost, so the
average cost curve lies below the marginal
cost curve.
99

• With concave total cost and decreasing
marginal costs, average costs will also
decrease as shown in Panel c in Figure
6.4.
• Because the first few units are produced
at relatively high marginal costs, average
is less than marginal cost, so the average
cost curve lies below the marginal cost
curve.
100

• The U-shaped marginal cost curve shown
in Panel d of Figure 6.4 reflects
decreasing marginal costs at low levels of
output and increasing marginal costs at
high levels of output.
• As long as marginal cost is below average
cost, the marginal will pull down the
average.
101

• When marginal costs are above average cost,
the marginal pulls up the average.
• Thus, the average cost curve must intersect
the marginal cost curve at the minimum
average cost; q* in Panel d of Figure 6.4.
• Since q* represents the lowest average cost, it
represents an “optimal scale” of production for
the firm.
102

Distinction between
the Short Run and the Long Run:
• The short run is the period of time in which a
firm must consider some inputs to be
absolutely fixed in making its decisions.
• The long run is the period of time in which a
firm may consider all of its inputs to be
variable in making its decisions.
103

Types of Short-Run Costs:
• Fixed costs; costs associated with inputs that are
fixed in the short run.
• Variable costs; costs associated with inputs that can
be varied in the short run.
104

Relationship between
Short-Run and Long-Run per-Unit Cost Curves:
• Figure 6.6 shows all cost relationships for a
firm that has U-shaped long-run average and
marginal cost curves.
• At output level q* long-run average costs are
minimized and MC = AC.
• Associated with q* is a certain level of capital,
K*.

SMC
MC
SAC
AC
AC, MC
Quantity
per week
0 q*
FIGURE 6.6:
Short-Run and Long-Run Average and Marginal Cost Curves at
Optimal Output Level:

Relationship between
Short-Run and Long-Run per-Unit Cost Curves:
• In the short-run, when the firm using K* units
of capital produces q*, short-run and long-run
total costs are equal.
• In addition, as shown in Figure 6.6
AC = MC = SAC(K*) = SMC(K*).
• For output above q* short-run costs are higher
than long-run costs. The higher per-unit costs
reflect the facts that K is fixed.
107

Shifts in Cost Curves:
• Any change in economic conditions that affects
the expansion path will also affect the shape
and position of the firm’s cost curves.
• Three sources of such change are:
• change in input prices
• technological innovations, and
• economies of scope.
109

Cost variations:
Home Health budget includes the following:
Total direct labor costs: $400,000
Total indirect costs: $96,000
Total direct (professional) labor-hours: 16,000

Cost variations:
What is the budgeted direct labor cost rate?
$400,000 ÷ 16,000 = $25
What is the budgeted indirect cost rate?
$96,000 ÷ 16,000 = $6

Cost variations:
Suppose a patient uses 25 direct labor-hours.
Assuming no other direct costs, what is the
cost to Home Health?
Direct labor: 25 hours × $25 = $625
Indirect costs: 25 hours × $6 = 150
Total $775

Absorption costing:
• Let’s assume the following additional
information
for Harvey Company.
• 20,000 units were sold during the year at a
price
of $30 each.
• There is no beginning inventory.
• Now, let’s compute net operating
income using absorption costing.

Absorption Costing Income Statement:
Fixed manufacturing overhead deferred in
inventory is 5,000 units × $6 = $30,000.
Unit product
cost.

Absorption Costing Income Statement:
Fixed manufacturing overhead released from
inventory is 5,000 units × $6 = $30,000.
Unit product
cost.

Supporting Decision Making :
• Because absorption costing assigns fixed
manufacturing overhead costs to units
produced ($6 per unit for Harvey Company), it
gives the impression that fixed manufacturing
overhead is variable with respect to the
number of units produced, but it is not.
• The result can be inappropriate pricing
decisions and product discontinuation
decisions.

Cost-volume-profit Analysis:
•Cost-volume-profit Charts
• Cost-volume-profit analysis shows
effects of varying scale.
• Breakeven analysis shows zero
profit points of cost coverage.

Degree of Operating Leverage:
•DOL=Q(P-AVC)/[Q(P-AVC)-TFC]
•DOL is the elasticity of profit
with respect to output.

Cost Minimizing vs. Output Maximizing:
 With smooth isoquants: firm determines best factor
proportions by either
 Minimizing cost: what is the lowest cost, C*, at which the
firm can produce output q*?
 Maximizing output: What is the most output, q*, that can
be produced at cost C*?

Economies of Scale:
economies of scale AC falls as output expands
no economies of scale AC does not change as output
increases
diseconomies of scale AC rises when output increases

Potential Ethical Issues:
• Earnings management
• Low-cost production at any cost
• Whistle-blower retaliation
• Fixing prices
• Bribery and other corruption
• Hiding managerial acts

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