Relevant Costs
In light of this conflicting advice, what type of cost analysis could guide the firm in determining its profit-maximizing course of action?
Cost analysis is the bedrock on which many managerial decisions are grounded. Reckoning costs accurately is essential to determining a firm’s current level of profitability. Moreover, profit-maximizing decisions depend on projections of costs at other (untried) levels of output. Thus, production managers frequently pose such questions as, What would be the cost of increasing production by 25 percent? What is the impact on cost of rising input prices? What production changes can be made to reduce or at least contain costs? In short, managers must pay close attention to the ways output and costs are interrelated. In this chapter, we build on Chapter 5’s analysis of production to provide an overview of these crucial cost concepts. In the first section, we discuss the basic principles of relevant costs—considering the concepts of opportunity costs and fixed costs in turn. Next, we examine the relationship between cost and output in the short run and the long run. Then we turn to economies of scale and economies of scope. Finally, we consider the importance of cost analysis for a number of key managerial decisions.
RELEVANT COSTS A continuing theme of previous chapters is that optimal decision making depends crucially on a comparison of relevant alternatives. Roughly speaking, the manager must consider the relevant pros and cons of one alternative versus another. The precise decision-making principle is as follows: In deciding among different courses of action, the manager need only consider the differential revenues and costs of the alternatives. Thus, the only relevant costs are those that differ across alternative courses of action. In many managerial decisions, the pertinent cost differences are readily apparent. In others, issues of relevant cost are more subtle. The notions of opportunity costs and fixed costs are crucial for managerial decisions. We will consider each topic in turn.
Opportunity Costs and Economic Profits The concept of opportunity cost focuses explicitly on a comparison of relative pros and cons. The opportunity cost associated with choosing a particular decision is measured by the benefits forgone in the next-best
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