Essential Concepts in Cost Management and Classification
Cost Management: Key Decision Costs
Costs Important for Decisions
- Explicit Costs: Actual expenditures incurred by the firm to hire, rent, or purchase the inputs required for production.
- Implicit Costs: The value of inputs owned and used by the firm in its own production activity.
Cost Classification
- Historical (Accounting) Costs: Explicit costs representing what has actually been spent or paid for inputs.
- Replacement Costs: Costs associated with duplicating the productive capability of an item using current technology.
- Sunk Costs (Nepovratni Troškovi): Costs that cannot be recovered regardless of future decisions. Examples include investments in marketing, R&D, or purchased assets.
- Incremental Costs: Costs that arise because of a specific activity or decision (e.g., launching a new production line or PR campaign). These are added costs resulting from an action.
- Marginal Cost: The change in total cost incurred when output is incremented by one unit.
Time Span in Cost Analysis
Short Run
In the short run, at least one input is fixed.
- Fixed Costs: Costs that do not vary with the level of output.
- Variable Costs: Costs that vary directly with the level of output.
Long Run
In the long run, all inputs are variable, meaning all costs are variable. The managerial task is to adjust the level of all inputs optimally.
Learning Curve and Economies of Scale
The Learning Curve
The learning curve typically has a U-form.
The cost function is often represented as C = aQb.
The exponent b indicates that average costs fall as output increases. This is a negative curve because average input costs decline with increases in cumulative output. For example, the cost of labor input decreases as total output increases.
Reasons for Learning Curve Effects
- Labor efficiency
- Shared experience effects
- Standardization and specialization
- Better use of equipment and resources
- Changes in the resource mix
Learning or Experience Rate
The learning or experience rate is calculated by dividing the costs of the second production series by the costs of the first production series.
Importance of the Learning Curve for Pricing Policy
As costs decrease when production or output rises, the strategic goal is to increase production volume to drive costs down. This often involves setting the initial price of new products below marginal costs to rapidly increase output. Subsequently, this price level becomes sustainable or even high relative to the reduced costs.
Economies of Scale
Economies of scale describe how long-term average costs change as total output increases.
- Increasing Returns to Scale: Initially, long-term average costs decrease as total output rises due to factors like technological advantages, financial efficiencies, and division of labor.
- Decreasing Returns to Scale: Later, average costs increase as output continues to rise. This is especially because of problems with managerial coordination.
Why Economies of Scale Change
Economies of scale can be increasing, decreasing, or constant depending on the relationship between output and long-run average costs.
Related Cost Concepts
Economies of Scope
Economies of scope occur when producing multiple products together results in lower costs than producing them separately.
Cost Complementarity
Cost complementarity exists when the marginal cost of producing the first product falls (is less than zero) if the output of a second product is increased.
Operating Leverage (Poslovna Poluga)
Operating leverage measures the relationship between variable and fixed costs. The higher the ratio of fixed costs to total costs, the more highly leveraged the firm is.
IT Sector Cost Considerations
- The marginal cost of reproducing digital goods (e.g., software) is often close to zero.
- Two primary kinds of sunk costs in the IT sector are:
- “First-copy” costs (development)
- Marketing costs