469-7 - CHAPTER 7 COST ANALYSIS Profit maximizing decisions...

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CHAPTER 7 - COST ANALYSIS Profit maximizing decisions depend on accurate estimates and projections of costs. Examples: What would be the cost of increasing production by X%, what is the impact on production costs if input costs increase by X%, what production changes will reduce costs, etc. These examples illustrate the important role that cost analysis plays in managerial decisions, and how costs affect profits, etc. We consider several issues related to COSTS: RELEVANT COSTS The only factors to consider are always the relevant costs and the relevant benefits , which are the differential (marginal) costs and benefits of alternative courses of action. Opportunity Cost (OC) OC is always one of the relevant costs for decision making. OC is defined as the benefits foregone in the next highest valued alternative. For example, if you are making an exclusive choice between A and B (movies, jobs, vacations, majors, etc.), the OC of choosing A (B) is B (A). Examples: 1. What is the OC of getting an MBA degree? a. Explicit, Monetary cost: b. Implicit OC (foregone benefit): 2. What is the OC of using excess factory capacity to supply specialty orders? What is the foregone benefit of using the factory to supply specialty orders? 3. What is the OC of city-owned land that will be used as the site for a downtown parking garage? Foregone benefit: Application of using OC for optimal decision making: Pursue activities ONLY when the incremental (marginal) benefits exceed the incremental (marginal) costs. Applies to individuals, households, organizations, governmental units, etc. Pursue an MBA ONLY if the MB > MC (including OC). Problem: Check Station 1 on p. 255. Economic Profit vs. Accounting Profit Accounting profit = TR - TC (explicit, accounting costs) = NIAT (after-tax profits, earnings). Most of the time, when the word "profit" is used, we are referring to accounting profits (NIAT). Accounting profits are important to managers, shareholders, govt. (for taxes), etc. However, managerial decisions should not be based only on accounting profits, but should always include the more comprehensive concept of "economic profits." ECN 469: Managerial Economics Professor Mark J. Perry 1
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Economic Profits = TR - TC (explicit accounting costs + implicit costs, including OC). Managerial decisions should always be based on Economic Profits, not accounting profits. Example, p. 255, "Starting a Business." Accounting Profit from new business = $74,000 (explicit costs only) Opportunity costs: a) Foregone interest on $80,000 personal funds tied up in business @ 8% = $6400 per year. b) Foregone income at current job = $56,000 Economic Profit from new business = $11,600 Other considerations: Benefits: Being your own boss Costs: Uncertainty of starting a new business, especially during the first few years. Long Run Condition: ZERO ECONOMIC PROFIT.
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469-7 - CHAPTER 7 COST ANALYSIS Profit maximizing decisions...

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