Cost Concepts for Managerial Decision Making
Prepared for instructional use in
Economics For Managers
College of Management
North Carolina State Universiy
© Stephen E. Margolis 2000
Soon we will be using the concepts of cost that are presented in Landsburg’s chapters five and six to analyze market behavior of firms. With a bit of interpretation, however, these concepts have immediate application to ordinary decisions that firms make on a daily basis. The first three sections of this essay should help to establish the connections between the economics textbook treatment of cost and these decision problems. The final section presents some examples of decision problems that exercise these cost concepts
I. Foundations: Three Normative Principles
There are three simple but general normative principles that underpin rational or profit maximizing choice. They are: Opportunity cost, comparison of costs and benefits, and incrementalism.
A. Evaluate opportunity costs.
Opportunity cost is the concept of cost in economics. The cost of any action is the value of what is forgone as a result of the action. If an activity does not displace something else, then we could say that it has no cost. Of course, it seems a bit odd to suggest that an action does not have some cost. That is because almost any activity will displace something.
In some instances, opportunity cost is manifest as ordinary or explicit cost. It is "out of pocket expenditure" or more simply, "expenditure." So, for example, a project might require that we hire five people for one day each, at a cost of $200.00 per person per day. The expenditure is an opportunity cost: We must forgo something worth $1000 in order to undertake the project.
Sometimes opportunity costs can be more remote. Imagine that a firm owns a factory and is considering using a portion of the factory for assembling laptop computers. The cost of the use of the factory for laptop computer assembly would depend entirely upon what else the space might be used for. At one extreme, it might be that the firm has no alternative use for the space. It is considering no other activity, and it is unable to sell or sublet the space to anyone else. In that circumstance, the cost of using the factory for laptop production is properly considered to be zero. Of course, there may be alternative uses. If the best alternative use of the space is to sublet it, then the net revenues of from the lease is a cost of producing laptops. Or laptop production may displace another productive activity that would yield positive net revenues. In that case, those net revenues that are sacrificed to make laptop computers become a cost of making them.
Notice that in considering the cost of laptop production, there was no mention of how much the factory cost, whether or not it was paid for, what the interest rate is, or whether the factory had been fully depreciated in the firms financial accounts. While those considerations are certainly important to the firm, they do not affect the cost of using the factory. They are determined by past actions and do not affect current opportunities. They pertain to sunk costs, if anything.
B. Compare costs and benefits.
Profit maximizing behavior involves choosing actions for which benefit exceed cost. That is to say, decision makers should consider all the benefits of an action, all of the costs, and take appropriate action. This dictum may seem more nearly self evident in the context of the firm than in personal or social decisions, but the same principles could be applied in any of these settings.
In order to add up costs and benefits and compare them, it is necessary to translate them all into a common dimension. Most often, that dimension is money. (This is the familiar apples and oranges problem.) In most cases, and certainly in most business...
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