CHAPTER SIX
COST ANALYSIS
OBJECTIVES
1. To explain relevant costs and related concepts. In particular, to contrast
opportunity cost and fixed costs and to contrast accounting profits and
economic profits. (Relevant Costs)
2. To explain the relationship between production and cost. To apply the
concepts of the short run and long run to cost. (The Cost of Production)
3. To explore economies of scale and scope. (Returns to Scale and Scope)
4. To apply optimization concepts to cost minimization and optimal
decision making. (Cost Analysis and Optimal Decisions)
TEACHING SUGGESTIONS
I. Introduction and Motivation
The same motivation that applies to production applies to cost. However,
cost is in some sense a broader concept than production in that 1) it
summarizes the underlying production process and 2) it includes factors not
taken into account by production analysis, that is, opportunity costs.
II. Teaching the “Nuts and Bolts”
Opportunity Cost, etc. We begin by emphasizing the difference between
accounting concepts and decision making concepts. One way to highlight
the differences in class is to put the following on the board and to let the
students fill in the yes’s and no’s and to give reasons.
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Type of Cost Relevant to
Accountant?
Relevant to
Decision Maker?
Fixed Cost Yes No
Sunk Cost Yes No
Variable Cost Yes Yes
Opportunity Cost No Yes
From a discussion of opportunity cost one can go into the idea of economic
profit. From our experience, we find it useful to continually reiterate the
idea of economic profit as we do problems and examples. This is to prepare
students for the idea of long-run equilibrium later in the course.
Cost and production. Here we like to discuss the shapes of the cost curves
and how they depend on underlying assumptions about production. Again,
we are careful to distinguish short-run and long-run ideas.
Returns to Scale and Scope. Students are very interested in these concepts.
The instructor might also choose to introduce the notion of the lee learning
curve (not covered in the chapter) and take care to distinguish the learning
curve from increasing returns to scale.
Optimization. Again, following the philosophy of the book, we present
optimization yet again, this time in the context of cost. In this concluding
section we introduce the shut-down rule. We also consider multiple products
and transfer pricing.
ADDITIONAL MATERIALS
I. Short Readings
E. Chhabra, “ Select Homecare Weighs new Wage and Labor Regulations,”
The New York Times, June 19, 2014, p. B4.
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J. Trop, “ Steel Industry feeling Stress as Automakers Turn to Aluminum,”
The New York Times, February 24, 2014, p. B1.
N. Hodge, “Big Law Mergers Fuel Skepticism,” The Wall Street Journal,
November 11, 2013, p. B1.
C. J. Hughes, “Manhattan’s Vanishing Gas Stations,” The New York Times,
August 23, 2013, p. B9.
C. Rogers, “Open All Night: America’s Car Factories,” The Wall Street
Journal, August 17, 2013, p, B1.
M. L. Wald, “US moves to Abandon Costly Reactor Fuel Plant,” The New
York Times, June 26, 2013, p. A15.
S. McCartney, “How Airlines Spend your Airfare,” The Wall Street Journal,
June 7, 2012, p. D1.
N. Hodge, “Pentagon Loses War to Zap Airborne Laser from Budget,” The
Wall Street Journal, February 11, 2011, pp. A1, A10.
W. S. Cohen, “Obama and the Politics of Outsourcing,” The Wall Street
Journal, October 12, 2010, pp. A1, A10.
“E-commerce Favors Large Companies,” The Economist, July 3, 2010, p.
74.
J. Whalen, “Glaxo Tries Biotech Model to Spur Drug Innovations,” The
Wall Street Journal, July 1, 2010, pp. A1, A14.
L. A. E. Schuker and E. Smith, “Hollywood Eyes Shortcut to TV,” The Wall
Street Journal, May 22, 2010, pp. A1, A4.
R. Smith, “What Utilities have Learned from Smart-Meter Tests,” The Wall
Street Journal, February 22, 2010, p. R6.
E. Smith and L. A. E. Schuker, “Unlocking DVD Release Dates,” The Wall
Street Journal, February 12, 2010, p. B4.
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R. G. Mathews, “Fixed Costs Chafe at Steel Mills,” The Wall Street Journal,
June 10, 2009, p. B2.
J. Surowiecki, “The Free-Trade Paradox,” The New Yorker, May 26, 2008, p.
30.
Evan Perez, “How Delta’s Cash Cushion Pushed it onto a Wrong Course,”
The Wall Street Journal, October 29, 2004, p. A1.
“Wal-Mart: How Big can it Grow?” The Economist, April 17, 2004, pp.
67-69.
II. Longer Readings
R. Mosheim and C. Lovell, “Scale Economies and Inefficiency of US Dairy
Farms,” American Journal of Agricultural Economics 91(3), August 2009,
777–794.
P. J. Ferraro and L. O. Taylor, “Do Economists Recognize an Opportunity
Cost When They See One?” Contributions to Economic Analysis and Policy,
Vol. 4, 2005.
R. S. Kaplan and D. P. Norton, “Using the Balanced Scorecard as a Strategic
Management System,” Harvard Business Review, Jan.-February. 1996, pp.
75-85. (Reprint # 96107).
R. Cooper and R.S. Kaplan, “Measure Costs Right: Make the Right
Decisions,” Harvard Business Review, Sept.-Oct. 1988, pp. 96-103.
III. Cases
Fineprint Company (A), (B) and (C), (UVA-C-2193, 2194, and 2195),
Darden Business School, University of Virginia, 2004.
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Blackheath Manufacturing Company, (UVA-C-2197), Darden Business
School, University of Virginia, 2004.
Blackheath Manufacturing Company Revisited, (UVA-C-2198), Darden
Business School, University of Virginia, 2004.
Gibberson’s Glass Studio, (UVA-C-2205), Darden Business School,
University of Virginia, 2004.
Wendy’s Chili: A Costing Conundrum (UVA-C-2206hgbkm), Darden
Business School, University of Virginia, 2004.
Align Technology, Inc.: Matching Manufacturing Capacity to Sales Demand
(9-603-058), Harvard Business School, 2002.
Monster.com: Success Beyond the Bubble (9-802-024), Harvard Business
School, 2002.
Chemical Bank: Implementing the Balanced Scorecard, (9-195-210),
Harvard Business School, 1999. Teaching Note (5-198-090).
The Growth of Intel and the Learning Curve, (OIT27), Stanford Business
School, 1999. (Available from Harvard Business School Publishing.)
Choice International, 1995 (9-795-165), Harvard Business School, 1996.
Teaching Note (5-796-073)
Sony Corp.: The Walkman Line (9-195-076), Harvard Business School,
1997. Teaching Note (5-195-077).
IV. Quips and Quotes
In the long run, we are all dead. (John Maynard Keynes)
The easiest way to make money is to stop losing it.
If you start to take Vienna, take Vienna. (Napoleon Bonaparte)
(Was Napoleon aware of the sunk-cost fallacy?)
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On opportunity costs:
There’s not much to be said for old age except that it’s better than the
alternative. (J.K. Galbraith)
On the whole, I’d rather be in Philadelphia. (on W. C. Field’s gravestone)
Most people my age are dead. (Casey Stengel)
If it wasn’t for golf, I’d probably be a caddy today. (Professional golfer
George Archer)
Cost means sacrifice, and cannot, without risk of hopelessly confusing ideas,
be identified with anything that is not sacrifice. (J. E. Cairnes)
Costs merely register competing attractions. (Frank H. Knight)
Cost [is] of two kinds, either (1) the endurance of pain, discomfort, or
something else undesirable, or (2) the sacrifice of something desirable, either
as an end or a means. (Henry Sidgwick)
V.Mini-Case, Economies of Scale in Public Schools
Economies of Scale
in Public Schools
Over the last 20 years, there have been growing concerns about the
quality and cost of public education. Parents, teachers, school
administrators, and general taxpayers have an interest in maintaining
quality schools while holding down costs. One crucial question is the
extent to which economies of scale exist in public schools. Can
schools with greater enrollments provide quality instruction at a lower
cost per pupil?
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Empirical studies of per-pupil costs across schools indicate the
answer is yes. In a study of Maryland public elementary and
middle-level schools, John Riew compared costs (in 1979) across a
sample of schools of different sizes, using multiple regression analysis
to measure the degree of scale economies.1 The basic regression
equations were designed to measure the relationship between a
school’s average operating costs per pupil (the dependent variable)
and its enrollment (the main independent variable). The regression
also included independent variables measuring teacher training,
teacher experience, professional support staff, and teachers’ aides to
account for the separate effect of “school quality” indices on cost.
Finally, the regressions included the school’s utilization rate (the ratio
of actual enrollment to the school’s capacity). If, as expected,
short-run average costs decline, increasing a school’s utilization rate
should mean a reduction in its average cost per pupil.
The regression results confirm that economies of scale are present in
both types of schools. For elementary schools, average cost per pupil
declines significantly over the range from 200 to 400 students before
leveling off as enrollments approach 500 students. For a typical
school, an increase in enrollment from 200 to 300 students, with all
other variables held constant, affords a savings of $115 in average
operating expenditures per pupil. In addition, if this increase also
represents a rise in utilization (say, from 50 to 75 percent given a
school capacity of 400 students), then there is an additional average
cost reduction of $97. Thus, the combined average cost savings for
this enrollment increase come to $212 per student.
For middle schools, economies of scale occur at higher enrollments,
in a range between 500 and 900 students, and are exhausted as
enrollments approach 1,000 students. An increase in enrollment from
600 to 800 students reduces the average cost per student by $142. The
accompanying increase in utilization (say, from 60 to 80 percent given
a school capacity of 1,000 students) produces an additional savings of
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$55. Thus, the combined average cost savings come to $197 per
student.
The average cost savings are comparable with elementary and
middle schools but occur at different enrollment levels and stem from
a different mix of scale economies and utilization. For elementary
schools, increasing utilization is the key to average cost savings. In
this respect, massive enrollment declines during the 1970s and early
1980s contributed to cost escalation, whereas enrollment increases in
the last decade should contribute to cost declines. For middle schools,
scale economies are the most important factor. The efficient operation
of these schools with their more varied programs, specialized
teaching, and administrative functions requires a larger population of
students.
1 See J. Riew, “Scale Economies, Capacity Utilization, and School Costs: A Comparative
Analysis of Secondary and Elementary Schools,” Journal of Education Finance (Spring
1986): 433-446.
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