Cost Analysis QA Chapter 8 ME

QUESTIONS & ANSWERS Q8.1 What advantages or disadvantages do you see in using current costs for tax and stockholder 

reporting purposes?   ANSWER

Current cost is the amount that must be paid under prevailing market conditions for many managerial decisions. Taxes and stockholder reporting rely heavily on the Historical Cost. Theoretically, it would be preferable to use current costs for income tax calculations and stockholder reporting. On a practical level, however, this would be nearly impossible. Estimation of current cost, based upon current market values, would be a difficult task with a great deal of room for subjectivity. This could result in many arbitrary cost designations, and the "policing" of tax returns would become a much more formidable task. On a practical basis, the use of historical costs for tax and stockholder reporting purposes has obvious advantages over the theoretically superior current costs. Q8.2  Assume that two years ago, you purchased a new Jeep Wrangler SE 4WD with a soft top for $16,500

using five-year interest-free financing. Today, the remaining loan balance is $9,900 and your Jeep has a trade-in value of $9,500. What is your opportunity cost of continuing to drive the Jeep? Discuss the  financing risk exposure of the lender.  ANSWER

$9,500. If you sell the Jeep, $9,500 can be generated to pay down your remaining loan balance. It is the current cost or replacement value of your current vehicle. It is the relevant economic cost of continuing to drive the Jeep. Historical cost of  $16,500, and the remaining loan balance of  $9,900 are irrelevant for decision-making purposes. With a current market value of only $9,500 against a remaining loan balance of $9,900, the lender faces the risk of borrower default. Q8.3 Southwest  Airlines offers four flights per weekday from Cleveland, Ohio to Tucson,  Arizona.  Adding a

  fifth flight per weekday would cost $15,000 per flight, or $110 per available seat. Calculate the incremental costs borne by Southwest following a decision to go ahead with a fifth flight per day for a minimal 60-flight trial period. What is the marginal cost? In this case, is incremental cost or marginal cost  relevant for decision making purposes?   ANSWER

cost is the change in cost following a 1-unit change in output. Whereas Incremental costs typically involve multiple units of output associated with a given managerial decision. Incremental costs may also relate to output changes, but the output change involved is that of a relevant block or increment of service. In this instance, the incremental cost associated with a decision to go ahead with a fifth flight per day for a minimal 60-flight trial period is $900,000 (= $15,000  60) The marginal cost per passenger is only $110. In this case, the incremental cost of  $900,000 is the relevant cost for decision making purposes. With expected revenues in excess of  $900,000, Southwest should go ahead with the planned expansion.

Marginal

Q8.4 Suppose the Big Enchilada restaurant has been offered a binding one-year lease agreement on an

attractive site for $5,200 per month. Before the lease agreement has been signed, what is the incremental  cost per month of site rental?  A fter the lease agreement agreement has been signed, what is the incremental cost per  month of site rental? Explain.

 ANSWER

cost that does not vary across decision alternatives is called a sunk cost. Sunk costs are irrelevant for current decision-making purposes and should not enter into decision analysis. Before the lease agreement has been signed, all costs are variable, and the incremental cost per month of site rental is $5,200 per month. After the lease agreement has been signed, lease costs are sunk, and the incremental cost per month of site rental is $0. A

Q8.5 What is the relation between production functions and cost functions? Be sure to include in your 

discussion the effect of competitive conditions in input factor markets.  ANSWER

There is a direct relation between production and cost functions. A cost function is determined by combining a given production function with the related price functions for the inputs actually employed in production. If inputs are purchased in competitive markets so that their prices are constant irrespective of how many are purchased, the relation between production and cost functions is straightforward. With imperfect competition in input markets, the relation becomes somewhat more complex. In all cases, cost/production relations can be employed either to minimize total costs subject to an output constraint or to maximize output subject to a total cost or budget constraint. Q8.6 The definition of output elasticity is Q =  /   X  /  X  (  X  represents all inputs), whereas the

definition of cost elasticity is C = C  / C  C   / . Explain why Q > 1 indicates increasing returns to scale, where C < 1 indicates economies economies of scale.  ANSWER

OE is the percentage change in output associated with a 1 percent change in all inputs. Whereas a CE measures the percentage change in total cost associated with a 1 percen change in output. Therefore: If 

Then

Implies

Q > 1

 /  >  X  /  X 

Rising Q/X ratio, Returns to Scale, falling f alling AC.

C < 1

C  / C  C  <  / 

Falling C/Q ratio, Economies of Scale, falling AC.

This means that  Q > 1 and C < 1 are both consistent with falling average costs. Q8.7  The president of a small firm has been complaining to the controller about rising labor and material 

costs. However, the controller notes that average costs have not increased during the past year. Is this  possible?   ANSWER Yes, the phenomenon of

constant (or even decreasing) average costs coupled with increasing input prices is quite feasible. It stems from an increase in input productivity that could result from any number of  causes. One obvious possibility would be the introduction of new capital equipment, either replacement or expansion, into the production system.

Q8.8  With traditional medical insurance plans, workers pay a premium that is taken out of each paycheck 

and must meet an annual deductible of a few hundred dollars.  A fter that, insurance picks up most of their 

health-care costs. Companies complain that this gives workers little incentive to help control medical  insurance costs, and those costs are spinning out of control. Can you suggest ways of giving workers better  incentives to control employer medical insurance costs?   ANSWER

In hopes of slowing the growth in medical costs, some companies are moving towards A consumer driven at medical coverage that gives employees a financial stake in what they pay for medical care. Such plans feature high deductibles of as much as $500 per year for prescriptions and $1,000 per year for all other medical costs. To help pay these costs, some companies deposit $300 to $1,800 per year in an A employee benefits account. If employees don't spend their money in one year, they get to carry it over to future years. After the deductible is reached, the plan operates more like a traditional one, picking up 80% of most medical expenses. The hope is that once the money feels as though it belongs to them, people won't get an MRI when an X-ray (or an ice pack) might do. The plans have one big drawback: People with chronic conditions can take a big hit, since they have little choice about how often they go to the doctor. Some critics fear that the plans will discourage people from getting the care they need. Q8.9 Will firms in industries in which high levels of output are necessary for minimum efficient scale tend 

to have substantial degrees of operating leverage?   ANSWER Yes,

in industries where the minimum efficient scale is large, long-run average costs tend to decrease rapidly as output increases. Fixed costs tend to be a substantial share of total costs. When fixed costs are large, the degree of operating leverage also tends to be high, and firms with high levels of output necessary for minimum efficient scale will tend to have a substantial degree of operating leverage.

Q8.10  Do operating strategies of average cost minimization and profit maximization always lead to

identical levels of output?   ANSWER No,

operating strategies of average cost minimization and profit maximization lead to identical rates of  input combination, but do not typically lead to identical levels of total output. Average cost minimization is an appropriate strategy when managers wish to produce a target level of output in an optimal or leastcost fashion. On the other hand, profit maximization implies production of an optimal level of output, as revealed by product demand, in an optimal or least-cost fashion.