Objectives

1. To explain the meaning and use of different concepts of cost.

2. To show how different concepts of cost are relevant for managerial decision-making.

3. To explain how production relationships underlie cost relationships.

4. To explain cost behaviour in the short run.

5. To explain cost behaviour in the long run.

6. To explain how cost relationships can be derived in mathematical terms.

7. To explain the purpose and principles of cost–volume–profit analysis.

8. To describe a problem-solving approach for applying cost–volume–profit analysis.

Introduction

Importance of costs for decision-making

Demand analysis is fundamentally concerned with the revenue side of an organization's operation; cost analysis is also vital in managerial economics, and managers must have a good understanding of cost relationships if they are to maximize the value of the firm. Many costs are more controllable than are factors affecting revenue. While a firm can estimate what effect an increase in advertising expenditure will have on sales revenue, this effect is generally more uncertain than a decision to switch suppliers, or invest in new machinery, or close a plant.

Just as with production theory, the distinction between short run and long run is an important one. In the short run, managers are concerned with determining the optimal level of output to produce from a given plant size (or plant sizes, for a multiplant firm), and then planning production accordingly, in terms of the optimal input of the variable factor, scheduling and so on.