Modeling the Firm - Costs

Overview

Costs are the flip side of a firms production function. That is, costs are the inputs needed ot create a given level of production.

Fixed versus Variable Costs

A common way to understand the production function is to split costs into two categories, fixed costs and variable costs.

• Fixed Costs: are costs that are incurred once and do not change, regardless of how many units of product is produced.
• Variable Costs: are costs that increase with each additional unit of product produced.

Cost Assumptions

• Constant Variable Costs
• Non Constant Variable Costs
• Experience Curve
• Average Costs

Leverage

The operating leverage is defined as

• {% FC %} = fixed costs
• {% TC %} = Total costs (fixed plus variable)

High operating leverage is generally considered to be a risk. (see strategy considerations)

Topics

• Strategy - the cost structure of a firm can have strategic implications which need to be understood when planning.
• Forecasting - costs can change over time
• Accounting Treatment
• Hedging