Overview
Costs are the expenses that a firm bears in order to pay for the inputs to its production process. Understanding the nature of costs and how to manage them are a crucial aspect of maximixing firm profitability.
Fixed versus Variable Costs
A common way to understand a firm's total costs is to split it 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.
Average Costs - summarize the combined effect of fixed and variable costs on the production of a unit of product.
Cost Assumptions
There are two types of assumptions that can be made about how variable costs change with the amount of product.
- Constant Variable Costs - variable cost per product is independent of the amount of product produced.
- Non Constant Variable Costs
- variable costs can change as the level of production changes.
- Experience Curve - variable costs decline as the result of economies of scale.
Leverage
The operating leverage is defined as
{% OpLev = \frac{FC}{TC} %}
- {% FC %} = fixed costs
- {% TC %} = Total costs (fixed plus variable)
High operating leverage is generally considered to be a risk. (see strategy considerations)
Topics
- Cost 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