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

• {% 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