roll no 23 manu nair

8/2/2019 Roll No 23 Manu Nair

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ESTIMATION OF COST FUNCTION

MANU NAIRROLL NO : 23

MBA (FT), SEM: 1

S.M.S , CUSAT


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COST FUNCTION

Cost function expresses the relationship

between cost and cost determining factors.

In mathematical form, it is expressed as,

C=f (S,O,P,T,E)


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DETERMINANTS OF COST FUNCTION

The main determinants of a cost function

are:

Plant size

Output level

prices of inputs used in production

nature of technology

managerial efficiency


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INFLUENCE OF EACH FACTORS ON COST

Plant Size

Plant size is an important variable in

determining cost

The scale of operations or plant size and

the unit cost are inversely related.

Such a relationship gives downward slope

of cost function depending upon thedifferent sizes of plants taken into

account.


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Output Level

Output level and total cost are positively

related.

As the total cost increases with increase in

output and total cost decreases with

decrease in output

This is because increased productionrequires increased use of raw materials,

labour, etc.


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Price of Input

Changes in input prices influence cost,

depending on the relative usage of the

inputs and relative changes in their prices.

the cost of production varies directly with

the prices of production.


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Technology:

Technology is a significant factor in

determining cost.

improvement in technology increases

production leading to increase in

productivity and decrease in production

cost. cost varies inversely with technological

progress.


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Managerial efficiency

More the managerial efficiency less the

cost of production.

Managerial efficiency is inversely related

to cost of production


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ESTIMATION OF COST FUNCTION

Three most important and commonly used

method for measurement of cost function

are:

Accounting Method

Engineering Method

Econometric Method


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ACCOUNTING METHOD

The cost-output relationship isestimated by classifying the total costinto fixed, variable and semi-variable

costs. fixed, variable and semi-variable costs

all are determined on the basis ofinspection and experience

Total cost, Average cost and marginalcost for each level of output can thenbe obtained through simple arithmetic

procedure.


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Drawbacks:

Detailed breakdown of accounts kept on

same basis over a period of years.

Experience with wide range of

fluctuations in output rate to come up with

accurate estimates.


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ENGINEERING METHOD

Based directly on the physical relationship

of inputs to output and uses the price of

inputs to determine costs.

What will be cost behaviour in future onbasis of capacity of equipments, modified

by experience with manpower requisites

and efficiency factors, with past costbehaviour.


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Note:

This method is more relevant in short run.

Useful when old data are difficult to be

found.

This method requires a sound

understanding of engineering and a

detailed sampling of the differentprocesses under controlled conditions.


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ECONOMETRIC METHOD

Cost function are estimated on basis of

statistical analysis.

uses multiple correlation analysis to find

the functional relation between changes incost and cost determinants.

It picks the fixed cost element in cost

components and shows whether themarginal cost is constant or variable with

changes in cost determinants.


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Most scientific method.

Very expensive

Time consuming


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LONG RUN COST FUNCTION

Long run cost functions are used in

planning firms investment decisions

To determine the extent of economies and

diseconomies of the scale in order to

select optimal plant size.


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SHORT RUN COST FUNCTION

Short run cost function are estimated to

help managers to determine optimal

pricing policies for the company.

Used to determine marginal cost of

producing additional units of output.


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Estimation of Long-Run Cost Functions

Techniques used:

Regression Analysis

Engineering cost method

Survivor Technique


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Regression Analysis in L-R Cost Estimation

Mostly with cross-sectional data

Pluses:

since data comes from different firms, quantity ofoutput can vary over relatively wide ranges.

All data from same point of time, so technology will

not change

Do not have to regard price changes


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Regression Analysis in L-R Cost Estimation Contd

Minuses:

Interregional cost differences

All firms not necessarily operating at optimal level of

technology

Cost may be recorded differently in different firms

Different companies may pay their cost factor differently


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Based on understanding of inputs and outputs and their

relationship

In this approach, the analysis begins with an engineering

production function: optimal production input combinations

for producing any given level of production is identified.

Cost can be obtained by multiplying each level of input usage

by current price of input and summing over the inputs.

Engineering Cost Method


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Engineering Cost Method Contd

Pluses:

technology held constant

no problem with inflation (current input prices)Less error from measurement

Minuses:

cost estimation are normative only direct output costs are estimated

often made based on pilot plant operations, not

actual production.


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Survivor Technique

This method, suggested by G.Stigler, bases its

findings on the change in

the proportion of total industry output produced byfirms of different size categories.

Look at company size that is successful in anindustry!

Used for deciding optimal plant size.


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Survivor Technique Continued

Pluses:Simple

Avoids unreliable data

Minuses:No help in measuring cost for planning

purposes

Just tell which company size appears to be

more efficientImplicitly assume that the industry is highly

competitive, so survival and prosperity are solely

a function of efficient use of resources, not the

market power or erection of barriers of entry.


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Shapes of Short Run Cost Functions

Cubic cost function:

A cubic cost function represents the normaltheoretical cost function, which exhibits both

decreasing marginal and average costs and

increasing marginal and average cost.


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Cubic Cost Functions continued

TC = a + bQ - cQ + dQ

AC = a/Q + b - cQ + dQ

MC = b - 2cQ + 3dQ


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CUBIC COST FUNCTIONS

TC$

Q


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QUADRATIC COST FUNCTION

If data does not fit to a cubic cost function, we can

try to fit it in a quadratic one.

Quadratic cost function:

TC= a + bQ + cQ

AC = a/Q + b + cQ

MC = b + 2cQ


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Linear Cost Function

Also a linear total cost function can be fitted.

Then the three functions get the following

form

TC = a + bQ

AC = a/Q + b

MC = b


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CONCLUSION

In order to make rational policies regardingcost in an organization, one should know

the relation between cost and cost

determining factors. For this empiricalanalysis of cost function is required.


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