CONTROLLING COSTS

Because of Profit Motive

Businesses or firms strive to earn the most profits possible. Call that the Law of Gordon “Greed Is Good” Gekko. Businesses try to increase profitability by trying to increase revenue and decrease cost. In a competitive environment, firms can’t do much to increase revenue. If Target is selling Beautiful Brand toilet paper for $1 per four-pack, Walmart is also going to have to sell Beautiful Brand toilet paper for about $1 per four-pack. They lack pricing power. Firms do, however, have the ability to control costs, so in order to maximize their profits they try to produce at the lowest cost possible.

Think of it this way: If you’d like to have enough money in the bank to retire someday, you may be able to work toward getting a raise (or a better job with an increase in pay), but you may not have a lot of control over this—your boss/company will determine how much, if any, of a raise you can get, and your ability to get a better-paying job depends on where you live, your credentials, your work experience, how competitive your job market is, and other factors. But even if you couldn’t easily get an increase in salary, you probably could cut out Netflix and save a few bucks that way.

Money Talks

depreciation

As capital ages, its value declines because it breaks down and eventually needs replacement.

TYPES OF COSTS

Economists break down costs into different categories:

  1. The first category of costs is fixed costs or overhead. A firm’s fixed costs are those costs that don’t change regardless of the level of production. Rent, property tax, management salaries, and depreciation are examples. Whether a factory is running at full capacity or is idle, the overhead remains the same.
  2. Firms also face variable costs. Variable costs change with the level of a firm’s output. Utilities, hourly wages, and per-unit taxes are representative of variable costs. As a firm’s production increases, so do its variable costs.
  3. Total cost is the sum of a firm’s fixed and variable costs.

Remember how we said earlier that economists also consider opportunity cost when calculating profitability? Forget that for now. For the purposes of this discussion on costs, we’re looking at profit exactly the way an accountant does: Revenue − Costs (Fixed and Variable) = Profit.

Costs over the Long Run

In the long run, all costs are variable. Over time, firms are able to add or subtract capital, renegotiate rent, and alter management salaries. The distinction between fixed and variable costs disappears with the passage of time.

Marginal Cost of Production

The marginal cost of production is of special interest to economists. Marginal cost is the change in total cost for each unit produced. Think of marginal cost as the additional cost of producing one more item. For each additional unit of output a firm produces, it incurs more variable cost and hence more total cost. This means that its marginal cost increases as well. For example, each Big Mac costs more to produce than the previous Big Mac because McDonald’s had to pay for more ingredients and pay its workers more for the extra time it took to produce the additional Big Mac.

Marginal Revenue

Firms like McDonald’s maximize their profits when they produce at the point where marginal cost equals marginal revenue. In other words, if a firm wants to make the largest profits it can, it will produce up to the point where the additional cost of producing one more item is the same as the additional revenue earned by producing one more item.

If the additional cost of making “one more hamburger” is 99 cents (for example) and that hamburger can be sold for 99 cents, then marginal cost and marginal revenue are equal. This is the happy place economists dream of. If the additional cost of making “one more hamburger” is instead $1.29 and selling it can only generate revenue of 99 cents, McDonald’s will have some explaining to do to their stockholders and will probably shortly be in search of a new CEO.