Managerial uses of Cost Analysis

Managers should bear in mind some key lessons from cost theory in making cost decisions.

1.       Focus should be on relevant cost while making economic decisions. Relevant cost should be distinguished from the irrelevant cost.

2.       One should recognise the possibility of diminishing returns in short run production process, and be aware that this will cause the marginal cost to increase as output increases. It is often assumed that the production of additional units of output of a product will cost the same extra amount. However, the additional profit from the sale of additional units may begin to decline, if marginal cost begins to rise even though the firm is able to sell more at the same price.

3.       The economies of scale and the economies of scope may enable a firm to reduce its unit cost of production as it increases its entire scale of operation. It should be considered whether the unit costs of production decrease as a firm increases the size of a particular site (like sales branch office, manufacturing facilities, and warehouses) or its scale of operation for the entire firm.

4.       Increase in the entire scale of operation does not automatically lead to reduction in per unit cost. This may be due to firstly insufficient demand for the product to enable the firm to take advantage of larger scale of operation. At lower levels of demand, it is beneficial to operate at a lower level of capacity at less than maximum efficiency. Secondly, increase in scale of operation may lead to an increase in unit costs. This is so because of diseconomies of scale resulting mainly from managerial diseconomies (like large bureaucracy and disproportionate increase in staff positions). 

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