What is the key point for management to understand how to formulate the cost structure of the business? The management needs to analyze several factors before take a decision about it. I write a summary about cost structure based on Keat, P. and Phillip Young. 2008. Managerial Economics, 6th edition. Pearson (KY) e-book.
Cost Structure Analysis
At the managerial level, the cost is one of the important things in the decision-making process. For internal analysis, the cost that is considered on analysis and making a decision is the cost that affected by a management decision. The manager can analyze the cost by cost function calculation expressed in monetary rather than physical units. In the short-run cost, the function had assumption pertains to the inputs used in the production process. The variable input cost calculates by multiplying the number of units by the unit price. When the total of the product (Q) increases at the increasing rate, the total variable cost (TVC) will increase at the decrease rate. For the cost analysis, we can put attention on the marginal product and marginal cost, it means we calculate the additional cost affected for one additional quantity of product.
The Marginal Cost
The marginal product defined as the change in total product divided by the change in the amount of variable input used in the production process. The marginal cost is either the change in variable cost or change in total cost related to change in input. The total fixed cost component of total cost never change as output increase. The marginal cost decrease when the marginal product increase. It happens when the law of diminishing returns takes effect.
The relation between diminishing of return and increasing marginal cost can be illustrated below:
Assume the variable input is Labor (L) with wage rate (W) as unit cost.
The total variable cost is the total variable cost multiple by total input. So if the total input is Labor (L) and the unit cost is the wage rate (W) :
The marginal cost is the additional cost for one additional input. Based on the equation above, the marginal cost function illustrated by :
The marginal product is an additional product for one additional input. Then the equation for the marginal product is :
The marginal product for one additional labor is the amount of quantity change divide by the amount of labor change. So we can conclude that :
By assuming the wage rate is constant, the marginal cost will decrease when the marginal product increase, and then the marginal cost will increase when the marginal product decrease it happens when the law of the diminishing of return takes effect. The condition means when marginal product addition increases so the marginal cost will decrease because the product output greater than the increase of cost The relationship between diminishing return and marginal cost represents a key link between a firm’s short-run production function and short-run cost function.