Proper use of relevant cost concepts requires an understanding of the relation between cost and output, or the cost function. Two basic cost functions are used in managerial decision making: short-run cost functions, used for day-to-day operating decisions, and long-run cost functions, used for long-range planning.
How Is the Operating Period Defined?
The short run is the operating period during which the availability of at least one input is fixed. In the long run, the firm has complete flexibility with respect to input use. In the short run, operating decisions are typically constrained by prior capital expenditures. In the long run, no such restrictions exist. For example, a management consulting firm operating out of rented office space might have a short-run period as brief as several weeks, the time remaining on the office lease. Afirm in the hazardous waste disposal business with 25- to 30- year leases on disposal sights has significant long-lived assets and faces a lengthy period of operating constraints.
The economic life of an asset and the degree of specialization affect the time length of operating period constraints. Consider, for example, a health maintenance organization’s (HMO) automobile purchase for delivering home-based health care. If the car is a standard model without modification, it represents an unspecialized input factor with a resale value based on the used car market in general. However, if the car has been modified by adding refrigeration equipment for transporting perishable medicines, it ecomes a more specialized input with full value only for those who need a vehicle with refrigeration equipment. In this case, the market price of the car might not equal its value in use to the HMO. To the extent that specialized input factors are employed, the short run is lengthened. When only unspecialized factors are used, the short run is condensed.
The amount of time required to order, receive, and install new assets also influences the duration of the short run. Many manufacturers face delays of several months when ordering new plant and equipment. Air carriers must place their equipment orders 5 or more years in advance of delivery. Electric utilities frequently require 8 or more years to bring new generating plants on line. For all such firms, the short-run operating period is an extended period of time.
Long-run cost curves are called planning curves; short-run cost curves are called operating curves. In the long run, plant and equipment are variable, so management can plan the most efficient physical plant, given an estimate of the firm’s demand function. Once the optimal plant has been determined and the resulting investment in equipment has been made, short-run operating decisions are constrained by these prior decisions.
Fixed and Variable Costs
Fixed costs do not vary with output. These costs include interest expenses, rent on leased plant and equipment, depreciation charges associated with the passage of time, property taxes, and salaries for employees not laid off during periods of reduced activity. Because all costs are variable in the long run, long-run fixed costs always equal zero. Variable costs fluctuate with output. Expenses for raw materials, depreciation associated with the use of equipment, the variable portion of utility charges, some labor costs, and sales commissions are all examples of variable expenses. In the short run, both variable and fixed costs are often incurred. In the long run, all costs are variable.
Asharp distinction between fixed and variable costs is not always possible nor realistic. For example, CEO and staff salaries may be largely fixed, but during severe business downturns, even CEOs take a pay cut. Similarly, salaries for line managers and supervisors are fixed only within certain output ranges. Below a lower limit, supervisors and managers get laid off. Above an upper limit, additional supervisors and managers get hired. The longer the duration of abnormal demand, the greater the likelihood that some fixed costs will actually vary. In recognition of this, such costs are sometimes referred to as semivariable.
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