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Relevant Costs 227

In light of this conflicting advice, what type of cost analysis could guide the firm in deter-

mining its profit-maximizing course of action?

Cost analysis is the bedrock on which many managerial decisions are

grounded. Reckoning costs accurately is essential to determining a firm’s cur-

rent level of profitability. Moreover, profit-maximizing decisions depend on

projections of costs at other (untried) levels of output. Thus, production

managers frequently pose such questions as, What would be the cost of

increasing production by 25 percent? What is the impact on cost of rising

input prices? What production changes can be made to reduce or at least

contain costs? In short, managers must pay close attention to the ways output

and costs are interrelated.

In this chapter, we build on Chapter 5’s analysis of production to provide

an overview of these crucial cost concepts. In the first section, we discuss the

basic principles of relevant costs—considering the concepts of opportunity costs

and fixed costs in turn. Next, we examine the relationship between cost and

output in the short run and the long run. Then we turn to economies of scale

and economies of scope. Finally, we consider the importance of cost analysis for

a number of key managerial decisions.

RELEVANT COSTS

A continuing theme of previous chapters is that optimal decision making

depends crucially on a comparison of relevant alternatives. Roughly speaking,

the manager must consider the relevant pros and cons of one alternative ver-

sus another. The precise decision-making principle is as follows:

In deciding among different courses of action, the manager need only consider

the differential revenues and costs of the alternatives.

Thus, the only relevant costs are those that differ across alternative courses of

action. In many managerial decisions, the pertinent cost differences are read-

ily apparent. In others, issues of relevant cost are more subtle. The notions of

opportunity costs and fixed costs are crucial for managerial decisions. We will

consider each topic in turn.

Opportunity Costs and Economic Profits

The concept of opportunity cost focuses explicitly on a comparison of rela-

tive pros and cons. The opportunity costassociated with choosing a

particular decision is measured by the benefits forgone in the next-best

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