Market Failure and Government Intervention
To analyze cost control for any of these departments, you would conduct a cost effectiveness study. Cost effectiveness analysis and purchasing reports examine how to minimize the cost of producing a given output (least cost studies) or, similarly, how to maximize output for a given level of expenditure or budget (constant cost studies). For example, if you were in a production department targeting a particular level of production you would want to conduct a least cost study, while you would recommend a constant cost study for a department facing a fixed budget. In all of these departments you are affected by markets through your purchases of outside resources and must therefore become aware of the changing determinants of supply; technological change, seller expectations, price of resources, and government policies. The theories and applications of production and cost are presented in chapters 7, 8, and 9.
D. Profit Maximization: the financials, income statements and Business Plans
Firms exist to maximize profits for their owners. Since profits are the difference between revenues and costs, managers must continue to increase revenues until added costs begin to offset revenue gains. At the end of the year, the firm's income statement represents a study of the profitability of the firm.
If you work in the accounting or finance departments of a private firm, there will be many people looking over your shoulder as you compute the "bottom line" of an income statement which represents the firm's profit. In economics it is assumed that managers will be trying to maximize profits through their choices on the investment of cash balances, choices on renting or leasing equipment, choices on inventories and production, and many other managerial tools. Furthermore, the rate at which profits are earned is of great concern to a firm's owners (the stockholders), its creditors and, of course, the government which uses profits as a basis for levying taxes on the firm.
E. Maximizing Net Present Value:
When decisions affect revenues and costs in future years, long range planning is required. If you work in a finance department or serve on a long range planning committee, you may be contributing to decisions on plant location, plant size, and plant technology which will affect the profitability of a firm for many years in the future. Many marketing, production, and cost decisions also have long term consequences. Capital budgeting is the appropriate tool for such long term planning.
Long term planning requires that future profitability must be weighed against current profits. For this purpose the present value formula is useful. However, capital budgeting requires that future discounted profits be greater than the initial costs of land, plant, and equipment. Thus, in a finance department, you would compute the "net present value" of various choices. This requires that you subtract the initial costs of land, plant, and equipment from the present value of each choice. The net present value serves as the basis for capital budgeting