What Is Economic Cost Analysis?

Osmand Vitez

Economic cost analysis represents a method companies use to determine how additional production will affect a company’s bottom line. This type of analysis often has a concern with what happens when the company produces one additional product. The increase in profits compared to the increase in production costs is of essential importance as a company typically attempts to reach an economy of scale point. Economy of scale means large organizations can reduce costs by increasing output, thereby lowering the per-unit costs of production. Economic cost analysis can also discover diseconomies of scale when production output increases to a point that costs increase higher than potential profits.

A company uses an economic cost analysis to see how additional production will impact its bottom line.
A company uses an economic cost analysis to see how additional production will impact its bottom line.

In macroeconomics, supply and demand rule a free market economy. The principle states that an equilibrium point exists in all markets where total production output — that is, supply — meets the total demand for goods by consumers. This principle also works its way into companies, often via economic cost analysis. For example, a company may have low production output as they enter a market. This allows the company to measure both costs and profits to ensure the business can make money with the new production process.

Companies often have an interest in economic cost analysis due to the different factors present in a business market. Once the company has a bead on the costs and potential profits necessary to run operations, it then can begin to look at external factors. For example, competition, quantity of available resources, and government regulations that restrict a company’s actions in a given industry are common external factors. These factors can increase the costs of doing business, ultimately lowering any financial returns. If the benefits from increased production fail to materialize, the economic cost analysis proves worthy of its analysis.

Economies and diseconomies of scale are typically among the most important items in economic cost analysis. Companies often compute a marginal cost for each unit, which represents the additional costs for producing one more unit than previously. Then, they create aggregate reports of how many more additional units they can produce and lower fixed costs on a per-unit level. This portion of economic analysis typically provides good data for calculating profitability. This analysis works well for the entire company and specific product lines or divisions.

Diseconomies of scale occur at some point for almost every organization. Companies must ensure production output does not exceed this point. When it does, the company receives no more economic benefits from higher production output, creating financial losses rather than gains.

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