In decision making, planning and analysis, it is important to know the difference between the average and marginal cost of units produced. An average cost is calculated by adding up the total fixed and variable costs and dividing them by the units produced. The limitation here is that fixed costs- because they are already committed or “sunk” are not relevant in present decision-making because we have no control over them. What is relevant is the marginal cost, which is the cost of producing and selling an additional unit, something firms do have some influence over. Also relevant is marginal revenue, which is the additional revenue made by selling another unit. The goal here, always easier said than done, is the minimize marginal cost and maximize marginal revenue.
A challenge faced by firms in deciding what opportunities to pursue with their limited resources is that the sacrifice of limited resources is made in the present, but the hoped-for rewards do not arrive until some time or times in the future. In order to evaluate these in the decision-making process, discounting is used, which is the process of translating future cash flows into today’s equivalent amounts. Doing this accurately, as you will see in this week’s learning, is a very desirable and valuable skill to develop and apply.
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