Professional Documents
Culture Documents
Akoka
Lagos
Department of Electrical Engineering
Objectives:
•Issues on Cost
•Cost as it relates to
production
•Application to the power
sector
Cost:
What we pay for. Proper understanding of the term
cost, requires we distinguished Economic Cost from
Accounting Cost.
Very Short and Short run, only the fixed cost is incurred.
This is the change in This is a cost that cannot This is the cost incurred
Total Cost due to a unit be recovered when in transacting a good or
change (up or down) in production of a good or service.
Quantity (Q) of good or service ceases. It consist of:
service produced. •search costs (the costs
For example of locating information
Also referred to as decommissioning cost of about opportunities for
Incremental Cost. a power station. exchange)
•negotiation costs (costs
MC = ΔTC/ΔQ of negotiating the terms
of the exchange)
•enforcement costs (costs
of enforcing the contract)
Time – Cost- Technology Dimension
Variable Cost
(VC)
Fixed Cost
(FC)
Quantity
(Q)
Figure 1.1
Cost
(N)
Marginal Cost
(MC)
Average Cost
(AC)
Average Variable Cost
(AVC)
Average Fixed Cost
(AFC)
Quantity
(Q)
Figure 1.2
It’s important to know the cost of producing a particular unit of output. The
cost of producing a particular unit of output is its marginal Cost (MC). From
the example and the above diagrams, the MC of producing the first unit
includes all the Fixed Costs (FC) and some Variable Costs(VC).
Hence, in the short run where some costs are fixed, MC (i.e. Short Run
Marginal Costs SRMC) is different from the long run, where no costs are
fixed (i.e. Long Run marginal Costs LRMC).
0 5 9 9 0 0 -9
1 5 10 9 1 10 1 5 -5
2 5 12 9 3 6 2 10 -2
3 5 15 9 6 5 3 15 0
4 5 19 9 10 4.75 4 20 1
5 5 24 9 15 4.8 5 25 1
6 5 30 9 21 5 6 30 0
7 5 45 9 36 6.43 15 35 -10
Table 1.1
From the above table 1.1 we can determine the following:
If the company does not sell a single unit, it will not collect any revenue.
At quantity (Q) =0, Total Revenue (TR) is 0. We mark this down in our chart.
If we sell one unit, our total revenue will be the revenue we make from that sale,
which is simply the price. Thus TR at quantity 1 is N5, since our price is N5.
With 2 units, revenue will be from selling each unit. Since we get N5 for each unit,
our TR = N10.
MC are the costs a company incurs in producing one additional unit of a good.
In this question, we want to know what the additional costs to the firm are when it
produces 2 goods instead of 1 or 5 goods instead of 4.
From Total Costs (TC), we can calculate the MC from producing 2 goods instead of
1. It is simply:
Here the total costs from producing 2 goods is N12 and the total costs from
producing only one good is N10. Thus the marginal cost of the second good is N2.
If we want to know how much profit we will receive if we sell 3 units, we simply use
the formula:
Profit(3 units) = Total Revenue (3 units) - Total Costs (3 units)
Fixed Cost (FC)
FC are the costs that do not vary with the number of goods produced. In the short-run
factors like land and rent are fixed costs, whereas raw materials and fuel used in
production are not.
FC are costs the company has to pay before it even produces a single unit. Here we can
collect that information by looking at the total costs when quantity is 0. Here that is N9.
Average Cost (AC) for producing 1 unit is 10/1 = N10, for 2 units will be 12/2 =N6
Economies of Scale
For many productive activities:
•Average Cost (AC) is high for low output
•Average Cost (AC) is lower in range of output
•Average Cost (AC) is high for high level of output
The above confirms from table 1.1 for small quantities, fixed costs are high; for
large quantities, variable increases as production approaches full capacity.
When Average Cost (AC) is falling, Marginal Cost (MC) is below Average Cost (AC).
This is because if a unit of production costs less than AC of all previous production,
then AC falls.
If unit of production costs more than average, then AC rises. Then MC is greater
than AC.
If the cost of producing two products by one firm is less than cost of
producing the same two products by two separate firms, the production
process of the former firm exhibits Economies of Scope. For example is
Company A with two power stations of different capacities can operate at
a lower cost combined compared to Companies B & C with one power
station each, then Company A exhibit Economies of Scope.
Application to the Power Sector
Cost Symbol Units
Fixed FC N/MWh
Variable VC N/MWh
Average ACk = FC + (cfxVC) N/MWh
N/MWh
ACE = (FC/cf) + VC
cf : Capacity factor
Table 1.3
Cost (N)
Gas Turbine
Coal Station
VC
FC
Energy (MWh)
From tables 1.2 & 1.4 we can determine the Average Cost for the different
power station technology.
Using data from Table 1.4, select the appropriate generator technology
investment based on Average Cost of capacity using the following cf:
0.1
0.3
0.5
0.7
0.9
Lesson 2
Profit
Profit is the difference between Revenues from sales and the cost of
production. The aim of most business organisation is to maximise Profit.
PR = TR – TC
TR = Price multiply by Quantity sold (PxQ) : Total Revenue
TC: Total Cost
PR: Profit
For a particular product j,
= (dP/dQj). Qj + P 2.4
Under a competitive market condition, MRj is equal to P (i.e. the market price),
because (dP/dQj) = 0.
Therefore a profit maximising firm chooses output such that price is equal to
Marginal Cost (MC). Letting P = MRj in 2.2;
When there are economic losses and no barriers to exiting the market
•Firms exit
•Output declines
•Prices rise (because of an inward shift in supply)
•Economic losses decline
Consumer surplus
Competitive
Price Producer surplus
True demand curve
Competitive Q
Quantity
Power Supply and Demand
Interaction between Demand and Supply is very crucial in the
Power Industry than in most industry.
8,000
6,000
Load
4,000
2,000
From the above, we can deduced that for 20% of the time, demand is about
5,500MW or greater; 50% of the time, demand is about 5,000MW or greater
and for 100% or whole duration demand is about 4,000MW or greater.
Price – Elasticity of Demand in the Power Industry
Price Elasticity of Demand ,means a change in Price lead to change in
Quantity demanded.
ɛ = -ΔQ%/ΔP% (ɛ is –ve)
= -(ΔQ/Q)/(ΔP/P)
= -(dQ/dP)(P/Q)
It measures the responsiveness / sensitivity of Demand to Price. Normally
referred to as Demand Elasticity. Technically Demand Elasticity is –ve, but
in this course we assume it to be +ve.
Example:
Coal
MW Capacity Factor
GT
Coal
0 Duration 1
3. Cost of Capital
Financing the an investment can involve borrowing money from financial institutions
or the owner putting in its own money from his/her savings.
Borrowing money from a financial institution (e.g. a bank) requires the borrower
pays interest on the borrowed money (i.e. principal). This type of fund is Debt
Capital. The cost of this borrowing is the Rate of Interest charged.
However, if the owner of the investment put in its own money, this type of fund is
called Equity Capital. The Rate of Return is the rate the owner earn from their
investment.
Dem
and
Interest Rate
Supply
An investor expects to gain a premium on his investment (i.e. regain his money, plus
a return that tallies with the market), to allow for the following:
Inflation (i)
Risk taking (r)
Expectation of a real return
i : inflation,
rf : risk-free rate
If inflation is low (e.g. < 5%) and real risk free rate is low (e.g. <3%), then 3.2
prevails. Hence rf = Rf – i.
For risky projects, investors charge a risk premium (RP) to compensate them for the
unknown rate of return.
The real (risky) interest rate is equal to the real risk-free rate plus a real risk
premium (RP).
i.e r = r f + RP 3.3
The nominal (risky) interest rate is equal to the nominal risk free rate plus a nominal
risk premium, RP*, which also compensates the lender for the riskiness of an
unknown inflation rate.
To understand the proper worth of money in future years, its value has to be adjusted
to today’s value or the base year value. This phenomenon is term Time value of
Money for the following reasons:
•Future incomes are eroded by inflation. The purchasing power of N1m today is
higher than N1m in 2 year’s time
•The existence of risk, due to future uncertainty.
•The need for a return on the money by the investor. An investor needs to be reward
for forgoing expenditure today and undertaking the investment for future benefits.
Due to eroding effect of inflation, to properly account for the worth of a Future
earnings in today’s money, we apply a Discount Factor to the Future earnings.
At an interest rate r, one Naira today (Present Value) will be worth N1r in one year’s
time (Future Value).
FV = PV + r . PV = (1+r) . PV 3.5
PV = [1/(1+r)] . FV 3.6
1/(1+r) or (1+r)-1 is the Discount Factor (DF) (i.e. the Present Worth Factor), which
is who much a Naira in the future is worth today.
Taking current year as the base year, for future years, n is (+ve), for past years n is
(-ve), for current year n = 0 (i.e. base year).
The annual Discount period can be broken down into sub periods within the year.
For example into monthly and daily.
DF monthly = [1+(r/12)]-12
DF daily = [1+(r/365)]-365
If we are to consider a series of cash flows in future years discounted to the present.
Annuity: This is a case when we expect to earn the same amount A over a period
of time in the future from an investment . The Present Value (PV) of such investment
is expressed as
The inverse of the last part of 3.11 = [r(1 + r) n] / [(1+r) n -1] is the
Capital Recovery Factor (CRF).
Example: What amount must be collected for 30 years at annual interest rate (r) of
10%, if an initial investment of N1000 is made today
Using equation 3.12, with r = 10%, a sum of N106.08 must be collected each year
for 30 years.
Profit (PR) wish is (i.e. +ve net cash flow) = Total Revenue (TR) – Total Cost (TC)
The Net Present Value (NPV) of Profit over a time period n is expressed as:
NPV of an investment is the Present Value of future Revenues (TRn) less Present
value of Future Cost (TCn)
Since Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC)
With IRR, the investor calculates the rate of return that yields NPV = 0, and
compares with the firm’s rate of return.
From 3.14 NPV0 = 0 = -FC0 + (TR – VC) ∙ [ (1+IRR)n -1] / [IRR ∙ (1+ IRR)n ]
For most capital intensive investment (e.g. building a power station), a firm uses
debt and equity to finance a project.
For this type of investment, the cost of capital is a weighted average of the rate of
interest on debt and the expected return on equity.
For example, if 70% of an electric utility’s financing is in corporate bonds and 30%
is in corporate equities, R debt = 7% and R equity = 12%,
then WACC = 8.5%
Payback Analysis
Payback Rule is used in small investment. For example whether to install a
fluorescent light bulbs to reduce cost of electricity.
The decision to be made is to make the investment that pay back the cost of the
initial investment after some arbitrarily chosen (payback) period, e.g. 2 years.
For example, if
The cost of fluorescent bulb is N10 greater than the cost of the incandescent bulb
The reduction in electricity is 100 watts
The bulb is used 10 hours daily,
The price of electricity is N0.10/kWh (or N100/MWh)
From the money market we can determine the probability distribution for rates of
return r n to an investor over the n periods: r 1, r 2, r 3,…….,f n
For example, if a firm earned rates of return of 5%, 10%, 0% and 5 % during the
last 4 years, the mean is the average of these values : 5%. So the Expected
Return on investment must have rate of return >= 5%