The determination of a firm’s average production expenses when all inputs are variable, allowing for optimal adjustment to scale, is a critical aspect of long-term planning. This metric reflects the per-unit cost when the firm has adjusted all its resources to produce a given output level. It is derived by dividing the total cost of production by the quantity produced, after considering the optimal mix of inputs for each potential output level. For instance, if a company spends $1,000,000 producing 10,000 units in the long run, the average of those costs is $100 per unit.
Understanding the relationship between production volume and per-unit expenses in the long term offers significant advantages. It informs decisions regarding plant size, technology adoption, and overall operational scaling. Analyzing this relationship helps firms identify the most efficient scale of operations, allowing them to minimize costs and maximize profitability. Historically, this understanding has been crucial in shaping industries, driving mergers and acquisitions aimed at achieving economies of scale, and influencing strategic investment decisions.
Subsequent sections will delve into the underlying concepts of economies and diseconomies of scale, explore the relationship between the long-run average expense curve and its short-run counterparts, and provide a detailed example of its computation. Furthermore, the article will examine how this metric is used in strategic decision-making, particularly in the context of market entry and exit.
1. Optimal plant size
Optimal plant size, defined as the scale of operations that minimizes per-unit production expenses, is a foundational element in determining the long-run average total cost. The selection of an appropriate plant size directly influences a firm’s ability to exploit economies of scale and avoid diseconomies, consequently impacting the expense calculation.
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Economies of Scale and Plant Capacity
As plant size increases, a firm can often achieve economies of scale through specialization of labor, efficient use of capital equipment, and bulk purchasing of inputs. For example, a larger automotive manufacturing plant can implement assembly line techniques more effectively, leading to lower per-vehicle costs. However, these gains are not limitless. The extent to which a larger plant reduces costs depends on the production technology and the nature of the industry.
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Diseconomies of Scale and Managerial Complexity
Beyond a certain point, further increases in plant size may lead to diseconomies of scale. These occur when managerial coordination becomes more complex, communication breakdowns arise, and worker alienation increases. Consider a large multinational corporation where decision-making processes become bureaucratic, leading to delays and inefficiencies that increase overall costs. The manifestation of these inefficiencies impacts the cost calculation, increasing average expenses.
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Minimum Efficient Scale and Plant Choice
The minimum efficient scale (MES) represents the smallest plant size at which a firm can achieve the lowest possible average total cost in the long run. Identifying the MES is crucial for selecting the optimal plant size. If a firm operates below the MES, it faces a cost disadvantage relative to larger competitors. If it operates far beyond the MES, it risks encountering diseconomies of scale. The calculation process must consider this point in relation to the target output.
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Long-Run Flexibility and Investment Decisions
Selecting the optimal plant size involves assessing future demand and technological changes. Investing in a large plant may be efficient if demand is expected to grow, but it could result in excess capacity and higher average costs if demand stagnates. Conversely, choosing a smaller plant may limit the firm’s ability to exploit future growth opportunities. In either scenario, the correct choice impacts the cost calculations, requiring a long-term perspective and a flexible approach to investment decisions.
Therefore, determining the optimal plant size is an essential initial step in calculating the long-run average total cost. It involves a careful assessment of the trade-offs between economies and diseconomies of scale, consideration of the minimum efficient scale, and an evaluation of long-run flexibility. The accuracy of the cost calculation is predicated on a clear understanding of these factors.
2. Variable input costs
Variable input costs exert a direct and substantial influence on the determination of long-run average total cost. These costs, by definition, fluctuate with the level of output, encompassing expenditures on raw materials, direct labor, energy, and other resources directly tied to production volume. The cost calculation is inherently sensitive to changes in these expenses, as they directly affect the total cost component used in the average expense computation. For example, a bakery’s flour and sugar costs increase proportionally as it produces more cakes, impacting its per-cake expense. Similarly, a manufacturing firm faces higher energy bills when operating machinery for longer durations to meet increased demand. The magnitude of these variations is directly incorporated into the average cost analysis.
Understanding the dynamics of variable input expenses is vital for accurate long-run planning. Effective supply chain management and strategic sourcing can mitigate the impact of price volatility in these inputs. For instance, securing long-term contracts with suppliers can stabilize raw material costs, allowing firms to better predict and manage their total expenditure. Hedging strategies, employed to protect against price fluctuations in commodities markets, also contribute to cost control. Furthermore, investments in energy-efficient technologies can reduce energy consumption per unit of output, leading to lower variable expenses. These cost-control initiatives are crucial to optimizing the long-run average total cost and maintaining a competitive advantage.
In summary, variable input expenses are a fundamental determinant of long-run average total expenses. Their impact necessitates careful monitoring, proactive cost management strategies, and a comprehensive understanding of market dynamics. Firms that successfully manage these costs enhance their ability to optimize production processes, improve profitability, and make informed decisions regarding long-term capacity planning. The accuracy of any expense calculation is directly tied to the accurate assessment and control of variable input expenses.
3. Economies of scale
Economies of scale represent a critical determinant of the expense calculation, particularly in the long run. As production volume increases, firms often realize cost advantages arising from the ability to spread fixed expenses over a larger output, specialize labor, and leverage bulk purchasing. These factors lead to a reduction in the per-unit expense and directly influence the shape of the long-run average total expense curve.
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Fixed Cost Distribution
Fixed costs, such as rent, insurance, and administrative salaries, remain relatively constant regardless of the level of output. As a firm produces more units, these fixed expenses are distributed across a larger base, resulting in a lower average fixed expense per unit. This reduction in average fixed expense contributes directly to the overall decrease in long-run average total expense. For example, an airline with high fixed expenses for aircraft and airport operations can lower its average per-passenger expense by filling more seats on each flight.
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Specialization of Labor and Efficiency
Larger-scale operations facilitate the specialization of labor, where employees focus on specific tasks within the production process. This specialization leads to increased efficiency, improved skill development, and reduced waste, all of which translate into lower per-unit labor expenses. Consider an automotive assembly line where workers specialize in specific tasks like installing doors or wiring electrical systems. This specialization results in higher productivity compared to a scenario where each worker performs multiple tasks.
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Bulk Purchasing and Negotiating Power
Firms operating at a larger scale often possess greater negotiating power with suppliers, enabling them to secure lower prices for raw materials and other inputs through bulk purchasing. These volume discounts directly reduce the variable expenses associated with production, further contributing to the decline in long-run average total expense. For example, a large retail chain can negotiate lower prices with manufacturers compared to a smaller independent store due to its higher purchase volumes.
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Technological Advantages and Automation
Larger firms are more likely to invest in advanced technologies and automation systems that improve production efficiency and reduce labor expenses. These technological advancements often require significant upfront investments but yield substantial cost savings over the long run. A large manufacturing plant might implement robotic assembly lines and automated quality control systems, resulting in lower labor expenses and increased production output.
The influence of these facets underscores the importance of economies of scale in shaping the long-run average total expense curve. Firms must carefully consider these advantages when making decisions regarding plant size, production capacity, and technology adoption. The expense calculation is fundamentally linked to the firm’s ability to effectively harness economies of scale and minimize per-unit production expenses in the long run.
4. Diseconomies of scale
Diseconomies of scale represent a pivotal consideration in determining the long-run average total cost. As a firm expands its scale of operations beyond a certain point, it may encounter factors that lead to an increase in the per-unit expense of production. This phenomenon directly impacts the shape of the long-run average total expense curve, often resulting in an upward sloping portion.
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Managerial Complexity and Coordination Costs
As a firm grows, the complexity of managing and coordinating its operations increases significantly. This often leads to communication breakdowns, bureaucratic inefficiencies, and slower decision-making processes. For instance, a large multinational corporation may struggle to effectively coordinate activities across different geographic regions and business units, resulting in delays and increased administrative expenses. These managerial challenges directly inflate the total expense, contributing to an increase in the long-run average expense.
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Communication Breakdowns and Information Asymmetry
Larger organizations often suffer from communication breakdowns as information flows become more complex and hierarchical. This can result in misunderstandings, misinterpretations, and a lack of alignment between different departments or teams. For example, a large manufacturing plant may experience difficulties in transmitting critical production information between the engineering, operations, and quality control departments, leading to production errors and rework. Such inefficiencies increase expenses and impact the expense calculation.
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Worker Alienation and Reduced Motivation
In large organizations, employees may feel alienated from the overall goals and objectives of the company, leading to reduced motivation and decreased productivity. This can result in higher rates of absenteeism, lower quality output, and increased labor turnover. For example, a large call center may experience high employee turnover due to the repetitive nature of the work and the lack of opportunities for advancement, leading to increased training expenses and reduced customer service quality, thus affecting the expense structure.
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Increased Input Costs and Resource Constraints
As a firm expands its production, it may face increasing input costs due to resource constraints or increased competition for scarce inputs. For example, a large agricultural firm may face higher land prices or water costs as it expands its operations, leading to higher production expenses. Furthermore, the increased demand for certain raw materials may drive up prices, impacting variable expenses and, consequently, the average expense.
These factors underscore the importance of carefully considering the potential for diseconomies of scale when evaluating the optimal scale of operations. While economies of scale can drive down the long-run average total expense, exceeding a certain size threshold may lead to increased expenses and reduced efficiency. Therefore, the expense calculation must account for the potential impact of diseconomies of scale, necessitating a comprehensive analysis of managerial capabilities, communication structures, employee motivation, and resource availability.
5. Minimum efficient scale
The minimum efficient scale (MES) holds a pivotal position in the landscape of long-run average total cost analysis. It represents the lowest production volume at which a firm can attain the minimum long-run average total cost, thereby achieving maximum efficiency in its operations. Its identification and understanding are paramount to accurate cost calculations and strategic decision-making.
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MES as a Cost Benchmark
The MES serves as a crucial benchmark for assessing the cost-effectiveness of different production scales. A firm operating below the MES incurs higher average total costs compared to firms operating at or above this level. For instance, a small-scale pharmaceutical manufacturer with limited production capacity will likely have significantly higher per-unit production expenses than a larger manufacturer that benefits from economies of scale inherent in reaching or exceeding the MES. The calculated average total cost is directly influenced by the firm’s position relative to the MES.
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Impact on Market Structure
The MES has a significant influence on the structure of an industry. When the MES is large relative to market demand, the industry tends to be dominated by a few large firms that can achieve the necessary scale to minimize costs. Conversely, when the MES is small relative to market demand, the industry is likely to be more fragmented with numerous smaller firms competing. The size and distribution of firms within an industry directly impact the overall average cost levels observed in the market, and inform investment decisions.
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Capital Investment Decisions
The MES significantly influences capital investment decisions. A firm contemplating entering a new market or expanding its existing operations must carefully consider the MES in relation to the anticipated market demand. Investing in a plant with a capacity below the MES may result in a cost disadvantage, while investing in a plant with a capacity far exceeding the MES may lead to excess capacity and underutilization of resources. The strategic alignment of capital investment with the MES ensures cost efficiency and competitiveness.
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Technology Adoption and the MES
The adoption of new technologies can impact the MES. New technologies may lower the MES by enabling smaller firms to achieve economies of scale previously only attainable by larger firms. For example, advancements in 3D printing technology have allowed smaller manufacturing firms to produce complex parts at costs comparable to those of larger firms using traditional manufacturing methods. The integration of new technologies can shift the MES, requiring firms to reassess their cost structures and operational strategies.
In conclusion, the MES is an integral component in the calculation and interpretation of long-run average total costs. It not only serves as a benchmark for cost efficiency but also shapes market structure, influences capital investment decisions, and is affected by technological advancements. A thorough understanding of the MES is essential for firms seeking to optimize their production scales and maintain a competitive edge in the long run. The MES dictates strategic decisions that directly affect costs within its calculation.
6. Long-run planning horizon
The long-run planning horizon is inextricably linked to the determination of a firm’s average expenses when all inputs are variable. This time frame, often spanning several years, allows businesses to make strategic decisions regarding plant size, technology adoption, and market entry/exit. The validity of the average cost calculation hinges on the accuracy of projections within this planning horizon. For example, an airline purchasing new aircraft must consider fuel prices, passenger demand, and regulatory changes over the lifespan of the aircraft. Erroneous long-run forecasts would directly skew the average cost calculations, potentially leading to suboptimal investment decisions.
The length of the planning horizon significantly influences the scope of factors considered in the expense calculation. A longer horizon necessitates the inclusion of anticipated technological advancements, shifts in consumer preferences, and potential macroeconomic fluctuations. Firms operating in dynamic industries, such as technology or pharmaceuticals, require shorter planning horizons due to the rapid pace of innovation. Conversely, industries with more stable technologies and demand patterns, such as utilities or infrastructure, can utilize longer planning horizons. The selection of an appropriate planning horizon is therefore critical for ensuring the relevance and reliability of the cost assessment.
In summary, the long-run planning horizon is not merely a temporal dimension; it is a crucial input into the average expense estimation. The length and accuracy of the horizon dictate the inclusion of relevant factors, influencing the validity and utility of the cost calculation. Challenges arise from the inherent uncertainty associated with long-term forecasting, necessitating the use of scenario planning and sensitivity analysis to mitigate the risks of relying on a single, potentially flawed projection. The understanding of this interaction is imperative for strategic decision-making and long-term firm survival.
7. Technology adoption impacts
The integration of new technologies represents a significant factor influencing the determination of long-run average total cost. The decision to adopt a particular technology can fundamentally alter a firm’s cost structure, productivity, and overall competitiveness. The resulting shifts must be accurately reflected in long-term cost projections.
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Automation and Labor Costs
Automation technologies, such as robotic assembly lines or automated inventory management systems, often lead to reduced labor requirements and lower per-unit labor expenses. For example, a manufacturing plant that replaces human workers with robots for repetitive tasks can significantly decrease its wage bill. However, the initial investment in automation technology can be substantial, and the cost calculation must account for both the upfront capital expenditure and the long-term reduction in labor costs.
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Increased Efficiency and Output
Advanced technologies frequently enhance production efficiency, allowing firms to produce more output with the same level of inputs. For example, the implementation of advanced data analytics in a logistics company can optimize delivery routes and reduce fuel consumption. This increased efficiency translates into lower variable expenses and contributes to a reduction in the average expense of production. The cost assessment must factor in both the initial investment and the anticipated gains in output.
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Impact on Economies of Scale
The adoption of certain technologies can alter the minimum efficient scale (MES) of production. New technologies may allow smaller firms to achieve economies of scale previously only attainable by larger firms. Conversely, some technologies may require significant capital investments, increasing the MES and favoring larger-scale operations. Understanding the interaction between technology adoption and the MES is crucial for making informed decisions about plant size and capacity.
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Flexibility and Adaptability
Modern technologies often provide firms with greater flexibility and adaptability in their production processes. For example, cloud-based software allows businesses to scale their operations up or down quickly in response to changing market conditions. This flexibility reduces the risk of excess capacity or underutilization of resources, leading to lower average expenses over the long run. The value of this increased adaptability must be considered in the comprehensive expense projections.
The interplay between technology adoption and long-run average total cost is multifaceted. While new technologies can offer significant cost savings and efficiency gains, the initial investment, potential disruptions to existing processes, and the impact on the MES must be carefully evaluated. Accurate cost assessment requires a thorough understanding of these impacts and a strategic approach to technology adoption.
8. Cost minimization strategies
Effective cost minimization strategies are intrinsically linked to the calculation of long-run average total cost. These strategies, when successfully implemented, directly reduce the total production costs, thereby lowering the average expense per unit over an extended period. The accurate calculation of long-run average total cost relies on a thorough understanding and incorporation of the anticipated impact of these strategies.
For example, a manufacturing company adopting lean manufacturing principles aims to eliminate waste and improve efficiency throughout its production processes. This can involve streamlining workflows, reducing inventory levels, and implementing quality control measures to minimize defects. The anticipated cost savings resulting from these initiatives must be factored into the long-run average total cost calculation. Failure to accurately estimate the impact of such strategies can lead to an overestimation or underestimation of the firm’s true average production expenses. Another illustration involves strategic sourcing and supply chain optimization. Negotiating favorable contracts with suppliers, consolidating purchasing volumes, and improving logistics efficiency can significantly reduce the cost of raw materials and components. These savings, if realized, directly decrease the total cost and, consequently, the per-unit production expense in the long run. A practical application of this understanding is evident in industries characterized by intense price competition, where even marginal reductions in average production expenses can provide a substantial competitive advantage. Airlines, for instance, constantly seek ways to minimize fuel expenses, labor expenses, and maintenance expenses in order to offer competitive fares while maintaining profitability. The long-run average total expense calculation provides a critical benchmark for evaluating the success of these cost-reduction efforts.
In conclusion, cost minimization strategies are not merely adjuncts to the calculation of long-run average total expenses; they are integral components. Accurate and realistic long-term expense projections require a comprehensive assessment of the potential cost savings resulting from the implementation of these strategies. Challenges may arise in accurately forecasting the impact of complex or novel cost-reduction initiatives. Sensitivity analysis and scenario planning can help mitigate these uncertainties, ensuring that the long-run average total cost calculation provides a robust and reliable foundation for strategic decision-making.
9. Production quantity targets
Production quantity targets serve as a foundational input when estimating the long-run average total cost. The relationship is one of direct dependency: targeted output levels influence the selection of optimal plant size, technology investments, and resource allocation. A higher production target may necessitate a larger plant and more automated processes, potentially leading to economies of scale and lower per-unit costs, assuming that the scale of production isn’t exceeding and generating diseconomies of scale. Conversely, a lower production target might favor a smaller plant with less automation, possibly resulting in higher per-unit costs due to the inability to fully exploit economies of scale.
The impact of production quantity targets on long-run average total cost is exemplified in the semiconductor industry. A semiconductor manufacturer planning to produce a large volume of memory chips will likely invest in a large-scale fabrication facility with highly automated production lines. This large-scale investment is only justified by the anticipated high production volume, as the high fixed costs would be prohibitive if the facility were used for a smaller production run. If that same manufacturer reduces its production quantity targets drastically, the average expense per chip will increase significantly due to the underutilization of the production capacity. The impact is likewise seen in the agricultural sector. Farmers determine the scale of their operations — land use, equipment purchase, labor force — based on their output targets. The total cost of farming operations is directly related to this selection.
The establishment of realistic production quantity targets, aligned with market demand and strategic objectives, is thus vital to accurate calculation. Overly optimistic targets can lead to overinvestment in capacity, resulting in higher average costs due to underutilization. Conversely, overly conservative targets can lead to underinvestment, potentially resulting in lost sales and higher average costs due to the inability to fully exploit potential economies of scale. Accurately calculating production targets is difficult, and the average cost calculation itself is dependent on the accuracy of these targets. Successfully aligning these elements, however, yields effective strategic choices and contributes directly to long-term profitability.
Frequently Asked Questions
This section addresses common queries regarding the calculation and interpretation of long-run average total expenses, providing clarification and insights into key aspects.
Question 1: What is the fundamental difference between the long-run average total expense curve and the short-run average total expense curve?
The primary distinction lies in the flexibility of inputs. The long-run allows all inputs to be variable, enabling firms to adjust plant size and other fixed resources to achieve optimal cost efficiency for any output level. The short-run, conversely, assumes that at least one input is fixed, constraining the firm’s ability to optimize its cost structure in response to changing output levels.
Question 2: How are economies and diseconomies of scale reflected in the long-run average total expense curve?
Economies of scale are represented by the downward sloping portion of the curve, indicating that average total expenses decrease as output increases. Diseconomies of scale are represented by the upward sloping portion, indicating that average total expenses increase as output increases.
Question 3: What are the major challenges in accurately calculating long-run average total expenses?
Significant challenges include accurately forecasting future input prices, technological changes, and market demand. Inaccuracies in these projections can lead to substantial errors in the cost calculation, potentially resulting in suboptimal investment decisions.
Question 4: How does the minimum efficient scale (MES) influence long-term investment decisions?
The MES represents the optimal scale of operations at which a firm achieves minimum average total expense. Understanding the MES is critical for determining the appropriate plant size and capacity, thereby minimizing costs and maximizing profitability in the long run.
Question 5: Is it possible for a firm to experience both economies and diseconomies of scale simultaneously?
While not strictly simultaneous, a firm can experience economies of scale at lower output levels and diseconomies of scale at higher output levels. This transition is reflected in the U-shaped nature of the long-run average total expense curve.
Question 6: What strategies can a firm employ to mitigate the risks associated with inaccurate long-run average total expense calculations?
Strategies include conducting thorough market research, employing sensitivity analysis to assess the impact of various input price and demand scenarios, and maintaining flexibility in investment decisions to adapt to unforeseen changes.
Understanding these nuances contributes to a more informed approach to cost management and strategic decision-making.
The subsequent section will explore real-world examples and case studies illustrating the application of long-run average total cost analysis.
Tips for Accurate Calculation
Achieving precision in determining long-run average total expenses requires meticulous attention to detail and a thorough understanding of underlying cost drivers. The following tips provide guidance for conducting accurate calculations.
Tip 1: Conduct Thorough Market Research: Precise estimation of future demand is paramount. Detailed market analysis, including assessments of consumer preferences, competitive landscape, and macroeconomic trends, is crucial for establishing realistic production targets.
Tip 2: Accurately Forecast Input Prices: Labor, materials, energy, and other inputs constitute a significant portion of total costs. Develop realistic price projections using historical data, market forecasts, and supplier negotiations. Incorporate potential price volatility and supply chain risks into the assessment.
Tip 3: Incorporate Technological Advancements: Account for the impact of emerging technologies on production processes and cost structures. Assess the potential for automation, improved efficiency, and reduced labor requirements resulting from technology adoption.
Tip 4: Model Economies and Diseconomies of Scale: Carefully evaluate the relationship between production volume and per-unit cost. Identify the optimal plant size and capacity that minimizes average total costs, considering both economies and diseconomies of scale.
Tip 5: Implement Sensitivity Analysis: Conduct sensitivity analysis to assess the impact of changes in key variables, such as demand, input prices, and technology costs, on the expense calculation. This helps to identify potential risks and opportunities.
Tip 6: Regularly Update Projections: The long-run average total expense calculation is not a one-time exercise. Regularly update projections to reflect changing market conditions, technological advancements, and internal efficiency improvements. Incorporate actual cost data and performance metrics to refine future estimates.
These tips, when diligently applied, can significantly enhance the accuracy and reliability of calculations, providing a sound foundation for long-term strategic planning.
The final section will provide examples of how the accurate calculation of the item above impacts real-world strategic decisions.
Conclusion
This exploration has detailed various aspects essential to how to calculate long run average total cost, encompassing plant size, input expenses, and the interplay of economies and diseconomies of scale. The discussion has emphasized the importance of accurate forecasting, strategic cost management, and understanding the minimum efficient scale in formulating precise estimates. This information is fundamental for making informed decisions concerning resource allocation, investment, and competitive positioning.
The careful and considered calculation of a firm’s expenses when all production factors are variable provides a crucial metric that shapes its long-term viability. Businesses are encouraged to adopt robust methodologies, regularly updating their assessments to reflect market dynamics and technological advancements. The long-term prosperity of an organization is linked to its capacity to precisely estimate production costs at all levels.
