COSTS
IMBA Managerial Economics
Jack Wu
COSTS
INTRODUCTION
Cost and economies of scale
Cost and economies of scope
Experience Curve
Relevant / Opportunity costs
Transfer Pricing
Irrelevant Costs/ Sunk costs
ECONOMIES OF SCALE
Fixed cost: cost of inputs that do not change with
production rate
Variable cost: cost of inputs that change with the
production rate
Fixed/variable costs concepts apply in
Short run
Long run
EXPENSE STATEMENT
D aily Ink
Production Printing and Electric
(thousands) Labor Press Paper pow er Total
0 $5000 $1000 $0 $200 $6200
10 $5000 $1500 $1200 $300 $8000
20 $5000 $2000 $2400 $400 $9800
30 $5000 $2500 $3600 $500 $11600
40 $5000 $3000 $4800 $600 $13400
50 $5000 $3500 $6000 $700 $15200
60 $5000 $4000 $7200 $800 $17000
70 $5000 $4500 $8400 $900 $18800
80 $5000 $5000 $9600 $1000 $20600
90 $5000 $5500 $10800 $1100 $22400
FIXED AND VARIABLE COSTS
Daily Average Average
Production Fixed Variable Total Marginal Fixed Variable Average
(thousands) Cost Cost Cost Cost Cost Cost Cost
0 $6200 $0 $6200
10 $6200 $1800 $8000 $0.18 $0.62 $0.18 $0.80
20 $6200 $3600 $9800 $0.18 $0.31 $0.18 $0.49
30 $6200 $5400 $11600 $0.18 $0.21 $0.18 $0.39
40 $6200 $7200 $13400 $0.18 $0.16 $0.18 $0.34
50 $6200 $9000 $15200 $0.18 $0.12 $0.18 $0.30
60 $6200 $10800 $17000 $0.18 $0.10 $0.18 $0.28
70 $6200 $12600 $18800 $0.18 $0.09 $0.18 $0.27
80 $6200 $14400 $20600 $0.18 $0.08 $0.18 $0.26
90 $6200 $16200 $22400 $0.18 $0.07 $0.18 $0.25
ECONOMIES OF SCALE
Economies of scale (increasing
returns to scale): average cost
decreases with scale of
production
SCALE ECONOMIES: SOURCES
large fixed costs
research, development, and design
information technology
falling average variable costs
distribution of gas and water
container ships
DISECONOMIES OF SCALE
Definition: Diseconomies of scale (decreasing
returns to scale) – average cost increases with
scale of production
ECONOMIES OF SCALE:
STRATEGIC IMPLICATIONS
Either produce on large scale or outsource
Seller side – monopoly/oligopoly
Buyer side – monopsony/oligopsony
ECONOMIES OF SCALE:
GOOGLE VIS-À-VIS LIBRARY
Which link(s) in service chain are scaleable?
Compilation of information
Providing service: servers and network
Responding to enquiries
ECONOMIES OF SCALE:
CREDIT CARD PROCESSING
First Data, 44%
National Processing, 13%
Nova, 8%
“This is a scale business, and by adding PMT’s
volume to our operating platform there is a
tremendous advantage”
Nova Chairman Edward
Grzedzinski
ECONOMIES OF SCOPE
Economies of scope: total cost of production is
lower with joint than with separate production
Diseconomies of scope: total cost of production is
higher with joint than with separate production
EXPENSES FOR TWO PRODUCTS
Organization Output Labor Printing Ink etc. Total
Press Cost
Separate production
Daily Globe 50,000 $5,000 $3,500 $6,700 $15,200
Afternoon Globe 50,000 $5,000 $3,500 $6,700 $15,200
Two papers $30,400
Combined production
Two papers 100,000$10,000 $3,500 $13,400 $26,900
ECONOMIES OF SCOPE
source -- joint cost: cost of inputs that do not
change with scope of production
examples:
• cable television + telephone
banking + insurance
manufacturing: refrigerator + air-conditioner
strategic implication -- produce/deliver multiple
products
ECONOMIES OF SCOPE:
CORE COMPETENCE
Technology – apply common technology to
multiple products
LCDs – watches, PDAs
Manufacturing – apply same process to multiple
products
LCDs, semiconductors
Marketing – brand extensions
spread promotional costs over multiple
products/businesses
DISECONOMIES OF SCOPE?
TIME WARNER
Carl Icahn and Bruce Wasserstein: Time Warner
should break up into
cable television systems
film and television (including Warner Brothers, HBO and
CNN)
Time Inc. and magazines
America Online
HORIZONTAL BOUNDARIES
Economies of scale
Should bank merge with competitor?
Should trucking company acquire smaller rivals?
Economies of scope
Should airline run catering service?
Should bank sell insurance?
Should university open a medical school?
EXPERIENCE CURVE:
AIRBUS A350 VS BOEING 787
April 2004
Boeing launched 7E7 Dreamliner jet with 50 firm
orders from All Nippon Airways.
Aimed to secure 200 orders by December.
EXPERIENCE CURVE:
AIRBUS A350 VS BOEING 787
December 2004
Boeing achieved 52 firm orders.
Airbus launched A350.
Airbus Chief Commercial Officer John Leahy: A350 would attract a
substantial number of Boeing customers and “put a hole in
Boeing's Christmas stocking”.
Richard Aboulafia, Teal Group: Airbus had succeeded in its goal of
“disrupt[ing] the business case for the 7E7”.
EXPERIENCE CURVE
Incremental cost falls with cumulative production
run over time
Unit cost falls with cumulative production run
Distinguish from economies of scale within one
production period
EXPERIENCE CURVE
EXPERIENCE CURVE
Conditions
Relatively large human resources input per unit of
production
Relatively small production runs
Industries/processes (learning percentage)
Aerospace (85%)
Shipbuilding (80-85%)
Complex machine tools for new models (75-85%)
Repetitive electronics manufacturing (90-95%)
Repetitive machining or punch-press operations (90-
95%)
EXPERIENCE CURVE:
STRATEGIC IMPLICATION
Must accurately predict cumulative production
Then set price accordingly
Challenge – quantity demanded depends on
competition and price.
Example: Airbus A350 vs Boeing 787.
RELEVANCE
consider only relevant costs and ignore all other
costs
which costs are relevant depends on course of action
relevant costs may be hidden
irrelevant costs may be shown in accounts
OPPORTUNITY COST
definition -- net revenue from best alternative
course of action
two approaches
• show alternatives
• report opportunity costs
EXAMPLE
Williams bought a warehouse and paid $300,000
for it. She used her own money $200,000 and
made a bank loan of $100,000.
A developer were willing to buy warehouse for 2
million.
If Williams sells warehouse, she could invest
proceeds in government bonds and get a secure
income $160,000 (2 million*8%).
She could work elsewhere for salary $400,000.
INCOME STATEMENT
SHOWING ALTERNATIVES
Continue
Warehouse Shutdown
Operations
Revenue $700,000 $560,000
Expenses $220,000 $0
Profit $480,000 $560,000
Income statement reporting opportunity costs
Revenue $700,000
Cost $780,000
Profit ($80,000)
TRANSFER PRICING
Generally, for internal economic efficiency, set
transfer price = marginal cost
Special cases
Perfectly competitive market: transfer price = market
price
Production subject to full capacity: transfer price =
highest marginal benefit from internal use
Compare marginal benefit across internal users
TRANSFER PRICING
SUNK COST
definition-- cost that has been committed
and cannot be avoided
alternative courses of action
• prior commitments
• planning horizon
Fewer commitments fewer sunk costs;
longer planning horizon fewer sunk
costs.
EXAMPLE
Jupiter Athletic is about to launch a line of new
athletic shoes. Some month ago, management
prepared an ad campaign with total budget of
$310,000.
They forecast the ad would generate sales of
20,000 units. Each sale’s unit contribution
margin (price- average variable cost) is $20. The
total contribution margin is $20*20000=$400,000.
Their expected profit generated from ad is
$400,000-310,000=$90,000.
EXAMPLE: CONTINUED
Recently, a major competitor launch a new shoe.
Jupiter estimates sales fall to 15,000 units. The
contribution margin becomes
$20*15,000=$300,000.
Should Jupiter cancel the launch?
INCOME STATEMENT SHOWING
ALTERNATIVES
Continue Cancel
Product Launch Launch
Contribution margin $300,000 $0
Graphic arts $50,000 $50,000
consultant fee
Road Runner charge $60,000 $30,000
Daily Globe charge $200,000 $20,000
Profit ($10,000) ($100,000)
Income statement omitting sunk costs
Contribution margin $300,000
Graphic arts cost $0
Road Runner charge $30,000
Daily Globe charge $180,000
Profit $90,000
SUNK VIS-À-VIS FIXED COSTS
Not all sunk costs are fixed
Not all fixed costs are sunk