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									 Costs

  Dr. Yi LU
February, 2008




   @2008 Yi LU
Introductory Story: Samsung Electronics




                  @2008 Yi LU
Introductory Story: Samsung Electronics

• Samsung Electronics
  – US$5 billion profits in 2003: rivals Intel and dwarfs
    Motorola and Sony in profitability
  – Widely diversified
     • Consumer goods: refrigerator, TV, mobile phone
     • Industrial components: memory chips
  – World’s largest manufacturer of DRAM chips and
    TFT-LCDs (thin-film transistor liquid crystal displays)
  – Best-selling brand of TVs priced over US$3,000.



                          @2008 Yi LU
Introductory Story: Samsung
Electronics
• Costs of semiconductor and TFT-LCD
  manufacturing plants are huge
  – Average cost of new 300mm wafer fabrication was
    US$1.4 billion
  – Depends on the production technology
     • Semiconductor: up to 30% less costly using 300mm wafer
       technology than 200mm wafer
     • LCD: 7th generation substrate yield 1.5 t0 2 times as may
       displays as the current 6th generation substrate.




                           @2008 Yi LU
Introductory Story: Samsung
Electronics
• In may 2003, Samsung Electronics announced
  the construction of a 7th generation plant.
  – While the second-largest TFT-LCD manufacturer, LG.
    Philips LCD, just announced a 6th generation plant to
    be operational by 2005.
• In 2003, Samsung Electronics realized
  –   Sales: 64,817 trillion won
  –   Operation profits: 6,296 billion won
  –   After-tax profit: 5,962 billion won
  –   Debt: 23,466 billion won
                           @2008 Yi LU
Introductory Story: Samsung
Electronics
• Questions:
  – Does Samsung gain advantage by manufacturing
    both semiconductors and TFT-LCDs
  – How should Samsung price semiconductors and TFT-
    LCDs for internal use in manufacturing mobile
    phones, computers, and TVs?
  – Should Samsung borrow less?




                      @2008 Yi LU
Outline

•   Economies of Scale
•   Economies of Scope
•   Opportunity cost
•   Sunk cost
•   Cost estimation




                     @2008 Yi LU
Economies of Scale

• A fundamental issue for any business is whether
  to operate on a small scale or large scale
  – Large scale: mess marketing and relatively low
    pricing
  – Small scale: niche marketing and relatively high
    pricing
• Analyze how costs depend on the scale or rate
  of production
  – Fixed cost versus Variable cost
  – Market demand and competition; etc.
                        @2008 Yi LU
Economies of scale: Daily expense
statement
 Daily    Labor   Printing     Ink         Electric   Total
Prodn              Press       and         Power
(‘000s)                       Paper
  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
                             @2008 Yi LU
Economies of scale: Fixed/variable costs
 Daily Fixed Variable   Total     Marginal Avg     Avg    Avg
Prodn Cost    Cost      Cost       Cost    Fixed Variable Cost
(‘000s)                                    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   $0.25
                                 @2008 Yi LU
Economies of scale
   Marginal/average cost ($ per unit)

                                          1
                                        0.9
                                        0.8
                                        0.7
                                        0.6
                                        0.5
                                        0.4                             average cost
                                        0.3
                                                                        marginal, average
                                        0.2
                                                                        variable cost
                                        0.1
                                         0    10 20 30 40 50 60 70 80 90

                                                Production rate (Thousands a day)

                                                          @2008 Yi LU
Economies of scale

• Definitions:
   – The average cost decreases with the scale of production
   – Distinguished from
      • experience curve: costs fall with increases in cumulative
        production over time.
      • economies of scope
• Sources
   – large fixed costs
       • research, development, and design: e.g. pharmaceutical company
       • information technology
   – falling average variable costs
       • distribution of gas and water
       • container ships, tankers

                                 @2008 Yi LU
Economies of scale: Cost of tankers

• In 1833, Marcus Samuel opened a shop in
  London to sell seashells.
• While procuring shells in the Caspian Sea,
  Marcus’s son spotted a new business
  opportunity—to export kerosene from Russia to
  the Far East
• Historically oil had been transported in wooden
  barrels on cargo ships.


                     @2008 Yi LU
Economies of scale: Cost of tankers

• In 1892, Marcus Samuel Junior conceived the
  idea of building a ship in the shape of a tank,
  which became the world’s first oil tanker.
• Oil tanker is like a pipeline in the sense that its
  capacity increases with the cross-sectional area
  and hence the square of the radius of the cross-
  section
• The material and construction costs increase
  with the radius of the cross-section.

                       @2008 Yi LU
Economies of scale: Cost of tankers

                   Figure 7.2: New Tanker Prices, January
                                    2004
  deadweight ton




                   800
   (US dollars)
     Price per




                   600
                   400
                   200
                     0
                         0     100         200        300    400
                               Size ('000 deadweight tons)
                                  @2008 Yi LU
Economies of scale: diseconomies

• Diseconomies of scale
   – The average cost increases with the scale of
     production
   – Sources
      • Not substantial fixed costs
      • Variable cost rises faster
   – Examples
      • Hairdressing salon
          – Not significant fixed costs but important labors




                              @2008 Yi LU
Economies of scale: Strategic implications

• Either produce on large scale or outsource
   – seller side – monopoly/oligopoly
   – buyer side – monopsony/oligopsony
• Examples
   –   semiconductor manufacturing
   –   automobile manufacturing
   –   civil aircraft manufacturing: Boeing versus Airbus
   –   banking services


                          @2008 Yi LU
Economies of scale: Yahoo vis-à-vis library

 • Which link(s) in chain are scaleable?
    – compilation of information; service; maintenance.
 • Factors
    – compilation of information: fixed costs
    – providing service:
       • Basic system: fixed costs
       • servers and network: variable costs
    – responding to enquiries
       • FAQs: fixed costs
       • Human responses: variable costs



                           @2008 Yi LU
Economies of scale: Recorded music


            writing and performing


                 manufacturing


            publishing and marketing


                    retailing

                   @2008 Yi LU
Economies of scale: Credit cards processing




              transaction processing




 issuance to consumers             acquiring merchants




                     @2008 Yi LU
Economies of scale: Credit cards processing

• In the past, every transaction made with a credit
  card was processed manually.
• However, the advance of technology, i.e.,
  automation, has changed the processing of
  credit card transactions into a production-line
  operation.
• Automated processing requires significant fixed
  investments in computer systems.


                      @2008 Yi LU
Economies of scale: Credit cards processing

• Consequently the processing becomes a
  business with economies of scale. And the
  industry becomes increasingly concentrated.
    –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



                            @2008 Yi LU
Economies of scope

• A fundamental strategic decision is whether to
  offer many different products or focus on a
  single item
• Example: Haier
  – More than 30% of China's freezer, refrigerator, and
    washing machine markets.
  – Why not doing well in pharmaceuticals?




                        @2008 Yi LU
Economies of scope

• Economies of scope
  – The total cost of production is lower with joint than
    with separate production
• Diseconomies of scope
  – The total cost of production is higher with joint than
    with separate production
  – e.g. Levono: computer producers, in the mid-1990s,
    entered the real estate market, and incurred a huge
    lost and exited the market finally.


                         @2008 Yi LU
Economies of scope: 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


                             @2008 Yi LU
Economies of scope: Sources

• Joint cost
  – cost of inputs that do not change with scope of
    production
  – e.g., telecommunications and broadcasting
     • Both requires a wire network connecting the subscribers
     • Share the cost of building and maintaining the network
• Core competence
  – Technology
  – Manufacturing
  – Marketing

                           @2008 Yi LU
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

                       @2008 Yi LU
Economies of scope: Strategic implications

• produce/deliver multiple products
  – product mix
     • e.g., Samsung, Microsoft
  – brand extensions
     • e.g., Haier




                           @2008 Yi LU
Economies of scope: Samsung Electronics/
LG.Philips LCD
• Economies of scope
  across
  manufacturing
  semiconductors and
  LCD?
  – Similar
    manufacturing
    process


                    @2008 Yi LU
Economies of scope: Virgin – What’s in a
name?
 • Richard Branson -- iconoclast with integrity
     and taste for adventure
 •   targeted oligopolistic retail industries
      Music publishing
      airline travel
      soft drinks
 • Analysis
     • Core competency: deliver superior product
     • Pitfall: one failure may damage the whole
       company reputation
                          @2008 Yi LU
Economies of scope: Haier

 electrical appliances – refrigerators, air-
  conditioners, washing machines
 IT products – mobile telephones, PCs
 furniture
 robots, plastics, materials
 pharmaceuticals
 insurance
 etc

                       @2008 Yi LU
Economies of scope: Canadian Pacific

• 1881: founded to build transcontinental railway
• 2001: petroleum, coal, railway, shipping, hotels
• Feb. 2001: announced split into five companies;
  stock rose $3.51 to $37.45




                      @2008 Yi LU
Economies of scope: Buyer side

• Economies of scope in use/consumption
  – learning and usage skills
     • PC users stick to Windows or MAC but don’t mix operating
       systems
  – complementary items
     • airlines tend to buy aircraft in families




                              @2008 Yi LU
Economies of scale and scope: 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?




                       @2008 Yi LU
Opportunity Cost

• Consider only relevant costs and ignore all other
  costs
  – which costs are relevant depends on alternative
    courses of action
• Relevant costs may be hidden
• Irrelevant costs may be shown in accounts




                       @2008 Yi LU
Opportunity Cost: Alternative courses of
action

                 Continue        Shut down
                warehouse
                operations
 Revenue           $700,000       $560,000

 Expenses          $220,000             $0

 Profit            $480,000       $560,000


                   @2008 Yi LU
Opportunity cost: Showing hidden cost

                               Continue
                              warehouse
                              operations
 Revenue                           $700,000

 Cost (including hidden            $780,000
 costs)
 Profit                             $80,000


                     @2008 Yi LU
Opportunity cost

• Definition – net revenue from best alternative
  course of action
• Two approaches
      show alternatives
      report opportunity costs




                        @2008 Yi LU
Opportunity cost: Wing On Group

• Department Store Main
  store, Des Voeux Road
   – 25,000 sq.ft. on ground level
   – 64,000 sq.ft. on other levels
• The tenants of the street-
  level floors of other nearby
  buildings
   – Banks, fast-food chains, and
     Jewelers.



                         @2008 Yi LU
Opportunity cost: Wing On Group

Revenue              $1,623.0

Expenses             $1,239.0
Profit before tax     $384.0


Opportunity            $26.5
cost
Units: HKD million

                         @2008 Yi LU
Opportunity cost: Wing On Group

• The market rent for retail space around the Wing
  On Centre
  – HK$50-100 per square foot per month for ground
    floors
  – HK$15-25 for other floors
• Calculating the opportunity cost
  – 50*25,000*12=HK$15 million
  – 15*64,000*12=HK$11.5 million
  – Totally HK$26.5 million


                       @2008 Yi LU
Opportunity cost: Economic Value Added

• All forms of financing an investment are costly
  – must pay interest on debt
  – must provide return on equity
• EVA = revenue - all costs (including cost of
  equity capital)




                        @2008 Yi LU
Opportunity cost: Loewen Group, 1999

• In June 1999, the Loewen Group operated more
  than 1,100 funeral homes and 400 cemeteries in
  Canada, UK, and US.
• The businesses in cemeteries were financed by
  $2 billion of bonds and $300 million of bank
  loans.




                     @2008 Yi LU
Opportunity cost: Loewen Group, 1999

                        Before re-         after
                        capitalization
 revenue                            $566   $566
 operating earnings                 $ 73   $ 73
 interest                           $ 77      --
 net before                         ($4)   $ 73
 exceptionals

                      @2008 Yi LU
Opportunity cost: Loewen Group, 1999

• Facing huge loss, Loewen Group filed for
  bankruptcy protection in Canada and US.
• Loewen next claimed to focus on funeral home
  operations and away from cemeteries, and
  urged bondholders to convert bonds into equity.
• The conversion of debt to equity, however,
  would not change the group’s business situation,
  though reduction of losses would show up in
  accounting statements.

                     @2008 Yi LU
Opportunity cost: Transfer pricing

• Example
  – Mercury Group has two divisions—semiconductors
    and consumer electronics.
  – Semiconductor division supplies chips to the
    consumer electronics division for use in
    manufacturing personal digital assistants.
  – How to set the price of these chips.




                      @2008 Yi LU
Opportunity cost: Transfer pricing

• Generally, transfer price = marginal cost.
• Special cases:
  – perfectly competitive market: transfer price = market
    price
  – production subject to full capacity: transfer price =
    marginal benefit from internal use




                        @2008 Yi LU
Sunk cost

• Definition – cost that has been committed and
  cannot be avoided.
• Alternative courses of action depend on
      prior commitments
      planning horizon




                      @2008 Yi LU
Sunk cost: Jupiter Athletic

• Jupiter Athletic
   – Jupiter Athletic wants to launch a line of new athletic
     shoes
   – Several months ago, it prepared an advertising
     campaign and booked space in Road runner
     magazine and the Daily Globe newspaper, estimated
     at $310,000.
   – Estimated increase of sales: 20,000
   – Estimated profit margin: $20
   – Estimated profits: $20*20,000=$400,000

                          @2008 Yi LU
Sunk cost: Jupiter Athletic

• Jupiter Athletic
   – Major competitors also launched a new product
   – New estimated increase of sales: 15,000
   – New estimated profits: $20*15,000=$300,000
   – Should Jupiter continue?




                        @2008 Yi LU
Sunk cost: Jupiter Athletic

                  Continue         Cancel

 Cont. margin       $300,000                $0
 Agency fee            $50,000      $50,000
 Road Runner           $60,000      $30,000
 Daily Globe        $200,000        $20,000
 Profit             ($10,000)     ($100,000)

                    @2008 Yi LU
Sunk cost: Jupiter Athletic

                          Continue

   Cont. margin             $300,000

   Agency fee                         $0
   Road Runner                    $30,000
   Daily Globe              $180,000
   Profit                         $90,000
                    @2008 Yi LU
Sunk cost: DaimlerChrysler, Nov. 2000

• Chrysler reported Q3 loss
  – Analysts recommended laying off excess
    workers (30,000 of 128,000)
• UAW agreement, 1999-2002
  – 95% pay for entire contract
  – first 42 weeks, offset by state
    unemployment assistance




                        @2008 Yi LU
Sunk cost: Apple Computer, Summer 1988

• Apple bought several hundred million dollars of
  1-Megabit DRAMs at around $38 per chip;
• January 1989: market price dropped to $23
  – For pricing Macintoshes, what is the cost of a 1-
    megabit DRAM from inventory?




                       @2008 Yi LU
Sunk costs: Strategic implications

• Ignore sunk costs and consider only avoidable
  costs.
• Lock in customers
  – Printers versus cartridge.
• Lock out competitors
  – reduce future marginal cost, eg, Qwest




                         @2008 Yi LU
Sunk costs: Sunk vis-à-vis fixed costs

               sunk


    costs
                                 fixed
              relevant
                                 variable


                   @2008 Yi LU
Sunk costs: Sunk vis-à-vis fixed costs

• Some fixed costs become sunk once incurred
   – A manufacturer of rubber shoes
      • Needs molds to produce shoes
      • Design of molds is a fixed cost and also a sunk cost
• Not all sunk costs were fixed:
   – Qwest laid 48 strands of 10 Gbps fiber – sunk, once
     incurred. But Qwest could have chosen to lay fewer
     strands.
• Not all fixed costs are sunk:
   – Every commercial jet must have one pilot and co-pilot –
     these are fixed costs. But not sunk – can lay off the pilots.
                             @2008 Yi LU

								
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