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Costs

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									COSTS
IMBA Managerial Economics
Jack Wu
INTRODUCTION
 Cost and economies of scale
 Cost and economies of scope

 Relevant / Irrelevant costs

 Direct / Indirect costs
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      $0.25
ECONOMIES OF SCALE
     Marginal/average cost ($ per unit)


                                           1
                                          0.9
                                          0.8
                                          0.7
                                          0.6
                                          0.5
                                          0.4                                        average cost
                                          0.3
                                          0.2                                        marginal, average
                                                                                     variable cost
                                          0.1

                                          0     10   20     30   40   50   60   70   80   90

                                                          Production rate (Thousands a day)
SCALE ECONOMIES: SOURCES

   large fixed costs
     research, development, and design
     information technology

   falling average variable costs
     distribution of gas and water
     container ships
SCALE ECONOMIES:
STRATEGIC IMPLICATIONS
 large-scale production
 seller side: monopoly/oligopoly

 buyer side: monopsony/oligopsony
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 + telephony
   strategic implication -- produce/deliver multiple
    products
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)
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

								
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