Managerial Economics
Group E2 Presentation
Topic: Cost Drivers Analysis
Group Members
Brian Chan
Kitty Wong
Sarah Lee
Ting Cheng
Student ID
02707989G
02725393G
02708427G
02428884G
Introduction to Cost Drivers
ECONOMIES OF SCALE
(INTERNAL & EXTERNAL)
• Indivisibilities
• Specialization and division of labor
• External economies occur outside firm
ECONOMIES OF SCOPE
• Produce different models
• Resources can be shared
CAPACITY UTILIZATION
• Ratio of actual capacity used to design capacity
• Costs of installing and closing capacity
LEARNING EFFECT
GEOGRAPHICAL LOCATION
• Firm “learn by doing” how to be more efficient
• Production cost decrease with time
• Tax, Government Incentives
• Franchise, Government Policy
Introduction to Cost Drivers
TIMING
• Purchase cost of capital
• Level of demand
• Capacity utilization of supply industry
INSTITUTIONAL FACTORS
• Unionization, tariff, local content rules
FIRST MOVER COST
ADVANTAGE
• First to undertake the activity
• First mover gains from the late mover
LATE MOVER COST
ADVATAGE
• Rapid technology development
• First comer invested heavily
COOPERATION WITH SUPPLIER
AND DISTRIBUTION CHANNELS
• Reducing costs for both confectioner and supplier
• Undertake the activities within firm
Cost Drivers in MTR
Cost Drivers in MTR
MTR’s Cost Driver
Important
Capacity Utilization

Economies of Scale
(External)
Economies of Scope

Geographical Location
(Government Policy)
Learning Effect

Unimportant


Important Cost Drivers in MTR
Company Background

MTR was established in 1975 as a Government
Owned Statutory Corporation

MTR currently operates a railway network of 87.7
kilometers route with 49 stations
Important Cost Drivers in MTR
The MTR Route Map
Important Cost Drivers in MTR
Capacity Utilization
 Capacity Utilization = Actual capacity used
Design capacity
 Now, MTR’s daily patronage of over 2.2 million
passengers. MTR is transporting 1 in 3 of Hong Kong
population every day
Important Cost Drivers in MTR
Capacity Utilization (Con’t)
 Each of the Urban Lines , however, is capable of
running 34 trains per hour in each direction. This gives a
full capacity of 85,000 passengers for each Urban Line
in each direction
 To meet escalating passenger’s demand, the Corporation
expanded its train fleet from 140 cars in 1979 to 1,050
cars in 2002 (including 88 cars for the Airport Express),
84% of which are in service to meet the daily morning
peak demand
Important Cost Drivers in MTR
External Economies of Scale
 Economies of Scale occurs when mass producing a good
results in lower average cost. Economies of Scale occurs
within a firm (internal) or within an industry (external)
 External economies are the advantages which accrue to
a firm from the growth in the size of the industry and
they are especially significant when that industry is
heavily localized
Important Cost Drivers in MTR
External Economies of Scale (Con’t)
 Agglomeration Economies
 This is one type of the external economies of scale
 Hong Kong is an area with a population of high density
 MTR provides a good transport network in Hong Kong
Important Cost Drivers in MTR
Economies of Scope
 Economies of Scope arises whenever it is more efficient
to produce two or more products together than to
produce them separately
 In MTR, trains go to the “Airport” and “Tung Chung”
will be served by the same set of tracks and signalling
equipment
Important Cost Drivers in MTR
Government Policy
 MTR is one of the Hong Kong Public Utilities
 Government offers extra low interest rate of loan,
financial support, taxes and franchise to protect MTR
from competition of other transportations such as Buses,
Mini-buses and Private buses
Important Cost Drivers in MTR
Government Policy (Con’t)
 The new development of MTR should coincide with the
new town planning of the Government
 MTR contributes some resources to the improvement of
social and environment aspects to the society
Unimportant Cost Drivers in MTR
Learning Effect
 The new “Tseung Kwan O” Line takes some time for the
MTR staff and the passengers to get used to the new
station facilities and the inter-changing stations
 Learning effect occurs but does not happen too often
Cost-drivers in Import/Export
Cost Drivers in Import / Export
Cost Driver
Important
Cooperation with Suppliers

Timing

Geographical Location

Institutional Factors

Unimportant
Economies of Scale (General)

Economies of Scale (External)

Economies of Scope

Important Cost Drivers in Import/Export
Cooperation with Suppliers
“Mutual Relationship”
 Two-way cooperation increases efficiency and reduce cost
 Porter’s chocolate example (Davies & Lam, p. 185)
 Products that require special care - i.e. use of effective
methods to keep frozen meat from deterioration
 Real-life example - Supplier’s products not meeting firm’s
standards and need to be re-inspected
Important Cost Drivers in Import/Export
Timing
“Time=Money”-exceptionally true in I/E
 Time Management (production lead time, delivery date,
shipping date etc.)-to manage time-consuming factors
well or resulting in unexpected high cost and penalty
 Purchasing Time (Davies & Lamb, p. 185)-purchasing
at peak season when suppliers are overwhelmed with
orders and are experiencing material/product shortage
would result in cost rise
Important Cost Drivers in Import/Export
Geographical Location
“Know your destination”
 Freight cost--to be determined by the distance between
country of origin and shipping destination
 Climatical impact on goods--to take regional climate
into account so that damage to products can be avoided
(i.e. wooden products)
Important Cost Drivers in Import/Export
Institutional Factors
“…and the negotiations resume.”
 Unionization--unions’ action of the shipping industry is
influential to I/E (i.e. U.S. West Coast Ports Lockout
causing tremendous lost to U.S. I/E and costing the
economy $2 billion each day)
 Product test and Quality Assurance Inspection
Important Cost Drivers in Import/Export
 Tariffs--each country has established its own tariff
schedule (i.e. tariff schedule of the United States)
Unimportant Cost Drivers in Import/Export
Economies of Scale

Large number of existing trading firms with small
number of employees in each

Most trading firms maintain a small size to survive
because of competition
Unimportant Cost Drivers in Import/Export
External Economies of Scale-Agglomeration
“Learn from toilet gossips.”
 A large number of firms from the same industry cluster
together (i.e. commercial buildings in TST East)
 Firms (and their employees) learn from and exchange
ideas with each other on a more casual basis
 Convenient access for customers and other relevant
industries (i.e. Manufacturers, retailers and logistics
companies)
 Real-life example: Golden Chinachem Plaza (Mody
Road)
Unimportant Cost Drivers in Import/Export
Economies of Scope
 Dealing with a great variety of product and increase
product types
Question:
Is Capacity Utilization an important or unimportant cost
driver? How so?
Cost-drivers in Motor Industry
Cost Drivers in Motor Industry
Cost Driver
Important
Capacity Utilization

Economies of Scale

Economies of Scope

Learning Effect

First Mover Cost Advantage

Second Mover Cost Advantage

Unimportant
Timing

Geographical Location

Institutional Factor

Important Cost Drivers in Motor Industry
Capacity Utilization
 The actual capacity (output) should be equal to the design
capacity of the plant and equipment for vehicle production
 Under capacity means there will be a waste of resources or
with lower profitability
 Over capacity will lead to an increase in cost and leads to
motor plant closing
 However, the design capacity is market driven. So a good
forecast of customer demand on motor will lead to capacity
utilization
 Capacity utilization can also be achieved by reducing
bottleneck, e.g. coordination among different parties
Important Cost Drivers in Motor Industry
Economies of Scale
 Because there is existence of indivisibilities in the motor
industry, a large reduction in cost can be achieved by
economies of scale
 Integration is a way to achieve economies of scale, e.g.
the merging of Ford, Volvo, Mazda etc
 Technical economies made in the actual production of the
vehicles. For example, Ford or General Motor can use
expensive and advanced machinery
 Managerial economies (Division of labour) made in the
administration of a large firm by splitting up management
jobs and employing specialist accountants, salesmen, etc
Important Cost Drivers in Motor Industry
Economies of Scale (Con’t)
 Financial economies made by borrowing money at lower
rates of interest than smaller firms. Large motor
companies can repay the fixed costs over greater volumes,
compelling small competitors to withdraw from the market
 Marketing economies made by spreading the high cost of
advertising on television and in national newspapers,
across a large level of output e.g. Ford groups
 Commercial economies made when buying supplies in
bulk and therefore gaining a larger discount.
 Research and development economies made when
developing new and better products
Important Cost Drivers in Motor Industry
Learning Effect
 “Learning” effect first noted by T.P.Wright in 1936 who
created a “learning curve” math model
 Used to estimate aircraft production labour in WWII and
since then to estimate many kinds of repeated activities
Basic idea
 As people repeat a task again and again, the time it takes
to do the task gradually decrease due to “learning”
 Rate of learning is greatest at the beginning when
“ignorance” is greatest; rate of “learning” decreases as
“ignorance” decreases
Important Cost Drivers in Motor Industry
Learning Effect (Con’t)
 The learning effect will lead to a large reduction in cost
during the production process over a period of time.
 The idea is that as workers make more and more units of
a product, they become more experienced at their jobs,
and, as result, the variable production costs (such as those
associated with assembly, inspection, testing, etc.)
decrease
 Better tools and process will be applied through learning
 Learn faster can result in huge competitive advantages
(Note: The investment should be tradeoff against the
savings caused by faster learning)
Important Cost Drivers in Motor Industry
Cost saved by economies of scale and learning effect
Cost
($per unit
of output)
Economies of Scale
A
y
B
y1
AC 1
Learning
y2
C
x
AC 2
x1
Output
Economies of Scale: more output can be produced at a lower cost
Learning: cost will be high at first and then will fall with learning
Important Cost Drivers in Motor Industry
Economies of Scope
 Economies of scope exists if savings are achieved by
producing a wide range of motors within the firm
 Multiple vehicle types produced at each plant will
increases a firm’s ability to meet actual demand with less
under-utilization of each plant’s capacity
 TC(Qx, Qy) < TC(Qx, 0) + TC(0, Qy)
 Resources can be shared
 Savings in inventories
Important Cost Drivers in Motor Industry
First-mover Cost Advantages
 First to undertake the activity
 Gain more due to large learning effect
 The vehicles can be produced at a lower cost
Important Cost Drivers in Motor Industry
Late-mover Cost Advantages
 Great impact for industry with rapid technology
development like motor industry
 Take advantage on other’s learning and use the latest
technology to produce the firm’s own products.
Unimportant Cost Drivers in Motor Industry
 Timing
 Geographical Location
 Institutional factor
Cost-drivers in Passenger
Aircraft Manufacture
Cost Drivers in Passenger Aircraft Manufacture
Cost Driver
Important
Capacity Utilization

Economies of Scale

Economies of Scope

Learning Effect

First Mover Cost Advantage

Second Mover Cost Advantage

Unimportant
Timing

Geographical Location

Institutional Factor

Important Cost Drivers in
Passenger Aircraft Manufacture
Capacity Utilization
 High fixed cost of installing aircraft manufacturing
equipment which is of high degree of asset specificity
 => repay fixed cost by utilizing the capital
Important Cost Drivers in
Passenger Aircraft Manufacture
Economies of Scales
 High degree of specificity and division of labor in
aircraft manufacturing industry
 The need to install complex and expensive equipment
 Lower interest rate of financial lending
 Larger discount for bulk purchase of parts
 => increase aircraft production to lower the average cost
Important Cost Drivers in
Passenger Aircraft Manufacture
Learning Effects
 Great impact on production of highly complex products
like aircraft manufacturing
 Cost of production decreases as time of the process
decreases with better skills and techniques acquired by
technicians and engineers through learning
 e.g. Boeing invests heavily on training and established
Boeing Training Center
Important Cost Drivers in
Passenger Aircraft Manufacture
Cost saved by economies of scale and learning effect
Cost
($per unit
of output)
Economies of Scale
A
y
B
y1
AC 1
Learning
y2
C
x
AC 2
x1
Output
Economies of Scale: more output can be produced at a lower cost
Learning: cost will be high at first and then will fall with learning
Important Cost Drivers in
Passenger Aircraft Manufacture
Economies of Scope
 More profitable to produce wider range of aircraft
products and share the same resources
e.g. Boeing produces a wide range of products in
1) different types: commercial & military
2) models: 717, 747, 777
3) capacity : 100, 200, 500 seats
Important Cost Drivers in
Passenger Aircraft Manufacture
Vertical Integration I
 Backward vertical integration:
manufacturer owns the supply company of parts
 e.g. Boeing produces parts by itself
Important Cost Drivers in
Passenger Aircraft Manufacture
Vertical Integration II
 Forward vertical integration:
- manufacturer owns the distribution channel
 e.g. Boeing sells its aircraft through Boeing Aircraft
trading
Important Cost Drivers in
Passenger Aircraft Manufacture
Vertical Integration III








Reduce transaction cost
Achieve internal economies of scale
Achieve economies of scope
Higher efficiency
Greater flexibility
More reliable
Greater competitiveness
More profitable
Important Cost Drivers in
Passenger Aircraft Manufacture
First-mover Cost Advantages
 Great impact for industry with substantial learning
effects like aircraft manufacture
 Professionals like skilled technicians and engineers have
all been recruited
 e.g. Boeing has been the world leader in aircraft
manufacturing for more than 40 years
Important Cost Drivers in
Passenger Aircraft Manufacture
Late-mover Cost Advantages
 Great impact for industry with rapid technology
development like aircraft manufacture
 Late-mover can respond to the latest market trend and
customer needs with more investment fund in hand
 e.g. increase demand for new and smaller size aircraft
as older ones retired and passengers decreased after the
event of Sept 11
Unimportant Cost Drivers in
Passenger Aircraft Manufacture
 Timing
 Geographical location
 Institutional factors
Comparison of Important Cost Drivers
Service Industry
Cost Drivers
MTR
I/E Trading
Manufacturing Industry
Motor Car
Aircraft
Manufacturer
Economies of Scale



Economies of Scope



Capacity Utilization









Learning Effect
Geographical
Location
Cooperation with
Supplier
Timing
First Mover Cost
Advantage
Late Mover Cost
Advantage
Institutional Factors





Conclusion
 Different industries have their own set of Cost
Divers. Some of them are typical and some are
unique
 Cost Drivers will vary from time to time and
from place to place
 The study of Cost Drivers is crucial for
economic analysis
 Important to identify and evaluate Cost Drivers
for future improvement
THE END
THANK YOU