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
Production
(thousands)
0
10
20
30
40
50
60
70
80
90
Labor
$5000
$5000
$5000
$5000
$5000
$5000
$5000
$5000
$5000
$5000
Printing
Press
$1000
$1500
$2000
$2500
$3000
$3500
$4000
$4500
$5000
$5500
Ink
and
Paper
$0
$1200
$2400
$3600
$4800
$6000
$7200
$8400
$9600
$10800
Electric
pow er
$200
$300
$400
$500
$600
$700
$800
$900
$1000
$1100
Total
$6200
$8000
$9800
$11600
$13400
$15200
$17000
$18800
$20600
$22400
FIXED AND VARIABLE COSTS
Daily
Production
(thousands)
0
10
20
30
40
50
60
70
80
90
Fixed
Cost
$6200
$6200
$6200
$6200
$6200
$6200
$6200
$6200
$6200
$6200
Variable
Cost
$0
$1800
$3600
$5400
$7200
$9000
$10800
$12600
$14400
$16200
Total
Cost
$6200
$8000
$9800
$11600
$13400
$15200
$17000
$18800
$20600
$22400
Marginal
Cost
Average
Fixed
Cost
Average
Variable
Cost
Average
Cost
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.62
$0.31
$0.21
$0.16
$0.12
$0.10
$0.09
$0.08
$0.07
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.80
$0.49
$0.39
$0.34
$0.30
$0.28
$0.27
$0.26
$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


Manufacturing – apply same process to multiple
products


LCDs – watches, PDAs
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 (9095%)
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
Revenue
Expenses
Profit
Continue
Warehouse
Operations
$700,000
$220,000
$480,000
Shutdown
$560,000
$0
$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
Contribution margin
Graphic arts
consultant fee
Road Runner charge
Daily Globe charge
Profit
Continue
Product Launch
$300,000
$50,000
Cancel
Launch
$0
$50,000
$60,000
$200,000
($10,000)
$30,000
$20,000
($100,000)
Income statement omitting sunk costs
Contribution margin
Graphic arts cost
Road Runner charge
Daily Globe charge
Profit
$300,000
$0
$30,000
$180,000
$90,000
SUNK VIS-À-VIS FIXED COSTS
Not
all sunk costs are fixed
Not all fixed costs are sunk