COSTS IMBA Managerial Economics Jack Wu COSTS INTRODUCTION

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

FIXED AND VARIABLE COSTS

ECONOMIES OF SCALE w 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

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 A 350 VS BOEING 787 April 2004 Boeing launched 7 E 7 Dreamliner jet with 50 firm orders from All Nippon Airways. Aimed to secure 200 orders by December.

EXPERIENCE CURVE: AIRBUS A 350 VS BOEING 787 December 2004 Boeing achieved 52 firm orders. Airbus launched A 350. Airbus Chief Commercial Officer John Leahy: A 350 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 7 E 7”.

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 A 350 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 Income statement reporting opportunity costs

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 commitments fewer sunk costs; longer planning horizon fewer sunk costs. Fewer

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 Income statement omitting sunk costs

SUNK VIS-À-VIS FIXED COSTS Not all sunk costs are fixed Not all fixed costs are sunk