COSTSManagerial Economics

Jack Wu

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

DailyProduction(thousands) Labor

PrintingPress

InkandPaper

Electricpower Total

0 $5000 $1000 $0 $200 $620010 $5000 $1500 $1200 $300 $800020 $5000 $2000 $2400 $400 $980030 $5000 $2500 $3600 $500 $1160040 $5000 $3000 $4800 $600 $1340050 $5000 $3500 $6000 $700 $1520060 $5000 $4000 $7200 $800 $1700070 $5000 $4500 $8400 $900 $1880080 $5000 $5000 $9600 $1000 $2060090 $5000 $5500 $10800 $1100 $22400

FIXED AND VARIABLE COSTS

DailyProduction(thousands)

FixedCost

VariableCost

TotalCost

MarginalCost

AverageFixedCost

AverageVariableCost

AverageCost

0 $6200 $0 $620010 $6200 $1800 $8000 $0.18 $0.62 $0.18 $0.8020 $6200 $3600 $9800 $0.18 $0.31 $0.18 $0.4930 $6200 $5400 $11600 $0.18 $0.21 $0.18 $0.3940 $6200 $7200 $13400 $0.18 $0.16 $0.18 $0.3450 $6200 $9000 $15200 $0.18 $0.12 $0.18 $0.3060 $6200 $10800 $17000 $0.18 $0.10 $0.18 $0.2870 $6200 $12600 $18800 $0.18 $0.09 $0.18 $0.2780 $6200 $14400 $20600 $0.18 $0.08 $0.18 $0.2690 $6200 $16200 $22400 $0.18 $0.07 $0.18 $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 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

Organization Output Labor Printing Ink etc. TotalPress 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 $30,400Combined production Two papers 100,000$10,000 $3,500 $13,400 $26,900

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

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

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

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.

Continue Warehouse Operations

Shutdown

Revenue $700,000 $560,000 Expenses $220,000 $0

Profit $480,000 $560,000

Revenue $700,000

Cost $780,000

Profit ($80,000)

Income statement reporting opportunity costs

INCOME STATEMENT SHOWING ALTERNATIVES

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?

Continue Product Launch

Cancel Launch

Contribution margin $300,000 $0 Graphic arts

consultant fee $50,000 $50,000

Road Runner charge $60,000 $30,000 Daily Globe charge $200,000 $20,000

Profit ($10,000) ($100,000)

Contribution margin $300,000 Graphic arts cost $0

Road Runner charge $30,000 Daily Globe charge $180,000

Profit $90,000

Income statement omitting sunk costs

INCOME STATEMENT SHOWING ALTERNATIVES

SUNK VIS-À-VIS FIXED COSTS

Not all sunk costs are fixedNot all fixed costs are sunk

DISCUSSION QUESTIONS

Qantas operates a fleet of over 100 Boeing jet aircraft. Commercial passenger jets must be operated by a pilot and co-pilot. Many jets carry cargo in their "bellies", under the passenger seating areas. Consider each of the following costs. Identify which are joint costs of passenger and belly cargo services, which are fixed costs of passenger service, and which are both.

DISCUSSION QUESTIONS

(A)Cockpit personnel: All jets, large and small, require a pilot and co-pilot. Belly cargo service requires no additional officers in the cockpit.

(B)Airport landing fees: Some airports charge landing fees by weight of the aircraft, while others levy a fixed fee, regardless of weight.

(C)Fuel: Larger aircraft and those carrying heavier loads will consume relatively more fuel.