Managerial EconomicsJack Wu

Cost and economies of scale Cost and economies of scope Relevant / Irrelevant costs Direct / Indirect costs

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

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

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

10 20 30 40 50 60 70 80 90

average cost

marginal, averagevariable cost

Production rate (Thousands a day)

Marg

inal/avera

ge c

ost

($

per

unit

)

large fixed costs◦ research, development, and design◦ information technology

falling average variable costs ◦ distribution of gas and water◦ container ships

large-scale production seller side: monopoly/oligopoly buyer side: monopsony/oligopsony

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

source -- joint cost: cost of inputs that do not change with scope of production

examples:� Qwest’s IP network: voice + data� cable television + telephony

strategic implication -- produce/deliver multiple products

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

definition -- net revenue from best alternative course of action

two approaches� show alternatives� report opportunity costs

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

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.

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.

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

lock in customers lock out competitors

Not all sunk costs are fixed Not all fixed costs are sunk

direct cost: can be relatively easily identified with a particular product/job

activity-based costing◦ identify the activities◦ allocate the indirect cost of each activity

among the products◦ combine the allocated indirect costs with the

direct costs

One indirect cost centre is shipping department -- accounting statements show:

_wages _telephone and fax Must investigate to allocate: identify two

activities _shipments _handling enquiries

item expense shipmt inquiries

method

wages 48,000 30,000 18,000 worker hours

tel/fax 2,000 0 2,000 identified

total 50,000 30,000 20,000

shipmts inquiries

Alpha 500 1000

Beta 800 1600

Wkly expense $600 $400

Alloc: Alpha $600 x 5/13 $400 x 10/26

Alloc: Beta $600 x 8/13 $400 x 16/26