Costs
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Transcript of Costs
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COSTSIMBA Managerial EconomicsJack Wu
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COSTSCOSTS
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INTRODUCTION Cost and economies of scale Cost and economies of scope Experience Curve Relevant / Opportunity costs Transfer Pricing Irrelevant Costs/ Sunk costs
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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
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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
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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
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ECONOMIES OF SCALE Economies of scale
(increasing returns to scale): average cost decreases with scale of production
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SCALE ECONOMIES: SOURCES
large fixed costs research, development, and design information technology
falling average variable costs distribution of gas and water container ships
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DISECONOMIES OF SCALE Definition: Diseconomies of scale (decreasing
returns to scale) – average cost increases with scale of production
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ECONOMIES OF SCALE: STRATEGIC IMPLICATIONS Either produce on large scale or outsource
Seller side – monopoly/oligopoly Buyer side – monopsony/oligopsony
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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
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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
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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
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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
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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
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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?
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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
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EXPERIENCE CURVE
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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
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OPPORTUNITY COST
definition -- net revenue from best alternative course of action
two approaches� show alternatives� report opportunity costs
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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.
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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
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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
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TRANSFER PRICING
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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.
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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.
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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?
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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
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SUNK VIS-À-VIS FIXED COSTSNot all sunk costs are fixedNot all fixed costs are sunk