Managerial Economics Group E2 Presentation

1. Managerial EconomicsGroup E2 Presentation Group Members Student ID Brian Chan 02707989G Kitty Wong 02725393G Sarah Lee 02708427G Ting Cheng 02428884G Topic: Cost Drivers Analysis

2. Introduction to Cost Drivers • Indivisibilities • Specialization and division of labor • External economies occur outside firm ECONOMIES OF SCALE (INTERNAL & EXTERNAL) • Produce different models • Resources can be shared ECONOMIES OF SCOPE • Ratio of actual capacity used to design capacity • Costs of installing and closing capacity CAPACITY UTILIZATION • Firm “learn by doing” how to be more efficient • Production cost decrease with time LEARNING EFFECT • Tax, Government Incentives • Franchise, Government Policy GEOGRAPHICAL LOCATION

3. Introduction to Cost Drivers • Purchase cost of capital • Level of demand • Capacity utilization of supply industry TIMING • Unionization, tariff, local content rules INSTITUTIONAL FACTORS FIRST MOVER COST ADVANTAGE • First to undertake the activity • First mover gains from the late mover • Rapid technology development • First comer invested heavily LATE MOVER COST ADVATAGE COOPERATION WITH SUPPLIER AND DISTRIBUTION CHANNELS • Reducing costs for both confectioner and supplier • Undertake the activities within firm

4. Cost Drivers in MTR

5. MTR’s Cost Driver Important Unimportant Capacity Utilization  Economies of Scale (External)  Economies of Scope  Geographical Location (Government Policy)  Learning Effect  Cost Drivers in MTR

6. Important Cost Drivers in MTR Company Background • MTR was established in 1975 as a Government Owned Statutory Corporation • MTR currently operates a railway network of 87.7 kilometers route with 49 stations

7. Important Cost Drivers in MTR The MTR Route Map

8. Important Cost Drivers in MTR Capacity Utilization • Capacity Utilization = Actual capacity used Design capacity • Now, MTR’s daily patronage of over 2.2 million passengers. MTR is transporting 1 in 3 of Hong Kong population every day

9. Important Cost Drivers in MTR Capacity Utilization (Con’t) • Each of the Urban Lines , however, is capable of running 34 trains per hour in each direction. This gives a full capacity of 85,000 passengers for each Urban Line in each direction • To meet escalating passenger’s demand, the Corporation expanded its train fleet from 140 cars in 1979 to 1,050 cars in 2002 (including 88 cars for the Airport Express), 84% of which are in service to meet the daily morning peak demand

10. Important Cost Drivers in MTR External Economies of Scale • Economies of Scale occurs when mass producing a good results in lower average cost. Economies of Scale occurs within a firm (internal) or within an industry (external) • External economies are the advantages which accrue to a firm from the growth in the size of the industry and they are especially significant when that industry is heavily localized

11. Important Cost Drivers in MTR External Economies of Scale (Con’t) • Agglomeration Economies • This is one type of the external economies of scale • Hong Kong is an area with a population of high density • MTR provides a good transport network in Hong Kong

12. Important Cost Drivers in MTR Economies of Scope • Economies of Scope arises whenever it is more efficient to produce two or more products together than to produce them separately • In MTR, trains go to the “Airport” and “Tung Chung” will be served by the same set of tracks and signalling equipment

13. Important Cost Drivers in MTR Government Policy • MTR is one of the Hong Kong Public Utilities • Government offers extra low interest rate of loan, financial support, taxes and franchise to protect MTR from competition of other transportations such as Buses, Mini-buses and Private buses

14. Important Cost Drivers in MTR Government Policy (Con’t) • The new development of MTR should coincide with the new town planning of the Government • MTR contributes some resources to the improvement of social and environment aspects to the society

15. Unimportant Cost Drivers in MTR Learning Effect • The new “Tseung Kwan O” Line takes some time for the MTR staff and the passengers to get used to the new station facilities and the inter-changing stations • Learning effect occurs but does not happen too often

16. Cost-drivers in Import/Export

17. Cost Drivers in Import / Export

18. Important Cost Drivers in Import/Export Cooperation with Suppliers “Mutual Relationship” • Two-way cooperation increases efficiency and reduce cost • Porter’s chocolate example (Davies & Lam, p. 185) • Products that require special care - i.e. use of effective methods to keep frozen meat from deterioration • Real-life example - Supplier’s products not meeting firm’s standards and need to be re-inspected

19. Important Cost Drivers in Import/Export Timing “Time=Money”-exceptionally true in I/E • Time Management (production lead time, delivery date, shipping date etc.)-to manage time-consuming factors well or resulting in unexpected high cost and penalty • Purchasing Time (Davies & Lamb, p. 185)-purchasing at peak season when suppliers are overwhelmed with orders and are experiencing material/product shortage would result in cost rise

20. Important Cost Drivers in Import/Export Geographical Location “Know your destination” • Freight cost--to be determined by the distance between country of origin and shipping destination • Climatical impact on goods--to take regional climate into account so that damage to products can be avoided (i.e. wooden products)

21. Important Cost Drivers in Import/Export Institutional Factors “…and the negotiations resume.” • Unionization--unions’ action of the shipping industry is influential to I/E (i.e. U.S. West Coast Ports Lockout causing tremendous lost to U.S. I/E and costing the economy $2 billion each day) • Product test and Quality Assurance Inspection

22. Important Cost Drivers in Import/Export • Tariffs--each country has established its own tariff schedule (i.e. tariff schedule of the United States)

23. Unimportant Cost Drivers in Import/Export Economies of Scale • Large number of existing trading firms with small number of employees in each • Most trading firms maintain a small size to survive because of competition

24. Unimportant Cost Drivers in Import/Export External Economies of Scale-Agglomeration “Learn from toilet gossips.” • A large number of firms from the same industry cluster together (i.e. commercial buildings in TST East) • Firms (and their employees) learn from and exchange ideas with each other on a more casual basis • Convenient access for customers and other relevant industries (i.e. Manufacturers, retailers and logistics companies) • Real-life example: Golden Chinachem Plaza (Mody Road)

25. Unimportant Cost Drivers in Import/Export Economies of Scope • Dealing with a great variety of product and increase product types Question: Is Capacity Utilization an important or unimportant cost driver? How so?

26. Cost-drivers in Motor Industry

27. Cost Drivers in Motor Industry

28. Important Cost Drivers in Motor Industry Capacity Utilization • The actual capacity (output) should be equal to the design capacity of the plant and equipment for vehicle production • Under capacity means there will be a waste of resources or with lower profitability • Over capacity will lead to an increase in cost and leads to motor plant closing • However, the design capacity is market driven. So a good forecast of customer demand on motor will lead to capacity utilization • Capacity utilization can also be achieved by reducing bottleneck, e.g. coordination among different parties

29. Important Cost Drivers in Motor Industry Economies of Scale • Because there is existence of indivisibilities in the motor industry, a large reduction in cost can be achieved by economies of scale • Integration is a way to achieve economies of scale, e.g. the merging of Ford, Volvo, Mazda etc • Technical economies made in the actual production of the vehicles. For example, Ford or General Motor can use expensive and advanced machinery • Managerial economies (Division of labour) made in the administration of a large firm by splitting up management jobs and employing specialist accountants, salesmen, etc

30. Important Cost Drivers in Motor Industry Economies of Scale (Con’t) • Financial economies made by borrowing money at lower rates of interest than smaller firms. Large motor companies can repay the fixed costs over greater volumes, compelling small competitors to withdraw from the market • Marketing economies made by spreading the high cost of advertising on television and in national newspapers, across a large level of output e.g. Ford groups • Commercial economies made when buying supplies in bulk and therefore gaining a larger discount. • Research and development economies made when developing new and better products

31. Important Cost Drivers in Motor Industry Learning Effect • “Learning” effect first noted by T.P.Wright in 1936 who created a “learning curve” math model • Used to estimate aircraft production labour in WWII and since then to estimate many kinds of repeated activities Basic idea • As people repeat a task again and again, the time it takes to do the task gradually decrease due to “learning” • Rate of learning is greatest at the beginning when “ignorance” is greatest; rate of “learning” decreases as “ignorance” decreases

32. Important Cost Drivers in Motor Industry Learning Effect (Con’t) • The learning effect will lead to a large reduction in cost during the production process over a period of time. • The idea is that as workers make more and more units of a product, they become more experienced at their jobs, and, as result, the variable production costs (such as those associated with assembly, inspection, testing, etc.) decrease • Better tools and process will be applied through learning • Learn faster can result in huge competitive advantages (Note: The investment should be tradeoff against the savings caused by faster learning)

33. Economies of Scale y1 B Learning y2 C AC 2 x1 Important Cost Drivers in Motor Industry Cost saved by economies of scale and learning effect Cost ($per unit of output) A y AC 1 x Output Economies of Scale: more output can be produced at a lower cost Learning: cost will be high at first and then will fall with learning

34. Important Cost Drivers in Motor Industry Economies of Scope • Economies of scope exists if savings are achieved by producing a wide range of motors within the firm • Multiple vehicle types produced at each plant will increases a firm’s ability to meet actual demand with less under-utilization of each plant’s capacity • TC(Qx, Qy) < TC(Qx, 0) + TC(0, Qy) • Resources can be shared • Savings in inventories

35. Important Cost Drivers in Motor Industry First-mover Cost Advantages • First to undertake the activity • Gain more due to large learning effect • The vehicles can be produced at a lower cost

36. Important Cost Drivers in Motor Industry Late-mover Cost Advantages • Great impact for industry with rapid technology development like motor industry • Take advantage on other’s learning and use the latest technology to produce the firm’s own products.

37. Unimportant Cost Drivers in Motor Industry • Timing • Geographical Location • Institutional factor

38. Cost-drivers in Passenger Aircraft Manufacture

39. Cost Drivers in Passenger Aircraft Manufacture

40. Important Cost Drivers inPassenger Aircraft Manufacture Capacity Utilization • High fixed cost of installing aircraft manufacturing equipment which is of high degree of asset specificity • => repay fixed cost by utilizing the capital

41. Important Cost Drivers inPassenger Aircraft Manufacture Economies of Scales • High degree of specificity and division of labor in aircraft manufacturing industry • The need to install complex and expensive equipment • Lower interest rate of financial lending • Larger discount for bulk purchase of parts • => increase aircraft production to lower the average cost

42. Important Cost Drivers inPassenger Aircraft Manufacture Learning Effects • Great impact on production of highly complex products like aircraft manufacturing • Cost of production decreases as time of the process decreases with better skills and techniques acquired by technicians and engineers through learning • e.g. Boeing invests heavily on training and established Boeing Training Center

43. Economies of Scale y1 B Learning y2 C AC 2 x1 Important Cost Drivers inPassenger Aircraft Manufacture Cost saved by economies of scale and learning effect Cost ($per unit of output) A y AC 1 x Output Economies of Scale: more output can be produced at a lower cost Learning: cost will be high at first and then will fall with learning

44. Important Cost Drivers inPassenger Aircraft Manufacture Economies of Scope • More profitable to produce wider range of aircraft products and share the same resources e.g. Boeing produces a wide range of products in 1) different types: commercial & military 2) models: 717, 747, 777 3) capacity : 100, 200, 500 seats

45. Important Cost Drivers inPassenger Aircraft Manufacture Vertical Integration I • Backward vertical integration: manufacturer owns the supply company of parts • e.g. Boeing produces parts by itself

46. Important Cost Drivers inPassenger Aircraft Manufacture Vertical Integration II • Forward vertical integration: - manufacturer owns the distribution channel • e.g. Boeing sells its aircraft through Boeing Aircraft trading

47. Important Cost Drivers inPassenger Aircraft Manufacture Vertical Integration III • Reduce transaction cost • Achieve internal economies of scale • Achieve economies of scope • Higher efficiency • Greater flexibility • More reliable • Greater competitiveness • More profitable

48. Important Cost Drivers inPassenger Aircraft Manufacture First-mover Cost Advantages • Great impact for industry with substantial learning effects like aircraft manufacture • Professionals like skilled technicians and engineers have all been recruited • e.g. Boeing has been the world leader in aircraft manufacturing for more than 40 years

49. Important Cost Drivers inPassenger Aircraft Manufacture Late-mover Cost Advantages • Great impact for industry with rapid technology development like aircraft manufacture • Late-mover can respond to the latest market trend and customer needs with more investment fund in hand • e.g. increase demand for new and smaller size aircraft as older ones retired and passengers decreased after the event of Sept 11

50. Unimportant Cost Drivers inPassenger Aircraft Manufacture • Timing • Geographical location • Institutional factors