Lecture Seven: Costs

1. Lecture Seven:Costs IPEM Tohoku University Managerial Economics Lecturer: Jack Wu Period 1/February 17

2. Economies of scale • Economies of scale (increasing returns to scale): average cost decreases with scale of production

3. Scale Economies: Sources • large fixed costs • research, development, and design • information technology • falling average variable costs • distribution of gas and water • container ships

4. Diseconomies of scale • Definition: Diseconomies of scale (decreasing returns to scale) – average cost increases with scale of production

5. Economies of scale: Strategic implications • Either produce on large scale or outsource • Seller side – monopoly/oligopoly • Buyer side – monopsony/oligopsony

6. 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

7. 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

8. Expenses for two products

9. Economies of Scope • source -- joint cost: cost of inputs that do not change with scope of production • examples: • cable television + telephone banking + insurance • strategic implication -- produce/deliver multiple products

10. 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

11. Opportunity Cost • definition -- net revenue from best alternative course of action • two approaches • show alternatives • report opportunity costs

12. 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.

13. INCOME STATEMENT SHOWING ALTERNATIVES Income statement reporting opportunity costs

14. 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.

15. 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.

16. 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?

17. INCOME STATEMENT SHOWING ALTERNATIVES Income statement omitting sunk costs