Costs

1. Costs Maurizio Aragrande and Massimo Canali, University of Bologna (I) Florence Beaugrand, ONIRIS, Nantes (F) This presentation was developed within the frame of the NEAT project, funded with support from the European Commission under the Lifelong Learning Programme (Grant no. 527 855). Please attribute the NEAT network with a link to www.neat-network.eu. Except where otherwise noted, this presentation is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License.

2. Learning objectives • Cost identification, cost justification, cost definition (Section 1) • Identify how costs play in the animal health context (Section 2) • Identify the way inputs generate costs (Section 3) • Describe how individual behaviors may determine social cost (Section 4)

3. Section 1: Costs in general 1.1 - Cost: what is this? 1.2 - Opportunity cost 1.3 - Resources, inputs, costs

4. 1.1 – Cost : what is it?

5. A lexical approach 1.1 - Cost : what is this? • Cost is a term commonly used by people: • By families or individuals, when they purchase something • By farmers, when they purchase feed, machinery or build a cowshed in order to produce farm staples • By professional veterinarians, when they purchase e.g. laboratory hardware, hire a secretary or a colleague in order to perform their profession • The term cost is often associated to other terms or adjectives which identify particular aspects of the cost concept. Some examples: • Total cost and average cost • Fixed cost and variable cost • Monetary cost and non monetary cost • Individual and social cost Can you associate a meaning to these terms? Can you define the difference, for example, between a fixed cost and a variable cost? Or: can you provide some examples?

6. 1.1 - Cost : what is this? An exercise in cost identification • In the table below we listed some examples of real costs. Try to identify what kind of cost they are and to develop a reasoning to justify your choice Identifying costs categories

7. 1.1 - Cost : what is this? Identifying costs • Fixed and variable costs identify two different ways through which inputs generate costs • This distinction is relevant when we want to analyze the relationship between the production volume and the use (the cost) of some resources in any activity • For example: purchasing a milking machine costs once and lasts many years; a vet medicine costs each time we use it. • Monetary and non-monetary costs refer to costs that are easy to be quantified in monetary terms or not. • This distinction is relevant when we face situations related to marketable or non- marketable goods. For example: the purchase of an ultrasound machine in a vet lab is a monetary cost; the pain we feel for our sick cat can be hardly quantified and monetized Cost analysis is applied in different situations. The various specifications applied to costs identify concepts which are useful to different analytical aims

8. 1.1 - Cost : what is this? Finally, what is it? • Cost is the economic value of the resources we use to do something • Distinguishing among costs helps economists to develop cost analysis • The distinction among costs is based on some criteria which allow for the identification of cost categories • Cost categories are relevant to develop the cost analysis in a defined context and for a specific aim.

9. 1.2 – Opportunity cost

10. 1.2 - Opportunity cost The economic justification for cost • Scarce resources make costs • Resource scarcity means that an individual or a society are constantly faced to choose among alternative uses of the resources. • This immanent condition of the human beings is a basic assumption of the economics. The scarcity problem concerns relevant economic issues as well as daily life: • Should a state produce more bread or more guns? • Should I use my time to work (and get more money) or to go on holidays? • One day more spent for holidays reduces my worktime. Any choice implies a renounce. This renounce is a cost. (2)

11. 1.2 - Opportunity cost An exercise, to visualize the concept • Imagine that: • You have a fixed amount of a resource (a stock of time) • You can choose to allocate this resource to two alternative uses • X= time for holidays; and: Y= time for work • How can you visualize the alternatives (by a graph) ... and the consequences (in economic terms)?

12. 1.2 - Opportunity cost A more formal definition of opportunity cost • If I chose to have a little bit more of X (+dX)… • … I will get a little bit less of Y (- dY) • - dY is the Opportunity Cost of +dX Opportunity Cost “The loss of other alternatives when one alternative is chosen.” (2)

13. 1.2 - Opportunity cost From opportunity cost to real cost (I) • How does the opportunity cost concept works in reality? • Imagine a situation where two “economic agents” (Mr Worker and Mr Farmer) have to decide how allocate their resources (time, competences) to perform their job and get a revenue: Mr. Farmer breeds cows to produce milk. He has to milk his cows and organize the financial plan of the farm. Budgeting is a strategic activity. One day employed in this operation may save much money to the farm (say 100 €/day) Milking, operated by Mr Farmer, would just save 40€/day (the amount Mr Farmer spends if he hires Mr Worker) Mr. Worker is a worker specialized in cow milking. He offers his job on the market. He identifies the opportunity cost between employment time and non-employment time. Then he translates in money the sacrifice of 1 day of non-employment time (assumed to be the preferred alternative). This is the price he requires for 1 work unit (say 40€/day)

14. 1.2 - Opportunity cost From opportunity cost to real cost (II) • How will Mr Farmer allocate his time between budgeting and milking? • He compares the opportunity cost of the alternatives: Milking has an opportunity cost of 100 €/day Budgeting has an opportunity cost of 40 • He decides for the alternative whit the lower opportunity cost (budgeting in this case)

15. 1.3 – Resources, value, costs

16. 1.3 - Resources, value, cost Let’s combine some basic concepts • Opportunity cost outlines resource scarcity • Resource scarcity stimulates people to value resources • We use resources as inputs to implement an action or a process, that will produce benefits The value of an input used in a process is a cost

17. 1.3 - Resources, value, cost How can we analyse the cost of a process? • Resources and inputs are of many kinds and contribute to the production in many ways • The development of a cost analysis requires that we describe the mechanisms that generate costs • Before doing this, let’s spend a some time to have an insight of the animal health system in relation to cost • Costs are faced to get benefits • Who pays (and faces costs) in change of what (what benefits, goods, services)? • How this works when animal health is the focus of the social and economic relationships among people?

18. Section 2: Costs in relation to animal health

19. 2 – Costs in relation to animal health Who is concerned by costs in relation to animal health? • Many actors deal with animals for different reasons or motivations

20. 2 – Costs in relation to animal health Why do actors face cost for animal health? • Motivations determine the reasons for each actor to support costs for animal health

21. 2 – Costs in relation to animal health Which role does each actor play in animal health? • Different actors play different roles in animal health • Any role comes with some functions to be developed • To develop a function, actors must use resources and face costs

22. 2 – Costs in relation to animal health Which costs are related to each actor/role/function? • When actors spend money for animal health, what do they materially buy?

23. 2 – Costs in relation to animal health A simple exercise • Could you find out similarity and differences among the resources mentioned in the previous table? • Which criteria do you use to determine similarity and differences? • Are these criteria relevant on an economic perspective? Economics looks at how inputs generate costs and classify costs according to cost generating mechanisms

24. Section 3: Cost generating mechanisms • 3.1 - Costs and production • 3.2 - Investments • 3.3 - Costs over time • 3.4 - Economic and financial aspects of costs • 3.5 - Cost functions • 3.6 - Average cost and economies of scale • 3.7 - Organizational options

25. 3.1 Costs and production

26. 3.1 - Costs and production One of the most relevant mechanism of cost generation is the relationship between input use and production increase Input use and production • Two situations can be exemplified • Mr. Farmer buys feed for his cow • More feed > More cost > More milk • Mr. Farmer buys a tractor for 100.000 €, to be used during the next 10 years • The value of the tractor decreases along this period at the rate of 10.000 €/year: this amount is related to machine availability for Mr. Farmer, and does not depend if Mr Farmer uses the machine 3 or 15 hours/day • What is the difference between these two types of cost?

27. 3.1 - Costs and production Variable and fixed costs (I) • Variable costs • Variable costs are costs that change depending on variations in the size of the activity: they increase with the increase of production and decrease when production is reduced; • Common examples of variable costs are given by the use of inputs entirely consumed in one production cycle; e.g. in milk production variable costs may consist in expenses for:

28. 3.1 - Costs and production Variable and fixed costs (II) • Fixed costs • Fixed costs are costs that do not vary in the short term, even though the business’ activity, production volume and sales are significantly reduced; • Some common examples of fixed costs are:

29. 3.1 - Costs and production Similarity among production processes • Fixed and variable inputs are used in any production context • Mr. Vet spends 0.50 € for each cat vaccination kit • More vaccinations > More cost > More client served • Mr. Vet obtains a loan to buy the equipment of a surgery room • He will pay 1,000 €/month for 8 years • Either he uses the room for 7 or 15 surgeries per month, the bank will ask him 1,000 € every month over 8 years A relevant aspect of cost analysis is the ability to distinguish between variable and fixed cost in any context and understand the consequences for management

30. 3.2 Investments

31. 3.2 - Investments money Fixed costs and investments revenue • An investment is time, energy, matter, money... resources spent once on expectation of future benefits. • Some example: • Your training: you spend money and time learning a lot during 6 years; your hope is that you will have a job and revenues during the next 40 years. • As a vet, you buy a car on year 1 to visit farmers. You get money from your work for several years thanks to your car. 1-6 7-47 time time & money spent for training money Revenues from farmers 1 2 3 4 time money spent for the car

32. 3.2 - Investments Investment and uncertainty • An investment is made on the basis of a subjective evaluation on future activities, but nobody can exactly know what level of activity there will be in the future. Suppose that: A new vet recently installed in the area and he is very strong with bovines. This reduces your revenue from farmers ... but you didn’t know when you bought a new car to visit farmers abroad You stop working to take care of your children (and you didn’t plan it!) Investment is sunk, you cannot get money/time back easily. Investment is always affected by uncertainty on the return on investment.

33. 3.3 Costs over time

34. 3.3 - Costs over time • The vet’s car of the previous example maintains its functionality for several years, which define the useful life period of the asset, but it losses value because of consumption • As a consequence, the value of the car gradually declines along its useful life period • This gradual loss of value is the cost related to the availability of the car. It is called depreciation and corresponds to the purchase value of the car distributed along its useful life period. • The accounting of the depreciation cost does not necessarily implies a corresponding cash outflow in the reporting year (see section 3.4) Depreciation

35. 3.4 Economic and financial aspects of costs

36. 3.4 - Economic and financial aspects of costs The economic aspect of cost is related to the consumption of resources for production activities. The financial aspect of cost is related to the flows of moneygenerated along time by production activities. • In the example of section 3.3, the vet may have two options for buying the car: • 1) He may buy the car with its own money • in this case the vet has a cash outflow (area bordered by the red dashed line) for the whole price of the car at purchase ; • if after four years the car needs to be changed and has lost all its value, the cost of the car depreciation corresponds to the value of the car at purchase, but it is distributed along the four years of car utilization (grey dashed areas); Costs and cash flows (I) • the vet has a cash outflow when he purchases the car, but he does not have any cash outflows when he accounts the yearly cost of use of the car money Revenues 1 2 3 4 time yearly cost of depreciation (4 years) money spent for the car (cash outflow)

37. 3.4 - Economic and financial aspects of costs Costs and cash flows (II) • 2) A second option is that the vet may borrow a loan from a bank and repay it in four years: • in this case the vet makes use of the bank’s money to buy the car; • each year the vet supports the cost of car’s depreciation and also a corresponding outflow of money which pays back the loan received from the bank. Moreover the vet also pays the interest due to the bank as price of the loan; • the vet does not have a cash outflow when he purchases the car, but he does have yearly cash outflows corresponding to the yearly cost of use of the car money Revenues 1 2 3 4 time yearly costs of depreciation corresponding to the cash outflow for loan repayment interest on the loan (cash outflow)

38. 3.4 - Economic and financial aspects of costs Use of inputs, time and payments The two situations seem to be similar, but have very different implications. If we suppose that in year 3, for some reason, it happens that the vet’s customers do not pay the vet services: • in the second case (the vet has to repay a loan), the vet could be in the situation that he cannot afford his obligations with the bank … • … and the consequences may be significantly worse for his future activity than in the first case (in which he does not have a loan to pay back).

39. 3.4 - Economic and financial aspects of costs Economic and financial balances For any business activity, it is necessary that the value generated by production (income) be greater than the value of all the inputs consumed along the production process (costs). But this is not enough to determine the sustainability of a business. In fact, it is also necessary that the business activity be always able to satisfy its obligations to payments in due time. A correct economic balance implies that a business activity create an income greater than costs (i.e. the value of production created should be greater than the value of inputs consumed). A correct financial balance implies that a business activity be always able to satisfy its obligations to payments in due time. Both conditions are necessary to define the sustainability of any business.

40. 3.5 Cost functions

41. 3.5 - Cost functions Variable and fixed cost functions • As seen, feed (variable inputs) and tractors (fixed inputs) have different cost generating mechanisms with production increase; • The type of fixed assets may limit the production volume • For example a small tractor may constrain the production. If a farmer wants to increase the production above a given level, he needs a bigger tractor, which probably implies higher fixed costs for depreciation.

42. 3.5 - Cost functions Cost functions, sales and profit • A consequence of the difference between variable and fixed cost functions is that, in general: • a production process characterised by a high proportion of variable costs may generate a profit with relatively low levels of sales; • a production process characterised by a high proportion of fixed costs requires certain levels of sales to generate profit. But a good endowment of fixed assets may provide other advantages …

43. 3.6 Average cost and economies of scale

44. 3.6 - Average cost and economies of scale Total cost, average cost, production volume • The analysis of production costs may provide information on how costs change in relation to production volume • Think to a surgery room: how does cost change with utilization? And why? The cost per unit of product (average cost) can be reduced if the use of the equipment is optimized. These are called ECONOMIES OF SCALE

45. 3.6 - Average cost and economies of scale Economies of scale • Economies of scale may abate the average production cost of goods and services and may be specially effective in large production units;

46. 3.7 Organizational options

47. 3.7 - Organizational options Different options for the use of a machine • Mr. Farmer owns the machine he uses at farm • He did an investment years ago and repays a loan (fixed cost) • Mr. Vet bought an ultrasound machine • As in the case of Mr. Farmer, he has to repay a loan • Both of them are in trouble • They realized that their investments are oversized with respect to the use they actually do. They want to get rid of them, but they also want to use machine when they have need. • How can they do? What are the consequences? • In term of cost, this problem has two faces.

48. 3.7 - Organizational options Turning a fixed cost into a variable cost is possible • Investments can be dismantled and machinery and equipment can be rented • In this case, the cost generation mechanism changes • The purchase of machinery and equipment generates fixed costs • The renting of machinery or equipment generates variable costs The choices related to the use of a fixed input may actually turn a fixed cost into to a variable cost

49. 3.7 - Organizational options The mechanism generating cost changes For a production level corresponding to Y the renting of the asset allows a profit, while the cost of an owned asset generate losses (it would be rentable only for a Y’ production level) But... you must consider that some costs are not reversible...

50. 3.7 - Organizational options Sunk costs related to investments • The shifting from owning to renting the machinery implies that Mr Farmer and Mr Vet dismantle their investments; • The dismantling of investments generates losses: there are costs which cannot be recovered: • For the investment, they borrowed a 10,000 € loan from the bank, they have to pay back 2,000 €/year in 5 years; • At year 2 they dismantle the investment, they sell the equipment for 4,000 € cash; • The net loss of dismantling is 2,000 € (at the least!), resulting from: - Cash from equipment sale = + 4,000 €; - Remaining loan payments (3 years x 2,000) = - 6,000 € Dismantling investments may generate costs that cannot be recovered or SUNK COSTS