Costs

1. Costs Managerial Economics Jack Wu

2. Introduction • Cost and economies of scale • Cost and economies of scope • Experience Curve • Relevant / Opportunity costs • Transfer Pricing • Irrelevant Costs/ Sunk costs

3. 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

4. Expense Statement

5. Fixed and Variable Costs

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

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

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

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

10. 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

11. 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

12. Expenses for two products

13. 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

14. 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

15. 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?

16. 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

17. Experience curve

18. 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

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

20. 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.

21. INCOME STATEMENT SHOWING ALTERNATIVES Income statement reporting opportunity costs

22. 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

23. Transfer pricing

24. 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.

25. 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.

26. 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?

27. INCOME STATEMENT SHOWING ALTERNATIVES Income statement omitting sunk costs

28. Sunk vis-à-vis Fixed Costs • Not all sunk costs are fixed • Not all fixed costs are sunk

29. DISCUSSION QUESTIONS • Qantas operates a fleet of over 100 Boeing jet aircraft. Commercial passenger jets must be operated by a pilot and co-pilot. Many jets carry cargo in their "bellies", under the passenger seating areas. Consider each of the following costs. Identify which are joint costs of passenger and belly cargo services, which are fixed costs of passenger service, and which are both.

30. DISCUSSION QUESTIONS • (A)Cockpit personnel: All jets, large and small, require a pilot and co-pilot. Belly cargo service requires no additional officers in the cockpit. • (B)Airport landing fees: Some airports charge landing fees by weight of the aircraft, while others levy a fixed fee, regardless of weight. • (C)Fuel: Larger aircraft and those carrying heavier loads will consume relatively more fuel.