Chapter 7 Costs 1

Airbus and Bombardier  Bombardier: it didn’t commence until 2008 upon securing an order  Why so cautious about commencing development of the CSeries?  Airbus  Why meet competition with the A320neo rather than a completely new plane?  How would an increase in A320 production affect unit costs? 2

Learning objectives  Appreciate opportunity costs and apply in business decisions.  Understand to ignore sunk costs in business decisions.  Appreciate economies of scale and apply in business decisions.  Appreciate economies of scope and apply in business decisions.  Appreciate the experience curve and apply in business decisions.  Learn to avoid behavoral biases in cost decisions. 3

Sunk vis-à-vis fixed costs 4

 A cost is sunk if it has been committed and can’t be avoided  R&D expenses already spent  Fixed costs do not vary with the scale of production  Fixed costs are an essential reason for economy of scales  Joint costs do not vary with the number of products  Joint costs are an reason for economy of scope.  Airbus chooses to launch a new version of A320, not a complete new one 5 Sunk vis-à-vis fixed costs

Outline  Opportunity cost  Sunk cost  Economies of scale  Economies of scope  Experience curve  Bounded rationality 6

7 Opportunity cost  Opportunity cost: net revenue from best alternative course of action  Economic profit = Accounting profit – Opportunity cost + Sunk cost  Two approaches in decision making  Consider all alternatives  Report opportunity costs 7

Opportunity cost: Showing alternatives 8

Opportunity cost: Showing hidden cost 9

10 Value added: Luna Biotech  Luna has already spent 6 million on R&D  Two ways of arriving at correct decision: continue R&D, buy drug $ millionContinue R&DBuy drug Profit contribution20 R&D expenditure106 Acquisition cost2 Profit (accounting)1012

11 Value added: Luna Biotech  Continuing R&D:  Accounting profit =$10  Opportunity cost: $20 - $2 = $18 million  Sunk cost: $6 million  Economic profit = $10 - $18 + $6 = -$2 million  Continuing R&D is the worse choice

Outline  Opportunity cost  Sunk cost  Economies of scale  Economies of scope  Experience curve  Bounded rationality 12

Outline  Opportunity cost  Sunk cost  Economies of scale  Economies of scope  Experience curve  Bounded rationality 13

14 Sunk cost  Definition: Cost that has been committed and cannot be avoided.  Not relevant to business decisions  Alternative courses of action depend on  Prior commitments: Fewer commitments  fewer sunk costs;  Planning horizon: longer planning horizon  fewer sunk costs. 14

Sunk cost: Showing alternatives 15  Should Luna cancel the R&D project?  Luna had agreed to pay $10 million to an external contractor for R&D  Demand for drug has fallen due to new competition  If Luna continues with the R&D, its profit is $8 million.  If Luna cancels the project, it still has to pay $6 million

Sunk cost: Showing alternatives 16

Sunk cost: Omitting irrelevant cost 17  The avoidable costs of the R&D project is $10 – $ 6 (sunk cost) = $4  The economic profit = $4

Sunk costs: Strategic implications  Lock-in:  existing customers have incurred sunk cost  if they must incur similar cost with new provider, then that becomes a cost of switching => lock in  costs become switching costs  Technology : MS Office, mobile phone service  Customer investments Learning/training  Customization: MS-Excell has lock on large enterprises – many customized inhouse applications built around Excell 18

19 Avoiding sunk costs  Japan  Historically, life-time employment  difficult for businesses to adjust to lower demand  1990s (lost decade)  Businesses hired workers on temporary basis  Two-tier labor market 19

Outline  Opportunity cost  Transfer pricing  Sunk cost  Economies of scale  Economies of scope  Experience curve  Bounded rationality 20

21 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 scale  Cost of R&D for a new drug can vary – but it does not vary with scale of production  Cost of writing and compiling newspaper can vary -- but it does not vary with number of copies sold 21

22 Economies of scale  Fixed/variable costs concepts apply in  Short run  Short-run fixed costs are all sunk  Long run 22

Economies of scale: Expense statement 23

Economies of scale: Fixed/variable costs 24

Economies of scale Economies of scale (increasing returns to scale): average cost decreases with scale of production 25

26 Economies of scale: Sources  Large fixed costs  Design  Research and development  Information technology  ex., Biotech, software  Average variable cost decreases with volume  transport industry  distribution of gas and water  container ships, tankers Technology Knowledge 26

Economies of scale: Tankers 27

28 Diseconomies of scale  Definition: Diseconomies of scale (decreasing returns to scale) – average cost increases with scale of production  Examples:  mining : increase in production requires exploiting lower-quality ores  agriculture – to increase production, use less fertile land 28

Strategic implications  Economies of scale in product  industry becomes more concentrated  Large scale production means mass marketing and low pricing  Seller side – monopoly/oligopoly  Buyer side – monopsony/oligopsony  Industries with large scale economies  civil aircraft manufacturing -- industry is duopoly -- Boeing and Airbus  accounting services – Big Four  search – industry is triopoly – Google, Yahoo, MSN 29

Strategic implications  Diseconomies of scale in product  industry becomes more fragmented  Small-scale production is associated with niche marketing and high pricing. 30

Outline  Opportunity cost  Transfer pricing  Sunk cost  Economies of scale  Economies of scope  Experience curve  Bounded rationality "You can see a clear trend whether it is in Europe, in Asia or in the US. Having the scope and scale to develop a large presence in the key business market segments is absolutely crucial to succeeding in the industry," Jeff Smisek CEO, Continental Airlines May 4,

32 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 32

Economies of scope: Expenses for two products 33  Joint cost: the cost of inputs that does not change with the scope of production  The joint cost supports the production of multiple products.  The cost of printing press is a joint cost.

34 Economies of scope: Sources  Network: cable television + broadband services  Distribution: retail banking + insurance  Common technology, input, or process  Semiconductors and solar panels  LCDs – watches, PDAs 34

35 Economies of scope: Strategic implications  Production economies of scope  multiple products  Marketing economies of scope  the strategy of brand extensions  advertising expenditure is a joint cost of marketing all products marked with the same brand  spread promotional costs over multiple products/businesses  Sony, Samsung 35

Horizontal boundaries  Economies of scale  Should bank merge with competitor?  Should trucking company acquire smaller rivals? 36

Horizontal boundaries  Economies of scope  Should airline run catering service?  Should bank sell insurance?  Should university open a medical school? 37

Outline  Opportunity cost  Transfer pricing  Sunk cost  Economies of scale  Economies of scope  Experience curve  Bounded rationality 38

39 Experience curve  The costs of production may vary with experience over time  example: aerospace manufacturing, shipbuilding  The experience curve (learning curve) shows how the unit cost falls with cumulative production over time  Distinguish from economies of scale within one production period 39

Experience curve Normalized to

Experience curve  Conditions  Relatively large human resources input per unit of production  Relatively small production runs  Industries/processes (learning percentage)  Aerospace  Shipbuilding  Complex machine tools  Repetitive manufacturing Ironing out & optimizing 41

42 Experience curve: Strategic implication  Must accurately predict cumulative production and set price accordingly  Challenge – quantity demanded depends on competition and price.  The experience motivates a strategy of cutting price to increase sales 42

Airbus vs Boeing  In 1999, Airbus launched A380 in passenger and freighter versions:  Boeing took away demand for freighter through program that converted 747 and 767 using lower-cost facilities in Taiwan and Mainland China  By 2006, Airbus procured only 20 orders and then Airbus terminated the freighter program.  In 2004, Airbus tried to kill Boeing 787 by launching Airbus A350 to take away the demand 43

Outline  Opportunity cost  Transfer pricing  Sunk cost  Economies of scale  Economies of scope  Experience curve  Bounded rationality 44

45 Bounded rationality  Bounded rationality: people do not always behave rationally  They may have systematic errors in decisions  Bounded rationality leads to biases in decision- making

46 Decision-making  Sunk cost fallacy:  Consumers who have incurred a larger sunk cost tend to consume more  Over-consumption due to “mental lock-in”  E.g., membership fees  Status quo bias: decision makers tend to prefer the status quo  Anchoring: decision makers are subject to the influence of irrelevant information  E.g., high list price and high discount

Airbus and Bombardier  Bombardier: Very cautious about commencing development of the CSeries?  R&D costs are sunk  Manufacturing cost subject to experience curve  Airbus  Increase in A320 production – impact on unit costs depends on economies of scale and experience curve 47

Key takeaways  For effective decision-making, consider alternative courses of action and take account of opportunity costs and ignore sunk costs.  The opportunity cost is what must be foregone from the best alternative course of action.  Businesses financed by equity should take account of the opportunity cost of equity capital.  To maximize profit, set the transfer price equal to the marginal cost of the input.  Commit to sunk costs with caution as they cannot be reversed.  Economies of scale arise from fixed costs, which support the production multiple units of output.  With economies of scale, businesses should produce on a large scale and the industry would be concentrated. 48

Key takeaways, cont’d  Economies of scope arise from joint costs, which support production of multiple products.  With economies of scope, businesses should produce multiple products.  The experience curve shows that unit (average) cost of production falls with cumulative production over time at a rate according to the learning percentage.  With the experience curve, it is important to forecast cumulative production and the business can gain from increasing market share.  Managers should take care to avoid behavioral biases in decisions with respect to costs. 49