C OSTS IMBA Managerial Economics Jack Wu

C OSTS

I NTRODUCTION Cost and economies of scale Cost and economies of scope Experience Curve Relevant / Opportunity costs Transfer Pricing Irrelevant Costs/ Sunk costs

E CONOMIES 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

E XPENSE S TATEMENT

F IXED AND V ARIABLE C OSTS

E CONOMIES OF SCALE  Economies of scale (increasing returns to scale): average cost decreases with scale of production

S CALE E CONOMIES : S OURCES large fixed costs research, development, and design information technology falling average variable costs distribution of gas and water container ships

D ISECONOMIES OF SCALE Definition: Diseconomies of scale (decreasing returns to scale) – average cost increases with scale of production

E CONOMIES OF SCALE : S TRATEGIC IMPLICATIONS Either produce on large scale or outsource Seller side – monopoly/oligopoly Buyer side – monopsony/oligopsony

E CONOMIES OF SCALE : G OOGLE VIS - À - VIS LIBRARY Which link(s) in service chain are scaleable? Compilation of information Providing service: servers and network Responding to enquiries

E CONOMIES OF SCALE : C REDIT CARD PROCESSING First Data, 44% National Processing, 13% NovaNova, 8% “This is a scale business, and by adding PMT’s volume to our operating platform there is a tremendous advantage” Nova Chairman Edward Grzedzinski

E CONOMIES 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

E XPENSES FOR TWO PRODUCTS

E CONOMIES OF S COPE 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

E CONOMIES OF SCOPE : C ORE 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

D ISECONOMIES OF SCOPE ? T IME W ARNER Carl Icahn and Bruce Wasserstein: Time Warner should break up into cable television systems film and television (including Warner Brothers, HBO and CNN) Time Inc. and magazines America Online

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?

E XPERIENCE CURVE : A IRBUS A350 VS B OEING 787 April 2004 Boeing launched 7E7 Dreamliner jet with 50 firm orders from All Nippon Airways. Aimed to secure 200 orders by December.

E XPERIENCE CURVE : A IRBUS A350 VS B OEING 787 December 2004 Boeing achieved 52 firm orders. Airbus launched A350. Airbus Chief Commercial Officer John Leahy: A350 would attract a substantial number of Boeing customers and “put a hole in Boeing's Christmas stocking”. Richard Aboulafia, Teal Group: Airbus had succeeded in its goal of “disrupt[ing] the business case for the 7E7”.

E XPERIENCE 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

E XPERIENCE CURVE

Conditions Relatively large human resources input per unit of production Relatively small production runs Industries/processes (learning percentage) Aerospace (85%) Shipbuilding (80-85%) Complex machine tools for new models (75-85%) Repetitive electronics manufacturing (90-95%) Repetitive machining or punch-press operations (90- 95%)

E XPERIENCE CURVE : S TRATEGIC IMPLICATION Must accurately predict cumulative production Then set price accordingly Challenge – quantity demanded depends on competition and price. Example: Airbus A350 vs Boeing 787.

R ELEVANCE 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

O PPORTUNITY C OST definition -- net revenue from best alternative course of action two approaches  show alternatives  report opportunity costs

E XAMPLE 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.

Income statement reporting opportunity costs INCOME STATEMENT SHOWING ALTERNATIVES

T RANSFER 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

T RANSFER PRICING

S UNK C OST 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.

E XAMPLE 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=$90,000.

E XAMPLE : 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?

Income statement omitting sunk costs INCOME STATEMENT SHOWING ALTERNATIVES

S UNK VIS - À - VIS F IXED C OSTS Not all sunk costs are fixed Not all fixed costs are sunk