Cost, supply, and strategy Paul C. Godfrey Mark H. Hansen Marriott School of Management

Industry Differentiation

What strategists need to know: What types of costs are there? What drives costs? How do costs influence decision making? How can managers work with/influence cost to create competitive advantage?

What types of costs are there?

Opportunity costs The price paid to induce an actor to do X and not the next best thing Include a firm’s cost of capital—the next best alternative Accounting costs + opportunity costs = true costs What’s the true cost of your BYU MBA? –It may be Tuition + lost wages Tuition + increased family stress Tuition differential (HBS-BYU) + Opportunity differential (HBS - BYU) Opportunity costs underlie all other costs

Fixed Costs The true costs of opening the doors for business, before any sales are made Incurred once, at the beginning, later amortized over each unit The foundation of scale economies Only fixed in the short term—in the long run all costs are variable How important are fixed costs in airlines, restaurants, software, etc.? $ Quantity FC AFC

Variable Costs  cost of variable inputs total variable cost changes as output changes average variable cost falls and then rises $ Quantity AVC

Total Cost Fixed Costs + Variable Costs Total Cost always increases Differ significantly from Total Revenue, which have an inverted U shape $ Quantity FC VC TC

Marginal Costs The cost of producing the next unit Increases due to the law of diminishing returns (e.g., labor gets less efficient) Have many functional forms (step, continuous), but generally increase as quantity increases –Discrete units (flight attendants) –Continuous units (fuel) Marginal costs are the short term supply schedule for the firm $ Quantity MC

Average Total Cost Total costs / number of units produced Costs decrease for a while due to scale (economies of scale) Costs start to increase due to incremental costs (diminishing returns to scale) The long run supply curve $ Quantity AFC AVC ATC MC

What drives costs?

Key cost drivers Productivity (what you get for what you pay) is the name of the game Drivers –Efficiency of Human Capital –Embedded technology (chipsets) –Knowledge (surgery) & information (brand) –Economies of scale (shipbuilding) and scope (airline cargo) –Regulations (CAFE) / laws (COBRA) / customs (Sabbath days) –Macro economic conditions (interest rates) –Natural conditions (oil viscosity and location)

How do costs influence decision making?

The short run calculation Profit (p) = Revenue – Cost For a price-taking firm, price = Revenue Only marginal costs matter in the short run –Fixed costs are already sunk Profit maximized when every profitable unit has been produced, where p > mc Produce Q*, such that at Q*, p = mc $ Quantity MC P Q*

The long run: case I Potential profit still maximized when every profitable unit has been produced, where P > ATC Produce Q*, such that at Q*, P = MC (competitive market) In the long run, profit depends on average costs –Fixed costs now become variable If AC Q* < P, then profit is made $ Quantity MC P Q* ATC Profit

The long run: case II If MC min < p < ATC Q*, then loss is short term sustainable $ Quantity MC P Q* ATC Loss

The long run: case III If p < MC min < ATC Q*, the firm should exit the market What will be the total loss? –FC? No, FC – Opportunity cost $ Quantity MC P ATC

How can managers use/ influence cost to create competitive advantage?

Understand costs Understand which costs are fixed and which costs are variable Understand marginal costs, especially as compared to P and/or MR Understand how total costs get allocated –Fixed costs on square footage vs. sales volume –The difference between profitable and unprofitable Activity-based costing schemes are very helpful Identify and understand opportunity costs Understand the time frame for relevant costs –Marginal (short term) –Average (long term)

Marginal costs matter Would you buy a 6 th tire for your car? We intuitively understand marginal costs Make them explicit in decision making

Productivity is the crucial metric The fallacy is that what you pay drives costs –The case of the hand-held scanners –Why is any production done in high cost countries? It’s what you get for what you pay that matters –Hand held scanners radically improve productivity all along the line –High cost labor works when it is more productive It’s all about productivity

It costs money to lower costs Cost reductions aren’t free, but they may be worth it! Investments in new technology and processes Investments in knowledge and skill Investments in changing organizational behavior and routines Investments in personal change

Understand and look for producer surplus Market supply curve represents different companies ability to produce For firms to the right of P*(A), there is no value in producing The firm at P*(A) is just covering average costs, no profit All firms to the left of P*(A) are making more that it costs them to produce, and are making profits The same principle applies to each of the firm’s input suppliers (including labor) When actors earn surplus, they have incentives to do business with the firm $ Quantity S0S0 P*A Producer Surplus