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Chapter Four
Do you know where your
costs are?
Cost Quotes
“Costs are always higher than expected, even
when they are expected to fall. They
require scrupulous scrutiny and constant
containment.”
Theodore Levitt
Thinking About Management
Cost Quotes
“… the task of keeping costs from rising
requires constant struggle, absorbing a great
part of the energy of the manager. How
easy it is for an inefficient manager to
dissipate the differential on which
profitability rests.”
Frederich von Hayek
The Use of Knowledge in Society
Production Function
• In any production process the outputs
produced require “resources” or “factors of
production” or “inputs”
• Outputs = f (Inputs)
• Inputs are broadly classified in economics
Major Inputs and their Payments
• Land (N)
– Land is paid rents ( r )
• Labor (L)
– Labor is paid wages (w)
• Capital (K)
– Capital is paid interest (i)
• Entrepreneurship (E)
– Entrepreneurship is paid profits (p)
Time and Production
• Economists draw a distinction between the
short run (SR) and the long run (LR)
• The distinction is this:
– In the short run at least one of the factors of
production is fixed but in the long run no inputs
are fixed (all inputs become variable.)
Short Run in Production
• Output = f (L,K)
– Focus on a simple production function
employing capital (K) and labor (L)
• Capital is the fixed input in the short run
• Labor is the variable input in the short run
• Once capital is in place, successive units of
the variable input (L) are applied to the
fixed capital plant (K)
First, costs fall as you increase
output
• Initially, the K plant is underutilized relative
to the quantities of labor being applied to it
• As successive unit of L are applied to the
fixed K plant, the K plant is used more
efficiently
• This increased efficiency causes the per unit
costs of production, average costs (SRAC)
to fall
Second, costs reach their
minimum
• Through some range the plant is being used
efficiently
• As a result the per unit costs are at their
lowest
Last, costs begin to rise
• Finally, the per unit costs begin to rise again
as the fixed K plant becomes over utilized
So what?
• The fact that cost curves are U-shaped
means that there is some range of
production where your costs are lowest
• Empirically almost all evidence points to
either U-shaped or L-shaped cost curves
• L-shaped still implies an efficient range of
production
Costs in the Short Run
• Again, the short run in production is defined
as a time period in which at least one unit of
production is fixed
• SRAC curves are U-shaped due to the Law
of Diminishing Marginal Returns (LDMR)
LDMR
• Given a fixed K plant (i.e., we are in the short
run,) initial applications of labor will increase
productivity however, eventually the productivity
of additional (marginal) applications of labor will
fall as the K plant becomes over-utilized
• From a technical perspective
– Initially the K plant is underutilized, then there is some
range of production where it is efficiently utilized and
eventually it becomes over-utilized
– This creates the well known and empirically consistent
U-shaped SRATC curve
LDMR
• Is a consistent aspect of dealing with an
existing technology that yields a particular
form of K plant
• Is a technological consistency which
impacts the shape of cost curves
• Applies only to the short run
– Technologies change
– K plant can be changed in the LR
Costs in the Long Run
• Long Run per unit cost curves are also Ushaped
• Because all inputs are variable in the LR, it
can’t be due to fixed K plant and LDMR
• Introduce Economies of scale and scope
Economies of Scale
• exist if the firm achieves per unit cost reductions
as it increases production levels
• leads to U-shaped cost curves in the short run
Per Unit Costs
SAC
minimum per unit cost
or
minimum efficient scale
Production Quantities
Economies of scale - declining per unit costs
Diseconomies of scale - rising per unit costs
Per Unit Costs
Economies of Scale
Diseconomies of Scale
SAC
Q
increasing
returns to
scale
constant
returns to
scale
decreasing
returns to
scale
Economies of Scope
• exist when a firm expands the variety or scope of
its activities, e.g.,
– a lumber company sells chipped bark for lawn
decoration
– a finance company uses their financial data to produce
marketing reports
– a group of small firms shares a secretarial pool
– a slaughter house invents hot dogs
• and
Economies of Scope
• the relative costs of producing a variety of goods
and/or services in conjunction with each other is
lower than the costs of producing the same set of
goods and/or services in isolation of one another
• Management Speak
– “leveraging core competencies”
– “competing on capabilities”
– “mobilizing invisible assets”
Economies of Scope
• mathematically
• English TC(Qx, Qy)  TC(Qx,0)  TC(0, Qy)
– “producing these products together is cheaper
than producing them separately”
Major sources of scope and scale
economies
•
•
•
•
Spreading fixed costs and indivisibilities
Increasing variable input productivity
Inventories
Physical properties of production
Costs in the Long Run
• Long run costs curves are U-shaped due to
economies and diseconomies of scale
• Economies of scale cause costs to fall
• Diseconomies of scale cause costs to rise
• The LRAC is a collection of overlapping
SRAC curves
Costs in the Long Run
• Think of the SRAC curve as the manager
attempting to operate in a given plant at the
lowest possible costs
• Think of the LRAC curve as the manager
attempting to search out the most efficient
plant scale possible
Economies of Scale and Scope
- Major Sources
•
•
•
•
Spreading fixed costs and indivisibilities
Increasing variable input productivity
Inventories
Physical properties of production
Spreading fixed costs and
indivisibilities
• fixed, up-front costs usually exist
• these fixed, up-front costs are often difficult
to divide
• as these fixed costs are spread over larger
production quantities the per unit
production cost falls
Spreading fixed costs and
indivisibilities
• Suppose you have a hotdog stand
– Before you produce one hot dog you have to
buy the stand
• This represents a large, fixed, upfront cost
• On a per hotdog basis the cost of the first hot dog
includes the entire cost of the stand!
– As you produce more and more hotdogs, the
price of the stand per hotdog falls (until you hit
capacity and then the process begins anew.
Increasing variable input
productivity
• Economies of Scale through Specialization
– Opportunities for specialization often exist in
the production process
– Specialization increases productivity
– Increased productivity reduces per unit costs
Inventories
• Inventories have clear costs but running out
of stock does too
• Balancing the costs of holding inventory
with the costs of “stock out”
Inventories
• Inventory costs drive up cost of goods sold - but not equally
• firms doing higher volumes of business can
hold proportionately less inventories than
can firms doing lower volumes of business.
Queuing Theory
• As arrival rates at the main distribution
warehouse increase, the distributor can
carry smaller excess inventory in
percentage terms to maintain a fixed rate of
stock outages
– arrival rates - the rate at which stock comes into
the main warehouse
– service rates - the rate at which stock leaves the
warehouse
Queuing Theory - Implications
• There are economies of scale in inventories
held
• Note - Inventories are still costly!
– but, they are proportionally less costly for large
scale distribution systems
Physical properties of production
• Build a 10X10 block house
– suppose that running block is $30 per linear
foot
• Costs = linear feet X $30
– Costs = 40 X $30 = $1200
– square footage is 10 X 10 = 100 sq. ft.
– Cost per square foot is $1200/100 = $12 per
square foot
Physical properties of production
• Build a 20X20 block house
– suppose that running block is $30 per linear
foot
• Costs = linear feet X $30
– Costs = 80 X $30 = $2400
– square footage is 20 X 20 = 400 sq. ft.
– Cost per square foot is $2400/400 = $6 per
square foot
The cube-square rule
• the volume of a structure increases with the
cube of its linear dimensions whereas its
surface area increases with the square of its
linear dimension
Implications of the
cube-square rule
• Vessels exhibit economies of scale
– brewing
– pharmaceuticals
– super tankers
• Pipelines exhibit economies of scale
– Doubling the diameter of the pipeline more
than doubles the flow capacity through it
Other sources of Economies of
Scale and Scope
• Purchasing Inputs
• Marketing/Advertising
• Research and Development
Purchasing Economies –
Advantages
• Bulk Purchases of inputs often available at
lower prices
–
–
–
–
lower negotiation costs
lower packaging costs
lower distribution costs
lower information costs
Purchasing Economies –
Advantages
• Costs to service can be lower
– Large production runs
– Lower transactions costs, less contracting
required
• Increased price sensitivity among
purchasers
– “Big-ticket” price sensitivity
Marketing/Advertising
AC = Cost of sending a message
# of potential customers reached
DIVIDED BY
# of realized customers
# of potential customers reached
Numerator is the cost of sending messages per potential
customer.
Denominator is the proportion of potential customers who
become actual costumers.
Marketing/Advertising
• Ads may have large, up-front fixed costs to
construct but low marginal costs to distribute
• Campaign Costs
• Negotiation with distributor of ads
• Wide reach reduces AC
Marketing/Advertising
• Advertising Reach and Costs
– National Ads tend to be more cost effective
• Firms with a national presence...
– need not worry about consumers being unable to find their
product
– can reduce the number and cost of negotiations
– may be able to exert monopsony pressure on the price of
advertising
Research and Development
• R&D is usually an upfront, fixed expense
• R&D carries substantial risk and cost
• Exhibit large economies of scope
R&D Costs - Pharmaceuticals
• Pre-1962 estimated cost for the
development of a new drug = $6.5 million
• During the 1970s estimated cost for the
development of a new drug = $140 million
• 1991estimated cost for the development of a
new drug = $200 million
• In 1991, member firms of the
Pharmaceutical Manufacturers Association
spent $8.9 billion for R&D
Diseconomies of Scale
• Bidding up input prices (labor)
• Bureaucracy
• Over-utilization of specialized resources
Table 4.1 – Graphic Version
• The following slide uses the data in Table
4.1 of your text
• NOTE: There is a misprint in the book. The
1,400 total costs figure associated with output
quantity of 40 should be 1,600 rather than
1,400
Total Costs of Production
$4,000
$3,500
$3,000
$2,500
$2,000
$1,500
$1,000
$500
$0
Total Costs
($,000)
0
40
60
80
100
$500
$1,600
$1,848
$2,480
$3,500
Quantity
Table 4.2 – Graphic Version
• Here we look at the per unit costs of
production
Average Variable Costs
$35.00
$30.00
$30.00
$27.50
$25.00
$24.75
$20.00
$22.47
$15.00
$10.00
$5.00
$0.00
40
Average Variable $27.50
Costs
60
80
100
$22.47
$24.75
$30.00
Quantity
Table 4.3 – Graphic Version
• Here we look at the per unit costs of
production including the opportunity costs
of the K plant
• Maital refers to these as “Average Fully
Allocated Costs”
Average Fully Allocated Costs
$60.00
$56.00
$50.00
$41.47
$41.40
$40.00
$39.00
$30.00
$20.00
$10.00
$0.00
Average Fully
Allocated Costs
40
60
80
100
$56.00
$41.47
$39.00
$41.40
Quantity
Results
• If we ignore opportunity costs the lowest
cost production occurs at 60,000 units
• If we include opportunity costs the lowest
cost production changes to 80,000 units
The Fickleness of Cost Curves
“It is, perhaps, worth stressing that economic
problems arise always and only in
consequence of change.”
Frederich von Hayek
The Use of Knowledge in Society
Hall of Fame Cost Cutting
• Costs within a mass-production, consumer
oriented economy are CRITICAL.
• Profits are made in making products
available to the mass market
Sunk Costs
• Focus on the future, not the past. Time
flows in only one direction – forward.
• Only future costs and future benefits are
relevant.
• Accounting data based upon historical costs
may mislead you – be careful.
Cutting Costs
• Eat your own
• Often, one of the largest costs is managerial
overhead.
• Managers should always look at managerial
staff
Who is critical?
• The most important groups of people in any
business are those who make and those who
sell.
• Nearly every managerial unit in American
companies is bloated and bureaucratic.
• Look in the mirror.
Marginal Thinking
• Marginal costs are the only relevant costs to
decision-making
• Ask this question: “How much will it cost me to
produce one additional unit of my product, or to
supply one additional unit of my service?”
• Marginal and Average costs often differ
• Accounting costs are usually historical and
average
Marginal Costs
• Fortunately, is you have “good” average
costs (i.e., average costs that have been
adjusted for opportunity costs) you can
easily calculate marginal costs
• MC = d Total Costs / d Quantity
• For managers purposes
– MC = change in TC associated with the
smallest possible measured change in quantity
Table 4.4 – Graphic Version
• Now add it the marginal costs of production
including the opportunity costs of the K
plant
Marginal Costs
$60.00
$51.00
$50.00
$45.40
$40.00
$29.40
$30.00
$31.60
$20.00
$10.00
$0.00
$12.40
60
70
80
90
100
Marginal Costs $12.40 $29.40 $31.60 $45.40 $51.00
Quantity
Marginal-Cost Pricing
• Profit Maximize where MR = MC
• Where the additional revenues from the sale
cover the additional costs of the sale.
• If the additional revenues from an action
exceed the additional costs, taking the
action will increase firm profits
Accounting Costs
• Usually understate true economics costs because
they exclude opportunity costs of capital and
owner-supplied inputs
• You can easily show accounting losses when using
average measures that are typically reported
• There are ways to resolve these major issues and
get at the marginal measures you need for good
decision making