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 ()

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 U-shaped

• 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

Production Quantities

SAC

minimum per unit costor

minimum efficient scale

Economies of scale - declining per unit costsDiseconomies of scale - rising per unit costs

Per Unit Costs

Q

SAC

Economies of Scale Diseconomies of Scale

constantreturns to

scale

increasingreturns 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 – “producing these products together is cheaper

than producing them separately”

TC Q Q TC Q TC Qx y x y( , ) ( , ) ( , ) 0 0

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 reachedDIVIDED 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

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

Quantity

Total Costs($,000)

$500 $1,600 $1,848 $2,480 $3,500

0 40 60 80 100

Table 4.2 – Graphic Version

• Here we look at the per unit costs of production

Average Variable Costs

$22.47

$27.50

$24.75

$30.00

$0.00

$5.00

$10.00

$15.00

$20.00

$25.00

$30.00

$35.00

Quantity

Average VariableCosts

$27.50 $22.47 $24.75 $30.00

40 60 80 100

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

$56.00

$41.47

$39.00

$41.40

$0.00

$10.00

$20.00

$30.00

$40.00

$50.00

$60.00

Quantity

Average FullyAllocated Costs

$56.00 $41.47 $39.00 $41.40

40 60 80 100

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 = Total CostsQuantity• 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

$12.40

$29.40$31.60

$45.40

$51.00

$0.00

$10.00

$20.00

$30.00

$40.00

$50.00

$60.00

Quantity

Marginal Costs $12.40 $29.40 $31.60 $45.40 $51.00

60 70 80 90 100

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