Costs

1
Costs

• Cost is not a simple concept. It is important
  to distinguish between four different types -
  fixed, variable, average and marginal.
• What is the cost of an additional copy of Windows
  2000? Multiply this by the total number sold.
  Would Bill Gates recover his investment at this
  price? Why not?

2
Costs Profits

• Profits Revenues Costs
• Studied how revenues relate to output
• Next we study how costs relate to output.
• Then we can decide how profits vary with output
  and so what output levels are most profitable

3
Cost Structures

• First distinction
• (1) fixed costs vs.
• (2) variable costs.

4
Fixed Costs

• Independent of output level
• examples
• cost of borrowed money
• rental or mortgage payments on office/factory
  space
• corporate HQ costs.

5
Variable Costs

• Depend in some way on production levels within
  the organization
• examples
• materials
• some labor (depends on the contract)
• power

6

• Note that the line between fixed and variable
  costs is not always sharp and costs may be fixed
  for one analysis and variable for another - see
  the TV guide case.

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• TC total cost, VC variable cost, AC average
  cost, etc.
• TC FC VC
• VC VC(N) where N is the level of output
• AC TC/N FC/N VC(N)/N

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Variable costs linear in output

• VC(N) ?N
• Then AC FC/N ? is declining in N
• When are variable costs likely to rise
  proportionally to output? When more than
  proportionally? Less?

9
Variable cost proportional to output
Average cost
Large firms have cost advantage over
smaller ones.
FC/N b
b
Output
10
Cost curves Mergers

• Falling average costs can provide impetus for
  mergers
• Compaq-Hewlett Packard merger may be of this
  type, as were mergers of Chase and Chemical Bank.
• Other motives may be in terms of product
  complementarity.

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Variable costs quadratic in output

• VC(N) ?N ?N2
• Then AC FC/N ? ?N
• This is ?-shaped as a function of N, falling for
  small N and then rising for large N.

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Variable cost quadratic in output
Average cost
FC/N bgN
b
Output
13
Next Distinction

• Marginal (or incremental) vs.
• Average costs.
• MC is probably the most import cost concept

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Marginal Costs

• MC is change in total cost as result of one unit
  change in output, TC(N) - TC(N-1)
• Rate of change of total cost with respect to
  output
• MCDTC/DN
• DFC/DN DVC(N)/DN
• DVC(N)/DN

15
Marginal Costs

• MC depends only on variable costs
• Shows cost impact of change in production fixed
  costs have no relevance to cost consequence of
  output change

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Variable cost proportional to output
Average cost
FC/N b
b
Marginal cost
Output
17
What is the relationship between average and
marginal costs?

• If MC lt AC, then AC is falling
• If MC gt AC, then AC is rising
• If MC AC, then AC is constant

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Returns to scale

• A.k.a. Economies of scale
• Increasing returns to scale - AC falls as output
  rises.
• Decreasing returns - AC rises with output
• Constant returns - AC does not change with
  output.

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Returns to scale cost structure

• Large fixed costs imply increasing returns -
  e.g., autos, telecoms, networks.
• Small fixed costs and VCs rising with o/p imply
  diminishing returns - e.g farming.
• Assembly operations usually show constant
  returns.
• Large fixed costs - economies of scale - make
  entry of competitors difficult.

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Scale economies competition

• Autos - history of consolidation.
• Telecom networks prior to fiber optics - entry of
  MCI Sprint into long distance after ATT
  deregulation
• Microsoft and Windows

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Cost Categories
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Dynamic Changes inCosts--The Learning Curve

• The learning curve measures the impact of
  workers experience on the costs of production.
• It describes the relationship between a firms
  cumulative output and amount of inputs needed to
  produce a unit of output.

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The Learning Curve
Hours of labor per machine lot

• The horizontal axis measures the cumulative
  number of hours of machine tools the firm has
  produced
• The vertical axis measures the number of hours of
  labor needed to produce each lot.

10
8
6
4
2
10
20
30
40
50
0
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Dynamic Changes inCosts--The Learning Curve

• The learning curve in the figure is based on the
  relationship

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Dynamic Changes inCosts--The Learning Curve

• L equals A B and this measures labor input to
  produce the first unit of output
• Labor input remains constant as the cumulative
  level of output increases, so there is no learning

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Dynamic Changes inCosts--The Learning Curve

• L approaches A, and A represent minimum labor
  input/unit of output after all learning has taken
  place.
• The more important the learning effect.

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Dynamic Changes inCosts--The Learning Curve

• Observations
• 1) New firms may experience a learning curve,
  not economies of scale.
• 2) Older firms have relatively small gains from
  learning.

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Economies ofScale Versus Learning
Cost ( per unit of output)
Economies of Scale reversible.
Output
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Dynamic Changes inCosts--The Learning Curve

• The learning curve implies
• 1) The labor requirement falls per unit.
• 2) Costs will be high at first and then will
  fall with learning.

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The Learning Curve in Practice

• Scenario
• A new firm enters the chemical processing
  industry.
• Do they
• 1) Produce a low level of output and sell at a
  high price?
• 2) Produce a high level of output and sell at a
  low price?

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The Learning Curve in Practice

• The Empirical Findings
• Study of 37 chemical products
• Average cost fell 5.5 per year
• For each doubling of plant size, average
  production costs fall by 11 (economies of scale)
• For each doubling of cumulative output, the
  average cost of production falls by 27 (learning)

32
The Learning Curve in Practice

• Other Empirical Findings
• In the semi-conductor industry a study of seven
  generations of DRAM semiconductors from 1974-1992
  found learning rates averaged 20.
• In the aircraft industry the learning rates are
  as high as 40.

33
The Learning Curve in Practice

• Applying Learning Curves
• 1) To determine if it is profitable to enter
  an industry.
• 2) To determine when profits will occur based on
  plant size and cumulative output.

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How do cost concepts relate to pricing?

• Price should never be below marginal costs.
• Can it make sense for price to be above marginal
  cost but below average costs?
• Yes, but do not renew your investment in this
  case. This is a situation where you can stay in
  the business but it was a mistake to get into it
  in the first place.
• In this case we cover variable costs but dont
  recover fixed costs.

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Breakeven

• Occurs at the output level at which total cost
  equals total revenue.
• Let P(N) be the price at which N units can be
  sold. Then breakeven means
• P(N) . N FC VC(N)

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Total Cost FC VC(N) FC bN c N2
MC n 2cN
Costs
Average total cost AC FC/N b cN
Price
MC
Output
Breakeven
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Leverage

• Study the elasticity of profits ? with respect
  to output Q.
• Let output change from Q to Q ?Q, and profits
  from ? to ? ??
• Intuition - must be greater, the greater are
  fixed costs.

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• The elasticity of profits with respect to output,
  denoted E ?,Q, is
• E ?,Q ??/?
• This is the ratio of the proportional change in
  profits resulting from an output change to the
  proportional change in output causing it. If
  this number is 5, for example, it tells us that a
  1 change in output leads to a 5 change in
  profits

?? Q

?Q/Q
?Q ?
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• Profit ?
• ? PQ(revenue) - TC(total cost)
• PQ - FC - VC
• Elasticity of ? with respect to Q
• E?,Q (d?/dQ)(Q/?)
• d?/dQ P - (dVC/dQ) P - MC
• E?,Q ?P-MC?(Q/?)
• P - MC contribution to overhead or contribution
  margin

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• ?/Q (PQ - ACQ)/Q so
• (Q/?) 1/(P - AC) so
• E?,Q ?P-MC?/?P-AC?
• Operating leverage
• MC AC E?,Q 1
• MC lt AC E?,Q gt 1
• MC gt AC E?,Q lt 1

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Applications

• Combine operating leverage with income elasticity
  of demand.
• Firm has Op Lev of 5 and IED for products of 5.
  Then 1 rise in consumer income implies 5 rise
  in sales and 25 rise in profits and vice versa
  for fall in demand
• If Op Lev is 2 and IED is 2 then corresponding
  number is 4.

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Windows 95 Facts

• Development costs 1.1 billion
• Promotion costs 1.2 billion
• Variable costs
• zero for OEM use
• very low for site licenses
• 2-3 for retail sales
• Retail price 50 - 60 (to Microsoft)

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Windows 95 Questions

• What is the average cost for various output
  levels?
• What is the marginal cost?
• What are the demand elasticities and the income
  elasticity?
• What is the operating leverage?
• What is the nature of competition?
• Are there benefits to this product other than
  sales revenues?

45

46
Microsoft needed to sell 65 million units _at_ 35
to recover its fixed investment in the
development and promotion of Windows. At 30,
it had to sell 77 million units.
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Operating Leverage for Microsoft Windows

• Price averaging over range, let P 35
• Marginal cost assume MC 1, a constant
• Then for Output level Q, variable cost is VC Q
• Fixed cost is FC 2.3B (2.3 billion), so
• Total cost is TC FC VC 2.3B Q

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• Average Cost
• AC TC/Q 1
• Compute operating leverage using formula E?,Q
• E?,Q
• ? Q
• Q - 65M

2.3B Q
P - MC
P-AC
35 35 - 2.3B Q
Multiply numerator and denominator by Q/35
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Near the breakeven point, small fluctuations in
output induce large fluctuations in profits.
Thus if Q 70 million copies, operating
leverage is approximately 17 (a 1 increase in
sales leads to a 17 jump in profits) If output
expands to Q 90 million copies, then operating
leverage is 3.7A given fluctuation in sales
induces a smaller proportionate increase in
profits.
50
Cost Allocation

• How should a multi-divisional company allocated
  corporate overhead costs between its divisions?

51
PC Computer Company (PCCC) has two operating
divisions (1) Desk Top (DT) (2) Lap Top
(LT)PCCC corporate overhead cost 20m/year
composed of - interest on corporate debt -
salaries of the President, CEO, and CFO -
corporate promotional costs - central office
costs (accounting, HR, management,
etc.)
52
Divisional costs

• DTs division-specific fixed costs are 50m/year
  (equipment and fixed labor) and variable costs
  are 1,000/machine (components, labor, testing)
  DT sells machines for 1,500 each.
• LTs division-specific fixed costs are 50m/year
  and variable costs are 1,500 per machine, which
  sell for 2,000 each.

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Consider the following questions

• At what output level does each division cover its
  division specific costs?
• How does each divisions contribution to
  corporate overheads and profits change with
  output once it exceeds the output level which
  answers (1)
• When does PCCC as a whole make profits?

54
Answers

• DT will break even at sales of 100,000 relative
  to divisional costs.
• LT will also break even at 100,000.
• We will need an extra 40,000 units to cover
  corporate overheads of 20m - i.e. a total sales
  of 240,000.
• The make-up of this 40,000 sales total does not
  matter.

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• The CFO decides to allocate overheads to DT and
  LT, 10m/year to each. The CEO then decides to
  close down any division which is not covering
  division-specific costs plus its allocated
  overhead.
• Evaluate this policy. What conclusion can you
  draw about the appropriate test of a divisions
  financial performance?

56
Answer

• DT and LT now each need to sell 120,000 to break
  even, given the allocation of overhead.
• Suppose DT sells 121,000 and LT sells 119,000
  units. Closing LT will clearly make the company
  worse off. Why? Because its contribution of
  19,000X500 9.5 m to corporate overhead will
  be lost.

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Economic Accounting Approaches to Costs
58
Table 2Income Statement for Product A (1000s)
Sales (40 million lbs. _at_ 50 cents/lb) 20,000 le
ss Materials 8,000 Direct
labour 2,000 Manufacturing
overhead 2,200 Cost of Goods Sold 12,200 Gr
oss Margin 7,800 less Advertising
800 Promotion 200 Field
Sales 3,200 Product Management
50 Marketing Management 300 Product
Development 300 Marketing Research
150 General and Administrative 1,400 Total
Expenses 6,400 Net Profit Before
Taxes 1,400
59
Table 3Classifying Product A Costs into Variable
and Fixed (1000s)

• Cost Component
• Total Variable Fixed
• Materials 8,000 8,000 -------
• Direct Labour 2,000 2,000 -------
• Manufacturing Overhead 2,200
  1,000 1,200
• Cost of Goods Sold 12,200 11,000
  1,200
• Advertising 800 800
• Promotion 200 200
• Field Sales 3,200 1,000 2,200
• Product Management 50 50
• Marketing Management 300 300
• Product Development 300 300
• Marketing Research 150 150
• General and Administrative 1,400
  1,400
• Total Expenses 6,400 1,000
  5,400
• Total Costs 18,600 12,000
  6,600

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Table 4Reconfigured Income Statement for Product
A Using a Variable Budget Format (1000s)

• Sales (40 million lbs. _at_ 50 cents/lb)
  20,000
• less
• Variable Costs
• Materials 8,000
• Direct labour 2,000
• Manufacturing overhead 1,000
• Sales Commissions 1.000
• Total Variable Costs 12,000
• Variable Margin (Profit Contribution)
  8,000
• less
• Fixed Costs
• Advertising 800
• Promotion 200
• Field Sales 2,200
• Product Management 50
• Marketing Management 300
• Product Development 300
• Marketing Research 150
• Manufacturing Overhead 1,200

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Important differences between tables 2 and 4
In the typical financial income statement shown
in Table 2, when cost of goods sold is subtracted
from sales, these costs include allocated
overhead that does not vary with the quantity
produced. Fixed costs are combined with variable
costs.
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Operating Leverage

• Average cost 18,600,000/40,000,000 0.46
• MC AVC 12,000,000/40,000,000 0.30
• (P - MC)/(P - AC) (50 - 30)/(50 - 46) 5
• So even for this corporation with significant
  variable costs leverage is 5.

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Other Cost Concepts
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Opportunity Cost

• Non-cash cost of an alternative foregone
• Examples
• a company invests cash reserves internally for
  return of 10. Could have invested externally at
  12. Accounting cost of the investment is zero,
  economic or opportunity cost is 12
• a company owns a building. Uses it for its own
  office. Accounting cost is zero. Could have
  rented it for 20/ft2 and moved to the suburbs
  for 12/ft2. Opportunity cost is 20/ft2 and
  loss is 8/sq. ft.

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Opportunity Costs

• In may cases the main cost of continuing a
  division will be the human expertise involved in
  this.
• Example a skilled manager in a division barely
  breaking even may be much better used in a
  higher-margin division.

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Cost of Frequent Flier Schemes

• What does it cost United or American to provide
  Frequent Flier schemes?
• Dilution and displacement.
• What are the gains?
• Effect on PED.

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Sunk Costs

• Expenditures made which cannot be recovered.
  Should have no impact on a firms decisions.
• Example
• A firm is thinking of moving its headquarters.
  It pays 500,000 for an option to buy a building
  for 5,000,000. The total cost if it buys is the
  5,500,000.
• The firm finds a comparable building for
  5,250,000.
• Which should it buy?

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TV Listing Guide

• (1) Story Book
• (a) common to all editions, 16 pages long
• (b) coated paper, color photos
• (2) Program Book
• (a) specific to each edition
• (b) BW on newsprint
• (3) Cover Piece
• (a) 4 pages, color on special paper
• (b) specific to each edition

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• 1 sheet 4 pages, 1 plate per page BW, 4 plates
  per page, color
• Other costs binding, delivery, database
  management, account management

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Culver City

• Increase print run from 126,000 to 146,000. No
  other change.
• What are the extra costs?
• Binding _at_ 0.019/copy
• Delivery _at_ 0.013/copy
• Printing each copy is
• Cover Piece, 4 color coated pages, 1 sheet/copy _at_
  0.016
• Program Book, 48 BW newsprint pages, 12
  sheets/copy _at_ 0.004/sheet 0.048/copy
• Story Book, 16 pages color, coated paper. 4
  sheets/copy _at_ 0.012/sheet - 0.048

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• So, the total incremental cost/copy Binding
  Delivery Cover Piece Program Book Story
  Book 0.144
• Note this number does not depend on the level of
  sales

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Des Moines

• Only change length of Program Book from 16 to 48
  pages. Increase of 32 pages 8 sheets, BW
  newsprint
• Costs
• New plates for 32 pages _at_108/page 3456
  3456/84,000 0.041/copy
• Printing 8 sheets _at_ 0.004/sheet 0.032/copy
• So total incremental cost for constant
  production of 84,000 per week is 0.073
• Note This number depends on the level of sales

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Cheyenne

• Circulation 48,000
• Printing costs
• Cover 4 pages
• Story 16 pages
• Program 48 pages
• Printing delivery and binding costs will be same
  as in Culver City, 0.144/copy
• What other costs are there in this case?

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• Add 4 local channels to the d/b _at_ 1,800 per
  channel per year 7,200
• Customer service _at_6,000/account/year
• Plates
• Cover page plates 4 _at_ 405 1620
• Story book plates 16 _at_ 405 6480
• Program book plates 48 _at_108 5184

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• Makes total annual set up costs 13,200 per
  year. To express this per copy divide by
  52x48,000 making 0.0053 a copy. Total weekly
  setup costs are 13,284. Per copy this is 0.276
• Hence total incremental cost is 0.425 per copy

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Rules for Using Cost Data

• Dont use Average Cost, or Average Variable Cost,
  as a proxy for Marginal Cost. MC is the
  appropriate measure for decisions about the scale
  of production
• A single item of accounting costs can include
  both fixed and variable costs. These must be
  separated to identify MC
• MC should include all relevant opportunity costs,
  even those not identified explicitly in firms
  accounts
• Ignore sunk costs, even if they are explicit
• Concept of asset specificity can be a useful tool
  when identifying which costs are truly sunk

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Activity - Based Costing

• A method of trying to understand connections
  between overhead costs and their drivers in
  terms of levels of divisional activity.
• To be covered in managerial accounting course.

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Changing Fixed to Variable Costs

• Large fixed costs perceived as risky
• Outsourcing a method of transforming fixed to
  variable costs
• E.G. - computer operations. Outsource to ADP,
  EDS, IBM, PWC, etc. Pay on a usage basis so cost
  is now variable.
• Risk shifted to outsourcer.

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Outsourcing as Business Model

• Benetton, Liz Claiborne
• Subcontract production to third-world companies
• Subcontract distribution to Fedex, UPS, etc.
• Benetton franchises retail outlets

80
What does the corporation do?

• Follows market trends
• Designs products
• Markets products
• Assets - intellectual property. Hence emphasis on
  intellectual property rights.

81
Trend Spreading

• Compaq, Dell always outsourced component
  production.
• Cisco has NO production facilities - all
  production is outsourced.
• Now outsourcing assembly, often to Asia, Mexico.
• Even GM, Ford moving this way.

82
Motor Industry

• GM has sold off components division.
• Ford moving this way.
• Both looking to suppliers to provide entire
  pre-assembled subsystems.
• GM has stated publicly that it wants to be out of
  manufacturing to specialize in designing and
  marketing cars. Subcontract manufacturing to
  third-world countries.

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Issues Raised

• International mobility of jobs
• Labor conditions in third world countries
• Environmental issues in third world countries.

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Dematerialization of the Corporation

• Moving to situation where corporate assets are
  intellectual property rather than bricks and
  mortar.
• Quote CFO of GM when Microsoft first passed GM in
  market cap
• Microsoft - hey, their assets could fit in our
  executive parking lot!
• complex questions for valuation, depreciation,
  etc.