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?
 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
 Cost Structures

First distinction:

(1) fixed costs vs.

(2) variable costs.

 Fixed Costs

Independent of output level

examples:

cost of borrowed money

rental or mortgage payments on office/factory space

corporate HQ costs.
 Variable Costs
Depend in some way on production levels
within the organization
examples:

materials

some labor (depends on the contract)

power
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.
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

 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?
 Variable cost proportional to output

Average
cost Large firms have cost
FC/N + advantage over smaller
ones.

Output
 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
complementarities.
 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.

 Variable cost quadratic in output

Average
cost
FC/N + + N

Output
 Next Distinction

Marginal (or incremental) vs.

Average costs.
MC is probably the most import cost
concept
 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:
MC=DTC/DN
=DFC/DN + DVC(N)/DN
=DVC(N)/DN
 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
 Variable cost proportional to output

Average
cost
FC/N +

Marginal cost

Output
What is the relationship between
average and marginal costs?

If MC < AC, then AC is falling

If MC > AC, then AC is rising

If MC = AC, then AC is constant

 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.
 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.
 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
 Cost Categories

Average Costs Marginal Costs

Fixed Costs Yes No
Variable Costs Yes Yes
 Dynamic Changes in
Costs--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.
 The Learning Curve

Hours of labor
The horizontal axis per machine lot
measures the
cumulative number of
10
hours of machine tools
the firm has produced 8

The vertical axis 6

measures the number of
hours of labor needed to 4
produce each lot.
2

0 10 20 30 40 50
 Dynamic Changes in
Costs--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.
 Economies of
Scale Versus Learning

Cost
($ per unit
of output)

Economies of Scale
reversible.
A
B
AC1
Learning
C AC2

Output
 Dynamic Changes in
Costs--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.
 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)
 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%.
 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.
 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)
 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
 Leverage

Study the elasticity of profits with

respect to output Q.

Let output change from Q to Q + DQ,

and profits from to + D

Intuition - must be greater, the greater

are fixed costs.
The elasticity of profits with respect to
output, denoted E ,Q, is:

E ,Q = D/ D Q
=
DQ/Q DQ
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
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
/Q = (PQ - AC*Q)/Q so
(Q/) = 1/(P - AC) so

E,Q = P-MC/P-AC

Operating leverage

MC = AC: E,Q = 1
MC < AC: E,Q > 1

MC > AC: E,Q < 1

 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%.
 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)
 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?
Sales, M Av Cost
Av Cost
10 230.00
20 115.00 250.00
30 76.67
40 57.50 200.00
50 46.00
60 38.33
70 32.86 150.00
80 28.75 Av Cost
90 25.56 100.00
100 23.00
50.00

0.00
10 20 30 40 50 60 70 80 90 100
Sales, millions
Microsoft needed to sell 65 million units @ $35 to
recover its fixed investment in the development
and promotion of Windows.

At $30, it had to sell 77 million units.

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

 Average Cost:

AC = TC/Q = 1 + 2.3B
Q
Compute operating leverage using
formula E,Q = P - MC
P-AC
E,Q = 35
35 - 2.3B
Q
Multiply numerator and denominator by Q/35
Q
Q - 65M
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 3.7
A given fluctuation in sales induces a smaller
proportionate increase in profits.
 Cost Allocation

How should a multi-divisional company

allocated corporate overhead costs between
its divisions?
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.)
 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.
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?
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.
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?
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.
Economic & Accounting
Approaches to Costs
 Table 2
Income Statement for Product A (1000s)

Sales (40 million lbs. @ 50 cents/lb) $20,000

less:
Materials $8,000
Direct labour $2,000
Manufacturing overhead $2,200
Cost of Goods Sold $12,200
Gross 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
 Table 3
Classifying 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
 Table 4
Reconfigured Income Statement for Product A Using a Variable Budget Format
(1000s)
Sales (40 million lbs. @ 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
General and Administrative 1,400
Total Fixed Costs 6,600
Net Profit Before Taxes 1,400
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.
 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.
Other Cost Concepts
 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.
 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.
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.
 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?
 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) B&W on newsprint
(3) Cover Piece
(a) 4 pages, color on special paper
(b) specific to each edition
 Culver City

Increase print run from 126,000 to 146,000. No other

change.
What are the extra costs?
Binding @ $0.019/copy

Delivery @ $0.013/copy

Printing: each copy is

Cover Piece, 4 color coated pages, 1 sheet/copy @ $0.016

Program Book, 48 B&W newsprint pages, 12 sheets/copy
@ $0.004/sheet = $0.048/copy
Story Book, 16 pages color, coated paper. 4 sheets/copy @
$0.012/sheet - $0.048
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
 Des Moines

Only change: length of Program Book from 16 to

48 pages. Increase of 32 pages = 8 sheets, B&W
newsprint
Costs:
New plates for 32 pages @$108/page = $3456 =
3456/84,000 = $0.041/copy
Printing 8 sheets @ $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
 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?
 Add 4 local channels to the d/b @ $1,800
per channel per year = $7,200

Customer service @$6,000/account/year

Plates:
Cover page plates 4 @ $405 = $1620
Story book plates 16 @ $405 = $6480
Program book plates 48 @$108 = $5184
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

 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
 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.
 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.
Outsourcing as Business Model

Benetton, Liz Claiborne

Subcontract production to third-world
companies
Subcontract distribution to Fedex, UPS, etc.
Benetton franchises retail outlets
What does the corporation do?
Follows market trends
Designs products
Markets products

Assets - intellectual property. Hence

emphasis on intellectual property rights.
 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.
 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.
 Issues Raised
International mobility of jobs
Labor conditions in third world countries
Environmental issues in third world
countries.
 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.