Analyzing Costs and their Behavior

Microeconomics Essentials

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Course: Microeconomics Essentials Lesson 2: Analyzing Costs and their Behavior

Introduction to Costs

It's essential to understand how changes in price affect Pepsi's sales volume, since it's that price / volume relationship that drives Pepsi's sales revenues. But there's more to the story. Pepsi's profit equals sales revenue minus total costs, and total costs include the cost of manufacturing concentrate, as well as advertising and marketing costs and the costs associated with managing the company. To determine a price that maximizes Pepsi's profits, we need to study the behavior of these costs. In particular, we need to understand how the changes in sales volume that are induced by changes in Pepsi's price affect Pepsi's total costs.

Total Cost

It's one thing to have a good understanding of how total revenues and marginal revenues behave across different levels of quantity; we established that essential understanding in the prior module. But there's more; we also need to know how costs behave, since it's the difference between revenue and costs (i.e., profits) that creates value in business. What does it cost Pepsi to provide its product to the market?

As you can imagine, there are several kinds of cost. Within the production activities, there are costs of labor, raw materials, and machinery, among others. Beyond that, the company incurs advertising costs

to promote the product and administrative costs to run the business. As Pepsi produces more cola, total costs rise, which we can see in the upward slope of the total cost curve. But note that the curve begins to flatten after 10 million units. Why do you suppose that happens?

FAQ

Why must a total cost curve slope upward? Couldn't a total cost curve slope downward if the firm benefits from economies of scale?

If you assume that a firm is producing in the most efficient manner possible, given its current technological capabilities, then it follows that the only way for the firm to achieve more output is to use more labor, materials, and equipment. Using more of these "factors of production" will necessarily raise total costs, which is why the total cost curve must always slope upward. You will learn shortly that economies of scale pertain to the relationship between production volume and average cost, (i.e. cost per unit), not total cost.

When there are economies of scale, average cost will decrease as the firm produces more output.

Why does the total cost curve have an inverted "S" shape? Is this typical of real-world firms?

The inverted "S" shape for the total cost curve is thought to be typical of many real-world firms. The inverted "S" shape implies that the firm's total cost initially rises at a decreasing rate but eventually rises at an accelerating rate. Studies of cost functions in the real world confirm that this is a typical pattern.

Exercise: Total Cost

Exercise: Total Cost and Output

Total Cost Exercise

In the late 1990s, lots of venture capitalists, entrepreneurs and managers in the dot-com environment talked a lot about "scalability." What they meant was the notion that, as the business grew, total costs would increase less slowly than the quantity of output produced by the firm. The figures to the left show possible total cost curves for a technology business. Which total cost curve illustrates the notion of a "scalable" business?

Answer

Fixed Costs

We've established that there are production costs, advertising costs, administrative costs, and so on. But there's another way to distinguish costs and making this distinction is essential to understanding the microeconomics beneath business strategy. Some costs don't change in amount regardless of the quantity of products or services that a company produces.

These are called fixed costs, or output-insensitive costs, and they include (among others) the costs of heating and insuring the factory, property taxes and management salaries.

In contrast, variable costs, or output-sensitive costs, are costs that change as the firm produces more or less output. These include, among others, the cost of hiring workers on a temporary labor basis and the cost of buying whatever raw materials are required to produce product in greater quantities.

Stories

Iberia Airlines and the Implications of High Fixed Costs.

Is it good or bad for a business to operate with a proportionally high level of fixed costs? Actually, the question is misplaced; the economics that underlie the industry usually dictate the profile of a company's cost structure.

The better question is, "How well does the company manage its exposure to high fixed costs and the exaggerated profit volatility that is inherent in such a cost structure?”

Iberia Airlines dominates the Spanish market for domestic and international air travel. From May through September, it sells high volumes of seat-miles to leisure travelers from Europe and The Americas. Historically owned and protected by the national government, it operates with little competition and is thereby able to raise prices by 100% or more during this period.

Commentary

This example illustrates the challenges associated with managing in a business with high fixed costs. It's really a question of where you look for your edges. In baseball, for example, if you were like the Kansas City Royals of the nineteen-eighties, you would look for your edge in terms of guys who could steal a base, instead of a guy who could hit a 3-run home run. That's because home runs were unlikely events in Royals Stadium. In a business with high fixed costs like airlines, even small percentage increases in revenue can translate into large percentage increases in profit. And so in the airline business, managing revenue is critical, in terms of both generating additional profitability and managing the volatility that comes when demand is uncertain

FAQ

Some of a firm's costs (e.g., maintenance expenses) seem hard to classify as purely fixed or purely variable costs. How should we think about these costs?

Not all costs can be classified as purely fixed or purely variable. Some costs are semi-fixed. For example, a firm's maintenance expenses might be insensitive to its output volume over a certain range of output.

But these costs might rise if the firm increases its output outside this range. Semi-fixed costs are steady within a certain range of output, but then become variable in other ranges of output.

Some costs, such as advertising, are within the control of management. They can "go away" if management wants to eliminate them. Are these costs variable or fixed?

When we say that a cost is fixed, we mean that it remains the same no matter what the firm's volume of output. Advertising and promotional expenses are fixed in this sense. However, advertising and promotional expenses can be eliminated if management so desires, so they are considered discretionary fixed costs - or so-called programmed costs. In contrast to discretionary fixed costs, firms can have required fixed costs, many of which pertain to technology. For example, a cable T.V. company incurs a cost to string wires to connect houses to its network. This network has to be in place for the company to provide its service to its 1st customer. These fixed costs are forced upon the firm by the technological requirements of cable T.V. distribution.

Exercise: Fixed and Variable Cost

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Exercise: Managing Output with Fixed and Variable Cost

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Fixed Cost Exercise

Many technology businesses involve significant fixed costs, but relatively low variable costs. For example, firms such as Qwest or Level 3 that operate fiber optic networks incur large "up front" expenses to install underground fiber optic cables. However once those cables are installed, the additional cost associated with actually operating the cables is relatively small. The graphs below show several possible total cost curves. Which curve best approximates a technology company that has large fixed costs but low variable costs?

Answer

Average Cost and Marginal Cost

Now that we know how to distinguish fixed costs from variable costs, we go beyond the simple notion of Total Costs to explore the ideas of average cost and marginal cost. Let's start with average costs, the curve which depicts how per-unit cost varies with the volume of output produced.

As illustrated, Pepsi's average cost per unit of output decreases as quantity produced increases. At these points along the cost curve we have economies of scale. When average costs increase with output we have diseconomies of scale. When average cost remains unchanged across volume of output we have constant returns to scale.

FAQ

Why would average cost decrease with output?

Average cost could decrease with output for several reasons. First, if the firm has fixed costs, and output increases, the fixed costs are distributed over more and more units of output, so the average fixed cost goes down. Second, in many manufacturing processes, a firm can gain productivity through specialization of labor. As a firm produces more output, it can assign workers to increasingly specialized tasks (the assembly line theory), and increase the productivity of each worker and therefore reduce unit costs. Also, as the firm operates larger machinery, they may experience energy efficiencies. Finally, in some manufacturing processes, a firm can double the size of its operation for less than double the total cost.

Why would average cost increase with output?

Average cost increases with output for two main reasons. As the firm bumps up against the capacity of its production facilities, the productivity of additional workers that it hires, or the additional raw

materials it uses, goes down. Also, as the scale of any organization increases beyond a certain point, the cost of coordinating or managing activity tends to grow disproportionately.

Is it possible for average cost to fall while marginal cost rises?

Yes. Average cost can continue to decrease with output even when marginal cost is increasing because the fixed costs are continuing to be spread over more and more units of output. This drives down average cost but not marginal cost.

Average Cost and Marginal Cost

Do you remember the concept of marginal revenue? Well, its obverse is marginal cost, i.e., the cost of producing one additional unit of output. Click on the graphic above to see how, as Pepsi ramps up its production, the percentage increase in total costs is lower than the percentage increase in the level of output. And that's why, over those same levels of output, the average cost curve and the marginal cost curve both slope downward and to the right.

But at output levels between 20 - 30 million, marginal costs rise at an accelerating rate, which causes average costs to fall at a decelerating rate over that output interval. And beyond output of 30 million, the marginal costs rise even faster, which forces average costs to increase. And that in turn causes total costs to rise more rapidly. Click on the graphic above to learn how marginal cost, average cost and total cost relate to each other mathematically.

FAQ

Is marginal cost the same as variable cost?

Marginal cost is not the same as variable cost. Variable cost is a "total number" (i.e. the total of all costs that vary with output), while marginal cost is a "rate of change in the total" (the rate at which total cost changes with respect to volume of output produced).

What is the relationship between marginal cost and fixed costs?

The two concepts are closely linked. A firm will have marginal costs only if some of its costs are variable. A firm that has only fixed costs (theoretically, a software developer for example) will have zero marginal costs because as they produce additional units their total cost of production stays the same.

Is the idea of marginal cost similar to the idea of marginal revenue?

Yes, they are very similar in that they both describe the "rate of change in a total". Marginal cost is the rate at which total cost changes when an additional unit of output is produced. Marginal revenue is the rate at which total revenue changes when an additional unit of output is produced.

Exercise: Marginal and Average Cost

Exercise: Managing Output with Marginal and Average Cost

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Average Cost/Marginal Cost Exercise

Now let's think about average and marginal costs in technology companies. Many "new economy" companies incur large set-up costs to build infrastructure, or build knowledge. This is true of companies such as Qwest that operates fiber optic networks and for software companies such as Microsoft. A software company spends millions of dollars writing computer code, and debugging it. But once that code is built, distributing it to consumers entails low incremental cost. Indeed, if the software is distributed over the Internet the incremental cost might be virtually zero. Which of the graphs below might exemplify the average and marginal cost curves of a software company?

Sunk Costs

So far, you've learned how to classify various types of costs according to whether they are total, average, marginal, variable or fixed in nature. Having the skill to classify these costs is essential to effective analysis. But it's not quite enough. There are two more types of cost that you need to distinguish. The first is the concept of sunk costs, i.e., costs that can't be avoided and that, as a result, aren't affected by your decision.

You'll see sunk costs in most or every strategic analysis, including those listed above. For example, assume that the head of Pepsi's operations in Brazil is considering shutting down one of her three beverage product lines. Reaching the right conclusion depends upon her getting the analysis of sunk costs right.

FAQ

Is a sunk cost the same as a fixed cost?

No. Not necessarily. Sunk costs are costs that will not change based on the decision at hand. Sunk costs will not be recovered no matter what future decisions the firm makes. There are fixed costs that do not vary with the volume of output the firm produces, however they would go away if the firm produced no output. For example, the heat cost for a factory. If the factory is operating there is a heat bill, but if they close the factory, the heat bill goes away.

Exercise: Strategy and Sunk Costs

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Exercise: Sunk and Avoidable Costs

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Economic Costs

There's one more type of cost that's part of any thoughtful strategic analysis and it's one that you're very familiar with -Economic Costs. Economic costs not only include direct out-of-pocket costs, but also include opportunity costs; they represent the value that could be captured if a resource were put to its greatest alternative use. As a business school student, you incur a variety of direct monetary costs, of which some are fixed (e.g., tuition and rent) and others variable (e.g., travel between academic quarters, entertainment).

But there are additional economic costs of being a student, which include interrupting a career and foregoing a business professional's compensation, and they are at least as large as the monetary costs.

As a student, you hope that the additional compensation you will receive after you complete your degree (Area B on the above graph), more than offsets the foregone compensation while obtaining the degree (graph Area A) plus the monetary costs incurred to get the degree. Let's look at how the consideration of economic costs (and their analogue, Economic Profit) could play a key role in a business strategy analysis. Let's turn back to Pepsi.

FAQ

What is the definition of economic cost? Economic profit?

Economic cost equals all direct outlays of resources used by a firm (including labor, materials and equipment) plus the opportunity cost of what else the firm could be doing with their resources. Economic profit equals total revenue minus total economic cost.

How do you determine the return that a firm foregoes when it doesn't liquidate its assets?

This is a very deep and involved question. To answer it properly, you need to use the principals of corporate finance. In corporate finance, you will learn about a concept called the weighted average cost of capital. Weighted Average Cost of Capital is the best measure of the return that a firm's owners forego by not liquidating the firm's assets and deploying them elsewhere.

Economic Costs

Let's think about Economic Profits, i.e., Total Revenue - Total Economic Costs. For many years, Pepsi has relied on a network of bottlers to manufacture and distribute Pepsi Cola and other Pepsi products. Pepsi owns and operates some of these bottling operations, but others are owned and operated privately, often family-run businesses. Let's think about a family-owned Pepsi bottling company located in Cleveland, Ohio. In the current year, the company expects that its profit and loss statement will be as shown above.

At the beginning of the year, PepsiCo offered the family $300 million to buy the bottling company. The family estimated that it would have been able to earn a 12% annual return on the cash it receives from Pepsi. Furthermore, it expects that if it does not sell the firm to Pepsi, Pepsi will make an identical offer to buy the company next year.

Stories

Economic Costs: Philippines Soft Drink War

Sometimes even very successful companies can incur economic costs that are so high as to compel a change in strategy. Consider Cosmos Bottling, the bottler of carbonated drinks in the Philippines. From the late 1980s until 2001, Cosmos expanded its market share from 10% to 25% of the $1 billion local soft drink market and produced attractive financial results. But Cosmos sold its business and exited the market. Why? Because the economic costs of not selling were severe.

The local soft drink bottling market was dominated (65% market share) by Coca-Cola Philippines, a joint venture between Coca-Cola and San Miguel, Coke's local partner. By buying Cosmos, Coca-Cola Philippines figured to control 90% of the market. And with that increased scale of operations, Coca-Cola

Philippines figured to further leverage its fixed costs and thereby expand its already impressive profitability. In the process, Coca-Cola Philippines could, in practical terms, permanently exclude its archrival, Pepsi, from the local market. (Pepsi was the losing bidder on the deal.)

Cosmos recognized how strategically compelling this deal was for Coca-Cola Philippines. And with that view, Cosmos achieved a sale price whose size compelled Cosmos to sell and no longer operate as an independent company. For Cosmos's shareholders, the opportunity costs of not selling were simply too great.

Commentary

The point of this example is that economic profit is a fundamentally important piece of information for business managers. One way to think about it is, again, to use a sports analogy. Are you shooting par, or are you below par, or are you above par? If you're shooting par, what that basically means is that the return that you're generating on your capital in its current use, matches the return you can generate in its best alternative use. Below par in business terms is generating a return on assets that exceeds the return that can be generated by deploying those assets elsewhere.

FAQ

The adjacent example seems to imply that opportunity costs only arise with physical assets that the firm owns (property, plant, and equipment). Are there opportunity costs attached to other resources that a firm uses.

Yes, there are. If an owner of a firm supplies his or her own labor to manage the firm, that labor has an opportunity cost. The opportunity cost would be the salary that the owner of the firm forgoes by not working in the best available employment opportunity outside the firm.

Exercise: Economic Costs

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Exercise: Accounting Profit Versus Economic Profit