Cost, supply, and strategy
Paul C. Godfrey
Mark H. Hansen
Marriott School of Management
Industry
Differentiation
What strategists need to know:
• What types of costs are there?
• What drives costs?
• How do costs influence decision making?
• How can managers work with/influence cost to create competitive
advantage?
What types of costs are there?
Opportunity costs
• The price paid to induce an actor to do X and not the next best thing
• Include a firm’s cost of capital—the next best alternative
• Accounting costs + opportunity costs = true costs
• What’s the true cost of your BYU MBA?
– It may be
• Tuition + lost wages
• Tuition + increased family stress
• Tuition differential (HBS-BYU) + Opportunity differential (HBS - BYU)
• Opportunity costs underlie all other costs
Fixed Costs
$
•
The true costs of opening the
doors for business, before any
sales are made
•
Incurred once, at the beginning,
later amortized over each unit
•
The foundation of scale
economies
•
Only fixed in the short term—in
the long run all costs are variable
•
How important are fixed costs in
airlines, restaurants, software,
etc.?
FC
AFC
Quantity
Variable Costs
$
AVC
 cost of variable inputs
• total variable cost changes
as output changes
• average variable cost falls
and then rises
Quantity
Total Cost
TC
VC
$
FC
Quantity
•
Fixed Costs + Variable Costs
•
Total Cost always increases
•
Differ significantly from Total
Revenue, which have an inverted
U shape
Marginal Costs
$
MC
•
The cost of producing the next unit
•
Increases due to the law of
diminishing returns (e.g., labor
gets less efficient)
•
Have many functional forms (step,
continuous), but generally
increase as quantity increases
– Discrete units (flight attendants)
– Continuous units (fuel)
•
Quantity
Marginal costs are the short term
supply schedule for the firm
Average Total Cost
$
ATC
MC
•
AVC
•
AFC
Quantity
Total costs / number of units
produced
Costs decrease for a while due to
scale (economies of scale)
•
Costs start to increase due to
incremental costs (diminishing
returns to scale)
•
The long run supply curve
What drives costs?
Key cost drivers
• Productivity (what you get for what you pay) is the name of the
game
• Drivers
– Efficiency of Human Capital
– Embedded technology (chipsets)
– Knowledge (surgery) & information (brand)
– Economies of scale (shipbuilding) and scope (airline cargo)
– Regulations (CAFE) / laws (COBRA) / customs (Sabbath days)
– Macro economic conditions (interest rates)
– Natural conditions (oil viscosity and location)
How do costs influence decision making?
The short run calculation
MC
$
•
Profit (p) = Revenue – Cost
•
For a price-taking firm, price =
Revenue
•
Only marginal costs matter in the short
run
P
–
Q*
Quantity
Fixed costs are already sunk
•
Profit maximized when every profitable
unit has been produced, where p > mc
•
Produce Q*, such that at Q*, p = mc
The long run: case I
MC
•
Potential profit still maximized
when every profitable unit has
been produced, where P > ATC
•
Produce Q*, such that at Q*, P =
MC (competitive market)
•
In the long run, profit depends on
average costs
$
ATC
P
Profit
– Fixed costs now become variable
Q*
Quantity
•
If ACQ* < P, then profit is made
The long run: case II
MC
ATC
$
P
If MCmin < p < ATCQ*, then loss is
short term sustainable
Loss
Q*
Quantity
The long run: case III
ATC
MC
$
•
If p < MCmin < ATCQ*, the firm
should exit the market
•
What will be the total loss?
–
FC?
P
•
Quantity
No, FC – Opportunity cost
How can managers use/ influence cost to create
competitive advantage?
Understand costs
• Understand which costs are fixed and which costs are variable
• Understand marginal costs, especially as compared to P and/or MR
• Understand how total costs get allocated
– Fixed costs on square footage vs. sales volume
– The difference between profitable and unprofitable
• Activity-based costing schemes are very helpful
• Identify and understand opportunity costs
• Understand the time frame for relevant costs
– Marginal (short term)
– Average (long term)
Marginal costs matter
• Would you buy a 6th tire for your car?
• We intuitively understand marginal costs
• Make them explicit in decision making
Productivity is the crucial metric
• The fallacy is that what you pay drives costs
–
–
The case of the hand-held scanners
Why is any production done in high cost countries?
• It’s what you get for what you pay that matters
–
–
Hand held scanners radically improve productivity all along the line
High cost labor works when it is more productive
• It’s all about productivity
It costs money to lower costs
Cost reductions aren’t free, but they may be worth it!
• Investments in new technology and processes
• Investments in knowledge and skill
• Investments in changing organizational behavior and routines
• Investments in personal change
Understand and look for producer surplus
S0
$
P*
•
Market supply curve represents
different companies ability to
produce
•
For firms to the right of P*(A),
there is no value in producing
•
The firm at P*(A) is just covering
average costs, no profit
•
All firms to the left of P*(A) are
making more that it costs them to
produce, and are making profits
•
The same principle applies to
each of the firm’s input suppliers
(including labor)
•
When actors earn surplus, they
have incentives to do business
with the firm
A
Producer
Surplus
Quantity