Cost Structure and Break-even Point

Cost Structure and Break-even Point

• Total cost is comprised of fixed cost and variable cost.

• Variable costs are directly related to the volume produced.

  • An increase in production volume leads to an increase in total variable costs.
  • The relationship between variable costs and volume is not linear due to discounts on purchases and efficiency increases.
  • High variable cost incidence makes the total variable cost curve steeper.

• Fixed costs are independent of the production volume and determined by the production capacity available.

  • Fixed costs are affected by production capacity limits.
  • Fixed costs are more or less constant.

• Cost structures dominated by variable costs are considered flexible due to their ability to adapt to changing volumes.

• Cost structures dominated by fixed costs are considered rigid due to their difficulty in adapting to changing volumes, posing higher risk.

• Operating elasticity refers to the extent to which demand responds to price changes.

  • Higher elasticity means lower risk.
  • Operating risk can amplify losses below the Break-Even Point (BEP) but also amplify profits above the BEP.

• Startups tend to have higher fixed cost incidence leading to a higher break-even point (BEP) and quicker reaching of the BEP.

  • However, the profits per unit are slow.
  • Startups are encouraged to have a higher incidence of variable costs to reach the BEP quickly.

Volume Economies & Scale Economies

• The company's cost structure influences its growth potential.

• Maximum Production Capacity (MPC): Represents the maximum number of units a company can produce within a given time period.

• Current Production Capacity (CPC): Represents the number of units a company actually produces within a given time period.

• The degree of utilization is the ratio of CPC to MPC.

• Different methods quantify capacity depending on the company type:

  • Manufacturing firms measure capacity based on the number of units produced (e.g., shoes, cars).
  • Retail companies measure capacity based on the size of their store (e.g., supermarkets) which translates to more shelves and goods displayed.
  • Airline companies measure capacity based on the number of available seats and miles flown.

• Economies of scale arise when average unit costs decrease with increased output.

  • For example, the average unit cost per audience member in a smaller theatre is higher than a larger one with the same utilization rate.

• Economies of scale occur due to:

  • Indivisibility of inputs: Certain inputs cannot be divided into smaller units (e.g., teachers, desks, computers).
  • Bargaining power: Higher production volumes offer suppliers price discounts.
  • Greater technological efficiency: Some production plants become more efficient as their scale increases.
  • Specialization: Larger companies can specialize resources for specific projects.
  • Geometric properties of containers: The increase in capacity grows faster than the increase in costs, resulting in decreasing average unit costs.

• Economies of scale follow a U-shaped curve:

  • Initially, increasing capacity leads to lower average unit costs.
  • As capacity surpasses a certain point, operational complexity increases, leading to higher average unit costs and diseconomies of scale.

Scope Economies & Learning Economies

• Scope economies refer to cost advantages gained by expanding the variety of goods and services produced.

• Volume and scale economies refer to growth based on a single product, while scope economies achieve growth through a mix of products.

• Diversification can happen at different levels:

  • Single and dominant business: Focuses on one product (e.g., Walmart).
  • Related business: Expanding product line within the same industry (e.g., Leather belts to leather bags).
  • Unrelated business: Operating in different industries unrelated to the core business (e.g., Disney).
  • Conglomerate: a large corporation composed of independent and unrelated businesses (e.g., Amazon).

• Scope economies reduce costs by utilizing underutilized resources across different products.

  • Examples include Armani leveraging the brand across different sub-labels (Giorgio Armani, Armani casa, Emporio Armani) and Poste Italiane offering postal services, retail, and financial products.

• Phenomena related to scope economies:

  • Two-sided markets: Integration of goods that are complementary or correlated on both the demand and supply sides (e.g., Google search engine and advertising services).
  • Cross-subsidization: Pricing one product above its market value to cover losses on another product priced below market value.

• Learning economies occur when unit costs decrease and output quality improves over time as experience accumulates.

• Learning economies are measured based on cumulative production volume and are calculated each time production doubles.