Management of Cultural Companies and Institutions PDF

The relationship between volumes, costs and results Drivers of economic performance There is a relationship between specialization and size and between specialization and profitability: specialization impacts the cost structure of the firm but what is the optimal size...

The relationship between volumes, costs and results Drivers of economic performance There is a relationship between specialization and size and between specialization and profitability: specialization impacts the cost structure of the firm but what is the optimal size of a firm? Is it better to grow manufacturing one product only or offering a wide range of products? Size of companies matters. Looking at the company’s financial results there are different drivers of economic performance that are connected: structural drivers, sales volume, organization + efficiency and prices. This is the interplay of every company in order to improve profitability and best pursue their goals. Different levels of specialization affect performance. STRUCTURAL DRIVERS Companies can grow in many different ways: 1. by scale: optimization of capacity (increasing the number of seats) can affect revenues (ticketing in a theatre). 2. by scope: if there is a limit to grow by scale and a firm can still grow in variety. 3. make-buy: another way to grow is to internalize or outsource some activities because it determines a structural change in how results are generated. 1  PRICES Purchasing and selling prices determine the level of costs and revenues. If purchasing prices go up the profitability goes down but if the selling prices grow it is important to control the impact on volumes. If you increase the price the demand could decrease. Price elasticity is very important and it can change over time. Prices are affected in part by the company’s internal and external factors. Internal elements can be pricing policy of the company and external factors can be technological evolution and competitors. For example Ryanair and Alitalia operate in the same business but they have very different pricing strategies. VOLUMES Volumes are both drivers and consequences of other choices. Companies with the same cost and price structure will show a difference in profitability due to volumes produced. Then for a given capacity different levels of utilization will determine a change in profitability. So volumes depends also on utilization of capacity. ORGANIZATION AND EFFICIENCY Considering the same choices about extension, prices and volumes there could be different profits due to efficiency. You improve performance by modifying how processes are structured and how we assign tasks. By repeating an activity, we learn become more efficient (economies of learning). Efficiency drives cost savings. 2  Cost Structure and Break-even Point There is a relationship between the volumes of goods actually produced and sold by a company and the operating profits earned by the same. The structural configuration is the result of how I decided to configure my activities and it affects cost structure which affects profitability. If we look at the company's cost structure, we can identify two categories of structural costs: 1. variable costs: correlated to the volumes produced. The higher the volumes produced, the higher the total variable costs because the more I produce the more raw materials I need. The relationship between variable costs and volumes is not linear but it is a curve since there can be discounts on purchases of goods and services or increases in efficiency that can bring a reduction of the variable cost unit. The higher the incidence of variable costs, the steeper the total variable costs curve. 2. fixed costs: do not vary within a given interval of production. They don’t depend on the actual volumes produced but on the production capacity available. These are for example advertising campaign, website maintenance, rent, R&D. Fixed costs are not completely fixed but they increase by steps each time actual volumes reach the limit of production capacity. However fixed costs can be constant since production capacity is fixed by definition. 3  1. Cost structures dominated by variable costs are defined as flexible because they adapt easily to changes in volumes. 2. Cost structures dominated by fixed costs are rigid because they have difficulties in adapting to changes in volumes so they are more risky. This distinction is very evident but in practice it is not. Labor can be a fixed or a variable cost. ⇒ total operating costs = fixed costs + (variable costs x volumes produced). They have consequences on income and on finances. ⇒ non-operating costs = include passive financial operations (coverage of financial needs), active financial operations (decisions on the investment of liquidity), tax management and extraordinary events. Discretionary costs (avoidable costs) are costs that can be curtailed or even eliminated in the short term without having an immediate impact on the short-term profitability of a business. These include advertising, training, R&D. BREAK - EVEN POINT (BEP) break even point (BEP) = the point at which total costs equals total revenues, meaning there is no loss or gain for your business. In other words, you've reached the level of production at which the costs of production equal the revenues for a product. It makes us understand the impact of cost structure on profitability. 4  OPERATING RISK The break-even point also indicates the degree of flexibility-operating elasticity of a company’s cost structure. The cost structure impacts profits, before and after the break-even point and indeed at equal break-even there can be different situations. The flexibility index can be calculated in the break-even point and is = VC/FC. The higher the ratio, the greater the flexibility of the cost structure and the lower the loss if the break-even point is not reached. 1. flexible cost structure = low ratio of fixed costs to total costs; has a low break-even point so it is less risky but since the gap is symmetrical before and after break-even this structure implies limited losses before break-even and limited profits after breakeven. 2. rigid cost structures = high ratio of fixed costs to total costs; are more risky but the profits increase rapidly after break-even. For this reason flexible structure should be preferred only if there is the fear of not reaching the break-even point. For example if there are changes in volumes. If a firm has a rigid cost structure, the firm will lose money if there is a drop in volumes. But at the same time the firm will have profits when it increases volumes. Instead considering a firm has a flexible cost structure, if the volumes drop the firm can easily reduce costs instead if volumes increase the firm experiences also an increase in costs. For example Ryanair if the plane is not full it won’t fly. It is super-efficient in managing the cost structure however the business model require the plane to be full every time. It works only if there is a strong demand so it is based on fixed costs. 5 The operating leverage is the magnitude of the difference between revenues and total costs above and below the break-even point. The higher the leverage, the higher the operating risk. The operating risk is determined by two elements: - How far you are from break-even: the more you are above break-even point the less risky you are. The higher the break-even point the higher the risk. - The operating elasticity: the extent to which the demand reacts to variation in price. The higher the elasticity, the lower the risk. Operating risks is not necessarily a bad thing: it amplifies losses, when we move left to the BEP, but it amplifies profits when we move right to the BEP. So considering two plants with same BEP but with different operating risk, the choice depends on our estimate of how much volumes sold would exceed the BEP and on the manager’s degree of risk aversion. A startup is under break-even point and the higher the incidence of fixed costs the higher is the break-even point and you reach it earlier. However the profits will be slower per unit. Startups however are encouraged to have a high incidence of variable costs, so as to reach BEP as soon as possible. 6  Volume Economies & Scale Economies CAPACITY The cost structure affects the possibility to grow and size matters. The increase of actual volumes has an impact on average unit costs and revenues. 1. Maximum production capacity (MPC): maximum number of units of output that can be produced in a given time interval (in theaters it is the number of seats). 2. Current production capacity (CPC): units of output that are produced in a given time interval (is what we are currently producing). It is lower than the maximum production capacity because companies build plants with bigger capacity than the current needs since economic downturns determine lower production levels or because of scraps, interruptions and quality control issues. 3. The degree of utilization (of production activity): it's the ratio of CPC to MPC. It's the ratio of actual output to a potential one. A company has a MPC of 10000 washing machines a year but it’s CPC is 7000 so the degree of utilization is 70%. In order to measure capacity there are different ways basing on the typology of firm: 1. manufacturing firms: is the increased capacity is measured in terms of number of units produced (shoes, cars…). 2. retail companies: (such as a supermarket) the increased capacity is measured in terms of size of the store, which translates in higher number of aisles/shelves and goods displayed. 3. airline companies: the indicator of capacity is the seats. The output is measured as number of available seats and miles flown. Increasing capacity means increasing the number of flights of each plane or reducing legroom to increase the number of seats. 4. law firms: the indicator of capacity is the number of days/person invoiced to costumers. 5. theaters: the indicator of capacity is the number of seats/number of performances per show. VOLUME ECONOMIES In a shirt manufacturer the fixed costs include the rent and general expenses that is of 25.000€. Variable costs per unit (1 shirt) is €12 + €8 for external laboratories + sales commissions of of €4. Total variable costs per unit is 24€. The price per shirt is of €45. 7  income: revenues per unit (uR) - the fixed costs (FC) - the unit variable costs (uVC) The revenues and the costs change basing on volumes and the Average Unit costs (AUC). AUC = total costs (TC)/volumes produced (Q) but also AUC = unit variable costs (uVC) + (fixed costs/volumes) Improving the utilization of capacity is related to the concept of volume economies. There can be an important economic advantage from a greater use of a given capacity. Volume economies: (or fixed-cost absorption) are cost savings generated by increasing the rate of utilization capacity for a given MPC. They originate by the fact that fixed costs are spread over a higher number of units produced, leading to an average unit cost reduction. Total costs increase because total variable costs increase but fixed costs remain at the same level. The limit of volume economies is full capacity exploitation. This kind of economy is linked to the volumes actually sold and not to the benefits that derive from the increase of production capacity because these are economies of scale. SCALE ECONOMIES Scale economies are costs savings generated by increasing production capacity but at the same level of utilization of capacity. When the production capacity increases and there is a reduction of average unit costs there is the presence of economies of scale. The cost advantage (savings) can be obtained by reaching the minimal optimal dimension. The higher the production capacity and the dimension of the firm the lower the average unit cost. ex: plant A can produce 100.000 pieces per year and plant B can produce 200.000 pieces per year. There's economy of scale if the AUC of A > AUC of B at the same utilization rate in A and B. In the theatre sector there are economies of scale since the average unit costs per audience member in a theatre with only 100 seats is higher than the average unit costs in a theater with 1000 seats with the same utilization rate. 8 If I want to build a classroom and I want to double the capacity: - total costs increase but they don't double as we did for the capacity - variable costs increase proportionally (seats 100 to 200) - average unit cost decreases - fixed costs increases too but less than proportionally but why? where do economies of scale come from? variable costs increase proportionally: INDIVISIBILITY OF INPUTS = some inputs cannot be brought in sub-units. In a classroom some elements are indivisible such as the teacher, the desk, the computer. total costs increase but they don't double: BARGAINING POWER = higher volumes of production require higher volumes of factors of production, this means that they can get price discounts from suppliers. GREATER TECHNOLOGICAL EFFICIENCY = some production plants becomes more efficient as their scale increases. For example if you double the size of an engine power the fuel consumption increases less than proportionally (it doesn’t correspond to a doubling of energy consumption). SPECIALIZATION = larger size means that resources can be employed in a more specialized way (people to specific projects). 9 average unit cost decreases: GEOMETRIC PROPERTIES OF CONTAINERS = when production capacity relates to volumes, the increase in capacity grows by the 3rd power with respect to is linear dimension. But costs are often expressed in terms of the square surface area, which grows by the 2nd power. Capacity increases 8 times but costs only increase 4 times. Economies of scale are U-shaped: When operating activities are combined with significant activities the level of economies of scale rises a lot and so there is an increase in the minimal optimal dimension. However the concentration of the offer is higher so the size grow implies more disadvantages than advantages. The increase of production capacity implies a greater operational complexity and this causes an increase in average costs and thus economies of scale. Increasing capacity is a very delicate decision to make: increase of production capacity can imply a greater operational complexity and this causes an increase in average costs and thus diseconomies of scale.They depend on the size of the market, the incidence of transportation costs, coordination and control costs and on quality (in the classroom as the size increases the quality of teaching may decrease due to limited interactions). 10  Scope Economies & Learning Economies SCOPE ECONOMIES You could have an impact on profitability by increasing the size but the size could be increased not just leveraging on one product (volume and scale economies) but on a mix of products. You can have a cost advantage broadening the scope of your activity and increasing the variety of business in which the company operates. Volume and scale economies imply growth in size from the production of one product. Growth can be obtained also by increasing the variety of business in which the company operates. This is called diversification. There is diversification at different levels: - Single and dominant business (Walmart) - Related business (you manufacture leather belts and start offering leather bags) - Unrelated business (Disney): the businesses in which the company operate have completely different nature. - Conglomerate: one company operates in different businesses. Large corporation made up of independent and unrelated businesses. Amazon started as a digital bookseller and transferred its logistic infrastructure to several different sectors (from pharmacies to pet food). Indeed it uses a wide network of local branches to sell many different services and products. Diversification is a strategy that firms adopt in order to: reduce risks, make use of available cash investing, enter into attractive market segments, enjoy cost advantages (scope economies). In scope economies there's a reduction in costs because the combined production of 2 or more products is lower that the sum of the costs associated with their separate production. The costs of the combined production are lower because there are resources and factors of production that are underutilized (capacity) and they can be exploited on different products. - Examples of economies of scope: There are some sectors that exploit economies of scope significantly that doesn’t always come from the fact that resources are underutilized. An example can be Armani: economies of scope come from the possibility of utilizing immaterial assets so there are no constraints with capacity. An immaterial asset can be a brand, technological skills, a software but also contents and characters. The brand markets these products under several, highly-specialized sub-labels (Giorgio Armani, Armani casa, Emporio Armani with manufactures, jewelry, cosmetics) Instead others economies of scope can derive from a material asset. An example can be Poste Italiane: they offer postal services but also retail and financial products and services. 11 Phenomena related to economies of scope: 1. two-sided markets In scope economies there is a greater integration of systemic goods, that are goods or services complementary or correlated. A form of systemic goods is present when different goods are integrated not only on the demand side but also on the supply side. For example Google offers a search engine to end users but also an advertising service to companies. 2. cross-subsidization It's the pricing strategy of financing one product with the profits of another. With this type of strategy, a business intentionally prices one product above its market value. This extra profit covers any losses derived from pricing a separate product below its market value. The practice of charging higher prices to one type of consumers to artificially lower prices for another group. In the case of Google the search engine is a free service and the losses are more than offset by the sale of advertising. So these two services couldn’t survive independently. LEARNING ECONOMIES Learning economies refer to the decrease in unit cost and the enhancement of output quality that result from producing more units of a specific output as experience accumulates.The more people learn about how to produce a good, the more money and time are saved. Learning economies are measured on the cumulative volumes of production and they are calculated every time you double the cumulative production. The learning effect is a constant and brings regular reductions of the average unit cost when the production doubles the unit cost decreases by a specific percentage.To maintain the speed of learning a constant effort is needed because learning can stop and costs can began rising again and quality can began to deteriorate. It is important for the learning not to take place only at the individual level but above all at organizational level. For example in the Cirque du Soleil the learning is organizational, indeed the artists don’t benefit from personal notoriety and the turnover is planned so the organization won’t be affected. Cost advantages associated with learning are very high at the beginning of the production and then progressively reduce. The existence of learning curves explains why some companies characterized by high volumes production of very standardized product tend to grow significantly. 12 A curve showing a 20% cost reduction (learning economy) for every doubling of output is called an “80% experience curve”, indicating that unit cost drops to 80% of their original level. Learning economies derive from different factors: 1. Reinforced human skills: people improve their work habits and perform assigned tasks. This applies to all employees and managers. This regards both manual and intellectual activities. 2. Simplification of products and processes: when people gain experience regarding a certain product or production process, they can also understand possible pathways to simplification, leading to greater efficiency at lower costs. 3. Better selection of materials: it is possible to understand which production resources are the most appropriate for carrying out a given activity. 4. Higher programmability of activities: events become more predictable, and response-time to non-standard circumstances is quicker. This makes it possible to plan processes more effectively by timing each operation, optimizing the mix of different production capacities and coordination resources. 5. Higher coordination: people must interact and utilize different kinds of plants and equipment as they carry out the activities. With experience, individuals get to know one another and learn to work in team and coordinate different processes. Conceptually, the different economies and their sources are specific. In practice, though, they are often observed together. Interdependence of different economies: Multiple economies can emerge in a company and they can influence each other. Scale and volume economies coexist when you increase both capacity and utilization rate and then the AUC decreases. This can happen when there is a significant drop in unit price. There are scale economies with diseconomies of volume when by increasing the production capacity (scale economies) it becomes harder to saturate the production capacity (volume economies). 13  EXTENSION CHOICES There is an interplay between extension choices and economic theories. 1. vertical extension choices: choices about the size have to be made after analyzing the economies of scale and the expected demand on the relationship between utilization of capacity and absorption of fixed costs. These choices can be also influenced by positive externalities that lead to increase the value of the goods for the end clients. Vertical extension choices have to take into account transaction costs. There are higher fixed costs and lower variable costs and the cost structure becomes more rigid. 2. horizontal extension choices: linked to the economies of scope. 3. geographic extension choices: linked to economies of scale and of volume. TRANSACTION COSTS Transaction costs: it is the cost involved in making an exchange (internal or external to the company). Companies can grow by scale, scope or make-buy: another way to grow is to internalize or outsource some activities because it determines a structural change in how results are generated. 1. external exchange occurs when two separate businesses are involved and the external transaction costs represent the costs for a company to create an agreement with another company. When purchasing materials costs are very low however the use of the market increases them. External transaction costs are influenced by information complexity, the information of the transaction itself are complex so the market becomes less transparent and certain. 2. internal exchange occurs when the exchange takes place within the same company and the internal transaction costs are the costs to coordinate this internal exchange. With the growth of a company’s size, activities become more complex as well as coordination. The theory of transaction costs assumes that transaction costs must be considered when deciding if internalizing or externalizing an activity so when deciding if it is more convenient to make or buy a product. It is not sufficient to compare the production cost of a product, with the price of the product on the market because also the amount of transaction costs involved are essential. 1. you make, if (production costs + costs of internal coordination) < (market price + external transaction costs). 2. you buy, if (production costs + costs of internal coordination) > (market price + external transaction costs) 14