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Suppose Nike’s managers were considering expanding into producing sports beverages. Why might the company decide to do this under the Nike brand name?

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Attachment 1

Economies of Scale and Scope

©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images

CHAPTER

The law of diminishing marginal returns states that as you expand output, your marginal productivity (the extra output associated with extra inputs) eventually declines.

Increasing marginal costs eventually cause increasing average costs and make it more difficult to compute break-even prices. When negotiating contracts, it is important to know what your costs curves look like; otherwise, you could end up accepting contracts with unprofitable prices.

If average cost falls with output, then you have increasing returns to scale. In this case you want to focus strategy on securing sales that enable you to realize lower costs. Alternatively, if you offer suppliers big orders that allow them to realize economies of scale, try to share in their profit by demanding lower prices.

If your average costs are constant with respect to output, then you have constant returns to scale. If average costs rise with output, you have decreasing returns to scale or diseconomies of scale.

Learning curves mean that current production lowers future costs. It’s important to look over the life cycle of a product when working with products characterized by learning curves.

If the cost of producing two outputs jointly is less than the cost of producing them separately — that is

Cost(Q1,Q2) < Cost(Q1) + Cost(Q20)

— then there are economies of scope between the two products. This can be an important source of competitive advantage and shape acquisition strategy.

continued

Rayovac Company

Founded in 1906, three entrepreneurs started a battery production company that grew to rival Energizer and Duracell.

In 1996, The Thomas H. Lee Company acquired Rayovac – taking advantage of easy credit availability the company then bought many other battery production companies as well. A move the company said they made to take advantage of efficiencies and economies of scale.

They expected that as they produced more of the same good, average costs would fall.

The company also bought many unrelated companies at the same time as the battery binge – the reasoning being that because of synergies, if they centralized the production of many different goods the costs of production would be lower.

By February 2009 the new conglomerate was bankrupt

Moral of the story? In business investments if you hear the words “efficiency” or “synergy,” hold on to your money.

Increasing Marginal Costs

Definition: The law of diminishing marginal returns: as you try to expand output marginal productivity (the extra output associated with extra inputs) eventually declines.

Diminishing marginal returns g marginal productivity declines

Diminishing marginal productivity g increasing marginal costs

Increasing marginal costs eventually lead to increasing average costs

Some causes of diminishing marginal returns

Difficulty of monitoring and motivating a large work force

Increasing complexity of a large system

The “fixity” of some factor, like testing capacity

Graph 1: Marginal Cost

Graph 2: Marginal vs. Average Cost

When marginal cost rises above average, the average rises.

Increasing Marginal Cost (cont.)

Example: Akio Morita and the Sony Transistor radio

In 1955, Akio Morita found a retailer that would sell his $29.95 transistor radio under his “Sony” brand name

The problem: the retailer wanted to buy 100,000 for its 150 stores, 10 times more than Mr. Morita’s capacity.

Mr. Morita had to turn down the offer

He knew that he would lose money producing 100,000 units because increasing output would require hiring/training more workers and an expansion of facilities

This would raise his average costs.

The retailer agreed to settle for 10,000 units, the rest is history

Lesson: know what your costs look like!

Economies of Scale

Definition: short run “fixity” vs. long run “flexibility”

i.e. factors that are fixed costs in the SR but become variable in the long run

If long-run average costs are constant with respect to output, then you have constant returns to scale.

If long run average costs rise with output, you have decreasing returns to scale or diseconomies of scale.

If average costs fall with output, you have increasing returns to scale or economies of scale.

Example: Poultry Industry

In 1967 in the US, a total of 2.6 billion chicken and turkeys were processed

By 1992, that number was almost 7 billion BUT the number of processing facilities dropped from 215 to 174

The share of shipment plants with over 400 employees grew immensely

The shift in the structure of the industry was due largely to changes in technology, which reduced cost of processing poultry in larger plants

Learning Curves

Learning curve: when you produce more, you learn from the experience so that you produce at a lower cost in the future

Use the maxim “Look ahead and reason back”

Example: Every time an airplane manufacturer doubles production, marginal cost decreases by 20%

Airplane Learning Curve

American Airline negotiates with Boeing to purchase planes

Boeing sees a big order from the world’s largest airline as a chance to “walk down its learning curve”

Airplane Manufacturing Costs

Airplane Learning Curve (cont’d)

American knows its order will allow Boeing to reduce costs for future sales, they want to capture some of Boeing’s profit

If American could know how many planes Boeing would make over the lifetime of the plane, they could offer Boeing’s average cost

Airplane Learning Curve (cont’d)

What actually happened with American and Boeing:

American offered to purchase planes exclusively from Boeing over the next 30 years

This provided Boeing with a big chunk of demand that would lower costs

In exchange, Boeing offered a discounted price

Guitar Fingerboards

Firm X produces guitar fingerboards

Rosewood is used for budget guitars

Ebony is used for high-end guitars

However, there is a decreasing supply streak-free of ebony

Brown streaks in ebony are seen as a blemish for high-end guitars, but a step up from rosewood.

The streaked ebony can be used on budget guitars

Better than rosewoodg cost and quality advantage

Therefore, there are economies of scope between production of high-end and low-end guitars.

Economies of Scope

If the cost of producing two products jointly is less than the cost of producing those two products separately then there are economies of scope between the two products

Cost(Q1, Q2) < Cost(Q1) + Cost(Q2)

You want to exploit economies of scale by producing both Q1 and Q2

Major cause of mergers

Example: Kraft, Sara Lee and ConAgra sell a variety of meat products, hot dogs, sausage, and lunchmeats because they can derive economies of scope by distributing these products together

Diseconomies of Scope

Production can also exhibit diseconomies of scope when the cost of producing two products together is higher than the cost of separate production.

Pet Food Production

AnimalSnax, a pet food company has 2,500 products (SKU’s) with 200 different formulas

They receive a lot of pressure from large customers like Wal-Mart to reduce prices

These requests worry the firm because of the so-called 80/20 rule (80% of a firm’s profit comes from 20% of its customers)

To respond to Wal-Mart, the company shrinks it product offerings

AnimalSnax reduced its product offerings to 70 SKUs using only 13 different formulas AND it began offering price discounts for larger orders.

The company could consolidate small orders into large ones to reduce setup costs.

Pet Food Production Graph

Typical savings for one extruder line are illustrated below

Under the new approach, the same amount of pet food could be produced faster

This led to a 25% savings for the company because of reduced production costs (see graph)

Sample Question

Learning curves: every time you double production, your costs decrease by 50%. The first unit costs you $64 to produce. On a project for 4 units, what is your break-even price?

You can win another project for 2 more units.

What is your break-even price for those units?

Answer

The break-even price for 4 units is $33.

The extra costs for the fifth and sixth units is only $24, so break-even is $12/unit for those two.

If the project were for six units total, break-even would be $26/unit for those six.

Q MC TC AC 1 $64 $64 $64 2 $32 $96 $48 3 $21 $117 $39 4 $16 $133 $33 5 $13 $146 $29 6 $11 $157 $26

QMCTCAC

1$64$64$64

2$32$96$48

3$21$117$39

4$16$133$33