Introduction to Costs


Cost theory

The term "theory" is a Greek derivative and means: "seen from above." That is to say that a theory is an overall discussion of a subject, taken out of the concrete decision-making situations, while focusing on the general aspects, and not the specifics.

But in order to understand the general aspects, you have to understand the specifics, and the theory cannot be so general that it does not apply to the specific decision-making situation.

The defining of a cost theory, focusing on separating different decision-making occasions, and thereby allowing for the understanding and description of the differences these factors present in cost-theory, is a problem we hope to solve with this text.

Decisions have to be individualized

Some of the conditions that require the individualizing of cost decisions include:

o Different time perspectives

- Short-term, including planning of tomorrow's assignments and decisions

- Long-term, including planning of future assignments and production

o Different products

- Perish ability, e.g. Legos vs. fresh vegetables; Legos maintain their value in a warehouse, whereas fresh vegetables quickly lose value.

- Alternate values, e.g. milk not sold at supermarkets could be used in the production of milk-powder. A hotel room vacant for the night, on the other hand, has no value the following day.

o Different forms of production

- Automated production, e.g. production of Legos; i.e. if there are economies of scale or diseconomies of scale.

- Manual production, e.g. food in a restaurant.

- Service production, where knowledge is a decisive factor for production.

o Different levels of competition intensity in a market

- Low levels of competition allow for long-term planning.

- High levels of competition require short-term planning.

o Different future expectations

- Is an increase in production temporary or permanent?

- Is a decrease in production temporary or permanent?

o Different dependencies on external conditions, such as market conditions.

- Dependence on consumer confidence indexes, which influence long lasting consumer goods such as cars, as well as both small and large kitchen appliances.

- Dependence on business confidence indexes, which influence investments, production lines, automating initiatives, expansion/reduction in warehouse capabilities, the "Bull whip"/Forrester effect, i.e. when changes in consumption-level is multiplied up through the supply chain.

o Different seasonal dependencies

- Some businesses are influenced by high and low seasons, e.g. camping sites have high season in vacations, and clubs have high season during weekends.

- Some businesses, on the other hand, are not affected by seasonal deviations, e.g. cigarettes, milk, furniture etc. are sold independently of season.

o Random factors

- Weather-based production (agriculture)

- Affects of war/terror/disease (travel agencies)

Achieving the lowest possibly costs

For firm's long-term success, it is essential to produce a certain amount of goods or services at the lowest possible cost. Producing at the lowest possible cost is a holistic management job, contingent on the following points:

o The optimal production design: The production design is a combination of machines, technology, employees, IT, etc., together comprising the production machinery.

o The optimal production design: The production design is a combination of machines, technology, employees, IT, etc., comprising the production machinery of the firm.

- At the Harboe breweries the production machinery consists of fermentation containers, bottling machinery, bottle cleaning machinery, malting machinery, grain reception, IT systems, production leaders, employees, etc.

o The optimal combination of production factors: The production factors are all the factors applied when producing a good or a service. Production factors include:

- Natural resources, e.g. the sites of Harboe's factories

- Workforce, i.e. the knowledge and skills of e.g. master brewers, metal workers, bottling staff, etc.

- Physical capital, i.e. bottling machinery and storage tanks.

- Liquid physical capital, e.g. power for machinery, hops, and malt, at Harboe.

o Optimal technology: The firm can continuously renew the production machinery because of the technological development. However, technological improvements have to be assessed on the basis of cost-benefit analyses. Investments are to be made if the increased value exceeds the costs.

o Good, motivated employees: It is the competencies and motivation of the employees that determine whether or not the firm can produce at the lowest possible cost. In other words, it is futile to make the production machinery more effective if the benefits are neutralized by demoralized employees.

o Optimal outsourcing: The managers have to compare the production costs of the firm with the costs of buying from a supplier. In case the firm cannot produce the good at the lowest costs, the firm should outsource the production - and apply the effort elsewhere. Furthermore outsourcing has the advantage that part of the risk of the firm is transferred to the supplier. E.g. if the demand is lower than expected, some of the costs of a surplus production are assumed by the supplier.

o Optimal internationalization: The firm's degree of internationalization influences, among other things, the possibilities for outsourcing production to low-wage countries. The size of the production is also influenced by the degree of internationalization, which is important in terms of relation discounts, economies of scale, etc.

The significance of the above factors is dependent on the business sector, as well as distinctive features of the firm. For example, the production design, the combination of the factors of production and the technology are central management issues at the Harboe breweries. On the other hand, in an architect firm, a central issue will be attracting good employees - and making sure that they are constantly being motivated

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