CHAPTER 5: COST THEORY
Overview of Huxley Maquiladora
Huxley Manufacturing Company, a large firm in the defense industry, is considering a strategic move to shift production from its California plant to Mexico. Tariff reductions made possible by the North American Free Trade Agreement (NAFTA) opened up the potential to enjoy significant cost savings by shifting production south of the Mexican border.
Huxley is considering three options. The simplest option is to negotiate a subcontracting arrangement in which a Mexican firm manufactures steering column components (SCCs) according to the specifications of Huxley. The subcontracting firm would then be paid by Huxley on a per-piece arrangement. A subcontracting arrangement would allow Huxley to decrease or possibly eliminate expenditures for capital items such as facilities and equipment, but would also entail the highest cost per labor hour.
A second option was the shelter operation. Under a shelter arrangement, the Mexican firm would allow Huxley to maintain control over production. In return, the Mexican firm would provide various administrative, human resource management, and import/export services. A shelter arrangement would allow Huxley to enjoy a fast startup with while affording the client firm complete control over production. The shelter operation would entail more fixed costs than the subcontracting arrangement, but would also incur lower hourly labor expenses.
The final possibility was to set up a wholly-owned subsidiary. This option would require Huxley to select a plant site, staff its own employees, implement its own procedures and policies, and obtain the appropriate permits and licenses to operate. Over the long run, the wholly-owned subsidiary offered the greatest potential for cost savings. Although the wholly-owned subsidiary would exhibit the highest level of fixed costs, it also promised the lowest hourly costs of the three options.
Of course, Huxley might conclude that none of the options are in the firm’s best interests over the long run. In this case, the firm would continue to produce out of its San Diego facility.
Profit-maximizing decisions require the manager to be able to determine relevant cost. Relevant costs consist exclusively of those costs that will change if the decision is implemented. Our goal in this chapter is to derive a general theory on cost behavior that should apply to most firms. Having done so, we can closely examine how managers can determine unit costs and make effective decisions. In determining relevant costs, we must distinguish between fixed and variable costs. Fixed costs do not vary with production whereas variable costs rise as output increases. In the Huxley case, no fixed costs are associated with the subcontracting arrangement. If the firm decides to go with the shelter operation, fixed costs include construction, site leasing, startup expenditures, the plant manager’s salary, corporate taxes, and various other miscellaneous expenses. Variable costs include the hourly wage, materials, and transportation costs. The wholly-owned subsidiary includes most of the same fixed costs as the shelter operation, but adds the consulting fee and Mexican legal fees. Sometimes the distinction between fixed and variable costs can become blurred. For example, is the salary of an economics professor a fixed cost or a variable cost? Presumably, your professor will be paid the same salary regardless of how many students enroll in the course. However, your college probably has a pre-determined maximum enrollment for a specific section. If demand for a particular course exceeds the maximum capacity (a common problem in economics classes), the department may have to add one or more sections. If the instructor is already teaching a full load, the excess demand may have to be accommodated by adding another instructor to the teaching staff. When enrollment surpasses the maximum for...
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