Managerial Economics

Topics: Costs, Vertical integration, Strategic management Pages: 8 (2502 words) Published: March 14, 2013

Cost drivers, as propounded by Porter (1985) are the structural causes of the cost of an activity in the value chain. They determine the behaviour and level of costs within an activity. A cost driver can be completely, partly or not at all under the control of a firm. It is therefore important for a manager to understand these factors because according to the Neo-classical model of the firm, the firm’s objective is to maximise profit by producing a given level of output at the minimum cost level. Therefore in pursuit of this, factors such as learning effects, linkages and interrelationships between activities carried out by the firm, timing within the business cycle or with respect to other firms’ actions geographical location and the firm’s discretionary policies should be taken into account and asses their impact on the firm’s cost levels.

Learning effects and spill overs suggest that the cost of a value activity often declines over time due to the learning or improvements that increase efficiency or due to knowledge acquired from suppliers, consultants, former employees or reverse engineering. These savings derive from “learning by doing”. According to GHEMAWAT (1985),”increased efficiency can be achieved through the successful repetition of numerous tasks by the firm’s employees: thus learning. In this regard, costs can be reduced through various systematic ways such as improved scheduling, product design modifications that facilitate manufacturing, processes and procedures that allow utilisation of assets and probably better tailoring of raw materials to relevant processes as well as inspection.

In my organisation Tunnel Engineering, they inspect production at different points in the production process. They take a few products out of every batch and inspect them to determine the overall quality of the products produced. Similarly, scheduling is improved by calculating well in advance the time required to perform each activity in the manufacturing process and the time required to complete all activities. This ensures increased productivity of the workforce. In my organisation, this is achieved through sending workers for training.

Another set of cost drivers are linkages and interrelationships between activities carried out by firms. The activities of a firm are usually linked to each other within the organisation. As a result, the firm’s activities are affected by activities of those that link with it. Porter suggested basically two linkages: internal linkages and external linkages. Internal linkages exist between direct and indirect activities of the firm. For instance maintenance and audits have a significant impact on servicing costs. This is applicable in my organisation when it comes to maintenance of machinery and actually servicing them. Therefore, if we change the way of performing a linked activity, the cost of another activity as well as the total cost of all linked activities also change. For example if we improve proper handling of machinery and emphasise on strict healthy and safety measures, there will be a reduction on costs due to breakdowns as well as accidents and injuries.

External linkages on the other hand relate to suppliers and channels of distribution. Suppliers of factor inputs and distributors of the firm’s products can have an effect on the firm’s activities. External linkages with suppliers and distributors can reduce costs by improving coordination between activities of the firm and those of the suppliers and channels. For example, if suppliers frequently deliver the firm’s orders in time, the firm’s inventory needs are reduced and hence results in reduced storage costs. Similarly, appropriate packaging of products by suppliers reduces handling costs.

Interrelationships on the other hand refer to the relationships of mutual dependence between one business unit and other parts of the company’s operations that could have a bearing on costs. They involve sharing know how and...
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