Refer to text Ch.7, Example 7.2 The author provides the different cost components (sunk, xed and variable) of three industries - computers, software and pizzas. Choose any one industry and discuss the main cost components of this industry. EXAMPLE 7.2 SUNK, FIXED, AND VARIABLE COSTS: COMPUTERS, SOFTWARE, AND PIZZAS As you progress through this book, you will see that a firm's pricing and production decisionsand its profitabilitydepend strongly on the structure of its costs. It is therefore important for managers to under- stand the characteristics of production costs and to be able to identify which costs are fixed, which are variable, and which are sunk. The relative sizes of these different cost components can vary consider- ably across industries. Good examples include the personal computer industry (where most costs are variable), the computer software industry (where most costs are sunk), and the pizzeria business (where most costs are fixed). Let's look at each of these in turn. Computers: Companies like Dell, Lenovo, and Hewlett-Packard produce millions of personal com- puters every year. Because computers are very simi- lar, competition is intense, and profitability depends critically on the ability to keep costs down. Most of these costs are variablethey increase in proportion to the number of computers produced each year. Most important is the cost of components: the micro- processor that does much of the actual computation, memory chips, hard disk drives and other storage devices, video and sound cards, etc. Typically, the majority of these components are purchased from outside suppliers in quantities that depend on the number of computers to be produced. Another important variable cost is labor: Workers are needed to assemble computers and then package and ship them. There is little in the way of sunk costs because factories cost little relative to the value of the company's annual output. Likewise, there is little in the way of fixed costsperhaps the salaries of the top executives, some security guards, and electricity. Thus, when Dell and Hewlett-Packard think about ways of reducing cost, they focus largely on get- ting better prices for components or reducing labor requirementsboth of which are ways of reducing variable cost. Software: What about the software programs that run on these personal computers? Microsoft pro- duces the Windows operating system as well as a variety of applications such as Word, Excel, and PowerPoint. But many other firmssome large and some smallalso produce software programs that run on personal computers. For such firms, produc- tion costs are quite different from those facing hard- ware manufacturers. In software production, most costs are sunk. Typically, a software firm will spend a large amount of money to develop a new application program. These expenditures cannot be recovered. Once the program is completed, the company can try to recoup its investment (and make a profit as well) by selling as many copies of the program as possible. The variable cost of producing copies of the program is very smalllargely the cost of copying the program to CD5 and then packaging and shipping the product. Likewise, the fixed cost of production is small. Because most costs are sunk, entering the soft- ware business can involve considerable risk. Until the development money has been spent and the product has been released for sale, an entrepreneur is unlikely to know how many copies can be sold and whether or not he will be able to make money. Pizzas: Now let's turn to your neighborhood pizzeria. For the pizzeria, the largest component of cost is fixed. Sunk costs are fairly low because pizza ovens, chairs, tables, and dishes can be resold if the pizzeria goes out of business. Variable costs are also fairly lowmainly the ingredients for pizza (flour, to- mato sauce, cheese, and pepperoni for a typical large pizza might cost $1 or $2) and perhaps wages for a couple of workers to help produce, serve, and deliver pizzas. Most of the cost is fixedthe opportunity cost of the owner's time (he might typically work a [\\IIULIIVI IIIIIJUILLIII; vulluulu pug: I.) quul. vuulnylu are needed to assemble computers and then package and ship them. There is little in the way of sunk costs because factories cost little relative to the value of the company's annual output. Likewise, there is little in the way of fixed costsperhaps the salaries of the top executives, some security guards, and electricity. Thus, when Dell and Hewlett-Packard think about ways of reducing cost, they focus largely on get- ting better prices for components or reducing labor PIllMI lu- cost is fixed. Sunk costs are fairly low because pizza ovens, chairs, tables, and dishes can be resold if the pizzeria goes out of business. Variable costs are also fairly lowmainly the ingredients for pizza (flour, to- mato sauce, cheese, and pepperoni for a typical large pizza might cost $1 or $2) and perhaps wages for a couple of workers to help produce, serve, and deliver pizzas. Most of the cost is fixedthe opportunity cost of the owner's time (he might typically work a I u: um. PllLullu' ulv "'\"5\"'\" yum-Fully"; u- 244 PART 2 Producers, Consumers, and Competitive Markets 60- or 70-hour week), rent, and utilities. Because of these high fixed costs, most pizzerias (which might charge $12 for a large pizza costing about $3 in vari- able cost to produce) don't make very high profits. This textbook: Finally, let's consider the cost of this wonderful textbook that you've enjoyed read- ing so much. What do you think is the variable cost of production, i.e., the cost of producing one additional book? Ignoring royalties to the authors (which are a percentage of the wholesale selling price) and assuming you have the hardbound ver- sion of the book, the cost is only about $5 to $10. Most of the costs are sunk: the opportunity cost of the authors' time spent writing (and revising) the book and the costs of the publisher for copyedit- ing, typesetting, and proofing. As with computer software, textbook production costs need have little connection to the price you paid for the book. You'll learn more about that when you get to Chapter 12 and read Example 12.5