costs maurizio aragrande and massimo canali, university of bologna (i) florence beaugrand, oniris,...

Costs

Maurizio Aragrande and Massimo Canali, University of Bologna (I)

Florence Beaugrand, ONIRIS, Nantes (F)

This presentation was developed within the frame of the NEAT project, funded with support from the European Commission under the Lifelong Learning Programme (Grant no. 527 855). Please attribute the NEAT network with a link to www.neat-network.eu. Except where otherwise noted, this presentation is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License.

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Learning objectives

Cost identification, cost justification, cost definition (Section 1)

Identify how costs play in the animal health context (Section 2)

Identify the way inputs generate costs (Section 3)

Describe how individual behaviors may determine social cost (Section 4)

Section 1: Costs in general

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1.1 - Cost: what is this?

1.2 - Opportunity cost

1.3 - Resources, inputs, costs

1.1 – Cost : what is it?

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Chapter 4

Cost is a term commonly used by people: By families or individuals, when they purchase something

By farmers, when they purchase feed, machinery or build a cowshed in order to produce farm staples

By professional veterinarians, when they purchase e.g. laboratory hardware, hire a secretary or a colleague in order to perform their profession

The term cost is often associated to other terms or adjectives which identify particular aspects of the cost concept.

Some examples: Total cost and average cost

Fixed cost and variable cost

Monetary cost and non monetary cost

Individual and social cost

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Can you associate a meaning to these terms?

Can you define the difference, for example, between a fixed cost and a variable cost?

Or: can you provide some examples?

1.1 - Cost : what is this?

A lexical approach

Chapter 4

An exercise in cost identification

In the table below we listed some examples of real costs. Try to identify what kind of cost they are and to develop a reasoning to justify your choice

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Cost examples Cost identification

The money I spend for the fuel (Fixed or variable? Social or individual? Average or total?)

The cost of the car insurance (Fixed or variable? Social or individual? Average or total?)

The vaccination cost for my business travel abroad

(Fixed or variable? Social or individual? Average or total?)

The cost of a public vaccination plan against brucellosis

(Fixed or variable? Social or individual? Average or total?)

... ...

Identifying costs categories


Chapter 4

Identifying costs

Fixed and variable costs identify two different ways through which inputs generate costs

This distinction is relevant when we want to analyze the relationship between the production volume and the use (the cost) of some resources in any activity

For example: purchasing a milking machine costs once and lasts many years; a vet medicine costs each time we use it.

Monetary and non-monetary costs refer to costs that are easy to be quantified in monetary terms or not.

This distinction is relevant when we face situations related to marketable or non- marketable goods.

For example: the purchase of an ultrasound machine in a vet lab is a monetary cost; the pain we feel for our sick cat can be hardly quantified and monetized

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Cost analysis is applied in different situations. The various specifications applied to costs

identify concepts which are useful to different analytical aims


Chapter 4

Finally, what is it?

Cost is the economic value of the resources we use to do something

Distinguishing among costs helps economists to develop cost analysis

The distinction among costs is based on some criteria which allow for the identification of cost categories

Cost categories are relevant to develop the cost analysis in a defined context and for a specific aim.

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1.2 – Opportunity cost

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Chapter 4

The economic justification for cost

Scarce resources make costs Resource scarcity means that an individual or a society are constantly

faced to choose among alternative uses of the resources. This immanent condition of the human beings is a basic assumption of the

economics. The scarcity problem concerns relevant economic issues as well as daily life:

Should a state produce more bread or more guns?Should I use my time to work (and get more money) or to go on holidays?

One day more spent for holidays reduces my worktime.

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(2)


Any choice implies a renounce.This renounce is a cost.

Chapter 4

An exercise, to visualize the concept

Imagine that:

You have a fixed amount of a resource (a stock of time) You can choose to allocate this resource to two alternative uses

X= time for holidays; and: Y= time for work

How can you visualize the alternatives (by a graph) ... and the consequences (in economic terms)?

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Chapter 4

A more formal definition of opportunity cost

If I chose to have a little bit more of X (+X)…

… I will get a little bit less of Y (- Y)

- Y is the Opportunity Cost of +X

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Opportunity Cost

“The loss of other alternatives when one alternative is chosen.”

(2)


Chapter 4

From opportunity cost to real cost (I)

How does the opportunity cost concept works in reality? Imagine a situation where two “economic agents” (Mr Worker and Mr Farmer) have to

decide how allocate their resources (time, competences) to perform their job and get a revenue:

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Mr. Worker is a worker specialized in cow milking. He offers his job on the market.

He identifies the opportunity cost between employment time and non-employment time.

Then he translates in money the sacrifice of 1 day of non-employment time (assumed to be the preferred alternative).

This is the price he requires for 1 work unit (say 40€/day)

Mr. Farmer breeds cows to produce milk.

He has to milk his cows and organize the financial plan of the farm.

Budgeting is a strategic activity. One day employed in this operation may save much money to the farm (say 100 €/day)

Milking, operated by Mr Farmer, would just save 40€/day (the amount Mr Farmer spends if he hires Mr Worker)


Chapter 4

From opportunity cost to real cost (II)

How will Mr Farmer allocate his time between budgeting and milking?

He compares the opportunity cost of the alternatives:

Milking has an opportunity cost of 100 €/day

Budgeting has an opportunity cost of 40

He decides for the alternative whit the lower opportunity cost (budgeting in this case)

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Operation Mr Farmer(€/day)

Opportunity cost

(€/day)

Budgeting 100 40

Milking 40 100


1.3 – Resources, value, costs

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Chapter 4

Let’s combine some basic concepts

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1.3 - Resources, value, cost

Opportunity cost outlines resource scarcity

Resource scarcity stimulates people to value resources

We use resources as inputs to implement an action or a process, that will produce benefits

The value of an input used in a process

is a cost

Chapter 4

How can we analyse the cost of a process?

Resources and inputs are of many kinds and contribute to the production in many ways

The development of a cost analysis requires that we describe the mechanisms that generate costs

Before doing this, let’s spend a some time to have an insight of the animal health system in relation to cost

Costs are faced to get benefits• Who pays (and faces costs) in change of what (what benefits, goods,

services)?

• How this works when animal health is the focus of the social and economic relationships among people?

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1.3 - Resources, value, cost

Section 2: Costs in relation to animal health

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Chapter 4

Who is concerned by costs in relation to animal health?

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Who? (actors) Which economic reason?

Private owners of animals(Producers) revenue, profit

(Households) utility from good feelings for pets

Public institutions

Improve economy and welfare through animal production

Reduce health risks related to animals, animal production and consumption of animal products

Veterinarians Revenue, profit

Society as a wholeLife standards (avoid welfare losses), avoid sickness while using animals to satisfy different kinds of needs

Many actors deal with animals for different reasons or motivations

2 – Costs in relation to animal health

Chapter 4

Why do actors face cost for animal health?

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Who Why

Individual owners

Producers: suffer losses because of animal sickness→They accept to support monetary costs to defend the health of their animals, because these are a source of revenueFamilies: suffer for animal sickness, a loss of utility difficult to translate into money (non-monetary cost)→ They are willing to spend money to restore puppies’ health because they care

Public institutions

They spend money by trying to reduce the social risk related to animal disease on a large scale (loss of animal production, food scare, transmission of diseases among animal and to humans, etc.) → They spend money to safeguard health standards, prevent (or intervene in) animal health outbreaks, avoid social damages, etc.

The veterinarians

Veterinarians employ their time and competence for interventions in clinic or in the field. This is their profession;→ They spend money to move around, to manage vet office or hospital, update or improve their scientific knowledge.

Society as a whole

Society cares to avoid disease transmission, food scare and similar events that may cause losses of social welfare (in term of health, revenue, insecurity)→ Individuals may face costs to restore welfare.

Motivations determine the reasons for each actor to support costs for animal health


Chapter 4

Which role does each actor play in animal health?

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Different actors play different roles in animal healtho Any role comes with some functions to be developedo To develop a function, actors must use resources and face costs


Chapter 4

Which costs are related to each actor/role/function?

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When actors spend money for animal health, what do they materially buy?

Actors Costs

Individual owners

Producers: animals, buildings, feed, drugs, machinery, management, consultancy, workers, ....

Families: feed, drugs, recovery, consultancy

Public institutions

Veterinarians, supporting staff, labs’ materials, ....

Veterinarians

Vet’s time, staff, office, medical facilities and equipments, surgery room, microscope, ....

Society as a whole

Life quality (safe food, health insurance, wild animals preservation, ...)


Chapter 4

A simple exercise

Could you find out similarity and differences among the resources mentioned in the previous table?

Which criteria do you use to determine similarity and differences?

Are these criteria relevant on an economic perspective?

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Economics looks at how inputs generate costs

and classify costs according to

cost generating mechanisms


Section 3: Cost generating mechanisms

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3.1 - Costs and production

3.2 - Investments

3.3 - Costs over time

3.4 - Economic and financial aspects of costs

3.5 - Cost functions

3.6 - Average cost and economies of scale

3.7 - Organizational options

Chapter 4

3.1 Costs and production

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Chapter 4

One of the most relevant mechanism of cost generation

is the relationship between input use and production increase

Input use and production

Two situations can be exemplified

Mr. Farmer buys feed for his cow

More feed > More cost > More milk

Mr. Farmer buys a tractor for 100.000 €, to be used during the next 10 years

The value of the tractor decreases along this period at the rate of 10.000 €/year: this amount is related to machine availability for Mr. Farmer, and does not depend if Mr Farmer uses the machine 3 or 15 hours/day

What is the difference between these two types of cost?

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Chapter 4

Variable and fixed costs (I) Variable costs

Variable costs are costs that change depending on variations in the size of the activity: they increase with the increase of production and decrease when production is reduced;

Common examples of variable costs are given by the use of inputs entirely consumed in one production cycle; e.g. in milk production variable costs may consist in expenses for:

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• Feed • Veterinary assistance

• Fuel• Hired labour paid per hour, day, or

unit of product

• Electricity (only the elements related to consumption)

• Fertilizers, seeds, and pesticides for forage crops

• Drugs • etc…

• Rent of machinery


Chapter 4

Fixed costs

Fixed costs are costs that do not vary in the short term, even though the business’ activity, production volume and sales are significantly reduced;

Some common examples of fixed costs are:

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• Depreciation of tangible assets (machinery, buildings, tools, office equipment, etc.)

• Salaries paid to permanent employees of a company

• Amortization of intangible assets (patents, trademarks, etc.);

• Rents paid to landlords for the use of real estates

• Interests paid on loans used to buy assets

• Premiums paid for insurance on assets

• Property taxes • etc...

Variable and fixed costs (II)


Chapter 4

Similarity among production processes

Fixed and variable inputs are used in any production context

Mr. Vet spends 0.50 € for each cat vaccination kit

More vaccinations > More cost > More client served

Mr. Vet obtains a loan to buy the equipment of a surgery room

He will pay 1,000 €/month for 8 years

Either he uses the room for 7 or 15 surgeries per month, the bank will ask him 1,000 € every month over 8 years

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A relevant aspect of cost analysis is the ability to distinguish between

variable and fixed cost in any context

and understand the consequences for management


Chapter 4

3.2 Investments

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Chapter 4

Fixed costs and investments An investment is time, energy, matter,

money... resources spent once on expectation of future benefits.

Some example:

Your training: you spend money and time learning a lot during 6 years; your hope is that you will have a job and revenues during the next 40 years.

As a vet, you buy a car on year 1 to visit farmers. You get money from your work for several years thanks to your car.

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time

money

time & moneyspent for training

revenue

1-6 7-47

time

money

1 2 3 4

money spentfor the car

Revenues from farmers

3.2 - Investments

Chapter 4

Investment and uncertainty

An investment is made on the basis of a subjective evaluation on future activities, but nobody can exactly know what level of activity there will be in the future. Suppose that:

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3.2 - Investments

You stop working to take care of your children (and you didn’t plan it!)

A new vet recently installed in the area and he is very strong with bovines. This reduces your revenue from farmers ... but you didn’t know when you bought a new car to visit farmers abroad

Investment is sunk, you cannot get money/time back easily. Investment is always affected by

uncertainty on the return on investment.

Chapter 4

3.3 Costs over time

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Chapter 4

Depreciation

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The vet’s car of the previous example maintains its functionality for several years, which define the useful life period of the asset, but it losses value because of consumption

As a consequence, the value of the car gradually declines along its useful life period

This gradual loss of value is the cost related to the availability of the car. It is called depreciation and corresponds to the purchase value of the car distributed along its useful life period.

The accounting of the depreciation cost does not necessarily implies a corresponding cash outflow in the reporting year (see section 3.4)

3.3 - Costs over time

Chapter 4

3.4 Economic and financial aspects of costs

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Chapter 4

- the vet has a cash outflow when he purchases the car, but he does not have any cash outflows when he accounts the yearly cost of use of the car

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Costs and cash flows (I)

time

money

1 2 3 4

money spent for the car (cash outflow)

Revenues

yearly cost of depreciation(4 years)


The economic aspect of cost is related to the consumption of resources for production activities.

The financial aspect of cost is related to the flows of money generated along time by production activities.

In the example of section 3.3, the vet may have two options for buying the car:

1) He may buy the car with its own money

- in this case the vet has a cash outflow (area bordered by the red dashed line) for the whole price of the car at purchase ;

- if after four years the car needs to be changed and has lost all its value, the cost of the car depreciation corresponds to the value of the car at purchase, but it is distributed along the four years of car utilization (grey dashed areas);

Chapter 4

2) A second option is that the vet may borrow a loan from a bank and repay it in four years:

- in this case the vet makes use of the bank’s money to buy the car;

- each year the vet supports the cost of car’s depreciation and also a corresponding outflow of money which pays back the loan received from the bank. Moreover the vet also pays the interest due to the bank as price of the loan;

- the vet does not have a cash outflow when he purchases the car, but he does have yearly cash outflows corresponding to the yearly cost of use of the car

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Costs and cash flows (II)

time

money

1 2 3 4

Revenues

yearly costs of depreciation corresponding to the cash outflow

for loan repaymentinterest on the

loan (cash outflow)


Chapter 4

The two situations seem to be similar, but have very different implications.

If we suppose that in year 3, for some reason, it happens that the vet’s customers do not pay the vet services:

in the second case (the vet has to repay a loan), the vet could be in the situation that he cannot afford his obligations with the bank …

… and the consequences may be significantly worse for his future activity than in the first case (in which he does not have a loan to pay back).

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Use of inputs, time and payments


Chapter 4

For any business activity, it is necessary that the value generated by production (income) be greater than the value of all the inputs consumed along the production process (costs).

But this is not enough to determine the sustainability of a business.

In fact, it is also necessary that the business activity be always able to satisfy its obligations to payments in due time.

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Economic and financial balances

A correct economic balance implies that a business activity create an income

greater than costs (i.e. the value of production created should be greater than

the value of inputs consumed).

A correct financial balance implies that a business activity be always able to

satisfy its obligations to payments in due time.

Both conditions are necessary to define the sustainability of any business.


Chapter 4

3.5 Cost functions

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Chapter 4

Variable and fixed cost functions

As seen, feed (variable inputs) and tractors (fixed inputs) have different cost generating mechanisms with production increase;

The type of fixed assets may limit the production volume For example a small tractor may constrain the production. If a farmer wants to

increase the production above a given level, he needs a bigger tractor, which probably implies higher fixed costs for depreciation.

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Chapter 4

Cost functions, sales and profit

A consequence of the difference between variable and fixed cost functions is that, in general:

a production process characterised by a high proportion of variable costs may generate a profit with relatively low levels of sales;

a production process characterised by a high proportion of fixed costs requires certain levels of sales to generate profit.

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But a good endowment of fixed assets may provide other advantages …


Chapter 4

3.6 Average cost and economies of scale

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Chapter 4

Total cost, average cost, production volume

The analysis of production costs may provide information on how costs change in relation to production volume

Think to a surgery room: how does cost change with utilization? And why?

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The cost per unit of product

(average cost) can be reduced if

the use of the equipment is

optimized.

These are called

ECONOMIES OF SCALE

InputsCost of inputs

Production cost for 50 h/year

Productioncost for

1,000 h/year

Vet staff work and other variable inputs

130 €/hour 6,500 € 130,000 €

Use of surgery room (fixed input)

7,500 €/year 7,500 € 7,500 €

Total cost 14,000 € 137,500 €

Cost of surgery (€/hour) 280 €/hour 137.5 €/hour


Chapter 4

Economies of scale

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Economies of scale may abate the average production cost of goods and services and may be specially effective in large production units;


Chapter 4

3.7 Organizational options

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Chapter 4

Different options for the use of a machine

Mr. Farmer owns the machine he uses at farm

He did an investment years ago and repays a loan (fixed cost)

Mr. Vet bought an ultrasound machine

As in the case of Mr. Farmer, he has to repay a loan

Both of them are in trouble

They realized that their investments are oversized with respect to the use they actually do. They want to get rid of them, but they also want to use machine when they have need.

How can they do? What are the consequences?

In term of cost, this problem has two faces.

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Chapter 4

Turning a fixed cost into a variable cost is possible

Investments can be dismantled and machinery and equipment can be rented

In this case, the cost generation mechanism changes

The purchase of machinery and equipment generates fixed costs

The renting of machinery or equipment generates variable costs

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The choices related to the use of a fixed input

may actually turn a fixed cost into to a variable cost


Chapter 4

The mechanism generating cost changes

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For a production level corresponding to Y the renting of the asset allows a profit, while the cost of an owned asset generate losses (it would be rentable only for a Y’ production level)


But... you must consider that some costs are not

reversible...

Chapter 4

Sunk costs related to investments

The shifting from owning to renting the machinery implies that Mr Farmer and Mr Vet dismantle their investments;

The dismantling of investments generates losses: there are costs which cannot be recovered:

For the investment, they borrowed a 10,000 € loan from the bank, they have to pay back 2,000 €/year in 5 years;

At year 2 they dismantle the investment, they sell the equipment for 4,000 € cash;

The net loss of dismantling is 2,000 € (at the least!), resulting from:

- Cash from equipment sale = + 4,000 €;

- Remaining loan payments (3 years x 2,000) = - 6,000 €

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Dismantling investments may generate costs that

cannot be recovered or SUNK COSTS


Chapter 4

Many costs are difficult to be attributed to specific activities

Direct vs indirect costs

When the use of an input is clearly related to a specific activity/product, it generates a Direct Cost;

Common examples of direct costs are the materials consumed exclusively for a specific process

• feed, drugs, and veterinary assistance used for diary cows are direct costs of milk production

• kits used for vaccination are direct costs of vaccination, etc.

However it is difficult to attribute every input to a specific process, especially when the activity of the business is diversified

The costs that cannot be associated to a specific process or activity are Indirect Costs. The aggregate of a business’ indirect costs is commonly indicated as Overheads

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Chapter 4

Overheads

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Chapter 4

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Section 4: From private costs to social costs

Chapter 4

Individual behaviour and social costs

Mr Farmer breeds pigs. Consumers are happy with pig meat. But Mr Farmer’s neighbours are not happy with other “by-products” of Mr Farmer’s activity: air pollution, water pollution, noise, pig smell, etc.:

They should keep the windows closed even during summertime; They should install air conditioning and water filtering at home; Their kids cannot use the garden.

Which are the economic consequences of Mr Farmer’s behaviour? How far and in which ways people and society may be damaged by Mr

Farmer’s behaviour?

Mr Farmers neighbours should support unwanted costs due to Mr Farmer’s activity, they are limited in the use of their facilities and their houses lose value … but they do not receive any kind of compensation for that!!!

They suffer the externalities of Mr Farmer activity.

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4. From private costs to social costs

Chapter 4

Externalities may generate benefits and costs

Any production activity generates externalities. Externalities can be positive or negative

Pig meat satisfies consumer’s need (it contributes to food security)

This is a positive externality

Pigs breeding creates pollution and other problems (it deteriorates neighbours’ quality life)

This is a negative externality. To restore their quality of life, neighbours must afford additional costs

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Negative externalities from any production activity

impose unwanted costs to some social categories


Chapter 4

Dealing with (negative) externalities

Externalities (especially the negative ones) challenge economists because they are difficult to evaluate

Pig meat produced by Mr Framers is sold to consumers. Its value is easily identified by a market mechanism (there is a demand and there is a supply: the market establishes the price). Unfortunately, this is not always the case...

Some externalities are not valued through a market mechanism. This makes difficult to assess the value in monetary terms

No market means no price. But no price doesn’t mean no VALUE!

Some externalities are far reaching, their effects are not immediately visible or tangible. They may hit the socio-economic system in different ways and far away from the origin of the problem.

A careful understanding of the cause-to-effect chain

within the socio-economic system is required

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Chapter 4

The case of Aflatoxins

Aflatoxins are Mycotoxins found, among others, in maize. When this enters the food chain, it may endanger animals and, more seriously, human health.

Aflatoxins are dangerous for humans and animals when contaminated maize is consumed directly as food or feed.

By-products of Aflatoxins digestion in animals are found in animal food (meat, milk, eggs) and affect humans increasing the exposure to cancer risk in the long run.

Damages of minor entity (general pain, production reduction) are also found in animals, depending on the species.

What are the consequences of an Aflatoxins contamination when it affects the food chain?

Are consequences readily assessed? How do they flow in the socio-economic system? Are they easily valuable?

57


Chapter 4

Cause-to-effect chain in the Aflatoxins case

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Chapter 4

The Aflatoxins case in few words

Depending on the specific transmission chain of the contaminant agent...

Direct ingestion of contaminated food Use of contaminated feed by animals, and transmission of digestion by-products into

food

... the effects flow from the producers... Producers may suffer marginal production and revenue losses

... to consumers, ... Consumers are more seriously exposed to health risk, which translate in food

insecurity, increased medical expenses,

... to the whole society More public money will be allocated to food controls, public health services, public

information, preventative measures Production and revenue losses will reduce the social welfare.

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Chapter 4

Lessons learnt about externalities and costs

In economic terms, production makes sense because it creates benefits not only for producer but also for the society (food availability, social welfare). These are positive externalities

On the others side, production can also create bad outcomes (e.g. unexpected health risk) or negative externalities

Externalities are costs that are not taken into account by producers but are suffered by other categories or the whole society (unless corrective devices are applied)

In this sense, externalities are often cross-sectional cost as they are transmitted from one social category to another (producers vs. consumers)

Externalities may reduce resources availability for the next generations (like in the case of pollution). In this sense they are time-sectional costs

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Chapter 4

Now you know about cost concepts and tools……How can this help?

As a professional vet, your are advising Mr. Farmer about the way to solve mastitis diffusion among his cows. Two solutions are possible:

Improve the milking practices, or change milking devicesHow will Mr. Farmer take a decision?

A resilience of avian flu in the River Po Plane is a credible risk. Two solutions are possible:

Preventive vaccination of all hens, or accept the risk and prepare the stamping out of infected animals

How will national health authority decide?

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These are management problems. Cost concept is a good basis to approach them but you need to know more.

Contacts

Maurizio Aragrande, Massimo Canali

DISTAL, University of Bologna

[email protected]

[email protected]

http://www.neat-network.eu

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Florence Beaugrand

ONIRIS, Nantes

[email protected]

http://www.neat-network.eu

mailto:[email protected]



costs maurizio aragrande and massimo canali, university of bologna (i) florence beaugrand, oniris,...

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