Huxley Maquiladora

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.

Cost Behavior

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 one section, total salary payments to economics professors rises. Does this imply that the professors’ salaries are fixed costs or variable costs?

Production Theory and Cost Theory

In the previous chapter, we discussed the economic theory of production. Comprehending production theory (the relationship between inputs and output) is a necessary prerequisite to understanding cost theory (the relationship between production and costs). As we noted in the previous chapter, costs are derived from production activities. As worker productivity increases, for example, unit costs decrease.

The relationship between productivity and cost was implied in the Huxley case. Most of the employees at Huxley’s San Diego plant were women. The plant experienced high employee turnover because working with metals was a dirty job. The Huxley Maquila Project Report suggested that young Mexican women might be more productive than their American counterparts because they would be more patient. Hence, even if the going wage rate south of the border was identical to that paid in San Diego, unit costs would be lower due to the increased productivity at a Mexican facility.

As you may recall from the chapter on production theory, in the early stages of production, a firm is expected to encounter increasing marginal product. As inputs are used for production, they become more specialized and the resulting efficiency gains cause production to increase more than proportionately. For example, suppose one worker was capable of producing one unit/hour. By adding a second worker, each worker could assume specialized duties. Owing to specialization, the two workers are capable of producing four units of output. In other words, when the number of inputs doubled, output quadrupled.

Let’s convert this information into production costs. For simplicity’s sake, we will assume that labor constitutes the only variable input. Fixed costs are $10/hour. If a worker was paid a wage of $10/hour, the total cost of producing one unit of output would be $20. If the firm hires two workers, four units could be produced at a total cost of $30. Increasing production from one unit to four did not affect the firm’s fixed costs, but it caused total variable costs to rise from $10 to $20. Take special note of the proportionate changes in production and costs. Total variable costs increased as production increased, but when output quadrupled, variable costs doubled. The increase in variable costs was proportionately less than the change in production.

Table 1 shows the correlation between production theory and cost theory during