23 April 2021

The Tyranny of Average Cost - part the fifteenth

Well, well yet another episode in this continuing series, a paean to the power of amortization. Here's a tidbit from today's news. Regular reader clearly understands the notion underpinning the titles of this series: the more physical capital a production process requires, the less flexible it is in regard to profitable output level. The arithmetic is straightforward, by counter-example: with a labor intensive production function (say, plantation cotton), the bidnezzman hires (or just acquires) more workers to increase output; vice-versa should demand and output fall he simply sheds workers one way or another (unemployment insurance? we don't need no none of dat).

When the production function hits the tipping point (calculating that is no simple task) of capital/labor ratio, adjusting output to meet demand, i.e. reducing output, the cost of capital must still be paid, and average cost increases as that cost is spread over fewer units. The advantage of this mini-factory approach is a one-way street. It supports the idea of adding incrementally to capacity as demand builds, thus not having to build a River Rouge in the expectation that, some day, its full capacity can be sold. But the vice-versa does not happen; whenever demand slackens, some number of those mini-factories are just as redundant as a corner or two of a River Rouge, and their capital cost also does not disappear. The Piper still must be paid in either circumstance.

It is a problem. And, for the only time in recent memory, a Master of the Universe admits it. Be still my heart.
"The assembly line approach is very capital-intensive, and you have to get to very high production levels to make any margin," said Avinash Rugoobur, Arrival's president and a former General Motors executive. "The microfactory allows us to build vehicles profitably at really any volume."
[my emphasis, and Holy Shit!!! Who knew my readership went so far?]
Note well: Arrival isn't proposing to reduce capital content in its production function, if anything Arrival will end up with a higher capital/labor ratio in toto (all of those wonderful robots, which don't get sick or take lunch breaks, but you can't fire, either), but because of this mini-factory structure, they have convinced themselves that such yields a lower average cost. I doubt it.

Alas, Rugoobur is delusional. What matters: total sunk cost in physical capital and total output. It simply doesn't matter if that physical capital is embodied in The River Rouge plant or dozens of small plants scattered across the land. Shutting down one plant to reduce output still leaves the bill for the physical capital to pay. The Tyranny of Average Cost never goes away. Thinking that, by chopping capital into smaller bits, the Grim Reaper of amortization disappears is delusional. (I suspect this guy is an MBA. Let's see if we can find out. Perhaps goodly, not an MBA by that name. His last qualy is in Library Science.) The Tyranny of Average Cost applies to all costs and output levels. Slicing and dicing doesn't vanquish The Tyrant. The Tyrant lives in the production process, not the output level.

As a reminder: this basic idea, of dicing production into discrete bits and pieces, was attempted decades ago. It was/is called Cellular Manufacturing. The prime example: from 1987, and Volvo.
Building on concepts it pioneered at its 13-year-old plant here, Sweden's A. B. Volvo is now intent upon entirely jettisoning Ford's assembly line approach at a $315 million plant it is constructing at Uddevalla on the west coast of the Swedish peninsula. If all goes as planned, the plant will be organized into work teams - each of which will ultimately assemble a complete car by itself.
IOW, Arrival is old wine in new bottle. So, what happened to that Volvo plant? Let's see if we can find out. The plant was closed in 1994.

More detail here
Both are in southern Sweden, and negotiations began immediately with union leaders on the possibility of transferring some workers to Torslanda, on the west coast. Concentrating Volvo's car production in Sweden at one plant will save nearly $60 million annually, Mr. Jeansson said.
[my emphasis; how embarrassing]
Is past prologue? The Tyranny of Average Cost cannot be avoided. There is no veronica in physical production; you cannot escape The Bull by waving a red cape.

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