The Effects of Real Options, Returns-to-Scale, Structural Changes, and Levels of Aggregation on the Cost-Revenue Relationship

ABSTRACT. This paper extends the traditional, static cost and revenue model developed in manufacturing settings by studying four factors that moderate the cost-revenue relationship: real options, returns-to-scale, structural changes, and levels of aggregation. We use the motion picture industry as a research setting since it provides an interesting context for this type of research. For instance each product in the industry, a motion picture, is an experiential good with tractable costs and revenues. The critical costs to developing and marketing a successful motion picture are production and advertising costs. Using a sample of 1,695 motion pictures released between 1990 and 2003, we find that advertising costs – a result of the managerial exercise of real options – have a stronger association with revenues than do production costs – a first-stage investment. We also find that movies with larger costs have higher incremental revenues per cost, consistent with returns-to-scale. In addition, we discover that structural changes in the industry greatly affect the cost-revenue relationship during our observation period. Finally, we find that the cost-revenue relationship is stronger at a higher level of aggregation than at a lower level. In conclusion, our results indicate that the simple linear static model of cost-revenue relationship is limited. I