Managerial economics 3rd by froeb ch03

• In computing costs and benefits, consider all costs and benefits that vary with the consequences of a decision and only those costs and benefits that vary with the consequences of t

Chapter 3 Benefits, Costs, and Decisions

Chapter 3 – Summary of main

points

• Costs are associated with decisions, not activities.

• The opportunity cost of an alternative is the profit

you give up to pursue it.

• In computing costs and benefits, consider all costs

and benefits that vary with the consequences of a

decision and only those costs and benefits that vary

with the consequences of the decision These are

the relevant costs and benefits of a decision.

• Fixed costs do not vary with the amount of output Variable costs change as output changes

Decisions that change output will change only

Chapter 3 – Summary (cont.)

• Accounting profit does not necessarily correspond to

real or economic profit.

• The fixed-cost fallacy or sunk-cost fallacy means

that you consider irrelevant costs A common

fixed-cost fallacy is to let overhead or depreciation fixed-costs

influence short-run decisions.

• The hidden-cost fallacy occurs when you ignore

relevant costs A common hidden-cost fallacy is to

ignore the opportunity cost of capital when making

investment or shutdown decisions.

• EVA® is a measure of financial performance that

makes visible the hidden cost of capital.

• Rewarding managers for increasing economic profit

increases profitability, but evidence suggests that

economic performance plans work no better than

traditional incentive compensation schemes based on accounting measures.

Introductory anecdote: Big

Coal Power Company

• Big Coal Power Co switched to a 8400 coal when the price fell 5% below the price of 8800 coal

• 8400 coal generates 5% less power than 8800

• The manager was compensated based on the average cost of electricity, and expected this move to save money

• Instead – company profit reduced

• Why? What happened?

• Discussion: Diagnose the problem.

• Discussion: Come up with a proposal to fix

it.

Background: Types of costs

• Definition: Fixed costs do not vary with the

amount of output.

• Definition: Variable costs change as output

changes.

• For Example: A Candy Factory

• The cost of the factory is fixed.

• Employee pay and cost of ingredients are variable costs.

Total, Fixed, and Variable

Costs

Your turn

• Are these costs fixed or variable?

• Payments to your accountants to prepare your tax returns.

• Electricity to run the candy making machines.

• Fees to design the packaging of your candy bar.

• Costs of material for packaging

Background: Accounting vs Economic

cost

• Typical income statements include explicit costs:

• Costs paid to its suppliers for product ingredients

• General operating expenses, like salaries to factory managers and marketing expenses

• Depreciation expenses related to investments in buildings and equipment

• Interest payments on borrowed funds

• What’s missing from these statements are implicit costs:

• Payments to other capital suppliers (stockholders)

• Stockholders expect a certain return on their money (they

could have invested elsewhere)

• “Profit” should recognize whether firm is generating a return beyond shareholders expected return

• Economic profit recognizes these implicit costs; accounting profit recognizes only explicit costs

Example: Cadbury (Bombay)

• Beginning in 1978, Cadbury offered managers free housing in company owned flats to offset the high cost of living.

• In 1991, Cadbury added low-interest housing loans

to its benefits package Managers moved out of the company housing and purchased houses The empty company flats remained on Cadbury’s

balance sheet for 6 years

• 1997 Cadbury adopted Economic Value Added

Accounting costs for

Cadbury

Opportunity costs &

decisions

give up (forgone profit) to pursue it.

• Costs imply decision-making rules and vice-versa

• The goal is to make decisions that increase profit

• If the profit of an action is greater than the alternative, pursue it.

• Whenever you get confused by costs, step

back and ask “what decision am I trying to make.”

• If you start with costs, you will always get confused

• If you start with a decision, you will never get confused

• To Bombay division?; to company?

• How do we get GOAL ALIGNMENT?

Relevant costs and benefits

• When making decisions, you should consider all costs and benefits that vary with the

consequence of a decision and only costs

and benefits that vary with the decision

• These are the relevant costs and relevant

benefits of a decision.

• You can make only two mistakes

• You can consider irrelevant costs

• You can ignore relevant ones

• Discussion: does your company include

“overhead” in transfer prices?

• Discussion: outsourcing agitator production

• Diagnose problem using Decisions rights; evaluation metric; compensation scheme,

• Try to fix it: how do you better align the incentives of the plant managers with the profitability goals of the company?

Discussion: Outsourcing

Hidden-cost fallacy

• Definition: ignoring relevant costs when

making a decision

• Example: another football game

• Discussion: should you fire an employee?

• The revenue he provides to the company is $2,500 per month

• His wages are $1,900 per month

• His office could be rented out $800 per month

• Discussion: Come up with examples of the

hidden-cost fallacy.

Subprime mortgages

good example of the hidden-cost fallacy

the higher costs of loans made by dubious lenders.

• Example: Long Beach Financial

• Gave loans out to homeowners with bad credit, asked for no proof of income, deferred interest payments as long as possible.

costs of risky loans, as a result many Wall Street investors purchased packaged risky loans and eventually went bankrupt when

Hidden cost of capital

• Recall that accounting profit does not

necessarily correspond to economic profit.

• Discussion: Economic Value Added

• EVA ® = net operating profit after taxes minus the cost of capital times the amount of capital

utilized

• Makes visible the hidden cost of capital

• The major benefit of EVA is identifying costs If you cannot measure something, you cannot control it.

• Those who control costs should be responsible for them.

Incentives and EVA ®

• Goal alignment: “By taking all capital

costs into account, including the cost of equity, EVA shows the dollar amount of wealth a business has created or

destroyed in each reporting period … EVA

is profit the way shareholders define it.”

• Discussion: can you make mistakes using EVA?

• Does it help avoid the hidden cost fallacy?

• Does it help avoid the fixed cost fallacy?

Does EVA ® work?

Psychological biases

• Not enough information or bad incentives are not the only causes for business mistakes Often psychological biases get

in the way of rational decision making

• Definition: the endowment effect means that taking

ownership of item causes owner to increase value she places

on the item

• Definition: loss aversion – individuals would pay more to

avoid loss than to realize gains

• Definition: confirmation bias – a tendency to gather

information that confirms your prior beliefs, and to ignore

information that contradicts them.

• Definition: anchoring bias – relates the effects of how

information is presented or “framed”

In class problem

▮ You won a free ticket to see an Eric

Clapton concert (which has no resale

value) Bob Dylan is performing on the same night and is your next-best

alternative activity Tickets to see Dylan cost $40 On any given day, you would

be willing to pay up to $50 to see Dylan Assume there are no other costs of

seeing either performer Based on this

information, what is the opportunity cost

of seeing Eric Clapton?

A $0;

B $10;

C $40;

In class problem (1)

▮ You won a free ticket to see an Eric Clapton

concert (which has no resale value) Bob

Dylan is performing on the same night and is your next-best alternative activity Tickets to see Dylan cost $40 On any given day, you would be willing to pay up to $50 to see

Dylan Assume there are no other costs of

seeing either performer Based on this

information, what is the opportunity cost of seeing Eric Clapton?

A $0;

B $10;

In class problem (2)

concert (which has no resale value) Bob

Dylan is performing on the same night and is your next-best alternative activity Tickets to see Dylan cost $40 On any given day, you

would be willing to pay up to $50 to see

Dylan Assume there are no other costs of

seeing either performer Based on this

information, what is the minimum amount (in dollars) you would have to value seeing Eric Clapton for you to choose his concert?

B $10;

C $40;

Alternate intro anecdote

capital from its stockholders

aquaculture and wine These other businesses generated positive

profits, earning a ten percent return on capital invested.

businesses”

capital

foregone profit that could have been earned by investing in soft drinks

invested in soft drinks