Lecture #3: Topic #1Benefits, Costs, and

Decisions

Lecture 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 variable costs.

Lecture 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 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 explicit 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.

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 (EVA)® • A capital charge appeared on division income statements

• Senior managers then decided to sell the unused apartments after seeing the implicit cost of capital.

• Discussion: How did this action increase profitability?

Accounting costs for Cadbury

Opportunity costs & decisions• Definition: the opportunity cost of an action is

what you 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

• Discussion: What was cost of capital• 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

Fixed-cost fallacy• Definition: letting irrelevant costs influence a

decision

• Football game example – how does ticket price affect your decision to stay or leave at halftime? Should it?

• Launching a new product – what if overhead deters a profitable product launch

• 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

• The subprime mortgage crisis of 2008 is a good example of the hidden-cost fallacy.

• Credit-rating agencies failed to recognize 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.

• Credit ratings didn’t reflect the hidden costs of risky loans, as a result many Wall Street investors purchased packaged risky loans and eventually went bankrupt when the debtors defaulted.

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?

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”

• Definition: overconfidence bias – the tendency to place too much confidence in the accuracy of your analysis

Alternate intro anecdote• Coca-Cola in the 1980s had very little debt, preferring to raise

equity capital from its stockholders

• Company had a diversified product line, including products like aquaculture and wine. These other businesses generated positive profits, earning a ten percent return on capital invested.

• The company, however, decided to sell off these “under-performing businesses”

• Why?

• At the time, soft drink division was earning 16 percent return on capital

• The “opportunity cost” of investing in aquaculture and wine is the foregone profit that could have been earned by investing in soft drinks

• A dollar invested in aquaculture and wine is a dollar that was not invested in soft drinks

• Divisions sold off and proceeds invested in core soft drink business

Lecture 3: Topic #2Extent (How Much)

DecisionsMarginal Revenue, Costs

(Average and Marginal)Remember, We always

think on the MARGIN

Lecture 3: Topic 2 – Summary of main points

• Do not confuse average and marginal costs.

• Average cost (AC) is total cost (fixed and variable) divided by total units produced.

• Average cost is irrelevant to an extent decision.

• Marginal cost (MC) is the additional cost incurred by producing and selling one more unit.

Lecture 3: Topic #2 – Summary• Marginal revenue (MR) is the additional revenue

gained from selling one more unit.

• Sell more if MR > MC; sell less if MR < MC. If MR = MC, you are selling the right amount (maximizing profit).

• The relevant costs and benefits of an extent decision are marginal costs and marginal revenue. If the marginal revenue of an activity is larger than the marginal cost, then do more of it.

• An incentive compensation scheme that increases marginal revenue or reduces marginal cost will increase effort. Fixed fees have no effects on effort.

• A good incentive compensation scheme links pay to performance measures that reflect effort.

Introductory anecdote: US Financial Crisis• The financial crisis began in the subprime housing

market, where government policies encouraged lenders to extend credit to low-income borrowers (by lowering lending standards)

• Concurrently mortgages were being packaged into securities and sold to investors.

• If the risk had been recognized investor demand would have been low, but rating agencies were too liberal with AAA ratings, increasing demand for loans.

• The result? A credit “bubble”

• How did this lending crisis arise?

Background: Average cost

• Definition: Average cost is simply the total cost of production divided by the number of units produced. AC = TC/Q• Average costs often decrease as quantity

increases due to presence of fixed costs• AC = (VC + FC)/Q• FC does not change as Q increases

• Average costs are not relevant to extent decisions

Background: Average cost (cont.)

Background: Marginal cost

• Marginal cost is the cost to make and sell one additional unit of output. MC = TCQ+1 – TCQ.

• Marginal cost is often lower than average cost (due to falling average costs) but not always.

• Marginal costs are what matter in extent decisions

Extent (how much?) decisions• Definition: Marginal cost (MC) is

the additional cost required to produce and sell one more unit.

• Definition: Marginal revenue (MR) is the additional revenue gained from producing and selling one more unit.

• If the benefits of selling another unit (MR) are bigger than the costs (MC), then sell another unit.

• So, produce more when MR>MC; less when MR<MC. Profits are maximized when MR=MC.

Extent decisions (cont.)• Examples of extent decisions

• Should you change the level of advertising?• Should you increase the quality of service?• Is your staff big enough, or too big?• How many parking spaces should you

lease?

• Marginal analysis answers these questions• This analysis tells you direction of change

but not the distance. • You can only measure MR and MC at the

current level of output – make a change and re-measure

Extent decision example

• Discussion: How much advertising?• A $50,000 increase in the TV ad budget brings in

1,000 new customers

• Estimated MCTV is $50 (the cost to get one more customer)• $50,000 / 1,000 = $50

• If the marginal revenue generated by this customer is greater than $50, do more advertising.

Extent decision example (cont.)

• Even if we do not know the marginal revenue, we can still use marginal analysis to make extent decisions

• Compare TV advertising to telephone solicitation• Say you recently cut telephone budget by $10,000 and lost

100 customers

• Estimated MCPH = $100= ($10,000 / 100)

• So, to get one more customer costs $50 for TV and $100 for phone• MCPH > MCTV so shift ad dollars from phone to TV

• Advice: make changes one-at-a-time to gather valuable information about marginal effectiveness of each medium.

Another example

• SAH=“Standard Absorbed Hours” a measure of textile factory output• Allows managers to compare factories making different

items, e.g. t-shirt = 1 SAH while dress=3 SAH

• Suppose Factory A has costs of $30 per SAH while Factory B has cost of $20 per SAH. How can you profitably use this information?

• The decision seems simple, but• Make sure you are not including fixed costs in the analysis• Marginal costs matter, not average costs!• If the $20 and $30 rates are good MC proxies, shift some

production from Factory A to Factory B

Effort is an extent decision• Discussion: Royalty rates vs. fixed fee

contracts

• You receive two bids to harvest 100 trees on your land

• $150/tree or $15,000 for the right to harvest all the trees.

• On your tract there are pines (worth $200) and fir (worth $100)

• Which offer should you accept?

• Discussion: Sales Commissions

• Expected sales level: 100 units @ $10,000/unit=$1M

• Option 1: 10% commission

• Option 2: 5% commission + $50,000 salary

Tie pay to performance• A consulting firm COO received a flat salary of

$75,000

• After learning about the benefits of incentive pay in class, the CEO changed COO compensation to $50K + (1/3)* (Profits-$150K)

• Profits increased 74% to $1.2 M

• Compensation increased $75K $177K

• Discussion: what are the disadvantages to incentive pay?

Alternate intro anecdote• American Express offers a Platinum Card to affluent customers

• In 2001, there were approximately 2,000 Platinum cardholders in the Japanese market. Numbers had been limited to ensure high quality customer service

• With customer service technology advances, company considered expanding number of card holders

• How many more should be added?• As more members are acquired, average spending per card member

decreases because the financial threshold for membership is lowered

• Costs of customer service rise for each additional member added, and growing beyond a certain point would require building and operating an additional call center

• After analyzing the costs and benefits, American Express realized that it should expand its offering to only 15,000 more Platinum Card members

• We call this an “extent” decision, because the company needed to decide “how many” platinum cards to provide. In this lecture, we show you how to make profitable extent decisions.

Lecture 3: (Okay Maybe 4), Topic #3

Simple Pricingand demand

Summary of main points• Aggregate demand or market demand is the total number

of units that will be purchased by a group of consumers at a given price.

• Pricing is an extent decision. Reduce price (increase quantity) if MR > MC. Increase price (reduce quantity) if MR < MC. The optimal price is where MR = MC.

• Price elasticity of demand, e = (% change in quantity demanded) ÷ (% change in price)• Estimated price elasticity = [(Q1 - Q2)/(Q1 + Q2)] ÷ [(P1 - P2)/(P1 +

P2)] is used to estimate demand from a price and quantity change.

• If |e| > 1, demand is elastic; if |e| < 1, demand is inelastic.

• %ΔRevenue ≈ %ΔPrice + %ΔQuantity• Elastic Demand (|e| > 1): Quantity changes more than price.

• Inelastic Demand (|e| < 1): Quantity changes less than price.

Summary (cont.)• MR > MC implies that (P - MC)/P > 1/|e|; in words, if the

actual markup is bigger than the desired markup, reduce price• Equivalently, sell more

• Four factors make demand more elastic:• Products with close substitutes (or distant complements)

have more elastic demand.• Demand for brands is more elastic than industry demand.• In the long run, demand becomes more elastic.• As price increases, demand becomes more elastic.

• Income elasticity, cross-price elasticity, and advertising elasticity are measures of how changes in these other factors affect demand.

• It is possible to use elasticity to forecast changes in demand: %ΔQuantity ≈ (factor elasticity)*(%ΔFactor).

• Stay-even analysis can be used to determine the volume required to offset a change in costs or prices.

Introductory anecdote: Gas prices

• US: From early 2007 to mid 2008 gas prices rose in the US.• Gas prices caused people to find alternate methods of work and

travel to avoid using gas. • Some farms began using mules instead of tractors

• India: In Rajasthan, the rising gas prices caused many farmers to switch from tractors to camels on farms.• As oil prices rose, demand for camels increased.• Prices for camels tripled over a two-year period.

• A US company, NNS, that produces potash fertilizer experienced an increase in input costs due to their use of petrochemicals.• NNS doubled the price of the generic fertilizer, and priced it’s

branded fertilizer at a 35% premium above the generic price. • Costs increased rapidly over the first two quarters combined

with NNS’s policy of quarterly price revision led to stockouts and a price that ended up being 25% below the generic – NNS could have earned $13 million but failed to maintain their premium

Background: consumer surplus and demand curves• First Law of Demand - consumers demand (purchase)

more as price falls, assuming other factors are held constant.

• Consumers make consumption decisions using marginal analysis, consume more if marginal value > price

• But, the marginal value of consuming each subsequent unit diminishes the more you consume.

• Consumer surplus = value to consumer - price paid

• Definition: Demand curves are functions that relate the price of a product to the quantity demanded by consumers

Background: consumer surplus and demand curves (cont.)

• Hot dog consumer• Values first dog at $5, next at $4 . . . fifth at $1

• Note that if hot dogs price is $3, consumer will purchase 3 hot dogs

Background: aggregate demand• Aggregate Demand: the buying behavior of a group of

consumers; a total of all the individual demand curves.

• To construct demand, sort by value.

• Discussion: Why do aggregate demand curves slope downward?

• Role of heterogeneity?

• How to estimate?

Price Quantity RevenueMarginal Revenue

$7.00 1 $7.00 $7.00$6.00 2 $12.00 $5.00$5.00 3 $15.00 $3.00$4.00 4 $16.00 $1.00$3.00 5 $15.00 -$1.00$2.00 6 $12.00 -$3.00$1.00 7 $7.00 -$5.00

$0.00

$2.00

$4.00

$6.00

$8.00

$0.00 $2.00 $4.00 $6.00 $8.00