Managerial economics 3rd by froeb ch03

11

Chapter 3
Benefits,
Costs, and
Decisions
1

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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
variable costs.

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Chapter 3 – Summary (cont.)
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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 fixedcost 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 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.

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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.

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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.

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Total, Fixed, and Variable
Costs

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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.

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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

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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

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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

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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?
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Accounting costs for
Cadbury

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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

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Discussion: What was cost of capital

• To Bombay division?; to company?
• How do we get GOAL ALIGNMENT?
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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

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

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Discussion: Outsourcing

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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.

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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.
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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.
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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?

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Does EVA® work?
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Adopting companies of EPP’s (+ four years)

• ROA from 3.5 to 4.7%
• operating income/assets from 15.8 to 16.7%
Indistinguishable from non-adopters

• Bonuses increase 39.1% for EVA® firms

• But 37.4% for control group
Interpretations

• Selection bias?
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NO, cheaper to use existing plans

• Goal alignment, YES.
EVA® is no better or worse

• Rival EPP’s
• Bonus plans
• Discussion: WHY?
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Psychological biases
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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.

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Definition: the endowment effect means that taking
ownership of item causes owner to increase value she places

on the item.

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Definition: loss aversion – individuals would pay more to
avoid loss than to realize gains.

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Definition: confirmation bias – a tendency to gather
information that confirms your prior beliefs, and to ignore
information that contradicts them.

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Definition: anchoring bias – relates the effects of how
information is presented or “framed”

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

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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?
$0;
B. $10;
C. $40;
D. $50
A.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


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?
$0;
B. $10;

C. $40;
D. $50
A.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


In class problem (2)
▮ 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 minimum amount (in
dollars) you would have to value seeing Eric
Clapton for you to choose his concert?
$0;
B. $10;
C. $40;
D. $50
A.

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Alternate intro anecdote
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Coca-Cola in the 1980s had very little debt, preferring to raise equity
capital from its stockholders

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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.

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

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Why?

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

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

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

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Divisions sold off and proceeds invested in core soft drink business

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.