QUESTIONS & ANSWERS

Q8.1 What advantages or disadvantages do you see in using current costs for tax and stockholder
reporting purposes?

ANSWER
Current cost is the amount that must be paid under prevailing market conditions for many managerial
decisions. Taxes and stockholder reporting rely heavily on the Historical Cost. Theoretically, it would be
preferable to use current costs for income tax calculations and stockholder reporting. On a practical level,
however, this would be nearly impossible. Estimation of current cost, based upon current market values,
would be a difficult task with a great deal of room for subjectivity. This could result in many arbitrary cost
designations, and the "policing" of tax returns would become a much more formidable task. On a
practical basis, the use of historical costs for tax and stockholder reporting purposes has obvious
advantages over the theoretically superior current costs.

Q8.2 Assume that two years ago, you purchased a new Jeep Wrangler SE 4WD with a soft top for $16,500
using five-year interest-free financing. Today, the remaining loan balance is $9,900 and your Jeep has a
trade-in value of $9,500. What is your opportunity cost of continuing to drive the Jeep? Discuss the
financing risk exposure of the lender.

ANSWER
$9,500. If you sell the Jeep, $9,500 can be generated to pay down your remaining loan balance. It is the
current cost or replacement value of your current vehicle. It is the relevant economic cost of continuing
to drive the Jeep. Historical cost of $16,500, and the remaining loan balance of $9,900 are irrelevant for
decision-making purposes. With a current market value of only $9,500 against a remaining loan balance
of $9,900, the lender faces the risk of borrower default.

Q8.3 Southwest Airlines offers four flights per weekday from Cleveland, Ohio to Tucson, Arizona. Adding a
fifth flight per weekday would cost $15,000 per flight, or $110 per available seat. Calculate the
incremental costs borne by Southwest following a decision to go ahead with a fifth flight per day for a
minimal 60-flight trial period. What is the marginal cost? In this case, is incremental cost or marginal cost
relevant for decision making purposes?

ANSWER
Marginal cost is the change in cost following a 1-unit change in output. Whereas Incremental costs
typically involve multiple units of output associated with a given managerial decision. Incremental costs
may also relate to output changes, but the output change involved is that of a relevant block or
increment of service. In this instance, the incremental cost associated with a decision to go ahead with a
fifth flight per day for a minimal 60-flight trial period is
$900,000 (= $15,000 Η 60)
The marginal cost per passenger is only $110. In this case, the incremental cost of $900,000 is the
relevant cost for decision making purposes. With expected revenues in excess of $900,000, Southwest
should go ahead with the planned expansion.

Q8.4 Suppose the Big Enchilada restaurant has been offered a binding one-year lease agreement on an
attractive site for $5,200 per month. Before the lease agreement has been signed, what is the incremental
cost per month of site rental? After the lease agreement has been signed, what is the incremental cost per
month of site rental? Explain.
ANSWER
A cost that does not vary across decision alternatives is called a sunk cost. Sunk costs are irrelevant for
current decision-making purposes and should not enter into decision analysis. Before the lease
agreement has been signed, all costs are variable, and the incremental cost per month of site rental is
$5,200 per month. After the lease agreement has been signed, lease costs are sunk, and the incremental
cost per month of site rental is $0.

Q8.5 What is the relation between production functions and cost functions? Be sure to include in your
discussion the effect of competitive conditions in input factor markets.

ANSWER
There is a direct relation between production and cost functions. A cost function is determined by
combining a given production function with the related price functions for the inputs actually employed
in production. If inputs are purchased in competitive markets so that their prices are constant irrespective
of how many are purchased, the relation between production and cost functions is straightforward. With
imperfect competition in input markets, the relation becomes somewhat more complex. In all cases,
cost/production relations can be employed either to minimize total costs subject to an output constraint
or to maximize output subject to a total cost or budget constraint.

Q8.6 The definition of output elasticity is εQ = ∂ Q/Q <184> ∂ X/X (X represents all inputs), whereas the
definition of cost elasticity is εC = ∂ C/C <184> ∂ Q /Q . Explain why εQ > 1 indicates increasing returns to
scale, where εC < 1 indicates economies of scale.

ANSWER
OE is the percentage change in output associated with a 1 percent change in all inputs. Whereas a CE
measures the percentage change in total cost associated with a 1 percen change in output. Therefore:

If Then Implies

εQ > 1 ∂ Q/Q > ∂ X/X Rising Q/X ratio, Returns to Scale, falling AC.

εC < 1 ∂ C/C < ∂ Q/Q Falling C/Q ratio, Economies of Scale, falling
AC.

This means that εQ > 1 and εC < 1 are both consistent with falling average costs.

Q8.7 The president of a small firm has been complaining to the controller about rising labor and material
costs. However, the controller notes that average costs have not increased during the past year. Is this
possible?

ANSWER
Yes, the phenomenon of constant (or even decreasing) average costs coupled with increasing input prices
is quite feasible. It stems from an increase in input productivity that could result from any number of
causes. One obvious possibility would be the introduction of new capital equipment, either replacement
or expansion, into the production system.

Q8.8 With traditional medical insurance plans, workers pay a premium that is taken out of each paycheck
and must meet an annual deductible of a few hundred dollars. After that, insurance picks up most of their
health-care costs. Companies complain that this gives workers little incentive to help control medical
insurance costs, and those costs are spinning out of control. Can you suggest ways of giving workers
better
incentives to control employer medical insurance costs?

ANSWER
In hopes of slowing the growth in medical costs, some companies are moving towards A consumer driven
at medical coverage that gives employees a financial stake in what they pay for medical care. Such plans
feature high deductibles of as much as $500 per year for prescriptions and $1,000 per year for all other
medical costs. To help pay these costs, some companies deposit $300 to $1,800 per year in an A
employee benefits account.

If employees don't spend their money in one year, they get to carry it over to future years. After the
deductible is reached, the plan operates more like a traditional one, picking up 80% of most medical
expenses. The hope is that once the money feels as though it belongs to them, people won't get an MRI
when an X-ray (or an ice pack) might do.

The plans have one big drawback: People with chronic conditions can take a big hit, since they have little
choice about how often they go to the doctor. Some critics fear that the plans will discourage people
from getting the care they need.

Q8.9 Will firms in industries in which high levels of output are necessary for minimum efficient scale tend
to have substantial degrees of operating leverage?

ANSWER
Yes, in industries where the minimum efficient scale is large, long-run average costs tend to decrease
rapidly as output increases. Fixed costs tend to be a substantial share of total costs. When fixed costs are
large, the degree of operating leverage also tends to be high, and firms with high levels of output
necessary for minimum efficient scale will tend to have a substantial degree of operating leverage.

Q8.10 Do operating strategies of average cost minimization and profit maximization always lead to
identical levels of output?

ANSWER
No, operating strategies of average cost minimization and profit maximization lead to identical rates of
input combination, but do not typically lead to identical levels of total output. Average cost minimization
is an appropriate strategy when managers wish to produce a target level of output in an optimal or least-
cost fashion. On the other hand, profit maximization implies production of an optimal level of output, as
revealed by product demand, in an optimal or least-cost fashion.