Chapter 3 – Benefits, Costs, and Decisions
Decisions that change output will change only
Costs are associated with decisions, not activities.
The opportunity cost of an alternative is the profit you
give up pursuing 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.
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 (Economic Value Added) 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.
Types of Costs:
 Fixed costs do not vary with the amount of
output. Predetermined expenses that remain
the same throughout a specific period.
- Rent
- Telephone & internet costs
- Insurance
- Employee Salaries
- Loan Payments
 Variable costs change as output changes.
variable costs. These are based on the business
performance and the volume of services the
business generates.
- Direct labor
- Commissions
- Taxes
- Operational expenses
- Commissions on sales, credit card fees,
wages of part-time staff, etc.
Cost Formula & Computation
Total Cost: TC = TFC + TVC
Average Cost:
 AC = TC/Q(quantity)
 AC = AFC + AVC
Accounting Profit
 Only recognizes explicit costs.
 Typical income statements include explicit
costs:
- Costs paid to its suppliers for product inputs
- 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
Economic Profit
 recognizes only implicit costs.
 Similar to accounting costs but includes
opportunity costs.
 consists of revenue minus implicit (opportunity)
and explicit (monetary) costs; accounting profit
consists of revenue minus explicit costs.
(Lumen)
Opportunity Costs & Decisions
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.
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
The Sunk Cost
 Refers to money that has already been spent
and cannot be recovered. In business, the axiom
that one has to "spend money to make money"
is reflected in the phenomenon of the sunk
cost.
 Cannot be recovered. If equipment can be
resold or returned at the purchase price, for
example, it's not a sunk cost.
 Examples: costs on
- Marketing campaign
- New equipment
- Training
- Hiring
- Research and development
The fixed-cost/sunk-cost fallacy means you make
decisions using irrelevant costs and benefits. A common
fixed-cost fallacy is to let overhead or depreciation
costs influence short-run decisions. (Froeb, et. al.)
A sunk cost fallacy refers to a company's continuance of
a particular behavior or endeavor because they've
already made an investment. Under their logic,
continuing with their endeavor will ensure the
investment was not wasteful. It's important to note that
it's also possible for them to incur additional losses
going this route.
Example: Football game
 You pay $20 for a ticket. At halftime, your team
is losing by 56 points.
 You say you’ll stay to get your money’s worth,
but you can’t get your money’s worth!
 The ticket price does not vary whether you stay
or leave – it’s a sunk cost and irrelevant.
Hidden Cost
 Are unforeseen expenses added on to purchase.
 All costs associated with either production or
maintenance. When associated with
maintenance, hidden costs represent the loss
associated with unplanned downtime.
 In logistics, hidden costs mean costs which are
almost impossible to determine without a cost
allocation process from the data available in
conventional financial statements.
 Examples are manager's time, inventory
opportunity costs, or interests’ costs over the
period.
Hidden-Cost Fallacy - ignoring relevant costs (costs that
vary with the consequences of your decision) when
making a decision. A common hidden-cost fallacy is to
ignore the opportunity cost of capital when making
investment or shutdown decisions. (Froeb, et.al.)
Example: Football game (again)
 You buy a ticket for $20
 Scalpers are selling tickets for $50 because your
team is playing cross-state rivals
 You go to the game, saying, “These tickets cost
me only $20.” WRONG
 The tickets really cost you $50 because you give
up the opportunity to scalp them by going.
 Unless you value them at $50, you are sitting on
an unconsummated wealth-creating
transaction.
Example: 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
 YES, you are only making $600 a month from
this employee but could make $800 a month
from renting his office.
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.
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.
 Is a measure of a company's financial
performance based on the residual wealth
calculated by deducting its cost of capital from
its operating profit, adjusted for taxes on a cash
basis.
 Can also be referred to as economic profit, as it
attempts to capture the true economic profit of
a company.
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.
 EVA is the incremental difference in the rate of
return (RoR) over a company's cost of capital.
Essentially, it is used to measure the value a
company generates from funds invested in it.
 If a company's EVA is negative, it means the
company is not generating value from the funds
invested into the business.
 Conversely, a positive EVA shows a company is
producing value from the funds invested in it.
Calculating for EVA
EVA = NOPAT - (Invested Capital * WACC)
Where:
 NOPAT = Net operating profit after taxes
 Invested capital = Debt + capital leases +
shareholders' equity
 WACC = Weighted average cost of capital
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.”
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.
 The endowment effect – means that taking
ownership of item causes owner to increase
value she places on the item. This bias tends to
make sellers bid the price of their items higher
than would buyers.
 Loss aversion – individuals would pay more to
avoid loss than to realize gains.
 Confirmation bias – a tendency to gather
information that confirms your prior beliefs,
and to ignore information that contradicts
them. One way to avoid this is to let the
objective others collect information for you
and present their own evaluation or judgment
on the matter.
  Anchoring bias – relates the effects of how
information is presented or “framed”. To avoid
this bias, the decision maker should be guided
by his own frame of analysis, or establish
objective standard, or measures to evaluate the
worthiness of an information.
 Overconfidence bias – the tendency to place
too much confidence in the accuracy of your
analysis. The way to avoid this is to gather
analysis or ideas from others with adequate
competence/expertise on the matter.
Management meetings that brainstorm on company
matters is a way to avoid biases in decision making such
as the preceding ones.
Explicit Costs & Implicit Costs
Explicit Costs
 Explicit costs are normal business costs that
appear in the general ledger and directly
affect a company's profitability.
 Explicit costs have clearly defined dollar
amounts, which flow through to the income
statement.
 Examples of explicit costs include wages,
lease payments, utilities, raw materials, and
other direct costs.
 Accounting costs represent anything your
business has paid for.
 You can calculate accounting cost by
subtracting your expenses from your
revenue.
 Includes explicit costs, they are direct costs
associated with your business.
 Any other expenses incurred during the
normal course of business.
 Used for a specific period of time.
 Used for tax purposes, to determine
financial health of your business.
Economic Costs
 Economic costs represent any “what-if”
scenarios for your business.
 Economic cost is calculated by taking your
accounting cost, which has already been
calculated, and also subtracting any implicit
costs.
 Considers both explicit and implicit costs.
 Used to make long-term strategic decisions for
a long-term frame.

Implicit Costs

 An implicit cost is a cost that exists without

the exchange of cash and is not recorded
for accounting purposes.
 Implicit costs represent the loss of income
but do not represent a loss of profit.
 These costs are in contrast to explicit costs,
which represent money exchanged or the
use of tangible resources by a company.
 Examples of implicit costs include a small
business owner who may forgo a salary in
the early stages of operations to increase
revenue.
 an implicit cost comes from the use of an
asset, rather than renting or buying it.

Accounting Costs