Froeb3e 04a

Chapter 4
11
Extent (How
Much) Decisions
1
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.
Chapter 4 – 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.
Chapter 4 – Summary (cont.)
• 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
• Discussion: give example of royalty rate or
fixed fee contracts in your firm
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 chapter, we show
you how to make profitable extent decisions.

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Chapter 4

• FC does not change as Q increases

• Average costs are not relevant to extent decisions

• Discussion: How much advertising?

• If the marginal revenue generated by this customer is

• Advice: make changes one-at-a-time to gather valuable

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