Froeb3e 03a

Chapter 3
11
Benefits, Costs,
and 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 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.
Chapter 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
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.
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.
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
Production Costs
Total Costs Variable Costs
Fixed Costs
Output Level
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?
Does EVA® work?
• 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?
• NO, cheaper to use existing plans
• Goal alignment, YES.
• EVA® is no better or worse
• Rival EPP’s
• Bonus plans
• Discussion: WHY?
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
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?
A. $0;
B. $10;
C. $40;
D. $50
In class problem (1)
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?
A. $0;
B. $10;
C. $40;
D. $50
In class problem (2)
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?
A. $0;
B. $10;
C. $40;
D. $50
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

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Chapter 3

Total Costs Variable Costs

• Discussion: does your company include “overhead”

• Discussion: outsourcing agitator production

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