Lecture #3: Topic #1
Benefits, Costs, and
Lecture 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.
Lecture 3 – Summary (cont.)
• Accounting profit does not necessarily correspond to real or
• 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
• EVA® is a measure of financial performance that makes
explicit 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.
Background: Types of costs
• Definition: Fixed costs do not vary with the
amount of output.
• Definition: Variable costs change as output
• 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
• Are these costs fixed or variable?
• Payments to your accountants to prepare your
• 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
• Typical income statements include explicit costs:
• Costs paid to its suppliers for product ingredients
• General operating expenses, like salaries to factory managers and
• Depreciation expenses related to investments in buildings and
• 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
• “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
• 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,
• 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
• 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
• Discussion: outsourcing agitator production
• Diagnose problem using Decisions rights; evaluation metric;
• Try to fix it: how do you better align the incentives of the plant
managers with the profitability goals of the company?
• Definition: ignoring relevant costs when making a
• 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-
• 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
• 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
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
• Discussion: can you make mistakes using EVA?
• Does it help avoid the hidden cost fallacy?
• Does it help avoid the fixed cost fallacy?
• 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
• 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
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
• At the time, soft drink division was earning 16 percent return on
• 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
Lecture 3: Topic #2
Extent (How Much)
Marginal Revenue, Costs
(Average and Marginal)
Remember, We always think
on the MARGIN
Lecture 3: Topic 2 – Summary of
• 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
• Marginal cost (MC) is the additional cost
incurred by producing and selling one more
Lecture 3: Topic #2 – Summary
• 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
• The financial crisis began in the subprime housing market,
where government policies encouraged lenders to extend
credit to low-income borrowers (by lowering lending
• 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
• Marginal costs are what matter in extent
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
• So, produce more when MR>MC; less when
MR<MC. Profits are maximized when
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
• 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
• 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
• Estimated MCPH = $100= ($10,000 / 100)
• So, to get one more customer costs $50 for TV and $100 for
• 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
• 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
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 +
• Profits increased 74% to $1.2 M
• Compensation increased $75K $177K
• Discussion: what are the disadvantages to incentive
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
• 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
• 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 lecture, we show
you how to make profitable extent decisions.
Lecture 3: (Okay Maybe 4),
Summary of main points
• Aggregate demand or market demand is the total number of units
that will be purchased by a group of consumers at a given price.
• Pricing is an extent decision. Reduce price (increase quantity) if MR
> MC. Increase price (reduce quantity) if MR < MC. The optimal
price is where MR = MC.
• Price elasticity of demand, e = (% change in quantity demanded)
÷ (% change in price)
• Estimated price elasticity = [(Q1 - Q2)/(Q1 + Q2)] ÷ [(P1 - P2)/(P1 + P2)] is
used to estimate demand from a price and quantity change.
• If |e| > 1, demand is elastic; if |e| < 1, demand is inelastic.
• %ΔRevenue ≈ %ΔPrice + %ΔQuantity
• Elastic Demand (|e| > 1): Quantity changes more than price.
• Inelastic Demand (|e| < 1): Quantity changes less than price.
• MR > MC implies that (P - MC)/P > 1/|e|; in words, if the actual
markup is bigger than the desired markup, reduce price
• Equivalently, sell more
• Four factors make demand more elastic:
• Products with close substitutes (or distant complements) have more
• Demand for brands is more elastic than industry demand.
• In the long run, demand becomes more elastic.
• As price increases, demand becomes more elastic.
• Income elasticity, cross-price elasticity, and advertising
elasticity are measures of how changes in these other factors
• It is possible to use elasticity to forecast changes in demand:
%ΔQuantity ≈ (factor elasticity)*(%ΔFactor).
• Stay-even analysis can be used to determine the volume
required to offset a change in costs or prices.
Introductory anecdote: Gas prices
• US: From early 2007 to mid 2008 gas prices rose in the US.
• Gas prices caused people to find alternate methods of work and
travel to avoid using gas.
• Some farms began using mules instead of tractors
• India: In Rajasthan, the rising gas prices caused many farmers
to switch from tractors to camels on farms.
• As oil prices rose, demand for camels increased.
• Prices for camels tripled over a two-year period.
• A US company, NNS, that produces potash fertilizer experienced
an increase in input costs due to their use of petrochemicals.
• NNS doubled the price of the generic fertilizer, and priced it’s
branded fertilizer at a 35% premium above the generic price.
• Costs increased rapidly over the first two quarters combined with
NNS’s policy of quarterly price revision led to stockouts and a price
that ended up being 25% below the generic – NNS could have earned
$13 million but failed to maintain their premium
Background: consumer surplus
and demand curves
• First Law of Demand - consumers demand (purchase)
more as price falls, assuming other factors are held
• Consumers make consumption decisions using marginal
analysis, consume more if marginal value > price
• But, the marginal value of consuming each subsequent
unit diminishes the more you consume.
• Consumer surplus = value to consumer - price paid
• Definition: Demand curves are functions that relate
the price of a product to the quantity demanded by
Background: consumer surplus
and demand curves (cont.)
• Hot dog consumer
• Values first dog at $5, next at $4 . . . fifth at $1
• Note that if hot dogs price is $3, consumer will
purchase 3 hot dogs
Background: aggregate demand
• Aggregate Demand: the buying behavior of a group of consumers; a
total of all the individual demand curves.
• To construct demand, sort by value.
Price Quantity Revenue Revenue
$7.00 1 $7.00 $7.00
$6.00 2 $12.00 $5.00
$5.00 3 $15.00 $3.00
$4.00 4 $16.00 $1.00
$3.00 5 $15.00 -$1.00
$2.00 6 $12.00 -$3.00
$1.00 7 $7.00 -$5.00
• Discussion: Why do aggregate demand curves slope downward?
• Role of heterogeneity?
• How to estimate?