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					Opportunity Cost, Profits, and Value

       Shyam Sunder, Yale University
   Zhytomyr State Technological University
                 Zhytomyr
               May 18, 2006
                   An Overview
• Opportunity costs is the concept of cost necessary
  for economic decisions
     – Explore its nature and measurement for different kinds
       of resources
• Economic profit, the appropriate criterion for
  choice, depends on opportunity cost, and different
  from various agents
• Value is the capitalization of profit
• Value of the organization can be viewed as the
  some of the value generated for all participating
  agents
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            What Is Opportunity Cost?
• Sometimes it is easier to understand a concept
  starting out what it is not
• Usually we think of costs as out-of-pocket costs
     – $1 (cost of a cup of coffee)
     – $20,000 (cost of a car)
• At the time we make the decision to buy the cup
  of coffee or the car, this out-of-pocket cost is also
  (usually) the opportunity cost
• With the passage of time, the two tend to diverge
  from each other
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                 Opportunity Costs
• How are opportunity costs different from out-of-pocket
  costs?
     – Opportunity cost of choosing a decision (e.g., choosing A over B)
       is the sacrifice we make by not choosing B
     – Costs that were never, and would never, be incurred
     – Subjective, hypothetical (what might have been), speculative and
       uncertain, must be estimated
     – Opportunity cost has no existence apart from a decision problem
     – It is associated with the “road not taken”
• Why should such costs count in our decisions?
• Let us see a simple example

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     Example of Opportunity Cost
• An old painting bought for $5
• You plan to give it to a friend
• Just before you give it to your friend, you
  find out that it is a rare painting by an old
  master which costs $5,000
• What is the cost of giving the painting to
  your friend?

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              More Examples
•   Cost of material with no other use
•   Cost of material with other uses
•   Cost of material not yet bought
•   Interest on inventory
•   Cost of labor
•   Cost of capacity
•   Cost of excess capacity
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  Decision with Opportunity Cost
• Example illustrates that we can use one of two
  methods
     – Calculate the net benefit of each available option and
       pick the better one
     – Calculate the net benefit of one option, after subtracting
       the net benefit of the other option as the opportunity
       cost
• If we calculate correctly, the decision would be
  the same from both methods of making decisions

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      Opportunity Cost Illustration
                                       Customer A           Customer B
Benefit (Revenue)                100                  115
Costs
    Manufacturing                      40                   40
    Service                            20                   35
    Warranty                           15                   20
Total                            75                  95
Net Proceeds                     25 =                20 =
                                 (100 – (40+20+15)) (115 – (40+35+20))
Net Advantage of A over B        25 – 20 = 5
In opportunity cost format       100 – (40+20+15) –20 = 5
In either case decision is the
same

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            Contrast with Sunk Costs
• One person buys a ticket to see the
  Olympics final of soccer for 200 dollars
• A second person gets the ticket for free
  from a friend who has an emergency
• Severe weather is predicted for the day of
  the game
• Which person is more likely to attend the
  game? Why?
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     Measuring Opportunity Costs
In single person contexts,
• use subjective or objective probability to model and solve
   the decision problem
In multiperson contexts,
• Absence of objective measures of opportunity costs
   exacerbates agency costs
In either case, reduction in subjectivity of opportunity cost
   estimates may help make better decisions
Perhaps we can use public information to reduce subjectivity
   in measured opportunity costs

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 How resources behave with time
 may have to do with the problems
  of estimating opportunity costs

• Cash, being a timeless resource, offers no
  problems (or perhaps merely because it is
  defined as the numeraire)
• Let us explore the time dimension of
  resources


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     How Do Resources Behave Over
               Time?

• In acquisition
• In expiration of their benefits
• In consumption of their benefits




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       Resources Vary in Their
    Lumpiness or Granularity Along
        All Three Dimensions

•   Let us look at their
•   Acquisition granularity
•   Expiration granularity
•   Consumption granularity



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            Acquisition Granularity
Three crude classes:
• Low (electrical power, contract labor)
     – Acquisition and utilization are proximate
     – Not inventoried, JIT
• Medium (groceries)
     – Economic order quantity (EOQ) Model
• High (car, house, machinery and plant)
• One-off
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            Determinants of Acquisition
                   Granularity

• Transaction costs
• Storage costs
• Technology of supply




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            Expiration Granularity
•   Same as storability
•   Low (highway sign, receptionist)
•   Medium (bag of sugar, fruit, car)
•   High (gold bar)
•   Note: Distinguish expiration granularity or
    storability from the rate of expiration of
    benefits
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            Consumption Granularity
            (Closely linked to expiration
                    granularity)

• Extent of owner's control over the rate of
  extraction of benefits
• Low (street sign, gold ring)
• Medium (car)
• High (sugar, production gold)

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            Cross Tabulation


                         Consumption Granularity
                    (Range of controllability of the rate
                             of consumption)
                    Low        Medium High
 Expiration    Low  Road sign House? Duracell
 Granularity Medium Software   Car         Fresh fruit?
 (Storability) High Gold ring Oil field Steel bar


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                     Decisions
•   Consider a decision
•   List options
•   List resource consequences of options
•   For each resource, consider
•   Acquisition Granularity
     – If low, OC = purchase price
     – If high, consider expiration granularity of each
       relevant attribute of the resource
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            Decisions (Continued)
• Expiration granularity
     – If low, it is a pure capacity resource; Use time
       as the cost driver,
     – If high, consider consumption granularity of
       each attribute of the




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            Decisions (Continued)
• Consumption granularity
     – List driver for each attribute i
     – For each attribute/driver i calculate cost/unit ci
     – If a product consumes ui units of attribute i,
       cost of the resource assigned to the product =
       maxi (ciui)



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            Example: Rental Car
•   Cost (net of salvage value) = $24,000
•   Attribute 1: Time (Capacity 600 days)
•   Attribute 2: Mileage (Capacity 60,000 m)
•   Time Rate: $24,000/600 = $40 per day
•   Mil. Rate: $24,000/60,000 = $0.40 per m.
•   Cost of rental = max ($40.Days, $0.40.
    miles)
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                     Profits
• Economic profit of an agent from a decision is the
  revenue less the opportunity cost of the decision
• The profit from participation in an organization
  can be defined not only for the shareholders but
  for every participating agent
• We can determine who gets how much profit and
  what is the total profit generated by an
  organization for all participants combined

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            Neoclassical Firm

• Firm is the instrument of the owner- entrepreneur
• Every other agent gets the opportunity cost of the
  resource he/she contributes (i.e. no goodies)
   – All these factor markets are assumed to be
     perfectly competitive
• All the surplus goes to the owner-entrepreneur
• Value of the firm is the discounted present value
  of cash flows to the owner
• IRR = O.C. of capital => zero value
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 Contract or Organization Theory
If the total surplus is negative the firm is infeasible;
   redesign the contracts or shut down
• If the total surplus is zero, there is a unique
   distribution in which everyone gets zero surplus
• If the total surplus is positive, there are multiple
   feasible allocations. There is no basis for
   choosing one allocation over another. Therefore,
   the distribution of surplus among agents is
   undetermined
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            Firm as a Set of Contracts
                                   Managers
                                   nagerssss
                  Shareholder
                  s                                    Government



               Creditors
                                                           Auditors



                Employees
                                                      Vendors

                                Customers

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              A Brief Detour
•   Am I talking about “social accounting?”
•   Yes, there are some common elements
•   But it differs in perspective
•   Let us do a brief overview of social
    accounting



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            Social Accounting
• Also called socioeconomic accounting, social
  responsibility accounting and social audit
• Measure and report efforts, achievements and
  impact of firms on “social” dimensions
• E.g., energy conservation, minority hiring,
  environmental preservation, support of community
  organizations (see Appendix A)
• Often descriptive, may include financial and non-
  financial data

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            Typical Elements of Social
                    Accounts
• A. Community Involvement: General philanthropy, Public and
  private transportation, Health services, Housing, Aid in personal
  and business problems, Community planning and improvement,
  Volunteer activities, Specialized food programs, Education,
• B. Human Resources: Employment practices, Training
  programs, Promotion policies, Employment continuity,
  Remuneration, Working conditions, Drugs and alcohol, Job
  enrichment, Communications,
• C. Physical Resources and Environmental Contributions: Air,
  Water, Sound, Solid waste, Use of scarce resources, Aesthetics
• D. Product or Service Contributions: Labeling, Warranty,
  Responsiveness to consumer complaints, Consumer education,
  Product quality, Product safety, Advertising, Constructive
  research
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   Examples of Social Accounting
• Tradecraft,
  http://www.globalnet.co.uk/~traidcraft/sa9495/index.ht
  ml
• British Telecom,
  http://www.groupbt.com/society/index.htm
• General Motors,
  http://www.gm.com/company/gmability/environment/e
  nv_annual_report/index.html
• Intel http://www.intel.com/intel/finance/social.htm
• United Airlines
  http://www.ual.com/site/primary/0,10017,1359,00.htm
  l
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    Social Accounting Perspective
• “Social” is construed narrowly, leaves out
  production, sale and distribution of goods and
  services, taken for granted
• Managers responsible for preparing the social
  accounts
• Information inherently dispersed
• Uses perspective of the firm, not the members of
  society
• Fuzzy image

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            Profit/Value of the Firm
•   Extensive income as the sum of:
•   To the shareholders
•   To customers
•   To Vendors
•   To employees
•   To creditors
•   To government
•   To community, etc.
•   Inducement from the firm – O.C. of contributions
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            Profit/Value to Investors
• Residual income and corresponding
  shareholder value created
• Focus of current financial reports
• Apply similar perspective to other
  participants in the firm



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      Profit/Value to Customers
• Customer’s “investment” in the form in the form
    of search, learning, negotiation, payments,
    settlement of disputes
• Expected PV of benefits from goods received
    should exceed the PV of investments
• Includes immediate transaction as well as the
    consequences of the transaction for resource flows
    associated with any future transactions (reduction
    in time, cost, search etc. for later transactions)
• In a perfect product market, consumer’s surplus
                         Value of the be
    from the firm is zero (mayFirm +ve from industry) 34
7/20/2010
         Value to Government
• Various levels of government provide mostly non-
    priced services plus some priced goods
• Resources from taxation
• Value of the firm to the government from
    providing priced services is the same as for
    vendors
• Value of the firm to the government from
    providing non-priced services is taxes plus fees
    minus O.C. of resources spent on providing
    services
• Major challenge to put of the Firm practice
7/20/2010               Value this in                35
 Value of the Firm to Community
• Local, national and global
• Most exchanges in form of externalities
• Value of the firm to the community is the
  sum of net externalities plus the net
  payments



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      Measurement of Profit/Value
• J.M. Clark (1936): Three fundamental
  challenges to determining the value of
  private enterprise
     – Imperfect and incomplete markets
     – Fundamental values not as exact as market
       values
     – Fundamental concepts should be independent
       of specific institutions of exchange (generality)
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  Markets and Value of the Firm
• In a perfect market Law of one price holds,
    everyone gets the same price
• Value to the supplier of factor is zero
• Existence of value =>market imperfection
• Perfection can be the tendency of markets under
    certain conditions, not the goal of any agent
• Agents seek and create imperfections
    (specialization, differentiation, monopolies)
• Value creation as a treadmill, not ski lift
• Market frictions/trans. Costs create room for value
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Externalities in Value of the Firm
• Difficult problems of measurement because
  there is no help from markets
• Most organizations produce and consume
  public goods
• Extensive concept of income includes the
  value of these benefits consumed and
  bestowed on the community

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            Difficulties of Measuring
                  Externalities
• Example: Vans to transport employees from train station
• Cost of service to the firm, and benefits of lowered costs of
  parking, absenteeism, morale, etc.
• Employee savings: cash, time, fatigue, etc. best estimated
  by employees
• Benefits to fellow commuters, local government, citizens
• Lump together as community, apply social cost-benefit
  analysis to determine income to community
• Sensitive to identity of preparer
• Valuation: social rate of discount lower than private

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            Implications: Mergers and
                  Acquisitions
• Extensive debates surrounding the consequences of
  corporate mergers and acquisitions
• Empirical studies: Target firm shareholders gain,
• Acquiring firm shareholders’ wealth effect not clear
• Occasional attention to bondholders, and tax consequences
• Effects on labor, customers, vendors, community rarely
  examined
• What kind of policy decisions possible on the basis of
  shareholder value alone?

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       Justification for Shareholder
              Value Criterion
• Assume neoclassical model of the firm (all
  surplus always goes to the owner,
  income/value to all other agents is zero both
  before and after the event): no need to look
  at the effects on any other class of agents
• Capital markets are said to be efficient, at
  least more perfect than other factor markets
• Contradiction between the two assumptions

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            Who Gets the Goodies?
• Agents who transact in relatively perfect markets
  should get prices close to O.C.
• U.S. capital markets said to be more perfect than
  others
• Suppliers of capital should be expected to get
  close to their O.C.
• Surplus/value of the firm should accrue mostly to
  agents who transact through less perfect markets
• Yet, we assume that the surplus goes to the
  shareholders
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            Contract Renegotiation
• Shareholders have the only open-ended contract in the firm
• All other contracts are periodically renegotiated; these
  agents try to capture a share of the surplus whenever
  possible
• Short term contract agents have an option value that
  shareholders lack
• Shareholders (as a group) and unvested pensioners cannot
  quit when faced with having to absorb negative surplus
• Many mergers and acquisitions are followed by contract
  renegotiations
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        Need Analysis of Extensive
           Income and Values
• For policy, need analysis of income/values to all agents,
  not just shareholders
• Given their long term inflexible contract, imperfections in
  corporate governance, they may not be able to capture all,
  or even most, of the ex post benefits of value-enhancing
  mergers and acquisitions
• Possible leakage to other agents through market
  imperfections, holes in corporate governance when value is
  enhanced
• Shareholders left holding the bag on depletion
• Would not know without analysis of extensive
  income/value of the firm
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  Shareholder Value As Guide for
        Accounting Policy
• Event, ERC, Value-Relevance, R2 studies
  cited as justifications for accounting policy
• What is the theoretical justification for
  using shareholder value for this purpose
  (other than neoclassical perspective)
• Law of the Instrument (Kaplan): Use
  whatever data is available, extensive
  income/value measures unavailable

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            Concluding Remarks
• Neoclassical perspective is not useful for
  analyzing many accounting issues
• Income and value concepts driven by this
  perspective have their limitations, and
  contradictions
• For important classes of accounting matters, we
  may need extensive concepts of income and value
• Lessons from national income accounting

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                Thank you
• The presentation will be available for
  downloading from
• www.som.yale.edu/faculty/sunder
• Please send your comments to
• Shyam.Sunder@yale.edu



7/20/2010          Value of the Firm       48

				
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