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Benefits, Costs, and Decisions

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CHAPTER

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.

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.

continued

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.

continued

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.

Big Coal Solution

Use our three questions for analysis

Who is making the bad decision?

The plant manager made the switch to the lower-priced 8400 coal.

Did he have enough information to make a good decision?

Yes, presumably he knew that this would reduce his output.

Did he have the incentive to make a good decision?

No, because he was evaluated based on the average cost of electricity produced at his plant.

Lesson From Coal Problem

The plant manager should have considered all the costs of switching to the lower Btu coal

Namely, the lost electricity

Average costs can be a poor measure of plant performance

Need to align incentives of a business unit with the goals of the parent company

Background: Types of Costs

Definition: Fixed costs do not vary with the amount of output.

Definition: Variable costs change as output changes.

FIGURE 3.1 Cost Curves

Example: A Candy Factory

The cost of the factory is fixed.

Employee pay and cost of ingredients are variable costs.

TABLE 3.1 Candy Factory Costs

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.

Real 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.

In 1997, Cadbury adopted Economic Value Added (EVA)®

Charges each division within a firm for the amount of capital it uses

Provides an incentive for management to reduce capital expenditures if they do not cover costs

Senior managers then decided to sell the unused apartments after seeing the implicit cost of capital.

Accounting Costs for Cadbury

TABLE 3.2 Cadbury Income Statement

Cadbury Accounting Profit

Accounting profit recognizes only 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

Cadbury Accounting Profit vs. Economic Profit

What’s missing from Cadbury’s 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

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.

Identifying Costs

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

Apply it to Cadbury:

The cost of the company of holding onto the apartments was the forgone opportunity to invest capital in the company’s organization to earn a higher return.

Cadbury’s Costs

Holding on to the flats cost the company £600,000 each year.

Unless the benefits to the company of holding onto the apartments were at least £600,000, the capital was not employed in its highest-valued use.

The cost of the company of holding onto the apartments was the forgone opportunity to invest capital in the company’s organization to earn a higher return.

By selling the flats, the company moved the capital to a higher-valued use.

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: The fixed-cost/sunk-cost fallacy means you make decisions using irrelevant costs and benefits

Fixed-Cost/Sunk-Cost Fallacy Examples

Football game:

You pay $20 for a ticket. At halftime, you’re 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.

Launching a new product:

You are in a new products division and will be able to distribute a new product through your existing sales force

You will be forced to pay for a portion of the sales force

If you believe this “overhead” is big enough to deter an otherwise profitable product launch, then you’ve committed the sunk-cost fallacy

Hidden-Cost Fallacy

Definition: ignoring relevant costs (costs that vary with the consequences of your decision) when making a decision

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 didnt 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 (1)

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 (2)

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

The 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