Chapter 3 – Benefits, Costs, + Decisions
BACKGROUND: VARIABLE, FIXED, + TOTAL COSTS
-Fixed cost: costs that do not vary with output
-Variable cost: costs that change as output levels change
-output levels of zero, both fixed + total costs are greater than zero
-total + variable costs both increase with output + variable costs appear as difference
between total cost curve + fixed cost line
BACKGROUND: ACCOUNTING VERSUS ECONOMIC PROFIT
-economic value added (EVA) gives management an incentive to incur capital
expenditures only if earn more than they cost
-gives managers an incentive to reduce capital expenditures if they are earning less than
they cost
-difference between accounting costs + economic costs take into account the costs of
capital
-Accounting costs: costs that appear on the financial statements of a company
-Implicit costs: additional costs that do not appear on the financial statements of a
company; these costs include items like the opportunity cost of capital
-Interest: cost that creditors charge for use of their capital
-stockholders provide equity, yet income statement reflects no charge for equity
-economic profit tells investors whether they should keep investing in the firm (negative
means firm is earning less than equity holders expect to make from investment)
-firms may show an accounting profit while experiencing an economic loss – two are not
equal because economic profit recognizes both explicit + implicit costs of capital
-by adopting EVA, firm made visible the hidden cost of equity
-managers should consider all benefits + costs of decision
COSTS ARE WHAT YOU GIVE UP
-Opportunity cost/cost: the opportunity cost of an alternative is the profit you give up to
pursue it
-costs depend on what give up + decision trying to make
SUNK-COST FALLACY
-when making decisions, should consider all costs + benefits that vary with the
consequence of a decision + only costs + benefits that vary with the consequence of the
decision – these are the relevant costs + relevant benefits of a decision
-two types of mistakes – consider irrelevant costs or ignore relevant ones
-Sunk-cost fallacy/fixed-cost fallacy: consideration of costs that do not vary with the
consequences of your decision (use irrelevant costs + benefits)
-Sunk cost: costs that cannot be recovered; they are unavoidable even in the long run
-most frequent causes of sunk-cost fallacy is “overhead” allocated to various activities
within a company + depreciation
-accounting profit does not necessarily correspond to economic profit
HIDDEN-COST FALLACY
-mistake to ignore hidden costs
-Hidden-cost fallacy: occurs when you ignore relevant costs, those costs that do vary
with the consequences of your decision
-Relevant costs: all costs that vary with the consequence of a decision
A FINAL WARNING
-recognize the relevant benefits + costs of a decision (sometimes hard to do because
easy to get lost in the data + distracted by irrelevant numbers)
-costs are defined by decisions trying to make
-if begin with the costs, will always get confused; if begin with the decision, never get
confused
-consider the consequences of the decision from company’s point of view
Summary of Main Points
Costs are associated with decisions.
The opportunity cost of an alternative is the profit you give up to pursue it.
Consider all costs + benefits that vary with the consequences of a decision + only costs +
benefits that vary with the consequences of a decision. These are the relevant costs +
benefits of a decision.
Fixed costs do not vary with the amount of output. Variable costs change as output
changes. Decisions that change output change only variable costs.
Accounting profit does not necessarily correspond to 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.
If you begin with by looking at the costs, you will always get confused; if you begin with
the decision you are considering, you will never get confused.
