Any Questions from Last Class?

Chapter 3Benefits, Costs, and Decisions

COPYRIGHT © 2008Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Chapter 3 – Take Aways

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 – Take Aways

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 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.

Review of Chapter 2

Voluntary transactions create wealth Anything that impedes the movement of

assets destroys wealth. The art of business consists of identifying

assets in lower valued uses, and devising ways to profitably move them to higher valued uses.

Companies create wealth

Introductory Anecdote: Cadbury (Bombay) Anecdote

1978 Cadbury offered Bombay apartments to managers 1991 Cadbury added low-interest housing loans 1997 adopted EVA®

Capital charge appeared on division income statement $600,000=(15%)$4,000,000

What happened? Discussion: diagnose problem

Discussion: fix it

Background: Types of Costs

Fixed costs do not vary with the amount of output Variable costs change as output changes Candy factory example

Factory is fixed cost Employees and ingredients are variable 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

Total, Fixed, and Variable Costs

Output Level

Pro

du

ctio

n C

ost

s

Fixed Costs

Total Costs Variable Costs

Background: Accounting vs. Economic Cost Typical income statement costs (explicit)

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 (implicit)? 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

does not

Accounting Costs

Opportunity Costs & Decisions Goal: make decisions that increase profit

If profit of an action is greater than alternative, pursue it.

Definition: opportunity cost of an action is forgone profit of alternative. Implies decision rule and vice-versa Alternatives vary with decisions, as do costs

Discussion: opportunity cost of capital To Bombay division To company 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 only make two mistakes as you make decisions You can consider irrelevant costs You can ignore relevant ones

Fixed-Cost Fallacy Definition: consider irrelevant costs

Football game example – how does ticket price impact your decision to stay or leave at halftime?

Launching a new product Discussion: does your company include “overhead” in transfer prices?

Discussion: outsourcing agitator

Diagnose problem

Decisions rights; evaluation metric; compensation scheme, GOAL ALIGNMENT!!!

INTERNAL PRODUCTION

OUTSOURCING

Category Cost Category Cost Material $0.60 Material $0.50 Labor $0.20 Labor $0.10 Depreciation $0.10 Tooling $0.10 Other overhead $0.10

Hidden-Cost Fallacy

Definition: ignore relevant costs Example: another football game

Discussion: should you fire an employee? (Rev=$2,500, wages=$1,900, rent=$800)

Discussion: give example of the hidden-cost fallacy.

Hidden Cost of Capital

Recall that accounting profit does not necessarily correspond to economic profit

Example: Making the hidden cost of capital explicit Discussion:

EVA®=net operating profit after taxes minus the cost of capital times the amount of capital utilized

Helps avoid committing the hidden cost fallacy

Major benefit: if you cannot measure something, you cannot control it. Those who control costs are held 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? Hidden cost fallacy? 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?

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 could have been earned by investing in soft drinks A dollar invested in aquaculture and wine is a dollar that can not be

invested in soft drinks Divisions sold off and proceeds invested in core soft drink business