Benefits, Costs, and Decisions 3 1. Who is making the bad decision?

 The plant manager made the switch to

 Costs are associated with decisions, not the lower-priced 8400 coal.
activities. 2. Did he have enough information to make a good
 The opportunity cost of an alternative is the decision?
profit you give up to pursue it.  Yes, presumably he knew that this
 In computing costs and benefits, consider all would reduce his output.
costs and benefits that vary with the 3. Did he have the incentive to make a good
consequences of a decision and only those costs decision?
and benefits that vary with the consequences of  No, because he was evaluated based
the decision. These are the relevant costs and on the average cost of electricity
benefits of a decision. produced at his plant.
 Fixed costs do not vary with the amount of
output. Variable costs change as output Lesson From Coal Problem
changes. Decisions that change output will  The plant manager should have considered all
change only variable costs. the costs of switching to the lower Btu coal
 Namely, the lost electricity
 Accounting profit does not necessarily  Average costs can be a poor measure of plant
correspond to real or economic profit. performance
 The fixed-cost fallacy or sunk-cost fallacy  Need to align incentives of a business unit with
means that you consider irrelevant costs. A the goals of the parent company
common fixed-cost fallacy is to let overhead or
depreciation costs influence short-run decisions. Background: Types of Costs
 The hidden-cost fallacy occurs when you ignore  Definition: Fixed costs do not vary with the
relevant costs. A common hidden-cost fallacy is amount of output.
to ignore the opportunity cost of capital when  Definition: Variable costs change as output
making investment or shutdown decisions. changes.

 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.
Example: A Candy Factory
Big Coal Power Company  The cost of the factory is fixed.
Big Coal Power Co. switched to a 8400 coal when the  Employee pay and cost of ingredients are
price fell 5% below the price of 8800 coal variable costs.
 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.

Your Turn

Big Coal Solution Are these costs fixed or variable?

 Payments to your accountants to prepare your
Use our three questions for analysis tax returns.
 Electricity to run the candy making machines.
  Fees to design the packaging of your candy bar.  Stockholders expect a certain return on
 Costs of material for packaging. their money (they could have invested
elsewhere)
Real Example: Cadbury (Bombay)  “Profit” should recognize whether firm
 Beginning in 1978, Cadbury offered managers is generating a return beyond
free housing in company owned flats to offset shareholders expected return
the high cost of living.  Economic profit recognizes these implicit costs;
 In 1991, Cadbury added low-interest housing accounting profit recognizes only explicit costs
loans to its benefits package. Managers moved
out of the company housing and purchased Opportunity Costs & Decisions
houses. The empty company flats remained on Definition: the opportunity cost of an action is what you
Cadbury’s balance sheet for 6 years. give up (forgone profit) to pursue it.
 In 1997, Cadbury adopted Economic Value  Costs imply decision-making rules and vice-
Added (EVA)® versa
 Charges each division within a firm for  The goal is to make decisions that increase
the amount of capital it uses profit
 Provides an incentive for management  If the profit of an action is greater than the
to reduce capital expenditures if they alternative, pursue it.
do not cover costs
 Senior managers then decided to sell the unused Identifying Costs
apartments after seeing the implicit cost of  Whenever you get confused by costs, step back
capital. and ask, “What decision am I trying to make?”
 If you start with costs, you will always
Accounting Costs for Cadbury 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
Cadbury Accounting Profit use.
 Accounting profit recognizes only explicit costs  The cost of the company of holding onto the
 Typical income statements include explicit apartments was the forgone opportunity to
costs: invest capital in the company’s organization to
 Costs paid to its suppliers for product earn a higher return.
inputs  By selling the flats, the company moved the
 General operating expenses, like capital to a higher-valued use.
salaries to factory managers and
marketing expenses
 Depreciation expenses related to
investments in buildings and equipment
 Interest payments on borrowed funds Relevant Costs and Benefits
 When making decisions, you should consider all
Cadbury Accounting Profit vs. Economic Profit costs and benefits that vary with the
 What’s missing from Cadbury’s statements are consequence of a decision and only costs and
implicit costs: benefits that vary with the decision.
 Payments to other capital suppliers  These are the relevant costs and relevant
(stockholders) benefits of a decision.
 You can make only two mistakes
  You can consider irrelevant costs  The subprime mortgage crisis of 2008 is a good
 You can ignore relevant ones example
 Definition: The fixed-cost/sunk-cost fallacy of the hidden-cost fallacy.
means you make decisions using irrelevant costs  Credit-rating agencies failed to recognize the
and benefits higher costs
of loans made by dubious lenders.
Fixed-Cost/Sunk-Cost Fallacy Examples  Example: Long Beach Financial
Football game:  Gave loans out to homeowners with
 You pay $20 for a ticket. At halftime, you’re bad credit, asked for no proof of
team is losing by 56 points. income, deferred interest payments as
 You say you’ll stay to get your money’s worth, long as possible.
but you can’t get your money’s worth!  Credit ratings didnt reflect the hidden costs of
 The ticket price does not vary whether you stay risky loans
or leave – it’s a sunk cost and irrelevant.  As a result, many Wall Street investors
Launching a new product: purchased packaged risky loans and eventually
 You are in a new products division and will be went bankrupt when the debtors defaulted.
able to distribute a new product through your
existing sales force Hidden cost of capital
 You will be forced to pay for a portion of the  Recall that accounting profit does not
sales force necessarily correspond to economic profit.
 If you believe this “overhead” is big enough to  Discussion: Economic Value Added
deter an otherwise profitable product launch,  EVA®= net operating profit after taxes
then you’ve committed the sunk-cost fallacy minus the cost of capital times the
amount of capital utilized
Hidden-Cost Fallacy  Makes visible the hidden cost of capital
Definition: ignoring relevant costs (costs that vary with  The major benefit of EVA is identifying costs.
the consequences of your decision) when making a If you cannot measure something, you cannot
decision control it.
 Those who control costs should be responsible
Example: Football game (again) for them.
 You buy a ticket for $20
 Scalpers are selling tickets for $50 because your Incentives and EVA®
team is playing cross-state rivals  Goal alignment: “By taking all capital costs
 You go to the game, saying, “These tickets cost into account, including the cost of equity, EVA
me only $20.” WRONG shows the dollar amount of wealth a business
 The tickets really cost you $50 because you give has created or destroyed in each reporting
up the opportunity to scalp them by going period.
 Unless you value them at $50, you are sitting on … EVA is profit the way shareholders define it.”
an unconsummated wealth-creating transaction  Discussion: can you make mistakes using EVA?
 Does it help avoid the hidden cost
fallacy?
 Does it help avoid the fixed cost
fallacy?

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
Does EVA® work? You won a free ticket to see an Eric Clapton concert
 Adopting companies of EPP’s (+ four years) (which has no resale value). Bob Dylan is performing on
 ROA from 3.5 to 4.7% the same night and is your next-best alternative activity.
 operating income/assets from 15.8 to Tickets to see Dylan cost $40. On any given day, you
16.7% would be willing to pay up to $50 to see Dylan. Assume
 Indistinguishable from non-adopters there are no other costs of seeing either performer. Based
 Bonuses increase 39.1% for EVA® on this information, what is the minimum amount (in
firms dollars) you would have to value seeing Eric Clapton
 But 37.4% for control group for you to choose his concert?
 Interpretations A. $0 B. $10 C. $40 D. $50
 Selection bias?
 NO, cheaper to use existing plans Alternate intro anecdote
 Goal alignment, YES.  Coca-Cola in the 1980s had very little debt,
 EVA® is no better or worse preferring to raise equity capital from its
stockholders
 Rival EPP’s
 The company had a diversified product line,
 Bonus plans
including products like aquaculture and wine.
 Discussion: WHY? These other businesses generated positive
profits, earning a ten percent return on capital
Psychological Biases invested.
 Not enough information or bad incentives are  The company, however, decided to sell off these
not the only causes for business mistakes. Often “under-performing businesses”
psychological biases get in the way of rational  Why?
decision making.
 At the time, soft drink division was
 Definition: the endowment effect means that
earning 16 percent return on capital
taking ownership of item causes owner to
 The “opportunity cost” of investing in
increase value she places on the item.
aquaculture and wine is the foregone
 Definition: loss aversion – individuals would
profit that could have been earned by
pay more to avoid loss than to realize gains.
investing in soft drinks
 Definition: confirmation bias – a tendency to
gather information that confirms your prior  A dollar invested in aquaculture and
beliefs, and to ignore information that wine is a dollar that was not invested
contradicts them. in soft drinks
 Definition: anchoring bias – relates the effects  Divisions sold off and proceeds
of how information is presented or “framed” invested in core soft drink business
 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)