Lecture 11
Economic Propositions about Costs
1. The higher the selling price of a good, the greater
the amount that producers will offer.
(The Law of Supply)
2. Marginal costs (MC) determine the rate of output
(supply curve).
3. Marginal costs rise (1) at higher production rates
than planned and (2) for quick changes in output.
4. Average Cost (AC) and MC decrease for larger
planned volumes of output. That is, 100 Boeing
787s will cost more per unit than if 1,000 Boeing
787s are made. This is economies of scale or
mass production. Engineering, not economics.
More economic propositions on costs
5. Money prices are measures of costs because the
buyer must pay at least the value of the
resources to their current owners—opportunity
costs. All costs are opportunity costs.
7. Implicit costs exist even if no accounting
expenditure is recorded for a good or service.
8. Cost and revenue should be calculated in terms of
present value (details in Finance class)
Present Value Example
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You can buy a membership in the
Executive Room at airports from an
airline for €125 per year or €300 now
for a 3 year membership. You know you
will use it all three years.
Should you buy the 3 year membership?
It Depends
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It depends on the interest (discount) rate.
If the interest (discount) rate is 5%, buy the 3 year
membership:
PV = €125 + €125/1.05 + €125/(1.05)(1.05)
€357.43 = €125 + €119.05 + €113.38
vs. €300 now
(savings is €57.43 not €75)
What if interest rate is 20%?
Discount or Interest Rates
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Discount rates always exist whether
we calculate them or not.
Money today is always more valuable
than a promise of money in the future.
Paying tomorrow is preferred to
paying today.
This is the time value of money that
represents its opportunity cost.
Suppose Things Change?
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The best plans can be upset by
changes in technology.
What was “state of the art” becomes
obsolete.
Obsolescence is an unanticipated
development that reduces the value of
existing assets.
Obsolescence and Cost
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A machine costs £100,000
It is expected to help produce 10,000 units
of output before it is depreciated to nothing.
If so, then there is a fixed cost of £10 per
unit spread over the units.
Assume other costs (labor and supplies) are
£20 per unit.
Output costs £30 per unit.
Obsolescence and Cost…
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Now a new and better machine comes on the
market. It costs £100,000 also. It is expected
to produce 10,000 units before it is out of
service. Hence, a fixed cost of £10 per unit.
However, it needs only £15 worth of labor and
supplies
Cost per unit output is £25, not £30.
What is the value of the old machine?
Considerations
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The old machine falls in value due to
unexpected obsolescence. Even if old
machine has never been used, the new
machine causes the present value of the old
machine to fall by £50,000 in value.
The old machine is what we have. Should
we sell it? Given changes in the market
price, how long can we continue
production?
Effects of Obsolescence
Old Machine:
Fixed Cost
£10
Variable Cost £20
Total cost: £30/unit
Market
Market
Market
Market
price
price
price
price
for
for
for
for
output
output
output
output
New Machine:
Fixed Cost
£10
Variable Cost £15
Total cost: £25/unit
£27.
£22.
£18.
£13.
What
What
What
What
do
do
do
do
we
we
we
we
do?
do?
do?
do?
Economic Value of Assets
Economic value of an asset requires an estimate
of the net cash flow expected from the asset
(discounted).
Hence, valuation is continuous and is subjective:
an educated guess about expected cash
flows. Past cash flows (accounting data) from
an asset can provide useful information to a
manager in making valuation decisions, but
alone should not drive the decision.
Consider New Asset
Purchase price is accounting value of asset.
Economic value? Higher than accounting value or
would not buy. Expected value in use of asset
must be more valuable than purchase price.
New machine purchased for $35,000 (asset
value).
Estimate machine life of five years with revenue
of $10,000/yr. (discounted 10%/yr.) for net
present value of $37,910.
Profit of $2,910 not recorded.
Changes in Asset Value
We acquired the machine for $35,000 (recorded
value) that had a present value (PV) of $37,910.
Suppose costs rise and cash flow falls to $9,000/yr.
from $10,0000/yr. Then PV falls to $34,120. Or
demand increases and allows us to extend the life
to six years for PV of $43,550. Or discount rate
(alternative investment return) changes to 12%;
then PV falls to $36,050. None of these changes
in economic value cause accounting value to
change. It continues to show initial value
($35,000) depreciated over 5 year expected life.
More Mundane: Small (Marginal)
Changes in Cost Add Up
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Most managerial decisions involve cost changes at the
margin—small changes that can have big impacts.
Starbucks, studying worker time in production, noticed
that employees had to dig twice into ice machines to
get sufficient ice for large drinks. The developed a
new ice scoop that requires one scoop for any size
drink. Time savings of 14 seconds for large drinks.
Working on such margins for 5 years reduced average
waiting time from 3.5 minutes to 3 minutes per
customer (a 15% improvement).
Small Changes Can Mean Higher Profits:
Where Managers Should Make a Difference
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Over five years, such improvements in productivity at
Starbucks (shorter waiting time for customers, so
more sales) meant store sales up an average of
$200,000.
Wendy’s developed a double-sided grill that cuts
cooking time for a hamburger patty from 5 minutes to
1.5 minutes.
Caribou Coffee uses “floater” workers who are not
assigned to one task but help direct others to where
need is greatest and jumps in to help where help is
needed. Added cost of one worker less than added
revenue from faster productivity (more sales).
Opportunity Costs
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“Few firms make a profit.”
Peter Drucker
Why? Most focus on accounting costs,
failing to consider opportunity costs,
so constantly overestimate profits.
Accounting Profit versus
Economic Profit
Accounting Profit = Sales Revenue – Accounting Cost
Economic Profit = Sales Revenue – Economic Cost
Economic Cost = Accounting Cost + Unrecorded
Opportunity Cost
Example of difference:
McDonald’s reported $2 billion accounting profit in 2002;
economic profit estimated to be - $124 million
Opportunity Cost:
A Real World Issue
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Why has there been a push to “just in time
inventory” in production?
Even if debt collection from customers is
certain to happen, why is sooner better
than later?
How do you get managers to be more
responsible about firm assets? Google
makes divisions bid for server use. Internal
competition.
Example: John Deere
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Tough competition in heavy equipment.
New CEO focused on reducing all costs:
Sold and leased excess plant space
(capitalized an undervalued asset)
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Reduced end of year unsold combines
from 1,600 to 200 in 5 years
(value of unsold inventory reduced $1/3
billion—opportunity cost of cash)
How one firm accounts for
opportunity cost:
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Gillette requires each division to count the
opportunity cost of cash tied up in different
parts of the operation.
Example: one new division showed accounting
revenues of $1,069 million and costs of $1,001
million, for an accounting profit of $68 million.
Division was required to count the opportunity
cost of cash, which changed the results.
Previously, the division had less incentive to
consider the value of cash used or idled.
Measuring Opportunity Cost
The rule is that 12% interest is charged by the
parent company to each division for idle cash:
 Average inventory in stock: 242 days
 Average time for debt collection, 105 days
 Cash tied up in equipment
Opportunity cost of this: $119 million.
Now: $68 million accounting profit minus $119
cost of cash yields $51 million loss. Managers
told to reform or division would be liquidated.
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Reducing Opportunity Cost
within the Firm
Steps taken to reduce those costs:
1.
Outsource debt collection to specialist firm.
Average debt collection time reduced from
105 to 41 days over 5 years.
2.
Average inventory time cut from 242 to 198
days over five years.
3.
New applications for existing production
machinery devised to increase revenue from
equipment (also new revenue source).
Net result: These opportunity costs cut $35
million. The division treated cash as a free
good from the parent company.
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Cost Control by InBev:
Much of This Should Seem Obvious
Wait 120 days to pay vendors (the jerks).
Double sided, no-color printing in England
offices saved $325,000 a year.
40% fewer Blackberries for U.S. employees.
Few private offices—everyone in large rooms
(one impact—faster communication).
No private airplanes; everyone flies commercial.
Zero-based budgets every year.
Ad firms paid by project, not by annual budget.
Efforts at other firms…
Nicholas & Co., a Salt Lake City food distributor
cuts sales commissions 25% when customers’
bills are more than 45 days past due. Sales
reps now think about creditworthiness. Bill
payment time dropped in half.
Slack & Co. Contracting, Houston, borrowed $1
million a month to cover late payments from
clients. Slack now refuses to deal with firms
with bad reputations and histories. Mr. Slack:
“Don’t confuse volume with profit.”
Think Outside of the Box:
Can we make cost fit demand?
Most firms imitate existing firms and processes.
But, if we want to serve the market better, we
should ask—can we supply something demanders
want—not just copy what is already there?
That is what Toyota and Honda did.
And now, Tata Motors. They asked—can we make a
car that millions in India can afford—they did.
Price is $2,200. No car in the U.S. is near that.
Also--$20 cell phones; efficient wood burning stove
for $23; water purifier for $43.
Summary: Costs
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The economic way of thinking about costs is
not the same as accounting costs or the
common way people think of costs.
This helps us consider opportunity costs —
what does it cost us to command resources
for some purpose — so we can contrast it to
our next best understood alternative.