Any Questions from Last
Class?
Chapter 4 – Take Aways

Do not confuse average and marginal costs.

Average cost (AC) is total cost (fixed and
variable) divided by total units produced.

Average cost is irrelevant to an extent decision.

Marginal cost (MC) is the additional cost
incurred by producing and selling one more unit.
Chapter 4 – Take Aways

Marginal revenue (MR) is the additional revenue gained from selling
one more unit.

Sell more if MR > MC; sell less if MR < MC. If MR ¼ MC, you are selling
the right amount (maximizing profit).

The relevant costs and benefits of an extent decision are marginal costs
and marginal revenue. If the marginal revenue of an activity is larger
than the marginal cost, then do more of it.

An incentive compensation scheme that increases marginal revenue or
reduces marginal cost will increase effort. Fixed fees have no effects on
effort.

A good incentive compensation scheme links pay to performance
measures that reflect effort.
Chapter 4
Extent (How Much) Decisions
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Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star
logo, and South-Western are trademarks used herein under license.
Review of Chapter 3

Costs associated with decisions—not
activities
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Opportunity cost
Relevant benefit-cost
The fixed-cost fallacy or sunk-cost fallacy
The hidden-cost fallacy
EVA®= opportunity cost of capital.
EVA® works no better than other economic
performance plans
Anecdote: Memorial Hospital


Large, community hospital offering a full line
of services
2005 performance review
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Obstetrics chief proposed increasing the number
of babies being delivered
Recent year: total costs = $3,132,000 while total
revenue = $2,754,000 for 540 deliveries
CEO asks: why increase the number of deliveries
when we are losing $700 per delivery??
Background: Average vs. Marginal Costs

Average cost is simply the total cost of production divided by the
number of units produced. AC = TC/Q

Average costs often decrease as quantity increases due to presence
of fixed costs

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AC = (VC + FC)/Q
FC does not change as Q increases
Average costs are not relevant in decision-making
Marginal costs are what matter


Marginal cost is the cost to make and sell one additional unit of
output. MC = TCQ+1 – TCQ.
Marginal cost is often lower than average cost (due to falling
average costs) but not always
Extent (How Much?) Decisions
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Definition: Marginal cost (MC) is the
additional cost required to produce and
sell one more unit.
Definition: Marginal revenue (MR) is
the additional revenue gained from
producing and selling one more unit.
Proposition: Produce more when
MR>MC; less when MR<MC. Profits are
maximized when MR=MC.
Extent Decisions (cont.)

Examples of extent decisions
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Advertising
Quality of service
Staff size
Number of parking spaces to lease
Difficulties


The rule tells you direction of change but not
distance
You can only measure MR and MC at current
level of output
Extent Decision Example

Discussion: TV advertising vs. telephone solicitations.
 $50,000 TV ad budget increase nets you 1,000 new
customers
 Estimated MCTV is $50 (the cost to get one more
customer)


$50,000 / 1,000 = $50
If the marginal revenue generated by this customer is
greater than $50, do more advertising
Extent Decision Example (cont.)


Even if we do not know the marginal revenue, we can
still use marginal analysis to make money
Compare TV advertising to telephone solicitation

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Say you recently cut telephone budget by $10,000 and lost 100
customers
 Estimated MCPH = $100 ($10,000 / 100)
So, to get one more customer costs $50 for TV and $100 for
phone
MCPH > MCTV so cut back on phone and do more TV
Advice: make changes one-at-a-time to gather valuable
information about marginal effectiveness of each
medium.
Another Example
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Fortune 50 company studying how much to produce
at different factories
Factory A has costs of $30 per hour
Factory B has cost of $20 per hour
Decision seems simple, but

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Make sure you are not including fixed costs in the analysis
Marginal costs matter, not average costs!
If the $20 and $30 rates are good MC proxies, shift some
production to Factory B
Incentive Pay

Discussion: 100 trees

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$150/tree vs. $15,000 for the right to harvest all the trees.
Discussion: Sales Commissions

Expected sales level: 100 units @ $10,000/unit=$1M

Option 1 10% commission

Option 2: 5% commission + $50,000 salary

Compare the marginal benefits salespeople receive for
making a sale under each approach

Lower commission = lower effort
Tie Pay to Performance

Consulting Firm COO

$75K  $50K + .33(Profits-$150K)

Profits increased 72% to $1.2 M

Compensation increased $75K  $177K

Marginal incentive of divorced employee?

Discussion: give example of royalty rate or
fixed fee contracts in your firm

Discussion: disadvantages of incentive pay
Alternate Intro Anecdote
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American Express offers a Platinum Card to affluent customers
In 2001, there were approximately 2,000 Platinum cardholders in the
Japanese market. Numbers had been limited to ensure high quality
customer service
With customer service technology advances, company considered
expanding number of card holders
How many more should be added?
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As more members are acquired, average spending per card member
decreases because the financial threshold for membership is lowered
Costs of customer service rise for each additional member added, and
growing beyond a certain point would require building and operating an
additional call center
After analyzing the costs and benefits, American Express realized that it
should expand its offering to acquire a total of 15,000 Platinum Card
members
We call this an “extent” decision, because the company needed to
decide “how many” platinum cards to provide. In this chapter, we show
you how to make profitable extent decisions.