Chapter 3: Benefits, Costs, and Decisions
Hi, this is Luke Froeb, I’m the co-author of Managerial Economics: A Problem-Solving
Approach. This video is designed to supplement Chapter 3: Benefits, Costs and Decisions.
Hidden costs and benefits
Five years ago, Company X closed its popular theme park because it was losing about $5
million dollars a year. In its place, they opened a shopping mall that earned $10 million. On its
face, this decision seemed to raise profit, but the loss of the theme park reduced demand for the
Company’s hotel, and hotel profit declined by $20 million. From the company’s point of view,
this was an unprofitable mistake.
At about the same time, a large regional power company adopted a new performance metric,
cost-per-kilowatt-hour, to measure the performance of their various divisions. To ensure that his
division reached its performance goal, the head of the nuclear division decided to defer routine
maintenance (saving about $1million) on the turbine at one of the nuclear plants. He also ran it
near the high end of its rated tolerance, which increased the amount of energy produced also
increased measured performance. However, somewhat predictably, the turbine threw a blade,
and it was knocked offline for a month, costing the company $50 million in foregone revenue.
Both of these decisions reduced the profitability of the parent company. In the former case the
company ignored the “hidden cost” of closing the theme park; in the latter, the company ignored
the “hidden benefit” of routine maintenance. Had the company recognized these hidden costs
and benefits, it would have made better decisions.
So, why were these mistakes made? Take a moment, and run these decisions through our
problem-solving algorithm to see if you can figure out what's wrong and how to fix it.
Lets begin with the theme park.
<<ADD THE TEXT IN (PARENTHESES, NOT SPOKEN ON TRACK) ABOVE THE
ANSWERS>>
(1. Who made the bad decision?): the theme park division of the company decided to replace
the theme park with a shopping mall.
(2. Did they have enough information to make a good decision?): It is possible that the theme
park managers knew that closing the theme park would reduce demand for the hotel, but…
(3. Did they have the incentive to make a good decision?): they were rewarded based on
division profitability, so they didn’t care.
The theme park had been serving as a kind of “loss leader” for the hotel. Whatever was lost on
the theme park was more than offset by increased hotel profit. But because the theme park
managers cared only about their own division, they made a bad decision from the parent
company’s point of view.
OK, now that we understand the problem, what can we do to fix it? A couple of solutions come
immediately to mind.
The first is to tie the incentives of the division managers more closely to company-wide
profitability. This should make them care about profitability of their “sister” divisions.
Another solution is to let senior managers make big decisions, or at least those that affect other
divisions in the same firm. In fact, I would go so far as to say that the primary responsibility of
senior management at a firm like this is to make sure that the divisions are not working at crosspurposes to each other.
Now lets turn to the nuclear power plant.
(1. Who made the bad decision?): the plant manager decided to defer maintenance.
(2. Did he have enough information to make a good decision?): he knew that deferred
maintenance raised the probability of a failure, but…
(3. Did he have the incentive to make a good decision?): …if he performed the routine
maintenance, the division was not going to reach its performance goal, and the manager, and
his subordinates, would not earn annual bonuses.
OK, now that we understand the source of the problem lets look at some solutions.
As above, we could change the incentives, but due to the long-lived nature of safety
investments, it is harder to measure their performance. To remove the incentive to defer
maintenance, we could put the safety expenditures into a separate budget, and measure the
division’s performance (still using cost-per-kilowatt hour) only on non-safety expenditures.
Alternatively, we could take the maintenance decisions away from the managers, and give them
to another person or entity, like a safety committee, concerned solely with safety.
OK, lets step back for a second and try to spot the common theme in these problems, and their
solutions. The first is goal alignment, from Chapter 1: by aligning the incentives of the decisionmakers more closely with the profitability goals of the parent company, you get better decisions.
By incentive alignment, we mean giving employees enough information to make good decisions,
and the incentive to do so (Remember that incentives have two parts: first you have to measure
performance, and then you have to find a way to reward it.) What this means is constructing
ways of rewarding good decision-making. That is the topic this chapter, benefit-cost analysis.
In the chapter we define the “economic costs,” of an alternative as what you give up to pursue it.
For example, when deciding between two alternatives—A and B—you want to choose the one
with the highest profit. If we define the economic, or opportunity costs of an alternative as what
we give up to pursue it, then we see the link between decisions and costs: the cost of A is what
we give up to pursue it <<PUT THE TEXT IN PARENTHESES ON THE SCREEN AT THEN
END OF A DECISION TREE, WITH “THIS” AND “THAT” AS THE TWO ALTERNATIVES>> (the
profit of B). If the benefit of A (the profit that we earn by choosing A) is bigger than the cost of A
(what we give up to pursue it) then choose A.
To make a good decision, you want to consider all costs and benefits that vary with the
consequence of a decision, but only the costs and benefits that vary with the consequence of a
decision. These are the relevant costs of the decision.
DEFINITION: If you ignore relevant costs or benefits, you commit the hidden-cost fallacy.
DEFINITION: If you take account of irrelevant costs or benefits, you commit the sunk-cost
fallacy.
To avoid these mistakes, begin your analysis with the decision you are trying to make, and then
figure out which of the costs and benefits vary with the decision—those are the relevant costs
and benefits of the decision.
The Hidden Cost of Capital
The most common and biggest hidden cost is the hidden cost of capital. Managers ignore the
hidden cost of capital because it does not appear on their company’s accounting statement, and
most of them are rewarded for increasing accounting profit, not economic profit.
To see why this is so, let’s look at the cost of borrowing. Normally, the interest owed to creditors
does show up in accounting costs; however, firms also raise money from shareholders. But, the
income statement shoes no charge for using such equity capital.
Obviously, if managers are not charged for the capital that they use, they will over-use it. In fact
companies, like Pepsi, are adopting new performance metrics like EVA® that charge managers
for the capital they use. If, for example, a manager wants to buy some equipment, and its
investor’s expect a 10% rate of return, then it would charge the manager 10% for the capital she
uses. With a rewards tied to performance metrics like this, managers will be reluctant to invest
unless they can earn at least 10% on the investments that they are contemplating.
In 2012, after Pepsi replaced bonuses based on stock market appreciation with bonuses based
on Economic Profit (including the cost of capital), managers started making better investment
decisions, and capital spending declined to 4.5% of revenue (from 5.5%). By making visible the
hidden cost of capital, managers were no longer committing the hidden cost fallacy.
Sunk cost Fallacy
The biggest fixed, or “sunk” costs are overhead and depreciation. Typically, these costs don’t
vary with any decision that you make, so you should ignore them. For example, if you’re
considering launching a product that you will be able to distribute through your existing sales
force without incurring additional expenses, then the cost of the sales force does not vary with
the decision to launch, and so should not be a factor in the decision. When company policy
requires that each division using the sales force pay a portion of its cost, and this prevents an
otherwise profitable product launch, then the company commits the sunk-cost fallacy.
Depreciation can also lead to mistakes. If you purchase a long-life capital good, it is typically
depreciated over a period of years instead of expensed in a single year. To see how this could
affect decision-making, lets consider a decision facing a GE Washing Machine plant manger.
[In general, I will not go over problems that are already in the textbook, but this is such a rich
and nuanced problem, I have found that students get a lot out of going through this more than
once.]
A trusted supplier who toured the plant asked the manger how much it costs him to make the
agitators internally. The manager ignored overhead and depreciation (they don't vary with the
decision to outsource), and added up the material cost ($0.20) and the labor cost ($0.60) (they
do vary with the decision to outsource) and told the supplier $0.80.
The supplier then offered to deliver agitators for only $0.70 each, a $0.10 savings. Since the
plant produced 1 million washing machines each year, outsourcing would save the plant
$100,000/year.
However, because the tooling costs had not yet been fully depreciated, the accountants at the
plant told the manager that the $400,000 “asset” on the balance sheet would be “made
worthless” by the outsourcing.
For those of you who have been paying attention, you will realize that the tooling cost is sunk (it
does not vary with the decision to outsource) because the molds have no resale value. The
“asset” is nothing more than a line item on the company’s balance sheet.
Just to make sure you understand this, the $400,000 doesn’t vary with the consequences of the
decision to outsource. The money was spent 6 years ago, and it cannot be recovered. However,
because the division manager’s compensation was tied to accounting profit, which would
decrease by $400,000 if he decided to outsource, he decided not to outsource even though
outsourcing would raise economic profit. In other words, he committed the sunk-cost fallacy.
OK, lets figure out what’s wrong and how to fix it:
(1. Who made the bad decision?): the plant manager decided not to outsource, even though
outsourcing would save the company $100,000/year.
(2. Did he have enough information to make a good decision?): The plant manager was the only
one with the information—he discovered the outsourcing opportunity.
(3. Did he have the incentive to make a good decision?): But, since the manager’s
compensation was tied to accounting profit, he would earn less if he outsourced.
In other words, the company would have penalized him for doing the right thing, so he did the
wrong thing.
The most common suggestion for “fixing” this problem is to switch from accounting profit to
some kind of economic performance measure that ignores sunk costs. This would allow the
manager to outsource without paying a penalty for doing so.
This would solve the sunk cost fallacy, but before implementing this solution, we want to make
sure that it wont create any other problems.
If you are a rule follower, and have been paying attention, you will reach the conclusion that
since sunk costs don't vary with the consequence of a decision, we shouldn’t let them influence
decisions. Allowing the manager to walk away from the sunk costs is the right thing to do, for
this decision.
But is this still true if the plant manager is the same one that decided to incur the sunk costs six
years ago? After all, sunk costs were relevant before we incurred them. Doesn’t the fact that
they lasted only 6 of the ten expected years trouble you?
Does your answer change if there is $900,000 worth of un-depreciated assets on the balance
sheet. In other words, what if the manager made the decision to incur the sunk costs just last
year? Last month? Last Week? Yesterday?
At some point you should realize that while allowing the manger to walk away from sunk costs
solves the sunk cost fallacy, it also creates incentives for managers to over-invest in new
activities, even if there is only a small probability of them being successful.
In other words, the initial investment decision is different from the outsourcing decision, and if
you allow the decision maker to walk away from investments that do not work out, then he
doesn’t face the full consequences of his decision.
I know this sounds unsatisfying for those of you who like stories with clear answers. But real
problems are messy, and solving one aspect of one problem--as you do in a textbook--ignores
the tradeoffs that complicate real (and often messier) problems. The best I can offer you is how
to spot these tradeoffs, and make decisions accordingly.
Conclusion
I want to end this section by recapping the main take-aways of the chapter.
*The first lesson is that benefits and costs are related to the decision you are trying to make.
For example, benefits and costs of outsourcing are different from the benefits and costs of
deciding whether to hire another employee.
*To make good decisions, you must consider:
1. all the costs and benefits that vary with the consequence of a decision—if you miss
some that is called the “hidden cost fallacy.”;
2. But Only costs and benefits that vary with the consequence of a decision—if you take
account of some extra ones that is called the “sunk” or “ fixed cost” fallacy.
*It is very easy to commit both of these mistakes. You can reduce the likelihood of making them
by beginning with decisions. In fact, one of the most useful maxims from the class is:
If you begin your analysis by looking at benefits and costs, you will always get confused;
but if you begin with decisions you will never get confused.
*There are hundreds of decisions that you want decision makers to make, and it is very difficult
to find performance metrics that align the incentives of the decision maker with the profitability
goals of the company for all of them. In fact, if you align incentives on one decision (like
outsourcing), you will likely mis-align incentives on another decision (like investments).