Any Questions from Last
Class?
Chapter 3
Benefits, Costs, and Decisions
COPYRIGHT © 2008
Thomson 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
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Costs are associated with decisions, not activities.
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The opportunity cost of an alternative is the profit you
give up to pursue it.
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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.
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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.
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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
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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)
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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

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Fixed costs do not vary with the amount of output
Variable costs change as output changes
Candy factory example
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Factory is fixed cost
Employees and ingredients are variable costs
Fixed or Variable?
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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
Production Costs
Total, Fixed, and Variable Costs
Total Costs
Fixed Costs
Output Level
Variable Costs
Background: Accounting vs. Economic
Cost


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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


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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
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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


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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
INTERNAL
PRODUCTION
Category
Cost
Material
$0.60
Labor
$0.20
Depreciation
$0.10
Other overhead
$0.10

OUTSOURCING
Category
Material
Labor
Tooling
Cost
$0.50
$0.10
$0.10
Diagnose problem

Decisions rights; evaluation metric; compensation scheme,
GOAL ALIGNMENT!!!
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
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Recall that accounting profit does not necessarily
correspond to economic profit

Example: Making the hidden cost of capital explicit

Discussion:

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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®
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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?
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Adopting companies of EPP’s (+ four years)
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ROA from 3.5 to 4.7%
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operating income/assets from 15.8 to 16.7%
Indistinguishable from non-adopters
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Bonuses increase 39.1% for EVA® firms
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But 37.4% for control group
Interpretations
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Selection bias?
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NO, cheaper to use existing plans
Goal alignment, YES.
EVA® is no better or worse

Rival EPP’s
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Bonus plans
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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”
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Why?
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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