Sunk Costs and Opportunity Costs Break Theory of the Firm Break Team Exercise BA 215 Agenda for Lecture 3

The microeconomic foundations of finance and accounting Sunk Costs: Costs that have already been incurred. Sunk costs are irrelevant for all decisions, because they cannot be changed.

Opportunity Costs: The profit foregone by selecting one alternative instead of another; the net return that could be realized if a resource were put to its best alternative use. The microeconomic foundations of finance and accounting

Relevant Costs: Also sometimes called Differential Costs or Incremental Costs A differential cost for a particular decision is one that changes if an alternative decision is chosen. The microeconomic foundations of management accounting

When are Costs and Revenues Relevant? Answer: The relevant costs and revenues are those which, as between the alternatives being considered, are expected to be different in the future.

The Jennie Mae Frog Farm Jennie Mae’s Frog Farm has fixed costs of $5,000 per month and variable costs of $2 per frog. All fixed costs are avoidable, in the sense that Jennie Mae could close the farm tomorrow, and not incur any fixed costs next month. However, she doesn’t want to do that because times are good in the frog business: she is operating at capacity, making and selling 1,000 frogs per month. Jennie Mae’s usual sales price is $9 per frog. The U.S. Army has approached Jennie Mae and proposed a one- time purchase of 300 frogs for $7 per frog. The sale would occur next month. Jennie Mae’s $2 per frog variable cost includes $0.25 of product packaging that would be unnecessary for frogs designated for the Army.

The Jennie Mae Frog Farm Question #1: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, what is Jennie Mae’s opportunity cost?

The Jennie Mae Frog Farm Question #1: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, what is Jennie Mae’s opportunity cost? Since Jennie Mae is operating at capacity, her opportunity cost is her profit foregone from the regular sales that are displaced by the sales to the Army. These profits are calculated either as $9 sales price minus $2 variable costs = $7 per frog, multiplied by 300 frogs = $2,100; or as the difference between this $7 per frog contribution margin and her contribution margin from sales to the Army of the $7 sales price less $1.75 in variable costs = $5.25 per frog. This difference is $7 minus $5.25 = $1.75, multiplied by 300 frogs = $525.

The Jennie Mae Frog Farm Question #2: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are sunk, and hence, are irrelevant to her decision?

The Jennie Mae Frog Farm Question #2: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are sunk, and hence, are irrelevant to her decision? No costs are sunk. Even the fixed costs are avoidable. Hence, although the fixed costs are irrelevant to Jennie Mae’s decision, they are not sunk.

The Jennie Mae Frog Farm Question #3: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are differential costs (i.e., relevant, or incremental costs)?

The Jennie Mae Frog Farm Question #3: With respect to Jennie Mae’s decision of whether to accept the Army’s offer, which costs are differential costs (i.e., relevant, or incremental costs)? The differential costs are the $0.25 product packaging costs. Nothing else is differential, because whether or not Jennie Mae sells to the Army, she will produce at capacity.

The Jennie Mae Frog Farm Question #4: Now assume that times are not so good, and Jennie Mae has excess capacity to make 500 frogs. The Army approaches Jennie Mae and proposes a one- time purchase of 300 frogs. What is the lowest price Jennie Mae should be willing to charge the Army per frog?

The Jennie Mae Frog Farm Question #4: Now assume that times are not so good, and Jennie Mae has excess capacity to make 500 frogs. The Army approaches Jennie Mae and proposes a one-time purchase of 300 frogs. What is the lowest price Jennie Mae should be willing to charge the Army per frog? $1.75 per frog, the variable cost of production, assuming Jennie Mae was going to continue operations. However, with only 500 customers, she is not covering her costs, and the price to the Army that will allow her to break even is $6.75, as follows: Revenues: from the Army: $6.75 x 300 =2,025 from normal customers: $9 x 500 =4,500 Costs: Variable costs (500 x $2) + (300 x $1.75) =1,525 Fixed costs5,000 Income$ 0

The Jennie Mae Frog Farm Question #5: Now assume that times are really bad, the market for frogs crashes, and Jennie Mae gets out of the frog business and starts producing platypuses instead. Jennie Mae has an aging inventory of frogs sufficient to meet market demand for 10 months (300 frogs per month), but unfortunately, frogs only have a useful life of 5 months and her inventory becomes obsolete after that. These frogs cost $7 each to make, consisting of $2 in variable costs and $5 in allocated fixed overhead. What is the lowest price Annie should accept from the Air Force for a one-time-only purchase of 300 frogs? What is her opportunity cost?

The Jennie Mae Frog Farm Question #5: Now assume that times are really bad, the market for frogs crashes, and Jennie Mae gets out of the frog business and starts producing platypuses instead. Jennie Mae has an aging inventory of frogs sufficient to meet market demand for 10 months (300 frogs per month), but unfortunately, frogs only have a useful life of 5 months and her inventory becomes obsolete after that. These frogs cost $7 each to make, consisting of $2 in variable costs and $5 in allocated fixed overhead. What is the lowest price Jennie Mae should accept from the Air Force for a one-time-only purchase of 300 frogs? What is her opportunity cost? Jennie should accept any price above zero. Her opportunity cost is zero.

Sunk Costs and Opportunity Costs Break Theory of the Firm Break Team Exercise BA 215 Agenda for Lecture 3

Sunk Costs and Opportunity Costs Break Theory of the Firm Break Team Exercise BA 215 Agenda for Lecture 3

Theory of the Firm Classical microeconomic theory –Firms exist to maximize profits to owners Agency Theory Transaction Cost Economics

Agency Theory Separation of management from ownership Examples: –The spice trade –The Hudson Bay Trading Company –The early railroads The concept of “span of control”

Types of Agency Costs Moral hazard (unobserved actions) –Employees don’t like to work hard –Other examples of moral hazard Adverse selection (unobserved type) –Employee ability is difficult to assess –Other examples of adverse selection problems Misaligned incentives Agency costs can be minimized through appropriate oversight. –Corporate governance

Misaligned Incentives Managers are more risk averse than owners. Managers enjoy consumption of perquisites. Managers may have a short-term time horizon. Managers may increase their personal utility through empire building.

Managerial Incentive Schemes Bonuses based on profits. Bonuses based on other financial measures. Bonuses based on operational measures (e.g. market share). Bonuses based on stock price.

Stock Option Incentive Plans Stock options gained popularity in the 1990s. They were especially popular with cash- poor, high-tech, start-up companies. Controversy over how to account for them. Backdating scandal. Stock options may not align incentives as effectively as originally thought.

Transaction Cost Economics Some transactions are less costly to execute within an organization than between two independent organizations. Other transactions are less costly to execute between independent parties than within the same organization.

Transaction Cost Economics The firm is a “nexus of contracts.” Boundaries of the firm Examples: –Piecework at a Levi Strauss factory –Volkswagen factory in Brazil –Retailers

Sunk Costs and Opportunity Costs Break Theory of the Firm Break Team Exercise BA 215 Agenda for Lecture 3

Sunk Costs and Opportunity Costs Break Theory of the Firm Break Team Exercise BA 215 Agenda for Lecture 3