Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PowerPoint Slides © Luke M. Froeb, Vanderbilt 2014

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 Chapter 4 Extent (How Much) Decisions 2

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Summary of Main Points 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.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Summary (cont.) 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 = 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.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Summary (cont.) 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. 5

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Introductory Anecdote: US Financial Crisis The financial crisis began in the subprime housing market, where government policies encouraged lenders to extend credit to low-income borrowers (by lowering lending standards) These high-risk loans, or mortgages, were being packaged into securities by lenders and sold to investors. If the risk had been recognized investor demand would have been low, but rating agencies were too liberal with AAA ratings, increasing demand for loans. The result? A credit “bubble” How did this lending crisis arise?

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Average Cost Caution! ▮ Memorial Hospital’s CEO conducted performance reviews of the hospital departments ▮ During this process, the chief of obstetrics proposed an increase in the number of babies being delivered in his department ▮ The CEO wondered why since the cost of delivering babies was higher than the revenues brought in ▮ The CEO’s mistake: He began with the costs instead of the decision. He committed the fixed-cost fallacy by looking at average cost, which include costs that do not vary with the decision. If he had ignored fixed costs, he would have seen that increasing the number of deliveries would increase profit 7

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Background: Average Cost Definition: Average cost (AC) is simply the total cost (TC) of production divided by the number of units produced (Q). AC = TC/Q Average costs often decrease as quantity increases due to presence of fixed costs (FC) AC = (VC + FC)/Q FC does not change as Q increases Key note: Average costs are not relevant to extent decisions

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Background: Average Cost (cont.)

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Memorial Hospital Revisited ▮ Memorial made 500 deliveries originally ▮ Fixed cost: $1,000,000 ▮ Variable cost: $3,000/delivery ▮ Total cost: $1,000,000 + ($3,000 x 500) ▮ Average cost: total costs/# of deliveries ▮ Average costs fall as you increase output, but the variable costs remain constant ▮ Marginal cost is only $3,000 at Memorial Hospital 10

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Marginal Cost & Marginal Revenue Definition: Marginal cost is the additional cost to make and sell one additional unit of output (Q) MC = TC Q+1 – TC Q. Marginal cost is often lower than average cost (due to fixed costs) but not always Marginal costs are what matter in extent decisions Definition: Marginal revenue (MR) is the additional revenue gained from producing and selling one more unit.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Extent Decisions Examples of extent decisions: Should you change the level of advertising? Should you increase the quality of service? Is your staff big enough, or too big? How many parking spaces should you lease? For extent decisions, we break the decision into small steps If taking a step provides more benefit than cost, take a step forward If not, step backward

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Extent (How Much?) Decisions This analysis tells you direction of change but not the distance. You can only measure MR and MC at the current level of output – make a change and re-measure If the benefits of selling another unit (MR) are bigger than the costs (MC), then sell another unit. Maxim: Produce more when MR>MC; less when MR<MC. Profits are maximized when MR=MC.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Memorial Hospital Marginal Analysis ▮ As we mentioned, the MC of a delivery was $3,000 ▮ The MR was $5,000 ▮ Therefore, MR>MC so the hospital was not delivering enough babies ▮ This explains why the CEO was wrong 14

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Advertising Extent Decision Example Answering the “How much advertising?” question A $50,000 increase in the TV ad budget brings in 1,000 new customers Estimated MC TV 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.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Advertising Extent Decision Example (cont.) You know the direction (do more), but you do not know how far to go You have to take a step and re-compute marginal cost and benefit to see if you should continue in the direction your analysis originally pointed you in Also, even if we do not know the marginal revenue, we can still use marginal analysis to make extent decisions by comparing marginal effectiveness of different media

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Competing Strategies & Marginal Analysis ▮ Example: Compare TV advertising to telephone solicitation The opportunity cost of spending one more $ on TV advertising is the forgone opportunity to spend $ on telephone solicitation Say you recently cut telephone (PH) budget by $10,000 and lost 100 customers Estimated MC PH = $100= ($10,000 / 100) So, to get one more customer costs $50 for TV and $100 for phone MC PH > MC TV so shift ad dollars from phone to TV Advice: make changes one-at-a-time to gather valuable information about marginal effectiveness of each medium 17

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Textile Production Example A textile company with manufacturing plants in Latin America uses SAH=“Standard Absorbed Hours” a measure of textile factory output Allows managers to compare factories making different items, e.g. t-shirt = 1 SAH while dress=3 SAH Suppose Factory A has costs of $30 per SAH while Factory B has cost of $20 per SAH. How can you profitably use this information? Should you move production to cheaper factory? 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 from Factory A to Factory B

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Incentive Pay Discussion: Royalty rates vs. fixed fee contracts How hard to work is an extent decision so you can design incentives to encourage hard work by using marginal analysis Example: You receive two bids to harvest 100 trees on your land $150/tree or $15,000 for the right to harvest all the trees. On your tract there are pines (worth $200) and fir (worth $100) Which offer should you accept? Hint: consider the effects of the two bids on the incentives of the logger.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Tree Harvesting Answer ▮ The bids have the same face value, but are very different in terms of logger’s incentives ▮ Fixed fee: the logger will ignore the $15,000 because it doesn’t vary with the decision to cut down trees. The logger will end up cutting down all trees that are profitable to cut down, MR>MC ▮ Royalty Rate: The logger will only cut down trees trees that generate profit of $150, MR>MC+150 Mix of $200- and $100-value trees – logger will harvest only the $200 The landowner receives less money since the logger only harvests one type of tree Royalties deter some wealth-creating transactions as fir trees are not harvested 20

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Sales Commission Example Motivating salespeople: Expected sales level: 100 $10,000/unit=$1M Option 1: 10% commission Option 2: 5% commission + $50,000 salary Hint: consider incentives for salespeople Use Option 1 because MR=$1000/sale > $500/sale, the MR under Option 2 The sales force responds to larger marginal benefits of selling with more effort Lower sales effort under option 2 is called “shirking” 21

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Tie Pay to Performance ▮ A consulting firm COO received a flat salary of $75,000 After learning about the benefits of incentive pay in class, the CEO changed COO compensation to $50K + (1/3)* (Profits-$150K) Profits increased 74% to $1.2 M Compensation increased $75K  $177K Discussion: What are the disadvantages to incentive pay?

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Alternate intro anecdote 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, the company considered expanding number of card holders How many more should be added? 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 only 15,000 more 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.