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 3 Benefits, Costs, and 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 Costs are associated with decisions, not activities. The opportunity cost of an alternative is the profit you give up to pursue it. 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.

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.) Accounting profit does not necessarily correspond to real or economic profit. 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. 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 visible 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.

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: Big Coal Power Company Big Coal Power Co. switched to a 8400 coal when the price fell 5% below the price of 8800 coal 8400 coal generates 5% less power than 8800 The manager was compensated based on the average cost of electricity, and expected this move to save money Instead – company profit reduced Why? What happened? Discussion: Diagnose the problem. Discussion: Come up with a proposal to fix 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. Big Coal Solution ▮ Use our three questions for analysis ▮ 1. Who is making the bad decision? The plant manager made the switch to the lower- priced 8400 coal. ▮ 2. Did he have enough information to make a good decision? Yes, presumably he knew that this would reduce his output. ▮ 3. Did he have the incentive to make a good decision? No, because he was evaluated based on the average cost of electricity produced at his plant.

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. Lesson From Coal Problem ▮ The plant manager should have considered all the costs of switching to the lower Btu coal Namely, the lost electricity ▮ Average costs can be a poor measure of plant performance ▮ Need to align incentives of a business unit with the goals of the parent company 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: Types of costs ▮ Definition: Fixed costs do not vary with the amount of output. ▮ Definition: Variable costs change as output changes.

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. Example: A Candy Factory The cost of the factory is fixed. Employee pay and cost of ingredients are variable costs. 9

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. Your turn Are these costs fixed or variable? 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.

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. Real Example: Cadbury (Bombay) Beginning in 1978, Cadbury offered managers free housing in company owned flats to offset the high cost of living. In 1991, Cadbury added low-interest housing loans to its benefits package. Managers moved out of the company housing and purchased houses. The empty company flats remained on Cadbury’s balance sheet for 6 years. In 1997, Cadbury adopted Economic Value Added (EVA)® Charges each division within a firm for the amount of capital it uses Provides an incentive for management to reduce capital expenditures if they do not cover costs Senior managers then decided to sell the unused apartments after seeing the implicit cost of capital.

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. Accounting Costs for Cadbury

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. Cadbury Accounting Profit Accounting profit recognizes only explicit costs Typical income statements include explicit costs: Costs paid to its suppliers for product inputs 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

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. Cadbury Accounting Profit vs. Economic Profit What’s missing from Cadbury’s statements are implicit costs: 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 recognizes only explicit costs 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. Opportunity Costs & Decisions Definition: the opportunity cost of an action is what you give up (forgone profit) to pursue it. Costs imply decision-making rules and vice-versa The goal is to make decisions that increase profit If the profit of an action is greater than the alternative, pursue 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. Identifying Costs Whenever you get confused by costs, step back and ask, “What decision am I trying to make?” If you start with costs, you will always get confused If you start with a decision, you will never get confused Apply it to Cadbury: The cost of the company of holding onto the apartments was the forgone opportunity to invest capital in the company’s organization to earn a higher return. 16

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. Cadbury’s Costs Holding onto the flats cost the company £600,000 each year. Unless the benefits to the company of holding onto the apartments were at least £600,000, the capital was not employed in its highest-valued use. The cost of the company of holding onto the apartments was the forgone opportunity to invest capital in the company’s organization to earn a higher return. By selling the flats, the company moved the capital to a higher-valued use. 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. 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 make only two mistakes You can consider irrelevant costs You can ignore relevant ones Definition: The fixed-cost/sunk-cost fallacy means you make decisions using irrelevant costs and benefits

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. Fixed-Cost/Sunk-Cost Fallacy Examples Football game: You pay $20 for a ticket. At halftime, you’re team is losing by 56 points. You say you’ll stay to get your money’s worth, but you can’t get your money’s worth! The ticket price does not vary whether you stay or leave – it’s a sunk cost and irrelevant. Launching a new product: You are in a new products division and will be able to distribute a new product through your existing sales force You will be forced to pay for a portion of the sales force If you believe this “overhead” is big enough to deter an otherwise profitable product launch, then you’ve committed the sunk-cost fallacy

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. Hidden-Cost Fallacy Definition: ignoring relevant costs (costs that vary with the consequences of your decision) when making a decision Example: Football game (again) You buy a ticket for $20 Scalpers are selling tickets for $50 because your team is playing cross-state rivals You go to the game, saying, “These tickets cost me only $20.” WRONG The tickets really cost you $50 because you give up the opportunity to scalp them by going Unless you value them at $50, you are sitting on an unconsummated wealth-creating transaction

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. Example: Should You Fire an Employee? The revenue he provides to the company is $2,500 per month His wages are $1,900 per month His office could be rented out $800 per month YES, you are only making $600 a month from this employee but could make $800 a month from renting his office 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. Subprime mortgages The subprime mortgage crisis of 2008 is a good example of the hidden-cost fallacy. Credit-rating agencies failed to recognize the higher costs of loans made by dubious lenders. Example: Long Beach Financial Gave loans out to homeowners with bad credit, asked for no proof of income, deferred interest payments as long as possible. Credit ratings didnt reflect the hidden costs of risky loans As a result, many Wall Street investors purchased packaged risky loans and eventually went bankrupt when the debtors defaulted.

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. Hidden cost of capital Recall that accounting profit does not necessarily correspond to economic profit. Discussion: Economic Value Added EVA ® = net operating profit after taxes minus the cost of capital times the amount of capital utilized Makes visible the hidden cost of capital The major benefit of EVA is identifying costs. If you cannot measure something, you cannot control it. Those who control costs should be responsible for them.

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. Incentives and EVA ® 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? Does it help avoid the hidden cost fallacy? Does it help avoid the fixed cost fallacy?

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. Does EVA ® work? Adopting companies of EPP’s (+ four years) ROA from 3.5 to 4.7% operating income/assets from 15.8 to 16.7% Indistinguishable from non-adopters Bonuses increase 39.1% for EVA® firms But 37.4% for control group Interpretations Selection bias? NO, cheaper to use existing plans Goal alignment, YES. EVA® is no better or worse Rival EPP’s Bonus plans Discussion: WHY?

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. Psychological Biases Not enough information or bad incentives are not the only causes for business mistakes. Often psychological biases get in the way of rational decision making. Definition: the endowment effect means that taking ownership of item causes owner to increase value she places on the item. Definition: loss aversion – individuals would pay more to avoid loss than to realize gains. Definition: confirmation bias – a tendency to gather information that confirms your prior beliefs, and to ignore information that contradicts them. Definition: anchoring bias – relates the effects of how information is presented or “framed” Definition: overconfidence bias – the tendency to place too much confidence in the accuracy of your analysis

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. In class problem (1) ▮ You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next- best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton? A. $0; B. $10; C. $40; D. $50

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. In class problem (2) ▮ You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next- best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the minimum amount (in dollars) you would have to value seeing Eric Clapton for you to choose his concert? A. $0; B. $10; C. $40; D. $50

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 Coca-Cola in the 1980s had very little debt, preferring to raise equity capital from its stockholders The 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” Why? 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 that could have been earned by investing in soft drinks A dollar invested in aquaculture and wine is a dollar that was not invested in soft drinks Divisions sold off and proceeds invested in core soft drink business