1. Lecture 11 Economic Propositions about Costs 1. The higher the selling price of a good, the greater the amount that producers will offer. (The Law of Supply) 2. Marginal costs (MC) determine the rate of output (supply curve). 3. Marginal costs rise (1) at higher production rates than planned and (2) for quick changes in output. 4. Average Cost (AC) and MC decrease for larger planned volumes of output. That is, 10 Boeing 777s will cost more per unit than if 100 Boeing 777s are made. This is economies of scale or mass production. Engineering, not economics.

2. More economic propositions on costs 5. Money prices are measures of costs because the buyer must pay at least the value of the resources to their current owners—opportunity costs. All costs are opportunity costs. 7. Implicit costs exist even if no accounting expenditure is recorded for a good or service. 8. Cost and revenue should be calculated in terms of present value.

3. Discount or Interest Rates Discount rates always exist whether we calculate them or not. Discount rates always exist whether we calculate them or not. Money today is always more valuable than a promise of money in the future. Money today is always more valuable than a promise of money in the future. Paying tomorrow is preferred to paying today. Paying tomorrow is preferred to paying today. This is the time value of money that represents its opportunity cost. This is the time value of money that represents its opportunity cost.

4. Suppose Things Change? The best plans can be upset by changes in technology. The best plans can be upset by changes in technology. What was “state of the art” becomes obsolete. What was “state of the art” becomes obsolete. Obsolescence is an unanticipated development that reduces the value of existing assets. Obsolescence is an unanticipated development that reduces the value of existing assets.

5. Obsolescence and Cost A machine costs £100,000 A machine costs £100,000 It is expected to help produce 10,000 units of output before it is depreciated to nothing. If so, then there is a fixed cost of £10 per unit spread over the units. It is expected to help produce 10,000 units of output before it is depreciated to nothing. If so, then there is a fixed cost of £10 per unit spread over the units. Assume other costs (labor and supplies) are £20 per unit. Assume other costs (labor and supplies) are £20 per unit. Output costs £30 per unit. Output costs £30 per unit.

6. Obsolescence and Cost… Now a new and better machine comes on the market. It costs £100,000 also. It is expected to produce 10,000 units before it is out of service. A fixed cost of £10 per unit. Now a new and better machine comes on the market. It costs £100,000 also. It is expected to produce 10,000 units before it is out of service. A fixed cost of £10 per unit. However, it needs only £15 worth of labor and supplies However, it needs only £15 worth of labor and supplies Cost per unit output is £25, not £30. Cost per unit output is £25, not £30. What is the value of the old machine? What is the value of the old machine?

7. Considerations The old machine falls in value due to unexpected obsolescence. Even if old machine has never been used, the new machine causes the present value of the old machine to fall by £50,000 in value. The old machine falls in value due to unexpected obsolescence. Even if old machine has never been used, the new machine causes the present value of the old machine to fall by £50,000 in value. The old machine can be used so long as the price of output is above £20, so variable costs are covered. If price below £20, stop production. The old machine can be used so long as the price of output is above £20, so variable costs are covered. If price below £20, stop production.

8. Effects of Obsolescence Old Machine:New Machine: Fixed Cost £10Fixed Cost £10 Variable Cost £20Variable Cost £15 Total cost: £30/unitTotal cost: £25/unit Market price for output £27. What do we do? Market price for output £22. What do we do? Market price for output £18. What do we do? Market price for output £13. What do we do?

9. Small (Marginal) Changes in Cost Add Up Most managerial decisions involve cost changes at the margin—small changes that can have big impacts. Most managerial decisions involve cost changes at the margin—small changes that can have big impacts. Starbucks, studying worker time in production, noticed that employees had to dig twice into ice machines to get sufficient ice for large drinks. The developed a new ice scoop that requires one scoop for any size drink. Time savings of 14 seconds for large drinks. Starbucks, studying worker time in production, noticed that employees had to dig twice into ice machines to get sufficient ice for large drinks. The developed a new ice scoop that requires one scoop for any size drink. Time savings of 14 seconds for large drinks. Working on such margins for 5 years reduced average waiting time from 3.5 minutes to 3 minutes per customer. Working on such margins for 5 years reduced average waiting time from 3.5 minutes to 3 minutes per customer.

10. Small Changes Can Mean Higher Profits Over five years, such improvements in productivity at Starbucks (shorter waiting time for customers, so more sales) meant store sales up an average of $200,000. Over five years, such improvements in productivity at Starbucks (shorter waiting time for customers, so more sales) meant store sales up an average of $200,000. Wendy’s developed a double-sided grill that cuts cooking time for a hamburger patty from 5 minutes to 1.5 minutes. Wendy’s developed a double-sided grill that cuts cooking time for a hamburger patty from 5 minutes to 1.5 minutes. Caribou Coffee uses “floater” workers who are not assigned to one task but help direct others to where need is greatest and jumps in to help where help is needed. Added cost of one worker less than added revenue from faster productivity (more sales). Caribou Coffee uses “floater” workers who are not assigned to one task but help direct others to where need is greatest and jumps in to help where help is needed. Added cost of one worker less than added revenue from faster productivity (more sales).

11. Opportunity Costs “Few firms make a profit.” “Few firms make a profit.” Peter Drucker Why? Most focus on accounting costs, failing to consider opportunity costs, so constantly overestimate profits.

12. Opportunity Cost: A Real World Issue Why has there been a push to “just in time inventory” in production? Why has there been a push to “just in time inventory” in production? Even if debt collection from customers is certain to happen, why is sooner better than later? Even if debt collection from customers is certain to happen, why is sooner better than later? If a firm is profitable, how do you account for the value of the money used to buy machinery (assets)? If a firm is profitable, how do you account for the value of the money used to buy machinery (assets)?

13. Example: John Deere Tough competition in heavy equipment market. Tough competition in heavy equipment market. New CEO focused on reducing all costs: New CEO focused on reducing all costs: - Sold and leased excess plant space (capitalized an undervalued asset) - Reduced end of year unsold combines from 1,600 in 2000 to 200 in 2005 (value of unsold inventory reduced $1/3 billion—opportunity cost of cash)

14. How one firm accounts for opportunity cost: Gillette requires each division to count the opportunity cost of cash tied up in different parts of the operation. Gillette requires each division to count the opportunity cost of cash tied up in different parts of the operation. Example: one division showed accounting revenues of $1,069 million and costs of $1,001 million, for an accounting profit of $68 million. Example: one division showed accounting revenues of $1,069 million and costs of $1,001 million, for an accounting profit of $68 million. Division was required to count the opportunity cost of cash, which changed the results. Previously, the division had less incentive to consider the value of cash used or idled. Division was required to count the opportunity cost of cash, which changed the results. Previously, the division had less incentive to consider the value of cash used or idled.

15. Measuring Opportunity Cost The rule is that 12% interest is charged by the parent company to each division for idle cash: The rule is that 12% interest is charged by the parent company to each division for idle cash: Average inventory in stock: 242 days Average inventory in stock: 242 days Average time for debt collection, 105 days Average time for debt collection, 105 days Cash tied up in equipment Cash tied up in equipment Opportunity cost of this: $119 million. Now: $68 million accounting profit minus $119 cost of cash yields $51 million loss. Managers told to reform or division would be liquidated.

16. Reducing Opportunity Cost within the Firm Steps taken to reduce those costs: Steps taken to reduce those costs: 1. Outsource debt collection to specialist firm. Average debt collection time reduced from 105 to 41 days over 5 years. 2. Average inventory time cut from 242 to 198 days over five years. 3. New applications for existing production machinery devised to increase revenue from equipment (also new revenue source). Net result: These opportunity costs cut $35 million. The division treated cash as a free good from the parent company.

17. Efforts at other firms… Nicholas & Co., a Salt Lake City food distributor cuts sales commissions 25% when customers’ bills are more than 45 days past due. Reps now think about creditworthiness. Bill payment time dropped in half. Slack & Co. Contracting, Houston, borrowed $1 million a month to cover late payments from clients. Slack now refuses to deal with firms with bad reputations and histories. Mr. Slack: “Don’t confuse volume with profit.”

18. Accounting Costs Lead Managers Over the Cliff Accounting numbers are very important management tools. But they can never account for all opportunity costs. Managers must see these within their own organization. Sometimes managers focus on accounting numbers only and drive the firm into bankruptcy.

19. Impact of One Change in Accounting Cost Rules FASB (U.S.) and International Accounting Standards Board intend to change the rule for long-term leases. It will mean about $1 trillion in “new” costs being recognized on the books. Long-term leases (like pension obligations) are often hidden. Some retailers do not own stores, they have long leases. Example: Whole Foods reported $639 million in long-term liabilities for 2006. Include lease obligations and that rises to $4.8 billion, reducing return on assets from 7.2% to 3.7% and increasing debt/equity ratio from 38% to 169%.

20. Summary: Costs The economic way of thinking about costs is not the same as accounting costs or the common way people think of costs. The economic way of thinking about costs is not the same as accounting costs or the common way people think of costs. This helps us consider opportunity costs — what does it cost us to command resources for some purpose — so we can contrast it to our next best understood alternative. This helps us consider opportunity costs — what does it cost us to command resources for some purpose — so we can contrast it to our next best understood alternative.