1. Any Questions from Last Class?

2. Chapter 4 – Take Aways 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.

3. Chapter 4 – Take Aways 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 ¼ 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. 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.

4. Chapter 4 Extent (How Much) 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.

5. Review of Chapter 3 Costs associated with decisions—not activities  Opportunity cost  Relevant benefit-cost The fixed-cost fallacy or sunk-cost fallacy The hidden-cost fallacy EVA ® = opportunity cost of capital. EVA ® works no better than other economic performance plans

6. Anecdote: Memorial Hospital Large, community hospital offering a full line of services 2005 performance review  Obstetrics chief proposed increasing the number of babies being delivered  Recent year: total costs = $3,132,000 while total revenue = $2,754,000 for 540 deliveries  CEO asks: why increase the number of deliveries when we are losing $700 per delivery??

7. Background: Average vs. Marginal Costs Average cost is simply the total cost of production divided by the number of units produced. AC = TC/Q  Average costs often decrease as quantity increases due to presence of fixed costs AC = (VC + FC)/Q FC does not change as Q increases Average costs are not relevant in decision-making Marginal costs are what matter  Marginal cost is the cost to make and sell one additional unit of output. MC = TC Q+1 – TC Q.  Marginal cost is often lower than average cost (due to falling average costs) but not always

8. Extent (How Much?) Decisions Definition: Marginal cost (MC) is the additional cost required to produce and sell one more unit. Definition: Marginal revenue (MR) is the additional revenue gained from producing and selling one more unit. Proposition: Produce more when MR>MC; less when MR<MC. Profits are maximized when MR=MC.

9. Extent Decisions (cont.) Examples of extent decisions  Advertising  Quality of service  Staff size  Number of parking spaces to lease Difficulties  The rule tells you direction of change but not distance  You can only measure MR and MC at current level of output

10. Extent Decision Example Discussion: TV advertising vs. telephone solicitations.  $50,000 TV ad budget increase nets you 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

11. Extent Decision Example (cont.) Even if we do not know the marginal revenue, we can still use marginal analysis to make money Compare TV advertising to telephone solicitation  Say you recently cut telephone 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 cut back on phone and do more TV Advice: make changes one-at-a-time to gather valuable information about marginal effectiveness of each medium.

12. Another Example Fortune 50 company studying how much to produce at different factories Factory A has costs of $30 per hour Factory B has cost of $20 per hour Decision seems simple, but  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 to Factory B

13. Incentive Pay Discussion: 100 trees  $150/tree vs. $15,000 for the right to harvest all the trees. Discussion: Sales Commissions  Expected sales level: 100 units @ $10,000/unit=$1M  Option 1 10% commission  Option 2: 5% commission + $50,000 salary  Compare the marginal benefits salespeople receive for making a sale under each approach  Lower commission = lower effort

14. Tie Pay to Performance Consulting Firm COO  $75K  $50K +.33(Profits-$150K)  Profits increased 72% to $1.2 M  Compensation increased $75K  $177K  Marginal incentive of divorced employee? Discussion: give example of royalty rate or fixed fee contracts in your firm Discussion: disadvantages of incentive pay

15. 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, 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 acquire a total of 15,000 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.