Lecture 11Lecture 11

Economic Propositions about CostsEconomic Propositions about Costs

1. The higher the selling price of a good, the 1. The higher the selling price of a good, the greater the amount that producers will offer. greater the amount that producers will offer. (The Law of Supply)(The Law of Supply)

2. Marginal costs (MC) determine the rate of 2. Marginal costs (MC) determine the rate of output (supply curve). output (supply curve).

3. Marginal costs rise (1) at higher production 3. Marginal costs rise (1) at higher production rates than planned and (2) for quick changes rates than planned and (2) for quick changes in output.in output.

4. Average Cost (AC) and MC decrease for larger 4. Average Cost (AC) and MC decrease for larger plannedplanned volumes of output. That is, 10 volumes of output. That is, 10 Boeing 777s will cost more per unit than if Boeing 777s will cost more per unit than if 100 Boeing 777s are made. This is 100 Boeing 777s are made. This is economies of scale or mass production. economies of scale or mass production. Engineering, not economics.Engineering, not economics.

More economic propositions on More economic propositions on costscosts

5. Money prices are 5. Money prices are measuresmeasures of costs because of costs because the buyer must pay at least the value of the buyer must pay at least the value of the resources to their current owners—the resources to their current owners—opportunity costs. All costs are opportunity opportunity costs. All costs are opportunity costs.costs.

7. Implicit costs exist even if no accounting 7. Implicit costs exist even if no accounting expenditure is recorded for a good or expenditure is recorded for a good or service.service.

8. Cost and revenue should be calculated in 8. Cost and revenue should be calculated in terms of present value.terms of present value.

Present Value ExamplePresent Value Example

You can buy a membership in the You can buy a membership in the Executive Room at airports from an Executive Room at airports from an airline for $125 per year or $300 airline for $125 per year or $300 now for a 3 year membership. You now for a 3 year membership. You know you will use it all three years.know you will use it all three years.

Should you buy the 3 year Should you buy the 3 year membership?membership?

It DependsIt Depends

It depends on the interest (discount) rate.It depends on the interest (discount) rate.

If the interest rate is 5%, buy the 3 year If the interest rate is 5%, buy the 3 year membership:membership:

PV = $125 + $125/1.05 + $125/(1.05)(1.05)PV = $125 + $125/1.05 + $125/(1.05)(1.05) $357.43 = $125 + $119.05 + $113.38 $357.43 = $125 + $119.05 + $113.38 vs. $300 nowvs. $300 now

(savings is $57.43 (savings is $57.43 notnot $75) $75)

What if interest rate is 20%?What if interest rate is 20%?

Discount or Interest RatesDiscount or Interest Rates

Discount ratesDiscount rates always exist whether always exist whether we calculate them or not.we calculate them or not.

Money today is always more Money today is always more valuable than a promise of money valuable than a promise of money in the future.in the future.

Paying tomorrow is preferred to Paying tomorrow is preferred to paying today.paying today.

This is the This is the time value of moneytime value of money that that represents its represents its opportunity costopportunity cost..

Simple Example of Simple Example of Underestimation of CostUnderestimation of Cost

A software company has total revenue of A software company has total revenue of 1,000,000 RMB. Total expenses of 850,000 1,000,000 RMB. Total expenses of 850,000 RMB.RMB.

Owner pays herself 100,000 RMB.Owner pays herself 100,000 RMB.Accounting profit: 50,000 RMB.Accounting profit: 50,000 RMB.But, the owner could earn 200,000 RMB if But, the owner could earn 200,000 RMB if

working for another software company. The working for another software company. The opportunity cost of her labor is 200,000, not opportunity cost of her labor is 200,000, not 100,000.100,000.

Real cost of labor is 200,000, not 100,000, so Real cost of labor is 200,000, not 100,000, so firm lost 50,000 RMB.firm lost 50,000 RMB.

Is she crazy to work for herself?Is she crazy to work for herself?

Example of Cost Example of Cost ConsiderationsConsiderations

Suppose you buy a truck for a business for 40,000.Suppose you buy a truck for a business for 40,000.What is the cost What is the cost todaytoday of acquiring this asset? of acquiring this asset?

Consider your alternatives and your plans for the Consider your alternatives and your plans for the vehicle right after purchase. The decision to buy vehicle right after purchase. The decision to buy the truck involves avoidable costs—by not the truck involves avoidable costs—by not buying the truck, you avoid costs.buying the truck, you avoid costs.

You buy the truck, the next day you decide it is a You buy the truck, the next day you decide it is a mistake and want to sell it. The value is now mistake and want to sell it. The value is now 37,000, so the cost is 3,000. That cost is “37,000, so the cost is 3,000. That cost is “sunk sunk cost.cost.” It cannot be recovered and is ” It cannot be recovered and is unavoidableunavoidable at this point to the decision made to keep or sell.at this point to the decision made to keep or sell.

Possession CostsPossession Costs

Next: You plan to keep the truck for two Next: You plan to keep the truck for two years. If you do not use it (just hold it), years. If you do not use it (just hold it), the value falls to 25,000 by then (from the value falls to 25,000 by then (from its current value of 37,000).its current value of 37,000).

But 25,000 in two years is not the same But 25,000 in two years is not the same as the value today — it must be as the value today — it must be discounted to current value. If the discounted to current value. If the discount ratediscount rate is 10% per year then is 10% per year then 25,000 x .826 = 20,650 25,000 x .826 = 20,650 present valuepresent value..

37,000 - 20,650 = 16,350 37,000 - 20,650 = 16,350 depreciation depreciation (the anticipated decline in value of an (the anticipated decline in value of an asset)asset)

Other possession costsOther possession costs

If you hold the truck, at the beginning of If you hold the truck, at the beginning of each year you must pay license and each year you must pay license and insurance of 2,000 each year at the start insurance of 2,000 each year at the start of the year. So you pay 2,000 now.of the year. So you pay 2,000 now.

The beginning of next year you pay 2,000: The beginning of next year you pay 2,000: covert that to present value .909 x 2,000 covert that to present value .909 x 2,000 = 1,818 for two year total of 3,818.= 1,818 for two year total of 3,818.

Add that to the holding cost to get two year Add that to the holding cost to get two year holding total 3,818 + 16,350 = 20,168holding total 3,818 + 16,350 = 20,168

Operating costsOperating costs

Suppose you use the truck 20,000 miles Suppose you use the truck 20,000 miles a year for each of two years. What a year for each of two years. What costs?costs?

Depreciation increases, since the Depreciation increases, since the expected value of the truck after two expected value of the truck after two years will be 22,000 (not 25,000) due years will be 22,000 (not 25,000) due to the mileage. Present value of 3,000 to the mileage. Present value of 3,000 added depreciation (x .826) = 2,487 added depreciation (x .826) = 2,487

(Note that these may be called (Note that these may be called incremental or variable costs)incremental or variable costs)

Operating CostsOperating Costs

Suppose the out-of-pocket expenses for fuel, Suppose the out-of-pocket expenses for fuel, oil, repairs, and tires equals 5,000 the end oil, repairs, and tires equals 5,000 the end of year one, 5,000 x .909 = 4,545; the of year one, 5,000 x .909 = 4,545; the present value if the bills are paid at the end present value if the bills are paid at the end of the year. And 7,000 in year two, paid at of the year. And 7,000 in year two, paid at the end of year two: 7,000 x .826 = 5,782the end of year two: 7,000 x .826 = 5,782

For a two year present value total of 10,327.For a two year present value total of 10,327.

Add to that extra depreciation, 2,487 for a Add to that extra depreciation, 2,487 for a two year operating cost of 12,814.two year operating cost of 12,814.

Total Cost of Using TruckTotal Cost of Using Truck

The expected cost of the decision to The expected cost of the decision to own and use the truck for two years is:own and use the truck for two years is:

Acquisition cost: Acquisition cost: 3,000 3,000

Possession costs:Possession costs: 20,168 20,168

Operating costs:Operating costs: 12,814 12,814

Total Total present valuepresent value of cost of obtaining of cost of obtaining the truck and using it:the truck and using it: 35,982 35,982

Suppose Things Change?Suppose Things Change?

The best plans can be upset by The best plans can be upset by changes in technology.changes in technology.

What was “state of the art” What was “state of the art” becomes obsolete.becomes obsolete.

Obsolescence is an unanticipated Obsolescence is an unanticipated development that reduces the development that reduces the value of existing assets.value of existing assets.

Obsolescence and CostObsolescence and Cost

A machine costs £100,000A machine costs £100,000 It is expected to help produce 10,000 It is expected to help produce 10,000

units of output before it is depreciated units of output before it is depreciated to nothing. If so, then there is a fixed to nothing. If so, then there is a fixed cost of £10 per unit spread over the cost of £10 per unit spread over the units.units.

Assume other costs (labor and Assume other costs (labor and supplies) are £20 per unit.supplies) are £20 per unit.

Output costs £30 per unit.Output costs £30 per unit.

Obsolescence and Cost…Obsolescence and Cost…

Now a new and better machine comes Now a new and better machine comes on the market. It costs £100,000 also. It on the market. It costs £100,000 also. It is expected to produce 10,000 units is expected to produce 10,000 units before it is out of service. A fixed cost of before it is out of service. A fixed cost of £10 per unit.£10 per unit.

However, it needs only £15 worth of However, it needs only £15 worth of labor and supplieslabor 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?

ConsiderationsConsiderations

The old machine falls in value due to The old machine falls in value due to unexpected obsolescence. Even if old unexpected obsolescence. Even if old machine has never been used, the new machine has never been used, the new machine causes the present value of the machine causes the present value of the old machine to fall by £50,000 in value.old machine to fall by £50,000 in value.

The old machine can be used so long as The old machine can be used so long as the price of output is above £20, so the price of output is above £20, so variable costs are covered. If price variable costs are covered. If price below £20, stop production. below £20, stop production.

Effects of ObsolescenceEffects of Obsolescence

Old Machine:Old Machine: New Machine:New Machine:

Fixed CostFixed Cost £10 £10 Fixed CostFixed Cost £10 £10

Variable CostVariable Cost £20 £20 Variable CostVariable Cost £15£15

Total cost: £30/unitTotal cost: £30/unit Total cost: £25/unitTotal cost: £25/unit

Market price for output £27. What do we do?Market price for output £27. What do we do?

Market price for output £22. 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 £18. What do we do?

Market price for output £13. What do we do?Market price for output £13. What do we do?

Small (Marginal) Changes in Small (Marginal) Changes in Cost Add UpCost Add Up

Most managerial decisions involve cost changes at Most managerial decisions involve cost changes at the margin—small changes that can have big the margin—small changes that can have big impacts.impacts.

Starbucks, studying worker time in production, Starbucks, studying worker time in production, noticed that employees had to dig twice into ice noticed that employees had to dig twice into ice machines to get sufficient ice for large drinks. The machines to get sufficient ice for large drinks. The developed a new ice scoop that requires one scoop developed a new ice scoop that requires one scoop for any size drink. Time savings of 14 seconds for for any size drink. Time savings of 14 seconds for large drinks.large drinks.

Working on such margins for 5 years reduced Working on such margins for 5 years reduced average waiting time from 3.5 minutes to 3 minutes average waiting time from 3.5 minutes to 3 minutes per customer.per customer.

Small Changes Can Mean Small Changes Can Mean Higher ProfitsHigher Profits

Over five years, such improvements in Over five years, such improvements in productivity at Starbucks (shorter waiting time productivity at Starbucks (shorter waiting time for customers, so more sales) meant store for customers, so more sales) meant store sales up an average of $200,000.sales up an average of $200,000.

Wendy’s developed a double-sided grill that Wendy’s developed a double-sided grill that cuts cooking time for a hamburger patty from 5 cuts cooking time for a hamburger patty from 5 minutes to 1.5 minutes.minutes to 1.5 minutes.

Caribou Coffee uses “floater” workers who are Caribou Coffee uses “floater” workers who are not assigned to one task but help direct others not assigned to one task but help direct others to where need is greatest and jumps in to help to where need is greatest and jumps in to help where help is needed. Added cost of one where help is needed. Added cost of one worker less than added revenue from faster worker less than added revenue from faster productivity (more sales).productivity (more sales).

Opportunity CostsOpportunity Costs

““Few firms make a profit.”Few firms make a profit.”

Peter DruckerPeter Drucker

Why? Most focus on accounting Why? Most focus on accounting costs, failing to consider costs, failing to consider opportunity costs, so constantly opportunity costs, so constantly overestimate profits.overestimate profits.

Opportunity Cost: Opportunity Cost: A Real World IssueA Real World Issue

Why has there been a push to “just Why has there been a push to “just in time inventory” in production?in time inventory” in production?

Even if debt collection from Even if debt collection from customers is certain to happen, why customers is certain to happen, why is sooner better than later?is sooner better than later?

If a firm is profitable, how do you If a firm is profitable, how do you account for the value of the money account for the value of the money used to buy machinery (assets)?used to buy machinery (assets)?

Example: John DeereExample: John Deere

Tough competition in heavy equipment Tough competition in heavy equipment market. market.

New CEO focused on reducing New CEO focused on reducing allall costs:costs:

- Sold and leased excess plant spaceSold and leased excess plant space

(capitalized an undervalued asset)(capitalized an undervalued asset)

- Reduced end of year unsold combines Reduced end of year unsold combines from 1,600 in 2000 to 200 in 2005from 1,600 in 2000 to 200 in 2005

(value of unsold inventory reduced $1/3 (value of unsold inventory reduced $1/3 billion—opportunity cost of cash)billion—opportunity cost of cash)

How one firm accounts for How one firm accounts for opportunity cost:opportunity cost:

Gillette requires each division to count the Gillette requires each division to count the opportunity cost of cash tied up in different opportunity cost of cash tied up in different parts of the operation.parts of the operation.

Example: one division showed accounting Example: one division showed accounting revenues of $1,069 million and costs of revenues of $1,069 million and costs of $1,001 million, for an accounting profit of $1,001 million, for an accounting profit of $68 million.$68 million.

Division was required to count the Division was required to count the opportunity cost of cash, which changed the opportunity cost of cash, which changed the results. Previously, the division had less results. Previously, the division had less incentive to consider the value of cash used incentive to consider the value of cash used or idled.or idled.

Measuring Opportunity CostMeasuring Opportunity Cost

The rule is that 12% interest is charged by the The rule is that 12% interest is charged by the parent company to each division for idle cash:parent company to each division for idle cash:

Average inventory in stock: 242 daysAverage inventory in stock: 242 days Average time for debt collection, 105 daysAverage time for debt collection, 105 days Cash tied up in equipmentCash tied up in equipment

Opportunity cost of this: $119 million.Opportunity cost of this: $119 million.

Now: $68 million accounting profit minus $119 Now: $68 million accounting profit minus $119 cost of cash yields $51 million loss. Managers cost of cash yields $51 million loss. Managers told to reform or division would be liquidated.told to reform or division would be liquidated.

Reducing Opportunity Cost Reducing Opportunity Cost within the Firmwithin the Firm

Steps taken to reduce those costs:Steps taken to reduce those costs:1.1. Outsource debt collection to specialist Outsource debt collection to specialist

firm. Average debt collection time firm. Average debt collection time reduced from 105 to 41 days over 5 years.reduced from 105 to 41 days over 5 years.

2.2. Average inventory time cut from 242 to Average inventory time cut from 242 to 198 days over five years.198 days over five years.

3.3. New applications for existing production New applications for existing production machinery devised to increase revenue machinery devised to increase revenue from equipment (also new revenue from equipment (also new revenue source).source).

Net result: These opportunity costs cut $35 Net result: These opportunity costs cut $35 million. The division treated cash as a free million. The division treated cash as a free good from the parent company.good from the parent company.

Accounting Costs Lead Accounting Costs Lead Managers Over the CliffManagers Over the Cliff

Accounting numbers are very Accounting numbers are very important management tools.important management tools.

But they can never account for all But they can never account for all opportunity costs. Managers must opportunity costs. Managers must see these within their own see these within their own organization.organization.

Sometimes managers focus on Sometimes managers focus on accounting numbers only and drive accounting numbers only and drive the firm into bankruptcy.the firm into bankruptcy.

Impact of One Change in Impact of One Change in Accounting Cost RulesAccounting Cost Rules

FASB (U.S.) and International Accounting FASB (U.S.) and International Accounting Standards Board intend to change the rule for Standards Board intend to change the rule for long-term leases. It will mean about $1 trillion long-term leases. It will mean about $1 trillion in “new” costs being recognized on the books.in “new” costs being recognized on the books.

Long-term leases (like pension obligations) are Long-term leases (like pension obligations) are often hidden. Some retailers do not own stores, often hidden. Some retailers do not own stores, they have long leases. Example: Whole Foods they have long leases. Example: Whole Foods reported $639 million in long-term liabilities for reported $639 million in long-term liabilities for 2006. Include lease obligations and that rises to 2006. Include lease obligations and that rises to $4.8 billion, reducing return on assets from $4.8 billion, reducing return on assets from 7.2% to 3.7% and increasing debt/equity ratio 7.2% to 3.7% and increasing debt/equity ratio from 38% to 169%.from 38% to 169%.

Summary: CostsSummary: Costs

The economic way of thinking about The economic way of thinking about costs is not the same as accounting costs is not the same as accounting costs or the common way people think costs or the common way people think of costs. of costs.

This helps us consider opportunity This helps us consider opportunity costs —what does it cost us to costs —what does it cost us to command resources for some purpose command resources for some purpose — so we can contrast it to our next — so we can contrast it to our next best understood alternative.best understood alternative.