Benefits, Costs, and Decisions

CHAPTER
3 Benefits, Costs,
and Decisions
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● 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.
©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 2
• continued
● 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.
• continued
● 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.
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.
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.
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
Background: Types of Costs
● Definition: Fixed costs do not vary with the amount

of output.
● Definition: Variable costs change as output changes.
FIGURE 3.1 Cost Curves

Example: A Candy Factory
● The cost of the factory is fixed.

● Employee pay and cost of ingredients are variable costs.
TABLE 3.1 Candy Factory Costs
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.
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.
Accounting Costs for Cadbury
TABLE 3.2 Cadbury Income Statement

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
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
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.
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.
Cadbury’s Costs
● Holding on to 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.
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
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
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
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
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.
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.
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?
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?
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
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
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
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

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CHAPTER

● Accounting profit does not necessarily correspond to

● EVA® is a measure of financial performance that

Big Coal Power Co. switched to a 8400 coal when the

Use our three questions for analysis

● The plant manager should have considered all the

● Definition: Fixed costs do not vary with the amount

FIGURE 3.1 Cost Curves

● The cost of the factory is fixed.

TABLE 3.1 Candy Factory Costs

Are these costs fixed or variable?

● Beginning in 1978, Cadbury offered managers free housing in

● Senior managers then decided to sell the unused apartments

TABLE 3.2 Cadbury Income Statement

● Accounting profit recognizes only explicit costs

● What’s missing from Cadbury’s statements are

Definition: the opportunity cost of an action is what

● Whenever you get confused by costs, step back and

● Holding on to the flats cost the company £600,000

● When making decisions, you should consider all costs

Launching a new product:

Definition: ignoring relevant costs (costs that vary with the

● The subprime mortgage crisis of 2008 is a good example

● Recall that accounting profit does not necessarily

● Goal alignment: “By taking all capital costs into

● Adopting companies of EPP’s (+ four years)

You won a free ticket to see an Eric Clapton concert

You won a free ticket to see an Eric Clapton concert

● Coca-Cola in the 1980s had very little debt, preferring to raise

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