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 rates 3. Marginal costs rise (1) at higher production rates than planned and (2) for quick changes in than planned and (2) for quick changes in output.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, 100 Boeing volumes of output. That is, 100 Boeing 787s will cost more per unit than if 1,000 787s will cost more per unit than if 1,000 Boeing 787s are made. This is economies of Boeing 787s are made. This is economies of scale or mass production. Engineering, not scale or mass production. Engineering, not economics.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..

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. Hence, a fixed before it is out of service. Hence, a fixed cost of £10 per unit.cost of £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 is what we have. The old machine is what we have. Should we sell it? Given changes in the Should we sell it? Given changes in the market price, how long can we continue market price, how long can we continue production? 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?

Economic Value of Assets

Economic value of an asset requires an Economic value of an asset requires an estimate of the net cash flow expected estimate of the net cash flow expected from the asset (discounted).from the asset (discounted).

Hence, valuation is continuous and is Hence, valuation is continuous and is subjective: an educated guess about subjective: an educated guess about expectedexpected cash flows. Past cash flows cash flows. Past cash flows (accounting data) from an asset can (accounting data) from an asset can provide useful information to a manager provide useful information to a manager in making valuation decisions, but alone in making valuation decisions, but alone should not drive the decision.should not drive the decision.

Consider New AssetConsider New Asset

Purchase price is accounting value of asset.Purchase price is accounting value of asset.

Economic value? Higher than accounting value Economic value? Higher than accounting value or would not buy. Expected value in use of or would not buy. Expected value in use of asset must be more valuable than purchase asset must be more valuable than purchase price.price.

New machine purchased for $35,000 (asset New machine purchased for $35,000 (asset value).value).

Estimate machine life of five years with revenue Estimate machine life of five years with revenue of $10,000/yr. (discounted 10%/yr.) for net of $10,000/yr. (discounted 10%/yr.) for net present value of $37,910. present value of $37,910.

Profit of $2,910 not recorded.Profit of $2,910 not recorded.

Changes in Asset ValueChanges in Asset Value

We acquired the machine for $35,000 (recorded We acquired the machine for $35,000 (recorded value) that had a present value (PV) of value) that had a present value (PV) of $37,910.$37,910.

Suppose costs rise and cash flow falls to Suppose costs rise and cash flow falls to $9,000/yr. from $10,0000/yr. Then PV falls to $9,000/yr. from $10,0000/yr. Then PV falls to $34,120. Or demand increases and allows us to $34,120. Or demand increases and allows us to extend the life to six years for PV of $43,550. extend the life to six years for PV of $43,550. Or discount rate (alternative investment Or discount rate (alternative investment return) changes to 12%; then PV falls to return) changes to 12%; then PV falls to $36,050. None of these changes in economic $36,050. None of these changes in economic value cause accounting value to change. It value cause accounting value to change. It continues to show initial value ($35,000) continues to show initial value ($35,000) depreciated over 5 year expected life.depreciated over 5 year expected life.

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.

Accounting Profit versusAccounting Profit versusEconomic ProfitEconomic Profit

Accounting Profit = Sales Revenue – Accounting CostAccounting Profit = Sales Revenue – Accounting Cost

Economic Profit = Sales Revenue – Economic CostEconomic Profit = Sales Revenue – Economic Cost

Economic Cost = Accounting Cost + Economic Economic Cost = Accounting Cost + Economic CostCost

Example of difference: Example of difference:

McDonald’s reported $2 billion accounting profit in McDonald’s reported $2 billion accounting profit in 2002; economic profit estimated to be - $124 million2002; economic profit estimated to be - $124 million

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

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

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

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

How do you get managers to be more How do you get managers to be more responsible about firm assets? Google makes responsible about firm assets? Google makes divisions bid for server use. Internal divisions bid for server use. Internal competition.competition.

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 new division showed Example: one new division showed accounting revenues of $1,069 million; costs accounting revenues of $1,069 million; costs of $1,001 million: accounting profit of $68 of $1,001 million: accounting profit of $68 million.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 rule is that 12% interest is charged by the parent company to each division for idle the parent company to each division for idle cash: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.

Cost Control by InBev: Much of This Should Seem Obvious

Wait 120 days to pay vendors (the jerks).Wait 120 days to pay vendors (the jerks).

Double sided, no-color printing in England Double sided, no-color printing in England offices saved $325,000 a year.offices saved $325,000 a year.

40% fewer Blackberries for U.S. employees.40% fewer Blackberries for U.S. employees.

Few private offices—everyone in large rooms Few private offices—everyone in large rooms (one impact—faster communication).(one impact—faster communication).

No private airplanes; everyone flies No private airplanes; everyone flies commercial.commercial.

Zero-based budgets every year.Zero-based budgets every year.

Ad firms paid by project, not by annual Ad firms paid by project, not by annual budget.budget.

Efforts at other firms…Efforts at other firms…

Nicholas & Co., a Salt Lake City food Nicholas & Co., a Salt Lake City food distributor cuts sales commissions 25% distributor cuts sales commissions 25% when customers’ bills are more than 45 when customers’ bills are more than 45 days past due. Sales reps now think about days past due. Sales reps now think about creditworthiness. Bill payment time creditworthiness. Bill payment time dropped in half.dropped in half.

Slack & Co. Contracting, Houston, borrowed Slack & Co. Contracting, Houston, borrowed $1 million a month to cover late payments $1 million a month to cover late payments from clients. Slack now refuses to deal with from clients. Slack now refuses to deal with firms with bad reputations and histories. firms with bad reputations and histories. Mr. Slack: “Don’t confuse volume with Mr. Slack: “Don’t confuse volume with profit.”profit.”

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.