Lecture 11 Economic Propositions about Costs

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Lecture 11Economic 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.

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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 ownersopportunity
  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.

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Present Value Example

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

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It Depends

• It depends on the interest (discount) rate.
• If the interest rate is 5, buy the 3 year
  membership
• PV 125 125/1.05 125/(1.05)(1.05)
• 357.43 125 119.05 113.38
• vs. 300 now
• (savings is 57.43 not 75)
• What if interest rate is 20?

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Discount or Interest Rates

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

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Simple Example of Underestimation of Cost

• A software company has total revenue of 1,000,000
  RMB. Total expenses of 850,000 RMB.
• Owner pays herself 100,000 RMB.
• Accounting profit 50,000 RMB.
• But, the owner could earn 200,000 RMB if working
  for another software company. The opportunity
  cost of her labor is 200,000, not 100,000.
• Real cost of labor is 200,000, not 100,000, so
  firm lost 50,000 RMB.
• Is she crazy to work for herself?

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Example of Cost Considerations

• Suppose you buy a truck for a business for
  40,000.
• What is the cost today of acquiring this asset?
• Consider your alternatives and your plans for the
  vehicle right after purchase. The decision to buy
  the truck involves avoidable costsby not buying
  the truck, you avoid costs.
• You buy the truck, the next day you decide it is
  a mistake and want to sell it. The value is now
  37,000, so the cost is 3,000. That cost is sunk
  cost. It cannot be recovered and is unavoidable
  at this point to the decision made to keep or
  sell.

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Possession Costs

• Next You plan to keep the truck for two years.
  If you do not use it (just hold it), the value
  falls to 25,000 by then (from its current value
  of 37,000).
• But 25,000 in two years is not the same as the
  value today it must be discounted to current
  value. If the discount rate is 10 per year then
  25,000 x .826 20,650 present value.
• 37,000 - 20,650 16,350 depreciation (the
  anticipated decline in value of an asset)

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Other possession costs

• If you hold the truck, at the beginning of each
  year you must pay license and insurance of 2,000
  each year at the start of the year. So you pay
  2,000 now.
• The beginning of next year you pay 2,000 covert
  that to present value .909 x 2,000 1,818 for
  two year total of 3,818.
• Add that to the holding cost to get two year
  holding total 3,818 16,350 20,168

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Operating costs

• Suppose you use the truck 20,000 miles a year for
  each of two years. What costs?
• Depreciation increases, since the expected value
  of the truck after two years will be 22,000 (not
  25,000) due to the mileage. Present value of
  3,000 added depreciation (x .826) 2,487
• (Note that these may be called incremental or
  variable costs)

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Operating Costs

• Suppose the out-of-pocket expenses for fuel, oil,
  repairs, and tires equals 5,000 the end of year
  one, 5,000 x .909 4,545 the present value if
  the bills are paid at the end of the year. And
  7,000 in year two, paid at the end of year two
  7,000 x .826 5,782
• For a two year present value total of 10,327.
• Add to that extra depreciation, 2,487 for a two
  year operating cost of 12,814.

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Total Cost of Using Truck

• The expected cost of the decision to own and use
  the truck for two years is
• Acquisition cost 3,000
• Possession costs 20,168
• Operating costs 12,814
• Total present value of cost of obtaining the
  truck and using it 35,982

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Suppose Things Change?

• The best plans can be upset by changes in
  technology.
• What was state of the art becomes obsolete.
• Obsolescence is an unanticipated development that
  reduces the value of existing assets.

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Obsolescence and Cost

• 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.
• Assume other costs (labor and supplies) are 20
  per unit.
• Output costs 30 per unit.

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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.
• However, it needs only 15 worth of labor and
  supplies
• Cost per unit output is 25, not 30.
• What is the value of the old machine?

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

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Effects of Obsolescence

• Old Machine New Machine
• Fixed Cost 10 Fixed Cost 10
• Variable Cost 20 Variable Cost 15
• Total cost 30/unit Total 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?

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Small (Marginal) Changes in Cost Add Up

• Most managerial decisions involve cost changes at
  the marginsmall 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.
• Working on such margins for 5 years reduced
  average waiting time from 3.5 minutes to 3
  minutes per customer.

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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.
• Wendys 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).

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Opportunity Costs

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

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Opportunity Cost A Real World Issue

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

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Example John Deere

• Tough competition in heavy equipment market.
• 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
  billionopportunity cost of cash)

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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.
• 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.

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Measuring Opportunity Cost

• 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 time for debt collection, 105 days
• 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.

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Reducing Opportunity Cost within the Firm

• Steps taken to reduce those costs
• Outsource debt collection to specialist firm.
  Average debt collection time reduced from 105 to
  41 days over 5 years.
• Average inventory time cut from 242 to 198 days
  over five years.
• 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.

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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.

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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.

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Summary 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.