For this first assignment you are to put togethe

For this first assignment you are to put together a tutorial that explains what opportunity costs are and how they are used in economic reasoning and decision making. Provide clear, practical examples of opportunity costs being utilized well in decisions (leads to increases in value) and opportunity costs utilized poorly in decision making (value is not maximized).

utilizing at least one outside scholarly or professional source related to organizational behavior. This source should be a published article in a scholarly journal. This source should provide substance and not just be mentioned briefly to fulfill this criteria. The textbook should also be utilized. Do not use quotes. Do not insert excess line spacing. APA formatting and citation should be used.

Benefits, Costs, and Decisions

©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

CHAPTER

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.

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.

continued

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

Who is making the bad decision?

The plant manager made the switch to the lower-priced
8400 coal.

Did he have enough information to make a good decision?

Yes, presumably he knew that this would reduce his output.

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)

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

The One Lesson
of Business

CHAPTER

Voluntary transactions create wealth by moving assets from lower- to higher-valued uses.

Anything that impedes the movement of assets to higher-valued uses, like taxes, subsidies, or price controls, destroys wealth.

Economic analysis is useful to business for identifying assets in lower-valued uses.

The art of business consists of identifying assets in low-valued uses and devising ways to profitably move them to higher-valued ones.

A company can be thought of as a series of transactions.
A well-designed organization rewards employees who identify and consummate profitable transactions or who stop unprofitable ones.

Kidney Transplants

Two prominent hospitals recently refused patients for kidney transplants because the organs were from “directed donations.”

The kidneys were meant for specific people

Demand for organs is high – far exceeding supply – and many never receive them.

Despite high demand and low supply, buying and selling organs is illegal.

Why?

Apartments

Suppose you want to move from Detroit to Nashville

First, you would try a two-way trade

Failing that, you’d try a three-way
connection with another city

Need to find correct trades with
correct timing = difficult!

Like with kidney transplants, compatibility problems lead to inefficiency

Detroit Nashville

Los Angeles

Capitalism 101

To identify money-making opportunities,
you must first understand how wealth is created
(and sometimes destroyed).

Key note: Wealth is created when assets are moved from lower to higher-valued uses

Definition: Value = willingness to pay

Desire + Income = You want something + you can pay for it

Key note: Voluntary transactions, between individuals or firms, create wealth.

Meaning, people create wealth by pursuing self-interest.

Housing Example

A house is for sale:

The buyer values the house at $130,000

This is the buyer’s top dollar – willingness to pay

The seller values the house at $120,000

This is the seller’s bottom line – won’t accept less

The buyer and seller must agree to a price that “splits” surplus between buyer and seller. Here, $128,000.

Surplus

The buyer and seller both benefit from this transaction:

Buyer surplus = buyer’s value minus the price

$130,000 – $128,000 = $2,000 buyer surplus

Seller surplus = the price minus the seller’s value

$128,000 – $120,000 = $8,000 seller surplus

Total surplus = buyer + seller surplus = difference in values

$2,000 + $8,000 = $10,000  $130,000 – $120,000 = $10,000

$10,000 are the gains from trade

Wealth-Creating Transactions

Which assets do these transactions move to higher-valued uses?

• Factory Owners • Corporate Raiders

• Real Estate Agents • Insurance Salesman

• Investment Bankers

Discussion: How does eBay create wealth?

Discussion: Which individual has created the most wealth during your lifetime?

Discussion: How do you create wealth?

Do Mergers Create Wealth?

Do mergers follow the wealth-creating engine of capitalism? Do they move assets to a higher-valued use?

Our largest and most valuable assets are corporations.

Ex: Dell-Alienware merger:

In 2006, Dell purchased Alienware, a manufacturer of high-end gaming computers.

Dell left design, marketing, sales and support in Alienware’s hands.

Dell took over manufacturing though, using its expertise
to build Alienware’s computers at a much lower cost.

Do Mergers Create Wealth?

However, many mergers and acquisitions do not create value

If they do, value creation is rarely so clear

To create value, the assets of the acquired firm must be more valuable to the buyer than to the seller

Does Government Create Wealth?

Discussion: What’s the government’s role is wealth creation?

Enforcing property rights and contracts legal tools that facilitate wealth creating transactions

Ensures that buyers and sellers keep gains from trade

Discussion: Why are some countries so poor?

No property rights

No rule of law

Discussion: Much of the justification for government intervention comes from the assertion that markets have failed. One money manager scoffed at this idea. “The markets are working fine, but they’re giving people answers that they don’t like, so people cry market failure.”

The One Lesson of Economics

Definition: An economy is efficient if all assets are employed in their highest-valued assets.

This is an unattainable, but useful benchmark

The One Lesson of Economics: The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

Must look at the intended and unintended effects of policies to understand their efficiency

The economist’s solution to inefficient outcomes is to argue for a change in public policy.

Business person’s solution is to try to make money on the inefficiency

The One Lesson of Business

Definition: Inefficiency implies the existence of unconsummated, wealth-creating transactions

The One Lesson of Business: The art of business consists of identifying assets in lower valued uses and devising ways to profitably moving them to higher valued uses.

In other words, make money by identifying unconsummated wealth-creating transactions and devise ways to profitably consummate them.

Destroying Wealth

Anything that stops assets from moving to higher valued uses is destroying wealth.

Taxes Destroy Wealth:

By deterring wealth-creating transactions – when the tax is larger than the surplus for a transaction.

Subsidies Destroy Wealth:

Example: flood insurance encourages people to build in areas that they otherwise wouldn’t

Price Controls Destroy Wealth:

Example: rent control (price ceiling) in New York City deters transactions between owners and renters

Which assets end up in lower-valued uses?

Profiting from Inefficiency

Taxes create a profit opportunity

Discussion: 1983 Sweden tax

Subsidies create opportunity

Discussion: health insurance

Price-controls create opportunity

Discussion: Regulation Q. & euro dollars

Discussion: What about ethics?

Wealth Creation in Organizations

Companies = a collection of transactions

They buy raw materials (capital, labor, etc.) and create and sell higher-valued goods and services

Can equate market-level problems (taxes, subsidies and price controls) with organization-level goal alignment problems

Ex: The overbidding from the oil company = “subsidy” paid to management for acquiring oil reserves

Allows us to use the same analysis

For this first assignment you are to put togethe

We offer the best custom paper writing services. We have done this question before, we can also do it for you.

Why Choose Us

How It Works