Download A) Sunk costs & opportunity costs

BA 215
Agenda for Lecture 3
• Sunk Costs and Opportunity Costs
• Break
• Theory of the Firm
• Break
• Team Exercise
The microeconomic foundations
of finance and accounting
Sunk Costs:
Costs that have already
been incurred. Sunk costs
are irrelevant for all
decisions, because they
cannot be changed.
The microeconomic foundations
of finance and accounting
Opportunity Costs:
The profit foregone by selecting
one alternative instead of
another; the net return that could
be realized if a resource were put
to its best alternative use.
The microeconomic foundations
of management accounting
Relevant Costs:
Also sometimes called Differential
Costs or Incremental Costs
A differential cost for a particular
decision is one that changes if an
alternative decision is chosen.
When are Costs and
Revenues Relevant?
Answer: The relevant costs and revenues
are those which, as between the alternatives
being considered, are expected to be
different in the future.
The Jennie Mae Frog Farm
Jennie Mae’s Frog Farm has fixed costs of $5,000 per
month and variable costs of $2 per frog. All fixed costs
are avoidable, in the sense that Jennie Mae could close
the farm tomorrow, and not incur any fixed costs next
month. However, she doesn’t want to do that because
times are good in the frog business: she is operating at
capacity, making and selling 1,000 frogs per month.
Jennie Mae’s usual sales price is $9 per frog. The U.S.
Army has approached Jennie Mae and proposed a onetime purchase of 300 frogs for $7 per frog. The sale
would occur next month. Jennie Mae’s $2 per frog
variable cost includes $0.25 of product packaging that
would be unnecessary for frogs designated for the Army.
The Jennie Mae Frog Farm
Question #1: With respect to Jennie Mae’s decision of
whether to accept the Army’s offer, what is Jennie Mae’s
opportunity cost?
The Jennie Mae Frog Farm
Question #1: With respect to Jennie Mae’s decision of
whether to accept the Army’s offer, what is Jennie Mae’s
opportunity cost?
Since Jennie Mae is operating at capacity, her opportunity
cost is her profit foregone from the regular sales that are
displaced by the sales to the Army. These profits are
calculated either as $9 sales price minus $2 variable
costs = $7 per frog, multiplied by 300 frogs = $2,100;
or as the difference between this $7 per frog contribution
margin and her contribution margin from sales to the
Army of the $7 sales price less $1.75 in variable costs =
$5.25 per frog. This difference is $7 minus $5.25 =
$1.75, multiplied by 300 frogs = $525.
The Jennie Mae Frog Farm
Question #2: With respect to Jennie Mae’s decision of
whether to accept the Army’s offer, which costs are sunk,
and hence, are irrelevant to her decision?
The Jennie Mae Frog Farm
Question #2: With respect to Jennie Mae’s decision of
whether to accept the Army’s offer, which costs are sunk,
and hence, are irrelevant to her decision?
No costs are sunk. Even the fixed costs are avoidable.
Hence, although the fixed costs are irrelevant to Jennie
Mae’s decision, they are not sunk.
The Jennie Mae Frog Farm
Question #3: With respect to Jennie Mae’s decision of
whether to accept the Army’s offer, which costs are
differential costs (i.e., relevant, or incremental costs)?
The Jennie Mae Frog Farm
Question #3: With respect to Jennie Mae’s decision of
whether to accept the Army’s offer, which costs are
differential costs (i.e., relevant, or incremental costs)?
The differential costs are the $0.25 product packaging
costs. Nothing else is differential, because whether or not
Jennie Mae sells to the Army, she will produce at capacity.
The Jennie Mae Frog Farm
Question #4: Now assume that times are not so good,
and Jennie Mae has excess capacity to make 500 frogs.
The Army approaches Jennie Mae and proposes a onetime purchase of 300 frogs. What is the lowest price
Jennie Mae should be willing to charge the Army per frog?
The Jennie Mae Frog Farm
Question #4: Now assume that times are not so good, and Jennie
Mae has excess capacity to make 500 frogs. The Army approaches
Jennie Mae and proposes a one-time purchase of 300 frogs. What is
the lowest price Jennie Mae should be willing to charge the Army per
frog?
$1.75 per frog, the variable cost of production, assuming Jennie Mae
was going to continue operations. However, with only 500 customers,
she is not covering her costs, and the price to the Army that will
allow her to break even is $6.75, as follows:
Revenues:
from the Army: $6.75 x 300 =
from normal customers: $9 x 500 =
Costs:
Variable costs (500 x $2) + (300 x $1.75) =
Fixed costs
Income
2,025
4,500
1,525
5,000
$
0
The Jennie Mae Frog Farm
Question #5: Now assume that times are really bad, the
market for frogs crashes, and Jennie Mae gets out of the
frog business and starts producing platypuses instead.
Jennie Mae has an aging inventory of frogs sufficient to
meet market demand for 10 months (300 frogs per
month), but unfortunately, frogs only have a useful life of
5 months and her inventory becomes obsolete after that.
These frogs cost $7 each to make, consisting of $2 in
variable costs and $5 in allocated fixed overhead. What is
the lowest price Annie should accept from the Air Force
for a one-time-only purchase of 300 frogs? What is her
opportunity cost?
The Jennie Mae Frog Farm
Question #5: Now assume that times are really bad, the
market for frogs crashes, and Jennie Mae gets out of the
frog business and starts producing platypuses instead.
Jennie Mae has an aging inventory of frogs sufficient to
meet market demand for 10 months (300 frogs per
month), but unfortunately, frogs only have a useful life of
5 months and her inventory becomes obsolete after that.
These frogs cost $7 each to make, consisting of $2 in
variable costs and $5 in allocated fixed overhead. What is
the lowest price Jennie Mae should accept from the Air
Force for a one-time-only purchase of 300 frogs? What is
her opportunity cost?
Jennie should accept any price above zero. Her
opportunity cost is zero.
BA 215
Agenda for Lecture 3
• Sunk Costs and Opportunity Costs
• Break
• Theory of the Firm
• Break
• Team Exercise
BA 215
Agenda for Lecture 3
• Sunk Costs and Opportunity Costs
• Break
• Theory of the Firm
• Break
• Team Exercise
Theory of the Firm
• Classical microeconomic theory
– Firms exist to maximize profits to
owners
• Agency Theory
• Transaction Cost Economics
Agency Theory
• Separation of management from
ownership
• Examples:
– The spice trade
– The Hudson Bay Trading Company
– The early railroads
• The concept of “span of control”
Types of Agency Costs
• Moral hazard (unobserved actions)
– Employees don’t like to work hard
– Other examples of moral hazard
• Adverse selection (unobserved type)
– Employee ability is difficult to assess
– Other examples of adverse selection
problems
• Misaligned incentives
• Agency costs can be minimized through
appropriate oversight.
– Corporate governance
Misaligned Incentives
• Managers are more risk averse than
owners.
• Managers enjoy consumption of
perquisites.
• Managers may have a short-term
time horizon.
• Managers may increase their
personal utility through empire
building.
Managerial Incentive Schemes
• Bonuses based on profits.
• Bonuses based on other financial
measures.
• Bonuses based on operational
measures (e.g. market share).
• Bonuses based on stock price.
Stock Option Incentive Plans
• Stock options gained popularity in the
1990s.
• They were especially popular with cashpoor, high-tech, start-up companies.
• Controversy over how to account for
them.
• Backdating scandal.
• Stock options may not align incentives
as effectively as originally thought.
Transaction Cost Economics
• Some transactions are less costly
to execute within an organization
than between two independent
organizations.
• Other transactions are less costly
to execute between independent
parties than within the same
organization.
Transaction Cost Economics
• The firm is a “nexus of contracts.”
• Boundaries of the firm
• Examples:
– Piecework at a Levi Strauss factory
– Volkswagen factory in Brazil
– Retailers
BA 215
Agenda for Lecture 3
• Sunk Costs and Opportunity Costs
• Break
• Theory of the Firm
• Break
• Team Exercise
BA 215
Agenda for Lecture 3
• Sunk Costs and Opportunity Costs
• Break
• Theory of the Firm
• Break
• Team Exercise