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Chapter 2. Identifying and Estimating Costs and Benefits. Which Costs and Benefits to Measure?. Controllability : Cost or benefit that changes because of the decision Measured relative to status quo

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Chapter 2

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Chapter 2

Identifying and Estimating

Costs and Benefits


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Which Costs and Benefits to Measure?

Controllability: Cost or benefit that changes because of the decision

Measured relative to status quo

Relevance: A controllable cost or benefit that is different for at least one decision alternative

Relevance helps focus attention on few costs and benefits

LO1: Understand how to identify the costs and benefits of decision options.


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Identifying Costs and Benefits

Controllable costs and benefits

Compare to status quo or doing nothing

Computes absolute change in profit

Relevant costs and benefits

Compare across all options

Preserves ranking of decision options with fewer measurements

Why learn two concepts?

Controllability = Relevance if status quo is a choice

Status quo is not a choice in many decisions

LO1: Understand how to identify the costs and benefits of decision options.


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Example: Buying a PC

Controllable

Relevance

Brand D

Brand H

Brand H over D

Base configuration

$925

$875

($50)

Flat panel display

125

125

Memory upgrade

225

225

100GB External hard drive

169

169

Upgrade to Vista

175

175

Office 2007 Suite

185

185

3

-

year service agreement

175

300

125

Total

$1,979

$2,054

$75

LO1: Understand how to identify the costs and benefits of decision options.


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Controllability and Relevance

LO1: Understand how to identify the costs and benefits of decision options.


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No

No

No

No

Yes

No

Yes

Yes

Yes

Yes

Yes

No

LO1: Understand how to identify the costs and benefits of decision options.


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Sunk Costs

Controllable costs and benefits pertain to the future

Sunk costs are costs and benefits that have been incurred in the past

Our decisions today will not change them

They are not controllable or relevant!

Sometimes, the magnitude of a sunk cost can affect a future cost or benefit

Purchase price => taxable gain on sale => taxes paid

Amount of past error => manager’s reputation => promotion prospects

LO1: Understand how to identify the costs and benefits of decision options.


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Time and Cost Controllability

Control over costs and benefits increases with passage of time

Commitments and contracts expire

Ability to change capacity resources varies over time

Cannot change capacity level in the short-term

Can change capacity level in long-term

Because all decisions measure controllable costs and benefits we can classify decisions as to whether they are short term or long term decisions

LO2: Consider how time affects the realization of costs and benefits.


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Example: Time and Controllability

LO2: Consider how time affects the realization of costs and benefits.


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Putting the Ideas Together: A digression

We have developed two concepts

PIER circle

Classify decisions along the dimensions of planning and control

Controllability

For every decision we need to only measure what changes

What changes depends on time horizon for problem

We can link the two ideas

Decisions are inter-linked

Long-term decisions shape short-term contexts and short-term decisions affect long-term outcomes

Planning is required for control and control feeds into planning

Part Opener 1


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How do we match the supply and demand for resources?

(C9, C10)

Are we using resources

effectively?

(C12, C13)

C11

Long term

Short

Term

How can we get the most from available resources?

(C4, C5, C6)

Are we using resources

efficiently?(C8)

C7

Planning

Control

Part Opener 1


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Costbehavior

Costestimation

Costprediction

Steps in Estimating Costs

Use estimated parameters to forecast costs at a particularactivity level.

Use historical data to test model and to determine parameters

Build model of expected relationshipbetween cost and activity

LO3: Explain the principles for estimating costs and benefits


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Estimating Costs and Benefits

Controllable costs and benefits are the outcomes of activities

Two key principles

Variability: Relation between cost or a benefit and some underlying activity

Traceability: Extent to which we can identify cost or benefit with decision option

LO3: Explain the principles for estimating costs and benefits


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Revenue/Sales Volume Relationship


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Variability

Relation between cost/benefit and activity volume

If we know activity volume, we can estimate cost/benefit

Terminology

Fixed and variable costs are extremes

Mixed costs

LO3: Explain the principles for estimating costs and benefits


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Variable, Fixed, and Total Costs

LO3: Explain the principles for estimating costs and benefits


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$12

$10

$12

$8

$12

$5

$12

$4


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Traceability

Degree to which we can relate cost or benefit to decision option

Affects confidence in estimate

Entire effect of direct cost/benefit pertains to decision option

Confidence is high

Part effect for indirect cost/benefit

Role for allocations

LO3: Explain the principles for estimating costs and benefits


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Controllability, Variability & Traceability

LO3: Explain the principles for estimating costs and benefits


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Cost Hierarchy

The cost hierarchy broadens the principle of variability

Allows us to consider multiple activities

The cost hierarchy recognizes four types of costs

Unit-level costs

Batch-level costs

Product-level costs

Facility-level costs

LO 4: Describe the hierarchical nature of costs and its implications for cost measurement.


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Behavior of Step Costs

LO 4: Describe the hierarchical nature of costs and its implications for cost measurement.


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Why the Cost Hierarchy?

Allows us to compute a more accurate estimate of costs

Can extend concept to other “levels”

Customer level costs, channel level costs,…

However,

Difficult to assign many costs to hierarchy categories

Need finer data on operations

Wrong classification of levels introduces errors in cost estimation

LO 4: Describe the hierarchical nature of costs and its implications for cost measurement.


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$600

$250 x 1 step

+

43 x $7

+

$1,151

=

$600

$250 x 3 steps

112 x $7

$2,134

=

+

+


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Example: Deluxe Checks

LO 4: Describe the hierarchical nature of costs and its implications for cost measurement.


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An Example: Art.com


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Problem 2.32

Controllability and relevance (LO1)

Sam Walters is leaving tomorrow for a three-day business trip and is trying to decide the most economical way to get to and from the airport and his home. Sam could either drive (using his own car) or take the shuttle. If Sam drives, then he estimates that it will cost $0.30 per mile driven in operating costs (e.g., for gas and oil) and $7.50 per day for parking. The one-way cost of the shuttle is $25. Sam’s home is exactly 30 miles from the airport.

Required:

What are the controllable costs for Sam’s decision?

What are the relevant costs and benefits for Sam’s decision?

Are the controllable costs the same as the relevant costs for Sam’s decision? If so, why? Can controllability and relevance give the same costs and benefits even when the status quo is not a feasible option?


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Problem 2.32 (Continued)

What are the controllable costs for Sam’s decision?

A cost is controllable if it changes relative to the status quo. Relative to not taking the business trip (the status quo where Sam does nothing), Sam expects to incur the following costs under each option:


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Problem 2.32 (Continued)

What are the controllable costs for Sam’s decision?

  • Thus, we find that Sam prefers driving to taking the shuttle. Sam’s preference for driving versus taking the shuttle changes as the length of his trip changes (e.g., for a five-day trip, the shuttle is cheaper as the cost of driving increases by $15 while the cost of taking the shuttle stays the same).

  • For short-duration trips, driving (and parking at the airport) is cheaper than taking the shuttle.

  • For trips that are longer in duration, taking the shuttle is cheaper than driving.

  • We can link this to students’ behavior – for winter break, it is likely that students take the shuttle to the airport to avoid 2-3+ weeks of parking costs. For shorter trips (e.g., Thanksgiving, long weekend at home), it is likely that many students drive and use the airport parking lot.


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Problem 2.32 (Continued)

What are the relevant costs and benefits for Sam’s decision?

A cost is relevant if it differs across decision options. We also know that relevant costs are a subset of controllable costs. By examining the controllable costs in part [b], we find that all of the controllable costs are relevant – i.e., the options do not share any common costs.

Thus, the relevant costs of driving = $40.50,

and the relevant costs of taking the shuttle = $50.


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Problem 2.32 (Concluded)

Are the controllable costs the same as the relevant costs for Sam’s decision? If so, why? Can controllability and relevance give the same costs and benefits even when the status quo is not a feasible option?

Yes, for Sam’s decision, the set of controllable costs is the same as the set of relevant costs. Moreover, we find that controllability and relevance give us the same amounts even when the status quo is not part of the opportunity set. How can this happen?

The answer is that controllability and relevance will give us the same amounts when decision options do not share any common costs or benefits. That is, when each cost or benefit is unique to a specific decision option.


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