1 / 23

Lecture 11 Economic Propositions about Costs

Lecture 11 Economic 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).

bryson
Download Presentation

Lecture 11 Economic Propositions about Costs

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. 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, 100 Boeing 787s will cost more per unit than if 1,000 Boeing 787s are made. This is economies of scale or mass production. Engineering, not economics.

  2. 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 owners—opportunity 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.

  3. 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?

  4. 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%?

  5. 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.

  6. 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.

  7. 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.

  8. 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. Hence, 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?

  9. 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 is what we have. Should we sell it? Given changes in the market price, how long can we continue production?

  10. 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?

  11. Economic Value of Assets Economic value of an asset requires an estimate of the net cash flow expected from the asset (discounted). Hence, valuation is continuous and is subjective: an educated guess about expected cash flows. Past cash flows (accounting data) from an asset can provide useful information to a manager in making valuation decisions, but alone should not drive the decision.

  12. Consider New Asset Purchase price is accounting value of asset. Economic value? Higher than accounting value or would not buy. Expected value in use of asset must be more valuable than purchase price. New machine purchased for $35,000 (asset value). Estimate machine life of five years with revenue of $10,000/yr. (discounted 10%/yr.) for net present value of $37,910. Profit of $2,910 not recorded.

  13. Changes in Asset Value We acquired the machine for $35,000 (recorded value) that had a present value (PV) of $37,910. Suppose costs rise and cash flow falls to $9,000/yr. from $10,0000/yr. Then PV falls to $34,120. Or demand increases and allows us to extend the life to six years for PV of $43,550. Or discount rate (alternative investment return) changes to 12%; then PV falls to $36,050. None of these changes in economic value cause accounting value to change. It continues to show initial value ($35,000) depreciated over 5 year expected life.

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

  15. Accounting Profit versus Economic Profit Accounting Profit = Sales Revenue – Accounting Cost Economic Profit = Sales Revenue – Economic Cost Economic Cost = Accounting Cost + Economic Cost Example of difference: McDonald’s reported $2 billion accounting profit in 2002; economic profit estimated to be - $124 million

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

  17. 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 billion—opportunity cost of cash)

  18. 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 new division showed accounting revenues of $1,069 million; costs of $1,001 million: 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.

  19. 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.

  20. 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.

  21. Cost Control by InBev: Much of This Should Seem Obvious Wait 120 days to pay vendors (the jerks). Double sided, no-color printing in England offices saved $325,000 a year. 40% fewer Blackberries for U.S. employees. Few private offices—everyone in large rooms (one impact—faster communication). No private airplanes; everyone flies commercial. Zero-based budgets every year. Ad firms paid by project, not by annual budget.

  22. Efforts at other firms… Nicholas & Co., a Salt Lake City food distributor cuts sales commissions 25% when customers’ bills are more than 45 days past due. Sales reps now think about creditworthiness. Bill payment time dropped in half. Slack & Co. Contracting, Houston, borrowed $1 million a month to cover late payments from clients. Slack now refuses to deal with firms with bad reputations and histories. Mr. Slack: “Don’t confuse volume with profit.”

  23. 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.

More Related