Chapter Two Hidden Costs Opportunity Costs and Sunk

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Chapter Two Hidden Costs: Opportunity Costs and Sunk Costs

Chapter Two Hidden Costs: Opportunity Costs and Sunk Costs

Memo to Managers “ I do not know you, nor do I know the

Memo to Managers “ I do not know you, nor do I know the business you are in. But I do know one thing. Some of your highest ongoing costs are for things you already bought and paid for. ” from Executive Economics: Ten Essential Tools for Managers

Costs and the Economic Way of Thinking • Economics deals with costs in a

Costs and the Economic Way of Thinking • Economics deals with costs in a couple of unique ways • Our view of costs is very inclusive • Good decision-making in business requires you to use of the tools economists have developed in thinking about costs

Opportunity Costs • the highest valued alternative forgone as the result of choice.

Opportunity Costs • the highest valued alternative forgone as the result of choice.

“Choosing is refusing. ” • When we make a particular choice from a list

“Choosing is refusing. ” • When we make a particular choice from a list of alternatives we rank them and choose the most valuable alternative. In doing so we refuse all other choices on that list. • Opportunity cost is the next or second best choice. You choose the first-best option and the next options is your opportunity cost.

Opportunity costs are relative. • It is always measured relative to alternative choices. •

Opportunity costs are relative. • It is always measured relative to alternative choices. • It is the most highly valued alternative forgone.

Opportunity costs are subjective. • The valuation of alternative choices may differ by decision-maker.

Opportunity costs are subjective. • The valuation of alternative choices may differ by decision-maker. • An individual decision-makers opportunity costs may vary over time.

Any Saturday Morning • Choices, choices… – Watch Ren and Stempy cartoon – Sleep-in

Any Saturday Morning • Choices, choices… – Watch Ren and Stempy cartoon – Sleep-in – Mow the yard – Play baseball with my children – Write power point slides for SMPU class – Clean the pool

Any Saturday Morning • I could choose any of these and in fact I

Any Saturday Morning • I could choose any of these and in fact I value them all. • To choose I must compare alternatives • To choose I must rank-order the list of possible activities

Any Saturday Morning 1. 2. 3. 4. 5. 6. – Write power point slides

Any Saturday Morning 1. 2. 3. 4. 5. 6. – Write power point slides for SMPU class Play baseball with my children Watch Ren and Stempy cartoon Clean the pool Mow the yard Sleep-in These are now ranked in the order I would choose at this time in my life.

Choices often include many options, • but…opportunity costs are not the summed list of

Choices often include many options, • but…opportunity costs are not the summed list of all possible choices. It is a singular cost. • The opportunity cost according to my ranking here is playing baseball with my children. That is the next highest valued alternative.

Opportunity Costs are subjective… • I may face the same choices next Saturday and

Opportunity Costs are subjective… • I may face the same choices next Saturday and choose to watch Ren and Stempy cartoons! – If I did choose Ren and Stempy next week what would be my opportunity cost? – The highest valued alternative forgone (i. e. , whatever is next on my list. )

Applications to business decisions • Recognize that using opportunity costs means thinking outside of

Applications to business decisions • Recognize that using opportunity costs means thinking outside of the traditional accounting framework • Accounting deals primarily with historical costs • Economic decision-making is future oriented

An Economic Approach to Costs • Read An Economic Approach to Costs

An Economic Approach to Costs • Read An Economic Approach to Costs

Economic Costs Vs. Accounting Costs • Economic costs will almost always be higher than

Economic Costs Vs. Accounting Costs • Economic costs will almost always be higher than accounting costs due to our inclusion of opportunity costs • Opportunity costs are only relevant to decision-making, they do not show up on an accounting balance sheet or an income statement but they have great influence on both

Economic Profit vs. Accounting Profit • As shown in the reading, accounting profits are

Economic Profit vs. Accounting Profit • As shown in the reading, accounting profits are almost always to high because accounting profits do not include foregone alternatives

Read Chapter Two on the Coca. Cola Company • What was Roberto Goizueta doing?

Read Chapter Two on the Coca. Cola Company • What was Roberto Goizueta doing? – Charging his business units a fee for the use of stockholders money. • Why was Goizueta doing this? – To require managers to take into account the hidden costs we call opportunity cost.

Read Chapter Two on the Caroline’s Cookies • Why was A&P charging Caroline a

Read Chapter Two on the Caroline’s Cookies • Why was A&P charging Caroline a fee for shelf space? – Because shelf space in an A&P is valuable. • “Each yard of shelf space in my store generates about $10, 000 in sales (revenues) every week!” – If I put Caroline’s Cookies on that shelf space what is my next best alternative? • My opportunity costs (or next best alternative) is top generate $10, 000 in revenues from the product that was in the space she is now in.

Time is Money • Suppose you had two client willing to hire you as

Time is Money • Suppose you had two client willing to hire you as a consultant. • Suppose the service you provided was essentially the same for both clients. • Client A offers $150 an hour • Client B offers $200 an hour

Client A or Client B? • I hope you choose client B! – Why?

Client A or Client B? • I hope you choose client B! – Why? • The opportunity cost of working for Client B is what you could have earned working for Client A – or $150 per hour. • The opportunity cost of working for Client A is what you could have earned working for Client B – or $200 per hour. • Your lowest opportunity cost is incurred by foregoing $150 an hour in favor of $200 an hour.

Sunk Costs • “Sunk Costs are sunk. ” – They have already been made,

Sunk Costs • “Sunk Costs are sunk. ” – They have already been made, they are historical and cannot be recovered, so they are irretrievable. – Forget about them – they are irrelevant to your future.

Sunk Costs • Extremely difficult for managers to deal with – ego trumps clear

Sunk Costs • Extremely difficult for managers to deal with – ego trumps clear thinking • Often requires them to admit they made a mistake • For these reasons they are prevalent and extremely costly to firms