Chapter 2

1. Chapter 2 Identifying and Estimating Costs and Benefits

2. 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.

3. 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.

4. 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.

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

6. No No No No Yes No Yes Yes Yes Yes Yes No LO1: Understand how to identify the costs and benefits of decision options.

7. 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.

8. 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.

9. Example: Time and Controllability LO2: Consider how time affects the realization of costs and benefits.

10. 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

11. 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

12. 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

13. 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

14. Revenue/Sales Volume Relationship

15. 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

16. Variable, Fixed, and Total Costs LO3: Explain the principles for estimating costs and benefits

17. $12 $10 $12 $8 $12 $5 $12 $4

18. 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

19. Controllability, Variability & Traceability LO3: Explain the principles for estimating costs and benefits

20. 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.

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

22. 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.

23. $600 $250 x 1 step + 43 x $7 + $1,151 = $600 $250 x 3 steps 112 x $7 $2,134 = + +

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

25. An Example: Art.com

26. 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?

27. 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:

28. 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.

29. 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.

30. 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.