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Chapter Two

Chapter Two. Hidden Costs: Opportunity Costs and Sunk Costs. Memo to Managers.

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Chapter Two

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  1. Chapter Two Hidden Costs: Opportunity Costs and Sunk Costs

  2. 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

  3. 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

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

  5. “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.

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

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

  8. Any Saturday Morning • Choices, 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

  9. 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

  10. Any Saturday Morning • 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.

  11. 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.

  12. 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.)

  13. 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

  14. An Economic Approach to Costs • Read An Economic Approach to Costs

  15. 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

  16. 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

  17. 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.

  18. 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.

  19. 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

  20. 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.

  21. 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.

  22. 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

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