Extent decision

Extent (How Much) Decisions

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CHAPTER

Do not confuse average and marginal costs.

Average cost (AC) is total cost (fixed and variable) divided by total units produced.

Average cost is irrelevant to an extent decision.

Marginal cost (MC) is the additional cost incurred by producing and selling one more unit.

Marginal revenue (MR) is the additional revenue gained from selling one more unit.

Sell more if MR > MC; sell less if MR < MC. If MR = MC, you are selling the right amount (maximizing profit!).

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The relevant costs and benefits of an extent decision are marginal costs and marginal revenue. If the marginal revenue of an activity is larger than the marginal cost, then do more of it.

An incentive compensation scheme that increases marginal revenue or reduces marginal cost will increase effort. Fixed fees have no effects on effort.

A good incentive compensation scheme links pay to performance measures that reflect effort.

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continued

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US Financial Crisis

The financial crisis began in the subprime housing market, where government policies encouraged lenders to extend credit to low-income borrowers (by lowering lending standards)

These high-risk loans, or mortgages, were being packaged into securities by lenders and sold to investors.

If the risk had been recognized investor demand would have been low, but rating agencies were too liberal with AAA ratings, increasing demand for loans.

The result? A credit “bubble”

How did this lending crisis arise?

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Average Cost Caution!

Memorial Hospital’s CEO conducted performance reviews of the hospital departments.

During this process, the chief of obstetrics proposed an increase in the number of babies being delivered in his department.

The CEO wondered why since the cost of delivering babies was higher than the revenues brought in.

The CEO’s mistake: He began with the costs instead of the decision.

He committed the fixed-cost fallacy by looking at average cost, which include costs that do not vary with the decision.

If he had ignored fixed costs, he would have seen that increasing the number of deliveries would increase profit.

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Background: Average Cost

Definition: Average cost (AC) is simply the total cost (TC) of production divided by the number of units produced (Q).

AC = TC/Q

Average costs often decrease as quantity increases due to presence of fixed costs (FC)

AC = (VC + FC)/Q

FC does not change as Q increases

Key note: Average costs are not relevant to extent decisions

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Background: Average Cost (cont.)

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FIGURE 4.1 Average Cost Curve

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Memorial Hospital Revisited

Memorial made 500 deliveries originally

Fixed cost: $1,000,000

Variable cost: $3,000/delivery

Total cost: $1,000,000 + ($3,000 x 500)

Average cost: total costs/# of deliveries

Average costs fall as you increase output, but the variable costs remain constant

Marginal cost is only $3,000 at Memorial Hospital

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Marginal Cost & Marginal Revenue

Definition: Marginal cost is the additional cost to make and sell one additional unit of output (Q)

MC = TCQ+1 – TCQ

Marginal cost is often lower than average cost (due to fixed costs) but not always

Marginal costs are what matter in extent decisions

Definition: Marginal revenue (MR) is the additional revenue gained from producing and selling one more unit.

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Extent Decisions

Examples of extent decisions:

Should you change the level of advertising?

Should you increase the quality of service?

Is your staff big enough, or too big?

How many parking spaces should you lease?

For extent decisions, we break the decision into small steps

If taking a step provides more benefit than cost, take a step forward

If not, step backward

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Extent (How Much?) Decisions

This analysis tells you direction of change but not the distance.

You can only measure MR and MC at the current level of output – make a change and re-measure

If the benefits of selling another unit (MR) are bigger than the costs (MC), then sell another unit.

Maxim:

Produce more when MR>MC

Produce less when MR

Profits are maximized when MR=MC

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Memorial Hospital Marginal Analysis

As we mentioned, the MC of a delivery was $3,000

The MR was $5,000

Therefore, MR>MC so the hospital was not delivering enough babies

This explains why the CEO was wrong

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Advertising Extent Decision Example

Answering the “How much advertising?” question

A $50,000 increase in the TV ad budget brings in 1,000 new customers

Estimated MCTV is $50 (the cost to get one more customer)

$50,000 / 1,000 = $50

If the marginal revenue generated by this customer is greater than $50, do more advertising.

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Advertising Extent Decision Example (cont.)

You know the direction (do more), but you do not know how far to go

You have to take a step and re-compute marginal cost and benefit to see if you should continue in the direction your analysis originally pointed you in

Also, even if we do not know the marginal revenue, we can still use marginal analysis to make extent decisions

by comparing marginal effectiveness of different media

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Competing Strategies & Marginal Analysis

Example: Compare TV advertising to telephone solicitation

The opportunity cost of spending one more $ on TV advertising is the forgone opportunity to spend $ on telephone solicitation

Say you recently cut telephone (PH) budget by $10,000 and lost 100 customers

Estimated MCPH = $100= ($10,000 / 100)

So, to get one more customer costs $50 for TV and $100 for phone

MCPH > MCTV so shift ad dollars from phone to TV

Advice: make changes one-at-a-time to gather valuable information about marginal effectiveness of each medium

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Textile Production Example

A textile company with manufacturing plants in Latin America uses SAH=“Standard Absorbed Hours” a measure of textile factory output

Allows managers to compare factories making different items, e.g. t-shirt = 1 SAH while dress=3 SAH

Suppose Factory A has costs of $30 per SAH while Factory B has cost of $20 per SAH. How can you profitably use this information?

Should you move production to cheaper factory?

Make sure you are not including fixed costs in the analysis

Marginal costs matter, not average costs!

If the $20 and $30 rates are good MC proxies, shift some production from Factory A to Factory B

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Incentive Pay

Discussion: Royalty rates vs. fixed fee contracts

How hard to work is an extent decision so you can design incentives to encourage hard work by using marginal analysis

Example: You receive two bids to harvest 100 trees on your land

$150/tree or $15,000 for the right to harvest all the trees.

On your tract there are pines (worth $200) and fir (worth $100).

Which offer should you accept?

Hint: consider the effects of the two bids on the incentives of the logger.

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Tree Harvesting Answer

The bids have the same face value, but are very different in terms of logger’s incentives

Fixed fee: the logger will ignore the $15,000 because it doesn’t vary with the decision to cut down trees.

The logger will end up cutting down all trees that are profitable to cut down, MR>MC

Royalty Rate: The logger will only cut down trees trees that generate profit of $150, MR>MC+150

Mix of $200- and $100-value trees – logger will harvest only the $200

The landowner receives less money since the logger only harvests one type of tree

Royalties deter some wealth-creating transactions as fir trees are not harvested

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Sales Commission Example

Motivating salespeople:

Expected sales level: 100 units @ $10,000/unit=$1M

Option 1: 10% commission

Option 2: 5% commission + $50,000 salary

Hint: consider incentives for salespeople

Use Option 1 because MR=$1000/sale > $500/sale, the MR under Option 2

The sales force responds to larger marginal benefits of selling with more effort

Lower sales effort under option 2 is called “shirking”

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Tie Pay to Performance

A consulting firm COO received a flat salary of $75,000

After learning about the benefits of incentive pay in class, the CEO changed COO compensation to $50K + (1/3)* (Profits-$150K)

Profits increased 74% to $1.2 M

Compensation increased $75Kg$177K

Discussion: What are the disadvantages to incentive pay?

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Title?

American Express offers a Platinum Card to affluent customers

In 2001, there were approximately 2,000 Platinum cardholders in the Japanese market. Numbers had been limited to ensure high quality customer service

With customer service technology advances, the company considered expanding number of card holders

How many more should be added?

As more members are acquired, average spending per card member decreases because the financial threshold for membership is lowered

Costs of customer service rise for each additional member added, and growing beyond a certain point would require building and operating an additional call center

After analyzing the costs and benefits, American Express realized that it should expand its offering to only 15,000 more Platinum Card members

We call this an “extent” decision, because the company needed to decide “how many” platinum cards to provide. In this chapter, we show you how to make profitable extent decisions.

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