MANECON CHAPTER 3

BENEFITS, COSTS, AND DECISIONS- midterms yr/sem 1

CHAPTER 3: BENEFITS, COSTS, AND DECISIONS

Core Concept:

Opportunity Cost and Decision-Centered Analysis

To make profitable decisions, a manager must be able to distinguish between relevant and irrelevant financial data.

Fixed Costs vs. Variable Costs:

Costs that do not vary with the level of output (e.g., factory capital costs).

Fixed Costs

Fixed Costs vs. Variable Costs:

Costs that change directly as output levels change (e.g., labor and raw ingredients).

Variable Costs

Accounting Profit vs. Economic Profit:

Calculated using only explicit, historical costs that appear on financial statements.

Accounting Profit

Accounting Profit vs. Economic Profit:

Calculated by subtracting both explicit costs and implicit costs—notably the opportunity cost of equity capital—from revenues. A firm can easily show an accounting profit while experiencing an economic loss.

Economic Profit

The opportunity cost of any alternative is the forgone opportunity to earn profit from the next-best alternative. Costs and decisions are fundamentally linked because costs depend entirely on what you give up.

Opportunity Cost

Critical Decision-Making Fallacies:

Considering irrelevant costs—those that do not vary with the consequences of the decision (such as overhead allocations, historical expenditures, or depreciation)—when making choices.

The Sunk-Cost (or Fixed-Cost) Fallacy

Critical Decision-Making Fallacies:

Ignoring relevant costs—those that do vary with the consequences of your decision (such as the opportunity cost of capital or asset resale value).

The Hidden-Cost Fallacy

Critical Decision-Making Fallacies:

Always begin with the decision you are considering, not the costs. Identify only the costs and benefits that will change as a consequence of that specific decision, and ignore those that will not.

The Golden Rule of Decisions