Benefits, Costs, & Decisions

By: Dr. Shirley Catley-Rinoza

Institute of Accounts, Business, & Finance
Far Eastern University, Manila

• Outline:
• Fixed costs & Variable Costs
• Sunk costs & Hidden Costs
• Implicit costs & Explicit Costs
• Accounting costs & Economic Costs
• Accounting profit vs. Economic profit
• Costs, Cost Fallacies & Decisions
• Biases in Decision Making
• Case Studies
•
Types of Costs in Accounting
• Fixed costs are predetermined expenses that remain the same throughout a specific
period. These overhead costs do not vary with output or how the business is
performing. To determine your fixed costs, consider the expenses you would incur if you
temporarily closed your business. You would still continue to pay for rent, insurance and
other overhead expenses.
• Variable costs, however, change over a specified period and are associated directly to
the business activity. These are based on the business performance and the volume of
services the business generates.
• Types of Costs in Accounting
• Fixed Costs
• Rent
• Telephone and internet costs
• Insurance
• Employee Salaries
• Loan Payments
• Variable Costs
• Direct labor
• Commissions
• Taxes
• Operational expenses
• Commission on sales, credit card fees, wages of part-time staff, etc.
• .
• Cost Formula & Computation
• formula
• Total Cost
• TC = TFC + TVC
• Average Cost
• AC = TC/Q
• AC = AFC + AVC
• computation
Benefits, Costs, & Decisions
By: Dr. Shirley Catley-Rinoza
Institute of Accounts, Business, & Finance
Far Eastern University, Manila

• TC = $65,000 + $180,000
= $245,000
• AC = $245,000/1000 pcs.
= $245/pc.
• AC = $65 + $180
= $245/pc.
•
Sunk costs
• A sunk cost refers to money that has already been spent and cannot be recovered. In
business, the axiom that one has to "spend money to make money" is reflected in the
phenomenon of the sunk cost.
• sunk costs cannot be recovered. If equipment can be resold or returned at the purchase
price, for example, it's not a sunk cost
• Examples: cost of machinery, equipment, and the lease expense on the factory.
• source: https://www.investopedia.com/terms/s/sunkcost.asp
• Sunk costs
• Examples: costs on
• Marketing campaign
• New equipment
• Training
• Hiring
• Research and development
Hidden Costs
• Hidden costs are unforeseen expenses added on to purchases.(pfcu.com)
• all costs associated with either production or maintenance. When associated with
maintenance, hidden costs represent the loss associated with unplanned downtime.
• In logistics hidden costs mean costs which are almost impossible to determine without a
cost allocation process from the data available in conventional financial statements
• Examples are manager's time, inventory opportunity costs, or interests costs over the
period. (https://ceopedia.org/index.php/Hidden_cost)

Explicit Costs & Implicit Costs

• explicit costs
• Explicit costs are normal business costs that appear in the general ledger and directly
affect a company's profitability. Explicit costs have clearly defined dollar amounts, which
flow through to the income statement. Examples of explicit costs include wages, lease
payments, utilities, raw materials, and other direct costs.
• What can you say about fixed costs and variable costs? Explicit or implicit costs?
• implicit costs
• An implicit cost is a cost that exists without the exchange of cash and is not recorded for
accounting purposes.
Benefits, Costs, & Decisions
By: Dr. Shirley Catley-Rinoza
Institute of Accounts, Business, & Finance
Far Eastern University, Manila

• Implicit costs represent the loss of income but do not represent a loss of profit.
• These costs are in contrast to explicit costs, which represent money exchanged or the
use of tangible resources by a company.
• Examples of implicit costs include a small business owner who may forgo a salary in the
early stages of operations to increase revenue.
• an implicit cost comes from the use of an asset, rather than renting or buying it.
•
Accounting Costs
• Accounting costs represent anything your business has paid for.
• You can calculate accounting cost by subtracting your expenses from your revenue.
• Includes explicit costs, they are direct costs associated with your business.
• Rent, Utility expenses, Food and entertainment expenses, Travel expenses, including
transportation and hotels, Payroll expenses, including salaries and related payroll taxes,
Supplies, Insurance
• Any other expenses incurred during the normal course of business
Economic costs
• Economic costs represent any “what-if” scenarios for your business.
• Economic cost is calculated by taking your accounting cost, which has already been
calculated, and also subtracting any implicit costs.
• Accounting costs vs. Economic costs
• Accounting costs
• Uses standard costs incurred in business
• Uses explicit costs only
• Determines profit or loss for a specific period of time
• Used for tax purposes or to determine financial health of your business
• Economic costs
• Uses a “what if” scenario
• Looks at a long-term time frame
• Considers both explicit and implicit costs
• Used to make long-term strategic decisions

Accounting Profit vs. Economic Profit

• Accounting profit is the net income for a company, which is revenue minus expenses.
• Economic profit is similar to accounting profit, but it includes opportunity costs.
• Accounting profit includes explicit costs, such as raw materials and wages.
• Economic profit includes explicit and implicit costs, which are implied or imputed costs.
• Economic profit consists of revenue minus implicit (opportunity) and explicit (monetary)
costs; accounting profit consists of revenue minus explicit costs. (Lumen learning.com)
• Accounting Profit & Economic Profit
•
•
Benefits, Costs, & Decisions
By: Dr. Shirley Catley-Rinoza
Institute of Accounts, Business, & Finance
Far Eastern University, Manila

Sunk Cost Fallacy

• The fixed-cost fallacy or sunk-cost fallacy means that you consider irrelevant costs. A
common fixed-cost fallacy is to let overhead or depreciation costs influence short-run
decisions. (Froeb, et. al.)
• A sunk cost fallacy refers to a company's continuance of a particular behavior or
endeavor because they've already made an investment. Under their logic, continuing
with their endeavor will ensure the investment was not wasteful. It's important to note
that it's also possible for them to incur additional losses going this route. (indeed.com)
• Business Case: on Sunk Cost
Launching a new product:
• You are in a new products division and will be able to distribute a new product
through your existing sales force
• You will be forced to pay for a portion of the sales force
• If you believe this “overhead” is big enough to deter an otherwise profitable product
launch, then you’ve committed the sunk-cost fallacy (Froeb, et.al.)

Hidden Cost Fallacy

• The hidden-cost fallacy occurs when you ignore relevant costs. A common hidden-
cost fallacy is to ignore the opportunity cost of capital when making investment or
shutdown decisions. (Froeb, et.al.)
•
• 2. Buying a football ticket for $20 which scalpers sell for $50 - The tickets really cost
you $50 because you give up the opportunity to scalp them by going
• Business Case: Should you fire an employee?
• The revenue he provides to the company is $2,500 per month
• His wages are $1,900 per month
• His office could be rented out $800 per month
• YES, you are only making $600 a month from this employee but could make $800 a
month from renting his office
• (Froeb, et.al., 5th ed.)
•
• Economic Value Added (EVA)
• Economic value added (EVA) is a measure of a company's financial
performance based on the residual wealth calculated by deducting its cost of capital
from its operating profit, adjusted for taxes on a cash basis. EVA can also be referred
to as economic profit, as it attempts to capture the true economic profit of a
company. This measure was devised by management consulting firm Stern Value
Management, originally incorporated as Stern Stewart & Co.
• EVA is the incremental difference in the rate of return (RoR) over a company's cost
of capital. Essentially, it is used to measure the value a company generates from
funds invested in it. If a company's EVA is negative, it means the company is not
Benefits, Costs, & Decisions
By: Dr. Shirley Catley-Rinoza
Institute of Accounts, Business, & Finance
Far Eastern University, Manila

generating value from the funds invested into the business. Conversely, a positive
EVA shows a company is producing value from the funds invested in it.
• Calculating for EVA
• EVA = NOPAT - (Invested Capital * WACC)
• Where:
• NOPAT = Net operating profit after taxes
• Invested capital = Debt + capital leases + shareholders' equity
• WACC = Weighted average cost of capital
• Use of EVA
• EVA®= net operating profit after taxes minus the cost of capital times the
amount of capital utilized
• Makes visible the hidden cost of capital
• The major benefit of EVA is identifying costs.
If you cannot measure something, you cannot control it. (Froeb, et.al.)
• Economic Value Added (EVA) is important because it is used as an indicator of how
profitable company projects are and it therefore serves as a reflection of
management performance. ... Economic value added asserts that businesses should
create returns at a rate above their cost of capital. (Investopedia.com)
•
EVA & Hidden Cost
• By taking all capital costs into account, including the cost of equity, EVA shows the
dollar amount of wealth a business has created or destroyed in each reporting
period.
• What may be the hidden cost if EVA is not determined?
•
Principles on Cost Decisions
• Costs are associated with decisions, not activities.
• In computing costs and benefits, consider all costs and benefits that vary with the
consequences of a decision and only those costs and benefits that vary with the
consequences of the decision. These are the relevant costs and benefits of a
decision.
• Decisions that change output will change only variable costs.
• Accounting profit does not necessarily correspond to real or economic profit.
• the opportunity cost of an action is what you give up (forgone profit) to pursue it.
• Costs imply decision-making rules and vice-versa
• The goal is to make decisions that increase profit
• If the profit of an action is greater than the alternative, pursue it
• Psychological Biases
• Not enough information or bad incentives are not the only causes for business
mistakes. Often psychological biases get in the way of rational decision making.
Benefits, Costs, & Decisions
By: Dr. Shirley Catley-Rinoza
Institute of Accounts, Business, & Finance
Far Eastern University, Manila

• Definition: the endowment effect means that taking ownership of item causes
owner to increase value she places on the item. This bias tends to make sellers bid
the price of their items higher than would buyers.
• Definition: loss aversion – individuals would pay more to avoid loss than to realize
gains. Usually, people tend to brood over their losses, than on gains that didn’t
materialize or would care less for free items but care more or worry on the prospect
of losing one’s asset even if it has to go; it is painful to let go of a business or an
asset, even if facts point to the need to decide to do so, such that more losses are to
be incurred when it is retained.
• Psychological biases
• Definition: confirmation bias – a tendency to gather information that confirms your
prior beliefs, and to ignore information that contradicts them. One way to avoid this
is to let the objective others collect information for you and present their own
evaluation or judgment on the matter.
• Definition: anchoring bias – relates the effects of how information is presented or
“framed”. To avoid this bias, the decision maker should be guided by his own frame
of analysis, or establish objective standard, or measures to evaluate the worthiness
of an information.
• Definition: overconfidence bias – the tendency to place too much confidence in the
accuracy of your analysis. The way to avoid this is to gather analysis or ideas from
others with adequate competence/expertise on the matter.
• Management meetings that brainstorm on company matters is a way to avoid biases
in decision making such as the preceding ones.
• References:
• https://www.freshbooks.com/hub/accounting/fixed-cost-vs-variable-cost?fb_dnt=1
• https://www.investopedia.com/terms/s/sunkcost.asp
• https://ceopedia.org/index.php/Hidden_cost
• https://www.investopedia.com/terms/e/explicitcost.asp
• https://www.investopedia.com/terms/i/implicitcost.asp
• https://www.fool.com/the-blueprint/accounting-cost/
• https://www.investopedia.com/ask/answers/033015/what-difference-between-
economic-profit-and-accounting-profit.asp
• https://www.investopedia.com/terms/e/eva.asp
• https://courses.lumenlearning.com/boundless-economics/chapter/economic-profit/
• https://www.indeed.com/career-advice/career-development/sunk-cost-definition-
and-examples
• Froeb, et.al.,. Managerial Economics. 5th ed. Cengage Learning.