Chapter Six: Managerial Economics, 8e William F. Samuelson Stephen G. Marks

Managerial Economics, 8e
William F. Samuelson ● Stephen G. Marks
CHAPTER SIX
Cost Analysis
RELEVANT COSTS
A continuing theme of previous chapters is that optimal
decision making depends crucially on a comparison of
relevant alternatives. Roughly speaking, the manager
must consider the relevant pros and cons of one
alternative versus another. The precise decision-making
principle is as follows:
 In deciding among different courses of action, the manager need
only consider the differential revenues and costs of the
alternatives.
 Thus, the only relevant costs are those that differ across
alternative courses of action. In many managerial decisions, the
pertinent cost differences are readily apparent. In others, issues
of relevant cost are more subtle. The notions of opportunity costs
and fixed costs are crucial for managerial decisions. We will
consider each topic in turn©. 2015 John Wiley & Sons, Inc. All rights reserved.
Copyright
OPPORTUNITY COSTS AND ECONOMIC
PROFITS
The opportunity cost associated with choosing a
decision is measured by the benefits forgone in the
next-best alternative.
Typical examples of decisions involving opportunity cost include
the following:
 • What is the opportunity cost of pursuing an MBA degree?
 • What is the opportunity cost of using excess factory capacity to
supply specialty orders?
 • What is the opportunity cost that should be imputed to city-
owned land that is to be the site of a public parking garage
downtown?
Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.
As the definition suggests, an estimate of the
opportunity cost in each case depends on identifying
the next-best alternative to the current decision.
The concept of opportunity cost is simply another way
of comparing pros and cons. The basic rule for
optimal decision making is this:

Undertake a given course of action if and only if its
incremental benefits exceed its incremental costs
(including opportunity costs).
Benefits > costs
ECONOMIC PROFIT
At a general level, the notion of profit would appear
unambiguous:
Profit is the difference between revenues and costs.
On closer examination, however, one must be careful to
distinguish between two definitions of profit.
 Accounting profit is the difference between
revenues obtained and expenses incurred.
The profit figures reported by firms almost always are
based on accounting profits; it is the job of accountants
to keep a careful watch on revenues and explicit
expenses. This information is useful for both internal
and external purposes: for managers, shareholders,
and the government (particularly for tax purposes).
With respect to managerial decision making,
however, the accounting measure does not present
the complete story concerning profitability. In this
case, the notion of economic profit is essential .
 Economic profit is the difference between
revenues and all economic costs explicit EX:
company borrows money from the bank at 8%
to buy a machine
and implicit EX: uses its own money (reserves and
surplus) to buy a machine .), including opportunity
costs. Economic profit involves costs associated
with capital and with managerial labor. Here is a
simple illustration
 STARTING A BUSINESS After working five years
at her current firm, a money manager decides to
start her own investment management service. She
has developed the following estimates of annual
revenues and costs (on average) over the first three
years of business:
From this list, the new venture’s accounting profit, the
difference between revenues and explicit expenses,
would be reckoned at $74,000.
Is going into business on one’s own truly profitable?
The correct answer depends on recognizing all
relevant opportunity costs. Suppose the money
manager expects to tie up $80,000 of her personal
wealth in working capital as part of starting the new
business. Although she expects to have this money
back after the initial three years, a real opportunity
cost exists: the interest the funds would earn if they
were not tied up. If the interest rate is 8 percent, this
capital cost amounts to $6,400 per year. This cost
should be included in the manager’s estimate.
Furthermore, suppose the manager’s compensation
(annual salary plus benefits) in her current position is
valued at $56,000
Presumably, this current position is her best
alternative. Thus, $56,000 is the
appropriate( suitable) cost to assign to her human
capital.
 After subtracting these two costs, economic profit
is reduced to $11,600. This profit measures the
projected monetary gain of starting one’s own
business. Since the profit is positive, the manager’s
best decision is to strike out on her own. Note that
the manager’s decision would be very different if
her current compensation were greater—say,
$80,000. The accounting profit looks attractive in
isolation. But $74,000 obviously fails to measure up
to the manager’s current compensation ($80,000)
even before accounting for the cost of capital.
In general, we say that economic profit is zero if ,
( TR=TC) where total costs include a normal return to
any capital invested in the decision and other income
forgone.
Here normal return means the return required to
compensate the suppliers of capital for bearing the
risk (if any) of the investment; that is, capital market
participants demand higher normal rates of return for
riskier investments
As a simple example, consider a project that requires
a $150,000 capital investment and returns an
accounting profit of $9,000. Is this initiative profitable?
If the normal return on such an investment (one of
comparable risk) is 10 percent, the answer is no. If
the firm must pay investors a 10 percent return, its
capital cost is $15,000. Therefore, its economic profit
is $9,000 - $15,000Copyright
= -$6,000
© 2015 John Wiley & Sons, Inc. All rights reserved.
The investment is a losing proposition. Equivalently,
the project’s rate of return is 9,000/150,000, or 6
percent. Although this return is positive, the
investment remains unprofitable because its return is
well below the normal 10 percent requirement.
FIXED AND SUNK COSTS
Costs that are fixed—that is, do not vary—with
respect to different courses of action under
consideration are irrelevant and need not be
considered by the manager.
The reason is simple enough: If the manager
computes each alternative’s profit (or benefit), the
same fixed cost is subtracted in each case.
Therefore, the fixed cost itself plays no role in
determining the relative merits of the actions.
Consider a typical business example. A production
manager must decide whether to retain his current
production method or switch to a new method.
The new method requires an equipment modification (at
some expense) but saves on the use of labor. Which
production method is more profitable?
The hard way to answer this question is to compute the
bottom-line profit for each method The easier and far more
insightful approach is to ignore all fixed costs
The original equipment cost, costs of raw materials, selling
expenses, and so on are all fixed (i.e., do not vary) with
respect to the choice of production method .
The only differential costs concern the equipment
modification and the reduction in labor. Clearly, the new
method should be chosen if and only if its labor savings
exceed the extra equipment cost
With respect to a shut-down decision, many (if not all) of the
previous fixed costs become variable. Here the firm’s
optimal decision depends on the magnitudes of costs saved
versus revenues sacrificed from discontinuing production.
A sunk cost is an expense that already has been incurred
and cannot be recovered.
so all fixed costs are not necessarily sunk costs but all sunk
costs are definitely fixed costs.
For instance, in the earlier factory example, plant space
originally may have been built at a high price. But this
historic cost is sunk and is irrelevant to the firm’s current
decision. As we observed earlier, in the case of excess,
unused factory capacity, the relevant opportunity cost is
near zero.
More generally, sunk costs cast their shadows in
sequential investment decisions. Consider a firm that has
spent $20 million in research and development on a new
product. The R&D effort to date has been a success, but
an additional $10 million is needed to complete a
prototype product that (because of delays) may not be
first to market. Should the
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John Wiley make
& Sons, Inc. the additional
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 The correct answer depends on whether the
product’s expected future revenue exceeds the
total additional costs of developing and producing
the product. (Of course, the firm’s task is to
forecast accurately these future revenues and
costs.) The $20 million sum spent to date is sunk
and, therefore, irrelevant for the firm’s decision. If
the product’s future prospects are unfavorable,
the firm should cease(stop) R&D
Example:
A firm spent $10 million to develop a product for market.
In the product’s first two years, its profit was $6 million.
Recently, there has been an influx of comparable
products offered by competitors (imitators in the firm’s
view). Now the firm is reassessing the product. If it drops
the product, it can recover $2 million of its original
investment by selling its production facility. If it continues
to produce the product, its estimated revenues for
successive two-year periods will be $5 million and $3
million and its costs will be $4 million and $2.5 million.
(After four years, the profit potential of the product will be
exhausted, and the plant will have zero resale value.)
What is the firm’s best course of action?
THE ANSWER
The past profits and development costs are
irrelevant. If the firm drops the product, it recovers
$2 million. If the firm continues the product, its
additional profit is 5 + 3 - 4 - 2.5 = $1.5 million.
Thus, the firm should drop the product
PROFIT MAXIMIZATION WITH LIMITED
CAPACITY: ORDERING A BEST SELLER.
 The notion of opportunity cost is essential for optimal
decisions when a firm’s multiple activities compete for
its limited capacity. Consider the manager of a
bookstore who must decide how many copies of a new
best seller to order. Based on past experience, the
manager believes she can accurately predict potential
sales. Suppose the best seller’s estimated price
equation is P =24-Q, where P is the price in dollars
and Q is quantity in hundreds of copies sold per
month. The bookstore buys directly from the publisher,
which charges $12 per copy. Let’s consider the
following three questions:
1. How many copies should the manager order, and what price
should she charge? (There is plenty of unused shelf space to stock
the best seller.)
2. Now suppose shelf space is severely limited and stocking the
best seller will take shelf space away from other books. The
manager estimates that there is a $4 profit on the sale of a book
stocked. (The best seller will take up the same shelf space as the
typical book.) Now what are the optimal price and order quantity?
3. After receiving the order in Question 2, the manager is
disappointed to find that sales of the best seller are considerably
lower than predicted. Actual demand is P= 18 - 2Q. The manager
is now considering returning some or all of the copies to the
publisher, who is obligated to refund $6 for each copy returned.
How many copies should be returned (if any), and how many
should be sold and at what price?
As always, we can apply marginal analysis to
determine the manager’s optimal course of action,
provided we use the “right” measure of costs.
In Question 1,
the only marginal cost associated with the best seller
is the explicit $12 cost paid to the publisher, And the
best seller’s estimated price equation is P =24-Q
The manager maximizes profit by setting MR = MC.,
TR = 24Q – Q2 . Since MR = 24 - 2Q
we have 24- 2Q = 12. The result is Q = 6 hundred
books and P = $18. This outcome is listed in Table
6.1a.
By comparison, what are the optimal order quantity
and price when shelf space is limited, as in Question
2? The key point is that ordering an extra best seller
will involve not only an out-of-pocket cost ($12) but
also an opportunity cost ($4). The opportunity cost is
the $4 profit the shelf space would earn on an
already stocked book—profit that would be forgone.
the total cost of ordering the book is 12+ 4 = $16.
Setting MR equal to $16, we find that Q =4 hundred
and P = $20
Given limited shelf space, the manager orders fewer
best sellers than in Question 1. Table 6.1b compares
the profitability of ordering 400 versus 600 books.
The cost column lists the store’s payment to the
publisher ($12 per best seller).
Forgone profit is measured at $4 per book. We
confirm that ordering 400 books is the more
profitable option, considering the forgone profit on
sales of other books. Indeed, the logic of marginal
analysis confirms that this order quantity is optimal,
that is, better than any other order size.
Finally, Question 3 asks how the manager should
plan sales and pricing of the 400 best sellers
already received if demand falls to P = 18 -2Q.
The key here is to recognize that the original $12
purchase price is irrelevant; it is a sunk cost.
However, opportunity costs are relevant. The
opportunity cost of keeping the best seller for sale
has two elements: the $4 profit that another book
would earn (as in Question 2) plus the $6 refund
that would come if the copy were returned.
Therefore, the total opportunity cost is 6 + 4 = $10.
 Setting MR equal to MC implies 18- 4Q = 10, or Q
= 2 hundred. The store manager should keep 200
books to be sold at a price of 18 - (2)(2) = $14
each. She should return the remaining 200 books
to obtain a $1,200 refund. As Table 6.1 indicates,
this course of action will minimize her overall loss
in the wake of the fall in demand. The table also
shows that selling all 400 copies or returning all
copies would generate greater losses

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William F. Samuelson ● Stephen G. Marks

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