Extent (How Much) Decisions

CHAPTER 4 Extent
(How Much)
Decisions
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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!).
©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 2
• continued
● 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.
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?
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.
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
Background: Average Cost (cont.)
(cont.)
FIGURE 4.1 Average Cost Curve
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
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.
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
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<MC
• Profits are maximized when MR=MC
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
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.
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
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
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
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.
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
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”
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?
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.

Extent (How Much) Decisions

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CHAPTER 4 Extent

● The relevant costs and benefits of an extent decision

● The financial crisis began in the subprime housing market,

● Memorial Hospital’s CEO conducted performance reviews of

● Definition: Average cost (AC) is simply the total

FIGURE 4.1 Average Cost Curve

● Memorial made 500 deliveries originally

● Definition: Marginal cost is the additional cost to

● Examples of extent decisions:

● This analysis tells you direction of change but not

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

Answering the “How much advertising?” question

● You know the direction (do more), but you do

● Example: Compare TV advertising to telephone solicitation

● Advice: make changes one-at-a-time to gather valuable

● A textile company with manufacturing plants in Latin America uses

● Discussion: Royalty rates vs. fixed fee contracts

● Use Option 1 because MR=$1000/sale > $500/sale,

● A consulting firm COO received a flat salary of

● American Express offers a Platinum Card to affluent customers

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