1. MBA 201A Section 2 - Costs

2. Overview  Cost Allocation: how to categorize and account for costs  Handling Assets and Loans  Using Costing Allocations for Production Decisions  Review PS2  Extra Problem from Old Midterm  Q&A  Exam Review: Wednesday 6:30-8:00pm in C210  Next Time: Demand and Pricing

3. Cost Allocation- back to the basics…  What is an Overhead (fixed) cost?  What is a Variable cost?  What is the “time horizon in question”? A Fixed cost is an expense that does NOT vary with production level for the given time horizon in question. These may related to a particular activity or not and may be sunk or not. A variable cost is an expense that DOES vary with production level for the given time horizon in question.

4. Cost Allocation- back to the basics…  What’s the marginal cost? How do variable and marginal cost relate?  What’s the Opportunity Cost?  What is a Sunk Cost? How does it relate to a fixed cost?  What’s the Economic Cost? The marginal cost of the nth product is simply the cost of producing The nth product, minus the cost of producing the n-1 product The net return on that asset or activity under its (next) best use Economic Cost = period expenditures – sunk cost + opportunity cost A cost that can’t be recovered or changed for the period in question

5. Cost Allocation – How do we do it?  Always Ask:  decision time horizon  shut down vs. + quantity decision  sunk vs. not  direct vs. not  fixed vs. variable  How do we allocate Marketing?  Labor?  Equipment?  without a loan (maintenance, cost of capital, and depreciation (if any))  with a loan (maintenance, interest (but not principal), and depreciation (if any))  No real difference. Interest = cost of capital = opportunity cost of the value locked in the asset

6. The Production Decision  When do we produce one more unit of a product?  When do we shut down the production of a given product line?  When do we shut down the firm? Produce an additional unit as long as marginal cost is less than marginal revenue If all expenses that can be eliminated AND are caused by the line’s production exceed revenue attributed to the product line, stop producing the product line AKA: average cost exceeds average revenue >> SHUT DOWN LINE

7. PS #2 / Question #1  Part (a) What are the annual economic costs of operation? Building is a sunk cost, why? According to problem, building is already been depreciated as well Total economics costs = $16mm (labor) + $20mm (packing / shipping)  Part (b) economic costs of each of the four lines? Remember calculate the actual costs, not some proxy $20mm (packing/shipping) / 5 mm units = $4 (problem assumes costs are same) Puzzles costs = $4mm + (1mm * $4) = $8mm (same for Teddies, Dolls) Guns costs = $4mm + (2mm * $4) = $12mm  Part (c) shut down guns…accounting allocation leads to wrong answers

8.  List the costs….  Rental $600k ($50k/month * 12)  Interest Cost $240k (6%*4,000k)  Depreciation and Maintenance $80k  Materials $1,000k  Labor $800k  Utilities $280k  Total: $3,000k  What about the $940k of profits?  Those are already expected. All the costs we identified above are the additional costs. So additional revenue has to exceed additional costs to increase profits. PS #2 / Question #2

9. PS #2, Question #2 In math terms:

10. PS #2, Question #3  Part (a), should you accept a $20k / year rental offer? $100k of revenue (100k calls * $1) LESS $25k of overhead costs and LESS $45k of variable costs (100k calls * $0.45) = $30,000 Therefore, we should not lease out the building since $20k in lease payments are less than $30k in profits we make  What is the minimum we should accept lease-wise? What if we had financed our building?  What is the minimum we should sell our property for  Just like calculating a perpetual bond

11. 2008 Midterm #2

12.  Should FIFO stop serving breakfast? Are costs above revenue?  What are the costs?  Food $600  Labor (other direct costs): $4,800  Licensing fees $0.20 * 2,400*.5= $240  Other overhead?  What are the revenues?  $7,200  Recommendation?  Breakfast makes a marginal profit of $1,560  Fix the accounting system

13. Questions on anything else?  Next section: Demand and Pricing…