CHAPTER 1-3 HOW TO THINK ABOUT COST Should you indulge yourself in having a couple of beers each day, or a chocolate Sundae from time to time, if your doctor tells you that such a pleasure may shorten your life? How about smoking, if the best research shows that each cigarette costs on the average of 5 minutes of life? The shortening of your life, if it will occur, is indeed a cost, and the expected effect must be considered a cost when you make your decisions about eating, drinking, and smoking. The subject of cost goes way beyond money costs. The most interesting and important costs relate to life itself -- how long your life will be, how you will use the time that may be available to you, and how healthy you will be to enjoy that time. These living-span costs are very difficult to think about clearly. The loss of 5 minutes of life may well have a different meaning if it is at the end of a life of 78 years than at the end of a life of 38 years. To avoid such complications, we will mainly consider examples from business, because money costs are simpler to deal with. But the underlying principles are the same. Most time costs do not affect length of life, though. Rather, they are a matter of spending time on one activity or another. The main difference between business-expenditure costs and living-span costs is that you have a limited lifetime to allocate, whereas the sources of payments of expenditures are not fixed from the outside. And in business both the costs and the expenditures are easily measured in money terms, whereas the benefit of being at your sister's wedding (or thought of another way, the cost of missing an airplane flight for the wedding) cannot so easily be figured in money terms. This is a major complication in personal decision-making. (Sometimes, however, even non-business costs are easily comparable. For example, you can easily compare bicycling to the airport to beat the traffic, versus taking the car. Or you can compare taking the bus, versus the more-expensive cab by considering the time saved against the amount of time you have to work to pay the extra expense. But these are unusually easy cases to deal with. A last general comment before we get down to business: Generally one thinks of costs as a negative factor. But costs also have a crucial positive role in making life meaningful. Many philosophers have noticed that if life were never to end, it would be unbearably dull. There would be no penalty for a mistake, because you would always have time to do it over again. And if there were no penalty for mistakes, there would be no exultation in success. Similarly, Navy liberty time ashore is so delicious for a sailor partly because you know it will end exactly at 3am tonight. Will life become less exciting as people become more affluent and no longer have the excitement of the cost constraint of a limited stock of purchasing power, and will that absence also remove a key discipline from life? Perhaps people will always find a substitute constraint and discipline. This may explain the current interest in physical fitness. The negative elements related to an alternative -- call them "expenditures" when they are monetary, and "costs" otherwise -- are remarkably easy to deal with conceptually. But they are often difficult to handle psychologically and organizationally, which often causes firms and individuals to reach disastrously wrong decisions. There are two major pitfalls in dealing with monetary expenditures: 1) not ignoring "sunk" expenditures, and 2) allowing accounting notions of overhead and depreciation to get in the way of clear thinking. We'll consider the two errors in that order, and then show how to deal correctly with costs. Lastly, the chapter will touch on the vexing matter of non- monetary costs. First let us make some distinctions, while noting that it is everyday practice for just about everyone -- this writer included -- to use language in a sloppy way here. The term "costs" or "cost" is more general than the term "expenditures", which properly refers to the actual outlays you will make, in the period in which you will actually pay them out. When making decisions you should attach expenditures to the period in which they will actually be paid out. More generally, the concept of costs can be dispensed with entirely when making decisions, working only with expenditures. Though I, as others, slip into using the two words interchangeably, it would be best to leave the word "cost" to accounting work, and to the analyses by economists of the economy and markets, neither of which is within our scope here. A variety of cost concepts are frequently used in talking about business: variable cost and fixed cost, incremental cost, marginal cost, and opportunity cost. These concepts sometimes are useful for shorthand figuring. But they also can confuse the issue, and you can get along very well without them. You cannot go wrong by working only with total costs, in the fashion described below. Sunk Costs A sunk cost -- which really should be called a "sunk expenditure" -- is an outlay that has already been paid out. An expenditure which has been paid out should not be allowed to affect any subsequent decision. That is the most important cost- related lesson in a nutshell. The rationale for ignoring sunk costs becomes obvious in the case of Farmer Jones. His operations were identical last year to his neighbor Smith except that Jones spent $10,000 on some research-and-development to try to improve productivity, whereas Smith did not make such an expenditure. Unfortunately Jones's R&D was useless, and Jones's crop is just like Smith's. If Jones tries to "recapture" his R&D expenditures by charging a higher price for his grain than the market price, he won't sell his grain at all. His only viable option is to consider the sunk costs sunk, ignore them even if he cannot forget them, and sell at the same price as Jones. The same would be true for Smith if he spent a bunch of money last year for new equipment, whether the equipment was useful or not; when it comes time to sell your product, get the best price you can, and that's that. Someone may ask: How will you ever recover your investments? This question fails to distinguish between the beforehand ("ex ante") investment-time decision and the afterwards ("ex post") selling-time decision. Jones's decision to spend the $10,000 for R&D may have been perfectly sound when he made it, and if the research had been successful he would have increased his production by more than $10,000. But the ex post decision must be made on the basis of how things actually turned out, and not how they were expected to turn out. Similarly, it may have been sensible to bet on a horse that stepped in a hole and broke its leg during a race, but afterwards all you can do is tear up the losing ticket. (Distinguishing between the situations ex ante and the ex post the decision is very often helpful to clear thinking.) Exactly the same sunk-cost logic applies to the price at which you buy an asset. Afterwards, your selling decision should be independent of whether you can "recover" some or all parts of that sunk cost. After the deal is consummated, the purchase of a truck is sunk to a truck dealer, and the price she paid is irrelevant to the price she should re-sell it for. She should simply sell it for the highest price she can get. If that price is below what she paid for it, and she insists on getting a price equal to her purchase price, she will not be able to sell, and she will lose the whole of the possible sale price. The lesson about ignoring sunk costs is simple to understand logically. But it is very hard to put into practice for psychological reasons. Many people become bewitched by the prices they pay for a stock or a piece of real estate. The thought of selling for less than they paid is painful, and therefore they hold on beyond the time that they would otherwise sell, to their damage. Furthermore, accountants tell managers that they must allow sunk costs to enter into subsequent decisions, to the great detriment of those decisions. A small but (to me) painful story illustrates how accounting-cost notions can lead to the wrong decision. One day, I asked an executive of the firm that had published a book of mine why the firm did not continue with a mail-order advertising campaign that had just been tested to sell the book. He told me that the advertising campaign was not profitable. I was curious, and we examined the figures. The test showed that the firm could expect to sell copies at the mail-order price of $8.95 for an average advertising expenditure of about $3.00. (This was many years ago when prices were lower.) I said that in view of the production expenditures necessary for printing additional books -- only abut $1.25 or $1.50 per copy, because the book had already gone through two printings, plus small expenditures for handling and mailing -- the advertising campaign clearly seemed to promise a profit. But the executive said no, we had to add in the "overhead" of several dollars, which meant that the advertising campaign would be below the breakeven point. When asked what the "overhead" charge was for, he replied that it was the standard charge the firm's accountants insisted be applied to all such decisions. He said the overhead covered executive salaries, editing, physical plant, and so on. He agreed with me that additional advertising for this book that had already been produced would not increase the firm's need for editors, and so on. But nevertheless, he insisted on including that overhead charge in the calculation, and hence the campaign was not continued. The result was that both the firm and I wound up a lot worse off than we could have been -- a bad decision because of bad reckoning -- not considering sunk costs as sunk. Allocating Over Time and Among Activities: Don't A difficulty in business decisionmaking is that accountants supply most of the routine data in business and non-profit organizations. Accounting concepts, however, are not suitable for decisionmaking, especially the concepts of depreciation and the allocation of overhead costs. The business of an accountant is to look backwards, to "account for", in order to audit for honesty and to apportion credit and blame for profitable operation, as well as to determine how much money the business earned (or lost) in the prior period. The concepts of depreciation and overhead allocation are crucial in making those assessments of what has already happened. But decisionmaking must always be forward-looking, and the backward-looking accounting concepts are not helpful and may be misleading. The appropriate procedure is to treat expenditures perfectly symmetrically to the treatment of revenues, as integral parts of the cost-benefit analysis. The sound operating rule is as follows: Write down the total revenues and total expenditures for the firm in each period, for each alternative that is being considered. (The term "total" means the total for all the firm's activities, and not just for the changes being contemplated.) Then choose that alternative which leaves the greatest excess of total discounted incomes over total discounted outgoes. More precisely, choose the alternative which produces the highest present value for the firm as a whole. Whenever there is the slightest doubt about the nature of costs -- more generally, whenever you are making a profit calculation for any kind of decision in business -- you should put aside shorthand concepts such as incremental costs, and go the confusion-free route of conducting a total-cost total-revenue analysis for each alternative. Consider the example of the movie theatre's Christmas-Eve decision. As of the day before Christmas, the situation was as follows P0 Q0 S0 E0 VT=0 _____________________________________________________ Shut __ __ __ __ __ Open $2.00 $50 $100 $60 $40 _____________________________________________________ The V of staying open is higher, as of the day before. For additional interest, let us also see how the situation would have looked as of almost a year before, the preceding December 31, when the lease was signed for the year's rent and insurance: PT=0 Qt=0 St=0 Et=0 VT=0______________________________________________________________ ________ Alternative of Various Yearly $50,000 $41,000 $9,000 being closed (not necessary Christmas Eve, to know) results for whole year _________________________________________________________________ _____ Alternative of Various, Yearly + $50,100 $41,060 $9,040 being open and $2.00 Christmas Christmas Eve, Christmas Eve results for Eve______________________________________________________________ ________ From the standpoint of the year before, also, taking the whole year into account, it is better to operate on Christmas Eve than to stay closed. The point is that you must understand correctly the alternatives as they face you at the particular moment of decision -- and the alternatives can and often will appear very different at different moments. Given the rules that (1) costs for which you are committed must be considered as committed for all alternatives, and (2) expenditures should be indicated when they actually will be paid, the following point is seen to be important: A crucial part of any cost estimation is to ascertain just which expenditures you are committed to for various periods in the future, from the vantage point of the moment when the decision is being made. In practice, you do not need to include data about most of the firm's other activities. You only need to record the actual data about activities that will be affected by the decision at hand. In the example above, you do not need to know the theatre's other revenues for the year. Nevertheless, it is important to indicate in table with X's or Y's or whatever that there are revenues and expenditures which are the same for all the alternatives being considered, in order to be sure you do not overlook possibility that they might be affected. Simply overlooking other possible changes frequently causes shorthand reasoning about costs to go wrong. Opportunity cost Opportunity cost is an important and sometimes useful concept, but it is slippery. The core of the idea is that the relevant cost for an alternative is the benefit you would receive if you adopted the best other alternative. For example, if someone offers you $50 for a day to help move some furniture, your opportunity cost depends on what you would otherwise do during the day. If it is a day when you would otherwise work as a gardener and earn $40, then your opportunity cost is $40, and it pays you to accept the furniture-moving alternative. If you would earn $60 as a gardener, then $60 is your opportunity cost, and you should turn down the furniture-moving job. Quite the same analysis would apply if you own the theatre business in the example above, and you must decide the value of your own time if you will have to be at the theatre to keep it open on Christmas Eve. So far the notion of opportunity cost boils down to the proposition that you should consider all the alternatives, and choose that one with the highest present value. In a business setting, therefore, the concept of opportunity cost adds little or nothing to our thinking. But what about if you get $60 a day working as a gardener Monday to Friday, and the furniture moving will be on Saturday? Or, what about if you must consider the value of your own time keeping the theatre open Christmas Eve when otherwise you would stay at home? What you earn as a gardener is irrelevant -- unless you can get gardening work for that Saturday. But if you would otherwise not work on Saturday, is your opportunity cost zero? No, because your time has value to you as leisure. The worth of the time as leisure is known as your "reservation price". It is an opportunity cost that you assign on the basis of your tastes. If you are terribly bored and would move furniture for nothing just to get out of the house, then your reservation price is indeed zero. But if it would take $100 to get you to give up your Saturday at the beach, then $100 is your reservation price and your appropriate opportunity cost. In practice, you can only know your reservation price by noticing how much it takes you to induce you to work rather than to not work. In brief, your reservation price is the appropriate opportunity cost to be assigned to a non-monetary input -- usually your own time -- in an otherwise-monetized cost-benefit analysis such as the decision about whether to keep the theatre own on Christmas Eve. Non-monetary Costs Other Than Time Non-monetary outlays of effort, emotion, reputation, and personal relationship present special difficulties. Businesses have the advantage that money is an all-purpose measuring rod which commensurates all activities and makes their comparison easily possible -- at least in principle. But many business costs are not obvious, sometimes because they are not paid or directly, or because they affect the firm only indirectly. An example is the attention of the top management. Many firms have long lists of projects that they are quite sure would bring a high rate of return on the capital invested in them. Nevertheless, many or most of these projects will never be undertaken, because every project requires some of the attention of top management, some of their time and mental energy. And this attention is in very short supply and cannot be increased easily, if at all. A small project may require almost as much attention as a big one. Hence, management rations its supply of attention, giving it to projects with the biggest total potential return rather than those with the highest rate of return. Attention is probably the resource that most inexorably limits the growth of active firms. Consider a firm that has embarked on a policy of growth by merger. As it grows, it may continue to enjoy solid or improved credit, to improve its reputation, to increase its pool of knowledge. Its greater organizational size creates problems, but many such problems can be avoided by maximum decentralization. Why, then, does the firm not grow even faster? One reason may be insufficient opportunities for merger or purchase. But more probably, top management may not be able to devote attention to more new alternatives. The need for close attention by the owner is also the chief reason why farms do not grow much larger than they are in the United States and elsewhere. This important hidden effect should not be omitted from the reckoning. Many personal decisions involve costs that are hidden, difficult to quantify, or difficult to admit to. And in the absence of a monetary measuring-rod, evaluation can be very difficult, as we have already seen in the case of valuing your own leisure time. Let's say that you are mulling a decision to move from Chicago to Atlanta for a new job. The differences in present salaries, and perhaps even in future salaries, are easy to compare, as are differences in living expenses, because they are expressed in money. But what about the cost of giving up the garden into which you have put so much sweat and devotion? Of leaving your old friends, and of the effort of making new friends? And the possible hassle of political difficulties in the new job? You could attempt to assess the cost of giving up the garden in Chicago by estimating how many hours it would take you to build a new garden like it, or one that would be equally satisfying to you, at your new Atlanta home. This procedure would at least provide a numerical measure which might help you judge the cost quantitatively. You might go even further and put a money value on the hours of time required to construct the new garden, and you could then directly weigh that cost along with the differences in salary and living expenses. Converting other measures to the common measuring-rod of money in this fashion can often be helpful. The cost of leaving your old friends, and of making new ones, is even more difficult to handle. You could ask yourself: How big a sum of money would it take to make me feel that the gain would be equal to the loss of the old friends? But the very process of trying to place a monetary value on friendship may be so odious to you that you will not do it, and perhaps wisely so. In that case, about all you can do is to make a list of the various non-monetary costs and benefits, and perhaps rank them according to their importance to you. The exercise of making the ranking can help you clarify for yourself how much weight to give to the various elements. But that may be as far as systematic cost-benefit analysis can go in such a situation. Some costs may even more difficult to think about because you do not choose to admit to yourself how large they are, or you do not choose to inquire. What if you are secretly in love at a distance with a married person with whom you have never even talked outside of the office? You do not wish to acknowledge to yourself that you care a lot about that person, and that you have hopes that circumstances might change in the future to make it possible for the love to come to fruition. Here I abandon you to the wilder shores of human decision-making, without even the hint of a suggestion about how to proceed. Everything said in this section about non-monetary costs applies equally to non-monetary benefits. Indeed, the two may be seen as opposite sides of the same coin. Not enjoying a benefit can be thought of as a cost, and not incurring a cost can be thought of as a benefit. After you have arrived at sound concepts of how to think about cost, you are left with the difficult job of actually estimating the expenditures for you alternatives you are considering. That task is discussed in Chapter 00. Page # thinking costs13% 3-3-4d