PowerPoint Slides © Michael R. Ward, UTA 2014. Opportunity Costs “Outsourcing” SceneScene Econ 5313.

PowerPoint Slides © Michael R. Ward, UTA 2014

Opportunity Costs• “Outsourcing” Scene

Econ 5313

Foreign CurrencyYou've completed your vacation in a foreign country. At the airport, you discover you have the equivalent of $20 local currency left over. The exchange control officer tells you that you can't convert the local money back to dollars. Nor can you take it out of the country. Because the gift shop was closed, you decided to spend the remaining money on refreshments—for complete strangers! • What is the cost of you providing the refreshments?

Econ 5313

Accounting vs. Economic CostsA construction manager earning $70,000 per year working for a regional home builder opened his own company. He took $100,000 out of one of his investment accounts that had been earning around 6% a year to use as start up money for the business. He worked hard the first year, hiring just one employee with total compensation costs of $40,000. Total material and subcontracted labor costs for the year were $900,000. He generated total sales of $1,000,000. • What are his accounting profits?

• $1,000,000-$900,000-$40,000 = $60,000

• What are the opportunity costs for the manager of being in this business relative to returning to his old job? • $70,000 + $100,000×6% = $76,000

• What is the economic profit of the business?• $60,000-$76,000 = -$16,000

Econ 5313

Own vs. RentYou currently pay $10,000 per year in rent for a $100,000 house, which you are considering purchasing. You can qualify for a loan of $80,000 at 9% if you put $20,000 down on the house. To raise money for the down payment, you would have to liquidate stock earning a 15% return. Neglect other concerns, like closing costs, capital gains, and taxes. • Is it better to rent or own?

• 80,000×9%+20,000×15% = $10,200 > $10,000

• Suppose that you can deduct mortgage interest from federal taxes and you are in the 25% tax bracket. Is it better to rent or own?• 80,000×9%×75%+20,000×15% = $8,400 < $10,000

Econ 5313

Input SupplyYour firm usually uses 200 to 300 tons of steel per year. Last year, you purchased 100 tons more steel than needed at a price of $200 per ton. Since then, the price of steel jumped and stabilized at $250 per ton delivered (i.e. the selling firm selling must pay any shipping costs). The cost of shipping steel to the nearest buyer would be $20 per ton. In the meantime, a business next door just went bankrupt, and the bank is offering a special deal where you can buy another 100 tons of steel for $180 per ton. Assume that the interest rate is 0%. • What are your possible choices?• What are the costs of these choices?

Econ 5313

Can Divisions IA can manufacturing company produces and sells three different types of cans: Versions X, Y, and Z. Corporate overhead (rent, general and administrative expense, etc.) is allocated equally among the three product versions. A high-level, simplified profit/loss statement for the company is provided. After reviewing the statement, company managers are concerned about the loss on Version Z and are considering ceasing production of that version.

Econ 5313

Can Divisions II

• Should they discontinue Version Z?• How does overhead affect this decision?

Econ 5313

Version X Version Y Version Z TotalNet Can Sales $180,000 $240,000 $105,000 $525,000Variable Costs $105,000 $135,000 $82,500 $322,500Corporate Overhead $60,000 $60,000 $60,000 $180,000Contribution to Profit $15,000 $45,000 -$37,500 $22,500

Washing Machine Agitator I• You are a manager of a washing machine company

considering outsourcing the production of an agitator. The following table summarizes costs.

• Which option is cheaper?

Econ 5313

Internal OutsourcedCategory Cost Category CostMaterial $0.60 Material $0.50 Labor $0.20 Labor $0.10 Depreciation $0.10 Tooling $0.10 Other Overhead $0.10

Washing Machine Agitator II• The washing machine company accountants tell you that if

you outsource, your division will have to accept a one time charge of $400,000. (They get this amount because the plant invested $1,000,000 in sunk costs for internal production six years ago and expected to depreciate this cost over ten years.) Which option would you choose?

• Is this accounting charge appropriate?• Suppose it was year 1 of the 10 years. Are the accounting

charges appropriate now?• Why might the company want these charges to apply?

Econ 5313

10 Principles of Economics• 10 Principles• Standup Economist

Econ 5313

All-Pay Auction• Auctioning a dollar.• But this is an all-pay auction (like poker).• If your bid is beaten by someone else, you still pay what

you previously bid.• However, if you bid twice, you only pay your highest bid.

• What is sunk and what is marginal to a bid decision?

Econ 5313

From the Blog• Chapter 3• Pitfalls of Modeling in the Americas Cup• CBO on Benefits and Costs of Policy• Designing welfare to blunt work disincentives

Econ 5313

Summary of Main Points• Costs <==> Decisions.• Opportunity cost is the value of what you give up.• To consider all costs, identify hidden costs. Do not commit

the hidden cost fallacy.• To consider only the relevant costs, identify sunk costs. Do

not commit the sunk cost fallacy.• Fixed costs do not vary with output, variable costs do.• Accounting profit (costs) usually differ from Economic

profit (costs) in how they treat durable assets.• Retrospective versus Prospective

Econ 5313