Chapter 6
Are You a Better Decision Maker … Yet?
Ultimately, the success of a manager boils down to how well he applies economic concepts to his decisions. Ironically, our observations seem to indicate that managers often rise through the ranks of companies without fully understanding the basic economic tenets of decision making. It isn’t that they are bad at their jobs; in fact, the opposite is usually true. Most firms only promote the most productive employees. But successful managers make their way up the corporate ladder not just because they’re hard-working or understand company politics. Rather, the successful manager is willing to question convention and think outside the box.
Let’s illustrate through a real-world example. Donald Washkewicz became chief executive of Parker Hannifin Corporation in 2001. Throughout its history, the firm employed simple cost-plus pricing techniques for its 800,000 products. The managers would calculate the cost of producing the item and tack on 35% as a markup. And why not? It’s simple, straightforward, and the firm had been doing it this way for years.
But Washkewicz was not convinced that the “tried-and-true” way to set prices was necessarily the best way. His new system separated each product into one of five categories, based largely on the price elasticity of demand. At one end of the spectrum were the core products that were produced in high volumes and subject to intense market competition. At the opposite extreme were products that were custom-designed for specific customers or otherwise available only through Parker Hannifin. Rather than mark each product up by a fixed percentage over unit cost, prices were set in accordance with the price sensitivity of buyers. As a result of the new approach to pricing, the firm’s profits soared from $130 million to $673 million in only five years.1
Washkewicz may not have consulted a microeconomics textbook when he changed his firm’s pricing strategy, but the results are consistent with the economic theory of the firm. If a manager uses economic theory as the foundation for making decisions, more often than not, the right decision will be made.
In writing this book, our goal is to help managers make better decisions. Let’s reflect on the past five chapters as a guide to decision-making. Our first major point was that each decision must add to the value of the firm. This means that the relevant revenue from each decision must exceed its relevant cost. Relevant revenues and costs are those that will change if the decision is implemented.
The extent to which revenues will change can be characterized by demand theory. As the price rises, fewer units will be sold. However, the rate at which consumers respond to price increases is determined by the price elasticity of demand. Until Donald Washkewicz revolutionized pricing at Parker Hannifin, prices were set in accordance with unit cost, not on the basis of demand. By separating the products into categories, Parker was able to set prices based on elasticities.
Demand analysis suggests other factors that ought to be considered by managers. One is potential price effects. It is too easy to equate relevant revenues to the revenues generated by the additional units produced and sold. But will increasing production place downward pressures on the prices of all units? If so, the relevant revenues will be less than originally estimated. In some cases, the firm can set a price for one cluster of customers without changing the price for other customers.2 In these circumstances, the revenue from the additional units is the relevant revenue and there are no price effects.
The cross-price elasticity of demand measures the sensitivity of unit sales for one good to changes in the prices of related goods. Few firms produce exactly one product. Quite often, the firm’s product lines include goods that are complementary or substitutes. Changing the price of one good will affect the unit sales of related goods. Managers need to be cognizant as to how pricing decisions affect all related products.
Chapters 4 and 5 help managers anticipate relevant costs. But measuring relevant cost is far more challenging than the concept implies. Relevant cost is, by definition, a measure of the opportunity cost of implementing the decision. But as we discussed in Chapter 5, accounting costs often differ from opportunity costs. Accounting costs are historical by nature whereas opportunity costs are always forward-looking. To the extent that accounting costs captured opportunity costs in the past and opportunity costs have not changed, then accounting costs will continue to capture opportunity costs. Otherwise, they are not the same.
Another difference between accounting and opportunity costs can be quite problematic. Chapter 4 demonstrated that unless a decision incurs avoidable fixed costs, relevant cost is the same as marginal cost. The economic theory of cost demonstrates that each unit of production has its own unique marginal cost. Although the marginal cost decreases initially, once the law of diminishing returns sets in, the marginal cost of each unit steadily rises.
But it would be prohibitively expensive for a cost accountant to be able to measure the cost of producing each individual unit. Consequently, cost accounting measures of unit cost are invariably based on averages. If the firm employs variable costing, only variable costs are reported as unit cost. But the reported figure is average variable cost, not marginal cost. Alternatively, absorption costing applies variable costs that are traced to products over short periods of production, as well as fixed costs that are allocated to products based on various cost drivers. In this case, the reported unit cost estimate is average total cost, which, again, is not the same as marginal cost. Activity-based costing is simply a more sophisticated way to allocate overhead on the basis of cost drivers; specifically, each activity is assumed to have its own cost driver. Nonetheless, because fixed overhead is allocated to individual units of production, the resulting unit cost estimate is average total cost, not marginal cost.
Does this really matter or is the distinction merely semantic? Theory suggests that marginal cost is rarely the same as average total or average variable cost. Therefore, if relevant cost is marginal cost, and the unit cost estimates are not the same as marginal cost, then the manager is in a position to make bad decisions. Failing to understand the difference between marginal cost and unit cost estimates can lead to producing too much or too little output and setting less than optimal prices.
While one might think this is acceptable over the long haul because the differences between marginal and average costs balance out over time, the distinction can actually be quite problematic. The problems arise because some projects with understated opportunity costs are chosen when they should not be. Similarly, some projects with overstated opportunity costs are dismissed when they should have been accepted. Thus, the company loses money whether opportunity costs are over or understated.
Rockwell International once became concerned with the erratic sales performance of its heavy-duty truck axles. By closely examining their costing practices, which routinely allocated overhead on the basis of direct labor hours, the firm realized it was overestimating the unit cost of its high-volume axles by 20% while underestimating the cost of the other axles by as much as 40%.3 Because prices were based on unit cost estimates, Rockwell set prices for the high-volume axles that allowed competitors to freely enter the market.
This does not imply accounting costs are without merit. Estimating opportunity costs can be extremely costly and accounting costs serve as a more affordable benchmark to use when making decisions. Additionally, many accountants use different methods to record accounting costs to try to compensate for some of the problems inherent to accounting based product costs. As discussed in Chapter Five, these methods all have their strengths and weaknesses.
So how can a manager use the information in this book to make better decisions? Here are a few practical steps that can be taken. The first step is rather simple: dive deeper into the data and ask questions. Oftentimes, the individuals who provide the data have some economic sense, but they see their job as providing the figures, not explaining or decomposing them. Ask the accountants who provide the cost information what is included and whether these costs are relevant to the decision. Ask whether the costs provided include any fixed costs that do not vary with changes in production volume. If the answer is yes, then those costs should be removed for a more accurate examination. Ask the marketing people how intense is the level of price competition and the degree to which prospective buyers can find adequate substitutes. Ask the finance people how the cost of capital was determined and what role it should play in the final project analysis.
Consider the following simple example. A local restaurant owner was considering whether he should purchase radio advertising. Based on local market characteristics and previous results, his marketing group concluded that advertising on the radio would increase his restaurant’s sales by 12%. The cost of radio advertisement was more than 12% of his profits, so he concluded it was not worth the investment. After some discussion, however, he soon realized that many of the costs included in his profit were fixed costs and would not increase with the changes in sales (e.g. rent, electricity, insurance, depreciation, and others). After excluding the fixed costs, the restaurant owner determined the increase in profit from extra sales far outweighed the cost of the advertising. Thus, asking questions, diving deeper into the data, and re-examining the costs with fixed costs removed is generally the first step.
If the accountant or other people who are providing you data are unable to provide sufficient insight as to what should be done or which costs do not vary, the second step is to ask what accounting method was used to determine the costs. Regardless of which method is used, it is important to remember that accounting costs are historical by nature and that things change over time. Thus, you should make sure the accounting costs presented are still consistent with current production cost estimates. If the production costs have changed, then the current cost estimates should be used rather than the historical accounting costs. Additionally, it is important to remember that accounting costs do not capture marginal costs because they are based on average costs. Nonetheless, more accurate cost data can be calculated in certain situations if it is deemed necessary. This more accurate data will still be based on averages, but it will be closer to the relevant cost figure.4
One last point inherent to all product costs is that allocated fixed costs may be beneficial because they can reflect negative externalities. That is, some of the allocations may capture the opportunity costs of strained supporting roles (e.g. janitorial, human resources, and others). Our suggestion is to eliminate fixed costs when making decisions, but this should be tempered by the caution to consider any effects decisions may have on supporting services.
After determining which costing method has been used, the following steps should be taken. If the absorption costing method is used, then fixed costs have been allocated to product costs and should be backed out before considering which price and production levels net the maximum profit. Although fixed costs are very important in terms of profitability, they are irrelevant when making decisions because they are fixed and do not vary between the available choices (assuming they are unavoidable, which is the case when examining product costs). Remember that you are only concerned with relevant costs and that these costs only include costs that vary between decisions. If the variable costing method is used to determine product costs, then fixed costs do not have to be backed out. Nonetheless, you still need to be mindful of the points discussed earlier. Finally, if activity-based costing is used, fixed costs have once again been allocated to product costs and should be removed before making a specific choice.
If you still feel uncomfortable or uncertain making a substantial decision after reading the first five chapters of this book and following the steps described earlier, then our last bit of advice is to consult with an external source. Many firms have the necessary staff in place to provide consulting internally. In the event that you do not have staff available to provide the correct guidance internally, the decision is of significant importance to your business, and you still feel uncomfortable making the decision based upon the knowledge you gained from reading this book, you may want to hire a professional consultant. Most cities have firms that specialize in consulting. You should contact a certified public accountant if you cannot find a firm that specializes in consulting. People are usually hesitant to hire consultants because the consulting cost represents an additional expense. However, making incorrect decisions also lowers profit. Hence, you may find that the benefits from hiring a consultant more than justify the costs. This book was written to help the business community benefit by explaining how to make better business decisions using economic theory and an understanding of how accounting costs are calculated. It is our hope that this book has and will continue to serve you well.