Opportunity Cost, Profits, and Value

1
Opportunity Cost, Profits, and Value

• Shyam Sunder, Yale University
• National University of Colombia, Bogota
• August 16, 2005

2
An Overview

• Opportunity costs is the concept of cost
  necessary for economic decisions
• Explore its nature and measurement for different
  kinds of resources
• Economic profit, the appropriate criterion for
  choice, depends on opportunity cost, and
  different from various agents
• Value is the capitalization of profit
• Value of the organization can be viewed as the
  some of the value generated for all participating
  agents

3
What Is Opportunity Cost?

• Sometimes it is easier to understand a concept
  starting out what it is not
• Usually we think of costs as out-of-pocket costs
• 1 (cost of a cup of coffee)
• 20,000 (cost of a car)
• At the time we make the decision to buy the cup
  of coffee or the car, this out-of-pocket cost is
  also (usually) the opportunity cost
• With the passage of time, the two tend to diverge
  from each other

4
Opportunity Costs

• How are opportunity costs different from
  out-of-pocket costs?
• Opportunity cost of choosing a decision (e.g.,
  choosing A over B) is the sacrifice we make by
  not choosing B
• Costs that were never, and would never, be
  incurred
• Subjective, hypothetical (what might have been),
  speculative and uncertain, must be estimated
• Opportunity cost has no existence apart from a
  decision problem
• It is associated with the road not taken
• Why should such costs count in our decisions?
• Let us see a simple example

5
Example of Opportunity Cost

• An old painting bought for 5
• You plan to give it to a friend
• Just before you give it to your friend, you find
  out that it is a rare painting by an old master
  which costs 5,000
• What is the cost of giving the painting to your
  friend?

6
More Examples

• Cost of material with no other use
• Cost of material with other uses
• Cost of material not yet bought
• Interest on inventory
• Cost of labor
• Cost of capacity
• Cost of excess capacity

7
Decision with Opportunity Cost

• Example illustrates that we can use one of two
  methods
• Calculate the net benefit of each available
  option and pick the better one
• Calculate the net benefit of one option, after
  subtracting the net benefit of the other option
  as the opportunity cost
• If we calculate correctly, the decision would be
  the same from both methods of making decisions

8
Opportunity Cost Illustration
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Contrast with Sunk Costs

• One person buys a ticket to see the Olympics
  final of soccer for 200 dollars
• A second person gets the ticket for free from a
  friend who has an emergency
• Severe weather is predicted for the day of the
  game
• Which person is more likely to attend the game?
  Why?

10
Measuring Opportunity Costs

• In single person contexts,
• use subjective or objective probability to model
  and solve the decision problem
• In multiperson contexts,
• Absence of objective measures of opportunity
  costs exacerbates agency costs
• In either case, reduction in subjectivity of
  opportunity cost estimates may help make better
  decisions
• Perhaps we can use public information to reduce
  subjectivity in measured opportunity costs

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How resources behave with time may have to do
with the problems of estimating opportunity costs

• Cash, being a timeless resource, offers no
  problems (or perhaps merely because it is defined
  as the numeraire)
• Let us explore the time dimension of resources

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How Do Resources Behave Over Time?

• In acquisition
• In expiration of their benefits
• In consumption of their benefits

13
Resources Vary in Their Lumpiness or Granularity
Along All Three Dimensions

• Let us look at their
• Acquisition granularity
• Expiration granularity
• Consumption granularity

14
Acquisition Granularity

• Three crude classes
• Low (electrical power, contract labor)
• Acquisition and utilization are proximate
• Not inventoried, JIT
• Medium (groceries)
• Economic order quantity (EOQ) Model
• High (car, house, machinery and plant)
• One-off

15
Determinants of Acquisition Granularity

• Transaction costs
• Storage costs
• Technology of supply

16
Expiration Granularity

• Same as storability
• Low (highway sign, receptionist)
• Medium (bag of sugar, fruit, car)
• High (gold bar)
• Note Distinguish expiration granularity or
  storability from the rate of expiration of
  benefits

17
Consumption Granularity(Closely linked to
expiration granularity)

• Extent of owner's control over the rate of
  extraction of benefits
• Low (street sign, gold ring)
• Medium (car)
• High (sugar, production gold)

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Cross Tabulation
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Decisions

• Consider a decision
• List options
• List resource consequences of options
• For each resource, consider
• Acquisition Granularity
• If low, OC purchase price
• If high, consider expiration granularity of each
  relevant attribute of the resource

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Decisions (Continued)

• Expiration granularity
• If low, it is a pure capacity resource Use time
  as the cost driver,
• If high, consider consumption granularity of each
  attribute of the

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Decisions (Continued)

• Consumption granularity
• List driver for each attribute i
• For each attribute/driver i calculate cost/unit
  ci
• If a product consumes ui units of attribute i,
  cost of the resource assigned to the product
  maxi (ciui)

22
Example Rental Car

• Cost (net of salvage value) 24,000
• Attribute 1 Time (Capacity 600 days)
• Attribute 2 Mileage (Capacity 60,000 m)
• Time Rate 24,000/600 40 per day
• Mil. Rate 24,000/60,000 0.40 per m.
• Cost of rental max (40.Days, 0.40. miles)

23
Profits

• Economic profit of an agent from a decision is
  the revenue less the opportunity cost of the
  decision
• The profit from participation in an organization
  can be defined not only for the shareholders but
  for every participating agent
• We can determine who gets how much profit and
  what is the total profit generated by an
  organization for all participants combined

24
Neoclassical Firm

• Firm is the instrument of the owner- entrepreneur
• Every other agent gets the opportunity cost of
  the resource he/she contributes (i.e. no goodies)
• All these factor markets are assumed to be
  perfectly competitive
• All the surplus goes to the owner-entrepreneur
• Value of the firm is the discounted present value
  of cash flows to the owner
• IRR O.C. of capital gt zero value

25
Contract or Organization Theory

• If the total surplus is negative the firm is
  infeasible redesign the contracts or shut down
• If the total surplus is zero, there is a unique
  distribution in which everyone gets zero surplus
• If the total surplus is positive, there are
  multiple feasible allocations. There is no basis
  for choosing one allocation over another.
  Therefore, the distribution of surplus among
  agents is undetermined

26
Firm as a Set of Contracts
27
A Brief Detour

• Am I talking about social accounting?
• Yes, there are some common elements
• But it differs in perspective
• Let us do a brief overview of social accounting

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Social Accounting

• Also called socioeconomic accounting, social
  responsibility accounting and social audit
• Measure and report efforts, achievements and
  impact of firms on social dimensions
• E.g., energy conservation, minority hiring,
  environmental preservation, support of community
  organizations (see Appendix A)
• Often descriptive, may include financial and
  non-financial data

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Typical Elements of Social Accounts

• A. Community Involvement General philanthropy,
  Public and private transportation, Health
  services, Housing, Aid in personal and business
  problems, Community planning and improvement,
  Volunteer activities, Specialized food programs,
  Education,
• B. Human Resources Employment practices,
  Training programs, Promotion policies, Employment
  continuity, Remuneration, Working conditions,
  Drugs and alcohol, Job enrichment,
  Communications,
• C. Physical Resources and Environmental
  Contributions Air, Water, Sound, Solid waste,
  Use of scarce resources, Aesthetics
• D. Product or Service Contributions Labeling,
  Warranty, Responsiveness to consumer complaints,
  Consumer education, Product quality, Product
  safety, Advertising, Constructive research

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Examples of Social Accounting

• Tradecraft, http//www.globalnet.co.uk/traidcra
  ft/sa9495/index.html
• British Telecom, http//www.groupbt.com/society/in
  dex.htm
• General Motors, http//www.gm.com/company/gmabilit
  y/environment/env_annual_report/index.html
• Intel http//www.intel.com/intel/finance/social.ht
  m
• United Airlines http//www.ual.com/site/primary/0,
  10017,1359,00.html

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Social Accounting Perspective

• Social is construed narrowly, leaves out
  production, sale and distribution of goods and
  services, taken for granted
• Managers responsible for preparing the social
  accounts
• Information inherently dispersed
• Uses perspective of the firm, not the members of
  society
• Fuzzy image

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Profit/Value of the Firm

• Extensive income as the sum of
• To the shareholders
• To customers
• To Vendors
• To employees
• To creditors
• To government
• To community, etc.
• Inducement from the firm O.C. of contributions

33
Profit/Value to Investors

• Residual income and corresponding shareholder
  value created
• Focus of current financial reports
• Apply similar perspective to other participants
  in the firm

34
Profit/Value to Customers

• Customers investment in the form in the form
  of search, learning, negotiation, payments,
  settlement of disputes
• Expected PV of benefits from goods received
  should exceed the PV of investments
• Includes immediate transaction as well as the
  consequences of the transaction for resource
  flows associated with any future transactions
  (reduction in time, cost, search etc. for later
  transactions)
• In a perfect product market, consumers surplus
  from the firm is zero (may be ve from industry)

35
Value to Government

• Various levels of government provide mostly
  non-priced services plus some priced goods
• Resources from taxation
• Value of the firm to the government from
  providing priced services is the same as for
  vendors
• Value of the firm to the government from
  providing non-priced services is taxes plus fees
  minus O.C. of resources spent on providing
  services
• Major challenge to put this in practice

36
Value of the Firm to Community

• Local, national and global
• Most exchanges in form of externalities
• Value of the firm to the community is the sum of
  net externalities plus the net payments

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Measurement of Profit/Value

• J.M. Clark (1936) Three fundamental challenges
  to determining the value of private enterprise
• Imperfect and incomplete markets
• Fundamental values not as exact as market values
• Fundamental concepts should be independent of
  specific institutions of exchange (generality)

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Markets and Value of the Firm

• In a perfect market Law of one price holds,
  everyone gets the same price
• Value to the supplier of factor is zero
• Existence of value gtmarket imperfection
• Perfection can be the tendency of markets under
  certain conditions, not the goal of any agent
• Agents seek and create imperfections
  (specialization, differentiation, monopolies)
• Value creation as a treadmill, not ski lift
• Market frictions/trans. Costs create room for
  value

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Externalities in Value of the Firm

• Difficult problems of measurement because there
  is no help from markets
• Most organizations produce and consume public
  goods
• Extensive concept of income includes the value of
  these benefits consumed and bestowed on the
  community

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Difficulties of Measuring Externalities

• Example Vans to transport employees from train
  station
• Cost of service to the firm, and benefits of
  lowered costs of parking, absenteeism, morale,
  etc.
• Employee savings cash, time, fatigue, etc. best
  estimated by employees
• Benefits to fellow commuters, local government,
  citizens
• Lump together as community, apply social
  cost-benefit analysis to determine income to
  community
• Sensitive to identity of preparer
• Valuation social rate of discount lower than
  private

41
Implications Mergers and Acquisitions

• Extensive debates surrounding the consequences of
  corporate mergers and acquisitions
• Empirical studies Target firm shareholders gain,
  
• Acquiring firm shareholders wealth effect not
  clear
• Occasional attention to bondholders, and tax
  consequences
• Effects on labor, customers, vendors, community
  rarely examined
• What kind of policy decisions possible on the
  basis of shareholder value alone?

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Justification for Shareholder Value Criterion

• Assume neoclassical model of the firm (all
  surplus always goes to the owner, income/value to
  all other agents is zero both before and after
  the event) no need to look at the effects on any
  other class of agents
• Capital markets are said to be efficient, at
  least more perfect than other factor markets
• Contradiction between the two assumptions

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Who Gets the Goodies?

• Agents who transact in relatively perfect markets
  should get prices close to O.C.
• U.S. capital markets said to be more perfect than
  others
• Suppliers of capital should be expected to get
  close to their O.C.
• Surplus/value of the firm should accrue mostly to
  agents who transact through less perfect markets
• Yet, we assume that the surplus goes to the
  shareholders

44
Contract Renegotiation

• Shareholders have the only open-ended contract in
  the firm
• All other contracts are periodically
  renegotiated these agents try to capture a share
  of the surplus whenever possible
• Short term contract agents have an option value
  that shareholders lack
• Shareholders (as a group) and unvested pensioners
  cannot quit when faced with having to absorb
  negative surplus
• Many mergers and acquisitions are followed by
  contract renegotiations

45
Need Analysis of Extensive Income and Values

• For policy, need analysis of income/values to all
  agents, not just shareholders
• Given their long term inflexible contract,
  imperfections in corporate governance, they may
  not be able to capture all, or even most, of the
  ex post benefits of value-enhancing mergers and
  acquisitions
• Possible leakage to other agents through market
  imperfections, holes in corporate governance when
  value is enhanced
• Shareholders left holding the bag on depletion
• Would not know without analysis of extensive
  income/value of the firm

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Shareholder Value As Guide for Accounting Policy

• Event, ERC, Value-Relevance, R2 studies cited as
  justifications for accounting policy
• What is the theoretical justification for using
  shareholder value for this purpose (other than
  neoclassical perspective)
• Law of the Instrument (Kaplan) Use whatever data
  is available, extensive income/value measures
  unavailable

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Concluding Remarks

• Neoclassical perspective is not useful for
  analyzing many accounting issues
• Income and value concepts driven by this
  perspective have their limitations, and
  contradictions
• For important classes of accounting matters, we
  may need extensive concepts of income and value
• Lessons from national income accounting

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Thank you

• The presentation will be available for
  downloading from
• www.som.yale.edu/faculty/sunder
• Please send your comments to
• Shyam.Sunder_at_yale.edu