PROBLEM SOLVING AND DECISION MAKING

A research output

Submitted To

Mrs. Angelita Mando

College of Business and Accountancy

Lipa City Colleges

G.A. Solis, St., Lipa City, Batangas

In Partial Fulfillment of the

Requirement for the Course

Managerial Economics

By:

John Paul Emmanuel L. Alonzo

BSA – AC2A

August 29, 2024

 I. USING ECONOMICS TO SOLVE PROBLEM

INTRODUCTION

Economics as a subject began when thoughtful observers asked themselves how such a complex
set of transactions is organized. Who coordinates the vast array of production, employment, and
consumption decisions? Who makes sure that all the activities fit together, providing jobs to
produce the goods and services that people want and delivering those things to where they are
wanted?

The answer is: no one!

The great insight of the early economists was that an economy based on free-market transactions
is self-organizing (Lipsey & Chrystal, 2011). This economic problem applies to individuals,
companies and governments. But, at an economy-wide (country-wide) level, how does a
government seek to solve the economic problem? The key element is that a government must
make choices. It must prioritize how it uses the scarce resources to achieve the best outcomes for
society as a whole. There are four key economic questions that a society needs to answer.

Economic question one: What to produce?

An economy cannot produce every single good and/or service demanded by consumers and
businesses. It does not have sufficient resources to do this. Instead, it must choose which goods
and services to produce...and maybe import the others from overseas.

Economic question two: How much to produce?

An economy cannot produce an infinite number of goods and services. Scarce resources put a
limit on production levels. Here, a government wants to avoid waste. For example, if you
produce more goods than consumers demand, you’ve got excess supply and a bunch of products
sitting on shelves.

Economic question three: How to produce?

How will an economy make the goods and services? Labor? Capital? A mix? The key here is to
make the goods and services efficiently — so with as little waste as possible. Maximum output
for the inputs!
Economic question four: How to distribute production?

Who gets to access the goods and services? Does it depend on your income? Are they subsidized
by the government? Are they given out free? This will depend on the goals of the government
(whether it’s essential for everyone to have this good or service) and the role of the free market.

The challenge for governments is the difficulty in getting these questions ‘right’. It is hard to
predict which goods and services to make — particularly how much of each to produce to
precisely meet demand. Governments (and markets) don’t always get it right when answering the
economic questions (Symonds, 2020).

According to Frank (2021), Managerial Economics is concerned with the application of

economic principles to key management decisions. It provides guidance to increase value
creation within an organization and allows for a better understanding of the external business
environment in which the organization operates. A primary purpose of this course is to develop a
tool kit useful in other MiM courses and useful in decision making in business. Economics is a
key foundation for much of what is taught in finance, marketing and strategy. Managers in
business, government and non-profit enterprises must make decisions under are constraints and
limited resources. Economics is fundamentally a unique way of thinking about these kinds of
problems, issues and decisions. This way of thinking stresses the importance of incentives as
determinants of human behavior and performance and emphasizes the consideration of costs and
benefits in reaching decisions. Adopting the economic approach should enable participants to
make consistent assumptions and predictions about the local and international business
environment. It should also allow them to enrich their strategies through economic analysis.

Rational choice theory states that individuals use rational calculations to make choices and
achieve outcomes that are aligned with their own personal objectives. These results are also
associated with maximizing an individual's self-interest. Using rational choice theory is expected
to result in outcomes that provide people with the greatest benefit and satisfaction, given the
limited options they have available (Investopedia, 2024). Many mainstream economic
assumptions and theories are based on rational choice theory. Rational choice theory is
associated with the concepts of rational actors, self-interest, and the invisible hand. Rational
choice theory is based on the assumption of involvement from rational actors. Rational actors are
the individuals in an economy who make rational choices based on calculations and the
information that is available to them. Rational actors form the basis of rational choice theory.
Rational choice theory assumes that individuals, or rational actors, try to actively maximize their
advantage in any situation and, therefore, consistently try to minimize their losses. Economists
may use this assumption of rationality as part of broader studies seeking to understand certain
behaviors of society as a whole.

Adam Smith was one of the first economists to develop the underlying principles of the rational
choice theory. Smith elaborated on his studies of self-interest and the invisible hand theory in his
book “An Inquiry into the Nature and Causes of the Wealth of Nations,” which was published in
1776. The invisible hand itself is a metaphor for the unseen forces that influence a free market
economy. First and foremost, the invisible hand theory assumes self-interest. Both this theory
and further developments in the rational choice theory refute any negative misconceptions
associated with self-interest. Instead, these concepts suggest that rational actors acting with their
own self-interest in mind can actually create benefits for the economy at large.

According to the invisible hand theory, individuals driven by self-interest and rationality will
make decisions that lead to positive benefits for the whole economy. Through the freedom of
production, as well as consumption, the best interests of society are fulfilled. The constant
interplay of individual pressures on market supply and demand causes the natural movement of
prices and the flow of trade. Economists who believe in the invisible hand theory lobby for less
government intervention and more free-market exchange opportunities
 II. PROBLEM – SOLVING PRINCIPLES

Problem-solving is a skill that can be learned and improved with practice. It involves identifying,
analyzing, and resolving issues that arise in various situations. Whether you are facing a
personal, professional, or academic challenge, you can apply some basic principles of problem-
solving to help you find the best solution (Braganca, 2023). Here are some of the basic principles
of problem-solving:

Define the problem clearly. The first step is understanding the problem and what you want to
achieve. Questions can be helpful in this process. For instance:

 What is the current situation?

 What is the desired outcome?

 What are the obstacles or constraints?

 What are the criteria for a good solution?

Gather relevant information. The next step is to collect and organize all the information that is
related to the problem. You can use sources such as your own knowledge and experience, other
people's opinions and feedback, books, articles, websites, etc. You can also use tools like
brainstorming, mind mapping, diagrams, charts, etc.

Generate possible solutions. The third step is to come up with as many ideas as possible for
solving the problem. You can use different techniques to explore ideas. For example, divergent
thinking, lateral thinking, creative thinking, etc. There are also exploratory methods that can be
helpful (trial and error, experimentation, simulation, etc.)

Evaluate and select the best solution. The fourth step is to compare and contrast the pros and
cons of each possible solution. Using criteria for evaluation can be very effective. Use criteria
such as feasibility, effectiveness, efficiency, cost, time, resources, etc. Evaluative tools can also
help as you come to a decision (SWOT analysis, decision matrix, cost-benefit analysis, etc.)

Implement and monitor the solution. The final step is to implement the chosen solution and
check its results. To execute the solution well, planning, executing, testing, reviewing, etc., are
necessary steps to coordinate and ensure alignment in the organization. Without communication
and continual assessment, you may not be responsive to necessary adjustments along the way.
Use measures such as feedback, evaluation, improvement, etc., to gather information and
respond to possible issues.

The field of economics requires students to use critical thinking and problem-solving skills, but
unfortunately many students have not had the opportunity to develop such skills prior to entering
the economics classroom. Thus, they find economics intimidating. This is unfortunate, but it
makes a strong case for why documented problem solving is so well suited to economics courses.
Documented problem solving provides students with a framework in which they can begin to
explore their problem-solving strategies. Documented problem solving has been used effectively
in Principles of Economics courses at a large, public, research institution over the last few years.
It's been used with the topics of production possibilities, supply and demand, price elasticity and
consumer demand, market structures, the labor market, unemployment, fiscal and monetary
policy, GDP per capita and economic growth, effective tax rates, international trade plus many
more. Clearly, it can be applied to virtually any economics course. Students find the process
challenging at first, but because the process itself is not graded, they soon relax and enjoy it as a
tool that serves to enhance their learning process.

Angelo & Cross (1993, p. 222) write "To become truly proficient problem solvers, students need
to learn to do more than just get correct answers to textbook problems. At some point, they need
to become aware of how they solved those problems and how they can adapt their problem-
solving routines to deal with messy, real-world problems. . . Understanding and using effective
problem-solving procedures is, after all, a critical component of mastery in most disciplines."

Documented problem solving requires students to reflect on how they solve a problem and then
write down the steps they use. Thus, documented problem solving provides a window through
which the instructor can see students' thinking processes. It is rewarding for instructors to see
students become more purposeful and deliberate in their approach to solving problems and to
even develop problem-solving patterns that can be transferred to other areas in economics and
other fields of study. Through the use of documented problem solving, students become more
efficient learners; more expert-like in their thinking process.
 III. HOW ECONOMICS IS USEFUL TO BUSINESS

Many people think that economics is a boring and dry subject and should be left to people who
love to read books. But the truth is, economics provides people with an understanding about
businesses, markets, jobs and governments. Knowing these helps people to better respond to
emerging threats or opportunities in an ever-changing world. For example, when the world
plunged into lockdowns due to COVID-19, many governments scrambled for ways to prevent
economic meltdown. But business people who understand economics can turn this threat into
opportunities and improvise new ways of doing businesses to stay afloat.

Economics is the study of what drives human behavior, which lead to decisions made in times of
affliction or success. Using scientific methods, economics helps in the allocation of scarce
resources to ensure efficiency in today’s world. It encompasses a variety of other fields, such as
mathematics, politics, sociology, psychology, finance, public policy, business, law and history. It
is of special importance to business students because businesses rely on economics for product
research and development, marketing, purchase and resource allocation, and many other strategic
decision-making strategies. Understanding all these is vital for any business to operate
efficiently, drive out competitors and succeed. In short, studying economics develops various
competencies and transferable skills, such as critical and analytical thinking, problem solving,
research, numeracy and communication. Students who major in economics have the opportunity
to delve into many other industries besides business, such as banking, finance, risk management,
accountancy, or consultancy.

Economists Help Stamp out Inequality and Promote Social Progress

For people who are into the issue of human development, the breadth and flexibility of
economics can help you understand issues of welfare impacts, inequality, health and social
progress. It equips people with the knowledge of the primary framework of public policy, the
communication skills and statistical analysis skills to enables them to engage in public policy
debates for health, education and wealth distribution, which ultimately stamps out inequality and
promotes social progress.

To sum up, economics helps shape and sway the world with ideas and perspectives. As the great
economist Lord Keynes said, “The ideas of economists and political philosophers, both when
they are right and when they are wrong, are more powerful than is commonly understood.”
Indeed, the decisions made by economists make a lot of difference to our daily lives and can
either bring world-shaking progress to a nation, or their mistakes can be nothing short of
catastrophic.

The vital role of an economist is best summed up by Robert L. Heilbroner in his book, “The
Worldly Philosophers: The Lives, Times, and Ideas of the Great Economic Thinkers”:

“This is a book about a handful of men with a curious claim to fame. By all the rules of
schoolboy history books, they were nonentities: they commanded no armies, sent no men to their
deaths, ruled no empires, took little part in history-making decisions. A few of them achieved
renown, but none was ever a national hero; a few were roundly abused, but none was ever quite
a national villain. Yet what they did was more decisive for history than many acts of statemen
who basked in brighter glory, often more profoundly disturbing than the shuttling of armies back
and forth across frontiers, more powerful for good and bad than the edicts of kings and
legislatures. It was this: they shaped and swayed men’s minds…. And because he who enlists a
man’s mind wields a power even greater than the sword or the sceptre, these men shaped and
swayed the world. Few of them ever lifted a finger in action; they worked, in the main, as
scholars-quietly, inconspicuously, and without much regard for what the world had to say about
them. But they left in their train shattered empires and exploded continents; they buttressed and
undermined political regimes; they set class against class and even nation against nation-not
because they plotted mischief, but because of the extraordinary power of their ideas.”

According to Chladek (2017) from Harvard Business School, there are 7 reasons to study
Economics:

1. Expanding Vocabulary

Whether it’s scarcity (limited resources), opportunity cost (what must be given up to obtain
something else), or equilibrium (the price at which demand equals supply), an economics course
will give fluency in fundamental terms needed to understand how markets work. Studying these
economic terms will give a better understanding of market dynamics as a whole and how they
apply to the organization.
2. Putting New Terms into Practice

Economics isn’t just learning a set of technical words, it’s actually using them to develop a viable
business strategy. Once people understand the terms, it’s easier to use theories and frameworks,
like Porter’s Five Forces and SWOT analyses, to assess situations and make a variety of
economic decisions for your organization. For example, many companies need to decide whether
to pursue a bundled or unbundled pricing model or strategize for the best ways to maximize
revenue.

3. Understanding One’s Spending Habits

Economics will teach about how organization and its market behave, but also offer insights into
own spending habits and values. For example, Willingness to Pay (WTP) is the maximum
amount someone is willing to pay for a good or service. There’s frequently a gap between
hypothetical and actual WTP, and learning about it can help them decode one’s own behavior and
enable them to make wiser financial decisions. For Shamari Benton, the concepts he learned
in Economics for Managers opened his eyes to how everyday decisions are infused with
economic calculations and principles. “A simple grocery store visit becomes filled with
economic references and analytical ponders,” Benton says.

4. Master the Nuances of the Field

Many people think of economics as just curves, models, and relationships, but in reality,
economics is much more nuanced. Much of economic theory is based on assumptions of how
people behave rationally, but it’s important to know what to do when those assumptions fail.
Learning about cognitive biases that affect our economic decision-making processes arms you
with the tools to predict human behavior in the real world, whether people act rationally or
irrationally.

5. Learn How to Leverage Economic Tools

Learning economic theory is one thing, but developing the tools to make business decisions is
another. Economics will teach the basics and also give concrete tools for analysis. For
example, conjoint analysis is a statistical approach to measuring consumer demand for specific
product features. This tool will allow them to get at the surprisingly complicated feature versus
price tradeoffs that consumers make every day. For example, imagine an individual work for
Apple Inc. and they want to know what part of the iPhone should improve: Battery life, screen
size, or camera. A conjoint analysis will let them know which improvements customers care
about and which are worth the company’s time and money.

6. Be Better-Prepared for Graduate School

In addition to helping people make better decisions in both their personal and professional life,
learning economics is also beneficial if they’re considering a graduate business degree. Studying
economics can equip them with the problem-solving skills and technical knowledge needed
to prepare for an MBA. An MBA typically includes courses in finance, accounting, management,
marketing, and economics, so if they decide an MBA is right for them, they’ll already be one
step ahead. Furthermore, a foundational knowledge of economics enables them to use economic
theories and frameworks to decide if graduate school is worth the financial investment.

7. Improve Career Prospects

An education in economics can improve employability in a variety of industries. According to

the World Economic Forum's Future of Jobs Report, analytical thinking and complex problem-
solving skills top the list of transferable skills that employers will find increasingly important by
2025, both of which can be gained by studying economics. In addition, many careers require
knowledge of economic concepts, models, and relationships. Some possible career paths for
economics students include finance, banking, insurance, politics, and healthcare administration.
They’ll also be able to further their career in your current industry, as an understanding of the
economics that power your industry can help them to be more effective in your role.
 IV. BENEFITS, COST, AND DECISION

In the complex world of business, decision-making is a critical function of management. The

phrase "Managers should consider all the benefits and costs of a decision" encapsulates the
essence of responsible and effective management. This statement highlights the importance of a
comprehensive evaluation process before implementing any decision.

Importance of Comprehensive Decision-Making

Risk Management: One of the primary reasons managers must weigh the benefits and costs of a
decision is to manage risk effectively. Decisions made without a thorough analysis can lead to
unforeseen consequences, potentially harming the organization. By evaluating all possible
outcomes, managers can anticipate challenges and mitigate risks. This practice is supported by
research in decision theory, which emphasizes the importance of assessing both positive and
negative outcomes to enhance decision quality (Kahneman & Tversky, 1979).

Maximizing Value: Decisions in business are often aimed at maximizing value, whether it's
financial, strategic, or operational. By considering all benefits, managers ensure that they are
optimizing the resources available to them. For example, when deciding whether to invest in new
technology, managers must consider not only the upfront costs but also the long-term benefits
such as increased productivity and competitive advantage. A study by McKinsey & Company
(2016) found that companies that rigorously analyze the benefits and costs of their strategic
decisions tend to outperform their peers in profitability and market share.

Stakeholder Impact: Decisions made by managers do not occur in a vacuum; they affect
various stakeholders, including employees, customers, shareholders, and the community. By
evaluating all costs and benefits, managers can ensure that they are considering the interests of
all stakeholders, which is crucial for maintaining corporate social responsibility and ethical
standards. This approach aligns with the stakeholder theory proposed by Freeman (1984), which
argues that businesses should create value for all stakeholders, not just shareholders.
Sustainability and Long-Term Success: In today’s business environment, sustainability is a key
consideration. Decisions that may seem beneficial in the short term can have detrimental long-
term effects if not carefully evaluated. For instance, a decision to cut costs by reducing product
quality might lead to immediate savings but could damage the brand's reputation and customer
loyalty in the long run. Research by Harvard Business Review (2019) suggests that companies
focusing on long-term value creation, including considering the full spectrum of costs and
benefits, are more resilient and successful over time.

Ethical Considerations: Ethical decision-making is another critical aspect that managers must
consider. Decisions that overlook ethical implications can lead to reputational damage, legal
issues, and a loss of trust among stakeholders. By considering all costs, including ethical costs,
managers can ensure that their decisions align with the organization's values and ethical
standards. Studies in business ethics have shown that ethical decision-making contributes to
long-term success and sustainability (Treviño & Nelson, 2016).

To effectively consider all benefits and costs, managers can use tools such as:

Cost-Benefit Analysis (CBA): This is a systematic process for calculating and comparing
benefits and costs of a project, decision, or policy. It helps in quantifying and comparing
different aspects of a decision, making it easier to see the trade-offs involved. This estimates and
assesses the value of a project's benefits and costs to determine whether or not it's worth
pursuing. Originating from the work of Jules Dupuit and Alfred Marshall and developed further
by the U.S. Corps of Engineers in the 1930s, CBA involves comparing all current and projected
costs and benefits of a project, both monetary and intangible. Before taking on a new project,
prudent managers perform a CBA to evaluate all the potential costs and revenues it might
generate. The analysis's outcome determines whether the project is financially viable or whether
a company should consider other alternatives. Many CBA models also factor opportunity
cost into the decision-making process. Opportunity cost represents the potential benefits a
business misses out on when choosing one alternative over another. It accounts for the value of
the next best option that isn't selected, highlighting the trade-offs involved in any
decision.3 Evaluating opportunity cost can make the decision-making process more
comprehensive and effective. Finally, a manager will compare the total costs and benefits to
determine if the benefits outweigh the costs. If they do, the rational decision is to proceed with
the project. If not, the business reviews the project to see if adjustments can be made to increase
benefits or decrease costs to make it viable. Otherwise, the project should likely be avoided
(Hayes, 2024).

Decision Trees: These are visual representations of possible outcomes, helping managers
evaluate the implications of each decision path. These trees are used for decision tree analysis,
which involves visually outlining the potential outcomes, costs, and consequences of a complex
decision. You can use a decision tree to calculate the expected value of each outcome based on
the decisions and consequences that led to it. Then, by comparing the outcomes to one another,
you can quickly assess the best course of action. You can also use a decision tree to solve
problems, manage costs, and reveal opportunities.
Scenario Planning: This involves envisioning different future scenarios and assessing how
different decisions might play out under each scenario. Scenario planning is making assumptions
on what the future is going to be and how a business environment will change overtime in light
of that future. More precisely, Scenario planning is identifying a specific set of uncertainties,
different “realities” of what might happen in the future of a business. For example, Farmers use
scenarios to predict whether the harvest will be good or bad, depending on the weather. It helps
them forecast their sales and also their future investments. Military institutions use scenario
planning in their operations to cope with any unlikely situations, anticipating the consequences
of every event. In this case, scenario planning can mean the difference between life and death.
Scenario planning might not have such dire consequences in an organization, but if not done,
they risk opening the door to increased costs, increased risks, and missed opportunities.
By employing these tools, managers can make more informed decisions that balance immediate
needs with long-term goals, ultimately leading to better outcomes for their organizations.

The Difference Between Fixed Cost, Total Fixed Cost, and Variable Cost

Fixed costs, total fixed costs, and variable costs all sound similar, but there are significant
differences between the three. The main difference is that fixed costs do not account for the
number of goods or services a company produces while variable costs and total fixed costs
depend primarily on that number.

As the name suggests, fixed costs do not change as a company produces more or less products or
provides more or fewer services. For example, rent paid for a building will be the same
regardless of the number of widgets produced within that building. In contrast, variable costs do
change depending on production volume. For example, the cost of materials that go into
producing the widgets will rise as the number of widgets produced increases.
Fixed Costs

A fixed cost is an expense that a company is obligated to pay, and it is usually time-related. A
prime example of a fixed cost would be the rent a company pays for office space and/or
manufacturing facilities on a monthly basis. This is typically a contractually agreed-upon term
that does not fluctuate unless both landlords and tenants agree to re-negotiate a lease agreement.
In the case of some rental properties, there may be pre-determined incremental annual rent
increases where the lease stipulates rent hikes of certain percentages from one year to the next.
However, these increases are transparent and baked into the cost equation. Consequently,
accountants can calculate their companies' overall budgets with the lead time necessary to ensure
a business's bottom line is protected. This is typically how rent-controlled properties operate.

Variable Costs

Variable costs are functions of a company's production volume. For example, widget company
ZYX may have to spend $10 to manufacture one unit of product. Therefore, if the company
receives and inordinately large purchase order during a given month, its monthly expenditures
rise accordingly. Another example is a retailer that doubles its typical order to prepare for a
holiday rush. This increases company ZYX's expenses to fulfill the order. Larger purchase orders
may also result in increased overtime pay for employees. Conversely, purchase orders may
decline during off-seasons and slower economic times, ultimately pushing down labor and
manufacturing costs accordingly. In addition, the costs of commodities and other raw
materials for manufacturing may rise and fall, which can also affect a company's variable
expenses.

Total Costs

Total costs are composed of both total fixed costs and total variable costs. Total fixed costs are
the sum of all consistent, non-variable expenses a company must pay. For example, suppose a
company leases office space for $10,000 per month, rents machinery for $5,000 per month, and
has a $1,000 monthly utility bill. In this case, the company's total fixed costs would be $16,000.
In terms of variable costs, if a company produces 2,000 widgets at $10 per unit, and it must pay
employees $5,000 in overtime to keep up with the demand, the total variable costs would be
$25,000 ($20,000 in products plus $5,000 in labor costs). Consequently, the total costs,
combining $16,000 fixed costs with $25,000 variable costs, would come to $41,000. Total costs
are an essential value a company must track to ensure the business remains fiscally solvent and
thrives over the long term.

IMPLICIT VS EXPLICIT COSTS

Economists consider all opportunity costs of production. Explicit costs are defined as costs that
involve spending money. Implicit costs on the other hand, are nonmonetary opportunity costs.

Explicit Costs

• Rental for building (including equipment)

• Cost of utility

• Cost of ingredients (flour, sugar, etc.)

• Cost of worker (you employ a buddy of yours)

Implicit Costs

• The interest someone would have earned on the money that they withdrew from their savings
account to pay first month’s rent and safety deposit.

• Cost of their time: they gave up a job where they were paid hourly.

Explicit costs, also known as accounting costs, are normal business expenses that appear in
the general ledger. These costs can directly affect a business’s profitability. Accounting costs
involve tangible assets and monetary transactions. Explicit cost examples include:

 Employee wages

 Lease payments

 Utilities

 Raw materials

 Advertising

 Supplies
  Rent

 Other direct costs

Accounting costs are generally easy for business owners to identify, track, and record. They can
use explicit costs to calculate a company’s profit and see where they need to make changes when
it comes to expenses.

Implicit costs are a little more complicated than explicit costs. Whereas explicit costs are more
straightforward, implicit costs deal with intangible costs. An implicit cost represents an
opportunity cost. Unlike explicit costs, implicit costs are the costs associated if they would do
something, like make an investment. With implicit costs, they do not track them like business
expenses in your books. Instead, they can calculate implicit costs to determine economic profit
and help make smart business decisions.

Basically, implicit opportunity cost comes from the use of an asset instead of a purchase or rental
of an asset. Check out a few implicit cost examples:

 Annual cash flow from stocks if someone sold their business

 Payments they would earn from a rented property

 Time spent on one business activity that could better be spent on a different task

 Business owner passing on taking a salary in the early stages of operations

 Time equipment is offline for maintenance

CALCULATE EXPLICIT COST

Calculating explicit costs is simple as long as an individual know their business expenses. To
calculate explicit costs, add together the business expenses on the general ledger. Again, this
could include insurance, rent, equipment, supplies, cost of goods sold, etc. Keep in mind that
expenses vary from business to business. So, there is no universal formula for computing explicit
costs. But, it’s pretty easy to compute if they have a list of their business expenses at the tip of
their fingers.

Explicit cost example

Say a business has $10,000 in cost of goods sold, $1,000 in rent, $200 in supplies, $300 in
insurance, $13,000 in employee wages, and $500 in utility costs for the period. To find the total
explicit costs, add together all of the expenses:

Explicit Costs = $10,000 + $1,000 + $200 + $300 + $13,000 + $500

The total explicit costs add up to $25,000 for the period. They can plug this amount into other
formulas, like the accounting or economic profit formulas, to find out financial information for
the business.

CALCULATE IMPLICIT COST

Essentially, implicit cost represents an opportunity cost when a company uses resources for one
decision over another. Because it can involve various types of situations, it’s hard to give an
implicit cost calculation a standard formula. To find the implicit or opportunity cost of a
situation, take a look at the costs associated with an opportunity. For example, a day spent
training a new employee means another employee misses out on sales and commission. That
opportunity cost (aka the commission and other pay) is an implicit cost for the employee/trainer.

Implicit cost example

Say a new business owner had just started their first company a few years ago. To help pay for
startup expenses, they decide not to take a salary for the first two years. Their salary would have
been $60,000 per year.

Because they did not receive a salary for two years, their implicit cost for their decision is
$120,000 ($60,000 X 2). If they would have received said salary, it would have been an explicit
cost instead.

SUNK COST AND SUNK COST FALLACY

A sunk cost is an expense that cannot be recovered by additional spending or investment.

Businesses should be careful to exclude sunk costs from future decisions because they will
remain the same regardless of the outcome of those decisions.

When a business or investor spends more money trying to reverse past losses, they risk
succumbing to the sunk cost fallacy. The expression "Don't send good money chasing after bad
money" is a caution against this type of mistake.

A sunk cost refers to money that has already been spent and cannot be recovered. A
manufacturing firm, for example, may have a number of sunk costs, such as the cost of
machinery, equipment, and the lease expense on the factory. Sunk costs are excluded from a sell-
or-process-further decision, which is a concept that applies to products that can be sold as they
are or can be processed further.

When making business decisions, organizations should only consider relevant costs, which
include the future costs that still needed to be incurred. The relevant costs are contrasted with the
potential revenue of one choice compared to another. To make an informed decision, a business
only considers the costs and revenue that will change as a result of the decision at hand. Because
sunk costs do not change, they should not be considered.

The sunk cost fallacy is the improper mindset a company or individual may have when working
through a decision. This fallacy is based on the premise that committing to the current plan is
justified because resources have already been committed. This mistake may result in improper
long-term strategic planning decisions based on short-term committed costs. Imagine a non-
financial example of a college student trying to determine their major. A student may declare as
an accounting major, only to realize after two accounting classes that this is not the career path
for them. The sunk cost fallacy would make the student believe committing to the accounting
major is worth it because resources have already been spent on the decision. In reality, the
student should only evaluate the courses remaining and courses required for a different major.

In business, the sunk cost fallacy is prevalent when management refuses to deviate from original
plans, even when those original plans fail to materialize. The sunk cost fallacy incorporates
investor emotions that cause irrational decision-making.
 V. INVESTMENT DECISION: LOOK AHEAD AND REASONBACK

Compounding refers to the process of reinvesting the interest earned on an investment, which
leads to exponential growth over time. It involves earning interest not only on the initial principal
amount but also on the accumulated interest. In simple terms, compounding allows your money
to work for you and generate additional income through the power of compound interest.

The Power of Compound Interest

Compound interest is the primary driver of growth in compounding. It occurs when the interest
earned on an investment is added back to the principal amount, and future interest calculations
include this increased balance. Over time, the interest earned keeps accumulating and
contributing to the growth of the investment. This compounding effect can significantly enhance
the overall returns on an investment, especially over long periods.

Compound Interest Formula

A = P(1 + r/n)^(nt)

Where:

o A represents the future value of the investment

o P is the principal amount (initial investment)

o r is the interest rate per period

o n denotes the number of compounding periods per year

o t represents the number of years

What is Discounting?

Unlike compounding, discounting is the process of determining the present value of future cash
flows. It involves estimating the current worth of money to be received or paid at a future date.
Discounting takes into account the time value of money, which states that the value of money
decreases over time due to factors such as inflation, risk, and opportunity cost.

Present Value and Future Value

The present value represents the current worth of a future amount, while the future value denotes
the value of an investment or cash flow at a specific future date. Discounting allows us to
determine the present value by discounting the future value based on an appropriate discount
rate.

Discounting Formula

PV = FV / (1 + r)^t

Where:

o PV represents the present value

o FV is the future value

o r is the discount rate

o t denotes the number of years

DIFFERENCES BETWEEN COMPOUNDING AND DISCOUNTING

Time Value of Money

Both compounding and discounting consider the time value of money but in different ways.
Compounding emphasizes the future value of money by accounting for the growth of
investments over time. On the other hand, discounting focuses on the present value of money by
considering the current worth of future cash flows.

Direction of Cash Flows

Compounding involves investments where the initial cash flow is in the form of a principal
amount, and subsequent cash flows come from accumulated interest. In contrast, discounting
deals with future cash flows and calculates their present value. The direction of cash flows is
opposite between compounding and discounting.

Application Areas

Compounding finds its application in various scenarios such as long-term investments, savings
accounts, retirement planning, and compound interest on loans. Discounting is commonly used
in capital budgeting, valuation of financial instruments, determining the present value of future
cash flows, and analyzing investment projects.

Compounding Example

Let's consider an example of compounding. Suppose you invest $10,000 in a savings account
with an annual interest rate of 5%. If the interest is compounded annually, the value of your
investment after 5 years can be calculated as follows:

bash

A = $10,000(1 + 0.05/1)^(1*5)

A = $12,763.63

Hence, your investment would grow to $12,763.63 through compounding.

Discounting Example

Now, let's demonstrate an example of discounting. Imagine you expect to receive $5,000 after
two years, and the discount rate is 8%. To determine the present value of this amount, we can
apply the discounting formula:

bash

PV = $5,000 / (1 + 0.08)^2

PV = $4,385.96

Therefore, the present value of $5,000 received after two years at an 8% discount rate is
$4,385.96.

IMPORTANCE IN FINANCIAL DECISION MAKING

Compounding and discounting are crucial in evaluating investment opportunities. By calculating
the future value of potential investments, compounding helps assess their growth potential over
time. Discounting, on the other hand, aids in estimating the present value of projected cash
flows, assisting in investment decision-making. Compounding plays a significant role in loan
amortization schedules. It helps determine the interest portion of each payment and how the
principal amount decreases over time. Discounting, on the other hand, is utilized to assess the
present value of future loan payments or to evaluate refinancing options. Both compounding and
discounting are vital in retirement planning. Compounding assists in accumulating savings and
investments over an extended period, allowing individuals to benefit from the growth of their
assets. Discounting helps estimate the present value of retirement income sources, such as
pensions or annuities, enabling individuals to plan their retirement finances effectively.

Net present value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows over a period of time. NPV is used in capital budgeting and
investment planning to analyze a project's projected profitability. NPV is the result of
calculations that find the current value of a future stream of payments using the proper discount
rate. In general, projects with a positive NPV are worth undertaking, while those with a negative
NPV are not.

If there’s one cash flow from a project that will be paid one year from now, then the calculation
for the NPV of the project is as follows:

If analyzing a longer-term project with multiple cash flows, then the formula for the NPV of the
project is as follows:

where:
Rt=net cash inflow-outflows during a single period
ti=discount rate or return that could be earned in alternative investments
t=number of time periods

NPV accounts for the time value of money and can be used to compare the rates of return of
different projects or to compare a projected rate of return with the hurdle rate required to approve
an investment. The time value of money is represented in the NPV formula by the discount rate,
which might be a hurdle rate for a project based on a company’s cost of capital, such as
the weighted average cost of capital (WACC). No matter how the discount rate is determined, a
negative NPV shows that the expected rate of return will fall short of it, meaning that the project
will not create value. In the context of evaluating corporate securities, the net present value
calculation is often called discounted cash flow (DCF) analysis. It’s the method used by Warren
Buffett to compare the NPV of a company’s future DCFs with its current price.

The discount rate is central to the formula. It accounts for the fact that, as long as interest rates
are positive, a dollar today is worth more than a dollar in the future. Inflation erodes the value of
money over time. Meanwhile, today’s dollar can be invested in a safe asset like government
bonds; investments riskier than Treasuries must offer a higher rate of return. However it’s
determined, the discount rate is simply the baseline rate of return that a project must exceed to be
worthwhile.

For example, an investor could receive $100 today or a year from now. Most investors would not
be willing to postpone receiving $100 today. However, what if an investor could choose to
receive $100 today or $105 in one year? The 5% rate of return might be worthwhile if
comparable investments of equal risk offered less over the same period.

If, on the other hand, an investor could earn 8% with no risk over the next year, then the offer of
$105 in a year would not suffice. In this case, 8% would be the discount rate.

Example of Calculating NPV

Imagine a company can invest in equipment that would cost $1 million and is expected to
generate $25,000 a month in revenue for five years. Alternatively, the company could invest that
money in securities with an expected annual return of 8%. Management views the equipment and
securities as comparable investment risks.

There are two key steps for calculating the NPV of the investment in equipment:

Step 1: NPV of the Initial Investment

Because the equipment is paid for upfront, this is the first cash flow included in the calculation.
No elapsed time needs to be accounted for, so the immediate expenditure of $1 million doesn’t
need to be discounted.

Step 2: NPV of Future Cash Flows

 Identify the number of periods (t): The equipment is expected to generate monthly cash
flow for five years, which means that there will be 60 periods included in the calculation
after multiplying the number of years of cash flows by the number of months in a year.

 Identify the discount rate (i): The alternative investment is expected to return 8% per
year. However, because the equipment generates a monthly stream of cash flows, the
annual discount rate needs to be turned into a periodic, or monthly, compound rate. Using
the following formula, we find that the periodic monthly compound rate is 0.64%.

Assume the monthly cash flows are earned at the end of the month, with the first payment
arriving exactly one month after the equipment has been purchased. This is a future payment, so
it needs to be adjusted for the time value of money. An investor can perform this calculation
easily with a spreadsheet or calculator. To illustrate the concept, the first five payments are
displayed in the table below.
The full calculation of the present value is equal to the present value of all 60 future cash flows,
minus the $1 million investment. The calculation could be more complicated if the equipment
were expected to have any value left at the end of its life, but in this example, it is assumed to be
worthless.

In this case, the NPV is positive; the equipment should be purchased. If the present value of these
cash flows had been negative because the discount rate was larger or the net cash flows
were
smaller, then the investment would not have made sense.

BREAK-EVEN ANALYSIS
Break-even analysis in economics, business, and cost accounting refers to the point at which total
costs and total revenue are equal. A break-even point analysis is used to determine the number of
units or dollars of revenue needed to cover total costs (fixed and variable costs).

The formula for break-even analysis is as follows:

Break-Even Quantity = Fixed Costs / (Sales Price per Unit – Variable Cost Per Unit) where:

 Fixed Costs are costs that do not change with varying output (e.g., salary, rent, building
machinery)

 Sales Price per Unit is the selling price per unit

 Variable Cost per Unit is the variable cost incurred to create a unit

It is also helpful to note that the sales price per unit minus variable cost per unit is
the contribution margin per unit. For example, if a book’s selling price is $100 and its variable
costs are $5 to make the book, $95 is the contribution margin per unit and contributes to
offsetting the fixed costs.

Break-Even Analysis Example

Colin is the managerial accountant in charge of Company A, which sells water bottles. He
previously determined that the fixed costs of Company A consist of property taxes, a lease, and
executive salaries, which add up to $100,000. The variable cost associated with producing one
water bottle is $2 per unit. The water bottle is sold at a premium price of $12. To determine the
break-even point of Company A’s premium water bottle:

Break Even Quantity = $100,000 / ($12 – $2) = 10,000

Therefore, given the fixed costs, variable costs, and selling price of the water bottles, Company A
would need to sell 10,000 units of water bottles to break even.

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