Accounting Information for Decision Making

CHAPTER 1
ACCOUNTING: INFORMATION FOR DECISION MAKING

SOLUTIONS
REVIEW QUESTIONS
1.1 Step 1: Specify the decision problem, including the decision makers goals.
Step 2: Identify options.
Step 3: Measure benefits ad!antages" and costs disad!antages" to determine the !alue
benefits reaped less costs incurred" of each option.
Step #: Make the decision, choosing the option $ith the highest !alue.
1.2 %ecause people place different emphasis on factors such as money, risk, and leisure.
1.3 &he benefits of an option less its costs. %ecause !alue is the contribution of an option to the
decision makers goals, $e measure !alue relati!e to the status 'uo, $hich is not doing
anything at all.
1.# &he !alue of the ne(t best option.
1.) *n organi+ation is a group of indi!iduals engaged in a collecti!ely beneficial mission. &he
key difference bet$een indi!idual and organi+ational decision making relates to goals ,
organi+ational goals rarely coincide $ith the goals of all indi!idual participants.
1.- 1" .olicies and procedures/ 2" Monitoring/ 3" Incenti!e schemes and performance
e!aluation.
1.0 .lanning decisions relate to choices about ac'uiring and using resources to deli!er products
and ser!ices to customers. 1ontrol decisions relate to moti!ating, monitoring, and
e!aluating performance.
1.2 .lan, Implement, 3!aluate, 4e!ise .I34 1ycle".
1.5 &o help measure the costs and benefits of decision options.
1.16 .ersons outside the firm. &hese indi!iduals make decisions about buying and selling stock,
lending money, di!idends, and ta(es.
1.11 .ersons inside the firm. &hese indi!iduals make decisions about $hich products and
ser!ices to offer, the prices of products and ser!ices, $hat e'uipment to purchase, $ho to
hire and ho$ to pay them.
%alakrishnan, Managerial *ccounting 1e 784 I9S&4:1&84 :S3 89;<
1.12 &he primary users e(ternal !s. internal", go!erning principles, the unit of analysis,
emphasis, periodicity, and types of data considered.
1.13 3thics relate to e!ery step of the decision frame$ork. 3thics can shape our goals, the
options $e consider, ho$ $e measure costs and benefits, and the ultimate decision $e
make.
1.1# &he 7oreign 1orrupt .ractices *ct of 1500.
1.1) &he key financial players include the 138, 178, controller, treasurer, and chief internal
auditor. &he roles of each player are described in detail in the appendi(.
1.1- 1" 1ompetence, 2" 1onfidentiality, 3" Integrity, and #" 8b=ecti!ity.
DISCUSSION QUESTIONS
1.10 <our ultimate goal could be to earn as much as you can before you retire, say, #6 years
after you graduate. >ith this goal in mind, you ha!e to plan a career path and e!aluate the
three =ob offers to see $hich of these =obs $ill take you on that path. %esides pay, factors
such as the reputation of the organi+ation, the 'uality of on?the?=ob training you $ill get,
opportunities to climb the organi+ational ladder are !ery important from a career
perspecti!e. If all three =ob offers are e'ually attracti!e in terms of the career you ha!e
chosen for yourself, then short?term goals and desires $ill dictate $hich =ob offer you
should accept. *ll else e'ual, you $ill naturally $ant to accept the =ob offer that pays you
the most, or you may be $illing to accept slightly lo$er pay to li!e in a city that you like,
or $ork for an organi+ation $ith better reputation, and so on.
1.12 <es, this statement is true. 8pportunity cost is the !alue of the ne(t best option. *s more
options become a!ailable, it is possible that a ne$ option may be more attracti!e than the
current best option, in $hich case the ne$ option becomes the best option, and the current
best option becomes the ne(t best option. In this case, the opportunity cost increases but it
can ne!er decrease as long as all the current options are also a!ailable to choose from.
1.15 ;et us assume that you are not fully prepared for your e(am tomorro$ if you are fully
prepared, then you might as $ell $atch &@ because you stand to lose nothing i.e., your
opportunity cost is +ero". %y $atching &@, you risk being unable to ans$er some 'uestions
and making a poorer grade in the e(am. &hus, the opportunity cost is the lost benefit from
not recei!ing a better grade that the preparation $ould ha!e helped you secure.
1.26 ;et us say that the full?time M%* program takes t$o years to complete. &he opportunity
cost of pursuing the program is the income she $ill be losing o!er this period by 'uitting
her e(isting =ob, the e(perience she $ill lose from not being on the =ob for t$o years, and
any promotions she may be foregoing.

%alakrishnan, Managerial *ccounting 1e, A 2665 784 I9S&4:1&84 :S3 89;<
1?2
1.21 Bifferences in indi!idual goals can arise from:
Bifferences in preferences: Some indi!iduals place a greater $eight on ma(imi+ing
$ealth, others place a greater $eight on being the best in $hat they do the t$o are not
al$ays perfectly correlated"
*ttitudes to$ard risk: Some ha!e a greater tolerance for risk than others
Bifferences in ethical thresholds: >hat is perfectly acceptable ethical beha!ior for some
may not be acceptable to others.
* 1asino is a good e(ample of a business that e(ploits !ariations in indi!idual tastes for risk.
1asinos tailor their offerings to accommodate indi!iduals $ith different risk tolerance le!els
, some in!ol!e high stakes $here risks and returns are higher, and others in!ol!e lo$ stakes.
1.22 &his problem is an e(ercise in conditional probability. <ou ha!e no choice but to pick a
door at random in the first stage. 8nce the door has been opened you ha!e only t$o
options: Stay $ith your initial pick or s$itch. ;et us e!aluate the chance of $inning $ith
both options.
1" Suppose you stay $ith your initial pick. &hen, the follo$ing outcomes are possible
a. <ou initially picked the door that had the pri+e. Since you are staying $ith your
choice, you $in for sure.
b. <ou initially picked a door that did not ha!e the pri+e. &hen, because you are
staying $ith your choice, you lose for sure.
%ecause the initial choice is random, the probability that you are in situation a" is 1C3
and the probability that you are in situation b" is 2C3. In situation a" staying $ith your
choice leads to 166D chance of $inning and in situation b" staying leads to 6D chance
of $inning. &hus, the probability of $inning by follo$ing this strategy is 1C3E1 F 2C3E6 G
1C3.
2" &he key to computing the probability of $inning in this case is to reali+e that Monty $ill
only open the door that does 98& ha!e the pri+e. &hen the follo$ing outcomes are
possible:
a. <ou initially picked the door that had the pri+e. &hen, if you s$itch, you lose for
sure.
b. <ou initially picked a door that did not ha!e the pri+e. &hen, one of the t$o
remaining doors has the pri+e. %ut, Monty $ill not pick this door. He $ill only
open the door $ithout the pri+e, meaning that the closed door $hich you did not
pick" has the pri+e for sure.
&he probability that you are in situation a" is 1C3 and the probability that you are in
situation b" is 2C3. In situation a" s$itching leads to 6D chance of $inning and in
situation b" s$itching leads to 166D chance of $inning. &hus, the probability of
$inning by follo$ing this strategy is 1C3E6 F 2C3E1 G 2C3I * random pick follo$ed by
s$itching doors is the smart choice.
&his problem has !e(ed many people do a Joogle search on KMonty Hall .roblemL"
because the solution is counter intuiti!e.
1?3
1.23 &he goal of a nonprofit hospital is to pro!ide ade'uate healthcare to the community it
ser!es at lo$ cost, $ithout a profit moti!e. &he goal of a uni!ersity is to meet the
educational needs of the communityCcountry and to promote kno$ledge and disco!ery.
Many uni!ersities also attract students from other statesCcountries as part of an outreach
effort to promote di!ersity and learning. State uni!ersities are mostly go!ernment funded
and do not ha!e an e(plicit profit moti!e, but most pri!ate uni!ersities do. &he goal of an
honor society in a uni!ersity is to promote academic e(cellence, cultural di!ersity, and
leadership.
1.2# &he goal of a class is typically articulated in the syllabus , to effecti!ely communicate the
sub=ect matter and its importance to the students, and to ensure that students lea!e the class
$ith a good understanding of the concepts, principles and methods relating to the sub=ect
matter. <our indi!idual goals might include learning the sub=ect thoroughly, making an * in
the class. Joals can di!erge. <ou may not be as interested in the sub=ect matter as you are
in getting an *. <ou $ould prefer easier e(ams, and less home$ork. %ut your instructor
may be more interested in your learning the sub=ect matter and may assign you a lot of
home$ork, and may administer tough e(ams. &he instructor can moti!ate you by making
you $ork hard, gi!ing challenging tests, presenting the sub=ect matter in a $ay that gets
you interested, and offering a lot of help and guidance outside the classroom.
1.2) Sales commissions are a $ay to moti!ate sales personnel to stri!e hard to sell more. &he
more they are able to sell, the more money they get. &he ad!antage of course is that
re!enues and profits increase for the organi+ation. &he disad!antage is that commissions
often make the sales people follo$ aggressi!e tactics $ith potential buyers you may ha!e
e(perienced this beha!ior in auto dealerships, department stores, furniture stores, and
consumer electronics stores". Such beha!ior may turn a$ay customers in the long run.
1ommissions also promote cut?throat competition among sales personnel in !ying for
customers, $hich can pro!e counter?producti!e.

1.2- In $ars and in combat situations, indi!iduals ha!e to depend on each other for sur!i!al.
>orking $ell in groups becomes a matter of life and death. So there is a natural alignment
bet$een team and indi!idual goals. In a typical profit?making organi+ation, the Kfree?riderL
problem is more difficult to eliminate, because there is a natural incenti!e for each
indi!idual to contribute minimally to team goals and yet try to reap the full benefit. <ou
may see this beha!ior $hen you $ork on group assignments for your class. Some
indi!iduals take responsibility and put in the effort needed, $hile others , reali+ing that the
$ork is going to get done , do not contribute as much, and de!ote their time to other
Kproducti!eL acti!ities. &he incenti!es are similar in profit?making organi+ations as $ell.
1.20 >hen $e say Kthat $asnt too bad,L $e are essentially comparing $hat happened $ith
$hat $e e(pected $ould happen. &hat is, our e(pectations $ere not met. Most of us plan
ahead, and sometimes things dont 'uite go the $ay $e plan, for reasons beyond our
control. In such instances, $e ad=ust our e(pectations and then e!aluate $hat actually
happened. 7or e(ample, let us say you set out on a dri!e to 1hicago from Houston and you
1?#
plan to co!er the distance in 12 hours. %ut along the $ay, you run into une(pected rough
$eather, and it takes you 12 hours to reach 1hicago. Ji!en the dri!ing conditions that you
had to endure, you say to yourself Kthat $asnt too badIL

1.22 <es, it doesI &here is a control problem in both scenarios. %ut in the first scenario the
control problem is not related to di!ergence in goals, $hich is the case $hen you ha!e to
e!aluate another indi!iduals performance. * process can go out of control for reasons
beyond your control, and all you can do is to fine tune the process. 7eedback on ho$ the
process is going helps in this respect. In the second case, you ha!e to control another
indi!iduals actions through monitoring or by pro!iding appropriate incenti!es.
1.25 7inancial statements of companies are in general !ery aggregate. &hey pro!ide an
assessment of performance o!er a period, say, a 'uarter or a year. &hey reflect the
combined outcome of scores of actions taken by thousands of indi!iduals $ithin the
organi+ation o!er that period. &hey also report past performance and are not for$ard
looking, $hich is $hat $e need for decision making. &herefore, financial statements are
not particularly useful for day?to?day decision making.

1.36 <es, in general, this is true. Most accounting systems are designed to measure historical
performance. Ho$e!er, the purpose of a management accounting system is to help decision
making by pro!iding reasonable estimates of opportunity costs. &o the e(tent that trends in
historical cost patterns can help in estimating future costs or opportunity costs", e!en
traditional financial accounting systems do help.
1.31 8ne could argue effecti!ely that firms, interested in sur!i!ing in a competiti!e marketplace,
$ould $ant to do so. %y engaging auditors e!en if not re'uired to do so, firms are signaling
to in!estors that they ha!e nothing to hide and that they are good firms to in!est in. &ake
another e(ample, in this increasing global product markets, many companies seek third?
party 'uality assurance such as IS8 5666" to con!ey to all the markets around the $orld
that their products are of high 'uality. 9ote that such third?party certifications are not
re'uired by go!ernments.
1.32 &his is a tough 'uestion. <ou face a difficult trade?off in!ol!ing a troubling ethical
dilemma. Many &@ channels, especially family?oriented channels, $ould opt to not sho$
the tape because it might hurt their !ie$ership in the long?run, let alone cause emotional
harm in the short run. Such channels do not face much of a trade?off. 8n the other hand,
other &@ stations, in particular cable channels, might $ell allo$ their profit moti!e to
dictate their decision.
1?)
EXERCISES
1.33.
a. Microsoft corporation lists [T]o enable people and businesses throughout the world to
realize their full potentialL as its o!erarching mission. &he firm also lists a !ariety of related
goals and strategies, such as trust$orthy computing and broad customer connection, designed
to accomplish this mission.
Microsofts goals and ob=ecti!es are particularly note$orthy because they do not make
e(plicit reference to the shareholders ultimate goal of ma(imi+ing the return on their
in!estment. &here are at least t$o $ays to !ie$ this omission.
Some argue that, as a modern organi+ation, Microsoft recogni+es the claims of multiple
stakeholders in the corporation arising because of the firms si+e and impact on the economy.
&hat is, the organi+ation recogni+es its obligations to parties such as its customers,
employees, and society. * modern firms mission statement reflects this broader !ie$ of the
organi+ation in $hich profit ma(imi+ation is not the firms only goal.
8thers argue that e!en the broader statements are a means to an end. 7or e(ample, the goal of
Ktrust$orthy computingL or Ke(cellence in e!erything $e doL surely increases the market for
Microsofts products. Similarly, a firm may stress en!ironment?friendly operations because
doing so is good business. &he focus helps the firm reduce costs by reducing the risk of
future litigation and payouts", increase re!enues by potentially enlarging the customer base",
and comply $ith go!ernmental regulations thereby a!oiding fines". Similar arguments apply
for firms attention to $orker health and safety. &hus, one might !ie$ all of Microsofts goals
and strategies as being consistent $ith profit ma(imi+ation.
%oth !ie$s are reasonable. &he strength of your belief in the for?profit orientation of
corporations determines your choice bet$een the t$o e(tremes listed abo!e.
b. &he mission statement for the Metropolitan Museum of *rt popularly kno$n as the Met"
states:
The mission of The Metropolitan Museum of Art is to collect, preserve, study, exhibit,
and stimulate appreciation for and advance knowledge of works of art that
collectively represent the broadest spectrum of human achievement at the highest
level of uality, all in the service of the public and in accordance with the highest
professional standards!
&his statement underscores the museums not?for?profit moti!e and emphasi+es the
museums mission on all aspects of the study of art. 9otice that, similar to the mission
statement of the 1orporation for .ublic %roadcasting, the Mets mission statement is !ery
inclusi!e regarding the definition of art and the museums beneficiaries.
1?-
%oth Microsofts and the Metropolitan Museum of *rts mission statements take a broad
!ie$ of the organi+ations mission. 1areful scrutiny re!eals that Microsofts mission
statement is !ery customer focused, $hereas the Mets mission statement focuses on the art
itself. &he differing foci are indicati!e of Microsofts for?profit orientation 'uality,
inno!ati!e products, and customer satisfaction are all stepping?stones to profit" and the Mets
orientation of increasing the appreciation for art regardless of profit".
1.3#. &he credo for Mohnson and Mohnson states:
"e believe our first responsibility is to the doctors, nurses and patients,
to mothers and fathers and all others who use our products and services!
#n meeting their needs everything we do must be of high uality "e must constantly
strive to reduce our costs in order to maintain reasonable prices! $ustomers% orders
must be serviced promptly and accurately! &ur suppliers and distributors must have
an opportunity to make a fair profit!
"e are responsible to our employees, the men and women who work with us
throughout the world! 'veryone must be considered as an individual!
"e must respect their dignity and recognize their merit! They must have a sense of
security in their (obs! $ompensation must be fair and adeuate,
and working conditions clean, orderly and safe! "e must be mindful of ways to help
our employees fulfill their family responsibilities! 'mployees must feel free to make
suggestions and complaints! There must be eual opportunity for employment,
development and advancement for those ualified! "e must provide competent
management, and their actions must be (ust and ethical!
"e are responsible to the communities in which we live and work and to the world
community as well! "e must be good citizens ) support good works and charities and
bear our fair share of taxes! "e must encourage civic improvements and better
health and education! "e must maintain in good order the property we are privileged
to use, protecting the environment and natural resources!

&ur final responsibility is to our stockholders! *usiness must make a sound profit!
"e must experiment with new ideas! +esearch must be carried on, innovative
programs developed and mistakes paid for! ,ew euipment must be purchased, new
facilities provided and new products launched! +eserves must be created to provide
for adverse times! "hen we operate according to these principles, the stockholders
should realize a fair return!
&he abo!e statement underscores MNMs multi?faceted ob=ecti!es. It recogni+es obligations to
customers, suppliers, employees, the community and shareholders. Interestingly, the
statement puts shareholders last, almost asserting that if $e take care of the others,
shareholders $ill automatically earn a fair return. &he importance of the credo to the firm
also is e!ident by its placement on the firms home page.
1?0
1.3).
a. 7or this decision, your goal is to minimi+e the amount that you pay o!er the semester for
fitness , cost is your primary consideration.
b. %ased on the information pro!ided, you ha!e t$o options:
1. Moin the fitness center for the semester at a cost of O26.
2. .ay for the fitness center on a per use basis at a cost of O# per !isit.
>e also could include a third option , not using the fitness center at all the status 'uo".
Ho$e!er, it appears that you ha!e re=ected this option and are committed to using the fitness
center in some fashion.
c. &he cash outflo$ associated $ith option is:
1. O26, or the amount it costs to =oin the fitness center.
2. 1- P O# G O-#. Since you plan on using the fitness center 1- times and each !isit costs
O#".
d. Ji!en the a!ailable options, you are better off to the tune of O1-, or O26?O-#" by payin !"#
$%& !i$n&'' (&n$&# on a per?use basis rather than =oining the fitness center.
9otice ho$ the four step frame$ork is applicable to Ke!erydayL decisions, in addition to
business decisions. Indeed, $e could use the four?steps to frame e!ery decision $e makeI
*dditionally, the timing of cash flo$ may be important , if a student has to pay the O26 all at
once, then this reduces the attracti!eness of =oining as some students may not ha!e the O26 to
spare, especially at the beginning of the semesterI
9ote: :ncertainty and beliefs might affect students choices , for e(ample, if students
belie!e that there is a significant chance they $ill really get into e(ercise routine and use the
fitness center more often than once a $eek, then =oining may be the best $ay to go. If
students belie!e that they $ill use the center more than 26 times, then =oining is the lo$?cost
alternati!e since 26 P O# G O26". 7urther, some may pay the fee to moti!ate themsel!es...KI
ha!e paid O26 and I better get some return for it.L Ho$e!er, as $e $ill learn later, such
thinking is a classic Ksunk cost fallacy.L
1.3-.
a. &he !alue associated $ith scrapping the action figures is the cost associated $ith disposing of
them. %ecause scrapping the action figures $ill cost O1,666, the !alue of this option is
)*1+,,,-.
b. 4e$orking the action figures $ill cost &oys *hoyI O1,266, but selling them to the toy store
$ill bring in O0)6 in re!enues. &hus, the !alue of re$orking the action figures and selling
them to the toy store is O0)6 , O1,266 G )*./,-0
1?2
:nfortunately, the !alue of both options is negati!e. Ho$e!er, relati!e to scrapping the toys,
re$orking them increases &oys *hoyIs profit by O#)6" , O1,666" G O))6. T%1'+
#&2"#3in $%& a($i"n !i1#&' i' $%& p#&!&##&4 "p$i"n.
c. Intuiti!ely, the fact that &oys *hoyI spent O-.2) to produce each action figure is n"$ #&5&6an$
$" $%& 4&(i'i"n at hand because &oys *hoyI has already incurred the e(penditure , it is a
sunk cost. That is, this cost does not change relative to the status quo. *s discussed in more
detail in 1hapter 2, !alue is for$ard looking and in!ol!es measuring future sacrifices and
future benefits.
1.30.
a. &he opportunity cost of any option is the !alue of the ne(t?best option. *ssume Mon could use
the same color paint for another =ob. >hats Mons ne(t?best optionQ &he problem makes it
clear that the paint is Kuni'ueL and has fe$, if any, alternati!e uses. Ji!en this, Mons
opportunity cost of using the paint for another =ob is *,. &his estimate assumes that there is
no cost to storing the paint.
b. Mons ne(t?best option is to dispose of the paint at a cost of O#6. Mon can a!oid this cost by
using the paint for another =ob. &hus, the opportunity cost of using the paint for another =ob is
)*.,-. Mon should therefore be $illing to pay someone up to O#6 to let him use the paint in
their =obI
c. &he fact that Mon recei!ed a non?refundable ad!ance of O3)6 does not change the opportunity
cost in any $ay. &he re!enue and the cash costs are past e!ents and are sunk. %oth !alue and
opportunity cost are for$ard looking , 7&(a1'& $%i' a8"1n$ 4"&' n"$ (%an& #&5a$i6& $"
$%& '$a$1' 91"+ $%& *:/, i' n"$ #&5&6an$ $" $%& 4&(i'i"n a$ %an4.
1.32.
a. Raps decision problem centers on $hat to do $ith the 2),666 unsold KR*.L kits. Raps goal
is to ma(imi+e profits. 7or the unsold 2),666 units, this means ma(imi+ing the re!enue, or
net cash inflo$, recei!ed number of units sold multiplied by the selling price per unit" from
the sales of this product.
It is important to note that the amount Rap paid to produce the 2),666 units, or 2),666 P
O0.)6 G O120,)66 is sunk and is not at all rele!ant to their decision. 7rom a financial
accounting standpoint, this amount $ill be e(pensed on the income statement regardless of
the option chosen.
b. %ased on the information pro!ided, Rap has t$o options:
1. Sell the 2),666 units to the national home?impro!ement store for O0 per unit.
2. Sell the product !ia the companys $ebsite. :nder this option, the company e(pects to
sell -6D of the remaining 2),666 units at a selling price of O5.5) per unit.
1?5
>e could, of course, concei!e of other options, such as discarding all of the KR*.L kits or
donating them to a municipality for parks, etc.". Ho$e!er, it appears that Rap does not $ish
to e(plore these options.
c. &he increase in Raps cash flo$ under each option is:
Op$i"n
1. Sell to store 2. Sell via website
3(pected sales in units 2),666 1),666
G 2),666 P .-6"
Selling price per unit O0.66 O5.5)
9et increase in cash flo$ *1;/+,,, *1.<+=/,

*gain, $e note that the cost of producing the 2),666 units, or 2),666 P O0.)6 G O120,)66 is a
sunk cost and is not rele!ant to measuring the net cash flo$ associated $ith each option.
Moreo!er, $e are interested in measuring the future sacrifices and future benefits associated
$ith each option. &he fact that Rap spent O120,)66 to produce the 2),666 units is not rele!ant
because the e(penditure and associated cash outflo$" occurred in the past , it is a sunk cost.
d. Ji!en the a!ailable options, Raps preferred option is to sell the remaining 2),666 units to the
home?impro!ement store for O0 a unit. 3!en though it appears that Rap $ill lose O0.66 ,
O0.)6 G O6.)6" per unit, the company ma(imi+es its cash flo$ and profit by selling the
unsold units Kat a loss.L
9ote: &his e(ercise illustrates the classic price?'uantity tradeoff , in this instance, the
company is better off selling more units at a lo$er price than selling fe$er units at a higher
price. In other instances, the relation flips.
1.35.
a. &he o$ners likely ha!e multiple goals. Making a profit is important, as is $inning games and
championships. Some o$ners also probably en=oy the prestige and glamour associated $ith
o$ning a professional sports team. <et other o$ners $ish to gi!e back to the city and
community by funding appropriate recreational outlets.
3ach person in the coaching staff ultimately $orries about his or her o$n career. Surely, the
coaching staff en=oys $hat they do and being associating $ith K$inners.L Ho$e!er, some
part of their concern about the teams success stems from its effect on their personal career
prospects. 1oaches are not as $orried as o$ners about the teams o!erall profitability or
other monetary issues.
.layers ha!e potentially conflicting goals. 8n the one hand, they $ish to do $hat is best for
the team. Ho$e!er, they also recogni+e that they ha!e only a fe$ years in their careers and
that their earnings during this period must sustain them through their li!es. &hus, players
bargain aggressi!ely $ith o$ners, sometimes putting team profitability in =eopardy. Such
actions may also create animosity among players and affect the teams effecti!eness. 7or
instance, a player may Khold outL i.e., not report to training camps" for more compensation.
1?16
.layers are also kno$n to engage in acts that increase their !isibility and stature at the teams
e(pense. >ho among us does not kno$ a Khot?doggingL athleteQ
b. &eams can and do use a number of systems to align players incenti!es $ith team incenti!es.
1lauses gi!ing incenti!e pay for reaching different le!els of the playoffs and reaching
milestones in performance e.g., batting a!erages, rushing yards" are common. 1ontracts also
usually specify parameters for physical fitness, as $ell as norms for e(pected beha!ior.
1ontracts often allo$ teams to Sfire players if they engage in beha!ior that damages a teams
reputation.
Besigning and implementing contract?based and formal control measures is difficult in this
setting as team performance depends on many factors. It is often difficult to specify $hat
players should do or to measure their contribution to the teams success. &eams therefore rely
a great deal on intangibles such as KleadershipL and KcultureL $hen moti!ating players to do
the right thing. 1oaches sometimes discipline players by benching them for games or
denying players time on the fieldCcourt. &hey also rely on the players ego and the !alue
players attach to their reputation to keep players in check.
1.#6.
8rgani+ations in!est in monitoring programs because the organi+ations goals may not
al$ays coincide $ith the goals of indi!idual employees. >hen o$ners and other stakeholders
delegate decision making, they run the risk that employees $ill make decisions that may not
be in the organi+ations best interests. 7or e(ample, employees may pad e(pense accounts,
take e(cessi!e breaks or time off, or e!en steal from the company.
Monitoring can help by either penali+ing undesired beha!ior or re$arding desired beha!ior.
7or e(ample, mystery shopper programs help assess the 'uality of store operations and make
sure that employees are follo$ing company policies. 7or e(ample, a %urger Ting franchisee
may substitute lo$er 'uality ketchup or other condiments, or not keep the facilities up to the
standards consistent $ith the franchisors corporate image. *udit !isits and other
mechanisms ser!e to deter such beha!ior , in e(treme instances, the franchisee could lose its
license.
Must telling someone to follo$ the rules is not enough. 3nforcement or follo$?up is
necessary. >ithout enforcement, employees might simply agree to the rules but then ignore
them and do $hate!er they $ant. Incenti!e schemes such as bonus pay and stock options also
help align indi!idual goals $ith organi+ational goals.
1.#1.
&he follo$ing table pro!ides the re'uired classifications, including comments pertaining to
the rationale underlying each classification.
A($i"n>D&(i'i"n S$a& Ra$i"na5&
>hether to hire t$o or three dental
hygienistsQ Br. Shapiro has narro$ed his
choices to t$o or thee hygienists based on
e(pected patient !olume.
P5an &his decision relates to the
choice of a resource le!el.
Hiring more staff pro!ides
greater capacity, allo$ing Br.
1?11
Shapiro to ser!e more patients,
but also commits Br. Shapiro
to greater costs.

.repare a staffing schedule so that at least
one hygienist is a!ailable during all times
the office is open.
I8p5&8&n$ &his action relates to
implementing the choice. &he
associated decision $e could
!ie$ each possible schedule as
a decision option" relates to
ho$ resources, in this case
hygienists, $ill be used to
deli!er ser!ices.
&rack the number of patients seen by each
hygienist per $eek.

E6a51a$& &his on?going control process
helps Br. Shapiro figure out
the efficiency and
effecti!eness $ith $hich he is
using costly resources.
Moreo!er, because Br. Shapiro
sees each patient during each
!isit, he also can personally
track the 'uality of $ork done
by each of his hygienists.
4e?e!aluate the ade'uacy of current
staffing le!els.
R&6i'& 8!er se!eral $eeks or months,
Br. Shapiro $ill get a sense of
$hether his hygienists are
fully utili+ed. He $ill also
determine $hether additional
hygienists need to be hired or
$hich, if any, of his hygienists
need to be let go.
&his problem illustrates the classical loop bet$een planning and control. >e typically begin
$ith a plan that is based on a set of assumptions in this case, e(pected patient !olume".
&hese assumptions are our beliefs about the unkno$n future. >e then implement our choices.
*s time passes, $e obtain ne$ information about the actual outcomes in this case, actual
patient !olume and the 'uality of $ork done by each hygienist". 8n an on?going basis, this
ne$ information $ill cause us to ad=ust ho$ $e implement our plans e.g., change the
schedule for the ne(t $eek". 8!er a period, $e $ill accumulate enough information to re!ise
our original set of assumptions, $hich might cause us to re!isit the decision.
&he o!erall point is that there is a natural cycle of doing something based on a set of
assumptions, comparing actual outcomes $ith e(pectations, and then re!ising our
assumptions. In many instances, the broad loop relating to a decision contains smaller loops
1?12
$ithin it. 7or instance, $e can think of creating each $eeks schedule as forming a separate
planning and control cycle.
1.#2.
&he follo$ing table lists the four stages of the planning and control cycle and the associated
decisionsCactions. &here are many possible decisions for each category.
S$a& A($i"n>D&(i'i"n
.lan 8ne possible decision is $hether to price at the same le!els as last
year or to raise prices by, for e(ample, 16D to account for the higher
cost of flo$ers this year. 8ther decisions include $hether to hire
additional help or ho$ much money to spend on ad!ertising.
Implement %ased on the chosen price le!el, order and stock enough bou'uets to
meet the e(pected demand. 9otice that $e could !ie$ this as a
decision in itself, !ie$ing each !olume of order as an option."
3!aluate 1ompare actual sales to budgeted sales. Identify reasons for any
de!iations. *gain, $e could !ie$ this as a decision by framing each
possible reason for a de!iation as a possible option. >e then choose
among possible e(planations."
4e!ise Jina $ould use data on actual sales, her prices !ersus the prices of
other florists, and national trends to re!ise her e(pectations about
future sales. &his re!ised belief $ill be a key input into her pricing
decision for ne(t Mothers day.
*s $e see, Jina begins $ith a plan that is based on a set of assumptions in this case, ho$
much demand she might e(pect for any gi!en price". &hese assumptions are her beliefs about
the unkno$n future. She then implements her choices e.g., post prices, order flo$ers". *s
Mothers day nears, pre?orders and information about other florists prices might gi!e Jina
an impetus to re!ise her prices. &hat is, she obtains ne$ information on an ongoing basis,
$hich in turn causes her to ad=ust her implementation e.g., re!ise prices, run more ads".
8!er a period, she $ill accumulate enough information to re!ise her original set of
assumptions, $hich might cause her to impro!e the ne(t pricing decision.
&he o!erall point is that there is a natural cycle of doing something based on a set of
assumptions, comparing actual outcomes $ith e(pectations, and then re!ising our
assumptions. In many instances, the broad loop relating to a decision contains smaller loops
$ithin it. 7or instance, $e can think of offering a discount at days end as forming a separate
planning and control cycle $ithin the o!erall cycle that $e discussed abo!e.
1.#3.
a. >e classify the data from the financial statements into three broad groups. >e interpret
financial statements broadly to mean any documentation filed $ith the Securities and
3(change 1ommission S31" or other regulatory bodies.
1?13
-inancial data such as the firms income and cash flo$ from operations are in!aluable in
assessing future prospects. &he in!estor might also perform ratio analysis, such as computing
the debt?to?e'uity and current ratio, to understand and e(plore a companys risk factors.
.overnance data such as the composition of the board of directors and compensation
arrangements help the in!estor assess the effecti!eness of the companys management and
control systems.
7inally, operating data such as the capacity of the plant, and the number of plants and
employees help in!estors understand the business. In!estors may also e(amine the firms
client base e.g., does one client account for 16D or more of salesQ". In addition, the
management discussion of results section probably $ill discuss the companys pipeline of
drugs and their potential.
b. In!estors $ould consider the costs and benefits of other in!estment options. * firms
financial statements pro!ide information only about its o$n affairs. &hus, the in!estor has to
look else$here to assess the firms relati!e standing i.e., to assess the opportunity cost of
in!esting in the firm". 7or instance, some competitor analysis is necessary to =udge $hether
the firm is earning similar or higher rates of return than its competitors.
In!estors also $ould likely collect data from pharmaceutical publications about the market
potential for the firms current and proposed drugs. 7or instance, financial statements might
not re!eal a lot about obtaining 7B* appro!al for the drugs in?process. Medical publications
and conference presentations might help refine these beliefs. 8ther data pertinent to market
share and gro$th from trade associations" also seem important.
7inally, considerations such as the e(tent of di!ersification pro!ided and fit $ith the
in!estors risk?profile also play an important part in the in!estment decision.
1.##.
*s sho$n in the table belo$, ;inda may be surprised to find managerial accounting
information in!aluable in her ne$ position. *s a manager, ;inda decides ho$ best to use the
organi+ational resources entrusted to her, and she $ill find both financial and non?financial
information from her companys managerial accounting system to be helpful for making
these decisions.
D&(i'i"n
In!"#8a$i"n
I$&8'
A#& $%& in!"#8a$i"n i$&8' !inan(ia5>n"n?!inan(ia5 in
na$1#&@
>hether actual
costs are in
line $ith
e(pectationsQ
%udgeted costs
*ctual costs
*ctual !olume of
production
%udgeted and actual cost data are financial in nature.
;inda may use non?financial data such as the !olume of
production to ad=ust her estimates of e(pected costs. *fter
all, the more units produced, the greater the e(pected cost
as the company $ill be using more materials and labor.
;inda also may rely on non?financial data such as
absenteeism rates and $hether her company $as starting a
ne$ product to figure out the source of the cost differences.
1?1#
>hether to
make a tool in?
house or buy it
from a
supplierQ
.rice charged by
the supplier
1ost to make the
tool internally
Supplier 'uality
and reliability
&he suppliers price and internal cost data are financial.
9on?financial data include supplier 'uality and reliability,
as $ell as the reliability and 'uality of the tools if they
$ere manufactured by ;indas firm.
Ho$ many
tools to
purchase for
making
166,666 units
of a productQ
4ate of $ear
3(pected cost of
tool
3(pected loss if
tool not a!ailable
:se data, such as rate of $ear, are non?financial. 1ost data,
$hich $ould be used to determine the amount of safety
stock, are in financial terms.
>hat is the
right in!entory
le!el for a
gi!en toolQ
3(pected rate of
use, !ariance in
use rates across
time periods e.g.,
;indas firm may
ha!e seasonal
production
cycles"
1ost of tool, cost
of capital, other
storage costs
Bata concerning use patterns, including rate of $ear and
!ariance in use rates, are non?financial. Bata about cost
estimates, including storage costs and capital costs, are
e(pressed in financial terms.
>hether to
make a ne$
tool or to
refurbish an
e(isting toolQ
1ost to make the
ne$ tool
1ost to refurbish
e(isting tool
3(pected li!es of
the t$o tools
Uuality of the
tools
*gain, the cost data are in financial terms $hereas data
pertaining to 'uality and e(pected li!es are non?financial in
nature.
1?1)
1.#).
;et us begin by computing the expected cost if you had stayed at a hotel:
1ost of hotel for one night O1#6.66
.er?diem meal allo$ance O166 .66
&otal *=., 0,,
9e(t, let us compute your actual expenses:
1ost of car rental O26.66
1ost of dinner >ednesday O56.66
1ost of other meals O#) .66
&otal cost *=1/ 0,,
At least five views exist regarding the appropriate expense report/

<ou could turn in a report for O2#6, arguing that the firm $ould ha!e spent this amount
for the trip. *ny cost sa!ings stemming from your actions should belong to you.
<ou ha!e sa!ed the firm some money by staying $ith Barren rather than in a hotel.
&hus, you should turn in a report for O21), =ustifying the dinner $ith Barren and the car
rental as offsetting hotel costs.
*t another e(treme, some $ould argue for a report of O#) only, being the actual meal
cost. :nder this !ie$, the car rental and the dinner are personal e(penses and non?
reimbursable. 7urther, you should only claim the lo$er of actual e(penses or the per?
diem allo$ance.
<ou could claim the O166 as the per?diem allo$ance for t$o days. *fter all, company
policy allo$s you to claim O)6 per day for meals, no matter $hat you actually spend.
* final !ie$, $hich is perhaps $hat many of us $ould do, is to claim the car rental and
the per?diem for t$o days O126 G O26 F 2 days P O)6 per day", reasoning that the car
rental is a reasonable off?set to the cost of the hotel.
*s you can tell, there is no clear ans$er, and different people $ould reasonably claim
different amounts.
Beciding the reasonableness of tra!el e(penses can be difficult. 7or instance, some might
argue that the cost sa!ings are fictitious. <ou might ha!e been more producti!e if you had
stayed in a hotel and had a restful night. .artying $ith friends might ad!ersely affect your
$ork 'uality the ne(t day. In addition, perhaps you $ould ha!e dined $ith clients or engaged
in other beneficial acti!ities e.g., ha!ing dinner $ith colleagues to continue the meeting".
&hese opportunities might ha!e been missed because of your desire to ha!e dinner $ith
Barren. 8n the other hand, some might argue that the company is imposing costs by ha!ing
1?1-
you tra!el and spend time a$ay from your family. *llo$ing you to spend time $ith friends
and sightsee is one $ay to compensate for these non?pecuniary costs.
Many firms a!oid these problems by formulating e(plicit policies. 7or instance, they might
reimburse you O166 per day as a flat fee if you do not stay at a hotel.
&his e(ercise nicely illustrates that, =ust like beauty Klies in the eyes of the beholder,L there
often is no bright line test for $hat is ethical or unethical. >e can see this confusion in ad!ice
columns such as K*sk the 3thicistL that appear in the New York Ties Maga+ine.
1.#-.
&here are se!eral a!ailable options. 7irst, May can bill the client for O),666, reasoning that
this is the Kmarket rateL for the $ork. &his option ma(imi+es Mays current income and
reduces the chance that the client $ould be disgruntled after comparing notes. Ho$e!er, this
option is unethical in the !ie$ of the *merican %ar *ssociation *%*". Specifically, *%*
7ormal 3thics 8pinion 53?305 says that attorneys can only charge for hours actually spent,
and for fees actually earned. It e(plicitly disappro!es billing the second client for $ork
already done, on the grounds that you ha!e not VearnedV the second set of fees. *%* 7ormal
3thics 8pinions are not binding on anyone, but they are often influential in =udicial
proceedings.
*nother option is to bill the second client for O1,2)6, the hours actually $orked. 1learly, this
strategy is ethical. Ho$e!er, it increases the chance of the first client being discontent.
7urther, the strategy is not fully consistent $ith Mays goal of ma(imi+ing income W He is
deli!ering a 'uality product for substantially belo$ market $ages.
>hat can be doneQ 9ote that the *%* 7ormal 8pinions conclusion appears to be limited to
hourly billing. &hus, a third strategy might be to arrange an alternati!e basis for billing the
client. 9otice that the client benefits from May ha!ing already done the research and kno$ing
ho$ to do the $ork. &hus, if May charges a flat fee, kno$ing that the $ork to accomplish the
matter $as already done and rendering his effecti!e hourly rate higher than it $ould ha!e
been other$ise, that $ould probably be acceptable to the client and to the *%*. 8f course,
$e are assuming that the ultimate fee is not Vunreasonable.V" In case he follo$s this strategy,
May $ill need to disclose to the client fully and honestly $hat the fee $as and the basis on
$hich it $ould be calculated. He might also be $ell ad!ised to disclose to the first client
staying $ithin bounds of client confidentiality" that he did find subse'uent use for $ork that
he belie!ed to be uni'ue. He might also consider gi!ing some kind of a price break to the
first client for future $ork.
More generally, $hen doing $ork that de!elops transferable skills or kno$ledge, good
managers do not seek to e(tract all of the cost from the first client. 4ather, they charge for
less than the actual $ork done, KbankingL some costs to be billed to future clients e(pected to
benefit from the $ork. 8f course, the client is billed to the full e(tent if the $ork is =udged to
be Kuni'ueL or Kone?off.L In either case, the key point is to stay in full, open and honest
communication $ith the clients, and to be fair in appearance and in fact.
1?10
9ote: >e thank .rofessor Margaret 4aymond of the :ni!ersity of Io$a ;a$ School for
helpful discussions on this topic.
PROALEMS
1.#0.
a. Ji!en the hourly $age rate of O2.2), #6 hours per $eek, and 12 $eeks, the money earned for
$orking as a checkout clerk this summer is:
Ea#nin' B W"#3in a' a (%&(3"1$ (5&#3 G 12 P #6 P O2.2) G *:+<C,.
b. 7irst, $e need to calculate the e(pected hourly compensation from $aiting tables, $hich
e'uals the base $age rate of O# per hour F tips. <our e(pected tips per hour G .)6 P O3" F
.)6 P O-" G O#.)6 i.e., there is a )6D chance you $ill earn O3 in tips per hour and a )6D
chance you $ill earn O- in tips per hour".
&hus, your e(pected hourly compensation G O# F O#.)6 G O2.)6. Ji!en this $age rate, #6
hours per $eek, and 12 $eeks, $e ha!e:
EDp&($&4 &a#nin' B Wai$in $a75&' G 12 P #6 P O2.)6 G *.+,E,.
c. %ased solely on our computations in XaY and XbY, $aiting tables is the preferred option
because it has the highest amount , you e(pect to earn O#,626 from $aiting tables this
summer !ersus O3,5-6 from $orking as a checkout clerk. &he additional money from $aiting
tables is O126 G O#,626 , O3,5-6.
&he difference bet$een the t$o options, ho$e!er, is rather small. &hus, $e could readily see
$here indi!iduals, based on $hat they !alue, might make differing =ob choices. 7or e(ample,
there is the risk associated $ith the tip component of being a $aiter. * risk?a!erse person
might take the sure thing of O2.2) per hour o!er the possibility that sChe may earn only O0 per
hour $aiting tables. *lternati!ely, someone $ho is sure of hisCher interpersonal skills may
assess a much higher than )6D chance that they $ill earn O# F O- G O16 per hour from
$aiting tables. &hus, the K$ait tablesL option may be more attracti!e than the checkout clerk
option.
&he nature of the t$o =obs also differs , as a $ait person, you are constantly on your feet and
mo!ing , some indi!iduals may or may not" prefer this to the more sedentary role of being a
checkout clerk, $ho typically is at hisCher station for the better part of the day.
1.#2.
a. >ynter has t$o options: 1" accept the O266,666 offer, or 2" re=ect the O266,666 offer and
$ait for a future offer. If she accepts the offer, then >ynters opportunity cost includes the
e(pected !alue of a bid from another buyer. In estimating this number, she has to factor in
both the probability of recei!ing a higher bid and the !alue of the bid. She also has to factor
in the time until the ne(t bid arri!es because, until the house is sold, she $ill incur costs to
1?12
maintain the house, pay the mortgage, and accrue for insurance and property ta(es by
accepting the offer, these costs $ill not be incurred". 7inally, >ynter has to factor in the cost
of the an(iety associated $ith selling a house , the house has to be clean all the time/ plans to
buy a ne$ house may ha!e to be put on hold. Many of these factors are 'ualitati!e and are
based on beliefs about the future.
9either >ynters initial purchase price of O22),666 nor the amount of time and money
$hich she !alues at O#6,666" associated $ith de!eloping a fabulous yard ha!e any rele!ance
in estimating her opportunity cost , both of these costs are sunk. >ynter currently has to
assess future bids and future costs, taking as gi!en the status of the market and her houses
relati!e attracti!eness. &he fact that the house has not attracted a bid for a month indicates
that the property may be o!er?priced at O20),666. *ll in all, >ynter may be $ell ad!ised to
gi!e the offer serious consideration.
b. >ynter no$ has a third option , make a counter offer. &his option may be preferred o!er an
outright re=ection because it preser!es the option of going back to the original offer price but
holds the promise of obtaining a higher price. In making the counter offer, >ynter has to
estimate the final selling price, $hich $ould likely result after se!eral offers and counter?
offers. &his estimation depends on >ynters assessment of the bu!er"s opportunity cost.
>ynter also has to factor in the probability that the sale might fall through because the buyer
may come across a better !alue from the buyers perspecti!e". 8!erall, >ynter faces a
difficult, and highly sub=ecti!e, decision. * realtor can often help in such situations by
bringing >ynter the latest market information and the e(perience of pricing many such
transactions.
1.#5.
a. *s stated in its $ebsite, the mission of the :nited >ay is to impro!e peoples li!es by
mobili+ing the caring po$er of communities. :nited >ay helps raise funds for o!er 1,#66
community?based organi+ations, each $ith its o$n board and !olunteers. 8ther ma=or
charities ha!e e'ually laudable goals.
b. &here is little doubt that the officers and staff subscribe to the charitys goals. :sually, these
are talented indi!iduals $ith multiple employment and lifestyle options. &hey often make
significant financial and professional sacrifices to $ork for the charity, perhaps because of
the satisfaction they deri!e from ad!ancing a goal they belie!e in.
Ho$e!er, the officers are also indi!iduals $ith their o$n $ants and needs. >hile they may
be $illing to $ork for a smaller salary or under harder operating conditions, they cannot
typically $ork for a nominal sum. &he 'uestion therefore turns on $hat is KappropriateL
compensation and not $hether they need to be compensated or not.
&o ans$er this 'uestion, notice that charities such as the :nited >ay are large organi+ations
that control significant assets the :nited >ay has re!enues in e(cess of O#6 million a year"
and operate in a highly comple( political and economic en!ironment. 7or instance, the
:nited >ay organi+ation itself not the member organi+ations" uses the ser!ices of se!eral
hundred professional staff and consultants. Bischarging these responsibilities is not a tri!ial
1?15
task and re'uires the ser!ices of competent managers. 1ompetiti!e market conditions
determine the Kgoing rateL for such professional managers. 8ften, charities $ill engage
outside consultants and re!ie$ers to help them assess $hat is and is not appropriate gi!en the
charitys operations and the indi!iduals skill set. Seen in this light, $e can =ustify an annual
compensation package in the hundreds of thousands of dollars for the 138 of a large charity.
1.)6.
a. 1ompare selling 22) confirmed seats to selling only 216 seats. If the airline only sells 216
seats, then there is high likelihood that not all 216 passengers $ill sho$ up. In this case, the
plane $ill ha!e one or more empty seats. If these seats could be filled $ith paying
passengers, then the airlines profit increases , there are fe$ additional costs associated $ith
the e(tra passengers. &he chance of lost profit due to empty seats decreases as the airline sells
more than 216 seats.
&he airline must balance this cost $ith the cost of bumping passengers. If the airline sells 22)
tickets, then there is a chance that more than 216 passengers $ill sho$ up. &he airline has to
pro!ide compensation to the bumped passengers. &he additional re$ards e.g., a tra!el
certificate, hotel accommodations, meal !ouchers, etc." and negati!e good$ill reduces the
airlines profit.
*irlines use sophisticated models to estimate these t$o costs and to determine the KoptimalL
number of seats to sell. 7or instance, they $ould not sell 366 tickets on a 216 seat flight."
Historical records help agents tailor the amount of o!erbooking to the time and the day of the
flight, as $ell as to the profile businessC!acationCfamily" of the a!erage passenger.
b. If bumped, the passenger gi!es up the confirmed seat. &he ma=or cost of being bumped is the
con!enience associated $ith tra!eling on the scheduled flight and arri!ing earlier at the
destination hopefullyI". &his cost !aries $idely across passengers, resulting in some rushing
to the podium to claim their re$ard $hile others $ait. 7or instance, a college student going
home for the holidays probably is more $illing to gi!e up the seat than a businessperson
attending an important meeting. &hat is, cost and !alue are specific to each indi!iduals goals.
c. ;ike the airline, the passengers are trading off benefits $ith sacrifices. Suppose the current
re$ard e(ceeds the costs associated $ith taking a later flight. <ou kno$ from prior
e(perience" that the re$ard increases $ith time. <ou therefore decide to $ait to get the
ma(imum possible re$ard. Ho$e!er, $aiting has a cost. *nother passenger may !olunteer
before you and claim the lo$er" re$ard. In this case, the option of gi!ing up your seat
e(pires, and you ha!e gi!en up the chance to get a re$ard $hich had positi!e !alue". <ou
must sub=ecti!ely tradeoff these t$o factors $hen deciding $hether to claim the current
re$ard or to $ait for the ne(t re$ard le!el.
9ote: >e consider expected costs and benefits, $hen unkno$n future e!ents $ill someone
else !olunteer firstQ" affect our reali+ed costs and benefits. &he problem also illustrates the
role of uncertainty $hen making decisions.
1?26
d. If a passenger is involuntaril! bumped, the cost of missing the scheduled flight e(ceeds the
offered re$ard. &hat is, the airline is imposing a cost on the passenger by in!oluntarily
remo!ing them from the flight. &his cost $ill translate into ill $ill, damage to public image,
and future lost business for the airline.
&his cost !aries across passengers. &he potential cost is much higher if the airline bumps a
full fare?paying businessperson $ho tra!els e!ery $eek than if the airline bumps a discount?
fare passenger $ho is tra!eling alone and $ho is not a fre'uent flier. %umping part of a group
is more e(pensi!e image $ise" than bumping single passengers. Indi!idual circumstances
again shape the airlines costs.
9aturally, airlines consider these !ariations $hen picking passengers to bump in!oluntarily.
*irlines de!elop detailed passenger profiles to help the ticket agent select passengers , the
airlines options include the set of all passengers $ith confirmed seats and the decision is
$hich one to pick.
1.)1.
a. 7or this decision, &erry has t$o options: 1" keep the old &@, and 2" sell the old &@ and buy
the ne$ HB&@. &errys spouse has informed us that $e can rule out the possibility that &erry
$ill keep both &@ setsI". &he option of keeping the old &@ really =ust postpones the problem
to a later date. &erry can al$ays sell the old &@ a year from no$ and purchase the ne$
HB&@ of course, the resale !alue of old &@ and the price for the ne$ HB&@ $ould change
in a year".
&erry should consider the follo$ing costs and benefits in his decision:
#ash outflow associated with purchasing the $%T&: &erry can ob=ecti!ely estimate this cost
, it is O1,-55 F 6.6- P O1,-55" G O1,266.5#. &his cost $ill only be incurred if &erry
purchases the HB&@.
#ash inflow associated with selling the old T&: &erry can ob=ecti!ely estimate this benefit , it
is O-66, or the amount the neighbor is $illing to pay &erry for his old &@. &erry $ill only
recei!e this money if he purchases the HB&@.
'etter qualit! picture and sound: &his is the primary benefit associated $ith the ne$ HB&@.
&erry must sub=ecti!ely estimate this benefit.
(tilit! fro being current: Many persons deri!e utility from their KtoysL such as fast cars,
stereos, boats, tele!isions, etc. &erry might be such a person and recei!e a psychological
benefit from o$ning a Kcutting?edgeL HB&@. Similar to better 'uality picture and sound,
&erry must sub=ecti!ely estimate this benefit.

&errys decision hinges on $hether the 'ualitati!e benefits associated $ith being current and
ha!ing a better 'uality picture and sound e(ceed the net monetary cost associated $ith
purchasing the ne$ HB&@. In other $ords, if &erry estimates that the benefits e(ceed
O1,266.5# , O-66, or O1,266.5#, then he should purchase the HB&@/ other$ise, &erry should
1?21
keep his old &@. %ifferent people will attach different weight to the qualitative factors and,
thus, ake different purchasing decisions.
9otice that the O1,)66 purchase price of &errys current &@ does not factor into &errys
decision. It is a sunk cost and, conse'uently, is not a rele!ant cost or benefit.
b. &erry may o$e money on his old &@ if he purchased it on an installment plan e.g., he
financed it $ith a store credit card". 9otice that &erry $ould o$e the store O366 regardless of
$hether he keeps his current &@ or buys the ne$ HB&@. Hence, the O366 is not rele!ant to
&errys analysis and should ha!e no impact on his decision to purchase the ne$ HB&@.
9ote: Installment contracts fre'uently contain clauses that, in this instance, $ould gi!e the
store a lien on the &@ set. &his clause may re'uire &erry to pay off the balance if he sells the
&@. Such a re'uirement affects &errys cash flo$ and, in turn, could affect his decision. &he
effect in this instance arises because of &errys constrained budget. *bsent such a budget
constraint i.e., if &erry had enough cash to pay off the loan and to purchase the ne$ HB&@",
the amount is not rele!ant.
c. In this case, &erry has three options: 1" keep the O-66 and not replace the &@, 2" use the
O-66 to replace his old &@, and 3" use the O-66 to$ard the purchase of the ne$ HB&@.
1ompared to part XaY, $e see that &erry has more options. Ho$e!er, &errys option of keeping
the old &@ is no longer a!ailable.
&he !alue associated $ith purchasing the HB&@, ho$e!er, has not changed. %efore the
flood, &erry had to pay O1,266.5# , O-66 G O1,266.5#. *fter the flood, &erry still needs to pay
O1,266.5# to purchase the ne$ set. In both cases, &erry has O-66 to assist $ith the purchase
of the HB&@ , it doesnt matter $here the O-66 comes from.
9ote: >e belie!e that many people $ho $ould ha!e stayed $ith the old &@ in part XaY $ould
purchase the HB&@ in part XcY, e!en though the !alue has not changed. >hile !alue has not
changed, the problem is fraed differently. .art XaY frames the problem as selling the old &@
to get a ne$ &@. In part XcY, the decision is $hether to spend O-66 to get a dated &@ or
O1,266.5# to purchase a state?of?the?art HB&@. *lthough there is no economic rationale for
the phenomenon, psychologists ha!e demonstrated that differences in framing often lead to
differences in decision making.
1.)2.
&his problem captures some of the comple(ities in administering a comple( organi+ation
such as a uni!ersity in a resource?constrained en!ironment. &he follo$ing costs and benefits
seem rele!ant.
9otice that there is !ery little in the form of incremental re!enue to the school as tuition
re!enue is independent of Bean Ma(tons decision. 8ne could possibly argue that the
decision could affect future donations to the school e.g., a student becomes rich and
attributes hisCher success to the school and the Beans decision to open up the course to
1?22
additional students". &his seems unlikely, ho$e!er, leading us to consider the direct out of
pocket costs !is?Z?!is a 'ualitati!e assessment of the educational benefits.
&he direct costs in this problem are relati!ely easy to measure. &hese costs only include the
cost of the instructor in option 2. If, for some reason, the schools budget is tight and the
school is not in a position to bear this cost, then the Bean $ould ha!e to choose either option
1 or option 3. More than likely, though, this cost $ould not limit the Beans options.
&hus, the decision seems to hinge on the educational tradeoffs and ma(imi+ing student
$elfare. Belineating the educational tradeoffs, or e!en defining student $elfare, is a rather
difficult and sub=ecti!e task. &he Bean $ill ha!e to measure and $eigh the follo$ing factors
in each option to arri!e at the !alue of each option:
8ption 1: >hat are the costs of not appearing to be responsi!e to student needsQ >hat are the
lost educational benefits, if any, of capping the enrollment in the Strategic 1ost
ManagementQ *re there other high 'uality courses offered by the school that lead to the
same, or similar, le!el of educational benefitsQ Ho$ costly is it for students to delay taking
the course by a semester or a yearQ
8ption 2: >hat are the costs of canceling a class that is Kon the booksQL Here, the Bean
needs to consider the costs to the si( enrolled students in the canceled class as $ell as any
costs associated $ith the school reneging on $hat many might !ie$ as a commitment.
7urther, in addition to the direct costs of hiring the instructor, the Bean needs to consider
$hether the 'uality of instruction in the course $ould decline , that is, $ill the ne$
instructor deli!er the goodsQ &he Bean must $eight all of these factors against the
incremental educational !alue of offering the Strategic 1ost Management course to the 1)
students $ho $ish to take the class.
8ption 3: &here are unlikely to be any costs or benefits for the 15 students enrolled in the
other course. &hus, Bean Ma(ton needs to assess the incremental benefits associated $ith
allo$ing the 1) students to take Strategic 1ost Management !ersus the cost to the 26 students
currently enrolled in the course e.g., due to the instructor changing to a lecture?oriented
teaching style and change in e(am format".
:ltimately, the Beans decision hinges on the 'ualitati!e factors, e!en though these factors
are difficult to measure $ith any reasonable degree of accuracy. 8!erall, it is likely that the
Bean $ould choose option 3 since the incremental benefits are likely to out$eigh the
incremental costs, $hereas the costs in options 1 and 2 likely o!er$helm any benefits. &his is
simply our con=ecture, though. 8ne can make plausible arguments to support choosing any of
the options.
1.)3.
a. <our decision problem relates to buying the KbestL computer, $ith your goal being to obtain
the ma(imum !alue from your computer purchase. Indi!idual preferences dictate the
definition of !alue. 7or e(ample, some students may place a premium on price, desiring to
obtain a computer that performs the basics for the lo$est possible amount. 8ther students
1?23
may place a premium on mobility or, alternati!ely, $orry about the potential for theft and
loss. 7inally, some students may emphasi+e computing po$er or monitor si+e. &he key point
to remember is that K!alueL is like beauty , it lies in the eyes of the beholder W as it is
measured $ith respect to an indi!iduals preferences.
b. * narro$ definition yields t$o options: 1" * desktop machine, and 2" a laptop machine. *
broader definition might include a laptop $ith a docking station, $hich gi!es us a hybrid of a
desktop and a laptop.
It also is important to recogni+e that e(ternal factors KconstraintsL" may limit you from
considering other options. 7or e(ample, a budget of O-66 is likely to rule out most laptop
machines. If taking notes in class is the primary role for your ne$ purchase, then desktops
$ould be eliminated. *t an e(treme, some schools specify that you choose among limited
configurations from a K!endor of choice,L a constraint that also limits your options.
c. &here are numerous costs and benefits to be considered , the follo$ing are perhaps the most
salient:
)rice* 7or e'ui!alent computing and storage po$er, laptops are more e(pensi!e than desktop
machines.
#oputing power. %y !irtue of their si+e, desktop machines offer features microprocessor
speeds, 4*M amounts, ability to handle add?on e'uipment !ia their multiple ports"
una!ailable in laptop machines.
+onitor si,e, &ideo #ards, - Speakers. >e can configure desktop machines $ith larger
monitors and better !ideo cards and speakers. &hese features may be particularly important to
students $ho plan to use the machine for gaming andCor $atching mo!ies.
+obilit!* >e can more easily mo!e laptop machines/ they can be used in the classroom,
library, cafeteria, and so on.
Safet!* :nfortunately, laptop machines can Kgro$ feet.L &hat is, they are far more susceptible
to theft and loss.
d. %ecause many of the costs and benefits are 'ualitati!e, they $ill !ary across indi!iduals. 7or
e(ample, students $ho are al$ays Kon the goL may assign more $eight to mobility, and
therefore be more likely to purchase a laptop. Similarly, students $ho lo!e !ideo games may
assign more $eight to monitor si+e and the 'uality of the !ideo card and speakers, and
therefore lean to$ards purchasing a desktop.
In the end, each person $ill add up all of the benefits and subtract all the costs of each
machine type, selecting the option $ith the highest personal !alue.
1?2#
1.)#.
a. &he ob=ecti!e is to obtain the ma(imum !alue from your !acation. Indi!idual preferences
dictate the definition of !alue. 7or e(ample, some indi!iduals may place a premium on
outdoor acti!ities, desiring a !acation that in!ol!es golf, scuba di!ing, fishing, hiking, or
camping. 8ther indi!iduals may place a premium on rest and rela(ation, desiring to !acation
at a spa or resort $here guests are pampered. 8ther indi!iduals may place a premium on
!isiting a foreign country or city, !isiting historical sites and monuments, or cultural e!ents.
7inally, some indi!iduals may place a premium on cost, desiring simply to take 1# days off
for the lo$est possible amount. 4emember that !alue is like beauty , it lies in the eyes of the
beholder.
3!en though you might share many interests, you and your friends ob=ecti!es are unlikely to
be perfectly aligned. %y definition, groups comprise multiple indi!iduals, each $ith uni'ue
preferences. &he groups preferences are some aggregation of indi!idual preferences. *s
discussed in the te(t, goal congruence is the o!erlap bet$een the groups and the indi!iduals
goals and is rarely perfect. 3ach indi!idual in the group therefore $ill try to push the group to
make the decision that ma(imi+es his or her o$n $ell being. %ecause of differences in
indi!idual preferences, this can lead to different indi!iduals pushing for different choices.
In this instance, e!en though you are best friends, it is likely that each of you attaches
differing !alues to different options. &here is both a group and a personal decision here. 3ach
!acation possibility must be e!aluated in terms of the relati!e benefits it yields to both parties
in!ol!ed. 7or e(ample, consider trips to <ello$stone 9ational .ark, the Jrand 1anyon, or
the Smokey Mountains of &ennessee. %eing a $hite $ater enthusiast, you may prefer the
Jrand 1anyon trip to the others. <our friend may prefer the Smokey Mountain trip because
of hisCher en=oyment of 'uiet long $alks and greenery. *s a group, you may settle on the
<ello$stone trip although it is not the first choice for either of you/ it offers a bit for both of
you.
b. &he option set here is !ery large and consists of all possible !acation destinations.
4ealistically, decision makers KpruneL the option set by eliminating an entire class of
choices. 7or e(ample, you and your friend may restrict your choice to outdoor acti!ities,
thereby eliminating a host of other !acation possibilities a $eek in 9e$ <ork 1ity, for
e(ample". *lternati!ely, you and your friend may restrict your choice to 3uropean cities or
$arm $eather places thereby eliminating :.S. !acation destinations and cruises to *laska,
respecti!ely".
It is !ery difficult, if not impossible, for a decision maker to consider more than a fe$
choices. *lmost all decision makers narro$ their options to a manageable number. Jood
managers, ho$e!er, try to make sure that the options they retain dominate those they
eliminate.
It also is important to recogni+e that e(ternal factors constraints" may limit the options you
consider. 7or e(ample, a budget of O2,666 for the !acation is likely to rule out a $eek at the
1?2)
.la+a hotel in 9e$ <ork 1ity. &he room rate is se!eral hundred dollars per dayI" or a $eek
of golf at .ebble %each the green fee is O3)6 per person per round".
c. &here are numerous costs and benefits to be considered , the follo$ing seem salient:
)rice* &his is important to =ust about e!eryone and can se!erely limit ones options. Most
indi!iduals $ish to a!oid spending a significant amount of their annual discretionary income
on one !acation, desiring to sa!e money for other goods such as car, tele!ision, clothes, and
food.
Tie* Most indi!iduals are !ery conscious of the amount of time the !acation $ill take , for
e(ample, because of =ob constraints fe$ indi!iduals could take a 3?month tour of 3urope.
*dditionally, indi!iduals likely $ill consider the amount of time spent tra!eling and the
amount of time actually spent at the !acation destination, $ishing to minimi+e the former and
ma(imi+e the latter.
+ode of Travel* Some persons are ner!ous about flying and may not take any !acation that
in!ol!es air transportation.
.ctivities* >hat you $ill be KdoingL on !acation, be it fishing, camping, or !isiting historical
sites, is clearly important as discussed abo!e".
/ocation, (niqueness* <ou may attach !alue to !isiting a place you ha!e ne!er been before
andCor doing something KdifferentL from the norm.
#rowds* Some persons like to !acation in relati!e isolation $hereas others are less concerned
about long lines.
d. %ecause many of the costs and benefits are 'ualitati!e, they $ill !ary across indi!iduals.
Indeed, there are a plethora of places to !acation, and $e see people making different
!acation choices all the time. In the end, you and your friend $ill add up all of the benefits
and subtract all the costs of !acation destinations in your option set, selecting the one $ith
the highest !alue.
*gain, it is important to remember that as discussed under part XaY" you and your friend $ill
likely attach differing !alues to the different !acation options. &hus, your final !acation
destination is likely to reflect a compromise bet$een $hat you truly desire and $hat your
friend truly desires. Many students $ill likely recall that this happens all the time $ith family
!acations $here the preferences of the children and adults do not coincide , in!ariably, some
compromise is struck.
1?2-
1.)).
a. 9atalies decision problem centers on $hat to do $ith the unsold merchandise. 9atalies goal
is to ma(imi+e her profit. 7or the unsold merchandise, this means ma(imi+ing the re!enues
recei!ed from selling the merchandise less any additional costs associated $ith selling the
merchandise. &he amount that 9atalie paid for the unsold merchandise, or O166,666 ,
O-),666" P .)6 G O10,)66 is sunk and is not rele!ant to 9atalies decision.
b. %ased on the information pro!ided, 9atalie has ) options:
1. Store the unsold merchandise for 16 months and attempt to sell it ne(t season.
2. Hold an 26D off sale.
3. Hold a 06D off sale.
#. Hold a -6D off sale.
). Hold a )6D off sale.
>e could, of course, concei!e of other alternati!es such as donating all of the unsold
merchandise, but 9atalie does not seem to be interested in e!aluating these options.
c. &he increase in 9atalies cash flo$ under each option is:
1. Store and Sell Next Year*
4e!enue ne(t year O166,666 , O-),666" .36 O16,)66
.acking and storage costs #,666"
Increase in cash flo$ *C+/,,
H"54 Fan1a#y a!$&#?C%#i'$8a' Sa5&
2. 012 off sale 3. 412 off sale 5. 612 off sale 7. 712 off sale
4emaining re!enues
at original price O3),666 O3),666 O3),666 O3),666
Biscount G
D off O3),666 22,666 2#,)66 21,666 10,)66
4e!enues at
discounted price O0,666 O16,)66 O1#,666 O10,)66
D of items e(pected
to be sold 166D 26D ))D #6D
Increase in 1ash flo$ *;+,,, *E+.,, *;+;,, *;+,,,
N"$&: >e focus on cash flo$s in this problem, rather than profit, because the cost of the
merchandise is sunk and not rele!ant to the decision at hand. Moreo!er, if 9atalie $ere to
focus on profit, $e $ould XerroneouslyY calculate the !alue of each option as being negati!e
as the amount 9atalie paid for the unsold merchandise e(ceeds the proceeds recei!ed from
sale. >hat $e need to remember is that the cost of the unsold merchandise $ill be e(pensed
e!en if 9atalie $ere to do nothing and hold onto the merchandise the status 'uo" , that is,
she $ould ha!e to $rite it off due to obsolescence.
1?20
d. &he opportunity cost of each option is the !alue of the ne(t best option. &hus, $e ha!e:

1. O2,#66
2. O2,#66
3. O0,066
#. O2,#66
). O2,#66
e. Ji!en the a!ailable options, $e find that 9atalies best strategy is to hold a K06D offL sale.
&his strategy nets 9atalie O066 more than the ne(t?best option, $hich is the -6D off sale.
Moreo!er, this option is the only one $hose !alue e(ceeds its opportunity cost.
<ou can take the problem a step further and link it to common business practice. Specifically,
$e often obser!e stores using a KstaggeredL discounting strategy , the store starts $ith, for
e(ample, a 2)D discount and increases the discount rate o!er time perhaps by as much as
1)?2)D a $eek". In this $ay, the store attempts to capture as much consumer surplus total
re!enues" as possible by stratifying customer types according to their $illingness to $ait and
run the risk of ha!ing the item selling out. Such a strategy may $ork 'uite $ell for 9atalie ,
notice in the problem abo!e 9atalie could sell #6D of the items if she offers a )6D discount.
9atalie could then sell an additional 1)D of her merchandise by increasing the discount to
-6D, and so on until she sells all of her merchandise. %y using such a strategy, 9atalie might
be able to earn as much as *1:+1=/, calculated as follo$s:
Sequential Strateg! %etail 8evenues
)6D off O3),666 .)6 .#6 O0,666
-6D off O3),666 .#6 .1) 2,166
06D off O3),666 .36 .2) 2,-2)
26D off O3),666 .26 .26 1,#66
EDp&($&4 R&6&n1&' *1:+1=/
1.)-.
a. &he opportunity cost of labor is the amount that $e can obtain from the ne(t best use of
labor. &he unskilled labor has +ero opportunity cost as there is no other use for the time
already paid for and is a!ailable. Ho$e!er, $e need to pay an additional amount for skilled
labor. >e sa!e this amount if the citys =ob $ere not there. >e calculate this amount as:
Skilled labor*
Hours needed for =ob: 166
Hours a!ailable 0)
3(tra hours needed 2)
1ost per hour [1) [1) G [)2)C3)
Opp"#$1ni$y ("'$ G:;/ W& i6& 1p $%i' a8"1n$ in (a'%0
1?22
(nskilled labor*
Hours needed for =ob: )6
Hours a!ailable 166
3(tra hours needed 6 &hat is, $e gi!e nothing upI
Opp"#$1ni$y ("'$ G,
&hus, the "pp"#$1ni$y ("'$ "! 5a7"# for completing the citys special =ob is G:;/.
b. &he opportunity cost associated $ith using the chromic acid is not the original purchase price
because it is a sunk cost. 7urther, if the chromic acid is used for the citys special =ob, >ood
Juardians $ill not be able to use these materials on the other =ob, as originally planned.
&hus, >ood Juardians $ill need to ac'uire additional chromic acid for [266. 1onse'uently,
$%& "pp"#$1ni$y ("'$ "! 8a$&#ia5' i' GE,,.
c. &his information changes the opportunity cost associated $ith using the chromic acid.
%ecause >ood Juardians has no alternati!e use for the chromic acid, they must dispose of it
at a cost of [)66. &hus, >ood Juardians actually saves [)66 by using the materials for the
citys special =ob. 1onse'uently, the "pp"#$1ni$y ("'$ "! 8a$&#ia5' ("'$ i' ?G/,, i.e., the
opportunity cost of this resource is negati!e".
d. >ood Juardians $"$a5 "pp"#$1ni$y ("'$ G [30) for skilled labor F [6 for unskilled labor ?
[)66 for materials G ?G1=/.
&he minimum price is the price at $hich >ood Juardians =ust reco!ers its opportunity cost.
%ecause the opportunity cost is negati!e, W""4 G1a#4ian' a($1a55y i' 2i55in $" pay $%&
(i$y G1=/ for the =obI &his, of course, is the minimum price that >ood Juardians is $illing
to accept.
%asing the price on >ood Juardians opportunity cost alone, ho$e!er, is not a good strategy.
&he recommended price must account for the cit!"s or more generally, customers"
opportunity cost as $ell. If the city $ent else$here, the ne$ supplier likely $ill ha!e to buy
the materials and pay for the labor i.e., it is unlikely that the ne$ supplier $ill ha!e both the
materials in stock and e(cess labor capacity". &hus, the ne$ suppliers opportunity cost is
likely to be positi!e, resulting in a positi!e price to the city. &his price is the citys
opportunity cost, and >ood Juardians management must estimate this opportunity costI &his
estimate $ill be important to >ood Juardians pricing strategy.
9ote: &his problem emphasi+es that $e compute opportunity cost on a resource?by?resource
basis. &hus, it is possible that $e ha!e some resources in short supply but ha!e plentiful
supply of others.
1.)0.
a. &here are many possible factors , the follo$ing four seem important:
1?25
.llowed inutes. %oth the total number of minutes and their distribution matters. 7or
instance, a plan $ith unlimited nights and $eekends may be preferred e!en if it has fe$er
KanytimeL minutes.
#ontract length. Jenerally, a shorter contract is preferred because it allo$s for more
fle(ibility. 8n the other hand, a long contract also protects you from a price increase a
remote possibility in the face of intense competition".
Service qualit!. &his is a !ery important dimension. Ha!ing all the minutes in the $orld
doesnt matter much if one cannot use themI
9nitial cost of phone and activation. 1arriers attract customers by subsidi+ing this cost
hiding it in the form of higher monthly fees andCor longer contract lengths". &he features
attracti!eness depends on ones current cash flo$. 9ot many students can afford to spend
O166 or more on a phone and acti!ation.
b. &his 'uestion highlights that people ha!e differing goals. * person $ho makes many long
distance calls state to state" $ould likely prefer plan *. &he plans KfreeL long?distance
feature lo$ers the total cost.
* person $hose calls are almost surely $ithin the calling +one $ould likely prefer plan %.
Many students are likely to be in this category. Ho$e!er, the relati!ely high cost for
acti!ation might pose a problem for cash?strapped students. &his plan also might be chosen
by someone $ho is looking to replace their landline $ith a cell phone.
.lan 1 is likely attracti!e to someone $hose usage !aries $idely , $ith other plans, unused
minutes e(pire $hereas they carry o!er in plan 1. .lan 1 also likely appeals to persons $ho
use the cell phone as a Ksecondary,L or emergency, phone rather than as a primary line.
7inally, plan 1 is attracti!e because it has fle(ibility , plans * and % lock the user into a t$o?
year contract $hereas plan 1 allo$s for easy s$itching.
1.)2.
a. 1asinos monitor their employees because of the di!ergence bet$een its goals and its
employees goals. &he casinos goal, $hich is to ma(imi+e profit, is at odds $ith employees
goals, $hich is to ma(imi+e their personal $ealth. >ithout monitoring, employees $ould be
tempted to increase their o$n $ealth by stealing money and chips. Such concerns are
particularly salient in casinos because employees handle large sums of money and, $ithout
monitoring, could easily hide the theft by simply claiming that a patron $as lucky and $on
the money.
1asinos therefore monitor their employees to reduce losses associated $ith employee theft.
1asinos can use both proacti!e and reacti!e controls to reduce this loss. .roacti!e controls
include !ideo sur!eillance, physical monitoring by floor super!isors and pit bosses, lock and
key de!ices for slot machines, safe?keeping of high?!alue chips by sliding them into a locked
cabinet, tracking gains and losses and comparing them to peer data, and using background
security checks. 4eacti!e policies could include firing or prosecuting employees caught
1?36
cheating. *s $e see, there are many means casinos use to stop employees and patrons from
cheating , the number is limited only by managements creati!ity.
b. 4elati!e to physical monitoring, !ideo monitors are less intrusi!e. &he casino $ants to
pro!ide a friendly en!ironment $here patrons feel at ease and are more $illing to gamble.
.atrons may not like ha!ing ob!ious KsecurityL types hang around. *nother ad!antage is that
!ideo feed can be recorded. &his allo$s e!ents to be re!ie$ed and makes for compelling
e!idence in a court of la$ $hile security staff can also testify, their memory is more fallible
and less ob=ecti!e". 7inally, the casino must also monitor the security guards themsel!es to
pre!ent them from colluding $ith other employees to cheat the casino.
@ideo monitoring, ho$e!er, does ha!e some dra$backs. 7irst, ha!ing a !isible security
presence may alter peoples beha!ior and make them more prone to obeying the rules. >e all
ha!e slo$ed do$n $hen $e see a patrol car in the distance. &he patrol car therefore ser!es a
useful role, e!en if aerial monitoring from a helicopter is more effecti!e at identifying
speeders. Second, !ideo monitoring may be more e(pensi!e than hiring security guards.
7inally, it may be more difficult to pick up subtle beha!ioral and body language type clues
from a !ideo monitor relati!e to direct obser!ation. In this regard, physical monitoring may
be more effecti!e than !ideo monitoring.
c. Multiple monitoring systems make sense because, as discussed in part XbY, any gi!en system
is likely to ha!e some $eak spots. &he use of multiple systems increases the probability that
an! improper beha!ior $ill be detected and corrected. &he best mi( of monitoring systems
depends on the specific circumstances. 7or e(ample, casinos rely hea!ily on !ideo
sur!eillance because indi!idual employees continuously recei!e and pay out large sums of
money $ithout physical or electronic documentation such as a receipt". * fast?food chain, on
the other hand, is less likely to use !ideo sur!eillance because employees monitor each other
i.e., $ork closely together", handle less money, and transactions $ith customers are better
documented e.g., all customers recei!e a receipt for their purchase" , in this case, the best
control may be to reconcile the money in the cash dra$er $ith the tape total at the end of
each day or shift.
&o understand this point better, consider $hy your instructor may use both multiple choice
and essay 'uestions on e(ams. 3ach type of 'uestion is ad!antaged in testing one aspect of
learning. Multiple choice 'uestions are easy to grade and can test Kfact learningL !ery $ell.
3ssay 'uestions test student understanding and integration of material, making them much
harder to grade. %ecause both types of learning are important, an instructor may use both
types of 'uestions.
9ote: *nother factor to consider is the concept of diminishing marginal returns. &hus, $e
usually find a portfolio of controls rather than one control alone.
1.)5.
a. 7eli( has four options:
Bo not paint the bedrooms no$.
1?31
.aint the bedrooms by himself.
.aint the bedrooms $ith 8scars help.
1ontract out the painting =ob.
b. &here appears to be little conflict bet$een 7eli(s and 8scars ob=ecti!es. %oth indi!iduals
$ish to ha!e a good 'uality paint =ob. &his congruence in ob=ecti!es, ho$e!er, does not
imply that monitoring is not needed. 7eli( $ould do $ell to monitor 8scars progress and
$ork 'uality. &he purpose of this monitoring is to pro!ide feedback and to impro!e 'uality
impro!e 8scars skill as a painter" rather than to e!aluate 8scars performance.
&ranslating to organi+ational settings, $e must pay attention to the purpose of the monitoring
mechanism $hen choosing the mechanisms. * system that is appropriate for monitoring
performance may $ell be ill?suited to pro!ide diagnostic and feedback information.
c. 7eli( and the contractor ha!e differing ob=ecti!es. &he contractors ob=ecti!e is to make a
profit. &he contractor can do this by deli!ering =ust the 'uality the a!erage customer cannot
discern the difference bet$een good and e(cellent 'uality" that the client demands, and by
taking the least amount of time possible. 7eli(, on the other hand, cares deeply about 'uality.
:nless 7eli( is !ery careful to spell out his 'uality e(pectations, it is likely that there $ill be
a dispute about =ob 'uality. .erformance e!aluation is the key role for control measures and
monitoring in this setting.
9ote: It is $orth$hile to contrast the differing roles for monitoring in the t$o settings.
:sually, the purpose of monitoring is to ensure compliance $ith policies and procedures.
Such monitoring is re'uired because organi+ational and employee goals differ. 7or e(ample,
attendance records ensure that employees sho$ up on time. &his role for monitoring does not
e(ist $ith 8scar but does $ith the contractor. *lthough 7eli( is likely to assess 'uality in
both settings, the purpose differs.
It also is possible that some types of e!aluations contain both performance assessment and
feedback aspects. Some instructors gi!e tests both $ith the ob=ecti!e of testing students
kno$ledge and $ith the ob=ecti!e of helping students figure out $hat they kno$ and $hat
they do not kno$. &he former is the e!aluati!e aspect of the e(am $hile the latter is a
feedback role.
1.-6.
It is true that, as a result of the bonus contract, Sally has a direct interest in ma(imi+ing the
Biamond Mubilees profit. &hus, the bonus contract does help align Sallys interests $ith those
of the casino. Ho$e!er, the bonus contract may not fully align Sallys interests $ith those of
the partnership/ there are at least t$o areas of concern:
1. Sally and the partnership may ha!e different time hori+ons. Sally may be more interested
in ma(imi+ing todays, or short?run, profit because, for e(ample, she is close to retirement,
she is planning to mo!e, or she is planning to s$itch =obs. 8n the other hand, the partnership
1?32
probably is more interested in ma(imi+ing the long?run stream of profits, or the present !alue
of future cash flo$s accruing to the casino.
Such differences in time hori+on could lead Sally to take actions that increase current profits
at the detriment of future profits. 7or e(ample, Sally may not in!est in ne$ e'uipment e.g.,
slot machines or other gaming de!ices" or may defer maintenance or upgrades to the
ri!erboat because such actions $ould increase e(penses, thereby reducing current profit and
Sallys bonus. &he partnership, ho$e!er, may prefer such actions be taken to ensure the long?
run !itality and success of the casino.
Bifferences in time hori+on also may lead Sally to not in!est in increasing customer loyalty
and good$ill. 7or e(ample, Sally may not offer casino patrons comps such as free drinks,
free food, free chips, or discounted rooms. >hile such actions may increase short?term
profits because they reduce the casinos costs" they may =eopardi+e long?term profits
because it has been sho$n that offering comps gets people and their friends" to come back to
the casino.
2. * second source of discord may arise because Sallys contract appears to encourage her to
consume many per'uisites. Sally may be moti!ated to consume per'uisites because she
recei!es all of the benefits $hile only bearing )D of the cost i.e., her lost share of profit".
7or e(ample, if Sally orders a ne$ chair for her office that costs O1,666, Sally gets e(clusi!e
use of the ne$ chair and it only costs her O1,666 .6) G O)6 in lost bonus income $hile
casino profit goes do$n by O1,666". Sally may decide that, at O)6, the ne$ chair is a bargain
, casino partners, though, may !ie$ the matter differently. *nalogously, Sally may be
moti!ated to gi!e herself a larger office andCor gi!e her friends and relati!es free meals and
free chips. 7inally, Sally may e!en engage in unethical and illegal beha!ior such as falsifying
receipts and e(penses. 7or e(ample, if Sally submits a false receipt asking for a O)66
reimbursement, Sally recei!es the O)66 less the O2) reduction in her bonus O)66 .6) G
O2)" G O#0). >e see that Sallys contract is indeed imperfect.
&hese e(amples sho$ that Sallys interests are not fully aligned $ith those of the partnership.
*ccordingly, it probably $ould not be in your best interest to delegate all decisions to Sally
and gi!e her complete control of the casino.
Moreo!er, the lack of incenti!e alignment may trigger the need for additional performance
measures abo!e and beyond linking Sallys compensation to casino profitability" to ensure
that Sally acts in the best interest of the partnership. 7irst, you probably $ould restrict the
decisions Sally could make , for e(ample, you may re'uire her to obtain appro!al before she
purchases a chair or submits an e(pense report. <ou also may form a committee to o!ersee
capital e(penditures and impro!ements related to the ri!erboat and the gaming e'uipment.
Second, you may decide to more closely monitor Sally. 7or e(ample, you may engage both
e(ternal and internal auditors to ensure that all physical and financial controls are in place
and that no?one has undue access to, or influence o!er, the books. 7inally, you may $ish to
gather data regarding ho$ the numbers from the Biamond Mubilee stack up against the
numbers from similar casinos , such benchmarking data can pro!ide !aluable insights
1?33
regarding ho$ your casino and employees" are performing !is?Z?!is other casinos and their
employees.
1.-1.
a. &here clearly is some !alue to teaching boys the !alue of $ork and the dignity of labor.
Ho$e!er, the States ob=ecti!e of Kreforming delin'uent youthL probably encompasses
turning troubled kids into producti!e members of society. It is unclear ho$ digging holes
accomplishes this ob=ecti!e , i.e., ho$ it $ill lead troubled kids to not commit crimes, find
gainful employment, and ac'uire social skills.
It is possible to assess the effecti!eness of the >ardens performance measure. 7or e(ample,
they $ould need to track the boys progress o!er a long?term hori+on and compare this to the
progress of youths at other =u!enile camps $here they use different methods to reform the
kids". In the short?run, it $ould seem that the State $ould $ant to measure the kids
academic progress i.e., reading and math skills" so that they are ac'uiring the necessary
tools to be producti!e upon release.
b. &he measure seems to correspond !ery $ell $ith the >ardens ob=ecti!e. &his is an e(treme
case of the >arden using her authority and po$er to further her o$n interests at the e(pense
of othersI
c. *s discussed in part XaY, the State could ha!e put in additional performance measures to
capture other dimensions of reforming delin'uent youth. &he State also has to closely
monitor the camp and the >arden !ia surprise !isits or formal grie!ance procedures. >ithout
additional performance measures or monitoring, the >arden is free to do as she pleases.
N"$&: &he mo!ie Shawshank 8edeption has a similar theme. In this mo!ie, a prison $arden
abuses his authority to e(ploit prison labor and build his fortune.

1.-2.
a. *ll else being e'ual, the partners in 7elipes firm $ould like to book the contract as early as
possible. Belaying the order until the ne(t fiscal year sub=ects the firm to uncertainty albeit
small" that the order may be canceled or delayed. *s the old adage goes, a bird in the hand is
$orth t$o in the bush. 7urther, the sales shortfall for the year pro!ides additional moti!ation
for the partners to book the sales no$ and meet targets.
b. &he timing of the sale matters a great deal to 7elipe. If he books the sale this year, he $ill
ha!e o!ershot last years performance by a substantial amount and he is already o!er last
years target". More importantly, booking the sale this year $ill make it that more difficult for
7elipe to increase sales ne(t year. Moreo!er, if he books the sale this year, he $ill not start
ne(t year $ith a bird in hand, but rather, in a hole. 8!erall, incenti!e considerations may $ell
spur 7elipe to delay the paper$ork sufficiently so that the sale counts for the ne(t fiscal year.
c. &his act falls in the gray +one of ethical beha!ior. &here is nothing illegal about the action
and it is not clear that 7elipes firm $ill be ad!ersely affected by a fe$ $eeks delay in
processing the order. Such massaging of last minute orders oftentimes it $orks the other
1?3#
$ay around $ith managers $orking hard to pull ne(t years orders into this years numbers"
is commonplace and una!oidable $ith budget?based performance measures. Most persons
$ould !ie$ this act to be a natural outgro$th of the incenti!es in place and that it is neither
unethical nor unprofessional for 7elipe to delay the sale until the ne(t fiscal year.
1.-3.
a. Stefans ob=ecti!es are clear , he likely $ill choose the option that ma(imi+es his bonus o!er
the t$o?year period. &hus, to understand $hat Stefan likely $ill do, $e should calculate his
bonus in t$o cases: 1" he undertakes the sales campaign/ 2" he does not undertake the sales
campaign. 9otice that $e can ignore Stefans base salary of \1),666 per month as it is the
same under both options.
:1; Sales capaign undertaken*
Sales G \22 million this year and \12 million ne(t year.
Stefans bonus this year G X\26 million , \16 million" .62Y F X\22 million , \26 million"
.6)Y G H:,,+,,,0
Stefans bonus ne(t year G X\12 million , \16 million" .62Y G H.,+,,,0
&hus, Stefans bonus o!er the t$o years G H:.,+,,,0
:2; Sales capaign not undertaken*
Sales G \1- million this year and \1- million ne(t year.
Stefans bonus this year G X\1- million , \16 million" .62Y G H1=,+,,,0
Stefans bonus ne(t year G X\1- million , \16 million" .62Y G H1=,+,,,0
&hus, Stefans bonus o!er the t$o years G H=.,+,,,0
&he net increase in Stefans bonus from undertaking the campaign G \166,666 G \3#6,666 ,
\2#6,666. Stefan clearly should undertake the sales campaign time !alue of money
considerations also $ould suggest adopting the campaign".
b. &he firms ob=ecti!es also are pretty clear , to ma(imi+e !alue, the parent company likely
$ould $ant Stefan to pursue the intensi!e sales campaign only if it increased t$o?year profit.
7rom the firms !ie$point, $e can calculate the increased benefits and costs associated $ith
the campaign:
Increase in profit \266,666 Increase in sales O6.#6"
less: incremental campaign costs \1 million" Ji!en
less: increase in commission to Stefan \166,666" *s calculated in part XaY
9et decrease \366,666"
1?3)
&hus, the sales campaign is not profitable from the firms !ie$point , accordingly, the firm
$ould prefer that Stefan not undertake the sales campaign.
c. >e indeed see that there is a di!ergence of interest bet$een Stefan and his parent company.
&his conflict stems from t$o sources. 7irst, Stefan is not held accountable for costs ,
Stefans current compensation arrangement re$ards him strictly for increasing re!enues ,
thus, Stefan XtheoreticallyY $ould undertake any action that increased re!enues regardless of
the cost to the parent company. 7or e(ample, Stefan $ould ha!e an incenti!e to choose an
option that increased sales by \1 million e!en if it increased o!erall cost by \2 million.
1learly, there is incenti!e misalignment and, to rectify this problem, the parent company
should hold Stefan accountable for both re!enue and costs.
Second, Stefan has clear incenti!es to manage sales across periods gi!en the structure of his
contract , i.e., the higher rate on sales o!er \26 million and the lo$er rate on sales under \16
million. &he company likely is using this non?linear contract in a belief that it moti!ates
Stefan to $ork hard. Such contracts, though, may also engender gamesmanship and the
company might $ish to consider alternati!e contracts, such as a linear specification.
1.-#.
a. &he follo$ing table pro!ides some key decisions, o!er the life of the machine, corresponding
to the four stages of the planning and control cycle.
S$a& D&$ai5
.lan &he decision of $hether to buy the ne$ press or not is part of this
stage. &he act of committing resources, be it money, time or space, is a
critical piece of this stage. 8ther decisions might include choosing the
products that $ill be produced $ith the ne$ press and the prices at
$hich these products $ill be sold.
Implement Implementation $ould include decisions about $hen and $here to
install the press and ho$ best to schedule production of the !arious
products. &his stage also includes control aspects, such as selecting
performance targets for the ne$ press both 'uantity and 'uality" and
ho$ best to moti!ate press operators to achie!e these performance
targets.
3!aluate &his stage $ould include measuring the 'uality and 'uantity of the
output and comparing it to the targets established in the
implementation stage. Managers at @ulcan $ould seek to understand
the reasons underlying significant de!iations bet$een planned and
actual results. Managers $ould e!aluate numerous other results, such
as repair statistics and operating costs.
4e!ise @ulcans management $ill continually re!ise their beliefs about the
$isdom of their choice as they gain e(perience using the press.
1?3-
3!entually, this updated information $ill influence the type of press
they buy ne(t, and might $ell influence $hen they buy the ne(t
machine. 7or e(ample, they might decide to scrap the machine in t$o
years if it breaks do$n more often than is e(pected.
b. *s $e see, $e usually begin $ith a plan that is based on a set of assumptions , in this case,
the costs and benefits of replacing the current press $ith a ne$ press. &hese assumptions are
our beliefs about the unkno$n future. >e then implement our choices and, as time passes, $e
$ill gather more information about the actual costs and benefits of the ne$ press. 8!er a
period, $e $ill accumulate enough information to re!ise our original set of assumptions,
$hich $ill influence our ne(t purchase.
&here are many smaller decisions $ithin this o!erall cycle. In many instances, the broad loop
relating to a decision contains smaller loops $ithin it. 7or e(ample, $e can think of the
schedule for any gi!en day as a decision , this has its o$n loop $here $e commit machine
time and e(ecute the plan. >e then figure out $hether the schedule indeed $orked as planned
and the reasons for any de!iations. &his information feeds into the ne(t days schedule. &he
o!erall efficiency, the outcome of numerous scheduling decisions, then becomes part of the
e!aluation stage of the larger cycle. &he fundamental point is that e!ery decision has a
natural cycle to it.
1.-).
Bre$s first statement reflects some ignorance about ho$ to make effecti!e decisions. *ll
decisions concern the future. &hus, most decisions include some uncertainty about future
costs and benefits. 3!en $hat seems to be a simple decision, such as $hether to $atch a
mo!ie a second tie, contains uncertainty because $e do not kno$ ho$ good the mo!ie $ill
be the second time around. Some mo!ies age $ell $hile others do not. &he point is that $e
make decisions $ith some e(pectations. *s the decision unfolds, $e obtain actual results and
re!ise our e(pectations. &his is the planning?control cycle. &his cycle does not mean that
people must regret or rethink their decisions. It =ust means that $e constantly e!aluate $here
$e are relati!e to our e(pectations and ad=ust our plans accordingly. &his is true e!en $ith
the most detailed plans]often, a $ar plan is discarded $ithin a fe$ hours of starting
operations because the enemy does not al$ays do $hat you e(pectI
Bre$s second comment is !alid. 7e$ decisions cleanly follo$ the #?stage .I34 process. *
comple( decision e.g., $ho to start, $hich machine to buy" usually contains many smaller
decisions. >e can legitimately construct a .I34 process for these smaller decisions as $ell.
Ho$e!er, this ability does not remo!e our need to think about the larger decision as a .I34
process. &he cycle is a $ay of sho$ing that e!ery decision follo$s a common template.
1.--.
&he follo$ing are among the many items that &om and ;ynda might consider:
1. Increase in number of members. &his non?financial item relates to a benefit, increased
re!enues. &he correct benchmark for the item is the number of members if yoga $ere not
1?30
offered. &he number has to be sub=ecti!ely estimated. 3(amining past data on classes offered
pre!iously and the resulting membership might pro!e helpful in forming this estimate.
2. 7ee per member. &his financial item relates to a benefit. It is easily and ob=ecti!ely
measured from the firms accounting systems.
3. Increase in cost of supplies and other member?related costs. &his financial item relates to a
cost. :sing data from Hercules managerial accounting system, &om and ;ynda can
reasonably estimate this cost. Ho$e!er, there is ine!itably some sub=ecti!e element , e.g., it
is no clear $hether the gym $ill ha!e data on the !ariable costs connected $ith a yoga class
e.g., number of mats to be replaced each month".
#. Increase in instructor salaries and ad!ertising. &his financial item relates to a cost. &his
item may ha!e to be estimated based on contract negotiations $ith the yoga instructor. Some
amount of this item may also be discretionary e.g., ad!ertising".
). Image of gym. &his item relates to a long?term benefit. 8ffering yoga must fit $ith
Hercules o!erall KimageL and Kbrand.L 7or e(ample, yoga might not be the best choice if
Hercules primarily catered to men interested in $eight lifting and strength training.
1.-0.
&he follo$ing are among the many items that you might consider:
1. Bemand for item. &his non?financial item relates to a benefit, increased re!enues. &he
number has to be estimated using some ob=ecti!e data and some sub=ecti!ity. 3(amining past
data on similar products and market research pro!ide 'uantitati!e input that is sub=ecti!ely
con!erted to an estimated demand.
2. .rice for item. &his financial item relates to a benefit. It is a choice !ariable. Ho$e!er,
notice that this choice affects demand and therefore costs".
3. 1osts. &his financial item relates to a cost. <ou need to estimate the cost of making and
selling the item. 1osts $ould include items such as materials, labor, and commissions, as
$ell as the $ear and tear on e'uipment and $arehouses.
#. 1apacity. &his non?financial item relates to both benefits and costs. &his item influences
the best price. * setting $ith limited capacity might push you to$ard premium pricing $hile
e(cess capacity might enhance the attracti!eness of getting !olume $ith lo$ prices.
). 3ffect on other products. Introducing this product might ha!e both planned and unplanned
effects on the demands for the firms other products. &he resulting profit impact $hich can
be a benefit or a cost" often is a crucial consideration in product launch decisions.
MINI?CASES
1?32
1.-2.
a. &o understand .rofessor Ts moti!ation, consider $hat happens if fe$er than 32 students
sho$ up and $hat happens if more than 32 students sho$ up. >ith too fe$ students, the
e(periment must be cancelled. In addition to delaying his research, .rofessor T no$ has the
problem of inducing the ne(t set of students to sho$ up. .rofessor T $ill incur substantial
costs in time and effort to reschedule the e(periment and recruit ne$ students. 8n the other
hand, consider $hat happens if too many students sho$ up. In this case, .rofessor T has to
pay the sho$?up fee to the e(cess students.
.rofessor Ts choice of the sho$ up fee amount tries to balance these t$o costs and minimi+e
their total. &o see this, consider $hat $ould happen if he offers a sho$?up fee of O)66 and
in!ites 32 students. 9ot many undergraduate students $ill pass up a chance to make O)66 for
sure. If .rofessor T in!ites 32 students, then he can be fully confident that all 32 $ill sho$
up. &his strategy, ho$e!er, implies that he $ill ha!e to pay O1-,666 G O)66 per student P 32
students" as a sho$?up fee. 9o$ suppose .rofessor T offers no sho$ up fee and still in!ites
only 32 students. &hen, a student may or may not sho$ up , &he student only gi!es up the
chance to spend an hour to make O26 or so. %ut, if less than 32 students sho$ up, the
e(periment must be cancelled and re?scheduled. .rofessor Ts cost of doing so may be, say,
O#66 or so. If there is a 56D chance that fe$er than 32 students sho$ up, then .rofessor Ts
e(pected cost is O#66 P 6.5 G O3-6.
.rofessor T can reduce his e(pected cost by reducing the probability of ha!ing fe$er than 32
students sho$ up. He can do this by increasing the number of students in!ited still by
keeping a O6 sho$?up fee". Ho$e!er, if he increases the number of students in!ited, $ord
$ill soon get out that some if not many" of the students $ho sho$ up $ill go home $ith
nothing for their trouble. .rofessor T may then ha!e difficulty recruiting students for future
e(periments. *s argued earlier, a sho$?up fee also reduces the probability of ha!ing fe$er
than 32 students sho$ up but is costly to .rofessor T. &he O) fee is a compromise bet$een
in!iting many students and building up a reputation for $asting students time and incurring
the cost of the sho$?up fee.
9ote: &his problem is useful in highlighting ho$ uncertainty shapes our decisions. 4eali+ed
e!ents lead to actual costs and benefits. Ho$e!er, as $e do not kno$ the future, $e rely on
e(pectations to compute the !alue and opportunity cost of decision options e.g., ^ of
students to in!ite". Indeed, $e could characteri+e many decisions as finding the best balance
bet$een the costs and benefits of alternate future possibilities. 1apacity choice is a salient
business e(ample that balances the costs of buying too much capacity !ersus the costs of
buying too little.
b. &o assess opportunity cost, consider the students options. &he student could sho$ up or not
sho$ up. &he opportunity cost of sho$ing up is the !alue of not sho$ing up and doing other
things e.g., $atching &@, hanging out $ith friends, studying". >e do not ha!e a good !alue
for this measure. Ho$e!er, if a student does sho$ up, then the student earns O) for sure. >ith
a 16D probability, the student $ill be done. SChe can then spend the freed?up time as sChe
$ishes. >ith 56D probability, sChe can earn O26 o!er the ne(t hour. >e can combine the t$o
possible outcomes to get an e(pected !alue associated $ith sho$ing up. &his e(pected !alue
1?35
must e(ceed the students sub=ecti!e !alue of not sho$ing up and doing other things. It is not
possible to get a 'uantitati!e measure of the opportunity cost of sho$ing up.
9ote: &he opportunity cost is lo$er than the e(pected earnings of O23 G X.56 P O26Y F O)"
for the student $ho does sho$ up, and is likely higher than O23 for the student $ho does not
sho$ up. It is not possible, though, to get a more precise measure of the opportunity cost.
c. Making the students earnings !ary is a mechanism to combat the incongruence in goals
bet$een .rofessor T and the students. .rofessor T $ould like the students to take the
decision task seriously so that he can get good 'uality data to study. &he students, on the
other hand, $ould like to e(ert the least cogniti!e effort possible, all else being e'ual. >ith a
flat $age, the student has no incenti!e to $ork at the problem and make good decisions. &his
lack of attention degrades data 'uality and erodes the !alue of .rofessor Ts study. ;inking
pay to the 'uality of decisions ho$e!er measured" pro!ides incenti!es to make good
decisions. &he student no$ has to tradeoff the cogniti!e effort $ith the e(pected increase in
hisCher compensation. .rofessor T $ill likely structure the pay scheme in a $ay that students
find it beneficial to $ork hard for that hour.
9ote: 8ne can formally analy+e the students decision task as $ell. 7or simplicity, restrict the
options to $orking hard and not $orking hard. &he decision to $ork hard trades off the cost
of effort $ith the e(pected increase in take?home pay.
1.-5.
a. >hat does Br. 1le!eland !alueQ &he problem suggests three factors: 1" her income, 2"
pro!iding 'uality medical care to her patients, and 3" making her ser!ices a!ailable to all.
*ll three components are important to her and shape her goals.
Br. 1le!elands current situation seems to suggest a tradeoff among these factors. &he
insurance companies allo$ her to reach out to many people but potentially compromise
'uality. >e note that there is !igorous debate regarding $hether the restrictions imposed by
insurance companies and HM8s compromise 'uality. &he problem indicates that Br.
1le!eland percei!es a compromise/ therefore, $e assume that 'uality $ould increase if Br.
1le!eland $ere to s$itch to the patient pays billed charges approach". *dditionally, it is
unclear ho$ much Br. 1le!elands income $ill be affected by her alternati!es.
&he presence of a tradeoff among the factors that Br. 1le!eland !alues suggests that her
relati!e preferences among these factors $ill play an important role. &hat is, Br. 1le!eland
$ill ha!e to decide $hich factor she !alues most , income, 'uality care, andCor making her
ser!ices a!ailable to all. &he choice is not at all clear cut.
b. &he follo$ing tables pro!ide the re'uired computations:
Item
HM8s and
Insurance .lans
.atient .ays
1harges *pproach
&ime per patient a!erage" 1) minutes _ hour
.atients per hour # 2
1?#6
9umber of hours in day 2 2
.atients per day 32 1-
9umber of days $orked 22) 22)
8ffice !isits per year 0,266 3,-66
4e!enue per patient O#6 O0)
Ann1a5 R&6&n1&' *=EE+,,, *=;,+,,,
7rom a purely monetary perspecti!e, the current approach appears to be more profitable than
s$itching to the patient pays billed charges approach. Ho$e!er, the abo!e comparison
ignores any cost effects. It is possible that costs $ould decrease under a Kpatient pays
chargesL approach. 7irst, Br. 1le!eland $ould be hal!ing the number of patients seen. &his
reduction in !olume could lead to a reduction in the demand for nursing staff as $ell as a
reduction in ancillary help such as receptionists and record clerks. Second, there $ill be
fe$er hassles connected $ith follo$ing up $ith insurance firms, reducing the demand for
accounts clerks.
&he re!enue comparison also lea!es out some benefits. 8ften, clinics conduct many routine
tests such as urinalysis. >ith reasonable assumptions about patient mi(, the re!enue from
these tests depends on the number of patients seen. &his re!enue $ould decrease under the
proposed plan as $ell.
8!erall, $e do not ha!e enough information to estimate fully the monetary impact on Br.
1le!elands practice from s$itching plans. &his is the topic of future chapters."
c. <oals* *s discussed in part XaY, at least three factors impact her goals: 1" income, 2" 'uality
of care pro!ided, and 3" reach of ser!ice. It is clear that Br. 1le!eland !alues all three
components. Her preferences $ill affect the indi!idual $eightings. @ariations in preferences
can lead to differing choices in seemingly similar settings. 7or e(ample, it is possible that
$hile Br. 1le!eland chooses the patient pays all approach attaching relati!ely lo$ $eight to
reach and money", another physician may choose to stay $ith the HM8s and insurance firms
attaching relati!ely lo$ $eight to 'uality of care but higher $eights to reach and to
monetary factors."
=ptions* &he opportunity set consists of t$o options. Br. 1le!elands first option is to stay
$ith her current practice of contracting $ith HM8s and insurance plans. Br. 1le!elands
second option is to go $ith the patient pays all approach.
&echnically, one can think of more options. 7or e(ample, Br. 1le!eland can 'uit the practice
of medicine altogether. *lternati!ely, she can de?list from some plans and not others. It is
likely, ho$e!er, that Br. 1le!eland $ould eliminate such options because the aforementioned
t$o options appear to dominate these hybrids. Becision makers often simplify the
opportunity set to a fe$ choices, moti!ated in part by cogniti!e considerations.
#osts - 'enefits* *s listed earlier, there are numerous costs and benefits to be considered:
1?#1
Impact on income. &he t$o plans $ill yield different incomes. 8ne is a lo$?price high
!olume plan $hile the other is a high price, lo$ !olume plan. In addition, the !olume
differences may affect o!erall costs as $ell.
Impact on 'uality. &he Kpatient pays billed chargesL approach potentially at least in Br.
1le!elands mind" allo$s her to pro!ide superior medical care. &his is an important
factor to a committed physician.
Impact on reach. Br. 1le!eland also belie!es that good 'uality medical care should be
a!ailable to all. She can reach out to the under?pri!ileged and uninsured by, for e(ample,
pro!iding free care three days in a $eek. Ho$e!er, doing so $ould reduce her income.
She seems to ha!e struck a compromise by contracting $ith many HM8s and insurance
plans this still lea!es out the uninsured". Joing to a patient pays charges approach
$ould further reduce her reach. 7e$ among us can pay the balance not co!ered by the
insurance payment $e still ha!e to pay the insurance premium". &he proposed approach
is therefore likely to change her patient profile to$ard the more $ell to do. &his shift is
in direct contrast to one of Br. 1le!elands core beliefs, and is the cru( of the dilemma.
+aking a choice* &he final step is to pick the option $ith the highest !alue , the option that
gi!es Br. 1le!eland the best KbalanceL bet$een income, 'uality and reach.
d. &he opportunity cost of this decision is the !alue obtained from the ne(t best use of that time.
&he problem states that Br. 1le!eland e(pects to be fully occupied e!en if she s$itches to the
patient pays billed charges approach. &hus, if Br. 1le!eland de!otes three hours to indigent
care, then she gi!es up the chance to see paying patients. >e are assuming that she is still
$orking for 2 hours per day. &he follo$ing paragraph rela(es this assumption." &hat is, she
$ill see - fe$er patients during a $eek. *t the rate of O0) per office !isit, this translates to
O#)6 per $eek.
>hat happens if Br. 1le!eland does indigent care outside her regular office hours 2 hours
per day", such as during the early morning and late e!ening hoursQ Specifically, assume that
she keeps the clinic open from ) .M to 2 .M on >ednesday e!enings, de!oting the time
only to indigent care. In this case, Br. 1le!eland is gi!ing up leisure time. She could be
pursuing other acti!ities family time, reading, hobbies" during this time. Spending the time
on indigent care reduces the time a!ailable for these other acti!ities. &he opportunity cost is
then the !alue of these other acti!ities. &he !alue of regular patients not seen does not apply
here because there $ould be no reduction in the number of paying" patients seen.
e. If she de!otes only 2) minutes per patient, Br. 1le!eland can see 15 patients per day, or 15 P
22) G #,20) patients per year. &his !olume yields re!enues of O326,-2) #,20) P O0)" per
year, a significant increase o!er the pro=ected re!enues of O206,666.
&he key tradeoff here is the potential reduction in 'uality 2) minutes !ersus 36 minutes per
a!erage !isit" $ith the increase in income patient reach also is affected". &he best decision
from Br. 1le!elands perspecti!e is unclear. &his change goes against one of her ob=ecti!es of
pro!iding 'uality care. Her =udgment about the 'uality loss due to the lo$er time spent $ith
each patient is crucial as she assesses her options. &he potential loss in 'uality along $ith any
associated loss in reputation is a long?term effect. It is likely that only one in many patients
1?#2
feels a significant decline in 'uality because of the lo$er time commitment. Ho$e!er, these
instances build up o!er time and lead to the lo$er o!erall perception of 'uality. Jood
managers consider both immediate and distant effects in their decision making, e!en if they
cannot measure $ell many of the long?term effects.
1.06.
a. &he Birectors ha!e fi!e options:
1. Bo not fund any pro=ect , that is, add the entire O)6,666 in remaining grant money to
the 7oundations endo$ment.
2. 7und pro=ect * alone.
3. 7und pro=ect % alone, and add the remaining O32,666 to the 7oundations endo$ment.
#. 7und pro=ect 1 alone, and add the remaining O22,666 to the 7oundations endo$ment.
). 7und pro=ects % and 1, and add the remaining O16,666 to the 7oundations
endo$ment.
>ith the gi!en budget, it is not possible to fund pro=ect * and some other pro=ect. &his
constraint remo!es the choice of funding .ro=ects * and % or .ro=ects * and 1" from the
option set.
In reality, pro=ects can and often are" funded at less than re'uested le!els. &his additional
fle(ibility e(pands the number of options. 7or instance, the fle(ibility permits the option of
funding .ro=ect * at O3),666 and .ro=ect % at O1),666.
b. If pro=ect * is funded, then the other t$o pro=ects cannot be funded. &he opportunity cost
depends crucially on $hether the Birectors belie!e .ro=ect % andCor .ro=ect 1 $ill generate
more !alue than the amount funded.
If both .ro=ects % and 1 are percei!ed as !aluable i.e., the Birectors belie!e each pro=ect
$ill generate more !alue than the amount of funding re'uested" then the opportunity cost is
the lost benefit from not funding pro=ects % and 1 plus the !alue of adding O16,666 to the
endo$ment.
Suppose pro=ect % is deemed to be !aluable $hereas pro=ect 1 is not. &hen, the opportunity
cost is the lost benefit from funding pro=ect % plus the !alue of adding O32,666 to the
endo$ment. &he opportunity cost is the benefit deri!ed from option 3 in part XaY. *nalogous
arguments apply if pro=ect 1 is deemed $orthy but pro=ect % is not."
Suppose neither pro=ect % nor pro=ect 1 is deemed to be !aluable. &hen, the opportunity cost
is the cost of holding O)6,666 in reser!e to fund future, yet to be determined, pro=ects. &his
opportunity cost is the !alue attached to option 1 in part XaY.
1?#3
c. &he approach has benefits and costs. &he benefit is that it makes the decision problem
manageable. 4ather than consider combinations of pro=ects e.g., pro=ects % and 1, pro=ect 1
by itself, pro=ect % by itself, and so on", the Birectors need e!aluate only one pro=ect at any
gi!en time. &his reduces their cogniti!e load significantly.
&he cost is that $e may poorly measure opportunity cost. Specifically, because .ro=ect 1 is
e(amined in isolation $ithout reference to other pro=ects", the approach assumes that the
opportunity cost of funding pro=ect 1 is O22,666. It does not consider the other uses for the
O22,666 e.g., that it may be used to fund .ro=ects * or %". In particular, assume that the
directors !alue pro=ect 1 at O2),666. &hen, pro=ect 1 $ill be funded. Ho$e!er, this decision
implies that pro=ect * $ill be unfunded, regardless of its merit. 7or e(ample, pro=ect * may
be !alued at O1)6,666 , clearly, a better return for the foundations money relati!e to funding
pro=ect 1. %ut, the se'uential decision rule leads to a poor decision.
&he takea$ay point is that the best decision rule should consider all of the options.
4estricting the number of options considered, as the se'uential rule does, could therefore
result in bad decisions.
9ote: * se'uential decision rule is sub?optimal in this setting because of limited resources.
Suppose the foundation had an unlimited budget. &hen, it does not matter $hether the
pro=ects are e!aluated se'uentially or simultaneously. &he opportunity cost of each pro=ect in
this case is the cost of the funds e(pended, and not the !alue of a pro=ect that the selected
pro=ect displaces.
d. %ased on the Birectors assessments, .ro=ects % and 1 should not be funded because the
!alue is less than the re'uested amount". &he decision boils do$n to $hether .ro=ect *
should be funded. &he opportunity cost of funding .ro=ect * is the best other use for the
O)6,666 i.e., the !alue of option 1". &his opportunity cost is likely greater than O)6,666.
4etaining the money allo$s the directors the fle(ibility of funding a future but $ith details
currently unkno$n" pro=ect. &he !alue of this should be included in the opportunity cost of
funding .ro=ect *. *ttaching a dollar figure to the !alue of the fle(ibility, ho$e!er, is a
difficult task. &he Birectors ha!e to use their =udgment to figure out the chance that a
superior pro=ect $ould materiali+e if .ro=ect * $ere not funded.
>e con=ecture that a net !alue of O)66 G O)6,)66 , O)6,666" is sufficiently small that the
Birectors $ill not fund .ro=ect * as $ell.
1.01.
a. 7or simplicity, let us assume that managements goals are the same as organi+ational goals.
Management then has at least t$o broad goals. &he first goal is to make profit for the
shareholders or at least breake!en if the o$ner is a not?for?profit entity. &he second goal is to
pro!ide 'uality medical care to as $ide a population base as possible.
Incenti!es from a profit ma(imi+ing perspecti!e are clear. .rofit is a percent of cost, and
management therefore $ill not take any effort to reduce cost. Indeed, gi!en its other goal of
1?##
pro!iding 'uality healthcare, costs are likely to e(plode. *nd, they didI" .atients recei!ed
the highest 'uality medical care a!ailable and no e(pense $as spared.
3(ecuting this strategy re'uired !ery little in the form of detailed cost information. Ho$e!er,
$e note the incenti!es to Sgame the system. 7or instance, as different payors had different
markups on actual cost, hospital accountants spent time in de!ising allocation schemes that
ma(imi+ed the hospitals reimbursement. Management accounting took a back seat in the
hospital administrators mind as their focus $as to get the latest and best in medical care.
9ote: >e note that the patients benefited greatly under this system. Ho$e!er, society as a
$hole suffered because Ktoo muchL healthcare $as pro!ided. &he ..S system gre$ out of a
desire to rein in the rampant rise in healthcare costs. :nfortunately, healthcare costs ha!e
continued to outstrip inflation e!en into the 21
st
century.
>e also note that this discussion is an e(tremely brief o!er!ie$ of the comple( changes that
ha!e s$ept the healthcare system in the :S*. 9umerous books and =ournal articles in health
economics discuss these changes e(tensi!ely.
b. Managements goals do not change because the reimbursement system changed. Ho$e!er,
the change does affect the actions management considers to meet its goals. 7or instance, cost
control becomes paramount under the ..S system. It is common for hospital administrators
today to get detailed cost information on indi!idual procedures and tests. &hey also set prices
and negotiate for B4J rate ad=ustments based on detailed estimates of the cost of !arious
procedures. .hysicians and other medical staff are assessed on their efficiency and utili+ation
rates. &he change in the reimbursement system has triggered a ma=or shift from 'uality
medicine at any cost to affordable medicine.
9ote: &he rise of Health Maintenance 8rgani+ations HM8s" creates another set of
incenti!es. HM8s, $hich may also operate hospitals, collect a fi(ed fee from each member
in return for pro!iding all needed healthcare. :nder an HM8 scheme, the HM8 makes profit
$hen its members get sick at lo$er than e(pected rates. &hus, HM8s and affiliated hospitals
encourage pre!enti!e measures much more than during earlier times. 9otice that a hospital
under a traditional ..S system has no incenti!e to ad!ocate pre!enti!e medicine.
c. &he change in the regime affects the information pro!ided to management by changing the
nature of the decisions they face. &he information during the cost?plus regime likely
pertained to the efficacy of the medical care pro!ided, more so than its efficiency. 1ost
information is accordingly de?emphasi+ed as there is no need to understand and manage cost
at the micro le!el. &he ..S system shifts the focus to cost control, meaning that both
efficiency and effecti!eness attain e'ual footing. 1ost information, detailed do$n to the
indi!idual department, B4J and procedure le!el, no$ takes center stage.
1?#)

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CHAPTER 1

ACCOUNTING: INFORMATION FOR DECISION MAKING

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