How do you compute a net economic impact?

Computing a net economic impact

Once relevant costs and benefits have been identified, it is possible to compute a net economic impact.

The net economic impact of a decision alternative is the net increase or decrease in Operating Income which may result from its implementation.

The net economic impact is sometimes easy to compute: it consists in subtracting differential costs from differential revenues. But in most cases it depends on changes in volumes, selling prices, unit variable costs and fixed costs. Therefore, as a general approach, I recommend building on the formulas of variance analysis with just a slight change in their interpretation: instead of computing variances between Actual and Budget, you compute impacts of choosing alternative A over alternative B. Here you can think of alternative A as indicating what you would have after (A) making the decision and alternative B as what you had before (B) making the decision:

\[ \begin{aligned} \text{+ Volume impact} & \rightarrow \color{purple}{(Q_{\color{red}A}-Q_{\color{blue}B})} && \times \quad (P_{\color{blue}B} - V_{c \color{blue}B}) \\ \text{+ Selling price impact} & \rightarrow \quad \quad Q_{\color{red}A} && \times \quad\color{purple}{(P_{\color{red}A}- P_{\color{blue}B})} \\ \\ \text{- Unit variable cost impact} & \rightarrow \quad \quad Q_{\color{red}A} && \times \quad \color{purple}{(V_{c \color{red}A}- V_{c \color{blue}B})} \\ \text{- Fixed cost impact} & \rightarrow && \quad \quad \color{purple}{(FC_{\color{red}A}-FC_{\color{blue}B})} \\ \text{_______________________} \\ \text{= Net economic impact} \end{aligned} \]

If the net impact is positive, this provides an economic argument in favor of alternative A against alternative B. Now, we will see later that this is only one argument among others. Moreover, if the estimated net economic impact is negative, it is possible to try to improve the alternative rather than reject it. This sends back to the formulation of the problem.

Solution. The volume goes from 1,500 to 1,700 (+200), the price from 7 to 6 (-1), the unit variable cost from 2.5 to 1.8 (-0.7), and the fixed costs increase by 250 euros. Therefore:

\[ \begin{aligned} \text{+ Volume impact} & \rightarrow + 200 \times (7-2.5) && = +900 \\ \text{+ Selling price impact} & \rightarrow +1,700 \times (6-7) && = -1,700 \\ \\ \text{- Unit variable cost impact} & \rightarrow - 1,700 \times (1.8-2.5) && = +1,190 \\ \text{- Fixed cost impact} & \rightarrow -250 && = -250 \\ \text{_______________________} & \text{_____________________} && \text{___________} \\ \text{= Net economic impact} & = +140 && = +140 \end{aligned} \]

Accounting for the uncertainty of economic impacts

All impacts are not equally likely to be realized. For instance, if a manager decides to stop selling and producing a product line, he is certain of losing the corresponding contribution margin. This impact is mechanical. He is also relatively certain to save on discretionary fixed costs which are direct to that product line. However, avoiding some direct committed fixed costs is usually more difficult and thus less likely, even when it is possible. For instance, it may necessitate contacting the owners of the equipment or buildings which are rented to cancel the leases. It may also imply dismissing employees, which is even more difficult as it is associated with important psychological costs. Finally, some benefits may only be earned by selling the owned equipment which is not used anymore, requiring the manager to look for and find a buyer.

In other words, some impacts are mechanical and thus certain; other impacts are easy to obtain through managerial actions and thus are likely but not certain; yet other impacts rely on a difficult managerial action, which makes them far less likely. Finally, some impacts suppose the contribution of an external agent, making them even more uncertain. It is possible to account for the uncertain realization of some impacts by weighting them by their probability, computing an expected net economic impact the way economists compute an expected utility.

Now, the expected net economic impact does not relate to anything real: a 50% percent chance of selling an equipment does not mean that the organization will get half of its market value. It has therefore a limited value beyond indicating what may require a special attention when implementing a decision. This is why other ways to account for uncertainty are often preferred: estimating indifference points and conducting sensitivity analyses. As we will see in the following sub-section, borrowing the formulaic approach of variance analysis greatly helps implementing these alternative ways to handle the fundamental uncertainty of the net economic impact.

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