Cost Classification for Decision Making (Decision Making Costs):
Learning objective of this article:
- Define, explain, and give examples of cost
classifications used in making decisions: differential costs,
opportunity costs, and sunk costs.
Costs can be classified for decision making. Costs are important feature of many business decisions.
For the purpose of decision making, costs are usually classified as differential
cost, opportunity cost, and sunk cost. It is essential to have a firm
grasp of the concepts
differential cost & differential
revenue, opportunity cost, and
sunk cost.
Definition and Explanation of Differential Cost and Differential Revenue:
Decisions involve choosing between alternatives. In business, each
alternative will have certain costs and benefits that must be compared to the
costs and benefits of the other available alternatives. A difference in cost
between any two alternatives is known as differential cost. A difference in
revenue between any two alternatives is known as differential revenues.
Differential cost includes both cost increase (incremental cost) and cost
decrease (decremental cost). In general the difference (cost and revenue)
between alternatives are relevant in decision making. Those items that are the
same under all alternatives can be ignored.
The accountant's differential cost concept can be compared to the
economist's marginal cost concept. In speaking of changes in cost and revenue,
the economists employ the term marginal cost and marginal revenue. The revenue
that can be obtained from selling one more unit of product is called marginal
revenue, and the cost involved in producing one more unit of a product is called
marginal cost. The economists marginal cost is basically the same as the
accountant's differential concept applied to a single unit of out put.
Example:
Differential cost can be either
variable or
fixed. To illustrate assume that
a company is thinking about changing its marketing method from distribution
through retailers to distribution by door to door direct sale. Present cost and
revenues are compared to projected costs and revenues in the following table.
Description |
Retailer Distribution (Present) |
Direct Sale Distribution (Proposed) |
Differential Costs and Revenues |
Revenue (variable) |
$700,000
|
$800,000
|
$100,000
|
|
--------- |
--------- |
--------- |
Cost of goods sold (V) |
350,000 |
400,000 |
50,000 |
Advertising (V) |
80,000 |
45,000 |
(35000) |
Commissions (F)* |
-0- |
40,000 |
40,000 |
Warehouse depreciation (V)** |
50,000 |
80,000 |
30,000 |
Other Expenses (F) |
60,000 |
60,000 |
-0- |
|
---------- |
---------- |
---------- |
Total |
540,000 |
625,000 |
85,000 |
|
---------- |
---------- |
---------- |
Net Operating Income |
$160,000 |
$175,000 |
$15,000 |
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*F = Fixed
**V = Variable |
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According to the above analysis, the differential revenue is $100,000 and the
differential cost is $85,000,leaving a positive differential net operating
income of $15,000 under the proposed marketing plan. The net operating income
under the present distribution is $160,000, whereas the net operating income
under door to door direct selling is estimated to be $175,000. Therefore the
door to door direct distribution method is preferred, since it would result in
$15,000 higher net operating income. Note that we would have arrive at exactly
the same conclusion by simply focusing on the differential revenue, differential
cost, and differential net operating income, which also shows a net operating
advantage of $15,000 for the direct selling method. The company can ignore other
expenses of $60,000. Because it has no effect on the decision. If it were
removed from the calculation, the door to door selling method would still be
preferred by $15,000. This is an extremely important principle in management
accounting.
In Business:
Using Those Empty
Seats:
Many corporate jets fly with
only one or two executives on board. Priscilla Blum wondered why some of
the empty seats could not be used to fly cancer patients who specialized
treatment outside their home area. Flying on a regular commercial
airline can be an expensive and grueling experience for cancer patients.
Taking the initiative, she helped found the Corporate Angle Network, an
organization that arranges free flights on some 1,500 jets from over 500
companies. Since the jets fly anyway, filling a seat with cancer patient
does not involve any significant incremental cost for the companies that
donate the service. Since its founding in 1981, the Corporate Angel
Network has arranged over 14,000 free flights.
Source: Scott McCormack, "Waste not,"
Forbes, July 26, 1999, p. 118. |
Definition:
Opportunity cost is the potential benefit that is given up when one alternative
is selected over another. To illustrate this important concept, consider the
following examples:
Example 1:
Vicki has a part-time job that pays
her $200 per week while attending college. She would like to spend a week at the
beach during spring break, and her employer has agreed to give her the time off,
but without pay. The $200 in lost wages would be an opportunity cost of taking
week off to be at the beach.
Example 2:
Suppose that Neiman Marcus is
considering investing a large sum of money in land that may be a site for future
store. Rather than invest the funds in land, the company could invest the funds
in high-grade securities. If the land is acquired, the opportunity cost will be
the investment income that could have been realized if the securities had been
purchased instead.
Example 3:
You are employed in a company that pays you $30,000 per year. You
are thinking about leaving the company and returning to school. Since returning
to school would require that you give up $30,000 salary. The forgone salary
would be an opportunity cost of seeking further education.
Opportunity cost is not usually
entered in the accounting records of an organization, but it is a cost that must
be explicitly considered in every decision a manager makes. Virtually every
alternative has some opportunity cost attached to it.
Definition:
A sunk cost is a cost that has already been incurred and that cannot be changed
by any decision made now or in future.
Example:
Sunk costs cannot be changed by any decision. These are not
differential
costs and should be ignored in decision making. To illustrate a sunk cost,
assume that a company paid $50,000 several years ago for a special purpose
machine. The machine was used to make a product that is now obsolete and is no
longer being sold. Even though in hindsight the purchase of the machine may have
been unwise, no amount of regret can undo that decision. And it would be folly
to continue making the obsolete product to recover the original cost of the
machine. In short, the $50,000 originally paid for the machine has already been
incurred and cannot be
differential cost in any future decision. For this
reason, such costs are said to be sunk costs and should be ignored in decision
making.
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