Top 9 Cost Concepts used in Decision Making

The following points highlight the top nine cost concepts used in decision making. The cost concepts are: 1. Marginal Cost 2. Out of Pocket Costs 3. Differential Costs 4. Sunk Costs 5. Opportunity Cost 6. Imputed Costs 7. Replacement Cost 8. Avoidable Cost and Unavoidable Cost 9. Relevant Cost and Irrelevant Cost.

Decision Making: Cost Concept # 1. Marginal Cost:

Marginal cost is the total of variable costs, i.e., prime cost plus variable overheads. It is based on the distinction between fixed and variable costs. Fixed costs are ignored and only variable costs are taken into consideration for determining the cost of products and value of work-in-progress and finished goods.

Decision Making: Cost Concept # 2. Out of Pocket Costs:

This is that portion of the costs which involves payment to outsiders, i.e., gives rise to cash expenditure as opposed to such costs as depreciation, which do not involve any cash expenditure. Such costs are relevant for price fixation during recession or when make or buy decision is to be made.

Decision Making: Cost Concept # 3. Differential Costs:

The change in costs due to change in the level of activity or pattern or technology or process or method of production is known as differential costs. If any change is proposed in the existing level or in the existing methods of production, the increase or decrease in total cost as a result of this decision is known as differential cost.

If the change increases the cost, it will be called incremental cost. If there is decrease in cost resulting from decrease in output, the difference is known as decremental cost.

Decision Making: Cost Concept # 4. Sunk Costs:

A sunk cost is an irrecoverable cost and is caused by complete abandonment of a plant. It is the written down value of the abandoned plant less its salvage value. Such costs are historical which are incurred in the past and are not relevant for decision-making and are not affected by increase or decrease in volume. Thus, expenditure which has taken place and is irrecoverable in a situation is treated as sunk cost.

For taking managerial decisions with future implications, a sunk cost is an irrelevant cost. If a decision has to be made for replacing the existing plant, the book value of the plant less salvage value (if any) will be a sunk cost and will be irrelevant cost for taking decision of the replacement of the existing plant.

Sunk costs are not affected by increase or decrease of volume. Examples of such costs include depreciated fixed assets, development cost already incurred etc.

Decision Making: Cost Concept # 5. Opportunity Cost:

It is the maximum possible alternative earning that might have been earned if the productive capacity or services had been put to some alternative use. In simple words, it is the advantage, in measurable terms, which has been foregone due to not using the facility in the manner originally planned.

It refers to the value of sacrifice made or benefit of opportunity foregone in accepting an alternative course of action. For example, if an owned building is proposed to be used for a project, the likely rent of the building is the opportunity cost which should be taken into consideration while evaluating the profitability of the project.

Some other examples of opportunity cost are as given below:

(i) The opportunity cost of funds invested in a business is the interest that could have been earned by investing the funds employed in the business somewhere else as in the bank as a fixed deposit.

(ii) The opportunity cost of using machine to produce a specific product is the earning forgone that would have been possible if the machine was used to produce some other product.

(iii) The opportunity cost of obsolete material lying in the firm and used for a specific job is the amount which can be realized by selling the obsolete material as scrap.

Thus, opportunity cost is the measure of the benefit of opportunity foregone.

Illustration 1:

Mr. Das has retired and plans to open a store selling photographic supplies and art materials. He has made a down payment on a lease for a store for one year. The down payment was Rs.1,500. An additional payment of Rs.3,000 must be made during the year. If the lease is cancelled by Mr. Das, the down payment of Rs.1,500 is forfeited.

Operating results for the year have been estimated as follows:

Mr. Das has made no provision for the cost of his own time, considering the business to be an extension of his hobby. A business friend offers him Rs 6,000 for the use of the store for the year.

Required:

(i) identify the sunk cost in this decisional situation. Also identify the opportunity cost.

(ii) What decision should Mr. Das make based upon his information given?

Solution:

(i) The sunk cost is the down payment of Rs.1,500 on the lease. This cost cannot be avoided by any future course of action. The opportunity cost is Rs.6,000 that a business friend has offered for the use of the store for the year.

(ii) Mr. Das should operate the store and by doing so will have an advantage of Rs.8,600 as shown below:

Mr. Das is retired and looks upon this activity as a hobby, no charge is made for his own time.

Illustration 2:

Modern Specialties Ltd. is considering the production of a new product line. This product line can be manufactured with the present equipment, and the only effect that this product line will have on manufacturing overhead is to increase the cost of supplies and indirect materials by Rs 18,000.

If this product line is not produced, it is estimated that another line can be manufactured and sold. The other time should contribute additional profit each year of Rs 12,000.

The new product line under consideration should produce the following results each year:

Required:

(i) Identify the sunk costs

(ii) Should Modern Specialties Ltd. produce new product line under consideration?

Show computations. Identify the opportunity cost.

Solution:

(i) All the manufacturing overhead costs with the exception of the supplies and indirect materials are sunk costs.

The sunk costs are listed below:

(ii) The line presently under consideration should be produced as it has an advantage over the other line as shown below:

The opportunity cost is the additional net income of Rs 12,000 that can be expected from another product line.

Illustration 3:

Three different product lines can be produced by Delhi Supply Company with the present equipment in one of the divisions. The annual depreciation of the equipment is Rs.8,000 and the annual cost of equipment operation is Rs.3,000. These costs will not be affected by the choice of the product lines.

Product A is expected to yield sales revenue of Rs.46,000 a year with increased cost of production amounting to Rs.28,000. Product B should yield sales revenue of Rs.34,000 a year with increased costs of Rs.11,000. Product C should yield sales revenue of Rs.39,000 with increased costs of Rs.24000.

Required:

(i) Which of the three product lines seem to offer the best profit potential based on information given? Show computations.

(ii) Identify the sunk costs

(iii) What is the opportunity cost of selecting only the best product line?

Solution:

(i) Product B has the best profit potential as shown below:

(ii) The sunk costs are the depreciation of Rs.8,000 and the annual cost of equipment operation of Rs.3,000.

(iii) The opportunity cost of selecting the best product line (Product B) is the sacrifice of the advantage to be derived from the next best product line (Product A).

Decision Making: Cost Concept # 6. Imputed Costs:

Notional costs or imputed costs are those costs which are notional in character and do not involve any cash outlay, e.g., notional rent charged on business premises owned by the proprietor, interest on capital for which no interest has been paid.

When alternative capital investment projects are being evaluated it is necessary to consider the imputed interest on capital before a decision is arrived as to which is the most profitable project.

The Chartered Institute of Management Accountants, London, defines notional cost as “the value of a benefit where no actual cost is incurred.” Even though such costs do not involve any cash outlay but are taken into consideration while making managerial decisions.

Examples of such costs are: notional rent charged on business premises owned by the proprietor, interest on capital for which no interest has been paid. When alternative capital projects are being evaluated it is necessary to consider the imputed interest on capital before a decision is arrived as to which is the most profitable project.

Decision Making: Cost Concept # 7. Replacement Cost:

It is the cost at which there could be purchase of an asset or material identical to that which is being replaced or revalued. It is the cost of replacement at current market price.

Decision Making: Cost Concept # 8. Avoidable Cost and Unavoidable Cost:

Avoidable costs are those which can be eliminated if a particular product or department, with which they are directly related, is discontinued. For example, salary of the clerks employed in a particular department can be eliminated, if the department is discontinued.

Unavoidable cost is that cost which will not be eliminated with the discontinuation of a product or department. For example, salary of factory manager or factory rent cannot be eliminated even if a product is eliminated.

Decision Making: Cost Concept # 9. Relevant Cost and Irrelevant Cost:

A cost that is relevant to a decision is called relevant cost. Past costs are not generally relevant costs because they are sunk costs or costs already incurred. Thus, the book value of an asset or depreciation charged in accounts in respect of an asset is not relevant cost. On the other hand, the fall in the resale value of an asset as a result of using it, as also the running expenses incurred to make use of the asset are relevant costs.

Similarly in the case of materials regularly in use, the relevant cost is its replacement cost and not the book value or the realizable value. For material that is not in regular use; the realizable value is the relevant cost. If it is possible to use this non-moving material in place of another material, the value of the latter for which substitution is made is the relevant cost of the non-moving material.

The relevant cost of any scarce resource (e.g., labour) is the direct cost of using the resource plus any contribution earned by that resource on the most profitable alternative use of the resource. In this sense the relevant cost is the opportunity cost. Generally relevant costs are the expected future costs relevant to a decision and they differ among different alternatives.