Understand cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.
Costs are an important feature of many business decisions. In making decisions, it is essential to have a firm grasp of the concepts differential cost, opportunity cost, and sunk cost.
Differential Cost and Revenue
Decisions involve choosing between alternatives. In business decisions, each alternative will have costs and benefits that must be compared to the costs and benefits of the other available alternatives. A difference in costs between any two alternatives is known as a differential cost . A difference in revenues between any two alternatives is known as differential revenue .
A differential cost is also known as an incremental cost , although technically an incremental cost should refer only to an increase in cost from one alternative to another; decreases in cost should be referred to as decremental costs. Differential cost is a broader term, encompassing both cost increases (incremental costs) and cost decreases (decremental costs) between alternatives.
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 economist uses the terms marginal costand 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 product is called marginal cost. The economist’s marginal concept is basically the same as the accountant’s differential concept applied to a single unit of output.
Differential costs can be either fixed or variable. To illustrate, assume that Nature Way Cosmetics, Inc., is thinking about changing its marketing method from distribution through retailers to distribution by a network of neighborhood sales representatives. Present costs and revenues are compared to projected costs and revenues in the following table:
According to the above analysis, the differential revenue is $100,000 and the differential costs total $85,000, leaving a positive differential net operating income of $15,000 under the proposed marketing plan.
The decision of whether Nature Way Cosmetics should stay with the present retail distribution or switch to sales representatives could be made on the basis of the net operating incomes of the two alternatives. As we see in the above analysis, the net operating income under the present distribution method is $160,000, whereas the net operating income with sales representatives is estimated to be $175,000. Therefore, using sales representatives is preferred because it would result in $15,000 higher net operating income. Note that we would have arrived at exactly the same conclusion by simply focusing on the differential revenues, differential costs, and differential net operating income, which also show a $15,000 advantage for sales representatives.
In general, only the differences between alternatives are relevant in decisions. Those items that are the same under all alternatives and that are not affected by the decision can be ignored. For example, in the Nature Way Cosmetics example above, the “Other expenses” category, which is $60,000 under both alternatives, can be ignored because it has no effect on the decision. If it were removed from the calculations, the sales representatives would still be preferred by $15,000. This is an extremely important principle in management accounting that we will revisit in later chapters.
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 $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 the 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 a future store. Rather than invest the funds in land, the company could invest the funds in high-grade securities. The opportunity cost of buying the land is the investment income that could have been realized by purchasing the securities instead.
Example 3 Steve is employed by a company that pays him a salary of $38,000 per year. He is thinking about leaving the company and returning to school. Because returning to school would require that he give up his $38,000 salary, the forgone salary would be an opportunity cost of seeking further education.
Opportunity costs are not usually found in accounting records, but they are costs that must be explicitly considered in every decision a manager makes. Virtually every alternative involves an opportunity cost.
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Because sunk costs cannot be changed by any decision, they are not differential costs. And because only differential costs are relevant in a decision, sunk costs should always be ignored.
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 purchasing the machine may have been unwise, the $50,000 cost has already been incurred and cannot be undone. And it would be folly to continue making the obsolete product in a misguided attempt to “recover” the original cost of the machine. In short, the $50,000 originally paid for the machine is a sunk cost that should be ignored in current decisions.
Exhibit 2–13 summarizes the types of cost classifications that we discussed in this chapter. Refer to this exhibit to keep the big picture in mind, which is that different costs for different purposes is a critically important concept in management accounting. This chapter discussed four main cost classifications that managers can use for different purposes within organizations.
Summary of Cost Classifications
In this chapter, we have discussed ways in which managers classify costs. How the costs will be used—for preparing external reports, predicting cost behavior, assigning costs to cost objects, or decision making—will dictate how the costs are classified.
For external reporting purposes, costs are classified as either product costs or period costs. Product costs are assigned to inventories and are considered assets until the products are sold. At the point of sale, product costs become cost of goods sold on the income statement. In contrast, period costs are taken directly to the income statement as expenses in the period in which they are incurred.
For purposes of predicting how costs will react to changes in activity, costs are classified into three categories—variable, fixed, and mixed. Variable costs, in total, are strictly proportional to activity. The variable cost per unit is constant. Fixed costs, in total, remain the same as the activity level changes within the relevant range. The average fixed cost per unit decreases as the activity level increases. Mixed costs consist of variable and fixed elements and can be expressed in equation form as Y = a + bX, where X is the activity, Y is the cost, a is the fixed cost element, and b is the variable cost per unit of activity.
If the relation between cost and activity appears to be linear based on a scattergraph plot, then the variable and fixed components of a mixed cost can be estimated using the high-low method, which implicitly draws a straight line through the points of lowest activity and highest activity, or the least-squares regression method, which uses all of the data points to compute a regression line that minimizes the sum of the squares errors.
The traditional income statement format is used primarily for external reporting purposes. It organizes costs using product and period cost classifications. The contribution format income statement aids decision making because it organizes costs using variable and fixed cost classifications.
For purposes of assigning costs to cost objects such as products or departments, costs are classified as direct or indirect. Direct costs can be conveniently traced to cost objects. Indirect costs cannot be conveniently traced to cost objects.
For purposes of making decisions, the concepts of differential cost and revenue, opportunity cost, and sunk cost are vitally important. Differential costs and revenues are the costs and revenues that differ between alternatives. Opportunity cost is the benefit that is forgone when one alternative is selected over another. Sunk cost is a cost that occurred in the past and cannot be altered. Differential costs and opportunity costs should be carefully considered in decisions. Sunk costs are always irrelevant in decisions and should be ignored.