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.

Differential Cost and Differential Revenue:

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.

Retailer Direct Sale

Differential Costs
Description Distribution Distribution
and Revenues
(Present) (Proposed)

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

======= ======= =======

*F = Fixed
**V = Variable

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.
Opportunity Cost:

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.

Sunk Cost:

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.