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Cost Concepts For Decision Making 2

The document discusses various cost concepts that are important for decision making, including marginal cost, which is the change in total cost from producing an additional unit of output, and opportunity cost, which refers to the value of the best alternative option that is given up in making a decision. It also defines sunk costs as past costs that cannot be recovered and should not influence future decisions, differential costs as the change in costs from a change in activity or production method, and out of pocket costs as expenses that require an actual cash payment.

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Coreen Elizalde
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249 views

Cost Concepts For Decision Making 2

The document discusses various cost concepts that are important for decision making, including marginal cost, which is the change in total cost from producing an additional unit of output, and opportunity cost, which refers to the value of the best alternative option that is given up in making a decision. It also defines sunk costs as past costs that cannot be recovered and should not influence future decisions, differential costs as the change in costs from a change in activity or production method, and out of pocket costs as expenses that require an actual cash payment.

Uploaded by

Coreen Elizalde
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Cost

Concepts
for Decision
Making
What is Cost
Concept ?
It refers to the amount of payment
made to acquire any goods and services.
In a simpler way, the concept of cost is a
financial valuation of resources,
materials, risks, time and utilities
consumed to purchase goods and
services.
MARGINAL COST
The marginal cost is the change
in the total cost that arises when
the quantity produced is
incremented, the cost of
producing additional quantity.[1]
In some contexts, it refers to an
increment of one unit of output,
and in others it refers to the rate
of change of total cost as output
is increased by an infinitesimal
amount.
EXAMPLE 1
EXAMPLE 2
EXERCISE 1
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.

Example:
In medicine, the amount of money a patient pays
for medical expenses that are not covered by a
health insurance plan
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.

Differential cost refers to the difference between the cost of two alternative
decisions.
Example 1
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.
Imagine a company that decides to build a new factory. They already did their analyses and
determined that the future benefit they will receive from the factory will outweigh the cost of
construction. They pay for the factory up front and expect to earn a certain level of cash flows from
the factory’s production each year. But after a few years, the factory is underperforming and cash
flows are less than expected.
A decision has to be made: should the factory be shut down or not? At this point, the initial cost of the
factory is a sunk cost and cannot be recovered. The decision should only be based on the future cash
flows—or the future expected benefit—of the factory compared to the value of selling the factory
today, not the original cost of the factory.

-Feel free to leave the baseball game if it’s raining.


-Don’t go to the gym just because you have an annual membership.
-There's no need to clean your plate.
-Sometimes there is an emotional component to sunk costs.

Cost Concept # 5. It is the maximum possible alternative earning


Opportunity Cost: 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.
Example
Choosing public transportation to
travel to a particular destination by
foregoing the option of traveling in
one's own car is a good example of
opportunity cost, because you end
up saving money which needs to be
spent on fuel.

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