| LEARNING OBJECTIVE 7 | Define and give examples of 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 RevenueDecisions 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 costA difference in cost between any two alternatives. Also see Incremental cost.. A difference in revenues between any two alternatives is known as differential revenueA difference in revenue between two alternatives.. A differential cost is also known as an incremental costAn increase in cost between two alternatives. Also see Differential 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. |  <![CDATA[<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/free/0073379352/568949/ipod.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (18.0K)</a>]]>
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The accountant’s differential cost concept can be compared to the economist’s marginal cost concept. When speaking of changes in cost and revenue, the economist uses the terms 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 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. | IN BUSINESS | The Cost of a Healthier Alternative | | | McDonald’s is under pressure from critics to address the health implications of its menu. In response, McDonald’s announced plans to switch from the partially hydrogenated vegetable oil that it had been using to fry foods to a new soybean oil that would cut trans-fat levels by 48%. After making the announcement, McDonald’s came to the realization that the unhealthy oil is much cheaper than the soybean oil and it lasts twice as long. What were the cost implications of this change? A typical McDonald’s restaurant uses 500 pounds of the relatively unhealthy oil per week at a cost of about $186. In contrast, the same restaurant would need to use 1,000 pounds of the new soybean oil per week at a cost of about $571. This is a differential cost of $385 per restaurant per week. This may seem like a small amount of money until the calculation is expanded to include 13,000 McDonald’s restaurants operating 52 weeks a year. Now, the total tab rises to about $260 million per year. Source: Matthew Boyle, “Can You Really Make Fast Food Healthy?” Fortune, August 9, 2004, pp. 134–139. |
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:  <![CDATA[<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/free/0073379352/pg50.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>]]>
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, since 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 the sales representatives. In general, only the differences between alternatives are relevant in decisions. Those items that are the same under all alternatives are not affected by the decision and 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, since it is not affected by 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 CostOpportunity costA potential benefit that is given up when one alternative is selected over another. 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 she attends 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. |  <![CDATA[<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/free/0073379352/568950/service_bell.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (15.0K)</a>]]>
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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. If the land is acquired, the opportunity cost 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. Since 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 the accounting records of an organization, but they are costs that must be explicitly considered in every decision a manager makes. Virtually every alternative involves an opportunity cost. In Example 3 above, for instance, the higher income that could be realized in future years as a result of returning to school is an opportunity cost of staying in his present job. | IN BUSINESS | Using Those Empty Seats | | | Cancer patients who seek specialized or experimental treatments must often travel far from home. Flying on a commercial airline can be an expensive and grueling experience for these patients. Priscilla Blum noted that many corporate jets fly with empty seats and she wondered why these seats couldn’t be used for cancer patients. Taking the initiative, she founded Corporate Angel Network (www.corpangelnetwork.org), an organization that arranges free flights on some 1,500 jets from over 500 companies. There are no tax breaks for putting cancer patients in empty corporate jet seats, but filling an empty seat with a cancer patient doesn’t involve any significant incremental cost. Since its founding, Corporate Angel Network has provided over 16,000 free flights. Sources: Scott McCormack, “Waste Not, Want Not,” Forbes, July 26, 1999, p. 118; Roger McCaffrey, “A True Tale of Angels in the Sky,” The Wall Street Journal, February 2002, p. A14; and Helen Gibbs, Communication Director, Corporate Angel Network, private communication. |
| YOU DECIDE | Your Decision to Attend Class | | | When you make the decision to attend class on a particular day, what are the opportunity costs that are inherent in that decision? |
Sunk CostA sunk costA cost that has already been incurred and that cannot be changed by any decision made now or in the future. 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 can and should 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. | | CONCEPT
CHECK | ü | - Which of the following cost behavior assumptions is true? (You may select more than one answer.)
- Variable costs are constant if expressed on a per unit basis.
- Total variable costs increase as the level of activity increases.
- The average fixed cost per unit increases as the level of activity increases.
- Total fixed costs decrease as the level of activity decreases.
- Which of the following statements is true? (You may select more than one answer.)
- A common cost is one type of direct cost.
- A sunk cost is usually a differential cost.
- Opportunity costs are not usually recorded in the accounts of an organization.
- A particular cost may be direct or indirect depending on the cost object.
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| IN BUSINESS | What Number Did You Have in Mind? | | | Caterpillar has long been at the forefront of management accounting practice. When asked by a manager for the cost of something, accountants at Caterpillar have been trained to ask “What are you going to use the cost for?” One management accountant at Caterpillar explains: “We want to make sure the information is formatted and the right elements are included. Do you need a variable cost, do you need a fully burdened cost, do you need overhead applied, are you just talking about discretionary cost? The cost that they really need depends on the decision they are making.” Source: Gary Siegel, “Practice Analysis: Adding Value,” Strategic Finance, November 2000, pp. 89–90. |
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