Costs Influencing Decision-Making and Planning (9 Types) (2024)

1. Opportunity Cost:

Opportunity cost is the cost of opportunity lost. An opportunity cost is the benefit given up or sacrificed when one alternative is chosen over another. It is the income foregone by selecting another alternative. An opportunity cost is the net cash inflow that could be obtained if the resources committed to one action were used in the most desirable other alternative.

Opportunity costs are not incorporated into formal financial accounting records. Why? Because historical record keeping is limited to transactions involving alternatives that were actually selected, rather than alternatives that were rejected. Rejected alternatives do not produce transactions and so they are not recorded.

Market Values, Profit Sacrificed:

Opportunity costs are often market values. Alternatively, they are measured by the profit that would have been earned had resources been used for the other purpose. For example, choosing to attend college instead of working has an opportunity cost equal to the salary foregone. Further, assume that a manufacturer can sell a semi-finished product to a customer for Rs 50,000. He decides, however, to keep it and finish it. The opportunity cost of the semi-finished product is Rs 50,000 because this is the amount of economic resources foregone by the manufacturer to complete the product.

Similarly, capital which is invested in plant and inventories cannot now be invested in shares and debentures that will earn interest and dividends, the loss of interest and dividend that would be earned is the opportunity cost. Other examples of opportunity cost are when the owner of a business forgoes the opportunity to employ himself elsewhere; or a machine used to make product A is said to have an opportunity cost if the machine can be sold or if it can also make product B.

Similarly, suppose a person has three job offers one for Rs 40,000 p.m., another for Rs 35,000 p.m., and a third for Rs 28,000 p.m., By selecting the best offer of Rs 40,000, the opportunity cost will be Rs 35,000, the next best alternative. Rs 35,000 was given up to get 40,000. The general rule is that the opportunity cost should not exceed the value of option selected.

Opportunity costs are important in decision-making and evaluating alternatives. Decision-making is selecting the best alternative which is facilitated by the help of opportunity costs. Such costs do not require cash outlays and are only imputed costs.

Opportunity costs is not usually entered in the accounting records of an organisation, 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.

Opportunity Costs and Scarce Resources:

It is important to note that opportunity costs apply to the use of scarce resources. If resources are not limited or scarce, no sacrifice exists from using these resources. Further, if no alternative use of resources exists, then the opportunity cost is zero, but if resources have an alternative use, and are scarce, then an opportunity cost does exist. For example assume a factory is producing a product working at 75% capacity and has an opportunity to obtain a contract for the production of a special component.

Accepting the contract will not affect in any way the revenue of existing product. Also, the available capacity cannot be put to any other use. Then the opportunity cost of accepting the contract will be zero. However, in case, the factory is working at 100% capacity and the output of the existing product needs to be reduced to accept the contract, giving a revenue loss of Rs 10,00,000, then opportunity cost will be Rs 10,00,000.

Example:

Sameer is a full-time student at a local university. He wants to decide whether he should attend at university a four-week summer session, where tuition is Rs 2,500 or take a break and work full time at a local departmental store, where he could make as much as Rs 1,500 a week. How much would going to the summer session cost him from a decision-making standpoint? What is the opportunity cost?

Solution:

The total cost of going to summer school would be Rs 8,500 p.m. that is, Rs 2,500 tuition plus Rs 6,000 which he would give up by attending the university. The opportunity cost would be Rs 6,000, since this is the amount he gives up by rejecting the alternative of working full time.

2. Relevant Cost:

Relevant costs are those future cost which differ between alternatives. Relevant costs may also be defined as the costs which are affected and changed by a decision. If a cost increases, decreases, appears or disappears as different alternatives are compared, it is a relevant cost. On the contrary, irrelevant costs are those costs which remain the same and not affected by the decision whatever alternative is chosen. Irrelevant costs do not mean that such costs are forgotten or that such costs need not be evaluated. It simply means that irrelevant cost is not one of the factors that will quantitatively affect the decision.

Relevant costs have the following two features:

(i) Future Costs:

Relevant costs are only future costs, i.e., those costs which are expected to be incurred in future. Relevant costs, therefore, are not historic (sunk) costs which have already been incurred and cannot be changed by a decision.

(ii) Incremental or Avoidable Costs:

Relevant costs are only incremental (additional) or avoidable costs. Incremental costs refer to an increase in cost between two alternatives. Avoidable costs are those which are not incurred from one alternative to another.

To take an example, assume a business firm purchased a plant for Rs 1, 00,000 and has now a book value of Rs 10,000. The plant has become obsolete and cannot be sold in its present condition. However, the plant can be sold for Rs 15,000 if some modification is done on it which will cost Rs 6,000.

In this example, Rs 6,000 (modification costs) and Rs 15,000 (sales values) both are relevant as they reflect future, incremental costs and future revenues respectively. The firm will have incremental benefit of Rs 9,000 (Rs 15,000 — Rs 6,000) on sale of the plant.

Rs 1, 00,000 has already been incurred and being a sunk cost is not relevant to the decision, i.e., whether modification should be done. Similarly, the book value of Rs 10,000 which has to be written off whatever alternative future action is chosen, is also not relevant because it cannot be changed by any future decision.

3. Differential Cost:

Differential cost is the difference in total costs between any two alternatives. Differential costs are equal to the additional variable expenses incurred in respect of the additional output, plus the increase in fixed costs, if any. This means that differential cost is only the difference in the amount of the two costs. This cost may be calculated by taking the total cost of production without the additional contemplated output and comparing it with the total costs incurred if the extra output is undertaken.

Incremental and Decremental Cost:

Differential costs are also known as incremental costs, although technically an incremental cost should refer only to an increase in cost from one alternative to another; decrease in cost should be referred to as decremental cost. Differential cost is a broader term, encompassing both cost increases (incremental costs) and cost decreases (decremental costs) between alternatives.

The concept of differential costing is vital in planning and decision-making. It is an impor­tant tool in evaluating the profitability of alternative choice decisions and helping management in choosing the best alternative. The differential cost analysis can assist management in knowing the additional profit that would be earned if idle or unused capacity is used for extra production or if some additional investments are made by the firm.

Example:

A printer is considering replacing an old machine, which he purchased for Rs 1, 50,000 three years ago, with some labour-saving equipment. The old machine is being depreciated at Rs 15,000 a year. The following alternative equipment options are available for consideration.

Machine A. The purchase price of machine A is Rs 2, 50 000 and yearly cash operating costs are Rs 50,000.

Machine B. The purchase price of machine B is Rs 2, 80,000 and yearly cash operating costs are Rs 45,000.

(a) What are the incremental costs, if any, in this alternative-choice situation?

(b) What are the sunk costs, if any, in this situation?

Answer:

(a) The following schedule will identify the incremental costs in this decision problem:

The incremental costs are purchase price (Rs 30,000) and cash operating costs (Rs 5,000).

(b) The depreciation on old equipment Rs 15,000 (on the total purchase price of Rs 1, 50,000), is a sunk cost because it represents an investment outlay made in the past.

4. Sunk Cost:

A sunk cost is the cost that has already been incurred. It is a past or committed cost, cost gone forever. Sunk costs (past costs) are costs that have been created by a decision in the past and cannot be changed once they have been incurred and cannot be avoided (changed) by any decision that is made in the future. Any asset obtained from the incurred cost can be used or sold, but its value is its present or future value — not the cost paid. Sunk costs are costs which are the result of previous decisions of the enterprise and which will be unaffected by any future decision as they have already been incurred.

Thus, any historical cost is a sunk cost. Examples of sunk costs are book values of existing assets such as plant and equipment, inventory, investment in securities etc. For example, if a plant was purchased five years ago for Rs 5, 00,000 with the expected life of 10 years and nil scrap value, then the written down value will be Rs 2, 50,000 if straight line method of depreciation has been used.

This written down value (Rs 2, 50,000) will have to be written off, no matter what alternative future action is chosen. For instance, if the plant is to be used in the future, Rs 2, 50,000 will be writ­ten off and if the plant is decided to be scrapped, again Rs 2, 50,000 will be written off. Even though in hindsight the purchase of the machine may have been unwise, no amount of regret can undo that decision. This historical cost cannot be changed by any future decision and therefore becomes sunk cost. Therefore, they can and should be ignored when making a decision.

Anderson and Sollenberger observe:

“Historical costs, which are fundamental to most balance sheet asset values and income measure­ment, have little or no significance in managerial analysis. A past cost has no meaning in decisions to hold, use or sell. Only current and future values have meaning. Even tax issues uses historical costs only to determine current and future tax costs. The temptation to continue to use historical costs in decision is great. But using any past cost will only distort the decision-making process.”

Sunk costs and Irrelevant Costs:

The costs which are irrelevant for decision-making are not necessarily sunk costs. Some costs may be found irrelevant but not sunk costs. For example, a comparison of two alternative production methods may result in identical direct material costs for both the alternatives. In this case, the direct material cost will remain the same whichever alternative is chosen. In this situation, though direct material cost is the future cost to be incurred in accordance with the production, it is irrelevant, but, it is not a sunk cost.

Sunk Costs and Salvage Value:

It is significant to mention that while book value of the old asset remains irrelevant, disposal and salvage values may be relevant as it involves relevant cash inflow. It is obtained only if the re­placement alternative is selected. Any salvage value available at the end of useful life of a machine is relevant. A loss on disposal may have a favourable tax impact if the loss can be offset against taxable gains or taxable income. Thus, the book value of the old asset remains irrelevant but the expected tax reduction would be relevant.

Sunk Costs, Differential Costs, Opportunity Costs:

A sunk cost is one that has already been incurred and therefore will be the same no matter which alternative a manager selects. Sunk costs are never relevant for decision-making because they are not differential cost.

Even though the historical cost of a resource is sunk, the resource can have a cost for decision-making purposes. If a resource can be used in more than one way, it has an opportunity cost. An opportunity cost is the benefit lost by taking one action as opposed to another. The “other” action is the best alternative available other than the one being contemplated.

A company that owns a warehouse (which is a sunk cost) can use it either to store its own products or rent it to another company. Using the space for storage requires that the company forego the opportunity to rent it. When the company considers any action that requires using the space for storage, the relevant cost of the space is its opportunity cost, the rent the company will not collect. Of course, the space might have other uses.

Sunk Costs and Ethical Dilemmas:

Although the book value of the old machine has no economic significance, the accounting treat­ment of past costs may make it psychologically difficult for managers to regard them as irrelevant.

Morse, Davis and Hart-graves observe:

“The possibility of recording an accounting loss may place managers in an ethical dilemma. Although an action may be desirable from the long-run viewpoint of the organization, in the short run, choosing the action may result in an accounting loss. Fearing the loss will lead superiors to question his or her judgment, a manager might prefer to use the old machine (with lower total profits over the four-year period) as opposed to replacing it and being forced to record a loss on disposal. Although this action may now avoid raising troublesome questions, the cumulative effect of many decisions of this nature will be harmful to organization’s long-run economic health. From an economic viewpoint, the analysis should focus on future costs and revenues that differ. The decision should not be influenced by sunk costs. Although there is no easy solution to this behavioral and ethical problem, managers and management accountants should be aware of its potential impact.”

Similarly, Jiambalvo advises:

“When managers make decisions, they need to be careful that they are not influenced by sunk costs. That’s difficult because, psychologically, people are pre-disposed to take sunk costs into account. Psychologists refer to this “irrational” economic behavior as the sunk cost effect. Consider an immensely expensive waterway project. Proponents of the project may suggest that its elimination would be inappropriate because so much money had already been spent on its completion. That is, proponents rationalize continuation of the project in terms of sunk costs!”

5. Imputed Cost:

Imputed costs are costs not actually incurred in some transaction but which are relevant to the decision as they pertain to a particular situation. These costs do not enter into traditional accounting systems. But they being related with economic reality help in making better decisions. Interest on internally generated funds, rental value of company-owned property and salaries of owners of a single proprietorship or partnership are some examples of imputed costs.

Costs paid or incurred are not imputed costs. For example, if Rs 50,000 is paid for purchase of raw materials it is an outlay cost but not an imputed cost, because it would enter into accounting systems. By itself, Rs 50,000 measures the monetary impact of this particular event.

When a company uses internally generated funds, no actual interest payment is required. But if the internally generated funds are invested in some projects, interest would have been earned. The revenue foregone (loss of interest) represents an opportunity cost, and thus, imputed costs are opportunity costs.

Similarly, the owner or manager should deduct from the profits of the business an amount equivalent to the salary the owner would have earned by working in some other profession and the interest which the owner’s capital would have earned in an alternative business.

6. Out-of-Pocket Cost:

While imputed costs do not involve cash outlays, out-of-pocket costs signify the cash cost associated with an activity. Non-cash costs such as depreciation are not included in out-of-pocket costs. This cost concept is significant for management in deciding whether or not a particular project will at least return the cash expenditures associated with the project selected by management.

Similarly acceptance of a special order for production may necessitate the consideration of out-of- pocket costs that need not be incurred if the special order proposal is not accepted. Depreciation on plant and equipment is not relevant in decision-making because no cash goes outside the business.

7. Fixed, Variable and Mixed Costs:

Fixed, Variable and Mixed Costs have been explained in the preceding sections.

8. Direct Cost and Indirect Cost:

Direct cost and indirect cost have been explained in the preceding sections.

9. Shutdown Cost:

Shut down costs are those costs which have to be incurred under all situations in the case of stopping manufacture of a product or closing down a department or division. Shut down costs are always fixed costs. If the manufacturing of a product is stopped, variable cost like direct materials, direct labour, direct expenses, variable factory overhead will not be incurred.

However, a part of fixed costs (if not total fixed costs) associated with the product will be incurred such as rent, watchman’s salary, property taxes etc. Such fixed costs are unavoidable. Some fixed costs associated with the product become avoidable and need not be incurred in case production is stopped such as supervi­sor’s salary, factory manager’s salary, lighting etc. Shut down costs; thus, refer to minimum fixed costs which are incurred in the event of closure of a department or division.