Cost

2.
COST
Managers make decisions that govern how a company reaches its goals.
Many of these goals have financial aspects, such as revenue and profit
targets. The level of costs included in such decisions has a major impact on
the finances of the company. Reliable reporting of actual costs, accurate
estimation of projected costs and the appropriate integration of such costs in
managerial decisions is a key component of business operations that meet
their targets and further the goals of the company.
Relevant Costs
Typical managerial decision making selects one of two or more alternatives.
Costs that remain the same no matter which alternative the manager
chooses are not relevant to the decision. In a cost-based decision on outsourcing, a manager has to consider the cost of the subcontract and the
savings in-house. For example, if the company still has to pay the full rent
despite having fewer employees, the rent is not a relevant cost. If the
company can move to a smaller location and pay less rent, the rent becomes
relevant.
Fixed Costs
The type of cost impacts a manager's decision making. Fixed costs are totals
that remain the same independently of the volume of production. Higher
production levels result in a reduced cost-per-unit as far as fixed costs are

concerned. Typical fixed costs are facility related, such as heating and
insurance. They are important for managerial decisions regarding optimal
production levels because they influence the product cost and, through the
cost, the pricing and profit levels.
Variable Costs
A type of cost with a different impact on managerial decisions is the variable
cost. Variable costs stay the same on a cost-per-unit basis, but their totals
increase with the volume of production. Typical variable costs are materials
used in production and direct labor to make the products. Variable costs are
important for overall company budget decisions and planning for financing.
Managers add variable costs as per-unit-costs times production volume to
fixed costs to determine total production costs.
Semi-variable cost
Step costs are a combination of fixed and variable costs that a manager has
to consider to avoid major discrepancies in cost calculations. They act as
fixed costs up to a certain limit and then change to a new value. Typical step
costs are those associated with machine capacity or batch processing. If
production volume exceeds certain limits, costs rise substantially to a new,
higher level as the company needs an additional machine or has to produce
an additional batch. The importance of including step costing in managerial
decision making is to either avoid exceeding step limits or to include the

relevant higher costs.
Cost Classifications for Decision-Making. Every decision involves choosing
from among at least two alternatives. Only those costs and benefits that
differ between alternatives are relevant in making the selection. This concept
is explored in greater detail in the chapter on relevant costs. However,
decision-making contexts crop up from time to time in the text before that
chapter, so it is a good idea to familiarize students with relevant cost
concepts.
1. Differential Costs. A differential cost is a cost that differs between
alternatives. The cost may exist in only one of the alternatives or the total
amount of the cost may differ between the alternatives. In the latter case,
the differential cost would be the difference between the cost under one
alternative and the cost under the other. Differential costs are also called
incremental costs. Differential costs and opportunity costs should be the
focus of decision-making. They are the only relevant costs and all others
should be ignored.
2. Opportunity Costs. An opportunity cost is the potential benefit that is
given up by selecting one alternative over another. The concept of an
opportunity cost is rather difficult for students to understand because it is
not an actual expenditure and it is rarely (if ever) shown on the accounting
books of an organization. It is, however, a cost that must be considered in

decisions.
3. Sunk 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. Since sunk
costs cannot be changed and therefore cannot be differential costs, they
should be ignored in decision making. While students usually accept the idea
that sunk costs should be ignored on an abstract level, like most people they
often have difficulty putting this idea into practice.

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2.

production levels result in a reduced cost-per-unit as far as fixed costs are

decision making is to either avoid exceeding step limits or to include the

books of an organization. It is, however, a cost that must be considered in

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