Work-in- Process

Opportunity Costs

An opportunity cost is defined as the benefit that is sacrificed when the choice of one action precludes taking an alternative course of action. If beef and fish are the available choices for dinner, the opportunity cost of eating beef is the foregone pleasure associated with eating fish.

Opportunity costs arise in many business decisions. For example, suppose a baseball manufacturer receives a special order for softballs from the city of Boston. If the firm accepts the softball order, it will not have enough productive capacity (labor and machine time) to produce its usual output of baseballs for sale to a large chain of sporting-goods stores. The opportunity cost of accepting the softball order is the foregone benefit is measured by the potential revenue from the baseball sales minus the cost of manufacturing the baseballs.

Opportunity costs also arise in personal decisions. The opportunity cost of a student’s college education includes the salary that is foregone as a result of not taking a full-time job during the student’s years in college.

From an economic perspective, a dollar of opportunity cost associated with an action should be treated as equivalent to a dollar of out-of-pocket cost. Out- of-pocket costs are those that require the payment of cash or other assets as a result of their incurrence. The out-of-pocket costs associated with the softball order consist of the manufacturing costs required to produce the softballs. In making the decision to accept or reject the softball order, the firm’s management should considered both the out-of-pocket cost and the opportunity cost of the order.

Studies by behavioral scientists and economists have shown that many people have a tendency to ignore or downplay the importance of opportunity costs. For example, in one study people were asked if they would pay $500 for two 50yard line tickets to the Super Bowl. Most people responded that they would not. However, many of the same people said that they would not sell the Super Bowl tickets for $500 if they were given the tickets free of charge. These people refused to incur the $500 out-of-pocket cost of buying the Super Bowl tickets. However, they were willing to incur the $500 opportunity cost of going to the game rather than sell the tickets. In each case, a couple who attends the game ends up $500 poorer than a couple who does not attend the game. (Try surveying your friends with this scenario).

Behavior such as that illustrated in the Super Bowl example is economically inconsistent. Ignoring or downplaying the importance of opportunity costs can result in inconsistent and faulty business decisions.

Ringo Percussion Instruments

Income Statement

For the Year Ended December 31, 19x5

Sunk Costs

Sunk Costs are costs that have been incurred in the past. Consequently, they do not affect future costs and cannot be changed by any current or future action. Examples of such costs include the acquisition cost of equipment previously purchased and the manufacturing cost of inventory on hand. Regardless of the current usefulness of the equipment or the inventory, the costs of acquiring them cannot be changed by any prospective action. Hence these costs are irrelevant to all future decisions.

Suppose, for example, that a university’s traffic department purchased a minicomputer to assist in the vehicle registration process. A year has passed, the computer’s warranty has expired, and the computer is not working well. An investigation reveals that this brand of computer is very sensitive to humidity and temperature changes. The traffic department is located in an old building with poor heating and no air-conditioning. As a result, the computer works only intermittently, repair bills have been high, and the office staff is fed up. The office manager requests that the department director junk the computer and instruct the staff to return to the old manual registration system. The director responds by insisting, “We can’t afford to junk the computer! We paid $3,400 for it”.

This illustration is a typical example of the inappropriate attention paid to sunk costs. The $3,400 paid for the minicomputer is sunk. No future decision about the computer or the office’s procedures can affect that cost. Future decisions should be based on future costs, such as the computer repair bills or the costs of upgrading the building’s heating and air-conditioning systems.

Although it is incorrect, from an economic perspective, to allow sunk costs to affect future decisions, people often do so. It is human nature to attempt to justify past decisions. When there is a perceived need to demonstrate competence, either to themselves or to others, managers may seek to justify their decisions. The response of the traffic department director that “We can’t afford to junk the computer!” may represent the director’s need to justify the past decision to purchase the computer. It is important for managerial accountants to be aware of such behavioral tendencies. Such an awareness enables the accountant to prepare the most relevant data for managers’ decisions, and sometimes to train the managers in using the information.

Differential Costs

A differential cost is the amount by which the cost differs under two alternative actions. Suppose, for example, that a county government is considering two competing sites for a new landfill. If the northern site is chosen, the annual cost of transporting refuse to the site is projected at $85,000. If the southern site is selected, annual transportation charges are expected to be $70,000. The annual differential cost of transporting refuse is calculated as follows:

Differential costs are also known as incremental costs. In the landfill example, the annual incremental cost of refuse transportation is $15,000 if the site is moved from the southern location to the northern location. Differential or incremental costs are found in a variety of economic decisions. The additional cost incurred by Gulliver’s Travels, a travel agency, in locating a new office in the suburbs is the incremental cost of the new business location. The difference in the total cost incurred by the travel agency with or without the suburban location is the differential cost of the decision whether to establish the new office. Decisions about establishing new airline routes, adding additional shifts in a manufacturing firm, or increasing the nursing staff in a hospital all involve differential costs.

Marginal Costs and Average Costs

A special case of the differential cost concept is the marginal cost, which is the extra cost incurred when one additional unit is produced.

It is important to distinguish between marginal costs and average costs.

The marginal cost of production is the extra cost incurred when one more unit is produced. The average cost per unit is the total cost, for whatever quantity is manufactured, divided by the number of units manufactured. Marginal costs and average costs arise in a variety of economic situations. A Harvard University administrator might be interested in the marginal cost of educating one additional student, and a Toyota executive might want to know the marginal cost of producing one more Toyota van. A bus tour company manager might be interested in the average cost per mile in the Pittsburgh to New York City route.

COSTS AND BENEFITS OF INFORMATION

Many different cost concepts have been explored in the unit 2. An important task of managerial accountant is to determine which of these cost concepts is most appropriate in each situation. The accountant attempts to structure the organization’s accounting information system to record data that will be useful for a variety of purposes. The benefits of measuring and classifying costs in particular way are realized through the improvements in planning, control, and decision making that the information facilitates.

Another important task of the managerial accountant is to weight the benefits of providing information against the costs of generating, communicating, and using that information. Some accountants, eager to show that they have not overlooked anything, tend to provide too much information. But when managers receive more data than they can utilize effectively, information overload occurs. Struggling to process large amounts of information, managers may be unable to recognize the most important facts. In deciding how much and what type of information to provide, managerial accountants should consider these human limitations.

SUMMARY

The term cost is familiar to everyone. We all discuss the cost of a sweater, a movie ticket, or a semester’s tuition. Yet, as we have seen in this unit, the word cost can have a variety of meanings in different situations. Managerial accountants often find it useful to classify costs in different ways for different purposes. An understanding of cost terms, concepts, and classifications is fundamental in any study of managerial accounting.

Several cost terms are defined and illustrated in this unit. A cost drive is any activity or event that causes costs to be incurred. Fixed and variable costs are defined by the behavior of total cost as the organization’s activity level changes.

Direct and indirect cost refer to the ability of the accountant to trace costs to various departments in the organizations. The terms controllable and uncontrollable are used to describe the extent to which a manager can influence a cost. Costs are classified into such functional categories as manufacturing costs, marketing costs, and administrative costs. Manufacturing costs are further subdivided into direct-material, direct-labor, and manufacturing overhead costs. The terms product cost and period cost refer to the timing with which costs become expenses.

Economic concepts are also important in describing costs. An opportunity cost is the benefit foregone because the choice of one action precludes another action. Sunk costs are costs incurred in the past that cannot be altered by a current or future decision. The term differential cost or incremental cost refers to the difference in the costs incurred under two alternative actions. Marginal cost

is defined as the cost of producing one additional unit. Finally, the average cost per unit is the total cost for whatever quantity is produced, divided by the number of units produced.

These cost terms are an integral part of the specialized language of business administration.

1.What is meant by the phrase “different costs for different purposes”?

2.Distinguish between fixed costs and variable costs.

3.How does the fixed cost per unit change as the level of activity (or cost driver) increases? Why?

4.How does the variable cost per unit change as the level of activity (or cost driver) increases? Why?

5.Why is the cost of idle time treated as manufacturing overhead?

6.Explain why overtime premium is included in manufacturing overhead.

7.Give two examples of each of the following costs, using well-known organizations: merchandise costs, selling costs, distribution costs, administrative costs, and research and development costs.

8.Distinguish between product and period costs.

9.What is the most important difference between a manufacturing firm and a

service industry firm, with regard to the classification of costs as product costs or period costs?

10.Why are product costs also called inventoriable costs? 11.Distinguish between out-of-pocket costs and opportunity costs.

12.Define the terms sunk cost, differential cost, and information overload. 13.Distinguish between marginal and average costs.

UNIT 3

COST BEHAVIOR AND ESTIMATION

After completing this unit, you should be able to:

Explain the relationships between cost estimation, cost behavior, and cost prediction.

Define and describe the behavior of the following types of costs: variable, step-variable, fixed, step-fixed, semivariable (or mixed), and curvilinear.

Explain the importance of the relevant range in using a cost behavior pattern for cost prediction.

Define and give examples of engineered costs, committed costs, and discretionary costs.

Describe and use the following cost-estimation methods: account classification, visual fit, high-low, and least-squares regression.

Describe the multiple regression, engineering, and work-measurement approaches to cost estimation.

Describe some problems often encountered in collecting data for cost estimation.

Managers in almost any organization want to know how costs will be affected by changes in the organization’s activity. The relationship between cost and activity, called cost behavior, is relevant to the management functions of planning, control, and decision making. In order to plan operations and prepare a budget, managers at Nabisco need to predict the costs that will be incurred as different levels of production and sales. To control the costs of providing commercial-loan services at Chase Manhattan Bank, executives need to have a feel for the costs that the bank should incur at various levels of commercial-loan activity. In deciding whether to add a new intensive care unit, a hospital’s administrators need to predict the cost of operating the new unit at various levels of patient demand. In each of these situations, knowledge of cost behavior will help the manager to make the desired cost prediction. A cost prediction is a forecast of cost at a particular level of activity. In the first half of the unit 3, we will study cost behavior patterns and their use in making cost predictions.

How does managerial accountant determine the cost behavior pattern for a particular cost item? The determination of cost behavior, which is often called cost estimation, can be accomplished in a number of ways. One way is to analyze historical data concerning costs and activity levels. Cost estimation is covered in the second half of this unit.