Cost Concepts for Managerial Decisionmaking

Purpose

Review cost concepts

Relate economists’ cost categories to accounting cost categories

Identify important operational implications of the normative cost principles

Examples

Three normative principles

• Evaluate opportunity Costs

• Compare costs and benefits

• Consider incremental effects

Evaluate Opportunity Costs

• Typically, expenditures are opportunity costs.

• Historical costs are often irrelevant. Opportunity cost can be more, can be less.

• Financing of a fixed asset is typically irrelevant.

• And yet, historical cost can be a guide.

Consider costs and benefits

This one is pretty much self evident.

What is the potential error?

It seems that it would be to focus primarily on benefits.

Or perhaps to take too narrow a view.

Incrementalism is the real world’s marginalism

• Well, sort of.

• Potential mistake: Comparing average total cost with the average revenue for some incremental business

Accounting Cost v. Economic Cost Concepts

• Them: Direct cost

Variable overhead Fixed overhead

• Us: Variable costFixed cost

A few nice words about accountants

• They are confronted with real problems and are often called upon to give specific quantitative answers.

• On the issue of allocated overhead (burden) they have a better case than you may think.

• The issue is opportunity cost, not fairness, or accounting for all costs, or making sure all the bills can be paid.

Operational occurrences of normative principles.

• Fixed costs are fixed: Average total costs does not offer a good measure of incremental cost.

• Some fixed costs are sunk: Ignore those

• And yet, some fixed assets to not constitute sunk costs: The can be used for other valuable things, their use has opportunity costs

Operational occurrences continued

• Some fixed costs are not fixed: If the increment is a project, and the project requires some durable asset, the cost of the asset is not “fixed” with respect to that project. It is incremental with respect to that project

• Some cost are forgone revenues. (opportunity cost revisited)

Problem 2 in the essay

For 8000 boxes of candy (current output)Direct materials $16,000Direct Labor 12,000Variable overhead 8,000Fixed Overhead 14,000

Total Cost $50,000ATC $6.25

The firm has an offer of 4000 boxes of candy per month at $6.00. They have a one-shift capacity of 10,000 boxes. Additional output can be produced, but there is a 15% premium on direct labor, and a 10% premium on variable overhead.

ATC is $6.25. Should they take this offer?

Incremental costs.

Unit direct costs (below 10,000 units)Direct:Labor 12000/8000 = 1.50Materials 16000/8000 = 2.00

Overhead:Variable overhead 8000/8000 = 1.00Fixed overhead (ignore)

TOTAL $4.50

More Incremental costs.

Unit direct costs (above 10,000 units)Direct:Labor 1.50X1.15 = $1.725Materials 16000/8000 = 2.00

Overhead:Variable overhead 1.00X 1.10 = 1.10Fixed overhead (ignore)

TOTAL $4.825

So, take the order

The price offered, though below the average total cost, is greater than the incremental cost.

Are you a team player, or not?

• Any objections?

Some appropriate concerns.

• Better offer coming? How long a commitment?

• How will these candy boxes be distributed? Won’t they just reduce our sales at $6.75?

• Should we be trying to expand our output thought our usual channel?