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 cost
Fixed 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
$16,000
Direct Labor
12,000
Variable overhead
8,000
Fixed Overhead
14,000
Total Cost
ATC
$50,000
$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 = 1.50
Materials
16000/8000 = 2.00
Overhead:
Variable overhead
Fixed overhead
TOTAL
8000/8000 = 1.00
(ignore)
$4.50
More Incremental costs.
Unit direct costs (above 10,000 units)
Direct:
Labor
1.50X1.15 = $1.725
Materials
16000/8000 = 2.00
Overhead:
Variable overhead
Fixed overhead
TOTAL
1.00X 1.10 =
(ignore)
1.10
$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?