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Cost Accounting – I

Notes will be incurred as a consequence of this decision. It will exclude any present-period explicit cost
that will be incurred regardless of the present decision. The opportunity cost of a resource under
use, as discussed earlier, becomes a relevant cost while arriving at the economic profit of the firm.
Many decisions will have implications for future costs, both explicit and implicit.
Sunk Costs and Incremental Costs

Sunk costs are expenditures that have been made in the past or must be paid in the future as
part of contractual agreement or previous decision. For example, the money already paid for
machinery, equipment, inventory and future rental payments on a warehouse that must be paid
as part of a long term lease agreement are sunk costs. In general, sunk costs are not relevant to
economic decisions. For example, the purchase of specialized equipment designed to order for a
plant. We assume that the equipment can be used to do only what it was originally designed for
and cannot be converted for alternative use. The expenditure on this equipment is a sunk cost.
Also, because this equipment has no alternative use its opportunity cost is zero and, hence, sunk
costs are not relevant to economic decisions. Sometimes the sunk costs are also called as non-
avoidable or non-escapable costs. On the other hand, incremental cost refers to total additional
cost of implementing a managerial decision. Change in product line, change in output level,
adding or replacing a machine, changing distribution channels etc. are examples of incremental
costs. Sometimes incremental costs are also called as avoidable or escapable costs. Moreover,
since incremental costs may also be regarded as the difference in total costs resulting from a
contemplated change, they are also called differential costs. As stated earlier sunk costs are
irrelevant for decision making, as they do not vary with the changes contemplated for future by
the management. It is the incremental costs, which are important for decision-making purpose.

Fixed and Variable Costs

Fixed costs are that part of the total cost of the firm which does not change with output.
Expenditures on depreciation, rent of land and buildings, property taxes, and interest payment
on bonds are examples of fixed costs. Given a capacity, fixed costs remain the same irrespective
of actual output. Variable costs, on the other hand, change with changes in output. Examples of
variable costs are wages and expenses on raw material. However, it is not very easy to classify
all costs into fixed and variable. There are some costs, which fall between these extremes. They
are called semi variable costs. They are neither perfectly variable nor absolutely fixed in relation
to changes in output. For example, part of the depreciation charges is fixed and part variable.
However, it is very difficult to determine how much of depreciation cost is due to the technical
obsolescence of assets and hence fixed cost, and how much is due to the use of equipments and
hence variable cost. Nevertheless, it does not mean that it is not useful to classify costs into fixed
and variable. This distinction is of great value in break-even analysis and pricing decisions. For
decision-making purposes, in general, it is the variable cost, which is relevant and not the fixed
cost. To an economist the fixed costs are overhead costs and to an accountant these are indirect
costs. When the output goes up, the fixed cost per unit of output comes down, as the total fixed
cost is divided between larger units of output.

Replacement Cost

Replacement cost is the cost, which will have to be incurred if that asset is purchased now. The
difference between the historical and replacement costs results from price changes over time.
Suppose a machine was acquired for ` 50,000 in the year 1995 and the same machine can be
acquired for ` 1,20,000 in the year 2001. Here ` 50,000 is the historical or original cost of the
machine and ` 1,20,000 is its replacement cost. The difference of ` 70, 000 between the two costs
has resulted because of the price change of the machine during the 5 period. In the conventional
financial accounts the value of assets is shown at their historical costs. But for decision-making,

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