Page 124 - DECO405_MANAGERIAL_ECONOMICS

Unit 8: Cost Analysis

8.1 Cost Concepts Notes

Costs play a very important role in managerial decisions involving a selection between alternative
courses of action. It helps in specifying various alternatives in terms of their quantitative values.
The kind of cost to be used in a particular situation depends upon the business decisions to be
made. Costs enter into almost every business decision and it is important to use the right
analysis of cost. Hence, it is important to understand what these various concepts of costs are,
how these can be defined and operationalised. This requires the understanding of the two
things, namely, (i) that cost estimates produced by conventional financial accounting are not
appropriate for all managerial uses, and (ii) that different business problems call for different
kinds of costs.

Future and Past Costs

Futurity is an important aspect of all business decisions. Future costs are the estimates of time
adjusted past or present costs and are reasonably expected to be incurred in some future period
or periods. Their actual incurrence is a forecast and their management is an estimate. Past costs
are actual costs incurred in the past and they are always contained in the income statements.
Their measurement is essentially a record keeping activity.

Incremental and Sunk Costs

Incremental costs are defined as the change in overall costs that result from particular decisions
being made. Incremental costs may include both fixed and variable costs. In the short period,
incremental cost will consist of variable cost — costs of additional labour, additional raw
materials, power, fuel, etc. — which is the result of a new decision being taken by the firm. Since
these costs can be avoided by not bringing about any change in the activity, incremental costs
are also called avoidable costs or escapable costs. They are also called differential costs.
Sunk cost is one which is not affected or altered by a change in the level or nature of business
activity. It will remain the same whatever the level of activity.

Example: The most important example of sunk cost is the amortisation of past expenses,
e.g., depreciation.

Out-of-Pocket and Book Costs

Out-of-pocket costs are those that involve immediate payments to outsiders as opposed to book
costs that do not require current cash expenditure.

Example: Wages and salaries paid to the employees are out-of-pocket costs while salary
of the owner manager.
If not paid, it is a book cost. The interest cost of owner's own fund and depreciation cost are other
examples of book costs. Book costs can be converted into out-of-pocket costs by selling assets
and leasing them back from the buyer.

Replacement and Historical Costs

Historical cost of an asset states the cost of plant, equipment and materials at the price paid
originally for them, while the replacement cost states the cost that the firm would have to incur
if it wants to replace or acquire the same asset now.

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