Another of Comet Computer Company’s interdisciplinary management teams was formed to take a close look at which of the raw materials and components used in Comet’s prod- ucts should be manufactured by Comet and which ones should be outsourced (purchased from outside vendors).8 This outsourcing action team consisted of the assistant manager
8The outsourcing decision is covered in detail in Chapter 14, together with several other common management decisions.
For the typical business unit, which had responsibility for profits, less than one-third of overhead costs were directly in its control. (2g)
Kraft Foods
Learning Objective 2-10 Define and give examples of an opportunity cost, an out- of-pocket cost, a sunk cost, a differential cost, a marginal cost, and an average cost.
of purchasing, a product design engineer, a product group sales manager, and a manage- rial accountant. As the team pursued its assignment, its members soon found that they were once again dealing with several different cost concepts.
In addition to accounting cost classifications, such as product costs and period costs, the team’s members also found themselves using economic concepts in classifying costs.
Such concepts are often useful in helping managers decide what cost information is rel- evant to the decisions faced by the organization. Several of the most important economic cost concepts are discussed next.
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 your favorite DJ is spinning on Saturday night, but a college football game you want to watch is on TV at the same time, the opportunity cost of seeing the DJ live is the foregone plea- sure of watching the game live.
Opportunity costs arise in many business decisions. For example, suppose a ball manufacturer receives a special order for softballs from the city of Boston to supply its summer recreational league. If the firm accepts the softball order, it will not have enough productive capacity (labor or 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, in part, the forgone benefit from the baseball production that cannot be achieved, measured by the potential revenue from the baseball sales minus the vari- able cost of manufacturing the baseballs. But it also includes all foregone future benefit caused by damage to the relationship with its sporting-goods customer. Calculating and considering such opportunity costs can be very complicated, but also very important in making the right decision.
Opportunity costs also arise in personal decisions, as in the DJ vs. football example above. More significantly, the opportunity cost of a student’s college education includes the salary that is forgone as a result of not taking a full-time job during the student’s years in college.9
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
9Not to worry. Studies consistently show that college graduates outearn high school graduates by a significant amount: “well over $1 million . . . during their working lives” for the average four-year degree, easily enough bene- fit to offset the cost of a college education, including opportunity costs, for most people. Jaison R. Abel and Richard Deitz, “Do the Benefits of College Still Outweigh the Costs?” Current Issues in Economics and Finance, Federal Reserve Bank of New York, volume 20, number 3 (2014).
Cost Item Manager Classification
Cost of raw material used to produce computer chips in an Intel factory
Supervisor of the production department for computer chips
Controllable (The production supervisor can exercise some control over the quantity of material used by ensuring that waste and defective units are minimized.) Cost of food used in a Subway
restaurant
Restaurant manager Controllable (The restaurant manager
exercises some control over the quantity of food used by scheduling production to ensure that excess food is not produced and wasted.)
Cost of national advertising for the Enterprise car rental company
Manager of the Enterprise rental agency at the Orlando airport
Uncontrollable Cost of national accounting and data
processing operations for Target
Manager of a Target store in Austin, Texas
Uncontrollable
Exhibit 2–11 Controllable and Uncontrollable Costs
order, the firm’s management should consider both the out-of-pocket cost and the oppor- tunity 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, try the following experiment on the biggest college basketball fanatic you know. First, ask them if they would pay the going price of $1,000 for a ticket to the basketball Final Four. Then ask them, if they were to win that same ticket to the Final Four, would they be willing to sell it for $1,000? You are likely to find that many of them would not pay $1,000 for the ticket, but they also would not sell the ticket they won for $1,000! In other words, they refuse to incur the $1,000 out-of-pocket cost of buying the Final Four ticket, effectively saying, “I’d rather have $1,000 than see the game in person.” However, they are willing to incur the $1,000 opportunity cost of going to the game rather than sell the ticket: “I’d rather see the game in person than have $1,000.” An interesting contradiction!
Behavior such as that illustrated in the Final Four example is economically inconsis- tent. And surprisingly common! Ignoring or downplaying the importance of opportunity costs can result in inconsistent and faulty business decisions.10
Comet Computer’s outsourcing action team found that the opportunity cost of using constrained production resources (such as space, machine time, and employee time) to produce a computer component in-house was an important factor to consider in deciding whether to outsource the component.11
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 parking and traffic department purchased a system of 10 tablet computers and dedicated software last spring to support the campus ticketing and enforcement process. Soon after the hardware’s one-year warranty expired, traffic officers began complaining that the tablets were unreliable and overly sensitive to damp, cold winter weather. Their supervisor requests that the parking and traffic director junk the tablet-based system and replace it with units custom-designed for parking and traffic enforcement. The director responds by insisting, “We can’t afford to junk the tablet system! We paid $40,000 for it just last spring.”
This illustration is a typical example of the inappropriate attention paid to sunk costs.
The $40,000 paid for the tablet-based system is sunk. No future decision about the tab- let computers or the office’s procedures can affect that cost. Future decisions should be based on future costs, such as the cost of weather-proofing the tablets if they are kept, the cost of replacing them with the custom-designed units if they are not, and the cost of training new traffic officers if the current ones get fed up with the tablet system and quit.
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 deci- sions. 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 parking and traffic director that “We can’t afford to junk the tablet system!” may represent the direc- tor’s need to justify her past decision to purchase the system. It is important for managers and accountants to be aware of such behavioral tendencies.
Comet Computer’s outsourcing action team encountered a sunk cost as it considered outsourcing production of a component called a monitor interface unit (MIU). The team
10This problem is called the endowment effect. For an interesting discussion of behaviorial problems in decision making, including an entire chapter on the endowment effect, see Nobel laureate Daniel Kahneman’s prize-winning book, Thinking, Fast and Slow, Farrar, Straus, and Giroux (2011).
11The details of the outsourcing decision, including its relevant costs and the role of opportunity costs, are covered in Chapter 14.
discovered that the automatic insertion robot used to insert components into the MIU was difficult to maintain and expensive to operate. Nevertheless, the department supervisor was inclined to keep the robot and continue in-house production of the MIU, because, as he put it, “Comet paid an arm and a leg for this robot.” The team was able to demonstrate that the robot’s acquisition cost was a sunk cost and was irrelevant to the outsourcing decision. We will explore sunk costs in more detail in Chapter 14.
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 recycling center. If the northern site is chosen, the annual cost of transporting recyclable waste to the site is projected at $285,000. If the southern site is selected, annual transportation charges are expected to be $240,000. The annual differential cost of transporting refuse is calculated as follows:
Annual cost of transporting refuse to northern site ... $285,000 Annual cost of transporting refuse to southern site ... 240,000 Annual differential cost ... $ 45,000
The increase in cost from one alternative to another is called an incremental cost. In the landfill example, the annual incremental cost of selecting the northern site is $45,000.
Differential or incremental costs are found in a variety of economic decisions. The addi- tional 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 and without the suburban location is the differen- tial 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.
At Comet Computer, the outsourcing action team estimated that the differential cost between outsourcing the production of the MIU and producing it in-house would be
$200,000 annually in favor of outsourcing, based on current projections of annual pro- duction. We will explore differential costs in more detail in Chapter 14.
Marginal Costs and Average Costs A special case of the differential-cost concept is the marginal cost, which is the incremental cost of producing one additional unit.
The additional cost incurred by Comet Computer when one additional high-performance laptop computer is made is the marginal cost of manufacturing the computer. The table in Exhibit 2–12 shows how marginal cost can change across different ranges of produc- tion quantities.
Marginal costs typically differ across different ranges of production quantities because the efficiency of the production process changes. At Comet Computer, the mar- ginal cost of producing a laptop computer declines as output increases. It is much more efficient for the company to manufacture 101 computers than to make only one.
Exhibit 2–12
Marginal Cost of Producing Laptop Computers at Comet Computer Company
Number of Laptops Produced
Total Cost of Producing Laptops
Marginal Cost of Producing a Laptop 1 ...
2 ...
$ 2,000 3,900
Difference is $1,900 Marginal cost of 2nd laptop is $1,900
10 ...
11 ...
18,000 19,690
Difference is $1,690 Marginal cost of 11th laptop is $1,690
100...
101...
150,000 150,995
Difference is $995 Marginal cost of 101st laptop is $995
It is important to distinguish between marginal costs and average costs. In the Comet Computer example, the marginal cost of the second computer is $1,900. However, the average cost per unit when two laptops are manufactured is $3,900 divided by 2, or
$1,950. Similarly, the marginal cost of the eleventh laptop is $1,690, but the average cost per unit when 11 laptops are produced is $1,790 (calculated by dividing $19,690 by 11).
What is the marginal cost of the 101st laptop computer? The average cost per unit when 101 laptops are manufactured?12
To summarize, 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 aver- age costs arise in a variety of economic situations. A University of Texas dean might be interested in the marginal cost of educating one additional student, and a Toyota exec- utive might want to know the marginal cost of producing one more Toyota Prius. An Amtrak route manager might be interested in the average cost per mile on the Boston to New York City route.