Cost Principles

Computation of profit is directly affected by the determination of what costs should be subtracted from total revenue. Because the conditions under which one decision is made may differ from the conditions under which another decision is made, it should be clear that costs should be tailored to a given decision. To an economist the basic idea of cost is that it is a sacrifice. Measurement of cost involves an attempt to determine the amount of sacrifice that will be made in a particular decision. Because a decision is made in the present about consequences that will occur in the future, the manager’s judgment may be important in estimating the total costs of sacrifices involved in the decision. This judgment can be improved by good analysis. Several cost principles are basic to this analysis.

Future Costs are the important Costs: Only those costs not yet incurred are important in a manager’s decision. A manager makes decisions for future actions. The manager’s viewpoint, like that of the managerial economist requires concern with future rather than with past costs. It is true that the manager will know more about past costs, which concern actions already taken place, because they have been recorded; yet, historical costs (those usually provided by the financial accountant) have limited value for the manager. They are important because they help the manager learn to make better future decisions. Also, certain computations such as income for tax reporting, must be based on past costs However, the basic criteria for current decisions are the expected benefits to be realized as a result of the decision compared with expected sacrifices that will need to be made. If you paid $1,000 for a useless item last year, it would be proper to forget the poor expenditure – it is a cost of a past decision. Any use (for example, scrapping) of the item in the future will involve only future sacrifices (certainly not the $1,000, which is past sacrifices). On the other hand, if an item which cost $1,000 last year has become extremely valuable today, the use of this item will involve a greater sacrifice than its use last year involved. It should be clear, at this stage that there are a number of cost classifications that are important under different conditions.

Opportunity Costs: Being interested in selecting the best alternative available, the manager must concentrate on the various opportunities that are open. A basic principle of economies is known as the principle of opportunity (alternative) costs, which is stated simply: The cost of any kind of action or decision consists of the opportunities that are sacrificed in taking that action. In deciding to use an hour of your time to file correspondence, you are sacrificing the chance of doing anything else with that hour. What is the cost of your filing correspondence for one hour? It depends. on what? If you otherwise would be waiting for someone and thus would have been idle, the cost is zero. If you are a doctor and could have performed an operation for which you would have been paid $200, the cost of filing would have been $200 (the sacrifice). If you could secure clerical help at the rate of $3.00 an hour so that you could perform the operation and have the correspondence filed, you would be able to allocate your time resources better (to the extent of $197, i.e. $200 less $3.00). Of course, it is often difficult to comprehend all the alternatives available and thus it is difficult to know all opportunity costs; yet the basic idea of opportunity cost is invaluable in helping to allocate resources properly.

Incremental Cost: We saw earlier that total costs, as shown on a breakeven chart, are useful to an analysis of operations. We indicated then that two other computations are possible: average cost per unit and changes in costs. The idea of average cost per unit is generally understood as dividing total cost by the number of units. Average cost is most useful when analyzing past costs; in fact, it can be misleading if used improperly in considering decisions for the future.

A most valuable concept in decision making is known as incremental cost defined as the additional (change in) total cost that results from a particular decision. Incremental analysis involves a comparison of changes in revenue and the associated changes in costs.