Kinds of costs and their relevance in decision making process

Author: Iloka Benneth Chiemelie

Published: 20th of February 2014

1. Distinguish between different types of costs

Cost is a very common concept in the accounting field, but different kinds of costs exist for different purposes. In order to understand the different kinds of cost, this research will focus on the definitions presented by Washington States University (2012) as:

1.1. Sunk cost (unrecoverable): this is the kind of cost that has already occurred in the business process and cannot be recovered.

1.2. Non-sunk cost (recoverable): this is a kind of cost that is incurred following a particular decision as to why such cost should be incurred.

1.3. Explicit cost: this is a kind of cost that has a direct monetary outlay.

1.4. Implicit cost: this is a kind of cost in which monetary outlay is not involved. For instance, this is the kind of money that an airline company can get from renting, rather than actually making use of its own plane.

1.5. Opportunity cost: this is the value of the best alternative choice that is forgone in the course of choosing another alternative.

2. What costs are relevant for decisions making?

All the costs discussed above are used in the course of decision except for sunk cost. This is because sunk cost is a reflection of a cost that has already occurred in the past and cannot be recovered and as such is not involved in the cost of present and future decisions. However, other costs are used for decision making because they involves costs related to the future as to what the company will benefit from incurring such costs such as the opportunity cost that is the incurred cost following a forgone alternatives.

3. How do managers overcome the natural tendency to consider historical and sunk cost when evaluating business alternatives?

Naturally, managers are forced to put past costs into present decision process by adopting such cost as a reflection on what the company did in the previous years and what they benefited from such decision, then comparing it with them present decision and future plans. However, the business is not statics and the increasing level of dynamism means that what was successful in the past might not be successful in the present and vice versa.

The Washington State University (2012) also present a discussion of how managers can avoid or at least control the tendency of looking back the costing decisions by maintaining that managers should focus on corporate goal and understand that changes in market can influences changes in the business process as well as expected outcome (WSU, 2012). Thus, the main ideology is having clear business focus as to what the management want and how they want to go about achieving such wants. Besides focus, the management should also have clear and defined principles as to what they can do and what they cannot do (WSU, 2012). Such principles will ensure that when the decision is to focus on the future and not compare with past experience, the management will stick precisely with such decisions through clear corporate and individual principles.

                                                  

4. Reference

Washington State University (WSU) (2012), “Chapter 7: cost and cost minimization.” Available at: http://faculty.ses.wsu.edu/Munoz/Teaching/EconS301_Fall2011/Slides_EconS301_only_pdfs/EconS301_Ch7.pdf  [Accessed on; 15/12/2013].