Cost Concepts for Managerial Decision Making

Prepared for instructional use in

Economics For Managers

ECG 507

College of Management
North Carolina State Universiy
Stephen E. Margolis 2000

Soon we will be using the concepts of cost that are presented in Landsburgs
chapters five and six to analyze market behavior of firms. With a bit of interpretation,
however, these concepts have immediate application to ordinary decisions that firms make
on a daily basis. The first three sections of this essay should help to establish the
connections between the economics textbook treatment of cost and these decision
problems. The final section presents some examples of decision problems that exercise
these cost concepts

I. Foundations: Three Normative Principles

There are three simple but general normative principles that underpin rational or profit
maximizing choice. They are: Opportunity cost, comparison of costs and benefits, and
incrementalism.
A. Evaluate opportunity costs.
Opportunity cost is the concept of cost in economics. The cost of any action is the value
of what is forgone as a result of the action. If an activity does not displace something
else, then we could say that it has no cost. Of course, it seems a bit odd to suggest that an
action does not have some cost. That is because almost any activity will displace
something.
In some instances, opportunity cost is manifest as ordinary or explicit cost. It is "out of
pocket expenditure" or more simply, "expenditure." So, for example, a project might
require that we hire five people for one day each, at a cost of $200.00 per person per day.
The expenditure is an opportunity cost: We must forgo something worth $1000 in order to
undertake the project.
Sometimes opportunity costs can be more remote. Imagine that a firm owns a factory
and is considering using a portion of the factory for assembling laptop computers. The
cost of the use of the factory for laptop computer assembly would depend entirely upon
what else the space might be used for. At one extreme, it might be that the firm has no
alternative use for the space. It is considering no other activity, and it is unable to sell or
sublet the space to anyone else. In that circumstance, the cost of using the factory for
laptop production is properly considered to be zero. Of course, there may be alternative
uses. If the best alternative use of the space is to sublet it, then the net revenues of from
the lease is a cost of producing laptops. Or laptop production may displace another
productive activity that would yield positive net revenues. In that case, those net revenues
that are sacrificed to make laptop computers become a cost of making them.
Notice that in considering the cost of laptop production, there was no mention of how
much the factory cost, whether or not it was paid for, what the interest rate is, or whether
the factory had been fully depreciated in the firms financial accounts. While those
considerations are certainly important to the firm, they do not affect the cost of using the
factory. They are determined by past actions and do not affect current opportunities.
They pertain to sunk costs, if anything.

B. Compare costs and benefits.

Profit maximizing behavior involves choosing actions for which benefit exceed cost. That
is to say, decision makers should consider all the benefits of an action, all of the costs, and
take appropriate action. This dictum may seem more nearly self evident in the context of
the firm than in personal or social decisions, but the same principles could be applied in
any of these settings.
In order to add up costs and benefits and compare them, it is necessary to translate them
all into a common dimension. Most often, that dimension is money. (This is the familiar
apples and oranges problem.) In most cases, and certainly in most business cases,
translation of benefits and costs into money terms would seem automatic. In fact, one
reason that a comparison of costs and benefits seems like such an obvious step in the
business setting is that many managerial decision problems naturally present themselves in
terms of revenues and costs, both of which are already expressed in dollars. However, it is
not strictly necessary to compare things in money terms. A hospital administrator
attempting to allocate a fixed budget might evaluate programs by considering the numbers
of lives saved versus the number of lives lost, as a result of some decision.
The use of money amounts for comparisons in business settings should not be understood
to mean that we should only consider those benefits and costs that are ordinarily expressed
in money terms. For example, an action may enhance the reputation of the firm, or
diminish employee morale. Such consequences should be considered as part of any real
problem. If these effects are large, it may be worth generating an estimate of their money
values. Alternatively, it may be helpful simply to note these effects in comparison with the
net of monetized benefits and costs.. (As in, "Assembly of laptop computers in the unused
factory space will result in a net loss of half a million dollars, but it will preserve job
continuity for 400 employees.")
C. Consider incremental effects.
Arguably this is a special case of the sunk cost principle, but it is special and important
enough to merit some discussion. In making the cost-benefit comparison for an
undertaking, the manager should look at the things that change, and only the things that
change, as a result of the undertaking: Examine incremental revenues and incremental
costs. Consider this unrealistically transparent example: I now have total revenues of
two million dollars and total costs of one and a half million dollars. If I accept a proposed
contract, I will have total revenues of two and a quarter million dollars and total costs of
two million dollars. With the contract, total benefits exceed total costs, but the contract
should be rejected. The incremental revenues from the contract are a quarter of a million
dollars, but the incremental costs are half a million.
Marginalism is a special case of incrementalism in which the increments are very small. In
deciding how many cases of shampoo to produce, the decision unit might be a case, and
we would consider the marginal cost and the marginal revenue of a case of shampoo. But
important business decisions sometimes come to us in bigger and indivisible pieces. They
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are, for example, whether to accept a contract for one hundred thousand shirts, or whether
to enter a new line of business, or whether to initiate a new degree program. There is no
inconsistency between the principles used in the two kinds of problems. To figure out
the optimal size of a degree program, we should be led to discussions of the benefits and
costs of educating an additional student. To consider whether to undertake the program,
we look at the incremental costs and benefits of the program as a whole. In one case the
increment is small, and we use the word marginal, in the other case the increment is large,
and we don't. In any case, we have to be sure to address problems in the form that they
come to us.

II. Relationships between economic and accounting cost concepts

Accounting and economics often seem to be at cross purposes. We distinguish, for
example, between accounting profits and economic profits. Often the differences in
approach reflect important differences in purpose. In particular, the demands of
consistency and reliability that are imposed by external uses of accounting information
often result in practices that appear to be puzzling from an economic point of view. But
the two disciplines come close together, or should, where managerial accounting and
managerial economics address the same subject matter.
There are some terminological differences. These probably arise from the fact that
economists can distinguish among types of cost on an abstract basis, while accountants are
compelled to offer conveniently operational distinctions. With a bit of understanding, it
should be possible to make the connections between the cost information that accountants
present and the cost ideas that economists use.
Economists separate the world of cost into those costs that are variable--that vary with the
level of output--and those that are not. With breathtaking lack of imagination, they call
these variable costs and fixed costs respectively. Accountants, on the other hand, divide
the world into those costs that may be directly associated with an objective or output (a
cost object) and those that are not. With a similar lack of creativity, they call these direct
and indirect costs, respectively. Indirect costs are often called overheads, and overheads
are usually further subdivided into fixed overheads and variable overheads. Other terms,
such as burden, or allocated burden, may be used in place of overhead, depending on local
practice. If we are selling hot-dogs, the expenditure on the dogs, the buns, the catsup,
mustard and slaw, and the cooks' time are direct costs. The storefront is fixed overhead,
the supervision is most often considered to be variable overhead.
There is a fairly simple rearrangement that does connect the two sets of ideas. Generally
speaking, fixed overheads will correspond to economists' fixed costs. Direct costs and
variable overhead then add up to economists variable costs.
Accountants use unit cost to mean the total cost divided by the total output.. This
operation can be applied to any cost dimension, as in "unit direct cost", or "unit total cost"
(often just unit cost). Economists use average variable cost and average total cost in the
same way.
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For many sorts of practical problems, it is important to be able to consider how these
various cost dimensions vary with output. Economists generally present these costs as
varying with output in a nonlinear fashion, especially when considering short-run
variations in output. (That is, total cost, or total variable cost is not proportional to
output.) Accountants, on the other hand, acknowledge the nonlinearities, but look to take
advantage of the linearities where they can be found. For example, accountants are apt to
make a simplifying approximation that unit direct costs are constant, over a specified
range. (This is the same as saying that total direct costs vary in proportion (or linearly)
with output.) This simplification is often a useful step. If, over the range of possible
output that is relevant to a decision, input prices are not changing, and labor is adjustable
so that it is always fully employed, and capacity constraints are not being encountered, the
approximation is probably a good one. Unfortunately, variable overhead is somewhat less
likely to vary in proportion to output.
If direct cost is proportional to output, and variable overhead is either proportional to
output or absent, then total variable cost is also proportional to output, which is to say
that average variable cost is constant. Where that is true, or reasonably approximated,
marginal cost is equal to, or reasonably approximated by, average variable cost. ( To see
this, notice that if average variable cost is constant, then total variable cost can be
expressed as a simple linear function TVC = aQ, where a is average variable cost and Q is
output. With that, it is easy to see that marginal cost, the slope of the total cost function, is
just a.) Where this approximation is satisfactory, there is a very useful connection
between the accounting data and the concepts of cost that are emphasized in
microeconomics. Unit direct cost plus unit variable overhead may be used as an
approximation of marginal cost. We have already seen, and will see again and again, that
profit maximization conditions are always defined with reference to marginal cost.
It is sometimes claimed that accounting ignores opportunity costs that are not manifest as
explicit costs, while economics does not. But this observation oversimplifies. It is true
that financial accounting does not treat a forgone opportunity as a cost. But good
managerial accounting, like economics, does. For example, let's say I take $100 and
invest in a bottle of wine. I hold the wine for a year, then sell it for $110. Meanwhile, best
alternative investment would have earned 7%. A financial accounting of the undertaking
would declare that I had revenues of $110 from the undertaking, costs of $100, and a
profit of $10. An economic analysis would argue that I collected $110 in revenues, and
had costs of $107 ($100 plus the foregone interest) and a profit of $3. Good cost
accounting would note the $100 expenditure (a direct cost, or cost of goods sold), and a
$7 implicit cost of capital, and would join the economic analysis in declaring a profit of $3.
When economists or accountants refer to accounting costs or accounting profits, as
something distinct from economic costs or economic profits, they are referring to the
conventions of financial accounting, not cost or managerial accounting.

III. Operational occurrences of the normative principles

The normative principles that are presented above have the advantage of being general,
simple, and few in number. The problems in section IV can all be addressed using only
those principles. There do seem to be, however, a few applications that come up with
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some regularity. Here are all the ones that I have been able to identify. You may be able
to think of some others.
A. Replacement cost
If an item can be replaced, and in the course of normal continuing business it would be
replaced, then the appropriate measure of cost of the item is its replacement cost. This
follows directly from the concept of opportunity cost. If I bought catsup for inventory at
$12 per case, but after the purchase the price has gone up to $20 a case, the consequence
of using up an additional case today is that I'll make an additional expenditure of $20 in
the future. If someone offers to pay me $ 18.00 for one of the cases in inventory, I should
refuse. The offer may look like it yields a profit of $6, but it imposes incremental costs of
$20 against incremental revenues of $18, and so is a loss of $2.
B. Fixed costs part one: Fixed costs are fixed.
A fairly common error is to base output decisions on average total costs, or in accounting
terminology, unit costs. Doing so treats fixed costs incorrectly. Variable costs may or
may not vary in proportion to output. But fixed costs cannot vary in proportion to output.
They cannot vary at all. If you multiply average total cost by a change in output, you will
be overstating incremental cost if there are any fixed costs that are included in the average.
C. Fixed costs part two: Some fixed costs are sunk.
Sometimes, fixed costs are sunk. In the laptop example above, where there was no
alternative use of the factory floor space, the cost of building, financing, insuring, etc., the
factory space is irrelevant to the question of whether or not it is profitable to assemble
laptop computers.
D. Fixed costs part three: Some fixed assets do not constitute sunk costs.
Much of the time, the use of fixed assets for one purpose will have some opportunity cost.
Even though the assets are durable, and the commitments to create them are long past,
they have current alternative uses. And again, it does not matter whether the asset is paid
for or not, depreciated or not, leased or not. Continuing with the laptop example, if the
factory space can be used for something other than laptop production, there is a cost to
using it.
The potential error here, of course, is ignoring the opportunity cost. This probably is not a
big hazard, since real alternative uses for an asset are likely to come up in real-world
decisions of the sort that we are considering. The only real hazard is that the message of
parts B and C above is oversimplified. It is not the case that the costs of using fixed assets
should always be ignored. Rather it is the present opportunities that they offer, and not
their historical costs, that are important.
E. Fixed costs part four: "Fixed" costs are not always fixed.

Some durable assets that will be fixed assets once they are created, are nevertheless
variable at the time that a decision is being made. Consider a line of business that requires
special tooling. That cost of that tooling will be a fixed cost when we are making the
decision regarding how much of the product to produce. In that decision, the cost of
tooling is properly ignored. But in deciding whether or not to enter the line of business,
the line of business is the relevant increment, and the cost of the tooling should not be
ignored. The potential for error arises from adopting the overly simple rule that all the
costs of all durable assets (say, tooling) are sunk costs. Costs that will be sunk, ex post,
are nevertheless variable before the commitment of resources.
F. Some costs are forgone revenues.
This idea overlaps with point D above, but it is important enough to risk redundancy. An
increment of new business may result in reduced sales of something else. In that case, cost
no longer will be manifest as expenditures, but will instead take the form of decreases in
revenue.
IV Exercises.
The exercises that follow illustrate basic cost principles. Develop your answer, then try to
associate the exercise with one or more of the operational ideas that are presented in
section III.
1. Toyotas: The local Toyota dealer has six Camry LE's on the lot with a popular
equipment package. The dealer sells about three of these cars per week and can get three
day delivery on these cars from the distributor. They have paid $19,600 for the cars on the
lot, net of all rebates, etc. They have just been notified, however, that all cars ordered on
or after today will cost the dealer $18,900.
Molly Golden is negotiating for one of these cars. The sales person talking to her has
gotten her to offer $19, 400. He is convinced that this is her final offer. The transaction
price on this deal is not expected to affect the terms of any other transaction. All warranty
costs are covered by payments from Toyota. Toyota also covers any preparation and
delivery costs, so that the price paid to Toyota reflects the full cost of selling the car.
Should the dealer accept this offer?
2. Candy: A confectioner has just received an offer from a large retail chain. The chain
has offered to buy 4,000 boxes of candy per month for a price (wholesale) of $6.00. The
confectioner has a one shift capacity of 10,000 boxes.
Total variable cost is proportional to output up to that capacity. Beyond that, additional
output can be produced, but there is a 15% premium on direct labor and a 10% premium
on variable overhead. They have been selling about 8,000 boxes of candy per month at
$6.75.
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For the most recent month their output is 8000 units and their costs are as follows:
Direct Materials
Direct Labor
Variable Overhead
Fixed Overhead

$16,000
12,000
8,000
14,000

Total

50,000

Should the confectioner take this order? State any simplifying assumptions that you must
make to reach your conclusion. (Adapted from Evan Douglas, Managerial Economics.)
3. Guitars: In the early seventies it was argued that Yamaha had a cost advantage in
making acoustic guitars because they used the scrap wood from their piano soundboards
to make the tops of guitars. Evaluate this argument. Does your answer imply that
Yamaha made profits in guitar sales?
4. Instruments: The Darn Close (DC) measurement company makes a line of precision
instruments. They face a make-or-buy decision for a new pressure gauge that is a part of
their oil well monitoring system. They will need 5000 of these gauges for their current
series system. After that, they expect to replace the series with all new technologies. This
new pressure gauge can be made in the RTP plant that was making the old pressure gauge.
For the past year, the costs for that plant for 5000 gauges were as follows:
Fixed Overhead
Variable Overhead
Direct Labor
Direct Materials

$125,000
200,000
100,000
80,000

Production of the new gauge at the RTP plant would be subject to the same costs as the
old gauge, except that production of the new gauge would require a one time fixed
investment of 75,000 in new tooling. This new tooling will not have any alternative use
when the new technology is introduced in about a year. DC has no alternative production
plans for this plant, but could lease it for $80,000 to a nearby manufacturer of business
machines as pilot production facility. If they do not manufacture the gauge themselves,
they could buy the gauge from an outside vendor for $115.00 each. There would be no
other costs associated with using the gauge from the outside vendor. What should DC do?
How much better is your solution than the alternative? (In dollars)
.
5. Awnings: A tent making company is considering an offer from a restaurant chain.
The Restaurant chain would contract to purchase 115 awnings in the next year, and none
after that. The tentmaker currently turns out 1500 tents per year, which it wholesales for
$140 each. The costs of production for the tents are shown below.
Fixed Overhead (rent, equipment, insurance, utilities, etc.)
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$12,000

Other Overhead (Manager)

Direct materials
Direct Labor

30,000
40,000
60,000

The tentmaker cannot accommodate any additional workers, but it estimates that it could
produce the awnings with the current staff and manager, but doing so would cut their tent
production in half. They would also have to have some special forms made at a cost of
$10,000. These forms are proprietary to the restaurant chain, so that they could not be
used for any other purpose. Direct materials costs, per awning, are $135. The contract
would pay them $800 per awning. Should they contract to produce the awnings? How
much better or worse off are they if they accept the offer.
6. Horticulture: Jim Easley is going to open up his Christmas tree operation again this
year. He buys trees for $16, 17, and $20, delivered to his lot. He marks up any of the
trees by $8 to retail prices of $24, 25 and $28. He has found a suitably located lot that he
can rent for $800 for the month of December. He will rent a portable office and associated
equipment for $400 for the month. He will pay and attendant $70 for each day that the
attendant is actually on the lot. He has no return rights with his Christmas tree suppliers.
a. Assuming that his program calls for him to keep the lot open for 15 days, and that he
has no wasted trees, how many trees must Jim sell to break even? (OK, we haven't
covered this yet. But you should be able to figure this out)
b. On December 22, Jim has run out of the $24 and $28 trees, but he has about a dozen of
the $25 trees left. He has to decide whether to close up his lot and call it quits for the
season, or stay open for one more day. How many trees must he expect to sell for it to be
worthwhile to stay open for one more day?
7. Chevrolets: GM seems to be pursuing a low price strategy with the Chevrolet
Cavalier. The business press has reported that "GM can afford to sell the Cavalier at a low
price because the tooling is paid for." Use the discussion above, together with the
discussion in chapter 5 to evaluate the statement. (At one level, this is a pretty trivial
problem. At another, it is very difficult, and draws on ideas that are yet to come in the
course. But a bit of thought about this problem is a good introduction to the market
organization chapters that are coming up. )