Using Costs in Decision Making
By: Achmad Faizal Azmi (361160)
This chapter discuss cost information and the important role it plays in strategy
development and in monitoring the results of implementing the strategy. The use
of cost information is pervasive throughout decision-making situations such as pricing, product
planning, budgeting, performance evaluation, and contracting.
Generally, there are two kinds of costs:
1. Variable cost one that increases proportionally with changes in the activity level
of some variable. For example, the activity of making a chair in a furniture factory
consumes the wood that goes into the chairs. The acquisition and consumption of the
wood creates a cost for wood that increases proportionately with the number of chairs
made.
2. Fixed cost cost that does not vary in the short run with a specified activity. The
defining characteristic of a fixed cost is that it depends on the amount of a resource
that is acquired rather than the amount that is used. For this reason fixed costs are
often called capacity-related costs.
Planners and decision makers like to know the risk associated with the decisions that
they make. A good understanding of cost and revenue behavior is critical in providing decision
makers with an understanding of the relationship between a projects revenues, costs, and
profits. One of the method that usually used by management is Costvolumeprofit (CVP)
analysis. It uses the concepts of variable and fixed costs to identify the profit associated with
various levels of activity.
There are some assumptions underlying CVP analysis to be practical in most organizations:
1. The price per unit and the variable cost per unit (and therefore the contribution
margin per unit) remain the same over all levels of production.
2. All costs can be classified as either fixed or variable or can be decomposed into
a fixed and variable component.
3. Fixed costs remain the same over all contemplated levels of production.
4. Sales equal production.
Other cost definition:
Mixed cost A mixed cost is a cost that has a fixed component and a variable component.
For example, your mobile telephone bill may have a fixed component that you pay each month,
independent of how many calls you make, and a variable component that depends on the
quantity of calls you make.
Step variable cost A step variable cost increases in steps as quantity
increases. For example, suppose that a company has a policy of hiring one factory
supervisor for every 20 factory workers. If each factory supervisor is paid $60,000, the
total cost of supervisory salaries increases in a series of steps with the number of
workers.
Incremental cost An incremental cost is the cost of the next unit of production and is similar
to the economists notion of marginal cost. In a manufacturing setting, incremental cost is
generally defined as the variable cost of a unit of production.
Sunk cost A sunk cost is a cost that results from a previous commitment and cannot be
recovered. For example, depreciation on a building reflects the historical cost of the building,
which is a sunk cost.
Relevant cost A relevant cost is a cost that will change as a result of some decision
Opportunity cost Opportunity cost is the maximum value forgone
when a course of action is chosen.
Avoidable cost An avoidable cost is a cost that can be avoided by undertaking some course
of action.
Various cost concepts (sunk, relevant, opportunity, and avoidable) occur in common
management decisions There are four types of decisions where these concepts provide useful
insights:
1. Make versus buy decisions and outsourcing.
2. Decision to drop a product.
3. Costing order decisionsthe floor price.
4. Short-term product mix decisions (with constraints).
Source:
A.A. Atkinson, R.S. Kaplan, E.M. Matsumura, and S.M. Young. 2012. Management Accounting:
Information for Decision-Making and Strategy Execution. Upper Saddle River: Pearson Prentice Hall
