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Marginal Cost Analysis
Short-run Alternative ChoiceDecisions
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Highlights
Alternative choice decisions: managerseeks to choose best out of several
alternatives. Introduces construct of differential costs
and revenues for several types of
problems, each having a relatively shorttime horizon.
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Differential Costs andRevenues
Costs that are different under one set ofconditions than under another.
Revenues that are different under one setof conditions than under another.
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Nature of Full andDifferential Costs
Full cost of a product or service= sum of
direct cost + fair share of applicableindirect costs.
Differential costs include only those
elements of cost that are different under acertain set of conditions.
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Source of Data for Full andDifferential Costs
Full costs come from a companys costaccounting system.
No comparable system for collectingdifferential costs.
Differential costs are calculated to meet
analytical requirements of a specificproblem.
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Historical, Full andDifferential Costs
Full cost accounting system collects
historical costs. Differential costs relate to future. Differential costs show what costs will be if
a certain course of action is adopted.
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Contribution Analysis
A tool for analyzing differential costs. Focuses on contribution margin. Contribution for a company (or for a
product line, division, or other segment ofa company) is the difference between itstotal revenue and its total variable costs.
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Variable and Fixed Costs
Variable costs (or expenses) are variable
because they vary proportionately withvolume of activity, such as sales. Fixed costs = in total do not vary with
activity (within relevant range).
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Direct and Indirect Costs
Direct costs = costs that are traced directly
to cost object. Indirect costs = costs that are not traced
directly to cost object.
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Alternative Choice Problems
2 or more possible alternative courses of action.
Manager chooses best alternative. Some choices may be quantified, but this is only
one aspect of analysis and may not be mostimportant factor e g wanting to penetrate a newmarket, community responsibilities, etc
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Objective of AlternativeChoice Problem
Seek alternative most likely to achieveobjectives of organization.
In a profit oriented business:
Maximizing value of shareholders investment bymaking alternative choices that earn a satisfactoryreturn on investment.
Return on investment is usually measured using anaccounting and not a market-determined measure ofreturn.
Other factors are also likely to influence decision.
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Steps in the Analysis
Define problem. Select possible alternative solutions including
status quo.
For each alternative, measure and evaluateconsequences in quantitative terms.
Identify consequences that cannot be expressedin quantitative terms.
Evaluate measured quantitative and non-quantitative consequences.
Make decision.
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Differential Costs
Out of pocket costs = avoidable costs =costs that will be different under the
proposed alternative than they are in thebase case. No general category of costs can be
labeled differential. Always relates to specific alternatives
being analyzed.
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Mechanics of Calculation
No prescribed format; use mostconvenient.
Cost items unaffected by decisions are notdifferential and may be disregarded (ortreated the same under each alternative).
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Opportunity costs
Value lost or sacrificed by giving up analternative course of action.
Not associated with cash outlays.
Not measured in accounting records. If an alternative requires resources that would
otherwise be used for income producingpurposes, opportunity cost is measured by
income that would have been earned hadresources been invested otherwise. Iffy costs.
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Differential Costs
Differential costs = incremental costs = relevant costs =out-of-pocket costs = avoidable costs
= variable costs(=marginal costs), if all alternativesinvolve operating at different volume levels within therelevant range.
May also include fixed costs if any alternative results inchanges in step-function costs.
Future costs, which may be best estimated by looking at
past/historical costs. Usually estimates are not precise unless determined by
contract.
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Sunk Cost
= a cost that has already been incurred andtherefore cannot be changed by any decision
currently being considered. e.g. all historical costs. Not a differential cost. If asset is used it is depreciated, if it is disposed
off it is written off, in either event it is expensed.
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Disposal Value
Relevant and differential cost/revenue ifone alternative is to keep equipment andanother alternative is disposal.
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Importance of Time Span
To make only one additional unit, only materialcost may be differential.
To produce an item over foreseeable future, allitems of production cost would be differential.
The longer the time span the more items of costare differential.
In the very long run full costs are differentialcosts.
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Types of Alternative ChoiceProblems
Problems involving costs.
Problems involving revenues and costs. Differential investments.
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Contribution Pricing
Full cost is normal basis for setting price. Orders may be accepted when differential
revenues exceed differential costs. Such a selling price is called a contribution price to
distinguish it from a normal price. A version of this is referred to as dumping and may
be illegal .
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