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Marginal Cost Analysis: Short-Run Alternative Choice Decisions

This document discusses marginal cost analysis and differential costs for short-run alternative choice decisions. It defines differential costs as costs that are different under one set of conditions than another, and explains that they include only elements of cost that vary between alternative courses of action being considered. The document outlines steps for analyzing alternatives, including defining the problem, selecting possible solutions, measuring consequences quantitatively and qualitatively, and making a decision. It also distinguishes types of costs such as variable, fixed, direct, indirect, sunk, and opportunity costs that are relevant to differential cost analysis for managerial decision making.

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Just Chill
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76 views

Marginal Cost Analysis: Short-Run Alternative Choice Decisions

This document discusses marginal cost analysis and differential costs for short-run alternative choice decisions. It defines differential costs as costs that are different under one set of conditions than another, and explains that they include only elements of cost that vary between alternative courses of action being considered. The document outlines steps for analyzing alternatives, including defining the problem, selecting possible solutions, measuring consequences quantitatively and qualitatively, and making a decision. It also distinguishes types of costs such as variable, fixed, direct, indirect, sunk, and opportunity costs that are relevant to differential cost analysis for managerial decision making.

Uploaded by

Just Chill
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Marginal Cost Analysis

Short-run Alternative Choice Decisions

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Highlights
Alternative choice decisions: manager seeks to choose best out of several alternatives. Introduces construct of differential costs and revenues for several types of problems, each having a relatively short time horizon.

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Differential Costs and Revenues


Costs that are different under one set of conditions than under another. Revenues that are different under one set of conditions than under another.

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Nature of Full and Differential Costs


Full cost of a product or service= sum of direct cost + fair share of applicable indirect costs. Differential costs include only those elements of cost that are different under a certain set of conditions.
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Source of Data for Full and Differential Costs


Full costs come from a companys cost accounting system. No comparable system for collecting differential costs. Differential costs are calculated to meet analytical requirements of a specific problem.
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Historical, Full and Differential 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 of a company) is the difference between its total revenue and its total variable costs.

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Variable and Fixed Costs


Variable costs (or expenses) are variable because they vary proportionately with volume 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 most important factor e g wanting to penetrate a new market, community responsibilities, etc

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Objective of Alternative Choice Problem


Seek alternative most likely to achieve objectives of organization. In a profit oriented business:
Maximizing value of shareholders investment by making alternative choices that earn a satisfactory return on investment. Return on investment is usually measured using an accounting and not a market-determined measure of return. 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 evaluate consequences in quantitative terms. Identify consequences that cannot be expressed in quantitative terms. Evaluate measured quantitative and nonquantitative 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 the base 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 most convenient. Cost items unaffected by decisions are not differential and may be disregarded (or treated the same under each alternative).

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Opportunity costs
Value lost or sacrificed by giving up an alternative 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 producing purposes, opportunity cost is measured by income that would have been earned had resources 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 alternatives involve operating at different volume levels within the relevant range. May also include fixed costs if any alternative results in changes 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 and therefore 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 if one alternative is to keep equipment and another alternative is disposal.

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Importance of Time Span


To make only one additional unit, only material cost may be differential. To produce an item over foreseeable future, all items of production cost would be differential. The longer the time span the more items of cost are differential. In the very long run full costs are differential costs.

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Types of Alternative Choice Problems


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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