How do you classify costs and benefits based on relevance?


Once a problem has been formulated as decision alternatives among which to choose, differential analysis consists in listing relevant costs and benefits.

Relevant costs or benefits are future costs or benefits (for the decision maker) which depend on the chosen decision alternative.

Differential analysis focuses on what differs between decision alternatives. The only thing that matters when choosing between two options is indeed their difference in cost benefits. Everything that is common to both options can be disregarded. This considerably simplifies computations. Note that the definition above lists two key conditions for a cost or benefit to be relevant: it must be 1) a future cost or benefit 2) affected by the decision.


Relevant costs and benefits

There are two kinds of relevant costs or benefits (also sometimes called differential costs or benefits): avoidable costs and opportunity costs.

Avoidable costs are future costs which can be avoided by choosing one decision alternative instead of another.

Depending on the alternative selected, some costs will be incurred or not in the future. For instance, if you stop producing and selling a product line, you will not incur the corresponding variable costs. You may even avoid some direct fixed costs like advertising for the product line or, if you can terminate employment contracts, the wage of employees working only on that product.

Opportunity costs are future economic benefits foregone as a result of pursuing one course of action instead of another.

Opportunity costs typically arise because available resources could be allocated to different courses of action but pursuing one means sacrificing another. For instance, if a manager chooses to maintain a product line, shared resources consumed by this product line cannot be redeployed to other product lines. This means sacrificing the contribution margin which could have been earned on these other product lines (to earn the contribution margin on the product line she decided to maintain). Selecting a decision alternative thus means sacrificing another. Opportunity costs require a special attention because they are not recorded in financial accounting; indeed, by definition, they relate to rejected alternatives which did not result in a transaction to record.


Irrelevant costs and benefits

Irrelevant costs are costs which do not differ between decision alternatives and should therefore not influence the decision at hand. They also refer to two different kinds of costs: unavoidable costs and sunk costs.

Unavoidable costs are future costs which will be incurred whichever course of action is chosen: they remain the same across decision alternatives.

Some costs are either completely unrelated to the decision alternative considered or have been committed and cannot be changed by any current action or decision. For instance, if a manager decides to stop making a product and to buy it from a supplier instead, neither variable nor fixed selling costs are affected as only the company keeps selling the product. In addition, if the organization has a notice period on the contracts of the production workers currently making that product, it will keep paying production wages until the end of the notice period, whether it makes or buy. These costs are thus unavoidable.

Sunk costs are costs which were incurred in the past and which therefore cannot be affected by the decision.

Book values typically belong to that category as they relate to past purchases and resources consumption. Just like depreciation, they never are relevant. This is important to stress as many managers tend to make the mistake of taking them into account when they make short-term decisions. Consider for instance the following example:

Solution. Operating Income would increase by 10 euros and the baker should definitely accept this exceptional offer. The cost of production is a sunk cost: it has already been incurred and therefore has already reduced the Operating Income. By accepting the deal, the baker gets 10 euros in exchange of something which has literally no market value. Unfortunately, some managers would refuse the order because they will mistakenly consider it leads to a loss of 15 euros (10-25). Note that the exceptional nature of the deal matters: it is important to ensure that customers do not start waiting for the last minute to negotiate more favorable prices…


It is not that irrelevant costs can be ignored: they must be ignored. They distract managers from what really matters, aggravate cognitive overload, distort perceptions, and lead to erroneous conclusions.


Listing and classifying costs

Differential analysis greatly simplifies decision making because it reduces the need for data collection and simplifies computations. Managers rarely have a complete set of information and must therefore acquire the information they need. Identifying what is relevant before collecting data can therefore save a lot of time compared to an exhaustive search. In addition, simple computations lead to less errors.

As a general approach, you should always start by breaking down cost components according to their timing (already incurred or not yet?), purpose (manufacturing or selling?), traceability (direct or indirect to the product considered?), and behavior (variable or fixed?). Past costs are always sunk costs and therefore irrelevant. Then, the set of alternatives considered indicates which future costs may differ depending on which decision alternative is chosen. Finally, to identify opportunity costs, ask yourself whether there are alternative uses for the resources which would or would not be available depending on the decision alternative chosen.

It is really important to stress that what is relevant is highly contextual: it depends on the decision maker, the alternatives considered, and the ability to satisfy the demand with available capacity. Each decision situation must therefore be carefully analyzed and not treated in a generic way.

Solution.

  • The 50 euros spent on buying the ticket are sunk costs because the expense has already been incurred; therefore, they are irrelevant to the decision of selling the ticket.
  • The 10 euros of transportation costs to go to the concert are avoidable as you do not incur them if you sell your ticket and do not go to the concert; therefore, they are relevant to the decision.
  • The 15 euros for the restaurant are unavoidable costs since they have not been incurred yet but they are not affected by the decision to sell the ticket, therefore, they are irrelevant to the decision.
  • The 100 euros are an opportunity cost because they are an economic benefit your forgo if you choose to go to the concert; therefore, they are relevant to the decision.

As we will see in the next subsection, it means that the net economic impact of selling the ticket is 100 + 10 = 110; alternatively, the net impact of going to the concert is a loss of 110. In other words, the utility of that concert for you should be greater than 110 euros for you to keep the ticket.



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