Earlier article, we discuss about relevant costs-its importance and functions on short term decisions.
In this articles we look at other costs namely OPPORTUNITY COST, INCREMENTAL OR DIFFERENTIAL COST AND AVOIDABLE COST which are also relevant or useful to management decision makings:
| OPPORTUNITY COST |
| Represents the opportunities which have been forgone by following one course of action rather than an alternative course.
The opportunity cost in this case is the profit foregone by utilizing scarce resources for one particular course of action. |
| Example: |
| Company A may either manufacture or buy a component from an outside supplier. If it buys from outside, the spare capacity can be rented out to another manufacturer for $20,000.
The opportunity cost of making the component would be to lose the opportunity to earn the $20,000
Note that the opportunity cost does not involve cash transaction but it is “relevant� to decision making. |
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| INCREMENTAL OR DIFFERENTIAL COST |
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Incremental cost is used interchangeably with differential cost.
Incremental cost is the additional cost and revenue that may result from each degree of change in the level or nature of activity. Whilst Differential cost is the difference in the cost and revenue between two alternatives. |
| Example: |
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Company A need to consider whether or not to accept a special order.
One relevant piece of information will be the variable cost.
The relevant cost before taking this special order is $25,000 and after taking the order it is $35,000.
Therefore the differential or incremental cost is $35,000-$25,000 which is $10,000 |
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| AVOIDABLE COST |
| Is cost that can be avoided if a given alternative is not adopted. |
| Example: |
| Assuming that a manufacturer decides not to proceed with a new product line which enable total savings in direct material, labor, direct expenses and variable costs of $10,000.
In this case, the differential cost of $10,000 can be avoided. The $10,000 is the avoidable cost. |
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