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Decision Making Costs

Discussion about decision making Costs. All costs are not taken into account when decisions are made. But  only those change with activity and therefore effect decision.

Making decision is one of the basic function of a manager. managers are constantly faced with problems of deciding what products to sell, what production methods to use whether to make or buy component parts, what prices to charge, what channel of distribution to use whether to accept special orders at special price, and so forth.

Every decision involves choosing from among at least two alternatives. In making a decision the costs and benefits of one alternative must be compared with costs and benefits of  other alternatives. Costs that differ between alternatives are called relevant costs.

Distinguishing between relevant and irrelevant cots is important for reasons. First irrelevant data can  be ignored and need not be analyzed. This can save decision makers tremendous amount of time and efforts. Second bad decisions can easily result from erroneously including irrelevant costs and benefit data when analyzing alternatives. To be successful in decision making managers must be able to tell the difference between relevant and irrelevant costs and must be able to use relevant data in analyzing alternatives.

Decision Making Cost Concepts

Four cost terms are particularly important in our further discussion. These cost terms have been discussed in the page cost terms, concepts and classifications. These terms are differential costs, incremental costs, opportunity costs, and sunk costs. You may find it help full to read first  the page "cost terms, concepts and classifications".

Identifying Decision Making Costs and Benefits

Only those costs and benefits that differ in total between alternatives are relevant in decision making. If a cost will be the same regardless of the alternative selected, than the decision has no effect on the cost and it can be ignored. Relevant costs are also referred as to avoidable costs.

An avoid able cost is a cost that can be eliminated in whole or in part by choosing one alternative over another. Avoidable costs are relevant costs and unavoidable able costs are irrelevant costs. Two broad categories of costs are never relevant in decision making.

1. Sunk Costs
2. Future costs that do not differ between the alternatives.

Sunk cost is a cost that has already been incurred and that cannot be avoided regardless of what a manager decides to do. Sunk costs are always the same, no matter what alternatives are being considered, and they are therefore always irrelevant and should be ignored.

Future costs, on the other hand, that do differ between alternatives are relevant. In managerial accounting the term avoidable cost, differential cost, incremental cost, and relevant cost are often used interchangeably. To identify the costs that are relevant these steps can be followed.

1. Eliminate costs and benefits that do not differ between alternatives, these irrelevant costs consist of sunk cost and future costs that do not differ between alternatives.
2. Use the remaining costs and benefits that do differ between alternatives between alternatives. The costs that remain are the differential or avoidable costs.

The costs that are relevant in one decision are irrelevant in another decision. The managers need different costs for different purposes. For one purpose a particular group of costs may be relevant; for another purpose an entirely different group of costs may be relevant. Thus in each situation the manager must examine the data at hand and isolate the relevant costs. Other wise the manager runs the risk of being misled by irrelevant data.

The concepts of differential costs for different purposes is basic to managerial accounting. We shall see its application frequently in the pages that follow.

An Example of Identifying Relevant Costs And Benefits

Suppose you want to visit your friend over the week end. and you are trying to decide whether to drive or take the train. Because you are on a tight budget, you want to carefully consider the costs of the two alternatives. If one alternatives is far less expensive than the other, that may be decisive in your choice. The difference between your apartment and of your friend's is 230 miles. You have compiled the following list of items to consider.

Additional Data

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