Apply economic cost concepts in making business decision
Accounting and Economic Costs 2. CIMA defines relevant costs as 'costs appropriate to aiding the making of specific management decisions'.
Importance of relevant cost in decision making
In short, the cost of using a resource for one purpose is its value in the best alternative use which has to be given up. Here, net effect on costs is important. Investing money in government bonds is relatively risk free, for example, sino there is virtually no risk of default in mature economies. Thus economic costs include accounting costs plus implicit costs, that is, both explicit and implicit costs. Historical and Replacement Costs: The historical cost is the actual cost of an asset incurred at the time the asset was acquired. The existence of economic profit confirms this. Implicit costs refer to the payments made to the self-owned resources used in production. Therefore, if they are used to produce one thing, they have to be withdrawn from other uses.
In the use of a machine or an equipment that has been completely written off the book, the accounts involve a cost if its use for the purpose under consideration, requires the giving up of alternative opportunities.
For example, depreciation which does not require current cash payments. Likewise, if the output of a mini steel plant or glass factory cannot be sold profitably, there is no opportunity cost associated with letting out the plant. In one case the increment is small, and we use the word marginal, in the other case the increment is large, and we don't.
All the explicit costs such as rent, wages, interest, transport charges, etc.
Cost based decision making
The costs of production for the tents are shown below. Suppose a manager can earn Rs. If these effects are large, it may be worth generating an estimate of their money values. Direct labor and materials costs and changes in the vari- abJ. This figure should be included as an incremental cost of deciding to produ the special order. It cannot be altered, increased or decreased by varying the level of activity or the rate of output. Adapted from Evan Douglas, Managerial Economics. He is convinced that this is her final offer. Some costs are forgone revenues. The relevant costs for decision purposes will be the sum of: i 'avoidable outlay costs', i. In effect, this is the familim ceteris pariqus requirement: the comparisofi of one investment with other investments oJ equal risk. An opportunity cost is the benefit foregone by choosing one opportunity instead of the next best alternative.
And, for most practical decision problems, the two terms incremental cost and differential cost are used synonymously. Similarly, many business school professors continue to teach in business schools, rather than accept positions with subStantially higher salaries in business and government, because of the psychic income associated with the academic life.
These costs are also called avoidable costs or controllable costs. Historical cost of assets is used for accounting purposes, in the assessment of net worth of the firm, while the replacement cost is used for business decision regarding the renovation of the firm. In the case of a car manufacturing company, the cost incurred in protecting the plant and equipment while it is temporarily idle must be calculated.
Concept 6. Normal profit, therefore means as much profit as the owners could get elsewhere. In contrast, replacement cost means the price that would have to be paid currently for acquiring the same plant.
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