marginal cost analysiis

8/13/2019 Marginal Cost Analysiis

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Marginal Cost Analysis

Short-run Alternative ChoiceDecisions


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Highlights

Alternative choice decisions: managerseeks to choose best out of several

alternatives. Introduces construct of differential costs

and revenues for several types of

problems, each having a relatively shorttime horizon.


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Differential Costs andRevenues

Costs that are different under one set ofconditions than under another.

Revenues that are different under one setof conditions than under another.


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Nature of Full andDifferential Costs

Full cost of a product or service= sum of

direct cost + fair share of applicableindirect costs.

Differential costs include only those

elements of cost that are different under acertain set of conditions.


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Source of Data for Full andDifferential Costs

Full costs come from a companys costaccounting system.

No comparable system for collectingdifferential costs.

Differential costs are calculated to meet

analytical requirements of a specificproblem.


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Historical, Full andDifferential 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 ofa company) is the difference between itstotal revenue and its total variable costs.


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Variable and Fixed Costs

Variable costs (or expenses) are variable

because they vary proportionately withvolume 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 mostimportant factor e g wanting to penetrate a newmarket, community responsibilities, etc


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Objective of AlternativeChoice Problem

Seek alternative most likely to achieveobjectives of organization.

In a profit oriented business:

Maximizing value of shareholders investment bymaking alternative choices that earn a satisfactoryreturn on investment.

Return on investment is usually measured using anaccounting and not a market-determined measure ofreturn.

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 evaluateconsequences in quantitative terms.

Identify consequences that cannot be expressedin quantitative terms.

Evaluate measured quantitative and non-quantitative 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 thebase 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 mostconvenient.

Cost items unaffected by decisions are notdifferential and may be disregarded (ortreated the same under each alternative).


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Opportunity costs

Value lost or sacrificed by giving up analternative 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 producingpurposes, opportunity cost is measured by

income that would have been earned hadresources 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 alternativesinvolve operating at different volume levels within therelevant range.

May also include fixed costs if any alternative results inchanges 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 andtherefore 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 ifone alternative is to keep equipment andanother alternative is disposal.


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Importance of Time Span

To make only one additional unit, only materialcost may be differential.

To produce an item over foreseeable future, allitems of production cost would be differential.

The longer the time span the more items of costare differential.

In the very long run full costs are differentialcosts.


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Types of Alternative ChoiceProblems

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 .

marginal cost analysiis

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