This module discusses using costs in decision making as well as accumulating and assigning costs. Discuss all of the following:
Different managerial uses of cost information The meanings and decision making uses of sunk costs, opportunity costs,
avoidable costs and relevant costs Experiences you have with these costs, whether it be in your daily personal life or
in your professional life
While going through this module there were many occasions where I paused for a moment and tried to consider how I could use this information in my day to day from a managerial standpoint. I currently am a project manager for a telecommunications company and assist with managing the construction to install internet/cable wiring in homes and apartment complexes across my region. I am constantly analyzing the costs of projects, which include installation, labor, time variables (different areas have different landscapes/needs), materials, and a lot of other things to create a scope of work for each project. I use this information to help identify what a good or bad bid would be for projects. I also use this information to help identify if there is a net profit on our time spent for these projects. From a labor standpoint, I’m also using this cost information to approximate how many people are needed for certain jobs and what the timeframes are for completion.
Sunk costs are costs that results from a previous commitment and cannot be changed or recovered (these should not be included when weighing new decisions). I recently had an example of this within my development projects recently where we had 2 extremely similar apartment complexes right next to each other on the same street. We had a contract on one and not the other, so we began doing work and installed all our services in the building. We found out later that our team accidentally did all the work/installation on the wrong building when we did not have a contract negotiated yet. Our team needed to meet to determine next steps, costs, and if it is worth it for our company to remove all the lines or keep them there in the hopes that we could secure something. This was a very expensive decision but when weighing this we removed the sunk costs from the assessment. These included the materials, supplies, and labor used to install everything in the wrong building.
Opportunity costs are the maximum value forgone when a course of action is chosen. I also come across this in my field when we have multiple developers (customers) looking for our team to install/build in their apartments. Often, we must decide which work we want to commence and need to give up the other opportunities due to time constraints and labor. Let’s assume my team receives 3 projects with an estimated return of 500k, 300k, and 400k. Due to location and time we choose the 400k option and forgo the other 2. The opportunity cost of this example would be 500k.
Avoidable costs are costs that can be avoided by taking a specific course of action. In my line of work, we have lots of different suppliers that offer tons of different products, materials, and delivery options for their services. Sometimes we need to examine the cost to produce our own coax cables or to purchase from a business partner. If we produce on our own, we could have direct material costs, direct labor, variable overhead, and avoidable fixed costs. If we choose to just buy these from a business partner those would all be examples of avoidable costs.
Relevant costs are costs that will change because of a decision. I have a personal example of this that happened last year. I purchased an early all-day ski pass ticket for around $80 in advance of a trip I was taking. On the day of the trip, it was a beautiful sunny day and the majority of ski slopes were closed down due to the warm weather. If I decided to still go on the trip (which I did do) the estimated costs were $100 for equipment rental, $20 or so for gas, and another $50 for food, which adds up to $170. These would all be examples of relevant costs and the previous $80 I spent on the all-day pass is a sunk cost since it could not be changed.
1. Different managerial uses of cost information
Managerial use of cost information is there to facilitate the decision-making process and to find the best resulting solution for the company. The different cost information allows a company to make a good decision, for example, how do they renew the machine or do they have the product manufactured somewhere else to work even more cost-efficiently. The different cost information helps the company to make a well-informed decision and is therefore essential for company success.
2. The meanings and decision-making uses of sunk costs, opportunity costs, avoidable costs and relevant costs
Sunk costs: Sunk costs refer to costs already incurred that can no longer be reversed and should not be taken into account in an upcoming decision, on whether to continue a project.
Opportunity costs: In simple terms, opportunity costs are the lost benefits of an alternative action that is not chosen or cannot be realized. So, you give up a possibility (opportunity). Therefore, opportunity costs are sometimes also called foregone costs or alternative costs. However, despite their name, they are not real costs. They are not taken into account in cost and activity accounting, as they are only used to quantify foregone alternatives. Overall it can be important in your decision making process.
Relevant costs: The relevant costs are costs that are relevant to the decision. Relevant costs are costs that arise in the course of a realized alternative course of action. Relevant costs cannot be defined in absolute terms, as they are determined by the context in which the decision is made.
Avoidable costs: are costs that can be avoided by making a specific decision.
3. Experiences you have with these costs, whether it be in your daily personal life or in your professional life
Sunk costs: An example of sunk cost in my personal life would be that I have purchased a show which has 6 seasons and I find the show not good anymore after watching 4 seasons. In that case, the purchase was made, and it cannot be changed. If I keep watching even though I don’t like it anymore just because I made that purchase is not a good solution for me because I could spend that time more productively because the money is gone anyways.
Opportunity costs: An example in my personal life would be first: I am invited to dinner at my grandparent's and second: I am invited to a house party. If I decide to go to the house party my opportunity costs are the free meal that I would have gotten and some pocket money that I always get when I visit my grandparents.
Relevant costs: An example of my personal life is that I once had the opportunity to go on a trip by train where the ticket would be paid for or by car where I could use the car for free, but I had to pay for gas. I decided the go by car because I would be more flexible, so my relevant costs are the costs I have to take now after deciding to go by car and not the train.
Avoidable costs: In that case, I would go back to my previous example of relevant costs. I could have avoided the costs of putting gas in the car by just deciding to go by train.
Managers use cost information to drive business forward. In an ideal situation the decisions they make are cost effective/revenue generating. However, that may not always be the case. Sometimes managers have to use cost information to cut losses, pursue better opportunities, or even move forward from poor decisions.
Sunk costs can be described as money already spent that cannot be recovered or recuperated. At my organization, they invested in an HR information system that was supposed to make the day to day functions operate smoothly and connect seamlessly to one another. After two years of using the product (at a cost of about $100K per year)
they decided this was not, in fact, a worthwhile system to use. We cannot get a refund on what was already spent on the system. However, we have decided to go with another system that actually has what we need in order to operate successfully and serve our employees better. The money already spent in the failed system is a sunk cost. No matter what system we move to, that money for the old system is gone. However, in order to save face with the board, our CEO has approved the implementation of a new system while we are still under contract with the old one.
Opportunity costs are what you are giving up when you decide to do something else: i.e. you cannot do both things at the same time. Organizations have to decide what they are going to do/produce and for what amount of time. If they decide to do "A" they are giving up the opportunity to do "B". Opportunity costs help managers decide which course of action will produce the best outcome.
Avoidable costs are costs that you avoid incurring by taking actions to prevent the cost. If employees are laid-off from work, the employer has avoided the cost of benefits and pay.
Conversely, relevant costs are related to the decisions you make and what changes your costs see. When I took my son to Disney World this summer, I already paid for the admission tickets (sunk costs). However, we had lunch, Mickey Mouse ice cream, purchase souvenirs, mouse ears, etc. Overall, I had significant relevant costs related to how we chose to spend our day at the amusement park. The additional money spent, outside of the tickets, is considered a relevant cost.
After reading chapter 3, I realized how often I unknowingly made decisions using cost information. A recurring example in the text and lecture is the decision to go to college. I have 15 years of experience in my field (HR) but I didn't have my degree. I decided to pursue my degree in order to learn higher level management skills that would help me qualify for a higher ranking position (hopefully). I debated whether to attend classes in person or online. It was more cost effective to attend online in order to reduce the costs of commuting (tolls and gas). The tuition was also less expensive when looking at online classes in comparison to other schools. My hope is that, by investing time and money in obtaining a graduate degree, I'll make up for the time and money spent by receiving an increase in compensation in the future.