Question No 4:
4.1: Explain concepts of opportunity cost, sunk cost, committed cost and sunk cost fallacy:
Committed Cost
A committed cost is a cost that a company has already incurred to or an obligation already made, that it cannot avoid by any means.
Sunk Cost
Sunk costs are costs that have already been incurred (historical costs) or costs that have already been committed by an earlier decision.
Opportunity Cost
An opportunity cost is a benefit that will be lost by taking one course of action instead of the next-most profitable course of action.
It exists for resources having more than one use.
A relevant cost is a future cash flow that will occur as a direct consequence of making a particular decision. Managers take decision regularly for the financial benefit of the organization, which is usually to increase profits or to increase the value of the business. Whatever the objective of decision making is, only relevant information should be considered in the process.
Sunk costs are the cost which has already been incurred in the past and cannot be recovered. In the business decision-making process, sunk costs should not be considered while deciding as they have already been incurred and whatever be the outcome of your decision, it will not affect the cost in any way as it already has been incurred.
For example:- you want to buy a building for $10K, and you have to decide whether to open a garage in the building or not (Estimated annual cost for that being $2K and estimated annual revenue being $4K). The timing of the decision decides whether the building cost of $10K is sunk cost or not which means that if you are deciding to open the garage after you have already bought the building, then the $10K spent should not affect your decision as they have already been spent and cannot be recovered even if you don’t open the garage. Hence they can be termed as a sunk cost. In this case, you should open the garage. But if you are deciding on buying the building, then it affects your decision as you can save your $10K if you decide not to open the garage. Hence it will not be a sunk cost but rather termed as a depreciable fixed asset.
4.2: Fixed cost and variable cost:
Fixed cost is a cost which remains constants throughout a specific period, e.g. rent, insurance etc.
Variable cost is a cost which changes with the change of activity level in a business, e.g. commission cost.
One should have a strong concept about the difference between fixed and variable cost because it is where the revenue depends upon.
Managers can use this knowledge to identify their break-even point.
Break-even point is a sales level at which a company earns no profit or incurs no loss.
At break-even:
Contribution=Fixed Cost
And
Contributions = Sales – Variable Cost
Changes in the company’s costs, both variable and fixed affect the company’s profit. CVP analysis is a powerful tool in estimating the costs
Example
The following data related to the product Z of Alpha Ltd.
Selling price=Rs 50 per unit
Variable cost=Rs 40 per unit
Annual Fixed cost=Rs 100,000
Calculate several units that must be sold to break even?
Answer
Contribution per unit=Rs. 50- Rs. 40 =Rs.10
Break-even point in units = Fixed cost ÷contribution/unit
=100,000÷10
=10,000 units
Operational gearing is the effect of Fixed cost on sales and profit.
To earn profit and to forecast sales, the company should have a minimum gearing.
So, in a nutshell, the managers must know the difference between variable a fixed cost.