Page 194 - Encyclopedia of Business and Finance

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Costs

that causes cost to change.) Strictly speaking, vari- In decision making, the cost concepts above often get
able costs are zero when the activity level is zero. further refined, as follows.
Careful writers use the term “semivariable costs” to
mean costs that increase strictly linearly with activity • Incremental cost; marginal cost; differential cost;
but have a positive value at zero activity level. Roy- avoidable cost. The firm will incur (save) incremental
alty fees of 2 percent of sales are variable; royalty costs if it carries out (or stops) a project. These four
terms tend to have the same meaning, except that
fees of $1,000 per year plus 2 percent of sales are the economist restricts the term “marginal cost” to
semivariable.
the cost of producing one more unit. Thus the next
• Fixed cost. A cost that does not change as activity unit has a marginal cost; the next week’s output has
levels change, at least for some time period. In the an incremental cost. If a firm produces and sells a
long run, all costs can vary. new product, the related new costs would properly
be called “incremental,” not marginal. If a factory is
In accounting for the costs of product or services or
closed, the costs saved are incremental, not mar-
segments of a business, accountants sometimes desegre-
ginal.
gate total costs into those that benefit a specific product
• Unavoidable cost; inescapable cost; sunk cost.
and those that benefit all products jointly produced.
Unavoidable costs will occur whether the decision is
• Traceable cost; direct cost. A cost the firm can identify made to go ahead or not, because the firm has
with a specific product, such as the cost of a com- already spent, or committed to spend, the cash. Not
puter chip installed in a given personal computer, or all unavoidable costs are book costs; consider a
with some activity. salary promised, but not yet earned, that the firm
will pay if it makes a no-go decision. Sunk costs are
• Common cost; joint cost; indirect cost. A cost incurred
past costs that current and future decisions cannot
to benefit more than one product or activity, such as
affect and, hence, are irrelevant for decision making
the cost of rent of a factory building in which the
(aside from income tax effects). For example, the
firm makes several different kinds of personal com-
acquisition cost of machinery is irrelevant to a deci-
puters or the cost of a steer from which the firm
sion of whether to scrap the machinery. In making
manufactures leather and hamburger. Some restrict
such a decision, one should consider only the sacri-
the term common cost to situations such as the first,
fice of continuing to own it and the cost of, say, the
where the firm chooses to produce products
electricity to run the machine, both incremental
together, while restricting “joint costs” to situations, costs. Sunk costs become relevant for decision mak-
such as the second, where the firm must incur the ing when the analysis requires taking income taxes
cost simultaneously. The major problem in cost (gain or loss on disposal of asset) into account, since
accounting is allocation of common and joint costs the cash payment for income taxes depends on the
to individual products. Managers and regulators tax basis of the asset. Avoid using the ambiguous
(e.g., the Securities and Exchange Commission and term “sunk costs.” Consider, for example, a machine
the IRS) often insist on such allocations, while costing $100,000 with current salvage value of
economists and some accountants recognize that $20,000. Some would say that $100,000 is sunk;
such allocations do not aid decision making. others would say that only $80,000 is sunk. Those
who say $100,000 have in mind a gross cost, while
Virtually all costs recorded by accountants require a
those who say $80,000 have in mind a net cost—
cash outlay at some time. Analysts sometimes need to dis-
original amount reduced by current opportunity
tinguish between costs associated with current or future
cost.
cash expenditures and those where the expenditure
already occurred. In deciding which employees to reward, management
often cares about desegregating actual costs into those that
• Out-of-pocket cost; outlay cost; cash cost. An item are controllable and those not controllable by a given
requiring a current or future cash expenditure. employee or division. All costs can be affected by someone
• Book cost; sunk cost. A cost incurrence where the in the firm; those who design incentive schemes attempt
cash expenditure has already occurred, such as the to hold a person responsible for a cost only if that person
cost of depreciation for a machine purchased several can influence the amount of the cost.
years ago. (In accounting, depreciation is an alloca- A firm incurs costs because it perceives that it will
tion of a previous expenditure, while in economics realize benefits. Careful usage of cost terms distinguishes
depreciation represents a decline in current value.) between incurrences where the firm will enjoy the benefits

ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 171