Question

The following terms are used to describe various economic characteristics of costs:

Opportunity cost	Differential cost
Out-of-pocket cost	Marginal cost
Sunk cost	Average cost

Required:
Choose one of the preceding terms to characterize each of the amounts described below. Each term may be used only once.
A. The cost of including one extra child in a day-care center.
B. The cost of merchandise inventory purchased five years ago. The goods are now obsolete.
C. The cost of feeding 300 children in a public school cafeteria is $450 per day, or $1.50 per child per day. What economic term describes this $1.50 cost?
D. The management of a high-rise office building uses 3,000 square feet of space in the building for its own administrative functions. This space could be rented for $30,000. What economic term describes this $30,000 of lost rental revenue?
E. The cost of building an automated assembly line in a factory is $700,000; a manually operated assembly line would cost $250,000. What economic term is used to describe the $450,000 variation between these two amounts?
F. Refer to the preceding question and assume that the firm is currently building the assembly line for $700,000. What economic term is used to describe the $700,000 construction cost?

	A	B	C	D	E	F
Cost classification

Answer 1

Solution :

Opportunity cost is defined as the cost of benefits foregone choosing one alternative rather than the other.

Out-of-pocket cost is defined as those costs that involve cash outflows during the year or period.

Sunk cost refers to the cost already spent. It is called as the historical cost as it cannot be recovered.

Differential cost is the cost of differences between two or more alternatives.

Marginal cost is the additional cost incurred in producing additional unit of the commodity or product.

Average cost is the cost per unit, when the total cost is divided by the number of units produced.

Analyzing each case (Refer to the above definition of costs to understand the classification of costs given below) :

A) Marginal cost :

The additional cost of including "one" extra child.

B) Sunk cost :

The merchandise inventory was purchased 5 years ago.

C) Average cost :

The cost $1.50 is arrived by dividing $450 by 300 units.

D) Opportunity cost :

The management foregoes the benefit of rent of $30,000 by choosing the alternative of using the building for administrative functions.

E) Differential cost :

The difference between both the options available is $700,000 - $250,000 = $450,000.

F) Out-of-pocket cost :

The expense of $700,000 indicates the cost to be paid during the year.