Question

In order to assist the managers, you are compiling a resource which will define the various terms used in the process of strategic analysis. Provide an explanation of the following terms, with examples, to include in the resource tool which incorporates a reason why each is relevant or not relevant to the decisions.

Sunk cost,

Incremental cost,

Opportunity cost

and Historic cost.

(each term should include definition, reference source of the definition , example and explanation of relevance )

Answer 1

A sunk cost refers to money that has already been spent and which cannot be recovered.

• Sunk costs are those which have already been incurred and which are unrecoverable.
• In business, sunk costs are typically not included in consideration when making future decisions, as they are seen as irrelevant to current and future budgetary concerns.
• Sunk costs are in contrast to relevant costs, which are future costs that have yet to be incurred.

When making business decisions, organizations only consider relevant costs, which include the future costs still needed to be incurred. The relevant costs are contrasted with the potential revenue of one choice compared to another. Because sunk costs do not change, they are not considered.

For example, a manufacturing firm may have a number of sunk costs, such as the cost of machinery, equipment, and the lease expense on the factory. Sunk costs are excluded from a sell-or-process-further decision, which is a concept that applies to products that can be sold as they are or can be processed further.

Incremental cost is the total cost incurred due to an additional unit of product being produced.

• Incremental cost is the amount of money it would cost a company to make an additional unit of product.
• Companies can use incremental cost analysis to help determine the profitability of their business segments.
• A company can lose money if incremental cost exceeds incremental revenue.

Since incremental costs are the costs of manufacturing one more unit, the costs would not be incurred if production didn't increase. Incremental costs are usually lower than a unit average cost to produce incremental costs. Incremental costs are always comprised of variable costs, which are the costs that fluctuate with production volumes.

Let's say, as an example, a company is considering increasing their production of goods but needs to understand the incremental costs involved.

Opportunity costs represent the benefits an individual, investor or business misses out on when choosing one alternative over another.

• Opportunity cost is the return of a foregone option less than the return on your chosen option.
• Considering opportunity costs can guide you to more profitable decision-making.
• You must assess the relative risk of each option in addition to its potential returns.

When making big decisions like buying a home or starting a business, you will probably scrupulously research the pros and cons of your financial decision, but most day-to-day choices aren't made with a full understanding of the potential opportunity costs. If they're cautious about a purchase, many people just look at their savings account and check their balance before spending money. Often, people don't think about the things they must give up when they make those decisions.

A historical cost is a measure of value used in accounting in which the value of an asset on the balance sheet is recorded at its original cost when acquired by the company.

• Most long-term assets are recorded at their historical cost on a company's balance sheet.
• Historical cost is one of the basic accounting principles laid out under generally accepted accounting principles (GAAP).
• Historical cost is in line with conservative accounting, as it prevents overstating the value of an asset.
• Highly liquid assets may be recorded at fair market value, and impaired assets may be written down to fair market value.

The historical cost principle is a basic accounting principle under U.S. GAAP. Under the historical cost principle, most assets are to be recorded on the balance sheet at their historical cost even if they have significantly increased in value over time. Not all assets are held at historical cost.

For example, marketable securities are recorded at their fair market value on the balance sheet, and impaired intangible assets are written down from historical cost to their fair market value.