Question

Do you believe a firm must have a firm grasp of the concepts of differential cost, opportunity cost and sunk cost to be effective in making business decisions? Please be sure that your first post talks about these three different types of costs. Consider giving examples - especially if you have examples within your own employment experience. Or - you can look for some online resources that offer you some other facets of this topic to discuss so that it isn't just a rehash of the textbook. Don't forget to cite any resources that you use - even the textbook.

Answer 1

Differential cost

Differential cost is "the increase or decrease in total cost or the change in specific elements of cost that result from any variation in operations." It represents an increase or decrease in total cost resulting out of :
1. Producing or distributing a few more or few less of the products,
2. a change in the method of production or distribution,
3. an addition or deletion of a product or a territory,
4. selection of an additional sales channel.
Differential costs includes fixed and semi-variable expenses. It is the difference between the total costs of two alternatives. Differential costs may either be incremental or decremental.

Opportunity costs

1.Oppportunity costs is a relevant cost where altrnatives are available. It involves choice and deciision makimg out of many alternatives.
2. It is generally evaluated for short term purposes.
3. It is not useful for accounting, reporting and cost control. It does not find any place in formal accounts and is calculated onlyfor comparison purposes.
4. It arises only in case of restriction of resources i.e. Key Factor Situation. If resources are abundantly available, they can be used for pursuing all available alternatives/ courses of action.
5. When a number of alternatives are available, the highest of the opportunity costs will be considered relevant for decision making.

Sunk Costs
It is a cost which has already been incurred or sunk in the past. These are irrelevant for decision making since these are pasts costs, i.e. :
1. either historical costs incurred in the past, cost of a resourse already acquired, etc.
2. or committed costs, i.e. costs in respect of which a decision has already made in the past, and cannot be altered by any future decision, e.g. bookmvalue of machinery already purchased.

Thus, if a firm has obsolete stock of some materials originally purchased for $50,000 which can be sold as scrap now for $18,000 or can be utilised in a special job, the value of stock already available $50,000 is a sunk cost and is not relevant for decision making.

Yes, it is very much necessary to have grasp of the concepts of differential cost, opportunity cost and sunk cost to be effective in making business decisions as these costs are relevant and irrelevant costs for decision making process. The above explanation of meaning and nature of these costs makes it very much clear that unless a firm has a complete knowledge about these costs and how to differentiate between different costs, it is not possible to evaluate the alternatives available in the market or make proper sound decisions required in smooth fuctioning of an entity.