Question

Relevant to Cost Accounting, briefly explain the following terms:

(a) Sunk cost

(b) Opportunity cost

(c) Relevant cost

Answer 1

Answer (a)

Sunk Cost: Sunk cost means the cost which does not influence the decision of a decision maker. It is the cost which should be -ignored while taking a decision. This type of cost is generally used under Relevant costing for decision making.

Conditions for being a sunk cost:

1. It should be past or historical cost, i.e., it should have been incurred before taking the decision.; or

For example:

• In making a decision whether to launch a new product, Research and Development cost already incurred represents a sunk cost and should be ignored before taking the decision on launch of new product.
• If an obsolete material which was originally bought for $ 500 is to scrapped and sold for $ 15, then the original cost of $ 500 is sunk cost and should be ignored.

2. It is future cost, obligation of which has already been decided. In other words, if decision has already been taken before making a decision that a future cost shall be incurred irrespective of the outcome, it can be classified as Sunk Cost and should be ignored.

For example:

• Salary of Permanent Labour Force, Manager's Salary and Factory rent represent Sunk cost as they are future cost which will be incurred in doing regular activity irrespective of whether a fresh one time order (other than regular order) is accepted or not.

Answer (b)

Opportunity Cost: Opportunity cost means the cost of next best alternative. Opportunity cost for selected alternative is the benefit forgone from the next best alternative course of action.

The concept of opportunity cost should be applied when more than one alternative course of action are available and all of them are mutually exclusive.

For example:

• For example Mr. X is a CPA and has two Job offers.

Offer 1: ABC Limited is offering Annual Salary of $ 50,000.

Offer 2: PQR Limited offering Annual Salary of $ 55,000.

In the above case, opportunity cost of Offer from PQR Limited in the hands of Mr. A will be $ 50,000/-, i.e.the benefit which would have been realised from the next best alternative.

Answer (c)

Relevant Cost: Relevant cost means the cost which assists in decision making. It is the cost which has an influence on the decision of decision maker. It is the cost to be incurred under a selected course of action.

Conditions for Relevant Cost:

1. It should be a future cost (i.e. it should be cost to be incurred); and
2. It should be different in amount for each alternative course of action.

For example: If a construction company is deciding whether to construct a new building or not by hiring a new supervisor for supervision. In this case the supervisor salary is a relevant cost for the new building as :

• It is a future cost; and
• It will only be incurred if the offer to construct the building is accepted and implemented.