Question

As a student what are the quantitative and qualitative costs associated with your obtaining an MBA, referencing costs from (Opportunity Cost, Relevant Cost, Irrelevant Cost, and Sunk Cost). Do the benefits outweigh the costs?

Answer 1

Opportunity cost

Relevant costs may also be expressed as opportunity costs. An opportunity cost is the benefit foregone by choosing one opportunity instead of the next best alternative.

Example

A company is considering publishing a limited edition book bound in a special leather. It has in stock the leather bought some years ago for $1,000. To buy an equivalent quantity now would cost $2,000. The company has no plans to use the leather for other purposes, although it has considered the possibilities:

a) of using it to cover desk furnishings, in replacement for other material which could cost $900
b) of selling it if a buyer could be found (the proceeds are unlikely to exceed $800).

In calculating the likely profit from the proposed book before deciding to go ahead with the project, the leather would not be costed at $1,000. The cost was incurred in the past for some reason which is no longer relevant. The leather exists and could be used on the book without incurring any specific cost in doing so. In using the leather on the book, however, the company will lose the opportunities of either disposing of it for $800 or of using it to save an outlay of $900 on desk furnishings.

The better of these alternatives, from the point of view of benefiting from the leather, is the latter. "Lost opportunity" cost of $900 will therefore be included in the cost of the book for decision making purposes.

The relevant costs for decision purposes will be the sum of:

i) 'avoidable outlay costs', i.e. those costs which will be incurred only if the book project is approved, and will be avoided if it is not

ii) the opportunity cost of the leather (not represented by any outlay cost in connection to the project).

Relevant cost

A relevant cost is a cost that only relates to a specific management decision, and which will change in the future as a result of that decision. The relevant cost concept is extremely useful for eliminating extraneous information from a particular decision-making process. Also, by eliminating irrelevant costs from a decision, management is prevented from focusing on information that might otherwise incorrectly affect its decision.

This concept is only applicable to management accounting activities; it is is not used in financial accounting, since no spending decisions are involved in the preparation of financial statements.

For example, the Archaic Book Company (ABC) is considering purchasing a printing press for its medieval book division. If ABC buys the press, it will eliminate 10 scribes who have been copying the books by hand. The wages of these scribes are relevant costs, since they will be eliminated in the future if management buys the printing press. However, the cost of corporate overhead is not a relevant cost, since it will not change as a result of this decision.

The reverse of a relevant cost is a sunk cost. A sunk cost is an expenditure that has already been made, and so will not change on a go-forward basis as the result of a management decision.

Irrelevant costs

An irrelevant cost is a cost that will not change as the result of a management decision. However, the same cost may be relevant to a different management decision. Consequently, it is important to formally define and document those costs that should be excluded from consideration when reaching a decision. For example, the salary of an investor relations officer may be an irrelevant cost if a management decision relates to issuing a new product, since dealing with investors has nothing to do with that particular decision. However, if the board of directors is considering taking the company private, then it may no longer need an investor relations officer; in the latter case, the salary of the investor relations officer is highly relevant to the decision. As another example, the rent for a production building is irrelevant to the decision to automate a production line, as long as the automated equipment is still housed within the same facility.

Non-cash items, such as depreciation and amortization, are frequently categorized as irrelevant costs for most types of management decisions, since they do not impact cash flows.

Sunk costs, such as the purchased cost of a fixed asset that was incurred in a prior period, are also usually considered irrelevant when making decisions on a go-forward basis.

Sunk Cost

A sunk cost refers to money that has already been spent and which cannot be recovered. In business, the axiom that one has to "spend money to make money" is reflected in the phenomenon of the sunk cost. A sunk cost differs from future costs that a business may face, such as decisions about inventory purchase costs or product pricing. Sunk costs are excluded from future business decisions because the cost will remain the same regardless of the outcome of a decision.

KEY TAKEAWAYS

• 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.

Cost–Benefit Analysis

Cost–benefit analysis (CBA) is a method for assessing the economic efficiency of proposed public policies through the systematic prediction of social costs and social benefits. The concepts of ‘willingness to pay’ and ‘opportunity cost’ guide the valuation of projected policy effects in terms of a money metric. Comprehensively valuing effects and aggregating across all members of society yields the net social benefits of the policy. A policy with positive net social benefits is economically efficient relative to the status quo. When economic efficiency is the only relevant social goal, CBA provides an appropriate decision rule: choose the policy, or set of policies, that maximizes net social benefits.

Cost–Benefit Analysis and Cost–Effectiveness Analysis

Cost–benefit analysis (CBA) and cost-effectiveness analysis (CEA) are methods used by economists to evaluate educational programs or investments. CBA evaluates programs in monetary terms; CEA evaluates programs against specified educational objectives. Both methods allow for a ranking of programs in terms of resource use and outcomes through the expression of a ratio. However, to calculate cost–benefit and cost-effectiveness ratios, detailed information on costs and outcomes is necessary and this information is often hard to collect. Hence, few formal CBAs and CEAs have been undertaken in educational contexts.