1. Introduction and Objectives
When choosing between competing business options, managers must isolate relevant financial data from historical noise. This lesson details the specific classifications used in quantitative business case evaluation.
2. Decision-Making Cost Concepts
- Relevant Costs: Future cash flows that differ between alternative choices. To be relevant, a cost must be a future cost and vary based on the decision made.
- Irrelevant Costs: Costs that will not change regardless of which action manager selects.
- Sunk Costs: Costs that have already been incurred by a past transaction and cannot be recovered or altered by any current or future decision. Rule: Sunk costs must be completely ignored in financial decision-making.
- Example: Spending $50,000 on market research last year is a sunk cost. The decision to launch the product today depends solely on future costs and revenues.
- Opportunity Costs: The potential benefit or contribution foregone when choosing one course of action over an alternative. It represents an implicit cost that does not appear in financial accounting ledgers.
- Example: If a company uses its idle warehouse to store its own inventory, the opportunity cost is the $5,000 per month it could have earned by renting the space to a third party.
- Incremental (Differential) Costs: The net difference in total cost between two distinct options.
- Marginal Cost: The variable cost incurred by producing exactly one additional unit of output.
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