The Impact of Sunk, Opportunity, and Accounting Costs

WMBA 6050: Accounting for Management Decision Making Week 6 Weekly Briefing

Welcome to Week 6! In Week 5, you studied standard costs and variances and their relationship to decision making. You analyzed the results of the direct labor and direct materials variances and discussed possible causes for the variances. All of these terms were added to your accounting vocabulary.

In Week 6, you will continue to build your accounting vocabulary as you study sunk costs, opportunity costs, accounting costs, and break-even analysis.

This week:

In terms of the specific Learning Objectives, you will:

• Analyze the impact on the organization of sunk costs, opportunity costs, and accounting costs

• Determine the impact of cost decisions • Apply appropriate accounting processes to determine break-even points • Evaluate break-even points • Utilize break-even point assessment for decision making

In terms of course-level Learning Outcomes, you will:

• Evaluate various accounting measures and their relevance to a wide range of stakeholders

• Analyze various types of budgets, strategic planning, and forecasting • Employ managerial accounting approaches and information to make effective

decisions • Demonstrate effective communication skills to present accounting information to

stakeholders • Assess managerial accounting tools and their usefulness to organizational

leaders • Apply accounting principles ethically and appropriately to personal and

professional contexts

Sunk Costs, Opportunity Costs, and Accounting Costs

In order to analyze sunk, opportunity, and accounting costs, you must first understand their meanings in the language of business. Sunk costs are costs that have been incurred previously and present or future decisions will not change that fact (Weygandt, Kimmel, & Kieso, 2010). They cannot be recovered. For example, a machine in your department was repaired two months ago and it cost $750. You are currently trying to decide which of two new machines you should buy to replace that machine. The $750 is a sunk cost and should not affect your decision. Even though sunk costs cannot be

recovered and should not be considered in deciding between alternatives, they do have value with respect to accountability. As you studied last week, managers should be held accountable for past actions and expenditures.

Opportunity costs are the benefits forgone from choosing one alternative over another (Zimmerman, 2014). If your department has a machine that is capable of making both product A and product B, and it is being used to make product A, the benefit of making product B is lost. Another example pertains to hiring an employee for $50,000. The opportunity cost is that the money is no longer available for other opportunities such as advertising, equipment purchases, etc.

Accounting costs are the actual historical costs incurred for a product or service and are recorded by the accounting system in monetary units (Zimmerman, 2014). In this course, the dollar is the unit of measure. If an organization buys some land for $2,000,000 with the intent of developing it, the $2,000,000 is the accounting cost of the land. If the organization is considering two alternative uses for the land, the opportunity cost will be the benefit forgone when it chooses one alternative over the other.

Using Accounting Data to Make Decisions

Managers use accounting costs to make decisions regarding how much it costs to make or buy a product or produce a service, and these costs are often used to determine the price to charge for the product or service. For example, if the average cost of producing one unit of Product M for ABC Company is $200 and the organization wants a markup of 30%, the selling price of Product M would be $200 + ($200 x 30%) or $260. This is termed cost-plus pricing. Many organizations use this method as it is relatively easy to compute (Zimmerman, 2014).

Organizations do not operate in a vacuum and consideration must be given to the pricing strategies of the competition. If there are many competitors who are selling very similar products, the market will determine the selling price of Product M not ABC Company. In this situation, ABC Company, which is called a price taker, must determine if it can still make a profit when it sells Product M at the market price. It will need to determine if the profit that can be realized by producing and selling Product M at the market price is worth the risk involved in making the product without knowing specifically how many units will be sold.

Another factor to be considered is market price itself. How will changes in the market price affect the organization? If the market price of product M is $20.00 and the average cost to make the product is $17.00, will ABC Company be satisfied with a profit of $3.00 per unit? What if the market price drops to $18.00 per unit? Will ABC Company be satisfied with a profit of $1.00 per unit? Management must weigh the risks associated with production, carrying inventory, and possibly selling at a loss when making the decision to produce Product M.

Although price takers have no market power, some organizations do have market power. An organization has market power if no perfect substitute exists for its products (Zimmerman, 2014). For example, Coach, Inc. sells handbags and other items at high prices because it has market power. If a woman wants a Coach handbag, there is no perfect substitute. Coach has to make a decision concerning how many handbags it wants to sell each year. If it raises the price, it will sell fewer handbags, and if it lowers the price, it will sell more handbags. The challenge is to determine the number of handbags to sell and the price to charge per handbag to optimize profitability.

Break-Even Analysis

One method that is helpful in determining profitability is break-even analysis. At the break-even point, sales revenue is exactly equal to total expenses and there is no profit or loss (Davis & Davis, 2012). The formula used to determine the break-even point is:

PQ - VCQ - FC = 0 where P is a constant sales price, Q is the output (quantity), VC are the variable costs and FC are the fixed costs.

Before you can proceed, you need to know how to determine which costs are variable and which are fixed. Variable costs are costs that vary directly with a change in the activity level (Weygandt, et al. 2010). A variable cost remains the same per unit at every level of activity. For example, Dulce Company makes candy bars and each bar requires 2 ounces of chocolate and 3 ounces of crushed peppermint. If the company makes 10 bars, 20 ounces of chocolate and 30 ounces of peppermint will be needed. If it makes 20 bars, 40 ounces of chocolate and 60 ounces of peppermint will be used.

Fixed costs remain the same in total regardless of the activity level. Examples include rent, property taxes, supervisory salaries, and depreciation on buildings and equipment.

If Dulce Company sells its candy bars for $2.00 each, variable costs are $1.50 each, and fixed costs are $50,000, how many candy bars must the company sell to break even? Using the break-even formula:

$2Q - $1.50Q - $50,000 = 0 $0.50Q - $50,000 = 0 $0.50Q = $50,000 Q = $50,000/$0.50 Q = 100,000 candy bars

Therefore, Dulce Company knows that it will not make a profit until it sells at least 100,001 candy bars. Perhaps, Dulce Company wants to know how many candy bars it must sell to earn a profit of $70,000. In this case, simply substitute $70,000 for the break-even point.

$2Q - $1.50Q - $50,000 = $70,000 $0.50Q = $120,000

Q = 240,000 candy bars

A very important concept in break-even analysis is contribution margin. Contribution margin is the amount of sales revenue left after deducting variable expenses. It is available to cover fixed costs and to contribute to profits. It can be expressed in terms of total sales revenue and total variable expenses or per unit revenue and expenses. Dulce Company's per unit contribution margin is $2.00 - $1.50 which is $0.50.

Contribution margin per unit is used to determine the break-even point in units. The formula is:

Total fixed expenses/contribution margin per unit

$50,000/$0.50 = 100,000 candy bars

The break-even point in total sales dollars can be determined using the formula:

Total fixed costs/contribution margin ratio

The contribution margin ratio is computed by dividing the contribution margin by sales revenue. This can be computed by using either total amounts or per unit amounts.

$0.50/$2.00 = .25 contribution margin ratio

$50,000/.25 = $200,000 in sales dollars required to break even

In summary, making decisions regarding pricing, costs, and sales volume can be assisted by break-even analysis, but also should take into consideration environmental factors, competition, tax rates, etc. Accounting measures can provide quantifiable data, but should be only a part of the decision making process. Good management decisions will include quantitative as well as qualitative information.

References

Davis, C. E., & Davis, E. (2012). Managerial Accounting. Hoboken, NJ: John Wiley & Sons.

Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2010) Managerial accounting: Tools for

decision making (5th ed.). Hoboken, NJ: John Wiley & Sons.

Zimmerman, J. L. (2014). Accounting for decision making and control (8th ed.). New York, NY: McGraw-Hill.