Decision-making technique

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Reference no: EM131321436

Cost Benefit
1. A cost-benefit analysis is a process by which business decisions are analyzed. The benefits of a given situation or business-related action are summed, and then the costs associated with taking that action are subtracted. Some consultants or analysts also build the model to put a dollar value on intangible items, such as the benefits and costs associated with living in a certain town, and most analysts will also factor opportunity cost into such equations. Prior to erecting a new plant or taking on a new project, prudent managers conduct a cost-benefit analysis as a means of evaluating all the potential costs and revenues that may be generated if the project is completed. The outcome of the analysis will determine whether the project is financially feasible or if another project should be pursued.

Incremental Analysis
2. An incremental analysis is a decision-making technique used in business to determine the true cost difference between alternatives. Also called the relevant cost approach, marginal analysis or differential analysis, incremental analysis disregards any sunk cost. Incremental analysis is a problem-solving approach that utilizes accounting information to assist in decision making. It is applied when more than one alternative is present.

A company sells an item for $300. The company pays $125 for labor, $50 for materials, and $25 total for variable overhead selling expenses. It also allocates $50 per item of fixed overhead costs. The company is not operating at capacity and will not be required to invest in equipment or overtime to accept a special order it received. The special order requests the purchase of 15 items for $225 each.
The sum of all variable costs and fixed costs per item is $250. However, the $50 of allocated fixed overhead costs are a sunk cost because they have already been incurred. The company has excess capacity and should only consider the relevant costs. Therefore, the cost to produce the special order is $200 per item ($125 + $50 + $25) and the profit per item is $25 ($225 - $200). While the company is still able to make a profit on this special order, the company must consider the ramifications of if it was operating at full capacity. If no excess capacity is present, additional expenses to consider include investment of new fixed assets, overtime labor costs and the opportunity cost of lost sales.

Opportunity Cost
3. Opportunity costs is defined as "the potential benefit that is given up when one alternative is selected over another" (Garrison, Pg. 46). When you are making a decision to purchase or buy something opportunity costs must be evaluated. Most alternatives to a decision are considered an opportunity cost because if you choose to go one route, you are giving up and opportunity to go another route. Another example of this would be if you decide not to go to work for the day, the opportunity cost is the lost wages from not going to work for the day.

Garrison, Ray, Eric Noreen, Peter Brewer. Managerial Accounting, 15th Edition. McGraw-Hill Learning Solutions, 01/2014. VitalBook file.

Opportunity Cost

4. An opportunity cost refers to a benefit that a person could have received, but gave up, to take another course of action. Stated differently, an opportunity cost represents an alternative given up when a decision is made. This cost is therefore most relevant for two mutually exclusive events, whereby choosing one event, a person cannot choose the other.

Example: In November 2015, President Barack Obama staunchly opposed TransCanada Corporation's Keystone XL oil pipeline on the grounds it would negatively affect climate change. However, both TransCanada and Alberta, the location of the pipeline, did not agree with President Obama, citing opportunity costs that included lost revenues for TransCanada and an inability for Canada's oil sands producers to capture higher prices for crude oil production. In this scenario, the opportunity cost of stopping the pipeline from continuing is lost income for Canadian companies, which also affects the Canadian economy.

Reference no: EM131321436

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