Cost concepts in decision making

Many business decisions require a firm knowledge of several cost concepts. Different types of costs have differing characteristics. Consequently, when reviewing a business case to determine which path to take, it is useful to understand the following cost concepts:

  • Fixed, variable, and mixed costs. A fixed cost, such as rent, does not change in lock step with the level of activity. Conversely, a variable cost, such as direct materials, will change as the level of activity changes. Those few costs that change somewhat with activity are considered mixed costs. It is important to understand the distinction, since a decision to alter an activity may or may not alter costs. For example, shuttering a facility may not terminate the associated building lease payments, which are fixed for the duration of the lease.
  • By-product costs. A product may be an incidental by-product of a production process (such as sawdust at a lumber mill). If so, it does not really have any cost, since its cost would have been incurred anyways as a result of the production of the main product. Thus, selling a by-product at any price is profitable; no price is too low.
  • Allocated costs. Overhead costs are allocated to manufactured goods only because it is required by the accounting standards (for the production of financial statements). There is no cause-and-effect between the creation of one additional unit of production and the incurrence of additional overhead. Thus, there is no reason to include allocated overhead in the decision to set a price for one additional unit.
  • Discretionary costs. Only a few costs can actually be dropped without causing any short-term harm to an organization. Examples are employee training and maintenance. Over the long-term, delaying these expenditures will eventually have a negative effect. Thus, managers need to understand the impact of their decisions over a period of time when determining which costs to cut back.
  • Step costs. Though some costs are essentially fixed, it may be necessary to make a large investment in them when the activity level increases past a certain point. Adding a production shift is an example of a step cost. Management should understand the activity volumes at which step costs can be incurred, so that it can manage around them - perhaps delaying sales or outsourcing work, rather than incurring step costs.

All of the cost concepts noted here are critical elements of many types of management decisions.