Opportunity, Fixed, Variable, and Sunk
Costs are functions of ACCOUNTING RULES. This
means that before one can discuss or compare costs you must carefully define
meaning. The definitions are arbitrary, but often there are conventional and
legal rules that must be followed by traditional accounting meyhods.
Professional Accounting Organizations, Tax, Revenue, and Customs have
established application specific rules. Costs are classified in various ways
for specific applications. It is useful to have an appreciation of COST classifications and their implications.
The data generated
by the traditional accounting methods is inherently misleading for many forms
of Economic Analysis, Decision-Making, and particularly for those concerned
associated with traditional accounting information must be carefully
appreciated. This understanding forms the basis for approaching the arduous
problems of cost estimation .
The monetary value
of resources at one time cannot be compared directly with the monetary value of
resources at other times. The usual approach is to use discount and inflation
estimates to make corrections. Money is usually worth more now than money
later. The Time Value of money is an opportunity cost, but it is seen as a
cost of Capital is not a constant. The time value of money varies from entity
to entity, from one time to another, just as opportunities and available
capital vary. No one time value can be assigned to capital. Its value must be
determined from the specific opportunities available. Capital from different
sources is often not strictly comparable. This possibility should always be
recognized when two or more sources are considered.
problem is that each individual entity operates what is usually considered a
closed system. Cost to one individual may be something else to an other entity.
A closed system is the basis for most Cost Models.
naively think that costs have a fundamental or universal definition. They do
not. The following are some conventional classifications:
- FIXED: - include all costs
that do not vary with activity for an accounting period. Fixed costs are
at any time the inevitable costs that must be paid regardless of the level
of output and of the resources used. A Fixed Cost is there fore not an Opportunity Cost. Overhead is considered a fixed
cost, even though it may vary somewhat according to the amount of
costs are usually expressed as Fixed + Variable
- VARIABLE: - all other costs
that are some function of activity. They are usually considered linear
because the unit cost is computed by dividing the total other costs for a
period or event by the amount of activity in the period. The linear
assumption is a matter of convenience. As the level of activity is varied
the non linear nature of the variable costs are revealed.
- DIRECT: - costs that can be
identified directly with a particular process.
- INDIRECT: - costs associated
with an enterprise, etc. which are not identified as direct costs but
which may be included in the accounting.
- INCREMENTAL COSTS
- those costs (or revenues) that change due to an incremental change in
activity, as compared those that are unaffected.
- MARGINAL COST (&
- the incremental cost or revenue due to a unit change of output at some
level of output.
- OPPORTUNITY COSTS: - the net revenue
that is forgone by not allocating resources to the another best
alternative use. The opportunity cost is the correct measure of the
cost of resources for Systems Analysis. Whereas it can be equal to the
price paid for a resource, it is often different from the outlay cost.
Resources may cost something to use (or not use) even though no monetary
price is paid to another entity for them. The opportunity cost is the
Shadow Price of a resource.
effect opportunity costs, in representing the cost of having less of a
resource, measure the rate of change of benefits per unit change in resource. The
opportunity cost of money is a measure of the maximum benefit that, for any
given situation, can be obtained from any extra unit of capital.
useful distinction can be made between resources that can be identically
replaced (such a materials, money, etc.) and those that are somehow
unique (e.g. a piece of property).
strictly replaceable resources for which there is a ready market, the
opportunity cost is simply the market cost of replacement, or equivalently,
the salvage price of the resource if it is already at hand and will not
- SUNK COSTS: - theoretically
those prior costs which cannot be recovered. For normal accounting
purposes the sunk cost is the difference between book value and salvage
value of an asset.
Cycle Costs are the total cost to an organization for
acquisition and ownership of a product or asset over the life of the
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