Introduction
In business management, understanding and analyzing costs are fundamental for strategic decision-making. Differentiating between types of costs and understanding their impact on operations allow companies to allocate resources efficiently and choose alternatives that maximize returns. In this article, I explore essential concepts such as differential cost, opportunity cost, and sunk cost, which help project managers, senior managers and advisors make more informed decisions. Additionally, practical examples are presented to illustrate the application of these concepts in corporate day-to-day activities.
Differential Cost and Revenue
Decisions involve choosing between alternatives. In business decisions, each alternative has costs and benefits that must be compared to those of other available options. The difference in costs between two alternatives is known as differential cost; the difference in revenues is called differential revenue.
A differential cost can be an incremental cost (an increase in cost from one alternative to another) or a decremental cost (a reduction in cost from one alternative to another).
Small Case Study
Let’s say a cosmetics company operating via retail distribution is considering switching to sales representatives. After listing the costs and revenues associated with retail distribution and estimating those for distribution via sales representatives, the company calculated a net operating profit of $160 million for retail distribution and $175 million for sales representatives, leading to a differential cost and revenue of $15 million.
The decision to maintain the current distribution model or switch to sales representatives can be based solely on the differential cost and revenue. Therefore, using sales representatives is the preferable option, as it has the potential to generate $15 million more in net operating profit.
Cost Classification for Predicting Cost Behavior
It is often necessary to predict how a cost will behave in response to changes in activity. For example, a telecommunications company might want to predict the impact of a 5% increase in long-distance calls on its electricity bill. Cost behavior refers to how a cost reacts to changes in the level of activity. When activity increases or decreases, a particular cost may increase, decrease, or remain constant. For planning purposes — or in other words, looking toward the future — a project manager, a senior manager or advisor must anticipate what might happen. If a cost is expected to change, it must be estimated by how much. To aid in this, costs are categorized as variable and fixed.
Variable Cost
- Total variable cost increases and decreases in proportion to changes in the level of activity.
- Variable cost per unit remains constant.
- Example: Direct material for producing a product; the more products produced, the higher the total cost, but the cost per unit remains constant.
Fixed Cost
- Total fixed cost is not affected by changes in the activity level within a relevant range.
- Fixed cost per unit decreases as activity level increases and increases as activity level decreases.
- Example: Machine rental; the rental amount remains the same regardless of the quantity produced, but the more units produced, the lower the rental cost per unit.
The small case study described above used the concepts of variable and fixed costs for the correct calculation of differential cost and revenue.
It is important to note that a specific cost can be variable or fixed depending on the circumstances.
Evaluating the Scenario and Correct Numbers
I have an old case from 2004 that illustrates this topic well. It discusses the cost of a healthier alternative. At the time, like on many other occasions, McDonald’s was under pressure to address health implications associated with its menu. In response, McDonald’s switched from partially hydrogenated vegetable oil for frying food to a new soybean oil that reduced trans fats by 48% — despite the soybean oil being much more expensive and lasting half as long.
What were the implications of this change?
At the time, a typical McDonald’s restaurant used 500 pounds of unhealthy oil per week at a cost of $186. The same restaurant would need 1,000 pounds of the new soybean oil per week at a cost of approximately $571. This is a differential cost of $385 per restaurant per week. Not much, right? However, expanding this action to the 13,000 McDonald’s restaurants at the time, operating 52 weeks per year, the total came to $260 million per year.
The Impact of a Good Cost-Based Decision
Another old case demonstrates that many ESG practices are associated with cost reduction. At the time, UPS truck drivers traveled over 1.3 billion miles annually to deliver more than 4.5 billion packages. It’s easy to see that fuel was a huge variable cost for the company. If UPS could save just a few cents per mile driven, the result would be enormous. So, UPS decided to replace its diesel vehicles with hybrid (diesel/electric) vehicles, which had the potential to cut fuel costs in half and reduce CO₂ emissions by 90%.
Opportunity Cost
Opportunity cost is the potential benefit forfeited when one alternative is selected over another and must be considered in decision-making. Some basic examples of opportunity cost include:
- Pedro works as a contractor earning $1,000 per week. He wants to take a week of unpaid vacation. The $1,000 he would earn is the opportunity cost of taking that vacation.
- Maria is considering investing a large sum in purchasing land to build a store in the future. Instead of buying the land, she could invest in a mutual fund. The opportunity cost of buying the land is the return the fund would generate.
- Manuel works for a company earning $2,000 monthly. He is considering leaving his job to finish his studies. The opportunity cost of leaving his job is $2,000 per month.
Sunk Cost
Sunk cost is a cost that has already been incurred and cannot be recovered by any current or future decision and, therefore, should not be considered a differential cost. Since only differential cost is relevant for decision-making, sunk costs can and should be ignored.
Suppose a company buys a machine for $3 million to produce a specific product. After some time, the product becomes obsolete and is no longer sold. Even though buying the machine was not a good decision, the company has already incurred a cost of $500,000 that cannot be changed. The company cannot even continue producing the product to recover the investment since the product won’t sell. Therefore, the $3 million invested in the machine is a sunk cost and should be ignored in current decision-making. There is no alternative to recover this loss.
Conclusion
The proper classification and analysis of costs are essential tools for effective business decisions. Concepts like differential cost, opportunity cost, and sunk cost provide valuable insights on how to allocate resources, assess risks, and maximize returns. More than just numbers, costs reflect strategic choices that shape the future of organizations. Understanding and applying these ideas practically can make the difference between stagnation and sustainable growth in the corporate environment.