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Sunk Costs and Opportunity Costs

  • Definition: Sunk Costs are costs that have already been incurred and cannot be recovered. They are irrelevant for future decision-making.
  • Example: "Water over the dam", "toothpaste that's out of the tube" signifies that once a cost has been incurred, it cannot influence current decisions.
  • Importance: Opportunity Costs are always relevant for decision-making. Opportunity cost is defined as the loss of potential gains from choosing one alternative over another.

Special Orders

Overview

  • Special order decisions focus on whether to accept or reject orders that deviate from the usual pricing or terms.
    1. Step One: Determine the revenue from the special order.
    2. Step Two: Calculate the avoidable costs related to the special order, which are usually variable costs.
    3. Step Three: Decide to accept or reject based on the analysis.

Example: Big Sky Farms

  • Product: Gift baskets containing fruits and nuts, priced at $50 each.
  • Tanya Williams requests 200 baskets at a price of $25 per basket.
  • Capacity: They have the ability to produce 1000 baskets but are currently producing 500.
    • Because capacity is not constrained, they can evaluate the special order.
  • **Costs per Basket:
    • Unit Level Materials:** $10
    • Unit Level Labor:** $4
    • Facility Level Overhead:** $15
    • Total cost per basket = $10 + $4 + $15 = $29
    • Proposed price for special order = $25 (suggesting a loss of $4 per basket).

Decision Analysis

  • Total Revenue from the special order: 200imes25=5000200 imes 25 = 5000
  • Total Avoidable Costs (Relevant Costs):
    • Direct materials: 200imes10=2000200 imes 10 = 2000
    • Direct labor: 200imes4=800200 imes 4 = 800
    • Total Relevant Costs = $2,800
    • Contribution to Net Income = 5000−2800=22005000 - 2800 = 2200
  • Decision: Accept the special order as net contribution is positive.

Outsourcing Decisions

Overview

  • Outsourcing involves considering whether to continue production in-house or to purchase from an external supplier.
    1. Step One: Identify the costs associated with making the product in-house.
    2. Step Two: Identify costs associated with buying the product from an external supplier.
    3. Step Three: Decide based on a cost-benefit analysis of making vs buying.

Example: River Valley Inc. (RVI)

  • RVI produces its own grapes currently costing 1919 per bottle compared to an outside supplier's price of 1515.
  • Reported Costs per Bottle:
    • Unit Level Material: $6
    • Labor: $5
    • Overhead: $8
    • Fixed Costs (Marketing and Selling): Remain constant regardless.

Decision Points

  • Buying Costs: $15 per bottle from supplier (minimum) resulting in a total of 300,000300,000 for 20,000 bottles.
  • Total Costs of Making: Consider total costs that will not change with decision.
    • Keep Production: Total to $19.
    • Outsource Total: $22