A Term Paper on the Recognition of Opportunity Cost and Relevant Cost: a Tool for Effective Business Decision Making

Topics: Decision making, Costs, Cost Pages: 8 (2582 words) Published: June 28, 2012

The role of opportunity cost and relevant cost cannot be overemphasized in the making effective decision making. They work hand in hand in making sure that the company makes the best economic decision, they are both used in making managerial decisions at every level of planning and decision making. To buttress my point I would like to give you an insight on the meaning of opportunity cost and relevant cost, also I would like to also show the similarities between them and also their use in effective decision making.

What Is Relevant Cost?
Relevant costs are costs that differ between two or more business alternatives. If costs are common or equal between the alternatives under consideration, then such costs are unlikely to be relevant to the decisions being made. An example would be historical costs because they are costs that are sunk or that have already been incurred, therefore they are not relevant to the decisions relating to the future prospects of the business. Relevant costs are similar to variable, avoidable and controllable costs, as these costs can only be incurred if a business decides to take a certain course of action. If the business decides to do nothing, then such costs will not be incurred or will be avoided. Relevant costs also share some characteristics of marginal costs because relevant costs are the incremental costs of the alternatives under consideration. It is relevant costs that matter or that are relevant when making decisions about choosing between two or more business alternatives because these relevant costs are directly related or correlated to the decisions being made. A relevant cost is a future cash flow arising as a direct result of a decision. It is a cost that needs to be taken into account in any particular decision making process. It is a cost which affects the action it is designed to facilitate or the result it is desired to produce. The costs that are relevant for a decision are future costs, any costs already incurred cannot be affected by any decision to be taken now. The basic principle is to identify all future incremental (or extra) cost that will be incurred if the contract is undertaken. These are costs that are relevant with respect to a particular decision. A relevant cost for a particular decision is one that changes if an alternative course of action is taken. Relevant costs are also called differential costs. Relevant costs are those costs that will make a difference in a decision. Relevant costs are future costs that will differ among alternatives.

Relevant costs are decision specific, meaning that a relevant cost may be important in one situation but irrelevant in another.
Special Decisions
There are special decisions where relevant costs and benefits are to identified before proceeding further. Such decisions are: * Accept or reject an order when there is excess capacity * Accepting or reject another when there is no excess capacity * Outsource a product or service

* Add, drop a product, service or department
* Sell or process further
* Optimization of limited resources or working under constraint.

What Is Opportunity Cost?
The cost of passing up the next best choice when making a decision. For example, if an asset such as capital is used for one purpose, the opportunity cost is the value of the next best purpose the asset could have been used for. * It is cost of opportunity foregone. Mr. Ahmed Shitta left a bank job which was paying him N.15,000 per month and got admission in a University. Monthly fee-charge in the university is N.10,000 per month. For Ahmed Shitta, this would be N.25,000 per month (N10,000 + N15,000). * Fola is a fresh graduate from a business university. She got two...

References: * An Overview by hafeezrm Managerial Accounting - Process Costing by hafeezrm.
* Managerial Accounting - Profit planning by hafeezrm Managerial Accounting Absorption.
* Variable & Throughput costing by hafeezrm.
* Managerial Accounting - Investment Centers & Transfer Pricing by hafeezrm
* Methods of Business Research by hafeezrm.
* Lecture notes on relevant cost opportunity cost.
* Wikipedia on relevant cost and opportunity cost.
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