Relevant Costs
9,000/150,000, or 6 percent. Although this return is positive, the investment remains unprofitable because its return is well below the normal 10 percent requirement. Now suppose the investment’s return is 12 percent; that is, its accounting profit is $18,000. In this case, the project delivers a 2 percent “excess” return (that is, above the normal rate) and would be economically profitable. Finally, suppose the project’s accounting profit is exactly $15,000. Then its economic profit would be exactly zero: $15,000 (.1)($150,000) 0. Equivalently, we would say that the project just earned a normal (10 percent) rate of return.
Fixed and Sunk Costs Costs that are fixed—that is, do not vary—with respect to different courses of action under consideration are irrelevant and need not be considered by the manager. The reason is simple enough: If the manager computes each alternative’s profit (or benefit), the same fixed cost is subtracted in each case. Therefore, the fixed cost itself plays no role in determining the relative merits of the actions. Consider once again the recent graduate who is deciding whether to begin work immediately or to take an MBA degree. In his deliberations, he is concerned about the cost of purchasing his first car. Is this relevant? The answer is no, assuming he will need (and will purchase) a car whether he takes a job or pursues the degree. Consider a typical business example. A production manager must decide whether to retain his current production method or switch to a new method. The new method requires an equipment modification (at some expense) but saves on the use of labor. Which production method is more profitable? The hard (and tedious) way to answer this question is to compute the bottom-line profit for each method. The easier and far more insightful approach is to ignore all fixed costs. The original equipment cost, costs of raw materials, selling expenses, and so on are all fixed (i.e., do not vary) with respect to the choice of production method. The only differential costs concern the equipment modification and the reduction in labor. Clearly, the new method should be chosen if and only if its labor savings exceed the extra equipment cost. Notice that the issue of relevant costs would be very different if management were tackling the larger decision of whether to continue production (by either method) or shut down. With respect to a shut-down decision, many (if not all) of the previous fixed costs become variable. Here the firm’s optimal decision depends on the magnitudes of costs saved versus revenues sacrificed from discontinuing production. Ignoring fixed costs is important not only because it saves considerable computation but also because it forces managers to focus on the differential costs that are relevant. Be warned that ignoring fixed costs is easier in principle than in practice. The case of sunk costs is particularly important.
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