Kevin Anderson is a sophomore at the University of Minnesota in Minneapolis. Following the most brutal winter ever recorded in the state’s history. Anderson is faced with an extremely important decision: Should he drive to Miami for spring break. or should he fly?
If he drives. he will leave on Saturday, stay in a· roadside motel Saturday night. and arrive in Miami late Sunday evening. This option will allow him to enjoy five full days in Miami (Monday through Friday). However, he would have to leave the following Saturday, and spend another Saturday night in a motel. in order to arrive back in Minneapolis late Sunday evening

• Cost per night to stay in a motel is $80.
• Cost to have someone watch Rex (Kevin’s dog) is $5 per day.
• Eating out costs approximately $20 per day.
In February. Kevin paid $600 for six months’ car insurance.
• Cost of gasoline to drive to Miami and back is about $200.
• An airline ticket and taxi service cost $500.

Let’s help Kevin analyze this information and make a decision regarding his vacation plans.

Relevant Information in Business Decisions

Identifying all of the information relevant to a particular business decision is a challenging task. because relevance is a broad concept. The process requires an understanding of quantitative and qualitative information. a grasp of legal issues. sensitivity to ethical
concerns. and an ability to discern fact from opinion. In short. identifying the information relevant to a decision requires judgment-and more careful thought than first meets the eye. To simplify mutters. our discussion will focus primarily on relevant financial informational-namely. costs and revenues.

Virtually all business decisions involve choosing among alternative courses of action. The only information relevant to a decision is that which varies among the possible courses of action being considered. Costs. revenues. and other factors that do not vary among possible courses of action are not relevant to the decision

To illustrate the concept of relevant information,’ assume that the Redstar Ketchup Company is closed for a labor strike. During the strike, Redstar is incurring costs of approximately $15.QOOper week for utilities. interest. and salaries of nonstriking employees.

A major film company has offered to rent the ketchup factory for a week at a price of $10;000 to shoot several scenes of a new Robo Cop movie. If the factory is rented, ,Rl!dstar”s management estimates ‘that its cleanup costs will amount to nearly $2.000. Based solely on this information, would it be profitable to rent the ketchup factory to the film company?

Opportunity Costs

An opportunity cost is the benefit that could have been obtained by pursuing an alternative course of action. For example, assume that you pass up a summer job that pays $4,000 in order to attend summer school. The $4.000 maybe viewed as an opportunity cost of attending summer school.

Although opportunity costs are not recorded in a company’s accounting records, they are important factors to consider in many. business decisions. Unfortunately. they sometimes are not known at the time a decision is made. To illustrate, consider the previous example involving the Redstar Ketchup Company.

We concluded that Redstar could reduce its operating loss by $8,000 by renting its factory to the film company. Assume, however, that the labor strike ends just before filming begins. As a consequence. Redstar must forego any profit that the factory could have earned during the week that filming is in process. Thus. if op rating profit for the week could have totaled $25,000, the opportunity cost of renting to the film company is the $25,000 foregone.

Sunk Costs Versus Out-of-Pocket Costs

As mentioned earlier. a sunk cost is one that has already been incurred and cannot be. changed by future actions. For example, Redstar’s investment in its ketchup factory is a sunk cost. This cost will not change regardless of whether Redstar rents the factory. resumes operations, or lets the building stand vacant.

Cash Effects

Cash effects differ among the concepts of opportunity costs, sunk costs, and out-of-pocket costs. Sunk costs represent cash outflows that have already occurred. No cash flow effects are associated with opportunity costs. They do not represent cash outflows or inflows. Out-of-pocket costs usually refer to planned cash outflows. Considering the cash effects of short-run business declslons is critical in an ongoing enterprise. More small Luslnesses fail because of poor short-run cash planning than for any other reason.

Posted on November 24, 2015 in Incremental Analysis

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