Relevant Costs 2319,000/150,000, 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 alter-
native’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 deliber-
ations, he is concerned about the cost of purchasing his first car. Is this rele-
vant? 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, sell-
ing 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 equip-
ment 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 dis-
continuing 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.c06CostAnalysis.qxd 9/29/11 1:46 PM Page 231