Decision Making-Notional Costs, Sunk Costs & Committed Costs

November 15th, 2006 Comments off
Share |

Notional Costs

Notional costs are also known as imputed cost. The primary objective of charging notional costs is to enable management to make clearer internal decisions by making sure that internal decision making become more realistic by assuming that the cost of all resources consumed reflects the full economic value – usually by applying market prices.

  • Notional charges are typically used to charge responsibility centres.
  • Notional interest is often charged for the use of internally generated funds.

Examples of using notional cost to enhance internal management making decisions:

  • Charging of ‘market rent’, where buildings have been purchased on a freehold basis. Such a mechanism helps to focus management attention on making best use of space so that surplus space across the whole organisation might then be sold or rented to another user.
  • Intra division charges to enable management to see the true performance of certain departments

Sunk Costs:

Sunk cost is defined by ICMA terminology as

A past cost not directly relevant in decision making.

  • If we refer to relevant costs, the main feature is that we are referring to FUTURE costs.
  • As Sunk costs are cost which have already been incurred therefore it should be ignored when making any decisions.
  • Sunk costs are irrelevant costs which are simply costs that will not affect the decision.
  • By analyzing these type of sunk costs, management will be wasting their time and efforts as these costs do not affect the decision they are going to make.

In short term decision making, fixed costs are generally regarded as sunk costs.

Illustration:

Say Company A has a factory which produced product A. Earlier last year it has extended and renovated the factory at an additional cost of $200,000 to produce product B. Now management is thinking of whether to let outsiders produce product B or not. Should this $200,000 be considered?

$200,000 is sunk costs which existed as a result of previous decision.

Committed Costs:

  • These costs are similar to sunk costs in that they exist as a result of previous decisions although the ‘charge’ has yet to be incurred or the cash released.
  • Committed costs are costs that have been committed by management.
  • Examples are like renovation of factory premises, capital expenditures being incurred as company’s purchase orders have been issued or workdone is partially completely and payment to suppliers still outstanding

However, the abovementioned costs committed contractually is effectively a sunk cost.

Illustration:

 

Question:

Say company A is unable to rent out its building/workshop but there is a need to sign off a contract to spend $70,000 on an air conditioning system. Would this make any difference to management decision?

Answer:
None whatsoever. This type of situation might be awkward but past costs (and mistakes) should not impact upon the logic of financial decision making. The $70,000 that has been committed contractually is effectively a sunk cost.

[ Also refer to earlier articles on Relevant Costs ]

Comments are closed now.

Financial Accounting

 
 

Advertise Here | Brain Teasers/Puzzles | Greeting Cards | Inspirational Quotes | Jokes/Humor | Useful Links | Motivational Stories | Resource | Shopping | Share/Express Your Views | Testimonials | Universities/Colleges | Words of Wisdom from Religions | FREE POSTING OF ACCOUNTING & FINANCE JOBS VACANCY|