Managerial Accounting: Incremental and Opportunity Costs
Managerial accountants know that when faced with two or more alternatives, incremental costs are those costs that change depending on which alternative you choose. Suppose you want to buy a new bicycle. Incremental costs of buying the bike include the actual price of the bike plus any accessories. You also need to pay for gas and tolls to drive to and from the bike store — another incremental cost.
On the other hand, the cost of buying lunch after purchasing the bike isn’t an incremental cost because you need to pay for that regardless of whether you buy the bike (and if there’s one thing accountants know, it’s that there’s no such thing as a free lunch).
As you analyze budgeting decisions, take special care to consider only incremental costs and to ignore all other costs.
Choosing one option may mean you lose money because you turned down another alternative. These incremental costs are called opportunity costs. For example, say you choose to take the day off from work to go bike shopping, losing $100 in income. That lost income is an opportunity cost.
When considering decisions to invest in long-term projects, one of the most significant opportunity costs is how much you could have earned by investing your money elsewhere.
When analyzing for incremental costs (and especially for opportunity costs), remember that they’re expected to happen in the future. That’s how you know that you can’t include sunk costs (costs that you incurred in the past). For example, say you already bought a new bike last week that you really liked and that just got stolen. The cost of the missing bike is a sunk cost.
Because you can’t change sunk costs, you can ignore them completely. It doesn’t matter how much that stolen bike cost you — it’s gone.