Costs for Decision Making
When choosing between alternatives, three cost concepts determine what’s relevant:
| Concept | Definition | Decision Rule |
|---|---|---|
| Differential Cost | Difference in cost between alternatives | Include—this is what matters |
| Opportunity Cost | Value of best foregone alternative | Include—even if not in accounting records |
| Sunk Cost | Already incurred, can’t be recovered | Exclude—never differential |
The Framework
When comparing alternatives, ask: What changes based on my choice?
- Anything identical across all options = noise → ignore
- Anything that differs = signal → include
- Value of paths not taken = hidden cost → include
Quick Reference
| If the cost… | Then… |
|---|---|
| Changes depending on which option you pick | Differential → include |
| Represents what you give up by not choosing alternative | Opportunity cost → include |
| Has already been spent regardless of decision | Sunk → exclude |
Why Sunk Costs Are Dangerous
Psychologically: “We’ve already invested $50K, we can’t stop now.”
Logically: That $50K is gone whether you continue or not. The only relevant question is whether future benefits exceed future costs from this point forward.
The Sunk Cost Fallacy
Continuing a failing project because of past investment. Past spending is irrelevant to future decisions.
North: Where this comes from
- Managerial Accounting (internal decision-making focus)
- Rational Choice Theory (economics foundation)
East: What opposes this?
- Financial Accounting (records all costs, not just relevant ones)
- Sunk Cost Fallacy (psychological pull to include irrelevant costs)
South: Where this leads
- Make or Buy Decisions (applies these concepts)
- Special Order Decisions (which costs matter?)
- Keep or Drop Decisions (segment profitability)
West: What’s similar?
- Marginal Analysis (economics—focus on changes at the margin)
- Ceteris Paribus (hold constant what doesn’t change)