On the basis of decision making, cost can be classified as follows:
- Relevant and Irrelevant cost
- Avoidable and Unavoidable cost
- Opportunity cost
- Marginal cost
- Differential cost
Relevant and Irrelevant cost:
Relevant costs are those costs which are affected by the action and decision of management.
- If management changes the decision, these costs will also change.
Irrelevant costs are those costs which are not affected by the action and decision of management.
- They are ignored in decision-making.
Avoidable and Unavoidable cost:
Avoidable costs are those costs that can be reduced or avoided by adopting a new alternatives.
- They are relevant to decision-making because they change depending on whether or not a specific action is taken.
Unavoidable costs are those costs that cannot be reduced or avoided by adopting a new alternatives.
- They are often irrelevant to decision-making since they do not change with different alternatives.
Opportunity cost:
The cost of forgoing the next best alternative when a decision is made is called as opportunity cost.
- They represents the potential benefit lost by choosing one option over another and is essential in decision-making as it highlights what is sacrificed.
Example: If a company uses a machine to produce Product A instead of Product B, the profit that could have been earned from Product B is the opportunity cost.
Marginal cost:
Marginal cost is the additional cost to produce extra units of output.
Example: If it costs $5 to produce 100 units and $5.50 to produce 101 units, the marginal cost of the 101st unit is $0.50.
Differential cost:
The difference in total costs between two alternatives is known as differential cost.
- It may be incremental or decremental.
- They are relevant to decision-making.
Example: If the cost of producing Product X is $10,000 and Product Y is $12,000, the differential cost between the two options is $2,000.
