Project managers are often called on to make decisions between different opportunities or different ways of accomplishing the goals and objectives of a company. The three types of cost that are used to make decisions are differential cost, sunk cost, and opportunity cost.
Differential cost is simply the difference in cost between choosing one of two or more options to pursue. The other side of differential cost is differential revenue. When considering the different options to pursue, the differential cost and revenue of each option is reviewed and the option that presents the higher income is usually chosen.
Let’s look at an example of how differential cost may be used to choose between two options. ABC Web Company creates and supports Internet web sites for other companies. Often its revenues are tied, in part, to the success of the web sites it designs. ABC Web has been approached to produce a web site that it feels will be very successful, but currently its resources are working over capacity and cannot begin the work immediately.
ABC Web’s alternatives are to ask the client to wait three months or to subcontract the work to another vendor that it has worked with in the past. The client has indicated that if ABC waits three months, it will pay a commission on the site’s revenues for only 9 months instead of 12. Yet subcontracting is fairly expensive. Here is the differential calculation that ABC Web made:
According to this analysis the differential revenues were $30,000, while the differential costs were $10,000, meaning that ABC Web would have $10,000 more revenue by choosing to subcontract this project to a vendor. By closing the differential cost study such as this, ABC Web is able to make a decision.* Project Monthly Commission $10,000
A Sunk Cost is any cost that is already incurred or sunk into a project. At times, when making decisions, managers may not wish to throw away money that has already been spent and will decide to continue so as to recoup the money already spent. This happens frequently in projects that are not going well. For example, take a software development project that was budgeted to cost $300,000. Now, with the delivery date six months past and the cost topping $400,000, the company must make a decision as to whether to continue or not.
Several of the programmers on the project want to continue. They say, “We think we are almost there, and besides, we’ve already spent $400,000. We don’t want to waste the money!” However, the money that has been spent is gone (or sunk). It must not enter into the decision. The decision as to whether to continue or not should be made only on the chances of successfully completing the project, no matter what costs have already been sunk into it.
Therefore, spending more money when the success of the project is not clear (or when failure is all too clear) is not justified. In reality, since the money is already spent, it cannot be used to make future decisions. Sunk costs should never have a place in deciding future activities or operations.
Opportunity cost results when a decision is made to pursue one benefit over another. Although opportunity cost is important in making decisions, it is not a cost that enters into accounting statements, such as income expense reports or balance sheets. Some examples of opportunity cost could be:
- The selection of one project over another. Since both projects represent potential revenue to the company, the revenue of the project not chosen is an opportunity cost.
- Not pursuing a particular new product in order to invest in other areas. The potential revenue of this product is an opportunity cost.
As we can see in each of the decision costs descriptions, often the information used to make a decision comes from the same source and is in a similar format as other costs, but is used for a different purpose. For example, in the differential cost example the production cost of the software could include variable, semi-variable, and fixed cost, but in order to make a decision about whether to subcontract, the type of cost was less important than the difference in cost between the two options.
Cost is a complex subject that reaches far beyond the individual budget of any given project. different areas of the company use cost information in different ways, and the information must be formulated to suit the company area that it serves.
When project managers are planning a project, and in particular are creating a project budget, knowledge of the different kinds of costs that the project will incur is essential to successful budgeting. In addition, an understanding of overall cost at a particular company in a specific industry will help project managers create budgets that take cost into proper consideration and deliver winning results.
This article is excerpted from the new book, Project Management Accounting: Budgeting, Tracking, and Reporting Costs and Profitability, Second Edition. Copyright 2011. This material is used by permission of John Wiley & Sons, Inc.