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As financial service professionals, we need to be cognizant of the myriad of definitions that surround the word "cost." Many individuals and their advisers have unsuccessfully attempted to determine a specific definition for the term "cost" for quite some time. The purpose of this month's column is to provide a cost terminology refresher. Unfortunately, agreement on the one true definition of cost has proven elusive because the word "cost" oversimplifies a concept that truly encompasses a wide spectrum of more specific terms. When individuals consider costs, they often neglect to recognize that there are different types and that some of these are made up of several components. Furthermore, the fact that several names are often used interchangeably to describe a given cost adds confusion when attempting to define a certain cost. In addition, there are certain types of costs that are noncash in nature that people frequently fail to take into account. Such costs, while not requiring cash expenditures, must be considered when making business or investment decisions because they reduce the overall benefit of a given opportunity. Ultimately, what must be taken into considetation when attempting to examine a cost and make a decision is that all costs are not the same; each and every cost is different, and only some should be evaluated for decision-making purposes.
Differential Costs and Revenues
When attempting to form a decision based on a certain cost, it is essential to recognize what types of cost should be considered in the decisionmaking process. Choices made based upon differences between cost alternatives are termed differential or relevant costs. More distinctively, a cost increase between alternatives is termed an incremental cost, while a cost decrease is a decrementai cost. Economists frequently define these costs as marginal, which is a term often employed by planners m assessing an individual's tax situation (e.g., marginal income tax bracket). Differential expenses are the only costs that should be considered when choosing between alternatives. Costs that are identical under all of the options are irrelevant and can be ignored in making a decision. Another type of cost that should not be considered when making a decision is a sunk cost. When a cost has already been incurred and cannot be changed at a given point...