Avoidable and Unavoidable Costs
Mark is a financial analyst at Pure Bottlers, Inc., a company which produces carbonated drinks, juices and mineral water. The company has recently launched a popular carbonated drink in a new flavor, Indigo. Marketing analysis shows that the company can’t increase its total revenue for the product by increasing its price. The CEO is concerned that the potential revenues aren’t enough to cover costs and the product should be dropped even though the company has excess capacity. He has sought Mark’s opinion on the matter.
Mark obtains the revenue of the products and all the direct and indirect costs allocated to the product from the company’s ERP system and conducts a margin analysis. Below is an excerpt from the analysis:
|Fixed manufacturing overheads-allocated||600,000|
|Initial advertisement outlay||1,200,000|
|Continuous advertisement and promotion||750,000|
Mark concludes that the new flavor is a loss-making product and should be discontinued.
While the analysis appears straight forward, Mark is making a serious mistake by ignoring the principle that potential decisions should be analyzed based on revenues that will be earned and costs that will be incurred if the product is continued. Including costs which will continue to be incurred regardless of whether a product is dropped or not overstates the costs and understates the margin on the product and may lead to a poor business decision.
In carrying out such analysis, analysts should only include such costs which are affected by the decision. It is important to classify costs into avoidable costs and unavoidable costs to identify which costs are relevant to a decision and which aren’t.
Avoidable costs are such costs which are incurred only when a product or activity is continued and a decision to discontinue a product or activity will eliminate or reduce these costs.
One the other hand, there are some costs which are immune to a decision in the sense that they are incurred regardless a product or activity is continued or dropped.
In identifying whether a cost is avoidable or unavoidable, the first test is to check whether the cost has already been incurred and can’t be reimbursed. If yes, the cost is unavoidable. Considering the analysis Mark carried in the example above, the cost of initial advertisement outlay is unavoidable because it is a onetime cost incurred to introduce the product and it won’t change even if the product is discontinued. Hence it is an unavoidable cost.
Second, we need to consider whether the cost shall continue to be incurred for other activities or products. For example, the fixed manufacturing overheads allocated to Indigo may include rent of warehouse which is to be paid even if the product is not manufactured. It is important to note that if the amount of cost item changes, it becomes an avoidable cost to the extent of reduction. For example, if a separate warehouse is required for the product, total warehouse rentals will decrease if a warehouse is no longer needed. This will result in the rent of warehouse becoming an avoidable cost.
The exact classification should be made by identifying whether a cost item will be avoided, completely or partially, regardless of whether it is a fixed cost or a variable cost. Avoidable costs and variable costs are not synonymous. While most of the variable costs are avoidable, some fixed costs may be avoidable too.
Some typical classes of avoidable costs include direct materials, direct labor, variable overheads, directly linked marketing and administrative costs, etc. Typical unavoidable costs are salaries of senior management like CEO, fixed general and administrative expenses like office rent, etc.