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Advising the small business client.

Advising the Small Business Client

Sharon's Cakery began operation on October 1, 1988, in the garage of Sharon Green. The business specializes in delivery of homemade cakes for weddings and special occasions. Due to the increased number of customers, Sharon is considering moving to a vacant office building and devoting full time to the business. Sharon is currently employed at Gold's Cafe as a waitress where she makes $20,000 a year.

Sharon has estimated the following costs of opening the new business:
Purchase of new oven $ 7,500
Purchase of delivery truck $ 18,000
Purchase of furnishings $ 12,000
Monthly rent $ 1,500
Wages of employees $ 5.50/hour
Insurance $ 500/year
Local advertising $ 600/month
Additional business licenses $ 300/year


Sharon plans to move the existing equipment from her garage to the new business. The existing equipment has an original cost of $15,000 and accumulated depreciation of $3,000. Straightline depreciation is used to depreciate all plant and equipment.

The situation described above is taken from a text book on management and cost accounting, an area of accounting which most practitioners carefully avoid. However, the circumstances as described are not unlike everyday problems of the typical small business client. To help these clients, it is necessary to understand various types of costs and how they relate to the planning and operation of a business.

One of Sharon's first considerations is just what will be the cost of expanding her business. In technical terms she is looking at "differential" or "incremental" costs. A differential cost is the difference in cost from one course of action compared to an alternative course. Upon review of the type of costs, Sharon may decide against the venture or she may be able to reduce or eliminate some expenses, for instance the purchase of the delivery truck.

Taking a second look at these costs, Sharon realizes that some costs are fixed and some are variable. Fixed costs remain constant even though the level of activity changes. Variable costs increase or decrease in total dollar amount as the level of activity increases or decreases. Sales must cover both types of costs. If she understands how to apply these costs, Sharon can determine what her break-even point will be, how much she will have to sell to reach that point, and what it will take to become profitable.

Are all these costs essential? Can Sharon eliminate any non-essential costs? A cost that is not essential to short-term operations is called a discretionary cost. If, however, Sharon wants her business to continue to expand over the long term, she may need to reconsider these costs at a later date.

Two other costs to consider are opportunity costs and sunk costs.

An opportunity cost is the amount of income lost when one alternative is chosen over another. Opportunity costs do not involve actual disbursements, but the loss of income must be considered.

Sunk costs are costs which have already occurred and cannot be reversed. Sunk costs are usually excluded from decision-making since no change will be made based on these costs.

Using the definitions presented in the article and the facts in the case above, can you complete the textbook problem on managerial accounting? Answers next month.

Instructions: Classify each of the preceding costs of opening the new business, using the following categories:

Variable costs

Fixed costs

Differential costs

Discretionary costs

Opportunity costs

Sunk costs

Note: Some costs may be classified into more than one category.
COPYRIGHT 1990 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Title Annotation:accountants
Author:Schwartz, Marlyn A.
Publication:The National Public Accountant
Article Type:column
Date:Oct 1, 1990
Words:579
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