Read the Reality Bytes section on p. 797 in Fundamental Financial & Managerial Accounting Concepts (see below). For what other business decisions may it be impossible to calculate the actual cost? What are some of the dangers of basing decisions on estimated rather than actual costs? How might these dangers be minimized?
How does Southwest Airlines know the cost of flying a passenger from Houston, Texas, to Los Angeles, California? The fact is that Southwest does not know the actual cost of flying particular passengers anywhere. There are many indirect costs associated with flying passengers. Some of these include
the cost of planes, fuel, pilots, office buildings, and ground personnel. Indeed, besides insignificant food and
beverage costs, there are few costs that could be traced directly to customers. Southwest and other airlines must use allocation and averaging to determine the estimated cost of providing transportation services to customers. Estimated rather than actual cost is used for decision-making purposes.
Business decisions that involve shared resources (indirect costs) are impossible to know exactly because it is the business that drives the cost, not a particular activity or product (think business license or tax return).
In business, estimated costs are used for a variety of activities and purposes. Why? This three-paragraph discussion gives the students ideas about when the practice of estimating may hurt businesses and is general enough to prompt students to think of their own examples to customize a response of their own. Discussion is in everyday language suitable for novices.