Cost Allocation Confusion

[tweetmeme source=”pricingright”] I heard on NPR a story on the cost to send a soldier to Afghanistan. The price tag is $1 million. So to send the 40,000 soldiers the total cost will be $40 Billion.  Correct?

Not quite. The actual total cost could be way more or less this number. The mistake lies in computing the true marginal cost – that is the incremental cost in sending one additional soldier.  The $1 million number is misleading because it includes a fraction of the fixed costs allocated to each soldier:

“So, it’s the cost of some allocation of the cost of the plane, some allocation of the cost of the fuel, some allocation of the cost of the pilots, the maintenance folks,” Zakheim explains. “If you focus just on the soldier, it seems outrageous. But if you focus on the support for the soldier — that’s not all that outrageous at all.”

But what if planes are already flying to Afghanistan and have spare capacity? What if the infrastructure is already there? What if the army already have soldiers on the payroll?  What if the army has to build new infrastructure for housing 40,000 soldiers at a new cost of $20 billion?

A moment’s reflection on these questions will convince you that the true marginal cost does not include fixed cost allocation and the total cost could be less or more than the $40 billion number.

Do you know your marginal costs?

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