The Importance of Cost in Management Decision Making - Term Paper Example

?The importance of cost in management decision making Accounting for Management, s “Managerial accounting provides the essential data with which the organizations are actually run. Managerial accounting is also termed as management accounting or cost accounting”. Cost accounting forms the basis for management decision making in relation various aspects of the business which include budget, variances, profitability, capital investment, make or buy decisions and pricing. Therefore good understanding of the cost and its concepts involved in costing is very important for application of the saem in taking strategic management decisions. This paper seeks to discuss the importance of understanding ‘cost’ from the managers’ perspective. Introduction The managers are involved in decision making of various types in the business, and the understanding in the following lines facilitate easy grasp of the concept of costing in relation to business management. 1. Behavior of cost The cost could be classified basically into variable and fixed or direct and indirect. All variable costs directly involved in manufacturing of a product or rendering services include direct material, labor or overheads which are variable in nature in tune with the level of production. Whereas, the ‘indirect costs’ have a tendency to remain constant within a range and may be called as ‘capacity costs’. 2. The objective or the purpose for which the cost is being considered There are various decision making situations in a business which include pricing, make or buy, sub-contracting and capital investment apart from cost control, budgeting and variance analysis which are done on a regular basis. The analysis of data and application of the costing techniques vary according to the objective. The intervention of the manager for decision making purposes is involved mainly in the situations like pricing, make or buy, outsourcing, sub-contract and capital investment. 3. Adoption of appropriate method of costing Adoption of appropriate method of costing, for example total costing or marginal costing, depends upon the nature and purpose of the management decisions. For instance, in the case of pricing of a product, different methods of costing need to be considered for different pricing situations or market types. In this paper, while discussing about the various methods, the influence of the variable and fixed costs in the decision making and the appropriate situations for using a particular method of costing is considered for better understanding. 4. Opportunity cost In the final count, the internal calculations need to pass the test of ‘Opportunity Cost’ because, any decision which is at least not compatible to the ‘opportunity cost’ may have to be discarded, because the opportunity cost it is not a simple calculation of future costs but, involves imputed costs. The opportunity cost means “The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action”. (Investopedia, 20110) Generally speaking, the managerial decision is not introvert in nature, but takes into account the economic justification considering the external environment and the marginal efficiency of the capital needs to justify a proposal. For instance, if the opportunity cost of capital does not justify a management decision, it signifies that the opportunities elsewhere available would yield superior returns on the capital invested. Methods of costing and its relevance to decision making The method of costing to be adopted depends on the nature of manufacturing activity. However, the paper is not dealing with the methods per se, in relation to the procedural aspects related to Job Costing, Batch Costing or Process Costing, in line with the objective of the study. The analysis is rather with reference to managerial accounting perspective for the purpose of decision making. For instance, Rama Gopal, C. (2009, p. 473) states “Marginal costing can be applied in the area of fixation of selling price” which is consistent with the discussions proposed. Total costing Total costing reflects the economic cost and takes into account all the variable and fixed costs involved in the cost of production, and is relevant to the pricing or other decisions related to any business organization in the long run. Standard costs can be used for working out the prices based on the actual historical cost after taking into account the inflation, fluctuations in the interest rates or exchange rates and other factors which would vary according to the economic conditions prevailing. However, “If the management of a company concentrates entirely on its present product range and markets, and the market shares and cash flows are allowed to decline, there is a danger that the company will be unable to generate sufficient cash flows to survive in the future.’ (Drury, C., p. 10) This could be considered as a signal for diversification calling attention for management decision making. Marginal costing Eskin & Baron (1977, p. 499) state “Two of the most important components of a marketing plan are pricing and the level of expenditure on advertising”. Marginal costing is useful in special pricing situations such as exports, new products, test marketing or usage of idle capacity. Rao, M. E. T. (2003, p. 271) states “The technique of marginal costing is largely used in managerial decision-making process.” In the case of exports, market dynamics are different, and the pricing for the export products is not going to affect sales in the domestic market. The underlining principle aims ‘contribution’ which represent the difference between the price and the total variable cost. The contribution available in the case of exports is translated into profits, if the fixed costs are completely recovered in the domestic volume, without affecting the pricing structure for the products sold domestically. Even otherwise, whatever contribution available in the export of the products would be useful in meeting the fixed or indirect costs which are to be incurred irrespective of the export order. The fixed costs may be deliberately not considered in the case of predatory pricing or test marketing. The fixed costs may be deliberately not considered in the case of predatory pricing or test marketing. The fixed costs need to be charged to the products on an equitable basis where the actual production is at lower level compared to the installed capacity. The Tata Motors have priced its small car Nano aggressively at INR 100,000 (US$ 2300 approximately) in India. The statement in connection with this pricing, “According to the Commission, a dominant player can be accused of predatory pricing if it sells its products below average variable cost with the intention of eliminating competition” (The Economic Times, 2008), needs to be considered carefully because the car has been priced based on the variable cost of production without taking into account the fixed costs. In an industrial undertaking production could be limited due to so many reasons such as break-down of the plant and machinery, strikes, maintenance of the machineries or other issues. Therefore, for example, the fixed cost in relation to the manufacturing such as depreciation, interest and salaries cannot be charged to the actual production which might be far below the breakeven level. This will not only vitiate the pricing process, but make the product not competitive in the market, because the price based on the total cost would be unrealistic. Bayati & Makui (2011, p. 371) observe “Making an appropriate pricing and marketing strategy is a crucial management issue in E-commerce”. The variable cost constitutes the ‘core’ in any management decision, and any decision which violates this principle would have a severe impact on profitability, which may not be justifiable in the long run. Moreover, as it could be inferred from the following example, it is only a strategy which could be effective in the short term to meet the challenging competition, to maintain the market share, but detrimental to the business in the long run. Actual Break-even Pricing Variable Cost 70 160 70 Fixed Cost 60 60 26.25 Total Cost 130 220 96.25 Actual Quantity produced 35 80 35 Cost per unit 3.71 2.75 2.75 Fixed cost per unit (@ BE level) 1.71 0.75 0.75 It could be observed that the price worked on the basis of actual cost is not realistic, whereas the pricing based on the marginal cost principle would be competitive. For every unit produced over and above the breakeven level, the company will make a profit of 0.75, because the fixed costs are fully recovered at break-even level where it is equivalent to contribution. Differential costing Differential costing is similar to marginal costing in concept, but with a small difference. Whenever, scaling up of production in a pricing situation calls for additional investment in creating production or infrastructural facilities, it results into increased fixed costs. Therefore, in this method the difference between the total cost in the proposed level of production and the current level of production is worked out which represent the cost of the additional output proposed. The pricing is now based on the differential cost expected to be incurred and the additional quantity planned to be produced. Make or buy decisions There are situations where manufacturing of a component within the company is not advisable due to cost considerations. Many a times, small undertakings are in a better position to manufacture a component at competitive cost prices due to advantages on account of lower labor cost and overheads or reduced investment on machineries. If the opportunity cost of capital does not justify in-house manufacturing based on the cost of production involved, the decision to buy the components is made by the management. However, this decision is required to be made after careful consideration of the marginal cost in view of idle capacity, technical know-how involved and other considerations. Similarly, decisions in respect of subcontracting of several activities either related to production, maintenance, security or other services are taken based on the comparative cost analysis for improving profitability. Transfer costs The transfer cost may be market-based, that is based on the market price or non-market based. The method adopted for transfer cost of intermediary products within the company from one division or profit centers to the other has an impact on the pricing of the final product. Chwolka, Martini & Simons (2010, p. 114) do not conceive transfer pricing as a separate incentive system which can be optimized in isolation. However, the transfer cost needs to be realistic, otherwise, it could vitiate the pricing decisions in respect of the final product. Cost of by-products Apportionment of joint costs in the case of by-products or associated products is determined based on the economic value of the product. When a product, for example molasses a by-product in the manufacture of sugar, gains economic value over a period of time on account of its use in distilleries, the raw material, labor and other overhead costs incurred in the manufacturing process are apportioned more towards molasses in relation to the realizable value of this by-product. Sometimes, the primary product may be relegated to the secondary place as a by-product consequent upon the decrease in its relative importance. Cost-plus contracts In the case of cost-plus contracts, it is agreed with the customer that the total cost incurred on the product on actual basis with margin is considered to be the price for the product or service. However, the basis for the calculation of the material, labor and overhead costs are specified with suitable clauses to protect the supplier from escalation in the cost of inputs. Therefore, records pertaining to the cost need to be maintained, for inspection if necessary by the customer for justification of the prices charged. These types of contracts are prevalent in supplies to government departments or public sector organizations. Conclusion In the backdrop of liberalization globalization of the economies of the countries, the management decision making process has become very complicated in view of the increasing cross border transactions or competition within the country fuelled by the international players. The managers need to be efficient and knowledgeable in costing, because various aspects such as pricing, taxation, subsidies, export formalities, warehousing, transport and demurrages are closely linked to costing and required to be taken into account for the purpose of decision making. Therefore, proper understanding of the concepts will enable the manager to efficiently firm up the management strategies for taking decisions and render professional advice to the board of directors or CEO in making strategic decisions. References Accounting for Management, 2011, What is Managerial Accounting, viewed 8 May 2011, Bayati, M. F. & Makui, A., 2011, ‘A multi objective geometric programming approach for electronic product pricing problem’, Management Science Letters, Volume1, Issue 3, viewed 8 May 2011, Chwolka, A., Martini, J. T. & Simons, D., 2010, ‘The Value of Negotiating Cost-Based Transfer Prices’, Business Research, Volume 3, Issue 1, viewed 8 May 2011,   Drury, C., 2006, Cost and Management Accounting: An Introduction, 6th Ed., Thomson Learning, London, viewed 8 May 2011, Eskin, G. J. & Baron, P. H., 1977, Effects of Price and Advertising in Test-Market Experiments, Journal of Marketing Research, American Marketing Association, Volume 14, Number 4. Investopedia, 2011, Opportunity Cost, viewed 8 May 2011, Rama Gopal, C. (2009), Accounting for Managers, New Age International. Rao, M. E.T., 2003, Management Accounting, New Age International Publishers. The Economic Times, 2008, Fixed cost not to be included in predatory pricing: CCI, 15 June 2008, viewed 5May 2011, Read More