326658597 Jurnal MSDM 3

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Journal of Asian Research Consortium http://www.aijsh.org

A P e e r R e v i e w e d I n t e r n a t i o n a l J o u r n a l o f A s i a n R e s e a r c h C o n s o r t i u m

AJRBF:

A S I A N J O U R N A L O F

R E S E A R C H I N B A N K I N G

A N D F I N A N C E

THE ROLE OF COST ANALYSIS IN

MANAGERIAL DECISION MAKING:

A REVIEW OF LITERATURE

FITSUM KIDANE*

*Ph.D Research Scholar, Lecturer in Accounting and Finance College of Business and Economics,

Mekelle University, Mekelle, Ethiopia.

ABSTRACT

This paper provides a review of empirical research on the role of cost analysis in managerial decision making in profit- oriented organizations. A well developed costing system is becoming increasingly important to profit oriented organizations. Cost analysis helps managers in making decisions in such areas like pricing, profit planning, setting standard cost, capital investment decisions, marketing decisions, cost management decisions and others. The review shows that, findings from different literatures stated that Cost analysis is crucial in various decisions and plays an important role in managerial decision making.

KEYWORDS: Cost, Cost analysis, decision making.

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INTRODUCTION

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Decision-making is a process where by managers respond to opportunities and threats. In this process managers analyze alternatives to deal with opportunities and threats and finally pass decisions about goals and strategies. Managerial decision- making relies heavily on the availability of relevant, reliable and timely information. To this end, managers depend on the company’s management information system to obtain relevant, reliable and timely information needed to base decisions. The accounting information system is a sub-system of the over all management information system and generates information to be used in a managerial decision making. The system provides management with quantitative and non-quantitative data and information which can advantageously be used by management in making decisions.

One of the many reports that can be generated from a management accounting system and that would be supplied for management to aid managerial decision-making and control is cost analysis report. In this article, we will discuss the role of cost analysis in managerial decision making in profit – oriented organizations. Cost analysis is defined as the allocation of costs to provide estimates of what a program's costs and benefits are likely to be, before it is implemented. Cost analysis is vital for managerial decision making in various organizations – profit-oriented and non-profit organizations. In profit-oriented organizations, cost and cost analysis reports are useful in various management decision making areas: product costing and pricing, cost management, special (tactical) decisions, profit planning, capital investment decisions, standard setting, product/ customer profitability, and the like. In non-profit organizations cost analysis provides useful input for cost-sharing decision, cost management (containment), cost-recovery pricing decisions, etc. In such organizations cost analysis is part of good program budgeting and accounting practices, which allow managers to determine accurate cost of providing a given unit of service (Kettner, Moroney, and Martin, 1990).

OBJECTIVE OF THE STUDY

To study the types of cost analysis that managers use to make business decisions and the sources of such information

LITERATURE REVIEW

In this paper empirical research will be organized under eight sections: a) Cost Analysis for Product Costing and Pricing Decisions, b) cost Analysis for Costs Management, c) Cost Analysis in Profit Planning, d) Cost Analysis in Capital Investment Decisions, e) Cost Analysis for Marketing Decisions, f) Cost Analysis for Setting Cost Standards, g) Cost Analysis for Life Cycle Cost Determination and h) Cost Analysis to Determine for Product/ Customer Profitability. This study concentrates on the main decision making by managers through the use of cost analysis prepared and submitted by managerial accountants.

COST ANALYSIS FOR PRODUCT COSTING AND PRICING DECISIONS

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the means by which a pricing objective is to be achieved. Most pricing strategies imply a relative price level related to costs, competition, or customers. Determinants are the internal and external conditions that determine managers' choices of pricing strategies.

Diamantopoulos (1991, 1994) refers to price sensitivity, product differentiation, and potential for economies of scale collectively as the "pricing environment" describing them as the elements that constitute the setting within which price decision-making takes place. Nagle and Holden (1995) state that when customers are insensitive to price and the products are highly differentiated'; a firm can use a price skimming strategy to achieve its profit maximization objective. Nagle and Holden (1995), on the other hand, state that when a firm is faced with highly price sensitive customers can reduce its unit costs by spreading its fixed costs over a high volume of output to allow it to use penetration pricing strategy to achieve its profit maximization objective.

Noble and Gruca (1999) mentioned four pricing situations for industrial goods pricing, namely: new product, competitive, product line, and cost-based. They further identify pricing strategies adopted under each pricing situations. Consequently, they identified three pricing strategies most closely associated with new products, namely: skim pricing, penetration pricing, and experience curve pricing. Every one of these strategies shares the distinction of being appropriate in the early life of a product. Therefore, the age of the product being priced will determine whether a manager chooses one of the new product pricing strategies. Competitive pricing situation focuses on the price of the product relative to the price of one or more competitors. The stage of the product life cycle and ease of estimating demand will influence whether a manager will choose one of these competitive pricing strategies. Product line pricing situation focuses on the price of the focal product influenced by other related products or services from the same company. Managers in firms which sell goods and services related to the focal product will choose one of the product line pricing strategies.

Product costs are widely used as major inputs in product pricing decisions. Hall and Hitch (1939) state the general pattern of price setting to be cost-based. Bonoma et al. (1988) found that managers continue to use cost data and information as primary pricing concern. Diamantopoulos (1991), claims that cost-plus pricing is by far and away the most widely used pricing approach. Cost-plus pricing is an inward oriented strategy, involving company and product considerations, Cost-based pricing situation focuses on the internal costs of the firm including fixed and variable costs, contribution margins, and so on. Several pricing strategies, such as target-return pricing, markup pricing, rate of return pricing, contribution pricing, contingency pricing are included as part of cost- based pricing strategies.

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COST ANALYSIS FOR COSTS MANAGEMENT

Managers face diverse problems in running their organizations, some internal and others external in nature. Selling prices tend to become inflexible, employees get organized and demand higher wages and other benefits, taxes increase, and governments impose new regulations. As a result of these and other factors, managers soon realize that costs must be controlled and reduced if continuous profits were to be earned. Furthermore, management begins to think of efficiency in company operations and lower costs. To accomplish these desired results, managers need cost and statistical records of current performance to compare with planned performance as a means of watching and controlling costs Crossman (1953).

Stanford (1948) defines cost control as the guidance and regulation of the internal operations of a business, by means of modern methods of costing, through which manufacturing and sales performances are measured. Jackson (1974) puts the purpose of cost control to be the discovery and correction of defects and weaknesses as these things consume resources of organizations unnecessarily and thereby increase its costs. Cost management refers to systems, method and practices employed by an organization to reduce costs of products and services without sacrificing quality.

Both cost control and cost management activities are important to assist management in its decisions and this is achieved though proper cost analysis. Current developments in cost and management accounting literature indicate the emergence of new concepts, which include value chain analysis, Activity-based Costing/Activity-based management (ABC/ABM), Target Costing, Life Cycle Costing (LCC), and Kaizen Costing. Consequently, the scope of cost analysis has been expanded to such areas as well. In ABC/ABM, activities consume resources (people, materials, equipment) and it becomes necessary to measure the consumption of these resources in financial terms. Cost analysis under ABC/ABM would then require the accumulation and reporting of costs by activities which then helps management to reduce costs by minimizing the cost of non-value added activities.

Target costing as stated by Horvath (1993) is as a cost management concept which is built on a comprehensive set of cost planning, cost management and cost control instruments which are aimed primarily at the early stages of product and process design in order to influence product cost structures resulting from the market-derived requirements. The target costing process involves value chain analysis and requires coordination of all product related functions in order economize on cost at each stage of the value chain. Monden (1989) presents three necessary steps in total cost management and these areas (1) planning a product that meets customers’ demand for quality, (2) determining a target cost under which customers’ demand for quality is attainable using a blueprint based on value engineering, and (3) determining which processes achieve the target cost in production performance.

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process are applied to products to determine the cost of manufacturing. The new thinking in cost management has forced accountants to breakthrough the typical product costing barriers by applying all organizational costs in a more relevant and enlightening way.

COST ANALYSIS IN PROFIT PLANNING

Cost analysis is indispensable to profit planning. Profit planning involves the determination of operating plan of a business organization for the coming operating period and summarizing it in financial presentations in the form of projected income statement. Costs are one of the major inputs in profit planning and cost analysis in profit planning helps management to understand the relationship of cost, volume and profit and finally decide on the optimal operational activity level. Jaedicke and Robichek (1964) explain cost-volume-profit analysis being useful to determine the optimal level and mixes of output to be produced with available resources, i.e. in making the firm's short-run output decision. Dickinson (1974) explains cost-volume-profit analysis as a means for enabling management to decide whether to make or buy, to continue or discontinue a particular product, to increase production of a product, to introduce new lines, and so on.

Weishih (1979) presented a general decision model for cost-volume-profit analysis which takes into account the crucial elements of random demand and level of production in the determination of actual sales and resulting profits. The purpose of the model offered is to investigate C-V-P analysis with realism, and to remove a basic deficiency from the traditional C-V-P model. The general model enables management to choose the best among alternative products and to determine, concurrently, optimal production levels in the light of a firm's goals and objectives. Zvi, Amir and Baruch (1977) presented a comprehensive approach to cost-volume-profit analysis under uncertainty. The approach is based on recently suggested economic models of the firm's optimal output decision under uncertainty, which were modified here with in the mean-standard deviation framework to provide for a cost-volume-utility analysis allowing management to determine optimal output, consider the desirability of alternative plans involving changes in fixed and variable costs, expected price and uncertainty of price and technology changes, and determine the economic consequences of fixed cost variances.

COST ANALYSIS IN CAPITAL INVESTMENT DECISIONS

Capital investment decisions basically examine two major items, namely benefits and costs. Thus, analysis of both the benefits and the costs are made and such analysis is commonly called cost-benefit analysis. Richard and Stewart (1996) define cost-benefit analysis as widely used technique for deciding whether to make a change or not and involves adding up the value of the benefits of a course of action, and subtracting the costs associated with it. Costs are either one time costs, or may be ongoing. The benefits are most often received overtime. Cost-benefit analysis can be carried out using only financial costs and financial benefits.

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benefits divided by the total monetary costs of obtaining those benefits. Weimer and Vining (1992), Thompson (1980) and Zeckhauser (1975), on the other hand use the net rate of return, which is basically the total value of benefits minus total costs as an alternative tool for comparison in cost-benefit analysis. Both, however, do not have fundamental difference, as one is a ratio and the other is an absolute amount.

Barnett (1993) outlines a nine-step process to conduct a cost-benefit analysis. These are defining the scope or perspective of the analysis; conducting cost analysis; estimating program effects; estimating the monetary value of outcomes; accounting for the effects of time; aggregating and applying a decision rule; describing distributional consequences; conducting sensitivity analyses; and discussing the qualitative residual. Cost analysis, as mentioned above, is, therefore, crucial in capital investment decisions and plays an important role in managerial decision making.

COST ANALYSIS FOR MARKETING DECISIONS

Cost analysis from the viewpoint of marketing decision provides useful information needed to plan and control marketing costs and to devise appropriate marketing strategies for selling products based on their contribution margins to the total company profit. Beik and Buzby (1973) stated that marketing cost analysis relates the cost of marketing activities to sales revenues. A profit or loss statement must be constructed for any marketing component being analyzed. The approach consists of dividing the firm's costs into their functional categories. The functional category amounts are then assigned within the appropriate marketing classifications.

Cost analysis by product categories and market segments promises improvement in marketing efficiency by way of better planning of expenditures and control of costs. Dunne and Wolk (1977) in their research explain that a modular contribution-margin income statement spotlights the behavior of controllable costs and indicates each segment’s contribution to profit and indirect fixed costs. They state that the modular approach is a useful tool for marketing managers who are concerned not only with the efficiency of the operation for which they are responsible, but also with the profitability of products, territories, channels, and customers.

Dunne and Wolk, further indicate that contribution margin income statements by department are also useful for budgeting, performance analysis, short-run decision-making, pricing, and decisions between alternatives. Market segment income statements are also useful for such marketing decisions as whether to drop a product line and whether to alter the physical distribution system. They also aid in the redirection of effort to the company’s more profitable products and markets.

COST ANALYSIS FOR SETTING COST STANDARDS

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standard costing and target costing state that ,although the purpose of standard costing is to give targets for product manufacturing, these costs differ from the target costing method, which is used in the early development phases of a product.

Shank & Fisher (1999) warn that standard costing is a simple and suitable method for actual cost follow-up, but may lead to inappropriate decisions when used incorrectly in future planning. They state the main problem of standard costing as being that it does not provide enough information to enable management to control the overheads and other indirect costs related to the product. Setting a standard cost may be based on a standard of technical performance (physical standard quantities) or statistical analysis of costs. In both cases the need for conducting reliable cost analysis is critical to set meaningful standard costs which would be used as a basis for managerial decisions, particularly on performance measurement and variance analysis.

COST ANALYSIS FOR LIFE CYCLE COST DETERMINATION

Life Cycle Cost determination for a product or service is based on the principle that the cost of a product or service is the costs incurred throughout its whole life. James L. (1982) explains Life Cycle Cost Analysis (LCCA) becoming popular in the 1960s when the concept was taken up by U.S. government agencies as an instrument to improve the cost effectiveness of equipment procurement. From that point, the concept has spread to the business sector, and is used in new product development studies, project evaluations and management accounting.

Fuller (1995) defined Life Cycle cost analysis (LCCA) as a method for assessing the total cost of facility ownership which takes into account all costs of acquiring, owning, and disposing of the facility. He states that LCCA is especially useful when comparing project alternatives that fulfill the same performance requirements, but differ with respect to initial costs and operating costs. James L. (1982) identified some three important benefits in life-cycle cost analysis: that all costs associated with a project/product become visible; that it allows an analysis of business function interrelationships, and that differences in early stage expenditures are highlighted. Thus these benefits enable managers to develop accurate revenue predictions. Life-cycle cost determination involves estimation the costs of a product throughout its whole life, which becomes an important input in preparing life cycle cost analysis report for managerial decision making.

COST ANALYSIS TO DETERMINE FOR PRODUCT/ CUSTOMER PROFITABILITY

Meghji (2005) stated that a profitability analysis starts with gathering pertinent, accurate and timely information. Sales by location, product or customer must be obtained from the company's financial statements and supporting management information systems. The ultimate goal in a profitability analysis is to use comparable information to identify products, customers or locations that are underperforming, to help make decisions that will increase the overall profitability of the company. It is important to set minimum performance criteria for each of the key profitability measures.

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ability to measure profitability at any level-products customer, segments, channel, and branch. A profitability analysis can be effective tool for identifying or confirming a distressed company's underlying problems. Industries that prosper have a strong customer focus in their decisions. Management accountants are giving increased attention to customer-profitability analysis, which is the reporting and analysis of customer revenues and customer costs. Horngren, Foster and Datar (2002) explain the two elements of customer profitability (customer revenues and customer costs). Two variables explain revenue differences across customers: the volume of products purchased and the magnitude of price discounting. Price discounts may be due to multiple factors, including the volume of product purchased (higher-volume customers receive higher discounts) and whether having the customer brings marketing benefits (name recognition) that helps promote other sales. Discounts could also be due to poor negotiating by a salesperson or the dysfunctional effect of an incentive plan that is based only on revenues. Managers find customer profitability analysis useful for several reasons. First, it frequently highlights how vital a small set of customers is to total profitability, managers need to ensure that the interests of these customers receive high priority. Second, when a customer is ranked in the "loss category," managers can focus on ways to make this customer more profitable in the future.

CONCLUSION

Based on this review, it can be seen reliable cost data and cost analysis has become a basic input to various decision makings in profit-oriented and non-profit organizations. In profit-oriented organizations, cost and cost analysis reports are useful in various management decision making areas: product costing and pricing, cost management, special (tactical) decisions, profit planning, capital investment decisions, standard setting, product/ customer profitability, and the like. Cost analysis employs various techniques which include break even analysis, comparative cost analysis, capital expenditure analysis, and budgeting techniques. The cost analysis technique to be used depends on the nature of the problem at hand and the professional judgment of the managerial accountant.

Conducting detailed cost analysis to ensure high degree of accuracy demands more time, energy and money for compiling and supplying cost information. In selecting cost analysis approaches and techniques, therefore, consideration of cost-benefit trade off becomes necessary. A general conclusion which could be made from the existing literature is that Cost analysis is crucial in various decisions and plays an important role in managerial decision making.

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