326658597 Jurnal MSDM 3
AJRBF
Volume , )ssue March,
)SSN:
A Peer Reviewed International Journal of Asian
Research Consortium
‐
AJRBF:
ASIAN JOURNAL OF
RESEARCH IN BANKING
AND FINANCE
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.
Journal of Asian Research Consortium
http://www.aijsh.org
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.
______________________________________________________________________________
INTRODUCTION
The goal of this paper is to provide a review of empirical research on the role of cost analysis in
managerial decision making in profit- oriented organizations. The importance of accounting in
managerial decisions has long been recognized in the literature. Particularly in the field of
management accounting, actual cost data, cost estimates and cost analysis. Cost data and 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.
One of the responsibilities of managers is to pass decisions on various issues concerning their
organizations.
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Volume , )ssue March,
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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
Journal of Asian Research Consortium
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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
One area where cost analysis is used in managerial decision making is in setting product or
services prices. Different pricing approaches are used by business organizations, which include
cost-based pricing, market-based pricing, target pricing, and others. Also, business organizations
are likely to adopt diverse pricing strategies. Noble and Gruca (1999) define pricing strategy as
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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.
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.
Journal of Asian Research Consortium
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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.
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.
Lere (1986) presents three common product costs, namely variable costing, full absorption
costing, and normal- overhead absorption costing. He mentioned that variable costing leads to
the complete- analysis price for firms with linear cost curves where demand and cost curves are
deterministic and the decision maker is risk-neutral. Thus, it can be seen from the available
literature that reliable cost data and cost analysis has become a basic input in pricing decisions in
both product manufacturing and service organizations.
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COST ANALYSIS FOR COSTS MANAGEMENT
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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).
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.
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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.
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.
In a series of three articles, Schnoebelen (1993) describes the design and implementation of an
advanced cost management system (ACMS). To provide maximum benefit, these new cost
management concepts must be practically integrated into the business processes and operating
systems. In conventional product costing methodologies only costs incurred in the manufacturing
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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
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.
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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.
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.
The basic question to address in a cost-benefit analysis in connection with capital investment
decision is whether the economic benefits of the investment outweigh the economic costs and
hence it is worth undertaking the investment project. One important financial indicator used in
cost-benefit analysis is the benefit to costs ratio, which is equal to the total monetary value of the
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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 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.
Journal of Asian Research Consortium
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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.
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
Standard costs furnish information for cost control and as a pricing policy base. In standard
costing the cost of a product or service is predetermined "scientifically". Any variance of actual
cost of production from the predetermined normal cost of product may indicate waste or
inefficiency, which is important information for management to control waste or inefficiencies.
Uusi-Rauva et al (1994) state that standard cost is used as an average target product cost and
followed up by comparing with the actual cost. Riistama and Jyrkkio, (1996) in differentiating
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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
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.
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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.
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.
Financial services organization determine where to focus and how to execute by gaining
meaningful in sight from a depth of complex financial and operational data. Sikidar and Gautam
(1999) indicate that financial services organization to remain competitive; they must have the
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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.
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.
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CONCLUSION
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.
REFERENCES
1. Barnett, W.S. (1993), “The economic evaluation of home visiting programs,” the David
and Lucile Packard Foundation, pp. 93 -112.
2. Beik LL, Buzby SL (1973). Profitability Analysis by Market Segments, J. Mark. 37: 3.
3. Bonoma, T. V., & Clark, B. H. 1988. Marketing performance assessment. Boston,
Massachusetts: Harvard Busienss School Press.
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4. Brealey, Richard A., and Stewart C. Myers. “Principles of Corporate Finance,” 5th ed.
New York: McGraw-Hill, 1996
5. Charles T. Horngren, George Foster, and Srikant M. Datar, (2002), “Cost Accounting, A
managerial emphasis,” Tenth edition
6. Clement L. Stanford (1948), Cost minimization and control as a function of cost
Accounting.
7. Diamantopoulos, A., "Pricing: Theory and Evidence A Literature Review" in Baker, M.
J. (ed): Perspectives on Marketing Management, Vol.I, Wiley, 1991, pp. 63-192.
8. Hall, R. and Hitch, C. 1939. "Price Theory and Business Behaviour" Oxford Economic
Papers Vol. 2, pp. 12-45.
9. Horvath P (1993), Target costing: A State-Of-The-Art Review. CAM-I research project,
IFS International Ltd., 64 p.
10. Jackson, D. H. (1974), New product management. Management Accounting (July): 5456.
11. J.K. Shank and J.Fisher (1999), Case study- Target costing as a strategic Tool, in: Sloan
Management Review, Fall,pp37-82
12. John C, Lere(1986), product pricing based on Accounting Costs.
Journal of Asian Research Consortium
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13. J.P. Dickinson (1974), Cost-volume-profit Analysis under uncertainty, pp. 182-187
14. Kettner, P.M., Moroney, R.M., and Martin, L.L (1990), Designing and managing
programs: An effectiveness-based approach, Newbury Park, CA: Sage.
15. Mohsin Y. Meghji (2005), Analyzing Profitability in a Turnaround, principal at Loughlin
Meghji & Company
16. Monden Y (1989), Total cost management system in Japanese automobile corporations.
Japanese management accounting, A world class approach to profit management.
Productivity Press, Massachusetts, USA, p 15-34.
17. Nagle, T., Holden, R., 1995. The Strategy and Tactics of Pricing: A Guide to Profitable
Decision Making. Prentice-Hall, England Cliffr, Nj
18. Patrick M.Dunne; Harry I.Wolk, (Jul., 1977), Marketing Cost Analysis: A Modularized
Contribution Approach, Journal of Marketing, Vol.41 No. 3. pp.83-94
19. Paul Crossman (1953), The function of the Cost Accountant in cost control, pp. 25-31
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20. Peter M.Nobel, Thomas S. Gruca (1999), Industrial pricing: Theory and Managerial
Practice, Marketing Science, vol. 18, No. 3, pp. 435-454.
21. Riggs, James L., (1982), Engineering economics. McGraw-Hill, New York, 2nd edition,
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22. Riistama V & Jyrkkio E (1996), Operatiivinen laskentatoimi. WSOY, Porvoo, 418 p (in
Finnish).
23. Robert K. Jaedicke and Alexander A. Robichek (1964), Cost-volume-profit Analysis
under conditions of uncertainty, pp.917-926.
24. Schnoebelen S (1993a) ,Integrating an advanced cost management system into operating
systems (part I). Journal of cost management, Vol 7, Winter, p 50-54.
25. -------------- (1993b), Integrating an advanced cost management system into operating
systems (part II). Journal of cost management, Vol 7, Spring, p 60-67.
26. ------------ (1993c), Integrating an advanced cost management system into operating
systems (part III). Journal of cost management, Vol 7, Summer, p 38-48.
27. Sieglinde Fuller(1995), Life cycle cost analysis, National Institute of Standards and
Technology (NIST)
28. S. Sikidar & H. C. Gautam (1999), Financial Statement Analysis -, New Central
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29. Thompson, M.S. (1980), Benefit-Cost analysis for program evaluation, Beverly Hills :
sage.
30. Uusi-Rauva, E., Paranko, J., Viloma, H. (1994) Toimintoperusteinen kustannuslaskenta –
Activity-Based Costing. TTKK Teollisuustalous. Opetusmonisteita 3/94. Tampere.105 p.
(In Finnish)
31. Weimer, D.L., and Vining, A.R. (1992), Policy analysis: concepts and practice, (2nd Ed.)
Englewood Cliffs, NJ: Prentice Hall.
32. Weishih (1979), A General Decision Model for cost-volume-profit Analysis under
uncertainty, pp. 687-706
33. Zechhauser, R. J. 1975. Procedures for Evaluating Lives. Public Policy, 23, 419- 464.
34. Zvi Adar, Amir Barnea and Baruch Lev (1977), A comprehensive cost-volume-profit
analysis under uncertainty, pp. 137-149.
Volume , )ssue March,
)SSN:
A Peer Reviewed International Journal of Asian
Research Consortium
‐
AJRBF:
ASIAN JOURNAL OF
RESEARCH IN BANKING
AND FINANCE
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.
Journal of Asian Research Consortium
http://www.aijsh.org
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.
______________________________________________________________________________
INTRODUCTION
The goal of this paper is to provide a review of empirical research on the role of cost analysis in
managerial decision making in profit- oriented organizations. The importance of accounting in
managerial decisions has long been recognized in the literature. Particularly in the field of
management accounting, actual cost data, cost estimates and cost analysis. Cost data and 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.
One of the responsibilities of managers is to pass decisions on various issues concerning their
organizations.
AJRBF
Volume , )ssue March,
)SSN:
‐
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
Journal of Asian Research Consortium
http://www.aijsh.org
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
One area where cost analysis is used in managerial decision making is in setting product or
services prices. Different pricing approaches are used by business organizations, which include
cost-based pricing, market-based pricing, target pricing, and others. Also, business organizations
are likely to adopt diverse pricing strategies. Noble and Gruca (1999) define pricing strategy as
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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.
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.
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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.
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.
Lere (1986) presents three common product costs, namely variable costing, full absorption
costing, and normal- overhead absorption costing. He mentioned that variable costing leads to
the complete- analysis price for firms with linear cost curves where demand and cost curves are
deterministic and the decision maker is risk-neutral. Thus, it can be seen from the available
literature that reliable cost data and cost analysis has become a basic input in pricing decisions in
both product manufacturing and service organizations.
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COST ANALYSIS FOR COSTS MANAGEMENT
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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).
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.
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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.
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.
In a series of three articles, Schnoebelen (1993) describes the design and implementation of an
advanced cost management system (ACMS). To provide maximum benefit, these new cost
management concepts must be practically integrated into the business processes and operating
systems. In conventional product costing methodologies only costs incurred in the manufacturing
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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
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.
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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.
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.
The basic question to address in a cost-benefit analysis in connection with capital investment
decision is whether the economic benefits of the investment outweigh the economic costs and
hence it is worth undertaking the investment project. One important financial indicator used in
cost-benefit analysis is the benefit to costs ratio, which is equal to the total monetary value of the
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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 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.
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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.
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
Standard costs furnish information for cost control and as a pricing policy base. In standard
costing the cost of a product or service is predetermined "scientifically". Any variance of actual
cost of production from the predetermined normal cost of product may indicate waste or
inefficiency, which is important information for management to control waste or inefficiencies.
Uusi-Rauva et al (1994) state that standard cost is used as an average target product cost and
followed up by comparing with the actual cost. Riistama and Jyrkkio, (1996) in differentiating
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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
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.
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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.
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.
Financial services organization determine where to focus and how to execute by gaining
meaningful in sight from a depth of complex financial and operational data. Sikidar and Gautam
(1999) indicate that financial services organization to remain competitive; they must have the
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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.
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.
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CONCLUSION
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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