MANAGEMENT ACCOUNTING: CONCEPTS AND TECHNIQUES
By Dennis Caplan
PART 2: MICROECONOMIC FOUNDATIONS OF MANAGEMENT ACCOUNTING
CHAPTER 3: RELEVANT COST ANALYSIS
The beginning of wisdom in using accounting for decision-making is a clear understanding that the relevant costs and revenues are those which as between the alternatives being considered are expected to be different in the future. It has taken accountants a long time to grasp this essential point.
- R. H. Parker (1969, 15)
Management Accounting: An Historical Perspective
- Sunk costs
- Relevant Costs
- Microeconomic Analysis and the Matching Principle
Management accounting uses the following terms from economics:
Costs: Resources sacrificed to achieve a specific objective, such as manufacturing a particular product, or providing a client a particular service.
Sunk costs: These are costs that were incurred in the past. Sunk costs are irrelevant for decisions, because they cannot be changed.
Relevant costs: These are costs that are relevant with respect to a particular decision. A relevant cost for a particular decision is one that changes if an alternative course of action is taken. Relevant costs are also called differential costs.
The following discussion elaborates on these definitions:
Costs are different from expenses. Costs are resources sacrificed to achieve an objective. Expenses are the costs charged against revenue in a particular accounting period. Hence, “cost” is an economic concept, while “expense” is a term that falls within the domain of accounting.
Costs can be classified along the following functional dimensions:
1. The value chain. The value chain is the chronological sequence of activities that adds value in a company. For example, for a manufacturing firm, the value chain might consist of research & development, design, manufacturing, marketing and distribution.
2. Division or business segment: e.g., Chevrolet, Oldsmobile, G.M.C.
3. Geographic location.
Classification of costs according to the value chain is particularly important for financial reporting purposes, because for external reporting, only manufacturing costs are included in the valuation of inventory on the balance sheet. Non-manufacturing costs are treated as period expenses. To some extent, traditional management accounting systems have been influenced by external reporting requirements, and consequently, costing systems usually reflect this distinction between manufacturing and non-manufacturing costs.
Sunk costs are costs that were incurred in the past. Committed costs are costs that will occur in the future, but that cannot be changed. As a practical matter, sunk costs and committed costs are equivalent with respect to their decision-relevance; neither is relevant with respect to any decision, because neither can be changed. Sometimes, accountants use the term “sunk costs” to encompass committed costs as well.
Experiments have been conducted that identify situations in which individuals, including professional managers, incorporate sunk costs in their decisions. One common example from business is that a manager will often continue to support a project that the manager initiated, long after any objective examination of the project seems to indicate that the best course of action is to abandon it. A possible explanation for why managers exhibit this behavior is that there may be negative repercussions to poor decisions, and the manager might prefer to attempt to make the project look successful, than to admit to a mistake.
Some of us seem inclined to consider sunk costs in many personal situations, even though economic theory is clear that it is irrational to do so. For example, if you have purchased a nonrefundable ticket to a concert, and you are feeling ill, you might attend the concert anyway because you do not want the ticket to go to waste. However, the money spent to buy the ticket is sunk, and the cost of the ticket is entirely irrelevant, whether it cost $5 or $100. The only relevant consideration is whether you would derive more pleasure from attending the concert or staying home on the evening of the concert.
Here is another example. Consider a student who is between her junior and senior year in college, deciding whether to complete her degree. From a financial point of view (ignoring nonfinancial factors) her situation is as follows. She has paid for three years of tuition. She can pay for one more year of tuition and earn her degree, or she can drop out of school. If her market value is greater with the degree than without the degree, then her decision should depend on the cost of tuition for next year and the opportunity cost of lost earnings related to one more year of school, on the one hand; and the increased earnings throughout her career that are made possible by having a college degree, on the other hand. In making this comparison, the tuition paid for her first three years is a sunk cost, and it is entirely irrelevant to her decision. In fact, consider three individuals who all face this same decision, but one paid $24,000 for three years of in-state tuition, one paid $48,000 for out-of-state tuition, and one paid nothing because she had a scholarship for three years. Now assume that the student who paid out-of-state tuition qualifies for in-state tuition for her last year, and the student who had the three-year scholarship now must pay in-state tuition for her last year. Although these three students have paid significantly different amounts for three years of college ($0, $24,000 and $48,000), all of those expenditures are sunk and irrelevant, and they all face exactly the same decision with respect to whether to attend one more year to complete their degrees. It would be wrong to reason that the student who paid $48,000 should be more likely to stay and finish, than the student who had the scholarship.
The term opportunity cost is sometimes ambiguous in the following sense. Sometimes it is used to refer to the profit foregone from the next best alternative, and sometimes it is used to refer to the difference between the profit from the action taken and the profit foregone from the next best alternative.
Example: Tina has $5,000 to invest. She can invest the $5,000 in a certificate of deposit that earns 5% annually, for a first-year return of $250. Alternatively, she can pay off an auto loan on her car, which carries an interest rate of 7%. If she pays off the auto loan, she will save $350 (7% of $5,000) in interest expense. (In this context, a dollar saved is as good as a dollar earned.)
Question: What is Tina’s opportunity cost from investing in the certificate of deposit?
Answer: The opportunity cost is the “profit foregone” from the best action not taken. The payoff from the action not taken is clear: it is the $350 in interest expense avoided by paying off the loan. However, there is some ambiguity as to whether the opportunity cost is this $350, or the difference between the $350, and the $250 that would be earned on the certificate of deposit, which is $100.
This ambiguity is only a question of semantics with respect to the definition of opportunity cost; it does not create any ambiguity with respect to the information provided by the concept of opportunity cost. Clearly, the opportunity cost of paying off the auto loan implies that Tina is better off paying off the loan than investing in the certificate of deposit.
When opportunity cost is defined in terms of the difference between the two profits (the $100 in the above example), then the opportunity cost can be either positive or negative, and a negative opportunity cost implies that the action taken is better than all alternatives.
Relevant costs are costs that change with respect to a particular decision. Sunk costs are never relevant. Future costs may or may not be relevant. If the future costs are going to be incurred regardless of the decision that is made, those costs are not relevant. Committed costs are future costs that are not relevant. Even if the future costs are not committed, if we anticipate incurring those costs regardless of the decision that we make, those costs are not relevant. The only costs that are relevant are those that differ as between the alternatives being considered.
Including sunk costs in a decision can lead to a poor choice. However, including future irrelevant costs generally will not lead to a poor choice; it will only complicate the analysis. For example, if I am deciding whether to buy a Toyota Camry or a Subaru Legacy, and if my auto insurance will be the same no matter which car I buy, my consideration of insurance costs will not affect my decision, although it will slightly complicate the analysis.
Microeconomic Analysis and the Matching Principle:
The matching principle (matching expenses with the associated revenues) provides useful information, if properly interpreted. However, there are ways in which the matching principle can obscure relevant costs. For example, to honor the matching principle, companies capitalize assets and depreciate them over their useful lives. In manufacturing companies, depreciation expense in any one year for assets used in production is allocated yet again, to individual products made during the period. The result is that the cost of each unit of product includes depreciation expense that represents the allocation of a cost that was probably incurred years ago. However, except for any tax implications that arise because depreciation expense reduces taxable income, depreciation expense should be ignored with respect to all decisions.