Monetary Costs and Economic Costs

Monetary costs are those commonly reflected in financial accounts. They include research and development costs, investment costs, and the costs of operations, maintenance, and replacement. At times, it may be appropriate to look beyond these monetary costs to what economists call opportunity costs, associated costs, and social costs.

Research and development (R&D) involve "front-end" costs that may or may not figure into the actual expenses of a given project or program. R&D costs incurred explicitly for a given project should be included as a project expense. However, general R&D costs that eventually benefit more than one project or program must be considered as sunk costs. Such costs should not be included in the direct cost estimate for a specific project or program.

Investment costs are expenses incurred to obtain future benefits. Such investments may be classified as sunk costs or actual project outlays, depending on their timing. Consider the decision to build a health clinic on land that was purchased some years earlier for another public purpose. Only those additional investment costs required to prepare the site for the clinic should be considered as project outlays. The previous investment for the land purchase is a sunk cost.

Sunk costs can become an inheritable asset if previous investments can be used to the particular advantage of one alternative over another. The decision regarding the site of the health clinic should not be based solely on the past investment, however. If that location would be an inferior alternative in view of identified client needs, this decision would simply result in throwing good money after bad.

Investment costs vary primarily with the size of a particular program or project, but not with its duration. Recurring costs, on the other hand, include operating and maintenance costs that vary with both the size and duration of the program. Such recurring costs include salaries and wages, employee benefits, maintenance and repair of equipment, miscellaneous materials and supplies, transfer payments, insurance, and direct overhead costs. These recurring, or operating costs, do not add to the stock of capital. Rather, they are incurred to maintain the value of the existing stock. In preparing cost estimates, it is important that these recurring costs be considered over the life of the project or program, not just in the initial fiscal period.

As these distinctions suggest, some program costs are fixed, that is, they are the same regardless of the size or duration of the program. Other costs are variable; that is, they may change significantly as the scope of the project or program is increased. Some uncertainty may exist regarding these costs, particularly if the project has a relatively long duration. It is important, therefore, to consider the marginal (or incremental) costs of increasing the size or scope of a program or project.

Suppose, for example, that the decision is whether to build one or two public health clinics. It may be possible to get quantity discounts on materials and equipment that would reduce the cost of a second clinic. As a result, suppose the cost of building one clinic is $1,200,000, and the cost of building two clinics is $2,000,000. The average cost of each clinic would be $1,000,000; however, the marginal cost of the second clinic would be only $800,000.

If resources are committed to one program, the opportunity has been pre-empted to use these resources elsewhere. The concept of opportunity costs can be illustrated by returning to the health clinic example. Having determined the monetary cost of the proposed facility, it may be appropriate to describe some of the alternative uses of these resources. For example, to what other purpose could the land be put? What other use could be made of the required staff salaries? If bonds are to be issued, what other uses might be made of the funds required for interest and principal payments?

If these alternative uses are sufficiently important, an attempt should be made to estimate their value. This evaluation would consider the benefits that must be given up if the decision is made to go ahead with the proposed clinic. Keep in mind that a basic purpose of cost analysis is to estimate the value of alternatives forgone. Opportunity costs may be extremely important in making decisions among alternative program strategies.

Associated costs are "any costs involved in utilizing project services in the process of converting them into a form suitable for use or sale at the stage benefits are evaluated." [7] Associated costs are often incurred by the beneficiaries of public programs and services. The associated costs that must be borne by users of public recreational facilities, for example, include the incremental costs of travel, food, lodging, and so forth. If access to a recreational facility is improved, so that the users' travel costs are reduced, then these savings in associated costs may be considered as benefits arising from improved access.

Social costs can be defined as the subsidies that would have to be paid to compensate persons adversely affected by a project or program for their suffering or "disbenefits." Such compensation rarely is made (except perhaps when affected individuals enter into litigation and are awarded damages). Thus, social costs represent an analytical concept.

In making a cost analysis, social costs can be handled in one of two ways. [8] They may be treated as external costs and subtracted from the market value of the output of the project to obtain a net social value. Alternatively, they may be treated as opportunity costs, by examining the potential benefits to those who are likely to be adversely affected if the project funds were spent on some other program. For example, the location of a sewage treatment facility may result in reduced property values in adjacent residential areas. These losses may be treated as "negative benefits" and subtracted from the overall benefits of the project to the larger community. Alternatively, the benefits that would accrue to these property owners from an alternative use of project funds (for example, development of a park site) might be calculated. The project with the larger "yield" would represent the better use of these resources.

Unfortunately, social costs, if included at all in a cost analysis, are seldom treated fairly. Such cost considerations are either underplayed by proponents of a project or overplayed by its opponents. Social costs often carry significant emotional overtones and, therefore, may be difficult to evaluate. Nevertheless, such an evaluation may be a very important factor in the decision to invest organizational resources in a project or program.

Activity-Based Costing

Cost accounting procedures were originally developed to help industries estimate the full costs of manufacturing goods, including the variable costs (labor and raw materials) involved in production as well as the fixed cost (overhead or indirect costs). The sum of these variable and fixed costs divided by the number of units produced/processed represent the per unit cost.

This accounting method was sufficiently accurate for managerial budgeting and planning in a fundamental business environment. Traditional costing models use direct cost factors (e.g., labor hours, machine hours, material dollars) as surrogates to allocate overhead or indirect costs to the various products. These allocation factors tend to vary proportionately with the volume of goods produced or services provided. Costs became more difficult to assign, however, as the range of goods and service provided increased. This difficulty was due, in part, to an increasingly complex production environment that resulted in added layers of overhead costs that could not be precisely allocated.

Traditional Methods for Analyzing Costs

Most accounting systems currently in use capture and distribute costs by one of the following methods:

Each of these methodologies has advantages and disadvantages and each has met the past needs of the organization. Yet, each fails to meet the full requirements for management information.

Under an organization-based accounting system , each of the elements of the traditional bureaucratic structure are identified and the identifiable costs are applied to those elements. Indirect costs are usually captured and paid in a central repository with no attempt to further subdivide or distribute these costs. In many traditional organizations, the only costs identified to the organizational elements are the direct salary costs.

This system was created to provide management with information on the costs of organizational elements. It was never intended to define the output costs either at the element or organizational level. Regardless of the approach taken within this methodology, this model is totally inadequate for making decisions on output variations. Costs are not applied to the ultimate output, activities or process flows of the organization.

Budgetary accounts track program costs in a manner very similar to that of the organizational element. Historically, public organizations have been most concerned with ensuring that their total expenditures do not exceed the allocated budgetary resources. Consequently, accounting systems became a safeguard mechanism to capture commitments, undelivered orders, and expenditures. These cost data are normally divided by organizational element to enable tracking of budget execution. The major objective is to fully use the resources assigned rather than enhance productivity or to reduce expenses. Any attempt to conserve resources may lead to a reduction in the future budget resource level. Like organizational accounting systems, no attempt is made to relate cost to output or, in most cases, to even define output.

The traditional model of cost accounting has been the mainstay for over 100 years of organizations that perform tasks which require a cost distribution to output Most of these organizations are reimbursed by their customers based on sales of their goods and services. Hence, cost accounting operations were established to capture and distribute costs to the output goods or services, using the classic model of cost distribution designed around the major factors of production: direct labor, direct materials and overhead.

With the recent advent of activity-based accounting, it has been discovered that the traditional cost accounting methodology can create a significant difference in output cost because of the manner in which overhead costs are allocated to output rather than traced to output. This difference in distribution can skew the ultimate price of the output and lead to poor management decisions.

Process-Oriented Approach

Robin Cooper and Robert Kaplan of the Harvard Business School have argued that the traditional approach to cost accounting is flawed because certain cost behavior is a function of the activities carried on in support departments and should not be driven by volume-related allocation factors. Activities describe what an organization does. The primary function of an activity is to convert resources (e.g., labor, material, and technology) into outputs (e.g., products and services).

The Activity-Based Costing (ABC) model, which Cooper and Kaplan developed, re-configures how organizations manage costs by attaching costs to activities--the processes or procedures that cause work to be performed in an organization. Cost management and cost control can then focus on the sources of cost rather than on where the costs are incurred or reported. In this way, the total cost of all traceable activities is based on how much of each activity is consumed by the product or service, regardless of organizational or functional boundaries. A fundamental premise of ABC is that managers can learn how to identify and eliminate waste by focusing on the root cause of a cost rather than merely addressing the symptoms.

The major difference between activity-based costing and traditional cost accounting is that ABC is a process-oriented accounting method, based on the recognition that labor-intensive processes may represent the single largest contribution to the increasing cost of doing business. Traditional cost accounting methods provide for tracking of costs by functional area, with functions tied to the end-items being produced. Direct costs can be identified relatively easily in this fashion, as can some, but not all, indirect or overhead costs. Those indirect costs that cannot be attributed to specific functions or programs are typically allocated across the functional areas using a pro-rating formula.

Activity-based costing, in contrast, recognizes that, while common processes or activities may be performed within each functional area, this pro-rating method does not truly account for the usage variance in process costs that may exist in different units.

A commercial production line, for example, may consume more direct labor, material, and even space than the facilities required for a small, high-precision, manufacturing contract undertaken for the NASA space shuttle program. However, the administrative overhead required to support the space shuttle contract is likely to be extraordinarily high, inflated by the additional (indirect) labor needed to perform such activities as the nonroutine handling of the small parts procurements, more stringent acceptance testing, and NASA contract reporting requirements. In this environment, ABC can provide for a surrogate form of direct costing by accounting for the significant variance in indirect costs and proportionately allocating those costs to the end item products that consume them.

Although manufacturing firms may gain the greatest benefit from ABC in the area of overhead cost allocation, the approach offers benefits to service industries in the tracking of both direct and indirect costs. The process orientation of ABC makes it valuable and applicable to all types of organizations, including government, nonprofit organizations, and colleges and universities.

Cost Drivers

Any event that causes a change in the total cost of an activity is defined as a cost driver (what has traditionally been called an allocation basis). Inputs are the resources that are consumed by activities (usually measured as costs). Outputs are the products (goods or services) that an activity supplies to its customers (internal or external). ABC provides a more representative distribution of resource use since the cost allocations are based on the direct cost drivers inherent in each of the work activities that make up the organizational structure. ABC applies resource use directly to the output products and services based on the actual work activities of the process that produces the output with limited arbitrary allocations of indirect or overhead costs.

The first step in applying Activity-Based Costing is to identify the management issues and decision-making needs for which better cost information is being sought. The output of each activity performed by the organization must be clearly defined. If multiple outputs can be defined, the subject of analysis probably needs to be split into several activities; if no output can be defined, then it is not an activity. In general, an increase in the quantity of an output will require an increase in the activity's resource consumption (i.e., total costs).

Costs must be traced from the traditional cost accounting structure (which identifies what resources are being used) to the activities (which relates why the resource is being consumed--for what purpose). The cost tracing can involve actual (historical) costs or budgeted costs. Some costs can be directly associated with an activity (most labor costs, for example), whereas other costs have to be allocated (such as utilities or rent). Costs of supporting departments are initially accumulated in overhead cost pools and are then allocated to appropriate activities. If costs must be allocated, the allocation basis is called a first-stage driver (e.g., square feet of floor space).

The next step is to quantify the volume of each activity's output, either as an actual (historical) volume or as a projected volume (define an output measure). The activity's total cost is then divided by its total volume to determine the average cost per unit of output. The total costs of individual activities then are allocated to a responsibility center or activity center (i.e., a group of having a common objective). If the costs of a responsibility/activity center are to be allocated to cost objectives, then the output measure (e.g., cost per unit of output) is a second-stage driver rate. Finally, performance measures are identified to deter-mine the results achieved by an activity or activity center (e.g., average cost per patient treated for a particular ailment).

The ABC approach is likely to produce a more accurate representation of indirect costs attributable to final cost objectives than using surrogate measures, such as direct labor hours or direct material dollars, as a means for allocating costs to products. The two-stage ABC process identifies activities and focuses on the cost drivers that are the major causal factors behind cost behavior.

The ABC method is more complex and requires additional time and effort to determine the attribution of indirect costs. In many situations, it is uncertain whether marked difference results are obtained by using the ABC method instead of more traditional approaches. If the costing system is used to determine fees or prices or to measure performance of selected activity centers or indirect cost pools, then the more complex ABC methodology may be appropriate.

What does ABC Provide to the Decision-maker?

The decision-maker is always faced with difficult choices and multiple alternatives. Although decisions can be made with feelings and intuition, this is not the predominant situation. Activity-Based Costing captures quantified cost and time and performance data and translates this into decision information. ABC measures process and activity performance, determines the cost of business process outputs, and identifies opportunities to improve process efficiency and effectiveness. These data assist in stratifying decision variables into a configuration which makes the decision clearer and easier to make.

Qualitative evaluation and determination alone is totally inadequate as a single measure of improvement. Although quality might determine "better", it does not contribute to other meaningful decisions such as what is "cheaper" and "faster". It is the integration of these two dimensions that is the critical decision support element of the total process. ABC is the mechanism to integrate these two views.

ABC is a technique to quantitatively measure the cost and performance of activities, resources and cost objects, including when appropriate, overhead. ABC captures organizational costs for the factors of production and administrative expenses, and applies them to the defined activity structure. The application can be as rigorous as a definite mathematical distribution or as creative as a selective assignment using a surrogate indicator. Regardless of the method, ABC is a process of simplifying and clarifying decisions required by the process evaluators and senior management using activity costs rather than gross allocations.

ABC provides analysis information for consideration and evaluation of the processes of the organization activity model. It is specifically intended to further the accomplishment of the objectives of process improvement which are to:

ABC functions in support of this process and enhances the analysis of selected opportunities and alternatives by gathering and interpreting existing organizational costs and translating the costs data into the activity structure. ABC analysis provides a meaningful appraisal of the identified activity costs along several dimensions. These various dimensions are like a menu to be selected from, as deemed necessary, to support the project objectives. The process improvement team can be provided with a vast amount of decision support information, depending on which items are selected for completion.

ABC has a very definite procedural flow, a set of steps that define the performance process.Although the process is relatively well-defined as a process flow, each of the activity steps has more than one set of application criteria and individual options. The process has a disciplined approach which is applied as rigorously as the situation allows, but still has flexibility for a certain amount of creativity in the final use and evaluation.

Accounting Methods Needed to Support ABC

What is the comparative advantage of ABC over traditional accounting methods? ABC is a consistent, disciplined process that is necessary to the functional process improvement effort in both an analytical and evaluation role. It is also a process that requires professional judgment and creativity when applied to a transitional business process model. This creativity does not invalidate the basic integrity of the idea, but is rather a necessity to bridge the gap from the traditional accounting data to the new process methodology. Although still an evolving discipline, ABC offers great advantages over these more traditional methods. ABC is applied with sound accounting principles to translate cost data and to provide a reliable information source upon which to base managerial decisions.

Under the traditional cost allocation process is allocated directly to the output based on the amount or share of total output production rather than through the activity utilization. This approach can overstate or understate the actual amounts of overhead that is actually used by each of the outputs. An analysis of the comparative differences between the current methods of accounting and that proposed as activity-based accounting indicates that the new applications are more representative and, therefore, more useful to the managerial decision-making process. Because of hidden, or less than apparent, internal process flow differences and actual resource uses, the traditional distribution does not align the amount of activity that is consumed individually by each output directly to the appropriate output.

One drawback to the adoption of ABC is that it is not readily supported accounting systems currently in use by most organizations. Such systems are oriented--by the established chart of accounts--to the tracking of costs by function rather than by process. ABC can only be fully implemented in organizations that have a clear understanding of the body of activities that are commonly performed in all functional areas, along with a means of identifying the time spent on these activities and relating them to charges against the general ledger accounts.

Continue Text

Return to Summary