COST ANALYSIS AND LONG-TERM RESOURCE COMMITMENTS
DIMENSIONS OF COST
Accounting data can be useful in assessing the internal strengths and weaknesses of any organization. Numbers connote precision, and precision often is assumed to have its own virtue. It is important to recognize, however, that the numbers provided in balance sheets and income statements are condensed from many detailed accounting records and reports. Therefore, any further analyses based on these data must be undertaken with full awareness of the abstractions that have already been made. While accounting data reflect the financial dimensions of an organization, other important factors that may impinge on the overall performance of the organization, however, and must also be considered.
Factors Influencing Future Costs
No program decision is free of cost, whether or not the decision leads to the actual commitment of organizational resources. Choices among alternative strategies for the accomplishment of the goals and objectives of any organization are likely to involve many costs. Such choices include not only the expenditure of money but also the employment of human resources, the consumption of physical resources, and the use of time--all critical commodities in any organization.
Often the tendency is to consider costs strictly in terms of dollar inputs--the financial resources required to support personnel, equipment, materials, and so forth. Future costs that cannot be easily measured in dollar terms all-too-often are dismissed as noncost consideration. Such costs, however, may have important implications beyond their measurable monetary value.
The program manager must be cognizant of the following factors that influence future costs:
(1) Scope and quality of the services or products to be delivered.
(2) Volume of activity required to deliver these services or products.
(3) Methods, facilities, and organizational structure required to perform these activities.
(4) Qualities and types of labor, materials, equipment, and other cost elements required by these programs.
(5) Price levels of the various cost elements.
These cost factors should be considered: (1) in the development of plans and programs; (2) in the preparation of budget requests; and (3) after commitments have been authorized, as programs or projects enter the implementation phase.
Many activities can be measured in terms of units of production (workload measures). Current records of personnel activities may provide sufficiently accurate and reliable data to determine workloads. In some cases, however, it may be necessary to undertake more extensive analyses of the nature and scope of the activities involved. Further refinements are possible where cost accounting procedures have been adopted.
Having established the volume of work required to perform certain activities, it may be appropriate to examine alternative methods and organizational approaches to determine if greater efficiency and effec-tiveness can be attained. Work methods should be analyzed to establish the appropriate mix of personnel, equipment, supplies, and other operating requirements to do the job with the least effort and at the least cost. Particular attention should be given to possible increases in productivity through simplified procedures and the use of labor-saving equipment.
Personnel costs are subject to management control in two important areas: salary rates and job classifications. Periodic reviews should be made to see that each employee has the proper work assignment in view of his or her pay rate. All-too-often, skilled employees with higher pay classifications are assigned tasks that lower-rated persons should perform. Eliminating positions at the lower end of the pay scale may result in serious false economies if higher-paid personnel eventually have to do the work previously assigned to these positions.
Changes in salary plans should be made only after a thorough study of such factors as trends in the cost of living, rates paid by comparable organizations, and fringe benefits, including sick leave, vacations, extra holidays, and security of tenure. Often, improved fringe benefits can provide a bigger "payoff" to employees than increases in salaries and wages, which are likely to be subject to a larger "tax bite." Sound personnel and compensation policies will yield economic benefits to the organization in the long run.
Prices for materials and equipment can be controlled to some the extent by scheduling purchases to take advantage of the lowest price consistent with necessary quality. Price trends of frequently used commodities should be continuously analyzed, and appropriate inventories should be maintained for those items subject to price fluctuations. At the same time, the cost of maintaining inventory (space requirements, shelf life, anticipated price changes, and so forth) also must be considered.
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.