The Hindu Business Line : Purpose defines cost

Full costs are neither possible to determine with any degree of accuracy nor recover, in all cases especially where there are multiple brands and product lines.

The competitive position as well as the business goals drive the choice of which costs to take note of and which ones to ignore.

In many ways, costs are as much a matter of opinion and managerial judgement as price — and far from being facts of history or fixed. What a product or project really costs depends on several imponderables. So there can be differences of opinion between two equally well-informed senior managers, leading to much heated debate in internal conferences. Accountants, marketing people, factory managers and top management might find themselves in fierce arguments, which have not just two but three or four sides.

Much confusion and controversy can be avoided if one thing is kept in mind: costs are defined by the purpose for which they are collected. Generally one wants to know the product costs as accurately as possible in order at least not to lose money, and to find a preferred price range or level of profit margin. Costing can help us decide what the rate of return could be from a new line of business or new factory and therefore whether to enter into that particular product field at all.

In some instances, especially of services, accessories and components, one could weigh up the options of either buying them outright from some one else or making them in-house. A popular example would be deciding whether to own canteen services, or such assets as a bus fleet or office cars to ferry people to and from the plant. Lastly, costs are also used in measuring the relative performance of people, projects, products, processes or even whole businesses.

In all of these, of course, a comparison with past numbers and competitive figures can also be usefully done. In any management discussion, the first point to agree on is which of the above is our current purpose. Unfortunately, we are all contaminated by the traditional cost accounting of more expansive days, when manufacturers could assume that costs are meant to be `fully recovered' from the customer. Thus `allocation of overheads' meant to link the common expenses to every unit of product had become sacrosanct, through some arbitrary formula such as direct labour hours or machine hours. All this was fine in factories where the process was fairly fixed for long periods, and costs could be collected for a month and apportioned to the various lines on top of costs that are directly variable with each unit of output. This led to much refinement and sophistication in methods of allocation, forgetting that the method of sharing costs is arbitrary anyway one does the numbers.

The common term describing all these variants is the notion of `relevant costs'. What costs are relevant for the particular purpose? What can we ignore, even if they are really incurred? These are the questions one must ask oneself in deciding which costs to include in the reckoning, because it is often only too tempting to lose sight of the reasons why costs are being discussed - and be led into the byways of talking about covering "full costs in any case" as the minimum need of the business.

Full costs are neither possible to determine with any degree of accuracy nor recover, in all cases especially where there are multiple brands and product lines which share many facilities in common. It is far more important in such instances to fix exactly what the costs directly attributable to the product in question even if some shared items, such as administration and general services are omitted. There are two conditions under which one resorts to marginal or incremental costing which to diehard accountants might look like a cop-out and a sort of admission of defeat.

Yet discretion is the better part of valour in some circumstances. Some costs that are deliberately ignored in decision-making are called `sunk costs' because they have been incurred anyway. For example where the product is new and would not stand a fair chance of survival if loaded with all the costs in its infancy. The other is where the business is facing severe price competition, and it is more important not to lose market share or volumes so one is content to make some contribution to the overheads, rather than wait for a price that would cover all the allocated costs. In other words, the competitive position as well as the business goals drive the choice of which costs to take note of and which ones to ignore - there are no such things as absolutes in management accounting, therefore, contrary to popular image carried by the non-accountants.

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