Interview Questions

Cost Analysis and Estimation

Fans of the Chevrolet Camaro and Pontiac Firebird mourned when General Motors (GM) announced that these classic muscle cars were headed for that big parking lot in the sky at the end of the 2001 model year. GM management said the Camaro and Firebird had become victims of America’s obsession with sport utility vehicles and light trucks. Management would have us believe that the kids who used to crave inexpensive but fun-to-drive muscle cars were now driving $35,000 Ford Explorers.

The truth is that poor product quality, outdated design, lackluster marketing, and tough competition from foreign rivals killed the Camaro and Firebird. It’s simply not true that young people, and the young at heart, no longer want cars that are fast, loud, and cheap. To convince yourself of this, simply go downtown in almost any city or suburb in America on Friday or Saturday night. It won’t be long before you get nearly blown off the sidewalk by some kid slouched behind the wheel of a “low-rider” with windows vibrating to the thump of ultra-amplified bass. In the 1970s or 1980s, that kid was in a Camaro or Firebird. Today, they probably drive a Honda Civic or Acura Integra. Both are relatively cheap, stylish, and easy to customize. If you’re not into customizing, try a Toyota Celica GT-S 2133 Lift back 2D (6-Spd.). It’s more than a stylish, dependable bargain priced at about $23,000. It’s fun to drive. A high quality car is more than neat looking and dependable; it’s a blast to get behind the wheel of a high-quality car.

Cost estimation and control is part of the continual process of making products that exceed customer expectations. Quick fixes don’t work. This chapter shows how making things faster, cheaper, and better requires a fundamental appreciation of cost concepts.1 1 Karen Lundegaard, “Big Three Trail Their Rivals in Consumer Reports Survey,” The Wall Street Journal Online, March 13, 2002.

WHAT MAKES COST ANALYSIS DIFFICULT?

Cost analysis is made difficult by the effects of unforeseen inflation, unpredictable changes in  echnology, and the dynamic nature of input and output markets. Wide divergences between economic costs and accounting valuations are common. This makes it extremely important to adjust accounting data to create an appropriate basis for managerial decisions.

The Link Between Accounting and Economic Valuations

Accurate cost analysis involves careful consideration of relevant decision alternatives. In many instances, the total costs of making a given decision are clear only when viewed in light of what is done and what is not done. Careful decision analysis includes comparing the relative costs and benefits of each decision alternative. No option can be viewed in isolation; each choice plays an important role in shaping the relevant costs and benefits of all decision alternatives.

Evaluation of a proposal to expand output requires that revenues gained from added sales be compared with the higher production costs incurred. In weighing a recommendation to expand, managers must compare the revenues derived from investment and the cost of needed funds. Expected benefits from an advertising promotion must be measured in relation to the costs of personal selling, media romotion, and direct marketing. Even a decision to pave the employees’ parking lot or to refurbish the company lunchroom involves a comparison between projected costs and the expected benefits derived from improved morale and worker productivity. In every case, the decision-making process involves a comparison between the costs and the benefits resulting from various decision alternatives.

Corporate restructuring often involves eliminating nonstrategic operations to redeploy assets and strengthen core lines of business. When nonessential assets are disposed of in a depressed market, there is typically no relation between low “fire sale” proceeds and book value, historical cost, or replacement cost. Conversely, when assets are sold to others who can more effectively use such resources, sale proceeds can approximate replacement value and greatly exceed historical costs and book values. Even under normal circumstances, the link between economic and accounting values can be tenuous. Economic worth as determined by profit-generating capability, rather than accounting value, is always the most vital consideration when determining the cost and use of specific assets.

Historical Versus Current Costs

The term cost can be defined in a number of ways. The correct definition varies from situation to situation. In popular terminology, cost generally refers to the price that must be paid for an item. If a firm buys an input for cash and uses it immediately, few problems arise in defining and measuring its cost. However, if an input is purchased, stored for a time, and then used, complications can arise. The problem can be acute if the item is a long-lived asset like a building that will be used at varying rates for an indeterminate period.

When costs are calculated for a firm’s income tax returns, the law requires use of the actual dollar amount spent to purchase the labor, raw materials, and capital equipment used in production.

For tax purposes, historical cost, or actual cash outlay, is the relevant cost. This is also generally true for annual 10-K reports to the Securities and Exchange Commission and for reports to stockholders.

Despite their usefulness, historical costs are not appropriate as a sole basis for many managerial decisions. Current costs are typically much more relevant. Current cost is the amount that must be paid under prevailing market conditions. Current cost is influenced by market conditions measured by the number of buyers and sellers, the present state of technology, inflation, and so on. For assets purchased recently, historical cost and current cost are typically the same.

For assets purchased several years ago, historical cost and current cost are often quite different. Since World War II, inflation has been an obvious source of large differences between current and historical costs throughout most of the world. With an inflation rate of roughly 5 percent per year, prices double in less than 15 years and triple in roughly 22 years. Land purchased for $50,000 in 1970 often has a current cost in excess of $200,000. In California, Florida, Texas, and other rapidly growing areas, current costs run much higher. Just as no homeowner would sell his or her home for a lower price based on lower historical costs, no manager can afford to sell assets or products for less than current costs.

A firm also cannot assume that the accounting historical cost is the same as the relevant economic cost of using a given piece of equipment. For example, it is not always appropriate to assume that use costs equal zero just because a machine has been fully depreciated using appropriate accounting methods. If a machine could be sold for $10,000 now, but its market value is expected to be only $2,000 1 year from now, the relevant cost of using the machine for one additional year is $8,000.2 Again, there is little relation between the $8,000 relevant cost of using the machine and the zero cost reported on the firm’s income statement.

Historical costs provide a measure of the market value of an asset at the time of purchase. Current costs are a measure of the market value of an asset at the present time. Traditional accounting methods and the IRS rely heavily on the historical cost concept because it can be applied consistently across firms and is easily verifiable. However, when historical and current costs differ markedly, reliance on historical costs sometimes leads to operating decisions with disastrous consequences. The savings and loan (S&L) industry debacle in the United States during the late 1980s is a clear case in point. On a historical cost basis, almost all thrifts appeared to have solid assets to back up liabilities. On a current cost basis, however, many S&Ls proved insolvent because assets had a current market value below the current market value of liabilities.

The move by federal and state bank regulators toward market-value-based accounting methods is motivated by a desire to avoid S&L-type disasters in the future.

Replacement Cost

Although it is typical for current costs to exceed historical costs, this is not always the case. Computers and many types of electronic equipment cost much less today than they did just a few years ago. In many high-tech industries, the rapid advance of technology has overcome the general rate of inflation. As a result, current costs are falling. Current costs for computers and electronic equipment are determined by what is referred to as replacement cost, or the cost of duplicating productive capability using current technology. For example, the value of used personal computers tends to fall by 30 to 40 percent per year. In valuing such assets, the appropriate measure is the much lower replacement cost—not the historical cost. Similarly, if a company holds electronic components in inventory, the relevant cost for pricing purposes is replacement costs.

In a more typical example, consider a construction company that has an inventory of 1,000,000 board feet of lumber, purchased at a historical cost of $200,000, or $200 per 1,000 board feet (a board foot of lumber is 1 square foot of lumber, 1 inch thick). Assume that lumber prices rise by 50 percent, and the company is asked to bid on a construction project that would require lumber. What cost should the construction company assign to the lumber—the $200,000 historical cost or the $300,000 replacement cost? The answer is the replacement cost of $300,000. The company will have to pay $300,000 to replace the lumber it uses on the new construction project. In fact, the construction company could sell its current inventory of lumber to others for the prevailing market price of $300,000. Under current market conditions, the lumber has a worth of $300,000. The amount of $300,000 is the relevant economic cost for purposes of bidding on the new construction project. For income tax purposes, however, the appropriate cost basis for the lumber inventory is still the $200,000 historical cost.


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