Costing Traps (Part 1)

Or Why Accounting Cost Is a Poor Criterion for Decision-Making.

Posted by Dmytro Dodenko

The main goal of any enterprise is to make as much money as possible, now and in the future. If an enterprise cannot earn enough money, the owners (shareholders) will try to invest their money in another enterprise that earns more. The primary indicator of a company’s success is profit—the amount by which revenues exceed expenses for the reporting period.

The Accounting Logic

Expenses are recognized in the Income Statement (P&L) based on the direct link between costs incurred and income earned under specific items (the Matching Principle). The profit of a manufacturing enterprise from its main activities is defined as revenue from product sales minus the Cost of Goods Sold (COGS) and minus other period expenses.

All enterprise costs associated with production are included in the cost of Finished Goods or Work in Progress (WIP) until the product is sold. At the time of sale, they are recognized as expenses and matched against sales revenue to calculate profit. Period costs are expenses not included in inventory valuation; therefore, they are treated as expenses falling within the period in which they were incurred.

Variable vs. Fixed Costs

Production costs can be variable or fixed (semi-fixed).

• Short-term variable costs change in direct proportion to the volume of production or level of activity (i.e., doubling activity leads to a doubling of variable costs). Thus, total variable costs are a linear function, while such costs per unit of output are constant.
• Fixed costs are costs incurred over a certain period that remain unchanged in magnitude over a wide range of production volumes (relevant range). Examples include depreciation of factory buildings, administrative salaries, equipment rent, heating costs, etc.

Variable costs per unit can be measured and matched directly. Fixed costs are attributed to the product cost by allocating them based on a selected allocation base (cost driver).

The Main Trap

If one evaluates the company’s performance guided solely by data from regulated financial accounting (absorption costing), which allocates both variable and fixed production costs to the product cost, one can reach erroneous conclusions. (For more details, see the note “When Accounting Can Deceive“).

Relevant Costs: The Decision-Making Standard

When making a decision, only those costs and revenues whose magnitude depends on the decision are significant.

• Such costs and revenues are called relevant (i.e., taken into account).
• Costs and revenues whose magnitude does not depend on the decision are irrelevant and should be ignored.

Thus, the relevant financial components analyzed in the decision-making process are future cash flows whose magnitude depends on the alternative options being considered. In other words, only incremental (differential) cash flows should be taken into account, while flows that remain unchanged under any scenario are irrelevant to the decision at hand.

Let’s look at specific examples:

Making Special Pricing Decisions

Sometimes, a company must make a decision about a deal that falls outside its primary market.

The Scenario:

For example, a company sells its product (pre-painted steel sheets) in Ukraine and exports to some European countries. During a low-demand month, when the company has idle production capacity, it receives an inquiry from a company in Belarus regarding a potential sale of 60 tons of painted steel at a price of 21,000 UAH/ton.

The normal selling price for such steel is 22,000 UAH/ton.

The company has had no prior sales to Belarus, and there are no other orders from this country yet. However, according to the Sales Department, even a one-time sale to Belarus would introduce consumers to the quality of our product and, in the future, allow us to enter this market with our standard prices.

The Question: Should the company accept this offer?

Let’s look at the budget information for this month:

Table 1: Monthly Budget Data

The Analysis

At first glance, the situation suggests the order should be rejected because the offered price of 21,000 UAH/ton is lower than the production cost of 21,170 UAH/ton.

However, a more detailed study of expenses shows that some production costs will remain unchanged regardless of whether we accept this order or not.

Table 2 presents information on the change in revenues and expenses if this order is accepted. This highlights which information is relevant to this decision.

Table 2: Relevant Cost Analysis

Qualitative Factors to Consider

However, before recommending acceptance of the order, it is necessary to consider the following key factors:

1. Market Price Erosion: It is assumed that the future selling price will not depend on selling part of the output at a price lower than the current market price. If this assumption is incorrect, competitors may resort to the same practice of lowering selling prices, trying to utilize their idle production capacity. This could lead to a decrease in the market price as a whole, which, in turn, will lead to a drop in profit from future sales. The reduction in future profits may turn out to be greater than the short-term gains obtained from accepting a one-time order with a below-market selling price.
2. Opportunity Cost: The decision to accept the order in question will not prevent the company from accepting other orders that might be received during its execution time. In other words, it is assumed that the company will not receive more profitable offers during the analyzed period.
3. Best Use of Resources: It is assumed that the company’s resources cannot be put to better use and will not be able to provide an additional contribution to profit exceeding 126,000 UAH per month.
4. Unavoidable Costs: Finally, it is assumed that the fixed costs for the period under consideration are unavoidable.

When trying to determine which costs are relevant for a specific decision, one may find that in one situation costs will be relevant, while in another, the same costs will be irrelevant.

Conclusion on the Special Order: As we can see, in this situation, selling a batch of products of 60 tons at a price lower than the production cost (calculated using the full absorption method) will bring the enterprise 126,000 UAH of additional profit.

Decisions to Discontinue a Product Line (The Death Spiral)

A similar approach should be applied to the decision to discontinue the production of a certain type of product.

There is a classic cautionary tale about a new manager who eliminated products from the production mix that were selling below their accounting cost.

• In the next period, he saw that other products had become unprofitable.
• He eliminated these products from the mix as well.
• Eventually, it turned out that the company completely stopped earning profit on the remaining products.

This happened because this manager made his decisions based on product cost calculated using the full absorption method of production costs. When excluding products that absorbed a portion of fixed costs, this portion of fixed costs was reallocated to the remaining products. Consequently, the margin earned by the remaining products ceased to cover the total fixed costs.

This phenomenon is known in management accounting as the “Death Spiral.”

Make-or-Buy Decisions: To Manufacture or Outsource?

To decide whether it is more profitable to manufacture a product (or component) internally or purchase it from an outside supplier, information about allocated fixed costs is irrelevant.

Relevant information includes:

1. Variable production costs compared to the purchase price from a third-party manufacturer.
2. The amount of income from the alternative use of the released production capacity (Opportunity Cost).

Information regarding whether the production capacity in question is a constraint (bottleneck) for the specific enterprise is also of great importance.

Equipment Replacement Decisions: Ignoring Sunk Costs

Equipment replacement is a capital investment decision, meaning it is a long-term decision that requires the application of Discounted Cash Flow (DCF) procedures.

One aspect of asset replacement decisions involves the book value (historical cost less accumulated depreciation) of the old equipment. This issue often causes confusion.

The correct approach is based on applying relevant cost principles—recognizing that past or sunk costs are irrelevant to this decision. Only future cash flows associated with purchasing and using the new equipment are relevant. However, one must not forget about cash inflows from the possible sale of the old equipment (Salvage Value) or other alternative equipment.

Summary

We have examined some aspects of information relevance for business decision-making and verified that in certain cases, selling products at prices lower than the accounting cost can bring the enterprise additional profit—provided the selling price exceeds the variable cost.

But in some cases, selling a product/good at a price higher than the cost can actually reduce the enterprise’s profit.

In which cases? Read “Costing Traps (Part 2)”.