Document created: 04 May 2004
Air University Review, July-August 1971

Management Uses of Cost Information

The idea of  “cost,” expressed in monetary terms, has been an integral part of every individual’s mental frame of reference for so long that it is often used as a sort of universal code word equally meaningful to just about everyone. Perhaps this is why many fledgling managers seem to be interested in “cost” for its own sake. In these days of austere funding and constant demands to reduce costs, virtually every Air Force manager needs and demands cost information. Yet often the cost information provided is useless for the intended purpose, and the manager concerned does not even recognize its inadequacy. For despite the fact that “cost” is bandied about as if it were the most explicit of words, the truth is that the word “cost,” when taken out of context, has no identifiable meaning for a manager.

Management uses cost information in three distinct management activities: programming, budgeting, and operating.¹ An examination of the management uses of cost information within each of these activities may help to identify the various types of cost information and serve to demonstrate that statements such as “The cost of X is $100” have absolutely no meaning unless the type of cost is clearly understood.² It should then become apparent that in most cases management must first decide how cost information is to be used before that information can be collected.³

Programming and Budgeting

Within the defense establishment, programming may be thought of in terms of the annually approved Five Year Defense Program (FYDP). In essence, the programming process is that activity which itemizes those time-phased changes in mission and force structure which will be undertaken in order to attain a specified military posture at some future date. The programming objective is that military posture which must be attained in order to be able to implement a proposed military plan. To be more specific, the Joint Strategic Operations Plan (JSOP) is a proposed course of action to be undertaken in the event of war at some future date. The FYDP is an approved course of action to be undertaken now in order to develop the force structure that would be required to implement the JSOP if such implementation should be called for at some future time.

The programming process necessarily involves trade-offs, since there are never enough resources to satisfy every desire. Such tradeoffs, however, can only be made if both the operational desirability/effectiveness and the cost of any given program are known. Here, then, is the way that cost information will be used by management in the programming activity: to ensure that a given program can be accomplished with available resources and to permit rational, objective trade-off deci­sions between program elements. The cost information required for this purpose is the total actual cost of each of the elements included in the program. Moreover, since the programming structure is such that only measurable costs (no allocations) are to be considered for any given program element, this type of cost information is similar to that which has been termed “Activity Cost.”⁴

The concept of activity costs aggregating upwards to depict total actual program element costs for use in the programming activity has little direct impact on wing/base-level Air Force managers, since the programming activity is performed at higher organizational levels. For this reason no detailed treatment of this subject will be presented here. For present purposes, this concept is germane only to the extent that activity costs must be initially collected at wing/base level. Suffice it to say, then, that cost information collected at wing/base level must be identifiable to program elements even though this activity cost aspect of cost information will be used only at higher echelons.

The second management activity that will use cost information is the budgeting activity. In this context, “budgeting” is used in its generic sense and includes all aspects of the budgeting process—budget estimates, financial plans, operating budgets, etc. When viewed in this perspective, budgeting may be considered as a composite of three activities—requesting funds, justifying requests for funds, and planning the expenditure of funds that have been made available. These activities necessarily involve the prediction of future costs and substantiation of the predictions. The accuracy of these predictions determines the effectiveness of any budgeting activity.

In this regard, management uses historical cost information as a basis for predicting future costs. This is done through equating costs, extrapolating costs, developing cost estimating relationships, and similar techniques. For example, if historical data show that it cost $100 to do something last year, and if the controlling cost parameters (such as pay scales, freight charges, cost of raw materials, etc.) have not changed, then management can predict, with a high degree of confidence, that it will cost very nearly $100 to do the same thing this year. If, on the other hand, no historical cost data of any kind had been available, then management could only guess what the costs might be this year. Such guesses, of course, would not deserve nor would they receive much confidence. Cost data, then, serve two purposes in the budgeting activity: they provide a basis for predicting future costs, and they lend credence to such predictions. Such credence is of the utmost importance in budgeting. In the preceding example, for instance, when the $100 cost prediction was based on historical cost data, there is no room for hedging—if management wants the job to be done, they must provide $100 for that purpose.

Within the defense establishment, budgets are developed for organizational units by functional categories, corresponding to the twelve military appropriations. In order for cost information to be of use to management in the budgeting activity, it must parallel the budget format. That is, it must reflect the total costs incurred by each organizational unit and must categorize such costs by function—Officer Pay, Facility Maintenance, Family Housing, Transportation of Things, TDY Travel, etc. These types of costs may be referred to as “organizational cost” and “functional cost,” respectively.

In order to relate these concepts to the introductory argument that “cost” has no meaning unless the type of cost has been identified, let us note that the statement “It costs one million dollars to operate Noname Air Force Base for one year” has several possible meanings. If the statement referred to activity costs, then it would entail only those costs attributable to the base operating support program element for Noname AFB. It would not include those costs chargeable to any mission program elements stationed at the base, such as B-52 or F-106 squadrons. If the statement had been made in reference to organizational costs, however, then it would involve those costs initially incurred by the combat support group and its subordinate units, whether or not they were chargeable to tenant units. Finally, if the statement referred to aggregated functional costs, then it would encompass all the costs incurred at Noname regardless of the unit or element incurring the cost.

We have just demonstrated three alternative meanings that could be intended by the same statement concerning cost, depending on the type of cost being discussed, and the possibilities are far from being exhausted. We have yet to consider those costs which managers use in their operating activities.

Operating—Management Control

The operating activity encompasses all the management functions involved in the day-to-day performance of organizational tasks and missions. As such, it is primarily a lower-echelon function and is, therefore, of considerable importance to wing/base level managers. In fact, it can be said that the preponderant portion of a wing/base-level manager’s efforts are expended in the operating activity. In this regard, many if not most management actions are concerned primarily with operational effectiveness, mission accomplishment, and the like—considerations which do not necessarily require cost data. Nevertheless, there are two areas of operating activity in which managers use cost information: management control and decision-making.⁵

In essence, management control is the function of ensuring that management plans and policies are implemented as intended.⁶ In performing this function, cost information can help in three important ways: it can serve as a means of communication; it can be used to motivate; and it can be used as a yardstick of appraisal.⁷

communication

The communicating role of cost data is inherent in the data themselves. Their very existence constitutes a record of some activity, and the simple act of transmittal constitutes a report, be it formal or informal. Perhaps it is this characteristic of cost information that is responsible for the interest in cost information for its own sake. A cursory consideration of the communicating role of cost data could lead to the erroneous argument that, since any and all cost information by its very nature constitutes a record and/or report, any and all cost information is of use to management. This argument, however, ignores one of the basic precepts of communication: to be effective, any communication must convey the intended thought. In order to be an effective means of communication, then, cost data must be collected and presented in a fashion suitable for conveying the intended thought. This is simply another way of stating the introductory premise—cost has no meaning unless the type of cost is specified. From this discussion it follows that no special category of cost data is required in performing the communicating function. What is required is that the correct type of cost data be used, depending on the purpose of the communication.

motivation

Cost information can be used as an important tool for motivating subordinates. If nothing else, the mere collection of cost data indicates that management is concerned about costs, and this fact alone will serve to motivate subordinates to comply with management plans and policies that can be measured in terms of cost.

At this point it would be appropriate to digress for a moment and consider the importance of motivation. Motivation, really, is the only way that management can ever accomplish anything. Mr. Robert Anthony expressed this idea most succinctly:

An obvious and fundamental fact about organizations is that they are made up of human beings. The management control process in part consists of inducing the people in an organization to do certain things and to refrain from doing others. Although for some purposes an accumulation of the costs of manufacturing a product is useful, management literally cannot “control” a product or the costs of making a product. What management does—or at least attempts to do—is control the actions of the people who are responsible for incurring these costs.⁸

Regardless of how it is attained, cost control is certainly one of the most important management objectives.⁹ But, to repeat, this objective can only be realized by motivating people. However, “. . . costs can be controlled only on the basis of accurate, comprehensive, well-coordinated knowledge of their nature, amount, and reason for existence . . .”¹⁰ The logical consequence of these arguments is that, for management control purposes, costs must be collected and people must be motivated. This twofold requirement can be satisfied by measuring costs incurred and categorizing them in terms of the person or persons responsible for incurring the costs. This process will fix responsibility for costs with those individuals who have control over the costs.¹¹ This concept of measuring and categorizing costs as either controllable or uncontrollable serves a dual purpose: to collect the required cost data and to motivate responsible individuals toward cost control and other management objectives, thereby satisfying the need of cost data for management control.

appraisal

Closely associated with the function of motiva­tion is the appraisal or evaluation function. As far as people are concerned, the two functions are practically inseparable—a man will be motivated to perform to the extent that he will be evaluated on his performance. Evaluation, per se, must be based on much more than just cost performance. Nevertheless, since cost performance, or efficiency, is a management objective, it must enter into evaluation to some extent. The other half of the evaluation coin is effectiveness—how well the job was done. In the military, effectiveness is rightfully considered to be more important than efficiency, and it should therefore be given primary consideration in evaluation. The problem, then, is to motivate toward efficiency and evaluate efficiency without jeopardizing effectiveness. This may be accomplished by evaluating efficiency in terms of extremes—the very good and the very bad being identified and evaluated accordingly, and all those in between being evaluated entirely on effectivenss.¹² At any rate, the same cost concepts are applicable to the appraisal of people as were developed in the preceding discussion on motivation—controllable costs and uncontrollable costs.

A further application of the appraisal function concerns the evaluation of decisions. Decisions are often based at least in part on cost considerations. In order to evaluate such decisions it is necessary to measure results in terms of the cost parameters used in the decision process.¹³ It is evident, then, that the same cost considerations and categories will be used in evaluating decisions as were used in making them, and these will be considered in succeeding paragraphs.

Suffice it to say in summary that cost information is used in the management control function of the operating activity in order to communicate, to motivate, and to evaluate, and that these uses of cost information require that costs be categorized as controllable or uncontrollable.

Operating—Decision-Making

“There’s more than one way to skin a cat” is a homespun adage which expresses one of the most basic and most generally accepted truisms of human activity—that there is more than one way to do anything. One of management’s most basic and most frequently performed tasks is selecting the best way to do something. This, of course, is the essence of management decision-making—choosing among alternatives. Moreover, the decision-making process is one of comparing the relative effects of the various possible alternatives. Any course of action may be thought of or measured in terms of change, based on the situation existing before and after the implementation of that course of action. The more a given course of action improves a given situation (or the less it degrades the situation), the better is that alternative. Or, in the words of Haynes and Massie, “. . . decisions are based on measuring the benefits to be derived . . . against the sacrifices (costs) incurred.”¹⁴  

One of the most important aspects of cost information in the decision-making process is futurity. Decisions are concerned with the impact of alternatives on future events, not with past history. It follows, then, that “only those costs not yet incurred are important to a . . . [management] decision,” and unavoidable costs should never even be considered in the decision-making process.

This concept of future costs applicable to decision-making is clearly illustrated by W. J. Vatter’s classic example of the cost of operating an automobile. The data in Table 1 depict the costs incurred relative to the operation of a family car for a one-year period.  

If this family is considering taking a vacation trip, their decision may well hinge on transportation costs. They may also want to consider the possibility of traveling by some means other than the family car. In either case they should certainly not compute the cost of driving the family car on the vacation trip at 9½¢ per mile. Instead, they may consider only those costs that vary directly with the number of miles driven, such as gasoline and lubricants, tires, and preventive maintenance, which would total only 3½¢ per mile. This, too, would be far from an accurate representation of the true costs involved, for many    other factors must be considered if one really wants to know the full cost of driving the family car on a vacation trip.

cost for decision-making

The effective communication of cost information for decision-making depends, in large part, on categorization of costs to reflect those aspects illustrated in the automobile example. The first requirement is to separate the costs incurred as a direct result of performing a given task from those only indirectly related to the task. These aspects may be identified as direct and indirect costs respectively.¹⁶ All the costs listed in Table I are direct costs associated with owning and operating an automobile. Indirect costs would be incurred for such things as upkeep of garage and driveway, utilities for the garage, etc.

A further distinction must be made between costs that vary in direct proportion to output and those that do not, termed “variable” and “fixed” costs respectively.¹⁷ In the illustration, gasoline and lubricants and tire replacements are examples of variable costs, and their magnitude is determined solely by the number of miles driven. Costs such as depreciation, registration, garage rent, insurance, etc., are fixed and they remain essentially the same regardless of how much the car is driven.

Of even more interest in decision-making is the distinction between costs that will be affected by a particular decision and those that will not, termed “incremental” and “sunk” costs respectively.¹⁸ Returning to our example once more, if the family lives in a house that has a garage and driveway, the costs of these facilities are sunk costs. They have been incurred and cannot be reduced by any decision concerning the use of the family car.

Finally, a manager must consider opportunity costs (or opportunity losses). He must consider that any gain which might have resulted from employing his resources in a manner other than the one being considered must be foregone if the alternative is selected and is therefore part of the cost (sacrifice) incurred by choosing the first course of action. This aspect of cost data has been termed “implicit” cost, as opposed to “explicit” costs, which represent the resources actually consumed by the alternative selected.¹⁹ All the costs listed in Table I, for example, are the explicit costs of owning and operating the family automobile for one year. However, if the total amount expended could have been invested so as to earn $50 during the course of that year, then $50 is an implicit cost.

Cost information is of value to management only to the extent that it is collected and presented in a manner compatible with management’s expressed purpose. The various management uses of cost data are itemized and the type or category of cost appropriate for each is identified in Table 2.

                                                                                                                            
Since Air Force managers are continually faced with new and unanticipated problems, situations, and tasks, it is virtually impossible to begin collecting specific cost information required for the various circumstances after the requirement is known and still have the information available for timely action. The only practical solution to the opportune acquisition of cost data for management’s use is the collection of data on a continuous basis and identification of each item of cost information in such a way that it can be selected and aggregated to portray any desired aspect of cost. This can be done if each element of expense is identified so as to depict

—the program element with which it is associated

—the organizational unit incurring the expense

—the functional nature of the expense

—the product or service with which it is associated (directly and/or indirectly)

—the individual(s) and/or managerial position(s) that can significantly influence the amount expended and the extent of that influence

—the nature of the expense in terms of output (fixed or variable)

—the extent to which the amount of the expense can be influenced by operating decisions.

If each element of expense is identified in these ways, then costs can be aggregated and presented to show any aspect that may be required by wing/base-level Air Force managers. However, if elements of expense are not identified to this depth, then the possible uses of cost information are correspondingly limited. Since cost data rarely are so clearly defined in the Air Force, it is imperative that Air Force managers be able to analyze the cost data available, determine what kinds of costs arc represented by the data, and then be able to determine if the data are really worthwhile for their specific purpose.

Vandenberg AFB, California

Notes

1.  Robert N. Anthony, “Management Uses of Expense Information,” an address delivered by the Assistant Secretary of Defense Comptroller) before the Thirteenth National Award Banquet, Armed Forces Management Association, on 13 October 1966, p. 3.

2. Robert N. Anthony, Management Accounting: Text and Cases, 3d ed. (Homewood, Illinois: Richard D. Irwin, Inc., 1964), p. 6.

3. Michael Schiff and Lawrence J. Benninger, Cost Accounting, 2d ed. (New York: The Ronald Press Company, 1963), p. 1.

4. Howard W. Wright, Accounting for Defense Contracts (Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1962), p. 51.

5. Anthony, Management Accounting, pp. 3-6.

6. Bradford Cadmus and Arthur J. E. Child, Internal Control Against Fraud and Waste (New York: Prentice-Hall, Inc., 1953), p. 5.

7. Anthony, Management Accounting, pp. 3-5.

8. Ibid., pp. 361-62.

9. Carl Thomas Devine, Cost Accounting and Analysis (New York: The Macmillan Company, 1950), p. 9.

10. Stanley B. Henrici, Standard Costs for Manufacturing, 2d ed. (New York: McGraw-Hill Book Company, Inc., 1953), p. 3.

11. Cadmus and Child, p. 5.

12. Ibid.

13. Ibid.

14. Warren W. Haynes and Joseph L. Massie, Management: Analysis, Concepts and Cases (Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1961), p. 274.

15. Ibid.

16. Ibid., p. 283.

17. Ibid.

18. Ibid.

19. Ibid.

Contributor

Major Fredrick T. Walker (USAFA; M.S., Air Force Institute of Technology) is Director, Communications-Electronics Plans and Programs, 1st Strategic Aerospace Division (SAC), Vandenberg AFB, California. A graduate of Air Command and Staff College, he has held command and staff management positions in communications or electronics, including assignments with 5th Tactical Control (PACAF) and Headquarters Command.