UV1130

KEY COST MANAGEMENT PRINCIPLES EVERY

EXECUTIVE MUST KNOW

Principle 1

The word cost should only be used with a modifier and not by itself because the word
has so many meanings. The following is an abbreviated costs glossary.

a. Direct costs can be clearly assigned to a product or an activity, as with the costs of parts
and the artisans salary associated with a particular maintenance action.
b. Indirect costs are related but not directly tied to a product or activity, as with the salary of
a manager who supervises several project teams.
c. Allocated costs are indirect costs that for reporting purposes are assigned to units or
activities based on some allocation basis, as with the CEOs salary.
d. Variable costs are incurred only as a result of an activity. They vary with the volume of
the activity in the near term; as with raw material.
e. Fixed costs are incurred regardless of the level of activity, as with depreciation. A word
of caution: Just because costs are hard to change (e.g., the salaries of personnel whose
separation is a lengthy procedure) does not make them fixed costs.
f. Sticky costs are half-way between variable and fixed. Sometimes called standby costs,
they vary with activity but only over a longer time frame, as with the salaries of skilled
tool makers who will only be laid off when activities are to be curtailed for an extended
period.
g. Sunk costs are expenditures made in the past that will not change regardless of future
activities and, in fact, are irrelevant to any future activity, as with the purchase of
equipment or other forms of property.
h. Marginal costs are only incurred as the level of activity changes. Also called incremental
costs, they are important when deciding whether or not to increase the level of operations,
as with the cost of hiring additional hourly people to manage a 3% increase in activity.

This technical note was prepared by Professor Emeritus Robert J. Sack with contributions from Visiting Lecturer
Dan McCarthy (VADM, USN, SC, Ret.). Copyright 2008 by the University of Virginia Darden School Foundation,
Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com.
No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in
any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission
of the Darden School Foundation.
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i. Controllable costs can be incurred or cut off by a responsible manager. They are
contrasted with those costs the manger can influence and those costs that are beyond the
control of the manager. For example, while a maintenance activity can control material
costs by regulating its orders from a working-capital-funded activity such as the Defense
Logistics Agency (DLA), it can only influence the costs DLA charges for those orders
through discussions with DLA.
j. Discretionary costs are costs related to projects that, if need be, can be delayed for short
or even longer terms. They are also called program costs, as with advertising costs.
k. Relevant costs are those that will be affected by the decision at hand: as with salary costs
in a make or buy decision.
l. Opportunity costs are earnings missed because of a failure to capitalize on an
opportunity, as with procurement clerks sitting in their offices instead of working on
executing contracts.
m. Second-effect costs are the costs incurred by an entity as a result of a decision by a
manager of one unit in the entity, as with the legal or insurance costs a company incurs
from a managers decision to reduce inventories by ordering parts on a more frequent
basis.

Although it is not a cost, the term contribution is important. It refers to the difference
between the revenues generated by an activity less the direct costs of conducting that activity.
Contribution refers to what that activity contributes to coverage of the entitys other, indirect
costs and profit.

Principle 2

When costs are a factor in a decision, all costs and only all costs that are relevant to the
decision should be considered.

For example, when considering a decision to outsource an activity such as facility

cleaning, a company would compare the fee quoted by the outside firm against only the direct
costs of the in-house activity. The analysis would look only at the salaries (and the related
benefits) paid to the in-house team and whatever materials the team uses in its work. The
analysis would not consider any equipment costs associated with the cleaning department (they
are sunk costs) nor would it consider indirect costs allocated to the cleaning department such as
heat, light, and power (those costs will remain regardless of the decision).

Principle 3

Allocating indirect costs to units, products, or services may be helpful in some cases but
could also result in misleading information or even a bad decision.
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For example, allocating corporate costs (CEOs salary, depreciation etc.) for the monthly
reports of revenue-producing units could drive managers to price their products or services so as
to recover those costs. It could also drive them to drop products that do not recover their direct
and allocated costs, which could be a mistake. As long as the product or activity covers its direct
costs and makes a contribution toward covering the total of fixed costs, it should stay in the
portfolio.

Allocating corporate costs to nonrevenue units could give them a view of the larger,
company-wide picture. But it could also frustrate them and give them an excuse to argue against
criticism of their own performance, if they are burdened with costs they cannot control or
influence.

Principle 4

Effective capacity utilization depends on good cost data and on good forward-looking
intelligence.

For example, consider a company that invested in a major computer installation in order
to solve a recurring but random operations problem. Because solving that problem justified the
cost of the computer, the unused capacity of the computer represents a significant asset for the
company. It could sell that capacity to outsiders and need only consider the marginal costs of
servicing that new business. Any revenue beyond the related incremental or marginal cost of that
new business is contribution to the overall good of the company. In fact, the failure to utilize that
unused capacity to its fullest is an opportunity cost.

If there comes a time when there are several opportunities to use that capacity, the one
that promises the most aggregate contribution is the one to take. Before taking any bird in hand,
however, management should consider what other opportunities might be in the pipeline that
promise even better contribution.

Principle 5

Be alert to second-effect costs.

Because of the way most entities are organized, managers tend to focus on their direct
responsibilities and not consider the cost implications of their decisions. For example, when the
commissary manager decides that the revenues generated after 9:00 p.m. do not cover the direct
costs of keeping the store open that late (in effect resulting in negative contribution) and so
decides to close the store every day at that time. That decision could seem sound when
considering only his unit but could result in a significant increase in the costs of the logistics unit
if delivery drivers who replenish the stores shelves are delayed in heavy daytime traffic.
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Principle 6

You get what you measure.

Its almost too obvious to say, but when people are measured against a target they take
actions and make decisions to achieve that target. It may not be as obvious, but it is equally true
that setting the target carefully is the critical management responsibility. In the words of Grail
Knight in the movie Indiana Jones and the Last Crusade: Choose wisely.

Establishing the right measurement index is critical. Consider a multioffice consulting

firm: If the firm holds managers in charge of each office responsible for their offices annual net
earnings, those managers will make the tradeoff decisions that drive toward that goal. They will
hire talented people who will work well with clients and can be billed at rates in excess of their
direct salary costs. But they may also be motivated to make decisions that help achieve that
target in the near term but that are hurtful in the longer termas in cutting back on discretionary
costs, such as training. A balanced-scorecard approach, where managers are measured against a
set of goals rather than one single target, could help.

Similarly, budgets must be set carefully with the entitys strategic goals in mind and with
the involvement of the managers affected, because the managers will strive to accomplish their
budgeted goalswhatever the budgeted targets. Also, the people who will be measured against
the budget must understand how (and why) the targets were set as they were. If the budget is
simply last years plus 10% (or an overall cost reduction of 10%), the managers will either
ignore the target as impossible or tend to work to achieve the target in the easiest way possible,
making short-term decisions that are not necessarily in the best long-term interest of the entity.