Although it may initially appear that the only decision to be made about costs
is related to their incurrence, cost behavior patterns make any cost decision
more complex. For example, curtailing library operations without properly
analyzing cost patterns may result in overstating any anticipated cost savings.
This chapter describes most of the cost terms that are introduced in this
book and provides examples of why cost analysis is important in nonprofit
managerial decision making. Managerial decision making encompasses both
future costs and historical costs. Future costs are most important in making
decisions about equipment purchases, whereas historical costs are important
in evaluating past performance.
1
Before beginning an analysis of cost concepts, a definition must be pro-
vided for the term cost and distinctions made among assets, costs, and ex-
penses. The term cost is defined as net resources used or consumed to
achieve specific organizational objectives. Net resources are the cash or other
assets remaining after those amounts owed are paid. Although the resources
consumed may consist of assets, it is not always necessary for assets to be
consumed to incur costs, as costs can increase when liabilities are incurred.
We are all faced with the choice between asset consumption or liability
incurrence when we choose how to pay our monthly credit card bill. If we
pay with cash, we experience the expiration of an asset. If we don’t pay a
credit card bill at the end of the month, we increase the amount we owe—
12
CHAPTER
2
Cost Concepts and
Decision Making
From
Managerial Accounting for Libraries and Other Not-for-Profit Organizations, Second
Edition
by G. Stevenson Smith. Copyright 2002 by the American Library Association. All
rights reserved. Permission granted to reproduce for nonprofit, educational purposes.
Check out the book at the ALA Online Store (www.alastore.ala.org).
our liability. The effect of a decrease in assets or an increase in liabilities is
the same—it is a reduction of net resources available for future use.
Expired or consumed assets are assigned to the proper fiscal periods for
financial reporting purposes and are called expenses on an income statement.
Expenses are costs incurred with no recognizable future benefit beyond the
current time period, and therefore they become deductions on a current in-
come statement. In other words, expenses are the costs of operating a library
in a time period when specific library services are rendered. Yet the incurrence
of some costs does not always create an immediate increase in expenses in the
current time period. Expense recognition can be deferred to later time periods.
For example, when cash is expended on a new library building, the building’s
cost is not an immediate expense, but it is still referred to as the cost of the
building. The cost becomes part of the cost of a property or an asset that will
provide a future benefit to the organization.
2
For that reason, the costs of a
building are recorded as the building’s services are received.
The term cost is referred to when net resources are either used to con-
struct a building or to pay for photocopying services, for example. Although
both cases involve cost incurrence, photocopying services are considered an
expense of the current time period; building costs result in a long-lived asset
that expires and turns into an expense as the building is used. The building
has the potential to provide services for a long time, but the photocopying
services are received in the immediate time period.
In some cases, costs that are usually considered an expense of the cur-
rent period may not be recorded as such because of special circumstances.
For example, if a large percentage of a library manager’s work time was de-
voted to planning and supervising the construction of a new library building,
charging a portion of that manager’s salary to the cost of the building, as
overhead, might be appropriate. This action is justified because the library
manager’s efforts are contributing to the future value of the building, and the
cost of the effort should not be recorded as an expense of the current period.
This manager’s contribution will provide services for a long-term period in
the same manner as other construction costs. Thus, the amount of salary ex-
pense recorded in the current period is reduced, and the asset value of the
building is increased by an equal amount.
To expand on this recognition concept, consider how the cost of a build-
ing is handled. The building’s cost is not immediately recorded as an ex-
pense because it has a useful value that is assumed to benefit a number of
future periods. Instead, the costs of the building are reasonably allocated to
the future periods that will receive benefits from building use. The process
of allocating the building’s costs to future time periods is called recording
Cost Concepts and Decision Making 13
depreciation expense. Depreciation expense is an allocation procedure that
assigns the costs of a long-term asset to future fiscal periods based on the
assumed estimated wear or obsolescence of that asset. Figure 2-1 highlights
the relationship between assets, costs, and expenses.
As costs are incurred, they either become expenses or create property—
an asset or a productlike asset. Over time this property is turned into an ex-
pense as it loses its usefulness.
3
Depreciation gradually transfers property
values into an expense by the allocation of cost to time periods.
4
COST CONCEPTS FOR MANAGERIAL DECISION MAKING
In a review of cost concepts, a time period for analysis needs to be assumed.
Without a time-period assumption, it is difficult to develop concise cost def-
initions. For example, in a long-run time frame all costs vary, but as time pe-
riods become shorter, some costs begin to vary less. For this review of cost
concepts, a twelve-month time period is assumed.
As initially stated, it may not be a simple matter of eliminating depart-
mental functions in order to cut costs. Some costs may behave in a manner
that shows little change even when departmental services are reduced. An or-
ganization chart for a typical medium-sized public library is shown in Figure
2-2. This organization chart will be used to illustrate the cost concepts high-
lighted here.
14 Cost Concepts and Decision Making
FIGURE 2-1 The expense-cost cycle
Incurred
cost
Expenses—benefit
current period only
Property/assets—
benefit future
periods
As property is used,
expenses such as
depreciation are
generated.
Actual Cost
What are the actual costs involved in decision making? Actual costs are costs
incurred at the time a transaction takes place. A service is received or goods
are purchased, and in return the organization either incurs a debt or makes a
payment. The usefulness of this information for managerial decision making
depends on the analysis under way. For some managerial decisions, cash
flow is the only information that is important. The importance of cash flows
will be explained in chapter 6. For other managerial decisions, however, ac-
tual costs need to be used together with other data to arrive at the correct
decisions. For example, will the actual cost of operating a bookmobile de-
termine the total cost per unit of services—miles traveled or books loaned—
provided by the vehicle? The answer is, not with actual costs alone. It is only
Cost Concepts and Decision Making 15
FIGURE 2-2 Organization chart for a medium-sized public library
Library
Board
Director of
Collections
Director
Assistant
Director
Special
Collections
Hospital
Extension
Extension
Department
Reference
Department
Children’s
Library
Circulation
Business
Manager
Director of
Human
Resources
Director of
Public
Relations
Technical
Services
Accounting PurchasingBindingCataloging Ordering Building
Maintenance
Branches
Bookmobile
when a portion of actual costs are mingled with costs that must be allocated
over time that the full cost of services can be determined on a per-unit basis.
5
Of course, a number of limitations to intermingling these costs need to be un-
derstood, and they are discussed later.
Note that the actual costs provide the raw data for the accounting system,
the basis for financial reports. These financial reports are only one part of
managerial reports that are used for decision making. Accounting rules must
be followed for external reporting purposes, but the only reporting rule that
has to be used for managerial decision making is to provide reports that are
useful to management.
Allocated (Indirect) Costs
For cost data to be useful for managerial decision-making purposes, service
objectives must be identified. The library’s service objectives are related to
the various departmental units, such as those shown in Figure 2-2. The ser-
vices provided directly to the public by the library are found in Circulation,
Children’s Library, Special Collections, the Extension Department, and the
Reference Department. These departments have direct contact with patrons,
and for that reason they are called program departments. The rest of the activ-
ities performed within the library support the library’s program departments.
Departments that provide supporting services are called service departments.
The costs of the service departments are usually allocated to the program
departments. Examples of allocated service department costs are deprecia-
tion on service department equipment, salaries and wages paid in the service
department, and the cost of materials used there. This allocation procedure,
which will be discussed in chapter 3, determines the full cost of operating
each program department, as well as the per-unit cost of the service objec-
tives within a program department. For example, in determining the unit cost
of specific service objectives, the full cost of program operations are divided
by a service unit, such as the number of books loaned, to determine the per-
unit cost of this service. Allocation procedures are followed because service
department costs are difficult to trace directly to specific patron services pro-
vided by the library.
In the organization chart, Technical Services, Human Resources, Public
Relations, the Business Department, and the salaries being paid to the library
director and assistant director represent service department operating costs.
These costs, also referred to as indirect or overhead costs, are allocated in a
“reasonable” manner to the program departments in order to determine the full
costs of operating each program. The main benefit from collecting this infor-
16 Cost Concepts and Decision Making
mation is that full-cost comparisons can be made on a year-to-year basis within
a library, as well as with annual periods. Additionally, full-cost data may be re-
quired to receive reimbursements on work performed under grant agreements.
6
Yet, the question remains: How useful is allocated cost information to
managerial decision making? Before answering, several problems with allo-
cated cost should be noted. First, the methods for allocating overhead costs
will vary widely from one library to another. Even within the same system,
different individuals could select different allocation methods. This variation
occurs because allocation methods are usually required to be “reasonable”
rather than “uniform.” A number of reasonable methods can be adopted to al-
locate costs. Therefore, full-cost data calculated on a per-unit basis should
only be used to make intralibrary cost comparisons because comparable or
uniform full-cost data are not likely to be available among libraries.
A second problem with full-cost data from a managerial perspective is
its misleading effect on the performance evaluations of managers. Allocated
costs have little bearing on actual manager performance because the manager
has no managerial control over costs allocated to his or her unit. Therefore,
there is little relationship between actual performance and full costs. In fact,
performance evaluation based on full costs can hide poor performance if the
reported results are strongly influenced by the method used to allocate over-
head costs rather than actual performance. For this reason, full-cost data
should not be used for making performance evaluations.
Therefore, the answer to the question of how useful allocated cost infor-
mation is to managerial decision making can only be answered within the
context of the circumstances in which it is used. Generally, the usefulness of
allocated cost information to managerial decision making is somewhat lim-
ited. Clearly, it must be used with caution whenever it is employed for analy-
sis purposes as it can easily lead to incorrect conclusions.
Exercise 2-1
Thinking about Overhead Costs
In the Moreover Library, the Human Resources Department is re-
sponsible for handling hiring, promotion packages, and health and
other benefit issues that relate to the entire library.
1. How do you think the costs of running the Human Resources
Department should be allocated to the Reference Department?
(All answers to the exercises are found in appendix C, at the end
of the book.)
Cost Concepts and Decision Making 17
Standard Costs
Unlike allocated costs, standard costs can be useful in evaluating efficient
performance. Standard costs are predetermined future costs set at efficient
levels that are attainable by employees. Through past experience or the use
of time and motion studies, it is possible to determine how long it should take
to efficiently perform many routine activities. Activities such as shelf read-
ing and book processing readily lend themselves to the determination of
time/cost standards. The standards for time spent or materials used are es-
tablished as cost performance criteria to be met by employees. The evalua-
tion of efficient operations requires that actual cost be at least equal to
standard costs. It is also possible to evaluate service objectives and determine
if they are being achieved efficiently. If actual costs do not meet the attain-
able standard, the differences need to be investigated so that corrections can
be made to reach efficient levels of operations.
An example of standard costs is the standard labor cost per book
processed, which can be established based on attainable time and labor rates.
These costs include the standard labor costs per hour for activities such as
sorting, affixing labels, stamping and attaching pocket and date due slip, in-
serting Tattle Tape Strips, and sorting for distribution. The standard labor
costs allow for determining if there is a dollar variance between the number
of books actually processed and the number of books that should have been
processed within the standard labor hours allowed for the task. In other
words, for the number of books processed, how many hours should have
been used? This number should be compared with the actual number of
hours used. It is assumed that these tasks or activities are similar from one li-
brary to another; therefore, work standards allow for more comparability be-
tween libraries as well as within the same library system.
It may appear that the dollar variances between actual work performed
and standards are similar to the differences between actual dollars expended
and budget appropriations, but they are not. When standard costs are deter-
mined, efficiency is the primary consideration. With standards, an attempt is
being made to determine if the staff is performing work at an efficient level.
This comparison is used to evaluate management performance.
When the differences between budget appropriations and actual expendi-
tures are determined, efficient work performance is not a concern. The differ-
ence between budget and actual expenditures is made to highlight deviations
from board-approved spending levels only, which is a quasi-legal concern, not
an efficiency consideration per se.
18 Cost Concepts and Decision Making
Controllable and Noncontrollable Costs
For managerial decision-making purposes, it is important to separate con-
trollable and noncontrollable costs. Without this cost separation, managers
may be held accountable for costs over which they have no control or re-
sponsibility, such as allocated costs. A controllable cost is a cost that can be
changed by a specific manager taking a specific action. An example of a
controllable cost is the amount of overtime incurred within a manager’s de-
partment. If such costs are not controllable by a manager, they are called
noncontrollable costs.
The definition of a controllable cost will vary at different organizational
levels within a library. For example, in the organization chart in Figure 2-2,
the business manager may be directly responsible for the incurrence of main-
tenance costs, but to the department head of the children’s library, any main-
tenance costs allocated to that department are not controllable. As another
example, consider the costs that are controllable by the library board. One
cost controllable by the board is the library director’s salary, but if a portion
of that salary is allocated to departments within the library in determining the
full costs of their operations, those individual department heads will view
that allocated cost as noncontrollable.
Cost responsibility and cost controllability for a manager should coin-
cide. Therefore, a manager’s performance evaluation should include consid-
eration of how well controllable costs are kept within cost limits. If a cost is
noncontrollable, however, a manager’s performance should not be evaluated
based on its incurrence.
Although allocated costs are generally associated with noncontrollable
costs, unallocated costs may also be noncontrollable. For example, the price
of supplies is an unallocated cost. Although the technical services manager
does have control over the efficient use of supplies, he or she is likely to have
little control over the price paid for those supplies by the business office. The
price of supplies is an unallocated cost that is noncontrollable by the man-
ager of technical services, but it is likely to be directly traced to the depart-
ment. This example illustrates that care must be exercised in determining
who has responsibility for costs.
When full costs, including allocated costs, are determined, it is helpful
to separate controllable costs from noncontrollable costs in managerial re-
ports. Managers need to realize that they are responsible only for those costs
over which they exercise control. The separation of costs into controllable
and noncontrollable classifications will highlight this fact.
Cost Concepts and Decision Making 19
Exercise 2-2
Why Am I in Trouble?
As head of the Reference Department, you are presented with the
following Cost Report from accounting.
Nicer Library
Reference Department
Annual Cost Report
January 1, 20xx
Personnel $ 95,000
Equipment purchases 100,000
Telephone 6,000
Supplies 10,000
Building 15,000
Administration 15,000
Total Cost $241,000
You are shocked to find out that the one phone in the Reference
Department is costing $500 per month and that your section of the
library is charged $15,000 in building charges. Finally, you also do
not understand why you are charged $15,000 of the director’s salary
when the director has only talked to you during nonlibrary events.
Explain why the Reference Department’s Cost Report is show-
ing charges for telephone, building, and administration costs.
Fixed, Variable, and Mixed Costs
The separation of costs into fixed, variable, or mixed costs is important in an-
alyzing cost behavior patterns and in making managerial decisions. Cost be-
havior patterns affect decisions about the savings or cost increases that are
likely to occur from changes in activities or service levels. Remember that
the time period under which these costs are being defined is one year. This
somewhat arbitrary designation of a one-year time frame means that care
should be exercised when separating fixed and variable costs in this manner.
For example, a cost recognized as a fixed cost in a one-year time frame may
be the most rapidly changing, or variable, cost in a two-year time frame.
A fixed cost is a cost that does not change as the level of services within
a library changes. Rent and insurance are examples of fixed costs. The
20 Cost Concepts and Decision Making
salaries of all contract employees are fixed and will not change directly with
the level of library services provided. If a cost changes as the volume of ser-
vices provided changes, it is a variable cost. Some costs may vary, but they
must vary directly with volume levels to be considered a variable cost.
Supplies used in the Technical Services Department in Figure 2-2 are an ex-
ample of a variable cost. Hourly salaries are another example of variable
costs because as service levels increase, so do hours worked and wage costs.
Some costs, however, may be variable or fixed depending on how they
are calculated. For example, depreciation on a bookmobile may be a fixed
amount every year, or the expense could vary with the number of miles
logged on the bookmobile. Depreciation expense may vary with time peri-
ods, but unless it varies directly with services—hours of use and mileage—
it is not a variable cost.
Figure 2-3 provides three illustrations of variable costs. Graph A in Figure
2-3 is the typical example of a variable cost—a 45-degree line between total
variable cost and volume or level of services. Graphs B and C are also exam-
ples of variable costs, but they change at decreasing and increasing rates, re-
spectively, with volume of service. Both graph B and graph C are illustrations
of variable costs because they vary with the volume level of services provided.
If the horizontal axis were changed to a measure of time instead of a volume
level, none of these costs would be considered a variable cost.
Although it may be useful to separate all costs into fixed and variable
costs, this practice may ignore actual cost behavior. Some costs do not exhibit
all the characteristics of either a fixed or variable cost. These costs can be
called mixed costs because they have characteristics of both variable and fixed
costs. An example of a mixed cost is found in the way total salaries for su-
pervisors behave when the span of control is taken into consideration. One su-
pervisor can efficiently handle a specific number of employees, but as
employees are added beyond a certain number, other supervisory personnel
Cost Concepts and Decision Making 21
FIGURE 2-3 Illustrations of variable costs
Total
$
Volume
AB C
must be added to help with the supervision tasks. The salary cost pattern for
total supervisors’salaries behaves as illustrated in Figure 2-4, graph A. As the
end of an efficient span of control is reached, a new supervisor is added and
total salary costs increase in a stair-step fashion. This mixed cost remains
fixed for only a limited change in volume of service. Therefore, it is not fixed
per se, but it does not exhibit all the characteristics of a variable cost either.
Another example of mixed costs is illustrated in Figure 2-4, graph B.
This cost pattern begins as a fixed cost and changes to a variable cost after a
specific volume level is reached. Utility rates that begin with a flat charge
and change to a variable rate per unit after a certain usage figure is reached
are an example of this cost pattern.
These cost patterns show that it is important to know cost behavior be-
fore assumptions about future cost reductions can be made. In a library fac-
ing budget curtailments, knowledge of cost behavior patterns assist the
library manager in initiating cost cuts with a minimum reduction in services.
The decision involves more than simply curtailing activities or instituting
across-the-board percentage budget cuts.
Exercise 2-3
Some Simple Cost Patterns
For each of the following descriptions, develop a cost pattern simi-
lar to those shown in Figures 2-3 and 2-4.
1. Assuming a budget purchase plan is not in effect, draw the seasonal
cost pattern of electrical cost usage for a library in Minnesota.
2. At the initial change, draw the cost pattern, to the library, of
switching from printed periodicals to online periodicals.
22 Cost Concepts and Decision Making
FIGURE 2-4 Illustrations of mixed costs
Total
$
Volume
AB
Direct and Indirect (Allocated) Costs
Direct costs are directly traceable to the cost of a service or department.
Examples of direct cost are the cost of labor and materials that go into a li-
brary’s in-house bookbinding operations, the labor costs of running branch
libraries, or the labor and material costs of processing interlibrary loans.
Indirect costs or allocated costs cannot be easily traced to an organizational
objective, program, or department. Allocated costs have already been de-
scribed, but they need to be compared here with direct costs.
A direct cost is a controllable cost if a specific manager can control it;
however, identification as a direct cost does not necessarily mean that cost is
controllable by a department manager. Indirect costs are similar to noncon-
trollable costs. But, again, a cost may be controllable by a manager even
though it is an indirect cost. Therefore, these definitions may overlap, but
they do not implicitly overlap.
Only direct costs can be eliminated. Therefore, separation of direct
costs from indirect or allocated costs is important if future costs savings
from curtailing department operations are to be accurately determined. If
the library director reviews full costs in determining the future cost savings
from curtailing activities, the amount of savings will be overestimated be-
cause a high percentage of indirect or allocated costs is likely to remain
when service is reduced. An analysis of direct and indirect costs to deter-
mine the cost savings from reducing services is important to sound man-
agerial decision making.
Discretionary Costs, Sunk Costs, and Differential Costs
Distinctions between discretionary costs, sunk costs, and differential costs are
important because only differential costs have an effect on managerial deci-
sion making.
The decision to incur discretionary costs is usually made as part of the
annual appropriation. Discretionary costs are expenditures based on the dis-
cretion of management rather than on managerial analysis. These costs are
easy to change; managers need only change their minds about the expendi-
tures to increase or decrease amounts expended.
Management may believe that discretionary expenditures are important,
but their value to the organization is difficult to measure. Examples of discre-
tionary costs are seminar training for employees in technical services, train-
ing for reference personnel on a new database, setting aside amounts for
travel to professional meetings, and promoting library programs. It is difficult
Cost Concepts and Decision Making 23
to determine the direct increase in service to the library that is being received
from making these expenditures.
Another cost classification is sunk cost. Unlike discretionary costs, sunk
costs are costs that cannot be changed. The organization has made a com-
mitment to their continuation. Examples of these costs are depreciation,
long-term contract payments, and liability insurance payments. Identifying
these costs will allow them to be separated from those costs that influence
managerial decisions. As an example of a sunk cost, consider the calculation
of depreciation. Depreciation is calculated by assigning the cost of an asset
to the time periods in which the asset is used. Although the future amount to
be paid for an asset is an important consideration in decision making, after
the purchase price has been paid, its accounting disposition is of little im-
portance to managerial decision making. The yearly depreciation charges
based on the price paid for an asset are not useful for future decision making
as long as the asset is in use. For this reason, the sunk cost or purchase price
of an asset acquired yesterday has no bearing on the decision to replace that
asset today. Many managerial decision-making questions are oriented toward
the future, not the past, and historical cost allocations have no effect on those
decisions.
Differential costs are another cost classification. Unlike discretionary or
sunk costs, differential costs are important for managerial decision-making
purposes. Differential costs are sometimes called incremental costs. These
costs are the dollar differences between the costs of alternative future actions
that can be taken by a manager. For example, if the purchase prices of two
vehicles are $10,800 and $10,000, the differential or incremental cost is
$800. If the cost of license plates for each vehicle is $35, this is not a differ-
ential because the charge is the same. Therefore, the cost of license plates
should not be a consideration in determining which of the two vehicles to
purchase.
Consider the decision to close a branch library as another example of dif-
ferential cost analysis. The costs of operating the branch are shown in Figure
2-5. The total cost of operating the branch is $36,500, and initially it may ap-
pear that this is the amount saved if the branch is closed.
However, to determine the actual amount of savings that will occur if the
branch is closed, the costs of operating the branch need to be individually an-
alyzed. The salary of an administrator within the Extension Department is al-
located to this branch based on the time spent assisting with branch
functions. As shown in Figure 2-5, $6,500 of the administrator’s salary is al-
located to the branch. This is an example of an indirect or allocated cost. The
administrator would not be released if the branch were closed; therefore, this
24 Cost Concepts and Decision Making
administrative salary would not be reduced. A technician working at the
branch who receives a salary of $10,000 would be laid off if the branch were
closed. Approximately one-half of the book purchases and video rental costs
would still have to be paid for by the main library. The differential cost sav-
ings from closing the branch are $26,000—the costs that change as a result
of closing the branch, not the total costs of operating the branch. Figure 2-5
shows that the cost savings from closing the branch are less than the branch’s
full operating cost—costs of $10,500 will continue to be incurred regardless
of whether the branch is closed ($36,500 – $26,000). These costs are un-
avoidable and should not enter into the decision-making process. Only costs
that will differ as a result of alternative future choices—the differential
costs—should be allowed to influence such a decision.
Exercise 2-4
Budget Cuts
Use the Cost Report from Exercise 2-2 to answer the questions
below.
To save money, the director of the Nicer Library has been forced
to cut the budget by 10 percent. As head of the Reference Department,
your portion of the reduction is equal to $24,100 (.10 × 241,000).
1. Can you explain to the director why the level of this reduction may
not be possible without seriously curtailing reference services?
2. And, further, can you explain how much of the 10 percent across-
the-board budget cut should be taken out of your department?
Cost Concepts and Decision Making 25
Cost Item Full Costs Differential Costs
Administrative salary $ 6,500 —
Technician wages 10,000 $10,000
Utility charges 3,000 3,000
Annual rent payments 9,000 9,000
Book purchases, exhibits, videos,
and movie rental 8,000 4,000
Totals $36,500 $26,000
FIGURE 2-5 Full costs and differential costs for a branch library
______ ______
______ ______
______ ______
Life Cycle Costs
Costs associated with an asset over its entire life or life cycle are called life
cycle costs. These costs are used in determining which of several similar assets
to purchase. Life cycle costing goes beyond the initial acquisition price in se-
lecting which asset to purchase; it includes a projection of the asset’s operat-
ing and maintenance costs over its entire life. This information may have to be
estimated from a number of sources. Besides the future operating and mainte-
nance costs, another factor in this analysis is the estimated salvage value of the
asset at the end of its useful life. All these variables affect the overall cost of
asset ownership. A complete discussion of this topic is presented in chapter 6.
Future operating and maintenance costs are not reflected in the acquisi-
tion price and may differ significantly between two assets. Therefore, in
making asset purchase decisions, total ownership costs need to be compared.
These costs are important because maintenance costs of an asset may equal
more than half the asset’s original cost, and with an aging asset, these costs
tend to increase.
For management to select the most cost-effective asset for use in the or-
ganization, the total ownership costs of an asset must be estimated. If the ini-
tial acquisition price is the major criteria used for the selection of an asset,
the asset acquisition process is likely to be misguided. This is especially true
with assets that have longer lives.
Historical Costs and Current Costs
The historical cost of an asset is the price that was originally paid for that
asset and is recorded in the accounting records when that asset is acquired.
This is the only cost that can be shown directly on the financial statements.
Yet, as inflation continues, the purchase cost of the same type of asset in-
creases. For example, a desk may have cost $225 ten years ago, and today
the market price of that same desk is $650. This amount is not recorded in
the books, but for managerial decision making, the current cost of $650 is
more important because it shows the resources that will have to be used to
acquire a new desk. Current cost adjustments will be used in chapter 3.
SUMMARY
This chapter provides a background to specific cost terms and concepts that
will be used in later chapters. It is not the purpose of this chapter to deal in
26 Cost Concepts and Decision Making
great detail with these concepts or to cover all the cost terminology that will
be introduced in the book but, rather, to provide an overview of cost concepts
and indicate how these concepts affect managerial decision making.
The chapter has highlighted cost terms that are useful to managerial de-
cision making. A total of sixteen cost terms were introduced: actual, allo-
cated, standard, controllable, noncontrollable, fixed, variable, mixed, direct,
indirect, discretionary, sunk, differential, life cycle, historical, and current.
Gaining a familiarity with these cost definitions is important because
they will be used throughout the remainder of the book. Terms such as con-
trollable, noncontrollable, and allocated costs; variance analysis and vari-
able and fixed costs; and life cycle costing techniques and differential cost
analysis will be covered in future chapters.
In managerial decision making, there is an emphasis on making future-
oriented decisions, and therefore the anticipated costs associated with these
decisions are also important. In evaluating managerial performance, histori-
cal cost information provides a measure of feedback on past performance.
The cost classifications described in this chapter are not available in
budget reports. Budget reports classify all costs together on budget lines to
ensure that appropriated budget dollars have not been exceeded. As a result,
budget reports cannot be used for most managerial decision-making issues.
Also, most budget reports do not provide for cost control except on a total
expenditure basis.
Additionally, the cost classifications described here cannot be found on
the financial statements prepared for a library. As constructed, financial state-
ments do not provide cost information that is required by operating managers
for decision making. Therefore, library managers have a special need for the
preparation of managerial reports containing this specific cost information.
Notes
1. It was stated in chapter 1 that it is more useful for a manager to know the amount of
deferred maintenance on an asset than the amount of accumulated depreciation on that
asset. This is still true. Many managerial decisions have a future orientation, and for
those decisions only costs that affect the future are important. Historical cost infor-
mation does have a place in managerial decision making, but the allocated purchase
price of an asset does not. A manager is responsible for the costs that he or she can
control, and managerial performance is evaluated on that basis. But, in neither decision
making nor performance evaluation is depreciation expense important.
2. For managerial decision making, it is not important how these costs are assigned to the
financial statements. From a managerial decision-making perspective, the primary con-
cern is when the cash flow related to the transaction occurs, not how it was allocated on
the financial statements. Cash flow analysis will be discussed in chapter 6.
Cost Concepts and Decision Making 27
3. In a corporation, product costs are eventually recorded on the income statement as the
cost of units sold. Libraries usually do not record the cost of sales on their financial
statements.
4. The terms costs and expenses are based on accrual accounting methods. The term
expenditures is based on modified accrual accounting methods. Cash accounting
methods do not record true expenditures, expenses, or costs, but they record dis-
bursements instead. For additional explanations of these accounting methods, see
Accounting for Libraries and Other Not-for-Profit Organizations (Chicago: American
Library Association, 1999), by G. Stevenson Smith. As the financial report for non-
profits becomes similar to corporate financial reporting (a current trend), the terms
costs and expenses will replace the term expenditures more commonly found in
modified accrual methods.
5. The term allocated cost is often used as a synonym for indirect costs or overhead costs.
6. Under federal grants where costs may be reimbursed, the allocation of overhead is
closely regulated.
28 Cost Concepts and Decision Making
