The Importance of Cost Analysis in Financial and Investment Decisions: A Review of Concepts, Advantages, and Disadvantages

Table of content Introduction: Financing decisions and investment decisions are considered to be two of the most vital decisions that corporations have to take. Cost analysis is one of the factors that should be taken into consideration while evaluating financial and investment decisions. This paper reviews the concept of cost analysis, how it is used in decision making, and how firms usually involve cost analysis in evaluating different projects.

Furthermore, the paper discusses some of the main concepts that are derived from cost analysis such as cost allocation, cost-effectiveness analysis, and cost-benefit analysis. In addition, some of the advantages and disadvantages of cost analysis will be discussed. Moreover, the concept of intangible cost analysis will be introduced. Then, the results and findings of the research paper will be illustrated. Finally, few recommendations that are based on the results and findings will be made. Literature Review:

Due to its high importance in the decision making process, cost analysis has been discussed in many books by several authors who illustrated different aspects of cost analysis. In his book “cost-benefit analysis,” E. J. Mishan discussed in depth the concept of cost-benefit analysis, which is a form of cost analysis. Professor Mishan focused on some of the key concepts that are related to cost-benefit analysis. The author started his book with few examples of cost analysis in order to illustrate to the reader the meaning of cost-benefit analysis. Then, Mr.

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Mishan illustrated the economical aspect of cost-benefit analysis and showed how opportunity cost could be related to cost-benefit analysis. Furthermore, Mr. Mishan tried to show how cost-benefit analysis is limited and can be used partially in the decision making process. A notable section of Mr. Mishan’s book is certainty equivalence. In this section, the author developed an assumption that “enables us formally to rank a number of alternative uncertain benefits without first reducing each to a certainty equivalent. In his article “Ways to Deliver More for Less,” Harry E.

Roberts, Senior Vice President and Chief Information Officer of Boscov’s Department Stores, discussed how cost analysis can be used to reduce IT spending. Mr. Roberts discussed how the IT budgeting has changed over time. The author suggested ways to enable Information Technology, which is a cost center rather than a profit center, to “deliver more than what is expected and at a lower cost than what was budgeted. ” Then, Mr. Roberts suggested that a revision for different costs, such as variable costs, fixed costs, and payroll costs, should be made.

The author concluded his research by emphasizing on the fact that “every dollar invested on a cost item must deliver as much value to the business as its highest-margin product or service. ” Cost Analysis: Definition According to The U. S. Office of Surface Mining Reclamation and Enforcement, cost analysis can be defined as “the process of obtaining cost breakdowns, verifying cost data, evaluating specific elements of costs and examining data to determine necessity, reasonableness, and appropriateness of the costs. Both financing and investment decisions are highly affected by cost analysis as corporations usually pay a great deal of attention to the different types of costs that are involved in the different projects that will be taken into consideration either to raise funds or to invest surplus funds that a corporation has. Sometimes cost analysis is perceived as a tool that is used only to reduce costs. In contrast to this point of view, cost analysis is believed to be a tool that helps management to choose the best possible solution or project among many different alternatives.

In their article ““Using Cost Analysis In Evaluation,” Meg Sewell and Mary Marczak believe that cost analysis methods and uses are “complex, require very sophisticated technical skills and training in methodology and in principles of economics, and should not be taken lightly. ” Three Types of Cost Analysis: Three of the main concepts that are derived from cost analysis are cost allocation, cost-effectiveness analysis, and cost-benefit analysis. These three methods are usually used simultaneously in order for corporations to evaluate different decisions or projects.

Some of these methods might seem simple and easy to use; however, they should never be ignored or taken slightly as they can be of great benefit in determining the right decisions. Cost Allocation: Cost allocation is the simplest among the three concepts that were mentioned earlier. Sewell and Marczak stated that cost allocation refers to “setting up budgeting and accounting systems in a way that allows program managers to determine a unit cost or cost per unit of service. Furthermore, Sewell and Marczak illustrated that in many corporations, cost allocation is used to provide “some of the basic information needed to conduct more ambitious cost analyses such as cost-benefit analysis or cost-effectiveness analysis. ” Therefore, it can be concluded that cost allocation is a prerequisite to both cost-benefit analysis and cost-effectiveness analysis. Example: The following table shows the monthly cost allocation for 3 different projects It is important to note that firms usually allocate their costs based on previous experience and estimation.

However, firms should expect costs to change, which can be due to financial crises, inflation, or other factors, and try to adapt their cost allocation systems in such a way that it will handle the new changes. Based on the costing method that the company uses, such as activity-based costing, a more detailed cost allocation system can be structured in order to determine the unit cost as precisely as possible Once costs have been identified and allocated, more advanced cost analysis methods, such as cost-effectiveness analysis and cost-benefit analysis, are used.

Cost-effectiveness Analysis: According to Sewell and Marczak, the concept of cost-effectiveness analysis holds that “a certain benefit or outcome is desired, and that there are several alternative ways to achieve it. ” However, cost-effectiveness analysis should not be used separately during the process of evaluating projects or decisions as it will favor the cheapest option. Instead, cost-effectiveness analysis should be used along with cost allocation and cost-benefit analysis in order to provide more precise and more informative outcomes.

It is important to mention that cost-effectiveness is a comparative tool that compares the cost of separate projects and favors the least expensive one. If we only used cost-effectiveness to decide which machine to buy, machine 1 will be favored by cost-effectiveness since it will generate products cheaper than machine 2. However, this is not necessarily the correct decision since cost-effectiveness analysis fails to take into consideration certain criteria such as the time each machine requires to generate the product and the quality of the generated products.

Cost-benefit Analysis: According to smbtn. com, cost-benefit analysis can be best described as “An analysis tool that measures the results or benefits of a decision compared with the required costs. ” Cost-benefit analysis is perceived as a powerful tool that management usually use whenever a “buy-or-build” decision needs to be taken. Buy-or-build decisions are usually taken when a firm faces a situation where it has two options: (1) To buy or outsource a certain part of its business (2) To internally manufacture or perform a certain part of its business.

Cost-benefit analysis can assist in taking buy-or-build decisions as it will illustrate the benefits and costs that are expected if buy decision or build decision is taken. Cost-benefit analysis consists of several tools, such as benefit-to-costs ratio, that are used to analyze and compare benefits and costs that are involved in a certain project. According to Sewell and Marczak, benefit-to-costs ratio is “the total monetary cost of the benefits or outcomes divided by the total monetary costs of obtaining them. Despite the fact the cost-benefit seems to be the most powerful tool to analyze costs and taking cost related decisions, it should be used along with other tools such as cost-effectiveness analysis and cost allocation. Using cost-benefit analysis separately from other tools can result in misleading decisions that can cost management dearly. If the benefits-to-costs ratio is greater than 1, then the project should be analyzed further, compared to other projects and taken into consideration as a potential project that the firm can invest in or use to raise funds.

Advantages of Cost Analysis: Cost analysis can be of great help for management as it can be used as a tool in the decision making process. Some of the most important advantages of cost analysis are: Cost analysis can clarify all costs that are involved in a certain project. Cost analysis will draw attention to costs that may not be obvious at first. Consequently, allowing managers to take more precise financing or investment decisions. Cost analysis can help management prioritize tasks and processes when budgets are limited.

It is believed that managers can distribute budgets more effectively when all costs are identified; therefore, it will be possible to get the most out of available resources. Disadvantages of cost analysis: On the other hand, cost analysis is not always sufficient by its own for management to make decisions. Some of the facts that cost analysis cannot provide information about are: _As Sewell and Marczak mentioned, cost analysis cannot always tell “whether the least expensive alternative is always the best alternative. _” Cost analysis by its own is not always enough to determine the best alternative.

Usually, other criteria that cannot be determined by cost analysis, such as time, have an effect on the decision making process. Cost analysis is very complex and requires great deal of skills and expertise. Cost analysis requires not only background in finance and accounting, but also economic and decision making skills. It is common nowadays for organizations to outsource cost analysis if it cannot be done effectively in-house. According to _Sewell and Marczak, “sometimes costs and monetary values are considered less important than other, more intangible values or program outcomes. ” Intangible cost analysis: Despite the fact that corporations frequently use cost analysis in evaluating the different decisions that have to be made, intangible cost analysis is not always taken into consideration. In his book “Intangible Management: Tools for Solving the Accounting and Management Crisis,” Ken Stanfield described intangible cost analysis as set of processes that “[allow] executives to identify, measure, and reduce costs that the organization has always been aware of, but has not been able to previously measure and control. Intangible cost analysis allows corporations to increase efficiency and productivity as well as decrease costs. According to Stanfield, in contrast to old cost analysis methods where tangible costs were the most important selection criteria, modern cost analysis methods favors alternatives, decisions, or projects “with the lowest total real cost (tangible costs + intangible costs). ” Some of the intangible costs that should be taken into consideration are knowledge costs, time costs, and relationship management costs.

Many organizations started to take intangible costs more seriously and established departments that are dedicated to deal with such costs such as knowledge management department. Intangible cost analysis is more complex than tangible cost analysis due to the fact that it depends on estimation skills and past experience. Therefore, possessing intangible cost analysis skills can be considered as a competitive advantage as it will result in better cost management and lower incurred costs. Results and Findings:

Cost analysis is one of the most sophisticated concepts in business, and many economists wrote several books about it. The following points illustrate the results and findings of the research paper: Cost analysis consists of multiple tools and techniques that are usually used simultaneously to reach the best decision possible. Cost analysis not only allows firms to find ways to reduce costs, but it also suggests methods that can be applied to turn a cost center into profit center.

It is vital for decision makers to be aware that cost analysis consists of tools that can estimate costs, which might differ from costs that will be incurred in reality. Intangible cost analysis should not be taken slightly as it has a great affect on the business of any company, especially on the long run. Cost analysis fails to take into consideration some factors such as time and quality Cost analysis needs advanced skills and is considered to be a competitive advantage for firms that have employees specialized in it.

Recommendations and Conclusion: Using multiple cost analysis tools, which is due to the fact that the use of only one or few tools will result in misleading decisions Pay great attention to intangible cost analysis as it can make the difference between success and failure. Take into consideration factors that cannot be quantified and analyzed such as time and quality.

Due to the fact that cost analysis has become a vital part of the decision making process, firms have to ensure that they possess the required cost analysis skills or outsource to specialized cost analysis firms. In conclusion, it is vital to emphasize on the fact that cost analysis is just one tool that can be used in the decision making process. Financing decisions and investments decisions are so critical that many tools and selection criteria have to be used while analyzing and evaluating these decisions.

Nowadays, the world is facing a financial crisis that is affecting all companies; consequently, firms are starting to analyze costs to determine how best to protect themselves. Bibliography Mishan, E. J. Cost Benefit Analysis: An Informal Introduction, 1982. Ramji, Al-Noor, Linda Reino, Harry E. Roberts, eds. , Inside The Minds: Ways To Reduce It Spending : Leading Executives On Managing Costs, Negotiating Pricing & Reducing Overall Technology Expenditures. United States of America: Aspatore, 2004. Sewell, Meg and Mary Marczak.

Using Cost Analysis In Evaluation. The University of Arizona; available from http://ag. arizona. edu/fcs/cyfernet/cyfar/Costben2. htm; Internet; accessed 1 November 2008. Stanfield, Ken. Intangible Management: Tools for Solving the Accounting and Management Crisis. Academic Press; 1st edition (July 1, 2002). The U. S. Office of Surface Mining Reclamation and Enforcement: Federal Assistance Manual. Washington, D. C. , 1998; available from http://www. osmre. gov/fam/defin. htm; Internet; accessed 16 November 2008.

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