Thursday 17 February 2022

The concept of costs in project analysis

 In modern economic literature, costs are sometimes replaced by the terms "expenses" or "expenditures". In financial management, management and financial accounting, this is unacceptable, since each of these concepts has a separate meaning. However, in the project analysis for the analyst, replacing the concept of "costs" with the term "costs" is not fundamentally important. Therefore, in the future, we will use these terms as synonyms.

When carrying out project analysis, quite often individual costs are more important than all others. Some of them already in their origin require closer attention of analysts. To this end, consider some costs and their classification features that will help during the evaluation of projects to make the only correct decision.

The most common classification features of expenses are as follows:

  • the possibility of reflection in the accounting statements (accounting and economic);
  • the degree of dynamics of costs depending on the increase or decrease in production volumes (constants, variables);
  • the period of cost (long-term, short-term);
  • method of attribution of costs per unit of production (average, marginal);
  • origin of costs (operating, financial);
  • the degree of coverage of the real cost;
  • possibility of distribution.

Modern accounting methods allow you to display in accounting documents only the cost of used resources that are not the property of the company. These costs are included in the cost of production, and, as a rule, are regulated by the relevant legislative framework. However, quite often a company that has its own resources and uses them is unable to reflect these resources in its accounting costs. Practice confirms the need to calculate for the entrepreneur not only accounting costs (obvious), which are formed when paying for resources to an external supplier, but also implicit costs that arise when the company uses its own resources. The analyst who decides on the feasibility of the project should be guided by the amount of economic costs that contain both accounting and implicit costs, reflecting the cost of resources used in the production process and owned by the business owner.

The division of costs into fixed and variables is associated with a causal mechanism for their changes. Costs that have their own dimensions in direct relation to changes in production (sales) volumes are called variables. At the same time, with an increase in production, costs also increase. If production volumes decrease, costs change accordingly. An example of this kind of costs can be the cost of raw materials - its acquisition is directly related to the volume of sales: the more they sell, the more you need to produce, and the more raw materials are bought. 


If nothing is sold, then theoretically it is not necessary to produce anything and the cost of raw materials for the manufacturer will be zero. Variable costs include such items as the cost of raw materials, direct remuneration, individual costs for the sale, payment of electricity consumed for the operation of equipment during the production process, etc.

All costs whose changes are not directly related to sales are called constants. These costs are paid regardless of whether anything can be sold (even if nothing is produced). Their size is approximately the same, regardless of the volume of sales. Fixed costs include depreciation, administrative overhead, insurance, rent and similar mandatory payments.


 It cannot be assumed that fixed costs do not change over time - 

insurance is more expensive, the administration receives a salary increase, etc. At the same time, we emphasize that the increase (decrease) in fixed costs is due to something other than changes in production (sales). Such a causal relationship with production is the most important factor in the difference between variable and fixed costs.

Since an enterprise operating in a short period is limited by the possibility of varying, replacing factors of production, it should be borne in mind that costs in the short term are limited by the conditions of existing technology, price characteristics of resources. Therefore, short-term costs, as a rule, are not flexible, which reduces the mobility of the company. In the long run, all costs (both fixed and variable) tend to change. The company can move to another house, which is not so expensive, pay lower rent, reduce wages, carry out preventive repairs of equipment, change the structure and size of insurance. All this greatly affects the reduction of the level of fixed costs. 


Therefore, long-term costs are much lower than short-term. The ability to maneuver as a positive characteristic of any entrepreneurial activity is greater the greater the wider the opportunities for the company to flexibly change its costs, that is, the lower its fixed costs.

The theory of rational behavior of the company requires determining not only the value of average costs per unit of output (average general, medium variables and average constants), but also the values of marginal or marginal costs. The limits are those additional costs that will require the manufacturer to produce one additional unit of production.

Let's illustrate the difference between average and marginal costs in the example given.

The data given in it characterize the production process in which three machines are used for the manufacture of the unit. Due to certain technological changes, each of them has different operating costs, but for the production of 125 units of products per hour, the operation of all three machines is required. 


The total production costs of 125 units of production are 2500 Dollar, average — 20 Dollar. per unit. The cost of nodes is different — 14, 16, 20 Dollar. To produce an additional unit per hour, the 3rd machine should be used. Production costs per unit of production on it are equal to 40 Dollar. Thus, the marginal production costs are 40 Dollar, and the average costs are 2500:125=20 Dollar.

The table shows that:

  • total production costs = 700 + 800 + 1000 = 2500 Dollar.;
  • quantity of manufactured products = 125 pcs.;
  • average production costs = 2500 : 125 = 20 Dollar.;
  • the cost of production of one additional unit = (2500 - 1500) : (125 - 100) = 40 Dollar.

The reason for the division of costs into medium and marginal is based on justifying the increase in production. The income received should be at least equal to the costs incurred, or 40 Dollar. It is impossible to get rich by producing anything for 40 Dollar, and selling for 20 Dollar, that is, at an average cost. On the contrary, for profit it is necessary to return 40 Dollar. marginal costs.

This is one of the most important principles of the manufacturer's behavior: to increase production until the marginal income is equal to the marginal costs.

 When assessing project costs, it is often necessary not only to determine the amount of operating costs associated with the company's activities and based on production costs, but also the amount of financial costs.

Operating expenses include the amount of all payments for material resources, remuneration, overhead costs associated with the production of products and the functioning of the enterprise.

Individual expenses, such as interest payments and rent, are financial in origin. Financial costs are as important for decision-making as operating costs, but they have another goal - to assess the effectiveness of the company and the impact on it of the appropriate method of financing (the ratio of borrowed funds and equity).

When assessing the real cost of project products, there is a serious problem of determining the amount of write-off of both fixed assets and working capital, primarily inventory. The practice of writing off in accordance with the principles of the company's accounting statements, regardless of the market price of the assets of the enterprise, evaluates fixed assets at the initial cost minus the accumulated depreciation. In the initial value reflect in the reporting and inventory (TMZ). 


This greatly worsens the state of the company during the period of inflation. The modern practice of assessing TMZ allows you to mitigate the impact of inflationary processes and get more realistic income indicators. There are several methodical approaches to the evaluation of TMZ. For example, at prices chronologically the first-in-first out (FIFO). 


These prices are used in this case to calculate income. However, in conditions of high inflation, when purchased inventory depreciate, and their reflection in the cost of production at initial prices leads to an overestimation of the company's income, they use the methodology for estimating TMZ at the prices of the latter in time of purchases (last-in-first out - LIFO). 


At the same time, even the LIFO technique does not eliminate the distortions that accompany the calculation process. In this case, you can offer the use of the replacement cost, or, as it is also called, methods for assessing the TMZ at the purchase price of the next unit (next-in-first out - NIFO). This method ensures the reproduction of sufficient funds for the purchase of a new unit with the operation of the old one.

Cost management requires information about the amount of costs that cannot be divided into components and identified with specific actions. Such costs are called complex or inseparable. During the production of additional volume of products, their size does not increase. Such costs include equipment insurance. Or: suppose that there is one meter of electricity consumed throughout the plant. If the machine works additional time above the norm established for the production of a unit of production, electricity costs will belong to the category of variables. 


However, if at the same time other machines work, the premises are illuminated, then the question arises, what part of the increase in electricity costs should be attributed to the account of additional production? Such costs are inseparable.

In the project analysis, the analyst decides on the feasibility of investments, assessing the future cash flows, benefits and costs that will accompany the project. At the same time, there are situations when certain investments in the project have already been implemented. Such costs are called costs of the past period (sunk cost). 


Suppose that yesterday 1000 Dollar were paid for equipment that is part of a new project. Today, in order to complete the project, you need to spend another 1000 Dollar. Suddenly, before the second payment was made, information was received that the maximum income that the project is able to bring is 1500 Dollar. That is, the total cost of the project is 2000 Dollar, and the income is only 1500 Dollar. Do I need to spend another 1000 Dollar.

To complete the project?

If the money is not paid, then 1000 Dollar have already been invested. will be lost, since no Dollar of income will be received before the completion of the project. If you spend an additional amount and complete the project, 1000 Dollar invested today will be reimbursed. and received another 500 Dollar. Only $500 will be lost. In other words, it is more profitable to complete the project (although the money will be lost in both cases). 


We emphasize that such a decision was based only on the forecast of future costs (1000 Dollar) and future benefits (1500 Dollar). For an analyst, previous gains and costs should not matter when making current decisions on how to make future-to-future investments because they have already been invested and are irrevocable.

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