|Management of agricultural research: A training manual. Module 7: Financial Management (1997)|
|Session 2. Financial management 2: Planning and budgeting|
|Reading note: Financial management 2: Planning and budgeting|
The organization uses inputs, such as land, buildings, people, etc., to produce outputs like goods and services. Inputs are measured in terms of monetary value and represent the cost of producing those outputs. It is very important to have some classification of costs to facilitate the analysis. For this purpose, the cost concept is defined in various ways.
· Total cost provides a single measure of the aggregate resource requirements for a particular scale of activity. Since most organizations would like to decide the scale of activity at which to operate, information about total cost is important.
· Average cost is the cost per unit of output. This is calculated by dividing total costs by output.
· Marginal cost measures the amount of cost which the organization would be required to incur to produce one additional unit of output.
The three cost concepts are very popular, but the application of these concepts in cost analysis, particularly in the case of research institutes, is not really straightforward.
To facilitate useful analysis of cost information, costs can be classified according to whether:
· they vary with change in volume of output produced; or whether
· they yield immediate results rather than long-term consumption benefits.
The first classification is typically scale-related cost, and such costs are classified as fixed or variable. The second classifies costs according to whether they are developmental or capital in nature and bring long-term benefits to the organizations, or costs are recurrent in nature.
Costs which do not vary with change in the volume or scale of activities are classified as fixed costs. Fixed costs generally constitute committed or discretionary components. Whenever research institutes start a new activity on a long-term basis, they make commitments towards the costs which cannot be changed in the short term. The committed component of fixed costs generally arises out of an organization's commitments for long-term activities. Costs, such as rent of buildings, salaries of permanent staff, etc., are generally unavoidable and cannot be controlled in the short run. A major proportion of recurring costs are committed costs and cannot be influenced in the short term. If an organization wants to control such costs, the only way is through better design of projects and activities.
In contrast, discretionary costs depend on management's discretion or its policy. Funds allocated to research and development, training of people, travel, etc., are examples of discretionary fixed costs. These costs are decided by management, and therefore they are also known as managed or programmed costs. The nature of these costs is such that there is no way of ascertaining the optimum standard output expected from inputs. Management's subjective judgment is needed to establish the 'right' amount of discretionary costs in a given situation.
Costs which vary with change in volume or scale of activities are called variable costs.
In most situations it may not be possible to clearly classify costs as fixed or variable. They often possess qualities both fixed and variable. The fixed component of mixed costs represents the minimum unavoidable amount for any given level of activity. Costs such as maintenance, telephones, repairs, etc., are examples of mixed costs.
Capital or developmental costs
In the beginning, when a project is initiated, all costs associated with the establishment or the basic infrastructure are called capital or development costs. Generally these costs include:
· cost of land;
· construction of buildings;
· purchase of capital equipment; and
· investment in human resources (i.e., initial training).
Costs which are incurred in order to keep the activity going and in maintaining assets or facilities are defined as recurrent or operating costs. The following are generally included in this category:
· salaries and wages;
· equipment maintenance and spare parts;
· supplies of consumables; and
· electricity, water and other basic utilities.
Recurrent costs are incurred for the duration of the planned activity. They are likely to increase during the later phases of a programme as maintenance costs are likely to increase.