These are the reasons:
Costs are calculated and presented by people and are affected by:
- their opinions; people have different opinions about how to go about calculating costs based on their training, their experience and world view – none of which may be relevant to the particular costing exercise the are undertaking.
- their prejudices; I have personally, when reviewing costs calculated in a business, that some people base their estimates on the time that will be taken to do work are affected by their views on gender, race and age. None of which are necessarily relevant.
- their knowledge; by this I mean a lack of knowledge of the type business and the type industry within which it operates. I have also seen someone who came from a mass production business to a jobbing (i.e. a business which makes routinely makes totally different things for different customers) business making big mistakes in costing.
- their diligence; routinely guessing rather than seeking and using all of the information that is available.
- the use of numbers prepared by accountants: There is no criticism of accountants of accountants implied here. Profit (and therefore costs taken into account in arriving at the profit figure) is something else. It is a number that is arrived at subjectively. I’ll give you a few examples below. There are more, but I’ll stick to the usual targets for manipulation. You may well ask why anyone would want to manipulate the profit figure. It happens when, for example, management wishes to have a lower or higher profit to meet the budget. There are also other reasons. So the profit figure is arrived at subjectively. By implication so are cost figures. Read more below:
Here are the usual suspects:
If management does not write down inventory that has become obsolete they are overstating profit. If they make unnecessary write downs they reduce the profit figure. This affects costs.
Debtors (Accounts Receivable)
To reduce profits management can make provisions for bad debts that are too high. On the other hand, if they fail to make the necessary provisions profit will be overstated. This affect costs.
Fixed assets lose value due to market forces (second-hand assets are worth less) or wear and tear due to usage – or a combination of both. This loss in value (depreciation) should be reflected in the financials by charging the depreciation to the Income Statement and reducing the value of the assets on the Balance Sheet by the same amount. The amount of depreciation is determined by deciding on the estimated useful life of the assets. A longer estimate of the useful life will result in higher profits – and a lower estimate will result in lower profits. Estimated useful lives are arrived at subjectively which also affects costs.