2.35 Intermediate (Collin Drury) - 1713

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(a)          ‘Discretionary costs are troublesome because managers usually find it difficult to separate and quantify the results of their use in the business, as compared with variable and other fixed costs.’

You are required to discuss the above statement and include in your answer the meaning of discretionary costs, variable costs, and fixed costs; give two illustrations of each of these named costs.

(b)          A drug company has initiated a research project which is intended to develop a new product. Expenditures to date on this particular research total £500,000 but now it is estimated that further £200,000 will need to be spent before the product can be marketed. Over the estimated life of the product the profit potential has a net present value of £350,000.

You are required to advice management whether they should continue or abandon the project. Support your calculation with a numerate statement and state what kind of costs is the £500,000.

(c)           Opportunity costs and notional costs are not recognized by financial accounting systems but need to be considered in many decisions taken by management.

You are required to explain briefly the meanings of opportunity costs and notional costs; give two examples of each to illustrate the meanings you have attached to them.

Solution Description

(a)    A large proportion of non-manufacturing costs are of a discretionary nature. In respect of such costs, management has some significant range of discretion as to the amount it will budget for the particular activity in question. Examples of discretionary (sometime called managed or programmed costs) include advertising, research and development, and training costs. These is no optimum relationship between inputs (as measured by the costs) and outputs (as measured by revenues or some other objective function) for these costs. Furthermore, they are not predetermined by some previous commitment. In effect, management can determine what quality of service it wishes to purchase. For example, it can choose to spend small or large amounts on research and development or advertising. The great difficulty in controlling such costs in that there is no established method for determining the appropriate amount to be spent in particular periods.