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What is Discretionary Cost Ratio and How to Compute it?

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Discretionary-cost ratio is used to analyze those cost that may easily be changed by management. Discretionary costs may be decreased when a company or department is having problems and desires a stable earnings trend. Discretionary costs include advertising, research and development, and repairs and maintenance.

There are three types of users who usually utilize discretionary ratios: (1) Financial Analysts; (2) Financial Managers; (3) Credit and Loan Officers. Each of them, with different purposes, utilize it in different ways. Therefore, each of them also has different point of views in interpreting the results they get.

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So, how to compute discretionary-cost ratio and how each user us the ratio? Through this post I show you how to compute the ratio (with a light case example) and how each type of user use the ratio. Read on…

How Is Discretionary Cost Ratio Used

Financial Analysts – Financial analysts recognize that a pull-back in discretionary costs results in overstated earnings from an analytical point of view. This move may have a long-term negative effect because management is starving the company of needed expenditures. Thus, business managers should note that cost-reduction programs may sometimes eliminate those costs necessary to compete and prosper effectively.

Financial Managers – Financial managers, however, cannot always conclude that any reduction in discretionary costs is improper. The reduction may be necessary when the prior corporate strategy is deficient or ill-conceived. Further, a reduction in discretionary costs (e.g., advertising) may be appropriate when a major competitor has gone out of business.

Credit and Loan Officers – Credit and loan officers should determine if the present level of discretionary costs conforms with the company’s prior trends and with current and future requirements. Index numbers may be used in comparing current discretionary expenditures with base-year expenditures. A vacillating trend in discretionary costs to revenue may indicate that the company is smoothing earnings by altering its discretionary costs. A substantial increase in discretionary costs may have a positive impact on corporate earning power and future growth.

How Is It Computed?

1. Discretionary costs/sales:

Discretionary Cost / Sales

2. Discretionary costs/related asset:

Discretionary Cost / Related Asset

Case Example

A company’s discretionary costs for two years are:

Years                                                                    2011                       2012

Repairs and maintenance                            $ 10,000              $6,000
Sales                                                                      100,000              110,000
Fixed assets                                                       200,000              230,000

The ratios are:                                                   2011                     2012
Repairs and maintenance/sales                10%                        5.5%
Repairs and maintenance/fixed assets   5%                          2.6%

The declining trend in the ratio of repairs and maintenance to both sales and fixed assets indicates that the net income of the company is overstated and there is inadequate maintenance of fixed assets, leading to possible future breakdowns. Although there are short-term benefits, the situation suggests that its continuance would have a detrimental effect in future years.

 

Analytical Example

The following relationship exists between advertising and sales:

Years                                     2011                        2012                             2013

Sales                                      $120,000             $150,000                    $100,000
Advertising                        11,000                   16,000                          8,000

2011 is the most typical year. Increasing competition is expected in 2014.

Advertising to sales is 9.2 percent in 2011, 10.7 percent in 2012, and 8 percent in 2013. In terms of base dollars, 2011 is assigned 100. In 2012, the index number is $16,000/$11,000 = 145.5; and in 2013 it is $8,000/$11,000 = 72.7. These are negative indicators regarding 2013. Advertising is at a lower level than in previous years. In fact, advertising should have risen due to the expected increased competition.

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