Discretionary spending as a source of model specification bias in statistical cost estimation

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Management spending discretion allows certain necessary expenditures to be timed according to funding. Statistical cost estimation uses ex post data to estimate incremental costs. When funds available for discretionary spending include revenues from current operations, discretionary fixed costs may appear to be variable because revenues and activity are correlated. Statistical association of cost with activity volume is biased by management spending in a pattern of apparent income smoothing. For such expenditures, statistical cost estimation must be supplemented with other analytic procedures. The article demonstrates the existence of model specification bias in cost estimation due to the discretionary timing of expenses. The severity of the bias is measured for a sample industry. The methodology developed allows assessment of statistical significance and relative magnitude of bias present in estimates of variable cost.