Finance with a review of accounting

Cost accounting

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Example of analysis per product line
The planning and monitoring cycle
The yearly budget
Analysis of discrepancies and corrective actions
More on cost centers and profit centers



Cost accounting
Today, we shall talk about elements of cost accounting, unit costs, and planning and budgeting. It is the last lesson of quick review of accounting procedures, to be in a good position to understand financial reasonings, techniques and results.

General accounting insufficient to manage a firm. Too crude
General accounting records transaction in a small collection of accounts of different nature (salaries, debtors, stocks, cash, creditors, bonds, etc.). It leads to two main year-end documents : the income statement and the balance sheet. These two year-end documents give a bird's-eye-view of how the firm did during the past twelve months and what is its situation today. But they are quite insufficient to manage the firm.

And turned to the past
The income statement and the balance sheet are turned to the past. The balance sheet for the year n-1 is ready only in March or April of year n. And they are very global : typically they lump all the sales in one account, they lump the salaries in one account, etc.

Cost accounting goes into much more details. And turned towards the future
The objective of cost accounting is to go into much more details, to analyse the operations of the firm in small units, to give results per significant subdivisions of the firm. Finally, it is the main tool to prepare plans and budgets. Modern firms are run relying heavily on plans and budgets, and then on monitoring how close we follow the budget, analysing discrepancies, and taking corrective action. Cost accounting also produces "cost per products", which are important to establish price lists. This cannot be done only from the figures produced by general accounting.

Private documents
Note that General accounting final documents must be made public, whereas Cost accounting documents are private, and you don't want your competitors, clients or suppliers to know them.

Fundamental to evaluate physical investments
Cost accounting will also play a major role in evaluating physical investments: when a physical investment is contemplated (new machinery, plant extension, new plant, advertising campaign, R&D program, etc.) the first step is to compute as accurately as possible the costs and future cash flows the investment will entail. This is traditionally called "number crunching". Then more specifically financial tools will be used to evaluate the investment. In short: if the present value of all the future extra cash flows is higher than the money to put up front, then it is an investment worth considering, otherwise it is a waste of money.


Example of analysis per product line

A bicycle manufacturer with two product lines
Consider a bicycle manufacturer who makes two types of bikes, adult bikes and kid bikes. It made, last year, 5000 bicycles. And it has the following income statement for last year.

This general accounting document does not tell us enough to manage the firm
This tells us that the firm had revenues of 1,75 million euros, direct costs of 1050 thousand euros (direct costs are those costs which are directly proportional to the level of activity ; if the firm produced twice as many bikes of each type, the direct costs would become 2100 K€ ; they are also called variable costs), etc. Since we are told that the firm sold 5000 bicycles, we can even compute the average selling price per unit : it was 350 € (it is a manufacturer of high end of the line bicycles !).

We need figures, results and performance measures per product line
The above figures do not tell us how the firm did per product line. And it does not tell us whether the firm achieved its objectives for last year. For that, we need much more detailed accounting results. We need to distinguish sales of adult bikes from sales of kid bikes. We need to distinguish salaries of workers in the various manufacturing departments (sawing, welding, assembling, etc.), we need to distinguish costs per fine nature, per product line, etc.

Simple figures per product line
Here is a first illustration of what cost accounting can produce. The above income statement is now split into two product lines, and some of the costs are clearly linked to one or the other of the product line.

This information is more interesting and useful to manage the firm than the first global income statement.
We see results per product line. The kid line is less profitable than the adult line. As we can see, not all the costs are split between the two product lines. As far as factory overheads and the other costs are concerned, only allocation keys can (artificially) compute costs per product lines, and produce a net result per product line.

(Overheads = "frais généraux", they are not directly proportional to activity ; factory OH (overheads) include the cost of supervisors, the maintenance costs, the material handling costs, forklift truck drivers, electricity - except that powering machines -, etc.)

Cost centers
In cost accounting, each small area of the firm (in various splits of the activity of the firm) where costs of the same nature are accumulated is called a cost center :
- steel purchases in the raw materials for the kid line is a cost center
- salary of assembly workers in the adult line is a cost center
- salary of maintenance workers (here included in the factory OH) is a cost center
- etc.

Profit centers
A subdivision of the activity of the firm to which we can assign a sale figure (on top of costs) is called a profit center. Then we can compute a profit per profit center. It is not necessarily a net profit ; it may be just a contribution (another name for profit after variable costs), before other non allocated costs. The typical typologies of profit centers are :

  • per product lines
  • per regions of the world
  • per type of clients

The real life case of Lego
To understand the management of firms with several product lines, the strategic choices to be made, and the problems we may run into, read this article on Lego. Lego is a famous toy manufacturer, founded before WWII, which has been extraordinarily successful for decades, and which had run into severe problems in the last five to ten years.

IMPORTANT: data on the environment: markets size, growth, market shares, etc.
All too often, firms tend not to pay enough attention to their environment: markets size, growth, market shares, competitive positions, what competitors do, what choices they made, clients, suppliers, legal environment, etc. The so-called N.I.H. syndrome ("not invented here") to downplay the importance of competitors inventions is still frequent. Back to our made-up example of a bicycle manufacturer, let's suppose the market and competitive situations are as follows :

  • The adult bike market is 5 million euros,
  • It is a mature market growing 2% per year in value. Next year it will be 5,1 million euros.
  • The firm is the leader, and holds a market share of 20%
  • The kid bike market is a new market, fast growing and already larger than the adult bike (remember this is a made up example)
  • The kid market is 15 million euros
  • Its yearly growth in value is 10%, that is next year it will be 16,5 million euros
  • The firm holds only a 5% market share, it is not the leader on this segment of market
  • The firm is a historic leader of the adult bike market but is a new entrant into the kid bike market, and it is hoping to catch up, with appropriate managerial decisions (allocation of resources in R&D, innovative design, "aggressive" promotion, etc.)

With these pieces of information, the P&L is more meaningful
With the market and competitive situations described above we can better understand the detailed P&L : the firm is leader in the adult bike segment, it has a well oiled efficient manufacturing process, the design has been optimised, the costs are well under control, and the adult bikes generate a good margin after variable costs of 45% on sales. In the kids segment the firm is new, it created an ambitious design to try and catch up a good position in the market, but so far it is costly, and the manufacturing process is not streamlined yet ; and even though kid bikes are simpler to manufacture and require less raw mat than adult bikes, the product line so far generates less margin after variable costs : only 33%.

Cost accounting deals with more accounts than this example, but the principles are there
This example is designed to give us a flavor of what cost accounting (also called managerial accounting) can give us and enable us to do. It is obviously necessary to have such information, and more, to manage correctly our firm.

Cost model, direct costs, overheads, allocations keys
In the cost accounting process we have to keep track not only of the sales per type of bike, but also as much as possible the expenditures per type of bike. For some of the expenditures it is straightforward or reasonably easy: for instance the salary of the workers directly working on the products. For other expenditures we cannot attach them to specific products: for instance the factory overheads, or the administration expenditures.

Managing is taking decisions
Managing a firm requires to constantly take decisions, every day concerning the day to day operations, as well as once in a while decisions of more long term, or even strategic, consequences. That's why managers are also called "decision makers".

Strategic decisions
An example of strategic decision is "Should we try to increase our position in the kid bike market or not ?". Examples of other strategic questions are :

  • "Should we outsource the cheap bikes from other countries and focus on more expensive bikes ?" that way we would still offer a complete range of products, but only manufacture ourselves the high end of the range
  • "Should we manufacture ourselves all the small gears or source them from Campagnolo, or Shimano, or elsewhere ?"
  • "Should we enter the market for motor cycles ?"

Operational decisions
There are also plenty of operational decisions to take very often. For instance, our supplier of steel tubes becomes more expensive, "Should we change supplier ?". What are the consequences ? One of our machine takes more and more time to set up when we change models, because it is getting old, or it produces more and more waste. "Should we replace it ?" We anticipate a temporary increase in the market, "Should we go two shifts instead of one, or hire temporary workers ?", etc.


The planning and monitoring cycle

All modern firms are run, by the management, using a planning and monitoring cycle.

a. The strategic plan : typically, every five years, firms establish a long term strategic plan, setting out the directions of development they want to follow. This is done after careful examination of markets per segment of activities, their possible evolution, the firm's "positions", the positions of competitors (in terms of market share, likely cost per product - they are not necessarily the same as ours -, mastery of product and of production technology, control of distribution networks, etc.)

Business strategy is very much like military strategy : target positions we want to reach per segment of market (kid bikes and adult bikes), analyse our strengths and weaknesses, those of our competitors (try to obtain as much information as we can on them, via the information they publish, articles, trade organisation information, clients, distributors, suppliers, models of how their costs must behave, scale effects, labor costs, etc.). And then make a long term plan of where we intend to put our efforts. In the business world, and in business wording, "effort" means "resources" and in the end means "money". We can also think of the game of Go.

b. The three year plan (with the acceleration of business evolution, this is often included in the strategic plan) : The strategic plan is transformed into a quantified plan with quantified targets in terms of sales, and costs per product lines, for the next three year. It is updated every year, according to how things unfold.

c. The yearly budget : The yearly budget is a very important tool to manage the firm. Every year, around its end, in october and november, all managers spend some time planning in great detail the sales they intend to reach per segment of activity, and the expenditures they plan to make in each cost centers.

d. As the new year unfolds, we check if we are in line with the budget, we note when discrepancies appear, and we analyse the discrepancies to find out the causes.

e. Take corrective actions

We go like this up to the end of the year, and the the cycle starts over again...


The yearly budget

A fundamental tool of management of the firm. Keeps a large part of the middle management busy for several weeks in the last three months of the year
In the last two or three months of the year, a good part of the management of the firm, as well as people in the accounting dept, are busy establishing the budget for next year. It is a set of detailed targets in terms of revenues and costs, that we plan to follow. How is it done ?

Begin with market forecasts, and market shares and sales targets. Segment by segment
We start with setting sales targets. In the bicycle manufacturer example, last year sales were 1 750 000 euros. What is a reasonable target for next year ? Business people don't pull out a number out of their [top] hat, they approach this question using analysis and rationality. It mixes up forecasts about the anticipated evolution of the market, and plans about the position we will try to achieve.

Impossible to forecast rationally the global sales directly
Setting sales objective is done market segment by market segment.
A forecast is a best guess (using as rationally as possible all the information we have) of what something outside our control will become. We forecast the weather tomorrow, we don't plan it. A plan is a chart we prepare, and we intend to follow as much as we can. We plan to go to beach, if the weather forecast is good. We may also prepare alternative plans, in case the weather turns out not to be what we had forecast.

Estimate market growth, and forecast market size per segment
First of all we forecast the growth of the market per segment. Suppose, as explained above, that we anticipate a 2% growth in value in the adult bike market, and a 10% growth in value in the kid bike market. (To keep this classroom example simple, let's not anticipate any movement in price for the bikes. The adult bikes sells for 500 € apiece, and the kid bikes for 250 €.) Secondly we plan to maintain our market share of 20% in the adult market, and we think that we can reach a market share of 7% in the kid market. We plan to spend more money in advertising than our competitors, and think that we can take advantage of a new design they don't have. Increasing market share is very difficult in mature markets, because all the competitive positions are rather entrenched, and steady. This is particularly true when we are the leader. In fast growing markets things are much more fluid. Positions evolve quickly. Some players will gain market shares, and necessarily some others will lose market share (there are only 100 percentage points in 100 !). If we have an advantage one way or another over our competitors, we may be able to turn it into more market share, and eventually more profit. There is more to say about this, but it is outside the scope of this quick review of cost accounting. Remember, cost accounting (that is accounting revenues and expenditures in a much more detailed manner than general accounting does) is necessary to establish a meaningful and achievable strategy, to prepare a budget and to manage the firm.

Sales: application to our small example
Our budgeted Sales figures are :

  • in the adult market : 5,1 million x 20% = 1 020 000 euros
  • in the kid market :  16,5 million x 7%   = 1 155 000 euros

Therefore we shoot for a 2,175 mio sales figure for the coming year, compared to 1,75 mio during the year just elapsed.

What about the costs? A very simple cost model
In a very simple cost model, there are two types of costs :

  • those which vary exactly proportionally to the level of activity (they are called direct costs, or variable costs),
  • and those which do not vary proportionally to the level of activity, but are either fixed or vary much less, or depend upon our choice of effort (like the selling and distribution costs, for instance)

What is a cost model
A cost model is a complete description of the links between the levels of activity and the various costs generated in the firm. The simplest cost model in a firm, used to teach cost accounting, considers that some costs are directly proportional to levels of activity and the others are fixed. Of course, this is an oversimplification, designed to introduce the concept. We can refine cost models ; we can make them very elaborate ; but we must keep in mind that too elaborate cost models are generally misleading, and hide disconnexion from reality behind illusory complexity. In accounting, and in running firms, a large dose common sense, on top of analyses and calculations, is required.

What is a business model
Sometimes, you will hear about business models, for instance : "the business model of Dell Company works very well". A business model is a set of assumptions and relationships between markets, market shares, prices and costs, describing the way the economics of an industry work, and that enable one to more or less predict the profitability of a certain type of business organisation. For instance, Dell Company is based on a business model of the market and industry of microcomputers that leads to the conclusion that it is more profitable to sell directly to end customers, via ads in magazines, via hotlines, and via the Net, without "brick and mortar" retail shops, or even wholesalers, than to use a traditional selling organisation and distribution network. The startling success of Dell proves that its business model is a good one !

Costs: application to our small example
Back to our simple cost model : we assume, in our simple classroom example, that Raw mat, Direct labor, and Direct expenses are exactly proportional to the level of activity of the product line, and that the evolution of the level of activity is measured by the number of bikes produced. Since prices don't change, the levels of activity are equivalent to the levels of sales.

Our level of activity will grow by

  • 2% in the adult segment (= 1,02 / 1,0)
  • 54% in the kid segment (= 1.155 / 0,75)

This gives us the budgeted variable cost figures (make sure you can calculate by yourself the direct cost figures presented in the table below).

Budgeting non variable costs
On top of that, suppose we intend to reduce Admin costs from 100 000 € to 80 000 € (they are always too high :-) !), and that we will spend more money in Selling & Distribution. We don't plan to change R&D expenditures.

R&D expenditures concern two different areas : product design and improvement, and production design and improvement. In the old days, before WWII, these two areas were worked separately ; the product people would come out with new products, and then the production enginers had to figure out how to manufacture them. Over the last generation, this changed : now products and their production processes are developed jointly. This makes for much more efficient production processes. The idea of modularity, with standard parts, is only one example of product design taking into consideration production. A generation ago, the development of a new car took ten years ; ten years elapsed between the first drawing on a drawing board, and the first car coming out of the assembly chain. With new design and engineering methods, now this period has been reduced to about three years !

Next year budget (built rationally)
We get the following budget for next year :


Analysis of discrepancies and corrective actions

Suppose our January expenditures in one of the cost centers is different from the budgeted figure
Suppose the activity of a normal year is evenly distributed over the twelve months, that is, each month represents one twelfth of the activity of the year (a highly unrealisic hypothesis, but let's not make our example more complicated than necessary). Suppose then that at the end of the month of January of this year, our cost accounting system indicates that we actually spent 35 000 € in Raw materials in the kid bike product line. Is it OK or not ?

Answer : No, it is not in line with our budget. Our actual expenditures are higher than budgeted. According to budget it should have been 32 083 €. There is an unfavorable discrepancy ("discrepancy" is another word for "difference") of almost 3000 € (or 9%) more than budgeted.

List of possible causes before taking action
Before taking a possible corrective action, we must find out the cause of this discrepancy. Here the cause can be one among many, which are quite different :

  • May be we simply produced more kid bicycles than planned. If we produced say 450 kid bicycles, then not only should we not worry, but we do even better than the normal Raw mat cost per bike ! Mind you, if we produce more bikes, we shall have to sell them, if we don't want to have increasing stocks... So it is good news only to a point.
  • May be the price of our supplier of steel tubes went up. We have to see what to do about it : Change supplier (always a complicated action) ? Purchase steel in larger bulk ? Increase the final bike selling price ?
  • May be the machines in the manufacturing dept are getting old and produce more waste. Should we change machines ?
  • May be the work force does not work as well as before. We must find out why.

The planning, monitoring and corrective action cycle
We see that, depending upon the cause of a discrepancy, we shall take different corrective actions. Don't lose sight that the planning and monitoring cycle system of management is just very much common sense. Budgets may be updated in the middle of the year.

Budgets are a very commonsense tool to manage firms, or families. But governments, even though they talk a lot about budget, are still reluctant to apply seriously these tools and procedures to their operations.


More on costs centers and profit centers

Cost accounting procedures are not different from general accounting's
The accounting techniques in cost accounting are exactly the same as in general accounting : double-entry accounting, every transaction is recorded into the journal, and then posted into accounts. If it is, for instance, the payment of a salary of a direct worker by check, the bank account will be credited and we shall debit the corresponding expenditure where appropriate.

Fine division of accounts
But now "where appropriate" is not longer just "the salary account" : we shall divide the "salary account" into many "salary accounts" to keep track exactly on what we make our expenditures. Say, for instance, that in our manufacturing process there are six meaningful areas where we want to trace direct labor :

  • kid bike product line : sawing steel tubes
  • kid bike product line : welding the frame
  • kid bike product line : assembling the bike
  • adult bike product line : sawing steel tubes
  • adult bike product line : welding the frame
  • adult bike product line : assembling the bike

Recording system of direct costs into different accounts. Time sheets
These will be the six manufacturing direct labor accounts. If the salary we pay pertains exactly to one account, we debit exactly one account. But in small firms workers work in different areas over one month, then they usually fill out card where they note exactly where they worked when. These cards go to the accounting dept, cost accounting section, and the accountants use them to debit exactly the proper accounts. For example, if a worker shows on his card, that for the month of February he worked 1/3 of the time in kid welding, and 2/3 of his time in adult assembling, and his monthly salary is 1500 euros, then the bank account is credited 1500, the "manufacturing labor kid welding account" is debited 500, and the "manufacturing adult assembling account" is debited 1000. This way, as always, the double-entries are balanced. Technically, accounting departments procedures may be a bit more involved, but the principle is the same as the one described above. So, at the end of the month of February, we know precisely how much money we spent in manufacturing kid bike sawing area.

Numbering system of cost centers
Each area of the firm where we want to keep a separate account of the expenses, is called a cost center. Accountants usually use elaborate numbering systems to name their cost centers.

Profit center: aggregation of cost centers to which we can attach a sales figure
A profit center is a part of the activity of the firm to which we can not only attach some specific cost centers, but also a part of the sales. In our example there are two profit centers : kid bikes and adult bikes.

Usual splits of profit centers
In elaborate accounting systems, the usual split to define all the profit centers is by :

  • type of product manufactured
  • geographic areas of sales
  • size of clients : national accounts, large regional distributors, small clients...

Cost centers which require allocation keys into various profit centers
Some cost centers clearly belong to one profit center (like "manufacturing kid bikes welding") and some do not (like : "factory overheads", or "general and administrative expenses", denoted G&A).

Contributions = margins (per profit center) after all specific (ie, clearly allocatable) cost centers
So, we can meaningfully compute a margin after all specific cost centers, in each profit center (in our example, the margin after variable costs, also called the contribution), but usually we cannot compute a meaningful bottom line per product line. We shall see, in the second part of the lecture, how we get around this ; because we need to know "our costs per bike" in order to fix our prices.

Back to our example
If we look at last year's accounts, we know that we produced 5000 bikes for a total expenditures of 1,6 million euros, this yields an average cost per bike of 320 €. But this is not a useful information to set prices. If we set the price of all our bikes to 350 €, we would sell no kid bike, and we would sell a lot of adult bikes, but it would create plenty of problems in our factory : idle workers in the kid line, overworked workers in the adult line, not enough revenues, etc. This is not realistic. We have to set different prices - of course - for kid bikes and for adult bikes. But which ones ? We shall explain this in a few minutes.

Cost accounting (= managerial accounting) is necessary to manage a firm
Now, we see where cost accounting is driving at: producing accounting information, much more detailed than what general accouting does, and that is useful to manage our firm. General accounting is legally required, turned toward the past, not detailed, must be published, and is insufficient to manage the firm. Cost accounting is the exact opposite, or complement : it is turned toward the future, it is not legally required, you definitely don't want to publish it, and it is necessary (and sufficient as far as accounting is concerned) to run the firm.

Responsibles for cost centers
In the process of preparing the budget for next year, we start with a forecast/plan of volumes of sales per profit center, and, forecasting price evolution, we forecast our sales in monetary units. Then, this is translated into measurements of activity in every part of the firm. Every cost center has a person responsible for it. That person provides an estimation of the costs that will be incurred in the cost center. Usually this is the result of discussions with the managers above ; objectives are set, rewards are promised, etc.

Cost accounting also useful to evaluate physical investments before deciding to launch them
Preparing a budget is only one aspect of planning the future. Cost accounting is also fundamental to evaluate future cash flows expected from an investment, and therefore to analyse, compare, and select investments. That is why not only general accounting, but also cost accounting are necessary tools for finance.


break time

Go to part two