Costs Analysis

MS Common Course 2022

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Course objectives

 Understand the importance of the knowledge, analysis and management of costs

in any organization and function

 Get familiar with the main tools to calculate and analyze costs in order to :

• Evaluate the firm’s and its different activities’ performance

• Make some decisions (investing, outsourcing, choosing between 2 scenarios, fixing
selling prices, etc)
• Simulate costs and results after changing some parameters

 At the end of the course, you will be able to :

• Identify cost objects and choose the right method according to the question raised
• Calculate and analyze the economical impact of a managerial decision
• Measure the products’ or customers’ or activities’ profitability

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 Agenda of the intensive session

 Introduction to Management Accounting; costing terms and purpose; costs

analysis

 Full costing and profitability

 Partial costs and simulation/decision

Evaluation : On line Quiz – Date to be confirmed

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References
 Course book reference: Drury C. (2019), Management Accounting for business,
Cengage Learning, Edition 10th

 Charles T. Horngren, George Foster, Srikant M. Datar, May 2020) Cost Accounting: A
managerial emphasis; Pearson / Prentice Hall International Edition-16th

 Cavélius et al. (avril 2019): Comptabilité de gestion : le pilotage des coûts, Éditions
Pearson, 2ème édition

 Demeestere, Lorino, Mottis (2017), Pilotage de l’entreprise et Contrôle de gestion,

Dunod

 Giraud F. et Zarlowski P.(2011), Fundamentals of Management Control, Éditions

Pearson (French and English)

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 Introduction
Cost Accounting: a tool for Management Control

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Management control: a definition which evolved
A constantly changing definition:
• Taylor: (1902): management process: monitoring activity, improving
productivity

• Sloan (1920): “management accounting” enabling the manager to assess

production costs: an evidence based monitoring tool

• Anthony (1965): “Management control is the process by which managers ensure

that resources are obtained and used efficiently and effectively to achieve
organisational objectives”: management tool through objectives, forecasts

• Simons (1990): “processes and procedures based on the information that

managers use to maintain or modify certain organisational configurations”:
information communication tool to ensure actions are consistent with strategy

• Bouquin (1994): “a set of activities, processes and systems that, guide

decisions, actions and behaviours in organisations, helping make them
consistent with long- and medium-term objectives, and based on information
systems”
from economic expertise to multi-criteria management

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Function and activity: Everyone is involved in management control eve... with
help from the management controller

• All managers undertake control activities

• Create a budget and check its implementation, analysing expenses and why
they are needed,
• Build and monitor performance indicators, monitoring a dashboard,
• Prepare an investment file,
• Present and comment on results in the Management Committee…

• The management controller is a management expert

• designs management tools and methods,
• produces and/or monitors information,
• leads management, ensuring management organisation and logistics,
• consults internally, providing advice and assistance for diagnosis, decision-
making, analysis, interpretation, and proposals
• teaches others, ensuring a transfer of skills to operational staff

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Various actors in the company and their management tools

Basically, roles are distributed as follows:

Choose a
strategy, guide Record events, report, in
particular to third parties
the work
Central
of operational Decision-makers Management Accountants
staff, decide, Controllers

manage the Budget – Dashboards Management Financial

company accounting accounting
Decentralized
Operational staff Management
Buy, produce, Controllers
sell, etc.
Analyse, interpret, propose

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 From financial accounting to management
accounting

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 A small group work

 groups 1 and 2: explain the different documents, usage, and users

for financial accounting documents
Financial statements for financial reporting purpose

 groups 3 and 4: what do you know about management accounting

and management control Detailed; for internal use; non-financial data combined

 groups 5 and 6: explain why financial accounting is limited for

General-purpose;
some internal management purposes GAAP compliance; Aggregated

 groups 7 and 8: find some structural differences between financial

accounting and management accounting

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 Management accounting: a specific information system that measures economic
facts according to each firm’s business model

 Two main objectives:

•Monitoring
•Support decision making and implementation (price setting, outsourcing decision, cost
reduction, diagnosis for other strategies,…)
•Induce alignment in managers towards organizational goals

• Support accounting processes (for instance, inventory valuation)

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Management accounting…cont.
 Information on business results, costs, resources, margins,…

 Different points of view (axis of analysis or cost objects)

• Firm: products, orders, markets, distribution and retail channels,…
• Hospital: DRG (GHM in France), pathology, departments…
• Activities
• Projects
• Responsibility center, business unit, …

 Focus on the particular information

needed for each situation

The ABC of DRGs: DRG adjustment and determinants of hospital cost

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 The various roles of management accounting

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Structural differences between management accounting and financial accounting
(1/2)

 There are no compulsory accounting principles for management accounting

• No legal standardization GAAP not required
• No need for external comparability
• But need for internal comparability (between units, products, along time)

 A « custom-made » system
• According to the specific needs of the economic sector, particularly strategic ones
• According to available information systems, management culture and historical context
Priorities, common values,
employee awareness, etc.

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Structural differences between management accounting and financial accounting
(2/2)

 Extent and precision of the information is very variable

• Management accounting includes and makes use of non financial information (regarding
activity, productivity, quality,…)
• Information can be very condensed or detailed, depending on the goals defined

 The time dimension:

• The periodicity of management accounting reports depends on the user needs: hourly,
daily, weekly, monthly, yearly,…
• These reports deal with historical information, real activity but also with expected results
(objectives, previsions, simulations, opportunity costs,…)

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Links between financial accounting and management control accounting
 Financial accounting informs on:
• Company’s worth and financial position: Balance Sheet
• Global performance: Profit & Loss Statements
 But Financial accounting does not inform on:
• The reasons for performance (why we earned or lost money)
• If a particular activity in the company is profitable or not
• How to choose between different options
• How to simulate results according to some assumptions

 Management accounting gives that information because:

• More detailed understanding of costs
• Non financial information (e.g. volumes)
• Different viewpoints (axis of analysis)

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Who are the users?
 Financial accounting
• Inside the firm: accountants record
transactions while managers take
financing decisions on the short and long-
run
• Outside the firm: shareholders, auditors,
financial analysts, potential investors,
banks, suppliers and customers (in order
to assess the durability of commercial
relationships). Consequently, this
information needs to be audited
(approved)

 Management accounting
• Only for internal use: management
accountants, financial accountants, cost
controllers, marketing department,
production department, every
responsibility center in its own perimeter,
and of course the general management of 17
 Synthesis: Management accounting and Financial accounting

Management accounting Financial accounting

Measures and reports financial information as well as Focuses on external reporting.
other types of information that are intented primarily Is mostly used by accountants, financial managers, external
to assist managers in taking decisions agents (suppliers, clients, banks, analysts, investors…).

Is organization-specific, with some legal restrictions, Is guided by prescribed accounting principles and is
but no regulation. Specific-purpose compulsory for all organizations.
Is not compulsory, not present in most small
companies General-purpose
Not audited Audited

Reports historical and current information and
provides information on expected future performance
and activities.
Very detailed, No GAAP
Variable reporting interval: monthly, weekly, hourly,
ad-hoc analysis…
Provides information for the past period.
Aggregate, GAAP (IFRS/SFAS)
Annual reporting (semi-annual and quarterly reports also
exist in some companies)

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 Costs terms and purpose

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 Definitions
The amount of economic resources acquired
 A Cost is a resource forgone to achieve a specific objective.
• It is usually measured as the monetary amount that must be paid to acquire goods and
service.
 A cost object is anything for which a separate measurement of costs is desired.
• It can be a brand (Taillefine), a product line (Taillefine natural yogurt), a reference
(Taillefine natural yogurt x4); a client; a project; an activity; in hospitals: Diagnosis
Related Groups, …
 Costs don’t necessarily result in expenses, all expenses are not costs…
• Acquisitions and investments: neither expenses nor costs, but decrease in cash and increase
in assets
• Depreciation allowances: don’t result in cash-out but constitute a cost and an expense

Economic resources which Economic resources

provide future benefits used

Assets Expenses
Unexpired cost Expired cost
Direct materials Inventory
Direct labor (MFG costs, Product costs)
Manufacturing overhead WIP Inventory
FG Inventory Cost of Goods Sold
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 Variable – Fixed costs
 Variable costs change in total in proportion to changes in the related level of total activity or
volume.

 Fixed costs do not change in total for a given time period despite wide changes in the related level
of total activity or volume.

 Whether a cost is variable or fixed with respect to a particular activity depends on

• The type of supply contract (ex. Telephone cost)
• the time span => More costs are variable with longer time spans.

(fc)
(VC) (v) (FC)

Proportional Constant Constant Decreasing

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 Direct vs indirect costs
 Direct costs of a cost object are those that are related to a given cost object (product,
department, etc.) and that can be traced to it in an economically feasible way without
any ambiguity

 Indirect costs are related to the particular cost object but cannot be traced to it in an
economically feasible way

 The direct/indirect classification depends on the choice of the cost object.

 The classification of a cost as direct or indirect can depend on the availability of

information-gathering technology, for example counter for production hours

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 Variable vs Fixed costs + Direct vs indirect costs

Can a cost be traced to a cost object?

Does a cost
change in
proportion
to the level
of activity?

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 Total Costs and Unit Costs

 A unit cost (also called an average cost) is computed by dividing some amount of cost total by some
number of units.
 The ‘units’ may be expressed in various ways:
– Hours worked
– Packages delivered
– Bicycles assembled

Use Unit costs cautiously!! Why?

Let’s have some practice! Storm Inc and Photocop

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Conclusion on this first part: costs diversity and diversity of decisions…

• Which cost for which decision and objectif?

Fix a selling price?

Manage clients portfolio?

Accept a special order?

Reduce costs?

Do or outsource?
Give up an activity?

Know the breakeven point?

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 Full costing

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 Rationale for full costing / total costing

 A full cost takes into account the whole set of costs inherent to a product
• Variable and fixed costs, direct and indirect costs
• Costs of supply, manufacturing, commercialization, overhead, administration,
…
 Managers frequently ask for the cost of products / services
• Pricing policy, business portfolio strategy,
• Cost cutting
• Caution: full costing should NOT be used for decision making on ending
products, outsourcing, … => relevant / differential cost – revenue analysis
• The structure of cost is an important element of competitivity for firms and
should be included in follow-up and reportings.
• Cost of good sold needed for financial accounting reporting

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 The problem of indirect costs: how to
allocate them to cost objects?

Cost Assignment

Direct Cost
Costs Tracing
Cost
Indirect Cost Object
Costs Allocation
?
Causal relation, Benefits received, Reasonableness

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 Methods to allocate indirect costs

 Constraints

• Simplicity (communication, swiftness, cost)

• « Good enough » modeling of « reality »

 Depending on the activity: single or repeated output?

 Depending on the complexity of the organization and information system

 Different methods in the world: coefficient method, costs pools method

(widespread in France) or ABC method (widespread in Anglosaxon countries)
depending on the context and activity

 In this course: we only see coefficient method

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Coefficient method

Indirect costs are affected to costs objects using one or several

coefficients

Total costs

Direct to the products Indirects to the products

Coefficient

Product A Cost Product B Cost Product C Cost

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Example: Biscuit Factory
Indirect costs allocation
Indirects costs are imputed to the products, in proportion to the direct costs.
Coefficient calculation: 147 000/ 300 000 = 0,49

Méthode des TOTAL Cookies Shortbreads Pound cakes

coefficients
Direct costs 300 000  70 000 200 000  30 000 
% coûts indirects 49% 70 000x49% 200 000x49% 30 000x49%

Coûts indirects
imputés (Indirect cost 147 000 34 300 98 000 14 700
allocated)

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Example: Biscuit Factory
Full costs and results

TOTAL Cookies Shortbreads Pound cakes

 

Volume (kg)   20 000 70 000 10 000

Selling price (kg)   10 6 6

Turnover 680 000 200 000 420 000 60 000

Total direct costs 300 000 70 000 200 000 30 000

Total indirects costs 147 000 34 300 98 000 14 700

Full costs 447 000 104 300 298 000 44 700

Cost per kg   5,22 4,26 4,47

Result 233 000 95 700 122 000 15 300

% profitability 34% 48% 29% 26%

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 Job-Costing and Process-Costing Systems

 There are two basic systems used to assign costs to products or services:
• Job costing
• Process costing

 In a job-costing system, the cost object is an individual unit, batch, or lot of a distinct product or
service called a job (specific to the customer’s need)
 In process costing, the cost object is masses of identical or similar units of a product or service.

Job-Costing System Process-Costing System

• Costs assigned to each job.
• Costs tracked through a series of
• Products have unique characteristics. manufacturing processes or departments.
• Products are uniform or relatively
homogeneous and produced in a large
volume.

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 Implementing job order costing

Identifying the job order that is the cost object

Identify costs directly linked to the job order

Identify indirect cost related to the job order

Identify the relevant application base to impute

indirect costs to the job orders

calculate the application base cost (coefficient)

Impute the indirect costs to the cost object

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 Process-costing
 In a process-costing system, the unit cost of a product or service is obtained by
assigning total costs to many identical or similar units.

 In a manufacturing setting, each unit is assumed to receive the same amount of direct
material costs, direct manufacturing labour costs, and indirect manufacturing costs

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 To conclude on this second part

 Need to assess the part of conventions attached to full costs, depending on:
• The method
• The indirect/direct costs relationship

 Is unit full cost relevant?

• It is functions of the business volume and the fixed/variable costs relationship
• Prefer the “total” full cost

 Impact of full costs on the income:

• Through inventory => Be careful about inventory!
• In such cases, it is risky to assess managers’ performance based on income

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 « The cost of a product is a construct »

 What type of cost are we talking about? Complete, direct, variable,…

 A cost often implies and includes calculation conventions
• How are indirect costs allocated to the full cost?
• On what activity is based a unit cost (« normal » or real)?
 Relative, intersubjective and conjectured nature of cost calculation

 It is necessary to specify:
• The goal of cost calculation
• The characteristics of the context
• The validity conditions of the calculation (clarification of definitions and hypotheses)

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 Partial Costs analysis and decisions

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 Examples of decisions where cost issues are important

 Should we buy a new machine or maintain the existing one?

 Should we change of supplier?
 Should we discount our product?
 Should we invest in equipment or rent it?
 Should we accept a special order request?
 Outsourcing: make or buy?
 Under resources constraints, which product / client should be favored?
 How should we price our products and services?

For decision making:

- Costs should never be analyzed without revenues
- Costs / revenues are only one criteria, not necessarily the most
important one => quality / customer loyalty / image, leadership…
- Historical costs / past costs are only used to help forecasting future
costs.

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 A first modelization of cost behavior: the Cost – Volume - Profit model
and breakeven analysis

 Cost-volume-profit (CVP) analysis examines the behaviour of total revenues, total costs,
and operating profit as changes occur in the output level, selling price, variable costs per
unit, or fixed costs.

 CVP is a very simplified model of economic reality:

• Changes in the level of revenues and costs arise only because of changes in the number of product (or
service) units produced and sold.
• Total costs can be divided into a fixed component and a component that is variable with respect to the
level of output. When graphed, the behaviour of total revenues and total costs is linear (straight-line) in
relation to output units within the relevant range (and time period).
• The unit selling price (p), unit variable costs (v), and fixed costs (FC) are known and constant.
• The analysis either covers a single product or assumes that the sales mix when multiple products are
sold will remain constant as the level of total units sold changes.
• All revenues and costs can be added and compared without taking into account the time value of
money.

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 Example of CVP analysis

 The shop Dresses by Mary can purchase dresses for £32 from a local factory; other variable costs amount
to £10 per dress. The local factory allows Mary to return all unsold dresses and receive a full £32 refund
per dress within one year=> no stock
 the average selling price per dress (p) is £70 ☞ variable cost per unit (v) = £42/unit
 Total fixed costs (FC) amount to £84,000.

 How much revenue will she receive if she sells 2,500 dresses? Would she show an operating profit or
an operating loss?
 Revenue: £70 × 2,500 = £175,000, Variable costs: £42 × 2,500 = £105,000
 Operating P&L: Revenue (p×Q) – Variable costs (v×Q) – Fixed costs (FC)
= £175,000 – 105,000 – 84,000 = (£14,000)

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 Example of CVP analysis

 Contribution margin per unit (cm)

= selling price (p) – variable cost per unit (v)
= £70 – £42 = £28 contribution margin per unit
 Contribution margin percentage (contribution margin ratio, cmr) is the contribution margin per
unit divided by the selling price.:£28 ÷ £70 = 40%

 How Mary could make her business profitable?

• Increase in sales (p×Q)? Increase the selling price (p)? Decrease in variable cost (v)? In
fixed cost (FC)?

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 Example of CVP analysis

 Suppose the management of Dresses by Mary anticipates selling 3,200 dresses.

 Management is considering an advertising campaign that would cost £10,000. It is anticipated
that the advertising will increase sales to 4,000 dresses.
 Should Mary advertise?
 3,200 dresses sold with no advertising:
 Contribution margin (£28×3,200) £89,600
 Fixed costs 84,000
 Operating profit £ 5,600

 4,000 dresses sold with advertising:

Mary should advertise
 Contribution margin (£28×4,000) £112,000
∵ Operating profit
 Fixed costs 94,000
increases by £12,400.
 Operating profit £ 18,000

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 Breakeven point

 Breakeven point is the sales level at which operating profit is zero.

• Sales – total variable costs – fixed costs = 0
• Selling Price x volume – variable unit cost x volume – fixed cost = 0
• Breakeven volume = Fixed cost / (Price – variable unit cost)
p×Q* – v×Q* – FC = 0
(p – v) × Q* = FC Unitary contribution
 Q* = FC  (p  v) = FC  cm

 Using the equation approach, compute the breakeven for Dresses by Mary.
• p×Q – v×Q – FC = 0
• £70Q – £42Q – £84,000 = 0
• £28Q = £84,000
• Q = £84,000 ÷ £28
• Q = 3,000 units

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 Breakeven point representation

Q > Q* ☞ (p – v)×Q > FC ☞ Profit

p×Q – (FC + v×Q) Q < Q* ☞ (p – v)×Q < FC ☞ Loss
= (p – v)×Q – FC
= cm×Q – FC

Sales p×Q
Value

Break-even point PROFIT Product costs FC + v×Q

BE Sales
FC + (p – v)Q*
FC Fixed costs
LOSS Variable costs v×Q

Volume (Q)
0
BE Q* = FC  (pv)
p×Q – (FC + v×Q) =0

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 The use of breakeven analysis

 Used in all business plans

 Feasibility analysis
 Cost behavior, profitability diagnosis, risk level of an activity
 Base for Casemix for hospital management

Value Profit p×Q – (FC + v×Q)

= (p – v)×Q – FC
= cm×Q – FC
LOSS PROFIT

Breakeven

0 Volume (Q)
BE Q* Actual Q
= FC  (pv)
Fixed costs
(FC)
Safety margin
Actual Q – BE Q*

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 Limitations of the model: Implicit assumptions

 Antecedents (PV, productivity…) and « sales mix » constant

 Costs and sales: linear functions--> relevance interval ☞ Range of activity over which a company
 Easy variable/fixed distinction expects to operate during a year.
 Simplistic model: only one variable, volume
• For many costs, volume is not a relevant variable
 The variable/fixed distinction depends on the time horizon

Value
Product cost for economists

Product costs for accountants

Volume (Q)
0
Relevance interval
 Let’s practise with Montvert!

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Relevant costs and revenues

 Model more sophisticated than CVP analysis

 Relevant costs and relevant revenues are expected future costs and revenues that differ among
alternative courses of action.
 Historical costs are irrelevant to a decision but are used as a basis for predicting future costs.
 Sunk costs are past costs which are unavoidable.
 Differential profit (net relevant profit) is the difference in total operating profit when choosing
between two alternatives.
 Differential costs (net relevant costs) are the difference in total costs between two alternatives.

When facing different scenarios, don’t consider the total

cost, but only the relevant costs and revenues that are
impacted by the decision.

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 Example: Noel

 Noel manufactures bath towels.

• The plant has a production capacity of 44,000 towels each month.
• Current monthly production is 30,000 towels.
• The assumption is made that costs can be classified as either variable with respect to
units of output or fixed.
• Variable manufacturing costs per unit are:
• Direct materials: €6.50
• Direct labor: €0.50
• Manufacturing costs: €1.50
• Total fixed direct manufacturing labor amounts €45,000
• Total fixed overhead is €105,000
 What is the full cost per towel?
 A Hotel group has offered to buy 5,000 towels from Noel at €11.50 per towel. Only
variable manufacturing costs would be impacted. Should Noel accept this order?

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 Example: Noel

 Cost per towel

(Total variable cost + total fixed costs) / total output
= (8.5 x 30,000 + 150,000) / 30,000 = € 13.50 per unit
 Which costs and revenues are impacted by this special order?
Here, the relevant costs of making the towels are variable costs only
8.5 per unit
Relevant revenue = 11.50 per unit
=> €3 of contribution margin per towel => € 15,000 for the total order.

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 Pitfalls to avoid

 General assumptions:
 Do not assume that all variable costs are relevant.
 Do not assume that all fixed costs are irrelevant.

 The Cost-Volume - Profit model (with breakeven) oversimplifies economic reality. We

generally need to turn to more sophisticated relevant costs/ revenues model.

 Unit-cost data can potentially mislead decision makers:

 Irrelevant costs are included.
 The same unit costs are used at different output levels.

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 Opportunity costs

 Opportunity cost is the contribution to profit that is foregone (rejected) by not using a limited
resource in its next-best alternative use.
 Opportunity costs are not recorded in formal accounting records since they do not generate
cash outlays.
 These costs also are not ordinarily incorporated into formal reports.

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 Costs and pricing policy
 Infinite number of ways depending on the economic sector, the past of the firm,…
 The cost is only one of the elements to take into account when making a decision
• Competition
• Customers capacity
• Value attached to the offer
 Cost + Margin
-Differentiate « special sales » from the usual price tag
-Consider mid-term impact, synergies in the product portfolio (loss leader)

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 Course conclusion

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 What we have covered in this one-day course on Costs Analysis:

 The financial accounting, management accounting, cost control articulation

 The different notions of cost and their use
 Full costs: their use, main principles of calculation
 Reasoning on partial costs: profitability threshold/breakeven point, relevant
costs/meaningful for the decision, differential costs, opportunity costs

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 Key takeaways

 Management accounting deals with information concerning the acquisition and

consumption of resources in order to facilitate managers’ decisions:
• Accounting tools, relying on financial accounting and other information systems
• Intended for cost controllers and managers
• Principles, general methods but no compulsory use: practices and customs differ from one firm
to the other
 Management accounting is one tool among others for Management Control : budgets,
scorecards, indicators, global performance management
 These tools are contextualized according to the business model of the firm and the
function/sector controlled : see in your specialized master!

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