Cost accounting
Introductory lecture
1. The need for detailed accounting
information
2. The planning and monitoring cycle
3. The yearly budget
4. Analysis of
discrepancies and corrective actions
5. Costs
centers and profit centers
6. Readings
1. The need for detailed accounting information
Today we start the second half of the accounting course, which is called cost accounting (aka managerial accounting).
So far we studied general accounting. We recorded all the transactions of the firm into the journal, and posted them into a small number of accounts: sales, purchases, rent, salaries, etc. plus some adjustments.
General accounting provides once a year a good synthetic view of the year just finished, with the profit and loss account and the balance sheet. The balance sheet lists, in a manner that you will eventually find simple, all the belongings (= assets) of the firm, and all the "initial origins" of these assets (capital from the shareholders, retained earnings, bank loans, credits from suppliers, etc.). The profit and loss account lists the sales figure and all the expenditures of the year.
This accounting is legally required. The P&L and the balance sheet are public documents that firms must publish. It is turned toward the past. It doesn't give detailed information about the operations of the firm, the accounts are too aggregated.
The information provided by general accounting is insufficient to manage the firm. Managers need much more detailed information on the sales and on the costs to have a proper view of the firm and to take appropriate decisions.
Let us take a look at a made up example of a bicycle manufacturer. Suppose this firm manufactures two types of bicycles: adults bicycles, and kids bicycles and sells them on the french market. The P&L produced by general accounting will be for instance this:
(I changed the numbers from what was given during the lecture)
| P&L account | ||
| thousand euros | ||
| Sales | 1750 | |
| Raw mat | 550 | |
| Direct labor | 400 | |
| Direct expenses | 100 | |
| Fact OH | 200 | |
| Admin | 100 | |
| R&D | 100 | |
| Selling&Distrib | 150 | |
| Profit or Loss | 150 | |
This tells us that the firm sold for 1,75 million euros of bikes, the raw materials consumed were 0,55 million, etc. It made a profit of 150 000 euros. Fine !
But what about the performance per product line ? We need of course to know the sales per type of bicycles. This will not require much elaborate procedures in the accounting process to obtain, we just have to keep track of that when we sell bicycles. But we also need to have an idea of the costs and profitability per product line. One step toward such information would be to establish a more detailed P&L for the past year 2003 as follows :
| (thousand euros, except when specified) | Total | ||
| Kids bikes | Adults bikes | P&L | |
| Volume (=number of bikes) | 3000 | 2000 | |
| Price per unit (euros) | 250 | 500 | |
| Sales | 750 | 1000 | 1750 |
| Raw mat | 250 | 300 | 550 |
| Direct labor | 200 | 200 | 400 |
| Direct expenses | 50 | 50 | 100 |
| Margin after variable costs | 250 | 450 | 700 |
| Margin/sales | 33,3% | 45,0% | 40,0% |
| Fact OH | 200 | ||
| Admin | 100 | ||
| R&D | 100 | ||
| Selling&Distrib | 150 | ||
| Profit or Loss | 150 |
This presents the very beginning of what a cost accounting system may produce : Sales per product line, Direct costs (aka Variable costs) per product line, the idea of a margin after variable costs per product line. We readily see in this example that the kids bikes generate less margin, in percentage, than the adults bikes.
To comment upon this detailed P&L, let's suppose the market and competitive situations are as follows :
This description may seem artificial, yet it is quite typical of real life. Read the article on LEGO company that is having great troubles because it did not succeed in the new kids toys segment : lego article, Le Monde, march 2, 2004. (Have it translated by a friend if necessary.)
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 kids 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%.
This first 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.
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 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".
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 :
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.
2. The planning and monitoring cycle :
All modern firms are run, by the management, using a planning and monitoring cycle.
a. The strategic plan : every five to ten years, firms will establish a long term strategic plan, setting out the directions of development chosen. This is done after having carefully considered the markets by segment of activities where we are, their possible evolution, our "positions", the competitive positions of our 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 (kids bikes and adults 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 : 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 (see next section) : The yearly budget is a very important tool to manage the firm. Every year around its end, in october and november, all the 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 account. We shall see that we will split the usual accounts into many more accounts.
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...
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 ?
We start with setting Sales (budgeted) targets. Our Sales last year 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. And this 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. An alternative plan is to go visit our great aunt, like we should have done for months.
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 adults bikes sells for 500€ apiece, and the kids 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 an introductory course in 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.
Our budgeted Sales figures are :
Therefore we shoot for a 2,175 mio sales figure in 2004, compared to 1,75 mio in 2003.
What about the costs ?
There are two types of costs :
We assume in our simple classroom example that Raw mat, Direct labor, and Direct expenses are exactly proportional to the level of activity, and that the evolution of the level of activity is measured by the evolution of the sales. Since the prices don't change, in our example, we may as well say that the level of activity per segment is measured by the number of bikes produced.
Our level of activity will grow by
This gives us the budgeted variable cost figures (make sure you can calculate by yourself the direct cost figures presented in the table below).
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 and Distribution.
We get the following Budget for 2004 :
| Budget P&L 2004 | |||
| (thousand euros, except when specified) | Total | ||
| Kids bikes | Adults bikes | P&L | |
| Volume (=number of bikes) | 4620 | 2040 | |
| Price per unit (euros) | 250 | 500 | |
| Sales | 1155 | 1020 | 2175 |
| Raw mat | 385 | 306 | 691 |
| Direct labor | 308 | 204 | 512 |
| Direct expenses | 77 | 51 | 128 |
| Margin after variable costs | 385 | 459 | 844 |
| Margin/sales | 33,3% | 45,0% | 38,8% |
| Fact OH | 200 | ||
| Admin | 80 | ||
| R&D | 100 | ||
| Selling&Distrib | 200 | ||
| Profit or Loss | 264 | ||
So we plan a growth, and more profit. Remember : the economic model where growth is always desirable has been the leading one since the Industrial Revolution, and is traditionally taught in Business schools. But now, at the scale of the planet, the model is reaching its limits and we are running into problems : we use non undepletable resources, in terms of fossil energy, and in terms of the capacity of the planet to absorb consumption and industrial wastes, CO2 in particular as well as other wastes. A large consciousness movement is necessary in the international community to set out new rules for all of us. Keep this in mind when you produce, exchange and consume.
4. Analysis of discrepancies and corrective actions
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 complicate our example).
Suppose then that at the end of the month of January 2004, 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 ?
Ans. : No, it is not OK. 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.
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 :
We see that depending upon the exact 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.
5. Costs centers and profit centers :
The accounting technique in cost accounting is 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.
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 :
These will be the six manufacturing direct labor accounts. If the salary we pay pertain exactly to one account, we debit exactly one account. But in small firms workers work in different areas over one month, then usually they 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. This way at the end of the month of February we know precisely how much money we spent in manufacturing kid bike sawing area.
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.
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.
In elaborate accounting systems the usual split to define all the profit centers is by :
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").
So we can meaningfully compute a margin after all specific cost centers, in each profit center (in our example, the margin after variable costs), but usually we cannot compute a meaningful bottom line per product line. We shall see in other sessions how we get around this. Because we need to know "our costs per bike" in order to fix our prices.
If we look at 2003, we see that we produced 5000 bikes for a total expenditures of 1,6 million euros, so an average cost per bike of 320€. But this is not a useful information to fix prices. If we fixed 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 kids, overworked workers in adults, not enough revenues, etc. This is not feasible. We have to fix different prices - of course - for kids bikes and for adults bikes. But which ones ? We shall see in forthcoming sessions how to do it.
Hopefully now you 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.
We saw that the 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.
Of course if we have a cost accounting system, we automatically have a general accounting system as well, since general accounting data are obtained by summarizing cost accounting data.
Read the case study "No problem" handed out in class.
Read the article on Lego.
Reread session 1 of the first semester, you will understand it better now.