Management Accounting (LSMS 2101)

Written exam in june: 100%

Exercices session in class: we have to prepare it in advance.
3 majors points:
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Cost calculations, concepts,...:

1. Basic cost calculation concept = traditional calculation.
2. Advanced cost calculation concept.
Cost management budgeting
1. Technical side
2. Management side
3. Human side it missed in previous courses
Performance measurement/management.

Chapter 1:
How management accounting information supports decision making
The difference between financial accounting and management accounting
Financial accounting
-

It is about the financial statement: balance sheet (overview of the

value/resources), income statement (is the company able to realize a profit, to
create value?) and the note.
Balance sheet: assets (cash, liquidity = what the company has) and
liabilities (debt and equity).
Income statement: revenues (coming from sales) and costs (decreasing
the value of the company).
Communicated to external users (employees, clients, government, shareholders
and partners). Internal users (labour unions and HR) can also read it but that is
not the main aim.
Is past oriented: it gives historical information on the past financial performance
of the company.
The income statement shows us the profit that the company can do.
What is created is mostly for external parties (bank, shareholders,
governments, suppliers,...). What is created depends on the performance
in the past.
Strictly regulated (formal and standardized rules): there is a legal framework to
follow that formalizes the output.
How to register the transactions? It depends on the company
standards/the rules used in accounting in the company. It is highly
regulated (strong rules).

Management accounting
-

It is about creating information that helps managers to take strategic decisions

and to implement them.
Information created for internal users: managers that have to make decisions on
a day-to-day basis at an internal level.
Is future oriented: it helps a company to develop and implement its strategy.
Not strictly regulated (guidelines and recommendations): every decision is
different and creates thus unique needs. The information is based on the specific
needs of the company so the way of creating information is much more flexible
and does not need to be compared with other companies. There is no rules.

Management accounting
It is a discipline that serves other areas in management. Management accounting is
based on the creation of information. This information comes from the area of
accounting but it comes from other areas in management (strategic, human
resources,...). Management accounting is never standing alone!
Management accounting helps a company to develop and implement its strategy.
A manager has to decide if he will create a new product or not and, if he goes to a new
product, what the price will be.
A manager has to decide if he will or not outsource the production in another country.
Plan-Do-Check-Act cycle (Deming cycle)
Management accounting and strategic management are strongly related, on a day-to-day
basis. The Deming cycle (Plan-Do-Check-Act) refers to four stages in strategic
management. At every stage, management accounting will give information to help
making decisions concerning the strategy and its implementation.
o Plan
Mission statement, definition of objectives & definition of strategies
- Take into account the external environment, the industry and the internal
strengths and weakness (internal analysis).
- Important to communicate the strategy (cf. strategy map and blanaced scorecard
in chapter 2).
- Cost-volume-profit (CVP) analysis (cf. chapter 3).
- Budgets (cf. chapter 10).
- Developing new products and services (cf. total life-cycle cost in chapter 8).
o Do: implementation of the strategy
- Use of management accounting information in daily decisions and work
activities.
Strategy: operational decision and activities.
o Check: measuring, evaluating and reporting
- Calculate cost and profitability of products and services (cf. chapter 4 and 5).
- Calculate cost of serving customers and customer profitability.
- Analyzing and improving operational processes (cf. chapter 7).
- Variance analysis (cf. chapter 10).
- Crucial importance of non-financial information.

o Act: take actions based on the information coming from the previous step
- Lower costs
- Improve quality
- Improve processes
- Change product mix
- Change customer relationships
- Redesign products
- Reward employees
Revision: take actions to improve the strategy, based on the previous results.
Conclusion
There is thus a strong link between strategic management and management accounting
but there is a huge gap between financial accounting and management accounting.

Chapter 3: Using costs in decision making

Management accounting supports internal decision making

-

Plan development of the strategy

Do implementation of the strategy
Check monitoring of the strategy
Act revision of the strategy

Use of cost information

In planning:
- Pricing decisions: market-determined price versus
- Product planning: target costing
- Budgeting: cost forecasts
In monitoring:
- Performance evaluation: variance analysis
Understand the behaviour of costs

Variable and fixed costs

Variable costs
- They increase proportionally with changes in the activity level. Increase
proportionally with changes in the short run activity level: the more we produce,
the higher the variable cost. So when the volume of production increases, the cost
increases in an approximately linear form. The cost varies in a direct proportion
with the volume of production (see graph)
Examples: raw materials, cost of supplies (wheels).
- A cost driver is a variable that causes a cost: for example number of units
produced.
- The TVC increases with the number of units.
- The VC/unit remains stable with the volume. The evolution has nothing to do
with the volume (see graph)
- Based on cost-drivers
Fixed costs
- They dont vary in the short run with specified activity: comes from the fact we
need capacity for our activity.

They depend on the amount of a resource acquired not used: capacity-related

costs).
Typical examples: depreciation of machines, administrative costs, the rent of a
building (the more we produce, the less is the rent price per unit).
The TFC remains stable for a certain time-period or a certain capacity level. The
cost will not change for a certain time period! When we talk about fixed cost, it
does not mean that the cost is fixed forever (for example, after 3 years, we can
change the capacity of production so the fixed cost changes but in the long run).
The FC/unit decreases with the number of units.
Based on capacity-related costs

Note that this distinction between variable and fixed is quite simplistic.

Cost-volume-profit analysis

Profit

= revenue total costs

= revenue variable costs fixed costs
= (P * Q) (VC/unit * Q) TFC

Contribution margin
Contribution Margin

= Total Revenue Total variable costs

= (P * Q) (VC/unit * Q)

In the short run, the TFC are a handicap because they are fixed and we cant change
them. Thus, it is not relevant to consider them, as we cant influence them.

In the short run, we will thus consider the Contribution Margin (CM) rather than the
profit to make a decision. Short term decisions must be based on the maximisation of the
CM and not on the maximization of the profit. We will only consider the variables that
can be changed.
To be profitable in the short run, the CM must be high enough to cover the fixed cost
handicap. The more CM you have, the more profit you have. It will help you to have more
profit in the long run. Profit is based on elements that we cannot control in the short
run.
Contribution margin per unit: the contribution that each unit makes to covering fixed
costs and providing a profit.
Contribution Margin per unit = [ (P * Q) (VC/unit * Q )] / Q
= Q * (P VC/unit) / Q
= P VC/unit
We can thus rewrite the profit formula:
Profit = (CM/unit * Q) Total fixed costs
/!\ the number of units produced is NOT the number of units sold: there can be stock in
our warehouse.
Conclusion: profit is a long run concept because we can change our fixed cost. In the
short term we consider only the contribution margin.
Breakeven analysis
The Breakeven analysis gives the number of units to sell in order to cover all the costs
(Profit = 0). I have no profit and no loss. Revenues are just enough to cover the costs.
Breakeven point = fixed costs/contribution margin
The Breakeven point (BE) is the point where the Total Revenue (TR) equals the Total
Cost (TC). At that point, the profit is zero. If we are after the BE point we make profit, if
we are before, we dont.
Do we launch this project? You will calculate how many goods you have to sell to cover
all the costs. The breakeven can be expressed in number of goods. Breakeven is also
used in strategic management when we introduce a new product.

Graphically:
1) We draw TVC and TFC
2) We deduce TC (TVC from TFC Y)
3) We draw the TR line
4) TR TC gives the BE point
5) We can draw the profit line
Analytically
Assumptions Underlying CVP Analysis:
- The price/unit and the variable cost/unit (and thus the CM/unit) remain the
same over all levels of production.
- All costs can be classified as either fixed or variable or can be decomposed into a
fixed and variable component.
- Fixed costs remain the same over all contemplated levels of production.
According to the definition, we have to find the Q that solves = sales VC FC = 0
Breakeven point is a quantity so we have to look for the Q.
TR TC = 0
(P * Q) (VC/unit * Q) TFC = 0
(P VC/unit) * Q TFC = 0
(P VC/unit) * Q = TFC
Q = TFC / (P VC/unit)
Q = TFC / (CM/unit)
Thank to this formula we can simulate the impact of decision.
If we reduce our price, it will increase the BE point (we need to sell more units)
If we decrease the VC/unit, it will decrease the BE point (we need to sell less unit)
This is the number of units to be sold in order to cover all the costs (profit = 0).

You can see quickly if the breakeven will go up or down: for example, if materials will be
more expansive, the price will go up so the quantity will go down and it is less easy to
reach the breakeven point.
If we have not enough information in our hands, it is more difficult to take decisions. You
have to create the right information (concerning these previous concepts).
What-if analysis.
Other useful cost definitions
Mixed costs have both a fixed and a variable component.
- Examples: telephone cost, electricity cost, salary cost of sales managers
Step variable costs (or semi-fixed cost) increase in steps as quantity increases (often
represented by a linear approximation). They are fixed for a certain period of time but
not for ever.
Incremental cost (or marginal cost) is the cost of the next unit of production. Without
this cost, we would take the wrong decision.
Example flight:
Fixed cost = fuel and crew
Variable cost = meals and newspaper
full cost: 100/seat
7/ seat
107/seat
150/seat
What is the full cost? One passenger more or less no problem, the flight will operate
but what would be the price of this last minute ticket? The full cost does not depend on
the last minute tickets because it is covered by the other passengers.
Incremental cost?
- 0 fixed cost.
- 7/last seat variable. We decide to sell the ticket at 75 (68+7). We charge the
last ticket for passengers at a much lower price than the full cost.
With the right information, we can take the right decision!
Sunk costs result from a previous commitment and cant be recovered, we cant it
change anymore. It is something based on past decisions that we cannot eliminate.
- Examples: R&D costs, depreciation costs, construction costs.
- Sunk cost phenomenon: point of no return.
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Relevant costs are costs that will change as a result of some decision (important
concept!). These are costs that we can change every day when decision change.
- There are different costs for different purposes.
Opportunity cost is the maximum value forgone (= lost) when a course of action is
chosen.
- Exists in case of limited resources. They are often neglected.
- Opportunity costs are often overlooked.
These costs become relevant as soon as you have 2 scenarios/2 options. It is the profit
that you lose/dont have because you go in one of the 2 options. If you know exactly
what the opportunity costs are, you are sure of your decision.
Avoidable costs are costs that can be avoided by undertaking some course of action.
- They become relevant when deciding on the elimination of products.
- Avoidable costs >< sunk costs.

A first set of decisions: 4 specific decisions

1. Make-or-buy decision (outsourcing decision what kind of information I need to
take this decision?)
2. Decision to drop a product
3. Costing orders
4. Short-term product mix decisions (what is the optimum mix to be sure that, in
the long run, I will maximize the profit?).
Make-or-buy decision (outsourcing decision)
Are we going to make it ourselves or to outsource it? We can avoid some cost thanks to
outsourcing decisions. However, there are still sunk costs that we need to cover,
whether we outsource or not.
Quantitative side = cost side buying cheaper than making.
Qualitative side it may be better to make and not to buy for the quality of the
service/product (for example, for the loyal customer, you prefer offering a quality
service).
Example: you can outsource a core business but from a qualitative side, it would be
better not to outsource because we can differentiate from competitors.
Core versus non-core activities
The non-core activities do not add value in a direct way to our product or service (HR,
legal department, maintenance, support, etc.).
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Pay attention: the distinction between core and non-core activities can change over
time.
Qualitative / Human considerations
Quality and human dimension are important: they may be cultural differences between
countries; my customers dont want me to export in a low wage country.
Outsourcing
We outsource when the internal cost that we can avoid is higher than the external cost.
internal costs avoided >external costs.
Manufacturing costs
There are three manufacturing costs.
-

Direct materials costs can be directly related to the cost object.

Example: the cost of the wheel in a bicycle production line.

Direct labor costs can be directly related to the cost object.

Example: the salaries of a production staff that is only working on a particular
product.
Pay attention: when some people work for several products, its not a direct cost,
we need to find a way to split the labour cost of these different workers.

Manufacturing overhead costs (indirect costs) cant be directly related to the cost
object (no clear relation between the cost and the cost object).
Example: a machine that produces three different bicycles (fixed), the
depreciation cost of a machine, the electricity required (variable)
DIRECT

INDIRECT = overhead costs

VARIABLE
FIXED
VARIABLE COSTS:
When you want to calculate the cost object, you have to link the direct cost to the cost
object. However, you do not have any link between the indirect cost and the cost object.
Example: electricity used to produce the object.
FIXED COSTS:
Direct cost: one specific machine for one product. It is for example the cost that I need to
produce a specific bicycle.
Indirect cost: one specific machine used for several objects. It is for example the cost
that I need to produce several bicycles. This is a cost that you cannot eliminate when you
outsource!!
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KEEP IN MIND: All costs are not eliminated when you outsource. For example, you have
to pay the machines, the electricity for the products you do not outsource.
The available capacity due to outsourcing (a machine that can be used for a new
product) can be used for something else.
Example: Chaps Company
Internal costs avoided ($22.01)
- Direct materials ($12.54)
- Direct labor ($5.77)
- Variable manufacturing overhead ($3.00)
- Fixed manufacturing overhead ($0.70)
External costs incurred ($21.94)
- Supply price ($21.80)
- Shipping costs ($0.12)
- Tool rework costs ($0.02)
The internal direct costs are all eliminated and a part of the manufacturing overhead
can be eliminated. In this case, we would save 0,07 per unit if we outsource. It is an
insignificant saving AND we have also to take non financial costs into account!
Example: Anjlees catering services
Internal costs avoided ($535,500)
- Source and purchase food ($180,000)
- Kitchen costs ($180,000)
- Rent for current store ($108,000)
- Drivers salary ($60,000)
- Delivery van operating costs ($7,500)
External costs incurred ($533,600)
- External supply price ($500,000)
- Rent for new office ($33,600)
Earned extra if outsourced ($30,000)
- Contribution margin provided by new business ($30,000)
Total savings if we outsource: $31,900. The business model has changed: the
customer service is more important than the catering itself. For this company,
outsourcing avoids a few costs. Here, we have more revenues because we focus more on
the service.
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Conclusion
We outsource when the internal cost that we can avoid is higher than the external cost
incurred.
Make-or-buy:
Avoidable VS non-avoidable
Opportunity cost : capacity and contribution margin.

Decision to drop a product (liminer/abandonner un produit)

We drop a product when it is unprofitable: when the costs saved by abandoning the
product are higher than the revenues that we lose.
Cost saved by abandoning the product > revenues forgone
What are the costs that we can eliminate when we drop a product? To determine this,
we need cost information. There are a lot of costs that are not avoidable because they
are fixed or used for other cost objects (indirect). When you can make a distinction
between the avoidable and non-avoidable costs (when you have enough information
about your costs), you can make a decision about dropping a product or not.
Relevant costs are:
- Variable costs directly related to the production: most of them are avoidable.
- Avoidable fixed costs: only few of them are avoidable.
Non-relevant costs are:
- Fixed costs that are not avoidable. Those are sunk costs.
Example: machine that produces three bicycles. If we stop the production of one
bicycle, we will still use the machine for the two remaining.
To take the decision, we have to look at several aspects:
- Current product profitability analysis
- Relevant costs (variable costs & avoidable fixed costs)
- Non-relevant costs (non-avoidable fixed costs)
- Time dimension: short run (a lot of non-avoidable fixed costs) vs. intermediate or
long run (most fixed costs are avoidable)
- New costs linked to the dropping of a product?
In practice: some activities may operate at losses, to support the core product (ex: hotel,
grocery store).
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Example: Messi Company

Most recent Income statement of the company

The fixed costs allocated to each product include:
- Fixed costs directly attributable to the product and fixed costs that could be
avoided if the product were drop.
- Corporate fixed costs that would continue if the product were discontinued
- The amount of avoidable fixed costs included in the fixed costs for Models X355,
X655, and X966 are 55%, 40%, and 20%, respectively.
Would dropping Model X966 improve the Companys overall profitability?

Product contribution to corporate fixed cost

We used information related to avoidable fixed costs to produce this income statement.
We can now see that, in fact, Model X966 provides the highest contribution of all the
products and dropping this product would decrease Messi Companys profitability by
$31,548.
Example: Buddys Bar and Grill

Results of the three operating units for the most recent year
The fixed costs can be split into:

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Corporate fixed costs (overhead): $340,000 (respectively shared 50%, 20% and
30%)
Attributable fixed costs: $300,000 (after calculations)

If the Games Room closes:

- Space will be allocated to the restaurant and to the bar. No increase in
attributable FC (corporate fixed costs remain the same).
- Sales in the restaurant and variable costs will increase by 10%.
- Half of the bar sales will be lost. Variable costs will decrease in the same
proportion.
Should the Games Room be closed?

The Games Room is not profitable. If we eliminate it, we can avoid part of the fixed costs
and we have space available.
However, if we drop it, the corporate profit decreases. This is because sales in one unit
affect sales in the others.
Closing the Games Room will decrease the corporate profit, as sales in one unit can
affect sales in another unit.
Conclusion
-

We drop a product when the costs saved are higher than the revenues we lose.
We only consider relevant costs. Non-avoidable fixed costs are not relevant.
The longer the time horizon, the more you have avoidable fixed costs.
We have also to look at the impact of our decisions on other business units.

Dropping a product:
- Contribution margin (and not profit)

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- Avoidable VS non-avoidable.
In the case of a product mix, sales are related to each other.
- Free extra capacity? (with stopping a product)
- Impact on sales of other products?
- New costs created?
It gives a completely different picture. Sometimes it is better to continue producing!

Costing orders

Only relevant when we produce unique (one-time) orders: companies that work on an
order basis and decide on the price for every order that is coming.
Costing orders:
- Before the breakeven point: full cost (mu profit is not enough to cover the full
cost).
- After the breakeven point: incremental cost.
I reach the breakeven point, so the context changes (and now I am profitable) and the
pricing can change.
Example: I have a limited capacity I have to choose and I need to take into account the
opportunity cost: which option I will chose? I have an opportunity to give up one of the 2
options. I lose something but because I have a limited capacity, I have to make a choice
between the 2 options.
Did I reach my maximum capacity? If yes, the opportunity cost become important.
To cover the incremental cost and the opportunity cost, you have a floor price.
The floor price is the minimum price that will cover the costs that the order will create.
- It represents the minimum price that we will have to charge.
- The floor price is thus the relevant incremental cost per product.
Pay attention that it is not equal to the actual price charged for the order: the price will
reflect strategic factors (amount of competition, amount of idle capacity, affecting
relationships, future orders, etc.).
Example: Pepper Industries
-

Important: there is a lot of idle (unoccupied) capacity, we look at the incremental

costs to cost the order.
Incremental cost analysis: what are the extra costs when accepting this new
order?
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Floor price = relevant incremental cost per cup.

Floor price is NOT an actual price charged.

Response of the factory accountant regarding a 50,000 mugs special order.

Overview of the incremental costs:
- Incremental cost analysis: what are the extra costs when accepting this new
order?
- All variable costs are incremental costs.
- Fixed manufacturing overhead costs will not change in the short run.
- Other administrative costs will not change in the SR (they are fixed).
The minimum price to be quoted by cup on this order is $1.13 ($56,500 for the
50,000).
Example: Brussels Airlines
Consider the last minutes flights. If we have reached the breakeven point, what price do
we need to ask for accepting new passengers?
Here again we will use the incremental costs analysis. Indeed, we will have extra costs
by accepting these passengers (one newspaper more, on drink more, etc.). We thus need
to identify those costs.
Example: Maggie Company
-

There is not enough capacity to accept the new order. They will have to give up
part of the existing production capacity opportunity cost.
The floor price for the new order will have to cover: the incremental costs + the
opportunity cost.

When there is insufficient capacity, we look at the opportunity cost of accepting the
order to cost it.
The floor price is thus the addition of the incremental and opportunity costs.

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Information per unit related to the product.

To produce the 10,000 bags order, the incremental costs are $10 (material) and $5
(labor). For every seven units produced, the company gives up to one unit of its current
products. Fixed costs dont change.
What is the Minimum Price (Floor Price) per unit that the company should consider
charging?
The total variable costs are the variable costs for a normal order and the incremental
costs incurred because of the special order.
The opportunity cost is the profit the company gives up to produce the other order. As
we are in the short run, we will consider the contribution margin.
CA
= Total Revenues TVC
= 45.99 24.78
= 21.21

$21.21 is thus the opportunity cost of one current product unit. As one is given up for
seven special order products, the opportunity cost per product is 3.03 (21.21/7).
The floor price for the new order will be $42.81.
Conclusion
- When we think of incremental order, we need to think on an incremental cost
basis.
- The incremental cost is not the final price of an order.
- When there is insufficient capacity, the floor price has to cover the incremental
and opportunity costs.

Short-term product mix decisions

Only relevant in case of limited resources/capacity. The company faces competing

demands and has to make choices among the different opportunities. This is a short18

term decision because we have limited capacity in the short run. In the long run, we can
increase our capacity.
We have to determine the most optimal mix of products making our profitability as high
as possible.
Example: Freds Wood Products
-

What is the incremental contribution of both products?

Limited capacity of labor hours: what is the contribution margin per labor hour?
Allocate in the first place the production capacity to the product with the highest
contribution margin per unit of the constraining factor of production.
The remaining production capacity (if relevant) can be allocated to other
products with a lower contribution margin per unit of the constraining factor.
Note that we focus only on ONE constraining factor. However, in reality there are
often multiple resource constraints.

Unit characteristics.
The sales manager promotes the change to an updated version of the product.
-

Workers are paid a flat wage irrespective of the number of hours that they work.
Labour costs are charged to products at the rate of $24 per hour.
Selling costs are 5% of the product price
Overhead is charged to products at 150% of direct materials costs.
Variable manufacturing overhead costs are about 10% of direct materials costs.
The maximum number of labour hours that can be used to produce cutting
boards is 10,000.

Should the product be upgraded?

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Incremental costs.
Only the costs that will change because of the upgrade should be considered.
However, there is a limited capacity of labour hours (10,000).

We know labour costs are charged to products at $24 per hour. From the first exhibit,
we can calculate the hours use and then the contribution per labour hour.
The total contribution to fixed costs of each product (if the 10,000 hours are allocated
to the production) is thus respectively $628,000 and $ 555,000. The current product is
thus the more profitable alternative.
Pay attention: If the company can only sell a certain amount of products, it will use
enough labour hours to produce them and will then allocate the remaining labour hours
to the other product.
Conclusion
When we have limited resources, we allocate the production capacity to the product
with the highest contribution margin per unit of the constraining factor of production
(contribution margin to maximize in the short run).
The remaining production capacity (if relevant) can be allocated to other products with
a lower contribution margin per unit of the constraining factor.
Priority to the product/service with the highest contribution per unit of limited
capacity.
We calculate first the incremental contribution of each product and then the
contribution margin per labour hour.
Note: we focus only on ONE constraining factor. However, in reality there are often
multiple resource constraints.

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Chapter 4: Accumulating and assigning costs to products

Cost flows in organizations
Companies with different costs flows have different MA priorities.
Manufacturing companies have three kinds of costs
-Direct materials
-Direct labour
-Manufacturing overhead (indirect costs): we need a method to allocate these costs
Retail organizations: buying and selling (ex: supermarkets) not so important.
-Purchase cost: cost that the supermarket has to pay to buy the products = direct cost.
We know exactly what we have paid before we sell it again.
-Overhead: are limited in a retail organization.
Service organizations: You have almost no direct cost anymore, all the costs are by
definition indirect costs. There is a huge complexity and diversity.
-Labour cost (direct or indirect): a lot for people work in the bank, give advice on credit
and investment, help customers on daily transactions. Hard to say what part of their
time is related to which service.
-Overhead

Cost management systems

The major objective of a cost management system is to assign indirect costs to cost
objects. A good allocation is obtained when the cost object reflects the reality, the
complexity.
Traditional cost management systems
Advanced cost management systems
- Activity-based costing
Many methods are based on the volume of production: big volumes products have to
cover more FC.
Some important costs terms
A cost object is anything for which a cost is computed.
Example: activities, products, product lines, departments, or even entire organizations

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The cost of a consumable resource (flexible resource) depends on the amount of

resource that is used. This is thus a variable cost.
Example: wood in a furniture factory, iron ore in a steel mill.
The cost of a capacity-related resource depends on the amount of resource capacity
that is acquired and not on how much of the capacity is used. It is thus a fixed cost (in
the SR).
Example: depreciation on production equipment and salaries paid to employees in a
consultancy.
Traditional cost allocation
Basic principle of indirect cost allocation:
- Direct costs are directly assigned to the cost objects
- Indirect costs (basically, the fixed manufacturing overhead) are first assigned to
indirect cost pools. The cost of the indirect cost pools is then allocated to the cost
objects. An indirect cost is a cost that is not direct, that cannot relate directly to
the cost object.
Example: electricity to run the machines that produces three types of bicycles
Example: Providing a credit to a customer in a bank
Variable
The bonus of an employee that is only
working for the credits. Bonus is
based on the number of credit files
they open.
Raw materials
Most Common

Fixed
The salary of an employee working
only for the credits. The fixed part
has nothing to do with the number of
credits.
Direct
Marketing campaign that is focused
only on credits.
IT system only used for credit
analysis
The bonus part of the salary of a The fixed salary part of employees
person that works for other services that work for different services.
Indirect as well.
IT system used for different services.
The electricity in the offices that Building rental
provide different types of services.
Most Common
A cost pool is a set of activities in the production that is driven by the same cost
factor/driver.
Per cost pool, we look for a cost driver (which factor drives the costs in this cost pool?)
- Typical cost drivers in traditional cost management: labor hours, machine hours
(volume related)
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 What is the practical capacity of the cost pool in units of the cost driver?
Per cost pool, we calculate the cost driver rate = total indirect costs assigned to the
cost pool practical capacity of the cost pool (cost driver units).
!! Important challenge: find the right cost pools!
A cost pool represents one or more activities in the production process driven by the
same cost driver (for example, all machine driven activities, all labor driven activities)
How much of every cost pool do the cost objects consume?
The consumption of the resources of the cost pools determines the total cost of a cost
object
Cost pool homogeneity?
- Costing distortions arise when indirect cost pools include costs that have
different cost drivers!
- This could lead to over- or underpricing of cost objects!
- Sometimes it is better to split up cost pools into more homogeneous cost pools (cf.
ABC)

Indirect cost allocation happens in several steps:

(1) Costs are classified between direct and indirect.
(2) Direct costs are directly assigned to the
appropriate cost object. Indirect costs (basically,
fixed manufacturing overhead) are assigned to
indirect cost pools.
* Identify the cost driver (labour hours, machine
hours).
* Identify the practical capacity of the cost pool, in
units of the cost driver.
* Calculate the cost driver rate:
Total indirect costs assigned to the cost pool
Practical capacity of the cost pool (in cost driver units)
* Identify the amount of resources used by the cost object.
(3) The appropriate portion of the indirect cost is allocated to the cost object.
An important challenge is to identify the right cost pools. It is important to have a
homogeneous cost pool: costing distortions arise when indirect cost pools include costs

23

that have different cost drivers. This could lead to over- or underpricing of cost objects.
Sometimes it is thus better to split up cost pools into more homogeneous cost pools.
Example: We produce two bicycles A and B
(1) Classification between direct and indirect costs.
Direct cost: Direct material (DM) and Direct labour (DL) costs per unit are easy to
allocate.
A: DM = 35
DL = 12
B: DM = 44,5
DL = 14,25
Indirect costs are 14 000 000 and include Machine depreciation, Heating cost,
Lightning cost and Supervisors costs.
(2) Identification of the activities that ate driven by the same factor and creation of the
costs pools.
In the Machining department, machines do most of the work: the cost driver is thus the
machine hours.
In the Assembly department, workers do most of the work: the cost driver is thus the
labour hours.
* Identification of the practical capacity:
I can produce 300 000 machine hours/year with my machining department.
I can operate 200 000 labour hours/year with my assembly department.
* Calculation of the cost driver rate:
First, we have to identify the amount of indirect costs of each pool.
Depreciation cost = 5 000 000 (80% machining department & 20% assembly
department)
Heating cost = 3 000 000 (75% machining department & 25% assembly department).
Lighting system = 3 000 000 (75% machining department & 25% assembly department).
Supervisor = 3 000 000 (75% machining department & 25% assembly department).
Thus, Machining department = 9 000 000 and Assembly department = 5 000 000.
Now, we can calculate the cost per cost unit hour.
Machining department: 9 000 000/300 000 machine hour = 300 /machine hour
Assembly department: 5 000 000/200 000 labour hours = 25/labour hour
* Identification of the number of hours needed to produce the objects.
24

A = 0,15 hour in the machining department 0,15*300 = 45/unit

B = 0,25 hour in the machining department 0,25*300 = 75/unit
A = 1,75 hour in the assembly department 1,75*25 = 43,75/unit
B = 0,75 hour in the assembly department 0,75*25 = 18,75/unit
(3) Now we have all the costs, we can allocate the costs from the two cost pools to the
cost objects.

DM
DL
Machining department
Assembly department
Total

35
12
45
43,75
135,75

44,50
14,25
75
18,75
152,50

The product B is more expensive because it remains longer in the machining

department so it has to cover more indirect costs.
Given that it is a very simplistic method, there are some issues.
Cost pool homogeneity. An error is easily made in the cost pools division and that we put
activities together that are not driven by the same driver. The more complex the process
becomes, the more difficult it will become to apply this simplistic method.
Information availability. The information system should be able to give information
needed

Overhead allocation: further issues

We often want to determine to cost of a cost object on beforehand (for example, to set
the price). By definition, this means that we use estimations of the indirect costs that we
assign to the cost pools and estimations of the capacity of the cost pools (practical
capacity). At the end of the accounting period, we know the actual cost of the cost pools
and the actual use of the capacity of the cost pools.
Two problems arise:
- What if the actual cost =/= estimated cost?
- What if the actual used capacity =/= practical capacity?
If the actual cost > estimated cost we have unallocated costs
If the actual used capacity < practical capacity, we have unused capacity, and thus also
unallocated costs (cost of unused capacity)

25

Two solutions to the unallocated cost problem:

- Charge the unallocated costs to the goods sold
Take all the unallocated costs together and split them over all the goods sold. It is not a
fair method because we also have work-in-progress goods and finished goods, for
example.
- Assign the unallocated costs to work in progress, finish goods and goods sold
(more balanced approach)
Take all the unallocated costs together and split them over the three different types of
unit: work in progress, finish goods and goods sold. This is a better and more balanced
approach.
Lesson to learn: cost estimations are not 100% accurate ( the true cost does not
exist ). We need to accept that our estimations will never be 100% correct.
However, the cost of unused capacity (= unused capacity in cost driver unit * cost
driver rate) is an interesting element for decision-making. We need to allocate that cost.
-

Using the actual used capacity to compute the cost driver rate does not make
sense from an economic point of view. This would lead to increasing prices when
the demand for the product goes down (what enhances the decreasing demand)!
It is better to use stable cost driver rates and determine at the end of the
accounting period the cost of unused capacity (this concept only exists in the
short run!).
Based on an analysis of this cost of unused capacity, decisions can be made to
reduce the capacity (in the long run)

How do we determine the practical capacity of a cost pool?

-

Keep in mind that the practical capacity (80%) < theoretical capacity (100%)
Use the average level of activity over the capacitys life (based on historical data if
possible)

We have to recall that the practical capacity is always lower than theoretical capacity
(around 80%). Using the theoretical capacity of a cost pool does not make sense in
calculations. Instead, we determine the practical capacity. In this purpose, we use the
average level of activity over the capacitys life, based on historical data if possible. After
one year, you know how many hours you really used for your activity and, year after
year, you can refine your estimation. The more historical data we have, the better our
estimations are.

Job order and process costing systems

Job order costing system

26

The job order costing is a system that estimates the cost of a specific order. The cost
object is an individual job or order, which varies from customer to customer, and each
order can be unique if we go to the extreme situation. The product/cost object is not a
standardized product: in a garage, every car is unique and has its specific
characteristics; in a consulting firm, every client comes with his own problem and
demands; etc. Consequently, there are many direct costs and few indirect ones.
We have thus to determine the cost to charge for every order. An advantage is that
many costs are direct cost (they can directly be related to the cost unit: material, etc.).
All cost information is collected on job cost sheets and the bid price is the job cost
(floor price) + the mark-up. To determine the job cost, we use the traditional system
with cost pools to allocate indirect costs.
In the case of individual orders:
Full costs: we consider the full cost because every cost object is unique.
The use of incremental costs is not relevant. The service is not standardized, there is no
extra cost from accepting a new order, as each of them is different.
The use of the opportunity cost is relevant only if there is limited capacity. In that case,
accepting an order is declining or postponing another one.
Process costing system
In that system, a continuous production line produces homogeneous products.
There is only one, standardized, cost object. There is thus no issue in terms of allocating
indirect costs. The overall cost of production can easily be divided to get the unit cost: all
the costs are direct costs.
Multistage process costing systems
It is a process costing system (one cost object and direct costs) but with several steps
across the production line. The costs are measured for individual process stages.

We start with raw materials, for which we know the costs, and we add direct materials,
labour and overhead costs at every stage, until the product becomes a finished good.
Allocating material costs is easy, as they can be directly related to the stage. Labour and
support (overhead) are less easy to allocate. The sum of those three cost is the
conversion costs. The cost driver is here always the time: we eliminate any discussion
about the most appropriate one. If we divide the conversion cost by the number of
process time unit, we get the cost of conversion per process time unit (hour, minute,
etc.).

27

This allows us to know in which step we use resources and we create costs. It is an
interesting input for process analysis. It gives insights/indications about in which part
of the stages we create costs and consume resources. It is the basis to improve/optimize
the costs in the production process.
To deal with the issue of partially completed work in process, we use the concept of an
equivalent unit of production. It expresses the work equivalent (in finished units of
the work) that has been invested in work in process. Work in progress is not relevant in
management accounting.
Example
At each stage, some units are not finished yet but have already consumed some
resources.
Stage 1
500 units
The units have already
used 80% of raw
materials and 50% of
the conversion costs.

Stage 2
300 units
The units have already
used 10% of raw
materials and 70% of
the conversion costs.

Stage 3
150 units

We want to determine for each stage, the equivalent unit of production of Work In
Progress (WIP).

Raw materials

Conversion costs

Stage 1
Stage 2
500*80% = 400
300*10% of raw materials = 30
500 WIP units = 400 finished 300 WIP units = 30 finished
goods
goods
500*50% = 250
300*70%= 210
500 WIP units = 250 finished 300 WIP units = 210 finished
goods
goods

This allows us to know exactly how much the units (WIP and FG) cost and optimize it.

Service department cost allocations

Another way to allocate indirect costs to cost pools is to make a distinction between
core and non-core activities. Non-core activities do not contribute to the cost object
directly but are needed to play a support role (catering, human resources, etc.). Core
activities are part of the Production Department.

28

There are three approaches to allocate service department costs.

The reciprocal approach implies a two stages allocation.

(1) We develop a reciprocal cost equation of each department.
TCosts SD1 = Costs SD1 + % TCosts SD2
TCosts SD2 = Costs SD2 + % TCosts SD1
We can use algebra to solve this.
(2) We allocate the Service Departments costs to the Production Departments, in
proportion of the use.
To calculate the unit cost, we take the sum of all the costs and divide it by practical
capacity.

29

Chapter 5: Activity-based costing

Traditional manufacturing costing system
If we use the traditional cost system, we see thanks to the gross margin (= Sales
TotalCosts) that standardized products are less profitable than specialized products.
Because standardized products are produced in larger volumes, more indirect costs are
allocated to them. Companies will thus put more efforts on specialized products.
However, the overall profitability is low, what is an important signal that something is
wrong with the costing system.
Standardized products: made in large volumes (vanilla or chocolate ice
cream for example).
Specialized products: made in small volumes, more complicated
production less labour because of the smaller volume (strawberry
ice cream for example).
This comes from an overestimation of indirect costs for large volume standardized
products and an underestimation of indirect costs for specialized products. Indeed,
they require a more complex production process and thus more indirect costs but that is
not reflected by the traditional method.
Standardized products do not need a complicated production process
thats why these products are cheaper
Specialized products have to cover a lot of indirect costs. They are
undercosted: the price is not enough to cover the real costs of these
products.
These 2 situations together lead to a loss in the long run. We have to
find a cost calculation system that lead to a profitable situation.
Due to increased automation, the proportion of direct labor hours / machine hours has
decreased. The simplistic rule the more volume, the more labour hours / machine
hours, thus the more indirect costs is not valid anymore. We need thus a system that
takes into account the complexity of the production processes in the indirect cost
allocation. Products that are more complex need to bear a larger proportion of overhead
costs: activity-based and no more volume-based cost system.
For example: cost pools are composed by several activities which are not driven by the
same factors (different cost drivers). The assembly is driven by:
- Starting production line.
- Running machine.
- Quality control.

30

Activity-Based Cost system (ABC)

The cost allocation in ABC happens in two steps and with two major innovations.
Tracing indirect costs to activities: we split the
cost pools into individual activities that are the
new cost pools (one activity per cost pool
better reflexion of the complexity of the
production process).
Indirect costs are allocated to the activities
based on the percentage time spend on that
activity. Pay attention that this is still an
arbitrary allocation.
This first allocation is complex, there are a lot of activities. Cost objects can rely on a lot
of activities, this is more expensive.
This allocation is based on estimations: companies do not necessary have objective
information = first weak. This is more work than in the traditional system.
Tracing costs from activities to products: the cost driver used to allocate the indirect
costs to the products is not always volume-driven (labour hours or machine hours).
Indirect costs are allocated to the products thanks to the calculation of the practical
capacity of every activity and the activity cost driver rate.
It is difficult to estimate the practical capacity = second weak.
ABC = taking decisions based on information about cost allocations.
Example: Ice cream activities and activity expenses
There are two types of ice creams:
Vanilla and chocolate: very standardized type of ice cream & high sale volume
Strawberry and mocha-almond: very specific & lower volume of production
After looking at the activities, we identified four individual, homogeneous activities. To
determine the amount of indirect costs used by each of them, we split up the cost in four
different parts (no more in two parts). We need an IT system that is able to tell us this
information: time ABC.
The cost of these activities is then allocated to the four cost objects (the four ice creams).
To calculate this, we divide the total cost of every activity by the cost driver (in terms of
practical capacity) and we multiply the result (the cost driver rate) by the consumption
of each activity.
31

There are four types of activities.

Unit-level activities. Those activities are considered in the traditional cost management.
Batch-level activities. They refer to lots of products or services.
Product-level activities. They are performed per type of product.
Facility-sustaining activities. They are not related to the cost object: they support the
activity but do not add value to the product (reception to welcome consumers, cost of
the CEO, electricity in the bank office, etc.). They are indirect costs by definition but we
need to make a distinction between them.
There are three types of activity costs drivers.
Transaction drivers. The number of time that we do an operation. For example, the
number of setups.
Duration drivers. Some products require a long set up and some do not.
Intensity drivers. If we consider two types of products, a basic product (3h with 1
worker) and a complex product (3h with 5 workers), the complex product is more
intense. Traditional ABC can not capture differences in intensity but TDABC includes
this notion.
To choose the optimal ABC model, we have to make a trade-off between measurement
cost and error cost. The aim of the manager is to dispose of a tool that can help him
make good decisions. However, a costing system that gives correct and reliable costs
calculations is very expensive (measurement cost) but a wrong decision because of not
enough reliable information has also a cost (error cost). We want as well a system easy
to implement and a system that gives us good calculations.
The Error cost depends on the complexity
and
dynamism
degree
of
the
environment. The Measurement cost
depends on the accuracy of the system.
The error cost is thus stable, as it depends
on the environment. To decrease the total
cost of the system, we can only bring the
measurement cost down.
Right, it is not worth investing more in the
accuracy because the error cost is low and measurement cost grows. Left, it is worth
investing because the error cost is still high.
The aim is to decrease the measurement cost, so we get another intersection point,
characterized by a lower total cost of the system and a higher accuracy (the
measurement cost goes down and the intersection point moves right and beneath).

32

Advantages of the system

Cost calculations are more accurate and better reflect the complexity of the production
process behind the cost objects.
Activity-based management. Management decisions are taken using the ABC system.
It gives opportunities to increase profitability: better price setting (activity-based
pricing), product mix decisions (dropping unprofitable products), better insight into the
cost of individual activities and input for process improvements. We can use the
information to improve the efficiency of the organisation.
Disadvantages of the system
The process to collect data is time-consuming and costly.
The information system needed is very complex to build and thus expensive, especially
in complex environments. This is the reason for the arbitrary cost allocation in the first
stage. However, this leads to three kinds of errors.
- Aggregation error: costs are aggregated over heterogeneous activities
- Specification error: the wrong activity driver is used
- Measurement error: the accuracy of the measures is not optimal (allocation of
indirect costs to activities, volume of the driver)
As there is an increasing complexity of the task environment, we need a trade-off
between errors.
It is difficult to keep the model up-to-date, which is a significant problem in a dynamic
environment. In practice, the traditional ABC uses the practical capacity of an activity to
compute a stable cost driver rate in the short run. However, in a dynamic environment,
the true activity quantities often change although the indirect costs do not change, so
the allocation of the indirect costs to the activities should change regularly. Thus, when
something changes in the production process, the company should re-estimate
everything but it does not in practice, as it is costly and time-consuming.
There is still no solution for the cost of unused capacity. When the demand for the cost
object is lower, we will not work at full capacity. We should thus not allocate a part of
the cost to the cost object but, in the case of ABC, we often do it practical capacity:
often based on arbitrary estimations.

33

Managing customer profitability

ABC reflects the complexity and thus we can reflect it in the price of the product.
Companies started to realise that they had to change their cost objects: they should
consider groups of customers. The basis product/service is the same for all customers
but different groups require different marketing, sales, distribution and administration
activities Companies try to differentiate with price setting.
Companies have very heterogeneous client portfolios: some are more profitable than
others.
Activity based pricing is based on ABC and on the theory of the Whale curve.
The Whale curve.
Accumulated
profit
increases with the most
profitable
customers
usually above the overall
profit of the company
until it
reaches a
maximum, and then
profit decreases until the
last customer (at which point accumulated profit is equal to the companys profits).
The distribution of revenues and profits follows the 80/20 rule: 80% of the profit of the
company comes from 20% of its customers. This means that 20% of your customers give
you a very high profit (150 300%), 60% make you break even (breakeven point where
you cover your costs, profit = 0) and 20% make you lose money (because the product is
expensive to produce example: strawberry ice cream). However, it is not a rule: we can
work on this. There are three ways to improve the customers profitability:
- Process improvements: reduce the costs of extra activities.
- Activity-based pricing: let people pay for extra-services (extra fee for example in
order to reduce the demand).
- Managing relationships: only 20% are profitable so we have to change that
relation.
For example: Ryanair. It is the same ticket for everyone but there are extra costs for
luggage, if you print your ticket or not, etc. Ryanair sell the same products to
everyone but there are different activities for different groups of customers (so different
prices more expansive if you want more luggage ,...)

34

Service companies
In service companies, almost all costs are indirect and fixed. The customer behaviour
determines the cost of serving them. They can thus benefit a lot from an ABC system.
Activity-based pricing: ask people to pay for extra services. Let the price reflect the
complexity of the service provided. Example: pay for luggage, for meal in the airplane,
etc.
ABC works well in a complex environment but not in a dynamic environment
(everything changes a lot, difficult to adapt the activity based costing for each change).
For example, ABC works well with 40 activities but only if there is no changes.
!! It is more interesting to look at the pricing for groups of customers and not at only 1
product.

Implementation issues
Lack of clear business purpose. ABC is not a purely accounting concept but, in the
beginning, companies were not convinced that it could be used for other purpose and
didnt see the added value of this tool. This is a problem because it is costly to implement
so some companies decided to stop it because they didnt see the real benefits of it (the
benefit is the technical side).
Lack of senior management commitment. They do not see the advantage of the ABC
so they are inherent resistant to changes (people dont like changes).
Consultants. Companies outsourced the implementation of ABC because they were
afraid of the complexity but consultancy firms lack information about the expertise, the
way the company is working, serving clients, etc. Thus, the tool is not adapted to the
specific needs of the company. Consultants do not have the same feelings than internal
people. The cost calculation system is a purely technical tool and not a reflexion of the
real work in the company.
Poor ABC model design. Estimations are made at the first stage, for the costs
allocations. It is very arbitrary and it creates distortions in the way cost is computed.
Individual and organizational resistance. It changes habits and ways of working.
People feel ABC as a trend.
People feel threatened. People can consider ABC as a way to control them and to
evaluate their performances. If ABC reveals unprofitable products, inefficient activities
or substantial unused capacity, it can lead to job losses or more work required.
35

Example: Invoicing department

We have an invoicing department with two activities: Invoices for EU clients and for
non-EU clients.
Indirect labour cost = 100 000 euros. 70% of the time spend on EU and 30% on non-EU
invoices.
If we have 8000 for EU and 2000 for non-EU invoices, the costs per invoice are:
EU = 70 000/8000 = 8, 75
NON-EU = 30 000/2000 = 15
Due to the dynamic environment, we have to do 6800 EU invoices and 2700 non-EU.
EU = 70 000/6800 = 10, 3
NON-EU = 30 000/2700 = 11,11
Increase
Decrease
One cost increases and the other decreases. The cost changes because people have
changed the way they spend time (not because of the amount of clients) and the
practical capacity has not changed. We need a cost calculation system that can capture
and be adapted for the changes in time spending.

Time-Driven Activity-Based Costing (TDABC)

TDABC helps solving two main issues of traditional ABC: allocation based on time and
managing of a complex and dynamic environment. Moreover, TDABC is transactionbased.
The cost allocation in ABC happens in three steps and with two major innovations.
(1) Tracing costs to resource pools. We
analyse costs per department, without
splitting them. All the costs are indirect by
definition.
Resource pools are departments (not
activities)
(2a) Calculate the cost per time unit. It is
the sum of the costs of the department
divided by the practical capacity of the
department in time units.
Cost per time unit is a universal cost driver.
(2b) Calculate the required time for each transaction. Time required for each activity of
the department to complete the transaction.
(3) Calculate the cost per transaction.
Use of time equations
First innovation: capacity cost rate. We calculate the cost per unit of time of supplying
capacity for each resource pool.
36

Example: Invoicing department

Total operating expenses for the customer service department: 567.000 per quarter
28 employees work in the customer service department. Each of them works 20 days
per month (60 days per quarter) and is paid for 7,50 hours of work each day (=
theoretical capacity).
Employees spent about 75 minutes per day in breaks, training, and education.
The practical capacity for each employee per quarter is
(7,50 hours * 60 75 minutes) * 60 days = 22.500 minutes
The total practical capacity of the customer service department is
22.500 minutes * 28 employees = 630.000 minutes
The cost per minute for the customer service department is
567.000 / 630.000 minutes = 0,90 per minute
Second innovation: time equation. The time needed for an activity is not constant but is
a function of different time drivers:
t = B0 + B1 X1 + B2 X2 +
t = time needed to perform an activity
B0 = estimated constant amount of time for this activity
B1 = estimated time consumption for one unit of activity time driver 1
X1 = estimated number of units of activity time driver 1
Example: Invoicing department
The capacity cost rate of the order processing is 0,90 per minute.
Assume that all orders take 4 minutes administration time each order line takes an
additional 2 minutes per order line out of stock items require an additional 8 minutes
per item when the order is a rush order it takes 5 more minutes when the order is
placed by customer Z, the administration time takes 7 minutes instead of 4.
We can thus compute the time equation:
1 order = 4min + 2min (# order lines) + 8min (# out of stock) + 5min (if rush) + 3min (if
customer Z)
Customer Z places a rush order with 2 order lines, of which 1 item was out of stock.
The activity time drivers for this transaction are:
number of orders (O): 1
number of order lines (OL): 2
number of out of stock items (OOSI): 1
number of rush orders (RO): 1
37

number of orders from customer Z: 1

We can calculate the activity time for this transaction
(1 O * 4 min) + (2 OL * 2 min) + (1 OOSI * 8 min) + (1 RO * 5 min) + (1 * 3 min) = 24
minutes
We can then calculate the activity cost for this transaction :
24 min * 0,90 per minute = 21,60
CCL: If there is a new factor, we can easily add it to the equation. It does not take too
much time and we dont have to re-estimate everything.
TDABC is transaction-based.
TDABC in complex and dynamic environments
This model captures the complexity with time.
Aggregation error: smaller because resources (costs) are no longer assigned to activities
but pooled on a higher level (in resource pools) and used by activities on a time unit
basis.
Specification error: no longer exists because in high complexity environments,
heterogeneous activities no longer have to be split (time = universal).
Measurement error: providing time estimates in minutes is easier than percentage
allocation over different activities.
This model captures the dynamism of the environment.
It is relatively easy to compute the cost of the overcapacity.
Neither mix changes, nor over- and undercapacity have an impact on the costing
outcomes.
When the way to perform an activity changes (which is likely in a dynamic
environment), the time equation can be easily adapted.
Advantages of the system
It is easier and faster to build an accurate model: we dont have to split up costs
anymore and change it every time a cost object appears.
It is easy to keep the TDABC model up-to-date.
There are good insights into capacity utilisation: per transaction we can compute how
much it costs.
We can produce detailed profitability analyses.
Integrates with operational data: time estimations are elements that we can get from
our IT system. We dont have to ask people how much time it takes, we just need to
observe them.
38

Enterprise-wide scalability: you can do that for every individual activity in the
company. It can be easily implemented at an enterprise level.
Enables process optimisation: we get insights about the time needed for an activity
and the factors that create inefficiencies. We can improve the IT system, give training to
optimize the process, etc.
Powerful forecasting tool: we can easily do simulations, what if.
Example: Invoicing department
The total cost is 100 000.
There are 3 full time employees, working 48 weeks per year, 30h/week. On a weekly
basis, they lose 2.22 hours for breaks, etc.
The practical capacity of employees is 30 h/week 2,22 h/week = 27,78 h/week.
The practical capacity of the department is 27,78 h/week * 48 weeks * 3 employees =
4000 hours
The cost of the department per time unit is 100 000 / 4 000 h = 25/h
The department has two different activities in the department: EU invoice (0,35h) and
non-EU (0,60h).
The costs of invoices are
EU invoice = 0,35h * 25/h = 8,75
Non-EU invoice = 0,60h * 25/h = 15
In year 1, they have 8000 EU and 2000 non-EU invoices.
The number of hours used is 8000 * 0,35h + 2000 * 0,6h = 4000 h They work thus at
full capacity.
In year 2, they have 5000 EU and 3000 non-EU invoices.
The number of hours used is 5000 * 0,35h + 3000 * 0,6h = 3550 They dont use the
full capacity.
The cost of unused capacity is 450 (unused cap.) * 25 /h (cost of department per time
unit) = 11250

39

Chapter 8: Measuring and managing life-cycle costs

We refer to total-life-cycle costing (TLCC) as the approach companies now use to
understand and manage all costs incurred in product design and development, through
manufacturing, marketing, distribution, maintenance, service, and, finally, disposal.
The TLCC aims at managing the total cost of ownership
Research, development and engineering cycle includes market research, product
design and product development. This first stage represents 80-85% of the total
committed costs of a product. To change fundamentally the cost of your product, we
have to focus on this stage.
cf. Target costing and Value engineering
Manufacturing cycle includes the production and distribution of the product.
cf. Traditional cost management, ABC and time-driven ABC & Kaizen costing
Post-sale service and disposal
cf. Environmental costing

1. R&D
Target costing
Breakeven time

2. Production
Kaizen costing
Lean management

3. Post sale disposal

Environmental costing

Target costing
This refers to the first stage of the life-cycle of the product: the R&D stage. It is
originating from the Japanese automobile industry.
The aim is to design (new) products that meet customers expectations and that can be
manufactured at a desired cost. Target costing is customer-driven: we need to know
the customers expectations (importance of market research). Target costing is also
characterized by target price: we need to know the price that the customers are willing
to pay. In the traditional pricing method (cost-plus method), the price is determined
depending on the total cost and the margin (price = cost + margin). In the target costing
(basic principle), we start from the higher price that the customers are willing to pay
and we determine on this basis the maximum cost of the product (target cost = target
price margin). The production is designed to reach that cost, the cost is not a result of
the production.
The market sets the price: we cannot sell a new product at a more expansive price than
the market price because we dont want loose customers.
Three important concepts in this method are cost, functionality and quality.

40

Companies using this concept are characterized by:

High tech, innovative products for which the product life cycle is short.
Demanding customers. The expectations and the demand change regularly.
Highly competitive industry
A lot of competitors (that offer +/- the same product)
Strong competition on price
Strong competition on speed of innovation
Large scale production of no specific items.
Majority of production costs are direct costs. This means that target costing fits well with
a traditional cost management system, rather that ABC because the more overhead costs
we have, the more we need an advanced costing system.
For example, for cell phones or cars, customers drive the market and there are a lot of
competitors.
Target costing in a company
The overall target cost is split up in target costs per component of the product cost. All
of them receive an individual target cost: raw materials, components, labour cost,
infrastructure cost (indirect).
At the practical side, we need to perform value engineering. We have to find, for every
element produced, the optimal balance between cost, functionality and quality.
There is a need for cross-functional product teams. A lot of people are involved in this
method because every department has to help in order to reach the target.
There must be an active supply chain management. We have to find the suppliers able
to deliver what is needed for the target cost. The success of target costing depends on it.
Example: Kitchenhelp
They want to improve an existing coffee maker because the desires of the customers
have changed. They have information about the 8 specific clients expectations and the
importance of each of them. A specific component can fulfil every specific expectation.
Link between component and expectation.
The most important components (that have the most value) are those who fulfil the
more expectations.
Value index (VI) = Value of the component (%)/ Current cost of the component (%).
This index gives information on which components are expensive regarding their value.
41

If VI < 1: the current cost is higher than the importance of the component Reduce it.
If VI > 1: the current cost is lower than the importance of the component Rethink this
component, invest, redesign because the expectations are much higher.
Target costing is not only about cost reduction. Its about the balance between cost,
quality and functionality.
Concerns about target costing
Lack of understanding of the concept. Target costing is a philosophy, it needs to be
integrated in the corporate culture. Without a clear understanding it might be rejected
by the senior management.
Poor implementation of the teamwork concept. Teamwork and trust issues can lead to
significant problems in implementing target costing.
Employee burnout. Especially design engineers might work under continuous pressure.
Long development time. Repeated value engineering cycle to reduce costs may lead to
coming late.
Target costing in Japanese versus Western environment
Business environment in Japan is different than anywhere else. Western companies that
have implemented target costing have been confronted to some problems:
Commitment to target cost is lower in western environments. Its harder to reach it.
(*)
Teamwork doesnt work as well in western environment.
Pressure on employees and suppliers does not work because of labour unions.
The labour cost is not fully under control because it is often linked to inflation.
(*) Link with kaizen costs. Western companies go to the market with too expensive
products because they cannot reach the target cost. The early movers will buy it. Then,
they will have time to implement kaizen costing: as soon as the product is on the market,
they will try step-by-step to decrease its cost and improve it in an incremental way
(minor changes that the customer will not notice). 6 months later, they will be able to
reach your target cost and customers will buy your product.

Breakeven Time (BET)

In target costing, we make a balance between the maximal target cost, the product
functionalities and quality. Here we add one aspect more in the balance: the time at
which you come into the market. The product development time and the product release
timing are important CSF.

42

The breakeven time is complementary to target costing. It represents the length of time
from the the projects beginning until the product has been introduced and generated
enough profit to pay back the investment originally made. It is thus the time taken to
recover all the R&D costs invested by the revenues.
The breakeven point is expressed in terms of units, of quantity in the contrary of the
breakeven time which is expressed in terms of time. Moreover, the breakeven point
applies to all the costs to cover in the contrary of the breakeven time which applies only
to the R&D costs to cover.
In the beginning, profit is negative
because we invest in R&D. We need to
produce because the R&D costs make us
lose profit. Then we go on the market and
start paying back our initial cost (payback
period). At some point, we have recovered
all our costs (labour, material, R&D,
infrastructure,...) and start making profit.
We then think of a new product or a new
version of it.
Moreover, the more you sell, the more you are able to cover your R&D costs.
It is possible that when you are at time to market, it does not coincide with the target
cost. The price could still be a bit too high for the customers but otherwise our
competitors will beat us with a similar product. Since you are in the market, you cant
change your product in a sense (technical features). Firm cant change the raw materials
for example. So even if your price is little too high, the firm has less options to reduce
price. Kaizen Costing.
Since we are in fast moving industry (short life cycles), quite quickly a new product
needs to be R&D. It is even possible that a new product is created before the firm gets at
the BET of the last product. So the line goes downward ones again.
Time is important: if you want to be the first on the market, you can recover your costs
faster but if you spend more money on R&D, you will need to wait more time before you
recover the R&D cost. The more time it takes, the more difficult it is for the company.
The breakeven point has no formula! You have to estimate the time thanks to market
studies, what the customers want, the price they want to pay for the new product, etc.
The company has to make a what if analysis.
The company has to maximize the R&D stage: time and money spent in R&D. The
product profitability is still the main concern: we want to generate a profit.
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Three characteristics of BET

Entire cost of design and development
Focus on product profitability
Stimulates faster product launch
The breakeven time is a tool for sensitivity analysis.

Environmental costing
This is the least developed concept. It is relatively new because 3-4 years ago,
companies didnt care about environmental issues.
The environmental costing refers to the decision time about the impact of the product
on the environment. We select suppliers whose philosophy and practice in dealing with
the environment match those of buyers. Both parties should thus have a clear
philosophy about environmental issues. Environmental costing is more than the cost
aspect: its a cultural thing, a philosophy, a way of working/acting/thinking. We have to
find suppliers that work in the same manner and have the same ideas/philosophy as us
because it can be a problem if we are environmentally friendly but our customers not.
Environmental costing includes several costs.
- The cost of the prevention or remediation of environmental impact (R&D
stage). Indeed, at the early stage, you have to discuss/think about the impact of
your product on the environment.
- The cost of disposing of waste products during the production process: waste
has a cost. Indeed, at the second stage (production stage), the waste has a
negative impact on costs how to manage this cost of waste at this stage?
- The cost of post-sale service (take back) and disposal issues has to be
incorporated into management accounting systems What happens when the
product is sold? How can we allocate these costs between customers?
This aims at avoiding the underestimation of the total cost of ownership. All those
costs have to be included in the total life cycle cost.
- Cost of doing more research (make the product more environmental friendly):
hard to estimate
- Cost of disposal: easy to predict.
- Cost of a loss of reputation: hard to estimate.
We can use the ABC philosophy to manage environmental costs.
Remove all environmentally related costs from the general overhead. We have to make a
distinction between explicit and implicit environmental costs.

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Explicit costs are the costs that you can directly identify. They include the direct costs of
modifying technology and processes, costs of cleanup and disposal, costs of permits to
operate a facility, fines levied by government agencies, and litigation fees. For example, 3
tons of waste each week.
Implicit costs are difficult to identify exactly. They are often more closely tied to the
infrastructure required to monitor environmental issues: administration and legal
counsel, employee education and awareness, and the loss of goodwill if environmental
disasters occur. For example, I am going to invest in a new machine and I know that if I
invest a little bit more, I will have a more environmentally friendly machine what is
the environmental cost?
Some environmental costs can be directly traced to the cost objects (products, distribution
channels, customers). The cost of waste disposal is created when we run the machines
(50%) and when we change the machines (50%). The cost of cleaning products comes
from machines change (80%) and product schedule (20%).
For indirect environmental costs, we need an allocation system. Indirect environmental
costs are allocated to the cost objects via the activities that use them. Cost objects
consume activities. Because it is a mass of indirect costs, it is not easy to distinguish the
environmental costs from all the indirect costs.
!! A company need some tools to manage the environmental costs because these
environmental costs require a lot of work. It starts by measuring environmental costs.
ABC schema:

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Chapter 7: Measuring and Managing process performance

Now, we are on a market where products are a little too expensive. Kaizen costing
consist in making small, incremental improvements to a process during the
manufacturing stage of a product, to reduce the production cost on a continuous basis.
We cant change the technical features of the product, as we are already on the market,
but we can try to reduce the cost to target the target costs by outsourcing some parts of
the production, changing suppliers, improving the efficiency of the production process,
etc. We will never change radically the cost of the product.
Kaizen means small. We go for small cost reduction. Make small initiative. Renegotiate
the price of your screens with your supplier or another supplier.
Example:
Actual cost = 127 >< Target cost = 120. The actual cost is too expensive. We have to
reduce our costs quickly. How to reduce the cost by 7 without touching technical
features? Who do that? Operational workers who know what are the aspects that are not
very efficient for example.
Ask the operational workers were the opportunities are to reduce costs. With supplier it
is risky since you need your supplier; need a good relationship with them. So it is better
to try to resolve the inefficiencies. Need a good stimulation and reward systems for the
workers. Because give an extra pressure on your workers. This is called the performance
Management. Give them the right incentive, motivate them.
It is complementary to target costing
- Especially when the target cost was not reached at product launch (cf. chapter 8)
- To convince the largest group of potential customers
It is complementary to lean production systems: improve the efficiency with less; do
more with less or with the same. Leans central philosophy is that any resource spending
that does not create value for the end customer is wasteful and must be eliminated. Can
we reduce the waste in term of time?
End-to-end (beginning to ending): a responsibility for a task is divided into pieces. You
have a waste of time because of the transfers of inputs. So you divide your task to reduce
the cost. Each person is responsible for a part of the production chain.
Lean manufacturing is a generic process management philosophy derived from the
legendary Toyota Production System that is associated with just-in-time manufacturing.
It is important to distinguish the target reduction rate (15 in 3 months) and the
actual reduction rate (3 in Month 1, 7 in Month 2 and 5 in Month 3). It is a topdown approach. For example, from 127 to 120, you have a limit imposed by the top
management.

46

Kaizen costing is applicable to the variable production costs that are not committed
yet during the R&D stage. When we are not at the breakeven time yet, we have to
decrease the costs that are not committed yet: variable costs. The real fixed costs are not
candidates for kaizen costing.
We can thus work
- On the cost elements itself: finding cheaper components.
- On the production process: trying to improve the efficiency, the productivity by
making small incremental improvements. Its about doing more with less.
Most of the knowledge to improve the production process comes from the operational
workers.
- Bottom-up approach: target reduction is top-down but the initiative comes
from the bottom.
What to do in order to increase the efficiency?
- Need for full transparency about production costs
- Pressure on operational workers (concern): kaizen costing is a working
philosophy. Operating people need to think about it every day while working. We
should thus remunerate them for it and give them incentives.
- Continuous cost reduction (ex.: material cost) should become a corporate
philosophy, not a one shot action. This element of cost on what we can intervene
directly depends on the contracts, relationships with suppliers, if they are flexible
or not, etc.
Kaizen costing implies a regular follow-up on production cost. We need an added
value analysis: we have to distinguish value adding and non-value adding activities
(waste). It is more efficient to try to reduce costs on the non-value adding activities.
Those small initiatives cannot take years. Since we are in a small life cycles. The firm
needs to attract the large mass of customers le plus vite possible. With a price a bit too
high, you only attract the fast adopters of new technology.
It is more than just technical concepts. It is technical ways but you need to put them in
place and that is much more difficult. This is because you also need to change the firms
culture and the way of the workers think. In other words, you need to change the
philosophy.

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Chapter 10: Using budgets for planning and coordination

There are three major areas in management accounting: cost management, budgeting
and performance measurement or management.
The Budgeting process determines the planned level of most variable costs.
A budget gives you an amount of money by
department or by group of person.
Budgets represent the quantitative translation of
the organizations objectives and strategic plans.
The company will determine strategies to achieve its objectives (reduce the waste,
create new products, etc.) and those can be realized thanks to the budget (expressed in
monetary terms).
When the top management delegate its activities, he needs people to realize the
objectives and by delegating its objectives, he needs budget.
It is clearly link with the strategic management.

Roles of a budget
A (pro-active) planning tool: define how to reach this objective and put the strategies
in execution.
A control tool: control how far objectives are realized and budget respected. This is
variance analysis: after one year, we compare budget and reality, look at the costs made,
overspending (and reasons), etc. The budget gives the limit but gives also the limit after
the operation. Goes both ways, I give you a budget but you give back to me by reporting
every x months and monitoring..
A communication tool: delegating budget activities to lower managers helps reflecting
how well they understand the organization goals through the priorities they make and
helps senior managers to correct misperceptions in case the budget is not optimally
allocated to reach those goals. By giving a certain amount of money, you show what you
expect people to do with the budget. Its an indirect way to influence the lower managers
by higher managers. Make them do what I think they should do. Budget is more than a
technical thing; it is a management tool since I can influence your behaviour. For
example, do not want you to go to Asia so I give you a limited budget. Budget is an
indirect communication tool, it is a reflection of what the higher manager wants the

48

lower manager to do. The amount must be enough to motivate, to avoid frustration but
also influence the direction taken with it. Moreover the timing is also important.
A coordination tool: most of the actions are interrelated and thus budget decisions
have consequences on other activities. What-if analysis helps identifying coordination
problems between activities. The timing of the budget is also important. The timing
must be adequate to the budget. People have to do the right things at the good moment.
Budget is a very subtle tool used by managers to influence/to guide
people behaviour to do the right things at the right moment.
A motivation tool: delegating budgets gives autonomy and delegates responsibility so it
motivates people to do their best to reach their objectives. There are human aspects of
budgeting. You have to make people enthusiastic about their job.
However, those human aspects may also have negative impact on the behaviour of
people: they will try to have the biggest budget for their department.

Budgeting
Four types of resources for which we can prepare a budget
Flexible resources (Short Run - create variable costs): the purchasing department
needs this estimation to see how many flexible resources we need. The link is clear with
the level of sales and production. The budget is directly related to the volume of
production.
Intermediate-term capacity resources (MR - create fixed costs infrastructure,
people): we need this estimation to know the storage space needed and the time we
need it. There is no direct link with the volume because this is FIXED costs. There are
link with the infrastructures.
Discretionary expenditures (MR & LR - create fixed costs): they help the
organisation to achieve its objectives (performance) but do not create physical evidence.
They do not vary with the level of activity (volume of production) but these costs are
related to the capacity. They are, for example, marketing, employee training, R&D, etc.
Long-term capacity resources (LR - create fixed costs): it includes new machines,
new building, new fabrication facility, etc. The link with the level of sales is less clear.
How to allocate the budget? There is the top down (could lead to frustration to not
have enough) or bottom up (higher motivation, potential risk that everyone ask more
than really needed) approach. Those two are the two extremes. The best option is a
49

combination of the two, so you go into a dialogue. As a CEO you decide a budget but you
dialogue with the lower rank to take the final decision. It is a human game this dialogue,
negotiation. Someone with a higher power will get a higher power in order to influence
the budget. So each department will reach a different result depending on the persons
(power). Budgeting exercise is a game!!! Budget is always an estimation since we
predict what the costs will be next year. This is done during November and December.
The two types of budgets of a master budget
A master budget is a one-year budget-planning document for the firm encompassing all
other budgets. It has usually two parts.
The operating budget is related to the operations of the company (production, sales
and support services like HR, marketing, etc.). We look at the income-generating
activities, including revenues and expenses, to determine the operational income for
next year. It generates the income statement.
The financial budget is related to the firms financial position. We look at the cash flows
to anticipate eventual CF problems and take actions in a proactive way to prevent them.
It generates the budgeted balance sheet. As cash is king in a company, the financial
budget is very important. To determine it, we first need the information contained in the
operating budget (because financial budgets are a translation of operating resources).
The better you are able to estimate your values, the better you are able to send out the
right predictions to the external shareholders. Every element in the budgeting process
are important to value your estimations and to take the right decisions.
Gaming the budgeting process
When we make a budget, we solicit information from managers or employees that are in
the best position to know the performance potential. Because those people know that
their actual performance will then be evaluated in function of that information, they
have incentives to misrepresent (dformer) it possibility to influence the amount of
money to receive.
To control those behavioural considerations that create personal comfort zones, a
solution is to exclude the provided information from the future evaluation of those
people.

Operating budget
Demand forecast Sales plan

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The demand forecast is an estimation of the sales demand at a specified selling price. It
can be determined through several ways:
- Market research through surveys performed by outside experts or internal sales
staff.
- Statistical models (regression) that use past information and trends to generate
forecasts: Y = 0+1.X1+2.X2+... with Y, the estimated sales. The better your
statistical parameters, the better your estimated sales.
- Take into account information on peers, competitors and benchmarks.
We can thus define the sales budget, i.e. the quantity of units we are going to sell (Q, the
volume estimated). Together with the price P, this quantity will give us estimations over
the sales revenues. Indeed, Q*P gives the CA. Also need to think about the when?.
Sales plan Production plan
Once we have the sales plan, we have to consider two other factors to determine the
production plan.
- The inventory policy: some companies produce goods for the inventory, in order
to dispose of a constant safety stock, while others prefer to produce with a justin-time policy.
- The capacity level of production is also a constraining factor.
Example:
100 = sales plan
+20 = inventory
-----------------------120
If my capacity is 80 units, I will not produce 120 units but only 80 units because of the
limited capacity.
We can then define the production budget to be able to sell what we have forecasted.
Production plan Spending plans
Spending plans based on the production plan
Based on the production plan & the resource commitments, we must determine the
purchasing plan.
The purchasing group prepares a materials purchasing plan, driven by two factors:
- The cycle of the organization production plans.
- The suppliers production plans (cf. supply chain management).

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The personnel and production groups prepare a labour hiring and training plan:
- Labour contracts (time horizon): it is a variable cost when it is a short-term
contract. The budget will influence how much those workers are paid. So if you
want this to change (reducing costs at maximum), you need to reduce the budget
allocating to this.
- Availability and capacity of employees: stimulate for more efficiency.
Example: how much budget I will give to people from the materials department? The
budget for the materials depends on the production.
All of your strategies must be translated in the budgets you allocate!!!
Sales plan (120) Production plan (80) Materials: Q & P Budget.
To set your price, you can look at the past (you take the existing price) or at the future
(potential behaviour).
!!! The budget changes people behaviour. The timing level at the production plan and the
quantity level change people behaviour too.

Production plan
Time (1h/bicycle)
Labor
Quantity

Past (80h/bicycle) Future (45 or 75h/bicycle)

Price

Past (45/h)

Decrease or increase,
40/h or 55/h

Administrative and discretionary spending plan

Administration and discretionary costs (R&D, marketing, training) help the company to
achieve its objective. They are not driven by the number of unit sold and thus not based
on the production plan.
They are rather driven by the strategic plans.
There are two techniques to create a budget for discretionary cost:
-

Incremental budgeting: we take the previous year budget and we increase or

reduce it by x%, x being a small amount. It is never a spectacular

52

change/improvement: we create a comfort room that becomes significant in the

LR. It is commonly used by the public sector.
Advantage:
Easy technique
Very fast technique
Disadvantages:
No link anymore with the objectives that we want to achieve, it is
completely arbitrary.
No stimulation to reach objectives and save money if people have more
money each year.
-

Zero-based budgeting (ZBB): we start at a zero budget and each department has
to justify and motivate any budget allocation. As a top manager (it is a top-down
approach), you have to stimulate that in order to improve efficiency. You will
make negotiations. It is commonly used by private companies

Capital spending plan

Finally, the capital spending plan for putting new productive capacity in place is
approved by the appropriate authority in the organization. The capital spending projects
usually involve long-term time horizons. If we do not have enough capacity, we need an
investment decision.

Financial budget
The financial budget is the financial translation of the operational budget (what we
have estimated until right now).
Internal point of view: the pro-active cash flow planning is crucial for the company.
- Payment terms have an impact: timing is very important to dispose of enough
cash.
- Net operating cash flow: we have to estimate them and anticipate the potential
problems.
- Investments: when investing, we may dispose of less cash.
- Financing activities (short term long term): we need to ensure enough cash all
year long.
- Exceptional elements: exceptional event can also provide extra cash.
External point of view: we can estimate the balance sheet and income statement.
With those projections, we can manage the shareholders expectations. Those
shareholders want a good and reliable estimation. Consequently, we have to put many
efforts on the operating estimations, to avoid any mistake that can misrepresent the
reality.
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Budget updates
Budgets are updated on a regular basis during the budget period: they are dynamic.
When people start spending, we need to follow up, to control and see if the budget is
respected or not. In this purpose, we make variance analysis (*) of the situation.
Moreover, the competitive situation may also evolve (new product launched by a
competitor, sales drop, higher demand than expected, etc.) and require new strategies.
According to the results or the changes in strategy, we might update the budget.
Important strategic tool for the future decisions.
(*) We can use variance analysis:
1/ We find out the difference between budget and reality: comparison of the actual cost
and the budget. Is it favourable or unfavourable?
2/ We need to find the reasons of this variance. Production volume higher than
expected: more money spent because of higher sales OK.
Price of raw materials higher than expected: unable to negotiate with suppliers.
Production is less efficient than expected.
Reduction in price from suppliers due to negotiation.
Production process improvement: we were able to use fewer raw materials than
expected.
Budgets as a decision supporting tool (in the short run)
We can use the budget as a simulation tool to make decisions: what-if analysis (what
happens if we do a price reduction for example?). This analysis is relevant and accurate
only if the model used to evaluate and estimate is relevant and accurate as well.
A sensitivity analysis is the process of selectively varying a plans or a budgets key
estimates to identify over what range a decision option is preferred. It enables planners
to identify the estimates that are critical for the decision under consideration. The
mechanism is the following: if you start to change some parameters, it will influence the
others.
Budget can influence behaviour!!

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Chapter 2: The Balanced Scorecard and Strategy Map

Performance Measurement Systems
We have objectives in our firm and this system helps us to get to them by motivating
employees, redirect them. It is more than just ones a year a measure. Performance
measurement systems can be used to fill five different roles.
-

Communicate the companys strategic objectives to the employees and thus the
expectations. You have direct ways of communication and indirect ways of
communication. Because sometimes direct is seen as a dictation. So need of more
than just direct communication. For example, the budget or the timing are
indirect. It is what you expect from people.
Delegate the responsibility and give a budget to reach a target objective.
Motivate the people to reach the corporate objectives. The motivation is
enhanced by the flexibility and freedom coming from the allocated budget. We
have to ensure that the personal objectives of the employees are congruent with
those of the organization. You have to motivate people for them to give the best
of themselves. They have to understand objectives to work well!
Evaluate and measure the way that the objectives were achieved after the
delegation. It is the evaluation of the performance and you have to find the
right/appropriate measure (must be realistic) of the performance to achieve
target objectives. Evaluation and feedback is important in the evolution of people.
Allocate again the resources to the people that get a good evaluation. Firstly, it is
related to the budgeting system. Where does the company needs to invest their
money in? To who? High performance employees? A good or bad system has to
be congratulated or punished. Secondly, people who work/perform well will
receive rewards. Remuneration is often a fix part plus a variable one which is
relied to your performance. So if you do well, you will receive a premium, a
bonus. Need to be very careful to not motivate wrong actions.

The challenge is to find the right mix of financial and nonfinancial measures to perform
these multiple tasks. You have to go further than the financial measure! It does not
guarantee the sustainability of the system in the long run. It is not enough to stimulate
people! That is why you need a balance between financial and non-financial measures of
performance. Since profit is not the only objective, as a firm you also need to survive in
the long run and have sufficient growth in the LR. (Stimulated work environment, good
process, etc. There is a huge causality between those non-financial things and the LR
profit.)
Physical and financial assets were enough for companies that generated value mainly
through physical assets. Nowadays, we have also to consider intangible assets like

55

customer loyalty and employee skills. Another aspect is that those intangible assets have
a perverse effect on financial performance. Indeed, investments in intangible resources
do not provide financial returns and are considered as expenses from a financial point of
view. Consequently, if we focus only on financial performance, we might never be
motivated to invest in intangible assets.
Another challenge is to find a performance measurement system (tool) that stimulates
everyone in the organisation to work towards the same objectives. You need to have as
employees to same goals. Not easy because people always have personal goals so
personal goals (eg. ambition) versus common goals. A firm needs to help employees
with their personal interest AND motivate them to achieve the common goals. A good
management is able to do this.
Need a balance between
(1) Financial versus Non-financial performance AND
(2) Short term (financial, customer and processes) versus Long term (learning and
growth) AND
(3) Leading versus Lagging indicators (Final one)

The Balanced Scorecard is a performance system on a continual basis.

The BSC is one of the most commonly used tools to measure (first) and manage
performance (then). There are other tools but this is the best one. It has been invented
by Kaplan & Norton1 in the 80s to support the evolution of the production economy to
a service economy. Companies were confronted to the perverse effect of intangible
assets and we needed to find incentives to invest in those assets. The BSC balances thus
between financial and non-financial performance (= trainee of people for example).
Techniques improvement cost a lot of money.
Moreover, the BSC balances short run and long run. The short run stands for financial
performance although the long run is for non financial performance. You have to find an
appropriate trade off between short run and long run for the measurement of
performance.
The BSC measures the performance across four perspectives derived from the
companys mission, vision and strategy. There are at least those 4 dimensions but could
have more dimensions in your firm.

Kaplan and Norton have brought a large impact on the management accounting.
Examen: Which tools/measures have not been created by Kaplan and Norton?
1

56

What?

Financial. The financial performance we should deliver to our shareholders. It is a very

basic perspective but it is the ultimate goal What can we do in term of financial
performance to keep shareholders satisfied?
Customers. The way we should deliver value to our consumers. We have to set objectives
for the operational people to satisfy the customers. This will increase profit and have an
impact on financial performance.
There is thus a link between those two dimensions.
CUSTOMER (to invest here) FINANCIAL (to have a great impact here)

How?

Process. The processes at which we must excel to create value for our customers and to
have a good financial performance. We have to ensure that the operational level is what
we expect it to be, to achieve the goals.
Learning and growth. The way we align and enhance our intangible assets to improve
the critical processes. To ensure the satisfaction of our consumers in the long run, we
need to invest in learning (people, technology, infrastructure, R&D, innovation
investments to make in the long run to keep on going performance). Concentrate on
the long term here.
Environment. The process depends on the context of the company such as the
environment of the company.

There are three interpretations of the balance between those four perspectives:
Balance between financial and non financial ( short run and long run)
Balance between: what do we want to achieve (1&2) and how are we going to do it
(3&4).
Balance between leading and lagging indicators: it is all about time.
- Leading: they occur before something happens. These indicators anticipate
something else. They are an early signal for future events.
Learning and Process
- Lagging: they occur after something happens. They follow an event.
Customers and Finance
There are cause and effect linkages between the dimensions: if we invest in one of
them, there are effects on others. For example, if we invest in learning, people will be
more trained and it will improve processes. It is important to show the causal
relationship to show that what we are doing is part of a bigger network. Through this,
we create transparency across objectives for the people.
Firms could have several BSC, one for the firm, one for the business segment, one for me.
You have in the end different levels of BSC. This translates BSC in a workable level. For
people, you need more than just one meeting a year!!

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Strategy
We have to create a strategy map: it is not part of management accounting; it is part of
strategic management. Before having a scorecard, we need a strategy. We need to ask:
what are the objectives of customer/finance/process...?
In a strategy, an objective is always action oriented.
2 important steps:
1. Create a good strategy. All managers have to do this.
2. Strategy map.
!! EXAMEN:
- Differences and similitude between budget and BSC?
- Cost management and performance.
The objectives of the BSC have to be based on a strategy. It is the first step that the
company has to take. A clear strategy has three principal functions:
- Create a competitive advantage by positioning the company in its external
environment where its internal resources and capabilities deliver something to
its customers that is better than or different from its competitors.
- Create a clear guidance for where internal resources should be allocated
- Make sure that all organizational units and employees make decisions and
implement policies that are consistent with achieving and sustaining the
companys competitive advantage.
BSC: Objectives, Measures and Targets
Once its strategy is determined, a company has to develop strategic objectives to
describe its strategic goals. Those objectives have to cover the four perspectives.
Then, it selects measures for each of them. It is a quantitative indicator of how the
performance will be assessed. It helps communicating the meaning and reducing the
ambiguity of word statements. Moreover, by giving indicators we motivate and trigger
people to take action to achieve them. Those performances indicators will indicate
employees actions. And those indicators should be able to measure, the information
should be available. Common mistake for firms, for half of their indicators, they do not
where to find their information. And possible to create those information at a
reasonable cost.
Finally, managers select targets for each measure. It represents the level or rate of
performance required. It should position the company as one of the best performers of
the industry but also create distinctive value for the shareholders. A target motivates
people when they know it is achievable. The target must me ambitious but achievable
and realistic in order to have high performance. The top down approach is important to
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keep a control on the targets. The bottom up approach is also important: you need to
have realistic targets.
Example: Airline company
Strategy: be the number one low
cost.
Clients objective: attract and
retain more customers.
Measure: we measure loyalty.
Target: X% of customers that take another flight in the year.
Creating a Strategy Map
The Strategy Map is a tool linked to the BSC and used in the beginning. It is a visual
representation of the causal relationships among the strategic objectives across the
four BSC perspectives. It is very useful to communicate the strategy as it is a visual tool.
For each dimension, there are several objectives and the map makes it possible to see
what we contribute to the ultimate goal. Putting in a visual aid, give the employees the
opportunity to see where they are in the relationship between the different objectives.
This is strategic management and should be done by CEO, managers (they decide the
target which should be very specific). Could be done by bottom up or top-down.
However top down is certainly not the best option in order to get together to the
common goal (and not feel the negative effect of the personal interests) especially for
the targeted objectives. Those objectives needs to be realistic but also ambitious.
To develop a Strategy Map, we follow a logical process. It gives guidelines to follow the
right track:
1/ Financial perspective: identify the long-run financial objectives to improve the
shareholders value. It is the ultimate goal of the profit-seeking companies.
The financial performance improves through two basic approaches:
If we want to have financial objectives, we focus on cost and revenues:
COST
FINANCIAL
PROFIT
REVENUE
-

Productivity improvements
Cost reductions through lower direct and indirect expenses.
More efficient assets use to reduce the working and fixed capital needed.
Revenue growth
Enhance existing customer value through the sale of additional products
or services.
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Expand revenue opportunities through the introduction of new products,

the sales to new customers or the expansion to new markets.

2/ Customer perspective: select the target customers and the objectives for the value
proposition
The customers objectives are not the same:
SERVICE
PRICE
CUSTOMER
PRODUCT
FUNCTIONALITIES
TIMING
The value proposition is based on a combination of price, quality, time, function and
service. There are three typical value propositions:
Low-total-cost value proposition: the cheapest one (Ryanair, Wall-Mart).
Product leadership value proposition: innovative and high tech products for
which customers are willing to pay more because of the functionalities (Apple,
Armani).
Customer solutions value proposition: broad range products/services, tailored
solutions (IBM).
3/ Process perspective: select objectives that create and deliver value proposition to
customers and improve productivity and efficiency to improve final performance
measures.
There are four critical processes to achieve customer, revenue growth, and
profitability objectives:
Operations management processes: production needs and necessary operations.
Customer management processes: relationship with customers (new and
existing).
Innovation processes: new products development and R&D excellence.
Regulatory and social processes: compliance to regulations and social
dimensions.
4/ Learning and growth perspective: identify the employee skills, information needs
and company culture & alignment that drive critical processes improvement.
There are three components of the intangible assets.
Human resources: training, development and motivation show that the
company cares about people and ensure the strategic capabilities availability.

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Information technology: good infrastructure serves customers and ensures

operational success.
Organizational culture and alignment: shared vision, aligned goals and
knowledge sharing.

All of this above is just a proposition. There is no need to study this by heart!!! It is only
an example.

Managing with the BSC

Developing the Strategy Map and the BSC is just the beginning of performance
improvement. Once they have understood the strategy, employees have to develop
personal objectives in link with it. Indeed, companies have one corporate BSC for the
whole organization but they can have several one: per different departments, per
different levels of the organization because they need to measure different objectives
and all the objectives.
To support this, most organizations link incentive compensation to the BSC. There is a
need for a good balance between financial and non-financial indications. If we measure
people only on financial performance, they will take actions that will only have a shortterm influence in order to increase profit. Remuneration is the ultimate way to change
people behaviours. People must also have some freedom to decide, otherwise there is no
need to link performance and remuneration. We have to stimulate people to follow the
performance philosophy, by using different types of compensation (bonus,...) and
freedom. Performances measures link to the remuneration is very delicate. There is a
difference between individual bonus and group bonus. Group bonus is good when there
is group effort. It is important to remunerate individual but also group efforts. Especially
since group efforts helps to create shared goals.
We can integrate concepts such target costing, break-even time, kaizen costing and
environmental costing into the BSC (into your performance indicators). It is not easy to
integrate concepts but you can help this by integrating it into performance measure
indicators. For example, kaizen costing aims at reducing costs.

Barriers to the effective use of the BSC

Several factors can lead to problems when building and implementing the performance
measurement and management system:
Too few or too many measures are used. It is difficult to define the number of
measures to use. However, using too few measures (1 or 2) does not allow depicting the
strategy and does not represent a balance between desired outcomes and the
performance drivers of those. We only capture a specific element. On the contrary, if we
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use too many measures (100), the managers attention is diffused and we cant pay
attention to the more critical ones. Moreover, we need then a complex IT system.
Measures dont reflect the strategy. We define the strategy and then identify the
measures. The wrong way to do it is to look at current measures and classify them into
the four perspectives. So measures should reflect objectives and strategies. There is a
direct link between measures and strategies.
Senior management is not committed. If they are not actively engaged in the project,
new measurements will focus on local operational improvements and not be a
comprehensive system that senior executives can use to manage the successful
implementation of their strategy. If it covers the whole organization, it can be used to
take decisions, to change the way they allocate resources, etc.
Scorecard responsibilities do not filter down. The strategy is not shared among the
employees and thus they cant contribute to the successful implementation. If we stop at
a high level, it will not work.
BSC is over-designed. They try to design the perfect BSC but it is impossible. We better
start with a basic BSC and improve it step by step. Moreover, some new performance
measures will be missing in the beginning so data need to be collected and created.
BSC is treated as a consulting project. BSC is not a system project you can ask a
consulting firm to do; it is rather a management project, a philosophy. It should be part
of the culture of an organisation.
EXAMEN!!!
3 blocks of questions:
1. 20 QCM (+1/0). Theory: more advanced concepts.
2. 2, 3 open questions: understand concepts conceptual question, 1
page/question. It is not pure theory!! Big concept not the details.
Example: What is the relation between target and Kaizen costing? What is the
relation between traditional cost management and BSC? Innovation in the ABC
system? Barriers of the BSC?
3. 1 or 2 exercises similar to the course exercises. Make or buy decision,
implementing system. ABC.
!!
!!

of the exam will be about COST MANAGEMENT.

Potential questions:
- Which tools/measures have not been created by Kaplan and Norton?
- Differences and similitude between budget and BSC? (Cost management and
performance.

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