Management Accounting

Pr. G. Sarens, Y. De Harlez & K.
Adamsen 2019
Management Accounting
2 group work (50%) + the exam (50%): QCM and open questions.
Course topics:
● Cost calculation and cost management
○ Concepts and cost behavior
○ Activity-based costing (ABC) and time-driven ABC: it’s a crossing technique to
answer questions like “How to make sure producing this car is profitable ”
○ Target costing and kaizen costing
○ Cost and decision-making
● Budgeting
● Performance management
Part 1: Yannick De Harlez
I. Intro management accounting
Picture of cars in a Ford factory. This is a manufacturing plan, and therefore, a set of expenses.
It represents a period of time where management accounting became more and more
important. Looking at this picture, the manager wants to know how much time it takes to
make a money.
At this time, what would be the most important questions I’d ask myself?
• How to reduce time / how long does it take to produce cars?
• How to reduce costs?
This picture could emphasize the cost side. There is a bunch of cost represented in it:
• Labor cost.
• Pieces and raw material.
• The accountant.
• The structure.
• The engines, etc.
At this time, Ford was more interested in cost by car. From the competition point of view,
they were the first industrial car producer. Car manufactures increased in competition
diversity, which means you want to know that the cost with expenses would not exceed
revenue if you still want to make profit So, if the competition increases, how to make sure
you’re still making money? Should I take the cost of factory, accountant, … into account? If
yes, how can I allocate it to one car, what proportion? Management accounting helps answer
those questions.
N.B.: debit and credit: now, no talking about debit

and credit anymore but those notions are warming
up notions.
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Pr. G. Sarens, Y. De Harlez & K. Adamsen 2019
II. Financial vs Management Accounting
How management accounting information supports decision making
A. Financial Accounting vs Management Accounting
Differences between both
Managerial Accounting Financial Accounting
CBP Analysis, etc. This is done because it Income Statement (I/S), Balance Sheet (B/S),
can help the firm. Journal Entries (J/E), etc.
Internal use of the information and the External use (regulators, lenders,
accounting numbers that you are creating. shareholders, organization you owe money
This is typically not reported. too, etc.). Those constituents are all outside
the firm.
Not required or mandated. Required. The firm has to be in compliance.

We have to respect the legislation for
standardization and access.
Does not have to follow the GAAP. GAAP (= Generally Accepted Accounting Principles).
Future-oriented. What are those number Past-oriented: what was the marketing
used for? To look at the future. Example: expense last year?
what will be the marketing expense for next
year.
Concerned with the relevance and the More concerned with objectivity and more
timing of the information (not at the end of precision. Without precision, you can be suit
the year). This is not precise to the dollar. by shareholders for fraud, etc.
Segment or divisions reporting. Example: by Consolidation reporting (At the firm level,
department, region. not division of the firm)
You have the form with three divisions: A, B and C. You will have an income statement for
each and you will report at each level. But with Fin. Acc you are putting together a
consolidated I/S, etc.
This presentation is accurate on how to describe the difference of the two fields.
Definition of Accounting
• ‘Debit’ and ‘credit’ are strange words, probably coming from latin. The predecessor is
Pacioli. He is the first leader of double book keeping. Accounting seems much more
like a language than something else.
• A new language is learned by practicing. If you want to learn a totally new language,
you could travel, etc. But first you should get familiar with some vocabulary and
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grammar. Even though you know the accounting basics, there are some subtleties.
Examples:
o Added Value on an asset: it is when the book value is significantly different of
the value, depending on some conditions, you may book a new value of the
asset.
o A Cost of Opportunity: it is the cost of the alternative that is not picked.
Making a choice, you neglect other possibilities which induce a cost: the CO.
N.B.: declaring the revenues is mandatory. But some expenses are not taken into account
(NDA). In Belgium we have optimal tax basis. For Management Accounting, there is no rules.
B. Management accounting (not seen in class)
Helps a company develop, implement and follow-up on its strategy. Through the ‘Plan-Do-
Check-Act’ (PDCA or Deming cycle = a continuous quality improvement and learning model consisting
out of a logical sequence of four repetitive steps ). American Engineer and Statistician, “The father of
quality management”. 1950: he proposed that the business processes are replaced byba
continuous loop, so managers can identified and change the parts that need improvement.
Therefore, he created a diagram called the PDCA. Simple and effective approach for problem
solving and change management.
Plan = design or revise business process to improve results. Mission statement, objectives
and strategies
• Take into account the external environment, the industry and the internal strengths
and weaknesses.
• Important to communicate the strategy (cf. strategy map and Balanced Scorecard).
• Cost-volume-profit (CVP) analysis.
• Budgets.
• Developing new products and services (cf. total life-cycle cost).
Do = implement the plan and tests its performance or implementation of the strategy. Use of
management accounting information in daily (operational) decisions and work activities.
Check = to assess the measurements and report the results to the decisions makers.
Measuring, evaluating and reporting
• Calculate cost and profitability of products and services.
• Calculate cost of serving customers and customer profitability.
• Analyzing and improving operational processes.
• Variance analysis.
Act = decide on changes needed to improve the process. Take actions based on the
information coming from the previous step. Examples:
• Lower corporate costs (ex: improve internal processes).
• Improve product quality.
• Change product mix.
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• Change customer relationships.

• Redesign products.
• Reward employees.
III. Basic Cost Management concept
Picture of two weird Mexicans enjoying tequila while playing guitar. Link with the class?
Fixed cost = cost that does not depend (or vary) on (with) the quantity produced. From a
financial point of view, it is a cost not related to the project, that cannot be erased. From the
managerial point of view, it is totally different.
There is the academic perspective (based on definition) vs pragmatic perspective (should we
care about the definition, when you take decisions related to do the costs?). Combine both is
super nice.
 What you see depends on the point of view.
A. Management accounting supports internal decision making
Use of cost information:

• In planning
o Pricing decisions (market price versus cost-plus price).
o Product planning (cf. target costing).
o Budgeting (cost forecasts).
• In monitoring. Example: evaluation of the performance of the firm (cf. variance
analysis).
 Understand the cost behavior.
B. Cost Categories
Costs should be assembled in different ways according to the requirement (“Different types
of cost for different purposes”).
• To assess the inventory value for internal and external profit measurement.
• To provide relevant information to help managers make better decisions.
• To provide information for planning, controlling and performance measurement.
Academic definition
• The objective is to make profit (economic perspective). Profit is the difference

between revenues and costs.
• MECE (a type of line of reasoning): Mutually Exclusive & Completely Exhaustive. It
describes the way you think, usually, with boxes. They should all reflect the entire
situation, not a piece of it.
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Example: is the light on? You have yes or no as possible answers. This is ME and both
answers are CE, together, they are sufficient to answer the question.
Example of profit: you have a profit problem: profit declines over time. You can either
look at the revenue or look at the expenses. Those two boxes are mutually exclusive,
there is no overlapping domain of being in one and in the other. They are also
exhaustive because it is a matter of revenue or expenses but nothing else.
In the revenue box, you could find the unit price (market aspects) or the sold quantities.
But you cannot neglect the fact that price has an impact on quantities and vice versa,
however it remains MECE.
If the profit is about 0 but the revenues grow 10% per year, the problem is in the
expenses box. Today, cost reduction is dangerous. Claiming this to the public scares
and all the skills vanish. In the expenses box, one way to deal with it are the ‘direct
versus indirect costs’. They are MECE. An example of a direct cost of a project could be
the salary of the person on the project tracked by the time he is working on it. You
can track it by time sheet or an IT system. But this Time Sheet system needs education
of the people using it. This takes time. You can also end up with materials, travels, etc.
But the main cost is probably the salary of the consultant. The other way is ‘variable
versus fixed costs’.
From an academic point of view, this is straightforward. But not always from a
pragmatic point of view.
a. Direct vs. Indirect costs
i) Direct costs
Costs that can be specifically and exclusively identified with a given cost object. Identifying
the cost object is essential!
Example: Donane is a company that produces two types of product: A and B. The company
only recruits temporary workers for manufacturing product A (not for product B); other
workers are full-time employed.
ii) Indirect costs
Costs that cannot be specifically and exclusively identified with a given cost object. Also
called overheads (frais généraux).
Example: Mr. Dupont is the production manager of Donane. His role is to ensure a proper
manufacture of both types of product: A and B.
Example of a consultant salary (suite): the initial purpose of a travel is a project. Then, being
there you shake some hands of other customers. You have an expense for a flight back ticket.
Is this a direct or indirect cost? Allocating costs needs to be with quantitative factors
(numerical outcomes) and you cannot do 80-20%. Another solution: think about the initial
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purpose. You need to travel for a project. Shaking hands was a side activity. You can base the
decision on the initial purpose.
Again, from a pragmatic perspective, even though you have a definition, it is not always
straightforward.
b. Variable vs. Fixed costs
This distinction tells how a cost behaves.
i) Variable costs
Variable costs (/!\ Warning: not variable cost are not necessarily fixed cost) are costs that
vary in direct proportion with activity of the firm. Will doubling the level of activity double
the total variable costs?
Example: energy to operate the machines.
The total variable cost is linear over wide ranges of activity. A unit variable cost is constant.
Example of a laboratory:
• If you make two experiments instead of one, you will consume more components. The
costs of chemicals vary in direct proportion with the number of experiments. It is a
variable cost.
• But the salary of the scientist, from a pragmatic point of view, is a fixed salary. If you
have a salary it is very likely to be a monthly salary, paid equally over time regardless
of the number of experiments.
• You pay a rent for 4 labs and it was very expensive. The CEO is a visionary, who likes
science fiction. He thinks he will grow 100% (8 labs). Thus, they will need to double
the size and the number of labs (from 12 000 rent to 24 000). Is rent a variable cost?
The second graph is 99% of the time when we talk about variables costs. Making different
requests for prices and playing with competition can be possible depending on one's position.
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ii) Fixed costs (in the short term)
Image of Magotteaux, in Liege. They have multiple facilities around the world. They also had a
production plant few miles from the headquarters. Professor had to audit to see how the
plant calculated the cost of production. They were too high compared to other plants. They
were some rumors of relocation were hand was cheaper. But the headquarters were
somehow attached to this plant, this was the start of the company. Closing this facility would
have involved closing a historical plant. They were tensions between headquarters managers
and the plant managers.
How would you tackle to find out the real cost of production and dig into the numbers? To
tackle a business problem, you have to make assumptions. For instance, « they are some
problems with the cost of materials ». Multiples assumptions are possible. Examples:
• Look at the material consumption.
• Electricity. Not one of the most important resources but still a big deal. The plant
considered it as a fixed cost, but at the headquarters, as a variable. Headquarters had
a more theoretical perspective. The classification of costs created a tension between
both entities.
• Cost of the steel, maintenance of the furnace, transport, supervisor, blue-collars,
depreciation of the machine, time of union, utilities (gaz, electricity), HSE (coat,
helmet, gloves), R&D, etc.
• Reallocating production, what costs would disappear, fixed or variable? Only variable
cost will disappear, fixed will remain. It is important to classify properly the costs.
Fixed costs
• Costs that do not vary in direct proportion with activity of the firm.
• Exist in the short term only. In the long term, all costs are variable.
• Depend on the amount of a resource acquired not used (capacity-related costs).
• Total fixed cost is constant over ranges of activity.
• Unit-Fixed cost decreases proportionally with the level of activity.
Example of the laboratory: on a monthly basis, a rent of 12 000€, tax value excluded. The
value was not impacted by the numbers of experiments.
N.B.: the first graph represents a total fixed cost. But some academic managers strongly
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believe in ‘unit fixed cost’. The professor has never seen this on the field. This is mentioned
to challenge the existing ideas, but this concept does not exist in practice.
Unit fixed cost is a fixed cost divided by the volume. If the volume is 10 experiments, the
cost will be € 1,200. For 20 experiments, it will cost € 600 per experience, and so on. From a
𝑎
mathematical perspective, 𝑌 = 𝑥 , where a is the total fixed cost and x the number of
experiments.
The managerial implication is economies of scale, which means the more you produce, the
lower the unit cost. However, every single cost should be characterized by a maximum
capacity. Then, you can’t seek to go further. There is a limit, the capacity. At some point, if
you want to increase the capacity, the rent will increase as well because you will need more
labs.
An essential classification for decision-making.

• Understanding “if” and “how” costs vary with different levels of activity.
• Examples of decisions to make:
o What should the planned level of activity be for the next year?
o Should we reduce the selling price to sell more units?
In practice
• Classifying between variable and fixed costs is not necessarily evident. The limit
between fixed and variable is blurry. However, many textbooks don not consider this
blurry line.
• Examples: https://www.youtube.com/watch?v=28Odav4L8i8 (explanation of the
different costs).
c. Important observations
Imagine a 2x2 matrix:
In principle, all four cases exist. In practice, however:

• Most direct costs are variable.
• Most indirect costs are fixed.
• Direct variable and indirect fixed are the two boxes more likely to happen.
Semi-fixed cost is a cost with a fixed base that is repetitive and an additional variable cost.
In practice, there is a lot of confusions:

• Variable = direct & Fixed = indirect
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• Direct = manufacturing & Indirect = non-manufacturing
N.B.: ‘absorption costing’ = a method of calculating the cost of a product by taking into
account indirect expenses (overheads) and direct costs.
N.B.2: ‘variable costing’ or ‘direct costing’ = an accounting method used to allocate

production costs by allocating all variable-manufacturing costs to a product.
d. Other useful cost definitions
The context and the decision have a lot of importance in the definition of the cost and to
understand the meaning of the cost. We will talk about this context with Pr. Adamsen.
• Mixed costs have both a fixed and a variable component. Typical examples: telephone
cost, electricity cost, salary cost of sales managers.
• Incremental cost or marginal cost is the cost of the next unit of production, it is a
semi-fixed cost. What is the cost of the next customer or the next order? It could
completely change your decision.
• Sunk costs are costs that result from a previous commitment and cannot be
recovered. A cost that your decision has no impact on. Typical examples: R&D costs,
depreciation costs, construction costs.
o The sunk cost phenomenon (point of no return)
o [?] Explain why it might sometimes be interesting to keep on producing/selling
(at first sight) non-profitable products.
• Avoidable costs are costs that can be avoided by undertaking some course of action.
It becomes relevant when deciding on the elimination of products. Avoidable costs
>< sunk costs.
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• Opportunity cost is the maximum value forgone (lost) when a course of action is
chosen. When there are at least two options in combination with limited resources
which makes that you have to choose. Opportunity costs are often overlooked (not
noticed). May completely change your decision.
C. Exercises (application of the definitions)
a. Are the following variable or fixed costs?
The criteria to distinguish both is « a cost that vary in direct proportion with the activity level
of the firm ». The implicit assumption is that the firm produces home theater systems.
Chicago Acoustics builds innovative home theater systems:

• Depreciation on routers used to cut wood enclosures: fixed, because it is a
depreciation expense. Regardless of the number of home speaker system, you
depreciate an asset (by definition it is a long-term asset, more than a year).
• Wood for speaker enclosure: variable. More home theater speaker, more wood.
• Patents in crossover relays: fixed.
• Crossover relays (a relay is an electronic piece/item to make a speaker): variable.
• Grill cloth (protection of the system): variable.
• Glue: variable.
• Quality inspector’s salary: fixed.
b. Are the following variable or fixed costs?
Sally’s nursery has been in operation for several years:

• Building rent: fixed.
• Toys: variable or fixed? There is a confusion, because we need to know more about
the context. Here, we have different experiences and backgrounds and, therefore,
implicitly assume different contexts. The activity level of the firm is the number of
kids. Professor’s answer is variable. He suspects that going from 5 to 6 kids, the
number of toys won’t change but from 5 to 10 it will change, knowing how kids act.
• Playground equipment: fixed. /!\ An expense and an asset are different. An
equipment is an asset, depreciated over time.
• Afternoon snacks: variable. Strongly vary in proportion with the number of kids.
• Sally’s salary: fixed. We assume it is fixed because we assume her salary is not
impacted by the number of kids. There is no direct proportion. Of course, she could
increase her salary, but regardless of the number of kids. However, if the salary was
x€/hour, it would have been variable because potentially impacted by the number of
kids.
• Wages of afterschool employees: variable. This depends also of the context. The
words induce it is not a regular work but rather additional hours of work. We suspect
this depends on the number of kids.
• Drawing paper: variable. It is variable because more kids mean more paper since they
really like that.
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• Tables (and chairs): fixed. This is an asset, thus depreciated over time. When we talk
about tables, we actually mean the depreciation of the asset and not the expenses.
N.B.: the more asset, the more administrative work. There are some benefits but for small
amounts it is more beneficial to not consider them as fixed but variable.
c. Four types of cost at two activity levels
Is each cost type variable, fixed or semi-variable?

Cost Cost 1 (1 Cost 2 (1 Answers
type 000 units) 500 units)
I $ 14 000 $ 21 000 Variable (because the unit variable cost is constant, i.e.
it’s equal to 14
𝑪𝒐𝒔𝒕𝟏 𝑪𝒐𝒔𝒕𝟐
=
𝑼𝒏𝒊𝒕𝒔𝟏 𝑼𝒏𝒊𝒕𝒔𝟐
14 000 21 000
=
1 000 1 500
II $ 22 000 $ 23 000 Semi-variable: $ 22 000 is the total cost. This includes
variable and fixed costs. If there was no fixed, then it
would have been purely variable and vice versa.
𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕𝒔 = (𝑼𝒏𝒊𝒕𝒔 ∗ 𝑼𝒏𝒊𝒕 𝒗𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒄𝒐𝒔𝒕)

+ 𝑭𝒊𝒙𝒆𝒅 𝒄𝒐𝒔𝒕
22 000 = 1 000 ∗ 𝑥 + 𝑌
Where X = Unit variable cost

Where Y = Total fixed cost
23 000 = 1 500 ∗ 𝑥 + 𝑌
Therefore, 𝑥 = 2; 𝑌 = 20 000
Volume
< 2 = 𝑢𝑛𝑖𝑡 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡
20 000 = 𝑡𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
[There is not enough information to refute the fact that it

is a semi-fixed cost]
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III $ 24 000 $ 24 000 Fixed. The easiest answer is that the cost remains
constant and, by definition, is a fixed cost.
IV $ 7 600 $ 11 000 Variable: the assumption is to meet the condition that the
unit variable cost is constant.
1 600
= 7,6
1 000
11 400
= 7,6
1 500
The condition is met. The total cost is purely variable.

Doing the mathematical exercise of II, you would end up
with 𝑌 = 0 (no fixed cost) and 𝑥 = 7,6 (unit variable cost).
d. Four types of cost at two activity levels
Is each cost type variable, fixed, semi-variable, or semi fixed?

Cost Cost 1 (1 Cost 2 (1 Answers
type 000 units) 500 units)
I $ 7 000 $ 10 500 7 000

=7
1 000
10 500
=7
1 500
Variable cost. The condition is met.
II $ 11 000 $ 12 500 11 000 = 1 000 ∗ 𝑥 + 𝑌

12 500 = 1 500 ∗ 𝑥 + 𝑌
11 000 − 1 000𝑥 = 12 500 − 1 500𝑥

𝑥 = 3 ; 𝑌 = 8 000
This is a semi variable cost (or semi-fixed). We don’t

have enough information to say it is a semi-fixed.
III $ 12 000 $ 12 000 Fixed. But this could actually also be semi-fixed.
IV $ 3 800 $ 5 700 Variable: the assumption is to meet the condition

that the unit variable cost is constant.
3 800 5 700
= 3,8 =
1 000 1 500
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e. Respond to the two following questions
A business produces one product which requires the following inputs:
Direct materials 6 kg @ £4.80 per kg
Directs labour 4 hours @ £7.00 per hour
Building costs £18,000 per quarter
Leased machines £600 for every 600 units of production
Stores costs £ 3,000 per quarter plus £3.00 per unit
i) What is the total cost of production and the cost per unit at each of the following
production level (units for a quarter):
1. 1 000 units?
2. 1 500 units?
3. 2 000 units?
1 000 units 1 500 units 2 000 units Cost type
Direct 6 ∗ 4,8 ∗ 1 000 6 ∗ 4,8 ∗ 1 500 = 6 ∗ 4,8 ∗ 2 000

materials = 28 800 43 200 = 57 600
Directs 4 ∗ 7 ∗ 1 000 4 ∗ 7 ∗ 1 500 4 ∗ 7 ∗ 2 000 Direct labor costs

labor = 28 000 = 42 000 = 56 000 behave has purely
variable costs.
Building 18 000 18 000 18 000 Fixed

costs
Leased 2 ∗ 600 = 3 ∗ 600 = 1 800 4 ∗ 600 Semi-fixed [? ≠ semi-

machines 1 200 = 2 400 variable?]
Stores costs 3 000 + 3 3 000 + 3 ∗ 3 000 + 3 ∗ The cost behaves as

∗ 1 000 1 500 = 7 500 2 000 = 9 000 semi-variable.
= 6 000
Total £ 82 000 £ 112 500 £ 143 000
Per unit £ 82/unit £ 75/unit £ 71,5/unit
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ii) Explain why the cost per unit is different at each level of production
The explanation of the graph is that the fixed costs are

divided by the rough units. The more you produced, the
more unit costs decreased.
The cost per unit is decreasing as production quantities

increase. This is because not all the costs are variable. The
buildings costs are fixed and part of the stores (inventories)
costs are also fixed. For these elements of total cost as the
production quantity increases so the cost per unit decreases.
This in turn reduces the total overall unit cost as the quantity
increases.
f. Flexible budgeting
Avocet Limited has produced an overhead budget for next year based on two levels of
activity: 10 000 units and 12 000 units. It needs to calculate budgeted figures based on an
activity level of 15 000 units. The budgeted figures for activity levels of 10 000 and 12 000
are shown below.
Avocet Limited - budgeted overheads for the year ending 31 December 20X2.
Production Type of cost 10 000 12 000 15 000
(units)
£ £ £
Factory rent Fixed 5,000 5,000 5,000
Machine Fixed 7,500 7,500 7,500

depreciation
Indirect labour Variable 20,000 24,000 30,000.
Indirect Variable 12,000 14,400 18,000

materials
Electricity Semi - variable 8,000 9,000 10,500 (3,000

fixed and 7,500
variable)
Stock insurance Semi- variable 9,500 11,000 13,250 (11,250

variable and
2,000 fixed)
Total 62,000 70,900 84,250
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Calculate the budgeted cost for each of the six types of overheads at an activity level of 15
000 units giving consideration to the fact that some overheads are fixed costs, some are
variable and some are semi-variable.
• Indirect labor: the unit variable cost should be constant. Therefore,

20 000 24 000
=
10 000 12 000
2 ∗ 15 000 = 30 000
12 000 14 400
• Indirect materials: 10 000 = 12 000 → 1,2 ∗ 15 000 = 18 000.
• Electricity: semi variable costs implies to make the equation to find the solution. We
have a variable and a unit variable component.
8 000 = 10 000 𝑥 + 𝑌
9 000 = 10 000 𝑥 + 𝑌
1 000 = 2 000 𝑥
𝑥 = 0,5 ; 𝑌 = 3 000
• Stock insurance
9 500 = 10 000 𝑥 + 𝑌
11 000 = 12 000 𝑥 + 𝑌
1 500 = 2 000 𝑥
𝑥 = 0,75 ; 𝑌 = 2 000
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IV. Cost Assignment & Management - ABC and Time driven ABC
A. Cost Assignment and Management
• Direct = NOT indirect.

• Indirect = NOT direct.
Such that there is no “in between”, there exists only those two cases. Mutually exclusive.
Example: a company that has two consulting projects:
• Project 1, financial and performance report.
• Project 2, financial and performance report.
The economic aspect is not important, neither are direct costs. We look into indirect costs
(which means that those cost are not specifically direct to the project). For example, we
allocate the € 12,000 of renting cost to the two different projects. How would we do that?
• Allocate rent based on the size of the project. This is a potential solution.
12 000
• If you are not interested in allocation process: .
2 (#𝑐𝑜𝑛𝑠𝑢𝑙𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑗𝑒𝑐𝑡𝑠)
There are zillions of options going from simple to very sophisticated.
Importance of two ways to allocate indirect costs. There is a clear pattern of action for more
than a 100-years.
We assume ABC (Activity Based Costing) reflects a different system than traditional ones. A
lot of companies do not have the time to focus on this. A way to deal with this in an efficient
way needs to be found.
There comes the notion of cost center (which is not more than an account).
a. Common denominators
• Same cost inputs in terms of value and nature.

• Same fundamental idea for the process of allocating indirect costs to cost objects.
Based on the use of allocation bases & cost centers.
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Definition of a Cost Center
A cost center is a financial account for expenses.
• In financial accounting: a pool of costs sharing the same nature (the ‘what’).
• In management accounting: a pool of costs sharing the same destination (the ‘what
for’).
 Both techniques are different.
You may have an equity account, a liability account, etc. Here, the cost center is an account
for expenses.
A ‘T’ account (debit/credit): we accumulate all the invoices. The common denominator (or
characteristic) between all the expenses in one financial account is that when you have an
invoice, you need to look up for the ‘nature’ of the invoice. This is basically asking yourself
“what did you buy?” regardless of the why. In management accounting the “why” is not
interesting but the “what” very. It is easy for an accountant to make this estimation and
interpret the invoice. Sometimes, classifying an invoice is not that easy. The point of
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attention is not one invoice but that they accumulate invoice. They are more interested in
how to allocate a set of invoices.
Moreover, they are all on the debit side.
There is a similar concept in management accounting, called cost center. It is more for the
“what for?”, “why did you buy the lab material?”. We wonder what the destination of the
expenses and do not care about the “What invoice?”. In the cost center, we have a list of
expenses sharing the characteristics about the information “for this department”.
So, how to allocate those € 12 000? We would focus on a set of invoices, asking “what
accounts?” And computing the total value of those expenses.
b. Traditionally, how to design a cost center?
• Copy the structure of the firm: 1 department = 1 cost center.
• In this context, the costs of the R&D department are pooled in the accounting center
called “610001 R&D department”.
• However, different possible levels of analysis:

• 1 cost center = 1 firm (the simplest perspective).
• 1 cost center = 1 department (a reasonable
perspective).
• 1 cost center = 1 unit (perspective adopted by geeks).
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c. ABC
Definition of Activities
The aggregation of many different tasks or units of work requiring the consumption of
resources to be performed.
[?] In operational finance, there are two major operational processes.
How to design a Cost Center?
Traditionally: a functional orientation (of the firm) is adopted (→ looks vertical).
The Activity Based Costing (ABC) is when a business process orientation of the firm is
adopted (→ looks horizontal).
• Copy the activity view of the firm: 1 activity = 1 cost center.
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• However, different possible levels of analysis

o 1 cost center = 1 firm (the simplest perspective).
o 1 cost center = 1 process (a simple perspective).
o 1 cost center = 1 activity (A reasonable
perspective).
o 1 cost center = 1 task (perspective adopted by
geeks).
Moreover,
• Important challenge: find the right cost pools in terms of cost homogeneity.
o A cost pool represents a set of expenses driven by the same cost driver.
Example: all production unit driven expenses, all batch driven (par lot)
expenses.
o Costing distortions arise when cost pools include expenses that are driven by
different cost drivers
o This could lead to over- or underpricing of cost objects.
• Sometimes it is better to split up cost pools into more homogeneous cost pools.
• A business process orientation minimizes the problem of resource heterogeneity
o Trad. - functions: you perform a large variety of different tasks → different
resources needed for different tasks → no homogeneity.
o ABC - processes: you perform a set of similar tasks → similar resources
needed for similar tasks.
The project manager will not accept a number allocated to him if he has no influence on it.
d. Allocation bases
Allocation bases is a quantitative measure used to allocate indirect costs to cost objects.
Is the allocation base a significant determinant of the indirect cost?

• If yes, the term “allocation base” is replaced by the term “cost driver”, which
emphasizes the use of a cause-and-effect allocation.
• If no, we say that an arbitrary allocation is used.
i) Allocation bases traditionally adopted
• Direct Labor Hours (DLH): the number of hours people work on a specific project or
product.
• Direct Machine Hours (DMH): the number of hours that manufacturing machines are
used to make a specific product.
• Proportion of cost: the percentage or proportion of another cost.
• Many others: floor area (m²), book value of machinery, number of employees,
volume, etc.
20
ii) Allocation bases adopted in ABC
B. Traditional Cost allocation process
• Assign all indirect costs to cost centers. Example: 1 cost center = 1 department:
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• For each cost center, what is the total cost over a specific period of time?
• For each cost center, what is the nature of the allocation base? Examples: DLH, DMH,
volume, etc.
• For each cost center, what is the value of the allocation base over a specific period of
time?
• For each cost center, what is the value (total cost over a specific period of time) of
the overhead absorption rate? Value of the allocation base over the same specific
period of time.
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡
𝑅𝑎𝑡𝑒 =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑙𝑙𝑜𝑐𝑎𝑡𝑖𝑜𝑛 𝑏𝑎𝑠𝑒
Example: imagine that the company that has 3 departments, called “A”, “B”, and “C”,
manufacturing 3 different types of product:
Questions:
• How many cost centers would you create? Why?
• What’s the probable name for these cost centers?
Indirect costs are directly assigned to the departments. Across the three separate
departments, costs and DLH (direct labor hours) are analyzed as follows:
Knowing that:
… the 3
departments are individual cost centers.
… all units of Z are manufactured in the department C only.
… manufacturing one unit of Z requires 20 DLH.
The DLH is used to allocate indirect costs to Z. In principal, it is possible to have one
potential factor per cost center. For a matter of simplicity, only one factor will be used here
to allocate (but not the same values).
22
N.B.: the factor (DHL = 20 000) is a management decision. Profitability could have been
different with another. This is called managerial discretion which lead to not having a
universal allocation.
Is it the traditional or ABC perspective adopted here? → Here it’s the traditional perspective
since the cost are allocated to each department.
Graph:
Questions:
• Calculate the plant-wide overhead rate charged per unit of Z.
• Calculate the separate departmental overhead rate charged per unit of Z.
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Answers:
Knowing that product Z has a prime cost of £500 per unit.

The total manufacturing cost for product Z (per unit):
Simplistic More elaborate
OH rate (£) OH rate (£)
Prime cost 500 500
Overheads 300 100
800 600
Knowing which one is good is a matter of opinion.
The market is more limited for sport’s cars. Therefore, the volume is limited, and you
manufacture less sport cars than Z. Z is the biggest product in terms of production and, as a
consequence, will get more cost allocated to it than sport cars, since it is allocated in
proportion of the produced volume. Logically, a sport car will cost less to produce than Z. But
intuitively, it should be the opposite. Therefore, why are more indirect costs allocated to the
Z car?
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C. ABC
a. Why ABC awakened?
• Shortcomings of traditional costing systems.

o Cost centers accumulate non-homogeneous resources.
o The nature of allocation bases is misleading.
▪ Use of a small number of allocation bases in complex organizations.
▪ Assume that costs are only driven by volume (typically DLH or DMH).
Consequence: distorted allocation → misleading costs reported to decision-makers.
• CAM-I was born and advocated the following principles:
o Designing cost centers differently to accumulate homogeneous resources.
Separate cost driver rates for support departments.
o Adopting more representative allocation bases and many different ones.
Assume that costs are driven by activity (potentially different than volume).
Effects:
o Provides managers with a better understanding of the business.
o Provides more accurate cost for each unit of product or service.
b. ABC allocation base
• Traditional costing systems use volume-based allocation bases.

o If the production volume varies, the value of allocation base varies too.
o A bigger proportion of indirect costs is allocated to HV than LV products. But
do HV products systematically cost more than LV products?
• (Datar & Gupta, 1998) Sophisticated costing systems consider that:

o Manufacturing a product requires significant resources that do not vary
directly with the volume of production.
o A volume-based cost system will mis-specify the demands placed on overhead
resources by individual products.
• Cost drivers: events or other influences which cause activities to be performed and
fluctuate. Example: a sales or work order is the trigger that causes an activity to utilize
resources to product output.
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c. ABC Cost Allocation Process: the ABC/M cross model
• Process view
o Cost driver = the unit of an activity that causes the change in activity's cost
o Cost reduction program: identifying the cost drivers and reducing the
consumption.
• Cost assignment view
o Bottom-up approach: what activities/resources are needed?
o Resource capacity.
d. What is wrong with ABC? (not seen in class)
• Difficult to capture the unused capacity.

Firms estimates the time spent on a task based on interviews and surveys but very
few interviewees or surveyed people report idle (inactif) time. However, the cost
allocation is based on a full capacity basis. This leads to overestimation of cost driver
rates.
• In theory, ABC could provide insight into capacity utilization. Example: distinguishing
actual from standard cost driver.
In practice, infeasible to obtain the information in context with many different
activities.
• In complex environments:
o Developing an ABC model demands a lot of time.
o The ABC model becomes too complex.
o The ABC model is not accurate enough. Example: with the insight into capacity
utilization.
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However, ABC should not be abandoned because it allows to identify cost and profit
enhancement opportunities.
To implement and maintain ABC on a larger scale, simplification is needed.
e. Two new parameters
For each group of resources, need for two estimates:
• The cost per time unit of supplying resource capacity to activities (parameter 1).
Resource capacity expressed in terms of time availability. But depending on the
resource it can be m², Mb, machine hours availability, etc.
• The unit times of activities (parameter 2) which is the time it takes to carry out one
unit of each kind of activity. But also: m², Mb, machine hours, etc. taking for each
activity.
To derive from these estimations: the cost-driver rates for each kind of activity.
i) Estimating the cost per time unit of resource capacity (parameter 1)
• With ABC: employees first make the estimation on how they spend their time
expressed usually in terms of percentage assigned to each activity.
• With TD ABC: managers first make the estimation on the practical (not theoretical)
capacity of the resources supplied expressed usually in terms of time availability (but
other capacity units).
ii) Example of the customer service department for parameter 1
• One resource.
• Representatives working on the front line of the firm.
• 29 reps, 8 hours per day, 63 business days for the next quarter.
• The practical capacity: about 80% of theoretical (due to breaks, arrival and departure,
communication, and training).
What is the capacity for the next quarter?
 Theoretical: 29 ∗ 8 ∗ 63 ∗ 60 (min) = 876 960 minutes.

 Practical: 876 960 ∗ 0,8 = 701 568 ≈ 700 000 minutes.
Knowing:
• Resource = Salary of reps = $560 000.
• Practical capacity = 700 000 minutes per quarter
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What is the cost per time unit of resource capacity?
560 000
 700 000
= $0,80/𝑚𝑖𝑛𝑢𝑡𝑒.
iii) Example of the customer service department for parameter 2
Estimating the unit times of activities (parameter 2).
With TD ABC: managers secondly make the estimation on the time it takes to carry out one
unit of each kind of activity on the basis of interviews with employees or direct observation.
Three activities:
• Process customer orders = 8 minutes to process one order.
• Handle customer inquiries = 44 minutes to handle one inquiry.
• Perform credit checks = 50 minutes to perform one credit check
Assumption: there is no different types of order, inquiry, and credit check.
Deriving the cost driver rate: multiplying the two input variables:
𝒄𝒐𝒔𝒕
∗ 𝒖𝒏𝒊𝒕 𝒕𝒊𝒎𝒆𝒔 𝒐𝒇 𝒂𝒄𝒕𝒊𝒗𝒊𝒕𝒚
𝒕𝒊𝒎𝒆 𝒖𝒏𝒊𝒕 𝒐𝒇 𝒓𝒆𝒔𝒐𝒖𝒓𝒄𝒆 𝒄𝒂𝒑𝒂𝒄𝒊𝒕𝒚
Three cost driver rates:

• $0,80 𝑝𝑒𝑟 min ∗ 8 𝑚𝑖𝑛. 𝑃𝑒𝑟 𝑜𝑟𝑑𝑒𝑟 = $6,40 𝑝𝑒𝑟 𝑜𝑟𝑑𝑒𝑟
• $0,80 𝑝𝑒𝑟 min ∗ 44 𝑚𝑖𝑛. 𝑃𝑒𝑟 𝑖𝑛𝑞𝑢𝑖𝑟𝑦 = $35,20 𝑝𝑒𝑟 𝑖𝑛𝑞𝑢𝑖𝑟𝑦
• $0,80 𝑝𝑒𝑟 min ∗ 50 𝑚𝑖𝑛. 𝑃𝑒𝑟 𝑐𝑟𝑒𝑑𝑖𝑡 𝑐ℎ𝑒𝑐𝑘 = $40,00 𝑝𝑒𝑟 𝑐𝑟𝑒𝑑𝑖𝑡 𝑐ℎ𝑒𝑐𝑘
Deriving the cost driver rate

• The cost driver rates in TD ABC < the cost driver rates in ABC.
• Key reason: ABC: Practical capacity is always fully utilized. In TD ABC:
o Practical capacity is not always fully utilized.
Less costs are then assigned to product cost if there is unused capacity.
The time of performing the three activities:

• 8 𝑚𝑖𝑛. 𝑝𝑒𝑟 𝑜𝑟𝑑𝑒𝑟 ∗ 49 000 𝑂𝑟𝑑𝑒𝑟𝑠 = 392 000 𝑚𝑖𝑛𝑢𝑡𝑒𝑠.
• 44 𝑚𝑖𝑛. 𝑝𝑒𝑟 𝑖𝑛𝑞𝑢𝑖𝑟𝑦 ∗ 1 400 𝑖𝑛𝑞𝑢𝑖𝑟𝑖𝑒𝑠 = 61 600 𝑚𝑖𝑛𝑢𝑡𝑒𝑠.
• 50 𝑚𝑖𝑛. 𝑝𝑒𝑟 𝑐𝑟𝑒𝑑𝑖𝑡 𝑐ℎ𝑒𝑐𝑘 ∗ 2 500 𝑐ℎ𝑒𝑐𝑘𝑠 = 125 000 𝑚𝑖𝑛𝑢𝑡𝑒𝑠.
The cost of performing the three activities:

• $6,40 𝑝𝑒𝑟 𝑜𝑟𝑑𝑒𝑟 ∗ 49 000 𝑜𝑟𝑑𝑒𝑟𝑠 = $313 600
• $35,20 𝑝𝑒𝑟 𝑖𝑛𝑞𝑢𝑖𝑟𝑦 ∗ 1 400 𝑜𝑟𝑑𝑒𝑟𝑠 = $49 280
• $40,00 𝑝𝑒𝑟 𝑐ℎ𝑒𝑐𝑘 ∗ 2 500 𝑐ℎ𝑒𝑐𝑘𝑠 = $100 000
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The time of performing the three activities:

• Consumed = 578 600 minutes.
• Available = 700 000 minutes.
• Productive work = 83%.
The cost of performing the three activities:

• Initial cost = $ 560 000.
• Productive work = 83%.
• Assigned to product cost = 83% of $ 560 000 = $ 462 880.
Who is responsible for the unused capacity?

• Unused capacity is not acquired to meet the demands of a specific customer but the
demands from all kinds of customers.
• The cost of unused capacity should not be allocated to individual customers/products.
D. Exercises
a. Hinj Limited
• Calculate the production cost per unit for arms and brackets using the machine hour
overhead absorption rate.
• Calculate the production cost per unit for arms and brackets using the Activity Based
Costing system.
• Comment on your findings.
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The total value of indirect cost is 182 500£. If we adopt an ABC line of reasoning, we should
have 4 cost centers.
The potential numbers of cost objects are 4 as well. The question of the exercise is “what is
the cost of production of arms, brackets, etc.”. Therefore, we need to allocate the value of
indirect costs (182 500£) to those. Importance of understanding what cost centers and costs
objects we are interested in are. Then, we can start to allocate.
Detailed explanations of computation in the board below:

1. Allocate indirect costs to cost centers. In this exercise there is no allocation process.
2. If you have four cost centers, you will have four allocation basis and they will
probably be all different. What are the cost drivers? Purchase order, Issuing notes,
etc. For each cost centers there is a different allocation key.
3. How many issue notes did you do last month? Then, allocate to cost objects.
4. What is the cost of one P.O.? Calculation of the ratio (a division). For one P.O., 41,5
pounds. Consuming one machine hour amounts to 10 pounds, etc.
5. Cost objects: the direct cost must not be forgotten. Count both: indirect and direct
costs. For arm, the total value of direct costs is 46 000£. The total direct costs =
(8250£ + 46 000£) and indirect costs for 1000 units = 45 225£.
Indirect costs Cost centers Cost objects
1. Purchasing: 41 500£ for Arms

1000 Purchase Order (P.O.) 1. 41,5 ∗ 190 = 7 885
2. 64 ∗ 105 = 6 720
𝑪𝒐𝒔𝒕 3. 132 ∗ 35 = 4 620
𝑹𝒂𝒕𝒆 =
𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒚 𝑳𝒆𝒗𝒆𝒍 4. 10 ∗ 2 600 = 26 000
41 500 Total indirect costs for Arms= 45 225 (for 1 000 units).
𝑅𝑎𝑡𝑒 = = 41,5
1 000
182 500£ Such that the production cost per unit =
45 225
= 45,2/𝑢𝑛𝑖𝑡
(directly It is 41,5 per P.O. 1 000
assigned costs
to the 4 cost 2. Storing: 41 600£ for Total value for direct cost = 45 225 (𝑖𝑛𝑑𝑖𝑟𝑒𝑐𝑡) +
centers) 8 250 (𝑑𝑖𝑟𝑒𝑐𝑡) + 46 000 (𝑑𝑖𝑟𝑒𝑐𝑡) = 99 475/1 000 𝑢𝑛𝑖𝑡𝑠 =
650 Issue Notes (I.N.)
99,5 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡.
Rate = 64
3. Setting up: 26 400£ for Brackets

200 Setups 1. 41,5 ∗ 325 = 13 487,5
2. 64 ∗ 200 = 12 800
Rate = 132 3. 132 ∗ 60 = 7 920
4. 10 ∗ 1 275 = 12 750
4. Running: 73 000£ for
7300 Machine Hours Total indirect costs for Brackets = 46 957,5 (for 500
units).
Rate = 10
Such that the production cost per unit = 93,92 per unit.
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Total value = 46 957,5 (𝑖𝑛𝑑𝑖𝑟𝑒𝑐𝑡) + 3 750 + 7 600 =

58 307,5 / 500 𝑢𝑛𝑖𝑡𝑠 = 116,62 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡.
Directly assigned
Arms is the higher volume product. If volume driven allocate costs is used, then arms will be
more expensive. Arms consume less setups but more machine hours.
b. Exercise on cost assignment (not in the slides)
The following statements describe various aspects of overhead costs and the roles cost pools
and cost drivers in the allocation overhead. Which is true and false?
1. Overhead costs cause cost drivers. False
2. In traditional manufacturing environments, most overhead costs are directly related
to production activities. False.
3. Overhead rates are calculated by multiplying manufacturing overhead costs by the
volume of cost pool activity. False, because it is not “multiplied by” but “divided by”.
See exercise just before.
𝑪𝒐𝒔𝒕 𝒐𝒇 𝒕𝒉𝒆 𝑪𝒆𝒏𝒕𝒆𝒓
𝐶𝑜𝑠𝑡 𝐶𝑒𝑛𝑡𝑒𝑟 ′ 𝑠 𝑟𝑎𝑡𝑒 =
𝑽𝒐𝒍𝒖𝒎𝒆 𝒐𝒇 𝒕𝒉𝒆 𝑪𝒆𝒏𝒕𝒆𝒓
4. Companies that are labor intensive are likely to allocate overhead costs such as
utilities expense on the basis of direct labor hours. True, companies that are labor
intensive can be interpreted as the fact that labor costs are the more intensive, it
would be labor based costs. Therefore, cost driver would be labor hours.
5. More overhead costs in a just-in-time environment are direct in nature as opposed to
indirect. This would be true, but this is a little bit confusing because we need to use
our understanding of the just-in-time. The professor’s understanding is that just-in-
time means you do cost object after cost object in order to create a flow as efficient
as possible with the lowest possible level of stock. This still does not prevent the fact
that you have overhead cost. Therefore, this would be true.
6. A “good” allocation base is one that drives the incurrence (l’arrivée) of overhead costs.
There is a difference between a good and a bad allocation base. A good (best way of
doing, in the sense relevant) allocation base drives the costs and the incurrence of
overhead costs. True. There is no correlation between cost allocation. Allocation base
drives the cost and do not drive the cost (= arbitrary allocation base).
7. Companies generally allocate overhead equally to all products produced during a
given period. False. Two technics.
c. ABC: Blake and Roscoe (simplified illustration of what can happen in a

company)
Blake and Roscoe are college friends planning a skiing trip to Aspen before the New Year.
They estimated the following costs for the trip.
(a) Blake suggests that the costs be shared equally. Calculate the amount each person would
pay.
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(b) Roscoe does not like the idea because he plans to stay in the room rather than ski. Roscoe
suggests that each type of cost be allocated to each person based on the above listed cost
driver. Using the activity allocation for each person, calculate the amount that each person
would pay based on his own consumption of the activity.
Estimated Cost driver Activity Activity allocation:

costs allocation: Blake Roscoe
Food $600 Pounds of food eaten 20 30
Skiing $210 # of lift tickets 3 0
Lodging $400 # of nights 2 2
TOTAL $1 210
i) Blake should pay the half which amounts to $605. Roscoe would pay the same.
This is a costing problem. But Blake consume much more resources than Roscoe.
$1 210 Blake = 605 ∗ 1 = 605.

1. Total: $1 210.
1 210
The rate = 2 = 605. Roscoe = 605 ∗ 1 = 605.
ii) Allocation based on the cost driver

$1 210 Blake
1. Skiing: $210 for 3. Rate = 1. 70 ∗ 3 = $ 210.
$70. 2. 12 ∗ 20 = $ 240.
3. 100 ∗ 2 = $ 200.
2. Eating: $600 for 50. Rate Roscoe

= 12. 1. 70 ∗ 0 = $ 0.
2. 12 ∗ 30 = $ 360.
3. Lodging: $400 for 4. Rate 3. 100 ∗ 2 = $ 200.
= 100.
d. Calculate the production cost per unit using DMH (not seen in class)
Data:
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𝑇𝑜𝑡𝑎𝑙 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑
𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠 𝑎𝑙𝑙𝑜𝑐𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 =
𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑐ℎ𝑖𝑛𝑒 𝐻𝑜𝑢𝑟𝑠
182 500
= = £𝟐𝟓 𝑫𝑴𝑯
7 300
Q: calculate the production cost per unit using the ABC system.
Activity based-costing Cost pool (£) Activity level Cost driver rate
Purchasing 41,500 1,000 P.O. £41.50/order
Stores 41,600 650 I.N. £64.00/issue
Set-ups 26,400 200 S.U. £132.00/set-up
Machine running hours 73,000 7,300 M.H. £10.00/mh
e. Overhead analysis and calculation of product cost (unseen)
A furniture-making business manufactures quality furniture to customers’ orders. It has three

production departments (A, B, and C) and two service departments (X and Y).
Overhead costs are as follows:

Rent and rates £12,800
Machine insurance £6,000
Telephone charges £3,200
Depreciation £18,000
Production supervisor’s salaries £24,000
Heating and lighting £6,400
Allocation information is as follows:
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Q: prepare a statement showing the overhead cost for each department, showing the basis
of apportionment used. Also, calculate suitable overhead absorption rates.
Steps:
• Assign all manufacturing overheads to …:
o … production departments A, B and C.
o … service departments X and Y.
• Allocation bases:
o Rent and rates: Square meter.
o Machine insurance: Machine value.
o Telephone charges: Square meter.
o Depreciation: Machine value.
o Production supervisor’s salaries: DLH.
o Heating and lighting: Square meter.
• Two pieces of furniture are to be manufactured for customers.

• Direct costs are as follows:
• Calculate the total costs of each job.
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Q: if the firm quotes prices to customers that reflect a required profit of 25% on selling price,
calculate the quoted selling price (prix indiqué) for each job.
f. Lewington
Lewington Ltd makes a variety of kitchen fittings and equipment. It uses a three stages
process involving cutting, assembly and finishing. The following figures are extracted from its
budget for the current year:
Cutting Assembly Finishing
Production overheads (k$) 1,600 2,000 1,400

Direct machine hours 40,000 25,000 14,000
Direct labor hours 10,000 40,000 20,000
A batch of 300 ’DX’ workstations has just been produced using $3,300 of materials, $4,500
of direct labor and the following quantities of time:
Cutting Assembly Finishing
Direct machine hours 50 25 10
Direct labor hours 20 45 20
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Questions:
• Calculate the Overhead Absorption Rate (OAR) for each department based on:
o Direct machine hours.
o Direct labor hours.
• Calculate the unit cost and total production cost for a batch of 300 “DX” based on:
o Direct machine hour.
o Direct labor hours.
o Mixed OAR.
▪ Direct machine hours for Cutting department.
▪ Direct labor hours for Assembly and Finishing departments.
i) Calculate the OAR for each department
ii) Calculate the unit cost and total production cost (based on DMH)
iii) Calculate the unit cost and total production cost (based on DLH)
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iv) Calculate the unit cost and total production cost (based on a mix)
36
Part 2 (M. Adamsen) Cost and Decision Making

Book: Management Accounting from B (cf moodle)
Exam: for his part the most important is not calculating it is that we can understand. Open
questions (definitely not QCM).
I. CH 6: Cost-Volume-Profit (CVP) relationships and analysis
Relationship between cost, volume and profit in the organization of a company. Basically,
there are two types of costs: developing cost (varying with the volume) and fixed cost.
Example of a company with 4 products: A, B, C and D. The cost are only variable costs. All the
products have a positive contribution markup. When the contribution margin is positive, but
the others gives a loss, the results are positive. Should we keep it or close it? If you decide to
close product D with a loss, you only lose the “D loses”. And now, the C also gives a loss. Will
you also close it? Yes. The B is a loss. You close it. And finally, you close the company. Well
done! Lol.
 Focusing on the turnover, variable costs, fixed costs altogether, etc. need to be done
before taking such decision.
CVP analysis helps managers understand the interrelationship between cost, volume and
profit in an organization by focusing on interactions between five variables:
• Prices of products.
• Volume or level of activity.
• Per unit variable costs.
• Total fixed costs.
• Mix of products sold.
CVP analysis is a vital tool in many business decisions (what products to manufacture or sell,
what pricing policy to follow etc.).
A. The basics of CVP analysis
Example of Wind Bicyle Co.: contribution statement of profit or loss for the month of June:
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Contribution Margin (CM) is the amount remaining from sales revenue after variable
expenses have been deducted. After covering fixed costs, any remaining CM contributes to
profit.
a. The contribution approach
Example suite: for each additional unit Wind sells, £200 more in contribution margin will help
to cover fixed expenses and profit. Meaning that for each bike we sell, we earn 200£.
Each month Wind must generate at least £80,000 in total CM to break-even. We have a
“need of contribution” of 80 000£.
If we are selling, what is the minimum needed? At least 400 bikes/month to perceive a profit.
Just by knowing contribution margin, etc. In this case, each time we sell one more bike than
400, the contribution will rise.
If Wind sells 400 units in a month, it will be operating at the break-even point, which is the
level of sales at which profit is zero.
If Wind sells one additional unit (401 bikes), profit will increase by £200.
If we are selling for 401 we will make profit of 200. With 402, we make 400 of profit. Etc.
b. Contribution Margin ratio
The contribution margin ratio is:
𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑴𝒂𝒓𝒈𝒊𝒏
𝑪𝑴 𝑹𝒂𝒕𝒊𝒐 =
𝑺𝒂𝒍𝒆𝒔
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Consequently, we obtain a percentage.
∆𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑴𝒂𝒓𝒈𝒊𝒏 = 𝑪𝑴 𝑹𝒂𝒕𝒊𝒐 ∗ ∆𝑺𝒂𝒍𝒆𝒔
It is important to compute both, the contribution margin and the CM ratio.
c. Changes in Fixed costs and Sales volume
Wind is currently selling 500 bikes per month. The company’s sales manager believes that an
increase of £10,000 in the monthly advertising budget would increase bike sales to 540 units.
Should the request be authorized of increasing the advertising budget?
If you can sell 540 bikes, with a contribution margin of 200, how much can you earn? This is a
very bad business. The reply is that it is a bad idea. To be a good idea, you should sell
minimum 50 bikes more than this. Could we do this if we allocated a larger amount of
money? Nope, it would be making too fast conclusions.
The shortcut solution:
 The increase in CM does not compensate the increase in ad expense.
d. Changes in Variable costs and Sales volumes
Wind is contemplating the use of higher-quality components, which would increase variable
costs by ￡20 per bike (and thereby reduce the contribution margin). However, the sales
manager predicts that the higher overall quality would increase sales from 500 to 550 bikes
per month. Should the higher-quality components be used?
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Current (500) Predicted (550)

Sales 250 000 275 000 + 15 000
VC 150 000 176 000 + 16 000
CM 100 000 99 000 - 1 000 less than
before
The shortcut solution: are the 50 plus sold bikes enough to compensate the loss in CM and
profit?
99 000
= 180 𝑝𝑟𝑜𝑓𝑖𝑡 𝑝𝑒𝑟 𝑏𝑖𝑘𝑒
550
180 ∗ 50 = 9 000 = 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑝𝑟𝑜𝑓𝑖𝑡 𝑓𝑜𝑟 50 𝑏𝑖𝑘𝑒𝑠
e. Break-Even analysis
Break-even analysis can be approached in two ways:
i) Equation method
𝑷𝒓𝒐𝒇𝒊𝒕𝒔 = 𝑺𝒂𝒍𝒆𝒔 − (𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔 + 𝑭𝒊𝒙𝒆𝒅 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔)

Or,
𝑺𝒂𝒍𝒆𝒔 = 𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔 + 𝑭𝒊𝒙𝒆𝒅 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔 + 𝑷𝒓𝒐𝒇𝒊𝒕𝒔
At the break-even point profits equal zero.
Here is the information from Wind Bicycle Co.:
We can use the first equation to compute the break-even point in sales.
𝑥 = 0.60𝑥 + £80,000 + £0
Where,
x = Total sales.
0.60 = Variable expenses as a percentage of sales.
£80,000 = Total fixed expenses.
0.40𝑥 = £80,000
𝑥 = £200,000
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We calculate the break-even point as follows (second equation):
£500𝑄 = £300𝑄 + £80,000 + £0

Where,
Q = Number of bikes sold.
£500 = Unit sales price.
£300 = Unit variable expenses.
£80,000 = Total fixed expenses.
£200𝑄 = £80,000
𝑄 = 400 𝑏𝑖𝑘𝑒𝑠
ii) Contribution margin method
How much do I need to sell, in dollars or in units? The contribution margin method is a
variation of the equation method.
𝑭𝒊𝒙𝒆𝒅 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔
𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 𝒊𝒏 𝒖𝒏𝒊𝒕𝒔 𝒔𝒐𝒍𝒅 =
𝑼𝒏𝒊𝒕 𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝒎𝒂𝒓𝒈𝒊𝒏
𝑭𝒊𝒙𝒆𝒅 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔
𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 𝒊𝒏 𝒕𝒐𝒕𝒂𝒍 𝒔𝒂𝒍𝒆𝒔 =
𝑪𝑴 𝑹𝒂𝒕𝒊𝒐
f. CVP relationships in Graphic Form
Viewing CVP relationships in a graph gives managers a perspective that can be obtained in
no other way. Consider the following information for Wind Co.:
CVP graph
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B. Target profit analysis
Here is another method. Suppose Wind Co. wants to know how many bikes must be sold to
earn a profit of £100,000.
a. The CVP equation
We can use the CVP formula to determine the sales volume needed to achieve a target
profit figure.
𝑆𝑎𝑙𝑒𝑠 = 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 + 𝐹𝑖𝑥𝑒𝑑 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 + 𝑷𝒓𝒐𝒇𝒊𝒕𝒔
£500𝑄 = £300𝑄 + £80,000 + £100,000

£200𝑄 = £180,000
𝑄 = 900 𝑏𝑖𝑘𝑒𝑠
b. The contribution margin approach
We can determine the number of bikes that must be sold to earn a profit of £100,000 using
the contribution margin approach.
𝑭𝒊𝒙𝒆𝒅 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔 + 𝑻𝒂𝒓𝒈𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕

𝑼𝒏𝒊𝒕𝒔 𝒔𝒐𝒍𝒅 𝒕𝒐 𝒂𝒕𝒕𝒂𝒊𝒏 𝒕𝒉𝒆 𝒕𝒂𝒓𝒈𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕 =
𝑼𝒏𝒊𝒕 𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑴𝒂𝒓𝒈𝒊𝒏
£80,000 + £100,000
= 900 𝑏𝑖𝑘𝑒𝑠
£200
c. The Margin of Safety
A margin of safety is an excess of budgeted (or actual) sales over the break-even volume of
sales. The amount by which sales can drop before losses begin to be incurred.
𝑴𝒂𝒓𝒈𝒊𝒏 𝒐𝒇 𝑺𝒂𝒇𝒆𝒕𝒚 = 𝑻𝒐𝒕𝒂𝒍 𝑺𝒂𝒍𝒆𝒔 − 𝑩𝒓𝒆𝒂𝒌𝒆𝒗𝒆𝒏 𝑺𝒂𝒍𝒆𝒔
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It is good to know how sensitive we are. When do you have to do something drastic? You
calculate beforehand when you need to close or open a new one. Those are important
decisions to take.
Let’s calculate the margin of safety for Wind.
Wind has a break-even point of £200,000. If actual sales are £250,000, the margin of safety
is £50,000 or 100 bikes. The margin of safety can be expressed as 20 per cent of sales
£50,000
( ).
£250,000
C. Operating leverage
Operating leverage is a measure of how sensitive profit is to percentage changes in sales.

With high leverage, a small percentage increase in sales can produce a much larger
percentage increase in profit.
𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑴𝒂𝒓𝒈𝒊𝒏
𝑫𝒆𝒈𝒓𝒆𝒆 𝒐𝒇 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 =
𝑷𝒓𝒐𝒇𝒊𝒕
£100,000
 £20,000
=5
With a measure of operating leverage of 5, if Wind increases its sales by 10%, profit would
increase by 50%.
Proof:
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 10% increase in sales (from £250,000 to £275,000) results in a 50% increase in profit
(from £20,000 to £30,000).
D. Automation from a CVP perspective
E. The concept of Sales mix
Sales mix is the relative proportions in which a company’s products are sold. Different
products have different selling prices, cost structures, and contribution margins. Changes in
the sales mix can cause interesting (and sometimes confusing) variations in a company’s
profits. “Sales mix” are all the possible combinations.
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Exhibit 7.4
Verification:
60,000 = 100%
4 1
𝑜𝑓 60,000 = 48,000 ; 𝑜𝑓 60,000 = 12,000
5 5
Exhibit 7.5
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F. Assumptions of CVP analysis
Some traps we need to be aware of: for example, we make the assumption that cost is linear
(not necessarily the case), which could influence the CM and, therefore, the decision.
• Selling price is constant throughout the entire relevant range.
• Costs are linear throughout the entire relevant range.
• In multi-product companies, the sales mix is constant.
• In manufacturing companies, inventories do not change (units produced = units sold).
G. E6-1 (EXAM)
Menlo Company manufactures and sells a single product. The company’s revenue and
expenses for the last quarter follow:
i) What is the quarterly break-even point in units sold and in revenue?
𝑆𝑎𝑙𝑒𝑠 = 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 + 𝐹𝑖𝑥𝑒𝑑 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 + 𝑃𝑟𝑜𝑓𝑖𝑡𝑠
£30𝑄 = £12𝑄 + £216,000 + £0

£18𝑄 = £216,000
𝑄 = £216,000 ∗ £18
𝑄 = 12,000 𝑢𝑛𝑖𝑡𝑠
At £30 per unit, £360,000.
Alternative solution:
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𝐹𝑖𝑥𝑒𝑑 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠
𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 =
𝑈𝑛𝑖𝑡 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛
£216,000
= 12,000 𝑢𝑛𝑖𝑡𝑠
£18
Or, at £30 per unit, £360,000.
ii) Without resorting to computations, what is the total CM at the break-even

point?
The contribution margin is £216,000 since the contribution margin equals the fixed expenses
at the break-even point.
iii) How many units would have to be sold each quarter to earn a target profit of
£90,000? Use the unit contribution method. Verify your answer by preparing a
contribution statement of profit or loss at the target level of revenue.
(𝐹𝑖𝑥𝑒𝑑 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 + 𝑇𝑎𝑟𝑔𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡)

𝑇𝑎𝑟𝑔𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 =
𝑈𝑛𝑖𝑡 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛
£216,000 + £90,000
= 17,000 𝑢𝑛𝑖𝑡𝑠
£18
Total Unit Price

Sales (17,000 units) £510,000 £30
Less variable expenses (17,000 units) 204,000 £12
Contribution margin 306,000 £18
Less fixed expenses 216,000
Net profit £ 90,000
iv) Referring to the original data, compute the company’s margin of safety in both
percentage and pound terms.
𝑀𝑎𝑟𝑔𝑖𝑛 𝑜𝑓 𝑆𝑎𝑓𝑒𝑡𝑦 = 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 − 𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑆𝑎𝑙𝑒𝑠
£450,000 − £360,000 = £90,000
Margin of safety in percentage terms:
𝑀𝑎𝑟𝑔𝑖𝑛 𝑜𝑓 𝑆𝑎𝑓𝑒𝑡𝑦 (𝑖𝑛 𝑝𝑜𝑢𝑛𝑑𝑠) £90,000

= = 20%
𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 £450,000
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v) What is the company’s CM ratio? If revenue increase by £50,000 per quarter and
there is no change in fixed expenses, by how much would you expect quarterly
profit to increase? Do not prepare a statement of profit or loss, use the CM ratio
to compute your answer. [?]
CM Ratio is 60%.
Expected total contribution margin: (£500,000: 60%) £ 300,000

Present total contribution margin: (£450,000: 60%) £ 270,000
Increased contribution margin £ 30,000
Alternative solution:
£50,000 𝑖𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 ∗ 60% = £30,000
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II. CH 7: Profit reporting under Variable and Absorption Costing
A. Overview of Absorption and Variable Costing
Example of Variable and Absorption costing:

VC: the only costs of driving my car on a 200 miles trip today are £12 for petrol.
AC: you must consider the other costs too.
VC: You’re wrong. I have the car payment and the insurance payment even if I do not make
the trip.
 Who’s right? Both are excellent.
Overiew:
How should we treat the car payment and the insurance? Let’s put some numbers on the
issue and see if it will sharpen our understanding.
d. Unit Cost computations
Harvey Co. produces a single product with the following information available:
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Unit product cost is determined as follows:
Selling and administrative expenses are always treated as period expenses and deducted
from revenue. They do not appear in costing methods.
e. Profit Comparison of AC and VC
Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this
year. Absorption costing:
Looking at variable costing by Harvey Co:
In this case, only a profit of £90 000.
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f. Comparison of the methods
Reconciliation
We can reconcile the difference between absorption and variable profit as follows:
𝐹𝑖𝑥𝑒𝑑 𝑚𝑓𝑔. 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 £150,000

= = £6.00 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
𝑈𝑛𝑖𝑡𝑠 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑 25,000
g. Extending the example: Harvey Co. year 2
Let’s look at the second year of operations for Harvey Company. In its second year of
operations, Harvey Co. started with an inventory of 5,000 units, produced 25,000 units and
sold 30,000 units.
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Unit product cost is determined as follows:
 No change in the Harvey’s cost structure.
Harvey’s statement of profit or loss assuming absorption costing:
Harvey’s statement of profit or loss assuming variable costing:
Between the two years, we try to make fixed costs variable. Then, they are putted in stock,
which increase.
52
Summary:
B. Advantages of Variable Costing and the Contribution approach
• Management finds it easy to understand.

• Consistent with CVP analysis.
• Operating profit is closer to net cash flow.
• Consistent with standard costs and flexible budgeting.
• Easier to estimate profitability of products and segments.
• Profit is not affected by changes in inventory.
• Impact of fixed costs on profits emphasized.
C. Chosing a costing method
Absorption costing: all manufacturing costs must be assigned to products to properly match
revenues and costs. Depreciation, taxes, insurance and salaries are just as essential to
products as variable costs.
Variable costing: fixed costs are not really the costs of any particular product. DTI&S are
capacity costs and will be incurred if nothing is produced.
• A basic problem with absorption costing is that fixed manufacturing overhead costs
appear to be variable with respect to the number of units sold.
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• A company that attempts to use variable costing on its external financial reports runs
the risk that its auditors may not accept the financial statements as conforming to
internationally accepted accounting principles.
• The issue of performance evaluation.
54
III. CH 10: Relevant costs for Decision Making
A. Identifying relevant costs
Cost Concepts for Decision Making: a relevant cost is a cost that differs between
alternatives. If you compare two alternative it is relevant but if there is no link between the
two costs it is not relevant.
Costs that can be eliminated (in whole or in part) by choosing one alternative over another
are avoidable costs. Avoidable costs are relevant costs.
Unavoidable costs are never relevant and include:

• Sunk costs: a cost that has already been incurred and that cannot be avoided
regardless of what a manager decides to do. Sunk costs are costs that are already
used, thereby it is not relevant to use them again.
• Future costs that do not differ between the alternatives.
Sunk Costs are not relevant costs
The White Company example: a manager at White Co. wants to replace an old machine with a
new, more efficient machine.
White’s sales are £200,000 per year. Fixed expenses, other than depreciation, are £70,000
per year. Should the manager purchase the new machine?
Correct analysis
Look at the comparative cost and revenue for the next five years.
55
Where,
• First column: 60 000 = the remaining book value of the old machine.
• Second column:
o 400,000 = £80,000 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 ∗ 5 𝑦𝑒𝑎𝑟𝑠.
o The total cost (90 000) will be depreciated over the five-years period.
• Last column: the remaining book value of the old machine (60 000) is a sunk cost and
is not relevant to the decision, since it is the same in both cases. We have to remove it
from the decision.
Would you recommend purchasing the new machine even though we will show a £45,000
loss on the old machine?
B. Relevant Cost Analysis
a. Adding/Dropping segments
One of the most important decisions managers make is whether to add or drop a business
segment such as a product or a store. Let’s see how relevant costs should be used in this
decision.
Example of Lovell Co.: due to the declining popularity of digital watches, Lovell Company’s
digital watch line has not reported a profit for several years. A statement of profit or loss for
last year:
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• If the digital watch line is dropped, the fixed general factory overhead and general
administrative expenses will be allocated to other product lines because they are not
avoidable.
• The equipment used to manufacture digital watches has no resale value or alternative
use.
 Should Lovell retain or drop the digital watch segment?
i) Contribution margin approach
Decision rule: Lovell should drop the digital watch segment only if its fixed cost savings
exceed lost contribution margin. Let’s look at this solution.
Remember, depreciation on equipment with no resale value is not relevant to the decision
since it is a sunk cost and is not avoidable.
ii) Comparative Profit approach
The Lovell solution can also be obtained by preparing comparative statements of profit or
loss showing results with and without the digital watch segment.
57
iii) Beware of allocated fixed costs
Why should we keep the digital watch segment when it’s showing a loss? Part of the answer
lies in the way we allocate common fixed costs to our products. Our allocations can make a
segment look less profitable than it really is.
b. The Make or Buy Decision
A decision concerning whether an item should be produced internally or purchased from an

outside supplier is called a “make or buy” decision. Example of Essex Company: Essex
manufactures part 4A that is currently used in one of its products. The unit cost to make this
part is:
• The special equipment used to manufacture part 4A has no resale value.

• General factory overhead is allocated on the basis of direct labor hours.
• The £30 total unit cost is based on 20,000 parts produced each year.
• An outside supplier has offered to provide the 20,000 parts at a cost of £25 per part
(500,000 in total).
 Should we accept the supplier’s offer?
20,000 ∗ £9 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = £180,000
• The special equipment has no resale value and is a sunk cost. Therefore, ‘depreciation
of equipment’ is not relevant and not taken into account.
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• General factory overheads are not avoidable and is irrelevant. If the product is
dropped, it will be reallocated to other products.
Decision rule in deciding whether to accept the outside supplier’s offer, Essex isolated the
relevant costs of making the part by eliminating the sunk costs and the future costs that will
not differ between making or buying the parts.
Beside sunk cost, dropping or selling, making or buying, there is the matter of Opportunity
Cost.
The Matter of Opportunity Cost : the economic benefits that are foregone (renoncer) as a
result of pursuing some course of action. Opportunity costs are not actual monetary outlays
and are not recorded in the accounts of an organization.
c. Special orders
• Jet plc. receives a one-time order that is not considered part of its normal ongoing
business.
• Jet plc. makes a single product with a unit variable cost of £8. Normal selling price is
£20 per unit.
• A foreign distributor offers to purchase 3,000 units for £10 per unit.
• Annual capacity is 10,000 units, and annual fixed costs total £48,000, but Jet plc. is
currently producing and selling only 5,000 units.
 Should Jet accept the offer?
If Jet accepts the offer, profit will increase by £6,000.
We can reach the same results more quickly like this:
𝑆𝑝𝑒𝑐𝑖𝑎𝑙 𝑂𝑟𝑑𝑒𝑟 𝐶𝑀 = £10 − £8 = £2

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑜𝑓𝑖𝑡 = £2 ∗ 3,000 𝑢𝑛𝑖𝑡𝑠 = £6,000
i) Joint Products Costs
In some industries, a number of end products are produced from a single raw material input.
Two or more products produced from a common input are called joint products. The point in
the manufacturing process where each joint product can be recognized as a separate
product is called the split-off point.
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The Pitfalls of Allocation: joint costs are common costs incurred to simultaneously produce a
variety of end products. Joint costs are often allocated to end products on the basis of the
relative sales value of each product or on some other basis.
Sell or Process Further: it will always be profitable to continue processing a joint product
after the split-off point as long as the incremental revenue (revenu marginal) exceeds the
incremental processing costs incurred after the split-off point.
ii) Example of Sawmill plc.
• Sawmill plc. cuts logs (bûches) from which unfinished lumber (bois) and sawdust
(sciure) are the immediate joint products.
• Unfinished lumber is sold ‘as is’ or processed further into finished lumber.
• Sawdust can also be sold ‘as is’ to gardening wholesalers or processed further into
‘presto-logs’.
Data about Sawmill’s joint products includes:
 Sell or process further?
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 Should we process the lumber further and sell the sawdust ‘as is?’
C. E10-10
The Regal Cycle Company manufactures three types of bicycle: a dirt bike, a mountain bike
and a racing bike. Data on revenue and expenses for the past quarter follow:
Management is concerned about the continued losses shown by the racing bikes and wants a
recommendation as to whether or not the line should be discontinued. The special equipment
used to produce a racing bike has no resale value and does not wear out.
i) Should production and sale of the racing bikes be discontinued? Show

computations to support your answer
No, production and sale of the racing bikes should not be discontinued. If the racing bikes are
discontinued, then the net profit for the company as a whole will decrease by £11,000 each
quarter: contribution margin lost £ (27,000).
• Fixed costs which can be avoided:
o Advertising, traceable £ 6,000.
o Salary of the product line manager 10,000 - 16,000.
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o Decrease in net operating profit for the company as a whole £ (11,000)

• The depreciation of the special equipment represents a sunk cost, and therefore is
not relevant to the decision.
• The common costs are allocated and will continue regardless of whether or not the
racing bikes are discontinued; thus, they are not relevant to the decision.
Why do we keep the racing bikes? If we stop producing them, we will lose £ 20,000 but if we
keep producing them, we only lose £ 9,000. In fact, you will always keep your products since
if you dropped it, it will make another product come down and you will finally close your firm.
Difference: Net
Keep Racing Bikes Drop Racing Bikes Profit Increase or
(Decrease)
Sales £60,000 £ -0- £(60,000)
Less variable 33,000 -0- 33,000

expenses
Contribution margin 27,000 -0- (27,000)
Less fixed expenses:
Advertising, 6,000 -0- 6,000

traceable
Depreciation on 8,000 8,000 -0-

special equipment
Salary of the product 10,000 -0- 10,000

line Managers
Common, but 12,000 12,000 -0-

allocated costs
Total fixed expenses 36,000 20,000 16,000
Net operating loss £ (9,000) £ (20,000) £ (11,000)
i) Recast the above data in a format that would be more usable to management in
assessing the long-run profitability of the various product lines
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ii) Recast the above data in a format that would be more usable to management in
assessing the long-run profitability of the various product lines
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IV. Budgeting
A. CH 8: Budgeting and Forecasting/Planning (+ Article 4)
a. Financial result controls
Three core elements:

• Financial responsibility centers: the apportioning (répartition) of accountability for
financial results within the organization.
• Formal management processes: planning and budgeting to define performance
expectations and standards for evaluating performance.
• Motivational contracts: to define the links between results and various organizational
incentives.
b. Planning and Budgeting
Produce written plans that specify:

• Where the organization wishes to go.
• How it intends to get there.
• What results should be expected.
Purposes of planning and budgeting processes:

• To enhance management control.
• To engage in long(er)-term thinking.
• To achieve coordination (top-down, bottom-up, sideways).
• To establish “challenging-but-achievable” performance targets.
 The objective is to know what to do next. For instance, we know maybe what we will
do tonight or next week but not next year.
c. Planning cycle
• Relatively broad processes of thinking about the missions,

goals, and strategies.
• Normally a top-management process.
• Specification of specific action programs to be implemented

over the next few years and specification of the resources each will
consume.
• It involves managers at different levels (top-down/bottom-up).
• Short-term financial planning.

• Budgets match the organization’s responsibility structure.
• Emphasis on quantitative data.
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d. Characteristics of a budget
• It is usually stated in monetary terms.

• It generally covers a period of one year. Can be 2-3 or 10 years. Example: in the
medical industry it is often 3 to 5 years because it is the time needed to make a new
medicine.
• It contains an element of management commitment, that is, the managers agree to
accept the responsibility for attaining the budgeted objectives.
• The budget is approved by an authority higher than the budgeteer. It is approved by
the board, therefore, when you are CEO you do not decide, you first propose.
• Once approved, the budget can be changed only under specified conditions.
• Periodically, actual financial performance is compared to budget and variances are
analyzed and explained.
e. Budgeting and management control
• Results control: budgeting involves setting targets that are commonly used as
standards against which to evaluate performance.
• Action controls: planning and budgeting processes involve formal reviews of plans
and include the actions that are felt to be good for the organization to take.
• Personnel controls: planning and budgeting processes provide the needed
information for decision-making to the relevant managers.
f. The budget preparation process
The budgeting process takes about 4 months in most firms since meetings with the board
occurs usually each quarter.
Here, process for big companies like GSK, implying a lot of employee, makes it important to
issues/draft guidelines. Then, you schedule meetings with every business manager to
negotiate and discuss. When you finally have every needed information, you draft the budget
with the updates.
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g. Types of financial performance targets
Model-based (engineered) / historical / negotiated
Internally / externally – derived: target costing and benchmarking (evaluate by comparison

with a standard).
Fixed / flexible: should managers be held accountable for achieving their plans regardless of
the business conditions they face? Relative performance targets.
h. Budget participation
Top-down / bottom-up budgeting

• The budgeteer is both involved and has influence over setting the budget.
• Leads to better acceptance of budget targets, and hence, commitment to achieve
them.
• It is an effective way of information sharing bringing together corporate priorities
and constraints with lower-level insights about business potentials and risks.
• But, potential for slack (peu sérieux), bias, conservatism, etc.
You have to be committed in order to achieve them.
i. Budget target difficulty
In theory (lab experiments): “Good targets” are about 25–40% achievable.
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In practice (field research):
Effective vs. ineffective management teams:
j. Challenging but achievable
Very important to have both. It is important to be involved, to have a link to power and
distance. Make sure that every department’s employees are involved and motivated.
• To minimize dysfunctional management actions: myopic behavior, data manipulation.

• To increase manager’s commitment to budget targets.
• To reduce the cost of organizational interventions: management-by-exception.
• To protect against the cost of optimistic revenue projections: over-commitment of
resources.
• To create a “winning” atmosphere and positive attitude.
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k. What is a “good” budget target?
Target should be after-the-fact (après coup) assessment of what could have been
accomplished, not any of the three choices listed (be aware of that)
l. “Beyond budgeting”? (skipped).
Some “principles”:
• Goals: set relative goals for continuous improvement; not fixed performance
contracts.
• Rewards: reward success based on relative performance; not on meeting fixed
targets.
• Planning: make planning a continuous and inclusive process; not a top-down annual
event.
• Coordination: coordinate interactions dynamically; not through annual planning
cycles.
• Resources: make resources available as needed; not through annual budget
allocations.
• Controls: base controls on relative indicators and trends; not on variances against
plan.
 Applicability in practice? Effectiveness? Problems? You cannot do your budget if you

do not do your plan.
Five myths leading to implementing strategies going wrong
• “Execution equals alignment”.

• “Execution means sticking to the plan”: it is not mandatory to stick to the plan.
Making a plan does not always means you have to stick to the plans.
• “Communication equals understanding”. Communication is important to understand
the situation. Example: Trump ask himself for a Nobel prize, do you understand? No.
• “A performance culture drives execution”. Just “perform” is not enough, you have to
execute also. Performing is not the same as executing the plans and do not lead
specifically to execution.
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• “Execution should be driven from the top”. Who is the most important? The
management or the 45 000 employees to do things? Of course, the 45 000. It is
important to consider their advice and what they want. In fact, execution should be
driven by the bottom. The starting point is a fundamental redefinition of execution -
as executions should be driven from the middle and guided from the top.
 Because of those myth companies do not stick to the plan or fulfill it.
What are the advantages and disadvantages of planning?

• Advantages: motivation, you know where you are going, reflect on the competitive
environment.
• Disadvantages: it takes time and resources.
What are the advantages and disadvantages of budgeting? Advantages/Disadvantages later

in the course.
What is disruption? And why are people talking about disruption? Even if we make a plan,
the world is going faster, and a plan is quickly unusable. In fact, it is necessary to follow
the plan but faster. If you have a plan for 1 year, do it faster because of the environment.
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B. CH 11: Profit Planning and the Role of Budgeting
Why planning is important? To know where we are going and why we are going in that
direction. People know what to do to go in that direction. Just to make the plan and get it
approved by the board it takes time (the less the professor has done is 3 months and it is
the average minimum). After, to implement it take even more time. We cannot do the
budget if the plan is not done. What is a budget? It is about what are our incomes and
expenses.
a. Definitions
A budget is a detailed plan for the acquisition and use of financial and other resources over a
specified time period.
The act of preparing a budget is called budgeting.
A Master Budget represents a comprehensive expression of management’s plans for the

future and how these plans are to be accomplished.
• Comprehensive (complet, exhaustif) is important because we will only present the
key figures to the board.
• It generally culminates in a cash budget (that a lot of companies forget), a
budgeted statement of profit or loss (P&L), and a budgeted balance sheet.
b. The basic framework of budgeting
Basically, the master budget is a summary of the different types of budget.
c. Planning and Control
• Planning involves developing objectives and preparing various budgets to achieve

these objectives.
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• Control involves the steps taken by management that attempt to ensure the
objectives are attained. Thanks to that we have the possibilities to see if the
objectives are fulfilled.
d. Advantages of budgeting
• Define goal and objectives.

• Think and plan about/for the future. This is how there will not be a surprise.
• Means of allocating resources.
• Uncover potential bottlenecks.
• Coordinate activities.
• Communicating plans: set a plan and communicate it in the objective of being
understood.
e. Responsibility accounting
Managers should be held responsible for those items — and only those items — that the
manager can actually control to a significant extent.
f. Choosing the budget period
Most of the companies choose one year. Why? Because there are variations during the
year. Example: Carlsberg sells more beer during the Easter holiday (special beer period),
the summer and in December because of the Christmas beer and this structure of selling
beer is repetitive each year.
The annual operating budget may be divided into quarterly or monthly budgets.
This budget is usually a twelve-month budget that rolls forward one month as the current
month is completed.
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g. Types of budget
i) Participative Budget system
The flow of data is coming from the bottom and goes to the top.
Advantages:
• Individuals at all levels of the organization are recognized as members of the team
whose views and judgements are valued.
• The person in direct contact with an activity is in the best position to make
budget estimates.
• People are more likely to work at fulfilling a budget that they have participated in
setting.
• A self-imposed budget contains its own unique system of control.
ii) The Master Budget
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The master budget is the sum of all the different budgets.

• It begins with the Sales budget because it is where an activity starts (how much
we expect to sell).
• After there is the Producing budget: how much do we need to produce enough
for the sales.
• The direct labor budget: how many people do I need to produce it.
 If we put every department budget together we have the final P&L statement.
iii) The Sales Budget
The Sales Budget is the starting point in preparing the master budget, a detailed schedule
showing expected sales for the coming periods expressed in units and pounds.
Example: a new producer of wine will not know how many he will sell and even how
many he will produce. To express this budget, we need to have the number of units and
pounds.
h. Budgeting example: Royal Company
Royal Company is preparing budgets for the quarter ending June 30. Budgeted sales for
the next five months are:
• April: 20,000 units.
• May: 50,000 units.
• June: 30,000 units.
• July: 25,000 units.
• August: 15,000 units.
The selling price is £10 per unit.
i) Step 1: The Sales Budget
Very easy to calculate.
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ii) Step 2: Production budget (once sales budget completed)
Production must be adequate to meet budgeted sales and provide sufficient ending
inventory.
Royal Company wants ending inventory to be equal to 20% of the following month’s
budgeted sales in units. On March 31, 4,000 units were on hand (à disposition).
Let’s prepare the production budget.
You take 20% of May: 50,000 = 10,000. Etc. 26,000 necessary in April since you need
20,000 units for April sales + 10,000 to answer 20% request for May – the beginning
inventory.
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In July, 25,000 units for Sales (see data given). For the quarter, the production needs to
be 101.000 pounds. You take 5,000 since you calculate for the quarter and it is the
Desired Ending Inventory. Same goes for the Beginning Inventory.
iii) Expected cash collection
All sales are on account. Royal’s collection pattern is:

• 70% cash collected in the month of sale.
• 25% cash collected in the month following sale.
• 5% is uncollectible.
The March 31 debtors balance of £30,000 (cash) will be collected in full.
We have all the data to calculate, we just have to understand what to do with it.
iv) The Direct Material Budget: raw materials we need to buy
The direct materials budget details the raw materials that must be purchased to fulfil the
production budget and to provide for adequate inventories.
• At Royal Company, 5 pounds of material are required per unit of product.
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• Management wants materials on hand at the end of each month equal to 10% of
the following month’s production.
• On March 31, 13,000 pounds of material are on hand.
The calculation is pure mathematic and logic.
10% of April = 13,000, therefore, 130,000 = Production needed for April. Or, 5 ∗ 26,000 =
130,000. You add the desired ending inventory which equals (46,000 ∗ 5) ∗ 0.10 =
23,000. After, you deduce the beginning inventory (- 13,000).
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You need to compute the production budget for July in order to get the desired
inventory needed in June (10% of July’s production).
v) Expected Cash Disbursement for materials
• Royal pays £0.40 per pound for its materials.

• ½ of a month’s purchases are paid for in the month of purchase; ½ is paid in the
following month.
• The March 31 accounts payable (dettes) balance is £12,000.
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vi) The Direct Labor Budget
The direct labor budget is also developed from the production budget. Direct labor
requirements must be computed so that the company will know whether sufficient labor
time is available to meet production needs.
• At Royal, each unit of product requires 0.05 hours of direct labor.

• The Company has a ‘no layoff’ policy so all employees will be paid for 40 hours of
work each week.
• In exchange for the ‘no layoff’ policy, workers agreed to a wage rate of £10 per
hour regardless of the hours worked (no overtime pay).
• For the next three months, the direct labor workforce will be paid for a minimum
of 1,500 hours per month.
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Now that we have sales, materials and labor costs, we can do:
𝑺𝒂𝒍𝒆𝒔 − 𝑴𝒂𝒕𝒆𝒓𝒊𝒂𝒍𝒔 − 𝑳𝒂𝒃𝒐𝒖𝒓 = 𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑴𝒂𝒓𝒈𝒊𝒏
But we have to take into account also the direct costs.
vii) Manufacturing Overhead Budget
The manufacturing overhead budget provides a schedule of all costs of production other
than direct materials and direct labor.
• Royal Company uses a variable manufacturing overhead rate of £1 per unit
produced.
• Fixed manufacturing overhead is £50,000 per month and includes £20,000 of
noncash costs (primarily depreciation of plant assets).
viii) Ending Finished Goods Inventory Budget
This budget determines the Cost Of Goods Sold (COGS) on the budgeted statement of
profit or loss and allows to know what amount to put on the balance sheet inventory
account for unsold units.
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At Royal, manufacturing overhead is applied to units of product on the basis of direct

labor hours.
𝑻𝒐𝒕𝒂𝒍 𝒎𝒇𝒈. 𝑶𝑯 𝒇𝒐𝒓 𝒒𝒖𝒂𝒓𝒕𝒆𝒓 £251,000

= ≈ £49.70 𝑝𝑒𝑟 ℎ𝑟.
𝑻𝒐𝒕𝒂𝒍 𝑳𝒂𝒃𝒐𝒓 𝑯𝒐𝒖𝒓𝒔 𝑹𝒆𝒒𝒖𝒊𝒓𝒆𝒅 5,050 ℎ𝑟𝑠.
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ix) Selling and Administrative Expense Budget
The selling and administrative expense budget lists the budgeted expenses for areas
other than manufacturing.
• At Royal, variable selling and administrative expenses are £0.50 per unit sold.
• Fixed selling and administrative expenses are £70,000 per month.
• The fixed selling and administrative expenses include £10,000 in costs – primarily
depreciation – that are noncash outflows of the current month.
x) The cash budget
The cash budget is composed of four major sections:

• The receipts section.
• The disbursements section.
• The cash excess or deficiency section.
• The financing section.
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You take back all what you calculated before to do it. There will be a fluctuation of the
cash over time and it will not specifically be the same as the production fluctuation
(example of Carlsberg with the summer peak).
N.B.: disbursement = décaissement.
Royal:
• Maintains a 16% (interest) open line of credit for £75,000 (maximum loan amount).
• Maintains a minimum cash balance of £30,000.
• Borrows on the first day of the month and repays loans on the last day of the
month.
• Pays a cash dividend of £49,000 in April.
• Purchases £143,700 of equipment in May and £48,300 in June paid in cash.
• Has an April 1 cash balance of £40,000.
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At the end of June, Royal has enough cash to repay the 50,000£ loan plus interest at 16%.
 Financing and repayment:
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Ending cash balance for April is the beginning May balance. In May, because the ending
cash balance is exactly £30,000, Royal will not repay the loan this month.
xi) Step 3: Budgeted Statement of Profit or Loss (once cash budget

completed)
After we complete the cash budget, we can prepare the budgeted statement of profit or
loss for Royal. It shows the company’s planned profit for the upcoming budget period.
It stands as a benchmark against which subsequent company performance can be
measured. It allows companies to compare their figures, growth margin, etc.
The Budgeted Balance Sheet
The budgeted balance sheet is developed by beginning with the current balance sheet
and adjusting it for the data contained in the other budgets.
Royal reported the following account balances on June 30 prior to preparing its budgeted
financial statements:
• Land: £50,000.
• Building (net): £175,000.
• Common inventory: £200,000.
• Retained earnings: £146,150.
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C. E11-8 (EXAM)
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Solution: production budget

Calculation is easy it is exactly like we see in the course just before.
July Augustus September October November
Budgeted 35 000 40 000 50 000 30 000 20 000

sales
Add desired 11 000 13 000 9 000 7 000

value
Tot need 46 000 53 000 59 000 37 000
Less: begin 10 000 11 000 13 000 9 000 7 000

inventory
Production 36 000 42 000 46 000 28 000

budget
D. E11-9
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V. CH 8: Performance Measurement and Reporting on segments
We take the breakdown products of different segments to compare them. This chapter
is about how can the organization make people more concerned about the results.
A. Decentralization and Segment Reporting
Decentralization: a decentralized organization is one in which managers at various levels

make key operating decisions relating to their sphere of responsibility.
A segment is any part or activity of an organization about which a manager seeks cost,
revenue, or profit data. A segment can be:
• An Individual Shop. Example: Marks & Spencer’s.
• A Sales Territory.
• A Service Centre.
There are sales centers that are responsible for the revenues.
B. Cost, Profit and Investments Centers
Cost center is a segment whose manager has control over costs, but
not over revenues or investment funds. They only control costs.
Profit center is a segment whose manager has control over both

costs and revenues, but no control over investment funds. They are
responsible for P&L.
Investment center is a segment whose manager has control over costs, revenues and
investments in operating assets. They control all the sales, the costs and investments.
They are responsible for the balance sheet. Example: corporate headquarters.
C. Traceable and Common Costs
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There are always some fixed costs. And if we have three division we should only
allocated those one that are traceable to each division.
Example: common cost could be for the finance department, but I cannot allocate it
directly to a division. Therefore, we do not allocate common costs!
a. Identifying Traceable Fixed Costs
We have to find out how to identify the fixed costs: traceable costs would disappear
over time if the segment itself disappeared (quite fast). Example: no computer division
means, no computer division manager.
b. Identifying Common Fixed Costs
Common costs arise because of overall operation of the company and are not due to the
existence of a particular segment. Example: no computer division but we still have a
company chairman. If a segment is dropped, the cost will remain.
D. Levels of Segmented Statements
 Our approach to segment reporting uses the contribution format.
• Variable COGS (Cost of Goods Sold) consists of variable manufacturing costs.

• Fixed and variable costs are listed in separate sections: ‘Other Variable Costs’ and
‘Traceable Fixed Costs’.
• ‘Segment margin’ is Television’s contribution to overall operations: 60 000.
How does the Television Division fits into Webber:
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Let’s add the Computer Division’s numbers.
Common costs arise because of overall operating activities. ABC may be helpful in
identifying whether a cost should be classified as traceable or common.
We see that the pool of common cost is not traceable, it is common to both and we
cannot allocate them.
All the segment’s manager will make plans to get their employees feel responsible and we
find this plan in the final plan of the company.
E. Traceable Costs can become Common Costs
Fixed costs that are traceable on one segmented statement can become common if the
company is divided into smaller segments. You have your division, and you will divide
them in smaller segments.
Example of Webber’s Television Division:
We obtained the following information from the Regular and Big Screen segments.
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Of the £90,000 costs directly traced to the Television Division, £45,000 is traceable to
the product lines Regular and £35,000 to Big Screen. The remaining £10,000 (Common
costs) cannot be traced to either the Regular or Big Screen product lines.
F. Segment Margin
The Segment Margin is the best gauge of the long-run profitability of a segment. It
represents the margin available after a segment has covered all of its own costs.
Example: Valandre Corporation sells different products (sleeping bags, jackets, etc.). This
means they have different segments. The margin of each segment can be calculated.
G. Alternative ways of segmentation
There are a lot of ways to segment. Here are some examples: you can do it by product
lines, by country, etc. There is no one good way to do it, it has to fit with the company
purposes and way of working.
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H. Omission of costs
Costs assigned to a segment should include all costs attributable to that segment from
the company’s entire value chain.
Business Functions making up the Value Chain:

• R&D.
• Product Design.
• Manufacturing.
• Marketing.
• Distribution.
• Customer service.
I. Inappropriate methods of allocating costs among segments
There are also a lot of “not good ways” to make segmentation.
• Failure to trace costs directly.

• Arbitrarily dividing common costs among segments.
• Inappropriate allocation base.
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J. Return on Investment (ROI)
a. Formula
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡
𝑅𝑂𝐼 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑠𝑠𝑒𝑡𝑠
𝐼𝑛𝑐𝑜𝑚𝑒 𝐵𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 & 𝑇𝑎𝑥𝑒𝑠 (𝐸𝐵𝐼𝑇)

=
𝐶𝑎𝑠ℎ, 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠, 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦, 𝑃𝑙𝑎𝑛𝑡&𝐸𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 & 𝑂𝑡ℎ𝑒𝑟 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑒 𝐴𝑠𝑠𝑒𝑡𝑠
Who’s going to calculate the ROI? The investment center because it requires to work
with the profit and the investments.
Example of Regal Company, reporting the following:
Operating profit £ 30,000

Average operating assets £ 200,000
Sales £ 500,000
£30,000
𝑅𝑂𝐼 = = 15%
£200,000
b. Controlling the Rate of Return
Three ways to improve ROI:

• Increase Sales: profit is higher.
• Reduce Expenses: profit is higher.
• Reduce Assets: investment is lower.
Example of Regal’s: manager was able to increase sales to £600,000 which increased
operating profit to £42,000. There was no change in the average operating assets of the
segment.
To calculate the new ROI, we can modify our original formula slightly:
𝑴𝒂𝒓𝒈𝒊𝒏 ∗ 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕 𝑺𝒂𝒍𝒆𝒔

𝑹𝑶𝑰 = ∗
𝑺𝒂𝒍𝒆𝒔 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑨𝒔𝒔𝒆𝒕𝒔
£42,000 £600,000
𝑅𝑂𝐼 = ∗ = 21%
£600,000 £200,000
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We increased ROI from 15% to 21%. You need to be aware of how it is calculated and
how your choices are going to influence it.
c. Criticisms of ROI
Example of Nespresso: they are able to give the machine for free, so people will buy the
capsules. But they continue to ask a fee and it is just there to increase the turnover.
Example of Mobile phone: you can buy it for half a euro (huge loss for companies). It is
because they have the possibility to get money elsewhere by selling data.
Example 3: the biggest cost for a bank is the banker but they continue to provide us with
them, so we will stay in the bank for the service aspect and make loans.
• As division manager at Winston, plc., your compensation package includes a salary

plus bonus based on your division’s ROI: the higher your ROI, the bigger your
bonus.
• The company requires an ROI of 15% on all new investments - your division has
been producing an ROI of 30%.
• You have an opportunity to invest in a new project that will produce an ROI of
25%.
As division manager would you invest in this project?
K. Residual Income and EVA (Economic Value Added).
Residual Income is the operating profit that an investment center earns above the
minimum required return on its operating assets. Usually the WACC is asked and it is
what you can use from the capital to pay costs.
Economic Value Added (EVA) is a similar concept that differs in some details from
residual income. Example: R&D are treated as investments rather than as expenses.
a. Residual income
In equation form, residual income is calculated as follows:
𝑹𝒆𝒔𝒊𝒅𝒖𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆
= 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕 − (𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑨𝒔𝒔𝒆𝒕𝒔
∗ 𝑴𝒊𝒏𝒊𝒎𝒖𝒎 𝑹𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝑹𝒂𝒕𝒆 𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏)
Example of a division of Zepher: it has average operating assets of £100,000 and is

required to earn a return of 20% on these assets. In the current period the division earns
£30,000. Residual income computation:
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b. Motivation and Residual Income
Residual income encourages managers to make profitable investments that would be

rejected by managers using ROI.
The disadvantage of Residual Income: the residual income approach cannot be used to
compare the performance of divisions of different sizes.
Why? The problem of Single Period Metrics: ROI, RI and EVA are all single period
metrics. A one-period measure cannot capture the economic value of a division or
investment.
The bonus bank approach [?].
L. E8-12
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Part 3: G. Sarens
A. Target Costing and Kaizen Costing: Cost Calculation Methods
Those technics are different from ABC and time driven ABC methods.
a. Managing products over their Life Cycle
Total-life-cycle costing is managing total cost of ownership. There are three stages that
correspond to the lifecycle of a product:
• Research, development and engineering cycle (development of the product).
o Market research.
o Product design.
o Product development.
o 80-85% committed costs! (most of the cost are decided in that stage).
o Target costing and value engineering.
o Break-even time.
• Manufacturing cycle (Production of the product)
o Traditional cost management systems, ABC, time-driven ABC.
o Kaizen costing.
• Post-sale service and disposal (you sell the product).
o Environmental costing (not discussed)
Today we are going backward: we will go to the first stage with target costing → we will
create a new product (there is no product yet).
When you are designing the product, you are already going to decide the cost (how,
where, what materials). This is the stage where you decide everything that has an impact
of the cost. This step is important because in the other stages you cannot change the
cost anymore.
If you want to change the cost in stage 3 you can do it only in small steps. In the second
stage it is possible with the kaizen costing.
Kaizen costing is used on markets where customers have a lot of power → context of the
price taking. Customers will go to another brand if you ask too much in terms of price
and have therefore power to decide which one they will buy. The market decides
because of competition and because the needs of the customers change a lot (which
means functionalities change regularly).
 Being a price setter or a price taker as a company creates a completely different

environment.
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b. Target Costing
Short video introduction: target costing is a technique for establishing the maximum
cost we could make a product for, yet still make the required profit margin. It is an
increasingly common technique in manufacturing and engineering.
The modern marketplace is extremely competitive which means that manufacturers often
struggle to increase their prices as it will male them uncompetitive.
This means the focus is on making the product as cheaply as possible, without affecting
quality, to ensure the company males the required profit margin. If it cannot make the
product cheaply enough, it will not continue with, or start, production.
Example: imagine considering introducing a new chocolate bar ‘Target’. Now, the market
for chocolate bars is very competitive, there is lots of different brands, which all sell a
similar price. Therefore, you cannot expect to sell a bar for more than the market rate
especially as it is a new product. If the market research suggests the maximum selling
price would be 70p. there are also some costs you cannot change: direct labor cost per
bar is 5p and the fixed overhead cost per bar is 15p. But the company also has to make a
minimum profit of 30%. We need to know the maximum we can spend on raw materials
in order to meet the required profit without exceeding the market-acceptable price.
The maximum we can spend on raw materials is: 70p – 5p – 15p – 21p = 29p. At the
moment, our standard cost for raw materials for one bar of Target is 33p. But that will not
make the company to the required profit margin unless they put the price up and the market
is to competitive to do that.
 You can either reduce the cost of the raw materials per unit of not make the
production.
How? You can use cheaper materials but that might affect the quality. Or you can use less of
the expensive ingredients in each bar (such as replacing coconuts by cheaper raisins),
negotiate better discounts, make the bars smaller, etc.
 Target costing allows to ensure that the products are making required level of profit
without increasing prices. If you cannot get the material cost down, there is no
financial sense in manufacturing the product.
 Target costing is used to calculate whether a product can be produced cheaply
enough to earn the required profit.
Origin: Japanese automobile industry. It comes initially from car manufacturing industry.
Japanese environment so it is more difficult to implement in a non-Japanese environment.
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Design (new) products that meet customers’ expectations and that can be manufactured at a
desired cost. Three important concepts: cost, functionality and quality. Balance between
those three elements is very important for the market and we need to listen to the market.
Traditional pricing method (cost-plus method)

• Price = Total Cost (that we can calculate with ABC for ex) + Margin.
• Can be used when products are unique and in markets with not much competition
(company = price setter). Companies prefer being price setters, but it is not often the
case.
Customer driven (importance of market research). This type of companies invests a lot in
market research to understand what the market (customers, future ones, etc.) wants.
Example: if you produce a smartphone you do not want only to target the early adopters but
the majority of the market.
Basic principle: companies want to know what customers are willing to pay.
Example: they want to pay 300 € so you can sell it at higher price. You want a margin of
50€.
• 𝑇𝑎𝑟𝑔𝑒𝑡 𝑐𝑜𝑠𝑡 = 𝑡𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 – 𝑡𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛
250€ = 300€ − 50€
• Company = price taker. It means the market decides because of competition and
type of market (high tech industry).
Price setter versus price taker : video to determine if companies are price taker or price
setter (interesting for exam).
Price taker:
• Price not unique.
• Intense competition.
• Pricing approach emphasizes target costing. 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 − 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡 =
𝑇𝑎𝑟𝑔𝑒𝑡 𝐹𝑢𝑙𝑙 𝑃𝑟𝑖𝑐𝑒.
Price-setters:
• Product is more unique.
• Less competition.
• Pricing approach emphasizes cost-plus pricing. 𝐹𝑢𝑙𝑙 𝑐𝑜𝑠𝑡 + 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡 =
𝐶𝑜𝑠𝑡𝑝𝑙𝑢𝑠 𝑃𝑟𝑖𝑐𝑒. Which is the market price.
More specifications on the characteristics of companies that use target costing:

companies characterized by:
• High tech, innovative products (short product life cycle).
• Demanding customers (demands change regularly).
• Highly competitive industry.
o A lot of competitors (that offer +/- the same product).
o Strong competition on price.
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o Strong competition on speed of innovation. Sometimes you can be at 270€

instead of 250€ but you have to decide if you go to the market or do not
go because timing is important. You have to choose if you want to go
quickly on the market. Important dilemma: go quickly to the market or
respect the target price?
o Large scale production.
Now you have to start producing the product:

• Overall target cost split up in target costs per component of the product cost.
Raw materials, components, labor cost, infrastructure cost. Example: target cost =
250€ → 100€ materials, 100€ labor, 50€ infrastructure.
• Value engineering: determine the price of each components, labor cost etc.
Cascade system. Finding optimal balance between cost, functionality and quality.
o Example: I split the 100€ materials into 5€ for the screen, etc.
o Example of Labor cost: target costing is the reason why companies relocate
themselves to diminish their costs. People complaint about that but it is
because of them (the target price).
o Infrastructure: do I have the right infrastructure, or do I have to change
that?
• Need for cross-functional product teams: if you look at the departments involved
in the production of a new product (HR, Sales, etc.) they all need to collaborate
with each other. To make it a success cross functional teams is necessary.
• Active supply chain management is needed because it is not an easy task. It is
important to develop a broad network of supplier (I do not need them today but
maybe tomorrow!). Companies invest a lot in supply chain management to make
sure to be on time. Reminder: importance of speed!
The advantage is that the target margin is generally respected. It is important to have
reserve for the future. Example: if next year you try to develop a new smartphone but it is
not a success, you have reserve for that. The goal is not to diminish the margin (and
increase the target cost), but to respect the target price.
Concerns about target costing: the way they invest, they develop supplier’s relationship
is all based on this.
• Lack of understanding of the concept:
o Target costing is a philosophy! (more than just a technic, it is part of the
company’s culture).
o Target costing needs to be integrated in the corporate culture. If you
consider it only as a way to calculate cost, it will not work.
• Poor implementation of the teamwork.
• Employee burnout: it can cause stress for employee to also check every supplier
at the market, etc. Japanese companies implement bonus and help to ensure
having motivate people.
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• Long development time: it takes a lot of time but sometimes there is no time
because of the pressure of the market (importance of speed). Choice between
going on the market directly or respecting the target price/cost. Example: you do
not have the time to have a cheaper supplier for the screen. If you go directly to
the market your product will be sell at higher price like 350€ but you prefer to be
the first one (so you decide to reduce the production time). However, once you
are on the market, the process does not end. You have to realize another 50€
reduction cost. This is where Kaizen costing intervenes.
Target costing in a Japanese versus Western environment

• Commitment to the target cost (link with kaizen costing).
• Commitment to teamwork: in Western companies, cross functional teams are not
well implemented so it is more difficult to work with target costing → fail of target
costing in non-Japanese environment. In Japanese companies there is a strong
culture based on collaboration (necessary to the target costing).
• Pressure on employees and suppliers: socially less accepted in Western
environment. But negotiating more aggressively with supplier is ok in Japan.
• Labor cost not fully under control. In Western environment the labor component
is not very flexible (lots of regulation, etc.). This is why there is not that many
Western companies that implement target costing culture.
B. Breakeven Time (BET).
You go to the market, you know that your product has a short lifecycle, so it has to be
very profitable.
Breakeven point = how many smartphones you need to sell to be profitable. But, what
we are concerns about is more time: how long does it take to be profitable? Because if it
is 3 years, it is too long for our short lifecycle product.
• Cost, functionality, quality and time.

• Product development time and product release timing are important CSF.
• Complementary to target costing
• BET brings time into new product development. Length of time from the project’s
beginning until the product has been introduced and generated enough profit to
pay back the investment originally made. At this point you start building profit for
the future (for new products!). The profit must be as big as possible!
• Three characteristics of BET
o Entire cost of design and development.
o Focus on product profitability.
o Stimulates faster product launch.
• Tool for sensitivity analysis.
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Note: when you go to the market you are a little bit too expensive so it is slow on the
market (early adopters). If you go with the market price necessary the breakeven time will
be smaller. If you are still too expensive, the breakeven time will be longer.
 When you go to the market, to diminish the price you sell your product you use
Kaizen Costing.
C. Kaizen Costing
Short video introduction: https://www.youtube.com/watch?v=r6aRTza9X2w.
Kaizen costing comes in the manufacturing stage of the lifecycle of your product.
Context: we have to reduce the target cost from 300€ to 250€. Pay attention to cost,
functionality and quality! In fact, we will do it step by step → reduce to 270€, 260€, etc.
Kaizen costing is a must, you have to do it or you are out of the market. In target costing
culture, it is a mindset to always try to reduce cost.
You need to make sure that everyone knows that the cost will diminish by 50€ within
the 3 months and everyone has to participate in this reduction. People at the operational
level (not the top level) are the ones that know the best how to proceed to reduce cost.
• Making small, incremental and continuous improvements to a process during the

manufacturing stage of a product with the objective to reduce the production
cost.
• Complementary
o To Target costing, especially when the target cost was not reached at
product launch.
o To Target costing to convince the largest group of potential customers.
o To lean production (production allégée) systems.
• Target reduction rate versus actual reduction rate: top-down approach.
• Applicable to those variable production costs that are not committed yet during
the R&D stage.
• Most knowledge to improve the production process comes from the operational
workers.
o Bottom-up approach: top level decide that the cost should be 250€ but
the rest comes from the bottom level.
o Quality circles: https://www.youtube.com/watch?v=poh0SCFTZb0
= regular brainstorming between operational people to put their ideas on
the table about how to produce at a cheaper way. It is a way to inspire
each other and have the ideas.
o Need for full transparency about production costs: motivate them to bring
new ideas.
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o Pressure on operational workers (concern): it is a concern because it is not

in the culture of western companies to be pressured.
o Continuous cost reduction should become a corporate philosophy.
• Regular follow-up on production cost: companies collect a lot of data to be sure
to know every change that happens and inform everyone about that.
• Added value analysis: value adding versus non-value adding activities (waste):
which activities add value and which can be deleted because they do not add
value. Studies have shown that 30-40% of activities add no value, which gives
opportunities. Eliminate step by step (incremental improvements) non-value
adding activities.
 A lot of small steps together makes big steps. This is the concept of kaizen
costing.
If everything goes well, you will end up with 250€ target cost and reach the large
majority of the market.
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VI. Performance Management and the Balanced Scorecard
This is a very important area in management, every manager has to deal with. How do
you make sure everyone make what it is supposed to do based on the agreed objectives?
The behavior of people needs to be managed (influences, not controlled). We have to be
sure that people do the right things and achieve the objectives.
Do we need just to ask them to do their best? No, it is more difficult than that. If you
have a big challenge, you can’t just expect people to do what they are supposed to. It is
very unlikely that just by this communication, things will happen the right way.
We need much more to influence their behaviours.
How to make sure you go all in the right and same direction? And that it is conscious that
people perform in this direction. Every (really) company deals with this.
Someday, we will be confronted with that, as an employer or as a manager (someone

who is managed or someone who is managing). Depending on the position, you will feel
this differently. A manager will define performance management are going to be used or
someone who is managed.
A. Performance Measurement Systems
= A set of measures (indicators) to know how to define the performance. This set of
indicators, communicated to the people, will hopefully be right to take the right effort,
action and to motivate people. What are the best ones?
Example of students vs teachers: teachers assess the performance of students through

exams. This is also a way to make sure we study what we need to study. Hopefully by
knowing what to study, the professors try to influence us to study what they want us to
know.
A good performance measure one gives the right measures to the people in order to
trigger the right behavior and therefore, performance. It also has a lot of impact and is
crucial in a company.
• Different roles:
o Communication role: It’s a way to tell people what you expect from them,
it’s a way of communicating “indirectly”. A direct way would be to give the
exam copy beforehands. A PM System is a good way to communicate in a
sense. You can tell indirectly what you expect thanks to the measures that
reflects what you are expecting as a manager.
Giving measures is guiding in a certain direction (“in which direction should
I go?”). Even if a certain freedom remains of the way to achieve the
goal. But with no indication of which part to take, the result is more
difficult to achieve.
o Delegation role: Delegating is necessary. Performance management is not

necessary if we don’t delegate. When you rely on others, you need to
manage their behavior. Managers delegate work. Delegation always means
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there is a way back. You expect someone to do something but you also
need to follow-up on the results. You need to evaluate, control and
monitor. Delegating without the right measures is not relevant because
you can be confronted with bad results too late, etc. This means there is
something wrong with the performance management. The green (+) and
the red (-) lights will guide a manager about the direction and whether the
objective is going to be achieved or not. Taking action is needed. Using a
dashboard is necessary (to see what happens and correcting what we have
to change). You should not wait until the crash. Without it you flight
without seeing. Dashboard = a tool to follow-up on the people and their
performances.
o Motivation role: Good performance management should motivate people

to give the best of themselves. The opposite of motivation is frustration.
Example: if the professor does an exam students were absolutely not
expecting, students will be demotivated, frustrated and disappointed. Bad
performance measures triggers bad behaviors. Some perverse effect can
happen if people act the way they thought was expected from them. Every
time you define a performance measure, you need to ask yourself: “what
behavior will this trigger?”.
o Evaluation role.
o Allocation role: It’s thanks to my dashboard that I can I decide. The green
lights will tell you were to put your efforts and resources (investment of
time and resources) while the red lights means you are not using your
resources the appropriated way. Red light should trigger action. Without a
dashboard that tells you about what you are doing, you might continue
investing into the wrong things.
• Challenge: finding the right mix of financial and nonfinancial measures

o Physical and financial assets versus intangible assets
o Perverse effect on financial performance…
• Challenge: finding a performance measurement system (tool) that stimulates
everyone in the organisation to work towards the same and the right objectives.
B. The Balanced Scorecard (= Dashboard)
Balanced: The measures on the scorecard need to be balanced. With a balanced set of
measures.
• Meaning 1: balance between financial measures (1st category) and non-financial
measures (3 next categories).
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• Meaning 2: balance between the 4 categories of measures. Balance between

leading and lagging.
• Meaning 3: balance between leading indicators and lagging indicators
Kaplan and Norton (consulting firm in the USA, 1990) invented ABC and Time ABC. They
had a client struggling with the finance and they designed a model for their client.
• Meaning 1: every light is a performance measure/indicator. Some are about

financial performance (RoA, etc.). This needs to be integrated. Not doing it would
be naive. If you are financially healthy and sustainable, you can start caring about
other dimensions such as environment, etc. But it’s the basic need, first (it’s about
surviving).
The distinction between financial and other measures exists. But of course, many
other measures than financial performance are needed. Only counting finance,
the employees will have the wrong behavior because they won’t care about the
long term, the customers, the others employees behavior, etc.
N.B.: And an ONG? Of course you need performance management as well
because even a non profit organization needs to be financially sustainable (enough
cash and able to pay for expenses).
• Meaning 2: the BSC measures performance across four perspectives derived from
the company’s mission, vision and strategy.
o Financial: “what financial performance should we deliver to our

shareholders?”.
o Customer: “how must we deliver value to our customers?” Clients’
satisfaction is mandatory to be included on the scorecard. If they are not
satisfied, you will have financial red lights (at least on the long term). The
link with the first point is clear. Client not happy → no profit.
o Process: “at which processes must we excel?”. Processes and internal
organization should be smooth. Otherwise, customers would experience
bad services and this will also influence the first point, the finances. The
quality of my process is crucial. Bad processes → clients not happy → bad
profits.
o Learning and growth (or L&D for Learning and Development): “how do we
align and enhance our intangible assets to improve the critical processes?”.
You cannot neglect the future. How well does your company invest in the
future, in physical and human resources? Example: Do you invest in
training (HR investment)? Do you invest in the quality of your
infrastructure? All of this does not last forever. To what extent do we
invest in that?
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→There are interrelations (correlations between those measures) that we

have to understand. Taking action now by making processes more
efficient, what will be the effect on the other performances?
• Meaning 3: lagging versus leading indicators: the first performance measure is the
one leading to the final result of the action. Lagging indicator only measures the
final result of your actions. If you only measure this, you have only the lagging
indicator. Example: the revenues for online sales. If you don’t have any other
measure, you won’t have warnings and you cannot prevent a bad final result to
happen. Early warning signals are needed such as number of visitors or the time
people spent on the website. Those are leading indicators. Thanks to those, you
can take corrective actions which is the first purpose of the scorecard. If the
dashboard guide your decisions on a daily basis, you need leading and lagging
indicators.
• Cause-and-effect linkages
C. BSC: objectives, critical success factors, performance indicators and

targets (arbre!)
Objectives Critical Success Critical Targets

Factors performance
indicators
Action phrases: verb- What is needed to How will success in Level of

object - means - achieve these achieving an performance
desired results objectives? objective be required
measured?
Without objectives, CSF are permanents. Ambitious
no PM. If you don’t CPI can change (promotes
know what and why Before measuring: overtime. excellent
you want to achieve We have to define performance) but
there is no sense of the CSF, those things “You get what you achievable
measuring it. that we need to measure” (otherwise it’s
Furthermore, data achieve that frustrating).
collection is cheap objective. We have to define Managers are too
nowadays. Moreover, for each CSF disconnected from
measuring without It’s permanent. several (2 to 3, the reality to
objective can be maximum 4) decide the bar.
nefaste for people. Example: Enough measures that can
visitors on the be classified in one When we have
Example: increasing website; Visitors of the 4 categories CPI (so a
the online sales by staying long enough that we have seen dashboard), we
20% on the website; in the dashboard. still don’t know: Is
Visitors should easily the light green or
find their products Example for “easily red? When should
finding the product”: it be green or red?
How many pages
do they click Example: The
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before buying; The target is maximum

percentage of 3 pages they click
visitors that leaves before buying. If
without buying ; they buy after
The number of more than 3 pages
questions to the → red.
helpdesk
D. Creating a strategy map (skipped)
• Financial perspective
o Productivity improvements
▪ Cost reductions
▪ More efficient use of assets
o Revenue growth
▪ Enhance existing customer value
▪ Expand revenue opportunities
• Customer perspective
o The value proposition is based on a combination of price, quality, time,
function and service
o Three typical value propositions
▪ Low-total-cost value proposition
▪ Product leadership value proposition
▪ Customer solutions value proposition
• Process perspective
o Operations management processes
o Customer management processes
o Innovation processes
o Regulatory and social processes
• Learning and growth perspective

o Human resources
o Information technology
o Organizational culture and alignment
E. Managing with the BSC (very important)
• Top-down versus bottom-up. Don’t lower a bar without your employees. There is
a gap between managers (not sufficiently in touch with the reality to define the
right measure) and people who are working on this daily. They can give input and
talk about their professional experience. Same stands for targets, don’t put targets
you think about but ask your people (just make sure they don’t put the bar too
low). They know probably very well what is realistic and what is not and they have
the experience. A CEO has not done all the tasks his people do to get more
realistic. Moreover, imposing something in people will never motivate them. But if
the target is theirs and created in a dialogue, this will become their measure and
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they will be more committed. You will have more by-in (commitment and
acceptance).
→ Always top-down in combination with bottom-up (from the operational
people).
• Linking incentive compensation to the BSC. Good behaviors should be rewarded,
bad behaviors should not be. Two months after the reward, the positive impact of
the bonus on the motivation has gone. It will be nice the day you gain the bonus
but there won’t be any impact 2 months later. Don’t exaggerate on the financial
bonus because the impact in the long term in limited. You can find alternatives
that will have longer lasting such as promotions, trainings, etc. But the best and
the cheapest is compliments (and not just once a year but on a day-to-day basis)
• Integrate concepts such as target costing, break-even time, kaizen costing into the
BSC. It’s good to include that in our performance measures. We have to integrate
that as much as possible in the scorecard in the way they influence your company.
f. Barriers to effective use of the BSC
• Using too few or too many measures. You don’t need hundreds measures (3 are
enough). Looking at those at the same will not work, as a manager or as a worker.
Attention can be given only to part of this. So, don’t exaggerate, don’t over-
design. This is a risk nowadays because we almost for free, collect data. There is a
seduction of including more but too many lines will turn it not into a management
tool anymore. Before, it was very expensive to collect even 1 data.
• Measures should reflect the strategy
• Employees are not committed. Bars lust be set sufficient high. Challenging the
people to make it sufficiently ambitious.
• Scorecard responsibilities do not filter down (ne parveniennet pas en bas). If it
does not filter down in the organization, it will not motivate people. Everyone
needs to know what are their measures. In bigger companies, you need sub-
balanced scorecards, per department.
• The BSC is over-designed (don’t fall in the trap of too many lights). Including new
performance measures means new data creation.
• The BSC is treated as a consulting project. The problem is that a consulting firm is
an external party that can help with the methodology, but they cannot never
design at your place a performance strategy, targets and the measures you will
use in your company. They give templates, examples and advice (the thinking
part), that are useful. But they cannot do everything. The target is our input.
More information on how the BSC is used in practice: www.thepalladiumgroup.com.
F. Assignment: BSC for the LSM
• Objective: be the preferred business school in Europe

• Define three critical success factors (what is needed to achieve this objective?)
• Define for each critical success factor two or three critical performance indicators
(how can the achievement of this objective be measured?)
• Define for each critical success factor the target.
[See notes for the exercise]
107
The first thing to do is to define the critical success factors. 3 Critical Success Factors (=
permanent, that we always need).
• For each CSF, we have to find performances Indicators/Measures
• It is expected to define, for each PI, targets.
It is important to keep in mind this: if we give our objective tree to LSM members, would
they be motivated and involved?
Our examples:
Lessons Quality
• Teachers with exceptional experience (> 10 years)
• At least 25% ⇒ Leading indicator
• “Guest” professors
• At least one per course ⇒ Leading indicator
• Ranking
• Top 50 ⇒ Lagging indicator
• Students feedback
• At least 75% of positive feedback
• Student attendance in class
• > 60%
Campus Attractiveness
• Extra-Scholar activities (companies talk, seminars etc)
• Once a week
• Facilities/ accessibility
• Investments (500.000 € per year) ⇒ Leading indicator
• Students Surveys
• % satisfaction ⇒ Lagging indicator
External relations
• Partnerships
• # new per year
• Hiring of students (Lag?)
• > 90%
• Erasmus leaving/incoming
• 1/1 ratio (one leaving, one coming).
Other students’ ideas:
Good Teachers
• Number of trainings attempted per year
• At least 2
Exam his part:
De Harlez
• 5 QCM (costing), doable (theory + very little exo) without neg points
108
• ABC (very small exercise, 15 min) + Understanding the difference between

Traditional and ABC (a lot of information already and some things missing)
Kim
• Cost-Volume-Profit (break-even point, CM, incremental costs, concepts,

opportunity costs) : no exercise (theory + understanding/interpretation)
• Profit planning and the role of budgeting (no exercise, conceptual questions)
• What is meant by the margin of safety? And please explain how it can be used.
• What is the basic difference between absorption costing and variable costing?
• Under absorption costing, how is it possible to increase profit without increasing
sales?
• Why is sales forecast often the starting point in budgeting?
• How can budgeting assists a firm in its workforce staffing levels?
Gerit
• Kaizen/Target Costing (understanding, how it works, showing the importance of

both methods and the link between both: why using the one first and the other
one after (the question).
• Performance Management (exercise like the last one done in class, BUT, the other
way around) “Are those measures the rights measures?” “Is this going to trigger
the right behaviour?”
109

Management Accounting

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Management Accounting

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Pr. G. Sarens, Y. De Harlez & K.

Part 1: Yannick De Harlez

I. Intro management accounting

N.B.: debit and credit: now, no talking about debit

II. Financial vs Management Accounting

How management accounting information supports decision making

A. Financial Accounting vs Management Accounting

Differences between both

Managerial Accounting Financial Accounting

Not required or mandated. Required. The firm has to be in compliance.

B. Management accounting (not seen in class)

• Change customer relationships.

III. Basic Cost Management concept

 What you see depends on the point of view.

A. Management accounting supports internal decision making

Use of cost information:

 Understand the cost behavior.

• The objective is to make profit (economic perspective). Profit is the difference

a. Direct vs. Indirect costs

ii) Indirect costs

b. Variable vs. Fixed costs

This distinction tells how a cost behaves.

ii) Fixed costs (in the short term)

An essential classification for decision-making.

Imagine a 2x2 matrix:

In principle, all four cases exist. In practice, however:

In practice, there is a lot of confusions:

• Direct = manufacturing & Indirect = non-manufacturing

N.B.2: ‘variable costing’ or ‘direct costing’ = an accounting method used to allocate

d. Other useful cost definitions

C. Exercises (application of the definitions)

a. Are the following variable or fixed costs?

Chicago Acoustics builds innovative home theater systems:

b. Are the following variable or fixed costs?

Sally’s nursery has been in operation for several years:

c. Four types of cost at two activity levels

Is each cost type variable, fixed or semi-variable?

𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕𝒔 = (𝑼𝒏𝒊𝒕𝒔 ∗ 𝑼𝒏𝒊𝒕 𝒗𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒄𝒐𝒔𝒕)

Where X = Unit variable cost

[There is not enough information to refute the fact that it

The condition is met. The total cost is purely variable.

d. Four types of cost at two activity levels

Is each cost type variable, fixed, semi-variable, or semi fixed?

I $ 7 000 $ 10 500 7 000

Variable cost. The condition is met.

II $ 11 000 $ 12 500 11 000 = 1 000 ∗ 𝑥 + 𝑌

11 000 − 1 000𝑥 = 12 500 − 1 500𝑥

This is a semi variable cost (or semi-fixed). We don’t

IV $ 3 800 $ 5 700 Variable: the assumption is to meet the condition

e. Respond to the two following questions

A business produces one product which requires the following inputs:

Direct materials 6 kg @ £4.80 per kg

Directs labour 4 hours @ £7.00 per hour

Building costs £18,000 per quarter

Leased machines £600 for every 600 units of production

Stores costs £ 3,000 per quarter plus £3.00 per unit

1 000 units 1 500 units 2 000 units Cost type

Direct 6 ∗ 4,8 ∗ 1 000 6 ∗ 4,8 ∗ 1 500 = 6 ∗ 4,8 ∗ 2 000

Directs 4 ∗ 7 ∗ 1 000 4 ∗ 7 ∗ 1 500 4 ∗ 7 ∗ 2 000 Direct labor costs

Building 18 000 18 000 18 000 Fixed

Leased 2 ∗ 600 = 3 ∗ 600 = 1 800 4 ∗ 600 Semi-fixed [? ≠ semi-

Stores costs 3 000 + 3 3 000 + 3 ∗ 3 000 + 3 ∗ The cost behaves as

Total £ 82 000 £ 112 500 £ 143 000