Cost Management & Variance Analysis Notes

Accounting Information & Decision Influencing

The course positions accounting information as a dual-purpose managerial tool:

1. Decision support – supplying the numbers, ratios and projections managers need for their own choices.

2. Decision influencing – shaping the behaviour of other managers in a decentralised organisation by signalling, rewarding or constraining actions.
   The lecture stresses that financial-accounting rules are highly regulated and historically aimed at external users, whereas cost & management accounting focuses on internal use, offering flexible techniques (GPK, ABC, target costing, etc.) to fit strategic and operational needs.

Learning Objectives (Ch. 5 & 6)

• Understand the range and content of cost management.
• Apply value-chain analysis, strategic cost analysis, and activity-based costing.
• Grasp the German cost accounting framework GPK and its ABC-style variant (Prozesskostenrechnung / PKR).
• Employ target costing and life-cycle costing.
• Perform variance analysis of costs, revenues, contribution margins; link results to behaviour (agency view).

Fundamentals of Cost Management

Cost management = all managerial activities that influence cost level, cost structure, and cost behaviour in order to enhance economic viability.
Influence works through:
a) Better cost information (the technical/accounting side).
b) Behavioural effects (incentives, information asymmetry mitigation).
Note: cost management does not always mean cost cutting; sometimes higher cost is accepted if it increases value.

Cost Accounting Systems & Long-Term Decision Making

Traditional systems struggle with:
• Allocation of fixed & indirect costs.
• Periodisation – squeezing multi-year effects into one fiscal year.
Strategic decisions that need longer-horizon data:
• Product-programme composition.
• Long-term price floors/ceilings.
• Launch prices for new products.
• Make-or-buy (vertical integration).

Environmental Changes Shaping Costs

Empirical findings: 70-80 % of a product’s lifetime costs are locked-in by early technology choices.
Trends:
• Rising fixed-cost share (automation, IT).
• Shorter product life-cycles; however R&D and after-sales costs remain.
• Intensified competition forces earlier and broader cost attention.

Strategic Management Accounting & Competitive Strategy

Strategic management accounting (SMA) widens the lens to external, non-financial, and competitor data (CIoMA definition).
Porter’s generic strategies and info needs:
• Cost leadership → granular cost, volume, and variance data to drive efficiency.
• Differentiation → customer willingness-to-pay, revenue analytics, and cost of added value.

Information Needs Under Different Strategies

Cost leaders emphasise production optimisation, overhead reduction, tight cost budgets, detailed cost/volume variances.
Differentiators focus on marketing, premium pricing, and willingness-to-pay metrics; cost info still relevant but in relation to price premium.

Activity-Based Costing (ABC)

Purpose: Trace overhead to value-adding activities instead of products en bloc.
Key steps (strategic cost analysis):

1. Identify activities along the value chain.

2. Distinguish activities; allocate indirect cost to them.

3. Determine cost drivers (volume, complexity, variants).

4. Compute $\text{Activity Rate}=\dfrac{\text{Total Cost of Activity}}{\text{Volume of Cost Driver}}$.

5. (German variant) Aggregate to 7-10 main activities to simplify reporting.
   Conceptual twist: overhead is not an “unwanted side-effect” but reflects resources consumed by value-adding tasks.

Example (Book-keeping centre): labour costs and non-labour costs allocated to four activities; management costs distributed proportionally (20 %) yielding lmi-rates (variable, volume-induced) and total rates (with lmn fixed portions).

German ABC, GPK & PKR

• GPK (Grenzplankostenrechnung) = standard German cost-centre accounting; PKR (Prozesskostenrechnung) is Germany’s ABC.
• Both share similar cost-driver bases for non-production cost pools, but GPK sometimes relies on value-related surcharges whereas PKR insists on volume-related drivers.
• Resource Consumption Accounting (RCA) is a hybrid merging GPK & ABC elements.

Applications & Assessment of ABC

Main uses:

1. Management of indirect costs – detect non-value activities, streamline or outsource.

2. Strategic calculation – long-term programme and pricing.

3. Customer profitability studies.
   ABC is a full (absorption) costing system, well-accepted but criticised for proportionalising several layers of indirect cost (labour → activity → product).

Target Costing

Applied to new products, begins in R&D/design.
Market-back logic:
$\text{Target Cost}=\text{Budgeted Selling Price}-\text{Target Profit}$
Creates cost-reduction pressure across all departments & suppliers during the entire life-cycle.
Variants for deriving target cost:

1. Market-into-company (price – profit).

2. Out-of-company (functional cost breakdown).

3. Combination.

4. Out-of-competitor (estimate competitor cost).

5. Out-of-standard (existing standard cost minus % reduction).

Cost-reduction levers include size/weight changes, material substitution, common parts, supplier involvement, process redesign, and outsourcing.

Relation to Competitive Strategy & Target Costs

• Cost leadership: survive longest in price wars.
• Differentiation: offer uniqueness customers value; price premium funds higher cost. Target costing must align with the chosen strategy.

Life-Cycle Costing (LCC)

LCC accumulates all cash flows from pre-production (R&D, marketing), production, and post-production (service, disposal).
Influence is greatest when started early.
Issues:
• Many early/late costs are indirect & multi-product.
• Allocation requires forecasts of future volumes & prices.
• Success rates (e.g., pharma < 5 %) add uncertainty.
Graph shows cumulative costs & revenues over time; traditional costing only covers the production-phase box.

Variance Analysis & Control (Ch. 6)

Functions:

1. Decision support – improve future plans.

2. Behaviour-guiding – align divisional managers despite goal incongruence & info asymmetry.
   Process: define control field → set budgets & measure actuals → compare & disaggregate variances → interpret.

Reference Systems

Total variance: $\Delta C=C<em>a-C</em>b$.
Two reference orientations:
• Decision-support view: reference = actual.
• Behavioural view (preferred in class): reference = budget.

Example (prices $r$, quantities $q$):
$\Delta C=\Delta r\,q<em>b+r</em>b\,\Delta q+\Delta r\,\Delta q$ (price, efficiency, composite variances).

Disaggregation & Geometry

Inner rectangle $r<em>b q</em>b$ vs outer $r<em>a q</em>a$; first-order (single-factor) vs higher-order composite variances.

n-Factor Case

For $C=r\,v\,b$ we generate 1st-order, 2nd-order, 3rd-order terms; causation assignment beyond first order is impossible.

Methods of Variance Analysis

1. Differentiation – report composite separately (most suitable).

2. Alternatives – assume one factor changes at a time.

3. Cumulation – choose a sequence; composite absorbed by first variance (common but sequence-sensitive).

4. Symmetric – split composite 50/50.

5. MIN – separate composite except in rule-defined cases (all ↑, all ↓, mixed).
   Criteria: completeness, invariance, fairness, coordination ability, practicability.

Comparative Example (80 € price ↑, 100 qty ↑)

Total variance $+52{,}000$.
Differentiation: price 24 000; efficiency 20 000; composite 8 000.
Alternatives & Cumulation produce different splits; symmetric adds 4 000 to each first-order variance.

Price & Revenue Variances with Interdependence

Simple variance ignores price-demand curve ⇒ misleading.
Corrected steps:
• Compute demand at new price $x<em>s=x(p</em>a)$.
• Decompose $\Delta x=\Delta<em>1 x+\Delta</em>2 x$.
• Adjust price variance by $+p<em>b\,\Delta</em>1 x$ and volume variance by $-p<em>b\,\Delta</em>1 x$; composite unchanged.
Result realigns interpretation.

External vs Internal Factors

Revenue decomposed as:
$R=p\,x = p<em>r\,p</em>m\,x<em>r\,x</em>m$
External: market price $p<em>m$, market size $x</em>m$.
Internal: relative price $p<em>r$, market share $x</em>r$.
Variance split into industry-price, market-size, price-efficiency, marketing-efficiency and higher-order cross terms.

Contribution Margin Variance

Combined cost & revenue perspective often clearer but caution: sign ambiguity.
Example: negative budgeted CM (–15) turns +3 actual. Total variance +52 200 even though volume fell. Positive “sales volume variance” is good here because lower production avoids losses.
Must check context: negative CM products might still be kept for life-cycle, portfolio, or image reasons.

Ethical, Behavioural & Practical Notes

• Variance systems can distort incentives; managers may game volume or mix to look good.
• Fair allocation of composite variances reduces blame-shifting.
• Target costing spreads cost pressure to suppliers – raises ethical sourcing questions.
• Life-cycle costing supports sustainability by revealing end-of-life costs.

Key Formulae (selection)

$\text{Target Cost}=P<em>{\text{sales}}-\pi</em>{\text{target}}$
$\text{Activity Rate}=\dfrac{\text{Cost}}{\text{Driver Volume}}$
$\Delta C=\Delta r\,q<em>b+r</em>b\,\Delta q+\Delta r\,\Delta q$
$\Delta R=(\Delta p)\,x<em>b+p</em>b\,(\Delta x)+\Delta p\,\Delta x$
$\text{Contribution Variance}=(cm<em>a-cm</em>b)\,x_b$

Study Tips & Connections

• Relate ABC drivers to Porter’s value chain for strategic insight.
• Use target & life-cycle costing early in product development to lock-in savings.
• Practise variance methods on multi-factor examples; understand when composite terms matter.
• Compare German GPK/PKR with your local costing system to see institutional impacts.