CHAPTER 4

Costs Analysis
1 Classifying costs

Classification is a means of analysing costs into

logical groups so that they may be summarised
into meaningful information for managers. For
example, a manager may be interested in the
total costs incurred in running a particular
department, or he may want to know the cost of
producing a unit of Product X.
•A direct cost is expenditure which
can be economically identified with a
specific saleable unit of output.
Indirect costs (or overheads) are
expenditure on labour, materials or
other items which cannot be
economically identified with a
specific saleable unit of output.
 The position is summarized in the table below.
Table 4.1 Direct and indirect costs

Direct materials
Direct labour Prime cost
Direct expenses Total production cost
Indirect materials Production
Indirect labour overheads
Indirect expenses
Cost behaviour is the way in which costs of
output are affected by fluctuations in the
level of activity. The level of activity usually
refers to the volume of production in a
period. When production doubles, the raw
materials cost doubles (roughly speaking).
We say that this is a variable cost.
However, the factory rental is unchanged.
We say that this is a fixed cost
The way in which costs behave
as production output changes is
a key element in the way prices
are set by suppliers.
Contribution is the selling price less the
variable cost of sales. Suppose that the
unit selling price of a widget is GHC1 and
its variable costs are GHC0.40. Its
contribution is therefore GHC0.60. What
this means is that every time we sell a
widget we earn a contribution of GHC0.60
towards covering fixed costs and making a
profit.
• If we sell only a few widgets, our
total contribution will not be
sufficient to cover fixed costs and
we will make a loss.
• If we sell very many widgets our
total contribution will more than
cover fixed costs and we will
make a profit.
• Somewhere in between there is a
sales level such that our total
contribution exactly matches our
fixed costs. In this case we make
neither profit nor loss: we breakeven.
 2 Standard costing and budgeting

Managers use costing information to help

them run operations more efficiently. An
important technique in this regard is that
of variance analysis. As the name implies,
this is based on a comparison of what
something should have cost with what it
actually did cost, the difference being
known as a variance.
In its usual form, variance analysis
is based on the use of standard
costs. Managers determine in
advance what a unit of output
should cost by drawing up
standards for each of the cost
elements comprised in it.
A budget is a plan expressed in monetary
terms. It is prepared and approved prior to
the budget period and may show income,
expenditure and the capital to be employed.
Budgetary control is the establishment of
budgets relating the responsibilities of
executives to the requirements of a policy,
and the continuous comparison of actual with
budgeted results.
Essentially the budgetary control
process consists of two distinct
elements.
•Planning. This involves setting the
various budgets for the
appropriate future period.
Control. This involves comparison of
the plan with the actual results
achieved. Significant divergences
between the budgeted and the actual
results should be reported to the
appropriate managers so that the
necessary action can betaken
A fixed budget is based on a particular
estimate of activity levels. For example, it
may assume that sales volume will be
200,000 units in the coming year. The
revenue and costs shown in the budget
will all be based on this assumption. The
problem arises when the assumption turns
out to be wrong.
To cope with this problem businesses
use flexible budgets in preference to
fixed budgets. A flexible budget is a
budget which, by recognising different
cost behaviour patterns, is designed to
change as volume of output changes.
This provides a more useful
comparison with actual outcomes.
There are various ways of establishing budget targets.

• With an incremental budget we

begin by looking at the actual
figures for the previous period.
We then adjust in line with known
changes to arrive at a budget for
the current period.
• With a zero-based budget we
ignore previous periods and
start completely from scratch.
• With a priority based budget
we allocate funds in line with
strategic goals.
 In practice, budgeting is invariably
carried out on spreadsheets. When
assumptions are changed, the
software automatically recalculates
all the numbers.
 3 Suppliers’ perspectives on costs

From a supplier’s perspective,

the difference between fixed
and variable costs is very
important.
A sales person will always be seeking to
generate at least enough business to cover
his organisation’s fixed costs. If the cost
structure of his organisation includes a
high proportion of fixed costs this puts
pressure on him to achieve high sales
volumes. Buyers may be able to take
advantage of the seller’s eagerness to do
business.
Open book management originated
as the idea that a company should
reveal financial information about its
business to its employees. A similar
concept can be applied to the
relationship between a company and
its supplier.
With open book costing, suppliers
provide information about costs to the
purchaser. Having cost information
from the supplier will reassure the
purchaser about getting value for
money, and that the supplier will not
be making excessive profits.
The main drawback to open book costing is
that the customer is in the driving seat and
the flow of cost information is all one way.
Cost transparency is something different.
With cost transparency, the customer and
the supplier share cost information, for
activities where they have a common
interest. The flow of information is two-
way.
The objective of cost transparency
is to reduce costs, because an
understanding of the costs of the
customer or supplier will help the
other party to appreciate where
the opportunities for savings might
lie.
 4 Value chain analysis

Value analysis is a method of gaining a

deeper insight into customer needs.
The value chain breaks down the firm
into its strategically important
activities in order to gain fuller
understanding of the value of each.
The concept of value should be continually
assessed from the point of view of the final
consumer or user of the product or service. This
may be overlooked by organisations which are
distanced from their final users by intermediaries
such as distributors, leaving them out of touch
with the realities of their markets. The consumers’
idea of value may change over time, perhaps
because of competitive offerings giving better
value for money becoming available.
According to Professor Michael
Porter, the business of an
organisation is best described by way
of a value chain in which total
revenue minus total costs of all
activities undertaken to develop and
market a product or service yields
value.
Value activities are the physically and
technologically distinct activities that an
organisation performs. The primary
activities are grouped into five main
areas: inbound logistics, operations,
outbound logistics, marketing/sales, and
customer service. Each of these may be a
source of competitive advantage.
•Alongside all of these primary activities
are the secondary, or support, activities of
procurement, technology, human
resource management and corporate
infrastructure. Each of these cuts across
all of the primary activities, as in the case
of procurement where at each stage
items are acquired to aid the primary
functions.