MBA 801: COST ACCOUNTING

CLASS 1: OVERVIEW

Course Overview
In this course, we will focus on the varied uses of accounting information within
an organization, how accounting information is generated to achieve these uses,
and some associated caveats that come with interpreting accounting information.
In doing so, we will first look briefly at the different purposes accounting data
serve. While this investigation will be cursory, it will hopefully give you a feel
for the variety of uses of accounting information, many of which will be
expanded upon in other coursework.

Broadly speaking, there are three primary uses of accounting information:

(1) it is presented to external parties such as debtholders and investors
(2) it is used internally to facilitate decision-making, and
(3) it is used internally as a tool in evaluation.
Financial accounting focuses mainly on (1). In this course, then, we will focus on
(2) and (3) which represent the internal uses of accounting information.

Armed with the view of multiple uses of accounting information, we will next go
about the task of generating accounting information (keeping the uses in mind).
The caveats that come with interpreting accounting information will be
highlighted throughout this process. As will be seen shortly, the rub in this
process rests in measuring costs (measuring revenues is typically much easier).

For those seeking a company- or firm-specific analysis of accounting data, I must

warn you that this class is intentionally broad – many accounting issues are
context-specific, so we will study simple examples to demonstrate the main
forces. The general nature of our study will be undertaken with the potential
downside of neglecting in depth analysis of specific companies. Since this is

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intended to be an introductory (not concluding) course in accounting, however,
such opportunities will abound in future coursework.

This is not to say that specific issues will not be addressed. Some questions we
will look at include:
• Why would a division be held responsible for something over which it has
no control?
• What would lead a profitable company to shut down all its divisions one
by one?
• How can a firm increase its profits by making more of a product it cannot
sell?
• Why do divisions charge prices to other divisions inside their own firm?
• What performance metric is appropriate for different situations: net
income, return on assets, or Economic Value Added?

In short, managerial accounting is a process of taking firmwide financial

accounting data and generating meaningful measures at the micro level. This
entails calculating profitability of different segments, different product lines,
different managers, different units of product, etc. Typically, revenues are pretty
simple to split apart since products are individually priced.1 Costs, on the other
hand, are harder to separate. After all, a firm chooses its quantities, product
lines, etc. due to efficiency gains from having all produced “under one roof”.
The inherent synergies in production mean that the cost of producing all
products is less than the sum of the costs of producing each product separately,
i.e., the cost function is non-separable. Nonetheless, accountants do their best to
separate the non-separable. This is admittedly a strange process, and
appreciating that splitting firmwide costs up among the various segments and

1 A notable exception is when products are bundled, such as a computer sold with a two-year
service contract. This entails one price for two products, a computer and an
insurance/service contract. Time permitting, we will discuss this later in the course

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units is more an art than a science goes a long way in gaining an appreciation for
how beest to interpret the accounting numbers that result.

Before we go about examining this process in more detail, it is worthwhile to

examine a variety of classifications of costs.

Classifying costs based on type

Roughly speaking, a cost is any sacrifice. Such sacrifices for a firm can be
classified as either a product cost, period cost, nonmonetary cost, or opportunity
cost.

A product cost is a monetary sacrifice that relates to making a product (be that a
tangible or intangible good). Product costs are further classified based on
whether they are directly incurred and easily traced to an individual product
(direct product cost) or indirectly related to individual products (indirect product
cost or overhead). Examples of direct costs include specific materials that make a
product (direct materials) and labor for those charged with assembling a product
(direct labor), etc. Examples of overhead costs include rent on a factory, utilities
costs, insurance, and supervisory salaries.

A period cost is a monetary sacrifice that is incurred for a particular period of time
and relates to selling a product and/or administering the company. Examples of
period costs include advertising charges, accountant fees, and attorney fees.

A nonmonetary cost is a sacrifice that does not arise in monetary terms.

Nonmonetary costs are typically incurred at the individual (and not firm) level,
but this does not mean they are unimportant to firms. An example of a
nonmonetary cost is a loss in morale or job satisfaction that comes from repetitive
tasks. While this cost is borne by the employee, the employee’s future behavior

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or decision to leave the firm could mean that a nonmonetary cost could translate
into a monetary cost in the future.

An opportunity cost is a sacrifice that arises not in what is but what could have
been. That is, an opportunity cost of a particular activity is the benefit that must
be foregone in order to undertake that activity. As an example, a firm whose
production is at capacity incurs an opportunity cost for each unit of one product
it produces because it could have used that capacity for making a different
product. Similarly, a firm with limited cash faces an opportunity cost of
diverting its cash to one project because it foregoes other possible uses of that
cash (or, alternatively, must borrow additional cash to pursue the other uses).

To think more about the types of costs, consider the costs of pursuing an MBA.
As discussed in class, there are many costs of this worthy pursuit, and many of
them fall in the nonmonetary and opportunity cost category. (It goes without
saying the benefits are even greater!)

Importantly, and as we will examine further, accountants are careful in

recognizing and classifying product costs and period costs, but accounting
figures do not reflect either nonmonetary or opportunity costs. Since these are
relevant costs for decision makers, it is important to recognize those costs and
adjust decisions accordingly.

Returning to our MBA costs example, notice that much of MBA rankings focus
on the revenue side, ignoring costs. An exception is Business Week’s ranking of
ROI for an MBA, which puts Fisher at 17th internationally (8th in the US). Not to
digress, but note that once costs are included, Fisher is ranked well above Tuck,
Yale, Stanford, Michigan, MIT Sloan, Harvard, Northwestern, Wharton,
Columbia, NYU, and Chicago. The question is what costs are included here?
Well, its not too bad: tuition, fees, living expenses, and the opportunity cost of

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median foregone salary. If one wanted to construct a proper measure, what else
would be included?

Classifying costs based on behavior

Another way of classifying costs is based on how they behave with respect to a
particular activity. Of course, this is a context-specific classification in that it
depends on what the activity is. The most common (but certainly no only)
activity is the production of units, which we will pursue next.

In this context, costs are either fixed or variable. Fixed costs are costs that do no
vary with the activity. Such costs could either inherently be fixed (such as the
cost of a factory building being fixed with respect to individual units made
therein) or could be fixed by the fact that they have already been incurred, i.e.,
sunk (such as “floors” on utility charges or advances paid to book authors).
Variable costs are costs that vary with the activity. In terms of units of production,
typical variable costs are hourly labor charges, materials charges, etc.

Given this classification, some additional amounts which are discussed are:
• Average total cost (total cost divided by number of units)
• Average variable cost (total variable cost divided by number of units)
• Marginal cost (the incremental cost of producing one more unit)

To think more about cost behavior, consider the costs of providing an MBA. As
discussed in class, there are many costs of providing this extremely valuable
service. In fact, many MBA programs lose money. Before one suggests that
cutting the MBA program would be a useful cost-cutting tool, it is important to
recognize the second key issue with accounting: accountants typically do not
split fixed and variable costs very well. This “flaw” is in part because the fixed
vs. variable distinction depends on the particular activity in question whereas
each firm has just one accounting profit calculation.

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In particular, in accounting profit calculations, per unit costs typically reflect
average total cost, while decision makers routinely make the mistake of
assuming they reflect marginal cost. Even when accounting calculations are such
that fixed costs are removed, they typically rely on a “local linear
approximation” in that they will reflect average variable cost and presume that
costs are approximately linear in that average variable cost approximates
marginal cost.

As it turns out, these two relatively simple classifications of costs (type and
behavior) hold the key to identifying the strengths and weaknesses of
accounting-generated data for internal uses.

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