13 The Value of Cost Information

In this part, I will discuss the role of cost accounting information. In the typical textbook, cost accounting will be the first topic in the textbook. I introduced budgets first because they are the quintessential strategic management accounting tool in my book ^[1]. Nevertheless, we already talked about the difference between variable and fixed costs, a distinction that is important for flexible budgets. In the simple examples we have seen so far, the company only had one service, filling a job position, and we could allocate all the costs to the one service. In a simple business, the budgets can fulfill its strategic role but advanced cost accounting is not really necessary. Advanced cost accounting will be more relevant when the organisation has a lot of products, services, and processes because we will need to allocate many more costs to the different products, services, and processes. Nevertheless, an important distinction will remain

The purpose of this chapter is to emphasise and explain that better cost information ^[2] is not always necessary. I find that this sometimes surprises students but it should not if you have absorbed the lessons from transaction cost economics: all management accounting tools have costs and benefits and we should weigh the costs and benefits to decide whether a management accounting tool is useful. In this chapter, I will mainly focus on the benefits of better information.

The main question to determine the value of (cost) information is whether the organisation would take a different decision when they have access to better information. I will make a distinction between three different decisions that organisations take based on cost information: (1) Set the price of a product or service, (2) Determine whether to offer a product or service, (3) Engineer a product or service to lower its cost.

Pricing Decisions

Let us start with the pricing decision because we have implicitly already talked about pricing decisions in a competitive market. In that chapter on transaction cost economics, I emphasised two features of market prices in a competitive market: prices incorporate all relevant information and they provide incentives for sellers to keep costs low. The last part is key for the decision on pricing. If an organisation sells a product at a price that is higher than the market price, no buyer will be willing to buy it. Thus, the only information relevant for the correct price is whatever the price is that competitors are charging. If organisations would only use cost information for setting the price of goods and services in a competitive market, they have no incentive to invest in advanced or detailed costing systems ^[3]. Another way of thinking about pricing in a competitive market is that the market price is general knowledge available to organisations which means they do not have to develop costly cost accounting systems to make pricing decisions.

Obviously, organisations do develop advanced costing systems and they spend time and money on data collection, data validation, and IT systems to process and disseminate the cost data because organisations either operate in a market that is not fully competitive or they are using the cost information for a different purpose than setting the price of goods and services.

Monopoly Pricing

Let us tackle the issue of not perfectly competitive markets first. Not all organisations operate in a competitive market all the time. For instance, if an organisation launches a new product that is not directly competing with an existing product, they have some leeway in how to set the price of the product. You can think of the launch of the Apple iPhone as an example. In such a case, there are no competitors yet and there is no market price that Apple needs to follow. The Apple example also highlights a second way how organisations can create leeway in how they set prices. Through a combination of marketing, product design, and technological lock-in, Apple has been able to create a customer perception that their computers and phones are a different product category than respectively Android phones or Windows PCs. If, in the customers’ perception, the product has no competitors, Apple can set a different price than Samsung, Huawei, or Lenovo.

When an organisation produces multiple products and services, they can also create a unique customer experience by explicitly or implicitly bundling these products and services. One simplified example is Microsoft that has two important software products; the Windows operating system and the Office application. Office works best when it is integrated in the Windows operating system and Microsoft knows it will sell more Office subscriptions when more people have a Windows operating system. This means that Microsoft has an incentive to ask a lower price than the market price for the operating system because they know that more people will buy it and more people will buy the Office subscription. Interestingly for Microsoft, they will also be able to set a higher price than the market price for the Office subscription. The higher price and/or higher sales for the Office subscription subsidize the lower price for the operating system.

This loss leader strategy does require a sophisticated costing system because the organisation sets a lower price than competitors and sometimes even lower than the cost of producing the goods for the loss leader product (the Windows operating system) and makes up for it by setting a higher than competitive price or more sales of another product  (the Office subscription). A further complication for Microsoft Office is that the subscription gives customers access to different software products (Words, Excel, Outlook), online and offline versions of the products, and different levels of support. Different customers will use the different Office products and services differently and Microsoft wants to charge heavy users, such as business, more than light users, such as university students. In the next chapter, I will introduce Activity Based Costing which is a natural cost accounting approach to deal with these complications.

Product Design Decisions.

The ability to set a better price will not always be the main reason to adopt or improve a cost accounting system. Another important advantage of better cost information is the ability to find potential cost savings when designing a product or producing a product. One obvious extension to the previous discussion is that an organisation that is a price taker and cannot raise prices. This organisation might find out that at the end of the year, they are not profitable or they did not reach the goals in their planned budget. Because this organisation cannot increase profitability by increasing its prices, it has to investigate its cost structure. A lack of profitability is typically the trigger for organisations to invest in better cost accounting systems as you will see when you study specific cases.

Detailed cost information will help organisations figure out which parts of the production process are too costly and need to be redesigned to use less resources. If that is not possible, the organisation might decide to no longer produce the product because they cannot produce it in a way where production costs are lower than the selling price. Not unlike with variance analysis, the numbers alone will only be a guide and the employees with the best knowledge of the production process will have to be involved in how to interpret the cost information and how to improve the cost structure of loss-making products. It will not surprise you that I believe it is important to combine objective and subjective knowledge when making product design decisions.

Some organisations go one step further and meticulously investigate the expected costs of the different steps and parts when they design a new product in an approach that is called target costing. With target costing, an organisation will use objective information such as the price of similar products and subjective knowledge from its marketing and sales team to decide on a feasible price first. They then decide the product so that it can be produced at a product cost that gives them a sufficiently high profit margin. There is little known about the Apple decision making process but from the outside, their high profit margins, relatively limited product variety, and strong emphasis on product design suggests that Apple follows the principles of target costing when launching new products.

Summary

In this chapter, I structured the discussion of when better information is valuable around whether it leads to better decision making or not. Just having better information is not enough, if we cannot change the price or cost of a product. That also means that, in my view, it is never sufficient to advise an organisation that they need a better cost accounting system if you cannot explain which decisions will improve.