# Cost Concepts

## Cost Concepts

### Cost Concepts

Cost Concepts

1.1       Costing and cost accounting

1.1.1    Costing is the process of determining the costs of products, services or activities.
1.1.2    Cost accounting is used to determine the cost of products, jobs or services. Such costs have to be built up using a process known as cost accumulation.

1.2.1    If a company manufactures a product, the cost of the product will include the cost of the raw materials and components used in it and cost of the labour effort required to make it. These are direct costs of the product. The company would, however, incur many other costs in making the product, which are not directly attributable to a single product, but which are incurred generally in the process of manufacturing a large number of product units. These are indirect costs or overheads. Such costs include the following, for example:
(a)        Factory rent and rates;
(b)       Supervision costs;
(c)        Machine depreciation;
(d)       Heating and lighting, etc.

 1.2.2 Key Terms (a)      A direct cost is a cost that can be traced in full to the product, service or department that is being costed. (b)      An indirect cost or overhead is a cost that is incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department. (c)      Cost allocation (成本分配) is the process of allocating the whole overhead to a cost centre where this cost can be identified with a particular cost centre. (d)      Cost apportionment (成本分攤) – When an overhead is common to more than one cost centre, it must be shared out or split on an equitable basis.

1.3       Overhead cost allocation and apportionment

1.3.1    This section we focus in more detail on the two-stage overhead process of assigning overhead to products. The procedure is as follows:
(a)     Assign all factory overheads to production and service cost centres.
(b)     Reallocate service centre costs to production cost centres.
(c)     Calculate separate overhead rates for each cost centre.
(d)     Assign cost centre overhead to products.
Items (a) and (b) comprise stage one while (c) and (d) relate to stage two of the overhead assignment procedure.

1.3.2    Also, the item (a) is called the primary apportionment which is the distribution of overheads basing on the data from source documents, such as utilities bills, to respective cost centers. The item (b) is called the secondary apportionment which is the further re-distribution of overhead costs from service cost centres to the production costs centres. Costs of goods manufactured can then be calculated basing on the overhead costs per unit after secondary apportionment.

1.3.3

# Example 1

A company is preparing its production overhead budgets and determining the apportionment of those overheads to products. Cost centre expenses and related information have been budgeted as follows.

 Total Machine Dept A Machine Dept B Assembly Canteen Maint. \$ \$ \$ \$ \$ \$ Indirect wages 78,560 8,586 9,190 15,674 29,650 15,460 Consumable materials 16,900 6,400 8,700 1,200 600 - Rent & rates 16,700 Buildings insurance 2,400 Power 8,600 Heat and light 3,400 Depn. (machinery) 40,200 Value of machinery 402,000 201,000 179,000 22,000 Power usage (%) 100 55 40 3 2 Direct labour (hours) 35,000 8,000 6,200 20,800 - - Machine usage (hours) 25,200 7,200 18,000 - - - Area (sq. ft.) 45,000 10,000 12,000 15,000 6,000 2,000

Required:

Using the direct apportionment to production department method and bases of apportionment which you consider most appropriate from the information provided, calculate overhead totals for the three production departments.

Solution:

 Total Machine Dept A Machine Dept B Assembly Canteen Maint. Basis of apportion. \$ \$ \$ \$ \$ \$ Indirect wages 78,560 8,586 9,190 15,674 29,650 15,460 Actual Consumable materials 16,900 6,400 8,700 1,200 600 - Actual Rent & rates 16,700 3,711 4,453 5,567 2,227 745 Area Buildings insurance 2,400 533 640 800 320 107 Area Power 8,600 4,730 3,440 258 - 172 Usage Heat and light 3,400 756 907 1,133 453 151 Area Depn. (machinery) 40,200 20,100 17,900 2,200 - - Value of machine 166,760 44,816 45,230 26,832 33,250 16,632 Reallocate - 7,600 5,890 19,760 (33,250) - Direct labour Reallocate - 4,752 11,880 - - (16,632) Machine usage Total 166,760 57,168 63,000 46,592 - - OH absorb. basis Machine hour Machine hour Labour hour OAR 57,168 63,000 46,592 7,200 18,000 20,800 = \$7.94 \$3.50 \$2.24

1.3.4    The choice of an absorption basis is a matter of judgement and common sense. There are no strict rules or formulae involved. But the basis should realistically reflect the characteristics of a given cost centre, avoid undue anomalies and be fair.

1.4       Over and under absorption of overheads

 1.4.1 Over- or Under-absorbed Overhead (a)      Over-/under-absorbed overhead occurs when overheads incurred do not equal overheads absorbed. (b)      Over absorption means that the overheads charged to the cost of sales are greater than the overheads actually incurred. (c)      Under absorption means that insufficient overheads have been included in the cost of sales.

1.4.2    The rate of overhead absorption is based on estimates (of both numerator and denominator) and it is quite likely that either one or both of the estimates will not agree with what actually occurs.

1.4.3

# Example 2

Suppose that the budgeted overhead in a production department is \$80,000 and the budgeted activity is 40,000 direct labour hours, the overhead recovery rate (using a direct labour hour basis) would be \$2 per direct labour hour. Actual overheads in the period are, say \$84,000 and 45,000 direct labour hours are worked.

In this example, the cost of production has been charged with \$6,000 more than was actually spent and so the cost that is recorded will be too high. The over-absorbed overhead will be an adjustment to the profit and loss account at the end of accounting period to reconcile the overheads charged to the actual overhead.

Question 1
The total production overhead expenditure of the company in Example 1 was \$176,533 and its actual activity was as follows.

 Machine shop A Machine shop B Assembly Direct labour hours 8,200 6,500 21,900 Machine usage hours 7,300 18,700 -

Required:

Using the information above and the results of Example 1, calculate the under- or over-absorption of overheads.

1.4.4    The overhead absorption rate is predetermined from budget estimates of overhead cost and activity level. Under or over recovery of overhead will occur in the following circumstances.
(b)       The actual activity level is different from the budgeted activity level.
(c)        Actual overhead costs and actual activity level differ from those budgeted.

2.       Absorption Costing and Marginal Costing

 2.1 Absorption costing and marginal costing (a)      Absorption costing (full costing) is a form of costing in which the costs of products are calculated by adding an amount for indirect costs (overheads) to the direct costs of production. (b)      Marginal costing (variable costing) is an alternative to absorption costing. Only variable costs (marginal costs) are charged as a cost of sales. Fixed costs are treated as period costs and are charged in full against the profit of the period in which they are incurred.

2.2

# Example 3

A company makes and sells a single product. At the beginning of period 1, there are no opening inventories of the product, for which the variable production cost is \$4 and the sales price \$6 per unit. Fixed costs are \$2,000 per period, of which \$1,500 are fixed production costs. Normal profit is 1,500 units per period. In period 1, sales were 1,200 units, production was 1,500 units. In period 2, sales were 1,700 units, production was 1,400 units.

Required:

(a)       Prepare profit statements for each period and for the two periods in total using both absorption costing and marginal costing.
(b)       Reconcile the profits between absorption costing and marginal costing for period 1.

Solution:
(a)
Absorption costing
The absorption rate for fixed production overhead is \$1,500/1,500 units = \$1 per unit. The fully absorbed cost per unit = \$(4 + 1) = \$5.

 Period 1 Period 2 Total \$ \$ \$ \$ \$ \$ Sales 7,200 10,200 17,400 Production costs Variable 6,000 5,600 11,600 Fixed 1,500 1,400 2,900 7,500 7,000 14,500 Add: opening inventory b/f - 1,500 1,500 7,500 8,500 16,000 Less: closing inventory c/f (1,500) - (1,500) Production cost of sales 6,000 8,500 14,500 Under-absorbed OH - 100 100 Total costs 6,000 8,600 14,600 Gross profit 1,200 1,600 2,800 Other costs (500) (500) (1,000) Net profit 700 1,100 1,800

Marginal costing
The marginal cost per unit = \$4.

 Period 1 Period 2 Total \$ \$ \$ \$ \$ \$ Sales 7,200 10,200 17,400 Production costs Variable 6,000 5,600 11,600 Add: opening inventory b/f - 1,200 1,200 6,000 6,800 12,800 Less: closing inventory c/f (1,200) - (1,200) Variable prod. cost of sales 4,800 6,800 11,600 Contribution 2,400 3,400 5,800 Fixed costs (2,000) (2,000) (4,000) Profit 400 1,400 1,800

(b)
The profits reported for period 1 would be reconciled as follows.

 \$ Marginal costing profit 400 Adjusted for fixed overhead in inventory (inventory increase of 300 units × \$1 per unit) 300 Absorption costing profit 700

 2.3 Reconciliation of Profits between Two Methods (a)      If opening inventory = closing inventory, MC profit = AC profit (b)      If opening inventory > closing inventory, MC profit > AC profit (c)      If opening inventory < closing inventory, MC profit < AC profit
 Question 2 – Manipulating profit ABC Co budgeted to make and sell 10,000 units of its product in 2011. The selling price is \$10 per unit and the variable cost \$4 per unit. Fixed production costs were budgeted at \$50,000 per year. The company uses absorption costing and budgeted an absorption rate of \$5 per unit. During 2011, it became apparent that sales demand would only be 8,000 units. The management, concerned about the apparent effect of the low volume of sales on profits, decided to increase production for the year to 15,000 units. Actual fixed costs were still expected to be \$50,000 in spite of the significant increase in production volume. Required: Calculate the profit at an actual sales volume of 8,000 units, using the following methods. (a)       Absorption costing (b)       Marginal costing Explain the difference in profits calculated.

3.       Activity-Based Costing (ABC)

3.1       Concept of ABC

 3.1.1 Activity Based Costing (a)      Activity based costing (ABC) is a form of absorption costing. However, it differs from traditional absorption costing, because it takes a different approach to the apportionment and absorption of production overhead costs. (b)      ABC involves the identification of the factors (cost drivers) which cause the costs of an organization’s major activities. Support overheads are charged to products on the basis of their usage of an activity. (i)      For costs that vary with production level in the short term, the cost driver will be volume related (labour or machine hours). (ii)     Overheads that vary with some other activity (and not volume of production) should be traced to products using transaction-based cost drivers such as production runs or number of orders received.

3.2       Reasons for the development of ABC

3.2.1    In recent years, there has been dramatic fall in the costs of processing information. And, with the advent of advanced manufacturing technology (AMT), overheads are likely to be far more important and in fact direct labour may account for as little as 5% of a product’s cost. It therefore now appears difficult to justify the use of direct labour or direct material as the basis fro absorbing overheads or to believe that errors made in attributing overheads will not be significant.
3.2.2    Many resources are used in non-volume related support activities, such as setting-up, production scheduling, inspection and data processing. These support activities assist the efficient manufacture of a wide range of products and are not, in general, affected by changes in production volume. They tend to vary in the long term according to the range and complexity of the products manufactured rather than the volume of output.

3.2.3

# Example 4

The wider the range and the more complex the products, the more support activities will be required. Consider, for example, factory X which produces 10,000 units of one product, the Alpha, and factory Y which produces 1,000 units each of ten slightly different versions of the Alpha. Support activities costs in the factory Y are likely to be a lot higher than in factory X but the factories produce an identical number of units. For example, factory X will only need to set-up once whereas factory Y will have to set-up the production run at least ten times for the ten different products. Factory Y will therefore incur more set-up costs for the same volume of production.

3.2.4    Traditional costing systems, which assume that all products consume all resources in proportion to their production volumes, tend to allocate too great a proportion of overheads to high volume products and too small a proportion of overheads to low volume products. ABC attempts to overcome this problem.

3.3       Outline of an ABC system

3.3.1    An ABC system operates as follows:
Step 1:    Identify an organization’s major activities.
Step 2:    Identify the factors which determine the size of the costs of an activity/cause the costs of an activity. These are known as cost drivers.
Step 3:    Collect the costs associated with each cost driver into what are known as cost pools.
Step 4:    Charge costs to products on the basis of their usage of the activity. A product’s usage of an activity is measured by the number of the activity’s cost driver it generates.
3.3.2    It is not always obvious what the cost driver for an activity might be. A cost driver might be unique to the activity. Here are some examples.

 Activity Possible cost driver Materials handling and storage Raw materials: purchases of materials Finished goods: volume of products made Customer order processing No. of customer orders Materials purchasing No. of purchase orders Quality control and inspection No. of inspections Production planning No. of production runs or batches Repairs and maintenance No. of machines, or machine hours operated

3.4       Traditional absorption costing and ABC

3.4.1    The difference between traditional absorption costing and ABC is shown by the following diagrams:

3.4.2    Although ABC is a form of absorption costing, the effect of ABC could be to allocate overheads in a completely different way between products. Product costs and product profitability will therefore be very different with ABC compared with traditional absorption costing.

3.4.3

# Example 5

Entity Blue makes and sells two products, X and Y. Data for production and sales each month are as follows:

 Product X Product Y Sales demand 4,000 units 8,000 units Direct material cost/unit \$20 \$10 Direct labour hours/unit 0.1 hour 0.2 hours Direct labour cost/unit \$2 \$4

Production overheads are \$500,000 each month. These are absorbed on a direct labour hour basis.

An analysis of overhead costs suggests that there are four main activities that cause overhead expenditure.

 Activity Total cost Cost driver Total number Product X Product Y \$ Batch setup 100,000 No. of set-ups 20 10 10 Order handling 200,000 No. of orders 40 24 16 Machining 120,000 Machine hours 15,000 6,000 9,000 Quality control 80,000 No. of checks 32 18 14 500,000

Required:

Calculate the full production costs for Product X and Product Y, using:
(b)       activity based costing.

Solution:
The overhead absorption rate = \$500,000/ (4,000 × 0.1 + 8,000 × 0.2) = \$250

 Product X Product Y Total \$ \$ Direct materials 20 10 Direct labour 2 4 Overhead (at \$250 per hour) 25 50 Cost per unit 47 64 No. of units 4,000 8,000 Total cost \$188,000 \$512,000 \$700.000

Activity based costing

 Activity Total cost Cost driver Product X Product Y \$ \$ \$ \$ Batch setup 100,000 Cost/setup 5,000 50,000 50,000 Order handling 200,000 Cost/order 5,000 120,000 80,000 Machining 120,000 Cost/machine hour 8 48,000 72,000 Quality control 80,000 Cost/check 2,500 45,000 35,000 500,000 263,000 237,000
 Product X Product Y Total \$ \$ \$ Direct materials 80,000 80,000 Direct labour 8,000 32,000 Overhead 263,000 237,000 Total cost 351,000 349,000 700,000 No. of units 4,000 8,000 Cost per unit \$87.75 \$43.625

Using ABC in this situation, the cost per unit of Product X is much higher than with
traditional absorption costing and for Product Y the unit cost is much less.

The difference is caused by the fact that Product X use only 20% of total direct labour hours worked, but much larger proportions of set-up resources, order handling resources, machining time and quality control resources. As a result, the overheads charged to each product are substantially different.

This is an important feature of activity-based costing. The overheads charged to products, and so the overhead cost per unit of product, can be significantly different from the overhead cost per unit that would be obtained from traditional absorption costing.

Question 3
The Gadget Co produces three products, A, B and C, all made from the same material. Until now, it has used traditional absorption costing to allocate overheads to its products. The company is now considering an activity based costing system in the hope that it will improve profitability. Information for the three products for the last year is as follows:

 A B C Production and sales volumes (units) 15,000 12,000 18,000 Selling price per unit \$7.50 \$12 \$13 Raw material usage (kg) per unit 2 3 4 Direct labour hours per unit 0.1 0.15 0.2 Machine hours per unit 0.5 0.7 0.9 Number of production runs per annum 16 12 8 Number of purchase orders per annum 24 28 42 Number of deliveries to retailers per annum 48 30 62

The price for raw materials remained constant throughout the year at \$1.20 per kg. Similarly, the direct labour cost for the whole workforce was \$14.80 per hour. The annual overhead costs were as follows:

 \$ Machine set up costs 26,550 Machine running costs 66,400 Procurement costs 48,000 Delivery costs 54,320

Required:

(a)     Calculate the full cost per unit for products A, B and C under traditional absorption costing, using direct labour hours as the basis for apportionment.                     (5 marks)
(b)     Calculate the full cost per unit of each product using activity based costing.    (9 marks)
(c)     Using your calculation from (a) and (b) above, explain how activity based costing may help The Gadget Co improve the profitability of each product.                         (6 marks)
(Total 20 marks)

3.5       When using ABC might be appropriate

3.5.1    Activity based costing could be suitable as a method of costing in the following circumstances:
(a)        In a manufacturing environment, where absorption costing is required for inventory valuations.
(b)        Where a large proportion of production costs are overhead costs, and direct labour costs are relatively small.
(c)        Where products are complex.
(d)        Where products are provided to customer specifications.
(e)        Where order sizes differ substantially, and order handling and despatch activity costs are significant.

3.6       ABC and decision making

3.6.1    The traditional cost behaviour patterns of fixed cost and variable cost are felt by advocates of ABC to be unsuitable for longer-term decisions, when resources are not fixed and changes in the volume or mix of business can be expected to have an impact on the cost of all resources used, not just short-term variable costs.
3.6.2    ABC attempts to relate the incidence of costs to the level of activities undertaken. A hierarchy of activities has been suggested.

 Classification level Cause of cost Types of cost Cost driver Unit level Production / acquisition of a single unit of product or delivery of single unit of service Direct materials Direct labour Units produced Batch level A group of things being made, handled or processed Purchase orders Set-ups Inspection Batches produced Product level Development, production or acquisition of different items Equipment maintenance Product development Product lines produced Facility sustaining level Some costs cannot be related to a particular line, instead they are related to maintaining the buildings and facilities. These costs cannot be related to cost objects with any degree of accuracy and are often excluded from ABC calculations for this reason. Building depreciation Organisational advertising None – supports the overall production or service process

(a)        ABC provides useful information about the activities that drive overhead costs. Traditional absorption costing and marginal costing do not do this.
(b)        ABC therefore provides information that could be relevant to long-term cost control and long-term product selection or product pricing.
(c)        ABC can provide the basis for a management information system to manage and control overhead costs.
(d)        With ABC, overheads are charged to products on the basis of the activities that are required to provide the product: Each product should therefore be charged with a ‘fair share’ of overhead cost that represents the activities that go into making and selling it.
(e)        It might be argued that full product costs obtained with ABC are more ‘realistic’, although it can also be argued that full product cost information is actually of little practical use or meaning for management.
(f)        There is also an argument that in the long run, all overhead costs are variable (even though they are fixed in the short-term). Measuring costs with ABC might therefore provide management with useful information for controlling activities and long-term costs.

(a)        The analysis of costs in an ABC system may be based on unreliable data and weak assumptions. In particular, ABC systems may be based on inappropriate activities and cost pools, and incorrect assumptions about cost drivers.
(b)        ABC provides an analysis of historical costs. Decision-making by management should be based on expectations of future cash flows. It is incorrect to assume that there is a causal relationship between a cost diver and an activity cost, so that increasing or reducing the activity will result in higher or lower activity costs.
(c)        In some cases, ABC may be little more than a sophisticated absorption costing system.
(d)        Within ABC systems, there is still a large amount of overhead cost apportionment. General overhead costs such as rental costs, insurance costs and heating and lighting costs may be apportioned between cost pools. This reduces the causal link between the cost driver and the activity cost.
(e)        Many ABC systems are based on just a small number of cost pools and cost drivers. More complex systems are difficult to justify, on grounds of cost.
(f)        Many activities and cost pools have more than one cost driver. Identifying the most suitable cost driver for a cost pool/activity is often difficult.
(g)        Traditional cost accounting systems may be more appropriate for the purpose of inventory valuation and financial reporting.
(i)         It might be a costly system to design and use. The costs might not justify the benefits. It must be remembered that full product costing is of little relevance for management decision-making.

3.8       Activity-based management (ABM)

3.8.1    ABM draws upon ABC as a major source of information. It uses ABC information to set and implement strategic priorities, analyse and measure performance and to identify low-cost product designs, cost reduction opportunities, potential for improvements in quality, cost inefficiencies in supplier relationships, and to redirect capital expenditure toward the most profitable activities.
3.8.2    A major benefit of ABM is value analysis. This involves classifying activities as value-added or non-value added. Non-value added activities do not add value to a product or service from the customer's perspective or for the business. ABM therefore focuses management attention toward those activities that can be eliminated without detriment to the organisation or the customer.
3.8.3    Once major non-value added activities are identified, cost driver analysis can be used to find their root causes. A cost reduction programme is developed to work towards the reduction and eventual elimination of these cost drivers. ABM also highlights opportunities for re-engineering of an organisation's activities, benchmarking value-added activities and the development of a performance measurement system for continuous improvement.

4.      Target Costing

4.1       Implementation of target costing

4.1.1    Target costing originated in Japan in the 1970s. It began with recognition that customers were demanding more diversity in products that they bought, and the life cycles of products were getting shorter. This meant that new products had to be designed more frequently to meet customer demands.

 4.1.2 Target Costing Target costing involves setting a target cost by subtracting a desired profit margin from a competitive market price.

4.1.3    Target costing is used mainly for new product development. This is because whenever a new product is designed and developed for a competitive market, a company needs to know what the maximum cost of the new product must be so that it will sell at a profit.

 4.1.4 Implementing Target Costing Steps in the implementation of the target costing process. Step 1:     Determine a product specification of which an adequate sales volume is estimated. Step 2:     Set a selling price at which the organization will be able to achieve a desired market share. Step 3:     Estimate the required profit based on return on sales or return on investment. Step 4:     Calculate the target cost = target selling price – target profit Step 5:     Compile an estimated cost for the product based on the anticipated design specification and current cost levels. Step 6:     Calculate target cost gap = estimated cost – target cost. Step 7:     Make efforts to close the gap. This is more likely to be successful if efforts are made to design out costs prior to production, rather than to control out costs during the production phase. Step 8:     Negotiate with the customer before making the decision about whether to go ahead with the project.

4.1.5

# Example 6

Swedish retailer IKEA continues to dominate the home furniture market with more than 300 stores across 35 countries at the end of 2009. The "IKEA concept" as defined on the company website www.ikea.com is "based on offering a wide range of well designed functional home furnishing products at prices so low as many people as possible will be able to afford them."

IKEA is widely known for pricing products at 30-50% below the price charged by competitors. Extracts from the website outline how the company has successfully employed a strategy of target pricing:

"While most retailers use design to justify a higher price, IKEA designers work in exactly the opposite way. Instead they use design to secure the lowest possible price. IKEA designers design every IKEA product starting with a functional need and a price. Then they use their vast knowledge of innovative, low-cost manufacturing processes to create functional products, often coordinated in style. Then large volumes are purchased to push prices down even further.

Most IKEA products are also designed to be transported in flat packs and assembled at the customer's home. This lowers the price by minimising transportation and storage costs. In this way, the IKEA Concept uses design to ensure that IKEA products can be purchased and enjoyed by as many people as possible."

4.2       Deriving a target cost

4.2.1

# Example 7

A company has designed a new product. NP8. It currently estimates that in the current market, the product could be sold for \$70 per unit. A gross profit margin of at least 30% on the selling price would be required, to cover administration and marketing overheads and to make an acceptable level of profit.

A cost estimation study has produced the following estimate of production cost for NP8.

 Cost item Direct material M1 \$9 per unit Direct material M2 Each unit of product NP8 will require three metres of material M2, but there will be loss in production of 10% of the material used. Material M2 costs \$1.80 per metre. Direct labour Each unit of product NP8 will require 0.50 hours of direct labour time. However it is expected that there will be unavoidable idle time equal to 5% of the total labour time paid for. Labour is paid \$19 per hour. Production overheads It is expected that production overheads will be absorbed into product costs at the rate of \$60 per direct labour hour, for each active hour worked. (Overheads are not absorbed into the cost of idle time.)

Required:

Calculate:
(a)     the expected cost of Product NP8;
(b)    the target cost for NP8;
(c)     the size of the cost gap.

Solution:

 (a) Expected cost per unit \$ \$ Direct material M1 9.0 Direct material M2: 3 metres x 100/90 × \$1.8 6.0 Direct labour: 0.5 hours x 100/95 × \$19 10.0 Production overheads: 0.5 hours × \$60 30.0 Expected full cost per unit 55.0 (b) Target cost Sales price 70.0 Minimum gross profit margin (30%) (21.0) Target cost 49.0 (c) Cost gap 6.0

The company needs to identify ways of closing this cost gap.

4.3       Closing the target cost gap

4.3.1    Target costs are rarely achievable immediately and ways must be found to reduce costs and close the cost gap.

 4.3.2 Commend methods of closing the target cost gap (a)       To re-design products to make use of common processes and components that are already used in the manufacture of other products by the company. (b)       To discuss with key suppliers methods of reducing materials costs. Target costing involves the entire ‘value chain’ from original suppliers of raw materials to the customer for the end-product, and negotiations and collaborations with suppliers might be an appropriate method of finding important reductions in cost. (c)       To eliminate non value-added activities or non-value added features of the product design. Something is ‘non-value added’ if it fails to add anything of value for the customer. The cost of non-value added product features or activities can therefore be saved without any loss of value for the customer. Value analysis may be used to systematically examine all aspects of a product cost to provide the product at the required quality at the lowest possible cost. (d)       To train staff in more efficient techniques and working methods. Improvements in efficiency will reduce costs. (e)       To achieve economies of scale. Producing in larger quantities will reduce unit costs because fixed overhead costs will be spread over a larger quantity of products. However, production in larger quantities is of no benefit unless sales demand can be increased by the same amount. (f)        To achieve cost reductions as a result of the learning curve or, more likely, the experience curve effect. The learning curve is most likely to exist in a labour intensive environment. It results in cost savings as labour becomes more familiar with performing a new and complex task. The experience curve effect relates to cost savings made in costs other than labour costs as the company becomes more familiar with production of a new product. For example, management of the process and marketing may become more efficient as the company gains experience of making and selling the product.

4.4       Benefits and limitations of adopting target costing

 4.4.1 Benefits of target costing (a)       The organisation will have an early external focus to its product development. Businesses have to compete with others (competitors) and an early consideration of this will tend to make them more successful. Traditional approaches (by calculating the cost and then adding a margin to get a selling price) are often far too internally driven. (b)       Only those features that are of value to customers will be included in the product design. Target costing at an early stage considers carefully the product that is intended. Features that are unlikely to be valued by the customer will be excluded. This is often insufficiently considered in cost plus methodologies. (c)       Cost control will begin much earlier in the process. If it is clear at the design stage that a cost gap exists then more can be done to close it by the design team. Traditionally, cost control takes place at the ‘cost incurring’ stage, which is often far too late to make a significant impact on a product that is too expensive to make. (d)       Costs per unit are often lower under a target costing environment. This enhances profitability. Target costing has been shown to reduce product cost by between 20% and 40% depending on product and market conditions. In traditional cost plus systems an organisation may not be fully aware of the constraints in the external environment until after the production has started. Cost reduction at this point is much more difficult as many of the costs are ‘designed in’ to the product. (e)       It is often argued that target costing reduces the time taken to get a product to market. Under traditional methodologies there are often lengthy delays whilst a team goes ‘back to the drawing board’. Target costing, because it has an early external focus, tends to help get things right first time and this reduces the time to market.

 4.4.2 Limitations of target costing (a)       the prerequisite for the effective implementation of target costing is the development of detailed cost data for analysis purposes which will require precise cost calculation subject to dynamic market influences. (b)       Multi-departmental cooperation is crucial for the successful implementation of target costing which also requires managing departments’ willingness to cooperate and their commitment. (c)       The process may be long and detailed, therefore, it requires lot of meetings for coordination, and conflicting meeting schedules may also affect progress. (d)       It is always the case that the use of cheaper components, which may be of inferior quality, may accordingly reduce the quality of the products and increase the cost of warranty.

Question 4
Edward Co assembles and sells many types of radio. It is considering extending its product range to include digital radios. These radios produce a better sound quality than traditional radios and have a large number of potential additional features not possible with the previous technologies (station scanning, more choice, one touch tuning, station identification text and song identification text etc).

A radio is produced by assembly workers assembling a variety of components. Production overheads are currently absorbed into product costs on an assembly labour hour basis.

Edward Co is considering a target costing approach for its new digital radio product.

Required:

(a)     Briefly describe the target costing process that Edward Co should undertake.
(3 marks)
(b)     Explain the benefits to Edward Co of adopting a target costing approach at such an early stage in the product development process.                                                         (4 marks)
(c)     Assuming a cost gap was identified in the process, outline possible steps Edward Co could take to reduce this gap.                                                                              (5 marks)

A selling price of \$44 has been set in order to compete with a similar radio on the market that has comparable features to Edward Co’s intended product. The board have agreed that the acceptable margin (after allowing for all production costs) should be 20%.

Cost information for the new radio is as follows:

Component 1 (Circuit board) – these are bought in and cost \$4.10 each. They are bought in batches of 4,000 and additional delivery costs are \$2,400 per batch.

Component 2 (Wiring) – in an ideal situation 25 cm of wiring is needed for each completed radio. However, there is some waste involved in the process as wire is occasionally cut to the wrong length or is damaged in the assembly process. Edward Co estimates that 2% of the purchased wire is lost in the assembly process. Wire costs \$0.50 per metre to buy.

Other material – other materials cost \$8.10 per radio.

Assembly labour – these are skilled people who are difficult to recruit and retain. Edward Co has more staff of this type than needed but is prepared to carry this extra cost in return for the security it gives the business. It takes 30 minutes to assemble a radio and the assembly workers are paid \$12.60 per hour. It is estimated that 10% of hours paid to the assembly workers is for idle time.

Production Overheads – recent historic cost analysis has revealed the following production overhead data:

 Total production overhead Total assembly labour hours \$ Month 1 620,000 19,000 Month 2 700,000 23,000

Fixed production overheads are absorbed on an assembly hour basis based on normal annual activity levels. In a typical year 240,000 assembly hours will be worked by Edward Co.

Required:

(d)     Calculate the expected cost per unit for the radio and identify any cost gap that might exist.                                                                                                                  (13 marks)
(Total 25 marks)

4.5       Tear-down analysis

4.5.1    Tear-down analysis (also known as reverse engineering) involves examining a competitor’s product in order to identify opportunities for product improvement and/or cost reduction.
4.5.2    The competitor’s product is dismantled to identify its functionality and design and to provide insights about the processes that are used and the cost to make the product.
4.5.3    The aim is to benchmark provisional product designs with the designs of competitors and to incorporate any observed relative advantages of the competitor’s approach to product design.

4.6       Value engineering

4.6.1    Value engineering (also known as value analysis) is a systematic interdisciplinary examination of factors affecting the cost of a product or service in order to devise means of achieving the specified purpose at the required standard of quality and reliability at the target cost.
4.6.2    The aim of value engineering is to achieve the assigned target cost by:
(a)        identifying improved product designs that reduce the product’s cost without sacrificing functionality; and/or
(b)        eliminating unnecessary functions that increase the product’s costs and for which customers are not prepared to pay extra.
4.6.3    Value engineering requires the use of functional analysis. This process involves decomposing the product into its many elements or attributes. For example, in the case of automobiles, functions might consist of style, comfort, operability, reliability, quality, attractiveness and many others.
4.6.4    A price, or value, for each element is determined which reflects the amount the customer is prepared to pay. To obtain this information companies normally conduct surveys and interviews with customers. The cost of each function of a product is compared with the benefits perceived by the customers.
4.6.5    If the cost of the function exceeds the benefit to the customer, then the function should be either eliminated, modified to reduce its costs, or enhanced in terms of its perceived value so that its value exceeds the cost.

5.       Life Cycle Costing

5.1       The nature of life cycle costing

 5.1.1 Life Cycle Costing Life cycle costing tracks and accumulates costs and revenues attributable to each product over the entire product life cycle.

5.1.2    A product’s life cycle costs are incurred from its design stage through development to market launch, production and sales, and finally to its eventual withdrawal from the market.

5.1.3    A product life cycle can be divided into five phases.
(a)        Development – The product has a research and development stage where costs are incurred but no revenue is generated. Here, target costing may be used in combination with life cycle costing.
(b)       Introduction – The product is introduced to the market. Potential customers will be unaware of the product or service, and the organization may have to spend further on advertising to bring the product or service to the attention of the market.

When a product is new to the market, and a competitor has not already established a rival product in the market, a company may be able to choose its pricing strategy for the new product.
(i)         If a market penetration strategy is chosen, the aim should be to sell the product at a low price in order to obtain a large share of the market as quickly as possible. This pricing strategy is therefore based on low prices and high volumes.
(ii)        If a market skimming strategy is chosen, the aim is to sell at a high price in order to maximize the gross profit per unit sold. Sales volumes will be low, and the product will be purchased only by customers who are willing to pay a high price to obtain a “unique” item. Gradually, the selling price will be reduced, although it will be kept as high as possible for as long as possible. This approach is often used with high technology products.
(c)        Growth – The product gains a bigger market as demand builds up. Sales revenues increases and the product begins to make a profit.
(d)       Maturity – Eventually, the growth in demand for the product will slow down and it will enter a period of relative maturity. It will continue to profitable. The product may be modified or improved, as a means of sustaining its demand.
(e)        Decline – The market will have bought enough of the product and it will therefore reach saturation point. Demand will start to fall. Eventually it will become a loss-maker and this is the time when the organization should decide to stop selling the product or service.

5.1.4    The horizontal axis measures the duration of the life cycle, which can last from, say 18 months to several hundred years. Children’s crazes or fad products have very short lives while some products, such as binoculars (invented in the eighteenth century) can last a very long time.

5.1.5

# Example 8

ABC Co specializes in the manufacture of solar panels. It is planning to introduce a new slimline solar panel specially designed for small houses. Development of the new panel is to begin shortly and Solaris is in the process of determining the price of the panel. It expects the new product to have the following costs.

 Year 1 Year 2 Year 3 Year 4 Units manufactured and sold 2,000 15,000 20,000 5,000 \$ \$ \$ \$ R&D costs 1,900,000 100,000 Marketing costs 100,000 75,000 50,000 10,000 Production cost per unit 500 450 400 450 Customer service costs per unit 50 40 40 40 Disposal of specialist equipment 300,000

The Marketing Director believes that customers will be prepared to pay \$500 for a solar panel but the Financial Director believes this will not cover all of the costs throughout the lifecycle.

Required:

Calculate the cost per unit looking at the whole life cycle and comment on the suggested price.

Solution:

Lifecycle cost

 \$000 R&D (1,900 + 100) 2,000 Marketing (100 + 75 + 50 + 10) 235 Production (1,000 + 6,750 + 8,000 + 2,250) 18,000 Customer service (100 + 600 + 800 + 200) 1,700 Disposal 300 Total lifecycle costs 22,235 Total production (‘000 units) 42 Cost per unit 529.40

The total lifecycle costs are \$529.40 per solar panel which is higher than the price proposed by the marketing director. Solaris will either have to charge a higher price or look at ways to reduce costs.

It may be difficult to increase the price if customers are price sensitive and are not prepared to pay more. Costs could be reduced by analysing each part of the costs throughout the life cycle and actively seeking cost savings. For example, using different materials, using cheaper staff or acquiring more efficient technology.

5.2       Maximising the Return over the Product Life Cycle – design costs out of products

5.2.1    Between 70% to 90% of a product’s life cycle costs are determined by decisions made early in the life cycle, at the design or development stage. The following figure illustrates a typical pattern of cost commitment and cost incurrence during the three stages of a product’s life cycle – the planning and design stage, the manufacturing stage and the service and abandonment stage.
5.2.2    You will see from the figure that approximately 80% of a product’s costs are committed or locked in during the planning and design stage. At this stage product designers determine the product’s design and the production process. In contrast, the majority of costs are incurred at the manufacturing stage, but they have already become locked-in at the planning and design stage and are difficult to alter.

5.3       Minimise the time to market

5.3.1    Competitors watch each other very carefully to determine what types of product their rivals are developing. If an organization is launching a new product it is vital to get it to the market place as soon as possible. This will give the product as long a period as possible without a rival in the market place and should mean increased market share in the long run.
5.3.2    Furthermore, the life span may not proportionally lengthen if the product’s launch is delayed and so sales may be permanently lost. It is usual for the product’s overall profitability to fall by 25% if the launch is delayed by six months. This means that it is usually worthwhile incurring extra costs to keep the launch on schedule or to speed up the launch.

5.4       Maximise the length of the life span

5.4.1    Product life cycles are not predetermined; they are set by the actions of management and competitors. Once developed, some products lend themselves to a number of different uses; this is especially true of materials, such as plastic, PVC, nylon and other synthetic materials. The life cycle of the material is then a series of individual product curves nesting on top of each other as shown below.

5.4.2    By entering different national or regional markets one after another an organisation may be able to maximise revenue. This allows resources to be better applied, and sales in each market to be maximised. On the other hand, in today's fast moving world, an organisation could lose out to a competitor if it failed to establish an early presence in a particular market.

5.5       Minimise breakeven time

5.5.1    A short breakeven time is very important in keeping an organisation liquid. The sooner the product is launched the quicker the research and development costs will be repaid, providing the organisation with funds to develop further products.

5.6       Implications of Using Life Cycle Costing

5.6.1    Traditional costing systems do not attempt to measure the profitability of a product over its entire life.
5.6.2    Life cycle costing compares the revenues and costs of the product over its entire life. This has many benefits.
(a)        The potential profitability of products can be assessed before major development of the product is carried out and costs incurred. Non-profit-making products can be abandoned at an early stage before costs are committed.
(b)       Techniques can be used to reduce costs over the life of the product.
(c)        Pricing strategy can be determined before the product enters production. This may lead to better control of marketing and distribution costs.
(d)       Attention can be focused on reducing the research and development phase to get the product to market as quickly as possible. The longer the company can operate without competitors entering the market the more revenue can be earned and the sooner the product will reach the breakeven point.
(e)        By monitoring the actual performance of products against plans, lessons can be learnt to improve the performance of future products. It may also be possible to improve the estimating techniques used.
5.6.3    An understanding of the product life cycle can also assist management with decisions with:
(a)        Pricing;
(b)       Performance management;
(c)        Decision-making
5.6.4    Pricing. As a product moves from one stage in its life cycle to the next, a change in pricing strategy might be necessary to maintain market share. For example, prices might be reduced as a product enters its maturity phases (and annual sales volume stops rising).
5.6.5    Performance management. As a product moves from one stage of its life cycle to another, its financial performance will change. Management should understand that an improvement or decline in performance could be linked to changes in the life cycle and should therefore (to some extent at least) be expected.
5.6.6    Decision-making. In addition to helping management with decisions on pricing, an understanding of life cycle costing can also help with decisions about making new investments in the product (new capital expenditure) or withdrawing a product from the market.

Question 5
A company manufactures MP3 players. It is planning to introduce a new model and development will begin very soon. It expects the new product to have a life cycle of 3 years and the following costs have been estimated.

 Year 0 Year 1 Year 2 Year 3 Units manufactured and sold 25,000 100,000 75,000 Price per unit \$90 \$80 \$70 R&D costs \$850,000 \$90,000 - - Production costs Variable cost per unit \$30 \$25 \$25 Fixed costs \$500,000 \$500,000 \$500,000 Marketing costs Variable cost per unit \$5 \$4 \$3 Fixed costs \$300,000 \$200,000 \$200,000 Distribution costs Variable cost per unit \$1 \$1 \$1 Fixed costs \$190,000 \$190,000 \$190,000 Customer service costs per unit \$3 \$2 \$2

Required:

(a)     Explain life cycle costing and state what distinguishes it from more traditional management accounting techniques.                                                                (10 marks)
(b)     Calculate the cost per unit looking at the whole lifecycle and comment on the price to be charged.                                                                                                          (7 marks)
(Total 17 marks)

Total Quality Cost Management

6.1       Quality costs

6.1.1    Total Quality Management (TQM) is a philosophy where organisations strive to create an environment that will enable the production of zero defect products or services.
6.1.2    Management accounting systems can help organizations achieve their quality goals by providing a variety of reports and measures that motivate and evaluate managerial efforts to improve quality. These include financial and non-financial measures.
6.1.3    Managers need to know the costs of quality and how they are changing over time. A cost of quality report should be prepared to indicate the total cost to the organization of producing products or services that do not conform with quality requirements.

 6.1.4 Four categories of quality cost (a)       Prevention costs are the costs incurred in preventing the production of products that do not conform to specification. They include the costs of preventive maintenance, quality planning and training and the extra costs of acquiring higher quality raw materials. (b)       Appraisal costs are the costs incurred to ensure that materials, products and services meet quality conformance standards. They include the costs of inspecting purchased parts, work in process and finished goods, quality audits and field tests. (c)       Internal failure costs are the costs incurred when products and services fail to meet quality standards or customer needs. They include costs incurred before the product is dispatched to the customer, such as the costs of scrap, repair, downtime and work stoppages caused by defects. (d)       External failure costs are the costs incurred when products or services fail to conform to requirements or satisfy customer needs after they have been delivered. They include the costs of handling customer complaints, warranty replacement, repairs of returned products, lost market share and the costs arising from a damaged company reputation. Costs within this category can have a dramatic impact on future sales.

6.2       Cost of quality report

 6.2.1 Cost of quality report The cost of quality report can be used as an attention-directing device to make top management of a company aware of how much is being spent on quality-related costs and the areas where they should focus their attention.

6.2.2

# Example 9 – Cost of quality report

The following presents a typical cost of quality report.

 \$000 % of sales (\$100 million) Prevention costs Quality training 1,000 Supplier reviews 300 Quality engineering 400 Preventive maintenance 500 2,200 2.2 Appraisal costs Inspection of materials received 500 Inspection of WIP and completed units 1,000 Testing equipment 300 Quality audits 800 2,600 2.6 Internal failure costs Scrap 800 Rework 1,000 Downtime due to quality problems 600 Retesting 400 2,800 2.8 External failure costs Returns 2,000 Recalls 1,000 Warranty repairs 800 Handling customer complaints 500 Foregone contribution from lost sales 3,000 7,300 7.3 14,900 14.9
• It shows that significant savings can be made by reducing the costs of scrap and rework.
• The report can also draw management’s attention to the possibility of reducing total quality costs by a wiser allocation of costs among the four quality categories.
• For example, by spending more on the prevention costs, the amount of spending in the internal and external failure categories can be substantially reduced, and therefore total spending can be lowered.
• Also, by designing quality into the products and processes, appraisal costs can be reduced, since far less inspection is required.

6.2.3

# Example 10 – Cost of quality: bad quality and high costs – Toyota

In late 2009 and early 2010, Toyota recalled several accidents occurred due to a faulty accelerator pedal. The recall involved over 5 million vehicles and sales and production were suspended for a time in the US. According to author Paul Ingrassia, the problem occurred because Toyota broke one of their key principles called the “three nevers” at its US manufacturing plants: never build a new product, in a new facility, with a new workforce. In the case of the Camry in the US, all three were broken. A report by the Forbes.com put the estimated cost of problem at \$2 billion as of February 2010.

Question 6
Sunshine Watch Ltd produces watches and related products. The company is a recognized leader in the industry for quality products. In recent months, the directors have become interested in trying to quantify the costs of quality in the company. As an initial effort, the company was able to identify the following costs for the year ended 30 June 2012, by categories that are associated with quality:

 \$ Quality training 150,000 Scrap and waste 65,000 Quality inspections 180,000 Warranty handling 95,000 Waste disposal 21,000 Quality technology 500,000 Test equipment 140,000 Procedure verifications 90,000 Quality circles 320,000 Customer reimbursement/returns 76,000

Managers were also aware that in the above, 250 of the 8,000 watches that were produced had to be sold as scrap. As a result, each of the 250 watches earned \$800 less in profit than “good” watches. Also, the company incurred \$60,000 rework costs that were necessary in order to sell 200 other watches through regular market channels.

Required:

(a)        Prepare a quality cost report for the year ended 30 June 2012 showing clearly the four major categories of quality costs.                                                                   (12 marks)
(b)       Assuming that the company intends to extend the warranty period from one year to two years, describe the impact of this intended change on quality costs.        (3 marks)
(c)        Briefly describe the characteristics of total quality management (TQM) and explain why it is important to all kinds of organizations.                                             (5 marks)
(Total 20 marks)

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