CHAPTER 9: ALTERNATIVE COSTING PRINCIPLES Flashcards
how do modern manufacturing techniques vary from traditional
Modern manufacturing is different from traditional manufacturing techniques:
much more machinery and computerised manufacturing systems are used
smaller batch sizes are manufactured at the request of customers
less use of ‘direct’ labour due to the higher use of computers and machinery.
why are traditional costing methods (absorption and marginal) less applicable to modern day manufacturing
Modern manufacturing has had an impact on production costs:
more indirect costs (overheads)
less direct labour costs.
This means that the traditional methods of costing using Absorption costing and Marginal costing are less useful.
Absorption costing charges overheads to products in an arbitrary way – usually based on the volume of production in units or hours.
Marginal costing values products based on the variable cost to produce them and fixed costs are treated as a period charge. In modern environments the variable costs might be small in comparison to the fixed costs and the fixed cost may not be truly fixed if considering all aspects of the production process.
what is activity based costing (ABC)
Activity based costing (ABC) is an alternative approach to product costing. It is a form of absorption costing, but, rather than absorbing overheads on a production volume basis it firstly allocates them to cost pools before absorbing them into units using cost drivers.
what is a cost pool and cost driver
A cost pool is an activity that consumes resources and for which overhead costs are identified and allocated. For each cost pool there should be a cost driver.
A cost driver is a unit of activity that consumes resources. An alternative definition of a cost driver is the factor influencing the level of cost.
how does ABC overcome problems associated with absorption costing
in the example of a machining department in a clothing business, an absorption costing system would be based solely on machine hours. However not only would the department have machine related costs, but also a share of rent and rates which would be inappropriately absorbed into the machine hours.
ABC overcomes this by using activates to group costs (cost pools) which are caused (driven) by an activity.
There would be an activity that related to each of the following: power usage, machine depreciation and machine maintenance. Machining would not pick up a share of personnel costs or rent and rates as these would be charged to another activity. For example:
the cost of setting up machinery for a production run might be driven by the number of set-ups (jobs or batches produced)
the cost of running machines might be driven by the number of machine hours for which the machines are running
the cost of order processing might be related to the number of orders dispatched or to the weight of items dispatched
the cost of purchasing might be related to the number of purchase orders made.
ABCs flexibility reduces the need for arbitrary apportionments.
Using ABC should lead to more accurate product and/or service costs being calculated.
advantages of ABC
ABC has a number of advantages:
It provides a more accurate cost per unit. As a result, pricing, sales strategy, performance management and decision making should be improved.
It provides much better insight into what causes overhead costs.
ABC recognises that overhead costs are not all related to production and sales volume.
In many businesses, overhead costs are a significant proportion of total costs, and management needs to understand the drivers of overhead costs in order to manage the business properly. Overhead costs can be controlled by managing cost drivers.
It can be applied to calculate realistic costs in a complex business environment.
ABC can be applied to all overhead costs, not just production overheads.
ABC can be used just as easily in service costing as in product costing.
disadvantages of ABC
Disadvantages of ABC:
ABC will be of limited benefit if the overhead costs are primarily volume related or if the overhead is a small proportion of the overall cost.
It is impossible to allocate all overhead costs to specific activities.
The choice of both activities and cost drivers might be inappropriate.
ABC can be more complex to explain to the stakeholders of the costing exercise.
The benefits obtained from ABC might not justify the costs.
what is a target cost
A target cost is a product cost estimated by subtracting a desired profit margin from a competitive market price. This may be less than the planned initial product cost, but will be expected to be achieved by the time the product reaches the mature production stage.
what is the conventional approach to product costing
The conventional approach to product costing is an internal approach. The organisation builds up the cost of the product incurred in its production and will often determine its selling price by adding on an amount to the cost of production. This approach ignores the external environment within which the organisation operates – the market demand conditions and the prices set by competitors may not be fully reflected in the organisation’s pricing policy.
how was target costing designed to avoid the problems associated with the conventional approach
The starting point for target costing is an estimate of a selling price for a new product that will enable a firm to capture a required share of the market. The next step is to reduce this figure by the firm’s required level of profit. This will take into account the return required on any new investment and on working capital requirements. This will produce a target cost figure for the organisation. All departments responsible for getting the product to market will estimate costs and must jointly find ways to achieve the target. Value analysis and/or value engineering can be used to reduce costs (discussed in a later chapter).
In essence, conventional costing and pricing methods can be described as bottom up in their approach, they start with internal costs and build up to a selling price.
Target costing is a top down approach – it starts with a target price and derives a cost from that price.
what is life cycle costing
Life cycle costing tracks and accumulates the actual costs and revenues attributable to each product from inception to abandonment.
This is a technique which compares the revenues from a product with all the costs incurred over the entire product life cycle.
what is the product life cycle and its stages
The product life cycle suggests that all products pass through a number of stages from development to decline and is the basis for life cycle costing.
At the development stage the product is not yet being sold. Sales are nil and development costs are creating a loss.
At the introduction the product is launched on to the market. Sales volume is likely to be at a low level during this stage whilst the product establishes itself in the market place. In addition, potential customers may not be fully aware of the existence of the product or may be reluctant to try a new product, preferring to remain loyal to the products already established in the market place.
During the growth stage it is hoped that sales volume will increase rapidly as consumers become more familiar with the product and it begins to take over from existing products in the market.
At some point the growth in sales will slow and probably stop. The product has now reached the maturity stage in its life cycle. Sales are still at a high level. At this stage some form of modification may be required to prevent the product from going into the final stage.
During the decline stage, sales will fall, perhaps slowly at first, but the pace of decline is likely to increase. The product may have become outdated or unfashionable, or new products may have entered the market and attracted
advantages of life cycle costing
the forecast profitability of a given product over its entire life is determined before production begins
accumulated costs at any stage can be compared with life cycle budgeted costs, product by product, for the purposes of planning and control.
how does life cycle costing compare with more traditional management accounting practices
Most traditional accounting reporting systems are based upon periodic accounts, reporting product profitability in isolated calendar-based amounts, rather than focusing on the revenues and costs accumulated over the life cycle to date.
Recognition of the commitment needed over the entire life cycle of a product will generally lead to more effective resource allocation than the traditional annual budgeting system.
Research and development, design, production set-up, marketing and customer service costs are traditionally reported on an aggregated basis for all products and recorded as a period expense. Life cycle costing traces these costs to individual products over their entire life cycles, to aid comparison with product revenues generated in later periods.
Relationships between early decisions on product design and production methods and ultimate costs can therefore be identified and used for subsequent planning.
what factors need to be managed in order to maximise a products return over its life cycle
Design costs out of the product:
Around 70% of a product’s costs are often incurred at the design and development stages of its life. It is absolutely vital therefore that design teams do not work in isolation but as part of a cross-functional team in order to minimise costs over the whole life cycle. Value engineering helps here.
Minimise the time to market:
It is vital for the first organisation to launch its product as quickly as possible after the concept has been developed, so that it has as long as possible to establish the product in the market and to make a profit before competition increases.
Maximise the length of the life cycle itself:
One way to maximise the life cycle is to get the product to market as quickly as possible. Another way of extending a product’s life is to find other uses, or markets, for the product. On the other hand, it may be possible to plan for a staggered entry into different markets at the planning stage.
