Professional Documents
Culture Documents
Introduction
The development and use of new managerial policies and models have dramatically changed the costing systems used to
generate, the more accurate, detailed, and timely informations. A tabular relationship of some of the new management
models and management accounting techniques is as follows:
The issue of activity-based costing (ABC) lies on how factory overhead and other indirect expenses are allocated among
two or more products. Traditionally, factory overhead is predominantly and conveniently allocated based on direct labor
costs or direct labor hours. This is because under an intensive labor-oriented production environment, direct labor costs
comprise a significant portion of total manufacturing costs.
Again the pervasive introduction of technology has changed the way production processes are done. Labor has become
an insignificant portion of total production costs. The changes made in the production process have redefined meanings in
accumulating costs and classifying production costs. It was found out that many of the factory overhead accounts are not
significantly related to direct labor. As costs are accumulated not with their relationship with the product but based on their
relationship with the process and the activities in a process. It was observed that factory overhead costs are incurred or
not incurred based on activity drivers. An activity driver (i.e., cost driver) causes costs to change (e.g., increase or
decrease) or not to change. Examples of activity drivers are number of batches, setups, material moves, production
orders, number of produces, design changes, design hours, square footage occupied and many more.
Activity (or cost) drivers are identified per batch, product or plant levels. Each level has its own set of activities and costs.
The costs include materials, direct labor and factory overhead. Materials and labor are easily identified and is therefore
directly assigned to a product and in a process. Factory overhead is an indirect cost, not directly identified with a product
or process and should be therefore allocated among products.
CHAPTER 12 STRATEGIC MANAGEMENT AND COSTING SYSTEMS 523
To illustrate the main difference between traditional costing and activity-based costing, consider that Dianne Company
produces two products with the following related production data:
Product 1 Product 2
Prime costs P 120 P 200
Production in units 20,000 80,000
Direct labor hours 6,000 hrs 14,000 hrs
Set-up time 900 hrs 100 hrs
Factory overhead, P8,000,000
Determine the unit costs under the traditional costing (TC) and activity-based costing (ABC) models.
Solutions /Discussions:
Under the traditional costing method, the factory overhead is allocated based on direct labor hours. Under the
ABC method, the factory overhead’s cost driver is the set-up time.
The total unit costs under the two methods are calculated below (DLH = direct labor hours, SUH = set-up
hours):
Product 1 Product 2
TC ABC TC ABC
Prime costs P 120 P 120 P 120 P120
Factory overhead
[(6,000 DLH x P400)/ 20,000] 120
[(14,000 DLH x P400)/80,000] 70
[(900 SUH/20,000)] 360
[(100 SUH x P8,000)/80,000] 10
Total unit costs P 240 P 480 P 270 P 210
Production
ABC unit costs is
Unit sales price tends to
Resulting to
CHAPTER 12 STRATEGIC MANAGEMENT AND COSTING SYSTEMS 524
Activity (or cost) drivers are identified per batch, product or plant levels. Each level has its own set of activities
and costs. The costs include materials, direct labor and factory overhead. Materials and labor are easily
identified and is therefore directly assigned to a product and in a process. Factory overhead is an indirect cost,
not directly identified with a product or process and should be therefore allocated among products.
The unit costs computed under the ABC method are ore reliable than that computed under the traditional
costing method. In short, the traditional costing unit costs are misstated which leads to an erroneous decision of
setting unit sales price.
Under the activity-based costing method, the unit cost of low-volume products is lower while the unit cost of
high volume products tends to be higher. This is the effect of “peanut-butter costing “. In this costing system
when the indirect costs are spread over a grater number of units produced, the unit cost becomes lower. While
if the production is lower, the unit costs gets higher.
This is in direct contrast with the traditional costing where unit costs are still higher when production is higher,
and unit costs are lower when production is lower.
This miscasting (e.g., understatement or overstatement) does not give the business an advantage to allocate
factory overhead based on traditional (or convenience-based) costing. Accuracy which is the underlying
premise of activity0based costing should substitute convenience (which is the justification of traditional costing)
to produce and provide more reliable, precise, and meaningful information for more progressive decisions.
To illustrate further the applications of activity-based costing, let us consider the next illustration presented in the next
page.
525 STRATEGIC MANAGEMENT AND COSTING SYSTEMS CHAPTER 12
Deming Corporation now employs a full-cost system and has been applying its manufacturing overhead on the basis of
machine hours. The corporation plans using 50,000 direct labor hours and 30,000 machine hours in the coming year. The
following data shows the manufacturing overhead that is budgeted as follows:
Budgeted Budgeted
Activity Cost Driver Activity Cost
Materials handling No. of parts handled 6,000,000 P 720,000
Setup costs No. of setups 750 315,000
Machining costs Machine hours 30,000 540,000
Quality control No. of batches 500 225,000
Total manufacturing overhead costs P1,800,000
Costs, sales, and production data for one of the organization’s products for the coming year are as follows:
Prime costs:
Direct materials cost per unit P 4.40
Direct labor cost per nit (.05 DLH $ P 15/DLH) 0.75
Total prime costs P 5.15
Determine the cost per unit for the product for the coming year using the traditional costing and the activity-based costing
methods.
Solutions / Discussions:
The unit cost under the traditional costing method is computed as follows:
ABC assigns costs to activities rather than to organizational units. The ABC process may be summarized as follows:
Set-up the ABC system. This is done through the establishment of the activity-based management (ABM) system
which serves as the linkage of product costing and the continuous improvement of processes. Process
improvements start from process value analysis which is a comprehensive understanding of how an organization
generates its output by mapping out its activities in the process. Thereupon, activities are classified as value-
adding or non-valued-adding activities.
Identify the resource drivers. These are factors that cause changes in the costs of an activity. Costs are
accumulated for an activity-based system where the flow of resource consumption is observed.
Identify the activity drivers. Activities are classified according to their relation to a particular activity driver known
as driver analysis. It is an analysis that emphasizes the search for
• The cause-and-effect relationship between an activity and its consumption of resources, and
• An activity and the demands made on it by a cost pool.
Unit level direct labor hours, direct labor pesos, machine hours,
unit of output
The ABC process is included in the system of activity-based management (ABM). This system serves as a linkage of
product costing and continuous improvement of processes which encompasses driver analysis, activity analysis, and
performance measurement.
BENEFITS COSTS
Traditionally, costs of units produced are computed based on the costs of materials, labor and overhead. The production
costs are accumulated based on job-order costing and process costing. This model is now considered too shortsighted,
not comprehensive, erratic and does not provide decision makers the overall and accurate picture of the entire costing
process. Consequently, if the computed cost is incorrect, sales price tends to be incorrect. To address the weaknesses of
the traditional coating systems and to capture the new ways of managing, the life-cycle costing was developed.
Life cycle-costing estimates and determines the total cost of a product over its life cycle. A product life cycle has five (5)
stages, namely: pre-infancy (or start-up stage), growth stage, expansion stage, and maturity/decline stage, as shown
below:
The product life-cycle costing is related to quality –based business cycle premise on the proposition that quality starts
from “effective listening to customers”. It commences from research and development, to design engineering, production,
marketing, channels of distribution, and customer services. This process is shown below.
Production
This new business cycle has four (4) groupings of costs: upward costs (e.g., research and development and design
engineering), production costs, downward costs (e.g., marketing and channels of distribution), and post-sales services
costs (e.g., customer services). Recent studies have shown that about 80 % of the total business cycle costs are already
locked-in even before the very first unit of product is produced. This pushes the issue that product costing should not be
confined within the production costs but should include all costs of doing business from research and development to
customer services. In this approach, strategic costing should be more reliable and accurate leading to better strategic
pricing and operating performance.
Life-cycle costing gets the average unit cost over the entire life span of a product. This would give managers an idea on
the long-term sales price of a product. As product costing fine tunes the business costs strategically, product pricing may
be made equally throughout the product life, or product pricing may be higher during the initial years of product life and
gradually decreases as the product nears its maturity and decline. Or, still, product pricing may be initially set at a lower
price and gradually increases as the product approaches growth and expansion. On top of all these, life-cycle costing is
also affected by the introduction of new technology or processes even before a product reaches its maturity stage. This
situation also calls for consideration in strategic pricing.
Rene Corporation is introducing a new model in one of its product lines. This model is expected to have a 3-year product
life and would incur the following costs and production (M = millions):
Required: Determine The strategic sales price over the life of the model if:
Solutions / Discussions:
1. The life-cycle unit cost is P6.00 (eg, P90M / 15M). The unit sales price is P12.00 (eg, P6 x 200%).
2. The sales price are:
First year P6 x 150% P 9.00
Second year P6 x 200% 24.00
Third year P6 x 120% 7.20
Statistical control techniques are operations research models used to map up processes, monitor and evaluate quality
indicators, and provide intelligent alternative solutions. Statistical control techniques are numerical reports expressed in
statistical terms and presentations used to predict and monitor activities towards a more efficient and more effective
operations. These techniques include lines (eg, regression line, line graph, etc.), graphs (eg, bar graph, histograph, etc.),
dispersion or deviations (eg, such as those expressed in x-graph, r-graph, etc.), and other related analysis that are
conveniently used to identify and describe patterns and potential problems in the business operations.
The other quantitative techniques include Gantt Chart, PERT/CPM, Pareto’s Law, regression analysis, fish-bone analysis,
linear and dynamic programming, and learning curve theory. Gantt Chart is used to trace project schedules and activities
as to their sequence, parallel undertakings, and time of completion. PERT/CPM is used in estimating a project (or
process) completion time and activity costs using probabilistic principles. Pareto’s Law is the 80-20 rule, which states, for
example, that 80% of the problems in a particular process is contributed by 20% of the total activities, or vice-versa.
Pareto’s Law is applicable in every conceivable business process and in all fields of managing such as human resources,
financial management, marketing management, warehousing, logistics, legal department, accounting department, etc.
Productivity Rate
Learning Curve Theory
0 Time
531 STRATEGIC MANAGEMENT AND COSTING SYSTEMS CHAPTER 12
There are two models used in the learning curve theory, the Wright Model and Crawford Model. The Wright Model states
that each time the cumulative quantity of output doubles, the cumulative (or moving) average time to produce per unit
decreases by a certain percentage. The decrease I percentage to produce an additional unit is 20%. This rate changes
across industries between 60% and 85%.
The Crawford model (i.e., incremental-unit-time learning model) predicts the time required to produce the last units
requires getting the total of each unit’s time to compute cumulative total time and cumulative average time per unit.
To illustrate the learning curve theory using the Wright model, let us assume a 20% learning rate, and a worker initially
needs 20 hours to produce the first unit. The average direct labor cost is P30. analyze the effects of the learning curve
theory.
Solutions / Discussions:
Take note, as the number of units produced doubles, the average labor hours per unit decreases (i.e, from 20 hours
to 16 hours, to 12.8 hours, to 10.24 hours, etc.).
Also note that the average direct labor cost per unit decreases by 20% as number of output doubles (e.g., P600 x
80% - P480; P 480 x 80% - P384, etc.).
The application of the balanced scorecard as discussed in chapter 3 brings an extended analysis of profitability.
Under the balanced scorecard philosophy, evaluating the success of a strategy involves the use of the Strategic
Profitability Analysis (SPA). It dissects the change in profit into growth factor, price-recovery factor, and productivity factor.
An example of such strategic analysis is given below:
Consider the following income statements of BS Company for the years ended 2006 and 2007:
Amount %
2006 2007 Change Change
Revenues P 16,000,000 P 22,000,000 P 6,000,000 10 %
Materials (9,600,000) ( 10,648,000) (1,048,000)
Direct labor (4,000,000) (6,072,000) (2,072,000)
Other expenses (2,000,000) (2,000,000) -
Profit P 400,000 P 3,280,000 P 2,880,000
Solutions / Discussions:
The change in profit accounted for by itemizing the effects of the growth factor, price recovery factor, and
productivity factor, as follows:
Growth factor
Sales growth factor 50,000 F x P40 P1,600,000 F
DM growth factor 80,000 UF x P12 960,000 UF
DL growth factor 20,000 UF x P20 400,000 UF P 240,000 F
Price-Recovery Factor
Sales price-recovery factor P10 F x 440,000 4,400,000 F
DM price-recovery factor P(1) F x 880,000 (880,000) F
DL price-recovery factor P3 UF x 220,000 660,000 UF 4,620,000 F
Productivity Factor
DM productivity factor 880,000 F x P11 968,000 UF
DL productivity factor 44,000 UF x P23 1,12,000 UF 1, 980,000 UF
Productivity factor
DM productivity factor = (actual DM quantity this year – Standard DM this year) x Standard
Unit DM price this year
DL productivity factor = (actual DL hours this year – Standard DL hours this year) x unit
DL rate this year
CHAPTER 12 STRATEGIC MANAGEMENT AND COSTING SYSTEMS 534
BACKFLUSH COSTING
The use of Just-in-time inventory system among small and medium-sized companies in the industrialized economies has
brought the development of backflush costing.
In just-in-time, the trigger point is traced from the date a customer made an order. From their, machines and men are
prepared, and materials are ordered. As materials are ordered, it is safe to assume that the same would be immediately
used in the production process. This means that no materials inventory, or only a little materials inventory, would be
maintained by the enterprise. And since machines are maintained on their top operating conditions, men at their best
possible performance, and having an error-free production processes, the materials are certain to be converted into
finished goods and delivered to customers. To do all of these things, the applications of technology would be inevitable.
This brings direct labor costs minimal and indirect to the product being produced. This makes direct labor cost more of a
fixed cost rather than a variable cost.
This new manufacturing set-up suggests that materials inventory and work-in-process inventory would be an insignificant
cost in the production process. Backflush costing records until after the events have taken place, then costs are worked
backwards to “flush” out the manufacturing costs. So the accounting question is: at what point in the production and sales
processes would material costs be summarized and recognized? The point where the materials costs are backflushed is
called the trigger point.
There are three events that trigger the records kept in many backflush accounting systems:
Trigger
point Events Comments
1 Sale of goods This is the true trigger point because satisfying customers initially happens
when the right goods are delivered or sold to them. The completion of
goods does not give value to the enterprise until and only when the goods
are delivered to the customers.
Completion of This is only a secondary trigger point in a true backflush coating system
2 production because the quality of the JIT system is measured on the date the goods
are delivered to the customers and not on the dare of production.
In a true JIT system where there are absolutely no raw materials held on
Purchase of materials hand, this trigger point is irrelevant. However, while companies have not yet
3 reached the dream of backflush environment, the use of the materials
purchases date and the date of sale or production would still be popular.
Sample Problem 6. Backflush costing- the trigger point is the date of sale
Aquatic Corporation applies the just-in-time philosophy in its materials procurement and production systems. It
uses backflush accounting and the following selected transactions occurred in one of its products in the month of
January 2009:
Required: Record the foregoing transactions assuming that materials are backflushed at the date the goods are
delivered to customers.
Solutions / Discussions:
b. Incurrence of conversion
costs Conversion costs P62,000
Accounts payable, etc. P62,000
The backflushing of direct materials costs, and therefore the recording of the creditors account, is made at the date of
sale. No finished goods inventory is maintained. Conversion costs are recorded at the date of incurrence.
Required: Record the foregoing transactions assuming that materials are backflushed at the date of completing
the goods produced.
Solutions / Discussions:
b. Incurrence of conversion
costs Conversion costs P62,000
Accounts payable, etc. P62,000
The backflushing of direct materials costs, and also the recording of the creditors account, is made at the date of
completing the production. As such, finished goods inventory is maintained. Later, the finished goods inventory is also
backflushed to cost of goods sold. Conversion costs are recorded at the date of incurrence.
Sample Problem 8. Backflush costing-trigger points are materials purchases and point of sale
Aquatic Corporation applies the just-in-time philosophy in its materials procurement and production systems. It
uses Raw and In Process account to keep track of its materials and backflushed materials at the date goods are
completed. The following selected transactions occurred in one of its products in the month of January 2009:
RIP FG
Beginning balance Direct materials 2,000 3,100
Conversion costs 900 1,200
Total 2,900 4,300
Ending balances Direct materials (1500) (4,200)
Conversion costs (600) (2,200)
Total 2100 6,300
Required: Record the foregoing transactions using the company’s backflush accounting system.
Solutions / Discussions:
In this version of backflush accounting, raw materials purchases are immediately recognized on the date of receipt. The
debit is made to the “Raw and in Process” account to impress that there is no materials stored in the warehouse,
however, still in the process of production. The cost of materials used is backflushed at the date of sale. There is no
finished goods inventory account to be maintained. Conversion costs are recorded at the date of incurrence.
Sample Problem 9. Backflush costing-the trigger points are materials purchases and point of production
Aquatic Corporation applies the just-in-time philosophy in its materials procurement and production systems. It uses Raw
and In process account to keep track of its materials and backflushed materials at the date goods are completed. The
following selected transactions occurred in one of its products in the month of January 2007:
RIP FG
Beginning balance Direct materials 2,000 3,100
Conversion costs 900 1,200
Total 2,900 4,300
Ending balances Direct materials (1500) (4,200)
Conversion costs (600) (2,200)
Total 2100 6,300
Required: Record the foregoing transactions using the company’s backflush accounting system.
Solutions / Discussions:
In this version of backflush accounting, raw materials purchases are also immediately recognized on the date of receipt.
The debit is made to the “Raw and in process” account to impress that there is no materials stored in the warehouse,
however, still in process of production. The cost of materials used is backflushed at the date of completing the production.
Finished goods inventory account is maintained and is later transferred to the cost of goods sold account. Conversion
costs are recorded at the date of incurrence.
Standard costing and backflush accounting
Standard costing may be used in the backflush accounting. If used, the variance between the actual conversion costs are
to be closed to the cost of materials and conversion costs.
Throughput Accounting
The concept behind the theory of constraints was first formulated and developed by Goldratt and Cox (1986) in their book,
The Goal. In 1990 Goldratt refined the concepts and eventually gave it the name the “Theory of Constraints”.
The theory focuses on constraints or bottlenecks which hinder speedy production. This binding constraint in the
production process dictates the pace of the manufacturing throughput rate. The idea is to remove or unclog the bottleneck
to accelerate the production process from the point of procuring materials up to the point of delivering the goods to the
customers.
There could be as many bottlenecks that could be found in the production processes. The bottlenecks could be in terms of
machine hours, direct labor hours, materials availability, market capacity, financial constraints and priorities, talents and
technology. These bottlenecks impede the capacity of the enterprise to produce more goods and services. In case the
market could still accommodate, the constraints or the bottlenecks should be managed with an aim of allowing the
production process to produce goods up to where they could meet customer demands. This means that if the present
bottleneck is machine hours, then efforts should be made to speed up the production process in the use of machine either
by re-lay-outing the production process, training men to be more skilled, acquiring more durable materials, or acquisition
of more machines. In the process, creativity, innovations, and systems improvements would come into play. The
processes of eliminating or unclogging the bottleneck should be made using the overriding criterion of benefit-cost
analysis as the guiding principle.
Once the most constraining bottleneck is remedied, then another most constraining bottleneck that principally hinders the
potential of the production process would be identified. This would then be remedied, and the cycle goes on until the
maximum capacity of the plant is attained. In such case, the overall plant becomes the bottleneck in responding to
customer demands.