Professional Documents
Culture Documents
2. Target costing
a) Derive a target cost in manufacturing and service industries.[2]
b) Explain the difficulties of using target costing in service industries.[2]
c) Suggest how a target cost gap might be closed.[2]
3. Life-cycle costing
a) Identify the costs involved at different stages of the life-cycle.[2]
b) Derive a lifecycle cost in manufacturing and service industries.[2]
c) Identify the benefits of life cycle costing.[2]
4. Throughput accounting
a) Calculate and interpret a throughput accounting ratio (TPAR).[2]
b) Suggest how a TPAR could be improved.[2]
c) Apply throughput accounting to a multi-product decision-making problem.[2]
5. Environmental accounting
a) Discuss the issues business face in the management of environmental costs.[2]
b) Describe the different methods a business may use to account for its
environmental costs.[1]
ADVANCE COSTING
METHODS
THROUGHP
ACTIVITY LIFE- UT
TARGET ENVIRONMENTA
BASED CYCLE ACCOUNTIN
COSTING L ACCOUNTING
COSTING COSTING G
• Inventory valuation the cost per unit can be used to value inventory in the
statement of financial position (balance sheet).
• To record costs the costs associated with the product need to be recorded in the
income statement.
• To price products the business will use the cost per unit to assist in pricing the
product. For example, if the cost per unit is $0.30, the business may decide to
price the product at $0.50 per unit in order to make the required profit of $0.20
per unit.
• Decision making the business will use the cost information to make important
decisions regarding which products should be made and in what quantities.
$
Direct materials per unit X
Direct labour per unit X
Production overhead per unit X
—
Full production cost per unit X
—
It is relatively easy to estimate the cost per unit for direct materials and labour. In
doing so we can complete the first two lines of the cost card. However, it is much
more difficult to estimate the production overhead per unit. This is an indirect cost
and so, by its very nature, we do not know how much is contained in each unit.
Therefore, we need a method of attributing the production overheads to each
unit. All production overheads must be absorbed into units of production, using a
suitable basis, e.g. units produced, labour hours or machine hours. The
assumption underlying this method of absorption is that overhead expenditure is
connected to the volume produced.
Requirement
Using traditional absorption costing, calculate the full production cost per unit and
the profit per unit for each product. Comment on the implications of the figures
calculated.
Solution
The activity level must be appropriate for the business. Saturn must choose
between three activity levels:
• Units of production - This would not be appropriate since Saturn produces more
than one type of product. It would not be fair to absorb the same amount of
overhead into each product.
= $80,000
——————
16,000 hours
Based on absorption costing, the Sky Bar and the Sun Bar are both profitable.
However, the Moon Egg is loss making. Managers would need to consider the
future of the Moon Egg. They may look at the possibility of increasing the selling
price and/ or reducing costs. If this is not possible, they may make the decision to
stop selling the product. However, this may prove to be the wrong decision
because absorption costing does not always result in an accurate calculation of
the full
production cost per unit. ABC can be a more accurate method of calculating the
full production cost per unit and as a result should lead to better decisions.
This was appropriate in the past because businesses only produced one simple
product or a few simple and similar products, e.g. Cadbury originally produced
one product only, the Cadbury Dairy Milk.
A cost pool is an activity which consumes resources and for which overhead costs
are identified and allocated. For each cost pool, there should be a cost driver. The
terms ‘activity’ and ‘cost pool’ are often used interchangeably.
Step 2: Identify cost drivers for each activity, i.e. what causes these
activity costs to be incurred.
A cost driver is a factor that influences (or drives) the level of cost.
The OAR is calcuated in the same way as the absorption costing OAR. However, a
separate OAR will be calcuated for each activity, by taking the activity cost and
dividing by the cost driver information.
The activity costs should be absorbed back into the individual products.
Step 5: Calculate the full production cost and/ or the profit or loss.
Some questions ask for the production cost per unit and/ or the profit or loss per
unit. Other questions ask for the total production cost and/ or the total profit or
loss.
Illustration 2 ABC
In addition to the data from illustration 1, some supplementary data is now
available for Saturn company:
$
Machining costs 5,000
Component costs 15,000
Setup costs 30,000
Packing costs 30,000
———
Production overhead (as per
illustration 1) 80,000
Solution
Step 1: Group production overheads into activities, according to how they are
driven.
This has been done above. The $80,000 production overhead has been split into
four different activities (cost pools).
Step 2: Identify cost drivers for each activity, i.e. what causes these activity costs
to be incurred.
Target costing
Illustration
Music Matters manufactures and sells cds for a number of popular artists. At
present, it uses a traditional cost-plus pricing system.
The price that customers are willing to pay - pricing the cds too high could
result in low sales volumes and profits.
Cost control - the cost of the cd is established at $15 but there is little
incentive to control this cost.
Music Matters could address the problems discussed above through the
implementation of target costing:
(1)The first step is to establish a competitive market price. The company would
consider how much customers are willing to pay and how much competitors
are charging for similar products. Let's assume this is $15 per unit.
ATC – Adding Value To Your Future 8
(2) Music Matters would then deduct their required profit from the selling price.
The required profit may be kept at $5 per unit.
(3) A target cost is arrived at by deducting the required profit from the selling
price, i.e. $15 - $5 = $10 per unit.
(4)Steps must then be taken to close the target cost gap from the current cost
per unit of $15 per unit to the target cost of $10 per unit.
Step 2 - Set a selling price at which the organization will be able to achieved a
desired market share.
Step 4 - Calculate the target cost = target selling price – target profit (Step 2
less step 3)
Step 5 - Compile an estimated cost for the product based on the anticipated
design specification and current cost levels.
Step 6 - Calculate the target cost gap = estimated cost – target cost (step
5 less step 4)
Step 7 - Make efforts to close the gap. This is more likely to be successful if
efforts are made to ‘design out’ cost prior to production, rather than
to ‘control out’ cost during the production phase.
Step 8 - Negotiate with the customer before making the decision about
whether to go ahead with the project.
Activity 1
A car manufacturer wants to calculate a target cost for a new car, the price of
which will be set at $17,950. The company requires an 8% profit margin.
Calculate the target cost of the company. If the company required an 8% profit
markup how would the target cost be different?
Activity 2
LMN Ltd uses a minimum contribution/sales (C/S) ratio target of 25% when
assessing the viability of a product. In addition, management wish to achieve an
overall net profit margin of 12% on sales in this period in order to meet return on
capital targets.
Required:
Calculate the C/S ratio for each product and the overall net profit margin. Explain
how target costing may be used in achieving the required returns.
The target cost gap is established in step 6 (above) of the summary target costing
process.
Questions that a manufacturer may ask in order to close the gap include:
A key aspect of this is to understand which features of the product are essential to
customer perceived quality and which are not. This process is known as ‘value
analysis’. Attention should be focused more on reducing the costs of features
perceived by the customer not to add value.
The major cost of any new product or service is salaries and unless lower
cost delivery mechanisms (e.g. the internet) or radically different ways of
working can be exploited there is limited scope for substantial cost
reduction.
A key performance target for many banks is to reduce staff costs as a percentage
of total bank costs.
The launch of first telephone banking and then internet banking for personal
customers (both services enabling bank customers to access their bank accounts,
transfer funds and pay bills on a 24hour
basis) has enabled the banks to vary the level of bank staff involvement in the
provision of these services and to provide a relatively cost effective service.
Lifecycle costing:
Is a concept which traces all costs to a product over its complete lifecycle
from design to cessation.
The various cost of a product during its product life cycles from development
through to its eventual withdrawal from the market are as follows:
(1) Development – The product has a research and development stage where
costs are incurred but no revenue is generated.
(3)Growth – The product gains a bigger market as demand builds up. Sales
revenue increase and the product begins to make a profit.
(4) 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 be profitable.
The product may be modified or improved, as a means of sustaining its
demand.
(5)Decline – At some stage, 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.
Pricing
• Pricing decisions can be based on total lifecycle costs rather than simply the
costs for the current period.
Decision making
• In deciding to produce a product, a timetable of lifecycle costs helps show what
costs need to be allocated to a product so that an organisation can recover its
costs. If all costs cannot be recovered, it would not be wise to produce the product
or service.
Performance management
• Improved control many companies find that 90% of the product’s lifecycle costs
are determined by decisions made in the development and launch stages.
Focussing on costs after the product has entered production results in only a small
proportion of lifecycle costs being manageable. Lifecycle costing thus reinforces
the importance of tight control over locked-in costs, such as R&D in the
development stage.
• Improved reporting costs such as R&D and marketing are traditionally reported
on an aggregated basis for all products and recorded as a period expense.
Lifecycle costing traces these costs to individual products over their entire life
cycles, to aid comparison with product revenues generated in later periods
Throughput accounting
Main assumptions:
The only totally variable cost in the short-term is the purchase cost of raw
materials that are bought from external suppliers.
Direct labour costs are not variable in the short-term. Many employees are
salaried and even if paid at a rate per unit, are usually guaranteed a
minimum weekly wage.
Throughput calculation
Note: the total factory cost is the fixed production cost, including labour.
The total factory cost may be referred to as 'operating expenses'.
Activity
X Limited manufactures a product that requires 1.5 hours of machining. Machine
time is a bottleneck resource, due to the limited number of machines available.
The product is sold for $85 per unit and the direct material cost per unit is $42.50.
Total factory costs are $8,000 each week.
Calculate
(a) the return per factory hour
(b) the TPAR.
Interpretation of TPAR
Criticisms of TPAR:
The usual objective in questions is to maximise profit. Given that fixed costs are
unaffected by the production decision in the short run, the approach should be to
maximise the throughput earned.
Environmental accounting
The accounting profession is often accused of being too concerned with the
numbers and not concerned enough about the more intangible aspects of a
company's operations. Environmental accounting, also called social accounting, is
a type of accounting that attempts to measure both the social and environmental
impacts of business decisions.
History
Environmental accounting started receiving attention during the energy crisis in
the 1970s. Although the issue was given consideration for a time, the energy
crises ended and the 1980s ushered in a new era of economic prosperity. The
practice of environmental accounting faded into the background before any
standards for measuring economic impacts were developed. Legislation and
agreement on how to account for environmental factors and what factors should
be counted were difficult to come by. In the 1990s, a large upswing in
environmental protection activism brought environmental accounting back into
the consciousness of both consumers and businesses.
Benefits
Environmental accounting allows companies to take all costs, rather than just
company expenses, into account when making production and pricing decisions.
The depletion of natural resources involves more costs than the monetary ones
that appear on company financial statements. Examining our use of and affect on
Types
There are several relationships that can be examined using environmental
accounting. Environmental accounting can be used to monitor our use of minerals
and natural oil. We can also examine the costs of water and air pollution. Animal
habitats and the farm land needed to produce food can also be examined to
determine what impact our activities are having. Opportunity costs are another
cost category which can be examined with an environmental and social
accounting. Opportunity costs refer to what we do without in order to have
something else. For example, the pieces of steel we use to make beams for
building construction cannot also be used to make a new car. The health and
happiness of employees and other stakeholders can also be weighed when
making decisions.
Considerations
Although environmental accounting has many benefits and is a good idea in
theory, it can be difficult to put into practice. When instituting environmental and
social accounting practices, it is necessary to remember that many of the costs
calculated in environmental accounting are intangible and difficult to measure.
The company must make sure it applies the same standards and assigns the
same values to resources across the organization. Some values are subjective and
vary with individuals, so it can be difficult to come to a consensus on what to
measure and how. Social accounting can also be challenging, as social values
sometimes change quickly.
Potential
Environmental and social accounting have the potential to raise awareness about
public concerns. This can help us substantially reduce pollution, protect wildlife
habitats and save farmland from development. Environmental and social costing
can also help companies to set product and service prices at levels that take into
account the true costs. This means that consumers will have to pay more for a
product whose production results in a lot of air pollution or whose manufacture
required the development of manufacturing plant facilities on farm land. If prices
are set in this manner, environmental accounting could possibly help make
environmentally costly products more expensive to purchase and green products
less so. The goal is to make damaging the environment more costly and thereby
less profitable while increasing awareness about the environmental and social
impacts of the products we produce and consume.