costing techniques

COST MANAGEMENT TECHNIQUES

Costing is the process of determining the costs of products, services or activities.  Such costs have to be built up using a process known as cost accumulation.

A direct cost is a cost that can be traced in full to the product, service or department.

An indirect cost or overhead is 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.

MARGINAL COSTING

Marginal cost is the variable cost incurred as a result of undertaking a specific activity. It is cost of producing one additional item. Marginal is also called as variable costs. Variable costs are those costs, which vary with the level of activity of a business.

Marginal cost = Direct Material + Direct Labor + Direct Expenses + Variable Overheads.

Contribution = Sales – Marginal cost

Profit            = Contribution – Fixed cost

Total Cost     = Variable cost + Fixed costs OR Marginal cost + Fixed cost

The sales can be expressed as:

Sales    = Total Cost + Profit

Sales    = Marginal Cost + Fixed Cost + profit

Marginal Costing Profit Statement

	$	$
Sales (Sales Units x S.P per Unit)		xx
Variable Cost of Sales:
Opening Inventory (units x V.C/ Unit)	xx
Add: Production (units x V.C/ Unit)	xx
Less: Closing Inventory (units x V.C/ Unit)	(xx)
Contribution		xx
Less: Fixed Costs		(xx)
Profit		xx

Example 1

A manufacturing company produced and sold 10,000 units during the month of April.  The following additional information was also provided:

Direct materials           $ 8 per unit

Direct labor                 $4 per unit

Variable overheads     $4 per unit

Fixed cost for the month of April $36,000.  Selling price per unit $20

Required:

Prepare a statement showing the marginal cost and the profit or loss for the month of April.

Example 2

MS Ltd has the following information:

Opening Stock	-
Production Units	15000
Sales Units	10000
Sales Price Per Unit	$20
Unit Costs:
Direct Materials	$8
Direct Labor	$4
Variable Production OHs	$2
Fixed Cost for the Month	$50,000

Required:

Using Marginal Costing Principles, Calculate the Profit for December 2013.

ABSORPTION COSTING

In absorption costing, all costs are absorbed into production and in this case, there is no distinction between fixed and variable costs. Absorption Costing is also known as Total Costing or Full Costing.

Absorption costing is necessary to absorb overheads into units of production using a suitable basis.

Overheads absorption rate (OAR) = Total budgeted department overheads

                                                          Budgeted department direct labor hrs

All overheads must first be allocated/apportioned/reapportioned into production departments.

Absorption Costing Profit Statement

	$	$
Sales (Sales Units x S.P per Unit)		xx
Cost of Sales:
Opening Inventory (units x T.C/ Unit)	xx
Add: Production (units x T.C/ Unit)	xx
Less: Closing Inventory (units x T.C/ Unit)	(xx)
Gross Profit		xx
Less: Non Production Costs		(xx)
Profit		xx

Example 1

At the beginning of Period 1, there is no opening inventory for the product for which the Variable production costs is $6 per unit and the Sales price is $10 per unit.

Fixed Costs are $3500 per period of which $3000 are fixed production costs.

Details	Period 1	Period 2
Sales	1200 units	1700 units
Production	1500 units	1500 unit

Required:

Determine the Profit in each period using the following methods of costing

a)      Absorption Costing

b)      Marginal Costing

Example 2

In a period, 20, 000 units of Z were produced and sold. Costs and revenues were:

                                                                                                                              $

                        Sales                                                                                        100, 000

                        Production costs:                    Variable                                     35, 000

                                                                        Fixed                                         15, 000

                        Administrative + Selling overheads: Fixed                              25, 000

Required:

Calculate the Profit using both A.C and M.C Principle

RECONCILIATION OF MARGINAL AND ABSORPTION COSTS

When reconciling the Marginal Costing Profit to the Absorption Costing Profit, note the following points:

1.      When there is an increase in inventory, the A.C Profit is always higher than the M.C Profit.

2.      When there is a decrease in inventory, the M.C Profit is always higher than the A.C Profit.

3.      When there is no change in inventory, the M.C Profit and the A.C Profits are the same.

4.      The difference in A.C Profit and M.C Profit = Change in Inventory x F. Prod. C/ Unit

                                                                                   

ACTIVITY BASED COSTING (ABC)

ABC and Cost Drivers

ABC is an alternative approach to the traditional methods costing.

The ABC approach is to link overhead costs to the products or services that causes them by absorbing overhead costs on the basis of activities that ‘drive’ costs (cost drivers) rather than on the bases of production volume.

ü  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.

ü  A cost driver is a unit of activity that consumes resources.  OR a cost driver is a factor influencing the level of cost.

Calculation of costs per driver and per unit using ABC

The are five basic steps in establishing and applying a system of ABC

Step 1: Identify activities that consume resources and incur overhead costs

Step 2: Allocate overhead costs to the activities that incur them. (Directly allocated to a cost pool)

Step 3: Determine the cost driver for each activity or cost pool.

Step 4: Collect data about actual activity for the cost driver in each cost pool.

Step 5: Calculate the overhead cost of products or services.  This is done by calculating an overhead cost per unit of the cost driver (a cost per unit of activity).  Overhead costs are then charged to products or services on the basis of activities used for each product or service.

Example 1

X Ltd makes two types of high quality – the light (L) and the heavy (H)

Details of the two products are as follows:

     L                               H

Budgeted production volume (units)              10,000                         5,000

Direct material cost per unit                               $ 8                            $16

Direct labor hours per unit                              1.5                               1.0

Machine hour per unit                                     2                                  3

Direct labor costs $8 per hour and labor hours for the period are budgeted at 20,000.

Machine hours for the period are budgeted at 25,000.

Production overheads are estimated at $ 260,000. An analysis of the production overhead establishes that this cost arises in relation to four activities in the following proportions and has the following associated volumes:

	Proportion Of production Overhead costs	Activity volume		Total
		L	H
Order handling	24%	167	83	250 (No of orders processed)
Set ups	38%	40	90	130 (No of set ups)
Materials handling	18%	67	33	100 (No of movements of materials)
Quality control	20%	287	193	480 (No of inspections)
	100%

Required:

a)      Calculate the cost per unit for each product using traditional methods, absorbing overhead on the basis of labor hours.

b)      Calculate the cost per unit using ABC principles.

c)      Drawing upon the information from X Ltd to illustrate your answer, explain why the use of ABC often produces costs that are different to those calculated under more traditional methods.

d)     Discuss the implications of a switch to ABC on pricing and profitability.

Example 2

Y Ltd makes and sells two products, plus and doubles plus.  The direct costs of production are ₤12 for one unit of plus and ₤24 per unit of Double plus.

Information relating to annual production and sales is as follows:

                                                                        Plus                             Double plus

Annual production and sales                          24,000 units                24,000 units

Direct labor hours per unit                                1.0                             1.5      

Number of orders                                               10                             14

Number of batches                                              12                            24

Number of setups per batch                                  1                              3

Special parts per unit                                             1                               4

Information relating to production overhead costs is as follows:

                                                Cost driver                                          Annual cost

                                                            ₤                                                   ₤

Setup costs                              Number of setups                                73,200

Special parts handling             Number of special parts                      60,000

Other materials handling         Number of batches                              63,000

Order handling                        Number of orders                                19,800

Other overheads                      -                                                           216,000

                                                                                                            432,000

Other overhead costs do not have an identifiable cost driver, and in an ABC system, these overheads would be recovered on a direct labor hour’s basis.

Required:

1)      Calculate the production cost per unit of plus and of Double Plus if the company uses traditional absorption costing and the overheads are recovered on a direct labor hours basis.

2)      Calculate the production cost per unit of plus and of Double plus if the company uses ABC.

Advantages of ABC

1. It provides much better insight into what drivers overhead costs
2. Recognizes that overhead costs are not all related to production and sales volume.
3. Overhead costs are important and management needs to understand the drivers of overhead costs in order to manage the business properly.
4. ABC can be applied to complex businesses environment
5. ABC can be applied to all overhead costs, not just production overheads.
6. ABC can be used just as easily in service costing as in product costing.

Disadvantages of ABC

1. It is impossible to allocate overheads costs to specific activities.
2. The choice of both activities and costs drivers might be inappropriate. (ABC based on assumption and simplifications).
3. ABC can be more complex to explain to the stakeholders.
4. The benefits obtained from ABC might not justify the costs.

Implications of switching to ABC

1. Pricing can be based on more realistic cost data.
2. Sales strategy can be more soundly based
3. Performance management and decision making can be improved.

THROUGHPUT

Throughput is the rate of converting raw materials and purchased components into products sold to customers.

In money terms, throughput can be therefore be defined as the extra money that is made for an organization from selling its products:

Throughput = Revenue - Totally variable costs

Totally variable costs are raw materials and bought in components.

Throughput = Revenue - Raw material costs

Inventory

Inventory is money tied up in assets so that business can make the throughput.

Operating expenses

Money a business spends to produce the throughput (i.e. to turn the inventory into output)

Example1

Ann recorded a profit of $120,000 in the accounting period just ended, using marginal costing.  The contribution/sales ratio is 75%, raw materials cost were 10% of sales value and there were no other variable production overhead costs.  Fixed costs in the period were $300, 000.

Required:

What was the value of throughput in the period?

The Throughput Accounting Ratio (TPAR) or TA ratio

Where there is a bottleneck resources, performance can be measured in terms of throughput for each unit of bottleneck resources consumed.

TA Ratio = Throughput per hour of bottleneck resources

                   Operating expenses per hour of bottleneck resources

Example 2

A business manufacture’s a single product that it sells for $10 per unit.  The materials cost for each unit of product sold is $ 3.  Total operating expenses are $ 50,000 each month.  Labor hours are limited to 20,000 each month.  Each unit of product takes 2 hours to assemble.

Required:

Calculate the throughput accounting ratio

Interpretation of TPAR or TA ratio

ü  TPAR> 1 would suggest that throughput exceeds operating costs so the product should make a profit.

ü  TPAR<1 would suggest that throughput is insufficient to cover operating costs, resulting in a loss.

Improving the TPAR or ratio

Options to improve the TPAR include:

1. Increase the sales price for each unit sold, to increase the throughput per unit
2. Reduce material cost per unit (switching suppliers)
3. Reduce total operating expenses, to reduce the cost per assembly hour
4. Improve the productivity of the assembly work force, and reduce the time required to make each unit of product.

Example 3

Suppose in the illustration above the following changes were made:

ü  The sales price were increased from $10 to 13.5

ü  The time taken to make each product fell from 2 hours to 1.75 hours

ü  The operating expenses fell from $ 50,000 to $45,000. 

Required:

Calculate the Throughput Accounting Ratio

Criticisms of TPAR or TA ratio

1. It concentrates on the short-term, when a business has a fixed supply of resources and expenses are largely fixed.
2. It is more difficult to apply throughput accounting concepts to the longer-term, when all costs are variable with volume of production and sales.
3. In the longer-term an ABC might be more appropriate for measuring performance.

BACK-FLUSH ACCOUNTING

Back flush accounting is a modern technique which can be used with just-in-time.  It has a major impact on efficiency, inventory and costs.

Back flush accounting offers a simplified approach to costing by getting rid of “unnecessary” costing records.

It is an alternative approach to cost and management accounting that can be applied where:

The speed of throughput is high and inventories of raw materials, work-in-progress (WIP) and unsold finished goods are very low.

TARGET COST

A target cost is a cost estimate derived by subtracting a desired profit margin from a competitive market price.  It is sometimes referred to as “price minus” costing.

Target Cost = Target Selling – Target Profit

Target cost is used in both manufacturing and service industries.

Target cost allows firms to focus on which costs can be reduced and reductions must be seen in both context of quality concerns as well.  This will involve product comparisons with the competitors used to set the competitive market price in the first place.  Real world users are: Sony, Toyota, Swiss watch makers.

Target costing has its greatest impact at the design stage because a large percentage of a product’s life cycle costs are determined by decisions made early in its life cycle.

The target costing approach is to develop a product, determine the market selling price and desired profit margin, with a resulting cost which must be achieved.

Steps in the implementation of target costing

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 – target profit

Step 5: Compute an estimated cost for the product based on the anticipated design specification and current cost levels.

Step 6: Calculate cost gap = estimated product cost – target cost

Step 7: Make efforts to close the gap.

Step 8: Negotiate with the customer before making the decision about whether to go ahead with the project.

Management can then set benchmarks for improvement towards the target costs, by improving technologies and processes.  Various techniques can be employed.

1.      Reducing the number of components

2.      Using standard  components wherever possible

3.      Training staff in more efficient techniques

4.      Using different materials

5.      Using cheaper staff

6.      Acquiring new, more efficient technology

7.      Cutting out non-value-added activities.

Example 1

A toy manufacture is about to launch a new type of bicycle on which it requires a return on investment of 30%.

Buildings and equipment needed for production are to cost $ 5,000,000.

Expected sales levels are 40,000 toys pa at a selling price of $ 67.50 per item costs are currently estimated to be $ 32 per unit.

Required

What is the target cost for annual production?

Implications of using target cost.

Target costing requires managers to change the way they think about the relationship between cost, profit, and price.

Traditionally the approach is to develop, determine production cost of the

1.      Product setting a selling price, with a resulting profit or loss.

2.      The target costing approach is to develop a product, determine the market selling price and desired profit margin, with a resulting cost which must be achieved.

With target costing there is a focus on:

1)      Price – led costing

2)      Customer’s requirements for, quality, cost and time are incorporated into product and process decisions.

3)      Cost control is emphasized at the design.

LIFE CYCLE COSTING

Tracks and accumulates costs and revenues attributable to each product over the entire product life cycle (accumulation of costs over a product’s entire life).

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.

The component elements of a product’s cost over its life cycle could therefore include the following:

1)      Research and development costs design, testing and production process and equipment

2)      The cost of purchasing any technical data needed

3)      Training costs (including initial operator training and skills updating)

4)      Production costs

5)      Distribution cost (transportation and handling costs)

6)      Marketing costs-customer service, field maintenance-Brand promotion.

7)      Inventory costs (holding spare parts, and warehousing)

8)      Retirement and disposal costs.  Costs occurring at the end of a product’s life

The product life cycle

A product life cycle can be divided into five phases.

Every product goes through a life cycle

1. Development-research and development stage where costs are incurred but no revenue is generated.
2. Introduction- The product is introduced to the market.
3. Growth-the product gains a bigger market as demand builds up.  Sales revenues increases and the product begin 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-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.

The level of sales and profits earned over a life cycle can be illustrated diagrammatically as follows:

 

Profit

   

Time

  

				Maturity		Decline

 

Implications of life-cycle costing

1. Pricing

Pricing decisions can be based on total life-cycle costs rather than simply the costs for the current period.

2. Decision making

1. In deciding to produce or purchase a product or service, a timetable of life-cycle costs helps show what costs need to be allocated to a production so that an organization can recover its costs.
2. If all costs cannot be recovered, it would not be wise to produce the product or service.
3. Life-cycle costing allows an analysis of business function interrelationships.

3. Performance management-reporting

Life-cycle costing traces these costs to individual products over their entire life cycles, to aid comparisons with product revenues generated in later periods

ENVIRONMENTAL MANAGEMENT ACCOUNTING (EMA)

EMA is concerned with the accounting information needed of managers in relation to corporate activities that affects the environment as well as environment -related impact on the corporation. This includes:

1. Identifying and estimating the costs of environment-related activities
2. Identifying and separately monitoring the usage and cost of resources such as water, electricity and fuel and enable costs to be reduced
3. Ensuring environmental considerations form a part of capital investment decisions
4. Assessing the likelihood and impact of environmental risks
5. Including environment-related indicators as part of routine performance monitoring
6. Benchmarking activities against environmental best practice

The importance of environmental management

Organizations are beginning to recognize that environmental awareness and management are not optional, but are important for long-term survival and profitability. All organizations:

1. Are faced with increasing legal and regulatory requirements relating to environmental management
2. Need to meet customers’ needs and concerns relating to environment
3. Need to demonstrate effective environmental management to maintain a good public image
4. Need to manage the risk and potential impact of environmental disasters
5. Can make cost saving by improved use of resources such as water and fuel
6. Are recognizing the importance of sustainable development, which is the meeting of current needs without compromising the ability of future generations to meet their needs.

Accounting for environmental costs

Conventional management accounting practice does not provide adequate information for managing the environment in a world where environmental concerns, as well as environment-related costs, revenues, and benefits, are on the rise. Environmental costs are not traced to particular processes or activities.

Environmental activity-based accounting

In ABC, environmental costs are removed from general overheads and traced to products and services. This means that cost driver are determined for these costs and products are charged for the use for these environmental costs based on the amount of cost drivers that they contribute to the activity.

Advantages of environmental costing

1. Better/fairer product costs
2. Improved pricing- so that products that have the biggest environmental impact reflect this by having higher selling prices
3. Better environmental cost control
4. Facilitates the quantification of cost saving from ‘environmentally –friendly’ measures
5. Should integrate environmental costing into the strategic management process
6. Reduces the potential for cross-subsidization of environmentally damaging products

Disadvantages of environmental costing

1. Time consuming
2. Expensive to implement
3. Determining accurate costs and appropriate costs drivers is difficult
4. External costs not experienced by the company (e.g. carbon footprint) may still be ignored/ unmeasured
5. Some internal environmental costs are intangible (e.g. impact on employee health) and these are still ignored
6. A company that incorporates external costs voluntary may be at a competitive disadvantage to rivals who do not do this

ASSIGNMENT

Over and Under Absorption of Overheads