STRATEGIC MANAGEMENT ACCOUNTING

At the end of the chapter, you should be able to

• Identify the strategic management accounting techniques in a quality environment

• Explain the processes of the activity-based analysis and compute the unit cost using the Activity-based
costing.
• Discuss the importance and procedures of the product life-cycle costing.
• Determine the effects of learning curve analysis with the total and the per-unit labor costs.
• Illustrate the procedures in the strategic profitability analysis.
• Prepare the journal entries using the backflush costing system in its different trigger points.
• Discuss the theory of constraints and relate it with the procedures used in throughput accounting.
• Discuss and illustrate customer profitability analysis.
• Relate with statistical control techniques.

Introduction
The development and use of new managerial philosophies have dramatically changed the systems applied in
cost and management accounting to produce more accurate, detailed, and timely managerial information. A
matrix of selected new management models and their related management accounting techniques is shown
below:
Note: These are the concepts that are not commonly discussed in detail in Managerial Accounting but are
really important not only in preparation for your board exam but also in applying such in real-life scenarios.
Take note of the strategic management accounting techniques for the different models presented.
Table 1. Management Models and the Cost and Management Accounting Techniques
Management Models Cost and Management Accounting Techniques
1. Just-in-time (JIT) philosophy • Backflush costing
2. Theory of constraints • Throughput accounting
3. Activity-based management • Activity-based costing
4. Learning curve theory • Learning curve analysis
5. Balanced scorecard • Strategic profitability analysis
6. Life-cycle analysis • Life-cycle costing
7. Continuous improvements • Kaizen costing

JIT philosophy and the theory of constraints

• relate to direct materials management and accounting.

Learning curve theory

• pertains to direct labor management and accounting.

Activity-based management

• directly impacts the factory overhead accounting.

Balanced scorecard

• relates to the strategy of the enterprise and its effectiveness to generate profit.
Life-cycle analysis and the principle of continuous improvements

• directly amplify the importance and power of total quality management.

Activity-Based Costing (ABC)
It’s a cost allocation issue…
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. Other
traditional bases in the allocation of overhead costs are machine hours, materials weights, and units of
production. The irritating downside of these overhead allocation bases is that not all overhead items are
driven by the usual allocation bases.
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. Costs are accumulated not in terms of
their relationship with the product but based on their relationship with the process and the activities in a
process in producing the product or delivering a service.
It was also 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, be allocated among products.
Sample Problem 1. Activity – Based Costing – 1
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, P 8,000,000

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 overhead allocation rates are:

Overhead rate (TC) = P 8 M / 20,000 DLH = P 400 per DLH
Overhead rate (ABC) = P 8 M/ 1,000 set-up hours = P 8,000 per set-up hour

• The total units costs under the two methods are calculated below (DLH = direct labor hours, SUH
= set-up hours):

• The unit costs computed under the ABC method are more reliable than that computed under the
traditional costing method. In short, the traditional costing unit costs are king misstated which leads
to an erroneous basis of setting unit sales prices.
 Product 1 Product 2
TC ABC TC ABC
Prime Costs P 120 P 120 P 200 P 200
Factory Overhead
[(6,000 DLH x P 400)/20,000] 120
[(14,000 DLH x P 400)/80,000] 70
[(900 SUH x P 8,000)/20,000] 360
[(100 SUH x P 8,000)/80,000] 10
Total unit costs P 240 P 480 P 270 P 210
Production ↓ ↑
ABC unit cost ↑ ↓
Units sales price ↑ ↓
Resulting to lost market share loss per unit

• In this illustration, product 1 is a low-volume product (20,000 units) and product 2 is a high-
volume product (80,000 units). Under the activity-based costing method, the unit cost of low-
volume product is lower, while the unit cost of high-volume product tends to be higher. This is
the effect of “peanut-butter costing”. In this costing system when the indirect costs are spread
over a greater number of units produced, the unit cost becomes lower. And if the production is
lower, the unit cost 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 activity-based 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 below:
Sample Problem 2. Activity-based Costing and Traditional Costing
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:
Activity Cost Driver Budgeted Activity Budgeted 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 P 1,800,000

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 unit (.05 DLH x P 15/DLH) 0.75
Total prime cost P 5.15
Sales and production data:
Expected sales 20,000 units
Batch size 5,000 units
Setups 2 per batch
Total parts per finished unit 8 parts
Machine hours required 80 MH per batch

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:

Overhead rate per machine hour (P 1,800,000/ 30,000 MH) P 60

Overhead rate per unit (P 60/ MH x 80 MH / 5,000 units) P 0.96

Prime costs 5.15
Total unit cost (traditional costing) P 6.11

• The unit cost under the ABC model is calculated as follows:

o The budgeted overhead rates per cost drivers are

Activity OH Rate / Cost Driver

Materials handling (P 720,000/ 6 million parts) P 0.12 per part
Setup costs (P 315,000/750 setups) P 420 per setup
Machining costs (P 540,000 / 30,000 MH) P 18 per MH
Quality control (P 225,000/ 500 batches) P 420 per batch
o The budgeted unit costs are:
Factory overhead per unit:
Materials handling (P 0.12 per part x 5 parts) P 0.600
Setup costs (P 420 per setup x 2 / 5,000 units) 0.168
Machining costs (P 18 per MH x 80 MH / 5,000 units) 0.288
Quality control (P 420 per batch/ 5,000 units) 0.084 P 1.14
Prime costs per unit 5.15
Total unit costs (activity-based costing) P 6.29

The ABC Process

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-value 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
o The cause-and-effect relationship between an activity and its consumption of resources, and
o An activity and the demands made on it by a cost pool.
Activity Drivers

Activity drivers are grouped into different processing levels such as facility level, product level, batch level, or
units level, as shown below:

Table 2. Examples of Activity Drivers

Process levels Activity drivers

Unit level direct labor hours, direct labor pesos, machine hours, or units of output
Batch level setup time, number of batches, material moves, orders processed, number of receipts,
weight of materials handled, number of inspections, or number of production orders
Product level design time, testing time, number of engineering change orders, number of categories
of parts, design changes, or number of products
Facility level square footage occupied, no. of personnel, no. of departments, kilowatt hours, fair
values of assets, or no. of products.
 • Group similar or homogeneous activities in relation to a specific activity driver.
• Estimate costs based on their cost-driver or activity-driver.

The ABC process is the accounting component of the activity-based management (ABM). This system serves
as a linkage of product costing and continuous improvement of processes which encompass driver analysis,
activity analysis, and performance measurement.

ABC has its advantages and limitations, as presented below:

BENEFITS COSTS
Accuracy. Overhead is accumulated based on Costly to implement
multiple cost pools related to activities instead of in
a single pool. Product costing does not conform with IFRSs.
Example, ABC may classify research as product
Continuous improvement. Activities are cost, and plant depreciation, insurance, or taxes as
continuously mapped, analyzed, and studied in period costs.
relation to a particular cost object thereby useful in
identifying non-value adding activities. These
advantages result to a better cost control and more
efficient operations.

ABC is most applicable to those organizations with products or services that

• Vary significantly in volume, diversity of activities, and complexity of operations;
• Relatively high overhead costs; or
• Operations that have undergone major technological or design changes.

Product-Life Cycle Costing

Traditionally, costs of unit 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 whole product life costing process. Consequently, if the computed cost is not
strategic, sales price tends to be unstable in the long run. To address this weakness of the traditional costing
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.
o A product life cycle has five (5) stages, namely:
▪ pre-infancy stage,
▪ infancy (or start-up stage),
▪ growth stage,
▪ expansion stage,
▪ and maturity decline stage, as shown on the following page:

Fig. 1. Product Life Cycle

The product life-cycle costing is related to quality-based business cycle premised 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.

Fig. 2. Strategic Business Cycle

Strategic Business Cycle

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 would 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.

Sample Problem 3. Life-Cycle Costing

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):

Upstream costs (e.g., research, development and product design) P 20 M

Production costs 40 M
Downstream costs (e.g., marketing and channel distribution) 20 M
After-sale services costs 10 M
Total product costs P 90 M
Estimated production in units:
Infancy period 1M
Growth period 4M
Expansion period 8M
Maturity period 2M
Total P 15 M

Required: Determine the strategic sales price over the life of the model if:
1. Unit sales price is set at 200% of the total product costs.
2. Unit sales price is set at 150% in the first year, 400% in the second year, and 120% in the third year.
Solutions/ Discussions:

1. The life-cycle unit cost is P 6.00 (e.g., P 90 M / 15 M). The unit sales price is P 12.00 (e.g., P 6 x
200%).
2. The sales prices are:
First year P 6 x 150% P 9.00
Second year P 6 x 400% 24.00
Third year P 6 x 120% 7.20

Learning Curve Analysis

Fig. 3. Learning Curve Graph

One of the applications of Pareto’s law is the learning curve

theory which states that productivity rate marginally
increases as employees gain experience in his work.
Normally, efficiency increase by an average of 20% for
every doubling of output, e.g., 1,2,4,8, 16, 32, etc. The
Learning Curve graph is depicted in Fig. 3 on the right.

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 in 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 unit and 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 analysis, let us consider the following sample problem:

Sample Problem 4. Learning Curve Theory Applications: Cumulative Average Time

A worker initially needs 20 hours to produce the first unit. The average direct labor cost is P 30. Analyze the
effects of the learning curve theory up to the fifth doubling of activities to the unit costs of production using
the:
1. Cumulative average time model.
2. Incremental unit time model.

Solutions/ Discussions:

1. Cumulative average time model.

• The cumulative learning curve theory has the following effects:

a b c (a x b) d e (c x d) f (e/a)
Units Moving average labor hours Estimated total DL Rate Total DL Ave. DL
per unit hrs. to produce per hr. per hr. Cost/ unit
the units
1 20.00 20.00 P 30.00 P 600.00 P 600.00
2 (20 x 80%) 16.00 32.00 30.00 960.00 480.00
4 (16 x 80%) 12.80 51.20 30.00 1,536.00 384.00
8 (12.80 x 80%) 10.24 81.92 30.00 2,457.60 307.20
16 (10.24 x 80%) 81.92 131.072 30.00 3,932.16 245.76
32 (8.19 x 80%) 6.5536 209.7152 30.00 6,291.456 196.608

• Note, as the number of units produced doubles, the average labor hours per unit decreases (i.e.,
form 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., P 600 x 80% - P480; P 480 x 80% - P 384, etc.)

• Learning curve rate may be determined as follows:

a. Based on average DLH per unit
Learning curve rate = 16 hrs. / 20 hrs. = 80%

b. Based on average DL cost per unit

Learning curve rate = P 480 / P 600 = 80%

2. Incremental unit-time model.

• The incremental learning curve theory has the following effects:
a b c (a x b) d e (c x d) f (e/a)
Units Incremental labor hours Estimated total DL Rate Total DL Ave. DL
hrs. to produce per hr. per hr. Cost/ unit
the units
1 20.00 20.00 P 30.00 P 600.00 P 600.00
2 (20 x 80%) 16.00 36.00 30.00 1,080.00 540.00
4 (36 x 80%) 28.80 64.80 30.00 1,944.00 486.00
8 (64.80 x 80%) 51.84 116.64 30.00 3,499.20 437.40
16 (116.64 x 80%) 93.312 209.952 30.00 6,298.56 393.66
32 (209.952 x 80%) 167.962 377.914 30.00 11,337.30 354.29

Strategic Profitability Analysis

The application of the balanced scorecard as discussed in the previous chapter brings an extended analysis of
profitability.

• Evaluating the success of a strategy

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
factory, and productivity factor. An example of such strategic analysis is presented below:

Sample Problem 5. Strategic Profitability Analysis

Consider the following profit and loss statements data of BS Company for the years ended 2019 and 2020:

2019 2020 Amount %

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

An analysis of related data are as follows

Quantity sold 400,000 440,000 40,000 F 10%
Unit sales price P 40 P 50 P 10 F
Actual direct materials quantity 800,000 lbs. 968,000 lbs.
Actual direct materials price P 12 P 11 P (1) F
DM productivity measure (400,000 / 0.50) 0.50
Standard DM Quantity based on 2019 data (440,000/ 0.50) 880,000
DM Growth Change (800,000 – 880,000) 80,000 UF
DM Productivity variance (968,000 – 880,000) 88,000 UF
Actual DLH 200,000 264,000 64,000
Actual DLR P 20 P 23 P 3 UF
DL Productivity measure (400,000/200,000) 2
Standard DLH based on 2019 data (440,000/2) 220,000
DL Growth Change (200,000 – 220,000) 20,000 UF
DL Productivity variance (264,000 – 220,000) 44,000 UF

Required: Account for the change in profit in 2020 using the strategic profitability analysis.
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 40,000 F x P 40 P 1,600,000 F
DM growth factor 80,000 UF x P 12 960,000 UF
DL growth factor 20,000 UF x P 20 400,000 UF P 240,000 F

Price- Recovery Factor

Sales price-recovery factor P 10 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 P 3 UF x 220,000 660,000 UF 4,620,000 F

Productivity Factor
DM productivity factor 88,000 F x P 11 968,000 UF
DL productivity factor 44,000 UF x P 23 1,012,000 UF 1,980,000 UF

Increase in profit P 2,880,000 F

• The growth-recovery factor is computed as follows:

Sales growth factor = (Sales volume this year – Sales volume last year)
x Unit sales price last year
DM growth factor = (Standard DM quantity this year – Base DM quantity last year)
x Unit direct materials price last year
DL growth factor = (Standard DL hours this year – Base DL hours last year)
x Unit direct labor rate last year

• The price-recovery factor is computed as follows:

Sales price-recovery factor
DM price-recovery factor
DL price-recovery factor
= (USP this year – USP last year) x Actual quantity sold this
year
= (Actual UDM price this year – Actual UDM price last year)
x Standard DM quantity this year
= (Actual UDL rate this year – Actual UDL rate last year)
x Standard DL hours this year

• Productivity-recovery factor
DM productivity factor
DL productivity factor
= (Actual DM quantity this year – Standard DM this year) x
Unit DM price this year
= (Actual DL hours this year – Standard DL hours this year)
x Unit DL rate this year

We can restate and summarize the formulas as follows:

Sales Direct Materials Direct Labor
Price-recovery factor (AP-SP) x AQ (AP-SP) x AQ (AR-SR) x AH
Productivity-recovery factor n.a. (AQ-SQ) x AP (AH-SH) x AR
Growth-recovery factor (AQ-SQ) x SP (SQ-BQ) x SP (SH – BH) x SR

where:
SQ = Actual units sold x Std. materials per unit
SH = Actual units sold x Std. hours per unit
BQ = Base quantity
BH = Base hours
Standard materials per unit = DM used last year/ Sales in units last year
Standard DLH per unit = DLH last year/ Sales in units last year
Backflush Costing
JIT and Backflush Costing

The use of just-in-time inventory system 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 there, men are prepared, machines are put into place, and materials are ordered.
o As materials are ordered, it is safe to assume that the same would be immediately used in the
production process.
o This means that no materials inventory, or only of little materials inventory, would be
maintained by the enterprise.
o 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.
o This brings direct labor costs to the minimum and becomes indirect to the product being
produced.
o It also makes direct labor cost more of a fixed cost rather than a variable cost.
o 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 costs 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 materials
costs be summarized and recognized?
• The point where the materials cost are backflushed is called the trigger point.

The Backflush points (e.g. trigger points)

There are three events that trigger the records kept in backflush accounting systems:

Table 3. Trigger Points in Backflush Costing

Trigger points Events Comments

1 Sale of goods
2 Completion of
production
3 Purchase of materials
This is the true trigger point because satisfying customers
initially happens when the right goods are promptly delivered to
them. The completion of goods does not give value to the
enterprise until and only when the goods are delivered to the
customers.
This is only a secondary trigger point in a true backflush costing
system because the quality of the JIT system is measured on the
date the goods are delivered to the customers and not on the
date of production.
In a true JIT system where there is absolutely no raw materials
held on hand, this trigger point is irrelevant. However, while
companies have not yet reached the matured backflush
environment, the use of the materials purchase date and the
date of sale or production would still be popular.

Sample Problem 6. Backflush Costing – Point 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 t

Raw materials purchases, 12,000 lbs. @ P 10, P 126,000

Standard costs per unit:
Materials, 4 lbs. @ P 10, P 40.00
Conversion costs, P 20.00
 Production costs with 3,000 units
Direct materials used 11,400 lbs.
Conversion costs P 62,000
Sales, 3,000 units

Required: Record the foregoing transactions assuming that materials are backflushed at the date the goods
are delivered to customers.

Solutions/ Discussions:

• The transactions are to be recorded as follows (amounts in currency units):

Transactions Accounts Dr. Cr.

a. Raw materials purchases No entry
b. Incurrence of conversion costs Conversion costs 62,000
Accounts payable, etc. 62,000
c. Finished goods completed No entry
d. Sale of goods to customers, Cost of goods sold 188,000
materials are backflushed to cost Conversion costs 62,000
of goods sold Accounts Payable 126,000

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.

Sample Problem 7. Backflush Costing – Point of Production

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 2019:

Raw materials purchases, 12,000 lbs. @ P 10, P 126,000

Standard costs per unit:
Materials, 4 lbs. @ P 10, P 40.00
Conversion costs, P 20.00
Production costs with 3,000 units
Direct materials used 11,400 lbs.
Conversion costs P 62,000
Sales, 3,000 units

Required: Record the foregoing transactions assuming that materials are backflushed at the date of completing
the goods purchased.

Solutions/ Discussions:

• The transactions are to be recorded as follows (amounts in currency units):

Transactions Accounts Dr. Cr.

b. Raw materials purchases No entry
b. Incurrence of conversion costs Conversion costs 62,000
Accounts payable, etc. 62,000
c. Finished goods completed. Finished Goods 126,000
Materials are backflushed to Accounts Payable 126,000
finished goods
d. To close conversion costs to cost Cost of goods sold 62,000
of goods sold Conversion costs 62,000
e. Transfer of finished goods to cost Cost of goods sold 126,000
of goods sold Finished goods 126,000

The backflushing of direct materials costs, and also the recording of the creditors account, is made at the date
of completing the production process. 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 – Materials Receipts 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 (RAIP) account to keep tract 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 2019:

Raw materials purchases

Direct materials 12,000 lbs. @ P 10, P 126,000
Indirect materials P 4,400
Production costs with 3,000 units
Other conversion costs P 62,000
Beginning and ending balances:

RAIP FG
Beginning balances Direct materials 2,000 3,100
Conversion costs 900 1,200
Total 2,900 4,300
Ending balances Direct materials (1,500) (4,200)
Conversion costs (600) (2,200)
Total 2,100 6,300

Required: Record the foregoing transactions using the company’s backflush accounting system.

Solutions/ Discussions:

• The transactions are to be recorded as follows (amounts in currency units):

Transactions Accounts Dr. Cr.

c. Raw materials purchases Raw and in process 130,400
Accounts payable 130,400
b. Incurrence of conversion costs Conversion costs 62,000
Accounts payable, etc. 62,000
c. Finished goods completed. No entry
d. Materials are backflushed to the Cost of goods sold 126,500
cost of goods sold and is Raw and in process 126,500
computed as follows:
DM, Beginning P 2,000
DM, Purchases 126,000
- DM Ending 1,500
DM used (to be backflushed) P 126,500
e. To close conversion costs to cost Cost of goods sold 62,000
of goods sold Conversion costs 62,000
f. Adjustment to RAIP account on Cost of goods sold 300
conversion costs Raw and in process 300
(DM (900-600)

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 process of production. The cost of materials used is backflushed to the
cost of goods sold on 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 – Materials Receipts 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 (RAIP) account to keep tract 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 2019:

Raw materials purchases

Direct materials 12,000 lbs. @ P 10, P 126,000
Indirect materials P 4,400
Production costs with 3,000 units
Other conversion costs P 62,000
Beginning and ending balances:

RAIP FG
Beginning balances Direct materials 2,000 3,100
Conversion costs 900 1,200
Total 2,900 4,300
Ending balances Direct materials (1,500) (4,200)
Conversion costs (600) (2,200)
Total 2,100 6,300

Required: Record the foregoing transactions using the company’s backflush accounting system.

Solutions/ Discussions:

• The transactions are to be recorded as follows (amounts in currency units):

Transactions Accounts Dr. Cr.

d. Raw materials purchases Raw and in process 130,400
Accounts payable 130,400
b. Incurrence of conversion costs Conversion costs 62,000
Accounts payable, etc. 62,000
c. When goods are completed, the Finished goods 126,500
materials are backflushed to the Raw and in process 126,500
finished goods inventory with its
cost computed as follows:
DM, Beginning P 2,000
DM, Purchases 126,000
- DM Ending 1,500
DM used (to be backflushed) P 126,500

d. To close conversion costs to cost Cost of goods sold 62,000

of goods sold Conversion costs 62,000
e. Transfer of finished goods to cost Cost of goods sold 128,100
of goods sold computed as Finished goods 128,100
follows
FG, Beginning P 3,100
+ Materials backflushed 126,500
- FG, Ending 1,500
FG transferred to CGS P 128,100
f. Adjustment to RAIP and FG Finished Goods 1,000
balances on conversion costs Cost of goods sold 700
(DM (900-600) Raw and in process 300
FG (1,200 – 2,200)

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 process of production. The cost of materials used is backflushed at the
point of completing the production. Finished goods inventory account is maintained and is later transferred
to the cost of goods sold account when the goods are already sold. Conversion costs are recorded at the date
of incurrence.
Standard costing and backflush accounting

Standard costing must be used in the backflush accounting. This could be conveniently used because the
strategic contracts with accredited suppliers predetermine the prices of materials input. If there is a variance
between the actual input costs and standard input costs, such shall be charged to operating inefficiencies and
errors, and be closed directly to expenses. This approach follows the overriding principle that inefficiencies,
errors, and similar items shall not be capitalized but should be expensed when incurred.

Throughput Accounting
The Theory of Constraints (TOC)

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.

The Theory of Constraints has a five-step procedure as follows:

1. Identifying constraints.
2. Exploiting the binding constraints.
3. Subordinating everything else to the decisions made in the second step.
4. Increasing the capacity of the binding constraints.
5. Repeating the process when new binding constraints are identified.

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 bottleneck 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 the point 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-layouting 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
process 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 a case, the overall plant
becomes the bottleneck in responding to customer demands.

TOC and the drum-buffer-rope system

TOC aims to operate in a drum-buffer-rope system. The bottleneck (drum) dictates the overall pace of the
work. Stock is only allowed to build up in finished goods and in front of the bottleneck to act as the buffer,
which allows the crucial function to continue even if there are breakdown upstream. The rope links all
upstream operations to the pace of the bottleneck, to keep those at the front-end of the production process
from producing out more than the bottleneck can handle.

Taking the bottleneck (or the drum) as the center point in the production process, all activities preceding the
bottleneck operations are considered downstreams and all activities subsequent to the bottleneck operations
are considered upstreams. The downstream operations should be maintained to operate up to the limiting
capability of the bottleneck while the upstream operations could operate more than limiting factors capability.
TOC Costs

In the process of analyzing the cost of production, TOC identified following types of costs:
• Throughput or Throughput contribution. It is the difference between the revenues and completely
variable costs which refer to direct materials costs only. Direct materials costs include purchased
components and materials handling costs. Take note, direct labor is not considered as a variable cost
but rather as a fixed cost.
• Conversion costs. It includes all manufacturing costs except direct materials that are needed in
manufacturing a product. Take note, direct labor is not considered as a variable cost but rather as a
fixed cost. Direct labor cost tends to more fixed than variable in the present manufacturing set-up.
• Operating expenses. It encompasses all costs of business operations except direct materials. It includes
conversion costs, selling expenses, and administrative expenses.
• Investments. It includes all stock, raw material, work-in-process, finished goods, research and
development costs, equipment, building, etc.
The aim of the TOC is increase throughput contribution while decreasing conversion costs and investment.
Throughput Accounting (TA)

In 1989, Galloway and Waldron developed throughput accounting from the theory of constraints. TA
considers only direct materials as the cost of the production process and treats all the other costs of production
as expenses. It considers direct materials as the only pure variable costs. The total cost of production process
(i.e., cost of direct materials purchases) is deducted from revenues regardless of the number of units sold, and
the difference is called the throughput. Labor costs have been considered fixed and are included as part of
indirect costs (i.e., factory overhead).

Profit = Throughput – Operating expenses

Profit = (Sales – Direct Materials) – Operating expenses

With this accounting environment, there is no value allocated to the remaining stock on hand. The philosophy
is all the goods are to be delivered to the customers anyway and the stocks on hand would not stay long in the
custody of the enterprise.

To illustrate the effects of throughput accounting, let us consider the following:

Sample Problem 10. Throughput Accounting, Profit Computation

Francis Beau Manufacturing uses throughput accounting and provides the following information on January
2019:
Production in units 20,000
Sales in units @ P 40 18,000
Beginning inventory 5,000
Materials purchases 34,000 lbs. @ P 12
Variable conversion costs (including
labor of P 1.20 per hour) 12,000 hrs. @ P 6
Fixed factory overhead based on the
normal capacity of 10,000 hrs. P 120,000
Marketing and Administration expenses P 60,000

Required: Determine the profit using the throughput accounting.

<
Solutions/ Discussions:
• The company’s profit using the throughput accounting system is computed as follows:

Sales 18,000 x P 40 P 720,000

- Direct materials costs 32,000 x P 12 408,000
Throughput 312,000
- Operating expenses
Variable conversion costs 12,000 x P 6 P 72,000
Fixed factory overhead 120,000
Marketing and administrative expenses 60,000 252,000
Profit P 60,000
The emphasis of Throughput Accounting

TA is not only concerned on recording transactions and details. It follows clear strategy on which element of
the production process should be emphasized. It emphasizes throughput first, stock minimization second,
and cost control third.

Throughput is the difference between sales and materials costs. The emphasis to throughput is analyzed in
relation to the bottleneck. In TA, bottleneck refers to the key or the limiting factor that restraint the capacity
of the enterprise to produce more goods and services.

The return per bottleneck

The return per time period is basically a measure of throughput per time spent in producing the product. It
is computed as follows:

Return per bottleneck time = (Sales – Materials cost) / Time period

= Throughput / Minutes on bottleneck resource

This ratio measures the profitability of a throughput per time of a bottleneck. If the bottleneck operations are
used to produce two or more products, the aim is to keep the bottleneck operating at 100% performance,
and if possible find ways to alleviate the constraint.

Sample Problem 11. Return per Time Period

Sampaloc International Enterprises produces two products and found out that its most restraining
manufacturing bottleneck is its limited machine hours in the Cutting Department. Selected data are assembled
as follows:
A B
Unit sales price P 120 P 80
Unit direct materials cost 30 20
Direct labor cost per minute 4 3
Factory overhead cost per minute 3 1
No. of minutes spent in the cutting department per product 30 15

Required: Determine the return per time period per product on the bottleneck.

Solutions / Discussions:

• The return per minute in the cutting department, the identified most constraining production
bottleneck, is:
A B
Unit sales price P 120 P 80
- Unit direct materials cost 30 20
Throughput 90 60
/ Minutes used 30 15
Return per bottleneck minute 3 4
Expense per minute (DL + FOH) 7 4
Throughput accounting ratio 0.43 1.00
Rank (2) (1)

• The return per bottleneck minute reflects the profit potential of a product per limiting time of the
bottleneck. The higher the return per minute would mean the more prioritized the product is in
terms of using the limiting time.

• In case the enterprise finds ways to increase its available machine hours in the Cutting Department,
then such increase in machine time should be allocated first to product B, it having a higher return
per bottleneck time.

• The more effective measure in throughput accounting is the Throughput Accounting Ratio (TAR).
It is the “return per bottleneck” (RPB) divided by the “expense per bottleneck” (EPB).
Throughput cost and effectiveness measures

Some throughput cost and effectiveness measures are as follows:

TA Ratio = Value-added per time period / Conversion cost per time period
= (Sales – Materials costs) per time period / (Labor + Overhead) per time period
= Return per bottleneck time / Conversion cost per bottleneck time

In a profitable operations, this ratio is normally greater than one. The aim is to increase this ratio as
acceptably as possible. If a product has this ratio lower than one, the organization loses money every time it
is produced.

Current effectiveness ratio = Standard minutes of throughput achieve

Minutes available

Effectiveness is an important ratio. This ratio measures effectiveness and compares it to a current standard.

Customer Profitability Analysis

A new trend in management accounting is to determine accurate costing per customer, not only per product,
to be informed on profitability per customer. This is called as the customer profitability analysis (CPA).
Customer profitability analysis measures the value of transactions with customers by detailing the related price
and costs in order to know the level of profitability and take needed managerial actions to improve the overall
performance of an enterprise.
Each customer needs, or sometimes demands, specific service to get acceptably satisfied. Customers may be
classified as diagrammed in Fig. 4 shown below:
Fig. 4. Customer Classification
CUSTOMER CLASSIFICATON
High
Demanding Service conscious
Cost to
supply
customer
Price conscious Accepting
Low
Low High
Price customer is willing to pay

The objective is to serve accepting customers with corresponding low cost of service perhaps because they
are located close by or do not place rush orders, and are prepared to accept high price. Many large retail
organizations belong into the demanding category and expect that suppliers are willing to accommodate rush
orders, change production methods that suit their specifications, and so on.
Profitability can vary between different customers because various overhead costs are, to some extent, variable
or customer-driven, such as : quality control, merchandising, sales force (e.g. telesales are cheaper and more
time efficient than a sales field force), discounts (e.g., retrospective discounts), distribution, purchasing,
promotions, financing costs, and inquiries.
Sample Problem 12. Customer Profitability Analysis
The Cost and Management Accounting Department of CPA Company provided the following information
its four customers as to price, service activities, and related cost of each activity as follows:
A B C D
Costs Costs per activity
Selling price, net of discount P 25 P 23 P 21 P 22
No. of units sold 60,000 80,000 100,000 70,000 Product handling P 0.10 per unit
No. of sales visits 2 4 6 5 Sales visit P 210 per visit
No. of purchase orders 50 20 40 20 Order placing P 60 per order
No. of deliveries 10 15 25 14 Normal delivery cost P 2 per km
Kilometers per journey 20 30 10 50 Rushed delivery cost P 200 per delivery
Required:
1. What is the profitability percentage for each customer?
2. How would you rant the customers in order of profitability?
3. Draw the customer profitability curve. Comment on the customer profitability curve.
Solutions/ Discussions:
1. & 2. The customer profitability analysis is presented below.
A B C D
Revenue Units x USP P 15,000 P 18,400 P 21,000 P 14,400
Costs
Sales visits P 210 x P 2, etc. 420 840 1,200 630
Order processing P 60 x 30, etc. 1,800 1,200 2,400 1,200
Product handling P 0.10 x 60,000, etc. 6,000 8,000 10,000 7,000
Delivery P 2 x 20 x 10, etc. 400 900 500 1,400
Rush deliveries P 200 x 1, etc. 200 400
Total 8,620 10,940 14,360 10,630
Operating profit P 6,380 P 7,460 P 6,640 P 3,770
Profitability ratios 43% 41% 32% 26%
Ranking 1 2 3 4

3. The customer profitability curve shall be depicted based on the following tabulated data:
Rank Product Marginal Profit Units sold Cumulative Cumulative
Units Sold Percentage
1 A P 6,380 60,000 60,000 19
2 B 7,460 80,000 140,000 45
3 C 6,640 100,000 240,000 77
4 D 3,770 70,000 310,000 100

The marginal profit is graphed below to depict the behavior of the customer profitability, to wit:
Fig. 5. Customer Marginal Profitability Curve

It could be easily observed that the customer profitability curve depicts the Pareto analysis where almost 80%
of the customers served account for high marginal profitability. This means that about 20% of the customers
served should be improved either by finding ways to reduce the costs involved in serving them, increasing the
number of units delivered, or the possibility of increasing the unit sales price, net of discounts. The option of
dropping low-margin customers may not be technically feasible either because it contradicts the existing
customer strategy of the business, or the presence of some complementary effects to other customers.

Statistical Control Techniques and Other Quantitative Techniques

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 effective operations.
These techniques include lines (e.g. regression line, line graph, etc.) graphs (e.g., bar graph, histograph, etc.,),
dispersion or deviations (.g., such as those expressed in x-graph, r-graph, p-graph, etc.), and other related
analysis that are conveniently used to identify and describe patterns ad potential problems in the business
operations.
An advanced use of statistical control techniques to improve operations is the six-sigma analysis. “Six Sigma
at many organizations simply means a measure of quality that strives for near perfection. It can be called “Six-
Sigma,” or it may have a generic or customized name for the organization like “Operational Excellence”,
Zero Defects”, or “Customer Perfection.” Six Sigma is a disciplined, data-driven approach and methodology
for eliminating defects (driving toward six standard deviations between the mean and the nearest specification
limit) in any process – from manufacturing to transactional and from product to service.
(https://www.isixsigma.com)
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.

Reference:

Management Services, 2019 Edition by Franklin T. Agamata, MBA, CPA