Foundations of Management 2

Financial Control and Governance (MG459)

Week 5: Determining the Cost

of a Product or Service

Yally Avrahampour, Ph.D.

Associate Professor (Education)

12th February 2024

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 Foundations of Management 2: Sessions
Week 1: Making Business Decisions that Commit Capital
Reporting
Week 2: Representing a Firm’s Financial Condition: 1 To users of
Accounts
Week 3: Representing a Firm’s Financial Condition: 2

Week 4: Operations Management and Inventory Management Measuring

and
Managing
Week 5: Valuing and Managing Costs
Costs

Week 7: Financial Ratios and Social Return on Investment

Measuring
Performance
Week 8: Balanced Scorecard and Economic Value Added

Week 9: Occupations, Professions and Expertise Management

and the
setting of
Week 10: Individual and Institutional Investors In a Historical Context
standards
relating to
Week 11: Organization and Management Theory governance.
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 Outline of Lecture
1) Introduction
- Introducing management accounting and costing
- Historical overview: management accounting and costing
- Direct vs. Indirect and Flexible vs. Committed costs

2) Alternative methods for dealing with indirect costs (‘overheads’)

- Absorption (‘traditional’) costing, with example.
- Direct costing, with example.
- Activity Based Costing (ABC), with example.

3) Is greater precision always better? Introducing a behavioural perspective.

4) Costing for the environment

5) Summary

6) Appendices and case discussion: John Deere (A & B) case

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 Primary Functions of Management Accounting
There are three primary functions of management accounting:

1) Capital Budgeting – is an investment worthwhile? (Please see week 1)

2) Costing – what is the cost of a product or service? (Today)

3) Performance Measurement – how well has an investment performed? How

good has the management been? (Please see weeks 7 and 8)

Through our investigation of costing and performance measurement, we will

outline a perspective known as ‘Value Based Management’.

We will also examine critical engagements with Value Based Management

drawing on contrasting theoretical frameworks.

We will consider performance measurement in the context of firms social or

environmental objectives.
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 Deriving the Cost of a Product or Service
Our key question: ‘How do we determine the cost of a product (service) given
that production (provision of a service) involves overhead costs?’

The answer to this question assists in answering the following questions:

- What mix of products and / or services do we offer to which

customers?

- How do we enhance the productivity of our operations?

- How can we develop our strategy to better compete against rival

firms?

- What are the costs we disclose for financial accounting purposes?

Importantly, the financial accounting objective may conflict with the various
objectives associated with management accounting. Kaplan (1984) outlines
one view of how this is so.

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 Kaplan’s History of Management
Accounting (Kaplan 1984)
Initially, cost accounting appeared in various stages of development
in the early 19th century with the creation of textile mills and armouries, in the
mid and late 19th century with railroads the steel industry and retailers.

Greatest development in costing technique was concurrent with the rise of

scientific and systematic management between the 1880s and the 1920s.

Kaplan (1984) and Kaplan & Johnson (1987) argue that the development of
management accounting during this period reflected fundamental
improvements in managing companies that were later neglected.

‘There have been virtually no major innovations by practicing managers or

management accountants during the most recent 60 years to affect
contemporary management accounting thought.’ (Kaplan 1984:401)

See Kaplan, R. (1984) ‘The Evolution of Management Accounting’ The Accounting Review Vol. 59. No. 3:390-
418. See also Kaplan & Johnson (1987) ‘Relevance Lost’ for a fuller discussion.
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 Kaplan’s Explanation of Lack of Innovation
in Management Accounting
1) Exploiting accounting conventions: As financial accounting standards
developed, managers attention was diverted to earnings management arising
from the flexibility inherent in historical cost accounting conventions.

2) Financial entrepreneurship: instead of generating earnings through

production, managers increased earnings by engaging in financial transactions
such as mergers and acquisitions.

3) Reducing discretionary expenditures, including investment in the firm.

The internal management function became ‘subservient to external reporting.’

Kaplan (1984:409)

Kaplan, over the following three decades contributed to the development of

Activity Based Costing and the Balanced Scorecard, which together with
Economic Value Added partly comprise ‘Value Based Management’, which we
will study.
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Direct vs. Indirect and Committed vs. Flexible Costs
(Kaplan & Atkinson 2014:13-14)
Flexible costs:
“Costs associated with the
use of flexible resources.
The actual level of activity
used to make products
and serve customers
determines the quantity of
flexible resources used.”
Committed costs:
“Costs associated with
resources that are
acquired or contracted for
in advance of when the
work is actually done… are
unaffected by how much
the organization uses the
resource.”
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Direct costs:
“Costs that are
unambiguously linked to
the production
of a particular output.”
Examples: Materials,
labour.
Examples: Machine or
labour that is dedicated to
the production of only one
type of product.
Indirect costs:
“The cost of capacity that
provides services to more
than one product.”
Example: Power costs for
running machines, handling
materials, cost of setting up
machines, fuel used in
vehicles used to deliver
goods to customers.
Examples: Head office
costs, communication
systems, depreciation on
buildings and equipment,
amortization on intangibles.
 Absorption Costing

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 Production and Service Departments
‘Production departments’ directly produce or distribute the firm’s output.

Examples: Machining centres, assembly departments, data transport

departments, check processing.

‘Service departments’ provide services to production departments.

Examples: utilities, maintenance, purchasing, scheduling, production

control, stockroom, materials handling, housekeeping, customer order
handling and information systems.

Service departments consume resources in relation to multiple products.

The allocation of indirect costs seeks to assign the costs that are
associated with service departments (‘overheads’) to production
departments and to products or services.
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 Cost Control Objectives in Assigning Service
Department Costs
Assigning service department costs provides incentives for:

1) Managers of service departments to operate efficiently

- Adding a charge to the final product that reflects the cost of the service
department provides signals on service department efficiency.

- Assigning a price to the service provided by the service department

facilitates comparison with externally sourced services.

2) Managers of production departments to efficiently utilize service department

outputs.

- Managers of production departments incur costs for using a service

department and therefore their demand is rationed.

- Managers have information with which to negotiate with the service

department with respect to price / quality.
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Absorption Costing and the Allocation of Service Department
Costs to Production Department
‘Allocation’ is the process of assigning a resource cost to a department or
product when a direct measure does not exist for the quantity of the resource
consumed by the department or product.

In traditional costing the allocation of indirect costs to a department takes place

with reference to the proportion of a certain direct cost incurred by that
department.

For example, ‘direct labour hours’, refers to the proportion of total hours worked
that are attributable to a particular department to which the indirect cost is
allocated.

Example: The monthly cost for Service Department S is $1,000,000. The total
number of hours worked within the plant is 100,000. Within Department D
50,000 total hours were incurred. Therefore allocation of indirect costs to
Department D = 50,000 hrs / 100,000 hrs x $1,000,000 = $500,000.

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There are Various Cost Drivers for Allocating Costs
A ‘cost object’ is a product or service whose production generates costs.

A ‘cost driver’ is the measure used to allocate indirect costs to cost objects.

The selection of a particular driver to assign indirect cost to a product depends

on the nature of the business.

Direct labour dollars ………………... Manual assembly

Direct labour hours

Machine hours ………………….…… Automatic machines

Units produced

Materials processed…………...... Continuous use of resource

A cost system with 1000’s of cost centres uses many different cost drivers
through which indirect costs are allocated.

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 Example: Costing in a Three Product Firm
Product A Product B Product C Total
Units sold 20,000 15,000 5,000
Direct material cost 2,500 2,300 2,000
Direct labour cost 1,400 2,100 700
Labour Hours / unit 2 3 1 90,000
Machine Hours / unit 1 2 5 75,000
Production batches 2 4 6 12
Sales orders 10 18 20 48
Purchase orders 20 15 25 60

Indirect wages $33,000,000

Depreciation $85,000,000
Materials & tools $17,000,000
Total Indirect costs: $135,000,000

Our task now is to allocate the total indirect costs to the three products, using
labour hours as the cost driver.
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 Example Continued
Product A Product B Product C
Direct material cost 2,500 2,300 2,000
Direct labour cost 1,400 2,100 700
Indirect cost 3,000 4,500 1,500
Total 6,900 8,900 4,200

Product A: $135,000,000 indirect costs / 90,000 direct labour hours =

overhead rate of $1,500 / direct labour hour
$1,500 x 2 labour hours / unit = $3,000

Product B: = 135,000,000 / 90,000 x 3 = $4,500

Product C: = 135,000,000 / 90,000 x 1 = $1,500

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 The ‘Jointness’ of Overhead Costs
Example: I take a tourist trip. The train ride costs £20. Suppose I wish to
allocate the overhead cost associated with travel between sightseeing and
shopping.

Perhaps the relative time spent on sightseeing and shopping might be a basis
for allocating the overhead.

Suppose I spend 50% of the time sightseeing. I might allocate £10 of overhead
to the cost of sightseeing.

However, there is no direct cause-and-effect relationship between the time

spent sightseeing and the allocation of overhead cost to this activity.

If I could pay £10 (instead of £20) for travel on the condition that I did not do
any sightseeing, and nevertheless chose to pay £20, there would be a
relationship between the allocation of £10 overhead to sightseeing and the fact
that I do sightseeing.
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 Direct Costing

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 Direct Costing in a Multi-Product Firm
Product A Product B Product C
Revenue Revenue Revenue

minus minus minus

Direct cost Direct cost Direct cost

yields yields yields

Contribution Contribution Contribution

Total
Contribution

Total contribution – Indirect cost = Profit

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 Example: Direct Costing in a Three Product Firm
Product A Product B Product C Total
Units sold 20,000 15,000 5,000
Direct material cost 2,500 2,300 2,000
Direct labour cost 1,400 2,100 700
Labour Hours / unit 2 3 1 90,000
Machine Hours / unit 1 2 5 75,000
Production batches 2 4 6 12
Sales orders 10 18 20 48
Purchase orders 20 15 25 60

Indirect wages $33,000,000

Depreciation $85,000,000
Materials & tools $17,000,000
Total Indirect costs: $135,000,000

See ‘Labro, E. (2006) ‘Analytics of Costing System Design’ in Bhimani, A. ed. Contemporary Issues in
Management Accounting p. 217-242 (Available as e-book through the LSE library).
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 Costing in a Three Product Firm: Direct Costing
• Direct costing does not allocate indirect costs to products.
• Rather, the direct costs are related to the price at which the product is sold, to calculate
the product’s “contribution” towards recouping the firm’s indirect costs and generating a
profit.

• Example: A firm making three products incurs direct costs relating to the cost of
the material and labour for each product.

Product A Product B Product C

A) Units sold 20,000 15,000 5,000
B) Price / unit 7,500 8,500 5,000
C) Direct material cost / unit 2,500 2,300 2,000
D) Direct labour cost/ unit 1,400 2,100 700
E) Total Direct Cost / unit (C + D) 3,900 4,400 2,700
F) Contribution / unit (B - E) 3,600 4,100 2,300
Total Contribution (A x F) 72,000,000 61,500,000 11,500,000

Cumulative Contribution: $145,000,000 (=72,000,000 + 61,500,000 + 11,500,000)

- Total Indirect Costs $135,000,000
= Profit $10,000,000.
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 Direct Costing
and Idle Capacity

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 Example: Use of Idle Capacity
The rule of direct costing is that all opportunities should be accepted
provided that they make a positive contribution towards indirect costs
and profits.

For example, a firm has the following financial results for making
Product A:

Revenue $10,000
Less Direct cost of goods $6,000
Contribution $4,000
Less Indirect cost $3,000
Profit $1,000

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 Idle Capacity Example cont.
The firm can produce product B, which does not increase indirect costs.
If the cost of product B was estimated on a total cost basis where it
absorbed its share of indirect costs (for example, calculated as a
proportion of revenue) product B would not be produced:

Revenue $2,000
Less Direct cost of goods $1,600
Contribution $400
Less Indirect cost $500 (=2,000 / (2,000 + 10,000) x
3,000)
Profit -$100

Since the firm would pass on the opportunity to manufacture this

product, its profit would remain $1,000.
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 Idle Capacity Example cont.
However, if focus is placed on the contribution made by product B, it
would be produced and the firm’s profits increased.

Product A Product B Total

Revenue $10,000 $2,000 $12,000
Less Direct cost $6,000 $1,600 $7,600
Contribution $4,000 $400 $4,400
Less Indirect cost $3,000
Profit $1,400

Direct costing may be said to use the resources and the capacity of
the firm to produce and sell the maximum possible quantity of
products, yielding the greatest possible contribution.

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 Problems with Direct Costing
Direct costing does not usefully distinguish between the consumption
of indirect costs, “overheads” by different products.

Consequently, direct costing will not discriminate between two products

with the same direct costs but different effects on indirect costs.

There is therefore no guarantee that total indirect costs will be fully

covered by the cumulative contribution.

Also, when a salesforce is negotiating prices with potential customers,

direct cost figures may lead to excessively low quotations.

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 Activity-Based Costing

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 Activity-Based Costing (ABC)
Activity based costing links resource consumption to activities, establishing a
direct causal link between manufacture and cost.

Instead of allocating service centre costs to production centres ABC attributes

the costs associated with particular activities to products or clients.

‘Attribution is the process of assigning a cost that is unambiguously

associated with a particular cost object to that particular cost object’ (Kaplan &
Atkinson 2014:63).

Thus, ‘The goal of ABC is not to allocate common costs to products. The goal
is to measure and then price out all the resources used for activities that
support production and delivery of goods and services to customers’ (Kaplan
& Atkinson 2014:97)

The determination of cost reflects determination of activities that are both

production centre and service centre activities.

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 Activity-Based Costing

1) Resource Indirect Labour

Resource
Driver
Inspect
2) Activity Move Maintain Setup Prepare
Incoming
Materials Machines Machines Tooling
Materials

Activity No. of No. of Maintenance Setup No. of

Cost
Driver
Receipts Moves Hours Hours Setups

$/ $ / $ / Maintenance $ / Setup $/
Receipt Move Hour Hour Setups

3) Product /
Service /
Customers

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 Hierarchy of ABC Activities
Unit level activities represent work performed for every unit of product
or service produced. The quantity of resources used by unit-level
activities is proportional to products’ production and sales volumes.

Cost drivers for unit-level activities include labour hours, machine hours
and materials quantity processed.

However, Activity-Based Costing recognizes that support activities do

not only increase unit by unit in relation to increases in volume.

Rather, there is a hierarchy of activities as unit, batch, product and

customer sustaining levels.

These levels capture the fact that different activities consume resources
differently.

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 Levels of Activities Above the Unit Level
Batch-level activities include setting up a machine for a new production run,
purchasing materials, and processing a customer order.

Resources required to perform a batch-level activity are independent of the

number of units in the batch. For example, the number of components
produced after a setup does not influence the cost of setting up.

Product-sustaining activities represent work performed to enable the

production of individual products (or services) to occur.

For example, within Proctor and Gamble, environmental improvements to the

detergent products are associated just with that product line and not, say, the
potato chip product line.

Customer- sustaining activities represent work that enables the company to

sell to an individual customer, but that is independent of the volume and mix of
the products (and services) sold and delivered to the customer.

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 Costing example revisited

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 Three Product Firm Example - ABC
Activity Activity Driver Indirect Wages Depreciation Materials

Assembly Machine hours 12,000,000 58,000,000 5,000,000

Reception Purchaser orders 9,000,000 2,000,000 1,000,000
Set up No. of batches 6,000,000 15,000,000 3,000,000
Wrapping Sales orders 6,000,000 10,000,000 8,000,000
Total 33,000,000 85,000,000 17,000,000

Total indirect costs = 135,000,000

Example: calculating the reception cost of product A.

Total cost of reception = 12,000,000 (=9,000,000 + 2,000,000 + 1,000,000)

The number of purchase orders, the activity cost driver = 60 (see slide 14)
The activity cost driver rate = 12,000,000 / 60 = 200,000
The indirect cost allocation to product A, which consumed 20 purchase orders =
20 x 200,000 = 4,000,000
Reception cost / units of product A = 4,000,000 / 20,000 units = 200.
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 Example Continued
Product A Product B Product C
Direct material cost 2,500 2,300 2,000
Direct labour cost 1,400 2,100 700
Assembly 1,000 2,000 5,000
Reception costs 200 200 1,000
Set-up costs 200 533 2,400
Wrapping 250 600 2,000
Total 5,550 7,733 13,100

Comparison of product costs under absorption costing and ABC:

Product A Product B Product C

Absorption costing 6,900 8,900 4,200
Activity based costing 5,550 7,733 13,100
% Difference -20% -13% + 212%
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 Is More Accurate and Precise
Measurement Always Better?

Two Behavioural Arguments

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 Hiromoto (1988): Costing as Influencing,
versus Informing
Using direct labour as the means through which to allocate overhead costs in
absorption costing enables managers to enforce discipline and promotes
automation.

Overhead surcharges are added to products using non-standard parts to

promote standardization and reduce the cost of purchasing parts.

Beginning at the design stage and throughout the manufacturing process,

cost determination is a means of setting and lowering cost benchmarks.

Instead of optimizing within given cost constraints, the aim is to change the
constraints.

Management accounting thus supports the firm’s innovation objectives.

Hiromoto, T. (1988) ‘Another Hidden Edge – Japanese Management Accounting’ Harvard Business Review (July
– August)
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 Merchant & Shields (1993)
Distinguish between cost measures that are biased either upwards or
downwards and imprecision where the direction of the bias is unknown.

Biasing Costs Upwards: Overstating product costs (‘padding’) enables

the firm to retain product margins when sales agents wish to discount
heavily.

Biasing Costs Downwards: 1) Understating costs emphasizes the need

for cost reduction, improving the firm’s competitiveness.

2) Understating costs stimulates demand of services, e.g. IT and audit.

Additionally: directing managers’ attention and motivating managers is

most effective when using a small number of cost drivers.
Merchant, K. & Shields, M. (1993) ‘When and Why to Measure Costs Less Accurately to Improve Decision Making’ Accounting
Horizons Vol. 7 No. 2:76-81
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 Allocation of Environmental Costs
to Products or Services

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 Allocating Environmental Costs to Products
• Macve (1997) identifies two additional tiers relating to the
environment.

• Tier 0: Direct costs only

• Tier 1: Tier 0 + indirect costs
• Tier 2: Tiers 0 + 1 + legal liability costs
• Tier 3: Tiers 0 + 1 + 2 + intangible costs and benefits

• Tiers 2 and 3 reflect the different ways that environmental costs

can feature within the cost of a given product.

• This is also an attempt to be strategic and forward-looking and

consider the types of cost that may currently be ignored, but that
might in the future be part of the cost of products and services.

• For example, legal liability costs that may emerge in the future.
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 Summary

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 Summary
In today’s lecture we first introduced management accounting. We
summarized Kaplan’s account of the evolution of management accounting.

Second, we compared three methods for costing products in a context where

overheads need to be allocated between multiple products within a single firm.

These were: 1) Absorption Costing, 2) Direct costing and 3) Activity Based

Costing.

Until this point, the assumption was that more accurate and precise costing
methods are superior.

We examined two accounts adopting behavioural theories challenging this

assumption.

Case Discussion: John Deere Component Works (A and B)

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 Seminar

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 The John Deere (A) Case
In the seminar we will compare absorption and Activity Based Costing
methods.

Please answer the following questions (also available on the course outline)

1. How did the competitive environment change for the John Deere
Component Works between the 1970s and the 1980s?

2. What caused the existing cost system to fail in the 1980s? What are the
symptoms of cost system failure?

3. How were the limitations of the existing cost system overcome by the
Activity Based Costing (ABC) system?

4. Compare the cost of product A103 (see Exhibit 5) under the existing cost
system and under the ABC approach.
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 Appendix 2:

Data Gathering in
Activity Based Costing

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 Gathering Data on Activities
Data on the cost of different activities is gathered through:

- Interviews
- Surveys
- Activity dictionaries

The degree of acceptable approximation depends on cost and the

objective of the costing exercise.

Greater precision is required for productivity enhancements than for

costing products, services and customers.

‘One does not need extensive time and motion studies to link
resource spending to activities performed. The goal is to be
approximately right, rather than precisely wrong, as a virtually all
traditional product costing systems.’ Kaplan & Atkinson (2014:99)

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 Appendix 3: Target Costing

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 Target Costing
Target costing works back from the requirements of customers to
designing a product and a production process.

Given fixed requirements relating to customer price, quality and

functionality, target costing designs a process that allows the product to
be manufactured profitably for the firm.

Designing a production system that produces at lower costs than would

be achieved by imitators, so as to retain market leadership even after
low cost imitators enter the market.

Target costing may be seen as a response to intensifying global

competition, where firms no longer have time to recoup high set up
costs.

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 Target Costing and Cross-Functional Teams
Target costing provides a framework around which cross-functional
teams (e.g. market researchers, manufacturing engineers, designers)
discuss the manufacturing process.

This creates a context in which different groups, with different

priorities, tastes and professional objectives seek to cooperate.

This process increases clarity regarding the firm’s product development

goals.

The aim is to change the behaviour of participants in the organization

(see the OB course).

Target costing also highlights how overhead costs can also be allocated
so as to induce behaviour that reduces direct costs.

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 The Iterative Target Costing Design Process
Product specification:
target price, profit
and cost

Major product and process

design changes

The target
Does costing
the design no process is
Product meet the target iterative
planning cost? until a design
phase is found
yes
with the
Estimate life
right
cycle cost
projected
costs.
Is projected no
life cycle cost
acceptable?

yes
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 Target Costing and Alternative
Costing Methods
Target costing is in principle compatible with both absorption /
direct costing approaches and Activity Based Costing.

Absorption / direct costing approaches: Once the product price-

functionality-quality targets have been set, planners subtract a target
profit from the target selling price. This profit is a contribution towards
the organization’s overheads. The residual is the target cost which
relates to direct costs.

ABC approach: combining target costing with ABC emphasizes the

need to reduce the consumption of resources supporting the
manufacturing activity and thus improve management of indirect
costs.
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