Part A

Specialist cost and management accounting techniques

1 Costing
2a Activity based costing
2b Target costing
2c Life cycle costing
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2d Throughput accounting
 Costing
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.

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

An Indirect cost or overhead is a 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.

Absorption costing is a means of incorporating a fair share of these costs into the cost of
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each unit of product manufactured or each service provided. This fair share should
include a portion of production overhead expenditure and possibly administration and
marketing overheads too. This is the view embodied in the principles of absorption
costing
 Practical reasons for using absorption costing

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a) Inventory valuations:- Inventory in hand must be valued for two reasons.
I. For the closing inventory figure in the statement of financial position
II. To calculate the cost of sales figure in the income statement

b) Pricing decisions

Many companies attempt to set selling prices by calculating the full cost of production or
sales of each product, and then adding a margin for profit.
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c) Establishing the profitability of different products

This argument in favour of absorption costing states that, if a company sells more than one
product, it will be difficult to judge how profitable each individual product is, unless
overhead costs are shared on a fair basis and charged to the cost of sales of each product.
Absorption costing is a traditional approach to dealing with overheads, involving three
stages: allocation, apportionment and absorption.

Using marginal costing to deal with the problem of overheads

For many planning and decision-making purposes, absorption costing is less useful as a
costing method than marginal costing. In some situations, absorption costing can actually
be misleading in the information it supplies.

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Advocates of marginal costing take the view that only the variable costs of making and
selling a product or service should be identified. Fixed costs should be dealt with separately
and treated as a cost of the accounting period rather than shared out somehow between units
produced.
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Over and under-absorption of overheads
Over- or under-absorbed overhead occurs when overheads incurred do not equal
overheads absorbed.

Over-absorption means that the overheads charged to the cost of production or sales are

greater than the overheads actually incurred.

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Under-absorption means that insufficient overheads have been included in the cost of

production or sales.
Marginal costing

In marginal costing, inventories are valued at variable production cost whereas in absorption

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costing they are valued at their full production cost. Profit is calculated by deducting
variable costs of sales from sales revenue to obtain contribution, and then deducting fixed
costs to obtain a figure for profit.

Marginal cost is the cost of one unit of a product/service which could be avoided if that unit
were not produced/provided.
Contribution is the difference between sales revenue and variable (marginal) cost of sales.
 Activity based costing (ABC)
Activity based costing (ABC) is a method of costing which involves identifying the costs of the
main support activities and the factors that 'drive' the costs of each activity. Support overheads
are charged to products by absorbing cost on the basis of the product's usage of the factor driving
the overheads.

The major ideas behind activity based costing are as follows.

(a) Activities cause costs. Activities include ordering, materials handling, machining, assembly,
production scheduling and dispatching.
(b) Manufacturing products creates demand for the support activities.
(c) Costs are assigned to a product on the basis of the product's consumption of these activities.
An ABC system operates as follows.
Step 1 Identify an organization's major activities that support the manufacture of the
organization's products or the provision of its services.
Step 2 Use cost allocation and apportionment methods to charge overhead costs to each of these
activities. The costs that accumulate for each activity cost center is called a cost pool.
Step 3 Identify the factors which determine the size of the costs of an activity/affect the costs of

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an activity. These are known as cost drivers.
A cost driver is a factor which has most influence on the cost of an activity.
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Step 4 For each cost pool/activity cost center, calculate an absorption rate per unit of cost
driver.
Step 5 Charge overhead costs to products for each activity, on the basis of their usage of the
activity (the number of cost drivers they use). Overheads are charged by absorbing them into
product costs at a rate per unit of cost driver.
Cost drivers
ABC focuses attention on what factors are most influential in determining the level of support
activity costs, i.e. the cost drivers. However, it is important to understand that activity based
costs should not be regarded as variable costs that vary with the volume of the cost driver
Merits of ABC
a) The complexity of manufacturing has increased, with wider product ranges, shorter
product life cycles and more complex production processes. ABC recognizes this
complexity with its multiple cost drivers.
b) In a more competitive environment, companies must be able to assess product
profitability realistically. ABC facilitates a good understanding of what drives overhead
costs.
c) In modern manufacturing systems, overhead functions include a lot of non factory floor
activities such as product design, quality control, production planning and customer
services. ABC is concerned with all overhead costs and so it can take management
accounting beyond its 'traditional' factory floor boundaries.
 ABC and decision-making

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Many of ABC's supporters claim that it can assist with decision-making in a number of ways.
» It provides accurate and reliable cost information.
» It establishes a long-run product cost.
» It provides cost data which may be used to evaluate different ways of delivering business.
It is particularly suited to the following types of decision.
» Pricing, where selling prices are derived by adding a profit mark-up to cost
» Promoting or discontinuing products or parts of the business, since ABC may help
management to identify activity costs that may be either incurred or saved
» Developing new products or new ways to do business, because ABC focuses attention on the
support activities that would be required for the new product or business procedure
ABC attempts to relate the incidence of costs to the level of activities undertaken. A
hierarchy of activities has been suggested.

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 Criticisms of ABC
a) Cost apportionment may still be required at the cost pooling stage for shared items of cost, such as
rent, rates and building depreciation. Apportionment can be an arbitrary way of sharing costs.
b) A single cost driver may not explain the cost behavior of all items in a cost pool. An activity may have
two or more cost drivers.
c) Unless costs are 'driven' by an activity that is measurable in quantitative terms, cost drivers cannot be
used. What drives the cost of the annual external audit, for example?
d) There must be a reason for using a system of ABC due to it must provide meaningful product costs or
extra information that management will use. If management is not going to use ABC information for
any practical purpose, a traditional absorption costing system would be simpler to operate and just as
good.
e) Implementing ABC is often problematic due to problems with understanding activities and their costs.
 Target costing
Target costing involves setting a target cost for a product, having identified a target selling price and a
required profit margin. the cost at which a product must be produced and sold in order to achieve the
required amount of profit at the target selling price. The target cost is the target sales price minus the
required profit. The aim of target costing is then to find ways of closing this target cost gap, and producing
and selling the product at the target cost.

Implementing target costing

Step 1 Determine a product specification of which an adequate sales volume is estimated.
Step 2 Decide a target selling price at which the organization will be able to sell the product
. successfully and achieve a desired market share.
Step 3 Estimate the required profit, based on required profit margin or return on investment.
Step 4 Calculate: Target cost = Target selling price – Target profit.
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Step 5 Prepare an estimated cost for the product, based on the initial design specification and current
cost levels.
Step 6 Calculate: Target cost gap = Estimated cost – Target cost.
Step 7 Make efforts to close the gap. This is more likely to be successful if efforts are made to 'design
out' costs prior to production, rather than to 'control out' costs after 'live‘ production has started.

Closing a target cost gap

The target cost gap is the estimated cost less the target cost. Increasing the selling price will not close
the cost gap. In a system of target costing, the total target cost is split into broad cost categories, such as
development, marketing and manufacturing. Then the manufacturing target cost per unit is split up
across the different functional areas of the product. The product is designed so that each functional
product area can be made within the target cost.
Management can then set benchmarks for improvement towards the target cost, by improving production
technologies and processes. Various techniques can be employed.
 Reducing the number of components
 Using cheaper staff
 Using standard components wherever possible
 Acquiring new, more efficient technology
 Training staff in more efficient techniques
 Cutting out non value added activities
 Using different materials (identified using activity analysis etc.)

Target costing in service industries

Target costing is difficult to use in service industries due to the characteristics and information
requirements of service businesses.
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Characteristics of services
Unlike manufacturing companies, services are characterized by intangibility, inseparability, variability,
perishability and no transfer of ownership.
Examples of service businesses include: (a) Mass service eg the banking sector, transportation (rail, air),
mass entertainment (b) Either/or eg fast food, teaching, hotels and holidays, psychotherapy
(c) Personal service eg pensions and financial advice, car maintenance

Problems with target costing for services

Some of the characteristics of services make it difficult to use target costing, and identify a target cost for
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a service having established a target selling price. A target cost for a product is a cost for an item whose
design and make-up is specified in exact detail in a product specification. A target cost is the cost for this
detailed specification. Services are much more difficult to specify exactly. This is due to some of the
characteristics of a service
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(a) Intangibility. Some of the features of a service cannot be properly specified because they are
intangible. What exactly does a customer receive, for example, when they go to a cinema? When
services are provided by a human, the quality of the personal service can be critically important for the
customer, but this is difficult or impossible to specify.

(b) Variability/homogeneity. A service can differ every time it is provided, and a standard service
may not exist. For example, repairing a motor car, providing an accountancy service, or driving a
delivery truck from London to Paris are never exactly the same each time. When services are variable,
it is possible to calculate an estimated average cost, but this is not specific and so not ideal for target
costing.
 Life cycle costs
Life cycle costing estimates the costs and revenues attributable to a product over its entire
expected life cycle.
The life cycle costs of a product are all the costs attributable to the product over its entire life, from
product concept and design to eventual withdrawal from the market.
The component elements of a product's cost over its life cycle could therefore include the

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following.
 Research and development costs

 Design costs  Cost of making a prototype

 Testing costs  Production process and equipment: development and investment

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 The cost of purchasing any technical data required (for example purchasing the right from
another organization to use a patent)
 Training costs (including initial operator training and skills updating)
 Production costs, when the product is eventually launched in the market
 Distribution costs (including transportation and handling costs)
 Marketing and advertising costs
 Customer service
 Field maintenance
 Brand promotion
 Inventory costs (holding spare parts, warehousing, and so on)
 Retirement and disposal costs, i.e. costs occurring at the end of a product's life, which may include
the costs of cleaning up a contaminated site.
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 Life cycle costs can also be estimated for services, customers and projects as well as for physical
products.
 Traditional cost accumulation systems are based on the financial accounting year and tend to
dissect a product's life cycle into a series of 12-month periods. This means that traditional
management accounting systems do not accumulate costs over a product's entire life cycle and do
not therefore assess a product's profitability over its entire life. Instead they do it on a periodic
basis.
 Life cycle costing is the accumulation of costs over a product's entire life.
 The purpose of life cycle costing is to assess the total costs of a product over its entire life, to assess
the expected profitability from the product over its full life. Products that are not expected to be
profitable after allowing for design and development costs, or clean-up costs, should not be
considered for commercial development.
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The benefits of life cycle costing

There are a number of benefits associated with life cycle costing.
(a) It helps management to assess profitability over the full life of a product, which in turn helps
management to decide whether to develop the product, or to continue making the product.
(b) It can be very useful for organizations that continually develop products with a relatively short life,
where it may be possible to estimate sales volumes and prices with reasonable accuracy.
(c) The life cycle concept results in earlier actions to generate more revenue or to lower costs than
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(d) Better decisions should follow from a more accurate and realistic assessment of revenues and
costs, at least within a particular life cycle stage.
(e) It encourages longer-term thinking and forward planning, and may provide more useful information
than traditional reports of historical costs and profits in each accounting period.
 Maximizing return over the product life cycle
Design costs out of products
Between 70% and 90% of a product's life cycle costs are determined by decisions made early in the life
cycle, at the design or development stage. Careful design of the product and manufacturing and other
processes will keep cost to a minimum over the life cycle.
Minimize the time to market
'Time to market' is the time from the conception of the product to its introduction to the market.
Minimize breakeven time (BET)
The sooner the product is launched the quicker the research and development costs will be repaid,
providing the organization with funds to develop further products. In life cycle costing, breakeven occurs
when revenue from the product has covered all the costs incurred to date, including design and
development costs.
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Theory of constraints
• Throughput accounting supports a production management system which aims to maximize throughput,
and therefore cash generation from sales. It is not concerned with 'traditional' measurements of profit of
maximization of this profit. A just in time (JIT) production system is operated, with some buffer inventory
kept only when there is a bottleneck resource inventory is the amount of money the system has invested in
purchasing things that it intends to resell within its finished products.
Throughput = Sales – Material costs
• Operational expenses, also known as factory expenses, are all the other costs of operations
• Theory of constraints (TOC) is an approach to production management which aims to maximize sales
revenue less material cost. It focuses on bottlenecks which act as constraints to the maximization of
throughput.
• Bottleneck resource or binding constraint is an activity which has a lower capacity than preceding or
subsequent activities, thereby limiting throughput.
• traditional cost accounting, improving efficiency and creating more inventory will increase profits.
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• the theory of constraints, using non-bottleneck resources above the amount required for maximum throughput
is wasteful. It does not increase throughput; it only increases unused inventory levels.

Goldraftt devised a five-step approach to summaries the key stages of TOC.

 Identify the constraint (bottleneck resource).
 Decide how to exploit the constraint in order to maximize throughput.
 Subordinate and synchronize everything else to the decisions.
 Elevate the performance of the constraint.
 If the constraint has shifted during any of the above steps, go back to step 1. Do not allow inertia to cause a new
constraint.
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The overall aim of TOC is to maximize throughput. This may be called 'throughput contribution' (sales revenue –
material cost) while keeping operational costs (all operating costs except material costs) and investment costs
(inventory, equipment, and so on) to a minimum.
Throughput accounting (TA) is an approach to production management which aims to maximize sales revenue less
materials cost, while also reducing inventory and operational expenses.
 Performance measures in throughput accounting
 throughput accounting environment, production priority is given to the products best able to generate
throughput.
 Performance measures in throughput accounting are based around the concept that the aim is to
maximize throughput. This is achieved by maximizing the throughput per unit of bottleneck resource.
 Throughput is maximized by ranking products in order for production and sales according to the
throughput that they earn per unit of bottleneck resource they consume.

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 The top-ranking product should be manufactured up to the limit of maximum sales demand.
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 The second ranking product should be made next up to the limit of maximum sales demand.
 The ratio for ranking products is therefore as follows.
Throughput return per factory hour=
 Throughput accounting ratio (TA ratio)
Is the ratio of the throughput per unit of bottleneck resource to the factory cost per unit of
bottleneck resource. This ratio should be as high as possible, and certainly more than 1.0.
Throughput accounting ratio= Throughput per unit of bottleneck resource
Factory cost per unit of bottleneck resource

 A TA ratio that is not much higher than 1.0 is barely profitable. The aim should be to
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achieve as high a TA ratio as possible.

 TA ratios can also be used to assess the relative earning capabilities of different
products. Products can be ranked in order of priority for manufacture and sale in order
of their TA ratios. (Higher TA ratios should be given priority over lower TA ratios).
 Throughput and limiting factor analysis

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Limiting factor analysis
 An organization might be faced with just one limiting factor (other than maximum sales demand) but there might also
be several scarce resources, with two or more of them putting an effective limit on the level of activity that can be
achieved.
 limiting factors include sales demand and production constraints
- Labor
- Material
- Manufacturing capacity
 marginal costing ideas are applied.
 The limiting factor decision therefore involves the determination of the contribution earned per unit of limiting factor
by each different product.
 If the sales demand is limited, the profit- maximizing decision will be to produce the top ranked product(s) up to the
sales demand limit.
 fixed costs are the same whatever product or service mix is selected, so that the only relevant costs are variable costs
Thanks
You
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