PART COSTING

B TECHNIQUES
ACTIVITY BASED COSTING (ABC)
Activity based costing is an extension of absorption costing specifically
considering what causes each type of overhead category to occur, i.e., what
the ‘cost drivers’ are. Each type of overhead is absorbed using a different
basis depending on the cost driver.

Absorption Costing
Traditional absorption costing uses a single basis for absorbing all
overheads into cost units. Traditional absorption costing systems:

Under-allocates overhead costs to low-volume products; over-

allocates overheads to higher-volume products.

Under-allocates overhead costs to smaller products; over-allocates

overheads to larger products.
Activity Based Costing
Activity-based costing aims to identify the activities which cause overhead
costs to be incurred and to apportion the overhead costs to each product
based on the use of the activities by each product.

Steps
1. Identify major activities within each department which create costs.
2. Create a cost pool for each activity.
3. Determine what causes the cause of each activity (Cost driver).
4. Calculate the absorption rate for each cost driver.
5. Calculate the total overhead cost for manufacturing each product.
6. Calculate the overhead cost per unit.

Cost Driver
Any factor, reason or base which generates overheads cost.
Reason which increases or decreases overheads.

Cost Pool
Total costs that accumulate for each activity for the company as a whole.

Overhead Costs and Possible Cost Drivers – Examples

Activity Possible cost driver

Ordering costs Number of orders
Materials handling costs Number of production units
Machine set-up costs Number of machine set-ups
Machine operating costs Number of machine hours
Production scheduling costs Number of production runs
Despatching costs Number of orders despatched

ABC VS Absorption Costing - Example

Total budgeted fixed overheads for a company are $712,000. These have
traditionally been absorbed on a machine hour basis. The company makes
two products, A and B.
 A B
Direct material cost $20 $60
Direct labour cost $50 $40
Machine time 3 hrs 4 hrs
Annual output 6000 40000

The company is considering changing to an ABC system and has analysed

the overhead cost into three activities:

Activities Cost pool Cost driver

Machine related 178000 No. of Machine hours
Setup related 230000 No. of setups
Purchasing related 304000 No. of purchase orders
Total overhead 712000

Machine Annual Total machine Number of Number of

hours/unit output hours set-ups purchase
orders
A (3 hours) 6000 18000 16 52
B (4 hours) 40000 160000 30 100
Total 46000 178000 46 152

Required:
A. Calculate the total cost for each product on the assumption that the
company continues to absorb overheads on a machine hour basis.
B. Calculate the cost per unit using the ABC system.
C. Compare the cost per unit of each product using ABC with the cost
per unit using absorption costing, and identify the main reasons for
the difference.
Advantages of Activity Based Costing
Accurate cost calculation (fair distribution of overheads).
Accurate selling price.
ABC recognises the complexity of modern manufacturing by the use
of multiple cost drivers.
ABC can be applied to both production and non-production overheads.
Better cost control.

Disadvantages of Activity Based Costing

Time consuming and expensive.
Selection of cost driver may not be easy.
ABC does not eliminate the need for cost apportionment. Some
arbitrary apportionment may still exist.
The cost of implementing and maintaining an ABC system can exceed
the benefits. (Implementation of ABC is likely to be cost effective when
overheads costs are a high proportion of total costs.)
ABC is a form of absorption costing; an ABC cost is not a variable cost
and therefore not a relevant cost for decision.
ABC will be of limited benefit if the overhead costs are primarily volume
related or if the overhead is a small proportion of the overall cost.

5 MCQ
 TARGET COSTING

Target costing involves setting a target cost by subtracting a desired profit

from a competitive market price. In effect it is the opposite of conventional
‘cost plus pricing’.

Traditional approach Target Costing

Determine Unit cost Arrive at the target cost for Production

Add desired Profit margin Deduct profit margin desired

Determine Selling price Determine selling price

Illustration 1
Exclusive Motors is designing a new version of its luxury car, the Z series. The
vehicle will be launched next year. It is expected to have a lifecycle of 10
years.

The production of the car will require an investment of $3 billion. The

company needs a profit of 20% a year on this investment.

The marketing department believes that the car could be sold for a price of
$40,000 each. 100,000 cars would be manufactured and sold each year.

Required: Calculate the target cost of one Z?

Closing a Target Cost Gap
Possible ways to close a cost gap:

Value analysis can be used to determine which features are adding

value to the product and which will not affect it at all.
Reducing the number of components.
Using cheap labour/staff.
Using standard components wherever possible.
Acquiring new more efficient technology.
Training staff.
Using different materials.

A risk with target costing is that cost reductions may affect the perceived
value of the product.

Illustration 2
A car manufacturer wants to calculate a target cost for a new car, the price
of which will be set at $17,950. The company requires an 8% profit margin on
sales.

Required: Find the target cost?

Target Costing in Service Industries

The target costing approach is a sensible basis for estimating/driving down
costs regardless of the type of business. However, due to the nature of
service industries this process is more difficult in these businesses.

Characteristics of Service Industries

Service industries have the following characteristics which make cost and
performance measurement more difficult:

1. Simultaneity
2. Variability/Heterogeneity
3. Intangibility
4. Perishability
5. No transfer of ownership
Note: From the above ‘Intangibility and Variability/Heterogeneity’ make it
difficult to use target costing in service industry.

Advantages of Target Costing

Target costing encourages the management to continually improve
processes and innovate to gain a competitive cost advantage.
New market opportunities can be converted into real savings to
achieve the best value for money rather than to simply realize the
lowest cost.
The product is created from the expectation of the customer (i.e., cost
approach is more customer centric) and, hence, the cost is also based
on similar lines. Thus, the customer feels more value is delivered.
The company’s approach to designing and manufacturing products
becomes market-driven. Helps in creating economies of scale.

Disadvantages of Target Costing

The development process can be very lengthy as the product has to
go through several alterations to meet the target cost.
Cost reduction process may affect employee morale.

5 MCQ
 LIFECYCLE COSTING

Target costing emphasises cost control through good product design and
production planning. There might also be costs incurred after a product is
sold, such as warranty costs and plant decommissioning.

Therefore, to profit from a product, its total revenue must exceed its total
cost, whether these costs are incurred before, during or after the product is
produced. This is the concept of life-cycle costing.

Aim of Lifecycle Costing

Lifecycle costing aims to cost a product, service, customer or project over
its entire lifecycle with the aim of maximising the return over the total life
while minimising costs.

The product lifecycle describes how demand conditions for a product, a

brand and whole markets change with time.

Phases Of Life Cycle

Development stage: Product is designed and developed;
manufacturing process will also be created. Cashflow will be negative
as there is no revenue.
Introduction (Launch): Special price while launching (skimming,
penetration).
Growth: Competition may rise due to new suppliers entering the
market. This may force lower prices.
Maturity: Most profits are made during this phase. Prices may be
stable.
Decline: Prices may fall with demand unless a specialised market can
be found.
Lifecycle Cost – Examples
Research and development costs
Training costs
Production costs
Distribution costs
Marketing costs
Inventory costs
Retirement and disposal costs

Calculating Lifecycle Cost Per Unit

Total lifecycle costs

Average Lifecycle Cost per unit =
Total lifecycle units

Illustration 1

Year 1 Year 2 Year 3 Year 4

Units manufactured and sold 2,000 15,000 20,000 5,000
$ $ $ $
R&D costs 1,900,000 100,000 - -
Marketing costs 100,000 75,000 50,000 10,000
Production cost per unit 500 450 400 450
Customer service cost per unit 50 40 40 40
Disposal of specialist 300,000
equipment

Required: Calculate lifecycle cost per unit?

Maximising Return Over the Product’s Lifecycle

Careful design of product (can save design and manufacturing costs).
Take the product to market as soon as possible (minimise the time to
market).
Minimize breakeven time.
Maximize the length of the life span.
Minor changes in technology.
Advantages of Lifecycle Costing
It helps management to assess profitability over the full life of a
product, which in turn helps the management to decide whether to
develop the product, or to continue making the product.
It encourages longer-term thinking and forward planning.
The lifecycle concept results in earlier actions to generate more
revenue or to lower costs.
Life cycle costing encourages management to find a suitable balance
between investment costs and operating expenses.

Disadvantages of Lifecycle Costing

It is a time-consuming process.
Collecting data for analysis is a tedious job.

Relevance to Service Industries

Life-cycle costing is relevant to services that require significant upfront
research and development. Like software industries.

5 MCQ
 THROUGHPUT ACCOUNTING

Background
There are two aspects of modern manufacturing that you need to be
familiar with;

Total quality management (TQM)

Just in time (JIT)

Key features of companies operating in a JIT and TQM environment are:

High level of automation.

High level of overheads and low level of direct labour costs.
Low stocks.
Emphasis on high quality and continuous improvement.

Throughput Accounting
Throughput accounting aims to maximise the best use of scarce resource
in a JIT environment.

Throughput Contribution = Sales Revenue – Material Cost

Bottleneck Resource or Binding Constraint

Bottleneck resource or binding constraint is an activity which has a lower
capacity than other activities.

Bottleneck resources may be as follows:

Labour hours
Machine hours

Production is limited to the capacity of the bottleneck resource but this

capacity must be fully utilised. This may result in some idle time in non-
bottleneck resources.
Bottleneck – Example
A factory makes three products, all of which pass through three machines.
The time spent on each machine is the same for all three products. Demand
for the company’s products exceeds the amount that the company can
produce. The maximum daily output of the three machines is as follows:

Machine 1 Machine 2 Machine 3

200 units 180 units 210 units

Machine 2 is the bottleneck, which has the lowest output volume.

Aim of Throughput Accounting

As mentioned earlier, the throughput accounting system aims to maximise
the throughput contribution of the production process (i.e., to make the best
use of a scarce resource (bottleneck) in a JIT environment).

Throughput accounting is an approach to production management which

aims to maximise throughput, while reducing inventory and operational
expenses. It is based on the Theory of Constraints, which focuses on
maximising throughput while keeping the organisation’s bottleneck
resources in view, and trying to minimise the operational costs.

Theory of Constraints (TOC)

Theory of Constraints focuses on bottlenecks in the production process
which act as a barrier to throughput maximisation. The theory of constraints
is applied within an organisation by following ‘the five focusing steps.

Five Steps for Dealing with a Bottleneck Activity

1. IDENTIFY: the bottleneck resource.
2. EXPLOIT: the highest possible output must be achieved from
bottleneck resource. The output must never be delayed and as such a
buffer inventory should be held immediately before bottleneck
resource.
3. SUBORDINATE: operations prior to the binding constraint should
operate at the same speed as it so that WIP does not build up.
 4. ELEVATE the bottleneck: steps should be taken to increase resources or
improve its efficiency.
5. RETURN TO STEP 1: the removal of one bottleneck will create another
elsewhere in the system.

Maximising Throughput and Multiple Products

Optimum Production Plan.
Determine the bottleneck resource.
Calculate the throughput per unit for each product.
Calculate the bottleneck resource per unit. Example: labour hours per
unit or machine hours per unit.
Calculate throughput per unit of bottleneck resource (return per hour).
Rank products.
Allocate resources to arrive at optimum production plan.

Illustration 1

Product A Product B Product C

Sales price 2.80 1.60 2.40
Materials cost 1.20 0.60 1.20
Machine hours per unit 0.5 hours 0.2 hours 0.3 hours
Weekly sales demand 4,000 units 4,000 units 5,000 units

Machine time is a bottleneck resource and maximum capacity is 4,000

machine hours per week.
Operating costs including direct labour costs are $10,880 per week.

Required: Determine the optimum production plan for WR Co and

calculate the weekly profit that would arise from the plan?

Throughput Accounting Ratio (TPAR)

It is the ratio of the throughput per unit of bottleneck r5esource to the
factory cost per unit of bottleneck resource
 Return per factory hour
Throughput accounting ratio =
Cost per factory hour

Throughput per
Return per factory hour = unit
Production time on bottleneck resource

(Throughput generated from one unit of bottleneck resource.)

Total factory costs

Cost per factory hour =
Total time available on bottleneck resource

(The total factory cost is the operational expense [labour plus overhead] of
the organisation.)

In any organisation, you would expect the throughput accounting ratio to

be greater than 1. This means that the rate at which the organisation is
generating cash from sales of this product is greater than the rate at which
it is incurring costs.

Interpretation of TPAR

TPAR > 1 Throughput exceeds operating costs so the product

should make a profit.
TPAR < 1 Throughput is insufficient to cover operating costs,
resulting in a loss.

Criticisms of TPAR
It concentrates on the short-term.
It is more difficult to apply throughput accounting concepts to the
longer-term, when all costs are variable, and vary with the volume of
production and sales or another cost driver.
In the longer-term an ABC approach might be more appropriate for
measuring and controlling performance.
Illustration 2

Product A Product B Product C

Sales price 2.80 1.60 2.40
Materials cost 1.20 0.60 1.20
Machine hours per unit 0.5 hours 0.2 hours 0.3 hours
Weekly sales demand 4,000 units 4,000 units 5,000 units

Machine time is a bottleneck resource and maximum capacity is 4,000

machine hours per week. Operating costs including direct labour costs are
$10,880 per week.

Required: Calculate the Throughput Accounting Ratio for all the products?

Improving Throughput Accounting Ratio

Increase the sales price.
Reduce the material cost.
Reduce total operating expenses, to reduce the cost per hour.
Improve productivity, reducing the time required to make each unit of
product.
Elevate the bottleneck.

5 MCQ
 ENVIRONMENTAL ACCOUNTING

Introduction
Traditional management accounting systems do not provide any analysis
of environmental costs. Management is often unaware of them. The
implication of this is that:
Management cannot do enough to manage environmental activities.
Management accounts underestimate the costs of poor environmental
behaviour and underestimate the benefits of good environmental
behaviour.

Environmental Management Accounting (EMA) aims to overcome this.

Environmental management accounting is the generation and analysis of

both financial and non-financial information in order to support
environment management process.

Importance of Environmental Costs

Society as a whole has become more environmentally aware and
companies can increase their appeal to customers by portraying
themselves as environmentally responsible.
Environmental costs are becoming huge for some companies.
Regulation is increasing worldwide, with penalties for non-compliance
also increasing accordingly.
Identifying environmental costs associated with individual products and
services can assist with pricing decisions.

Environmental Costs – Examples

Consumable and raw materials
Transport and travel
Waste disposal
Water consumption
Energy
Types of Environmental Costs
1. Internal Environmental Costs
These are costs that directly impact on the income statement of a
company.
For example:
Waste disposal costs
Regulatory costs such as taxes

2. External Environmental Costs

These are costs that are imposed on society at large, but not borne by
the company that generates the cost in the first instance.
For example:
Carbon emissions
Usage of energy and water
Forest degradation

Classification of Environmental Costs

1. Environmental prevention costs
The costs of activities undertaken to prevent the production of waste.
For example:
The costs of the design and operation of processes to reduce waste.
Obtaining certification relating to meeting the requirements of
national and international standards.

2. Environmental detection costs

Costs incurred to ensure that the organisation complies with regulations
and voluntary standards.
For example:
Performing pollution tests.
Inspecting products to ensure regulatory compliance.

3. Environmental internal failure costs

Costs incurred from performing activities that have produced
contaminants and waste that have not been discharged into the
environment.
For example:
Recycling scrap.
Disposing of toxic materials.
4. Environmental external failure costs
Costs incurred on activities performed after discharging waste into the
environment.
For example: Costs of cleaning up contaminated soil, or restoring land
to its natural state.

Methods of Environmental Accounting

1. Input/Output Analysis Input/Output analysis
operates on the principle that what comes in must go out. Process flow
charts can help to trace inputs and outputs, particularly waste.
Any difference between the amount input and the eventual output is
'residual', which is called 'waste'.
Input and output quantities are measured and these can be given a
cost.

2. Flow Cost Accounting

Flow cost accounting is a development from input/output analysis. It
divides the material flows into three categories:
Material
System and delivery
Disposal

The values and costs of each of these three flows are then calculated.

3. Activity Based Costing

Environmental activity-based costing combined elements of
environmental costing with an activity-based costing system. ABC
allocates internal costs to cost centres and cost drivers on the basis of
the activities that give rise to the costs.

4. Lifecycle Costing
Within the context of environmental accounting, lifecycle costing is a
technique which requires the full environmental costs, arising from
production of a product to be taken account across its whole lifecycle.
Under this method of environmental cost accounting, environmental
costs for a product are considered from the design stage of the product
right up to the end-of-life costs, such as decommissioning and removal.
Advantages of Environmental Costing
Better environmental cost control.
Facilitates the quantification of cost savings from "environmentally-
friendly" measures.
Reduces the potential for cross-subsidisation of environmentally
damaging products.
Better/fairer product costs.
Improved pricing so that products that have the biggest environmental
impact reflect this by having higher selling prices.

Disadvantages of Environmental Costing

Time consuming and expensive.
Determining accurate costs and appropriate costs drivers is difficult.
External costs not experienced by the company (e.g., carbon footprint)
may still be ignored/ unmeasured.
Some internal environmental costs are intangible (e.g., impact on
employee health) and these are still ignored.

5 MCQ