ACCA F5: Ch 1 - Traditional and Advanced Costing Methods

1 What is the purpose of costing? - Value inventory - the cost per unit can be used to value inventory in the statement of financial position (balance sheet). - Record costs - the costs associated with the product need to be recorded in the income statement - Price products - the business will use the cost per unit to assist in pricing the product. For example, if the cost per unit is $0.30, the business may decide to price the product at $0.50 per unit in order to make the required profit of $0.20 per unit. - Make decisions- the business will use the cost information to make important decisions regarding which products should be made and in what quantities

1 What is the purpose of costing? - full production cost per unit (direct + indirect production costs) - production overheads absorbed into units of production, using a suitable basis, e.g. units produced, labour hours or machine hours. - overhead expenditure is connected to the volume produced

2 Under- and over-absorption 'Budgeted volume' may relate to units, direct labour hours, machine hours, etc. If either or both of the actual overhead cost or activity volume differ from budget, the use of this rate is likely to lead to what is known as under-absorption or over-absorption of overheads.

3 Marginal costing - extra cost arising as a result of making and selling one more unit of a product or service, or is the saving in cost as a result of making and selling one less unit - Contribution = sales cost-var costs

3 Marginal costing - Overheads used to be small in relation to other costs in traditional manufacturing
In addition, production overheads, such as machine depreciation, will have been a small proportion of overall costs. This is because production was more labour intensive and, as a result, direct costs would have been much higher than indirect costs. A rough estimate of the production overhead per unit was therefore fine. - Overheads are now a larger proportion of total costs in modern manufacturing
Manufacturing has become more machine intensive and, as a result, the proportion of production overheads, compared to direct costs, has increased. Therefore, it is important that an accurate estimate is made of the production overhead per unit. - The nature of manufacturing has changed. Many companies must now operate in a highly competitive environment and, as a result, the diversity and complexity of products has increased.

3 Marginal costing 1) Group production overheads into activities, according to how they are driven. A cost pool is an activity which consumes resources and for which overhead costs are identified and allocated. For each cost pool, there should be a cost driver. The terms ‘activity’ and ‘cost pool’ are often used interchangeably. 2) Identify cost drivers for each activity, i.e. what causes these activity costs to be incurred. A cost driver is a factor that influences (or drives) the level of cost. 3) Calculate an OAR for each activity. The OAR is calculated in the same way as the absorption costing OAR. However, a separate OAR will be calculated for each activity, by taking the activity cost and dividing by the cost driver information. 4) Absorb the activity costs into the product. The activity costs should be absorbed back into the individual products 5) Calculate the full production cost and/ or the profit or loss.

3 Marginal costing - It provides a more accurate cost per unit. As a result, pricing, sales strategy, performance management and decision making should be improved - It provides much better insight into what drives overhead costs - ABC recognises that overhead costs are not all related to production and sales volume - In many businesses, overhead costs are a significant proportion of total costs, and management needs to understand the drivers of overhead costs in order to manage the business properly. Overhead costs can be controlled by managing cost drivers. - It can be applied to derive realistic costs in a complex business environment - ABC can be applied to all overhead costs, not just production overheads - ABC can be used just as easily in service costing as in product costing

4 Target costing - setting a target cost by subtracting a desired profit from a competitive market price. - Sony, Toyota and the Swiss watchmakers, Swatch.

4 Target costing 1) Estimate a selling price for a new product that considers how much competitors are charging and how much customers are willing to pay. This selling price will enable a firm to capture a required share of the market 2) Reduce this figure by the firm’s required level of profit. This could take into account the return required on any new investment and on working capital requirements or could involve a target margin on sales. 3) Produce a target cost figure for product designers to meet. 4) Reduce costs to provide a product that meets that target cost

4 Target costing Estimated product cost – Target cost - Can any materials be eliminated, e.g. cut down on packing materials? - Can a cheaper material be substituted without affecting quality? - Can labour savings be made without compromising quality, for example, by using lower skilled workers? - Can productivity be improved, for example, by improving motivation? - Can production volume be increased to achieve economies of scale? - Could cost savings be made by reviewing the supply chain? - Can part-assembled components be bought in to save on assembly time? - Can the incidence of the cost drivers be reduced? - Is there some degree of overlap between the product-related fixed costs that could be eliminated by combining service departments or resources?

5 Life-cycle costing - Lifecycle costing tracks and accumulates actual costs and revenues attributable to each product over its entire product lifecycle. Hence, the total profitability of any given product can be determined. A product's costs are not evenly spread through its life - companies operating in an advanced manufacturing environment are finding that about 90% of a product's lifecycle costs are determined by decisions made early in the cycle. In many industries, a large fraction of the life-cycle costs consists of costs incurred on product design, prototyping, programming, process design and equipment acquisition.

5 Life-cycle costing 1) Design costs out of the product: Decisions made then commit the organisation to incurring the costs at a later date, design of the product determines components, production method, etc. It is vital design teams do not work in isolation but as part of a cross-functional team to minimise costs over the whole life cycle. Value engineering helps here; for example, Russian liquid-fuel rocket motors are intentionally designed to allow leak-free welding. This reduces costs by eliminating grinding and finishing operations (these operations would not help the motor to function better anyway.) 2) Minimise the time to market: Competitors will monitor each other closely so that they can launch rival products as soon as possible in order to maintain profitability. It is vital, therefore, for the first organisation to launch its product as quickly as possible after the concept has been developed, so that it has as long as possible to establish the product in the market and to make a profit before competition increases. Often it is not so much costs that reduce profits as time wasted 3) Maximise the length of the life cycle itself:
Generally, the longer the life cycle, the greater the profit that will be generated, assuming that production ceases once the product goes into decline and becomes unprofitable. One way to maximise the life cycle is to get the product to market as quickly as possible, find other uses, or markets, for the product, plan for a staggered entry into different markets at the planning stage to reduce costs, increase revenue and prolong the overall life of the product. eg new films released in the USA months before the UK . This is done to build up the enthusiasm for the film and to increase revenues overall. Other companies may not have the funds to launch worldwide at the same moment and may be forced to stagger it. Skimming the market is another way to prolong life and to maximise the revenue over the product’s life.

5 Life-cycle costing - Pre-production/Product development stage: High level of setup costs including R&D, product design and building of production facilities - Launch/Market development stage: Success depends upon awareness and trial of the product by consumers, accompanied by extensive marketing and promotion costs - Growth stage: Marketing and promotion continue Sales volume increases dramatically, and unit costs fall as fixed costs are recovered over greater volumes - Maturity stage: Initially profits continue to increase, initial setup and fixed costs are recovered. Marketing and distribution economies are achieved Price competition/product differentiation start to erode profitability as firms compete for the limited new customers remaining - Decline stage: Marketing costs cut as the product is phased out. Production economies lost as volumes fall. Replacement product will need to have been developed, incurring new levels of R&D and other setup costs. Alternatively additional development costs may be incurred to refine the model to extend the life-cycle (this is typical with cars where ‘product evolution’ is the norm
rather than ‘product revolution’).

6 Background 1) It aims to make the best use of a scare resource (bottleneck) in a JIT environment. 2) Throughput = sales revenue - direct material cost 3) To maximise this measure of profitability whilst simultaneously reducing operating expenses and inventory (money is tied up in inventory). The goal is achieved by determining what factors prevent the throughput from being higher. This constraint is called a bottleneck, for example there may be a limited number of machine hours or labour hours.

6 Background 1) The only totally variable cost in the short-term is the purchase cost of raw materials that are bought from external suppliers. 2) Direct labour costs are not variable in the short-term. Many employees are salaried and even if paid at a rate per unit, are usually guaranteed a minimum weekly wage.