Alternative costing principles

type

Activity based costing

Target costing

total quality management (tqm) as alternative cost management techniques

difference (vs)

life cycle costing

ABC vs. Traditional

A target cost is a cost estimate derived by subtracting a desired profit margin from a competitive market price.

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Target Costing Process

  1. Target costing begins by specifying a product an organisation wishes to sell. Ideally only those features valued by customers will be included in the product design.

2.The price at which the product can be sold at is then considered.

3.This will take into account the competitors’ products and the market conditions expected at the time that the product will be launched.From the above price a desired margin is deducted.This leaves the cost target.An organisation will need to meet this target if their desired margin is to be met.

4.Costs for the product are then calculated and compared to the cost target mentioned above.

5.If it appears that this cost cannot be achieved, then the difference (shortfall) is called a cost gap.
This gap would have to be closed, by some form of cost reduction, if the desired margin is to be achieved.

Where a gap exists between the current estimated cost levels and the target cost, it is essential that this gap be closed.Efforts to close a target cost gap are most likely to be successful at the design stage.It is far easier to ‘design out’ cost during the pre-production phase than to ‘control out’ cost during the production phase.

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target cost gap (value-engineering)

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ways to reduce a cost gap

1.Review the product’s features.

2.Remove features that add to cost but do not significantly add value to the product when viewed by the customer.

3.Team approach - The company should bring together members of the marketing, design, assembly and distribution teams to allow discussion of methods to reduce costs.Open discussion and brainstorming are useful approaches here.

4.Review the whole supplier chain - each step in the supply chain should be reviewed, possibly with the aid of staff questionnaires, to identify areas of likely cost savings.For example, the questionnaire might ask ‘are there more than five potential suppliers for this component?’ Clearly a ‘yes’ response to this question will mean that there is the potential for tendering or price competition.

5.Reduce waste or idle time that might exist.Where possible, standardised components should be used in the design.Productivity gains may be possible by changing working practices or by de-skilling the process.Automation is increasingly common in assembly and manufacturing.

Mark Lee Inman listed 8 requirements of quality:

It is all about quality of products made or services provided


Some companies thought that quality is an additional cost of manufacturing, but recently they have begun to realise that quality saves money.

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1.the customer is the most important

2.The customer-supplier relationship is crucial

3.Stop inspecting quality and start preventing the cause of the defect in the first place

4.Each employee must be personally responsible for defect-free production or service

5.Any level of defects is unacceptable

6.Try to get things right first time

7.Quality certification programmes should be introduced

8.The cost of poor quality should be emphasised as good quality generates savings

The basic principle of TQM is:

Costs of prevention (getting things right first time) are less than the costs of correction.


Therefore companies should focus on getting things right first time (zero defect) and then getting them better next time (continuous improvement).

4 types of Quality costs

1

prevention cost

are the costs incurred in preventing the production of quality products

They include the costs of:

  • preventive maintenance
  • quality planning and training
  • the extra costs of acquiring higher quality raw materials
  • quality circles

2.

appraisal cost

are the costs incurred to ensure that materials and products meet quality standards.

They include the costs of:

  • inspecting purchased parts
  • work in process and finished goods
  • quality audits
  • field tests

3.

internal failure cost

are the costs associated with materials and products that fail to meet quality standards.

They include costs incurred before the product is dispatched to the customer, such as:

  • the costs of scrap, repair, downtime
  • work stoppages caused by defects.

4.

external failure cost

are the costs incurred when products or services fail to meet requirements or satisfy customer needs after they have been delivered.

They include the costs of:

  • handling customer complaints
  • warranty replacement
  • repairs of returned products
  • the costs arising from a damaged company reputation

Costs within this category can have a dramatic impact on future sales.

Costs of compliance (conformance)

These are Prevention and appraisal costs.


Their aim is to eliminate the costs of failure.

Costs of non-compliance (non-conformance)

These are Internal and external failure costs


Costs of non-compliance are the result of production imperfections and can only be reduced by increasing compliance expenditure.

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Life-cycle costing tracks and accumulates the actual costs and revenues attributable to each product from inception to abandonment.

It enables a product’s true profitability to be determined at the end of the economic life.

Traditional cost accounting systems do not accumulate costs over a product’s entire life but focus instead on (normally) twelve month accounting periods.

As a result the total profitability of a product over its entire life becomes difficult to determine.

Product Life Cycle

Every product goes through a life cycle

The product has a research and development stage where costs are incurred but no revenue is generated.


During this stage, a high level of setup costs will be incurred, including research and development, product design and building of production facilities.

1.development

The product is introduced to the market. Potential customers will be unaware of the product or service, and the organisation may have to spend further on advertising to bring the product or service to the attention of the market. Therefore, this stage will involve extensive marketing and promotion costs. High prices may be changed to recoup these high development costs.

2.introduction

3.growth

The product gains a bigger market as demand builds up.

Sales revenues increase and the product begins to make a profit.

Marketing and promotion will continue through this stage.

Unit costs tend to fall as fixed costs are recovered over greater volumes.

Competition also increases and the company may need to reduce prices to remain competitive.

4.maturity

Eventually, the growth in demand for the product will slow down and it will enter a period of relative maturity.

It will continue to be profitable.

However, price competition and product differentiation will start to erode profitability.

The product may be modified or improved, as a means of sustaining its demand.

5.decline

At some stage, the market will have bought enough of the product and it will therefore reach 'saturation point'.

Demand will start to fall and prices will also fall.

Eventually it will become a loss maker and this is the time when the organisation should decide to stop selling the product or service.

During this stage, the costs involved would be environmental clean-up, disposal and decommissioning.

Meanwhile, a replacement product will need to have been developed, incurring new levels of research and development and other setup costs.

The level of sales and profits earned over a life cycle can be illustrated diagrammatically as follows.

Benefits of life cycle costing

1.All costs (production and non production) will be traced to individual products over their complete life cycles and hence individual product profitability can be more accurately measured.

2.The product life cycle costing results in earlier actions to generate revenue or to lower costs than otherwise might be considered.

3.Better decisions should follow from a more accurate and realistic assessment of revenues and costs, at least within a particular life cycle stage.

4.Product life cycle thinking can promote long-term rewarding in contrast to short-term profitability rewarding.

5.It helps management to understand the cost consequences of developing and making a product and to identify areas in which cost reduction efforts are likely to be most effective.Very often, 90% of the product’s life-cycle costs are determined by decisions made in the development stage.Therefore, it is important to focus on these costs before the product enters the market..

6.Identifying the costs incurred during the different stages of a product’s life cycle provides an insight into understanding and managing the total costs incurred throughout its life cycle.


Non production costs will become more visible and the potential for their control is increased.

7.More accurate feedback on the success or failure of new products will be available..

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This accounting method of costing recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product.

The Activity Based Costing Process Flow

1.Identify costs. The first step in ABC is to identify those costs that we want to allocate. This is the most critical step in the entire process, since we do not want to waste time with an excessively broad project scope. For example, if we want to determine the full cost of a distribution channel, we will identify advertising and warehousing costs related to that channel, but will ignore research costs, since they are related to products, not channels.

2.Load secondary cost pools. Create cost pools for those costs incurred to provide services to other parts of the company, rather than directly supporting a company’s products or services. The contents of secondary cost pools typically include computer services and administrative salaries, and similar costs. These costs are later allocated to other cost pools that more directly relate to products and services. There may be several of these secondary cost pools, depending upon the nature of the costs and how they will be allocated.

3.Load primary cost pools. Create a set of cost pools for those costs more closely aligned with the production of goods or services. It is very common to have separate cost pools for each product line, since costs tend to occur at this level. Such costs can include research and development, advertising, procurement, and distribution. Similarly, you might consider creating cost pools for each distribution channel, or for each facility. If production batches are of greatly varying lengths, then consider creating cost pools at the batch level, so that you can adequately assign costs based on batch size.

4.Measure activity drivers. Use a data collection system to collect information about the activity drivers that are used to allocate the costs in secondary cost pools to primary cost pools, as well as to allocate the costs in primary cost pools to cost objects. It can be expensive to accumulate activity driver information, so use activity drivers for which information is already being collected, where possible.

5.Allocate costs in secondary pools to primary pools. Use activity drivers to apportion the costs in the secondary cost pools to the primary cost pools.

6.Charge costs to cost objects. Use an activity driver to allocate the contents of each primary cost pool to cost objects. There will be a separate activity driver for each cost pool. To allocate the costs, divide the total cost in each cost pool by the total amount of activity in the activity driver, to establish the cost per unit of activity. Then allocate the cost per unit to the cost objects, based on their use of the activity driver.

7.Formulate reports. Convert the results of the ABC system into reports for management consumption. For example, if the system was originally designed to accumulate overhead information by geographical sales region, then report on revenues earned in each region, all direct costs, and the overhead derived from the ABC system. This gives management a full cost view of the results generated by each region.

8.Act on the information. The most common management reaction to an ABC report is to reduce the quantity of activity drivers used by each cost object. Doing so should reduce the amount of overhead cost being used.

example: We have now arrived at a complete ABC allocation of overhead costs to those cost objects that deserve to be charged with overhead costs. By doing so, managers can see which activity drivers need to be reduced in order to shrink a corresponding amount of overhead cost. For example, if the cost of a single purchase order is $100, managers can focus on letting the production system automatically place purchase orders, or on using procurement cards as a way to avoid purchase orders. Either solution results in fewer purchase orders and therefore lower purchasing department costs.

Uses of Activity Based Costing

1.Activity costs. ABC is designed to track the cost of activities, so you can use it to see if activity costs are in line with industry standards. If not, ABC is an excellent feedback tool for measuring the ongoing cost of specific services as management focuses on cost reduction.

2.Customer profitability. Though most of the costs incurred for individual customers are simply product costs, there is also an overhead component, such as unusually high customer service levels, product return handling, and cooperative marketing agreements. An ABC system can sort through these additional overhead costs and help you determine which customers are actually earning you a reasonable profit. This analysis may result in some unprofitable customers being turned away, or more emphasis being placed on those customers who are earning the company its largest profits.

3.Distribution cost. The typical company uses a variety of distribution channels to sell its products, such as retail, Internet, distributors, and mail order catalogs. Most of the structural cost of maintaining a distribution channel is overhead, so if you can make a reasonable determination of which distribution channels are using overhead, you can make decisions to alter how distribution channels are used, or even to drop unprofitable channels.

4.Make or buy. ABC provides a comprehensive view of every cost associated with the in-house manufacture of a product, so that you can see precisely which costs will be eliminated if an item is outsourced, versus which costs will remain.

5.Margins. With proper overhead allocation from an ABC system, you can determine the margins of various products, product lines, and entire subsidiaries. This can be quite useful for determining where to position company resources to earn the largest margins.

6.Minimum price. Product pricing is really based on the price that the market will bear, but the marketing manager should know what the cost of the product is, in order to avoid selling a product that will lose a company money on every sale. ABC is very good for determining which overhead costs should be included in this minimum cost, depending upon the circumstances under which products are being sold.

7.Production facility cost. It is usually quite easy to segregate overhead costs at the plant-wide level, so you can compare the costs of production between different facilities.

Problems with Activity Based Costing

1.Cost pool volume. The advantage of an ABC system is the high quality of information that it produces, but this comes at the cost of using a large number of cost pools – and the more cost pools there are, the greater the cost of managing the system. To reduce this cost, run an ongoing analysis of the cost to maintain each cost pool, in comparison to the utility of the resulting information. Doing so should keep the number of cost pools down to manageable proportions.

2.Installation time. ABC systems are notoriously difficult to install, with multi-year installations being the norm when a company attempts to install it across all product lines and facilities. For such comprehensive installations, it is difficult to maintain a high level of management and budgetary support as the months roll by without installation being completed. Success rates are much higher for smaller, more targeted ABC installations.

3.Multi-department data sources. An ABC system may require data input from multiple departments, and each of those departments may have greater priorities than the ABC system. Thus, the larger the number of departments involved in the system, the greater the risk that data inputs will fail over time. This problem can be avoided by designing the system to only need information from the most supportive managers.

4.Project basis. Many ABC projects are authorized on a project basis, so that information is only collected once; the information is useful for a company’s current operational situation, and it gradually declines in usefulness as the operational structure changes over time. Management may not authorize funding for additional ABC projects later on, so ABC tends to be “done” once and then discarded. To mitigate this issue, build as much of the ABC data collection structure into the existing accounting system, so that the cost of these projects is reduced; at a lower cost, it is more likely that additional ABC projects will be authorized in the future.

5.Reporting of unused time. When a company asks its employees to report on the time spent on various activities, they have a strong tendency to make sure that the reported amounts equal 100% of their time. However, there is a large amount of slack time in anyone’s work day that may involve breaks, administrative meetings, playing games on the Internet, and so forth. Employees usually mask these activities by apportioning more time to other activities. These inflated numbers represent misallocations of costs in the ABC system, sometimes by quite substantial amounts.

6.Separate data set. An ABC system rarely can be constructed to pull all of the information it needs directly from the general ledger. Instead, it requires a separate database that pulls in information from several sources, only one of which is existing general ledger accounts. It can be quite difficult to maintain this extra database, since it calls for significant extra staff time for which there may not be an adequate budget. The best work-around is to design the system to require the minimum amount of additional information other than that which is already available in the general ledger.

7.Targeted usage. The benefits of ABC are most apparent when cost accounting information is difficult to discern, due to the presence of multiple product lines, machines being used for the production of many products, numerous machine setups, and so forth – in other words, in complex production environments. If a company does not operate in such an environment, then it may spend a great deal of money on an ABC installation, only to find that the resulting information is not overly valuable.

1.Activity-based costing is more accurate because it takes important factors into account before assigning a cost to a product. However, for this same reason, it is a bit more complicated and time-consuming. It’s also more thorough and considers nonmanufacturing expenses as well, such as administrative and managerial costs.

2.Traditional costing is a much easier way of determining the cost of a product, since it relies solely on assigning average overhead rates. This also means it won’t always be as accurate, because it doesn’t factor in nonmanufacturing expenses or determine which overhead costs actually affect specific products.

3.A simple example of these costing methods can be demonstrated with the costs of living in an apartment with roommates. Two roommates in an apartment will typically split the costs of rent, utilities and groceries, and they have a couple of options for doing so. They could simply total the cost of all of the bills and divide it exactly in two. This would be similar to traditional costing.

4.The roommates also have the option of determining who uses specific utilities and paying only for what each one uses. They can then create an itemized bill for each roommate. For example, if one roommate doesn’t use the internet and the other doesn’t use cable, they won’t have to pay those parts of the bill. This method is similar to activity-based costing.

Which Should You Use?

Both forms of costing have various benefits as well as disadvantages. Determine which form of costing will be best suited for your project by considering your specific needs and your timeframe.

Activity-based costing should be used when accuracy is crucial, because it is the most precise. Although it is costly to implement, it should be used for:

1.Times when overhead is high, because small changes in each product cost can make a large difference overall. This method makes it easy to visualize and understand all indirect costs and activities.

2.Internal use, because decision-makers will be able to see all relevant spending and can document all indirect costs accurately. This method is good for finding areas of wasteful spending.

Traditional costing should be considered when time is limited or when accuracy won’t be affected much by production activities. Traditional costing is most effective for:

1.Times when overhead is low compared to the direct costs, because this is when it will be the most accurate. This works well when there are a large number of similar items (or a single item) being produced.

2.External use, because it will be easier for outsiders to determine the value of products.

Choosing appropriately between activity-based and traditional costing methods won’t be easy, but it’s a decision that shouldn’t be neglected. Taking the time to understand how each method affects your business could help you save money in the long run, leaving you with extra money to reinvest where you see fit.