F2-11 Alternative Costing Principles

Session 11
Alternative Costing Principles
FOCUS
This session covers the following content from the ACCA Study Guide.
B. Cost Accounting Techniques

4. Alternative cost accounting
a) Explain activity based costing (ABC), target costing, life cycle costing and
total quality management (TQM) as alternative cost management techniques.
b) Differentiate ABC, target costing and life cycle costing from the
traditional costing techniques (note: calculations are not required).
C. Budgeting
2. Statistical techniques
g) Describe the product life cycle and explain its importance in forecasting.
Session 11 Guidance
Understand the principles of alternative costing methods [Activity-Based Costing (ABC),
Target Costing and Life Cycle Costing] and the concept of Total Quality Management (TQM).
Work Example 1; focus on what is involved in the ABC approach. The ABC approach focuses on the
idea that specific activities create "cost drivers" which are then used to apportion costs to output.
Note that calculations are not examinable.
Note that target costing is not a costing method, but a calculation of what the cost per unit needs to
be to achieve a satisfactory margin when the company is a price taker in a competitive market (i.e. it
must accept the market price). Work Example 2.
(continued on next page)
F2 Management Accounting Becker Professional Education | ACCA Study System
Sadia sadia Afzal - gentledove004@gmail.com

VISUAL OVERVIEW
Objective: To explain alternative cost accounting techniques.
ALTERNATIVE
COST
ACCOUNTING
ACTIVITY-BASED TARGET LIFE CYCLE TOTAL QUALITY

COSTING (ABC) COSTING COSTING MANAGEMENT
• Total Product • Product • Product Life • Weaknesses
Cost Pricing Cycle of Traditional
• Advantages • Steps in • Life Cycle's Western
Target Importance in Approach
• Disadvantages
Costing Forecasting • A Holistic
• Use in Service • Costs Involved Approach
Industries at Different
• Narrowing Life Cycle
the Target Stages
Cost Gap • Benefits of Life
Cycle Costing
Session 11 Guidance
Understand that life cycle costing helps management to establish long-term pricing/costing
strategies as it takes account of specific features of a product's life stages and corresponding
expenses, income, profit/loss and cash flows for each stage.
Understand the principles of total quality management (s.4).
© 2013 DeVry/Becker Educational Development Corp. All rights reserved. 11-1

Session 11 • Alternative Costing Principles F2 Management Accounting
1 Activity-Based Costing (ABC)
1.1 Terminology
Activity-based costing (ABC): an approach to costing and
activity monitoring which assigns resources consumed to activities
and activities to cost objects (based on estimated consumption).
Cost driver: any factor which can cause a change in the
cost of an activity. Cost drivers are used to apportion activity
costs to output.
1.2 Total Product Cost

Just as in a traditional absorption costing system (see
Session 7), overheads are allocated and apportioned to
individual production departments (including reapportionment
of service department costs).
However, whereas a single absorption rate is used for each
department in a traditional costing system, under ABC an activity
will usually have more than one cost driver associated with it.
Illustration 1 Cost Drivers
A production process may have the following associated cost drivers:

= warehousing;
= plant and equipment;
= machine operator(s);
= floor space occupied;
= power consumption;
= quantity of waste and/or rejected output.
ABC provides a more "accurate" method of absorbing overhead

costs into cost units by determining the cost of each driver and
then including all of these into each unit of product (see Figure 1).
11-2 © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

F2 Management Accounting Session 11 • Alternative Costing Principles
Figure 1
Examples
Identify major 1. Production scheduling

activities within each 2. Machining
Step 1
department which 3. Despatching of orders
create cost 4. Inspections
1. Number of batch set-ups for scheduling

2. Machine hours for machining
Determine what 3. Number of despatch orders for despatching
Step 2 causes the cost of
4. Number of inspections
each activity—the
"cost driver"
Cost pool for:
1. all production scheduling costs
2. all machining costs
Create a cost centre/ 3. all despatching costs
Step 3 cost pool for each 4. all inspection costs
activity—the "activity
cost pool"
Cost per
1. batch set-up
2. machine hour
Calculate an 3. despatch order
Step 4 absorption rate for 4. inspection
each "cost driver"
e.g. Product Z:
1. No. of batch set-ups for Product Z
× Cost per batch set-up x
2. No. of machine hours for Product Z
Calculate the total × Cost per machine hour x
Step 5 overhead cost for 3. No. of despatch orders for Product Z
manufacturing × Cost per despatch order x
each product 4. No. of inspections for Product Z
× Cost per inspection x
y
e.g. Product Z
y
Step 6 Calculate overhead Overhead cost per unit =
No. of Zs produced
cost per unit

1.3 Advantages and Disadvantages of ABC

Advantages Disadvantages
Attributing overheads to drivers ABC is usually based on
(and hence individual products) historic information which
is fairer and therefore product may not be relevant for
costs are more "accurate". future strategic decisions.
There will be a better understanding Selecting the most appropriate
of what causes costs to be incurred. cost drivers may not be easy.
The company can concentrate on Additional time and cost of setting
producing the most profitable items. up and administering the system.
Control of overheads is easier, as To exclude non-production elements
responsibility for incoming costs of overheads can be difficult.
must be established before ABC Assessing the degree of completion
can be implemented. of work-in-progress with respect to
Performance evaluation and appraisal each cost driver is difficult.
will be more meaningful. Variance analysis is made more
Cost driver rates can be monitored complicated (see Session 16).
and used to identify areas of weakness Many judgemental decisions are
or inefficiency. still required in the construction
It provides more detailed information of an ABC system.
for budget-setting (see next session)
and "what if" analysis (Session 14).
New products can be designed to utilise
the most efficient cost drivers. Cost can
be "designed out" of products.
When cost-plus methods of pricing are
used, prices based on ABC are likely to
reflect more accurately the true cost of
producing a product.

Example 1 Total Product Cost
Total budgeted fixed overheads for a firm are $712,000. These have traditionally been
absorbed on a machine hour basis. The firm makes two products, X and Y.
X Y
Direct material cost $20 $60
Direct labour cost $50 $40
Machine time per output 3 hrs 4 hrs
Annual output 6,000 40,000
The firm is considering changing to an ABC system and has identified the following information:
Machine Annual Total No. of No. of

hours/unit output machine set-ups purchase
hrs orders
Product X 3 6,000 18,000 16 52
Product Y 4 40,000 160,000 30 100
46,000 178,000 46 152
Cost pools: Cost driver:

$
Machine related 178,000 Machine hours
Set-up related 230,000 Set-ups
Purchasing related 304,000 Purchase orders
Total overheads 712,000
Required:
(a) Calculate the total cost for each product on the assumption that the firm
continues to absorb overheads on a machine hours basis.
(b) Calculate the cost per unit using the ABC system.
This numerical example is provided solely for better understanding of

the topic. Calculations will not be required in the examination.

Example 1 Total Product Cost (continued)
Solution
(a) Traditional Overhead Absorption
Total overhead =
Total machine hours =
Rate per hour =
X Y
$ $
Direct material 20 60
Direct labour 50 40
Fixed overhead
Total cost per unit
(b) ABC
Activities Machine Set-up Purchasing

Related Related Related
Overheads $178,000 $230,000 $304,000

Consumption of activities
(cost drivers) 178,000 hours 46 set-ups 152 orders
Cost per unit of
consumption
Cost traced to products
X
Y
Cost per unit
X Y
$ $
Direct material 20.00 60.00
Direct labour 50.00 40.00
Fixed overhead
Total

2 Target Costing
2.1 Product Pricing

In traditional cost-plus pricing models, the cost of a product
is the starting point for calculating its price. That is, having
determined the unit cost of a product, a profit margin is then
added to calculate its selling price. In a competitive world, such
an approach may be unsuitable. The price calculated in this
way may be too high for the market to accept, as the price of a
product may be determined by the market. Companies therefore
have to accept the market price.
< Target costing is an attempt to achieve an acceptable margin
in a situation in which the price of a product is determined
externally. This acceptable margin is achieved by identifying
ways to reduce the costs of producing the product.*
*Traditionally, the cost of producing a product or service was

something companies assumed was a variable over which they had
little control. Japanese companies in particular, however, showed
that no matter how efficient operations are, there are always ways to
identify further cost savings. This philosophy underlies target costing.
< Target costing may be used;

= during the design phase of a product, where cost savings
can be identified by changing the design of the product; and
= for existing products, where cost savings can be achieved
without changing the design of the product.
2.2 Steps in Target Costing

1. Determine the price which the market will accept for the
product, based on market research. This may take into
account the market share required.
2. Deduct a required profit margin from this price to find the
target cost.
3. Estimate the actual cost of the product. If it is a new product,
this will be an estimate.
4. Identify ways to narrow the gap between the actual and target
costs of the product.

Target costing can be illustrated by the following flow diagram:
Define
current
Define Define Define cost Calculate Negotiate
sales investment required "cost with
volume requirement profit gap" customer
Define Set
product target Define Try to
specification price target close
cost gap
Source: Sakurai H, Journal of Cost Management for the Manufacturing Industries, "Target Costing
and how to use it," iii No. 2 (1989).
Example 2 Target Costing
Exclusive Motors is designing a new version of its luxury car, the Z123 series. The car will be
launched in 2015. It is expected to have a life cycle of 10 years.
The production of the car will require an investment of $3 billion. The company requires a
profit of 20% per annum 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 Z123.
Solution
$
Expected revenue
Required profit
Total target cost
Target cost per car
This numerical example is provided solely for better understanding of

the topic. Calculations will not be required in the examination.

2.3 Use in Service Industries

Target costing is most appropriate in manufacturing industries,
where a volume of standard products is to be made.
Target costing is more difficult to use in service industries because:
In many service industries, the "products" are non-standard
and customised. It is difficult to define a target cost when
there is no standard product.
A higher portion of costs in service industries are indirect
(overheads). It is therefore less easy to reduce these on
a product-by-product basis.
Reducing costs in a service industry may be at the
expense of customer service or quality. Whereas, in
manufacturing industries, it may be possible to identify
cost savings which remove parts of a product which are
not valued by a customer anyway.
2.4 Narrowing the Target Cost Gap

Target costing relies on multi-disciplinary teams, which discuss
ways to reduce the gap between the actual (expected) cost and
the target cost. Some of the methods which have been used
successfully in practice are as follows:
< Redesign to eliminate non-value added elements;
< Reduce the number of components or standardising
components;
< Use less expensive materials;
< Employ a lower grade of worker on production;
< Invest in new technologies;
< Outsource elements of the production or support activities;
< Reduce manning levels or redesigning the work flow.
3 Life Cycle Costing

< In the modern manufacturing environment, a high proportion
of a product's costs will be at the early stages in its life cycle
(e.g. development, design and set-up). However, revenues
only occur once the product is being manufactured and sold.
Life cycle costing—a
< Traditional financial and management accounting systems system which tracks
focus only on costs and revenues incurred during the and accumulates
manufacturing stage of the product's life. They ignore: the actual costs and
= costs incurred in developing and designing the product; and revenues attributable
= any abandonment and disposal costs at the end of the to each product
from development to
product's life.
abandonment.
< Life cycle costing estimates and accumulates costs over a
product's entire life cycle in order to determine whether the
profits earned during the manufacturing stage will cover the
costs incurred pre- and post-manufacturing.

Illustration 2 Life Cycle Costing
Zany developed a new computer game in 2011, at a cost of

$300,000. The game will be launched in 2012. Budgeted revenues Illustration 2 is
and costs of the game over its life cycle (life cycle costing) are provided solely for
presented below: understanding the
topic. The calculations
2011 2012 2013 2014 are not examinable.
$000 $000 $000 $000
Revenue 0 160 340 120
Variable costs 0 30 65 20
Contribution 0 130 275 100
Marketing costs 40 30 0 0
Development costs 200 0 0 0
Annual profit (240) 100 275 100

Cumulative profit (240) (140) 135 235
Managers can now see the expected profit of the product over
its entire life, rather than simply on a year-by-year basis. Actual
revenues and costs would be presented on a similar basis.
3.1 The Product Life Cycle

The product life cycle describes how demand conditions for
a product, brand and whole markets change with time. The
product life cycle begins with product introduction and ends
with its obsolescence and/or replacement as represented by
the "S-curve" model:
Point of
$ saturation
(3) Maturity
Sales
(4)
Profit
Decline
(2)
Introduction
Growth Cash flow
(1)
0 Time
Development

The basic stages in the product life cycle are as follows:

1. Development—introduction phase/launch. This represents
a period of slow growth as new products usually need time
to gain market acceptance. Special pricing strategies may
be used during the launch of a new product (e.g. to "skim"
profits with high prices while the product is new).
Companies also need to consider that the pricing strategy
used at the introductory stage may affect demand in later
years (e.g. an initial low price to penetrate the market may
discourage competitors from entering the market).
2. Growth—competition may rise as a result of new suppliers
entering the market. This may force down prices.
3. Maturity—most profits are made during this phase. Prices
may be stable. The company's price strategy during this phase
is more likely to focus on maximising short term profits, unlike
in the introduction phase.
4. Decline—prices may fall with demand unless a "niche" market
can be found.
3.2 Life Cycle's Importance in Forecasting

The stages of the life cycle provide a framework which can be
used to analyse the main factors which can affect a market and
product sales. The four basic stages may be expanded into a
more comprehensive model for forecasting. Measurements can
be made to determine the stage of the market. For example:
Market Investment
No. of Market
Stage Growth Profits in
Competitors Size
(%) Marketing
Research and
Unknown 0 0 0 Growing
development
Product
Few Highest 0 Small High
introduction
Development Growing fast High Low Small High
Exploitation Moderate growth Good Growing Modest High
Maturation Stable Low High Largest Stable
Saturation Stable None Lowering Stable Declining
Decline Reducing Negative Low Declining Stopped
Source: Frost & Sullivan
< The S-curve model (s.3.1) represents a long-term outlook

based on rational insight or market research. Other methods
such as time series models (see Session 13) usually produce
more accurate forecasts in the short term.
< Together these approaches provide a framework and planning
tools to identify, for example, when sales and marketing
strategies should be modified.

3.3 Costs Involved at Different Life Cycle Stages

< There are three main stages in a product's life cycle from a
costing perspective:
= Planning
and design stage
= Manufacturing stage
= Service and abandonment stage
< During planning and design, many decisions about the
product's design will determine the costs to be incurred in the
future. These are referred to as committed costs. Although
they are not actually incurred during the design phase, the
company is committed to incurring the expenditure in the
future—mainly during the manufacturing stage.
< Tools such as target costing may be used to reduce such
committed costs if they exceed acceptable limits.
< Actual costs incurred during the planning and design phase
include the costs of design, which entails the development of
prototypes and the cost of market research.
< Marketing and advertising costs will be incurred during the
manufacturing stage. These are likely to be higher at the start
of the manufacturing phase as the product is new and needs
to be introduced to the market.
< In some industries, there may be abandonment costs at the
end of the product's life. In the nuclear power industry, for
example, costs of decontaminating the land on which the plant
is built may be high.
< Clearly, the pattern of expenditure will vary from industry to
industry. It is not uncommon, however, for committed costs
during the planning and design phase to reach 80% of the
total costs over the product's life.
100 - Costs
committed
Percentage of costs
Manufacturing and sales stage

70
Service and
abandonment
Planning stage
and
Costs incurred
design
stage
Product life cycle phase

3.4 Benefits of Life Cycle Costing

It encourages management to plan the pricing strategy for
the whole product life, rather than on a short-term basis.
Identifying the costs which will be incurred throughout
the product's life means that management will be able to
understand and, therefore, control them better.
Monitoring a product's revenues and costs on a cumulative
basis over the life of the product provides more meaningful
information for control than monitoring costs and revenues
on a period-by-period basis.
It is much easier to "design out costs" during the design
phase of a product than to "control out costs" later in the
product's life cycle. By considering the whole life cycle at
the design phase, management is more likely to achieve
reasonable cost base and, therefore, reasonable profits.
Decisions whether to continue to develop and
manufacture products will be based on more complete
information avoiding the risk that potentially profitable
products will be scrapped in the development phase
because they do not yet generate revenues.
Life cycle costing is particularly relevant for considering
environmental "clean-up" costs, which may be substantial.
In the European Union, the End of Life Vehicles (ELV) Directive
makes it compulsory for car manufacturers
to collect and dispose of old cars. Such costs should
therefore be considered by manufacturers during life-cycle
costing exercises.
Illustration 3 Committed Cost
Xerox leases photocopying machines to its customers. These

machines are returned to Xerox at the end of their lives. One cost
which previously had been ignored was the cost of packaging. Xerox
would provide packaging for the new machines which were delivered
to the customer. The customer would dispose of this packaging and
have to pay to re-pack the old machine which was being returned.
As a result of including the costs of packaging in the life cycle costs
of the photocopying, the company was able to see the costs were
expensive. Xerox now delivers machines in reusable packaging. Just
two standard types of packing have been developed which cover all
of Xerox's machines. This led to a reduction in packaging costs and
increased customer satisfaction.

4 Total Quality Management
*Total quality
management (TQM) is
a philosophy of getting
Total quality management—a process which consists of continuous it right the first time.
improvement in activities involving everyone in the organisation, It is recognised that
managers and workers, in a totally integrated effort towards the costs of bad quality
improving performance at every level.* may exceed the costs
of good quality.
4.1 Weaknesses of Traditional Western Approach

The traditional Western approach to manufacturing was to
produce maximum capacity. Production was driven by internal
plans rather than external demand. This lead to:
Excessive inventory holding with the associated costs of
storage and obsolescence.
Delays between customers ordering products and the delivery
of the products.
Bottlenecks in the production process were not highlighted.
A lack of flexibility in meeting changes in customer
requirements.
4.2 A Holistic Approach

TQM looks beyond product quality and involves everyone in the
organisation and encompasses every function: administration,
communications, distribution, manufacturing, marketing,
planning, training, etc. It involves:
< Commitment and direct involvement of senior management
in setting quality goals and policies, allocating resources and
monitoring results.
< Fundamental changes in basic beliefs and practices that
transform everyone's job and the organisation.
< Building quality into products and practices from the outset.
< Understanding the changing needs of internal and external
customers and stakeholders, and satisfying them in a cost-
effective manner.
< Leadership rather than supervision so that every individual
performs to the best of his or her ability to improve quality
and productivity, thereby continually reducing total cost.
< Eliminating barriers between people and departments so they
work as teams to achieve common objectives.
< Instituting flexible programs for training and education.
< Providing meaningful measures of performance which guide
the self-improvement efforts of everyone involved.

Session 11
Summary
< ABC aims to provide a more reliable calculation of the cost of a product by relating the cost
to the activities used in producing it.
< Steps in ABC are:
1. Identify the activities which cause costs to be incurred.
2. Identify the cost drivers related to each activity.
3. Allocate and apportion costs to activity pools.
4. Calculate the absorption rate per unit of driver.
5. Calculate the total overhead cost for manufacturing each product.
6. Calculate overhead cost per unit.
< Target costing is used to identify what unit costs should be to ensure sufficient profit can
be made to justify the investment.
< The steps in target costing are:
1. Determine the price which the market will accept for the product, based on market
research. This may take into account the market share required.
2. Deduct a required profit margin from this price to find the target cost.
3. Estimate the actual cost of the product. If it is a new product, this will be an estimate.
4. Identify ways to narrow the gap between the actual and target costs of the product.
< There are many techniques to narrow any gap between actual and target costs (including
"designing out" costs).
< The product life cycle provides a view of long-term demand and market conditions which
can be used in forecasting.
< Life cycle costing tracks cumulative costs and revenues over the life of a product.
< TQM is an approach to continuous improvement concerning the whole entity, not just
product quality.
< TQM looks beyond product quality and involves everyone in the organisation and
encompasses every function.

Session 11 Quiz
Estimated time: 15 minutes
1. Describe a cost driver. (1.1)

2. True or false? Activity-based costing (ABC) method allows for more "accurate" valuation
of product. (1.2)
3. Give TWO advantages and TWO disadvantages of ABC. (1.3)
4. Describe how a firm determines an acceptable margin when using target costing. (2)
5. True or false? Target costing is widely used, especially in service industries. (2.3)
6. List the stages in a product life cycle. (3.1)
7. Describe TWO benefits of life cycle costing. (3.4)
8. Give FIVE organisational structures/elements which will be involved in a properly functioning
TQM system. (4.2)
Study Question Bank

Estimated time: 30 minutes
Priority Estimated Time Completed
Q45 Telmat 30 minutes

EXAMPLE SOLUTIONS
Solution 1—Total Product Cost

(a) Traditional Overhead Absorption
Total overhead = $712,000
Total machine hours = $178,000 (3 × 6,000 + 4 × 40,000)
Rate per hour = $712,000
= $4/hour
178,000
X Y
$ $
Direct material 20 60
Direct labour 50 40
Fixed overhead
3 hours @ $4 12
4 hours @ $4 16
Total cost per unit 82 116
(b) ABC
Activities Machine Set-up Purchasing
Related Related Related
Overheads $178,000 $230,000 $304,000

Consumption of activities
(cost drivers) 178,000 hours 46 set-ups 152 orders
Cost per unit of $1 per hour $5,000 per set-up $2,000 per order
consumption
Cost traced to products
X $18,000 $80,000 $104,000
Y $160,000 $150,000 $200,000
Cost per unit
X $18,000 + $80,000 + $104,000
= $33.67
6,000
Y $160,000 + $150,000 + $200,000
= $12.75
40,000
X Y
$ $
Direct material 20.00 60.00
Direct labour 50.00 40.00
Fixed overhead 33.67 12.75
Total 103.67 112.75

Solution 2—Target Costing
$
Expected revenue (100,000 × $40,000) 4,000,000,000
Required profit (20% × $3 billion) 600,000,000
Total target cost 3,400,000,000
Target cost per car ($3,400,000,000/100,000) 34,000

NOTES

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Session 11

Alternative Costing Principles

B. Cost Accounting Techniques

Sadia sadia Afzal - gentledove004@gmail.com

ACTIVITY-BASED TARGET LIFE CYCLE TOTAL QUALITY

© 2013 DeVry/Becker Educational Development Corp. All rights reserved. 11-1

Sadia sadia Afzal - gentledove004@gmail.com

1 Activity-Based Costing (ABC)

1.2 Total Product Cost

Illustration 1 Cost Drivers

A production process may have the following associated cost drivers:

ABC provides a more "accurate" method of absorbing overhead

11-2 © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Sadia sadia Afzal - gentledove004@gmail.com

Identify major 1. Production scheduling

1. Number of batch set-ups for scheduling

© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 11-3

Sadia sadia Afzal - gentledove004@gmail.com

1.3 Advantages and Disadvantages of ABC

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Sadia sadia Afzal - gentledove004@gmail.com

Example 1 Total Product Cost

Machine Annual Total No. of No. of

Cost pools: Cost driver:

Total overheads 712,000

This numerical example is provided solely for better understanding of

© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 11-5

Sadia sadia Afzal - gentledove004@gmail.com

Example 1 Total Product Cost (continued)

Activities Machine Set-up Purchasing

Overheads $178,000 $230,000 $304,000

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Sadia sadia Afzal - gentledove004@gmail.com

2.1 Product Pricing

*Traditionally, the cost of producing a product or service was

< Target costing may be used;

2.2 Steps in Target Costing

© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 11-7

Sadia sadia Afzal - gentledove004@gmail.com

Target costing can be illustrated by the following flow diagram:

Example 2 Target Costing

This numerical example is provided solely for better understanding of

11-8 © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Sadia sadia Afzal - gentledove004@gmail.com

2.3 Use in Service Industries

2.4 Narrowing the Target Cost Gap

3 Life Cycle Costing

© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 11-9

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Illustration 2 Life Cycle Costing

Zany developed a new computer game in 2011, at a cost of

Annual profit (240) 100 275 100

3.1 The Product Life Cycle

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Sadia sadia Afzal - gentledove004@gmail.com

The basic stages in the product life cycle are as follows:

3.2 Life Cycle's Importance in Forecasting

Development Growing fast High Low Small High

Exploitation Moderate growth Good Growing Modest High

Maturation Stable Low High Largest Stable

Saturation Stable None Lowering Stable Declining

Decline Reducing Negative Low Declining Stopped

Source: Frost & Sullivan

< The S-curve model (s.3.1) represents a long-term outlook