ACCA

PERFORMANCE MANAGEMENT
F5 PAPER
 Costing
Costing is the process of determining the costs of products, services or activities.
Cost accounting is used to determine the cost of products, jobs or services
(whatever the organization happens to be involved in). Such costs have to be built
up using a process known as cost accumulation.
purpose of costing:
• inventory valuation
• pricing of products
• cost recording
• decision making
The problem of overheads
Indirect costs, or overheads, are costs incurred in making a product or providing a
service, but which cannot be traced directly to products or services. Absorption
costing is a means of incorporating a fair share of these costs into the cost of each
unit of product manufactured or each service provided.
• Direct cost
A direct cost is a cost that can be traced in full to the product, service or
department that is being costed.
• Indirect cost
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.
 Revision of absorption costing
Absorption costing is a traditional approach to dealing with overheads, involving
three stages: allocation, apportionment and absorption. Apportionment has two
stages: general overhead apportionment and service department cost
apportionment.
Absorption costing
Absorption costing is a method of product costing which aims to include in the
total cost of a product (unit, job, and so on) an appropriate share of an
organisation's total overhead, which is generally taken to mean an amount which
reflects the amount of time and effort that has gone into producing the product. The
aim of traditional absorption costing is to determine the full production cost per
unit. Absorption costing is based on the principle that production overheads are
driven by the level of production. When we use absorption costing to determine the
cost per unit, we focus on the production costs only.
Traditional volume-based costing systems tend to overcost high-volume products
and undercost low-volume products. It includes an element of fixed overheads in
inventory values, in accordance with IAS 2.
The assumption underlying this method of absorption is that overhead expenditure
is connected to the volume produced.

Overhead absorption
After apportionment, overheads are absorbed into products using an appropriate
absorption rate based on budgeted costs and budgeted activity levels. In absorption
costing all production overheads must be absorbed into units of production, using a
suitable basis, e.g. units produced, labor hours or machine hours.
Overhead costs are absorbed using a predetermined rate based on budgeted figures.

Absorption rate = Estimated overhead ÷ Budgeted activity level

Over- and under-absorption of overheads

Over- or under-absorbed overhead occurs when overheads incurred do not equal
overheads absorbed.
The rate of overhead absorption is based on estimates in the budget, of both the
numerator (budgeted expenditure) and denominator (budgeted activity level), and
it is quite likely that what actually occurs will differ from either one or both of
these estimates. As a consequence, actual overheads incurred will probably be
either greater than or less than overheads absorbed into the cost of production, and
so it is almost inevitable that at the end of the accounting year there will have been
an over-absorption or under-absorption of the overhead actually incurred.
• Over-absorption
Over-absorption means that the overheads charged to the cost of production or
sales are greater than the overheads actually incurred.
• under-absorption
Under-absorption means that insufficient overheads have been included in the cost
of production or sales.
 Activity based costing
Activity based costing (ABC) is an alternative to traditional absorption costing as a
method of costing. ABC involves the identification of the factors (cost drivers)
which 'cause' or 'drive' the costs of an organisation's major activities. Overheads
are allocated and apportioned to activity cost centres or 'cost pools'. From these
activity cost centres, the overhead costs are then absorbed into the product costs on
the basis of their usage of the activity. The absorption rate for each activity is a rate
per unit of the relevant cost driver.
Reasons for the development of ABC
Traditional absorption costing was developed in a time when most manufacturers
produced only a narrow range of products, so that products underwent similar
operations and consumed similar proportions of overheads. In addition, overhead
costs were only a very small fraction of total production costs: direct labour and
direct material costs accounted for the largest proportion of the costs. With the
dramatic fall in the costs of processing information, and with the advent of
advanced manufacturing technology (AMT), overhead costs have become a much
larger proportion of total production costs, and direct labour has become much less
important.
The falling costs of information processing have also made it possible to switch to
a different and more complex system for accumulating and analysing overhead
costs. ABC may now be cost effective whereas in the past its high costs could have
made it difficult to justify.
Many resources are used in non volume related support activities, which have
increased due to AMT. Non volume related support activities are activities that
support production, but where the level of support activity (and so the level of cost)
depends on something other than production volume – such as settingup
production runs, production scheduling and inspection. These support activities
assist the efficient manufacture of a wide range of products and are not, in general,
affected by changes in production volume. They tend to vary in the long term
according to the range and complexity of the products manufactured, rather than
the volume of output.
Traditional absorption costing systems, which assume that all products consume all
support resources in proportion to production volumes, tend to allocate:
(a) Too great a proportion of overheads to high volume products, which cause
relatively little diversity and hence use fewer support services; and
(b) Too small a proportion of overheads to low volume products, which cause
greater diversity and therefore use more support services.
Activity based costing (ABC) attempts to overcome this problem.

The major ideas behind activity based costing are as follows.

(a) Activities cause costs.
(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.

ABC system
Step 1: Identify an organisation's major activities that support the
manufacture.
Step 2 : Use cost allocation and apportionment methods to charge
overhead costs . The costs that accumulate for each activity cost
centre is called a cost pool.
Step 3 : Identify cost drivers.
Step 4: 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.

Absorption costing versus ABC

Traditional absorption costing techniques result in a misleading and inequitable
division of costs between low-volume and high-volume products, and that ABC
can provide a more meaningful way of charging overhead costs to products.
Traditional absorption costing may be unsatisfactory for two main reasons.
(a) It under-allocates overhead costs to low-volume products and over-allocates
overheads to higher-volume products.
(b) It under-allocates overhead costs to smaller products and over-allocates
overheads to larger products.
ABC addresses these problems and arguably produces a more 'realistic' or
'satisfactory' cost.

Cost drivers
ABC focuses attention on what factors are most influential in determining the level
of support activity costs, ie 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. Some activity costs may be variable, but many are not.
Cost drivers affect or influence total costs of the activity, but not in a direct
'variable cost' relationship between activity level and cost.
• Traditional absorption costing charges overhead costs to products in a way
that ignores the costs of support activities and their cost drivers. As a
consequence, it produces less satisfactory or 'reliable' product costs.

Merits of ABC

(a) The complexity of manufacturing has increased.ABC recognises this

complexity with its multiple cost drivers.
(b) ABC facilitates a good understanding of what drives overhead costs.
(c) ABC is concerned with all overhead costs and so it can take
management accounting beyond its 'traditional' factory floor
boundaries.
 ABC and decision-making
• Accurate and reliable cost information.
• Establishes a long-run product cost.

ABC cost is not a variable cost. ABC is a form of absorption costing that seeks to
charge overheads to products on a more 'fair' basis than traditional absorption
costing. An ABC cost is therefore not a relevant cost for decision-making
purposes.

Criticisms of ABC
(a) Apportionment can be an arbitrary way of sharing costs.
(b) A single cost driver may not explain the cost behaviour 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.
(d) Cost of implementing and maintaining an ABC system.
(e) Implementing ABC is often problematic.
(f) ABC is an absorption costing system. Absorption costing has only
limited value for management accounting purposes.
 Marginal costing
Marginal cost is the cost of one unit of a product/service which could be avoided
if that unit were not produced/provided. OR
Marginal cost is the extra cost incurred for producing an extra unit.
Contribution is the difference between sales revenue and variable (marginal) cost
of sales.
Marginal costing is an alternative to absorption costing. Only variable costs
(marginal costs) are charged as a cost of sales. Fixed costs are treated as period
costs and are charged in full against the profit of the period in which they are
incurred.
Marginal costing:
• In marginal costing, closing inventories are valued at marginal (variable)
production cost whereas, in absorption costing, inventories are valued at
their full production cost which includes absorbed fixed production
overhead.
• If the opening and closing inventory levels differ in an accounting period,
the profit reported for the period will differ between absorption costing and
marginal costing.
• But in the long run, total profit for a company will be the same whichever
costing method is used, because in the long run total costs will be the same
by either method of accounting. The different costing methods merely affect
the reported profit for individual accounting periods.
 Target costing
Target costing involves setting a target cost for a product, having identified a target
selling price and a required profit margin. The target cost is the target sales price
minus the required profit.
Target costing is concerned with designing a product and its production process so
that it can be made and sold at a cost that delivers the required profit at the chosen
price. It focuses on getting the expected cost of a product down to a target cost
amount. Achieving a target cost will usually require some redesigning of the
product and the removal of unnecessary costs. Target costing therefore encourages
a business to examine its processes and costs carefully. Functional analysis can be
applied at the design stage of a new product and a target cost for each function can
be set.
Target costing is most effective at the product design stage, and is less effective for
established products that are made in established processes. At the design stage, it
is easier and cheaper to make changes that reduce costs.

Implementing target costing

Step 1: Determine a product specification with 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.
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.
It is usual for estimates of target cost to be based not only on a target selling price
per unit, but also on the expected volume of sales.

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.
• 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.
Activity analysis is an analysis of how much is being spent on particular
activities.
Value analysis involves examining the factors which affect the cost of a product or
service, so as to devise ways of achieving the intended purpose most economically
at the required standards of quality and reliability.

Target costing in service industries

Target costing is difficult to use in service industries due to the characteristics and
information requirements of service businesses.
Characteristics of services
Unlike manufacturing companies, services are characterized by intangibility,
inseparability, variability, perishability and no transfer of ownership.
(a) Intangibility. This refers to the lack of substance which is involved
with service delivery. Unlike goods (physical products such as
confectionery), there are no substantial material or physical aspects to
a service: no taste, feel, visible presence, and so on.
(b) Inseparability/simultaneity. Many services are created at the same
time as they are consumed. (Think of dental treatment.) No service
exists until it is actually being experienced or consumed by the
person who has bought it.
(c) Variability/heterogeneity. Many services face the problem of
maintaining consistency in the standard of output. It may be hard to
attain precise standardization of the service offered, but customers
expect it (such as with fast food). When services are delivered by
humans, it is very difficult to ensure that the same service is
provided in exactly the same way every time.
(d) Perishability. Services are innately perishable. The services of a
beautician, for example, are purchased for a period of time.
(e) No transfer of ownership. Services do not result in the transfer of
property. The purchase of a service only confers on the customer
access to or a right to use a facility.

Problems with target costing for services

Services are much more difficult to specify exactly. .The quality of the personal
service can be critically important for the customer, but this is difficult or
impossible to specify.
 The product life cycle
The 'classical' life cycle of a product has five phases or stages.
(a) Development. The product has a research or design and development stage.
Costs are incurred but the product is not yet on the market and there are no sales
revenues.
(b) Introduction. The product is introduced to the market. Potential customers are
initially unaware of the product or service, and the organization may have to spend
heavily on advertising to bring the product or service to the attention of the market.
In addition, capital expenditure costs may be incurred in order to increase the
production capacity as sales demand grows.
(c) Growth. The product gains a bigger market as demand builds up. Sales
revenues increase and the product begins to make a profit.
(d) Maturity. Eventually, the growth in demand for the product will slow down and
it will enter a period of relative maturity, when sales have reached a peak and are
fairly stable. This should be the most profitable phase of the product's life. The
product may be modified or improved, as a means of sustaining its demand and
making this phase of the life cycle as long as possible.
(e) 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. Eventually it will
become a loss-maker and this is the time when the organization should decide to
stop selling the product or service.
 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.
A product's life cycle costs are incurred from its design stage through development
to market launch, production and sales, and finally to its eventual decline and
withdrawal from the market.
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, on the other hand, tracks and accumulates actual costs and
revenues attributable to each product over the entire product life cycle. Hence the
total profitability of any given product can be determined.
 calculate life cycle costs
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.
Benefits of 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 otherwise might be considered.
(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.

With life cycle costing, all costs are traced to individual products or services over
their complete life cycles. This encourages management to think of the life cycle,
and ways in which this may perhaps be managed.
It has been reported that some organizations operating with an advanced
manufacturing technology environment find that approximately 90% of a product's
life cycle costs are determined by decisions made early within the cycle, at the
design stage. Life cycle costing is therefore particularly useful for these
organizations, to monitor spending during the early stages of a product's life cycle.
The techniques of life cycle costing and target costing can be combined, to plan
for achieving certain levels of cost at different stages of the product's life cycle.
Both are essentially forward-looking techniques of costing.
 Maximizing return over the product life cycle
• Design costs out of products
Between 70% and 90% of a product's life cycle costs aredetermined by
decisions made early in the life cycle, at the design or development stage.
• Minimize the time to market
Time to market' is the time from the conception of the product to its
introduction to the market. the life span of a product may be affected by
delay in its market introduction. It is not unusual for the product's overall
profitability to fall by 25% if the launch is delayed by six months. This
means that it is usually worthwhile incurring extra costs to keep the
launch on schedule or to speed up the launch
• Minimize breakeven time (BET
A short BET is very important in keeping an organization liquid. In life
Cycle costing, breakeven occurs when revenue from the product has
covered all the costs incurred to date,including design and development
costs.
• Maximize the length of the life span
Product life cycles are not predetermined; they can be influenced by the
actions of management and competitors. By entering different national
or regional markets one after another an organization may be able to
extend the growth phase of a product's life.
Service and project life cycles
Services have life cycles. The only difference with the life cycle of a product is
that the R&D stages will not usually exist in the same way.
 Managing environmental costs
Environmental costs are important to businesses for a number of reasons.
• Identifying environmental costs associated with individual products and services
can assist with pricing decisions.
• It ensures compliance with regulatory standards.
• There is potential for cost savings.
Environmental management accounting (EMA
Environmental management accounting (EMA) is the generation and analysis of
both financial and nonfinancial information in order to support internal
environmental management processes.

Defining environmental costs

There are many varied definitions of environmental costs.
Distinction between four types of cost:
(a) Conventional costs, such as raw materials and energy costs, have
an impact on the environment.
(b) Potentially hidden costs are relevant costs that are captured within
accounting systems but may be 'hidden' within 'general
overheads'.
(c) Contingent costs are costs that will be incurred at a future date as
a result of discharging waste into the environment, such as clean-
up costs.
(d) Image and relationship costs are costs incurred to preserve the
reputation of the business; for example, the costs of preparing
environmental reports to ensure compliance with regulatory
standards.
Environmental costs are internal or external. Internal costs are environmental costs
that an organization incurs. External environmental costs are costs that an
organization causes, but which are suffered by others – for example the general
public.
The internal environmental costs for an organization include, the costs of
preventing environmental damage (such as air filters and water treatment
equipment), the costs of detecting environmental damage or emissions, the costs of
correcting environmental damage that is caused, and the costs of disposal of any
waste.

Accounting for environmental costs

• 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. They effectively demonstrate the
details of the processes so that the relevant information can be
allocated to the main activities. Any difference between the
amount input and the eventual output is 'residual', which is called
'waste'. By accounting for process outputs in this way both in
physical quantities and in monetary terms, businesses are forced
to focus on environmental costs.

• Flow cost accounting

inputs and outputs are measured through each individual process
of production. A distinction is made between:
(a) Positive products: this is good output .
(b) Negative products: this is the measurement of waste .
 Positive products + Negative products = Total input .
Positive and negative products are measured in both physical and
cost terms. Under this technique, material flows through an
organisation are divided into three categories, and the cost of each
category is measured separately:
• Material.
• System: this is the in-house handling that is required (including
labour) and its cost.
• Delivery and disposal: this is the cost of transport and the cost
of disposal of waste.
An important focus of management attention with flow cost
accounting should be to reduce the proportion of negative
products in total output and increasing the proportion of positive
products.
This approach is applied to each individual process within the
overall production system.

• Environmental activity-based costing

Environmental activity-based costing combined elements of
environmental costing with an activity-based costing system.
Environment costs can be divided into two categories.
(a) Environment-related costs, such as an incinerator or a sewage
treatment plant, for which costs can be directly traced.
(b) Environment-driven costs, which are normally hidden within
total overheads in a conventional costing system.
The main challenge with environmental activity-based costing is to:
 (a) Identify the hidden environmental costs and link them to
'environmental activities'.
(b) Charge the costs of each environmental activity to individual
product costs according to the amount that each product is
responsible for the environmental activity.
Suitable environmental activities should be identified and an
activity cost centre created for it. It should be possible to trace
environment-driven costs to these cost centres. Environment costs
that have been allocated and apportioned to environmental activity
cost centres can then be absorbed into product costs on a suitable
basis.

• Environmental life cycle costing

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.
As with 'normal' life cycle costing, this approach makes an
assessment of expected environmental costs over the entire life of a
product. These costs will include 'internal' costs that the include
external environmental costs, which are costs that others in society
will incur, rather than the organisation itself.