MA - More Cost Accounting Techniques

Contents
Process Costing: Introduction ..................................................................................................... 2
DEFINITION AND CHARACTERISTICS:....................................................................................... 2
COST ALLOCATION: .................................................................................................................. 3
Process Costing: Losses and Gains .............................................................................................. 4
LOSSES: .................................................................................................................................... 4
GAINS: ...................................................................................................................................... 4
Process Costing: Losses and Gains .............................................................................................. 6
LOSSES: .................................................................................................................................... 6
GAINS: ...................................................................................................................................... 7
Process Costing: Closing Work-in-Progress ................................................................................. 8
Process Costing - Closing WIP - Different Stages of Completion .............................................. 10
Process Costing: Opening WIP .................................................................................................. 13
WEIGHTED AVERAGE METHOD: ............................................................................................ 13
Process Costing: Opening WIP (FIFO Method) .......................................................................... 17
Joint Products and By-Products ................................................................................................ 20
GENERAL PRINCIPLES AND TERMS: ....................................................................................... 20
APPORTIONMENT OF COMMON COSTS: .............................................................................. 20
Job Costing ................................................................................................................................ 24
Batch Costing ............................................................................................................................. 27
Service/Operation Costing ........................................................................................................ 29
Activity Based Costing ............................................................................................................... 31
Target Costing ........................................................................................................................... 34
Life Cycle Costing....................................................................................................................... 36
Total Quality Management ....................................................................................................... 39

1
Process Costing: Introduction
DEFINITION AND CHARACTERISTICS:

Process costing is a commonly-used cost accounting technique in manufacturing organisations

that mass produce identical units during a series of processes.

Process costing is defined by a number of characteristics which include the following:

1) Identical units. All of the products produced in one particular process will be the same
type of product;

2) Continuous process. A streamlined process that involves ongoing production where

different ingredients are added at different stages of the process;

3) Loss of units during the manufacturing process. Sometimes, during the process, units
might be lost due to general wastage, spillage, or evaporation;

4) Opening and closing work-in-process. At the end of an organisation’s financial year, it

might be necessary to attribute a value to partly-finished goods. Closing WIP is carried
forward from one accounting period to the next where it becomes opening WIP;

5) Joint products. It refers to the process when more than one product is produced from a
process and each has significant value;

6) By-products. These are products with relatively little value that emerge from the
common process along with the main product.

Note: Examples of industries that use process costing include: food and drink, oil, drugs,
chocolate, paint, etc.

2
COST ALLOCATION:

Costs incurred are debited to the process account, completed units are transferred to the next
Process as shown here:

Units $ Units $

Materials X Y Completed units transferred to the next Process X Y

Labour Y

Overheads Y

TOTAL X Y = X Y

We can calculate a cost per unit for the completed units as follows:

Total process costs

Cost per unit =
Total number of completed units

3
Process Costing: Losses and Gains
LOSSES:

There are two types of loss in process costing:

1) Normal loss - a loss that is expected during a costing process. Normal loss units are
valued at zero dollars. They do not have a value, because they are expected;

2) Abnormal loss - a loss which occurs over and above normal loss. Abnormal loss units are
valued at the same value as completed units.

When a process expects to lose a certain number of units, the cost per unit is calculated as
follows:

Total process costs

Cost per unit =
Expected number of completed units

If the actual output is less than expected output, then there is both normal loss and abnormal
loss.

Units $ Units $

Materials X Y Completed units transferred to Process B X Y

Labour Y Normal loss X 0

Overheads Y Abnormal loss X Y

TOTAL X Y = X Y

GAINS:

If the actual output is more than the expected output, then there is also an abnormal gain.
Abnormal gain units are valued at the same value as completed units.

4
 Units $ Units $

Materials X Y Completed units transferred to Process B X Y

Labour Y Normal loss X 0

Overheads Y

Abnormal gain X Y

TOTAL X Y = X Y

5
Process Costing: Losses and Gains
LOSSES:

There are two types of loss in process costing:

1) Normal loss - a loss which is expected during a costing process. Normal loss units are
valued at zero dollars. They do not have a value, because they are expected;

2) Abnormal loss - a loss which occurs over and above normal loss. Abnormal loss units are
valued at the same value as completed units.

When a process expects to lose a certain number of units, the cost per unit is calculated as
follows:

Total process costs

Cost per unit =
Expected number of completed units

If the actual output is less than expected output, then there is both normal loss and abnormal
loss.

Units $ Units $

Materials X Y Completed units transferred to Process B X Y

Labour Y Normal loss X 0

Overheads Y Abnormal loss X Y

TOTAL X Y = X Y

6
GAINS:

If the actual output is more than the expected output, then there is also an abnormal gain.
Abnormal gain units are valued at the same value as completed units.

Units $ Units $

Materials X Y Completed units transferred to Process B X Y

Labour Y Normal loss X 0

Overheads Y

Abnormal gain X Y

TOTAL X Y = X Y

7
Process Costing: Closing Work-in-Progress
Closing work-in-process (WIP) refers to partially completed units existing at the end of an
accounting period. It is necessary to value those units so that they can be included in an
organisation’s statement of financial position.

Opening work-in-process is the closing work-in-process transferred to the beginning of the next
accounting period.

It is a common practice to calculate a cost per equivalent unit (EU) for closing work-in-process,
rather than a cost per unit as we do for fully completed units. The Concept of equivalent units
refers to the process of sharing out process costs between fully-completed units and partially-
completed closing work-in-process units in order to calculate a cost per equivalent unit. The
number of equivalent units can be calculated as follows:

8
 EUs Example

Fully-completed units X 800

Work-in-process (WIP) Y 200

% of completion % 75%

Equivalent units at end of process X + Y*% 800+200*75% = 950

Total process costs

Equivalent cost per unit =
Total number of equivalent units

Value of fully completed units = Number of fully completed units x Cost per EU

Value of closing WIP = Number of EU x Cost per EU

Units $ Units $

Materials X Y Fully completed units X Y

Labour Y Closing WIP c/f X Y

Overheads Y

TOTAL X Y = X Y

Opening WIP b/f X Y

9
Process Costing - Closing WIP - Different Stages of Completion
When materials, labour, and overheads are processed to different degrees of completion, the
cost per equivalent unit calculation includes the following steps:

1) To calculate the number of equivalent units for materials and conversion:

EUs EUs
Materials Conversion

Fully-completed units X X

Materials X <= % of completion * q-ty

Work-in-process (WIP)
Conversion X <= % of completion * q-ty

Equivalent units at end of process Total Total

2) To calculate the equivalent cost per unit:

Materials process costs

Equivalent cost per unit (materials) =

Total number of equivalent units
(materials)

Total conversion costs

Equivalent cost per unit (conversion) =
Total number of equivalent units (conversion)

3) To calculate the value of fully completed units:

Number of fully completed units x

Value of fully completed units =
(Cost per EU (materials) + Cost per EU (conversion))

10
 4) To calculate the value of closing WIP:

Number of EU (materials) x Cost per EU (materials) +

Value of closing WIP =
Number of EU (conversion) x Cost per EU (conversion)

Units $ Units $

Materials X Y Fully completed units X Y

Labour Y Closing WIP c/f X Y

Overheads Y

TOTAL X Y = X Y

Opening WIP b/f X Y

Example 1:

2,000 units of material costing $5,000 are input to Process P. In addition, labour costing $2,000
and overheads costing $1,000 are incurred during the period. At the end of the period, there
are 1,500 fully completed units that are transferred to Process Q and there are 500 units of
work-in-process. The work-in-process is 100 percent complete for materials, and 60% complete
for labour and overheads.

Calculate the number of equivalent units at the end of the process and the cost per equivalent
unit.

11
Solution:

EUs: Materials EUs: Conversion

Fully-completed units 1,500 1,500

Work-in-process (WIP): Materials (500 x 100%) 500

Work-in-process (WIP): Conversion (500 xx 60%) 300

Equivalent units at end of the process 2,000 1,800

Cost per equivalent unit of materials = $5,000 / 2,000 = $2.5

Cost per equivalent unit of conversion costs = $3,000 / 1,800 = $1.67

12
Process Costing: Opening WIP
There are two different methods that are used to value opening work-in-process in process
costing:

1) The weighted average method;

2) First in, first out method (FIFO).

WEIGHTED AVERAGE METHOD:

The calculation of the opening work-in-process value using the weighted average method
includes the following steps:

1) To calculate the number of equivalent units for materials and conversion:

EUs EUs
Materials Conversion

Opening WIP X X

Units started and completed in the

X X
period

<= % of completion * q-
Materials X
ty
Work-in-process (WIP)
<= % of completion * q-
Conversion X
ty

Equivalent units at end of process Total Total

2) To identify the total process costs for materials and conversion:

Total process costs (materials) = Opening WIP (materials) + Materials added

Total process costs (conversion) = Opening WIP (conversion) + Conversion costs incurred

13
3) To calculate the equivalent cost per unit:

Materials process costs

Equivalent cost per unit (materials) =

Total number of equivalent units
(materials)

Total conversion costs

Equivalent cost per unit (conversion) =
Total number of equivalent units (conversion)

4) To calculate the value of fully completed units:

Number of fully completed units x

Value of fully completed units =
(Cost per EU (materials) + Cost per EU (conversion))

5) To calculate the value of closing WIP:

Number of EU (materials) x Cost per EU (materials) +

Value of closing WIP =
Number of EU (conversion) x Cost per EU (conversion)

Units $ Units $

Opening WIP b/f X Y Fully completed units X Y

Materials X Y

Conversion Y Closing WIP c/f X Y

TOTAL X Y = X Y

Opening WIP b/f X Y

14
Example 1:

The following information relates to the Process P account:

Units $ Units $

Opening WIP b/f 200 750 Fully-completed units 850 5,950

transferred to Process Q

Materials 1,050 4,400 Closing WIP c/f 400 2,050

Conversion 2,850

TOTAL 1,250 8,000 1,250 8,000

Opening WIP b/f 400 2,050

The closing WIP is 100% complete for materials and 37.5% complete for conversion costs.
Calculate the following:

− Equivalent units at the end of the process.

− Equivalent cost per unit

− Value of fully completed units

− Value of closing WIP

15
Solution:

EUs: Materials EUs: Conversion

Opening WIP 200 200

Units started and completed in the period 650 650

Work-in-process (WIP): Materials 400

Work-in-process (WIP): Conversion 150

Equivalent units at end of the process 1,250 1,000

Equivalent cost per unit for materials = $5,000 / 1,250 = $4

Equivalent cost per unit for conversion costs = $3,000 / $1,000 = $3

Value of fully completed units = 850 x $7 = $5,950

Value of closing WIP = ($4 x 400) + ($3 x 150) = $2,050

16
 Process Costing: Opening WIP (FIFO Method)
The scrap value from normal loss can be used to reduce the total process costs, thereby
resulting in a cost reduction per completed unit. When normal loss has a scrap value, the value
of the completed units in a process is calculated as follows:

The main difference between the weighted average method and the FIFO method is the
treatment of the opening WIP units:

− With FIFO the opening WIP units must be completed before work starts on any other
units;

− Opening WIP units are clearly distinguished from other units in a process.

Calculation of the opening WIP value using the FIFO method includes the following steps:

1) To calculate the number of equivalent units for materials and conversion:

EUs Materials EUs Conversion

Materials X
Opening WIP
Conversion X

Units started and completed in the period X X

Materials X
Closing WIP
Conversion X

Equivalent units at end of the process Total Total

Equivalent units = Number of units * % (completed in this period)

17
 2) To calculate the cost per equivalent unit:

Cost of materials added in the period

Cost per equivalent unit (materials) =

Total number of equivalent units
(materials)

The conversion costs incurred in the period

Cost per equivalent unit (conversion) =
Total number of equivalent units (conversion)

3) To calculate the cost to complete opening WIP units:

Cost to complete opening Number of EU (materials) x Cost per EU (materials) +

=
WIP units Number of EU (conversion) x Cost per EU (conversion)

4) To calculate the value of unit started and completed in the period:

Cost per unit = Cost per EU (materials) + Cost per EU (conversion)

Value of units started and completed in

= Number of EU x Cost per unit
the period

5) To calculate the value of the fully completed units transferred to the next process:

Value of fully Opening Cost to complete Value of units started

= + +
completed units WIP b/f opening WIP units and completed

18
6) To calculate the value of closing WIP:

Number of EU (materials) x Cost per EU (materials) +

Value of closing WIP =
Number of EU (conversion) x Cost per EU (conversion)

Units $ Units $

Opening WIP b/f X Y Fully completed units X Y

Materials X Y

Conversion Y Closing WIP c/f X Y

TOTAL X Y = X Y

Opening WIP b/f X Y

19
Joint Products and By-Products
GENERAL PRINCIPLES AND TERMS:

Joint products (JP) are produced when more than one product of significant value is produced
from a process and where all of the products are produced in similar quantities.

By-products (BP) are products of relatively little value that emerge from the common process
along with the main product.

When considering joint products and by-products, the total costs of the materials, labour, and
overheads that are input into a process are known as joint process costs.

Note: Joint process costs are also called pre-separation/split-off costs or common costs.

The three common characteristics by which joint process costs can be apportioned between the
joint products are as follows:

− Sales value of joint products;

− Units of production;

− Net realisable value.

APPORTIONMENT OF COMMON COSTS:

Apportionment of the common process costs between joint products includes the following
steps:

1) To calculate the common joint costs of the process:

Common joint costs = Material + Labour + Overheads

2) To calculate the net common process costs:

Sales revenue from BP = Number of units of BP x Sales revenue per unit

Net common process costs = Common process costs - Sales revenue from BP

Note: The sales revenue from by-products is treated the same way as the sales revenue from
normal loss when it can be sold for a scrap value. In both situations, it is used to reduce the
total costs of the process.

20
 3) To apportion the net common process costs using the appropriate basis:

a) Sales value of joint products:

Sales revenue of JP = Number of units x Selling price per unit

Sales revenue of JP
Net common process costs Net common
= x
apportioned to JP process costs
Total sales revenue

b) Units of production:

Number of units of JP
Net common process costs Net common
= x
apportioned to JP process costs
Total number of units

c) Net realisable value:

Net realisable value per unit = Selling price - Cost to make the sale

Note: Costs to make the sale are further costs, which will need to be incurred before goods can
be sold (e.g., finishing, repair, advertising, transportation costs).

Net realisable value of JP = Number of units x NRV per unit

Net realisable value of JP

Net common process costs Net common
= x
apportioned to JP process costs
Total net realisable value

Units $ Units $

Opening WIP b/f X Y Joint product 1 X Y

Materials X Y Joint product 2

Conversion Y By-product X Y

21
 TOTAL X Y = X Y

EXAMPLES:

Example 1

A business produces two joint products A and B in the quantity 15,000 and 5,000 respectively.
The total joint production costs are $500,000.

Calculate the apportionment of cost between the two products under units of production
method.

Solution:

Costs apportioned to A = $500,000 x ($15,000 / $20,000)

Costs apportioned to A = $375,000

Costs apportioned to B = $500,000 x ($5,000 / $20,000)

Costs apportioned to B = $125,000

Example 2

An organisation manufactures two joint products, JP1 and JP2, and one by-product, BP1 in a
process. During a period, 20,000 units of materials costing $200,000 were input into the
process. In addition, $60,000 of labour and $40,000 of overhead costs were also incurred during
the period.

At the end of the process, the following quantities of product were output:

JP1 = 10,000 units

JP2 = 6,000 units

BP1 = 1,000 units

The selling price of each unit is as follows:

JP1 = $40 per unit

JP2 = $30 per unit

BP1 = $10 per unit

22
If the organisation uses the sales revenue of any by-products produced to reduce the common
process costs, how would the joint process costs be apportioned between JP1 and JP2 on the
basis of their sales values?

Solution:

Sales revenue of JP1 = 10,000 x $40 = $400,000

Sales revenue of JP2 = 6,000 x $30 = $180,000

Sales revenue of BP1 = 1,000 x $10 = $100,000

Total revenue of joint products = $400,000 + $180,000

Total revenue of joint products = $580,000

Common joint costs = $200,000 + $60,000 + $40,000

Common joint costs = $300,000

Net common joint costs = $300,000 - $100,000

Net common joint costs = $200,000

Costs apportioned to JP1 = $200,000 x ($400,000 / $580,000)

Costs apportioned to JP1 = $137,931

Costs apportioned to JP2 = $200,000 x ($180,000 / $580,000)

Costs apportioned to JP2 = $62,068

23
Job Costing
Job costing is a costing method that is commonly used when work is carried out to specific
requirements, such as an individual job which is specific to a certain client.

Under job costing, the interaction between an organisation and its customers includes the
following steps:

1) The customer contacts the organisation and asks them for a cost estimate;

2) The organisation estimates the cost of any direct materials, direct labour, direct
expenses, variable overheads, and fixed overheads, that might be incurred;

3) The organisation prepares an estimate by totalling the costs and adding an element of
profit. For convenience, the organisation fills out a job quotation sheet;

$ $

Direct materials X

Direct labour X

Direct expenses X

Prime cost X

Variable overheads X

Fixed overheads X

Total cost of job X

Profit (% of total costs) X

Total estimated job cost X

Prime cost = Direct materials + Direct labour + Direct expenses

Total cost of job = Prime cost + Variable overheads + Fixed overheads

Selling price (Total estimated job cost) = Total costs + Profit

24
Note: Calculating a profit as a percentage of total costs is known as ‘cost-plus’ pricing.

4) The customer accepts the price and the organisation is in a position to begin the job.

Individual costs incurred on a specific job are recorded on a job cost sheet or a job cost card
(similar to the job quotation sheet). The selling price established in the job cost card is the
actual amount that will be charged to the customer.

Example 1:

ABC Company requires the industrial cleaning of its large city offices to be carried out by
Industrial Cleaning Co during a weekend when the offices are closed.

The following costs have been estimated by Industrial Cleaning Co:

$ $

Direct materials 80

Direct labour 1,792

Direct expenses 50

Prime cost 1,922

Variable overheads 176

Fixed overheads 100

Total cost of job 2,198

Profit (50% of total costs) 1,099

Total estimated job cost 3,297

25
Industrial Co wishes to keep a markup of 20% on the total estimated costs. Calculate the price
that should be quoted to ABC Company.

Solution:

Quoted price = Total cost + Profit

Quoted price = $3,297 + $3,297 x 20%

Quoted price = $3,956.4

26
Batch Costing
Batch costing involves the production of batches of identical units rather than an individual
order or contract produced to a customer’s specific requirements.

Note: The use of batch costing is appropriate when we consider the production of batches of
items such as bottles of water, bars of chocolate, toothbrushes, postcards, etc.

In batch costing, it is common to add together the costs involved in producing a batch of items
in order to establish a cost per batch:

Direct materials X

Direct labour X

Direct expenses X

Batch setup cost X

Variable overheads X

Prime cost X

Fixed overheads X

Total batch cost X

Cost per unit X

All direct costs are variable costs because they vary with the level of activity (or the batch size).
The batch set-up cost is a direct cost and also a fixed cost, as it does not vary with the level of
activity or batch size.

27
Total batch costs = Prime cost + Fixed overheads

Total batch cost

Cost per unit =
Number of units

In order to determine the price for each batch, organizations use the following calculations:

Sale price = Total batch cost + Profit

Total batch cost

Profit Sale price =
Profit margin = (1 - Profit margin)
Selling price

28
Service/Operation Costing
Service costing is commonly used when services are provided by an organisation. Organisations
that provide services include the following: advertising agencies, hotels, hospitals, restaurants,
accountants, etc. Services have the following characteristics:

− Intangible - they cannot be touched;

− Inconsistent - individual services provided are likely to be different from each other
because they are man-made and not machine-made;

− Perishable - they cannot be stored and used when needed;

− Simultaneous - services are provided and used at the same time as compared to
products which can be manufactured one day, stored and then used at a later date.

Note: A common problem with service costing is deciding on which service cost unit to use.
Advertising agencies might use a cost per advertising campaign, hotels - a cost per room,
hospitals - a cost per operation, restaurants - a cost per meal, accountants - a cost per
chargeable hour.

The cost per service unit is calculated as follows:

Total cost of providing a service

Cost per service unit =
Number of units of the service provided

Service organisations sometimes calculate composite cost units when they are analysing their
costs. Composite cost units are made up of more than one unit. For example, travel companies
commonly calculate a cost per passenger-kilometre.

Number of passenger/kilometres per day = Number of passengers x Number of km

The total number of passenger/kilometres is calculated by adding up all passenger/kilometres

during the analysed period.

Total running costs

The cost per passenger/kilometre =
Total number of passenger/kilometres

Note: Organisations that provide services find it useful to compare their costs with those in the
same industry to see if there are any legitimate savings to be made.

29
Example:

The Rapid Train Company runs a rail service in the hilly region in the north of the country for six
days of the week. The following data relate to the first week of March:

Day of the week Number of passengers Distance travelled (kms) Running cost ($)

Monday 265 500 76,000

Tuesday 281 500 77,500

Wednesday 316 500 75,000

Thursday 378 500 78,500

Friday 284 500 75,500

Saturday 236 500 79,500

Total 1,760 3,000 462,000

Calculate the cost for transporting one passenger one kilometre during the first week of March.

Solution:

Total cost = $462,000

Total number of passengers / kilometres = $1,760 x 500 = 880,000

Cost per passenger / kilometre = $462,000 / $880,000 = $0.525

Note: This method is slightly different from the one explained in the lecture. However, it is
equally acceptable.

30
Activity Based Costing
There are a number of alternative cost accounting methods that organisations can use:

− Activity based costing;

− Target costing;

− Lifecycle costing;

− Total quality management.

With activity-based costing (ABC), the reallocation of overheads from service departments to
production departments is based on the activities that cause the service department to incur
costs.

The steps involved in activity-based costing are as follows:

1) To identify the main activities of the department whose overheads are to be allocated.

2) To estimate (take budgeted or actual information) the costs associated with each of the
main activities. The costs associated with individual activities, typically by department or
service centre, are known as cost pools.

3) To identify what causes the cost pools’ costs. The cause of cost pools’ costs is known as
the cost driver.

For example, the costs associated with receiving materials are the costs of processing of goods
received notes, and the costs associated with issuing materials are the costs of processing the
materials requisition notes.

31
 4) To calculate a cost driver rate (or rate per cost driver) use the following formula:

Cost pool
Cost driver rate =
Total number of cost drivers

For example, the rate per goods received note is calculated in the following way:

Costs associated with processing goods received notes

Rate per goods received note =
Number of goods received notes

5) To allocate overheads to the particular department:

Department overheads = Cost driver rate x Number of cost drivers used by the department

Example 1:

An organisation manufactures two types of mobile phones which are manufactured in Mobile
Phone Department 1 and Mobile Phone Department 2.

The different components that are needed to make these two mobile phones are received by
the store’s department and are then issued to each of the Mobile Phone Departments when
requested.

The store’s department’s running costs for the coming year are budgeted to be $39,500 of
which $8,750 relates to the receipt of components from suppliers and $30,750 relates to the
issue of the components to the Mobile Phone Department 1 and Mobile Phone Department 2.
It is estimated that the store’s department will process 3,500 goods received notes and 8,200
materials requisition notes in the coming year.

If Mobile Phone Department 1 is responsible for 1,220 goods received notes and 3,980
materials requisition notes, how much of the store’s department’s overheads will be re-
apportioned to Mobile Phone Department 1?

32
Solution:

Rate per goods received note = $8,750 / 3,500 = $2.50

Rate per materials requisition note = $30,750 / 8,200 = $3.75

GRN cost of Department 1 = $2.50 x 1,220 = $3,050

MRN cost of Department 1 = $3.75 x 3,980 = $14,925

Total overheads of Department 1 = $3,050 + $14,925 = $17,975

33
Target Costing
Target costing is concerned with calculating the target cost of a product, with the target cost
being the cost that an organisation is aiming for.

The target selling price of a product (which is the same as the optimum selling price) is the price
that makes customers interested in buying the product at a price that they are willing to pay.

Once the target selling price has been established, it can be used to determine the target cost
of the product:

Selling price = Cost of product + Profit margin

There are two ways of calculating a product’s profit margin:

Cost plus pricing method. This method involves adding a profit margin to the cost of the
product which is equivalent to a percentage of the costs involved in manufacturing the product.

Selling price = Cost of product + Profit margin (% of the cost of product)

Selling price
Total costs =
(1 + Profit margin)

2) The second method involves the profit margin being a percentage of the selling price.

Selling price = Cost of product + Profit margin (% of the selling price of product)

Total costs = Selling price x (1 - Profit margin)

Organisations must have a clear idea of how much profit they want to earn from each product
in order to be able to work out the target cost from the target selling price.

Example 1:

A company has established the target price of a product to be $1,000. The company wishes to
keep a margin of 20% on sales. Calculate the target cost.

Solution:

If the term ‘margin on sales’ is used, always assume the selling price to be 100%. If the selling
price is 100% and the margin is 20%, the cost must be 80%.

34
Target cost = ($1,000 / 100) x 80

Target cost = $800

Example 2:

A company has established the target price of a product to be $1,000. The company wishes to
keep a markup of 20% on cost. Calculate the target cost.

Solution:

If the term ‘markup on cost’ is used, always assume the cost to be 100%. If the cost is 100% and
the markup is 20%, the selling price must be 120%.

Target cost = ($1,000 / 120) x 100

Target cost = $833.33

35
Life Cycle Costing
Life Cycle Costing is a cost accounting method that aims to ensure that a product will be
profitable during its lifetime. Life cycle costing aims to keep the following relationship:

Total costs incurred throughout the life Total income generated during the
<
of a product product’s lifetime

There are four stages in the product life cycle:

1) Launch (Introduction) - when a new product is introduced to the public;

2) Growth - if there is a demand for the new product, then sales of the product will
increase over time;

3) Maturity - when the product has been in the marketplace for a while, the demand for it
slows down. It will usually still generate profits at this stage;

4) Decline - the end of a product’s life (decrease in demand which can lead to losses).

A product is also likely to incur costs:

− Before a product is manufactured and before the introduction stage of the life cycle,
for example, the initial design and development costs of a product;

− After the decline stage of the life cycle and after the product has stopped being
manufactured. Such costs are known as end-of-life costs and include costs
associated with the disposal of items of plant and machinery no longer required.

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When using life cycle costing, the organisation usually proceeds with the following steps:

1) Calculation of the expected income that will be generated from sales:

Sales income = Price x Number of units

2) Estimation of the expected costs over the lifetime (i.e., purchase of a specialised
machine, advertising costs, production cost per unit, selling and distribution costs).

3) Those costs which are relevant are then added together in order to determine whether
they are greater or less than the expected sales income of the product.

Example:

An organisation is planning to manufacture a new product, Product NC, and has commissioned
a survey in order to establish likely sales volumes and prices of this product. The results of the
survey reveal that over the five-year life of the product, 25,000 units of Product NC are
expected to be sold at a selling price of $20.

The survey found that over the lifetime of this new product, the following costs were expected
to be incurred:

− The purchase of a specialised machine that is required for production of Product NC is

expected to be $40,000. The machine will not be suitable for re-sale at the end of the
project and will need to be disposed of at a cost of $1,500.

− Advertising costs when the product is introduced are expected to be $15,000 for the
first year and then budgeted to be $1,000 per year for the next four years.

− Staff will need to be trained during the first year of production and this will cost
$24,000.

− The production cost per unit of Product NC is budgeted to be $11.20 per unit.

− Selling and distribution costs are budgeted to be $1 per unit sold.

− The annual depreciation of the specialised machine will be $8,000 per annum.

Calculate the expected profit over the life of the project.

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Solution:

Expected sales = 25,000 units x $20 = $500,000

Expected costs:

Lifecycle costs - Product NC $

Purchase of specialised machine 40,000

Advertising - Year 1 15,000

Advertising - Years 2 - 5 4,000

Staff training 24,000

Production costs (25,000 x $14) 280,000

Selling and distribution costs 25,000

Disposal of specialised machine 1,500

Total 389,500

Expected profit = $500,000 - $389,500 = $110,500

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Total Quality Management
Total Quality Management (TQM) is a cost accounting method that seeks to improve the
quality of products and services.

− T for Total - the TQM process involves all parts of an organisation, including the
customers who buy the products and services, the suppliers who supply the raw
materials and the employees who work for the organisation;

− Q for Quality - customers will expect a certain standard of products or services to be

provided by an organisation and it is essential that such standards are achieved;

− M for Management - the expected quality or standard of an organisation’s products

or services should be achieved when the quality or standard of these goods and
services is effectively managed.

Costs of quality are costs that are involved when products and services of one hundred percent
quality are produced or provided. These costs can be divided into four groups:

1) Internal failure costs are those costs that are incurred in rectifying faulty products or
improving the quality of substandard services while the products or services are still
within the organisation. Internal failure costs include:

− Cost of correcting faulty products;

− Raising the standard of services when they are substandard;

− Costs involved in scrapping products that are produced below the required
standard;

− Cost of running the quality control department.

2) External failure costs are those costs that are incurred in rectifying faulty products or
improving the quality of substandard services once the products have left the
organisation and are with the organisation’s customers. External failure costs include:

− Cost of replacing faulty products and service;

− Cost of repairing faulty or substandard products and services;

− Associated loss of customer goodwill.

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 3) Prevention costs are the costs that are incurred when organisations avoid the
production of faulty products and substandard services. Prevention costs include the
costs involved in:

− Training and remunerating the quality control department;

− Costs of maintaining the equipment used in the quality control process;

− Costs of improving the design of an organisation’s products.

4) Appraisal costs include the costs involved in inspecting or appraising:

− The raw materials supplied by suppliers;

− The products and services produced or provided.

In order for Total Quality Management to be effective, the following relationship should be
kept:

Total costs of TQM < Total benefits of TQM

Organisations that employ the TQM management system are likely to spend more on
prevention and appraisal costs than on internal and external failure costs.

Rectification costs < Prevention costs

This is because they are more concerned with preventing faulty products and substandard
services from leaving the organisation and so they aim to highlight these problems as early as
possible.

TQM philosophy

Getting it right first time Continuous improvement

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This Leads to building up trust with customers so
that they have faith in an organisation and its
products or services. It also prevents money from
being spent on replacing or repairing faulty
products which can lead to a fall in turnover and
profits for an organisation.
This Leads to an increase in customer
goodwill and a reduction in the costs of
quality, which in turn should lead to an
increase in turnover and profits.

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