STRATHMORE UNIVERSITY

SCHOOL OF ACCOUNTANCY
FULLTIME COURSE
ACCA KNOWLEDGE MODULE
MANAGEMENT ACCOUNTING (F2)
A. COSTING METHODS
A costing method is designed to suit the way goods are processed or manufactured or
the ways services are provided.
We will consider these important costing methods:
-Job
-Batch
-Service

(1) Job costing

Job costing is a costing method applied where work is undertaken to customers’
special requirements and each order is of comparatively short duration.
A job is a cost unit that consists of a single order or contract. Each job is separately
identifiable and costs can be attributed to each job e.g. construction of a rail link.

Procedures for the performance of jobs

The normal procedure in jobbing concerns involves:
i) The prospective customer approaches the supplier and indicates the
requirements of the job.
ii) A representative sees the prospective customer and agrees with him the precise
details of the items to be supplied. For example the quantity, quality, size, colour,
e.t.c.
iii) The estimating department of the organization then prepares an estimate
for the job. This will be based on the cost of materials to be used, the labour
expense expected, the cost overheads, the cost of any additional equipment
needed specially for the job, and the supplier’s profit margin. The total of these
items will represent the quoted selling price.
iv)If the estimate is accepted, the job can be scheduled. All materials, labour and
equipment required will be ‘booked’ for the job.

Note: Costs for each job are recorded on a job cost sheet or job card.

Job cost information

Material costs for each job are determined from material requisition notes. Labour
times on each job are recorded on a job ticket, which is then costed and recorded on
the job cost sheet.
Some labour costs, such as overtime premium or the cost of rectifying sub-standard
output, might be charged directly to the job or else as an overhead cost, depending on
the circumstances in which the costs have arisen.
Overhead is absorbed into the cost of jobs using the predetermined overhead
absorption rates.

Rectification costs
If the finished output is found to be substandard, it may be possible to rectify the fault.
Rectification costs can be treated in two ways:
1 Job, Batch and Service Costing; Process costing| F2
 a)If the rectification work is not a frequent occurrence, but arises on occasions with
specific jobs to which it can be traced directly, then the rectification costs should be
charged as a direct cost to the jobs concerned.
b) If the rectification is regarded as a normal part of the work carried out generally
in the department, then the rectification costs should be treated as production
overheads. This means that they will be included in the total of production
overheads for the department and absorbed into the cost of all jobs for the period,
using the overhead absorption rate.

Work in progress
At the year end, the value of work in progress is imply the sum of the costs
incurred on incomplete jobs (provided that the costs are lower than the net
realizable value of the customer order)

Pricing a job
The method commonly used is cost plus pricing. This means that the desired profit
margin is added to total costs to arrive at the selling price.
A cost card can be drawn up for each job or batch using absorption costing or marginal
costing techniques in the same way as for individual products.
A job cost card would look like:
Job XYZ
$
Direct materials X
Direct labour (hrs x $/hr) X
Variable overheads (hrs x $/hr) X
Prime cost X
Fixed overheads X
Total cost X
Profit X
Selling price of job X

The organisation may also absorb non-production overheads and include these in the
estimate of the total jobs cost.
The profit on the job may be calculated in one of two ways:
-Mark-up
-Margin

Mark-up
A profit mark-up is calculated as a percentage of the total costs of the job.
For example a 20% mark up on a job with total costs of $20,000 would be calculated as
follows:
% $
Selling price 120 24,000
Total cost (100) (20,000)
Profit 20 4,000

Margin
A profit margin is calculated as a percentage of the selling price of the job.

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For example a 20% margin on a job with total costs of $20,000 would be calculated as
follows:
% $
Selling price 100 25,000
Total costs (80) (20,000)
Profit 20 5,000

Example 1
Suggest three examples of businesses that use job costing.

Example 2
A company is preparing for job X112. The job requires materials worth $1,350 and 150
hours of labour.
Labour is paid at $6 per hour, variable overheads are absorbed at a rate of $2 per
labour hour and fixed overheads at a rate of $3 per labour hour.
Required
(a) What is the selling price of job X112 if the company wants to earn a margin of 25%?
(b) What is the selling price of job X112 if the company wants to earn of mark-up of
25%?

Job costing and computerization

Job cost sheets exist in manual systems but iT is increasingly likely that in large
organizations the job costing systems will be computerized using accounting software
specifically designed to deal with job costing requirements.
A computerized job accounting system is likely to contain the following features:
a) Every job will be given a job code number, which will determine how the data
relating to the job is stored.
b)A separate set of codes will be given for the type of costs that any job is likely
to incur.
c) In a sophisticated system, costs can be analyzed both by job (for example, all
costs related to job 456) and also by type (for example, direct wages incurred on
all jobs). It is thus easy to perform control analysis and to make comparisons
between jobs.
d)A job costing system might have facilities built into it which incorporate other
factors relating to the performance of the job. In complex jobs, sophisticated
planning techniques might be employed to ensure that the job is performed in the
minimum time possible: time management features may be incorporated into job
costing software.

Example 3
F Ltd. is a jobbing company. On 1 June 2011, there was one uncompleted job in the
factory. The job card for this work is summarized as follows:
Job card, Job No. 6832
Costs to date: $
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Direct materials 630
Direct labour (120 hours) 350
Factory overhead ($2 per direct labour 240
hour)
Factory costs to date 1220

During June, three new jobs were started in the factory, and costs of production were as
follows:
Direct materials $
Issued to: Job 6832 2,390
Job 6833 1,680
Job 6834 3,950
Job 6835 4,420
Damaged inventory written off from 2,300
stores
Material transfers $
Job 6834 to Job 6833 250
Job 6832 to Job 6834 620

Material returned to stores $

From Job 6832 870
From Job 6835 170

Direct labour hour recorded

Job 6832 430 hrs
Job 6833 650 hrs
Job 6834 280 hrs
Job 6835 410 hrs

The cost of labour hours during June 2011 was $3 per hour, and production overhead is
absorbed at the rate of $2 per direct labour hour. Production overheads incurred during
the month amounted to $3,800. Completed jobs were delivered to customers as soon as
they were completed, and the invoiced amounts were as follows:
Job 6832 $5,500
Job 6834 $8,000
Job 6835 $7,500
Administration and marketing overheads are added to the cost of sales at the rate of
20% of factory costs. Actual costs incurred during June 2011 amounted to $3,200.

Required:
(i) Prepare the job accounts for each individual job during June 2011 (the accounts
should only show the cost of production, and not the full cost of sale).
(ii) Prepare the summarized job cost cards for each job, and calculate the profit on
each completed job.

Job costing for internal services

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It is possible to use a job costing system to control the costs of an internal service
department, such as, the maintenance department or the printing department.
If a job costing system is used, it is possible to charge the user departments for the
cost of specific jobs carried out, rather than apportioning the total costs of
these service departments to the user departments using an arbitrarily
determined apportionment basis.
Note: Read on the advantages of an internal job costing system for service departments

(2) Batch costing

Batch costing is similar to job costing in that each batch of similar articles is
separately identifiable. The cost per unit manufactured is the total batch cost divided by
the number of units in the batch.
A batch is a cost unit that consists of a separate, readily identifiable group of units, i.e.
production of 10,000 disposable razors. Here the cost of a single unit is too small to be
measured in $’s.

In general, the procedures for costing batches are very similar to those for costing jobs.
(a) The batch is treated as a job during production and the costs are collected.
(b)Once the batch has been completed, the cost per unit can be calculated as the
total batch cost divided into the number of units in the batch.

Example 4
R Ltd. manufactures Brazils to order and has the following budgeted overheads for the
year, based on normal activity levels.
Production Budgeted Budgeted activity
departments overheads, $
Welding 12,000 3,000 labour hours
Assembly 20,000 2,000 labour hours

Selling and administrative overheads are 25% of factory cost. An order for 500 Brazils,
made as Batch 38, incurred the following costs.
Materials $24,000
Labour 200 hours in the Welding department at $5 per hour
400 hours in the Assembly department at $10 per hour
Required: Calculate the cost per unit for Batch 38

(3) Service costing

Service costing is a costing method concerned with establishing the costs, not of items
of production, but of services rendered.
Service costing is used in the following circumstances:
- A company operating in a service industry will cost its services, for which sales
revenue will be earned; examples are electricians, road, rail or air transport
services, hotels, e.t.c.
- A company may wish to establish the cost of services carried out by some of its
departments; for example, the costs of the vans or lorries used in distribution ,
the costs of the computer department, or staff canteen.

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Example 5
(a) Examples of service organisations include:
(b) How do service organisations differ from manufacturing organisations?

Example 6
Suggested cost units that might be used by the service industry companies listed below.

Service Cost unit

Road, rail and air
transport
Hotel
Education
Hospital
Catering establishment

Cost per service unit = Total costs for period

Number of service units in the period

Charging customers for services

The procedure for charging customers for services is similar to that applied in job
costing. A mark up will be added to the cost per unit to give a selling price which will
provide the required level of profit.
The choice of the cost unit by the organization is important to ensure that an equitable
charge is made to the users of the service.

Composite cost units

These are used when a single measure would not be appropriate. For example, the
charge for excess baggage on an airline might be based on.
(a) how far in km baggage has to be transported.
(b) how heavy the baggage is.
Both of these will impact on the airline's fuel cost so it would be inappropriate to base
the charge on either distance or weight alone. Clearly taking 10kg 100 km will cost less
than taking 10kg 10,000 km.
To take account of this, a composite cost unit is derived i.e. cost per kg per km.

Example 7
In the last year the following information was collected:
Total kg of excess baggage carried 100,000 kg
Total miles excess baggage carried 30,000 miles
Total cost incurred (eg extra fuel) $5m
Required: What is the cost of carrying an extra 3kg an extra 7,500 miles?

Service department costing

Service department costing is used to establish a specific cost for an 'internal service'
that is a service provided by one department for another, rather than one sold
externally to customers. Service departments therefore include canteens and data
processing departments.

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Service department costing has two basic purposes:
(a) To control the costs and efficiency in the service department.
(b) To control the costs of the user departments, and prevent the unnecessary use of
services.

The bases for charging service costs to user departments

The ‘cost’ of support services charged to user departments could be based on any of the
following:
(a) No charge at all
(b) Total actual cost
(c) Standard absorption cost
(d) Variable cost
(e) Opportunity cost
(f) Cost plus a margin for profit

Note: Read more on service costing from your study text.

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 B. PROCESS COSTING
Process costing is a costing system used in situations where goods or services are
produced in a series of processes. The essence of process costing involves the
averaging of the total costs of each process over the total output of that process.
It is not an alternative to absorption costing or marginal costing.

Examples of processes where process costing may be used are:

• Oil refining
• Paper
• Food and drink
• Chemicals

Cost per unit = Input costs

Units

(1) Process costing no losses

Example 1
Input to Process I during a period was 1,000 units of raw materials, cost $40,000.
Other costs were: labour – $50,000, overheads – $20,000.
All output was transferred to Process II.
Required: Prepare the process account.

(2) Normal loss – with no scrap value

Normal loss is the loss that is expected from a business’s experience of the process eg.
Wastage or evaporation

Example 2
Input and costs same as in example 1.
Losses normally account for 10% of input.
Output was 900 units.
Required; Prepare the Process I ledger account

(3) Normal loss – with a scrap value

Any proceeds we receive for the normal loss can be used to reduce the processing
costs.
Cost per unit = Input cost - scrap value of normal loss
Input units - normal loss units
Normal loss can be calculated in several ways, depending on the normal expectation of
the process:
(a) % of input (most common) – this means materials input only not opening WIP;
(b) % of throughput = opening WIP + materials input – closing WIP;

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(c) % of good output
(d) % of total output = good output + losses.

Example 3
Required: Prepare the Process and Scrap ledger accounts for the following situations
using data as in example 1.
(a) All scrapped units have a scrap value of $20 each.
(b) Suppose that the scrap merchant does not pay $20 per unit as anticipated, but only
$19.

(4) Abnormal loss or gain

An abnormal loss or gain occurs when the actual loss is different to expected loss.

Abnormal loss
This is the excess of actual spoilage over normal spoilage. The abnormal loss should be
valued at the same cost per unit as a good unit and any losses or gains taken to the
income statement for the period.

Example 4
As before, but output to Process II is 880 units not 900 units as expected.
Required: Prepare appropriate ledger accounts.

Abnormal gains
This is the shortfall of actual spoilage from normal spoilage. It is treated in the same
way as the abnormal loss. (Actual loss is less than the normal loss expected.)

Example 5
As before but output to process II is 920 units, not 900 units as expected.
Required: Prepare appropriate ledger accounts.

(5) Subsequent processes

Costs in each process include the full cost of material inputs from previous processes.

Labour and overhead costs together are called conversion costs.

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Example 6
The output from process I (from example 5 – 920 units with a value of $110,400) is
input to process II.
Normal loss in process II is 10% of good output and has no scrap value. Output from
process II is 900 units.
Other inputs to process II are:
Added materials $20,600
Conversion $35,000
Required: Prepare appropriate ledger accounts given the above information.
Example 7
JJ has a factory which operates two production processes, cutting and pasting. Normal
loss in each department is 10%. Scrapped units out of the cutting process sell for $3 per
unit whereas scrapped units out of the pasting department sell for $5 per unit.
Output from the cutting process is transferred to the pasting process: output from the
pasting process is finished output ready for sale.
Relevant information about costs for control period 7 is as follows:
Cutting process Pasting process
Units $ Units $
Input materials 18,000 54,000
Transferred to pasting 16,000
process
Materials from cutting 16,000
process
Added materials 14,000 70,000
Labour and overheads 32,400 135,000
Output to finished goods 28,000

Required: Prepare accounts for the cutting process, the pasting process, abnormal
loss, abnormal gain and scrap

(6) Work in progress

At the end of the accounting period we may have two types of output from the process:
(a) Fully completed good output.
(b) Output that has not yet been finished.
This partially completed output is known as work in progress (WIP).

Valuing WIP
If we compare the value of one unit of WIP with the value of one unit of good output the
value of the unit of WIP will be less than the value of one unit of good output. This is
because WIP is only partially completed. To make comparison easier we restate
partially completed units in terms of equivalent whole units.

Example 8

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Required
(a) (i) Using the usual cost per unit calculation, what would the cost per unit be?
(ii) What would the value of WIP be?
(iii) What would the value of finished goods be?
(b) (i) Using equivalent units, what would the cost per equivalent be?
(ii) What would the value of WIP be?
(iii) What would the value of finished goods be?

Closing WIP (no opening WIP)

Example 9
The following are introduced into Process I.
Raw materials 1,500 units $12,975
Labour $9,576
Overheads $3,156
Normal loss is 10% of input with a scrap value of $1/unit.
Closing WIP: 50 units – completed as below
Raw materials 100% complete
Labour 60%complete
Overheads 30%complete
The output was as expected .
Required: Prepare appropriate ledger accounts given the information above.

Opening and closing WIP

The closing WIP from one accounting period will become the opening WIP in the next.
There are two methods that we can use when there is opening WIP.
(a) FIFO
• Assumes that opening WIP is completed first;
• Spreads costs incurred in the period over work done in that period;
ie. (i) FG/output (started and finished)
(ii) Opening WIP (finished)
(iii) Closing WIP (started)
and then add on the opening WIP costs to the sum of (i) and (ii) to give the total costs of
finished output.

(b) Weighted average

• all items are equally likely to be completed;
• spread all costs (including those b/fwd in opening WIP) over all units.

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Example 10
Same process as example 9 but for the following period:
Raw materials 2,050 units $22,140
Labour $16,497
Overheads $9,240
Normal loss 10% of input. Scrap value $1 each.
Opening WIP: 50 units
Output from Process I : 1,815 units
Closing WIP: 80 units complete as below
Raw materials 100% complete
Labour 60% complete
Overheads 60% complete
Required :Prepare a Process I ledger account using (a) FIFO and (b) weighted average
methods.

Previous processes
The output from one process may undergo further processing in a subsequent process.
Say we have Process I and Process II. The output from Process I becomes an input into
Process II. So in Process II we may have:
– opening WIP,
– materials from Process I,
– added materials,
– and conversion costs.
All WIP in Process II must by definition be 100% complete in terms of Process I
inputs (the Process I material).

Example 11
M Ltd. produces an item which is manufactured in two consecutive processes.
Information relating to process2 during September 2011 is as follows:
Opening inventory 800 units
Degree of completion: $
Process 1 materials 100% 4,700
Added materials 40% 600
Conversion cost 30% 1,000
6,300
During September 2011, 3000 units were transferred from process 1 at a valuation of
$18,100. Added materials cost $9,600 and conversion costs were $11,800.
Closing inventory at 30 September 2011 amounted to 1,000 units which were 100%
complete with respect to process 1 materials, 60% complete with respect to added
materials. Conversion cost work was 40% complete.
M Ltd. uses a weighted average cost system for the valuation of output and closing
inventory.
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Required: Prepare the process 2 account for September 2011.

Further points
FIFO or weighted average?
Questions will not always state which method to use. You can make this choice by
looking at how the opening WIP is quoted.
Information about opening WIP includes:
(1) % complete – materials FIFO Method
% complete – conversion
Total cost brought forward
(2) Not given % complete information Weighted Average Method
Total cost brought forward broken down into:
-$ materials
$ conversion

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PROCESS COSTING: JOINT PRODUCTS AND BY-PRODUCTS
Joint and by-products

Joint products
Joint products are two or more products which are output from the same processing
operation, but which are indistinguishable from each other up to their point of
separation.
They each have a substantial sales value either immediately or after further processing.

By-product
These are products produced at the same time and in the same process as the joint
products but are recognised by a relatively low sales value compared to the main
product or joint products and are produced in much smaller volumes. They are
secondary to the main products / processes.

Example 12
State three examples of joint products and by-products.

Treatment
By-products
(a) Do not allocate joint costs to them.
(b) If usual occurrence then calculate net proceeds of by-products and reduce process
costs by this amount.
(c) If one-off then calculate net proceeds and treat as miscellaneous income.

Joint products
Cannot identify until split-off point.
Therefore common costs incurred up to split-off point need to be apportioned on some
basis to the joint products.
Method of apportionment:
(a) physical units
(b) relative sales value

Physical units
Apportioning common costs on the basis of the proportion that the output of each
product be as by weight or volume of output.

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Example 13
Process: P1 600 kg
P2 1,200 kg
By-product 200 kg for which we expect to realise $50.
Required: Allocate the joint costs on a physical units basis.
Physical units basis useful where:
(a) the joint products are in the same form e.g. both solids or both liquids
(b) the joint products are components in another product and therefore have no
relevant sales value.

Relative sales value

The relative sales value method is the most commonly used method of apportioning
joint costs.

Example 14
From example 11 now suppose both products can be sold immediately.
P1 sells at $2/kg
P2 sells at $5/kg
Required
What is the profit on each under:
(a) physical measurement apportionment?
(b) relative sales value apportionment?

Relative sales value basis is useful where:

(a) products are to be sold immediately with no further costs being incurred (such as
selling costs);
(b) joint products are not in the same form of output.

Example 15
Three joint products are manufactured in a common process, which consists of two
consecutive stages. Output from process 1 is transferred to process 2, and output from
process 2 consists of the three joint products, Hans, Nils and Bumpsydaisies. All joint
products are sold as soon as they are produced.
Data for period 2 of 2011 are as follows:
Process 1 Process 2
Opening and closing inventory None None
Direct material (30,000 units at $2 per $60,000 -
unit)
Conversion costs $76,500 $226,200
Normal loss 10% of input 10% of input
Scrap value of normal loss $0.50 per unit $2 per unit
Output 26,000 units 10,000 units of Han
7,000 units of Nil
6,000 units of
Bumpsydaisy
Selling prices are $18 per unit of Han, $20 per unit of Nil and $30 per unit of
Bumpsydaisy.
Required:

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 a) Prepare the process 1 account
b) Prepare the process 2 account using the sales value method of apportionment
c) Prepare a profit statement for the joint products

Accounting for by-products

The most common method of accounting for by-products is to deduct the net
realizable value from the cost of the main products.

A by-product has some commercial value and any income generated from it may be
treated as follows:
(i) Income (minus any post-separation further processing or selling costs) from the sale
of the by-product may be added to sales of the main product, thereby increasing
sales turnover for the period.
(ii) The sales of the by-product may be treated as a separate, incidental source of
income against which are set only post-separation costs (if any) of the by-product. The
revenue would be recorded in the income statement as ‘other income’.
(iii) The sales income of the by-product may be deducted from the cost of
production or cost of sales of the main product.
(iv) The net realizable value of the by-product may be deducted from the cost of
production of the main product. The net realizable value is the final saleable value
of the by-product minus any post-separation costs. Any closing inventory valuation of
the main product or joint products would therefore be reduced.

Note: The method you are most likely to come across in examinations is method (iv).

Example 16
During November 2011, S Co. recorded the following results:
Opening inventory Main product P, nil
By-product Z, nil
Cost of production $120,000
Sales of the main product amounted to 90% of output during the period, and 10% of
production was held as closing inventory at 30 November.
Sales revenue from the main product during November 2011 was $150,000.
A by-product Z is produced, and output had a net sales value of $1,000. Of this output,
$700 was sold during the month, and $300 was still in inventory at 30 November.
Required: Calculate the profit for November using the four methods of accounting for
by-products.

ALTERNATIVE COSTING PRINCIPLES

a) Activity Based Costing (ABC)
Production overheads are by no means all volume-related and hence a single basis for
absorption, e.g. labour hours, would not adequately reflect the complexity of producing
certain products/cost units as opposed to others.
ABC is an extension of absorption costing specifically considering what causes each
type of overhead category to occur, i.e. what the cost drivers are. Each type of overhead
is absorbed using a different basis depending on the cost driver.

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When ABC should be used
(a) When production overheads are high relative to prime costs (eg service sector)
(b) When there is a whole diversity of product range
(c) When there are considerable differences in the use of resources by products
(d) Where consumption of resources is not driven by volume

Steps in ABC
(1) Group overheads into activities, according to how they are driven. These are known
as cost pools.
(2) Identify the cost drivers for each activity, ie what causes the activity cost to be
incurred.
(3) Calculate a cost per unit of cost driver.
(4) Absorb activity costs into production based on usage of cost drivers.

Cost driver analysis

Today's complex business environment means that costs are incurred because cost
drivers occur at different levels.
There are four key categories for activities and their related costs.
Categories Type of cost Cost driver
Unit Direct Units
Batches
Batch Set ups Produced
Inspection
Products
Product R&D produced
marketing
Facility
sustaining Depreciation None
Rent
In detail:
 Unit related activities and costs are those which can be closely related to each
item produced, such as direct labour and energy costs.
 Batch related activities are not identifiable with individual items but with
groups or batches of product, for example, machine set up or material ordering.

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  Product-sustaining activities relate to different products but are independent
of units or batches, engineering resources for individual products or specific
product enhancements are examples.
 Facility-sustaining activities, such as plant management and administration
and factory heating, support the general manufacturing capability but not
individual products. Such analysis is important when decisions are being made
about profitability, volume of production or retiring individual products. For
example, deleting an individual product or service would result in saving of direct
costs naturally, and unit and batch related overhead. Only if a product were
deleted would product sustaining costs be removed and facility sustaining would
still be incurred unless the whole facility was closed down. From a decision-
making point of view facility sustaining costs would not be assigned to individual
products, instead they are regarded as common to all products.

The difference between unit costs under absorption costing and ABC depends upon the
proportion of overhead in each category.
If most overheads are unit level or facility sustaining the costs will be similar.
If overheads are batch or product sustaining costs, the resulting unit costs will be very
different.

Absorption costing vs Activity based costing

Overhead absorption rates using ABC should be more closely linked to the causes of
overhead costs.
The modern business environment has much wider product ranges than seen before,
complex production process and decreasing product lifecycles. ABC recognises these
factors by using multiple cost drivers when absorbing overheads.

Why an activity based costing approach would be more useful in costing

products than a traditional absorption costing approach:
 The way in which fixed costs common to all products will have a significant effect
on product cost. ABC takes care of this.
 by linking activities and costs, more accurate costing is obtained-if an activity is
not carried out, there will be no cost
 In traditional absorption costing the overhead absorption rate is based upon
different bases thus different overheads are incurred. ABC is activity specific.
 ABC gives a more accurate costing when there is a strong price competition in
the market where over or under-pricing would otherwise be undesirable.
 Has shorter production runs, due to increased flexibility of production methods.

Advantages of ABC
 Unit costs calculated under ABC accurately reflect the activities performed and
resources used to make the product.
 ABC helps in distinguishing between profitable and unprofitable products and
customers.
 By focusing attention on cost drivers ABC helps managers understand and
manage overhead cost.
 An understanding of cost driver rates helps in budgeting overhead expenditure.

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  ABC concerns itself with all overhead costs, and as a consequence it has proved
very useful in service industries.

Criticisms of activity based approaches

 The costs of obtaining and interpreting the new information may be considerable.
Activity based analysis should not be introduced unless it can provide additional
information for management to use in planning or control decisions.
 Many overheads relate neither to volume nor to complexity and diversity. The
ability of a single cost driver to fully explain the cost behavior of all items in its
associated pool is questionable.
 Some measure of arbitrary cost apportionment may still be required at the cost
pooling stage for items like building depreciation. If an activity based system has
many cost pools the amount of apportionment needed may be greater than ever.

b) Life cycle costing

Life cycle costing aims to cost a product, service, customer or project over its entire
lifecycle with the aim of maximising the return over the total life while minimising
costs.
Traditionally the costs and revenues of a product are assessed on a financial year or
period by period basis.

Product life cycle costing considers all the costs that will be incurred from design to
abandonment of a new product and compares these to the revenues that can be
generated from selling this product at different target prices throughout the product's
life.
Different costs are incurred at different stages of a product’s life. Early stages will
involve research and development costs, buying in technical data, and the training of
staff. Later come marketing, production, stock holding and distribution costs.
Eventually retirement and disposal costs may be involved.

Traditional cost accounting systems do not accumulate costs over a product’s entire life
but focus instead on (normally) twelve month accounting periods. As a result the total
profitability of a product over its entire life becomes difficult to determine. Life-cycle
costing involves accumulating costs and revenues over a product’s entire life and hence
allows the total profitability of a product to be determined.

Product life cycle

The product life cycle (PLC) can be divided into five stages.

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Characteristics of the PLC
Sales
Stage volume Costs
Developme
nt None Research & development
Introductio Very low Very high fixed costs (eg fixed (non-current)assets,
n levels advertising )
Rapid Increase in variable costs. Some fixed costs
Growth increase increase (eg increase number of non-current
assets)
Stable
Maturity High volume Primarily Variable costs
Falling Primarily Variable costs (now decreasing)
Decline demand Some fixed costs (eg decommissioning costs)

Impact of PLC in the modern environment

(a) Shorter product life cycles.
(b) Clearer strategic planning required.
(c) 90% of costs to be incurred throughout its life cycle will have been determined
before a product reaches the market.

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Maximising return over the product lifecycle
There are a number of ways that return can be increased over the life cycle.
(a) Design costs out of products
Approximately 70% – 90% of a product's lifecycle costs are determined by decisions
made early in the lifecycle at the design and development stage. Thus design and
production teams must work together to ensure costs are minimised.

(b) Minimise the time to market

This is the time from the conception of the product to its launch. If a company can get a
product to the market place very quickly, it will give the product as long a span as
possible without competitors' rival products in the market place. This should mean that
market share is increased in the long run.

(c) Minimise breakeven time

Pricing strategies will affect both contribution and volumes generated. A short
breakeven time is very important for liquidity purposes.

(d) Extend the length of the life cycle itself

For example, product development, finding other uses for a product or staggering the
launch of the product in different markets.

Collected data are compared with budgeted costs to check whether expected savings
have been realised.

Advantages of LCC:
 All costs (production and non production) will be traced to individual products
over their complete life cycles and hence individual product profitability can be
more accurately measured.
 Non production costs will become more visible and the potential for their control
is increased.
 More accurate feedback on the success or failure of new products will be
available
 Improvement of decision-making and cost control. The early development costs
would have to be seen in the context of the expected trading results, therefore
preventing a serious over spend at this stage or under pricing at the launch point.

c) Target costing
In a modern environment with shortening product lifecycles, organisations have to
continually redesign their products. It is essential that they try to achieve a target cost
during the product’s development.

Under traditional approaches to pricing, businesses calculate the cost of manufacturing

and selling a product, and then add mark up, to give the profit element. These methods
are known as "cost plus pricing".

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A major criticism of cost plus pricing techniques is that they do not consider any
external factors (e.g. demand for product; no. of competitors, etc). They are therefore
unlikely to maximise the profits that a business will generate.

As product life cycles have become much shorter, the planning, development and design
stage of a product is critical to an organisation's cost management process. Cost
reduction must be considered at this stage of a product’s life cycle, rather than during
the production process.

Target costing involves setting a selling price for your product by reference to the
market. From this your desired profit margin is deducted leaving you with a target
cost.

Deriving a target cost

Traditionally:

Target Costing:

Implementing target costing

(a) Define product specification and estimate anticipated sales volume.
(b) Set a target selling price at which the company will be able to achieve the desired
market share.
(c) Required profit is estimated based on profit margins or return on investment.
(d) Target cost is calculated as:
$
Target selling price X
Less: target profit (X)
Target cost X
(e) The estimated cost of the product is calculated based on the product specification
and current cost levels.
(f) Estimated Product Cost – Target Cost = Cost Gap
(g) Efforts are made to close the cost gap. Aim to "design out" costs before production
starts.

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Possible ways to close a target cost gap.
Note: Altering the selling price is not a valid way of reducing the gap.
Cheaper materials
Fewer parts
Cheaper labour
No non-value adding activities
Training
Automation

Benefits of adopting a target costing approach

 The organization will have an early external focus to its product development.
 Only those features that are of value to customers will be included in the product
design.
 Cost control will begin much earlier in the process. If it is clear at the design
stage that a cost gap exists then more can be done to close it by the design team.
 Costs per unit are often lower under a target costing environment. This enhances
profitability.
 It is often argued that target costing reduces the time taken to get a product to
market. Under traditional methodologies there are often lengthy delays whilst a
team goes ‘back to the drawing board’.

Difficulties of using target costing in service industries

The very nature of services makes it difficult to use target costing. Unlike
manufacturing companies services are characterized by the following qualities:
 Intangibility- of what is provided
 Inseparability/simultaneity- created at time consumed
 Variability/heterogeneity- quality / consistency varies
 Perishability-cannot make in advance and store up.
 Transfer of ownership
In addition to these problems, service organisations will require more qualitative
information to arrive at a price and evaluate performance eg
 Quality of service
 Repeat customers etc

d) Total Quality Management (TQM)

TQM is a business philosophy aimed at improving quality.
Get it right, first time: The cost of preventing mistakes is less than the cost of
correcting them if they occur.
Continuous improvement: Never be satisfied with current achievement. It is always
possible to improve performance.

Goals of TQM
(a) To gain competitive advantage via continuously improved quality
(b) To continuously reduce the cost of providing enhanced quality
(c) Innovation
(d) Provide first class customer service
(e) To involve all employees
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Design for quality
Design quality into an organisation's products and operations from the outset.
(a) Reduce the number of parts in a product
(b) Use components common to other products in the organisation
(c) Improve physical characteristics to meet customers’ needs

Performance measurement
Traditional variance analysis is not appropriate in a TQM environment, due to the focus
on
• continuous improvement
• quality as opposed to cost

Alternative measures of performance, therefore, include:

(a) measuring incoming supplies
(b) monitoring work as it proceeds
(c) measuring customer satisfaction

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