PM - Specialist cost and management

accounting techniques
Target Costing

DEFINITION:

Target costing is a market driven approach to price that calculates the acceptable level of costs based on the
external selling price.

TARGET COSTING PROCESS:

Steps involved in the target costing process for manufacturing company are:

1) Specify the product that the company wishes to sell. This involves analysis of the market and
determination of product features;
2) Consider selling price. This is a market driven price based on what the customer is willing to pay or the
perceived value of the product, which is referred to as target price;
3) Calculate required profit. This profit is determined based on acceptable return on investment, which is
referred to as target profit;
4) Determine target cost. Target cost = target price - target profit. The target cost represents the highest
acceptable cost of the product;
5) Close the cost gap. If estimated costs are greater than target costs, there is a cost gap. It is important that
quality of the product is not impaired as a result of any cost reductions;
6) Negotiate with customers if a cost gap still exists. This is necessary in order to determine whether to
manufacture the product or not.

Example 1:

Company A has calculated a selling price for a new product, Product P, of $100. A profit margin of 30% is
required to satisfy the company investors. We are required to calculate target cost.
Solution:
 Sales price - Target profit = Target cost

We can assume that significant market research has been undertaken to ensure that Product P is of interest to
customers. We can also assume that the price of $100 is competitive and has been set based on what a
customer may be willing to pay for this product as well as the desired share of the market sought by Company A.
In other words, we can say that the $100 sales price is a target price.

A profit margin is calculated based on what is an acceptable return to Company A’s investors. A 30% required
profit margin equates to a $30 profit based on the product P’s sales price of $100. Based on these numbers we
can derive the target cost of the new product:

Target cost = $100 - $30 = $70

The target cost of $70 represents the highest acceptable cost to Company A of making Product P.

Example 2 (сontinued):

Company A calculates that material, labour and overhead costs associated with producing Product P are $40,
$25 and $13 respectively. We are required to calculate any cost gap that may exist regarding Product P.

Solution:

The total estimated cost of making Product P amounts to:

Estimated cost = $40 + $25 + $13 = $78

This estimated cost of $78 exceeds the maximum allowable cost (or target cost) of $70 by $8. This $8 is referred
to as a cost gap or a target gap. Company A must focus on reducing or eliminating this cost gap, i.e., the
anticipated material, labour and overhead costs incurred during the design and production of product P must be
re-visited to see if any cost reductions can be made.

Value engineering is a term often associated with target costing at this stage of the process. Value engineering
helps businesses achieve cost efficiencies and meet their cost and profitability targets. Attention, therefore,
should be focused more on reducing the costs of product features perceived by the customer as non-value
adding.

AREAS OF COST REDUCTION:

The following areas of cost reduction may be considered:

1) Materials:
- Eliminate unnecessary materials;
- Find alternative cheaper material;
- Quality should not be compromised;
2) Labour:
- Reduce labour costs;
- Use lower skilled labour;
- Increase productivity by improving staff morale;
3) Other areas:
- Increase automation by introducing machinery;
- Reduce incidence of cost drivers;
- Consider alternative product designs.

Note: It is not possible to close the gap by increasing the selling price or reducing the profit.

TARGET COSTING IN SERVICE INDUSTRIES:

Target costing is relevant to manufacturing sector as well as to service sector. However, problems can arise in
trying to apply target costing in service industries.

Characteristics of service industries which can make target costing more difficult to implement:

1) Spontaneity. A service is consumed at exact same time that it is produced;

2) Perishability. Because the service is consumed immediately, it can’t be stored or placed in inventory;
3) Intangible. A service can’t be seen or touched;
4) Unique. No two services can ever be seen to be homogenous;
5) No transfer of ownership. Services don’t result in transfer of property.
 PM - Specialist cost and management
accounting techniques
Activity Based Costing

ACTIVITY BASED COSTING VS ABSORPTION COSTING:

Activity based costing (ABC) is an alternative to Absorption costing (AC), which recognises that overheads are
no longer driven by manufacturing activities only or the number of units produced and looks for new ways to
trace overheads to products.

Under Absorption costing the company may decide to absorb its overhead based on:

1) The number of labour hours worked;

2) The number of machine hours worked;
3) The prime cost of each unit.

Example:

Company A manufactures two products: Product P and Product Q. Company A is trying to calculate the cost per
unit of production of Product P using an absorption costing (AC) system.

Product P Absorption costing Activity Based costing

Material 50/unit 50/unit

Direct costs
Labour 40/unit 40/unit

Indirect costs Overheads 30 ?

Note: Indirect costs cannot be linked directly to each unit of production so we must find a suitable method of
allocating the overhead amongst the units.
Solution:

Traditionally, under AC, the overhead per unit is calculated based on the overhead absorption rate (OAR). The
overhead absorption rate uses one basis of absorption, i.e., one way to divide the overhead amongst the units.

Say, for example, total company overhead equalled $3000 and it was decided to absorb overhead based on the
number of units produced. Let’s say 70 units of Product P as well as 30 units of Product Q were produced (100
units in total).

Total overhead per product $3000

OAR = = = $30 per unit
Total number of units 100

Product P Absorption costing (by unit of production)

Material 50/unit

Direct costs
Labour 40/unit

Indirect costs Overheads $30/unit

Total cost per unit $120

Company A may have decided to absorb its overhead based on the number of labour hours worked. So, if for
example, 250 labour hours had been worked in the period, then the overhead would be absorbed at the rate of
$12 per labour hour ($3000 / 250 hours). If we assume that each unit of Product P required 2 labour hours, then
the overhead absorbed by each unit would be calculated as:

Overhead absorbed per unit = 2 hours x $12 per hour = $24 per unit

Product P Absorption costing (by labour hour)

Material 50/unit

Direct costs
Labour 40/unit

Indirect costs Overheads $24/unit

Total cost per unit $114

CALCULATING ABC:

In the modern environment, ABC looks for a new way to trace (absorb) overheads to products as overheads are
no longer driven by manufacturing activities only or the number of units produced.

There is no difference in how we treat direct costs (material and labour) under AC and ABC. So the material cost
of 50 per unit and the labour cost of 40 per unit for Product P are the same under ABC as they are under AC.
However:
 ABC overhead cost per unit ≠ AC overhead cost per unit

There are four main steps involved in calculating the overhead cost per unit under ABC:

1) Separate overheads into cost pools (e.g. machines costs, setup costs, quality inspection costs);
2) Identify the cost driver for each cost pool (machine hours, production runs, inspections);
3) Calculate the overhead absorption rate (OAR) for each cost driver:

Overhead per cost pool

Cost driver rate (overhead absorption rate) =
Cost driver incidence

4) Use the OAR to absorb costs from each cost pool into the units of production:

Total overhead per product

Total overhead per unit =
Total number of units

Given the more precise allocation of overhead under ABC, each unit has a more accurate cost. Ultimately there
are longer term implications for the company's decision making and planning.

Example:

Costing company produces two products: Product A and Product B. The budgeted cost information for each
product is as follows:

Product A Product B
Material 35 45
Labour 25 20

Production overhead costs incurred:

Machine costs $300,000

Set-up costs $700,000
Quality inspection costs $250,000
Total overhead costs $1250,000

For each of product A and product B we are also given the following information:

Product A Product B
# of production units 25,000 50,000
# of production runs 200 80
# of inspections 250 500
# of machine hours 50,000 50,000

Requirement:

(i) Calculate the cost of each unit of Product A and Product B under absorption costing, using the number of
units as a basis of absorption.

(ii) Calculate the cost of each unit of Product A and Product B using an ABC system.

Solution:

Let’s calculate the cost per unit using AC. Using AC, the total overhead will be absorbed on the basis of the total
number of units produced by the company.

Product A Product B Total

# of production units 25,000 50,000 75,000
Total overhead costs $1,250,000

Total overhead per product $1,250,000

OAR = = = $16.67 per unit
Total number of units 75,000

If we add the overhead cost per unit to the material and labour cost, the total cost per unit amounts to:

Product A Product B
Material 35 45
Labour 25 20
Overhead** 16.67 16.67
Total cost 76.67 81.67

Let’s now calculate the cost per unit using ABC:

Step 1 - Separate overheads into cost pools. This has been done for us in the question in that the total
company overhead of 1,250,000 has been separated into 3 overhead types, or cost pools:

Machine costs $300,000

Set-up costs $700,000
Quality inspection costs $250,000

Step 2 - Identify the cost driver for each cost pool. Here we need to determine what is driving each of the
three overhead types:

Cost pool Cost driver Product A Product B

Machine costs # of machine hours 50,000 50,000

Set-up costs # of production runs 200 80
Quality inspection costs # of inspections 250 500

Step 3 - Calculate the overhead absorption rate for each cost driver. Now that we have linked the cost
drivers to the cost pools, we can calculate the cost driver rate (or the overhead absorption rate). This is
calculated as follows:
 $300,000
Cost driver rate (machine costs) = = $3 per machine hour
100,000

$700,000
Cost driver rate (set-up costs) = = $2,500 per production run
280

$250,000
Cost driver rate (inspection costs) = = $333.33 per quality inspection
750
Step 4 - Use the overhead absorption rate to absorb costs from each cost pool into the units of
production. This calculates the overhead cost per unit:

Product A Product B

Overhead cost Overhead cost

Cost pool Cost driver OAR OAR
per product per product
Machine costs 500 machine hours $3 $150,000 $3 $150,000
Set-up costs 200 production runs $2500 $500,000 $2500 $200,000
Inspection costs 250 inspections $333.33 $83,333 $333.33 $166,667
Total overhead $733,333 $516,667
Total # of units 25,000 50,000
Total overhead/unit $29.33 $10.33

Finally, now that the overhead cost per unit has been calculated we can add this to the direct material and labour
costs (discussed previously) to derive the cost per unit of production:

Product A Product B
Material 35 45
Labour 25 20
Overhead** 29.33 10.33
Total cost 89.33 75.33

Overall there is a different cost per unit for each product when comparing AC and ABC.

Under ABC Product A cost per unit has increased from 76.67 to 89.33, while Product B has seen a decrease in
the cost per unit from 81.67 to 75.33. Given the more precise allocation of overhead under ABC, each unit has a
more accurate cost.
PROBLEMS WITH ABC:

The following problems can arise when implementing an ABC system:

1) It may not be fully understood by managers and therefore not fully accepted as a means of cost control;
2) Staff within an organisation may be resistant to such change (ABC training would be required);
3) It is not always easy to identify a single cost driver, this can be an arbitrary process;
4) Compiling detailed accounting records can be a time consuming and costly exercise.
 PM - Specialist cost and management
accounting techniques
Lifecycle Costing

Life cycle costing considers all costs that will be incurred by a product from the design stage right through to its
retirement. It can be seen as a cost tracking system over the life of the product with the aim of minimising cost
and thus maximising return.

The life costs of a product can be linked to the five main stages of that product’s life cycle:

1) Research & Development. The costs incurred at this stage include research, product design, product
testing and training of staff;
2) Introduction. As the product is introduced to the market, significant advertising costs might be incurred in
addition to the production and distribution costs;
3) Growth. As the popularity of the product grows, production and warehousing costs also grow and customer
support costs increase;
Note: Product unit costs may begin to fall as economies of scale are achieved;
4) Maturity. Product sales are maximised at this point and unit costs should be low. Additional promotional
costs may be necessary to maintain customer awareness of the product or brand. Customer service costs
will most likely be significant at the maturity stage;
5) Decline. Companies may incur promotional costs to prolong product sales. Decommissioning and product
retirement costs will be maximised at this stage.

Note: To assess the profitability of the product over its entire life, the above costs associated with the life cycle of
the product need to be understood.

Example 1:

Company A will shortly launch a new product onto the market (Product T):

Year 1 Year 2 Year 3 Year 4 Year 5

 Units of production 12,000 20,000 7,000
Costs incurred
Market research 800,000
Product design 2,300,000
Advertising 1,500,000 2,100,000 400,000
Manufacturing cost per unit 110 95 115
Disposal costs 300,000

We are required to calculate the life cycle cost per unit of product T.

Solution:

The life cycle cost per unit is calculated by considering all costs incurred over the product’s 5 year life cycle.
Hence, we divide the total product costs by the total number of units in order to derive a unit cost.

Year 1 Year 2 Year 3 Year 4 Year 5 Total

Units of production 12,000 20,000 7,000 39,000
Costs incurred
Market research 800,000 800,000
Product design 2,300,000 2,300,000
Advertising 1,500,000 2,100,000 400,000 4,000,000
Manufacturing cost 1,320,000 1,900,000 805,000 4,025,000
Disposal costs 300,000 300,000
Total costs 11,425,000

Total costs 11,425,000

Life cycle cost per unit = = = $292.95
Total units 39,000

The benefits available to a company engaging in life cycle costing are:

- It generates a complete and more accurate product cost and a true picture of product profitability;
- It results in better decisions when considering the viability of the product, what price should be set or how
many units need to be sold in order to achieve break-even status;
- There are longer-term positive implications for the company’s decision making and planning.
 PM - Specialist cost and management
accounting techniques
Environmental Cost Accounting

ENVIRONMENTAL MANAGEMENT ACCOUNTING:

Organisations are beginning to recognise that awareness of the environment is important for long-term survival
and growth. Environmental management accounting has become increasingly topical:

- There are increased legal and regulatory requirements relating to environmental management;
- Financial penalties exist for non-compliance;
- Ethically, companies should be seen to be aware and care about how their activities (e.g. manufacturing)
impact the environment;
- There is increased need to manage the risk and potential impact of environmental disasters;
- In order to maintain a positive public image and a strong brand, companies need to demonstrate effective
environmental management;
- Environmental costs are becoming increasingly significant thus impacting a company’s financial
performance.

ENVIRONMENTAL COSTS:

Environmental costs can generally be split into two categories:

1) Internal Costs - costs that have direct impact on the profit or loss account of the company. They include:
- Water disposal and waste disposal costs;
- Financial penalties or increased taxes paid due to a poor environmental management record;
- Costs incurred in upgrading production processes to ensure compliance with regulations;
- Cost of securing a licence or permit which allows the company to give off a certain level of carbon
emissions.
2) External Costs - costs that are not borne by the company, but instead are imposed on society. They
 include:
- Carbon emissions;
- Increased health care costs;
- Energy and water usage;
- Deterioration of other natural resources, such as wildlife or forests;
- Social welfare costs.

In recent times governments have been trying to transfer such costs to the companies responsible for generating
them by way of imposing financial penalties or increasing taxes. Also, some organisations are voluntarily
converting external costs to internal costs.

MANAGEMENT ACCOUNTING TECHNIQUES:

Some appropriate management accounting techniques have been put forward to identify, measure and reduce
environmental costs:

1) Input-Output Analysis. All inputs to a process must be traced to outputs (finished unit of production, scrap
item, wastage or other);
2) Flow Cost Accounting. This aims to reduce the quantity of material by examining the physical quantities
involved, their costs and their value at each stage of the organisation. It monitors the flow of material
through a business in three categories of its organisational structure:
- Purchase of material;
- Production system and delivery to the customer;
- Disposal of waste.
3) Activity Based Costing. By identifying cost drivers, including environmental cost drivers, ABC helps us to
understand how costs arise and so the company can focus on reducing these costs;
4) Life Cycle Costing. It considers all costs at each stage of the product’s life cycle from the design stage
right through to its obsolescence. Once costs identified, management can then focus on reducing these
costs.

Key features of a company’s environmental management accounting system might include the following:

1) Ensure regulatory compliance:

- Monitor waste levels to ensure they are not exceeded;
- Ensure staff receive a standard level of training;
2) Carry out internal audits to ensure that company is compliant;
3) Implement an on-line environmental policy statement;
4) Set realistic targets to reduce carbon emissions and related environmental costs;
5) Compare budgeted environmental cost reduction targets to actual results.
 PM - Specialist cost and management
accounting techniques
Throughput Accounting

DEFINITION:

Throughput accounting assumes that the only totally variable cost is materials and that there is some element
of fixed costs within labour and overheads. As such, only material costs are considered within the throughput
calculation:

TP = Sales revenue - Material cost

Note: In order to maximise throughput and, therefore, profit, we need to maximise revenues and minimise
conversion and material costs.

THEORY OF CONSTRAINTS:

If we want to maximise profitability, we need to ensure that we maximise our output of all profitable products;
however, this is not always possible, as there are constraints.

Constraint (bottleneck) is a scarce resource or another factor that limits our output levels.

The sorts of issues that might cause a bottleneck would be:

- Availability of material;
- Unreliable suppliers;
- Labour or machines;
- Poor salesperson.

Note: If the output levels before the bottleneck are higher than the bottleneck can cope with, this will cause the
levels of work in progress before the bottleneck to continually increase.

There are 5 main steps in the theory of constraints process:

1) Identify the bottleneck or constraint;
2) Decide the best means of exploiting the bottleneck (i.e., make sure that output is maximised at the
bottleneck);
3) Ensure that production up to the bottleneck is at the same rate as after the bottleneck, so that work in
progress does not build up;
4) Work out ways to elevate the bottleneck (i.e., ways of increasing the output at the bottleneck point so that
total output can increase);
5) Return to step 1.

LIMITING FACTOR ANALYSIS:

Once we know the nature of the constraint or bottleneck, we can use limiting factor analysis to determine which
product or products should be produced to maximise throughput.
The calculations are performed in much the same way as for regular limiting factor analysis; however, we rank
the products based on throughput per bottleneck resource (rather than ranking them based on contribution per
limiting factor).

THROUGHPUT ACCOUNTING RATIO:

The throughput accounting ratio can help us to determine whether a particular product covers operating costs
and, therefore, makes a profit. We can then use this information to determine which product or products should
be made given the bottleneck.

1) The first ratio that we need to calculate is the Return per factory hour:

Throughput per unit

Return per factory hour =
Time taken in bottleneck

2) The second ratio is the Cost per factory hour:

Total factory cost

Cost per factory hour =
Total time available on bottleneck

3) The throughput accounting ratio is then calculated as follows:

Return per factory hour

Return per factory hour =
Cost per factory hour

TPAR > 1 TP > operating costs (profit)

 TPAR < 1 TP < operating costs (loss)

Note: Where more than one product has a throughput accounting ratio of greater than 1, products would be
ranked from the highest ratio to the lowest, and the production plan would be based on this ranking.

There are a number of criticisms of the throughput accounting ratio:

- It only considers the short-term when operating expenses are mainly fixed;
- It concentrates too much on materials, excluding other costs that might impact on the profitability;
- It is more difficult to apply in the longer term when labour costs are classed as a variable cost.