MANAGEMENT ACCOUNTING

( MA 300)
LECTURE NOTES

Compiled by
Wachawaseme Mwale
merviswacha@gmail.com
+265 999 335 012
STUDY TOPICS
1. Costing Methods
2. Process Costing
3. Planning Control and Performance Management
4. Information for decision making
5. Risk and uncertainty
6. Performance Management

2
COSTING METHODS
• Traditional costing systems
• Absorption costing
• Marginal Costing
• Back flush Costing
• JIT systems
• ABC, ABM AND ABB
• Life cycle costing, customer profitability analysis and
Target costing.
• Throughput accounting and theory of constraints

3
ABSORPTION COSTING/FULL COSTING
• A method whereby all production costs are included
in the costing of a cost unit ie.
• Direct materials,
• direct labour,
• variable production overheads and
• fixed production overheads.
• IAS 2 Inventories requires an element of fixed
production overhead to be ‘absorbed’ into product
cost for inventory valuation purposes.
• All production costs are charged to units of
production.

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Calculation of unit cost-absorption
costing method
Direct costs:
Direct materials (5kg @ $3/kg) 15.00
Direct labour (3hrs @ $6/hr) 18.00
33.00
Indirect costs:
Variable overheads 2.00
Fixed overheads(absorption) 3.00
Full product cost 38.00

5
The process of
absorption
Three Step Process:
(1) Allocate/apportion overheads to cost centres
(2) Re-apportion service centre costs to production cost
centres
(3) Absorb into production

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Under/Over absorption
• Over and under absorption of overheads occurs
because the predetermined overhead absorption
rates are based on estimates.
• The rate of overhead absorption is based on
estimates (of both numerator and denominator) and
it is quite likely that either one or both of the
estimates will not agree with what actually occurs.
• (a)

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• Over absorption means that the overheads charged
to the cost of sales are greater than the overheads
actually incurred.
• Under absorption means that insufficient overheads
have been included in the cost of sales.
• It is almost inevitable that at the end of the
accounting year there will have been an over
absorption or under absorption of the overhead
actually incurred.

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The reasons for under-/over-absorbed overhead

• Actual overhead costs are different from budgeted

overheads
• The actual activity level is different from the
budgeted activity level
• Both actual overhead costs and actual activity level
differ from the budgeted costs and level

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Treatment of under/over absorption
• Under absorption is added to cost of sales
• Over absorption is deducted from cost of sales

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Example
A company absorbs overheads based on labour hours.
Data for the latest period are as follows.
Budgeted labour hours 8,500
Budgeted overheads K148,750
Actual labour hours 7,928
Actual overheads K146,200
(a) Based on the data given above, what is the labour
hour overhead absorption rate?
(b) Based on the data given above, what is the amount
of under-/over-absorbed overhead?

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Example
Pembridge Co has a budgeted production overhead of
K50,000 and a budgeted activity of 25,000 direct labour hours
and therefore a recovery rate of K2 per direct labour hour.
Required
• Calculate the under-/over-absorbed overhead, and the
reasons for the under-/over-absorption, in the following
circumstances.
• (a) Actual overheads cost K47,000 and 25,000 direct labour
hours are worked.
• (b) Actual overheads cost K50,000 and 21,500 direct labour
hours are worked.
• (c) Actual overheads cost K47,000 and 21,500 direct labour
hours are worked.
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Advantages of absorption costing
1. It recognizes that selling prices must cover all costs
(Pricing purposes)
2. It complies with IAS 2 on accounting for inventory,
whereby the value of inventory must include an
appropriate amount of fixed production overhead
(Stock valuation).
3. By apportioning overhead to production it is
possible to compare how profitable different items
are.(profitability comparisons)

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Disadvantages of absorption costing

1. Profits can be manipulated by simply changing

production levels. This is because overheads will be
carried forward in closing inventory.
2. It is based on the assumption that overheads are
volume related

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 MARGINAL/VARIABLE COSTING

Marginal cost is the variable cost of one unit of product or service.

Marginal costing is an alternative method of costing to absorption
costing.
In marginal costing, only variable costs are charged as a cost of sale
and a contribution is calculated (sales revenue minus variable cost of
sales).
Closing inventories of work in progress or finished goods are valued at
marginal (variable) production cost.
Fixed costs are treated as a period cost, and are charged in full to the
profit and loss account of the accounting period in which they are
incurred.
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• The marginal production cost per unit of an item usually
consists of the following.
• Direct materials
• Direct labour
• Variable production overheads
• Contribution is an important measure in marginal costing,
and it is calculated as the difference between sales value
and marginal or variable cost of sales.
• Contribution is of fundamental importance in marginal
costing, and the term 'contribution' is really short for
'contribution towards covering fixed overheads and
making a profit'.

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 Example-Marginal costing
Selling price per unit K10
Variable costs per unit
direct materials K2
direct labour K3
selling and distribution K1
Fixed costs:
Production: budgeted K8,000
actual K8,500
Selling and distribution: (budgeted and actual) K2,000
Activity levels: Year 1
Units
• Budgeted production 4,000
• Actual sales 4,200
• Actual production 4,400
• There is no opening inventory in Year 1.
• Required
Prepare an income statement under absorption costing
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Advantages of marginal costing
1. Most appropriate for decision making as it highlights
contribution.
2. Fixed costs are treated in accordance with their
nature, ie as period costs.
3. Profit depends on sales and efficiency not on
production levels. Variable costing removes from
profit the effect of stock changes.
4. Variable costing provides more useful information for
decision-making.
5. Variable costing avoids fixed overheads being
capitalized in unsaleable stocks.

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Disadvantages of marginal costing
• There is a danger that products will be sold on an
ongoing basis at a marginal contribution which fails to
cover fixed costs.
• Does not comply with IAS 2, thus necessitating year
end adjustments for the preparation of published
accounts.
• Necessitates analysis of mixed costs between fixed
and variable.
• Seasonal variations in a year can cause unnecessary
profit variances.

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Absorption and Marginal Costing Compared
• In marginal costing, fixed production costs are treated
as period costs and are written off as they are
incurred. In absorption costing, fixed production costs
are absorbed into the cost of units and are carried
forward in inventory to be charged against sales for
the next period.
• Inventory values using absorption costing are
therefore greater than those calculated using
marginal costing.

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 Differences
Marginal Costing Absorption Costing

Closing inventories are Closing inventories are valued

valued at marginal at full production cost.
production cost.

Fixed costs are period Fixed costs are absorbed into

costs. unit costs.

Cost of sales does include a

Cost of sales does not share of fixed overheads
include a share of fixed
overheads.

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Reconciling profits
• Reported profit figures using marginal costing or
absorption costing will differ if there is any change in
the level of inventories in the period.
• If production is equal to sales, there will be no
difference in calculated profits using the costing
methods.

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 Explanation of the differences

1. If inventory levels increase between the beginning

and end of a period, absorption costing will report
the higher profit. This is because some of the fixed
production overhead incurred during the period will
be carried forward in closing inventory (which reduces
cost of sales) to be set against sales revenue in the
following period instead of being written off in full
against profit in the period concerned.
2. If inventory levels decrease, absorption costing will
report the lower profit because as well as the fixed
overhead incurred, fixed production overhead which
had been carried forward in opening inventory is
released and is also included in cost of sales.
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Profits are the same for both methods when
production equals sales(no changes in stock levels)
Where production exceeds sales (increasing stock
levels)the absorption costing system produces
higher profits.
Where sales exceed production (declining stock
levels) the variable costing system produces higher
profits.
With an absorption costing system profits can
decline when sales volume increases and costs
remain unchanged

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Reconciliation formula
Marginal Costing Profit x
Add: differences in closing inventory x
Less: differences in opening inventory (x)
Equals Absorption costing profit x

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Which one is better?
• Choice depends on the circumstances.
• Volatile sales and changing stock levels favour variable
costing for internal monthly or quarterly profit
measurement.
• Seasonal sales where stocks are built up in advance favours
absorption costing.
• Debate only applies to internal reporting – IAS 2,
Inventories requires that absorption costing is used for
external reporting.
• Debate only applies when historical cost accounting is
used.

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ACTIVITY BASED COSTING
The emergence of ABC systems
Traditional systems were appropriate when:
• Direct costs were the dominant costs
• Indirect costs were relatively small
• Information costs were high
• There was a lack of intense global
competition
• A limited range of products was produced.

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 WEAKNESS OF TRADITIONAL COSTING SYSTEMS
MARGINAL COSTING
The main problem is that fixed
overheads are virtually
ignored.
Ignoring overheads tends to
inflate profits artificially.
The profit is, in effect, the
contribution.
The major danger, therefore,
is that fixed overheads are not
allocated to products and may
not be recovered when setting
a selling price.
As a result, the company may
drift into loss and eventually
go out of business.
ABSORPTION COSTING
The process assumes that overheads
relate directly to the level of
production.
The problem with this approach is
that the allocation of costs is carried
out on an arbitrary basis and may
not reflect accurately on those
activities which are truly responsible
for the costs.
Sometimes, a particular product or
activity may show a loss simply due
to a change in the cost allocation
process.
It is time consuming
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Weaknesses of traditional costing systems
• They split costs into fixed and variable elements-this is
too simplistic and short termism. Overtime all costs are
variable.
• As businesses grow with time, their complexity also
grows. Costs therefore vary according to complexity and
not volume.
• Selling and administration costs are ignored i.e. not
included in product costs.
• Labour hours are often used as the basis for absorption,
even though direct labour often forms a relatively small
proportion of total cost.

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 Stages in ABC
• Identify those activities that cause overheads to be
incurred.
• Adjust the accounting system so that costs are collected by
activity rather than by cost centre.
• Identify those factors which cause each activity's costs to
change (the cost drivers)
• Establish the volume of each cost driver.
• Calculate the cost driver rates by dividing the activity's cost
by the volume of its cost driver.
• Establish the volume of each cost driver required by each
product.
• Calculate overheads attributable to each product by
multiplying step (e) by step (f).
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Cost pool/activity Possible cost driver

Materials handling costs Number of production

runs
Machine set-up costs Number of machine set-
ups

Machine operating costs Number of machine hours

Production scheduling Number of production

costs runs
Despatching costs Number of orders
despatched

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 Example

 A company manufactures two products, L and M, using the same equipment and similar
processes. An extract of the production data for these products in one period is shown below.
L M
 Quantity produced (units) 5,000 7,000
 Direct labour hours per unit 1 2
 Machine hours per unit 3 1
 Set-ups in the period 10 40
 Orders handled in the period 15 60
 Overhead costs $
 Relating to machine activity 220,000
 Relating to production run set-ups 20,000
 Relating to handling of orders 45,000

285,000
Required
 Calculate the production overheads to be absorbed by one unit of each of the products using
the following costing methods.
(a) A traditional costing approach using a direct labour hour rate to absorb overheads
(b) An activity based costing approach, using suitable cost drivers to trace overheads to products
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Merits of ABC
The complexity of manufacturing has increased, with wider
product ranges, shorter product life cycles and more
complex production processes. ABC recognizes this
complexity with its multiple cost drivers.
In a more competitive environment, companies must be
able to assess product profitability realistically. ABC
facilitates a good understanding of what drives overhead
costs.
In modern manufacturing systems, overhead functions
include a lot of non-factory-floor activities such as product
design, quality control, production planning and customer
services. ABC is concerned with all overhead costs and so it
can take management accounting beyond its 'traditional'
factory floor boundaries.
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Uses of ABC
1. It provides accurate and reliable cost information
2. It establishes a long-run product cost
3. It provides cost data which may be used to evaluate
different ways of delivering business.
4. It is particularly suited to the following types of
decision:
• Pricing, where selling prices are derived by adding a profit mark-up to
cost
• Promoting or discontinuing products or parts of the business, since
ABC may help management to identify activity costs that may be
either incurred or saved
• Developing new products or new ways to do business, because ABC
focuses attention on the support activities that would be
required for the new product or business procedure.
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 Criticisms of ABC
 Cost apportionment may still be required at the cost pooling stage for shared items
of cost such as rent, rates and building depreciation. Apportionment can be an
arbitrary way of sharing costs.
 A single cost driver may not explain the cost behaviour of all items in a cost pool.
An activity may have two or more cost drivers.
 Unless costs are ‘driven’ by an activity that is measurable in quantitative terms,
cost drivers cannot be used. What drives the cost of the annual external audit, for
example?
 There must be a reason for using a system of ABC. ABC must provide meaningful
product costs or extra information that management will use. If management is not
going to use ABC information for any practical purpose, a traditional absorption
costing system would be simpler to operate and just as good.
 The cost of implementing and maintaining an ABC system can exceed the benefits of
‘improved accuracy’ in product costs.
 Implementing ABC is often problematic, due to problems with understanding
activities and their costs. It is also complex. We need a lot of information.
 ABC is an absorption costing system. Absorption costing has only limited value for
management accounting purposes.
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JUST-IN-TIME SYSTEMS(JIT)
• JIT is a modern manufacturing concept with radical
implications for the associated costing systems.
• It is a method of providing production with the inputs it
requires as and when they are needed.
• A common misconception is that JIT is purely a form of
stock control, whereas it is in effect an overall
management philosophy covering all aspects of the
production process.

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• The first stage in implementing a JIT system involves the rearrangement of the
factory layout.

• In a traditional or functional plant layout similar machines are grouped

together, and the item being manufactured travels from department to
department as the various manufacturing processes occur to the item, e.g. the
item will go to the drilling department, then to the grinding department, then
to the turning department.

• In a JIT system dissimilar machines are arranged, often in a U shape, around a

JIT cell which manufactures the item. Each member of the cell can operate all
the machines and the aim is that the item is manufactured without ever leaving
the cell. The item does not go back to store or sit around awaiting for the next
process. JIT uses what is known as cellular manufacturing.

• The aim of JIT is to produce the right part at the right time. This results in the
"pull" manufacturing system as opposed to traditional manufacturing methods,
which are called "push" manufacturing systems because the items push their
way from department to department, often resulting in them waiting in queues
for the next process.
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 Aspects of JIT
ASPECT DETAIL
Quality This is not necessarily quality of the product to the final customer, but
rather quality in the following terms:
• Products should be standardized and easy to produce.
• Processes, e.g. plant layout and tool and machinery design, are of
critical importance.
• Suppliers should consist of a small number, each of whom provides
proven quality in terms of product and delivery deadlines.

Purchasing This is the most well known aspect whereby small numbers of items are
delivered when required, but much more frequently.
Production Final customer demand forms the basis of the determinants of output and
Control therefore materials used.
The speed of production should also be dictated by the needs of the
customer, i.e. how quickly the items are required.
In addition, set-up times do not add value and should therefore be
eliminated or reduced as much as possible.

Employee Employees are expected to be much more flexible in addition to

involvement experiencing greater levels of participation and responsibility. 38
 JIT Goals
Goal Explanation
Elimination of non JIT is dedicated to the elimination of waste, which is defined as anything that does not add value to
value adding a product. In manufacturing, the following activities occur before the item is sold (this is called the
activities lead time): process time/inspection time/move time/queue time/storage time.
Of these five activities only process time adds value to the product.

Zero Inventory JIT as a pull manufacturing system, the idea is that items are only produced as they are required
and thus no large stocks of manufactured goods are accumulated.

Zero Defect JIT is based on "doing it right first time". In a conventional system it is assumed that some items
will become defective and some departments will suffer breakdowns. This results in the
maintenance of stocks of work-in-progress to provide work for departments at all times. It also
results in high stock levels which JIT does not sanction.

Batch sizes of one As JIT works to eliminate set-up time as it is a non-value-adding activity, batch sizes can be
reduced, thus preventing the development of bottlenecks, which occur when long production runs
are used.
Zero break down Zero breakdown is aimed for by planning for preventive maintenance to be carried out within the
cell; all members are trained not only to use but also to maintain their machines. Breakdowns can
thus be reduced significantly and repair carried out more quickly should a breakdown occur.

100% on Can be achieved if the previous aims are achieved

time delivery
JIT The principles of JIT are applied equally to all outside purchases of components. Suppliers must
purchasing not only supply on time in the quantities required, but must also guarantee quality. This saves
costs by eliminating handling costs as inspection is no longer needed.

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Features of JIT
• Organization production in manufacturing cells
• Hiring and retaining multi-skilled staff
• Emphasizing total quality management
• Reducing manufacturing lead time and set-up time
• Building strong supplier relationships

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 Advantages and Disadvantages of JIT
Advantages
Work-in-progress and stock
levels are reduced,
representing cost savings of
working capital requirements.
Much smoother production
flow should lead to increased
productivity.
Improvements in quality
should result in less rework.
Because of shorter production
times, paperwork is reduced,
e.g. the amalgamation of the
Disadvantages
The JIT technique is tailored to situations of regular
demand, relatively unchanging processes and a large
percentage of common components. Thus, it is not
necessarily suitable for all types of production.
Problems can arise if attempts are made to implement JIT
in situations which do not match its requirements.
Implementation is over a very long time-scale and a
large degree of patience is required by those whose
responsibility it is
JIT involves a different cultural approach from that
traditionally to be found in Western manufacturing
industries –particularly in terms of consensus
decision-making.
JIT is considered weak in terms of medium-and long-
term planning.
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 TARGET COSTING
Target costing involves setting a target cost for a product,
having identified a target selling price and a required
profit margin.
The target cost is the target sales price minus the
required profit.
Target costing is concerned with designing a product and
its production process so that it can be made and sold at
a cost that delivers the required profit at the chosen
price. It focuses on getting the expected cost of a product
down to a target cost amount.
Achieving a target cost will usually require some
redesigning of the product and the removal of
unnecessary costs.
42
 Implementing target costing
Step 1 Determine a product specification of which an adequate
sales volume is estimated.
Step 2 Decide a target selling price at which the organization will
be able to sell the product successfully and achieve a desired
market share.
Step 3 Estimate the required profit, based on required profit
margin or return on investment.
Step 4 Calculate: Target cost = Target selling price – Target profit.
Step 5 Prepare an estimated cost for the product, based on the
initial design specification and current cost levels.
Step 6 Calculate: Target cost gap = Estimated cost – Target cost.
Step 7 Make efforts to close the gap. This is more likely to be
successful if efforts are made to 'design out' costs prior to
production, rather than to 'control out' costs after ‘live’
production has started. 43
Example
A car manufacturer wants to calculate a target cost
for a new car, the price of which will be set at
K17,950.
The company requires an 8% profit margin on sales.
Required
What is the target cost?

44
Great Games, a manufacturer of computer games, is in the process of introducing a
new game to the market and has undertaken market research to find out about
customers’ views on the value of the product and also to obtain a comparison with
competitors’ products. The results of this research have been used to establish a
target selling price of K60. This is the price that the company thinks it will have to
sell the product to achieve the required sales volume.
Cost estimates have been prepared based on the proposed product specification.
Manufacturing cost K
Direct material 3.21
Direct labour 24.03
Direct machinery costs 1.12
Ordering and receiving 0.23
Quality assurance 4.60
Non-manufacturing costs
Marketing 8.15
Distribution 3.25
After-sales service 1.30
The target profit margin for the game is 30% of the target selling price.
Required
Calculate the target cost of the new game and the target cost gap.

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Example
• Projected lifetime sales volume 300 000 units
• Target selling price of the product K800
• Target profit margin (30% of selling price)
• Projected cost K700

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 Closing the target cost gap
The target cost gap is the estimated cost less the target cost.
When a product is first manufactured, its currently-attainable
cost may be higher than the target cost. Management can then
set benchmarks for improvement towards the target cost, by
improving production technologies and processes. Various
techniques can be employed.
Reducing the number of components
 Using cheaper staff
Using standard components wherever possible
Acquiring new, more efficient technology
Training staff in more efficient techniques
Cutting out non-value-added activities
Using different materials

47
Target costing in service industries
Unlike manufacturing companies, services are
characterized by intangibility, inseparability, variability,
perishability and no transfer of ownership.
Some of the characteristics of services make it difficult
to use target costing, and identify a target cost for a
service having established a target selling price.
Intangibility. Some of the features of a service cannot
be properly specified because they are intangible. When
services do not have any material content, it is not
possible to reduce costs to a target level by reducing
material costs

48
• Variability/homogeneity. A service can differ every time it is
provided, and a standard service may not exist. When services are
variable, it is possible to calculate an estimated average cost, but this
is not specific and so not ideal for target costing.

49
 BACK FLUSH COSTING
• Back flush accounting is a costing short cut.
• It relies on a business having immaterial amounts of
work‑in-progress and is therefore particularly suitable for
businesses operating just-in-time inventory management.
• If the amount of work‑in‑progress is negligible, what is the
point in meticulously valuing it?
• Fretting that some products might be 25% complete and
others 60% complete, and then adding carefully
calculated labour and overheads to these (immaterial)
items, is a complete waste of time and effort.

50
In back flush accounting, costs are not associated
with units until they are completed or sold.
Back flush accounting is sometimes called delayed
costing, which is a helpful name, as costs are not
allocated to production until after events have
occurred.
Standard costs are then used to work backwards to
flush out manufacturing costs into production,
splitting them between stocks of finished goods (if
any) and cost of sales.
No costs, whether material or conversion costs, are
allocated to work-in-progress.
51
Variants of back flush accounting

• There are two variants of back flush accounting and

they differ according to what are called ‘trigger
points’. Trigger points are the events which cause
costs to be moved into inventories.

52
Variant 1
This is the less radical variant. There are two inventory
accounts, raw materials and finished goods, and there are two
trigger points:

1 Purchase of raw materials

Dr Materials account
Cr Creditors
The cost of labour and other manufacturing expenses are
debited to a conversion cost account and credited to cash or
creditors. The conversion cost account can be thought of as a
suspense account where amounts are placed temporarily.

2 On completion of units
Dr Finished goods account with the standard cost of goods
produced
Cr Materials account with the standard cost of materials
Cr Conversion cost account with the standard cost of
conversion.
53
Variant 2
This is more radical because no records are kept of work-in-
progress raw materials, so if this method is to be used,
stocks of both raw materials and work-in-progress must be
negligible. It has only one
trigger point.

As before, the cost of labour and other manufacturing

expenses are initially debited to a conversion cost account
and credited to cash
or creditors.

Entries into the finished goods inventory account are made

only when goods are completed, and the journal entries will
be:

Dr Finished goods account with the standard cost of goods

produced
Cr Creditors with the standard cost of material used in goods 54
 Back flush and variances
• Note that at some point the creditors account will have
to record correctly what is owing to them so, from time
to time, this will be adjusted by a cost variance. Thus, if
the standard cost of raw materials used was $50,000,
but the actual cost of materials was $52,000, an adverse
variance of $2,000 has to be recognized and the
creditors account would have two entries Cr $50,000
(and Dr $50,000 to finished goods), then Cr $2,000 and
(Dr $2,000 to profit and loss account).

55
So, are there any benefits in adopting backflush accounting other than
avoiding complex recording and calculations to value immaterial amounts of
inventory?
Let’s consider the trigger point found in both variants: costs are transferred
when goods are completed.
What would happen if that trigger point were changed to permit cost transfer
only when goods were sold?
That would mean conversion costs would remain as costs until goods were
sold, rather then being transformed into finished stock when goods were
completed.
Managers would then have no incentive to make goods unless they were
going to be sold imminently, otherwise they would simply
be incurring more expense, and that would make their performance look bad.
The purpose of a manufacturing business is not to make goods; its purpose
is to make and sell goods. Only then is there throughput, and backflush
accounting can be set up so that costing records encourage managers
to adopt this goal-orientated behaviour. 56
Illustration
Purchase of raw materials K1 515 000
Conversion costs K1 010 000
Finished goods manufactured 100 000 units
Sales for the period 98 000 units
No opening stocks
Standard unit cost is K25 (K15 materials and K10
conversion cost)

57
LIFE CYCLE COSTING
• Life cycle costing estimates the costs and revenues
attributable to a product over its entire expected life
cycle.
• The life cycle costs of a product are all the costs
attributable to the product over its entire life, from
product concept and design to eventual withdrawal
from the market.

58
Traditional management accounting procedures have
focused primarily on the manufacturing stage of a
product’s life cycle.
 LCC focuses on costs over the product’s entire life
cycle to determine whether profits earned during the
manufacturing phase will cover the costs incurred
during the pre- and post-manufacturing stages.
 A large proportion of a product’s costs can be
committed or ‘locked in’ during the planning and
design stage.
Cost management can be most effectively exercised
during the planning and design stage.
59
The ‘classical’ life cycle of a product has five phases or
stages.
(a) Development. The product has a research or design and
development stage. Costs are incurred but the product is not yet on
the market and there are no sales revenues.
(b) Introduction. The product is introduced to the market. Potential
customers are initially unaware of the product or service, and the
organization may have to spend heavily on advertising to bring the
product or service to the attention of the market. In addition, capital
expenditure costs may be incurred in order to increase the production
capacity as sales demand grows.
(c) Growth. The product gains a bigger market as demand builds up.
Sales revenues increase and the product begins to make a profit.
(d) Maturity. Eventually, the growth in demand for the product will
slow down and it will enter a period of relative maturity, when sales
have reached a peak and are fairly stable. This should be the most
profitable phase of the product’s life. The product may be modified or
improved, as a means of sustaining its demand and making this
phase of the life cycle as long as possible.
(e) Decline. At some stage, the market will have bought enough of
the product and it will therefore reach 'saturation point'. Demand will
start to fall. Eventually it will become a loss-maker and this is the 60
 Life cycle costs
The component elements of a product's cost over its life cycle could therefore include the following.
1. Research & development costs
Design costs
Cost of making a prototype
Testing costs
 Production process and equipment: development and investment
2. The cost of purchasing any technical data required (for example purchasing the right from
another organization to use a patent)
3. Training costs (including initial operator training and skills updating)
4. Production costs, when the product is eventually launched in the market
5. Distribution costs. Transportation and handling costs
6. Marketing and advertising costs
Customer service
Field maintenance
Brand promotion
Inventory costs (holding spare parts, warehousing and so on)
7. Retirement and disposal costs. Costs occurring at the end of a product's life. These may include
the costs of cleaning up a contaminated site.
61
 Life cycle costing vs traditional costing systems
• Traditional cost accumulation systems are based on the
financial accounting year and tend to dissect a product's
life cycle into a series of 12-month periods.
• This means that traditional management accounting
systems do not accumulate costs over a product's entire
life cycle and do not therefore assess a product's
profitability over its entire life. Instead they do it on a
periodic basis.
• Life cycle costing, on the other hand, tracks and
accumulates actual costs and revenues attributable to
each product over the entire product life cycle. Hence
the total profitability of any given product can be
determined.
62
 Benefits of life cycle costing
1. It helps management to assess profitability over the full life of a
product, which in turn helps management to decide whether to
develop the product, or to continue making the product.
2. It can be very useful for organizations that continually develop
products with a relatively short life, where it may be possible to
estimate sales volumes and prices with reasonable accuracy.
3. The life cycle concept results in earlier actions to generate more
revenue or to lower costs than otherwise might be considered.
4. Better decisions should follow from a more accurate and realistic
assessment of revenues and costs, at least within a particular life
cycle stage.
5. It encourages longer-term thinking and forward planning, and
may provide more useful information than traditional reports of
historical costs and profits in each accounting period.

63
Maximizing return over the product life cycle

Design costs out of products

 Between 70% to 90% of a product's life cycle costs are determined by decisions
made early in the life cycle, at the design or development stage. Careful design of
the product and manufacturing and other processes will keep cost to a minimum
over the life cycle.

Minimize the time to market

 ‘Time to market’ is the time from the conception of the product to its introduction
to the market.
 Competitors watch each other very carefully to determine what types of product
their rivals are developing. If an organization is launching a new product it is vital to
get it to the market place as soon as possible. This will give the product as long a
period as possible without a rival in the market place, and should mean increased
market share in the long run. Furthermore, the life span of a product may be
affected by delay in its the market introduction. It is not unusual for the product's
overall profitability to fall by 25% if the launch is delayed by six months. This means
that it is usually worthwhile incurring extra costs to keep the launch on schedule or
to speed up the launch.

64
Minimize breakeven time (BET)
A short BET is very important in keeping an organization liquid. The
sooner the product is launched the quicker the research and
development costs will be repaid, providing the organization with
funds to develop further products. In life cycle costing, break even
occurs when revenue from the product has covered all the costs
incurred to date including design and development costs.
Maximize the length of the life span
Product life cycles are not predetermined; they can be influenced
by the actions of management and competitors. For example some
products lend themselves to a number of different uses; this is
especially true of materials, such as plastic, PVC, nylon and other
synthetic materials. The life cycle of these materials can be
extended by finding new uses for them. The life cycle of the
material is then a series of individual product curves nesting on top
of each other.
65
Service and project life cycles

• Services have life cycles. The only difference with the

life cycle of a product is that the R & D stages will not
usually exist in the same way.
• The different processes that go to form the complete
service are important, however, and consideration
should be given in advance as to how to carry them out
and arrange them so as to minimize cost.
• Products that take years to produce or come to fruition
are usually called projects, and discounted cash flow
calculations are invariably used to cost them over their
life cycle in advance.
• The projects need to be monitored very carefully over
their life to make sure that they remain on schedule
and that cost overruns are not being incurred. 66
 Customer life cycles
Customers also have life cycles, and an organisation will wish to maximise
the return from a customer over their life cycle. The aim is to extend the
life cycle of a particular customer or decrease the 'churn‘ rate, as the
Americans say.
This means encouraging customer loyalty. For example, some
supermarkets and other retail outlets issue loyalty cards that offer
discounts to loyal customers who return to the shop and spend a certain
amount with the organisation.
As existing customers tend to be more profitable than new ones they
should be retained wherever possible.
Customers become more profitable over their life cycle. The profit can go
on increasing for a period of between approximately four and 20 years. For
example, if you open a bank account, take out insurance or invest in a
pension, the company involved has to set up the account, run checks and
so on. The initial cost is high and the company will be keen to retain your
business so that it can recoup this cost. Once customers get used to their
supplier they tend to use them more frequently, and so there is a double
benefit in holding on to customers. 67
Solaris specialises in the manufacture of solar panels. It is
planning to introduce a new slimline solar panel specially
designed for small houses. Development of the new panel is to
begin shortly and Solaris is in the
process of determining the price of the panel. It expects the new
product to have the following costs.
Year 1 Year 2 Year 3 Year 4
Units manufactured and sold 2,000 15,000 20,000 5,000
$ $ $ $
R&D costs 1,900,000 100,000 - -
Marketing costs 100,000 75,000 50,000 10,000
Production cost per unit 500 450 400 450
Customer service costs per unit 50 40 40 40
Disposal of specialist equipment 300,000

The Marketing Director believes that customers will be prepared to pay

$500 for a solar panel but the
Financial Director believes this will not cover all of the costs throughout the
lifecycle.
Required
Calculate the cost per unit looking at the whole life cycle and comment on
the suggested price. 68
THROUGHPUT ACCOUNTING
Throughput accounting and back flush accounting have
been developed in response to relatively modern
advances in manufacturing:
1. The increased reliance by manufacturing businesses on
sophisticated and expensive facilities and machinery.
This greatly increases the proportion of costs which are
fixed. (This was one reason why activity-based costing
has become more important: if fixed costs are more
significant they should be dealt with more accurately.)
2. A recognition that holding inventory is likely to be a
waste of resources.
3. The increased use of just-in-time manufacturing, so
that inventory (particularly work-in-progress) is much
reduced and its valuation is therefore less important. 69
• Throughput accounting has a very direct relationship with
decision making and performance management.
• It begins by focusing on what an organization’s purpose is
– its goal – and seeks to help organizations attain their
purpose by increasing their ‘goal units’( those units that
help to attain the goal.
• The approach can be applied to both profit-seeking and
not-for-profit organizations, provided meaningful goal
units can be identified.

70
 The theory of Constraints
• Theory of constraints (TOC) is an approach to
production management which aims to maximise
sales revenue less material cost.
• It focuses on bottlenecks which act as constraints to
the maximisation of throughput.
• Throughput is the money generated from sales minus
the cost of the materials used in making the items
sold.
• Bottleneck resource or binding constraint – an
activity which has a lower capacity than preceding or
subsequent activities, thereby limiting throughput.

71
• The theory of constraints also states that at any time
there will always be a bottleneck resource or factor
that sets a limit on the amount of throughput that is
possible.
• This bottleneck resource could in theory be sales
demand for the organisation’s output, but it is more
likely to be a resource that the organisation uses. This
‘bottleneck resource’ which prevents output and
throughput from getting any higher, could be:

72
Bottleneck resources
1. A production resource, such as time available on a
type of machine, or the available amount of skilled
employee time
2. A selling resource, such as the number of sales
representatives
3. The existence of an uncompetitive selling price
4. A need to deliver on time to particular customers
5. A lack of product quality and reliability
6. The lack of reliable material suppliers

73
 Throughput accounting concepts
Concept 1
• In the short run, all costs in the factory (with the exception of
materials costs) are fixed costs. These fixed costs include direct
labour costs. It is useful to group all these costs together and call
them Total Factory Costs (TFC).
Concept 2
• In a JIT environment, all inventory is a 'bad thing' and the ideal
inventory level is zero.
Concept 3
• Profitability is determined by the rate at which 'money comes in at
the door' (that is, sales are made) and, in a JIT environment, this
depends on how quickly goods can be produced to satisfy
customer orders

74
Example

Take a not-for-profit organization which performs a

medical screening service in three sequential stages:
1. Take an X-ray.
2. Interpret the result.
3. Recall patients who need further investigation/tell
others that all is fine.

75
• The ‘goal unit’ of this organization will be to progress
a person through all three stages.
• The number of people who complete all the stages is
the organization’s throughput, and the organization
should seek to maximize its throughput.
• However, there will always be a limit to throughput,
and the resource which sets that limit is called the
‘bottleneck resource’.
• Adding more detail to the medical screening process
above:

76
 Process Total hors
time/patient(hours) available/week

Take an X-ray 0.25 40 0.25 40

Interpret the result 0.1 20

Recall patients who need further

investigation/tell others that all is fine 0.2 30

77
• You can easily see from this table that the maximum
number of patients (goal units) who can be dealt with
in each process is:
• X-rays: 40/0.25 = 160
• Interpret results: 20/0.10 = 200
• Recall etc: 30/0.20 = 150

78
• So, the recall procedure is the bottleneck resource.
• Throughput, and thereby the organization’s
performance, cannot be improved until that part of the
process can deal with more people. Therefore, to
improve throughput:
1. Ensure there is no idle time in the bottleneck resource, as
that will be detrimental to overall performance (idle time in
a non‑bottleneck resource is not detrimental to overall
performance).
2. See if less time could be spent on the bottleneck activity.
3. Finally, increase the bottleneck resource available.

79
• The traditional approach to decision making in a
profit-seeking organization is to use contribution
analysis.
• The contribution per unit is the difference between
the selling price of a unit and the marginal cost of a
unit, where marginal cost consists of the material,
variable labour and variable overhead per unit.

80
• The contribution approach is not wrong in principle, but
the assumptions it makes about cost behaviour often do
not accurately reflect the reality of a modern
manufacturing business. In particular, the notion that
there are significant variable labour and overhead costs
is suspect.
• Many of these businesses rely on sophisticated
automated systems that run continuously with relatively
little manual involvement.

81
• Even when production is slack, provided the
downturn is expected to be short lived, most
employees will still be paid because it is expensive to
dismiss workers and then to rehire and retrain them.
• For short-term fluctuations in production it would be
more accurate to consider labour costs and all
overheads to be fixed, leaving material as the only
truly variable cost.

82
• If all costs except material are fixed, businesses will
become richer provided the sales revenue per unit
exceeds material price per unit.
• In effect, sales price less material price is the new
contribution per unit, but to make clear what we are
talking about this is not called ‘contribution’: it is
called ‘throughput’.
• In fact, ‘throughput’ is sometimes usefully known as
‘throughput contribution’:

83
Throughput = selling price – material
per unit per unit per unit

Throughput = sales revenue – cost of materials

84
 EXAMPLE-use the following information to do some throughput
calculations

PRODUCTS A B C

Expected demand/budgeted output

(units) 8,000.00 10,000.00 6,000.00
Selling price per unit (K) 130 100 135
Material cost per unit 33 20 40
Labour cost per unit 30 24 36
Variable overhead cost per unit 25 20 30
Fixed overhead cost per unit 15 12 18
       
Machine hours/unit 0.25 0.2 0.3
Labour hours per unit 0.25 0.2 0.3
Quality control time per unit 0.1 0.1 0.1 85
Identifying the bottleneck process
 

Needed for full production Available

Machine hours 0.25 x 8,000 + 0.2 x 10,000 + 0.3 x 6,000 = 5,800 5000

Labour hours 0.25 x 8,000 + 0.2 x 10,000 + 0.3 x 6,000 = 5,800 6000

Quality control hours 0.10 x 8,000 + 0.1 x 10,000 + 0.1 x 6,000 =

2,400 2500

86
Calculating throughput( Selling price less Material cost

Selling Material Throughput/u

Product Price(K) cost(K) nit(K)

A 130 33 97
B 100 20 80
C 135 40 95

87
We can’t simply conclude from this that Product A must
be best because it earns more per unit than the other
products.
It is essential to take into account the use that each
product makes of the bottleneck resource. Here, machine
hours have been identified as the bottleneck resource.
These are uniquely precious and must be used up in the
best possible way. This can be done by calculating for each
unit:
Throughput
Time in bottleneck resource
and then using the answers to rank the products. See
next slide
88
Calculating throughput per unit of the bottleneck
resource i.e. throughput per machine hour

Throughput/ Machine Throughput/

Product unit hrs/unit machine hr Rank

A 97 0.25 388 2

B 80 0.2 400 1

C 95 0.3 317 3
89
• This shows that priority should be given to making
Product B, the highest earner per machine hour, then
to Product A, and finally to Product C.

90
 Calculation of Profit
machine machine(bottleneck)
Product units hrs/unit hours used throughput  throughput

B 10,000 0.2 200010000 x 80=800000 800,000.00

A 8,000 0.25 20008000 x 97=776000 776,000.00
C(balance) 3,333 0.31000(balance) 3333 x 95=316635 316,635.00

 TOTAL THROUGHPUT
    1,892,635.00

Maximum
machine hours
available     5000   
 

 
Total expected non-material costs-Factory costs (from the original
budget) =
   

Product A: 8,000 x (30 + 25 + 15) = 560,000

 
Product B: 10,000 x (24 + 20 + 12) = 560,000

Product C: 6,000 x (36 + 30 + 18) = 504,000

Total factory costs-factory expenses 1,624,000 91
 Throughput Accounting Ratio(TAR)
The throughput accounting ratio (TA ratio) is the
ratio of the throughput per unit of bottleneck
resource to the factory cost per unit of bottleneck
resource. The factory cost is usually the total factory
cost. This ratio should be as high as possible, and
certainly more than 1
The TAR should be calculated for each product. The
products should then be ranked in order of TAR.
Start producing the product with the highest TAR.
For our example the TAR has been calculated in the
next slide

92
 Note: factory cost is uniform for all the products and is as
calculated in slide 87( K1,624,000.00). Machine hrs are
5000hrs)

Throughput
  accounting ratios    

  Product A Product B Product C

Return/factory
hour 388 400 317
Costs/factory
hour 324.8 324.8 324.8

Throughput
accounting ratio 1.17 1.21 0.93 93
The TAR tells us nothing that we have not worked out already. Its
interpretation is:
The higher the better (but we already knew the ranking of the
products from the return/ factory hour)
The TAR should be greater than 1 if a product is worthwhile
(earning rate greater than spending rate).
Organizations should focus on how they can increase their TAR.
Obvious routes are to increase selling prices, decrease material
costs, or decrease factory costs.
Provided a TAR is greater than 1 it will be worth trying to
increase throughput, and this must be done by eliminating idle
time in the bottleneck resource, increasing the bottleneck
resource (until another resource becomes the bottleneck), or
decreasing the use the product makes of the bottleneck
resource 94
 Examples
• For example, suppose that a factory manufactures a
single product. Each unit of product takes 2 hours to
make on Machine X and output capacity is restricted by
the available time on Machine X, which is restricted to
500 hours per week.
• The product has a material cost of K20 per unit and sells
for K160 per unit. Total operating costs are K30,000 per
week.

95
• Throughput per Machine X hour = K(160 – 20)/2 hours = K70
• Factory cost per Machine X hour = K30,000/500 hours = K60
• TA ratio = K70/K60 = 1.17

96
• A business manufactures product Z, which has a selling
price of K20. The materials costs are K8 per unit of
Product Z. Total operating expenses each month are
120,000.
• Machine capacity is the key constraint on production.
There are only 600 machine hours available each month,
and it takes three minutes of machine time to
manufacture each unit of Product Z.
Required
(a) Calculate the throughput accounting ratio.
(b) How might this ratio be increased

97
• Corrie produces three products, X, Y and Z. The capacity of
Corrie's plant is restricted by process alpha.
• Process alpha is expected to be operational for eight hours per
day and can produce 1,200 units of X per hour, 1,500 units of Y
per hour, and 600 units of Z per hour.
• Selling prices and material costs for each product are as
follows.
Product Selling price Material cost Throughput contribution
K per unit K per unit K per unit
X 150 80 70
Y 120 40 80
Z 300 100 200
Conversion costs are K720,000 per day.
98
Required
• (a) Calculate the profit per day if daily output achieved
is 6,000 units of X, 4,500 units of Y and 1,200 units of Z.
• (b) Calculate the TA ratio for each product.
• (c) In the absence of demand restrictions for the three
products, advise Corrie's management on the optimal
production plan.

99
 MANAGEMENT
ACCOUNTING
( MA 300)
LECTURE NOTES

Compiled by
Wachawaseme Mwale
merviswacha@gmail.com
+265 999 335 012
STUDY TOPICS
1. Costing Methods
2. Process Costing
3. Planning Control and Performance Management
4. Information for decision making
5. Risk and uncertainty
6. Performance Management

101
COSTING METHODS
• Traditional costing systems
• Absorption costing
• Marginal Costing
• Back flush Costing
• JIT systems
• ABC, ABM AND ABB
• Life cycle costing, customer profitability analysis and
Target costing.
• Throughput accounting and theory of constraints

102
ABSORPTION COSTING/FULL COSTING
• A method whereby all production costs are included
in the costing of a cost unit ie.
• Direct materials,
• direct labour,
• variable production overheads and
• fixed production overheads.
• IAS 2 Inventories requires an element of fixed
production overhead to be ‘absorbed’ into product
cost for inventory valuation purposes.
• All production costs are charged to units of
production.

103
Calculation of unit cost-absorption
costing method
Direct costs:
Direct materials (5kg @ $3/kg) 15.00
Direct labour (3hrs @ $6/hr) 18.00
33.00
Indirect costs:
Variable overheads 2.00
Fixed overheads(absorption) 3.00
Full product cost 38.00

104
The process of
absorption
Three Step Process:
(1) Allocate/apportion overheads to cost centres
(2) Re-apportion service centre costs to production cost
centres
(3) Absorb into production

105
Under/Over absorption
• Over and under absorption of overheads occurs
because the predetermined overhead absorption
rates are based on estimates.
• The rate of overhead absorption is based on
estimates (of both numerator and denominator) and
it is quite likely that either one or both of the
estimates will not agree with what actually occurs.
• (a)

106
• Over absorption means that the overheads charged
to the cost of sales are greater than the overheads
actually incurred.
• Under absorption means that insufficient overheads
have been included in the cost of sales.
• It is almost inevitable that at the end of the
accounting year there will have been an over
absorption or under absorption of the overhead
actually incurred.

107
The reasons for under-/over-absorbed overhead

• Actual overhead costs are different from budgeted

overheads
• The actual activity level is different from the
budgeted activity level
• Both actual overhead costs and actual activity level
differ from the budgeted costs and level

108
Treatment of under/over absorption
• Under absorption is added to gross profit
• Over absorption is deducted from gross profit

109
Example
A company absorbs overheads based on labour hours.
Data for the latest period are as follows.
Budgeted labour hours 8,500
Budgeted overheads K148,750
Actual labour hours 7,928
Actual overheads K146,200
(a) Based on the data given above, what is the labour
hour overhead absorption rate?
(b) Based on the data given above, what is the amount
of under-/over-absorbed overhead?

110
Example
Pembridge Co has a budgeted production overhead of
K50,000 and a budgeted activity of 25,000 direct labour hours
and therefore a recovery rate of K2 per direct labour hour.
Required
• Calculate the under-/over-absorbed overhead, and the
reasons for the under-/over-absorption, in the following
circumstances.
• (a) Actual overheads cost K47,000 and 25,000 direct labour
hours are worked.
• (b) Actual overheads cost K50,000 and 21,500 direct labour
hours are worked.
• (c) Actual overheads cost K47,000 and 21,500 direct labour
hours are worked.
111
Advantages of absorption costing
1. It recognizes that selling prices must cover all costs
(Pricing purposes)
2. It complies with IAS 2 on accounting for inventory,
whereby the value of inventory must include an
appropriate amount of fixed production overhead
(Stock valuation).
3. By apportioning overhead to production it is
possible to compare how profitable different items
are.(profitability comparisons)

112
Disadvantages of absorption costing
1. Profits can be manipulated by simply changing
production levels. This is because overheads will be
carried forward in closing inventory.
2. It is based on the assumption that overheads are
volume related

113
 MARGINAL/VARIABLE COSTING
Marginal cost is the variable cost of one unit of product
or service.
Marginal costing is an alternative method of costing to
absorption costing.
In marginal costing, only variable costs are charged as a
cost of sale and a contribution is calculated (sales
revenue minus variable cost of sales).
Closing inventories of work in progress or finished goods
are valued at marginal (variable) production cost.
Fixed costs are treated as a period cost, and are charged
in full to the profit and loss account of the accounting
period in which they are incurred.
114
• The marginal production cost per unit of an item usually
consists of the following.
• Direct materials
• Direct labour
• Variable production overheads
• Contribution is an important measure in marginal costing,
and it is calculated as the difference between sales value
and marginal or variable cost of sales.
• Contribution is of fundamental importance in marginal
costing, and the term 'contribution' is really short for
'contribution towards covering fixed overheads and
making a profit'.

115
 Example-Marginal costing
Selling price per unit K10
Variable costs per unit
direct materials K2
direct labour K3
selling and distribution K1
Fixed costs:
Production: budgeted K8,000
actual K8,500
Selling and distribution: (budgeted and actual) K2,000
Activity levels: Year 1
Units
• Budgeted production 4,000
• Actual sales 4,200
• Actual production 4,400
• There is no opening inventory in Year 1.
• Required
Prepare an income statement under absorption costing
116
Advantages of marginal costing
1. Most appropriate for decision making as it highlights
contribution.
2. Fixed costs are treated in accordance with their
nature, ie as period costs.
3. Profit depends on sales and efficiency not on
production levels. Variable costing removes from
profit the effect of stock changes.
4. Variable costing provides more useful information for
decision-making.
5. Variable costing avoids fixed overheads being
capitalized in unsaleable stocks.

117
Disadvantages of marginal costing
• There is a danger that products will be sold on an
ongoing basis at a marginal contribution which fails to
cover fixed costs.
• Does not comply with IAS 2, thus necessitating year
end adjustments for the preparation of published
accounts.
• Necessitates analysis of mixed costs between fixed
and variable.
• Seasonal variations in a year can cause unnecessary
profit variances.

118
Absorption and Marginal Costing Compared
• In marginal costing, fixed production costs are treated
as period costs and are written off as they are
incurred. In absorption costing, fixed production costs
are absorbed into the cost of units and are carried
forward in inventory to be charged against sales for
the next period.
• Inventory values using absorption costing are
therefore greater than those calculated using
marginal costing.

119
 Differences
Marginal Costing Absorption Costing

Closing inventories are Closing inventories are valued

valued at marginal at full production cost.
production cost.

Fixed costs are period Fixed costs are absorbed into

costs. unit costs.

Cost of sales does include a

Cost of sales does not share of fixed overheads
include a share of fixed
overheads.

120
Reconciling profits
• Reported profit figures using marginal costing or
absorption costing will differ if there is any change in
the level of inventories in the period.
• If production is equal to sales, there will be no
difference in calculated profits using the costing
methods.

121
 Explanation of the differences

1. If inventory levels increase between the beginning

and end of a period, absorption costing will report
the higher profit. This is because some of the fixed
production overhead incurred during the period will
be carried forward in closing inventory (which reduces
cost of sales) to be set against sales revenue in the
following period instead of being written off in full
against profit in the period concerned.
2. If inventory levels decrease, absorption costing will
report the lower profit because as well as the fixed
overhead incurred, fixed production overhead which
had been carried forward in opening inventory is
released and is also included in cost of sales.
122
Profits are the same for both methods when
production equals sales(no changes in stock levels)
Where production exceeds sales (increasing stock
levels)the absorption costing system produces
higher profits.
Where sales exceed production (declining stock
levels) the variable costing system produces higher
profits.
With an absorption costing system profits can
decline when sales volume increases and costs
remain unchanged

123
Reconciliation formula
Marginal Costing Profit x
Add: differences in closing inventory x
Less: differences in opening inventory (x)
Equals Absorption costing profit x

124
Which one is better?
• Choice depends on the circumstances.
• Volatile sales and changing stock levels favour variable
costing for internal monthly or quarterly profit
measurement.
• Seasonal sales where stocks are built up in advance favours
absorption costing.
• Debate only applies to internal reporting – IAS 2,
Inventories requires that absorption costing is used for
external reporting.
• Debate only applies when historical cost accounting is
used.

125
ACTIVITY BASED COSTING
The emergence of ABC systems
Traditional systems were appropriate when:
• Direct costs were the dominant costs
• Indirect costs were relatively small
• Information costs were high
• There was a lack of intense global
competition
• A limited range of products was produced.

126
 WEAKNESS OF TRADITIONAL COSTING SYSTEMS
MARGINAL COSTING
The main problem is that fixed
overheads are virtually
ignored.
Ignoring overheads tends to
inflate profits artificially.
The profit is, in effect, the
contribution.
The major danger, therefore,
is that fixed overheads are not
allocated to products and may
not be recovered when setting
a selling price.
As a result, the company may
drift into loss and eventually
go out of business.
ABSORPTION COSTING
The process assumes that overheads
relate directly to the level of
production.
The problem with this approach is
that the allocation of costs is carried
out on an arbitrary basis and may
not reflect accurately on those
activities which are truly responsible
for the costs.
Sometimes, a particular product or
activity may show a loss simply due
to a change in the cost allocation
process.
It is time consuming
127
Weaknesses of traditional costing systems
• They split costs into fixed and variable elements-this is
too simplistic and short termism. Overtime all costs are
variable.
• As businesses grow with time, their complexity also
grows. Costs therefore vary according to complexity and
not volume.
• Selling and administration costs are ignored i.e. not
included in product costs.
• Labour hours are often used as the basis for absorption,
even though direct labour often forms a relatively small
proportion of total cost.

128
 Stages in ABC
• Identify those activities that cause overheads to be
incurred.
• Adjust the accounting system so that costs are collected by
activity rather than by cost centre.
• Identify those factors which cause each activity's costs to
change (the cost drivers)
• Establish the volume of each cost driver.
• Calculate the cost driver rates by dividing the activity's cost
by the volume of its cost driver.
• Establish the volume of each cost driver required by each
product.
• Calculate overheads attributable to each product by
multiplying step (e) by step (f).
129
Cost pool/activity Possible cost driver

Materials handling costs Number of production

runs
Machine set-up costs Number of machine set-
ups

Machine operating costs Number of machine hours

Production scheduling Number of production

costs runs
Despatching costs Number of orders
despatched

130
 Example

 A company manufactures two products, L and M, using the same equipment and similar
processes. An extract of the production data for these products in one period is shown below.
L M
 Quantity produced (units) 5,000 7,000
 Direct labour hours per unit 1 2
 Machine hours per unit 3 1
 Set-ups in the period 10 40
 Orders handled in the period 15 60
 Overhead costs $
 Relating to machine activity 220,000
 Relating to production run set-ups 20,000
 Relating to handling of orders 45,000

285,000
Required
 Calculate the production overheads to be absorbed by one unit of each of the products using
the following costing methods.
(a) A traditional costing approach using a direct labour hour rate to absorb overheads
(b) An activity based costing approach, using suitable cost drivers to trace overheads to products
131
Merits of ABC
The complexity of manufacturing has increased, with wider
product ranges, shorter product life cycles and more
complex production processes. ABC recognizes this
complexity with its multiple cost drivers.
In a more competitive environment, companies must be
able to assess product profitability realistically. ABC
facilitates a good understanding of what drives overhead
costs.
In modern manufacturing systems, overhead functions
include a lot of non-factory-floor activities such as product
design, quality control, production planning and customer
services. ABC is concerned with all overhead costs and so it
can take management accounting beyond its 'traditional'
factory floor boundaries.
132
Uses of ABC
1. It provides accurate and reliable cost information
2. It establishes a long-run product cost
3. It provides cost data which may be used to evaluate
different ways of delivering business.
4. It is particularly suited to the following types of
decision:
• Pricing, where selling prices are derived by adding a profit mark-up to
cost
• Promoting or discontinuing products or parts of the business, since
ABC may help management to identify activity costs that may be
either incurred or saved
• Developing new products or new ways to do business, because ABC
focuses attention on the support activities that would be
required for the new product or business procedure.
133
 Criticisms of ABC
 Cost apportionment may still be required at the cost pooling stage for shared items
of cost such as rent, rates and building depreciation. Apportionment can be an
arbitrary way of sharing costs.
 A single cost driver may not explain the cost behaviour of all items in a cost pool.
An activity may have two or more cost drivers.
 Unless costs are ‘driven’ by an activity that is measurable in quantitative terms,
cost drivers cannot be used. What drives the cost of the annual external audit, for
example?
 There must be a reason for using a system of ABC. ABC must provide meaningful
product costs or extra information that management will use. If management is not
going to use ABC information for any practical purpose, a traditional absorption
costing system would be simpler to operate and just as good.
 The cost of implementing and maintaining an ABC system can exceed the benefits of
‘improved accuracy’ in product costs.
 Implementing ABC is often problematic, due to problems with understanding
activities and their costs. It is also complex. We need a lot of information.
 ABC is an absorption costing system. Absorption costing has only limited value for
management accounting purposes.
134
JUST-IN-TIME SYSTEMS(JIT)
• JIT is a modern manufacturing concept with radical
implications for the associated costing systems.
• It is a method of providing production with the inputs it
requires as and when they are needed.
• A common misconception is that JIT is purely a form of
stock control, whereas it is in effect an overall
management philosophy covering all aspects of the
production process.

135
• The first stage in implementing a JIT system involves the rearrangement of the
factory layout.

• In a traditional or functional plant layout similar machines are grouped

together, and the item being manufactured travels from department to
department as the various manufacturing processes occur to the item, e.g. the
item will go to the drilling department, then to the grinding department, then
to the turning department.

• In a JIT system dissimilar machines are arranged, often in a U shape, around a

JIT cell which manufactures the item. Each member of the cell can operate all
the machines and the aim is that the item is manufactured without ever leaving
the cell. The item does not go back to store or sit around awaiting for the next
process. JIT uses what is known as cellular manufacturing.

• The aim of JIT is to produce the right part at the right time. This results in the
"pull" manufacturing system as opposed to traditional manufacturing methods,
which are called "push" manufacturing systems because the items push their
way from department to department, often resulting in them waiting in queues
for the next process.
136
 Aspects of JIT
ASPECT DETAIL
Quality This is not necessarily quality of the product to the final customer, but
rather quality in the following terms:
• Products should be standardized and easy to produce.
• Processes, e.g. plant layout and tool and machinery design, are of
critical importance.
• Suppliers should consist of a small number, each of whom provides
proven quality in terms of product and delivery deadlines.

Purchasing This is the most well known aspect whereby small numbers of items are
delivered when required, but much more frequently.
Production Final customer demand forms the basis of the determinants of output and
Control therefore materials used.
The speed of production should also be dictated by the needs of the
customer, i.e. how quickly the items are required.
In addition, set-up times do not add value and should therefore be
eliminated or reduced as much as possible.

Employee Employees are expected to be much more flexible in addition to

involvement experiencing greater levels of participation and responsibility. 137
 JIT Goals
Goal Explanation
Elimination of non JIT is dedicated to the elimination of waste, which is defined as anything that does not add value to
value adding a product. In manufacturing, the following activities occur before the item is sold (this is called the
activities lead time): process time/inspection time/move time/queue time/storage time.
Of these five activities only process time adds value to the product.

Zero Inventory JIT as a pull manufacturing system, the idea is that items are only produced as they are required
and thus no large stocks of manufactured goods are accumulated.

Zero Defect JIT is based on "doing it right first time". In a conventional system it is assumed that some items
will become defective and some departments will suffer breakdowns. This results in the
maintenance of stocks of work-in-progress to provide work for departments at all times. It also
results in high stock levels which JIT does not sanction.

Batch sizes of one As JIT works to eliminate set-up time as it is a non-value-adding activity, batch sizes can be
reduced, thus preventing the development of bottlenecks, which occur when long production runs
are used.
Zero break down Zero breakdown is aimed for by planning for preventive maintenance to be carried out within the
cell; all members are trained not only to use but also to maintain their machines. Breakdowns can
thus be reduced significantly and repair carried out more quickly should a breakdown occur.

100% on Can be achieved if the previous aims are achieved

time delivery
JIT The principles of JIT are applied equally to all outside purchases of components. Suppliers must
purchasing not only supply on time in the quantities required, but must also guarantee quality. This saves
costs by eliminating handling costs as inspection is no longer needed.

138
Features of JIT
• Organization production in manufacturing cells
• Hiring and retaining multi-skilled staff
• Emphasizing total quality management
• Reducing manufacturing lead time and set-up time
• Building strong supplier relationships

139
 Advantages and Disadvantages of JIT
Advantages
Work-in-progress and stock
levels are reduced,
representing cost savings of
working capital requirements.
Much smoother production
flow should lead to increased
productivity.
Improvements in quality
should result in less rework.
Because of shorter production
times, paperwork is reduced,
e.g. the amalgamation of the
Disadvantages
The JIT technique is tailored to situations of regular
demand, relatively unchanging processes and a large
percentage of common components. Thus, it is not
necessarily suitable for all types of production.
Problems can arise if attempts are made to implement JIT
in situations which do not match its requirements.
Implementation is over a very long time-scale and a
large degree of patience is required by those whose
responsibility it is
JIT involves a different cultural approach from that
traditionally to be found in Western manufacturing
industries –particularly in terms of consensus
decision-making.
JIT is considered weak in terms of medium-and long-
term planning.
140
 TARGET COSTING
Target costing involves setting a target cost for a product,
having identified a target selling price and a required
profit margin.
The target cost is the target sales price minus the
required profit.
Target costing is concerned with designing a product and
its production process so that it can be made and sold at
a cost that delivers the required profit at the chosen
price. It focuses on getting the expected cost of a product
down to a target cost amount.
Achieving a target cost will usually require some
redesigning of the product and the removal of
unnecessary costs.
141
 Implementing target costing
Step 1 Determine a product specification of which an adequate
sales volume is estimated.
Step 2 Decide a target selling price at which the organization will
be able to sell the product successfully and achieve a desired
market share.
Step 3 Estimate the required profit, based on required profit
margin or return on investment.
Step 4 Calculate: Target cost = Target selling price – Target profit.
Step 5 Prepare an estimated cost for the product, based on the
initial design specification and current cost levels.
Step 6 Calculate: Target cost gap = Estimated cost – Target cost.
Step 7 Make efforts to close the gap. This is more likely to be
successful if efforts are made to 'design out' costs prior to
production, rather than to 'control out' costs after ‘live’
production has started. 142
Example
A car manufacturer wants to calculate a target cost
for a new car, the price of which will be set at
K17,950.
The company requires an 8% profit margin on sales.
Required
What is the target cost?

143
Great Games, a manufacturer of computer games, is in the process of introducing a
new game to the market and has undertaken market research to find out about
customers’ views on the value of the product and also to obtain a comparison with
competitors’ products. The results of this research have been used to establish a
target selling price of K60. This is the price that the company thinks it will have to
sell the product to achieve the required sales volume.
Cost estimates have been prepared based on the proposed product specification.
Manufacturing cost K
Direct material 3.21
Direct labour 24.03
Direct machinery costs 1.12
Ordering and receiving 0.23
Quality assurance 4.60
Non-manufacturing costs
Marketing 8.15
Distribution 3.25
After-sales service 1.30
The target profit margin for the game is 30% of the target selling price.
Required
Calculate the target cost of the new game and the target cost gap.

144
Example
• Projected lifetime sales volume 300 000 units
• Target selling price of the product K800
• Target profit margin (30% of selling price)
• Projected cost K700

145
 Closing the target cost gap
The target cost gap is the estimated cost less the target cost.
When a product is first manufactured, its currently-attainable
cost may be higher than the target cost. Management can then
set benchmarks for improvement towards the target cost, by
improving production technologies and processes. Various
techniques can be employed.
Reducing the number of components
 Using cheaper staff
Using standard components wherever possible
Acquiring new, more efficient technology
Training staff in more efficient techniques
Cutting out non-value-added activities
Using different materials

146
Target costing in service industries
Unlike manufacturing companies, services are
characterized by intangibility, inseparability, variability,
perishability and no transfer of ownership.
Some of the characteristics of services make it difficult
to use target costing, and identify a target cost for a
service having established a target selling price.
Intangibility. Some of the features of a service cannot
be properly specified because they are intangible. When
services do not have any material content, it is not
possible to reduce costs to a target level by reducing
material costs

147
• Variability/homogeneity. A service can differ every time it is
provided, and a standard service may not exist. When services are
variable, it is possible to calculate an estimated average cost, but this
is not specific and so not ideal for target costing.

148
 BACK FLUSH COSTING
• Back flush accounting is a costing short cut.
• It relies on a business having immaterial amounts of
work‑in-progress and is therefore particularly suitable for
businesses operating just-in-time inventory management.
• If the amount of work‑in‑progress is negligible, what is the
point in meticulously valuing it?
• Fretting that some products might be 25% complete and
others 60% complete, and then adding carefully
calculated labour and overheads to these (immaterial)
items, is a complete waste of time and effort.

149
In back flush accounting, costs are not associated
with units until they are completed or sold.
Back flush accounting is sometimes called delayed
costing, which is a helpful name, as costs are not
allocated to production until after events have
occurred.
Standard costs are then used to work backwards to
flush out manufacturing costs into production,
splitting them between stocks of finished goods (if
any) and cost of sales.
No costs, whether material or conversion costs, are
allocated to work-in-progress.
150
Variants of back flush accounting

• There are two variants of back flush accounting and

they differ according to what are called ‘trigger
points’. Trigger points are the events which cause
costs to be moved into inventories.

151
Variant 1
This is the less radical variant. There are two inventory
accounts, raw materials and finished goods, and there are two
trigger points:

1 Purchase of raw materials

Dr Materials account
Cr Creditors
The cost of labour and other manufacturing expenses are
debited to a conversion cost account and credited to cash or
creditors. The conversion cost account can be thought of as a
suspense account where amounts are placed temporarily.

2 On completion of units
Dr Finished goods account with the standard cost of goods
produced
Cr Materials account with the standard cost of materials
Cr Conversion cost account with the standard cost of
conversion.
152
Variant 2
This is more radical because no records are kept of work-in-
progress raw materials, so if this method is to be used,
stocks of both raw materials and work-in-progress must be
negligible. It has only one
trigger point.

As before, the cost of labour and other manufacturing

expenses are initially debited to a conversion cost account
and credited to cash
or creditors.

Entries into the finished goods inventory account are made

only when goods are completed, and the journal entries will
be:

Dr Finished goods account with the standard cost of goods

produced
Cr Creditors with the standard cost of material used in goods 153
 Back flush and variances
• Note that at some point the creditors account will have
to record correctly what is owing to them so, from time
to time, this will be adjusted by a cost variance. Thus, if
the standard cost of raw materials used was $50,000,
but the actual cost of materials was $52,000, an adverse
variance of $2,000 has to be recognized and the
creditors account would have two entries Cr $50,000
(and Dr $50,000 to finished goods), then Cr $2,000 and
(Dr $2,000 to profit and loss account).

154
So, are there any benefits in adopting backflush accounting other than
avoiding complex recording and calculations to value immaterial amounts of
inventory?
Let’s consider the trigger point found in both variants: costs are transferred
when goods are completed.
What would happen if that trigger point were changed to permit cost transfer
only when goods were sold?
That would mean conversion costs would remain as costs until goods were
sold, rather then being transformed into finished stock when goods were
completed.
Managers would then have no incentive to make goods unless they were
going to be sold imminently, otherwise they would simply
be incurring more expense, and that would make their performance look bad.
The purpose of a manufacturing business is not to make goods; its purpose
is to make and sell goods. Only then is there throughput, and backflush
accounting can be set up so that costing records encourage managers
to adopt this goal-orientated behaviour. 155
Illustration
Purchase of raw materials K1 515 000
Conversion costs K1 010 000
Finished goods manufactured 100 000 units
Sales for the period 98 000 units
No opening stocks
Standard unit cost is K25 (K15 materials and K10
conversion cost)

156
LIFE CYCLE COSTING
• Life cycle costing estimates the costs and revenues
attributable to a product over its entire expected life
cycle.
• The life cycle costs of a product are all the costs
attributable to the product over its entire life, from
product concept and design to eventual withdrawal
from the market.

157
Traditional management accounting procedures have
focused primarily on the manufacturing stage of a
product’s life cycle.
 LCC focuses on costs over the product’s entire life
cycle to determine whether profits earned during the
manufacturing phase will cover the costs incurred
during the pre- and post-manufacturing stages.
 A large proportion of a product’s costs can be
committed or ‘locked in’ during the planning and
design stage.
Cost management can be most effectively exercised
during the planning and design stage.
158
The ‘classical’ life cycle of a product has five phases or
stages.
(a) Development. The product has a research or design and
development stage. Costs are incurred but the product is not yet on
the market and there are no sales revenues.
(b) Introduction. The product is introduced to the market. Potential
customers are initially unaware of the product or service, and the
organization may have to spend heavily on advertising to bring the
product or service to the attention of the market. In addition, capital
expenditure costs may be incurred in order to increase the production
capacity as sales demand grows.
(c) Growth. The product gains a bigger market as demand builds up.
Sales revenues increase and the product begins to make a profit.
(d) Maturity. Eventually, the growth in demand for the product will
slow down and it will enter a period of relative maturity, when sales
have reached a peak and are fairly stable. This should be the most
profitable phase of the product’s life. The product may be modified or
improved, as a means of sustaining its demand and making this
phase of the life cycle as long as possible.
(e) Decline. At some stage, the market will have bought enough of
the product and it will therefore reach 'saturation point'. Demand will
start to fall. Eventually it will become a loss-maker and this is the 159
 Life cycle costs
The component elements of a product's cost over its life cycle could therefore include the following.
1. Research & development costs
Design costs
Cost of making a prototype
Testing costs
 Production process and equipment: development and investment
2. The cost of purchasing any technical data required (for example purchasing the right from
another organization to use a patent)
3. Training costs (including initial operator training and skills updating)
4. Production costs, when the product is eventually launched in the market
5. Distribution costs. Transportation and handling costs
6. Marketing and advertising costs
Customer service
Field maintenance
Brand promotion
Inventory costs (holding spare parts, warehousing and so on)
7. Retirement and disposal costs. Costs occurring at the end of a product's life. These may include
the costs of cleaning up a contaminated site.
160
 Life cycle costing vs traditional costing systems
• Traditional cost accumulation systems are based on the
financial accounting year and tend to dissect a product's
life cycle into a series of 12-month periods.
• This means that traditional management accounting
systems do not accumulate costs over a product's entire
life cycle and do not therefore assess a product's
profitability over its entire life. Instead they do it on a
periodic basis.
• Life cycle costing, on the other hand, tracks and
accumulates actual costs and revenues attributable to
each product over the entire product life cycle. Hence
the total profitability of any given product can be
determined.
161
 Benefits of life cycle costing
1. It helps management to assess profitability over the full life of a
product, which in turn helps management to decide whether to
develop the product, or to continue making the product.
2. It can be very useful for organizations that continually develop
products with a relatively short life, where it may be possible to
estimate sales volumes and prices with reasonable accuracy.
3. The life cycle concept results in earlier actions to generate more
revenue or to lower costs than otherwise might be considered.
4. Better decisions should follow from a more accurate and realistic
assessment of revenues and costs, at least within a particular life
cycle stage.
5. It encourages longer-term thinking and forward planning, and
may provide more useful information than traditional reports of
historical costs and profits in each accounting period.

162
Maximizing return over the product life cycle

Design costs out of products

 Between 70% to 90% of a product's life cycle costs are determined by decisions
made early in the life cycle, at the design or development stage. Careful design of
the product and manufacturing and other processes will keep cost to a minimum
over the life cycle.

Minimize the time to market

 ‘Time to market’ is the time from the conception of the product to its introduction
to the market.
 Competitors watch each other very carefully to determine what types of product
their rivals are developing. If an organization is launching a new product it is vital to
get it to the market place as soon as possible. This will give the product as long a
period as possible without a rival in the market place, and should mean increased
market share in the long run. Furthermore, the life span of a product may be
affected by delay in its the market introduction. It is not unusual for the product's
overall profitability to fall by 25% if the launch is delayed by six months. This means
that it is usually worthwhile incurring extra costs to keep the launch on schedule or
to speed up the launch.

163
Minimize breakeven time (BET)
A short BET is very important in keeping an organization liquid. The
sooner the product is launched the quicker the research and
development costs will be repaid, providing the organization with
funds to develop further products. In life cycle costing, break even
occurs when revenue from the product has covered all the costs
incurred to date including design and development costs.
Maximize the length of the life span
Product life cycles are not predetermined; they can be influenced
by the actions of management and competitors. For example some
products lend themselves to a number of different uses; this is
especially true of materials, such as plastic, PVC, nylon and other
synthetic materials. The life cycle of these materials can be
extended by finding new uses for them. The life cycle of the
material is then a series of individual product curves nesting on top
of each other.
164
Service and project life cycles

• Services have life cycles. The only difference with the

life cycle of a product is that the R & D stages will not
usually exist in the same way.
• The different processes that go to form the complete
service are important, however, and consideration
should be given in advance as to how to carry them out
and arrange them so as to minimize cost.
• Products that take years to produce or come to fruition
are usually called projects, and discounted cash flow
calculations are invariably used to cost them over their
life cycle in advance.
• The projects need to be monitored very carefully over
their life to make sure that they remain on schedule
and that cost overruns are not being incurred. 165
 Customer life cycles
Customers also have life cycles, and an organisation will wish to maximise
the return from a customer over their life cycle. The aim is to extend the
life cycle of a particular customer or decrease the 'churn‘ rate, as the
Americans say.
This means encouraging customer loyalty. For example, some
supermarkets and other retail outlets issue loyalty cards that offer
discounts to loyal customers who return to the shop and spend a certain
amount with the organisation.
As existing customers tend to be more profitable than new ones they
should be retained wherever possible.
Customers become more profitable over their life cycle. The profit can go
on increasing for a period of between approximately four and 20 years. For
example, if you open a bank account, take out insurance or invest in a
pension, the company involved has to set up the account, run checks and
so on. The initial cost is high and the company will be keen to retain your
business so that it can recoup this cost. Once customers get used to their
supplier they tend to use them more frequently, and so there is a double
benefit in holding on to customers. 166
Solaris specialises in the manufacture of solar panels. It is
planning to introduce a new slimline solar panel specially
designed for small houses. Development of the new panel is to
begin shortly and Solaris is in the
process of determining the price of the panel. It expects the new
product to have the following costs.
Year 1 Year 2 Year 3 Year 4
Units manufactured and sold 2,000 15,000 20,000 5,000
$ $ $ $
R&D costs 1,900,000 100,000 - -
Marketing costs 100,000 75,000 50,000 10,000
Production cost per unit 500 450 400 450
Customer service costs per unit 50 40 40 40
Disposal of specialist equipment 300,000

The Marketing Director believes that customers will be prepared to pay

$500 for a solar panel but the
Financial Director believes this will not cover all of the costs throughout the
lifecycle.
Required
Calculate the cost per unit looking at the whole life cycle and comment on
the suggested price. 167
THROUGHPUT ACCOUNTING
Throughput accounting and back flush accounting have
been developed in response to relatively modern
advances in manufacturing:
1. The increased reliance by manufacturing businesses on
sophisticated and expensive facilities and machinery.
This greatly increases the proportion of costs which are
fixed. (This was one reason why activity-based costing
has become more important: if fixed costs are more
significant they should be dealt with more accurately.)
2. A recognition that holding inventory is likely to be a
waste of resources.
3. The increased use of just-in-time manufacturing, so
that inventory (particularly work-in-progress) is much
reduced and its valuation is therefore less important. 168
• Throughput accounting has a very direct relationship with
decision making and performance management.
• It begins by focusing on what an organization’s purpose is
– its goal – and seeks to help organizations attain their
purpose by increasing their ‘goal units’( those units that
help to attain the goal.
• The approach can be applied to both profit-seeking and
not-for-profit organizations, provided meaningful goal
units can be identified.

169
 The theory of Constraints
• Theory of constraints (TOC) is an approach to
production management which aims to maximise
sales revenue less material cost.
• It focuses on bottlenecks which act as constraints to
the maximisation of throughput.
• Throughput is the money generated from sales minus
the cost of the materials used in making the items
sold.
• Bottleneck resource or binding constraint – an
activity which has a lower capacity than preceding or
subsequent activities, thereby limiting throughput.

170
• The theory of constraints also states that at any time
there will always be a bottleneck resource or factor
that sets a limit on the amount of throughput that is
possible.
• This bottleneck resource could in theory be sales
demand for the organisation’s output, but it is more
likely to be a resource that the organisation uses. This
‘bottleneck resource’ which prevents output and
throughput from getting any higher, could be:

171
Bottleneck resources
1. A production resource, such as time available on a
type of machine, or the available amount of skilled
employee time
2. A selling resource, such as the number of sales
representatives
3. The existence of an uncompetitive selling price
4. A need to deliver on time to particular customers
5. A lack of product quality and reliability
6. The lack of reliable material suppliers

172
 Throughput accounting concepts
Concept 1
• In the short run, all costs in the factory (with the exception of
materials costs) are fixed costs. These fixed costs include direct
labour costs. It is useful to group all these costs together and call
them Total Factory Costs (TFC).
Concept 2
• In a JIT environment, all inventory is a 'bad thing' and the ideal
inventory level is zero.
Concept 3
• Profitability is determined by the rate at which 'money comes in at
the door' (that is, sales are made) and, in a JIT environment, this
depends on how quickly goods can be produced to satisfy
customer orders

173
Example

Take a not-for-profit organization which performs a

medical screening service in three sequential stages:
1. Take an X-ray.
2. Interpret the result.
3. Recall patients who need further investigation/tell
others that all is fine.

174
• The ‘goal unit’ of this organization will be to progress
a person through all three stages.
• The number of people who complete all the stages is
the organization’s throughput, and the organization
should seek to maximize its throughput.
• However, there will always be a limit to throughput,
and the resource which sets that limit is called the
‘bottleneck resource’.
• Adding more detail to the medical screening process
above:

175
 Process Total hors
time/patient(hours) available/week

Take an X-ray 0.25 40 0.25 40

Interpret the result 0.1 20

Recall patients who need further

investigation/tell others that all is fine 0.2 30

176
• You can easily see from this table that the maximum
number of patients (goal units) who can be dealt with
in each process is:
• X-rays: 40/0.25 = 160
• Interpret results: 20/0.10 = 200
• Recall etc: 30/0.20 = 150

177
• So, the recall procedure is the bottleneck resource.
• Throughput, and thereby the organization’s
performance, cannot be improved until that part of the
process can deal with more people. Therefore, to
improve throughput:
1. Ensure there is no idle time in the bottleneck resource, as
that will be detrimental to overall performance (idle time in
a non‑bottleneck resource is not detrimental to overall
performance).
2. See if less time could be spent on the bottleneck activity.
3. Finally, increase the bottleneck resource available.

178
• The traditional approach to decision making in a
profit-seeking organization is to use contribution
analysis.
• The contribution per unit is the difference between
the selling price of a unit and the marginal cost of a
unit, where marginal cost consists of the material,
variable labour and variable overhead per unit.

179
• The contribution approach is not wrong in principle, but
the assumptions it makes about cost behaviour often do
not accurately reflect the reality of a modern
manufacturing business. In particular, the notion that
there are significant variable labour and overhead costs
is suspect.
• Many of these businesses rely on sophisticated
automated systems that run continuously with relatively
little manual involvement.

180
• Even when production is slack, provided the
downturn is expected to be short lived, most
employees will still be paid because it is expensive to
dismiss workers and then to rehire and retrain them.
• For short-term fluctuations in production it would be
more accurate to consider labour costs and all
overheads to be fixed, leaving material as the only
truly variable cost.

181
• If all costs except material are fixed, businesses will
become richer provided the sales revenue per unit
exceeds material price per unit.
• In effect, sales price less material price is the new
contribution per unit, but to make clear what we are
talking about this is not called ‘contribution’: it is
called ‘throughput’.
• In fact, ‘throughput’ is sometimes usefully known as
‘throughput contribution’:

182
Throughput = selling price – material
per unit per unit per unit

Throughput = sales revenue – cost of materials

183
 EXAMPLE-use the following information to do some throughput
calculations

PRODUCTS A B C

Expected demand/budgeted output

(units) 8,000.00 10,000.00 6,000.00
Selling price per unit (K) 130 100 135
Material cost per unit 33 20 40
Labour cost per unit 30 24 36
Variable overhead cost per unit 25 20 30
Fixed overhead cost per unit 15 12 18
       
Machine hours/unit 0.25 0.2 0.3
Labour hours per unit 0.25 0.2 0.3
Quality control time per unit 0.1 0.1 0.1 184
Identifying the bottleneck process
 

Needed for full production Available

Machine hours 0.25 x 8,000 + 0.2 x 10,000 + 0.3 x 6,000 = 5,800 5000

Labour hours 0.25 x 8,000 + 0.2 x 10,000 + 0.3 x 6,000 = 5,800 6000

Quality control hours 0.10 x 8,000 + 0.1 x 10,000 + 0.1 x 6,000 =

2,400 2500

185
Calculating throughput( Selling price less Material cost

Selling Material Throughput/u

Product Price(K) cost(K) nit(K)

A 130 33 97
B 100 20 80
C 135 40 95

186
We can’t simply conclude from this that Product A must
be best because it earns more per unit than the other
products.
It is essential to take into account the use that each
product makes of the bottleneck resource. Here, machine
hours have been identified as the bottleneck resource.
These are uniquely precious and must be used up in the
best possible way. This can be done by calculating for each
unit:
Throughput
Time in bottleneck resource
and then using the answers to rank the products. See
next slide
187
Calculating throughput per unit of the bottleneck
resource i.e. throughput per machine hour

Throughput/ Machine Throughput/

Product unit hrs/unit machine hr Rank

A 97 0.25 388 2

B 80 0.2 400 1

C 95 0.3 317 3
188
• This shows that priority should be given to making
Product B, the highest earner per machine hour, then
to Product A, and finally to Product C.

189
 Calculation of Profit
machine machine(bottleneck)
Product units hrs/unit hours used throughput  throughput

B 10,000 0.2 200010000 x 80=800000 800,000.00

A 8,000 0.25 20008000 x 97=776000 776,000.00
C(balance) 3,333 0.31000(balance) 3333 x 95=316635 316,635.00

 TOTAL THROUGHPUT
    1,892,635.00

Maximum
machine hours
available     5000   
 

 
Total expected non-material costs-Factory costs (from the original
budget) =
   

Product A: 8,000 x (30 + 25 + 15) = 560,000

 
Product B: 10,000 x (24 + 20 + 12) = 560,000

Product C: 6,000 x (36 + 30 + 18) = 504,000

Total factory costs-factory expenses 1,624,000 190
 Throughput Accounting Ratio(TAR)
The throughput accounting ratio (TA ratio) is the
ratio of the throughput per unit of bottleneck
resource to the factory cost per unit of bottleneck
resource. The factory cost is usually the total factory
cost. This ratio should be as high as possible, and
certainly more than 1
The TAR should be calculated for each product. The
products should then be ranked in order of TAR.
Start producing the product with the highest TAR.
For our example the TAR has been calculated in the
next slide

191
 Note: factory cost is uniform for all the products and is as
calculated in slide 87( K1,624,000.00). Machine hrs are
5000hrs)

Throughput
  accounting ratios    

  Product A Product B Product C

Return/factory
hour 388 400 317
Costs/factory
hour 324.8 324.8 324.8

Throughput
accounting ratio 1.17 1.21 0.93 192
The TAR tells us nothing that we have not worked out already. Its
interpretation is:
The higher the better (but we already knew the ranking of the
products from the return/ factory hour)
The TAR should be greater than 1 if a product is worthwhile
(earning rate greater than spending rate).
Organizations should focus on how they can increase their TAR.
Obvious routes are to increase selling prices, decrease material
costs, or decrease factory costs.
Provided a TAR is greater than 1 it will be worth trying to
increase throughput, and this must be done by eliminating idle
time in the bottleneck resource, increasing the bottleneck
resource (until another resource becomes the bottleneck), or
decreasing the use the product makes of the bottleneck
resource 193
 Examples
• For example, suppose that a factory manufactures a
single product. Each unit of product takes 2 hours to
make on Machine X and output capacity is restricted by
the available time on Machine X, which is restricted to
500 hours per week.
• The product has a material cost of K20 per unit and sells
for K160 per unit. Total operating costs are K30,000 per
week.

194
• Throughput per Machine X hour = K(160 – 20)/2 hours = K70
• Factory cost per Machine X hour = K30,000/500 hours = K60
• TA ratio = K70/K60 = 1.17

195
• A business manufactures product Z, which has a selling
price of K20. The materials costs are K8 per unit of
Product Z. Total operating expenses each month are
120,000.
• Machine capacity is the key constraint on production.
There are only 600 machine hours available each month,
and it takes three minutes of machine time to
manufacture each unit of Product Z.
Required
(a) Calculate the throughput accounting ratio.
(b) How might this ratio be increased

196
• Corrie produces three products, X, Y and Z. The capacity of
Corrie's plant is restricted by process alpha.
• Process alpha is expected to be operational for eight hours per
day and can produce 1,200 units of X per hour, 1,500 units of Y
per hour, and 600 units of Z per hour.
• Selling prices and material costs for each product are as
follows.
Product Selling price Material cost Throughput contribution
K per unit K per unit K per unit
X 150 80 70
Y 120 40 80
Z 300 100 200
Conversion costs are K720,000 per day.
197
Required
• (a) Calculate the profit per day if daily output achieved
is 6,000 units of X, 4,500 units of Y and 1,200 units of Z.
• (b) Calculate the TA ratio for each product.
• (c) In the absence of demand restrictions for the three
products, advise Corrie's management on the optimal
production plan.

198