ACCA F5 Performance Management - 2010 - Study text - Emile Woolf Publishing
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Chapter 1: Costing systems
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2.4 ABC and traditional absorption costing
The difference between traditional absorption costing and ABC is shown by the
following diagrams:
Traditional absorption costing
Production overheads
Allocated/apportioned to
Production cost centre
Production cost centre
Absorbed from cost centres into:
Product costs
Activity-based costing
Production overheads
Allocated/apportioned to
Activity (cost pool)
Activity (cost pool)
Absorbed from cost pools into:
Product costs
Although ABC is a form of absorption costing, the effect of ABC could be to allocate
overheads in a completely different way between products. Product costs and
product profitability will therefore be very different with ABC compared with
traditional absorption costing.
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Example
Entity Blue makes and sells two products, X and Y. Data for production and sales
each month are as follows:
Product X
Product Y
Sales demand 4,000 units
8,000 units
Direct material cost/unit $20
$10
Direct labour hours/unit 0.1 hour
0.2 hours
Direct labour cost/unit $2
$4
Production overheads are $500,000 each month. These are absorbed on a direct
labour hour basis.
An analysis of overhead costs suggests that there are four main activities that cause
overhead expenditure.
Activity
Total
cost
Cost driver
Total
number
Product
X
Product
Y
$
Batch setup 100,000
Number of set-ups 20
10
10
Order handling 200,000
Number of orders 40
24
16
Machining 120,000
Machine hours 15,000
6,000
9,000
Quality control 80,000
Number of checks 32
18
14
500,000
Required
Calculate the full production costs for Product X and Product Y, using:
(a) traditional absorption costing
(b) activity based costing.
Answer
Traditional absorption costing
The overhead absorption rate = $500,000/ (4,000 × 0.1 + 8,000 × 0.2) = $250
Product X
Product Y
Total
$
$
Direct materials 20
10
Direct labour 2
4
Overhead (at $250 per hour) 25
50
Cost per unit 47
64
Number of units 4,000
8,000
Total cost $188,000
$512,000
$700,000
Chapter 1: Costing systems
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Activity based costing
Activity
Total
cost
Cost driver
Product
X
Product
Y
$
$
$ $
Batch setup 100,000
Cost/setup 5,000
50,000 50,000
Order handling 200,000
Cost/order 5,000
120,000 80,000
Machining 120,000
Cost/machine hour 8
48,000 72,000
Quality control 80,000
Cost/check 2,500
45,000 35,000
500,000
263,000 237,000
Product
X
Product
Y
Total
$
$
$
Direct materials 80,000
80,000
Direct labour 8,000
32,000
Overheads 263,000
237,000
Total cost 351,000
349,000
$700,000
Number of units 4,000
8,000
Cost per unit $87.75
$43.625
Using ABC in this situation, the cost per unit of Product X is much higher than with
traditional absorption costing and for Product Y the unit cost is much less.
The difference is caused by the fact that Product X use only 20% of total direct
labour hours worked, but much larger proportions of set-up resources, order
handling resources, machining time and quality control resources. As a result, the
overheads charged to each product are substantially different.
This is an important feature of activity-based costing. The overheads charged to
products, and so the overhead cost per unit of product, can be significantly different
from the overhead cost per unit that would be obtained from traditional absorption
costing.
2.5 When using ABC might be appropriate
Activity based costing could be suitable as a method of costing in the following
circumstances:
In a manufacturing environment, where absorption costing is required for
inventory valuations.
Where a large proportion of production costs are overhead costs, and direct
labour costs are relatively small.
Where products are complex.
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Where products are provided to customer specifications.
Where order sizes differ substantially, and order handling and despatch activity
costs are significant.
2.6 Advantages and disadvantages of ABC
Advantages
ABC provides useful information about the activities that drive overhead costs.
Traditional absorption costing and marginal costing do not do this.
ABC therefore provides information that could be relevant to long-term cost
control and long-term product selection or product pricing.
ABC can provide the basis for a management information system to manage and
control overhead costs.
With ABC, overheads are charged to products on the basis of the activities that
are required to provide the product: Each product should therefore be charged
with a ‘fair share’ of overhead cost that represents the activities that go into
making and selling it.
It might be argued that full product costs obtained with ABC are more ‘realistic’,
although it can also be argued that full product cost information is actually of
little practical use or meaning for management.
There is also an argument that in the long run, all overhead costs are variable
(even though they are fixed in the short-term). Measuring costs with ABC might
therefore provide management with useful information for controlling activities
and long-term costs.
Disadvantages
The analysis of costs in an ABC system may be based on unreliable data and
weak assumptions. In particular, ABC systems may be based on inappropriate
activities and cost pools, and incorrect assumptions about cost drivers.
ABC provides an analysis of historical costs. Decision-making by management
should be based on expectations of future cash flows. It is incorrect to assume
that there is a causal relationship between a cost diver and an activity cost, so
that increasing or reducing the activity will result in higher or lower activity
costs.
In some cases, ABC may be little more than a sophisticated absorption costing
system.
Within ABC systems, there is still a large amount of overhead cost
apportionment. General overhead costs such as rental costs, insurance costs and
heating and lighting costs may be apportioned between cost pools. This reduces
the causal link between the cost driver and the activity cost.
Many ABC systems are based on just a small number of cost pools and cost
drivers. More complex systems are difficult to justify, on grounds of cost.
Many activities and cost pools have more than one cost driver. Identifying the
most suitable cost driver for a cost pool/activity is often difficult.
Chapter 1: Costing systems
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Traditional cost accounting systems may be more appropriate for the purpose of
inventory valuation and financial reporting.
It might be a costly system to design and use. The costs might not justify the
benefits. It must be remembered that full product costing is of little relevance for
management decision-making.
2.7 Implications of switching to ABC
The cost information produced using ABC can be used to improve:
pricing decisions
sales strategy
performance measurement
decision-making
Companies may use various methods to decide the selling prices for their products,
but in the long run whatever method of pricing is used, the sales price must exceed
the average total cost per unit sold in order to make a profit.
Traditional absorption costing often leads to too much overhead allocated to high
volume standardised products and too little overhead being allocated to low
volume, complex products. Standard products might therefore seem much less
profitable than low-volume complex products. ABC costs may reflect more
accurately the resources used and so the costs incurred to make a product and
therefore provide better information for managers when deciding on sales prices
and the product and sales mix.
Activity based costing may be used to analyse costs of product lines, customer
groups and distribution outlets to more accurately assess profitability and
determine where management attention should be focused. Sales strategy may be to
improve the profitability of low margin products and customers, increase marketing
to high margin products and customers with the intention of increasing market
share or even to change the mix of products or distribution outlets.
ABC information may improve understanding of how costs are incurred in
overhead departments. It is difficult to control overhead costs in an absorption
costing system as often responsibility is not assigned to specific managers. By
understanding the activities which drive costs, responsibility for monitoring key
performance indicators can be assigned to specific managers and action can be taken
if performance is not as expected.
The benefits of using ABC information for decision-making are mainly due to the
improved accuracy of cost information and better understanding of the activities
which drive costs. However, short-run decision-making is based on relevant costs,
that is, future cash flows which change as a result of the decision, and many
commentators argue that marginal costing is more suitable for this purpose. ABC
might be helpful for controlling longer-term overhead costs, but not for controlling
overhead costs in the short term.
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2.8 Problems with switching to activity-based costing
There can be major practical difficulties in switching from a system of traditional
absorption costing to a system of ABC.
Management have to understand ABC and how it differs from the costing
system that has been used in the past. This will require training.
It might be difficult to identify the activities that drive most overhead costs.
Even if activities are successfully identified, it might be difficult to identify the
most suitable cost driver for that activity.
The costing system will have to be changed so that overheads are allocated and
apportioned to cost pools. This will require administrative effort.
There is often resistance amongst employees to change. Managers and other
employees might not trust the information about costs that ABC provides.
2.9 Activity-based costing and costs of services
Activity-based costing was developed initially as a method of costing in a
manufacturing environment. However, ABC can also be applied to service
industries and the costing of services provided to customers. The same basic
principles apply to service costing with ABC as to product costing with ABC.
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Paper F5
Performancemanagement
CHAPTER
2
Other costing systems
Contents
1 Target costing
2 Product life cycle costing
3 Back-flush accounting
4 Throughput accounting
5 Throughput accounting and constraints
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Target costing
Origins of target costing
The purpose of target costing
The target costing method
Elements in the estimated cost and target cost
Closing the target cost gap
Advantages of target costing
The implications of using target costing
Target costing and services
1 Target costing
1.1 Origins of target costing
Target costing originated in Japan in the 1970s. It began with recognition that
customers were demanding more diversity in products that they bought, and the
life cycles of products were getting shorter. This meant that new products had to be
designed more frequently to meet customer demands.
Companies then became aware that a large proportion of the costs of making a
product are committed at the design stage, before the product goes into
manufacture. The design stage was therefore critical for ensuring that new products
could be manufactured at a cost that would enable the product to make a profit for
the company.
1.2 The purpose of target costing
Target costing is a method of strategic management of costs and profits. As its name
suggests, target costing involves setting a target or objective for the maximum cost
of a product or service, and then working out how to achieve this target.
It is used for business strategy in general and marketing strategy in particular, by
companies that operate in a competitive market where new products are continually
being introduced to the market. In order to compete successfully, companies need to
be able to:
continually improve their existing products or design new ones
sell their products at a competitive price; this might be the same price that
competitors are charging or a lower price than competitors, and
make a profit.
In order to make a profit, companies need to make the product at a cost below the
expected sales price.
Chapter 2: Other costing systems
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Target costing and new product development
Target costing is used mainly for new product development. This is because
whenever a new product is designed and developed for a competitive market, a
company needs to know what the maximum cost of the new product must be so
that it will sell at a profit.
A company might decide the price that it would like to charge for a new product
under development, in order to win a target share of the market. The company then
decides on the level of profitability that it wants to achieve for the product, in order
to make the required return on investment. Having identified a target price and a
target profit, the company then establishes a target cost for the product. This is the
cost at which the product must be manufactured and sold in order to achieve the
target profits and return at the strategic market price.
Keeping the costs of the product within the target level is then a major factor in
controlling its design and development.
New product design and development
$
Decide: The target sales price X
Deduct: The target profit margin (X)
Equals: The target cost (maximum cost in order to meet or exceed the
target profit)
X
The reason that target costing is used for new products, as suggested earlier, is that
the opportunities for cutting costs to meet a target cost are much greater during the
product design stage than after the product development has been completed and
the production process has been set up.
Typically, when a new product is designed, the first consideration is to design a
product that will meet the needs of customers better than rival products.
However, this initial product design might result in a product with a cost that is
too high, and which will therefore not be profitable.
The estimated cost of a product design can be compared with the target cost. If
the expected cost is higher than the target cost, there is a cost ‘gap’.
A cost gap must be closed by finding ways of making the product more cheaply
without losing any of the features that should make it attractive to customers
and give it ‘value’. For example, it might be possible to simplify that product
design or the production process without losing any important feature of the
product. It might also be possible to re-design the product using a different and
cheaper material, without loss of ‘value’.
Having worked out how to reduce costs at the product design stage,
management should try to ensure that the product is developed and the method
of producing it is introduced according to plan, so that the target cost is
achieved.
1.3 The target costing method
The principles of target costing may therefore be summarised as follows.
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Target costing is based on the idea that when a new product is developed, a
company will have a reasonable idea about:
the price at which it will be able to sell the product, and
the sales volumes that it will be able to achieve for the product over its expected
life.
There may also be estimates of the capital investment required, and any incremental
fixed costs (such as marketing costs or costs of additional salaried staff).
Taking estimates of sales volumes, capital investment requirements and incremental
fixed costs over the life cycle of the product, it should be possible to calculate a
target cost.
The target cost for the product might be the maximum cost for the product that
will provide at least the minimum required return on investment.
However, an examination question might expect you to calculate the target cost
from a target selling price and a target profit margin.
The elements in the target costing process are shown in the diagram below.
Target costing
1.4 Elements in the estimated cost and target cost
A problem with target costing is to make sure that the estimates of cost are realistic.
It is difficult to measure the cost of a product that has not yet been created, and the
cost must include items such as raw material wastage rates and direct labour idle
time, if these might be expected to occur in practice.
Raw materials costs
The target cost should allow for expected wastage rates or loss in processing. The
price of materials should also allow for any possible increases up to the time when
the new product development has been completed. Estimating prices of materials