ACCA F5 Performance Management - 2010 - Study text - Emile Woolf Publishing
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Chapter 2: Other costing systems
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can be difficult when prices are volatile – such as commodity prices, which can be
subject to large increases and falls within relatively short periods of time.
Direct labour
The target cost should allow for any expected idle time that will occur during the
manufacture of the product. This might be the normal level of idle time in the
company’s manufacturing operations.
Production overheads
A target cost could be a target marginal cost. However production overhead costs
are often a large proportion of total manufacturing costs, and it is therefore more
likely that the target cost will be a full cost, including production overheads. If
activity-based costing is used, it might be possible to identify opportunities for
limiting the amount of production overheads absorbed into the product cost by
designing the product in a way that limits the use of activities that drive costs, for
example by reducing the need for materials movements or quality inspections.
Example
A company has designed a new product. NP8. It currently estimates that in the
current market, the product could be sold for $70 per unit. A gross profit margin of
at least 30% on the selling price would be required, to cover administration and
marketing overheads and to make an acceptable level of profit.
A cost estimation study has produced the following estimate of production cost for
NP8.
Cost item
Direct material M1 $9 per unit
Direct material M2
Each unit of product NP8 will require three metres of
material M2, but there will be loss in production of 10%
of the material used. Material M2 costs $1.80 per metre.
Direct labour
Each unit of product NP8 will require 0.50 hours of direct
labour time. However it is expected that there will be
unavoidable idle time equal to 5% of the total labour time
paid for. Labour is paid $19 per hour.
Production
overheads
It is expected that production overheads wil lbe absorbed
into product costs at the rate of $60 per direct labour
hour, for each active hour worked. (Overheads are not
absorbed into the cost of idle time.)
Required
Calculate:
(a) the expected cost of Product NP8
(b) the target cost for NP8
(c) the size of the cost gap.
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Answer
Expected cost per unit
$ $
Direct material M1
9.0
Direct material M2: 3 metres × 100/90 × $1.80
6.0
Direct labour: 0.5 hours × 100/95 × $19
10.0
Production overheads: 0.5 hours × $60
30.0
Expected full cost per unit
55.0
Target cost
Sales price 70.0
Minimum gross profit margin (30%) 21.0
Target cost
49.0
Cost gap
6.0
The company needs to identify ways of closing this cost gap.
1.5 Closing the target cost gap
Target costs are rarely achievable immediately and ways must be found to reduce
costs and close the cost gap.
Target costing should involve a multi-disciplinary approach to resolving the
problem of how to close the cost gap. The management accountant should be
involved in measuring estimated costs. Ways of reducing costs might be in product
design and engineering, manufacturing processes used, selling methods and raw
materials purchasing. Ideas for reducing costs can therefore come from the sales,
manufacturing, engineering or purchasing departments.
Common methods of closing the target cost gap are:
To re-design products to make use of common processes and components that
are already used in the manufacture of other products by the company.
To discuss with key suppliers methods of reducing materials costs. Target
costing involves the entire ‘value chain’ from original suppliers of raw materials
to the customer for the end-product, and negotiations and collaborations with
suppliers might be an appropriate method of finding important reductions in
cost.
To eliminate non value-added activities or non-value added features of the
product design. Something is ‘non-value added’ if it fails to add anything of
value for the customer. The cost of non-value added product features or
activities can therefore be saved without any loss of value for the customer.
Value analysis may be used to systematically examine all aspects of a product
cost to provide the product at the required quality at the lowest possible cost.
To train staff in more efficient techniques and working methods. Improvements
in efficiency will reduce costs.
Chapter 2: Other costing systems
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To achieve economies of scale. Producing in larger quantities will reduce unit
costs because fixed overhead costs will be spread over a larger quantity of
products. However, production in larger quantities is of no benefit unless sales
demand can be increased by the same amount.
To achieve cost reductions as a result of the learning curve or, more likely, the
experience curve effect. The learning curve is described in a later chapter and is
most likely to exist in a labour intensive environment. It results in cost savings as
labour becomes more familiar with performing a new and complex task. The
experience curve effect relates to cost savings made in costs other than labour
costs as the company becomes more familiar with production of a new product.
For example, management of the process and marketing may become more
efficient as the company gains experience of making and selling the product.
1.6 Advantages of target costing
There are several possible advantages from the use of target costing.
It helps to improve the understanding within a company of product costs.
It recognises that the most effective way of reducing costs is to plan and control
costs from the product design stage onwards.
It helps to create a focus on the final customer for the product or service, because
the concept of ‘value’ is important: target costs should be achieved without loss
of value for the customer.
It is a multi-disciplinary approach, and considers the entire supply chain. It
could therefore help to promote co-operation, both between departments within
a company and also between a company and its suppliers and customers.
Target costing can be used together with recognised methods for reducing costs,
such as value analysis, value engineering, just in time purchasing and
production, Total Quality Management and continuous improvement.
1.7 The implications of using target costing
The use of a target costing system has implications for pricing, cost control and
performance measurement.
Target costing can be used with pricing policy for a company’s products or services.
A company might decide on a target selling price for either a new or an existing
product, which it considers necessary in order to win market share or achieve a
target volume of sales. Having identified the selling price that it wants for the
product, the company can then work out a target cost.
Cost control and performance measurement has a different emphasis when target
costing is used.
Cost savings are actively sought and made continuously over the life of the
product
There is joint responsibility for achieving benchmark savings. If one department
fails to deliver the cost savings expected, other departments may find ways to
achieve the savings
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Staff are trained and empowered to find new ways to reduce costs while
maintaining the required quality.
Target costing is more likely to succeed in a company where a culture of
‘continuous improvement’ exists.
1.8 Target costing and services
Target costing can be used for services as well as products. Services vary widely in
nature, and it is impossible to make general statements that apply to all types of
services. However, features of some service industries that make them different
from manufacturing are as follows.
Some service industries are labour-intensive, and direct materials costs are only
a small part of total cost. Opportunities for achieving reductions in materials
costs may therefore be small.
Overhead costs in many services are very high. Effective target costing will
therefore require a focus on how to reduce overhead costs.
A service company might deliver a number of different services through the same
delivery system, using the same employees and the same assets. Introducing new
services or amendments to existing services therefore means adding to the work
burden of employees and the diversity or complexity of the work they do.
A system of target costing therefore needs to focus on quality of service and
value for the customer. Introducing a new service might involve a loss of value
in the delivery of existing services to customers. For example, adding a new
service to a telephone call centre could result in longer waiting times for callers.
New services might be introduced without proper consideration being given to
whether the service is actually profitable. For example, a restaurant might add
additional items to its menu, in the belief that the only additional cost is the cost
of the food. In practice there would be implications for the purchasing and
preparation of the food and possibly also for the delivery of food from the
kitchen to the restaurant dining area. New items added to the menu might
therefore make losses unless all aspects of cost are properly considered.
When a single delivery system is used for services, the cost of services will
consist largely of allocated and apportioned overheads. For target costing to be
successful, there must be a consistent and ‘fair’ method of attributing overhead
costs to services (both existing services and new services).
Services might be provided by not-for-profit entities. For example, health
services might be provided free of charge by the government. When services are
provided free of charge, target costing can be used for new services. However, it
is doubtful whether concepts of ‘target price’ and ‘target profit’ can be used by a
not-for-profit entity. This raises questions about how to decide what the target
cost should be.
Chapter 2: Other costing systems
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Product life cycle costing
The nature of life cycle costing
A product life cycle
Research and development phase
Introduction phase
Growth phase
Maturity phase
Decline phase
The implications of using life cycle costing
2 Product life cycle costing
2.1 The nature of life cycle costing
Life cycle costing is sometimes called ‘whole life costing’ or ‘whole life cycle
costing’. As these terms suggest, it is a costing method that considers the costs of a
product or an asset over its entire marketable or useful life.
Life cycle costing can be applied to:
Products that are introduced to the market and then manufactured and sold
over a number of years until they are eventually withdrawn from the market
Buildings and other major construction items, whose costs change over their
useful life from construction to eventual demolition.
Life cycle costs
The costs of a product or asset over its life cycle could be divided into three
categories:
Acquisition costs, set-up costs or market entry costs. These are costs incurred
initially to bring the product into production and to start selling it, or the costs
incurred to complete the construction of a building or other major construction
asset
Operational costs or running costs throughout the life of the product or asset
End-of-life costs. These are the costs incurred to withdraw a product from the
market or to demolish the asset at the end of its life.
Acquisition costs or set-up costs are usually ‘one-off’ capital expenditures and other
once-only costs, such as the costs of training staff and establishing systems of
documentation and performance reporting. Similarly, end-of-life costs are ‘one-off’
items that occur just once.
Running costs or operational costs are regular and recurring annual costs
throughout the life of the product or asset. However, these may vary over time: for
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example maintenance costs for an item of equipment, such as the maintenance costs
of elevators in a building, are likely to increase over time as the asset gets older.
Although costs are incurred throughout the life of an asset, a large proportion of
these costs are committed at a very early stage in the product’s life cycle, when the
decision to develop the new product or construct the new building is made.
2.2 A product life cycle
Most products made in large quantities for selling to customers go through a life
cycle. A life cycle consists of several stages:
research and development of the product (design and development stage)
introduction to the market
a period of growth in sales and market size
a period of maturity and finally
a period of decline.
Eventually, a product is withdrawn from the market.
At each stage in the life cycle, total sales revenue and total profits from the product
are different. The diagram below indicates what the characteristics of sales revenue
and profit are at each stage.
Length of a life cycle
The length of a product life cycle varies between different products. As a general
rule:
a broad type of product may have a long life of several decades
the product may be produced in several different forms, and the life cycle of
each form of the product may be shorter than the total life of the broad product
a company may produce a form of the product, and the life cycle of a company’s
product may be shorter than the total life of broad product form.
$
0
R&D Introduction
Growth Maturity Decline Withdrawal
Profit or Loss
Time
Sales
Chapter 2: Other costing systems
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For example, the life of the television has already been many decades long, and
shows no obvious sign of coming to an end. However, the life cycle of the black-
and-white picture television set has been shorter, and the end of the life of the
analogue television can now be foreseen as flat screen digital televisions take over
the market.
As some products of a company reach the end of their life cycle, they need to be
replaced with new products. Product innovation is essential to survival. Companies
need to have a portfolio of products that:
provides a profit, and also
ensures the survival of the company’s business in the longer term.
At each phase in its life cycle:
selling prices will be altered
costs may differ
the amount invested (capital investment) may vary
spending on advertising and other marketing activities may change.
Sales volume, sales revenue, profitability, investment and cash flow will all vary as
the product goes through the different stages of its life.
2.3 Research and development phase
This is the phase during which a product is designed and developed for the market.
It is at this stage that a large proportion of the life cycle costs are committed, for
example capital expenditure decisions are taken and new production systems may
be introduced.
Target costing may be used in combination with life cycle costing.
2.4 Introduction phase
When a product is new to the market, and a competitor has not already established
a rival product in the market, a company may be able to choose its pricing strategy
for the new product.
If a ‘market penetration’ strategy is chosen, the aim should be to sell the product
at a low price in order to obtain a large share of the market as quickly as
possible. This pricing strategy is therefore based on low prices and high
volumes.
If a ‘market skimming’ strategy is chosen, the aim is to sell the product at a high
price in order to maximise the gross profit per unit sold. Sales volumes will be
low, and the product will be purchased only by customers who are willing to
pay a high price to obtain a ‘unique’ item. Gradually, the selling price will be
reduced, although it will be kept as high as possible for as long as possible. This
approach is often used with high technology products.
If a competitor has already introduced a rival product to the market, the selling
price should be set at a level to compete for market share with the rival product
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During the introduction phase the average cost per unit of production may be high
if products are produced in small batches. Marketing costs may be high to establish
the product in the market.
The product could therefore make a loss during its initial introductory phase. Even
if the product is profitable, unit profits could be low.
At some time during the introductory stage, a decision will have to be made about
increasing production quantities to meet rising sales demand. New capital
expenditures could be required in order to increase output and sales capacity.
2.5 Growth phase
In the growth phase of a product’s life, sales demand grows rapidly, but more
competitors enter the market. Companies need to focus on market share and
reducing unit costs. Control reduction can be achieved mainly through economies of
scale and producing in larger quantities. However, it is also important to ensure that
customers believe that they are receiving good value and quality for the price they
pay.
It is during the growth stage that a product should be expected to move from
making losses to making a profit each year.
2.6 Maturity phase
In the maturity phase of a life cycle, the objective should be to maintain market
share. It may be necessary to reduce prices to sustain market share. Alternatively, a
company may look for new distribution channels that offer an opportunity to sell at
higher prices or at lower costs.
During this phase the product should generate good profits.
2.7 Decline phase
In the decline phase, sales demand starts to fall. Initially the product might be
profitable, but profits will fall as sales volume declines and eventually the product
ceases to be profitable. The company may continue to sell the product for a tie,
provided that the sales price exceeds variable cost. The aim should be to sell any
existing inventory and keep production to a minimum. When price falls below
variable cost the product should be withdrawn from the market.
However, when a product is withdrawn from the market, the company should
consider whether there are any ‘end-of-life’ costs that will be incurred. The costs of
withdrawing from the market, if any, could persuade a company to defer its
decision to withdraw the product.
2.8 The implications of using life cycle costing
Traditional costing systems do not attempt to measure the profitability of a product
over its entire life.
Chapter 2: Other costing systems
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Research and development costs are written off as they are incurred
Profits are measured on a time basis (annual basis) rather than on a ‘whole of
life’ basis
Non-production costs are not linked to products but are written off as general
expenses.
Life cycle costing compares the revenues and costs of the product over its entire life.
This has many benefits.
The potential profitability of products can be assessed before major development
of the product is carried out and costs incurred. Non-profit-making products can
be abandoned at an early stage before costs are committed.
Techniques can be used to reduce costs over the life of the product.
Pricing strategy can be determined before the product enters production. This
may lead to better control of marketing and distribution costs.
Attention can be focused on reducing the research and development phase to get
the product to market as quickly as possible. The longer the company can
operate without competitors entering the market the more revenue can be
earned and the sooner the product will reach the breakeven point.
By monitoring the actual performance of products against plans, lessons can be
learnt to improve the performance of future products. It may also be possible to
improve the estimating techniques used.
An understanding of the product life cycle can also assist management with
decisions about:
Pricing
Performance management
Decision-making.
Pricing. As a product moves from one stage in its life cycle to the next, a change in
pricing strategy might be necessary to maintain market share. For example, prices
might be reduced as a product enters its maturity phases (and annual sales volume
stops rising).
In addition, an understanding of life cycle costs help with strategic decisions about
price. Over the entire life of the product, sales prices should be sufficiently high to
ensure that a profit is made after taking into account all costs incurred – start-up
costs and end-of-life costs as well as annual operating costs.
Performance management. As a product moves from one stage of its life cycle to
another, its financial performance will change. Management should understand that
an improvement or decline in performance could be linked to changes in the life
cycle and should therefore (to some extent at least) be expected.
Decision-making. In addition to helping management with decisions on pricing, an
understanding of life cycle costing can also help with decisions about making new
investments in the product (new capital expenditure) or withdrawing a product
from the market.
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2.9 Life cycle costing and building construction
Life cycle costing is relevant to the construction of buildings and other major items
of construction. An international standard on life cycle costing for buildings was
published in 2008.
When a building is planned, several different designs might be considered. Each
design will have different construction features and therefore a different initial
capital cost. Over the life of the building, annual running costs will vary according
to the design that is selected. For example:
Energy-efficient buildings will incur lower energy costs each year
The choice of construction materials will affect the life of the building and the
annual costs of repairs and maintenance
The choice of design could affect the costs of demolition at the end of the life of
the building.
When two or more different building designs are considered, the preferred design
might be:
the design that will achieve the lowest total cost over the life of the building, or
the design that will provide the most value for money (or benefits less costs)
over the life of the building.