1.2.2

Key Terms

(a)      A direct cost is a cost that can be traced in full to the product, service or department that is being costed.
(b)      An indirect cost or overhead is a cost that is incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department.
(c)      Cost allocation (成本分配) is the process of allocating the whole overhead to a cost centre where this cost can be identified with a particular cost centre.
(d)      Cost apportionment (成本分攤) – When an overhead is common to more than one cost centre, it must be shared out or split on an equitable basis.

1.3.3

Example 1

A company is preparing its production overhead budgets and determining the apportionment of those overheads to products. Cost centre expenses and related information have been budgeted as follows.

Required:

Using the direct apportionment to production department method and bases of apportionment which you consider most appropriate from the information provided, calculate overhead totals for the three production departments.

Solution:

1.4.1

Over- or Under-absorbed Overhead

(a)      Over-/under-absorbed overhead occurs when overheads incurred do not equal overheads absorbed.
(b)      Over absorption means that the overheads charged to the cost of sales are greater than the overheads actually incurred.
(c)      Under absorption means that insufficient overheads have been included in the cost of sales.

1.4.3

Example 2

Suppose that the budgeted overhead in a production department is $80,000 and the budgeted activity is 40,000 direct labour hours, the overhead recovery rate (using a direct labour hour basis) would be $2 per direct labour hour. Actual overheads in the period are, say $84,000 and 45,000 direct labour hours are worked.

In this example, the cost of production has been charged with $6,000 more than was actually spent and so the cost that is recorded will be too high. The over-absorbed overhead will be an adjustment to the profit and loss account at the end of accounting period to reconcile the overheads charged to the actual overhead.

Question 1
The total production overhead expenditure of the company in Example 1 was $176,533 and its actual activity was as follows.

Required:

Using the information above and the results of Example 1, calculate the under- or over-absorption of overheads.

2.1

Absorption costing and marginal costing

(a)      Absorption costing (full costing) is a form of costing in which the costs of products are calculated by adding an amount for indirect costs (overheads) to the direct costs of production.
(b)      Marginal costing (variable costing) is an alternative to absorption costing. Only variable costs (marginal costs) are charged as a cost of sales. Fixed costs are treated as period costs and are charged in full against the profit of the period in which they are incurred.

2.2

Example 3

A company makes and sells a single product. At the beginning of period 1, there are no opening inventories of the product, for which the variable production cost is $4 and the sales price $6 per unit. Fixed costs are $2,000 per period, of which $1,500 are fixed production costs. Normal profit is 1,500 units per period. In period 1, sales were 1,200 units, production was 1,500 units. In period 2, sales were 1,700 units, production was 1,400 units.

Required:

(a)       Prepare profit statements for each period and for the two periods in total using both absorption costing and marginal costing.
(b)       Reconcile the profits between absorption costing and marginal costing for period 1.

Solution:
(a)
Absorption costing
The absorption rate for fixed production overhead is $1,500/1,500 units = $1 per unit. The fully absorbed cost per unit = $(4 + 1) = $5.

Marginal costing
The marginal cost per unit = $4.

(b)
The profits reported for period 1 would be reconciled as follows.

2.3

Reconciliation of Profits between Two Methods

(a)      If opening inventory = closing inventory, MC profit = AC profit
(b)      If opening inventory > closing inventory, MC profit > AC profit
(c)      If opening inventory < closing inventory, MC profit < AC profit

Question 2 – Manipulating profit
ABC Co budgeted to make and sell 10,000 units of its product in 2011. The selling price is $10 per unit and the variable cost $4 per unit. Fixed production costs were budgeted at $50,000 per year. The company uses absorption costing and budgeted an absorption rate of $5 per unit. During 2011, it became apparent that sales demand would only be 8,000 units. The management, concerned about the apparent effect of the low volume of sales on profits, decided to increase production for the year to 15,000 units. Actual fixed costs were still expected to be $50,000 in spite of the significant increase in production volume.

Required:

Calculate the profit at an actual sales volume of 8,000 units, using the following methods.
(a)       Absorption costing
(b)       Marginal costing
Explain the difference in profits calculated.

3.1.1

Activity Based Costing

(a)      Activity based costing (ABC) is a form of absorption costing. However, it differs from traditional absorption costing, because it takes a different approach to the apportionment and absorption of production overhead costs.
(b)      ABC involves the identification of the factors (cost drivers) which cause the costs of an organization’s major activities. Support overheads are charged to products on the basis of their usage of an activity.
(i)      For costs that vary with production level in the short term, the cost driver will be volume related (labour or machine hours).
(ii)     Overheads that vary with some other activity (and not volume of production) should be traced to products using transaction-based cost drivers such as production runs or number of orders received.

3.2.3

Example 4

The wider the range and the more complex the products, the more support activities will be required. Consider, for example, factory X which produces 10,000 units of one product, the Alpha, and factory Y which produces 1,000 units each of ten slightly different versions of the Alpha. Support activities costs in the factory Y are likely to be a lot higher than in factory X but the factories produce an identical number of units. For example, factory X will only need to set-up once whereas factory Y will have to set-up the production run at least ten times for the ten different products. Factory Y will therefore incur more set-up costs for the same volume of production.

Activity

Possible cost driver

Materials handling and storage

Raw materials: purchases of materials

Finished goods: volume of products made

Customer order processing

No. of customer orders

Materials purchasing

No. of purchase orders

Quality control and inspection

No. of inspections

Production planning

No. of production runs or batches

Repairs and maintenance

No. of machines, or machine hours operated

3.4.3

Example 5

Entity Blue makes and sells two products, X and Y. Data for production and sales each month are as follows:

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.

Required:

Calculate the full production costs for Product X and Product Y, using:
(a)       traditional absorption costing
(b)       activity based costing.

Solution:
Traditional absorption costing
The overhead absorption rate = $500,000/ (4,000 × 0.1 + 8,000 × 0.2) = $250

Activity based costing

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.

Question 3
The Gadget Co produces three products, A, B and C, all made from the same material. Until now, it has used traditional absorption costing to allocate overheads to its products. The company is now considering an activity based costing system in the hope that it will improve profitability. Information for the three products for the last year is as follows:

The price for raw materials remained constant throughout the year at $1.20 per kg. Similarly, the direct labour cost for the whole workforce was $14.80 per hour. The annual overhead costs were as follows:

Required:

(a)     Calculate the full cost per unit for products A, B and C under traditional absorption costing, using direct labour hours as the basis for apportionment.                     (5 marks)
(b)     Calculate the full cost per unit of each product using activity based costing.    (9 marks)
(c)     Using your calculation from (a) and (b) above, explain how activity based costing may help The Gadget Co improve the profitability of each product.                         (6 marks)
(Total 20 marks)

Classification level

Cause of cost

Types of cost

Cost driver

Unit level

Production / acquisition of a single unit of product or delivery of single unit of service

Direct materials
Direct labour

Units produced

Batch level

A group of things being made, handled or processed

Purchase orders
Set-ups
Inspection

Batches produced

Product level

Development, production or acquisition of different items

Equipment maintenance
Product development

Product lines produced

Facility sustaining level

Some costs cannot be related to a particular line, instead they are related to maintaining the buildings and facilities. These costs cannot be related to cost objects with any degree of accuracy and are often excluded from ABC calculations for this reason.

Building depreciation
Organisational advertising

None – supports the overall production or service process

4.1.2

Target Costing

Target costing involves setting a target cost by subtracting a desired profit margin from a competitive market price.

4.1.4

Implementing Target Costing

Steps in the implementation of the target costing process.
Step 1:     Determine a product specification of which an adequate sales volume is estimated.
Step 2:     Set a selling price at which the organization will be able to achieve a desired market share.
Step 3:     Estimate the required profit based on return on sales or return on investment.
Step 4:     Calculate the target cost = target selling price – target profit
Step 5:     Compile an estimated cost for the product based on the anticipated 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 during the production phase.
Step 8:     Negotiate with the customer before making the decision about whether to go ahead with the project.

4.1.5

Example 6

Swedish retailer IKEA continues to dominate the home furniture market with more than 300 stores across 35 countries at the end of 2009. The "IKEA concept" as defined on the company website www.ikea.com is "based on offering a wide range of well designed functional home furnishing products at prices so low as many people as possible will be able to afford them."

IKEA is widely known for pricing products at 30-50% below the price charged by competitors. Extracts from the website outline how the company has successfully employed a strategy of target pricing:

"While most retailers use design to justify a higher price, IKEA designers work in exactly the opposite way. Instead they use design to secure the lowest possible price. IKEA designers design every IKEA product starting with a functional need and a price. Then they use their vast knowledge of innovative, low-cost manufacturing processes to create functional products, often coordinated in style. Then large volumes are purchased to push prices down even further.

Most IKEA products are also designed to be transported in flat packs and assembled at the customer's home. This lowers the price by minimising transportation and storage costs. In this way, the IKEA Concept uses design to ensure that IKEA products can be purchased and enjoyed by as many people as possible."

4.2.1

Example 7

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.

Required:

Calculate:
(a)     the expected cost of Product NP8;
(b)    the target cost for NP8;
(c)     the size of the cost gap.

Solution:

The company needs to identify ways of closing this cost gap.

4.3.2

Commend methods of closing the target cost gap

(a)       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.
(b)       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.
(c)       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.
(d)       To train staff in more efficient techniques and working methods. Improvements in efficiency will reduce costs.
(e)       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.
(f)        To achieve cost reductions as a result of the learning curve or, more likely, the experience curve effect. The learning curve 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.

4.4.1

Benefits of target costing

(a)       The organisation will have an early external focus to its product development. Businesses have to compete with others (competitors) and an early consideration of this will tend to make them more successful. Traditional approaches (by calculating the cost and then adding a margin to get a selling price) are often far too internally driven.
(b)       Only those features that are of value to customers will be included in the product design. Target costing at an early stage considers carefully the product that is intended. Features that are unlikely to be valued by the customer will be excluded. This is often insufficiently considered in cost plus methodologies.
(c)       Cost control will begin much earlier in the process. If it is clear at the design stage that a cost gap exists then more can be done to close it by the design team. Traditionally, cost control takes place at the ‘cost incurring’ stage, which is often far too late to make a significant impact on a product that is too expensive to make.
(d)       Costs per unit are often lower under a target costing environment. This enhances profitability. Target costing has been shown to reduce product cost by between 20% and 40% depending on product and market conditions. In traditional cost plus systems an organisation may not be fully aware of the constraints in the external environment until after the production has started. Cost reduction at this point is much more difficult as many of the costs are ‘designed in’ to the product.
(e)       It is often argued that target costing reduces the time taken to get a product to market. Under traditional methodologies there are often lengthy delays whilst a team goes ‘back to the drawing board’. Target costing, because it has an early external focus, tends to help get things right first time and this reduces the time to market.

4.4.2

Limitations of target costing

(a)       the prerequisite for the effective implementation of target costing is the development of detailed cost data for analysis purposes which will require precise cost calculation subject to dynamic market influences.
(b)       Multi-departmental cooperation is crucial for the successful implementation of target costing which also requires managing departments’ willingness to cooperate and their commitment.
(c)       The process may be long and detailed, therefore, it requires lot of meetings for coordination, and conflicting meeting schedules may also affect progress.
(d)       It is always the case that the use of cheaper components, which may be of inferior quality, may accordingly reduce the quality of the products and increase the cost of warranty.

Question 4
Edward Co assembles and sells many types of radio. It is considering extending its product range to include digital radios. These radios produce a better sound quality than traditional radios and have a large number of potential additional features not possible with the previous technologies (station scanning, more choice, one touch tuning, station identification text and song identification text etc).

A radio is produced by assembly workers assembling a variety of components. Production overheads are currently absorbed into product costs on an assembly labour hour basis.

Edward Co is considering a target costing approach for its new digital radio product.

Required:

(a)     Briefly describe the target costing process that Edward Co should undertake.
(3 marks)
(b)     Explain the benefits to Edward Co of adopting a target costing approach at such an early stage in the product development process.                                                         (4 marks)
(c)     Assuming a cost gap was identified in the process, outline possible steps Edward Co could take to reduce this gap.                                                                              (5 marks)

A selling price of $44 has been set in order to compete with a similar radio on the market that has comparable features to Edward Co’s intended product. The board have agreed that the acceptable margin (after allowing for all production costs) should be 20%.

Cost information for the new radio is as follows:

Component 1 (Circuit board) – these are bought in and cost $4.10 each. They are bought in batches of 4,000 and additional delivery costs are $2,400 per batch.

Component 2 (Wiring) – in an ideal situation 25 cm of wiring is needed for each completed radio. However, there is some waste involved in the process as wire is occasionally cut to the wrong length or is damaged in the assembly process. Edward Co estimates that 2% of the purchased wire is lost in the assembly process. Wire costs $0.50 per metre to buy.

Other material – other materials cost $8.10 per radio.

Assembly labour – these are skilled people who are difficult to recruit and retain. Edward Co has more staff of this type than needed but is prepared to carry this extra cost in return for the security it gives the business. It takes 30 minutes to assemble a radio and the assembly workers are paid $12.60 per hour. It is estimated that 10% of hours paid to the assembly workers is for idle time.

Production Overheads – recent historic cost analysis has revealed the following production overhead data:

Fixed production overheads are absorbed on an assembly hour basis based on normal annual activity levels. In a typical year 240,000 assembly hours will be worked by Edward Co.

Required:

(d)     Calculate the expected cost per unit for the radio and identify any cost gap that might exist.                                                                                                                  (13 marks)
(Total 25 marks)

5.1.1

Life Cycle Costing

Life cycle costing tracks and accumulates costs and revenues attributable to each product over the entire product life cycle.

5.1.5

Example 8

ABC Co specializes 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.

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.

Solution:

Lifecycle cost

The total lifecycle costs are $529.40 per solar panel which is higher than the price proposed by the marketing director. Solaris will either have to charge a higher price or look at ways to reduce costs.

It may be difficult to increase the price if customers are price sensitive and are not prepared to pay more. Costs could be reduced by analysing each part of the costs throughout the life cycle and actively seeking cost savings. For example, using different materials, using cheaper staff or acquiring more efficient technology.

Question 5
A company manufactures MP3 players. It is planning to introduce a new model and development will begin very soon. It expects the new product to have a life cycle of 3 years and the following costs have been estimated.

Required:

(a)     Explain life cycle costing and state what distinguishes it from more traditional management accounting techniques.                                                                (10 marks)
(b)     Calculate the cost per unit looking at the whole lifecycle and comment on the price to be charged.                                                                                                          (7 marks)
(Total 17 marks)

6.1.4

Four categories of quality cost

(a)       Prevention costs are the costs incurred in preventing the production of products that do not conform to specification. They include the costs of preventive maintenance, quality planning and training and the extra costs of acquiring higher quality raw materials.
(b)       Appraisal costs are the costs incurred to ensure that materials, products and services meet quality conformance standards. They include the costs of inspecting purchased parts, work in process and finished goods, quality audits and field tests.
(c)       Internal failure costs are the costs incurred when products and services fail to meet quality standards or customer needs. They include costs incurred before the product is dispatched to the customer, such as the costs of scrap, repair, downtime and work stoppages caused by defects.
(d)       External failure costs are the costs incurred when products or services fail to conform to requirements or satisfy customer needs after they have been delivered. They include the costs of handling customer complaints, warranty replacement, repairs of returned products, lost market share and the costs arising from a damaged company reputation. Costs within this category can have a dramatic impact on future sales.

6.2.1

Cost of quality report

The cost of quality report can be used as an attention-directing device to make top management of a company aware of how much is being spent on quality-related costs and the areas where they should focus their attention.

6.2.2

Example 9 – Cost of quality report

The following presents a typical cost of quality report.

• It shows that significant savings can be made by reducing the costs of scrap and rework.
• The report can also draw management’s attention to the possibility of reducing total quality costs by a wiser allocation of costs among the four quality categories.
• For example, by spending more on the prevention costs, the amount of spending in the internal and external failure categories can be substantially reduced, and therefore total spending can be lowered.
• Also, by designing quality into the products and processes, appraisal costs can be reduced, since far less inspection is required.

6.2.3

Example 10 – Cost of quality: bad quality and high costs – Toyota

In late 2009 and early 2010, Toyota recalled several accidents occurred due to a faulty accelerator pedal. The recall involved over 5 million vehicles and sales and production were suspended for a time in the US. According to author Paul Ingrassia, the problem occurred because Toyota broke one of their key principles called the “three nevers” at its US manufacturing plants: never build a new product, in a new facility, with a new workforce. In the case of the Camry in the US, all three were broken. A report by the Forbes.com put the estimated cost of problem at $2 billion as of February 2010.

Question 6
Sunshine Watch Ltd produces watches and related products. The company is a recognized leader in the industry for quality products. In recent months, the directors have become interested in trying to quantify the costs of quality in the company. As an initial effort, the company was able to identify the following costs for the year ended 30 June 2012, by categories that are associated with quality:

Managers were also aware that in the above, 250 of the 8,000 watches that were produced had to be sold as scrap. As a result, each of the 250 watches earned $800 less in profit than “good” watches. Also, the company incurred $60,000 rework costs that were necessary in order to sell 200 other watches through regular market channels.

Required:

(a)        Prepare a quality cost report for the year ended 30 June 2012 showing clearly the four major categories of quality costs.                                                                   (12 marks)
(b)       Assuming that the company intends to extend the warranty period from one year to two years, describe the impact of this intended change on quality costs.        (3 marks)
(c)        Briefly describe the characteristics of total quality management (TQM) and explain why it is important to all kinds of organizations.                                             (5 marks)
(Total 20 marks)