Compiled By CA.

nirmal shrestha Cost and Management Accounting Techniques

CHAPTER 1
COST AND MANAGEMENT ACCOUNTING TECHNIQUES

ABSORPTION COSTING
The linking of all production costs to the cost unit to prepare a full cost per unit.
Absorption costing is a traditional approach to dealing with overheads, involving three stages: allocation,
apportionment and absorption.

Uses:
1. Inventory Valuation- cost of inventories will affect profitability
2. Pricing decisions - set selling prices by calculating the full cost of production or sales of each
product, and then adding a margin for profit
3. Budgeting - to judge how profitable each individual product is where a company sells more than
one product

Traditional overhead analysis

Overhed
Cost Cost Cost
Item Centres Units

Steps using absorption costing

The steps using absorption costing are:
1. Overhead costs are collected in various cost centres
Allocation: Specific overhead costs directly relating to individual cost centres, for example, supervision,
indirect materials.

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Apportionment: General or common overhead costs like rent, heating, electricity are incurred as a whole
item by the company and therefore have to be distributed to cost centres on some sharing bases like floor
area, machine hours, number of staff etc.

2. Overhead absorption is achieved by means of a predetermined Overhead Absorption Rate.

a. Overhead Absorption Rate =
∗
* Activity levels generally used by examiners are number of units, labour hours or
machine hours, which means overheads are charged to units on these bases.
b. Absorbed overheads = OAR x Actual Activity
Appropriate absorption base may be:
(a) A percentage of direct materials cost
(b) A percentage of direct labour cost
(c) A percentage of prime cost
(d) A percentage of factory cost (for administration overhead)
(e) A percentage of sales or factory cost (for selling and distribution overhead)
(f) A rate per machine hour
(g) A rate per direct labour hour
(h) A rate per unit
Example 1: A manufacturing company makes two products, X and Y. Budget information about these
products is as follows.
Product X Product Y
Direct cost per unit $10 $7
Direct labour time to make each unit 15 minutes 20 minutes
Budgeted production for the year 8,000 units 9,000 units
The budgeted production overheads for the year are $120,000. The company uses an absorption costing
system and a direct labour hour absorption rate.
What is the absorption rate for overheads and what is the budgeted cost per unit of X and unit of Y?
Hints: OAR = $24 per DLH; Full production costs: X – $16 and Y - $15

Over- and under-absorption of overheads

 Over-absorption means that the overheads charged to the cost of production or sales are greater than
the overheads actually incurred.
 Under-absorption means that insufficient overheads have been included in the cost of production or
sales.

The reasons for under-/over-absorbed overhead

1. Actual overhead costs are different from budgeted overheads.
2. The actual activity level is different from the budgeted activity level.
3. Actual overhead costs and actual activity level differ from those budgeted.
Example 2: A production department has a budgeted production overhead of $180,000 and budgeted
activity of 45,000 machine hours. Overheads are absorbed on a machine hour basis.
Required
Calculate the under-/over-absorbed overhead, and note the reasons for the under-/over- absorption in the
following circumstances.
(a) Actual overheads cost $170,000 and 45,000 machine hours were worked.
(b) Actual overheads cost $180,000 and 40,000 machine hours were worked.
(c) Actual overheads cost $170,000 and 40,000 machine hours were worked.
Hints: Over-absorbed overhead/(Under-absorbed overhead) = (a) $ 10,000 (b) ($20,000) (c) ($10,000)

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MARGINAL COSTING
In marginal costing, inventories are valued at variable production cost whereas in absorption costing
they are valued at their full production cost. Profit is calculated by deducting variable costs of sales from
sales revenue to obtain contribution, and then deducting fixed costs to obtain a figure for profit.
Marginal cost is the cost of one unit of a product/service which could be avoided if that unit were not
produced/provided.
Contribution is the difference between sales revenue and variable (marginal) cost of sales.
Marginal 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.
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.
There are no variable selling costs. Fixed costs are $2,000 per period, of which $1,500 are fixed
production costs. Normal output 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
Prepare profit statements for each period and for the two periods in total using both absorption costing
and marginal costing.
Hints:
Under absorption costing – NP = $700 (Period 1) and $1,100 (Period); Total $1,800
Under marginal costing – NP = $400 (Period 1) and $1,400 (Period); Total $1,800
It is important to notice that although production and sales volumes in each period are different, over
the full period, total production volume equals sales volume. The total cost of sales is the same and
therefore the total profit is the same by either method of accounting. There are differences in the reported
profit in period 1 and in period 2, but these are merely timing differences which cancel out over a longer
period of time (in this example, over the two periods).

Manipulating profits
Example 4: Gloom Co budgeted to make and sell 10,000 units of its product in 20X1. The selling price
is $10 per unit and the variable cost $4 per unit. Fixed production costs were budgeted at $50,000 for the
year. The company uses absorption costing and budgeted an absorption rate of $5 per unit. During 20X1,
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.
Hints:
(a) Absorption costing = 33,000
(b) Marginal costing = (2,000)
Reconciliation
The difference in profits of $35,000 is explained by the difference in the increase in inventory values
(7,000 units  $5 of fixed overhead per unit). With absorption costing, the expected profit will be higher
than the original budget of $10,000 (10,000 units ($10 – 9)) simply because $35,000 of fixed overheads
will be carried forward in closing inventory values. By producing to absorb overhead rather than to

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satisfy customers, inventory levels will, of course, increase. Unless this inventory is sold, however, there
may come a point when production has to stop and the inventory has to be sold off at lower prices.
Marginal costing reports a contribution of $6 per unit, or $48,000 in total for 8,000 units, which fails to
cover the fixed costs of $50,000 by $2,000

Criticisms of absorption costing

Criticisms of absorption costing are:
 A big amount of guess work in relating overhead costs to the products.
 Inappropriate bases to link overheads to products
 Can only work in single product and simple manufacturing environments

Recent changes in manufacturing

The reason for the increasing inaccuracy of absorption costing is due to two basic issues:
1. Increased production complexity.
2. Increased proportion of overhead costs.
3. Increased proportion of support services’ costs

1. Production complexity
A wide variety of production processes have become more complex in recent years in a number of
ways:
a. Flexible manufacturing systems
– allow for a number of widely differing products to be produced on the same machinery
– absorbing overhead on a simple volume base is unlikely to reflect the differing overhead costs
incurred by each product

b. Fast product development

– may mean that a number of differing iterations of the same product may be produced in quick
order
– With such products having differing production volumes again a volume base is unlikely to work

c. Wider product ranges lead to a more complex cost analysis.

2. Increased proportion of overhead costs

– Overheads have increased in importance as a percentage of total costs due to both
o the substitution of direct labour with indirect labour
o companies mechanize to a greater degree
o Costs increased for disciplines as production planning and logistics

3. Increased proportion of support services’ costs

– cost of servicing customers are often more important than production
– therefore an accurate cause effect relationship should be established as to
o what generates the cost and
o what is the real impact of this cost on the volume of units sold

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ACTIVITY BASED COSTING

Activity based costing (ABC) is an alternative to traditional absorption costing as a method of costing.
ABC involves the identification of the factors (cost drivers) which 'cause' or 'drive' the costs of an
organization’s major activities. Overheads are allocated and apportioned to activity cost centres or 'cost
pools'. From these activities cost centres, the overhead costs are then absorbed into the product costs on the
basis of their usage of the activity. The absorption rate for each activity is a rate per unit of the relevant cost
driver.
 For activity costs that seem to relate to the volume of production, the cost driver will be volume
related (labour or machine hours).
 For activity costs that do not seem to relate to production volume, a different cost driver is
identified, such as the number of production runs or number of orders received

Activity-based costing is based on the following assumptions:

 In a modern manufacturing environment, with the advent of advanced manufacturing technology
(AMT), a large proportion of total costs are overhead costs, and direct labour costs are relatively small.
 Because overhead costs are large, it is appropriate to trace these costs as accurately as possible to the
products that create the cost.
 The falling costs of information processing have also made it possible to switch to a different and
more complex system for accumulating and analysing overhead costs. ABC may now be cost effective
whereas in the past its high costs could have made it difficult to justify.
 Many resources are used in non-volume related support activities, which have increased due to
AMT. These support activities assist the efficient manufacture of a wide range of products and are
not, in general, affected by changes in production volume. They tend to vary in the long term
according to the range and complexity of the products manufactured, rather than the volume of
output.
 The traditional methods of absorbing production overhead costs on the basis of direct labour hours or
machine hours do not have any rational justification and a better method is needed for charging
overheads to different products or jobs.

A revised analysis – ABC

Overhea
d cost Cost Pool Cost unit
item

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Steps using ABC

The steps involved in ABC are:
1. Identify an organisation’s activities.
2. Collect the cost of each activity into what is called cost pool (equivalent to cost centre under
traditional costing).
3. Identify the factors which determine the size of the costs of an activity. These are called cost drivers.
Activity Possible Cost Drivers
Ordering number of orders
Material handling number of production run
Production scheduling number of production run
Dispatching number of dispatches
Customer order processing Number of customer orders
Materials purchasing Number of purchase orders
Quality control and inspection Number of inspections
Repairs and maintenance Number of machines, or machine hours operated
Selling Number of sales orders
Warehousing and dispatch Number of deliveries made
4. Assign the cost of activities to products according based on the number of units of driver used.

Cost Pool is an activity that consumes resources and for which overhead costs are identified and
allocated. For each cost pool there should be a cost driver.
Cost Driver is any factor which causes a change in the cost of an activity.

Let us take one example

Example 5: Assume that a company makes widgets and the management decides to install an ABC
system. The management decides that all overhead costs will have only three cost drivers viz. Direct
labour hours, Machine hours and number of purchase orders and the general ledger of the company shows
the following overhead costs –
General Ledger Amount ($)
Payroll taxes 1,000
Machine maintenance 500
Purchasing Dept. labour 4,000
Fringe benefits 2,000

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Purchasing Dept. Supplies 250

Equipment depreciation 750
Electricity 1,250
Unemployment insurance 1,500
Total 11,250
Assume that the total number of labour hours be 1,000 hours, machine hours be 250 hours and total
purchase orders be 100 orders. Generally, in the traditional costing method, overheads are applied on the
basis of direct labour hours (total 1,000 labour hours in the given case).
Two widgets A and B details are given below:
Particulars Widget A Widget B
Labour hours 400 600
Machine Hours 100 150
Purchase Orders 50 50
Hints:
Under ABC
So, total overhead costs applied to widget A = (400 ×4.50) + (100×10) + (50×42.50) = $ 4,925
And total overheads applied to widget B = (600×4.50) + (150×10) + (50×42.50) = $ 6,325
So total overheads = $ 4,925 + $ 6,325 = $ 11,250.
Traditional costing method
Widget A = $ 4,500 and to Widget B = $ 6,750.
Hence Widget A would have been undervalued and Widget B overvalued by $ 425.

Example 6: 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
Hint:
(a) Traditional costing approach
Product L 1 hour × $15 = $15 per unit; Product M 2 hours × $15 = $30 per unit
(b) ABC approach
Product L : $163,000; OAC per unit $32.60
Product M : $122,000; OAC per unit $17.43
These figures suggest that, with traditional absorption costing, Product M absorbs an 'unfair' amount of
overhead costs using a direct labour hour absorption rate. If overhead costs are absorbed accordingly
for each activity, based on the cost drivers for the activity, the resulting costs are more 'fair'.

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Example 7: Hensau Ltd has a single production process for which the following costs have been
estimated for the period ending 31 December 2010:
£
Material receipt and inspection costs 15,600
Power costs 19,500
Material handling costs 13,650
Three products - X, Y, and Z are produced by workers who perform a number of operations on material
blanks using hand held electrically powered drills. The workers are paid £4 per hour.
The following budgeted information has been obtained for the period ending 31 December 2010:
Product X Product Y Product Z
Production quantity (units) 2,000 1,500 800
Batches of Material 10 5 16
Data per product unit:
Direct material (square metres) 4 6 3
Direct material cost (£) 5 3 6
Direct labour (minutes) 24 40 60
No. of power drill operations 6 3 2
Overhead costs for material receipt and inspection, process power and material handling are presently
each absorbed by product units using rates per direct labour hour.
An activity based costing investigation has revealed that the cost drivers for the overhead costs are as
follows:
Material receipt and inspection: Number of batches of material
Process power: Number of power drill operations
Material handling: Quantity of material (square metres) handled
Required
(a) Prepare a summary which shows the budgeted product cost per unit for each product of X, Y, and Z
for the period ending 31 December 2010 detailing the unit costs for each cost element using:
(i) the existing method for the absorption of overhead costs and
(ii) an approach which recognises the cost drivers revealed in the activity based costing
investigation. (13 marks)
(b) Explain the relevance of cost drivers in activity based costing. Make use of figures from the summary
statement prepared in (a) to illustrate your Hint.
Hints: (a) (i) X=14.1; Y = 18.2; Z = 28.75
(a) (ii) X=18.4; Y = 14.82; Z = 24.32

Conditions under which ABC is most appropriate

The usefulness of ABC techniques will depend on the characteristics of the organisation, in particular the
following:
(1) Complexity of Cost structure or cost drivers
(2) Product mix or diversity
(3) Information
(4) Environment

Benefits:
1. More accurate product costing.
2. Is flexible enough to analyze costs by activity providing more useful costing data.
3. Provides a reliable indication of long-run variable product cost.
4. Helps understanding of cost.
5. Provides a more logical basis for costing of overhead.
6. Cost can be designed out of products by eliminating unnecessary activities.

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Limitations:
1. Cost vs benefit.
2. ABC information is historic and internal.
3. Difficult to apply in practice as selection of cost drivers may not be easy.
4. Focuses on the allocation of cost rather than minimizing the cost incurred
5. Many judgmental decisions still required in the construction of an ABC system.
6. Additional time and cost of setting up and administering the system.
Example 8: The following budgeted information relates to Brunti plc for the forthcoming period.
Products
XYI(000s) YZT(000s) ABW(000s)
Sales and production (units) 50 40 30
£ £ £
Selling Price (per unit) 45 95 73
Prime cost (per units) 32 84 65
Hours Hours Hours
Machine department (machine hours per unit) 2 5 4
Assembly department (direct labour hours per unit) 7 3 2
Overheads allocated and apportioned to production departments (including service cost centre costs)
were to be recovered in product costs as follows.
 Machine department at £1.20 per machine hour
 Assembly department at £0.825 per direct labour hour
You ascertain that the above overheads could be re-analysed into 'cost pools' as follows:
Cost pool £000 Cost driver Quantity for the period
Machining services 357 Machine hours 420,000
Assembly services 318 Direct labour hours 530,000
Set-up costs 26 Set-ups 520
Order processing 156 Customer orders 32,000
Purchasing 84 Suppliers' orders 11,200
941
You have also been provided with the following estimates for the period:
Products
XYI YZT ABW
Number of set-ups 120 200 200
Customer orders 8,000 8,000 16,000
Suppliers' orders 3,000 4,000 4,200
Required:
(a) Prepare and present profit statements using:
(i) conventional absorption costing, and
(ii) activity based costing.
(b) Comment on why activity based costing is considered to present a fairer valuation of the product cost
per unit.
Hints: (a) (i) Profits: XYI = 241,250; YZT = 101,000; ABW = 46,500
(a) (ii) Profits: XYI = 287,500; YZT = 119,000; ABW = (17,500)

ABC attempts to relate the incidence of costs to the level of activities undertaken. A hierarchy of
activities have been suggested.

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Classification Cause of cost Types of cost Cost driver

level
Unit level Production/acquisition of a single unit Direct materials Units produced
of product or delivery of single unit of Direct labour
service
Batch level A group of things being made, handled Purchase orders Batches produced
or processed Set-ups
Inspection
Product level Development, production or Equipment Product lines
acquisition of different items maintenance Produced
Product
development
Facility Some costs cannot be related to a Building None – supports
sustaining particular product line; instead, they depreciation the
level are related to maintaining the buildings overall production
and facilities. These costs cannot be Organizational or service process
related to cost objects with any degree Advertising
of accuracy and are often excluded Plant Security
from ABC calculations for this reason.
ACTIVITY BASED BUDGETING (ABB)
 Activity based budgeting analyse the resource input or cost for each activity.
 Actual results can be compared with budgeted results to highlight both in financial and non-financial
terms those activities with major discrepancies from budget for potential reduction in supply of
resources.
 It is a planning and control system which seeks to support the objectives of continuous
improvement.
 It means planning and controlling the expected activities of the organization to derive a cost-effective
budget that meet forecast workload and agreed strategic goals.

ABB is the reversing of the ABC process to produce financial plans and budgets.
 Activity based budgeting extends the use of ABC from individual product costing, for pricing and
output decisions, to the overall planning and control systems of the business.
 The basic principle of ABB is that the work of each department for which a budget is to be prepared is
analyzed by its major activities, for which cost drivers may be identified. The budgeted cost of resources
used by each activity is determined (from recent historical data) and, where appropriate, cost per unit
of activity is calculated.
 Future cost can then be budgeted by deciding on future activity levels and working back to the required
resource input.

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THROUGHPUT ACCOUNTING
Basics
Throughput accounting is a method of accounting that focuses on throughput, and relates costs of
production to throughput. Throughput accounting applies the theory of constraints as advocated by Goldratt
and Cox.
In the theory of constraints and throughput accounting, throughput is the money generated by a system
through the sales that it makes.

Rationale:
 Profitability of a product is determined by the rate at which it contributes money and the rate at which
the factory spends money. To increase profitability, Goldratt and Cox advocated that managers
should aim to increase throughput while simultaneously reducing inventory and operational expenses.
 Inventory is the amount of money the system has invested in purchasing things that it intends to resell
within its finished products. Inventory has no value because it does not create throughput until it is
used to sell products.
 Throughput is the money obtained from sales minus the cost of materials that have gone into making
them. In conventional cost accounting terms, the materials are the direct materials used in production.
 However, the scope of reducing operational expenses is limited as they are to be maintained at some
minimum level for production to take place.
 In throughput accounting, all operational expenses or factory expenses are assumed to be 'fixed' costs.

Key terminology
(Please note the similarity to marginal costing terminology that you already know)
Marginal costing Throughput accounting
Variable Cost = Direct Material Cost

Fixed Cost = Total Factory Cost

(Including labour cost)

Contribution = Throughput
(Sales – Variable Cost) (Sales – Direct Material Cost)

Throughput is calculated as the difference between sales and material cost.

Throughput (contribution) = Sale – material cost.

Concepts underpinning throughput accounting

Throughput accounting is based on following concepts:
1. Cost Behaviour: In the short-term all manufacturing cost with the exception of material cost are fixed.

2. Inventory: Just as in the concept of JIT, holding and producing stocks do not add to the value of products
(no value addition). The longer it takes to output, the lower the profitability. Therefore, Managers should
aim to increase throughput whilst simultaneously reducing inventory and operational expenses.

3. Profitability: 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. Making money means maximizing throughput.

Factors affecting the value of throughput accounting

 The selling price of the item sold
 The purchase cost of direct materials

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 Efficiency in the usage of direct materials

 The volume of the throughput.

Bottleneck is any limitation or restraint in the production process which limits the production
managers to fully utilize some of their resources.
-Machine capacities
-Human resources
-Materials in scarcity
In order to maximize throughput, managers should focus attention on any bottlenecks and remove them. If
this is not possible they should ensure that the bottlenecks are fully utilized at all times
Theory of constraints (TOC) is an approach to production management which aims to maximize sales
revenue less material cost. It focuses on bottlenecks which act as constraints to the maximization of
throughput.

Steps in throughput accounting

1. Identify the system bottlenecks.
These are the constraints that restrict output from being increased
2. Concentrate on each bottleneck in turn to ensure that they are being fully and efficiently utilized.
3. Scale down the throughput of non-bottleneck activities to match what can be dealt with by the bottleneck.
4. Remove the bottlenecks if possible.
5. Since throughput accounting is a continues improvement process, return to step 1 and re-evaluate the
system now that bottlenecks have been removed.
Elevating the constraint
Example 9: A company manufactures a single product, which is processed in turn through three
machines, Machine type A, Machine type B and Machine type C. The current maximum output capacity
per week on the existing machinery is as follows.
Machine type A: 1,800 units
Machine type B: 1,600 units
Machine type C: 1,500 units
The company could purchase an additional Machine type C for $8 million which would increase output
capacity on Machines C by 600 units per week. It could also purchase an additional Machine type B that
would cost $5 million and increase output capacity by 300 units per week. An increase in weekly output
capacity is worth (in present value terms) $50,000 per unit of additional output.
What should the company do? Should it buy either or both the additional machines?
(1) The current bottleneck resource is Machine type C and output is restricted to 1,500 units per week.
There is no point in buying an additional Machine type B unless a new Machine type C is purchased
first, to elevate the bottleneck resource.
If an additional Machine type C is purchased, output capacity will increase as follows.
Machine type A: 1,800 units
Machine type B: 1,600 units
Machine type C: 2,100 units
By elevating the capacity of Machine type C, Machine type C is no longer the bottleneck resource. The
new bottleneck resource is Machine type B and output is restricted to 1,600 units per week, which is 100
units per week more than the current output limit.
The benefit will be (100 units × $50,000) – $8 million = –$3,000,000 (= net loss).
(2) If an additional Machine type C and an additional Machine type B are purchased, output capacity
will increase as follows.
Machine type A: 1,800 units
Machine type B: 1,900 units
Machine type C: 2,100 units

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The new bottleneck resource is Machine type A and output is restricted to 1,800 units per week, which
is 300 units more than the current limit.
The benefit will be (300 units × $50,000) – $8 million – $5 million = + $2,000,000.
Conclusion. By purchasing an additional Machine type C and Machine type B, output would be increased
by 300 units per week. The new bottleneck constraint would be Machine type A. The company would
benefit from this by $2,000,000.

Formulae to remember:
Return per Factory Hour =

∗
Cost per Factory Hour =

Throughput Accounting Ratio (TPAR) =

* Total factory cost includes direct labour and production overheads.

Example 10: Maximizing throughput and multiple products

WR Co manufactures three products, A, B and C. Product details are as follows.
Product A Product B Product C
$ $ $
Sales price 2.80 1.60 2.40
Materials cost 1.20 0.60 1.20
Direct labour cost 1.00 0.80 0.80
Weekly sales demand 4,000 units 4,000 units 5,000 units
Machine hours per unit 0.5 hours 0.2 hours 0.3 hours
Machine time is a bottleneck resource and maximum capacity is 4,000 machine hours per week.
Operating costs including direct labour costs are $10,880 per week. Direct labour workers are not paid
overtime and work a standard 38-hour week.
Required: Determine the optimum production plan for WR Co and calculate the weekly profit that
would arise from the plan.
Hints:
Step 1 Determine the bottleneck resource Machine time
Step 2 Calculate the throughput per unit for each product: 1.6/1/1.2
Step 3 Calculate throughput per unit of limiting factor (machine hours): 3.2/5/4
Step 4 Rank products: B/C/A
Step 5 Allocate resources to arrive at optimum production plan: 4,000/5,000/3,400 units of B, C, A.
Profit per week = $ 4,560

Interpreting the TA ratio

 TPAR > 1 means product profitable
 TPAR = 1 means break even
 TPAR < 1 means product makes a loss
TA ratios can also be used to assess the relative earning capabilities of different products. Products can
be ranked in order of priority for manufacture and sale in order of their TA ratios. (Higher TA ratios should
be given priority over lower TA ratios).

However, ranking products in order of priority according to their TA ratio will always give the same ranking
as putting them in order of throughput per unit of bottleneck resource.

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Example 11: Corrie Company 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
$ per unit $ per unit $ per unit
X 150 80 70
Y 130 40 90
Z 300 100 200
Operating costs are $720,000 per day.
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.
Hints: (Derive TP, Cost and FC per hour)
(a) Profit per day = $345,000
(b) TA ratio = X – 0.93; Y – 1.5; Z – 1.33
(c) If it is not possible to increase the number of factory hours available, priority should be given to
making and selling Product Y, since it has the highest TA ratio. If only Product Y is made and sold (since
there is no restriction on sales demand), total output per day would be (1,500 × 8 hours) = 12,000 units
of Product Y. Total throughput would be $1,080,000 (= 12,000 units × $90) per day.
Total profit per day would be $1,080,000 – $720,000 = $360,000.
This is $60,000 more per day than the profit from the production mix in the Hint to part (a).
The TA ratio of Product X is 0.93, which is less than 1.0. Product X makes less throughput per hour
than its factory cost per hour.
Management should consider ways of raising the TA ratio above 1.0, or should give consideration to
ceasing production of Product X entirely.
Example 12: A company manufactures a product which requires four hours per unit of machine time.
Machine time is a bottleneck resource as there are only ten machines which are available for 12 hours
per day, five days per week. The product has a selling price of $130 per unit, direct material costs of $50
per unit, labour costs of $40 per unit and factory overhead costs of $20 per unit. These costs are based
on weekly production and sales of 150 units. What is the throughput accounting ratio (to 2 decimal
places)? Hints: 1·33
Example 13: 3P3M Ltd produces three products using three different machines. The following
information is available for a product for a period:
Product X Y Z
Sales (£) 20 15 10
Direct materials (£) 8 5 4
Direct labour (£) 5 3 2
Overheads (£) 2 1 1
Estimated sale demand (unit) 200 200 200
Machine hours required per unit:
Machine 1 6 2 1
Machine 2 9 3 1.5
Machine 3 3 1 0.5
Machine capacity is limited to 1,600 hours for each machine.
Required:

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Calculate throughput accounting ratio and rank the products.

Hints:
Return per factory hour: X = 1.33; Y = 3.333; Z=4
Cost per factory hour = 1.75 each
Throughput accounting ratio: X = 0.76; Y =1.90; Z = 2.29

How to improve TPAR

 Eliminate bottlenecks or reduce time spent on bottleneck resources.
 Reduce other factory costs.

Limitations of throughput accounting

 Selling price could be uncompetitive
 Material suppliers may not be reliable
 Product quality is low
 Need to deliver on time
 Very little attention is paid to overhead costs.

TARGET COSTING
Traditional costing systems
1. Calculate unit cost.
2. Add profit margin.
3. Equals Selling price.

Problems:
 No consideration of market
 Costs are not challenged

TARGET COSTING
Target costing: (emerged in Japan in 1970s as a response to difficult market conditions)
 “A structured approach to determining cost
 at which a proposed product with specified functionality and quality must be produced,
 to generate a desired level of profitability at its anticipated selling price.”

Target costing steps:

1. Determine possible selling price – with reference to the market/customer and taking into consideration
the specification of the product.
2. Establish the required profit margin – this is based upon the overall required return of the business
and the level of perceived risk of the product
3. Calculate the target cost – i.e. the cost that the company must produce at in order to be able to achieve
the required profit level (Selling price – profit margin)
4. Close the gap – reduce the cost from the original expected cost to the target cost.
For example:
$
Target selling price 60.00
Target profit margin (30% of selling price) 18.00
Target cost (60.00 – 18.00) 42.00

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If Projected cost $45.89 then the projected cost exceeds the target cost by $3.89. This is the target cost gap.
Company will therefore have to investigate ways to reduce the cost from the current estimated amount
down to the target cost i.e. close the gap.
Steps in Target Costing Process
Set target selling price based on customer expectations and sales forecasts

Establish profit margin based on long term profit

objectives and projected volumes

Determine Target (or Allowable) cost per Compare Establish the “current
unit (Target selling price less required with cost” of the new
profit margin) product

Establish cost reduction targets for each component and production activity using value
engineering activity, using value engineering and value analysis

Value Engineering: It involves searching for opportunities to modify the design of each component or
part of a product to reduce cost, but without reducing functionality or quality of the product.
Value Analysis: It entails studying the activities that are involved in producing the product to detect
non-value adding activities that may be eliminated or minimized to solve costs, but without reducing the
functionality or quality of the product.

Example 14:
a) CMC Ltd, a car manufacturing company, wants to calculate a target cost for a new car. The price
will be set at £20,000. CMC Ltd requires a 10% profit margin. What is the target cost? Hints:
Target cost £18,000
b) The selling price of Product X is set at $350 for each unit and sales for the coming year are
expected to be 500 units. A return of 30% on the investment of $300,000 in Product X will be
required in the coming year. What is the target cost for each unit of Product X? Hints: $170
c) A company has calculated that the target cost for Product Z is $40 per unit. This is based on an
expected production and sales volume of 3,000 units. The company wishes to earn a profit of
25% on sales. Hints: $53.33
Example 15: Fantata Ltd makes and sells a product H which is manufactured through two consecutive
processes; assembly and finishing. Raw material is input at the commencement of the assembly process.
An activity-based costing approach is used in the absorption of product specific conversion cost.
The following estimated information is available for the period.
Product A
Production/ sales units 12,000
Selling price per unit £75
Direct material cost per unit £20
ABC variable conversion cost per unit:
Assembly £20
Finishing £12
Product specific fixed costs £170,000
Company fixed costs £50,000

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Fantata Ltd uses a minimum contribution to sale ratio target of 25% when assessing the viability of a
product. In addition, management wish to achieve an overall net profit margin of 12% on sales in this
period in order to meet return on capital target.
Required:
(a) Calculate target cost.
(b) Calculate the cost gap.
(c) Suggest specific areas of investigation.
Hints:
(a) Target Cost = £66
(b) Cost Gap (70.34 – 66) = £4.34
(c) The company is falling considerably short of its 12% net profit margin target. If sales quantities and
prices are to remain unchanged, costs must be reduced if the required return is to be reached.
Product B is falling short of the C/S ratio target. Cost reduction methods exercise must be concentrated
particularly on this product if its production is to continue to be seen to be worthwhile.
The designed specification for each product and the production methods should be examined for
potential areas of cost reduction that will not compromise the quality of the products. For example:
 Can any materials be eliminated, eg cut down on packing materials?
 Can a cheaper material be substituted without affecting quality?
 Can part assembled components be bought in to save on assembly time?
 Can the incidence of the cost drivers be reduced, in particular for product Y?
 Is there some degree of overlap between the product-related fixed costs that could be eliminated by
combining service departments or resources?

Closing a target cost gap (without compromising quality)

The designed specification for each product and the production methods should be examined for potential
areas of cost reduction that will not compromise the quality of the products.
For example:
1. Reduced component count
 Reducing the number of components
 Using standard components wherever possible
 Using different materials
2. Reduce production complexity
 Acquiring new, more efficient technology
 Cutting out non-value added activities.
3. Revise production process
4. Revise specification
5. Employ lower grade staff with training.
6. Outsource parts of manufacture.

Target costing in service industries

Unlike manufacturing companies, services are characterized by intangibility, inseparability, variability,
perishability and no transfer of ownership. Examples of service businesses include:
(a) Mass service eg: the banking sector, transportation (rail, air), mass entertainment
(b) Either/or eg: fast food, teaching, hotels and holidays, psychotherapy
(c) Personal service eg: pensions and financial advice, car maintenance

There are five major characteristics of services that distinguish services from products hence makes
difficulty in target costing.

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(a) Intangibility. Lack of substance which is involved with service delivery (physical products such as
confectionery), so it is not possible to reduce cost to a target level by reducing material costs. Also, service
given by employee is difficult to specify.
(b) Inseparability/simultaneity. Many services are created at the same time as they are consumed. (Think
of dental treatment.) No service exists until it is actually being experienced or consumed by the person who
has bought it.
(c) Variability/heterogeneity. Problem of maintaining consistency in precise standardization of the service
offered, but customers expect it (such as with fast food). When services are delivered by humans, it is very
difficult to ensure that the same service is provided in exactly the same way every time.
(d) Perishability. Services are innately perishable. The services of a beautician, for example, are purchased
for a period of time.
(e) No transfer of ownership. Services do not result in the transfer of property. The purchase of a service
only confers on the customer access to or a right to use a facility.

Implications of using target costing

Advantages:
 Reduction and control [elimination of non-value added elements and activities]
 Market based costing
 Customers focus for quality and value
 Design [Cost control at the design stage]

LIFE CYCLE COSTING

Cradle to grave
The term life-cycle costing is used to describe a system that tracks and accumulates the actual costs and
revenues attributable to each product from inception to abandonment.
In life-cycle costing the profitability of each product can therefore be determined right from design stage
through development to market launch, production and sales, and finally to its eventual withdrawal from
the market.
Life cost per unit =

The component elements of a product’s cost over its life cycle could therefore include the following:
1. Research and development costs
 Design
 Cost of making prototype
 Testing
 Market research
 Production process and equipment.
2. The cost of purchasing and any technical data required.
3. Training costs (including initial operator training and skills updating).
4. Manufacturing or production costs.
5. Marketing costs
 Customer service
 Field maintenance
 Brand promotion.
6. Distribution cost (including transportation and handling costs).

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Characteristics of Product Life Cycle

 Products have finite lives and pass through 5 phases
 Product cost, revenues and profit pattern tend to follow predictable course through phases
 Profit per unit varies in each phase
 Each phase poses different opportunities and threats
 Different functional emphasis in each phase is required
 R & D emphasis in the decline phase
 Cost control emphasis in the decline phase
 Product life cycle may be extended by finding new or new users or getting present uses to
increase their consumption.

Phases of Product Life Cycle

1. Development
The product has a research and development stage where costs are incurred but no revenue is
generated.
Examples: R&D costs; Capital Expenditure decisions
2. Introduction
 New product launched into market
 Customers are innovators
 Competition is almost negligible
3. Growth
 Sales and profits rise at rapid pace
 Competitions enter the market in large numbers
 Profits starts declining near the end of this phase
4. Maturity
 Sale continues to increase but at a decreasing rate
 Profit decline
 Price began to soften
 Some firms extend their product lines with new models
5. Decline
 Decline in sales volume
 Demand for product disappears
 Technical advances leading to product substitution

Benefits of Product Life Cycle Costing:

 Results in earlier actions to generate revenue or to lower costs
 A more accurate and realistic assessment of revenues and costs lead to better decisions
 Promote long term rewarding
 It provides an overall framework for considering total incremental costs over the entire life span of
a product.
 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.
 It can be very useful for organisations that continually develop products with a relatively short
life, where it may be possible to estimate sales volumes and prices with reasonable accuracy.

Comparison of life cycle costing and traditional management accounting

 Traditional MA merely report on a periodic basis, and product profits are not monitored over their life
cycle. Such a practice does not, therefore, assess a product’s profitability over the entire life but rather
on a periodic basis.

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 LCC involves tracing costs and revenues on product-by-product basis over several calendar periods
throughout their entire life cycle.
 Recognition of the commitment needed over the entire life cycle of a product will generally lead to
more effective resource allocation than the traditional annual budgeting system.

Maximizing return over the product life cycle

1. Design costs out of products
Between 70% and 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.
2. Minimize the time to market
If an organization is launching a new product it is vital to get it to the marketplace as soon as possible. This
will give the product as long a period as possible without a rival in the marketplace, and should mean
increased market share in the long run. This means that it is usually worthwhile incurring extra costs to
keep the launch on schedule or to speed up the launch.
3. Minimise breakeven time (BET)
A short BET is very important in keeping an organisation liquid. The sooner the product is launched the
quicker the research and development costs will be repaid, providing the organisation with funds to develop
further products.
4. Maximise the length of the life span
Product life cycles are not predetermined; they can be influenced by the actions of management and
competitors. The life cycle of these materials can be extended by finding new uses for them.

Example 16: 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 life cycle.
Required
Calculate the cost per unit looking at the whole life cycle and comment on the suggested price.
Hints:
Life cycle costs
$'000
Total life cycle costs 22,235
Total production ('000 units) 42
Cost per unit 529.40
Example 17: A company is about to launch a new product. Total lifetime sales are expected to be 44,000
units. $3,250,000 has been incurred on design and development. Promotional costs over the product’s
life are expected to be $2,000,000. De-commissioning of the machine will cost $250,000 at the end of
the product’s life. Production of the product is expected to cost an average of $150 per unit. What is the
life cycle cost per unit over the product’s life? [Hints: $275]

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ENVIRONMENTAL ACCOUNTING
Introduction
Many organisations worldwide like Greenpeace, Environmental Protection Agency, Kyoto Protocol are
seeking to reduce emissions of greenhouse gases which are believed to be causing global warming.
In order to comply with different local and global requirements, businesses and governments spend huge
amounts of money protecting environment in the name of environmental costs, e.g. improving production
process to reduce or eliminate pollutants and cleaning up contaminations in soil and water resources.

Importance of Environmental costs

 Identifying environmental costs associated with individual products and services can assist with
pricing decisions
 Ensuring compliance with regulatory standards to prevent legal repercussions
 Potential for cost savings
 Government support
 Reputation and goodwill

Typical environmental costs

 Consumables and raw materials
 Transport and travel
 Waste disposal
 Energy consumption
 Recycled material
 Water usage
 Pollution

Types of environmental costs

1. Public sector costs (social sector costs)
 Costs borne by taxpayers.
 Include staffing costs of the public sector organisations involved, reduce or eliminate pollution from
society, natural resources.
 Health and Medicare costs caused due to pollutants.

2. Private sector costs

 Business investments in environment related costs.
 Incurred to comply with local and global environmental requirements.
 Include, for example: costs of cleaning water resources due to pollutants such as toxic wastes from
production and chemical processes; compensation on a social level such as investing in parks, public
gardens, schools, forestry; and Medicare projects.

Identifiable and non-identifiable costs

Some of the above costs are clearly identified and known as attached to environment protection, such as
environmental organizations’ staffing costs, costs of cleaning up a polluted lake or a river etc.
Some environment costs are hidden as they are not directly tied to environment but are caused by
environmental issues. Such costs are borne by individuals, insurance companies, or even governments,
examples include medicare costs (due to cancer or other illnesses caused by environmental pollutants).

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Managing environmental costs

1. Monitoring costs.
2. Prevention costs.
3. Clean-up costs: On-site costs vs. Off-site costs.

Environmental costs strategies

1. End-of-pipe strategy
This strategy focuses on cleaning up pollutant and toxic waste before it is released into environment.

2. Process improvement strategy

The focus is on products and process modification to reduce or eliminate pollutants.

3. Prevention strategy
The focus is to design the production process in such a way which does not create any pollutant in the first
place.

Methods of accounting for environmental costs

The following methods are generally in practice to deal with reporting of environmental costs.
1. Input / output method
This method records material inflows, and balances these with outflows on the same basis. The simple idea
is that what comes in should go out.

2. Material flow cost accounting

Under this method the material inflows are divided into three categories based on physical quantities
involved, their costs and value:
 Material
 System and delivery
 Disposal.
The values and costs of each of these three flows are then calculated.

3. Activity based costing (ABC)

ABC clearly distinguishes between environment related costs which can be charged to joint cost centres
and environment driven costs hidden in general overheads. It provides an allocation of internal costs to cost
centres and cost drivers on the basis of activities that give rise to the costs.

4. Life cycle costing

This method focuses on adding environment related costs, such as cost of waste disposal, energy emissions
etc. into total cost of products over entire life cycle. The main aim is to reduce total cost with environment
friendly options in all stages of the cycle.

ENVIRONMENTAL MANAGEMENT ACCOUNTING (EMA)

EMA aims to provide internal information to management in the form of physical information on the use
of energy, water and materials (including waste), and monetary information on environment related costs
and savings.

Relevance for business

Bennett and James suggested six benefits of EMA:
(1) Capex decisions can take account of environmental impact of investments.

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(2) Better understanding of environmental costs normally hidden within other overheads.
(3) Reducing waste and saving energy.
(4) Understanding environmental effects on life cycle costs (e.g. costs of recycling at end of product life).
(5) Stakeholders are interested in environmental performance measures.
(6) Involving management accountants in longer term strategic decision making for environment-related
issues.

Environmental costs
Broad definitions (e.g. as proposed by the US Environmental Protection Agency) are:
 Conventional costs – buying inputs with environmental relevance (e.g. energy);
 Potentially hidden costs – items with environmental relevance hidden in overheads;
 Contingent costs – such as cleaning up damage;
 Image and relationship costs.

Hansen and Mendova’s more narrow definition:

 Environmental prevention costs – such as redesigning production processes to reduce pollution;
 Environmental detection costs;
 Environmental internal failure costs – cost of cleaning up pollution before it is released into the
environment.
 Environmental external failure costs – cost of cleaning up pollution after release into the
environment.

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