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ACMA - UNIT 2

OTHER ADVANCED ACCOUNTING TECHNIQUES

Target costing is the process of determining the maximum allowable cost for a new product and then developing a
prototype that can be made for that maximum target cost figure. The equation for determining a target cost is shown
below:

Target cost =Anticipated selling price – Desired profit

Once the target cost is determined, the product development team is given the responsibility of designing the product
so that it can be made for no more than the target cost.

The four stages in target costing are:

1. Determine the target price which customers which customers will be prepared to pay for the product
2. Deduct the target profit margin from the target price to determine target cost
3. Estimate the actual cost of the product
4. If estimated actual cost exceeds the target cost, (Target Gap) investigate ways of driving down the actual
cost to the target cost

EXAMPLE – Target Costing

Regal Kitchens, Inc. is considering the production of a new kitchen vent system. The Marketing Department has
determined that there would be demand for the product at or below a selling price of $150 per unit. Anticipated
unit costs are as follows:

Direct materials $26.00

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Direct labor costs

Manufacturing

Hours 2.2 hours

Hourly rate $12.00

Assembly

Hours 2.5 hours

Hourly rate $10.00

Machine hours 2 hours

Regal uses the following activity-based costs:

Materials handling 120% of direct material

Production $7.00 per machine hour

Shipping and handling $10 per unit

The company's desired profit is 25 percent over total production and shipping costs.

Required:

Calculate the target cost for this product and determine whether or not the new kitchen vent system should be
produced.

Solution - Regal Kitchens, Inc

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Step 1 Target Price = $150

Step 2 Target cost: $150 ÷ 1.25 = $120.00

Step 3 Estimating Actual Cost

Projected total cost per unit: $

Direct materials cost 26.00

Manufacturing labor (2.2 X $12.00) 26.40

Assembly labor (2.5 X $10.00) 25.00

Prime Costs 77.40

Overhead costs

Materials handling (1.2 X $26.00) 31.20

Production (2 machine hours X $7.00) 14.00

Shipping and handling 10.00

Projected total unit cost $132.60

Step 4 Compare target cost and ‘actual’ estimated cost; where applicable investigate ways of driving down
‘actual’ estimated cost to the target cost or below

Summary:

Target unit cost ($150 ÷ 1.25) $120.00

Projected unit cost 132.60

Difference above target (Target Gap) ($ 12.60)

The projected costs are above the target cost calculated to given a 25 percent profit and as such the vent system
should not be produced unless the entity can find ways of driving down the ‘actual’ estimated cost to the target
cost or below.

LIFE-CYCLE COSTING

Traditional costing methods are based on annual accounting period may give misleading results. Traditionally,
management accounting systems assesses products profits based on a periodic basis rather than based on the
entire life cycle.

The essence of life cycle costing is to accumulate the actual costs over the entire life cycle of the products,
calculate its total costs and its profitability. Reason is, more than 90% of a products costs are determined by
decisions made in the early stages of its life cycle. A product’s life cycle has the following stages:

Introduction:
His involves a high level of research and development, design as well as set up costs. This stage also involves
huge marketing expenses to launch he product initially.

Growth:
The growth stage involves high marketing and promotional costs which is normally recouped by a large sales
volume and a high selling price to recover these fixed costs.

Maturity:
During the third stage, the demand for the product reaches a steady state as numerous competitors enter the
market, hence, reducing supernormal profits. Nevertheless, economies of scale are still achieved as in the second
stage

Decline:
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During the final stage, sales volumes are at a decreasing rate and fixed costs per unit are increasing. To stay
competitive, entities, try to revitalize the product to increase is life span.

Example:
A company manufactures a part that has the following cost over its entire life cycle:

Costs in millions Year 1 Year 2 Year 3 Year 4

R & D costs 400

Design costs 100

Production costs 300 200

Production in units (‘000) 10 40

Required:
Determine the unit cost based on life-cycle costing
Unit cost: ($400m+$100M+$300m+$200m)/50,000 = $20,000

THROUGHPUT COSTING

The objective of throughput accounting is to make the best use of an entity’s resources after considering limiting
resources. Hence, rather than producing the products that have the highest contribution margin, products with the
highest throughput margin per bottleneck should be prioritized.

Throughput return = Selling price – direct material

Throughput accounting aims to maximize the entity’s profitability and simultaneously reducing operating expenses.
This is done by ascertaining the factors that gives rise to bottlenecks and maximizing the production of products given
those bottlenecks.
As s result, the method assumes the following:
1) Direct material cost is the only variable cost
2) Direct labour costs are not variable in the short term given that some employees are guaranteed a fixed basic
wage.
The method uses a throughput accounting ratio (TPAR) to ascertain whether the product should be prioritized. That is,
products which a TPAR greater than one (1) should be given priority, while, the converse should not be prioritized.

Calculating TPAR involves the following steps:

Example:
Lumbers Limited sells a product for $50 which incurs direct material cost per unit of $10. The direct labour hours are
very scarce. Two hours are required per unit and the factory has only 10,000 direct labour hours. The total operating
expense for the factor is $150,000 for the year.
Required: Calculate the TPAR

Solution:
Step one:
Return per factory hour = (Sp-material cost per unit)/scarce resource per unit = ( $50 - $10)/2 = $20
Step two:
Cost per factory hour = $150,000/10,000 hrs. = $15
Sep three:
TPAR : $20/$15 = 1.3333
How to improve the TPAR:
1) Increase selling price
2) Reduce direct material cost without affecting the product’s quality
3) Reduce factor operating expense (You should able to state specific ways of cost reduction)

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Throughput involving multiple products

Whether multiple products or single products throughput account has the same main objective, that is, maximizing
returns given scarce resources. However, the steps are a little different:
Step one:
Identify the scarce resource
Step two:
Calculate the return per factory hour
Step three:
Rank the products
Step four:
Allocate the scarce resources based on the ranking

LIMITING FACTORS

The objectives of limiting factor and throughput accounting are the same, however, when considering limiting
factors the approach depends on a single limiting factor or multiple limiting factor. When there is a single
limiting factor involving multiple products, the steps are the same as indicated above in throughput accounting
with multiple products. However, when there are more than one limiting factors, linear programming is to be
used to identify the optimal product mix.

Multiple limiting factors

As mentioned earlier multiple products involves the use of linear programming, the following are the steps.

Steps in linear programming:

Step one: Define the variables

Step two: Define and formulate the objectives

Step three: Formulate the constraints

Step four: Draw the graph and identify the feasible region

Step five: Determine the optimal production plan