Purpose of costing
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Inventory valuation
To record cost
To price product
Decision making
Fixed cost /period cost
A cost which is incurred for an accounting period, within certain output or turnover
limits, tend to be unaffected by fluctuation in the level of activity.
Stepped fixed cost
The cost is constant within the relevant range for each activity level but when a
critical level of activity is reached, the total cost incurred increases to the next step.
Variable cost
Cost that varies with a measure of activity.
Semi variable cost /semi fixed/hybrid/mixed cost
Cost containing both fixed and variable components and thus partly affected by a
change in the level of activity.
Absorption costing aim: Full production cost per unit
overhead absorption procedure
1. overhead allocation
2. overhead apportionment
3. overhead absorption
over or under absorption
{(budgeted overhead rate per unit x actual units) -actual overheads incurred}
Advantage
Include fixed production overhead in
inventory values
Analysis of under/over absorbed
overhead
Follows matching concept (accruals
concept)
Production overhead are absorbed into
product cost
All cost is variable in long term, ABC
costing
Disadvantage
The apportionment and absorption of
overhead cost is confusing
Profits vary with changes in production
volume
Marginal costing
Is a costing method which charges products with variable cost alone
Advantage
No requirement of apportionment and
absorption of overhead cost
In case of short-term decision-making
marginal costing is more relevant than
absorption costing
Disadvantage
Marginal costing is not useful for long``
term decision making
Doesn’t follow matching concept. (IAS)2
Key changes in a modern production environment
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2.
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5.
6.
7.
greater use of advanced manufacturing technology (MRP, ERP, JIT)
global environment
cost reduction
customer focus
flexible production systems
employee participation
shorter product life cycle quality
value analysis
A systematic interdisciplinary examination of factors affecting the cost of a product or
service, in order to devise means of achieving the specified purpose most
economically at the required standard of quality and reliability.
Purpose of value analysis is to identify any unnecessary costs elements within the
components of goods and services
Total quality management
the features of Total Quality Management
1. total: means that everyone in the value chain is involved in the process
2. quality: products and services must meet the customers’ requirements
3. management: quality is actively managed rather than controlled so that
problems are prevented from occurring
Three basic principles of TQM
1. get it right first time
2. continuous improvement
3. customer focus
TQM is often seen as being at odds with traditional standard costing methods
1)
2)
3)
4)
TQM expects continuous improvement rather than a standard performance
TQM expect everyone to take responsibility for failures in the system
TQM system do not accept waste as being acceptable
concerned with quality related cost rather than production cost
5) TQM often incorporates JIT inventory control so that material variance is less
likely
Quality related cost is the cost of ensuring and acquiring quality as well as the cost
incurred when quality is not achieved
Quality cost are classified as
prevention cost
Conformance cost
appraisal cost
internal failure cost
Non conformance cost
external failure cost
Just in time is a method of inventory control based on two principles
1) produced only when they are needed
2) delivered to the customer at the time the customer wants them
JIT means zero inventories
JIT is based on pull through system not push system
Types of waste
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6)
Overproduction
waiting time
unnecessary movement of materials or people
waste in the process
inventory
complexity in work process
Advantages
Less Cash tied up in inventory
Less storage space needed
better quality
more flexible production
fewer bottleneck
Better co-ordination
more reliable and supportive suppliers
Disadvantage
Reliance on predictable demand,
flexible supplier, flexible workforce
there will be initial setup cost
it is very difficult for businesses with the
wide geographical spread
there is no fallback position if
disruptions occur in the supply chain
it may be harder to switch suppliers
7) defective goods
8) inspection time
Requirements for the successful implementation of JIT production
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2)
3)
4)
high quality
speed
flexibility
lower cost
Material Requirement Planning can be defined as a computerized planning system
that first determine the quantity and timing of the finished goods demanded and then
uses this to determine the requirements for raw materials components and
subassembly at each of the prior stages of production.
Benefit of MRP
1) A significant benefit of MRP system is that new production schedule can be
prepared in a very short time
2) it should reduce inventory levels
The core data requirements for operating an MRP system are:
1) The master production Schedule
2) the bill of materials
3) the inventory files
Enterprise resource planning is a powerful computer system that Integrates
information from all parts of the organization.
Elements of ERP system
1) manufacturing
2) sales and distribution
3) accounting
4) human resources
Backflush accounting is the method of accounting that is typically used with jit
inventory control systems. Costs are not tracked sequentially to production but
instead calculated and charged when the product is sold.
Benefits
Disadvantages
Much fewer accounting entries
Materials used and WIP values are not
require
Getting rid of unnecessary costing
records
Suitable for JIT environment
Significance reduction in accounting
cost
Not appropriate if inventory is high
Not appropriate for long production
cycles
provides less detailed information
losses may be over valued
Throughput
Long term decision
Concept of product cost is rejected
No attempt is made to charge operating
expenses to products
Marginal
Short term decision making
Throughput Accounting is based on three concepts
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throughput (increase)
inventory(reduce)
Operating expenses(reduce)
Using throughput accounting the aim should be to maximize throughput, on the
assumption that operating expenses are a fixed amount in each period
Constraints of throughput accounting is called bottleneck
A bottleneck maybe a machine whose capacity limits the output of the whole
production process. the aim is to identify the bottleneck and remove them or if this is
not possible ensure that they are fully utilized at all times
5 steps to remove the constraints that restrict output which is known as theory of
constraints
step 1.
step 2.
step 3.
step 4.
step 5.
identify the systems bottleneck
decide how to exploit the bottleneck
subordinate everything else to the decision in step 2
alleviate the system's bottleneck
if in the previous steps a bottleneck has been broken go back to step 1
Constraints on Profit Throughput
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2.
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5.
inadequate trained Sales force
poor reputation for meeting delivery dates
poor physical distribution system
Unreliability of material supplies delivery or quality
inadequate production resources in appropriate Management Accounting
system which cannot provide sufficient information to decision making
ABC
An approach to the costing and monitoring of activities which involves tracing resource
consumption and costing final outputs. Resources are assigned to activities and
activities to cost objects based on consumption estimates. the latter utilize cost drivers
to attach activity cost outputs
Traditional methods of Costing (marginal and absorption) produce standard cost cards
that are less useful due to inaccurate product cost because
1. the largest cost of production is indirect overheads but these are categorized
together in one figure that lacks detail and not useful to measurement
2. because management does not know what the components are of the largest
production cost (indirect overhead), so they cannot implement proper cost
control
3. cost is often allocated between products on the basis of direct labor hours.
despite the fact that directly power is becoming a smaller proportion of product
cost and does not clearly reflect the relationship between the product and the
indirect overhead
4. because cost is in inappropriately or inaccurately shared between product it
means that the total production cost can be wrong which can lead to poor
pricing and production decisions
Activity based costing has been developed to solve all these problems which cannot
be solved by traditional costing
Activity based costing process
1. allocate production volume basis to cost pool
2. absorbing them into units using cost drivers
Cost pool is an activity that consumes resources and for which overhead cost are
identified and allocated. for each cost pool there should be a cost driver
cost driver is a unit of activity that consumes resources. cost driver is a factor
influencing the level of cost
Identifying activities
A useful approach to identifying a suitable activity within a business is to consider four
different categories of activity or transaction
1. Logistic transactions: Concerned with moving materials or people and track the
progress
2. balancing transactions: Concerned with ensuring that the resources required for
an operation are available
3. quality transactions: Concerned with ensuring that output or service levels meet
quality requirements and customer expectation
4. change transactions: change in accordance with customer demand
Identifying cost drivers
1. relevant
2. easy to measure
Cost driver
Setting up machinery
assembling the product
running machine
Cost of order processing
cost of dispatch
cost of purchasing
cost of quality control
number of setups
number of direct labor hours
machine hour
order received
weight of item dispatched
number of purchase order made
number of inspections carried out
When is ABC relevant?
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indirect costs are high relative to direct cost
product cost or services are complex
products or services are tailored to customer specification
some products or services are sold in large numbers but others are sold in
small numbers
The structure of reporting cost which is termed as hierarchy of cost has four levels of
activity
 unit level activities
 batch level activities
 product level activities
 facility level activities
if overhead is made up of unit level activities and facility level activities it is obvious
that the traditional approach and the ABC approach will lead to very similar product
cost
but if the overhead falls into batch level activities and product level activities there
will be a very significant difference between the two
Advantages
More accuracy
better cost understanding
fairer allocation of cost
Better cost control
can be used in complex situations
can be applied beyond production
can be used in service industries
Disadvantages
Not always relevant
still need arbitrary cost allocation
need to choose appropriate drivers and
activities
Complex
expensive to operate
Implications of switching to ABC
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pricing can be based on more realistic cost data
sales strategy can be more soundly based
decision making can be improved
performance management can be improved
Importance of environmental management
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organizations are faced with increasing legal and regulatory requirements
related to environmental management
need to meet customers’ needs and concerns relating to the environment
need to demonstrate effective and governmental management to maintain a
good public image
need to manage the risk and potential impact of environmental disasters
can make cost savings by improved use of resources
recognizing the importance of sustainable development which is the meeting
of current needs without compromising the ability of future generation to meet
their needs
The contribution of environmental management accounting
EMA is considered with the accounting information needs of managers in relation to
corporate activities that affect the environment as well as environment related
impacts on the cooperation
 identifying and estimating the cost of environment related activities
 identifying and separately monitoring the users and cost of resources
 ensuring environmental considerations from a part of capital investment
decisions
 assessing the likelihood and impact of environmental risk
 including environment related indicators as part of routine performance
monitoring
 benchmarking activities against environmental best practice
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improving revenue
cost reduction
increase in cost
 cost of failure
Effect on financial performance
environmental costs can be categorized as quality related cost by four cost
categories
 environmental prevention cost
 environmental appraisal cost
 environmental internal failure cost
 environment external failure cost
accounting for environmental cost
environmental cost is not traced to particular process or activities and are instead
“lumped in “with general business overheads or other activity cost.
environmental activity-based costing
In ABC environmental cost are removed from General overheads and traced to
products and services
Advantage
Better product cost
improved pricing
better environmental cost control
environmentally friendly measures
integrated environmental costing into the
strategic management process
reduces the potential for Cross
subsidization of environmentally damaging
products
Disadvantage
Time consuming
expensive to implement
determining a great cause and appropriate cost
drivers is difficult
external cost not experienced by the company may
still be ignored
some internal environmental costs are intangible and
ignored
companies that incorporate external cause voluntarily
may be at a competitive disadvantage to rivals who
do not do this
Risk (Quantifiable): there are a number of possible outcomes and the probability of
each outcome is known.
Uncertainty (unquantifiable): there are a number of possible outcomes but the
probability of each outcome is unknown.
There are three main types of decision maker
1. risk neutral: Maximize
2. risk seekers: Maximax
3. risk averse: minimax or maximin
utility theory: the basis of the theory is that an individual attitude to certain risk
profiles will depend on the amount of money involved.
Expected value
Advantage
Take account of Risk
easy decision rule
Simple
Disadvantage
ignores attitudes to risk
answer may not be possible
not useful for one off
Subjective
Working Capital Management is the management of all aspects of both current
assets and current liabilities, To minimize the risks of insolvency while maximizing
the return on assets
cost of working capital
1. Cost of funding it
2. The opportunity cost
The objectives of Working Capital Management: balancing between liquidity and
profitability
Working capital balancing act
Liquidity
Profitability
ensuring current asset liquid to minimize maximizing the return on capital
the risks of insolvency
employed hence minimizing investment
in working capital
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Mismanagement of working capital is a common cause of business failures
inability to meet deals as they fall due
demand on cash during periods of growth being too great (over trading)
Overstocking
Cash flow versus profit
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unprofitable companies can survive If they have liquidity profitable companies
can fail if they run out of cash to pay their liabilities
The financing decision
working capital financing decisions involved the determination of the mix of long
versus short term debt. the financing of working capital depends upon how current
and noncurrent assets funding is divided between long term and short-term sources
of funding. three possible policies exist
1. conservative: long-term financing. short term financing is only used for part
of the fluctuating current asset. least risky and lowest expected return.
2. Aggressive: short term financing. greatest risks of liquidity and the greatest
return
3. Moderate: Short term finance to the fluctuating current asset and the long-term
finance to the permanent part of asset.
The working capital cycle is the time span between incurring production cost and receiving
cash returns.
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Shortening the working capital cycle
reduce raw materials inventory holding
obtain more finance from suppliers by delaying payment
reduce work in progress by improving production techniques
reduce finished goods inventory
reduce credit given to the customers
debt factoring: generating immediate cash flow by the sale of receivables to a
third-party on immediate cash terms
Typical indicators of over Trading
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Rapid increase in turnover
Rapid increase in the volume of current assets
most of the increase in asset being financed by credit
dramatic drop in the liquidity ratios
Solutions to over trading
overtrading can be very serious problem if there is a possibility that the bank will
withdraw its overdraft facility
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raising more long-term capital in the form of new shares or loans
slowing down growth to reduce the increase in working capital requirements
until sufficient cash has been built up to finance it
Improving Working Capital Management, so that there is a reduction in the
inventory holding period or a reduction in the average time for customers to
pay