LECTURER: JUDITH ROBB-WALTERS

UNIT 9: MANAGEMENT ACCOUNTING:
COSTING AND BUDGETING
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LEARNING OBJECTIVE1: BE ABLE TO ANALYSE
COST INFORMATION WITHIN A BUSINESS

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1. Be able to analyse cost information within a business.
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2.Be able to propose methods to reduce costs and enhance value within a business.
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3. Be able to prepare forecasts and budgets for a business.
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4. Be able to monitor performance against budgets within a business.

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Be able to analyse cost information within a business
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At the end of the class the students should be able to:
1.3 Calculate costs using appropriate techniques

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To accumulate costs for their various uses, there is a need for systems that gather data, refine them and put them in the proper format. A variety of methods are available today for systematizing data.
In some industries, a specific system is almost mandatory; in others, several other methods are available to choose from.

Absorption costing
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Absorption costing technique is also termed as Traditional or Full Cost Method. Under this method, the cost of a product is determined, after considering both fixed and variable costs. The variable costs, such as direct materials, direct labour, etc. are, directly, charged to the products. The fixed costs are apportioned on a suitable basis over different products, manufactured during a period.

Absorption costing
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Under absorption costing, all costs, both variable and fixed, are charged to the products for cost determination.
Thus, in case of absorption costing, all costs are identified with the products manufactured.
Both Fixed costs and Variable costs are also treated as product costs. The cost unit is made to bear the burden of full cost, irrespective of the current level of operations.

Absorption costing
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Sales X
Less: Cost of Sales:
Opening Inventory X
Production Costs:
Variable costs X
Fixed overhead absorbed X
X
Less: closing inventory (x) x
Fixed overhead under/(over) absorbed x/(x)
(x)
GROSS PROFIT X
Less: Selling, administration etc. costs (non production) (x)
NET PROFIT x

Marginal Costing
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Marginal costing is the accounting system in which variable costs are charged to cost units and fixed costs of the period are written off in full against the aggregate contribution.
Note that variable costs are those which change as output changes - these are treated under marginal costing as costs of the product. Fixed costs, in this system, are treated as costs of the period.

Marginal Costing
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Marginal costing is also the principal costing technique used in decision making. The key reason for this is that the marginal costing approach allows management's attention to be focussed on the changes which result from the decision under consideration. The contribution concept
The contribution concept lies at the heart of marginal costing. Contribution can be calculated as follows.
Contribution = Sales price - Variable costs
The idea of profit is not a particularly useful one as it depends on how many units are sold. For this reason, the contribution concept is frequently employed by management accountants.

Marginal Costing
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- Contribution gives an idea of how much
'money' there is available to 'contribute' towards paying for the overheads of the organisation.
- At varying levels of output and sales, contribution per unit is constant.
- At varying levels of output and sales, profit per unit varies.
- Total contribution = Contribution per unit x Sales volume.
- Profit = Total contribution - Fixed overheads

MARGINAL cOSTING
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$ $
Sales x
Less: Variable cost of sales:
Opening inventory X
Production costs:
- Variable X
X
Less: closing inventory (x)
(x) x
Less: Variable selling, distribution and administrative costs (x)
Contribution X
Less fixed costs:
Production x
Selling and distribution x
Adminisatrion x
(x)
Net Profit X

Absorption overhead
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Overhead absorption rates are our attempt at coming up with the best ‘guess’ of how much overhead should be given to a product. In traditional costing systems, the rates are likely to be based on machine hours or labour hours.

Absorption overhead
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The process is a little more refined in activity based costing, but the intention is still the same: we are trying to find an equitable way of sharing out the overheads to products and are therefore looking for a method that relates the absorption base to the incidence of the overheads (establish a ‘causal link’).

Absorption overhead
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If a business is machine intensive, machine hours would be the most appropriate base as the overheads would be related to machine usage. But this is taking a very wide view: it would be better to break the business down into separate departments and choose individual rates for each department.

Absorption overhead
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In order for the business to move along and not wait a full year before it can sell its products we need to forecast the overheads and forecast the total hours to be used when making all of our products
(assuming a traditional system), in other words we work with budgeted figures when calculating the overhead absorption rates.

Absorption overhead
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The formula to use is:
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Overhead absorption rate =
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 budgeted overhead budgeted base

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Activity based costing refines this process and, instead of looking at the overheads of departments, it records the costs of similar activities together in cost pools and then absorbs these costs by using the activity that drives the cost as the absorption rate.

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The formula to use is:
Activity Based Costing =
Total Cost
Cost driver
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Stock valuation
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The difficulty in inventory valuation is in finding out the cost price of inventory – this is not easy when quantities of a particular inventory item are continually being bought in – often at different prices
– and then sold. Some companies have inventory in a number of different forms, eg a manufacturer may well have raw materials, work-in-progress and finished goods.

Stock valuation
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IAS 2, Inventories, allows companies to use one of two methods to calculate the cost price of their inventory:
FIFO (first in, first out)
In this method, the first (oldest) inventories acquired are assumed to be used first. This means that the inventory on hand at any time is assumed to consist of the most recently acquired items.

Stock valuation
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The LIFO method first matches against revenue the cost of the last goods purchased. If a periodic inventory is used, then it would be assumed that the cost of the total quantity sold or issued during the month would have come from the most recent purchases. The ending inventory would be priced by using the total units as a basis of computation and disregarding the exact dates of sales or issuances.

Stock valuation
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AVCO (average cost)
In this method, the weighted average cost of items held at the beginning of the year is calculated, using the formula: weighted average cost = total cost of goods in inventory number of items in inventor.
The weighted average cost is then used to value goods sold. A new weighted average cost must be calculated each time that further inventories are bought during the year.

Stock valuation
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CIMA, the UK’s Chartered Institute of
Management Accountants defines
standard costing as a “control technique that reports variances by comparing actual costs to pre-set standards so facilitating action through management by exception”.

Stock valuation
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It goes on to further set out that a
“standard cost is a carefully predetermined unit cost which is prepared for each cost unit. It contains details of the standard amount and price of each resource that will be utilised in providing the service or manufacturing the product”. Costs included within standards comprise direct material costs, direct labour costs together with indirect or overhead costs.

Cost plus pricing
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In an environment with little or no competition, a company may have to set its own price.
When a company sets price, the price is normally a function of product cost: costplus pricing.
Approach requires establishing a cost base and adding a markup to determine a target selling price.
Size of the markup (the ― plus ‖ ) depends on the desired return on investment for the product:

Cost plus pricing
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In determining the proper markup, a company must consider competitive and market conditions.
Cost-plus formula is expressed as:
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COST + (MARK UP X COST )= TARGET
SELLING PRICE

MARKET PRICING
 The current price at which an asset or service can be bought or sold. Economic theory contends that the market price converges at a point where the forces of supply and demand meet. Shocks to either the supply side and/or demand side can cause the market price for a good or service to be re-evaluated.

TARGET COSTING
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Target costing is very much a marketing approach to costing. The Chartered
Institute of Marketing defines marketing as:
‘The management process responsible for identifying, anticipating and satisfying customer requirements profitably.’

TARGET COSTING
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Target costing is primarily a technique to strategically manage a company’s future profits. It achieves this objective by determining the life-cycle cost at which a company must produce a proposed product with specified functionality and quality if the product is to be profitable at its anticipated selling price.

TARGET COSTING
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Target costing makes cost an input to the product development process, not an outcome of it. By estimating the anticipated selling price of a proposed product and by subtracting the desired profit margin, a company can establish its target cost. The key is then to design the product so that it satisfies customers and can be manufactured at its target cost.

REVIEW QUESTIONS
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TARGET COSTING GLOWS WITH THE “NEON”
In 1990 Chrysler Corporation found itself in a very unhappy financial situation. Profits were down, cash flow was tight, and the stock was trading at a low price of $10 per share. The Japanese auto industry posed a serious threat. Despite a strong Yen, they had captured and continued to preserve a healthy share of the U.S. auto market. Chrysler management decided it was time to change their approach to new car design.
They adopted a competitive weapon that the Japanese auto industry had used for many years called target costing. Target costing was applied to all product development efforts in the Company including the NEON, a new small car developed for the lower price range.

REVIEW QUESTIONS
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A price and profit target was set for the car and it was then designed to meet that profit without sacrificing major customer requirements. The results of using target costing on the NEON were impressive.
The NEON:
• Provided dual airbags and a powerful engine for a small car.
• Was named" Auto of the Year" in 1994.
• Had a relatively short development time going from product concept to market in 31 months.
• Came in below its project development and investment budget.
• Is one of a handful of small cars made in the USA that makes a positive return.
• Is environmentally friendly built using a recyclable facia and non-toxic materials.
Since the introduction of target costing, Chrysler's profits have increased significantly. Its share price went up from $10 per share in 1990 to $54 per share in 1995.

REVIEW QUESTIONS
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Assume that you worked for Chrysler in 1990 and were assigned to the development team for the Neon project. This project was developed under the target costing approach rather than the traditional cost-plus approach.
Answer the following questions regarding the development of the Neon car. Be creative, using your knowledge of cars in general, in answering the questions. You should provide car specific examples.
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Identify the seven steps in the establishment phase of target costing. Provide specific examples of activities undertaken for each of the seven steps.
Source:http://www.csus.edu/indiv/p/pforsichh/accountinginfo/
121/Ch12%20-20Target%20Costing/

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Available at: http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki
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[Accessed 8 Sep. 2015].
Joyce, John. MANAGEMENT ACCOUNTING – PERFORMANCE
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Osborne bookshop,. 'Inventory Valuation'. N.p., 2015. Web. 8 Sept. 2015.
Tilley, Charles. 'Standard Costing Insights From Leading Companies'.
cimaglobal.com/. N.p., 2015. Web. 8 Sept. 2015.
Harmon, Coby. 'Managerial Accounting'. 2015. Lecture.
Investopedia,. 'Market Price Definition | Investopedia'. N.p., 2007. Web. 8
Sept. 2015.

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Garrett, Ken. 'TARGET COSTING AND LIFE CYLCE COSTING'. N.p.,
2015. Web. 8 Sept. 2015.
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MIT Sloan Management Review,. 'Develop Profitable New Products With
Target Costing'. N.p., 1999. Web. 8 Sept. 2015.