Chapter 2 - Alternative Costing Methods PDF

Chapter Two Alternative Costing methods Course Name : Management Accounting - I Course Code BA AC2208 Specialization : Accounting And Finance College of Economics and Business Administration Outcome 2 :Explain and differentiate the various alternative costing methods...

Chapter Two Alternative Costing methods Course Name : Management Accounting - I Course Code BA AC2208 Specialization : Accounting And Finance College of Economics and Business Administration Outcome 2 :Explain and differentiate the various alternative costing methods CONTENTS  Activity Based Costing  Life Cycle Costing  Target Costing Activity Based Costing Essential Reading : M.N. Arora, Cost and Management Accounting – Theory, Problems and Solutions , Himalaya Publishing House https://ebookcentral.proquest.com/lib/momp/reader.action?docID=588 039&ppg=720 Suggested Reading : P. Periasamy, Textbook of Financial Cost and Management Accounting , Global Media https://ebookcentral.proquest.com/lib/momp/reader.action?docID=301 Introduction  The direct costs (direct materials, direct labor) are chargeable to the end products without difficulty and are thus convenient to handle.  It is the indirect costs (overhead) require allocation and apportionment.  In order to determine the total cost of an end product, under the traditional approach, the indirect costs are allocated and apportioned.  Activity based costing is a more refined approach for charging indirect costs to Image (URL) https://www.urgenthomework.com/project-management-homework-help/activity-based-costing products and computing more accurate Traditional Approach Apportionment of Traditionally, indirect costs are distributed to Overheads to production & end products on the assumption that service departments products consume resources in proportion to the production volumes. Reapportionment of service The main steps in this approach are: department’s overheads to First, allocation and apportionment of production departments overhead to various production departments and service departments. Absorption of production Second, reapportionment of service departments overhead by departments' overhead to production end products departments. Basis of absorption : Third, absorption of production departments' Machine hours, labor hours overhead by the end products. or wages In this traditional approach, overhead are absorbed on the basis of machine hours or  Traditional Approach – Problem of Under-Costing and Overcosting  Traditional costing uses an average overhead rate for all activities (like labour hour rate or machine hour rate) to allocate costs to cost objects i.e., products or services.  Cost smoothing leads to under-costing of certain products and over-costing of other products.  Where one product is under-costed, it results in other product being over-costed because total amount of overhead remain unchanged. This is known as product cost cross-subsidisation.  Activity Based Costing  Developed by Cooper and Kalpan (1988)  "ABC systems calculate the costs of individual activities and assign costs to cost objects such as product and services on the basis of activities undertaken to produce each product or service."  Overheads are assigned to activities or grouped into cost pools before they are charged to cost objects, i.e., jobs or products.  Def: "cost attribution to cost units on the basis of benefits received from indirect activities. i.e. ordering. setting up. Assuring quality. etc.“ C.I.M.A., London  Terms used in ABC Activity: An activity may be defined as a particular task or unit of work with a specific purpose. Ex: placing of a purchase order, setting up of a machine, after sales service Cost object: It is an item for which cost measurement is required. Ex: a product. a service, a job or a customer Cost driver: It is a factor that causes a change in the cost of an activity. It can be Image (URL): https://www.myabcm.com/blog-post/act 1. Resource cost driver and, ivity-based-costing-abc-methodology/ 2. Activity cost driver Terms used in ABC Resource cost driver:  It is a measure of the quantity of resource consumed by an activity.  Ex: number of purchase orders placed will determine the cost of purchasing the materials.  The number of times machines are set up will determine the cost of setting up of machines.  Resource cost driver is used to assign the cost of a resource to an activity or cost pool. Terms used in ABC Activity cost driver:  It is a measure of the frequency and intensity of demand placed on the activities by cost objects.  It is used for assigning activity costs to cost objects consuming the activity. Review Questions 1. Activity based costing is considered to be a traditional costing method. ◦ True ◦ False 2. Under ABC, indirect manufacturing costs are predominantly assigned based on direct machine hours. ◦True ◦False 3. In ABC the assumption is that __________ use resources or cause costs. ◦ Activities ◦ Products  1. Identification of the main activities: Steps in ABC  Identify the major activities  The number of activities in an organization Split Overheads to activities (cost pools) should neither be too large or too small.  Total cost involved in the activity should be significant enough to justify to give an activity a separate treatment. Identify what causes cost for each activity (cost 2. Creation of cost pool: driver)  Cost pool is grouping of individual cost items. Calculate cost per unit of  A cost pool or cost bucket should be created cost driver (cost pool/total for each activity. number of cost driver)  Cost pool is like a cost centre around which costs are accumulated. Allocate costs to the product based on how  Ex: the total cost of machine set ups might much the product uses of the cost driver. constitute one cost pool for all set up related Steps in ABC 3. Determination of the activity cost drivers: The factors that influence the cost of a activity is known as cost driver. In other words, cost drivers signify the factors or events that determine the cost of activity. Example of cost drivers are number of machine set ups, number of purchase orders, etc. 4. Calculation of the activity cost driver rate: Just as an overhead absorption rate is calculated in traditional costing system, in ABC a cost driver rate is calculated as follows:  Steps in ABC 5. Charging the costs of activities to products: The costs of activities are traced to products on the basis of demand by products. The cost drivers are used to measure product demand of activities. For example, the total cost allocated to cost centre for machine set up related costs is RO 50,000 and that there were 100 set ups during the period. Thus the rate per set up is RO 50,000 / 100 = RO. 500. If a particular product needs 10 set ups, charge to that product will be RO 500 x 10 = RO5,000. http://www.bepsuor.com/FunctionalAreas/Financials Summary Traditional Methods Activity Based Costing Overheads are allocated 1) Identify the activity based on 2) Creating the cost pool a)Direct labor hours 3) Determine the activity cost b) Direct labor hours driver 4) Calculation of the activity cost driver rate 5) Charging the cost of activities to products Summary Activity Based Suppose we want to allocate Procurement expenses Costing 1) Identify the activity 2) Creating the cost pool 1. The activity is “Purchase Order” placed 3) Determine the activity cost driver 2. Accumulate all the costs to this activity. 4) Calculation of the activity cost driver rate 3. Activity Cost Driver: The number of 5) Charging the cost of orders placed. activities to products 3. Activity Cost Driver Rate : Total Overhead/Number of orders placed 5. Allocate overhead based on Activity cost driver rate.  Selecting appropriate cost drivers Functional Areas Activities Suitable Cost Drivers Material Management Issue of purchase orders No of Purchase orders Inspection of materials No of purchase orders Stores Management Storing of materials Value of materials stored Servicing of requisitions No of requisitions Inspection and verification No of times inspected Stock taking Value of stock Quality Control Testing of samples No of batches produced Personnel Management Recruitment of employees No of employees recruited Maintenance of leave records and No of employees attendance Marketing Demand creation Increase in sales Advertising Increase in sales Dispatches No of orders Research and Development Research No of research projects Machining Set up cost No of production runs Power cost Machine hours Question 1 Y Company has G1 G2 Overhead Assigned decided to produce Direct labor hours 50,000 100,000 two types of Sewing machine 1,000 1,000 RO200,0 garments.They are hours 00 deciding whether to Machine set up 100 400 RO100,0 use job-order costing hours Requirement 00 or activity based 1. Calculated pre-determined overhead rate if costing. Based on next overhead is applied based on the direct labor year’s budget, two hours cost pools have been 2. Compute overhead rates using activity developed with the based costing. following information: 3. Determine the difference in the amount of overhead allocated to each product between  Answer 1. Pre – determined over head rate based on direct labor hours = (200,000+100,000)/(50,000+100,000) = 300,000/150,000 = RO2 2. Overhead rate using Activity Based Costing Activities Overhead cost Cost Driver Activity Cost Driver Rate Sewing RO200,000 1000+1000 RO100 per machine hours Sewing machine hours Machine set up RO100,000 100+400 RO200 per hours machine set up hours Overhead calculated using traditional method Direct labor Activity Rate Overhead hour assigned Games 50,000 RO2.000 RO100,000 Calculators 100,000 RO2.000 RO200,000 Overhead calculated using traditional method G1 G2 Activity Usage Activity Overhead Activity Usage Activity Overhead Rate Assigned Rate Assigned Sewing machine hours RO100 RO100,000 Sewing machine hours RO100 RO100,000 1,000 1,000 Machine set up hours 100 RO200 RO20,000 Machine set up hours RO200 RO80,000 400 RO120,000 RO180,000 Test yourself ABC Company is A B C producing three Direct labor hours 10,000 15,000 25,000 Number of orders 15 25 10 products, A, B and C in placed their unit. Machine set up 150 300 50 hours During the year 2019,the total Requirement overhead expenses 1. Calculated pre-determined overhead rate if are; overhead is applied based on the direct labor hours Procurement cost 2. Compute overhead rates using activity RO200,000 based costing. Machine set up cost 3. Determine the difference in the amount of RO100,000 overhead allocated to each product between Problem Solving activity: Class Activity 1: A company manufacturing two products furnishers the following data for a year: Product Annual Total Total number Total Output (units) machine of purchase number of hours orders set ups A 750 1200 85 15 B 450 800 115 10 1200 2000 200 25 The annual overheads are as under: Volume related activity costs OMR 55000 Set up related costs OMR 120000 Purchase related costs OMR 85000 Total OMR 260000 You are required to calculate the cost per unit of each product A and B based on: a. Traditional method of charging overheads b. Activity based costing method  1. Accurate and reliable : ABC is a more accurate and reliable system of ascertaining product costs as it is based on cause and effect relationship in cost incurrence. 2. Better pricing decision : It overcomes the problem of under costing and over- costing as a result of which management is Advantage able to make more judicious selling price s of ABC decisions based on accurate costs. 3. Realistic approach : Distribution of overhead based on activities is an objective and realistic approach. As against this, traditional method of overhead costing uses more arbitrary bases of apportionment of overhead and is a subjective approach.  4. Control of costs : ABC produces more meaningful information regarding cost behaviour and enables management to control many fixed overhead by exercising more control over those activities which cause these fixed overhead. Advantage 5. Greater cost efficiency : ABC helps to identify those activities which are s of ABC unnecessary and may be weeded out and thus achieving greater cost efficiency. 6. Useful cost driver rates : ABC helps, through its cost driver rates, in the modification of existing products and also in the development of new products. Life Cycle Costing Essential Reading : Roger Hussey , and Audra Wei Ming Ong, Strategic Cost Analysis , Business Expert Press https://ebookcentral.proquest.com/lib/momp/reader.action?docID=876 652&ppg=140 Introduction Companies are increasingly concerned with the life cycle cost when they either purchase an item or manufacture it. Ex: Implementation of a new computerized system, there is not only the initial cost of purchasing it. There will be;  Training costs of staff to operate the system  Costs of the supplier for maintenance, breakdowns, and upgrades.  Costs of the disruption caused during implementation  Other costs associated with running the old Life Cycle Costing Life cycle costing tracks and accumulates costs and revenues attributable to each product over the entire product life cycle. Categories of Life Cycle Costs 1. Research and Development Cost 2. Production and Construction Cost 3. Operation and Maintenance Support Cost 4. Retirement and Disposal Cost  Case Study A company is planning a new product. Market research information suggests that the product should sell 10,000 units at $21.00/unit. The company seeks to make a mark-up of 40% product cost. It is estimated that the lifetime costs of Life the product will be as follows: Cycle 1. Design and development costs $50,000 Costin 2. Manufacturing costs $10/unit g 3. End of life costs $20,000 The company estimates that if it were to spend an additional £15,000 on design, manufacturing costs/unit could be reduced. Source: https://www.accaglobal.com/sg/en/student/exa What is the original lifecycle cost per unit and is the product m-support-resources/fundamentals-exams- worth making on that basis? study-resources/f5/technical-articles/target- lifestyle.html Answer The original life cycle cost per unit ◦Design and Development Costs 50,000 ◦Manufacturing Cost (10,000 x10) 100,000 ◦End of life costs 20,000 ◦Total Cost 170,000 ◦Cost Per unit (170,000/10,000) 17 Conclusion : This cost/unit is above the target cost per unit, so the product is not worth making. Benefits of Life Cycle Costing  It is future oriented, and it compels managers to examine the long- term financial implications of the strategic decisions they are making.  It also encourages managers to examine and question the costs incurred at every significant stage in the life of the product.  The purposes for which organizations could choose to use life- cycle costing are the acquisition of a system or project on long- term budgets and operating results and the comparison among competing suppliers of products and services. Repair costs, maintenance, and warranties are all other concerns that encourage management to look at the life- cycle costing. Essential Reading : Roger Hussey , and Audra Wei Ming Ong, Strategic Cost Analysis , Business Expert Press https://ebookcentral.proquest.com/lib/momp/reader.action?docID=876 652&ppg=140 Target Costing Target costing was developed by Toyota in Japan during the 1960s. This technique ensures that the product is introduced to the market with a specific functionality, quality, and selling price. It is also planned that the product can be produced at a life- cycle cost that generates an acceptable level of profitability. Target costing involves the establishment of target costs for each product and each product- related activity, starting with the design of the product and culminating with the sale of the product.  Target costing is a reversal of the cost- plus model, and we start with the market price. The organization uses market research information to determine the price customers are willing to pay given the product’s functionality and quality and the alternatives Calculation provided by competitors. We then deduct the of Target profit we wish to make, and the balance is the Cost target cost we must achieve to be successful. The target cost is the maximum cost that is allowable in the production, distribution, and disposal of the product: Target cost = Target Selling Price – Target Profit. Example Cost Mark Up Selling If a company Price normally expects a mark-up on cost of 100% 50% 150% 50% and estimates $8 $4 $12 that a new product will sell successfully at a price of $12, then the maximum cost of production should be $8:  1. Calculate the target cost that satisfies the market price and the organization’s target profit. 2. Evaluate the types of actions that may be implemented in different departments or areas to bring actual Process of costs in line with the target. Target 3. Assess whether the reduction in costs in one area may lead to a consequential Costing increase in costs in other areas. 4. Set targets for each area in discussion with managers. 5. Monitor the cost reductions to ensure that the actions implemented produce the required results. Target cost Gap The target cost gap is the estimated cost less the target cost. The various ways to close the gap are the following: -Reducing the number of components -Using standard components wherever possible -Training staff in more efficient techniques -Using different materials -Using cheaper staff -Acquiring new, more efficient technology -Cutting out non-value-added activities (identified using activity analysis etc) Even if the product can be produced within the target cost the story does not end there. Target costing can be applied throughout the entire life. This means that cost savings must be actively sought and made continuously over the life of the product. Practice Problem 1 A Company wants to calculate a target cost for a new product, the price of which will be set at RO 200. The company requires an 8% profit margin on sales. Solution : Target Profit = 200*8/100 = 16 Target Cost = 200-16 = 184 Practice Problem 2 A Company wants to introduce new mobile phone into the market. The estimated price of each mobile phone is RO 800. The company requires a profit margin of 15% on sales. Calculate a target cost for the new mobile phone. Practice Problem 3 A Company wants to introduce new product. The estimated price of each mobile phone is RO 60. The company requires a profit margin of 20% on sales. The estimated cost of manufacturing the product is : Material cost : RO 9.500 Labour Cost : RO 12.750 Other Direct Expenses : RO 7.500 Administrative Costs : RO 5.000 Marketing and Selling expenses : RO 15.000 Calculate the Target Cost of the product and the Target Cost Gap. References: https://management.web.uniroma1.it/sites/default/files/ABC_EXwSOL_0.pdf https://ebookcentral.proquest.com/lib/momp/reader.action?docID=876652&p pg=140 https://ebookcentral.proquest.com/lib/momp/reader.action?docID=588039&p pg=720 Thank you