F5-02 Developments in Management Accounting

Session 2
Developments in
Management Accounting
FOCUS
This session covers the following content from the ACCA Study Guide.
A. Specialist Cost and Management Accounting

Techniques
2. Target costing
a) Deriveatargetcostinmanufacturingandserviceindustries.
b) Explainthedifficultiesofusingtargetcostinginserviceindustries.
c) suggesthowatargetcostgapmightbeclosed.
3. Life-cycle costing
a) Identifythecostsinvolvedatdifferentstagesofthelifecycle.
b) Derivealifecyclecostinmanufacturingandserviceindustries.
c) Identifythebenefitsoflifecyclecosting.
4. Throughput accounting
a) Discussandapplythetheoryofconstraints.
b) Calculateandinterpretathroughputaccountingratio(TPAr).
c) suggesthowaTPArcouldbeimproved.
d) Applythroughputaccountingtoamulti-productdecision-makingproblem.
5. Environmental accounting
a) Discusstheissuesbusinessesfaceinthemanagementofenvironmental
costs.
b) Describethedifferentmethodsabusinessmayusetoaccountforits
environmental costs.
Session 2 Guidance
Know the four new management accounting techniques this session introduces; understand
the reasons for these techniques and be able to do the calculations. All of the areas are highly
examinable.
Read the following articles to strengthen your understanding of this contentit is highly
examinable. These articles and all other technical articles relating to this paper are available on the
ACCA website: www.accaglobal.com.
"EnvironmentalManagement Accounting"(Dec2011)
"ThroughputAccountingandtheTheoryofConstraints"parts1and2(Oct,Nov2011)
"TargetCostingandLifecycleCosting"(Feb2010)
Understand the rational behind target costing and be able to discuss ways that businesses can reduce
thecostofmakingproductsandservices(s.2).
(continued on next page)
F5 Performance Management Becker Professional Education | ACCA Study System
Ali Niaz - ali.niaz777@gmail.com

VISUAL OVERVIEW
Objective: Toexplaintheuseofspecialistmanagementaccountingtechniques.
DEVELOPMENTS IN
MANAGEMENT ACCOUNTING
Traditional Management
Accounting
BusinessEnvironment
Changes
GrowthofservicesIndustries
responseofCompanies
responseofManagement
Accountants
TARGET COSTING LIFE-CYCLE THROUGHPUT ENVIRONMENTAL

COSTING ACCOUNTING MANAGEMENT
Aim and Use ACCOUNTING
Steps ProductLife Theory of
Cycle Constraints Introduction
Service
CostsInvolved Throughput Importance
Industries
Benefits Contribution EMA
Narrowingthe
Cost Gap Service Throughput Environmental
Industries Accountingratio Costs
EMATechniques
Session 2 Guidance
Understand the meaning of life-cycle costing and be able to calculate a life-cyclecost(s.3and

Illustration 3).
Appreciate the problemofbottlenecks,andtheimportanceofmaximisingthroughputper
bottleneckhour(s.4)
Know how tocalculatethethroughputaccountingratio(s.4).
Appreciate the importance of environmental issues and how environmental management
accounting can provide information to management.
2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved. 2-1

Session 2 Developments in Management Accounting F5 Performance Management
1 Developments in Management Accounting

1.1 Traditional Management Accounting
Traditionalmanagementaccountingwasinwardlooking,focusing
on controlling costs. The most important of these are:*
< costingsystems(marginalandabsorptioncosting);
< budgeting systems; *You should already
< standard costing and variance analysis; and be familiar with many
of the techniques
< working capital management. used in traditional
management
1.2 Business Environment Changes accounting from earlier
papers.
Duringthe1950sand1960s,theWesternindustrialisednations
enjoyed strong positions in international markets. There was little
competitioneitheronpriceorquality.Businessescouldcontinue
to be successful by just continuing to do what they had always
done.Duringthe1970s,however,thisstablebusinessworld
began to disappear:
< Less protection in home markets and increased globalisation
led to increased competition from newly emerging
industrialisednations(particularlyJapan).
< Introductionofcomputerisedmanufacturingsystemsledto
the opportunity to reduce manufacturing costs while increasing
the quality of products.
< Products'lifecyclesbegantofallsotherewasincreased
demand for new products from consumers.
< The growth of service industries.
< Businesscombinationsresultedinlargermultinational
organisations with diverse operations.
< Change in the structure of business with more decentralised
decision-making.
1.3 Growth of Services Industries

Many of the traditional management accounting practices were
aimedatmanufacturingbusinesses.Inrecentdecades,however,
many"post-industrial"economieshavedevelopedthatinclude
a significant proportion of service industries. Service industries
can be distinguished from manufacturing by the following Several performance
characteristics: measures can be
< Intangibility:Tangibleproductshaveaphysicalpresence, established for
monitoring.
and customers can point to the specific features of a product
and indicate the physical characteristics of it that they
value.Aservice,ontheotherhand,doesnothavephysical
characteristics,andthismakesitmoredifficulttoidentify
what aspects of the service customers value.
< Heterogeneity: The standard of services will vary from
servicetoservice.Forexample,hairdressersinasalonwill *This characteristic
usuallyhavedifferenttalents,andeachhaircutandstyling makes it more
difficult to ensure
that is performed will be different.*
that all services are
< Simultaneity: The service is consumed at the same time as it of a consistently high
isperformed,sothereisusuallymoreemphasisongettingit standard.
rightthefirsttime,astheremaybenosecondchances.
2-2 2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved.

F5 Performance Management Session 2 Developments in Management Accounting
< Perishability:servicescannotbestored.Businesses
therefore need to strike a careful balance between the need
for sufficient resources to meet demand at peak times and the
need for efficiency.
< Non-transferability of ownership:Oftenthereisno
transferofownershipwhenaserviceisprovided.For
example,ahotelguesthasonlyarightofaccesstohishotel
room and guest facilities during the period of his stay.
1.4 Response of Companies

Two developments in the commercial world are worth specific
mention:
1. Total Quality Management*
2.Just-in-Timemanufacturing
1.4.1 Total Quality Management (TQM)

*TQM is a philosophy
of getting it right
thefirsttime.Itis
recognised that the
costs of bad quality
mayexceedthecosts
Total Quality Managementconsists of continuous improvement of good quality.
inactivitiesinvolvingeveryoneintheorganisation,managersand
workers,inatotallyintegratedefforttowardsimprovingperformance
at every level.
ThetraditionalWesternapproachtomanufacturingwasto
producetomaximumcapacity.Productionwasdrivenbyinternal
plansratherthanexternaldemand.Thisledtoavarietyof
weaknesses:
Excessiveholdingofinventorywiththeassociatedcostsof
storage and obsolescence.
Delaysbetweenthecustomerorderingproductsandthe
delivery of the products.
Bottlenecksintheproductionprocesswerenothighlighted.
Alackofflexibilityinmeetingchangesincustomer
requirements.
1.4.2 JIT Manufacturing

A just-in-time (JIT) production system is driven by the
demand for finished products so each component on a production
lineisonlyproducedwhenneededforthenextstage.
< A"pullthroughphilosophy"customerdemanddrives
production.
< requirescarefulplanningofdemandandproduction
requirements.
JIT purchasing means the receipt of materials close to when
theyareusedsothatrawmaterialstockisreducedtonear-zero
levels.
< Achieved by having a series of small production units to which
stock is delivered.
< Afewdedicatedsuppliersdeliverdefect-freecomponentson
time two or three times a day.

1.5 Response of Management Accountants

Inresponsetothechangingbusinessenvironment,severalnew
management accounting techniques evolved. The techniques
includedinthesyllabusforpaperF5are:
< Activity-BasedCosting(seeSession 1)
< Target Costing
< Life-CycleCosting
< Throughput Accounting
< EnvironmentalAccounting.
2 Target Costing
2.1 Aim and Use

< Intraditional cost pluspricingmodels,thecostofaproduct
is the starting point for calculating price. Having determined
theunitcostofaproduct,aprofitmarginisthenaddedto
calculatetheprice.Inacompetitiveworld,suchanapproach
may not be realistic. The price calculated in this way may be
too high for the market to accept.
< Inacompetitive market, the price of a product may be
determined by the market. Companies therefore have to
accept the market price.
< Target costing is an attempt to achieve an acceptable
margin in a situation where the price of a product is
determinedexternallybythemarket.Thisacceptable
margin is achieved by identifying ways to reduce the costs of
producing the product.*
*Traditionally,thecostofproducingaproductorservicewas
something companies assumed was a variable over which they
hadlittlecontrol.Morerecently,Japanesecompaniesinparticular
showedthatnomatterhowefficientoperationsare,therearealways
ways to identify further cost savings. This philosophy underlies
target costing.
< Target costing may be used:

= duringthedesignphaseofaproduct(wherecostsavings
canbeidentifiedbychangingthedesignoftheproduct);
= forexistingproducts(wherecostsavingscanbeachieved
withoutchangingthedesignoftheproduct).

2.2 Steps in Target Costing

1.Determinethepricethemarketwillacceptfortheproduct,
based on market research. This may take into account the
market share required.
2.Deductarequiredprofitmarginfromthispricethisgivesthe
target cost.
3.Estimatetheactualcostoftheproduct.Ifitisanewproduct,
this will be an estimate.
4.Identifywaystonarrowthegapbetweentheactualcostofthe
product and the target cost.
Target costing can be illustrated by the following flow diagram:
Source:sakurai,M.,JournalofCostManagementfortheManufacturingIndustries,Target
Costing and How to Use It,iiiNo.2(1989).
Example 1 Target Costing
ExclusiveMotorsisdesigninganewversionofitsluxurycar,the
Z123series.Thecarwillbelaunchednextyear.Itisexpectedto
havealifecycleof10years.
Theproductionofthecarwillrequireaninvestmentof$3billion.
Thecompanyrequiresaprofitof20%ayearonthisinvestment.
The marketing department believes that the car could be sold for a
priceof$40,000each.100,000carswouldbemanufacturedand
sold each year.
Required:
Calculate the target cost of one Z123.
Solution
$m
Expectedrevenue
requiredprofit
Total target cost
Target cost per car

2.3 Application to Service Industries

Target costing is likely to be most appropriate in manufacturing
industries,whereavolumeofstandardproductsistobemade.
Target costing is likely to be more difficult in service industries
because:
Inmanyserviceindustries,the"products"arenon-standard
andcustomised.Itisdifficulttodefineatargetcostwhen
there is no standard product.
A higher portion of costs in service industries are indirect
(overheads).Itisthereforehardertoreducetheseona
product-by-productbasis.
reducingcostsinaserviceindustrymaybeattheexpenseof
customerserviceorquality.Inmanufacturingindustries,it
may be possible to identify cost savings that remove parts of a
product that are not valued by a customer anyway.
Illustration 1 Target Costing

for Services
Gates&JobsCoisataxadvisorybusiness.Thereisalotof
competitionfortaxservicesinthemarketwhereGates&Jobsis
located,andonecompetitorhasrecentlystartedtoadvertisethatit
willdotaxreturnsforaflatrateof$100areturn.
Gates&JobsCohasdecidedtomatchthispriceforabasictax
return,providedthattheclientdoesnothaveanycapitalgainstax
topay.Gates&Jobscurrentlyaimstomakeaprofitof20%ofall
fees charged to clients.
Thetargetcostofthetaxreturnistherefore:
$
Standard fee 100
Less:requiredmargin 20
Target cost 80
Basedonobservationanddiscussionswiththemanagement
accountant,theactualcostofa"typical"taxreturnisasfollows:
Directcosts
Timeofsenioradviser(1hourat$15perhour) 15
Timeofpartnerreview(15minutesat$100perhour) 25
Total direct costs 40
Overheadsapportionedat150%oflabourtime 60
Actual cost 100
Thereis,therefore,acostgapof$20.Althoughitcanbeargued
thatthepriceofthetaxreturnof$100doescoveralldirectcosts,
andthereforeincreasescontribution,thepartnersarekeenthatall
services should contribute to the overheads of the business at the
rateof150%.

Illustration 2 Cost Gap Reduction
FollowingonfromIllustration 1, methods which might be used to

reduce the cost gap include:
< reducethetimetakenbythesenior(e.g.usingasoftware
package).
< reducepartnertime(e.g.thepartnermightnotreviewreally
basicreturnsatall).
< reducetheoverheadsofthebusiness(e.g.byusingactivity-
based costing methods to identify more accurately the drivers of
overheads)andfindingwaystoeconomise.
2.4 Narrowing the Target Cost Gap

Targetcostingreliesonmulti-disciplinaryteams,whichdiscuss
waystoreducethegapbetweentheactual(expected)costand
the target cost.
Some methods which have been used successfully in practice are:
reconsiderthedesigntoeliminatenon-valueaddedelements.
reducethenumberofcomponentsorstandardise
components.
Uselessexpensivematerials.
Employalowergradeofstaffonproduction.
Investinnewtechnology.
Outsourceelementsoftheproductionorsupportactivities.
reducemanninglevelsorredesigningtheworkflow.
Such methods may be assisted by the following techniques:
< "Tear down analysis"(alsocalled"reverse
engineering")thisinvolvesexaminingacompetitor's
product to identify possible improvements or cost reductions.
< Value engineeringinvolvesinvestigatingthefactorswhich
affect the cost of a product or service. The aim is to improve
the design of a product so the same functions can be provided
foralowercost,ortoeliminatefunctionswhichthecustomer
does not value but which increase costs.
< Functional analysisinvolvesidentifyingtheattributes/
functions of a product which customers value. The
determination of a price the customer is prepared to pay
foreachofthesefunctionsisthenperformed.Ifthecostof
providingthefunctionexceedsthevalue,thenthefunctionis
dropped.
Increasingthesalespriceisnot a viable method of reducing the
gap.
< The whole purpose of target costing is to achieve a reasonable
margin when the price is determined competitively by the
market.
< Charging a higher price would lead to a big fall in demand for
the product.

3 Life-Cycle Costing
3.1 Product Life Cycle

The product life cycle describes how demand conditions for a
product,abrandandwholemarketschangewithtime.
Sales
(4) Maturity
(5)
(3) Decline
Growth
Profit
Introduction
(2) Cash flow
Development
(1)
Time
1. Development stage (planning and design stage)during

thisstagetheproductisdesignedanddeveloped.Prototypes
may be produced. Manufacturing processes will also be
designed,includinganyspecialmachineryrequiredtomake
theproduct.Atthisstage,cashflowwillbenegative,asthere
is no revenue.
2. Introduction phase/launchSpecial pricing strategies may
be used during the launch of a new product such as market
skimming or market penetration. Companies also need to
consider that the pricing strategy used at the introductory
stagemayaffectdemandinlateryears.Forexample,setting
a low price initially may discourage competitors from entering
the market. This will allow the company to enjoy higher
demand later in the product life cycle.
3. GrowthCompetition may rise due to new suppliers entering
the market. This may force lower prices.
4. MaturityMostprofitsaremadeduringthisphase.Prices
maybestable.Thecompany'spricestrategyduringthisphase
ismorelikelytofocusonmaximisingshort-termprofits,unlike
in the introduction phase.
5. DeclinePricesmayfallwithdemand,unlessanichemarket
can be found.
Life-cycle costinga system which tracks and accumulates

the actual costs and revenues attributable to each product from
development through to abandonment.

< Inthemodernmanufacturingenvironmentahighproportion
ofaproduct'scostswillbeincurredattheearlystagesin
itslifecycle(e.g.development,designandset-upcosts).
revenuesonlyarise,however,whentheproductisactually
being manufactured and sold.
< Traditional financial and management accounting systems
focus only on costs and revenues incurred during the
manufacturingstageoftheproduct'slife.Theytherefore
ignore:
= costs incurred in developing and designing the product; and
= any abandonment and disposal costs at the end of the
product'slife.
< Life-cyclecostingestimatesandaccumulatescostsovera
product'sentirelifecycletodeterminewhethertheprofits
earned during the manufacturing stage will cover the costs
incurredpre-andpost-manufacturing.
< Ittracesdevelopment,designandset-upcoststoindividual
products over their entire life cycles.
Illustration 3 Life-Cycle Costing
Zanydevelopedanewcomputergameduringtheyear20X2ata
costof$200,000.Thegamewillbelaunchedintheyear20X3.
Budgetedrevenuesandcostsofthegameoveritslifecycle(life-
cyclecosting)arepresentedbelow:
20X2 20X3 20X4 20X5
$000 $000 $000 $000
sales(units) 0 16,000 34,000 12,000
revenue 0 160 340 120
Variablecosts 0 30 65 20
Contribution 0 130 275 100
Marketing costs 40 30 0 0
Developmentcosts 200 0 0 0
Annual profit (240) 100 275 100
Cumulative profit (240) (140) 135 235
Life-cyclecostperunit: $000
Total variable costs 115(30+65+20)
Marketing costs 70(40+30)
Developmentcosts 200
Totallife-cyclecosts 385
Totaloutput(000units) 62
Life-cyclecostperunit $6.21
Managerscannowseetheexpectedprofitoftheproductover
itsentirelife,ratherthansimplyonayear-by-yearbasis.Actual
revenues and costs would be presented on a similar basis. The
life-cyclecostperunitincludesallcosts,notjustthoserelatingto
manufacturing.

3.2 Costs Involved

< Forthepurposesoflife-cyclecosting,threestagescanbe
identifiedintheproduct'slife-cycle:
= Planninganddesignstage
= Manufacturing stage
= Service and abandonment stage.
< Duringtheplanninganddesignphase,manyofthedecisions
madeabouttheproduct'sdesignwilldeterminethecosts
which will be incurred in the future. These are committed
costs. Although they are not actually incurred during the
designphase,thecompanyiscommittedtoincurringthe
expenditureinthefuture(mainlyduringthemanufacturing
stage).
< Toolssuchastargetcosting(seeprevious)maybeused
toreducesuchcommittedcosts,iftheyexceedwhatis
acceptable.
< Actual costs incurred during the planning and design phase
includethecostsofdesign,includingthedevelopmentof
prototypes,andthecostofmarketresearch.
< Marketing and advertising costs will be incurred during the
manufacturing stage. These are likely to be higher at the start
of the manufacturing phase as the product is new and needs
to be introduced to the market.
< Insomeindustriestheremaybeabandonment costs at the
endofaproduct'slife.Inthenuclearpowerindustry,for
example,costsofdecontaminatingthelandonwhichtheplant
is built may be high.
< Clearlythepatternofexpenditurewillvaryfromindustryto
industry.Itisnotuncommon,however,forcommittedcosts
duringtheplanninganddesignphasetoreach80%ofthe
totalcostsovertheproduct'slife.
100 - Costs
Percentage of costs
committed
Manufacturing and sales stage

70
Service and
abandonment
Planning stage
and
Costs incurred
design
stage
Product life-cycle phase

3.3 Benefits
Life-cyclecostingencouragesmanagementtoplanthepricing
strategyforthewholeproductlife,ratherthanonashort-
termbasis.(Pricing,andinparticulartheeffectoftheproduct
lifecycleonpricingdecisions,isdiscussedlaterinSession 6).
Identifyingthecostswhichwillbeincurredthroughoutthe
product'slifemeansthatmanagementunderstandsthecosts
better and therefore enables management to control them
better.
Bymonitoringaproduct'srevenuesandcostsonacumulative
basisoverthelifeoftheproduct,managementisprovided
with more meaningful information for control than it would
have by monitoring costs and revenues period by period.
Itismucheasierto"designoutcosts"duringthedesignphase
ofaproductthanto"controloutcosts"laterinaproduct's
lifecycle.Byconsideringthewholelifecycleoftheproduct
atthedesignphase,managementismorelikelytoachievea
reasonable cost base and therefore reasonable profits.
Decisionsaboutwhethertocontinuetodevelopand
manufacture products will be based on more complete
informationwhentheproductlifecycleisconsidered.Where
costsandrevenuesaremonitoredonaperiod-by-periodbasis,
there is a risk that products in the development phase will be
scrapped because they do not bring in revenues.
3.4 Relevance to Services Industries

Life-cyclecostingisrelevanttoservicesindustriesthat
provide services that require significant upfront research and
development.Anexampleisthe softwareindustry,inwhich
considerable research and development is invested in a new
application or operating system. The cost of this development
must be recovered before the software becomes obsolete.
Life-cyclecostingcanalsobeperformedinrelationtocustomers.
The costs of providing goods or services to customers may vary
overtheir"life"ascustomers.
Some businesses incur high costs in setting up a new customer.
However,havingattractednewbusiness,thecostofmaintaining
acustomerrelationshipislikelytobemuchlower.Effortis
therefore directed to ensuring customer loyalty.
Forexample,thefollowingone-offcostsmightbeincurredbya
retailbankatthestartofanewcustomer'slife:
< Financialincentives(e.g.below-market-rateintereston
borrowingsfor12months).
< Initialregistration,includingvalidationofpersonaldetailsand
identification documents.
< Creditworthiness checks if loans are to be provided.
< Setting up bank account access.
< IssuinguserIDsandpasswordsforInternetbanking.
Oncethecustomer'saccountshavebeensetup,manyofthe
costs above will not need to be incurred again. The bank needs to
ensure that the costs incurred at the start are recovered over the
customer'slife.

4 Throughput Accounting
4.1 The Theory of Constraints

Duringthe1980s,manyfactoriesinWesternEuropeandtheUs
became heavily automated. At that time there was a general
beliefthatautomationwouldleadtoreducedcosts(byreducing
labour)andhigherprofits.Managementaccountants,therefore,
focused on performance measures of efficiency.
However,inspiteofimprovedefficiency,manybusinessesdid
notseeincreasedprofits.Instead,theydiscoveredthefollowing
problems:
< Theywerefailingtomeetcustomerordersontime,leadingto
customer frustration.
< The volume of work in progress and finished goods was
growingsignificantly,leadingtohighcostsofinventory
obsolescence and lack of storage space in factories.
GoldrattandCox,intheirnovel,"TheGoal",pointedoutthatthe
causeoftheapparentparadoxbetweenincreasedefficiencyand
reduced profits was production bottlenecks.
Bottlenecksareprocessesthatareslowerthantheprocessesthat
precede and succeed them. They therefore slow down the whole
production process.
Illustration 4 Bottleneck
Afactorymakesthreeproducts,allofwhichpassthroughthreemachines.Thetime
spentoneachmachineisthesameforallthreeproducts.Demandforthecompany's
productsexceedstheamountthatthecompanycanproduce.Themaximumdaily
output of the three machines is as follows:
Machine2isthebottleneck,asthisproducesthelowestvolumeofoutput.
GoldrattandCoxpointedoutthefollowing:
< Ifthenon-bottleneckprocessesoperateatmaximum
efficiency,workinprogresswillbuildupinfrontofthe
bottleneck process.
InIllustration 4,ifMachine1continuestoproduce200unitsa
day,20unitsadayworkinprogresswillaccumulateinfrontof
Machine2,whichcanonlydealwith180unitsaday.
< The bottlenecks themselves restrict the amount of inputs to
the"downstream"processes.
InIllustration 4,Machine3canonlyprocess180unitsa
day,asthisisallitreceivesasinputfromMachine2.Thus,
bottlenecks reduce the rate at which finished goods are
produced.

Whatmadetheproblemworsewasthatfactorieswouldsetup
machines for large production runs. After producing a large
batchofoneproduct,themachineswouldhavetobesetupfora
differentproduct.Itwasthoughtthatlargebatcheswouldreduce
costsfurtherbyreducingset-upcosts.However,itactually
compoundedtheproblemsofabuild-upofworkinprogressand
the delays in meeting customer order deadlines.
GoldrattandCoxconcludedthatinsteadoffocusingonefficiency,
organisationsshouldfocuson"throughput"(i.e.focuson
producingforsale,notproducingforworkinprogress).
GoldrattandCoxproposedthefollowingprocesstomaximise
profit when faced with bottlenecks: Throughputthe rate
at which the system
1.Identifythesystemsbottlenecks.Intherealworldthiswillbe generates money
morecomplexthanthesimplifiedIllustration 4 here. through sales.
2.Decidewhichproductstomake,giventhebottlenecks.This
requires limiting factor analysis using the time spent on the
bottleneckasthelimitedfactor(seeExample 3).
3.Ensurethatotherresourcesdonotproduceatahigherrate
thanthebottleneck.InIllustration 4,ifMachine1wereto
operateatitsmaximumcapacityof200unitsperday,Machine
2wouldonlybeabletotake180units,so20unitsofworkin
progress would build up.
4.Eliminatethesystemsbottlenecks.Thiscanbedone,for
example,bybuyingadditionalmachines,trainingthemachine
operators or reducing the time spent on the bottleneck
resource.
5.Oncethebottleneckhasbeenbroken,anotherresource
becomesthebottleneck.Forexample,ifthecapacityof
Machine2wereincreasedto240unitsperday,Machine
1wouldbecomethebottleneck.steps14arerepeated.
Therefore this is a process of continuous improvement.
The ideas above conflict with traditional management accounting:
< The idea that Machine A should not operate at full capacity
would lead to idle time of the operators of Machine A. Goldratt
andCoxarguethatthisisfineasthecostofidletimeisless
than the cost of the work in progress which would build up if
Machine A were to operate at full capacity.
< Undertraditionalmanagementaccounting,thebuild-upof
work in progress would not affect the profits of the business
(sinceclosingworkinprogressispartofclosinginventory
anddeductedindeterminingcostofsales).Goldrattand
Coxarguethatthisiswrongbecausethebuild-upofworkin
progress in front of a bottleneck is a cost to the company if
the volume of work in progress is continually increasing.
4.2 Throughput Contribution

GoldrattandCoxintroducedtheideaof"throughput
contribution" as the measure of performance.
They argue that all other costs which are traditionally treated
asvariablearefixedintheshortrun(e.g.labour).When
Throughput
performing limited factor analysis to determine which products to contributionsales
produce,givenabottlenecktheywouldadvocateproducingthose revenue less direct
productswhichproducemaximumthroughputcontributionper material costs.
hour of bottleneck.

Example 2 Theory of Constraints
Afactoryproducestwoproducts,AandB.Bothproductspassthrough
threeprocesses;Process1,Process2andProcess3.Process2has
beenidentifiedasthebottleneck.Thereare10hoursofProcess2time
availableperday.Informationrelatingtothetwoproductsisasfollows:
A B
$ $
Selling price per unit 100 80
Directmaterialsperunit 70 60
Directlabourperunit 5 10
Traditional contribution per unit 25 10
Maximumdemandperday 8 14
TimeonProcess2perunit(hours) 1 0.5
Required:
Determine the daily production plan that would maximise
throughput contribution.
Solution
A B
$ $
Selling price per unit
Directmaterialsperunit
Throughput contribution per unit
TimeonProcess2perunit(hours)
ThroughputreturnperhourofProcess2
ranking
Units produced Hours used

B:
A:
Total throughput contribution

4.3 Throughput Accounting Ratio ("TPAR")

4.3.1 Calculation
Basedontheideasofthetheoryofconstraints,Gallowayand
Waldrondevelopedthethroughputaccountingratio("TPAr")
as a performance measure to be used for evaluation of factory
managers. This aims to motivate factory managers to focus on
maximisingthroughput.Theratioiscalculatedasfollows:
Return per factory hour

TPAr* =
Cost per factory hour
Throughput per unit

returnperfactoryhour=
Hours of bottleneck resource used per un
nit
Other factory costs

Cost per factory hour =
Bottleneck resource hours available
*returnperfactoryhourmeansthroughputcontributionperunit Otherfactorycosts
divided by time spent on the bottleneck where materials are the only would not include
variable cost. administration
Otherfactorycostsmeansallcostsincurredinthefactoryotherthan or marketing
materials; since materials are considered to be the only truly variable costsif these
costs,allothercostsarefixed.TheTPArthereforeshows: are mentioned in
Contribution per hour aquestion,they
Fixed cost per hour should be ignored.
4.3.2 Interpreting TPAR

< IfTPAr>1theproductisprofitable;asthethroughput
contributionexceedsthefixedcosts.
< IfTPAr=1theproductbreakseven.
< IfTPAr<1theproductislossmaking.Thethroughput
contributiongenerateddoesnotcoverthefixedcostsrequired
to make it.
4.3.3 Ways to Improve the TPAR

TPArisaperformancemeasurementtoolwhichmaybeused
inevaluatingtheperformanceofmanagers.Itishopedthat
managers would take the following actions to increase their
measured performance:
< Eliminatebottlenecksorreducethetimespentonbottleneck
resources.
< reduceotherfactorycosts.
Mathematically the ratio could also be improved by increasing
sellingpricesorreducingmaterialcosts.Inacompetitive
environment,however,increasingsellingpricesmaynotbe
feasible.reducingmaterialcostsmayhaveimplicationson
quality,sothismaynotbedesirable.

Example 3 TPAR
Continuing on from Example 2.Thefixedcostsperdayofthefactoryareasfollows:
$
Labour costs 120
Variableoverheads 180
Fixed 50
Totalfixedcostsperday 350
Required:
Calculate the TPAR for products A and B.
Solution
Throughput return per factory hour
A B
$ $
ThroughputreturnperhourofProcess2
Fixed cost per factory hour
A B
TPAR

5 Environmental Management Accounting

5.1 Introduction
Overthepast30years,environmentalissueshavebecomean
areaofincreasinginterest.Environmentalactivistsassertthat
currenthumanactivityiscausingglobalwarming,andwarn
of dire consequences for the planet unless we reduce our poor
environmental behaviour. The most pressing issues are:
< Globalwarming,causedbytheemissionofgreenhouse
gasses.
< Manynaturalresourcesarescarce,andglobalreservesof
theseresourcesarebeingdepleted.Inparticular,energyand
water are resources that are forecast to become scarce over
thenext50years.
< Pollutioniscausingthelossofhabitatsfornatureandfor
humans.
5.2 Importance of the Environment for Business

5.2.1 Environmental Behaviour and Performance
Oneofthepioneeringarticlesonenvironmentalmanagement
accountingwas"TheGreenBottomLine:ManagementAccounting
forEnvironmentalImprovementandBusinessBenefit",published
byMartinBennettandPeterJamesin1998.Thisidentified
several ways in which a company can improve its performance by
becoming more aware of the impact on the environment:
< Poorenvironmentalbehaviourcanhaveanadverseeffecton
anorganisation'simage,whichmayleadtoalossofsalesas
customersboycotttheorganisation'sproducts.
< Many governments may impose heavy fines on companies
which harm the environment. Companies also may have to
pay large amounts to clean up any pollution for which they are
responsible.
< Increasinggovernmentregulationsonenvironmentalissues
such as pollution has increased the costs of compliance for
businesses.
< Improvingenvironmentalbehaviourcanreducecosts.For
example,aprogrammeofincreasingenergyefficiencywill
reduce the depletion of natural resources while also reducing
energy costs for the companies concerned.
< Businessesascorporatecitizenshaveamoraldutytoplay
their part in helping to reduce the harm they do to the
environment.

Exhibit 1 BP
TheDeepwaterHorizonoilspillinApril2010wasoneoftheworstenvironmental
disastersonrecord.AnexploratoryoilrigintheGulfofMexicoexploded,leadingto
apartiallycappedoilwellamilebelowthesurfaceofthewater.Expertsestimate
thatfrom35,000to60,000barrelsofoiladayleakedfromthiswell,dependingon
weatherconditions.Ittookapproximatelythreemonthstore-sealtheoilwelland
stop the leak.
BPwasthemajorityowneroftheoilfield.Althoughtherigwasoperatedbya
sub-contractoronbehalfofBP,theUsgovernmentstatedthatitheldBPprimarily
responsible for the leak.
BPrecognisedapre-taxcostof$40.9billioninits2010financialstatements
relatingtotheoilspill(comparedwithaprofitfortheyear2009of$16.6.billion).
Thisincludedafundof$20billionwhichwassetuptocompensatethelocal
community for damages caused as well as costs incurred on cleaning up the spill.
5.2.2 Achieving Environmental Benefits

BennettandJamessuggestedsixwaysinwhichbusinessand
environmental benefits could be obtained through environmental
management accounting:
1. Taking account of environmental effects in making capital
expendituredecisions.
2. Betterunderstandingofenvironmentalcoststhatareotherwise
hidden within other overheads so management is not aware
of them.
3. reducingwasteandsavingenergy.
4. Understandingenvironmentaleffectsonlife-cyclecosts,many
ofwhichareincurredattheendofaproduct'slife(e.g.to
dispose of electronic goods in accordance with local laws on
recycling).
5. Measuring environmental performance as stakeholders are
becoming more interested in the impact that organisations
have on the environment.
6. Involvingmanagementaccountantsinlonger-termstrategic
planningforenvironmental-relatedissues.

5.3 Environmental Management Accounting

Traditional management accounting systems do not provide any
analysis of environmental costs. Management are often unaware
of them. The implication of this is that:
< Management cannot do enough to manage environmental
activities.
< Management accounts underestimate the costs of poor
environmental behaviour and underestimate the benefits of
good environmental behaviour.
Environmental Management Accounting (EMA) aims to
overcome this.
EMAtheidentification,collection,analysisanduseoftwotypes
ofinformationforinternaldecision-making:physicalinformationon
theuse,flowsandratesofenergy,waterandmaterials(including
wastes);andmonetaryinformationonenvironmentrelatedcosts,
earnings and savings.
Environmental Management Accounting
Research and Information Centre (EMARIC)
Itisimportanttorememberthattherearetwoaspectsto
environmental management accounting:
< Physicalinformation,whichfocusesonthephysicaluseof
scarce resources and how much waste occurs.
< Monetaryinformationonenvironment-relatedcosts,earnings
and savings.
5.4 Defining Environmental Costs

The first step in dealing with environmental costs is to define what
ismeantbyenvironmentalcosts.Variousdefinitionsorcategories
ofenvironmentalcostshavebeensuggested.Oneoftheseisthe
definitionsprovidedbytheUsEnvironmentalProtectionAgency
(EPA),whichidentifiedthefollowingcategoriesofenvironmental
costs:
*Infinancial
< Conventional costs: costs having environmental relevance statements,contingent
(e.g.costsofbuyingenergyandotherscarceresources). costs might be
< Potentially hidden costs: those environmental costs which disclosed as contingent
arerecorded,butsimplyincludedwithingeneraloverheads,so liabilities or provided
management is not aware of them. for if they meet
the definition and
< Contingentcosts:potentialfuturecosts(e.g.costsof
recognition criteria
cleaningupdamagecausedbypollution).* ofIAs37Provisions,
< Image and relationship costs: the costs of producing Contingent Liabilities
environmentalreportsandpromotingthecompany's and Contingent Assets.
environmental activities.

An alternative categorisation of environmental costs was proposed

by HansenandMendova,whocameupwithadefinitionbasedon
total quality management:
< Environmentalprevention costs are the costs of activities
undertakentopreventtheproductionofwaste(e.g.spending
on redesigning processes to reduce the amount of pollution
releasedintotheatmosphere).
< Environmentaldetection costs are those incurred to
ensure that the organisation complies with regulations and
voluntarystandards(e.g.costsofauditingtheorganisation's
environmentalactivities).
< Environmentalinternal failure costs are costs incurred to
clean up environmental waste and pollution before it has been
releasedintotheenvironment(e.g.costsofdisposingoftoxic
waste).
< Environmentalexternal failure costs are costs incurred
on activities performed after discharging waste into the
environment(e.g.costsofcleaningupanoceanafter
spillingoil).
5.5 EMA Techniques

Havingidentifiedthevarioustypesofenvironmentalcosts,itis
necessary to provide useful information to management to help
manage and control environmental activitieswith the purpose of
saving money and reducing the harm caused by operations to the
environment.Varioustoolshavebeenproposedforthis:
< Anenvironmentalcostreport,basedonthecostsdefinedby
HansenandMendova,witheachcategoryofcostsshownasa
percentage of revenues.
< Environmentalactivity-basedcosting.
< Inputoutputanalysis.
< Flowcostaccounting.
< Life-cyclecosting.
5.5.1 Environmental Activity-Based Costing
Environmentalactivity-basedcostingappliesactivity-
based costing principles to environmental costs so that the
environmentalcostsareapportioned"correctly"totheproducts
which use the drivers which cause the costs to be incurred.
Normallymanyenvironmentalcostsarehiddenwithingeneral
overheads and therefore apportioned to products using
inappropriate drivers. This can mean that product costs do not
truly reflect the environmental costs associated with making
them.
Underenvironmentalactivity-basedcosting,environmental-
related costs are removed from general overheads and allocated
toenvironmentalactivities.Investigationoftheseactivities
occurstoidentifythekeydriversofthecost.Forexample,one
activity may be monitoring emissions. The driver of this may
be production time of products using a particular process which
produces emissions. The costs of monitoring emissions can
then be apportioned to the products based on the amount of
production time used by each product.

Themainmethodsofallocatingtheenvironmentalcost(the
allocationkeys)tothevariousactivitiesmightbethefollowing:
< Volumeofemissionsorwaste.
< Toxicityofemissionandwastetreated.
< Volumeofemissiontreated.
< The relative costs of treating different types of emissions.
5.5.2 Input Output Analysis
Inputoutputanalysisof"massbalance"aimstomakeit
clear to management how much waste is being generated by
their activities. The aim is simply to compare the output of a
productionprocess(inphysicalunits)withtheinputonthebasis
that"whatcomesinmustgoout".Whatisnotincludedinoutput
mustthereforebewaste.Processflowsareoftenusedtoshow
thesemorespecifically.Forexample:
60%Product
20%scrapforrecycling
INPUT
100% PrOCEss
15%Disposalaswaste
5%Notaccountedfor
5.5.3 Flow Cost Accounting

Flowcostaccountingisamoredetailedversionofinputoutput
analysis.Inputoutputanalysisconsidersonlythephysicalinputs
and ensures that these are accounted for as physical outputs at
the endoftheproductionprocess.Flowcostaccountingconsiders
the inputs and outputs for eachprocess,toidentifythewasteat
each process.
Flowcostaccountingexaminesnotonlythephysicalquantities
ofmaterial,butalsothecostsandvaluesofoutputandwaste
for each process. So the costs of input into each process are
calculated and apportioned between output of the process and
waste using process costing principles.

The costs used in flow cost accounting are sometimes categorised as:
< material costs;
< systemcosts, which are the costs incurred within the various
processeswhichaddvaluetotheproduct(e.g.wagesand
overheads);and
< deliveryanddisposalcosts,whichareincurredindelivering
goods to customers or disposing of waste.
5.5.4 Relevance of Life-Cycle Costing

Life-cyclecostingisparticularlyrelevantforenvironmentalcosts,
because many environmental costs are not incurred during
theproductionphase.Clean-upcostsmaybesignificant,but
are not incurred until after the production process is finished.
TheEuropeanUnion"EndofLifeVehiclesDirective"makesit
compulsoryforcarmanufacturersintheEUtocollectanddispose
of old cars which have reached the end of their useful life. Such
costs should therefore be considered by manufacturers during
life-cyclecostingexercises.
Exhibit 2 XEROX
XeroxLtdleasesphotocopyingmachinestoclients.Themachinesarereturnedto
thecompanyattheendoftheirlives.Onecostwhichhadpreviouslybeenignored
wasthecostofpackaging.Xeroxwouldprovidepackagingforthenewmachines
which were delivered to the customer. The customer would then dispose of this
packaging,andhavetopaytore-packtheoldmachinewhichwasbeingreturnedto
Xerox.
Asaresultofincludingthecostsofpackaginginthelife-cyclecostsofthe
photocopying,thecompanywasabletoseehowlargethesecostswere.The
companynowusesastandardre-usablepack.Whenamachineisdeliveredtoa
customer,thepackageinwhichitisdeliveredisusedtopacktheoldmachinewhich
isbeingreturnedtoXerox.Twostandardtypesofpackinghavebeendeveloped
whichcoverallofXerox'smachines.Thisledtoareductioninpackagingcostsand
increased customer satisfaction.

Session 2
Summary
< The business environment within which companies operate has become more competitive.
Productshaveshorterlifecyclesandthereisemphasisonquality.
< Newmanagementaccountingtechniqueshaveevolvedtomeetthisnewenvironment.
< Target costing is used to identify what unit costs would ensure that companies make
sufficient profit to justify investment. Companies then try to narrow the gap between the
actualcostandthetargetcostbyredesigningtheproduct,to"designout"costs.
< Life-cyclecostinginvolvestrackingthecumulativecostsandrevenuesoverthelifeofa
productratherthanusingthetraditionalapproachtoaccounting,wherecostsandrevenues
arereviewedonaperiod-by-periodbasis.Life-cyclecostingenablesmanagerstoseemore
clearly how successful a product has been over its whole life.
< Throughput accounting is a system which aims to focus management attention onto
bottlenecks. Throughput means sales revenue less material cost. Throughput accounting
aimstomaximisethroughputgeneratedperhourbyeliminatingbottlenecks.
< Environmentalmanagementaccountingaimstoprovidemanagementwithmonetaryand
non-monetaryinformationtoenablethemtounderstandandmanagetheenvironmental
impactoftheorganisation'sactivities.

Session 2 Quiz
Estimatedtime:20minutes
1. ListFOUrfactorswhichhaveoccurredinthelast50yearswhichhaveledtoafundamental
changeintheenvironmentswithinwhichbusinessesoperate.(1.2)
2. ListTWOgoalsofjust-in-timemanufacturing.(1.4.2)
3. statetheFOUrstepswhichtargetcostinginvolves.(2.2)
4. suggestFOUrwaysofreducingthetargetcostgap.(2.4)
5. Identifythemaincategoriesofcostswhichwillbeincurredduringthefollowingstagesofthe
productlifecycle(3.2):
i. Planninganddesignstage.
ii. Manufacturing and sales stage.
iii. Service and abandonment stage.
6. Explainthedifferencebetweenthroughputcontributionandtraditionalcontribution.(4.2)
7. State the steps management should take to improve the measured throughput accounting
ratio.(4.3.3)
8. IdentifytheFOUrcategoriesofenvironmentalcostsaccordingtotheUsEnvironmental
ProtectionAgency'scategorisation.(5.4)
Study Question Bank

Estimatedtime:110minutes
Priority Estimated Time Completed
MCQssession2 20 minutes
Q5 Flopro 50 minutes
Q6 Telmat 20 minutes
Environmental
Q7 management 20 minutes
accounting

EXAMPLE SOLUTIONS
Solution 1Target Costing

$m
Expectedrevenue(100,000$40,000) 4,000
requiredprofit(20%$3billion) 600
Total target cost 3,400
Targetcostpercar($3,400million/100,000) 34,000
Solution 2Theory of Constraints

A B
$ $
Selling price per unit 100 80
Directmaterialsperunit 70 60
Throughput contribution per unit 30 20
TimeonProcess2perunit(hours) 1 0.5
ThroughputreturnperhourofProcess2 30 40
ranking 2 1
Units produced Hours used

B: 14 7
A: 3 3
10
Totalthroughputcontribution:(14x20)+(3x30) 370
Solution 3TPAR
Throughput return per factory hour
Ascalculatedin2above:
A B
$ $
ThroughputreturnperhourofProcess2 30 40
350
Fixedcostsperfactoryhour= =$35
10
A B
30 40
TPAR =0.86 =1.14
35 35
Where,asinthisExample,allproductsareproducedinthesame
division,theycanberankedbasedonreturnperhouraswellasTPAr.

F5-02 Developments in Management Accounting

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Session 2

A. Specialist Cost and Management Accounting

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TARGET COSTING LIFE-CYCLE THROUGHPUT ENVIRONMENTAL

Understand the meaning of life-cycle costing and be able to calculate a life-cyclecost(s.3and

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1 Developments in Management Accounting

1.3 Growth of Services Industries

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1.4 Response of Companies

1.4.1 Total Quality Management (TQM)

1.4.2 JIT Manufacturing

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1.5 Response of Management Accountants

2.1 Aim and Use

< Target costing may be used:

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2.2 Steps in Target Costing

Example 1 Target Costing

Target cost per car

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2.3 Application to Service Industries

Illustration 1 Target Costing

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Illustration 2 Cost Gap Reduction

FollowingonfromIllustration 1, methods which might be used to

2.4 Narrowing the Target Cost Gap

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3.1 Product Life Cycle

1. Development stage (planning and design stage)during

Life-cycle costinga system which tracks and accumulates

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Illustration 3 Life-Cycle Costing

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3.2 Costs Involved

Manufacturing and sales stage

Product life-cycle phase

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3.4 Relevance to Services Industries

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4.1 The Theory of Constraints

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4.2 Throughput Contribution

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Example 2 Theory of Constraints

Throughput contribution per unit

Units produced Hours used

Total throughput contribution

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4.3 Throughput Accounting Ratio ("TPAR")

Return per factory hour

Throughput per unit

Other factory costs

4.3.2 Interpreting TPAR

4.3.3 Ways to Improve the TPAR

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Continuing on from Example 2.Thefixedcostsperdayofthefactoryareasfollows:

Fixed cost per factory hour

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5 Environmental Management Accounting

5.2 Importance of the Environment for Business

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5.2.2 Achieving Environmental Benefits

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