F5 - Performance Management

Part A Specialist cost and management accounting techniques

Difference between absorption costing and marginal costing.

Absorption costing is a method whereby all production costs are charged to units of production. Marginal costing
is a method whereby variable production costs only are charged to units of production and the fixed costs are treated
as a cost of the accounting period. The main differences between the two methods:

1. If the opening and closing inventory levels differ, the profit reported under the two methods will also be
different. In the long run, total profit under the two methods will be the same.

2. Marginal costing is more useful for decision-making purposes, but absorption costing is needed for financial
reporting purposes to comply with accounting standards.

Why absorption costing will produce higher profit than marginal costing?
In marginal costing, inventories are valued at variable production cost, whereas, in absorption costing, inventories are
valued at their full production cost. So, if the opening and closing inventory levels differ, the profit reported under the
two methods will also be different.

If opening inventory values are less than closing inventory values, profit under absorption costing will be lower than
that under marginal costing.

If opening inventory values are higher than closing inventory values, profit under absorption costing will be greater
than that under marginal costing.

Briefly outline the steps involved in allocating overheads using activity based costing.
Identify the organizations major activities.
Collect the costs associated with each activity into cost pools.
Identify the cost drivers i.e. those factors which give rise to the costs.
Charge the costs to the products on the basis of the cost driver.

Why activity-based costing may be preferred to traditional absorption costing in the

modern manufacturing environment.
Absorption costing uses volume as a basis for cost allocation. Therefore it tends to allocate too great a
proportion of overheads to high volume products and too small to low volume products.
ABC uses several bases or cost drivers to allocate overheads and as such will more closely link overhead
allocations to the causes of overhead costs.
Therefore ABC recognizes the complexity of manufacturing in its use of multiple cost drivers and so more
detailed cost information is available.
ABC also enables a good understanding of what drives overhead costs as it accumulates a good deal of data
for analysis. Therefore ABC can be used as an information source for budget planning based on activity rather
than incremental budgeting.
ABC also establishes a long run product cost.

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F5 - Performance Management
Part A Specialist cost and management accounting techniques

Advantages of activity-based costing.

The complexity of manufacturing has increased and ABC recognized the complexity with its multiple cost
drivers.
ABC facilitates a good understanding of what drives overhead costs.
ABC in concerned with all overhead costs.

Criticisms of activity-based costing.

Some measure of cost apportionment may still be required at the cost pooling stage.
A single cost driver cannot explain the cost behavior of all items in its associated pool.
ABC is sometimes introduced because it is fashionable.
The costs of implementation ABC may exceed the benefits.
Implementing ABC is often problematic.

Implementation problems experienced when ABC is first introduced.

Lack of data
ABC requires detailed accounting records which may not be available in the business.
Information is required on cost pools and cost drivers.
This information is usually time consuming to derive and there may be resistance from employees.

Identifying cost drivers

It may be difficult to identify a single cost driver which explains the cost behavior of all items in its associated
pool.

Lack of understanding
ABC is a complex, time consuming technique which will not be sufficiently understood and accepted by
managers to enable them to provide meaningful product costs or extra information.
The costs of implementation ABC may exceed the benefits.

Main steps involved in developing a target price and target cost for a product in a
typical manufacturing company.
Step 1: Determine a product specification of which an adequate sales volume is estimated.
Step 2: Set a selling price at which the organization will be able to achieve a desired market share.
Step 3: Estimate the required profit based on return on sales or return on investment.
Step 4: Calculate the target cost = target selling price target profit
Step 5: Compile an estimated cost for the product based on the design specification and current cost levels.
Step 6: Calculate target cost gap = estimated cost target cost.
Step 7: Make efforts to close the gap.
Step 8: Negotiate with the customer before deciding whether to go ahead with the project.

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F5 - Performance Management
Part A Specialist cost and management accounting techniques

Limitations of target costing.

1. If unrealistic and unachievable targets were set, the workforce would not be committed to them or would be
demotivated.
2. Current costing system may not be able to provide the data needed to operate target costing effectively. Cost
tables can be used to predict the costs of products with acceptable degree of accuracy.

How a target cost gap might be closed?

Various techniques can be employed to close the target cost gap.
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.

Key characteristics that distinguish services from manufacturing.

Spontaneity: Service is consumed at the exact same time as it is made available.
Heterogeneity/Variability: Services involve people and, because people are all different, the service received
may vary depending on which person performs it. Standardization is expected by the customer but it is
difficult to maintain.
Intangibility: Services cannot be physically touched.
Perishability: Unused capacity cannot be stored for future use.
No transfer of ownership takes place when a service is provided.
Service industries rely heavily on their staff, who often have face-to-face contact with the customer, and
represent the organizations brand.

Benefits of adopting target costing.

External focus
Traditionally the business use an internal focus when developing a new product by calculating the cost and
then adding a margin to get a selling price.
Target costing makes the business look at what competitors are offering at a much earlier stage in the
development process.

Customer focus
Customer requirements for quality, cost and time are incorporated into product and process decisions.
The value of product features to the customers must be greater than the cost of providing them and only
those features that are of value to customers are included.

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F5 - Performance Management
Part A Specialist cost and management accounting techniques

Cost control
Cost control is emphasized at the design stage so any engineering changes must happen before production
starts.

Faster time to market

The early external focus enables the business to get the process right first time and avoids the need to go
back and change aspects of the design and/or production process. This then reduces the time taken to get a
product to the market.

Benefits of life cycle costing.

Life cycle costing tracks and accumulates actual costs and revenues attributable to each product over its
entire life cycle.
The total profitability of any given product can be determined.

Life cycle costing shows all costs relating to product rather that relating to single period, thus providing more
accurate information for decision making.

The costs of researching, developing and designing products are also taken into account. This will allow more
accurate analysis when measuring the performance of new products.

The life cycle concept results in earlier actions to generate revenue or to lower costs than otherwise might be
considered.

Better decisions should follow from a more accurate and realistic assessment of revenues and costs, at least
within a particular life cycle stage.

Life cycle thinking can promote long-term rewarding in contrast to short-term profitability rewarding.

The life cycle concept helps managers to understand acquisition costs vs. operating and support costs.
It encourages businesses to find a correct balance between investment costs and operating expenses.

Difference between traditional management accounting system and life cycle costing.
Traditional management accounting system do not accumulate costs over a products entire life and do not assess a
products profitability over its entire life. Instead, they do it on a periodic basis and this makes the product seem less
profitable than they really are.

Life cycle costing tracks and accumulates actual costs and revenues attribute to each product over its entire life cycle.
Hence, the total profitability of any given product can be determined.

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F5 - Performance Management
Part A Specialist cost and management accounting techniques

Principles and limitations of throughput accounting.

Throughput accounting is a system of cost and management accounting which is designed for use in JIT
manufacturing environment.
Throughput is sales revenue less direct materials and it aims to maximize the cash generation from sales.

The system is based on three concepts:

1. In short run, most factory costs are fixed, except the materials.
2. In a JIT environment, the ideal inventory level is zero.
- Work in progress should be valued at material cost only.
3. Profitability is determined by the rate at which revenue is generated, because there are no significant
inventories, depends on how quickly goods can be produced to meet customer orders.

Limitations of throughput accounting:

1. The existence of an uncompetitive selling price.
2. The need to deliver on time to particular customers.
3. Poor product quality and reliability.
4. The lack of reliable materials suppliers.

How can a business improve a throughput accounting ratio?

1. Increase the selling price of the product.
2. Reduce the material cost per unit of the product.
3. Reduce the operating expenses.
4. Change the working practices on the bottleneck resource.

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