Full List of Management Accounting for Decision Makers_6 pot

With activity-based costing, overheads are assigned to cost pools and then cost units are charged with overheads to the extent that they drive the costs in the various pools.. In some ty

Traditional versus activity-based costingFigure 5.1

With the traditional approach, overheads are first assigned to product cost centres and then absorbed by cost units based on an overhead recovery rate (using direct labour hours worked

on the cost units or some other approach) for each cost centre With activity-based costing, overheads are assigned to cost pools and then cost units are charged with overheads to the extent that they drive the costs in the various pools.

Source: Adapted from Innes, J and Mitchell, F., Activity Based Costing: A Review with Case Studies, CIMA Publishing, 1990.

Comma Ltd manufactures two types of Sprizzer – Standard and Deluxe Eachproduct requires the incorporation of a difficult-to-handle special part (one ofthem for a Standard and four for a Deluxe) Both of these products are made inbatches (large batches for Standards and small ones for Deluxes) Each new batchrequires that the production facilities are ‘set up’.

Details of the two products are:

Standard Deluxe

In recent months, Comma Ltd has been trying to persuade customers who buythe Standard to purchase the Deluxe instead An analysis of overhead costs forComma Ltd has provided the following information

Overhead cost analysis £ Cost driver

Required:

(a) Calculate the profit per unit and the return on sales for Standard and DeluxeSprizzers using

(i) the traditional direct-labour-hour based absorption of overheads;

(ii) activity-based costing methods

(b) Comment on the managerial implications for Comma Ltd of the results in (a) above

Solution

Using the traditional full (absorption) costing approach that we considered inChapter 4, the overheads are added together and an overheads recovery ratededuced as follows:

333,200

Example 5.3

Overhead recovery rate =

=

=

= £6.17 per hourThe total cost per unit of each type of Sprizzer is calculated by adding the directcost to the overheads cost per unit The overheads cost per unit is calculated bymultiplying the number of direct labour hours spent on the product (2 hours foreach Standard and 21/2 hours for each Deluxe) by the overheads recovery rate calculated above Hence:

The return on sales is calculated as follows:

Return on sales [(profit /sales) × 100%] 22.55% 22.49%

Using the ABC costing approach, the activity cost driver rates will be calculated asfollows:

£333,200[(12,000 × 2) + (12,000 × 21/2)]

Total overheadsNumber of labour hours

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Criticisms of ABC

Although many businesses now adopt a system of ABC, its critics point out that ABCcan be time-consuming and costly Set-up costs as well as costs of running and updat-ing the ABC system must be incurred These costs can be very high, particularly wherethe business’s operations are complex and involve a large number of activities and costdrivers Furthermore, ABC information produced under the scenario just describedmay be complex If managers find ABC reports difficult to understand, there is a riskthat the potential benefits of ABC will be lost

Not all businesses are likely to benefit from ABC Where a business sells products

or services that all have similar levels of output and involve similar activities and

The activity-based costs are derived as follows:

(f ) (g) Overhead Total costs Total costs Unit costs Unit costs cost pool Standard Deluxe Standard Deluxe

The return on sales is calculated as follows:

Return on sales [(profit/sales) × 100%] 32.67% 14.94%

The figures show that under the traditional approach the returns on sales appearbroadly equal However, the ABC approach shows that the Standard product is farmore profitable Hence, the business should reconsider its policy of trying to per-suade customers to switch to the Deluxe product

Example 5.3 continued

processes, it is unlikely that the finer measurements provided by ABC will lead to ingly different results from those gained under the traditional approach As a result,opportunities for better pricing, planning and cost control may not be great and maynot justify the cost of switching to an ABC system.

strik-Measurement and tracing problems can arise with ABC, which may undermine anypotential benefits Not all costs can be easily identified with a particular activity andsome may have to be allocated to cost pools This can often be done on some sensiblebasis For example, factory rent may be allocated on the basis of square metres of spaceused In some cases, however, a lack of data concerning a particular cost may lead tofairly arbitrary cost allocations between activities There is also the problem that therelationship between activity costs and their cost drivers may be difficult to determine.Identifying a cause-and-effect relationship can be difficult where a large proportion ofactivity costs are fixed and so do not vary with changes in usage

ABC is also criticised for the same reason that full costing generally is criticised:because it does not provide very relevant information for decision making The pointwas made in Chapter 4 that full costing tends to use past costs and to ignore opportun-ity costs Since past costs are always irrelevant in decision making and opportunitycosts can be significant, full costing information is an expensive irrelevance In con-

trast, advocates of full costing claim that it is relevant, in that it provides a long-run

average cost, whereas ‘relevant costing’, which we considered in Chapter 2, relates only

to the specific circumstances of the short term The use of ABC, rather than the tional approach to job (or product) costing, does not affect the validity of this irrelev-ance argument

tradi-Real World 5.2shows how ABC came to be used at the Royal Mail

Real World 5.3 provides some indication of the extent to which ABC is used in practice

REAL WORLD 5.2 Delivering ABC

Early in the 2000s the publicly-owned Royal Mail adopted ABC and used it to find the cost

of making postal deliveries Royal Mail identified 340 activities that gave rise to costs, created a cost pool and identified a cost driver for each of these

Roger Tabour, Royal Mail’s Enterprise Systems Programme Director, explained, ‘A newregulatory and competitive environment, plus a down-turned economy, led management

to seek out more reliable sources of information on performance and profitability,’ and thisled to the introduction of ABC

The Royal Mail is a public sector organisation that is subject to supervision byPostcomm, the UK government appointed regulatory body The government requires theRoyal Mail to operate on a commercial basis and to make profits

Source: www.sas.com.

REAL WORLD 5.3 ABC in practice

A recent survey of 176 UK businesses operating in various industries, all with an annualturnover of more than £50 million, was conducted by Al-Omiri and Drury This indicatedthat 29 per cent of larger UK businesses use ABC

The adoption of ABC in the UK varies widely between industries, as is shown in Figure 5.2

Al-Omiri and Drury took their analysis a step further by looking at the factors that ently tend to lead a particular business to adopt ABC They found that businesses thatused ABC tended to be:

appar-l Large

l Sophisticated, in terms of using advanced management accounting techniques generally

l In an intensely competitive market for their products

l Operating in a service industry, particularly in the financial services

All of these findings are broadly in line with other recent research evidence involving nesses from around the world

busi-Source : Al-Omiri, M and Drury, C., ‘A survey of factors influencing the choice of product costing systems in UK organisations’, Management Accounting Research, December 2007.

ABC in practiceFigure 5.2

Psilis Ltd makes a product in two qualities, called ‘Basic’ and ‘Super’ The business is able

to sell these products at a price that gives a standard profit mark-up of 25 per cent of fullcost Management is concerned by the lack of profit

Full cost for one unit of a product is calculated by charging overheads to each type ofproduct on the basis of direct labour hours The costs are as follows:

Basic Super

The total overheads are £1,000,000

Based on experience over recent years, in the forthcoming year the business expects

to make and sell 40,000 Basics and 10,000 Supers

Recently, the business’s management accountant has undertaken an exercise to try

to identify activities and cost drivers in an attempt to be able to deal with the overheads

on a more precise basis than had been possible before This exercise has revealed the following analysis of the annual overheads:

Activity (and cost driver) Cost Annual number of activities

£000

Total Basic Super

The management accountant explained the analysis of the £1,000,000 overheads as follows:

l The two products are made in relatively small batches, so that the amount of the finished product held in inventories is negligible The Supers are made in very smallbatches because demand for them is relatively low Each time a new batch is produced,the machines have to be reset by skilled staff Resetting for Basic production occursabout 20 times a year and for Supers about 80 times: about 100 times in total The cost

of employing the machine-setting staff is about £280,000 a year It is clear that the moreset-ups that occur, the higher the total set-up costs; in other words, the number of set-ups is the factor that drives set-up costs

l All production has to be inspected for quality and this costs about £220,000 a year Thehigher specifications of the Supers mean that there is more chance that there will bequality problems Thus the Supers are inspected in total 1,500 times annually, whereasthe Basics only need about 500 inspections The number of inspections is the factorthat drives these costs

l Sales order processing (dealing with customers’ orders, from receiving the originalorder to despatching the products) costs about £240,000 a year Despite the largeramount of Basic production, there are only 1,500 sales orders each year because theBasics are sold to wholesalers in relatively large-sized orders The Supers are soldmainly direct to the public by mail order, usually in very small-sized orders It is believedthat the number of orders drives the costs of processing orders

Self-assessment question 5.1

‘

The increasingly competitive environment in which modern businesses operate is ing to greater effort being applied in trying to manage costs Businesses need to keepcosts to a minimum so that they can supply goods and services at a price that cus-tomers will be prepared to pay and, at the same time, generate a level of profit neces-sary to meet the businesses’ objectives of enhancing shareholder wealth We have justseen how ABC can help manage costs We shall now go on to outline some other tech-niques that have recently emerged in an attempt to meet these goals of competitive-ness and profitability These can be used in conjunction with ABC.

lead-Total (or whole) life-cycle costing

This method of costing starts from the premise that the total (or whole) life cycle of aproduct or service has three phases These are:

1 The pre-production phase This is the period that precedes production of the product or

service for sale During this phase, research and development – both of the product

or service and of the market – is conducted The product or service is invented/designed and so is the means of production The phase culminates with acquiringand setting up the necessary production facilities and with advertising and promotion

2 The production phase comes next, being the one in which the product is made and

sold or the service is rendered to customers

3 The post-production phase comes last During this phase, any costs necessary to

cor-rect faults that arose with products or services that have been sold (after-sales vice) are incurred There would also be the costs of closing production at the end ofthe product’s or service’s life cycle, such as the cost of decommissioning productionfacilities Since after-sales service will tend to arise from as early as the first product

ser-or service being sold and probably, therefser-ore, well befser-ore the last one is sold, thisphase would typically overlap with the manufacturing/service-rendering phase.Businesses often seem to consider environmental costs alongside the more obviousfinancial costs involved in the life of a product

The total life cycle is shown in Figure 5.3

Other approaches to cost management in the

The answer to this question can be found in Appendix B at the back of the book.

Self-assessment question 5.1 continued

In some types of business, particularly those engaged in an advanced manufacturingenvironment, it is estimated that a very high proportion (as much as 80 per cent) ofthe total costs that will be incurred over the total life of a particular product are eitherincurred or committed at the pre-production phase For example, a car manufacturer,when designing, developing and setting up production of a new model, incurs a highproportion of the total costs that will be incurred on that model during the whole ofits life Not only are pre-production costs specifically incurred during this phase, butthe need to incur particular costs during the production phase is also established This is because the design will incorporate features that will lead to particular manu-facturing costs Once the design of the car has been finalised and the manufacturingplant set up, it may be too late to ‘design out’ a costly feature without incurringanother large cost.

The total life cycle of a product or serviceFigure 5.3

From the producer’s viewpoint, the life of a product can be seen as having three distinct phases During the first the product is developed and everything is prepared so that produc- tion and marketing can start Next comes production and sales Lastly, dealing with post- production activities is undertaken.

A decision taken at the design stage could well commit the business to costs after the manufacture of the product has taken place Can you suggest a potential cost that

could be built in at the design stage that will show itself after the manufacture of the

product?

After-sales service costs could be incurred as a result of some design fault Once the facturing facilities have been established, it may not be economic to revise the design; itmay be better to deal with the problem through after-sales service procedures

manu-Activity 5.3

Total life-cycle costingseeks to focus management’s attention on the fact that it isnot just during the production phase that attention needs to be paid to cost manage-ment By the start of the production phase it may be too late to try to manage a largeelement of the product’s or service’s total life-cycle cost Efforts need to be made toassess the costs of alternative designs.

There needs to be a review of the product or service over its entire life cycle, whichcould be a period of 20 or more years Traditional management accounting, however,tends to be concerned with assessing performance over periods of just one year or less

Real World 5.4provides some idea of the extent to which total life-cycle costing isused in practice

Real World 5.5shows how a well-known international carmaker uses total life-cyclecosting

‘

REAL WORLD 5.4 Total (whole) life-cycle costing in practice

A survey of management accounting practice in the US was conducted in 2003 Nearly2,000 businesses replied to the survey These tended to be larger businesses, of whichabout 40 per cent were manufacturers and about 16 per cent financial services; theremainder were across a range of other industries

The survey revealed that 22 per cent extensively use a total life-cycle approach to costcontrol, with a further 37 per cent considering using the technique in the future

Though the survey relates to the US, in the absence of UK evidence it provides someinsight to what is likely also to be practised in the UK and elsewhere in the developedworld

Source: 2003 Survey of Management Accounting, Ernst and Young, 2003.

REAL WORLD 5.5 Total life-cycle costing at Renault

According to Renault, the French motor vehicle manufacturer:

The life of a vehicle is long and comprises several phases:

design: Creating a vehicle manufacturing: Extracting and producing materials, manufacturing and assembling the com-

ponents, and then the whole vehicle

distribution: Transition between the vehicle’s departure from the production plant and its

Note that Renault divides the production phase into two sections: manufacturing and distribution It also divides the post-production phase into vehicle service life and recycling.

price-Target costingapproaches the problem from the other direction First, with the help

of market research or other means, a unit selling price and sales volume are established.From the unit selling price is taken an amount for profit This unit profit figure must

be such as to be acceptable to meet the business’s profit objective The resulting figure

is the target cost The target cost may well be less than the ‘current’ cost; there may be

a ‘cost gap’ Efforts are then made to bridge this gap, that is, to provide the service ormake the product in such a way as to enable the target cost to be met These effortsmay involve revising the design, finding more efficient means of production or requir-ing suppliers of goods and services to supply more cheaply

Target costing is seen as a part of a total life-cycle costing approach, in that cost ings are sought at a very early stage in the life cycle, during the pre-production phase

sav-Real World 5.6indicates the level of usage of target costing

The Ernst and Young survey of management accounting practice in the US conducted in

2003 revealed that 27 per cent use target costing extensively, with a further 41 per centconsidering using the technique in the future

Source: 2003 Survey of Management Accounting, Ernst and Young, 2003.

Though target costing seems effective and has its enthusiasts, some people feel it has its problems Can you suggest what these problems might be?

There seem to be three main problem areas:

l It can lead to various conflicts – for example, between the business, its suppliers andits own staff

l It can cause a great deal of stress for employees who are trying to meet target coststhat are sometimes extremely difficult to meet

l Although, in the end, ways may be found to meet a target cost (through product or vice redesign, negotiating lower prices with suppliers, and so on), the whole processcan be very expensive

ser-Activity 5.4

We shall discuss total life-cycle costing and target costing more in Chapter 9 when

we consider the strategic aspects of management accounting

Costing quality control

Such is the importance that their customers place on quality that businesses are forced

to make sure that their output is of a high quality In the competitive environment inwhich most businesses operate, a failure to deliver quality will lead to customers going

to another supplier Businesses, therefore, need to establish procedures that promotethe quality of their output, either by preventing quality problems in the first place

or by dealing with them when they occur These procedures have a cost It has beenestimated that these quality costscan amount to up to 30 per cent of total processing

costs These costs tend to be incurred during the production phase of the product life

cycle They have been seen as falling into four main categories:

1 Prevention costs These are involved with procedures to try to prevent items being

pro-duced that are not up to the required quality Such procedures might include stafftraining on quality issues Some types of prevention costs might be incurred during

the pre-production phase of the product life cycle, where the production process could

be designed in such a way as to avoid potential quality problems with the output

2 Appraisal costs These are concerned with monitoring raw materials, work in progress

and finished products to try to avoid substandard products from reaching the customer

3 Internal failure costs These include the costs of rectifying substandard products

before they pass to the customer and the costs of scrap arising from quality failures

4 External failure costs These are involved with rectifying quality problems with

prod-ucts that have passed to the customer There is also the cost to the business of its loss

of reputation from having passed substandard products to the customer

Figure 5.4 sets these out in diagram form

Kaizen costing

Kaizen costing is linked to total life-cycle costing and focuses on cost saving during

the production phase The Japanese word kaizen implies ‘continuous changes’ The application of the kaizen costing approach involves continuous improvement, in terms

of cost saving, throughout the production phase Since this phase is at a relatively latestage in the life cycle (from a cost control point of view) only relatively small cost savings can usually be made The major production-phase cost savings should alreadyhave been made through target costing

With kaizen costing, efforts are made to reduce the unit manufacturing cost of the

particular product or service under review, if possible taking it below the unit cost

in the previous period Target percentage reductions can be set Usually, productionworkers are encouraged to identify ways of reducing costs This is something that the

‘hands on’ experience of these workers may enable them to do Even though the scope

to reduce costs is limited at the production stage, valuable savings can still be made

Real World 5.7 explains how a major UK manufacturer used kaizen costing to

advantage

Benchmarking

Benchmarkingis an activity – usually a continuing one – where a business, or one ofits divisions, seeks to emulate a successful business or division and so achieve a similarlevel of success The successful business or division provides a benchmark against whichthe business can measure its own performance, as well as examples of approaches thatcan lead to success Sometimes the benchmark business will help with the activity, but

‘

‘

REAL WORLD 5.7

Kaizen costing is part of the package

Kappa Packaging is a major UK packaging business It has a factory at Stalybridge where

it makes, among other things, packaging (cardboard cartons) for glass bottles containingalcoholic drinks In 2002, Kappa introduced a new approach to reducing the amount

of waste paper and cardboard Before this the business wasted 14.6 per cent of the rawmaterials it used This figure was taken as the base against which improvements would

be measured

Improvements were made at Kappa as a result of:

l making staff more aware of the waste problem;

l requiring staff to monitor the amount of waste for which they were individually ible; and

respons-l establishing a kaizen team to find ways of reducing waste.

As a result of kaizen savings, Kappa was able to reduce waste from 14.6 per cent to

13.1 per cent in 2002 and 11 per cent in 2003 The business estimates that each 1 per centwaste saving was worth £110,000 a year So by the end of 2003, Kappa was saving about

£400,000 a year, relative to 2001: that is, over £2,000 per employee each year

Source: Taken from ‘Accurate measurement of process waste leads to reduced costs’, www.envirowise.gov.uk, 2003.

even where no co-operation is given, outside observers can still learn quite a lot aboutwhat makes that business successful.

Businesses are under no statutory obligation to benchmark and are understandablyreluctant to divulge commercially sensitive information to competitor businesses.They may, however, benchmark internally, with one division or department com-paring itself with another part of the same business They may also benchmark withbusinesses with which they are not directly competing but which may have similarfunctions

Real World 5.8provides an example of two known divisions of an equally known parent business that are able to benchmark, one against the other

well-Ford sold Jaguar and Land Rover to the Indian motor business Tata in March 2008, butthe inter-divisional benchmarking still continues, no doubt

As we saw in Chapter 4, full costs can be used as a basis for setting prices for the ness’s output We also saw that it can be criticised in that role In this section we aregoing to take a closer look at pricing We shall begin by considering some theoreticalaspects of the subject before going on to look at some more practical issues, particu-larly the role of management accounting information in pricing decisions

busi-Pricing

REAL WORLD 5.8 Tracking the Jaguar

The solid off-road qualities of Land Rover vehicles inspire devotion among many of their owners, who include members of Britain’s royal family.

But the brand has been plagued by quality problems, setting spurious warning lights flashing

in some of its vehicles and putting it last in consultancy JD Power’s 2007 Initial Quality Study in the US.

Land Rover is now benchmarking the quality levels of Jaguar, its sister brand, and clawing its way back up the league tables.

‘They’re still below the average, but improving relative to the competition,’ said Brian Walters,

JD Power’s vice-president of European operations.

Lewis Booth, head of Ford Motor’s premium-brands group, told the Financial Times: ‘We want

to get Land Rover to Jaguar quality levels.’

The problems owe something to the complexity of the vehicles, packed with electronic control units aimed at keeping them stable off road.

Land Rover, formerly owned by BMW and now up for sale by Ford, has seen a flurry of new vehicle launches in recent years, even as it changed owners.

Source: Royal following but quality issues remain, Financial Times (Reed, J.), © The Financial Times Limited, 3 October 2007.

FT

a relatively low price per unit (P1), the quantity of units demanded by the market (Q1)

is fairly high When the price is increased to P2, the demand decreases to Q2 The graphshows a linear (straight-line) relationship between the price and demand In practice,the relationship, though broadly similar, may not be quite so straightforward

Not all commodities show exactly the same slope of line Figure 5.6 shows thedemand/ price relationship for Commodity B, a different commodity from the onedepicted in Figure 5.5

Though a rise in price of Commodity B, from P1to P2, causes a fall in demand, thefall in demand is much smaller than is the case for Commodity A with a similar rise

in price As a result, we say that Commodity A has a higher elasticity of demandthanCommodity B Demand for A reacts much more dramatically to price changes (stretchesmore) than does demand for B Elastic demand tends to be associated with commod-ities that are not essential, perhaps because there is a ready substitute

It is very helpful for those involved with pricing decisions to have some feel for the elasticity of demand of the commodity that will be the subject of a decision Thesensitivity of the demand to the pricing decision is obviously much greater (and thepricing decision more crucial) with commodities whose demand is elastic than withcommodities whose demand is relatively inelastic

‘

Graph of quantity demanded against price for Commodity AFigure 5.5

As the price of the commodity under consideration increases from P1to P2, the quantity that the

market will buy falls from Q1to Q2

Real World 5.9is an extract from a Financial Times article that suggests that patterns

of elasticity of demand can be modified by an economic recession in the US

Graph of quantity demanded against price for Commodity BFigure 5.6

As the price of the commodity increases from P1to P2 , the quantity that the market will buy falls

from Q1to Q2 This fall in demand is less than was the case for Commodity A, which has the greater elasticity of demand.

Which would have the more elastic demand – a particular brand of chocolate bar,

or Mains electricity supply?

A branded chocolate bar seems likely to have a fairly elastic demand This is for several

reasons, including the following:

l Few buyers of the bar would feel that chocolate bars are essentials

l Other chocolate bars, probably quite similar to the one in question, will be easily available

Mains electricity probably has a relatively inelastic demand This is because:

l Many users of electricity would find it very difficult to manage without fuel of somedescription

l For neither household nor business users of electricity is there an immediate, practicalsubstitute For some uses of electricity – for example, powering machinery – there isprobably no substitute Even for a purpose such as heating, where there are substitutessuch as gas and oil, it may be impractical to switch to the substitute because gas andoil heating appliances are not immediately available and are costly to acquire

Activity 5.5