Chapter 1
Advanced costing method
Chapter learning objectives
Upon completion of this chapter you will be able to:
§ explain what is meant by the term cost driver
§ identify appropriate cost drivers under activity-based costing (ABC)
§ calculate costs per driver and per unit using (ABC)
§ compare ABC and traditional methods of overhead absorption based on production units, labour hours or machine hours.
§ explain the implications of switching to ABC on pricing, performance management and decision making.
§ explain what is meant by the term ‘target cost’ in both manufacturing and service industries.
§ derive a target cost in both manufacturing and service industries.
§ explain the difficulties of using target costing in service industries
§ explain the implications of using target costing on pricing, cost control and performance management.
§ describe the target cost gap.
§ suggest how a target cost gap might be closed.
§ explain what is meant by the term ‘life-cycle costing’ in a manufacturing industry
§ identify the costs involved at different stages of the life-cycle.
§ explain the implications of life-cycle costing on pricing, performance management and decision making.
§ describe the process of back-flush accounting and contrast with traditional process accounting.
§ explain, for a manufacturing business, the implications of back-flush accounting on performance management
§ evaluate the decision to switch to back-flush accounting from traditional process control for a manufacturing business.
§ explain throughput accounting and the throughput accounting ratio (TPAR), and calculate and interpret, a TPAR.
§ suggest how a TPAR could be improved.
§ apply throughput accounting to a given multi-production decision making problem.
1 Activity based costing
1.1 Introduction – absorption cost
In F2 we saw how to determine a cost per unit for a product. Key issues of relevance here are the following:
Firms have the choice of two basic costing methods – marginal costing and absorption costing.
To enable this, all overheads must first be allocated/apportioned/reapportioned into production departments, again using a suitable basis (e.g. rent on the basis of floor area).
Overhead expenses incurred/budgeted
Step 1: Overheads allocated or apportioned to cost centres using suitable bases Cost centres (usually departments)
Step 2: Service centre costs reapportioned to production centres
Step 3: Overheads absorbed into units of production using an OAR (usually on the basis of direct labour hours) output
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The assumption underlying the traditional method of costing is that overhead expenditure is connected to the volume of production activity.
§ This assumption was probably valid many years ago, when production system were based on labour-intensive or machine-intensive mass production of fairly standard items. Overhead costs were also fairly small relative to direct materials and direct labour costs; therefore any inaccuracy in the charging of overheads to products costs was not significant.
§ The assumption is not valid in a complex manufacturing environment, where production is based on smaller customised batches of products, indirect costs are high in relation to direct costs, and a high proportion of overhead activities – such as production scheduling, order handling and quality control – are not related to production volume.
§ For similar reasons, traditional absorption costing is not well-suited to the costing of many services.
1.2 ABC and cost drivers
ABC is an alternative approach to the traditional method of absorption costing outlined above.
The traditional method of overhead absorption effectively absorbs on a production volume basis and may be misleading for costs where the behaviour is not directly related to production volume.
For example, the cost of quality control may be driven more by the number of inspections made rather than the overall volume of units manufactured.
The ABC approach is to link overhead costs to the products or services that cause them by absorbing overhead costs on the basis of activities that ‘drive’ costs (costs drivers) rather than on the basis of production volume.
§ A cost pool is an activity that consumes resources and for which overhead costs are identified and allocated. For each cost pool, there should be a cost driver.
§ A cost driver is a unit of activity that consumes resources. An alternative definition of a cost driver is a factor influencing the level of cost.
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The concepts or assumptions underlying ABC are:
§ In the long run, all overhead costs are variable. Some overheads are variable in the short run. However, overhead costs do not necessarily vary with production volume or service level.
§ Activities consume resources.
§ The consumption of resources drives cost.
Products incur overhead costs because of the activities that go into providing the products or services, and these activities are not necessarily related to the volumes of the product that are manufactured. Direct labour hours and machine hours are not the drivers of cost in many modern business environments.
Understanding the relationship between overhead costs, activities and products (or services) is essential for managing overhead costs and product or service profitability.
Absorption of overheads into unit costs on a volume basis may be misleading, particularly in a modern manufacturing environment where overhead costs are influenced by the diversity and complexity of output rather than volume.
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