UNIT 1

Introduction to performance Management:

Performance Management is about how to manage the performance of a business towards profitability,
across four main areas. Those four areas are the four parts of the syllabus:
A – Costing and Management Accounting Techniques,
B – Decision Making,
C – Budgeting & Control and
D – Performance Measurement & Control.
Introduction to cost, costing, cost accounting and cost accountancy:
Cost:
Cost is defined as the cash amount (or the cash equivalent) given up for an asset. Cost includes all costs
necessary to get an asset in place and ready for use. For example, the cost of an item in inventory also
includes the item's freight-in cost. The cost of land includes all costs to get the land ready for its use or
The term ‘cost’ represents the total of all expenses incurred, whether paid or due, in the production and
sale of product or expended in rendering a service.
Costing:
The Chartered Institute of Management Accountant (CIMA) has defined costing as – “The techniques
and processes of ascertaining cost.” “The techniques and processes of ascertaining costs.”
The ‘techniques’ refers to the principles and rules that are applied for ascertaining cost of products
manufactured and services rendered.
The ‘Process’ of costing is the day-to-day affairs of ascertaining costs, whether the costs ascertained
may be and by whatever means these costs are determined.

Cost accounting:
According to definition given by CIMA, London “Cost Accounting is the process of accounting for cost
from the point at which expenditure is incurred to the establishment of its ultimate relationship with
cost centres and cost units”.
Kohler – “It is that branch of accounting dealing with the classification, recording, allocation,
summarization and reporting of current and prospective costs”.
Wheldon – “It is the classifying, recording and appropriate allocation of expenditure for the
determination of the costs of products or services, the relation of these costs to sales values and the
ascertainment of profitability”.
Cost accountancy:
Cost Accountancy is the application of costing and cost accounting principles, methods and techniques
to the science, art and practice of cost control and the ascertainment of profitability. It includes the
presentation of information derived there from for purposes of managerial decision-making. Thus, cost
accountancy is the science, art and practice of a cost accountant.
Objectives of cost accounting:

To ascertain cost: The basic objective of cost accounting is to ascertain cost of cost centre. Cost
ascertainment is the process of determining costs after they have been incurred. Basically there are two
methods of cost ascertainment - Job costing and Process costing. Different industries follow different
methods of costing because of the difference in the nature of their activity.
To control cost: Cost accounting aims at controlling costs by using various techniques such as
budgetary control, standard costing, Inventory control etc.

To provide information for decision making: Cost accounting aims at providing information for
various managerial decisions

a. Whether to make or buy component

b. Whether to retain or replace an existing machine
c. Whether to process further or not
d. Whether to shut down or continue operations
To determine selling price: Cost accounting provides cost information to determine the selling
price of products or services. During the period of depression, it guides the management to decide,
“How much reduction in selling price may be made to meet the situation?”
To ascertain costing profit: Cost accounting aims at ascertaining the costing profit or loss of any
activity on an objective basis by matching cost with the revenue of that activity.
Need and importance of cost accounting:
1. Profitable and unprofitable Activities:
In Cost Accounting profitable and unprofitable activities are disclosed. Management can take steps to
eliminate or to reduce those activities from which little or no profit is earned. It can change the method
of production in order to render such activities more profitable.
2. Classification and Subdivision of costs:
Costs are accumulated and classified by every possible division of business. In a good costing system
data regarding costs by functions, departments, processes, jobs or orders, contracts and services can be
easily computed. Thus it helps management to ascertain the profitability of each product, sales area,
division etc. in order to improve profit.
3. Cost Finding and Price-Fixing:
It provides accurate cost data which help in the fixation of selling price and for submitting quotations.
In periods of depression it enables the management to determine the extent to which prices can be
reduced.
4. Control of Materials and supplies:
Since in all types of cost accounting, materials and supplies must be accounted for in terms of
departments, processes, and units of production or services; a system of receiving, handling, and issuing
materials and supplies is an essential part of cost control. This will eliminate or reduce misappropriation,
embezzlement, obsolescence, and losses from scrap, defective, and spoiled materials and supplies.
5. Control of Wages and Salaries:
Cost Accounting activities encourage accounting for labour by jobs and by operations. In many
manufacturing concerns daily summary reports are prepared to show the number of hours and minutes
worked and the wage rate for each worker per job or operation.
Cost Accounting is a benefit to the employer by establishing standards to measure the efficiency of
labour to assist in assignment of work to employees best fitted for it, and to determine the unit cost of
labour arising from each activity.
6. Overhead costs:
The Cost accountant first separates costs into direct and indirect items. Direct costs consists of materials
and labour that can be definitely
The advantages of cost accounting are:

● Disclosure of profitable and unprofitable activities.

Since cost accounting minutely calculates the cost, selling price and profitability of product, segregation
of profitable or unprofitable items or activities becomes easy.
● Guidance for future production policies.
On the basis of data provided by costing department about the cost of various processes and activities
as well as profit on it, it helps to plan the future.
● Periodical determination of profit and losses.
Cost accounting helps us to determine the periodical profit and loss of a product.
 ● To find out exact cause of decrease or increase in profit.
With the help of cost accounting, any organization can determine the exact cause of decrease or increase
in profit that may be due to higher cost of product, lower selling price or may be due to unproductive
activity or unused capacity.
● Control over material and supplies.
Cost accounting teaches us to account for the cost of material and supplies according to department,
process, units of production, or services that provide us a control over material and supplies.
● Relative efficiency of different worker.
With the help of cost accounting, we may introduce suitable plan for wages, incentives, and
rewards for workers and employees of an organization.
Limitations of cost accounting:
1. It is Expensive:
Many people raise the objection against cost accounting on the basis that it involves a considerable
amount of expenditure in the introduction stage. Double set of account books has to be maintained and
it is not economical for small concerns. In the installation stage, it consumes a good amount of finance.
But when we install a system of costing, bearing in mind the requirements of the industry in the long
run; with the active cooperation of the personnel of the costing organization, benefits will be more than
the initial cost. Moreover, the purpose of costing is not only to find out the cost, but also to try to
introduce cost reduction schemes, which bring adequate return to the firm.
2. It is Unnecessary:
It is argued that costing is only recently originated and that many industries have prospered well and
are still prospering without cost accounting. Therefore, the system is unnecessary.
It may be true; however the present period is different from the past. At present, cut throat competition,
economic policies of the government, production of variety of products etc., contribute to uncertainty
and risk. Even in the case of absolute monopoly, substitutes may appear in the market. The modern
industries are passing- through highly competitive conditions, and as such every manufacturer should
know the actual cost in order to fix the selling price, at the minimum. Therefore, it is a must for
progressing firms.
3. Matter of Routine Forms and Statements:
Reporting of the costing information to the management involves the use of a number of forms. As
such, filling of forms becomes a stereotyped mechanical reporting of cost data and is a monotonous
work. There is unnecessary paper work.
It is right to say that introduction of costing system involves additional work. It is not merely one system
of forms and statements. When time passes, the forms are to be revised to make them up-to-date and
fewer in numbers.
4. Failure of Costing System:
It is claimed that Costing system has failed to bring good or desired results in many cases. Therefore, it
is defective.
But the costing system is not faulty. There is no rigid system of cost accounting applicable to all the
industries of all types. The unsuited costing system will naturally bring failure. The adoption of proper
system into practice through cooperation of the personnel will not be a failure. Deliberate obstructions
from the management, non-cooperation of the personnel, non-availability of facilities for efficient work
etc. are the causes for failure, and for these, the costing system should not be blamed.
5. Not Applicable to Many Industries:
Modern methods of costing cannot be applied to certain type of industries.
There is no ready-made system of cost accounting applicable to all concerns. But the cost system, in
the modified form, can be adopted to suit the special requirements of an industry. A modified costing
system has to be devised to suit the concern and not the business to suit the system.
6. It is not reliable:
It is stated that cost accounting is based on estimates and therefore cannot be relied upon.
But, in costing, it is not mere estimates. Estimate in costing is based on scientific technique of reasoning,
and actual figures of the past. As such, it is quite near to reality. There are certain circumstances, where
the estimation is only the method, such as tenders, fixation of standard costs etc. Standard cost is widely
used in modern times.
 Other limitations of Cost Accounting
● Lack of uniformity
● Conceptual diversity
● Costly
● Ignorance of futuristic situation
● Lack of double entry systems
● Developing stage

CLASSIFICATION OF COSTING:

Unit costing:
It is also called the single output costing. It is used in costing of products that are expressed in identical
units and suitable for products that are manufactured by continuous activity.
Example: Cement manufacturing, Dairy, Mining etc.

Job costing:
Under this method, costs are ascertained for each work order separately as each has its own specification
and scope. Tailor made products also get covered by this type of costing.
Example: Repair of buildings, Painting etc

Contract costing:
In this method costing is done for jobs that involve heavy expenditure and stretches over long period
and across different sites. It is also called as terminal costing.
Example: Construction of roads and bridges, buildings etc

Batch costing:
Through this method the costing is done for units that are produced in batches that are uniform in nature
and design.
Example: Pharmaceuticals

Process costing:
It is used for the products which go through different processes. Like in the process of manufacturing
cloth, different processes are involved namely spinning, weaving and finished product. Each process
gives an output that is a finished product in itself and can be sold. That is why; process costing is used
to ascertain the cost of each stage of production.

Service or operating costing:

It is the method used for the costing of operating a service such as Public Bus, Railways, Nursing home.
It is used to ascertain the cost of a particular service.

Multiple costing:
When the output comprises different assembled parts like in televisions, cars or electronic gadgets, cost
has to be ascertained for the component as well as the finished product. Such costing may involve
different / multiple methods of costing.
Product Costing:
Product costing methods are used to assign cost to a manufactured product. The main costing methods
available are process costing, job costing and direct costing. Each of these methods apply to different
production and decision environments.
 The main product costing methods are:
● Job costing: This is the assignment of costs to a specific manufacturing job. This method is
used when individual products or batches of products are unique, and especially when jobs are
being billed directly to customers or are likely to be audited by customers.
● Process costing: This is the accumulation of labor, material and overhead costs across
departments or entities, with the total production cost then being allocated to individual units.
Process costing is used when large quantities of the same product are manufactured, usually in
long production runs.

Inventory Costing:
Different inventory costing methods are best suited to different situations and financial goals.
● First In, First Out
Under the First In, First out (FIFO) method, the oldest costs are assigned to inventory items
sold, regardless of whether the sold items were actually purchased at that cost. When the
number of inventory items purchased at the oldest cost is sold, the next oldest cost is assigned
to sales.
● Last In, First Out
The last in, first out method (LIFO) is the exact opposite of the FIFO method, assigning the
most recent inventory costs to items sold
● Average Cost Method
The average cost method assigns inventory costs by calculating a moving average of all
inventory purchase costs.
● Specific Identification Method
The specific identification method perfectly matches inventory costs with units sold, assigning
the exact cost of each sold inventory item when the specific item is sold.

TECHNIQUES OR TYPES OF COSTING:

A. Marginal Costing:
Through this method only the variable cost is allocated i.e. direct materials, direct expenses, direct labor
and variable overheads to production. It does not include the fixed cost of production.
B. Absorption Costing:
It is the technique to absorb the fixed and variable costs to production. In this method, full costs i.e.
fixed and variable costs are absorbed to the production.

C. Standard Costing:
When the costs are predetermined on certain standards in a given set of operating conditions, it is called
standard costing.

D. Historical Costing:
In this method the costs are determined in terms of actual costs and not predetermined standard costs.
Costs are determined only after it is incurred. Almost all organizations adopt this method of costing.

TERMS ASSOCIATED WITH COSTING:

1. Fixed cost:
Fixed costs are those costs that do not vary with respect to changes in output and would accrue even if
no output was produced. E.g. Rent, interest payments, property taxes and employee salaries. However,
fixed costs are restricted to specific time frame, since over the long run fixed costs can vary. For
example, a manufacturer may decide to expand capacity in tandem to the increase in demand for its
product, requiring a higher level of expenditure on plant and equipment.

2. Variable Cost:
Variable cost changes proportionately to the level of output. For manufacturers, the key variable cost is
the cost of materials.

3. Total Cost:
It is defined as the sum of fixed, variable and semi variable costs.

4. Direct and Indirect cost:

Direct costs typically include the major components for manufacturing goods and the labor directly
required to produce those goods. Direct costs are also referred to as prime costs. On the other hand,
indirect costs include plant-wide costs such as those resulting from the use of energy and fixed capital.
Indirect costs are also referred to as overhead.

5. Incremental cost:
It is mainly the extra cost associated with manufacturing one additional unit of production. It is also
referred to as differential cost.

6. Opportunity Cost:
It is defined as the cost of an alternative that is forgone (benefit, profit, value given up) in order to
pursue a certain action.

7. Sunk Cost:
It is the cost that is already incurred and cannot be recovered.
Advanced Management Accounting Techniques (AMATs):
Advanced Management Accounting Techniques (AMATs) are generally defined as multidimensional
composite of planning and controlling subsystems that aim to provide information
for managerial decision-making and enhance an organizational performance.
Activity-based costing (ABC)

ABC is a costing method that identifies activities in an organization and assigns the cost of
each activity to all products and services according to the actual consumption by each. This model
assigns more indirect costs (overhead) into direct costs compared to conventional costing

Definition of ABC:

CIMA, the Chartered Institute of Management Accountants defines ABC as an approach to the costing
and monitoring of activities which involves tracing resource consumption and costing final outputs.
Resources are assigned to activities, and activities to cost objects based on consumption estimates. The
latter utilize cost drivers to attach activity costs to outputs.

The Institute of Cost & Management Accountants of Bangladesh (ICMAB) defines activity-based
costing as an accounting method which identifies the activities which a firm performs and then assigns
indirect costs to cost objects

CIMA,

Cost attribution to cost units on the basis of benefit received from indirect activities e.g. ordering, setting
up, and assuring quality.
Kaplan and Cooper’s ABC
Kaplan and Cooper of Harvard Business School who have developed new accounting methodology in
costing to calculate product costs. They classify the costs into two types. They are
i. Short term variable costs and
ii. Long term variable costs.
The reason is that all the costs are variable in the long run. But, only variable costs are variable in the
short term. Fixed costs i.e. long term variable costs are varying but not immediately.
For example production scheduling costs can be changed in the long term by changing number of runs
rather than changing number of units produced.
Under ABC system, some activities are responsible for the determination of cost of a product. They are
named cost drivers. A cost driver is an activity which generates cost.
Why activity based costing
Activity-based costing provides a more accurate method of product/service costing, leading to more
accurate pricing decisions. ... ABC enables effective challenge of operating costs to find better ways of
allocating and eliminating overheads. It also enables improved product and customer profitability
analysis.
Who invented ABC:
Robert Kaplan is regarded as the founder of the theoretical principles of activity based costing within
the cost management knowledge area. In the 1970s the activity based costing method was introduced
in the manufacturing industry to solve the problems of traditional cost price calculation.
Steps in ABC
Step 1: Identify the products that are the chosen cost objects.
Step 2: Identify the direct costs of the products.
Step 3: Select the activities and cost-allocation bases to use for allocating indirect costs to the
products for allocating indirect costs to the products.
Objectives of Activity Based Costing:
The objectives of Activity Based Costing are given below.

1. To rectify the inaccurate cost information.

2. To allocate the overheads on activity basis.

3. To help the management in taking quality and timely decision.

Features or Characteristics of Activity Based Costing

The features or characteristics of Activity Based Costing are briefly explained below.

1. The total cost is divided into two types i.e. fixed cost and variable cost which is necessary to provide
quality information to design a suitable cost system in a manufacturing concern.

2. The proper distinction is made between the cost behavior patterns.

3. The cost behavior patterns are volume related, diversity related, events related and time related.

4. The appropriate cost driver has to be identified for tracing the overhead to a product.

5. The cost drivers dictate the cost behavior pattern.

Advantages of Activity Based Costing (ABC):

The following are the advantages of ABC:

1. Accurate Product Cost:

ABC brings accuracy and reliability in product cost determination by focusing on cause and effect
relationship in the cost incurrence. It recognizes that it is activities which cause costs, not products and
it is product which consume activities. In advanced manufacturing environment and technology where
support functions overheads constitute a large share of total costs, ABC provides more realistic product
costs.

2. Information about Cost Behavior:

ABC identifies the real nature of cost behavior and helps in reducing costs and identifying activities
which do not add value to the product. With ABC, managers are able to control many fixed overhead
costs by exercising more control over the activities which have caused these fixed overhead costs. This
is possible since behavior of many fixed overhead costs in relation to activities now become more
visible and clear.

3. Tracing of Activities for the Cost Object:

ABC uses multiple cost drivers, many of which are transaction based rather than product volume.
Further, ABC is concerned with all activities within and beyond the factory to trace more overheads to
the products.
4. Tracing of Overhead Costs:

ABC traces costs to areas of managerial responsibility, processes, customers, departments besides the
product costs.

5. Better Decision Making:

ABC improves greatly the manager’s decision making as they can use more reliable product cost data.
ABC helps usefully in fixing selling prices of products as more correct data of product cost is now
readily available.

6. Cost Management:

ABC provides cost driver rates and information on transaction volumes which are very useful to
management for cost management and performance appraisal of responsibility centres. Cost driver rates
can be used advantageously for the design of new products or existing products as they indicate
overhead costs that are likely to be applied in costing the product.

7. Use of Excess Capacity and Cost Reduction:

ABC, through the processes of pooling of activity costs and the identification of cost drivers, can lead
to a range of applications. These include the identification of spare capacity and the fostering of cost
reduction by comparing the resources required under ABC with the resources that are currently
provided. This provides a platform for the development of activity-based budgeting in which the
resource relationships identified by ABC are used to project future resource requirements.

8. Benefit to Service Industry:

Service organizations, such as banks, hospitals and government departments, have very different
characteristics than manufacturing firms. Service organizations have almost no direct costs, most of the
costs are overheads and they do not hold stocks of service as the service is consumed when it is
produced. Traditional costing has generally been considered inappropriate for these organizations,
whereas ABC offers the potential of benefits from improved decision making and cost management.

Development of Activity Based Costing:

The development of Activity Based Costing involves the following steps.

1. The main functional areas of the organization have been identified. For example production, sales,
distribution etc.
2. Each functional area has separate activities. Out of many activities, the main activities of each
functional areas have been identified. For example: Purchase of raw materials, purchase of packing
materials etc.
3. The support activities of main activities have been identified. For example: repairs and maintenance
of machine, maintaining power supply, testing of quality etc.
4. The factors which are influencing the main activities and support activities identified i.e. cost drivers.
5. The data relating to direct labor, material and overhead costs have been collected accurately.
6. The cost driver rates have been fixed on the basis of the overheads incurred.
7. The cost of each activity is also find out in order to calculate the cost of each product separately.
Thus, ABC is the process of tracing costs first from resources to activities and then from activities to
specific products.

Implementation of Activity Based Costing:

The following steps are involved in implementing Activity Based Costing to achieve the desired results.
1. Identify the functional areas of organization.
2. Identify the main activities of each functional areas.
3. Allocate common indirect costs to each functional areas on suitable basis.
4. Identify the most suitable cost driver in each activity under functional areas.
5. Preparing the statement of expenditure on activity wise.
6. Compare this statement with the value addition activity wise.
7. Find the activities which are to be eliminated or improved for better performance of the organization.
Definition of cost driver:
Chartered Institute of Management Accountants
Cost driver is any factor which causes a change in the cost of an activity. — Chartered Institute of
Management Accountants. "Cost drivers are the structural determinants of the cost of an activity,
reflecting any linkages or interrelationships that affect it".
A cost driver is the unit of an activity that causes the change in activity's cost. Cost driver is any factor
which causes a change in the cost of an activity. — Chartered Institute of Management Accountants
Cost drivers are the structural determinants of the cost of an activity, reflecting any linkages or
interrelationships that affect it". Therefore we could assume that the cost drivers determine the cost
behavior within the activities, reflecting the links that these have with other activities and relationships
that affect them.
What is a Cost Driver?
A cost driver is the direct cause of a cost and its effect is on the total cost incurred. For example, if you
are to determine the amount of electricity consumed in a particular period, the number of units
consumed determines the total bill for electricity. In such a scenario, the number of units of electricity
consumed is a cost driver.
Example of cost driver
A cost driver is a unit of activity that causes a company to incur costs. Some examples are: Direct labor
- Machine use.
Types of Drivers in Cost Accounting
In a traditional system of accounting, the indirect costs or manufacturing overheads are allocated to the
production cost based on a predetermined rate. In some accounting systems, cost drivers are almost
irrelevant in determining the contribution.
● Number of set-ups
● Number of machine hours
● Number of processed orders
● Number of orders completed
 ● Number of labor hours
● Number of orders packed and delivered
What is cost Pool and cost driver?
Your cost drivers are all the activities that you do that cost you money to make your product. Your cost
pools are your cost drivers divided into groups of related costs.
Importance of cost driver
● A cost driver simplifies the allocation of manufacturing overhead.
● The correct allocation of manufacturing overhead is important to determine the true cost of a
product.
● Internal management uses the cost of a product to determine the prices of the products they
produce.
Meaning of cost per unit:
The cost per unit is commonly derived when a company produces a large number of identical products.
The cost per unit is derived from the variable costs and fixed costs incurred by a production process,
divided by the number of units produced.
Hoe to calculate cost per unit:
Formula is: (Total fixed costs + Total variable costs) ÷ Total units produced
For example, ABC Company has total variable costs of $50,000 and total fixed costs of $30,000 in
May, which it incurred while producing 10,000 widgets. The cost per unit is:
($30,000 Fixed costs + $50,000 variable costs) ÷ 10,000 units = $8 cost per unit
In the following month, ABC produces 5,000 units at a variable cost of $25,000 and the same fixed cost
of $30,000. The cost per unit is:
($30,000 Fixed costs + $25,000 variable costs) ÷ 5,000 units = $11/unit
Definition of Traditional costing:
The allocation of manufacturing overhead (indirect manufacturing costs) to products on the basis of a
volume metric such as direct labor hours or production machine hours.
Advantages of the Traditional Costing System
1. It offers accurate cost figures with large production volumes.
The traditional costing system is best used when an organization has low overhead costs compared to
the direct production costs they pay. When volumes are large and overhead costs don’t create a
significant difference when calculating costs, then it provides an accurate figure that can then be added
as a rate to the finished goods or services.
2. It is cheap to implement.
There are no fancy calculations or forms required to determine the average overhead rate under the
traditional costing system. All you must do is calculate the amount of time it takes to produce a specific
product or provide a unique service. Then you take the average rate of labor or machine use costs per
hour, multiplying it by the length of time necessary to create saleable goods and services.
2. It creates reports which are easier to understand.
If you’re trying to determine what goods or services offer the best profit ratios for an organization,
outsiders will prefer to use the traditional costing system. The reports generated by this calculation are
often easier to read and understand because it puts everything into a dollars and cents category. For
investors, employees, or other interested parties, the traditional costing system makes it possible to
understand some of the basics of a company’s financial picture. Activity-based costing cannot be
accurately used for external reports because of the multiple activity rates involved.
4. It is still able to tract all direct costs.
Traditional costing might not offer the specificity of activity-based costing, but it still offers the ability
to trace direct costs. Anything that is related to a specific product, including direct labor and materials,
is included with this information. It follows GAAP principles to offer a reasonably analysis of
production costs when an organization is producing a handful of products or services to their targeted
demographics.
5. It applies one rate to the entire system.
The reason why the traditional costing system was developed in the first place was that it could quickly
accommodate the high cost of machine or human labor into the finished products being offered. Instead
of incorporating multiple costs that must be calculated to determine an outcome, this system utilized
one rate for overhead allocation which applies to the entire business operation. That means your
accounting department only needs to run one set of books, unlike activity-based costing, which must
run two sets of books.
6. It keeps workers more productive.
If a company uses an activity-based costing system, then their workers are forced to take the time to
assign costs each day. The accounting department will spend several hours per week assigning costs to
the various products or services offered. Imagine having 15 cost activities, called pools, with rates that
must be assigned to 200 different products. With the traditional costing method, you might use estimates
more often, but there are fewer cost assignment procedures which must be completed.
7. It streamlines the accounting process.
Imagine that your company only produces one product. You could track all of the activities which create
overhead costs to find specific data patterns. At the end of the day, however, all of the costs will still
fall into an overhead category which will be assigned to that one product that is produced. By using the
traditional costing method, you’re able to streamline that process to keep details reasonably accurate
without boosting your labor costs to reach that number.
8. More than one different costing approach is used.
Under the traditional costing system, you have multiple approaches to consider when looking for the
best option to convey information about cost. Your options include volume-based costing, the French
cost accounting approach, and planned marginal cost accounting. Each specific system offers
advantages and disadvantages to consider, based on the structure of the organization and the number of
products which are offered.
Disadvantages of the Traditional Costing System
1. It offers limited accuracy, even in the best of situations.
Traditional costing may work when there are a handful of products being manufactured with low
overhead costs. It does not offer the same accuracy when trying to look at the actual expenses that are
incurred by an organization. It tends to distort the actual expense, looking at the profitability of products
or services by arbitrarily assigning costs for all activities instead of considering the cost of each action
required to bring the product to sale.
2. It wants to ignore unexpected circumstances.
Any unanticipated expenses are ignored when the traditional costing system is used. That is because
the overall average is factored into the product. It may cost an organization more to manufacture goods
or provide services after the first projections are made, and there is no way for this accounting system
to take that into account. When companies dig into their raw figures for detailed data, they might find
that their products or services earned a lot less (or a lot more) than they anticipated at the end of the
year.
3. It isn’t always a helpful system.
The traditional costing system does not show enough specifics to identify where waste might be
occurring within the system. The indirect costs of manufacturing products or providing services are not
accounted for under this system. It only looks at the overhead costs in general, ignoring the specifics
for the overall number. For that reason, some organizations prefer to use activity-based costing if they
suspect that there are cost-cutting measures that could be implemented.
4. Its simplicity may be too simple.
The modern business must analyze non-manufacturing costs as part of their overall accounting process.
It must evaluate the vast variety of expenses that are associated with an offer of numerous products or
services. You cannot receive that information from the traditional costing system. Although the
calculations are easy, and the information is easy to convey to others, the overall lack of data is limiting
to organizations which offer numerous items for sale.
5. It does not account for non-manufacturing costs.
When you look at the cost of producing goods or services today, there are numerous costs which must
be paid that do not apply to the production cycle. The traditional costing system wouldn’t look at
marketing, sales, or outreach costs because those occur after the manufacturing process. If those costs
are high, then this system might indicate profitability for a company when none exists. Its failure to
analyze non-manufacturing costs is one of its greatest weaknesses.
Differences between activity based costing and traditional costing:
The main points of difference between activity based costing and traditional costing are given
below:
1. Primary Focus:
The primary focus of traditional costing is the apportionment of overhead costs to the activities of
production. Irrespective of the specific allocation of resources, traditional costing sets a single metric
for every activity involved in production and allocates costs based on the consumption of that metric.
Although, activity based costing is also used for cost allocation but it adopts a different approach. Under
activity based costing, appropriate cost drivers are determined for every different activity and cost is
then allocated according to these cost drivers.
2. Application:
Traditional costing method is easy to implement as a single cost driver is set for all activities and
overheads are simply divided into fixed and variable overheads. Activity based costing is difficult to
implement because it involves choosing a suitable basis of absorption and absorbing overheads on that
same basis is a complicated and time-consuming exercise. Additionally, in some cases it becomes
difficult to determine a proper basis for the allocation of an activity.
3. Scope:
Traditional costing can only be used for the absorption of manufacturing overheads but activity based
costing can effectively be used to allocate manufacturing as well as non-manufacturing overheads like
selling, administration etc. This is because activity based costing considers the actual center of cost for
the period cost and then allocates it.
4. Management use:
The figures extracted by traditional costings can be included into cost figure of statement of profit or
loss because it only inculcates product costs but activity based costing can only be used
for management purposes. The main reason being activity based costing is based on the subjectivity of
the user and two users may not find a cost metric suitable for the same activity. However, activity based
costing can be actively used by the management of a company to make better cost pools and allocate
costs more accurately.
5. Effectiveness of operations:
Activity based costing improves business processes in long term. This is because management of a
company needs to investigate deeply into production activities and related costs. This highlights the
reasons for certain costs being incurred, which can ultimately help control and manage these costs.
Traditional costing does not compel management to look for different cost centers and so it becomes
difficult for management to gather incremental data about production activities.
Introduction or meaning of Absorption costing
Sometimes called full absorption costing, is a managerial accounting method for capturing all costs
associated with manufacturing a particular product. The direct and indirect costs, such as direct
materials, direct labor, rent, and insurance, are accounted for using this method
Definition of Absorption Costing:
Absorption costing (also known as full absorption costing) indicates that all of the manufacturing
costs have been assigned to (absorbed by) the units of goods produced. In other words, the cost of a
finished product includes the following costs:
● direct materials
● direct labor
● variable manufacturing overhead
● fixed manufacturing overhead
Features of Absorption Costing
The features associated with absorption costing are as follows:
▪ In the absorption costing a product, the cost is determined on the basis full cost, i.e., variable
and fixed manufacturing cost.
▪ The cost of inventory will be higher in absorption costing as product cost includes fixed factory
overhead.
▪ Absorption costing net income changes with production,
▪ It is a conventional costing where gross profit is determined by subtracting the cost of goods
sold from sales and net profit is determined by subtracting all commercial expenses from the
gross profit.
▪ Under or over-allocation of fixed factory overhead is required to be adjusted in absorption
costing as it is included in the cost of production.
Advantages of Absorption Costing:
1. It suitably recognizes the importance of including fixed manufacturing costs in product cost
determination and framing a suitable pricing policy. In fact all costs (fixed and variable) related to
production should be charged to units manufactured. Price based on absorption costing ensures that all
costs are covered. Prices are well regulated where full cost is the basis.
2. It will show correct profit calculation in case where production is done to have sales in future (e.g.,
seasonal sales) as compared to variable costing.
3. It helps to conform to accrual and matching concepts which require matching cost with revenue for
a particular period.
4. It has been recognized by various bodies as FASB (USA), ASG (UK), ASB (India) for the purpose
of preparing external reports and for valuation of inventory.
5. It avoids the separation of costs into fixed and variable elements which cannot be done easily and
accurately.
6. It discloses inefficient or efficient utilization of production resources by indicating under-absorption
or over-absorption of factory overheads.
7. It helps to make the managers more responsible for the costs and services provided to their
centers/departments due to correct allocation and apportionment of fixed factory overheads.
8. It helps to calculate gross profit and net profit separately in income statement.
Disadvantages of Absorption Costing:
1. Difficulty in Comparison and Control of Cost:
Absorption costing is dependent on level of output; so different unit costs are obtained for different
levels of output. An increase in the volume of output normally results in reduced unit cost and a
reduction in output results in an increased cost per unit due to the existence of fixed expenses. This
makes comparison and control of cost difficult.
2. Not Helpful in Managerial Decisions:
Absorption costing is not very helpful in taking managerial decisions such as selection of suitable
product mix, whether to buy or manufacture, whether to accept the export order or not, choice of
alternatives, the minimum price to be fixed during the depression, number of units to be sold to earn a
desired profit etc.
3. Cost Vitiated because of Fixed Cost included in Inventory Valuation:
In absorption costing, a portion of fixed cost is carried forward to the next period because closing stock
is valued at cost of production which is inclusive of fixed cost.
4. Fixed Cost Inclusion in Cost not justified:
Many accountants argue that fixed manufacturing, administration and selling and distribution overheads
are period costs and do not produce future benefits and, therefore, should not be included in the cost of
product.
5. Apportionment of Fixed Overheads by Arbitrary Methods:
The validity of product costs under this technique depends on correct apportionment of overhead costs.
But in practice many overhead costs are apportioned by using arbitrary methods which ultimately make
the product costs inaccurate and unreliable.
6. Not Helpful for Preparation of Flexible Budget:
In absorption costing no distinction is made between fixed and variable costs. It is not possible to
prepare a flexible budget without making this distinction.
Hoe to calculate Absorption Costing
Formula is
1. Total cost = Direct Cost + Indirect Cost. Or.
2. Total cost = Fixed Cost + Variable Cost. Or.
3. Total cost = Cost Per Unit * Total Quantity Produced. In absorption costing, there are the
following cost components: Direct Material cost. Direct Labor. Variable Overheads. Fixed
Overhead.
Why is absorption costing important.
The main advantage of absorption costing is that it is in compliance with GAAP and does a better job
of accurately tracking profits than variable costing. Drawbacks include that it can skew the picture of a
company's profitability, and is not helpful for analysis to improve operations or to compare product
lines.
Definition of Target Costing:
CIMA defines target cost as “a product cost estimate derived from a competitive market price OR
Target costing can be viewed as a proactive cost management tool used to reduce the total cost of the
product, over its complete lifecycle, through production, engineering, research and design. It helps the
firm in managing the business in reaping profits in the extremely competitive market.
Objectives of target costing
The objectives of target costing are-
● Decreasing the costs to ensure the required profit level of new products
● Meeting the set standards of the market for new products in terms of price, delivery time and
quality levels
● Motivating employees to achieve target profit during the development of new products
Why Target Costing?
In industries such as FMCG, construction, healthcare, and energy, competition is so intense that prices
are determined by supply and demand in the market. Producers can’t effectively control selling prices.
They can only control, to some extent, their costs, so management’s focus is on influencing every
component of product, service, or operational costs.
Example:
ABC Inc. is a big FMCG player that operates in a very competitive market. It sells packaged food to
end customers. ABC can only charge $20 per unit. If the company’s intended profit margin is 10% on
the selling price, calculate the target cost per unit.
Solution:
Target Profit Margin = 10% of 20 = $2 per unit
Target Cost = Selling Price – Profit Margin ($20 – $2)
Target Cost = $18 per unit
Key Features of Target Costing:
● The price of the product is determined by market conditions. The company is a price
taker rather than a price maker.
● The minimum required profit margin is already included in the target selling price.
● It is part of management’s strategy to focus on cost reduction and effective cost management.
● Product design, specifications, and customer expectations are already built-in while formulating
the total selling price.
● The difference between the current cost and the target cost is the “cost reduction,” which
management wants to achieve.
● A team is formed to integrate activities such as designing, purchasing, manufacturing,
marketing, etc., to find and achieve the target cost.
Advantages of Target Costing:
● It shows management’s commitment to process improvements and product innovation to gain
competitive advantages.
● The product is created from the expectation of the customer and, hence, cost is also based on
similar lines. Thus, the customer feels more value is delivered.
● With the passage of time, the company’s operations improve drastically, creating economies of
scale.
● The company’s approach to designing and manufacturing products becomes market-driven.
● New market opportunities can be converted into real savings to achieve the best value for
money rather than to simply realize the lowest cost.
Disadvantages of Target Costing:
Since the target costing depends on the prediction of the final selling price of the product, any error in
it may cause the entire marketing strategy failure.
To achieve the target cost there is a possibility for the company to opt for cheaper technology or
materials which is not an advantageous option in the long run and even becomes the greatest
disadvantage.
Target costing can create an unrealistic burden on the production department when the estimated cost
is too low.
Failure of proper estimation of the quantity may lead to a loss when the business fails to sell all the
produced quantity.
The primary difference between target costing and traditional cost-based pricing is
a. traditional cost-based pricing is designed to appeal to any customers, but target costing targets specific
customers.
b. traditional cost-based pricing considers the market that is available for the product at the end of the
process, whereas target costing considers the market at the beginning of the process.
c. product costs are irrelevant under traditional cost-based pricing, but are very important under target
costing.
d. product costs are irrelevant under target costing, but are very important under traditional cost-based
pricing.
Process of target costing:
● Identifying customer needs
● Planning selling price as per the needs
● Identifying the target cost
● Keep the price in consideration after identifying suppliers and fixing the manufacturing process
● Compare sample product with the target and start production for product launch.
Target Costing Principles:
▪ Price-led costing
▪ Cross functional teams
▪ Customer focus
▪ Focus on product design and process
▪ Lifecycle cost reduction
▪ Value Chain involvement
Steps involved in target costing
1. Market research. The organization conducts market research to understand and determine the
wants of a customer.
2. Identifying the market.
3. Product features.
4. Product design.
5. Determine cost, margin, and price.
6. Value engineering process.
7. Improve designs.
8. Formal approval.
Definition of life cycle costing (LCC)
“The present value of the total cost of that asset over its operating life, including Capital cost Occupation
costs Operating costs and Cost or benefit of the eventual disposal of the asset at the end of its life”
Essentially, it means the total cost that the project will impose throughout its whole life All future cost
are reduced to present value by the use of discounting techniques, and therefore, the economic worth of
a project can be assessed
What is life cycle costing?
Life cycle costing, or whole-life costing, is the process of estimating how much money you will spend
on an asset over the course of its useful life. Whole-life costing covers an asset’s costs from the time
you purchase it to the time you get rid of it.
Buying an asset is a cost commitment that extends beyond its price tag. For example, think of a car.
The car’s price tag is only part of the car’s overall life cycle cost. You also need to consider expenses
for car insurance, interest, gas, oil changes, and any other necessary maintenance to keep the car
running. Not planning for these additional costs can set you back.
The cost to buy, use, and maintain a business asset adds up. Whether you’re purchasing a car, a copier,
a computer, or inventory, you should consider and budget for the asset’s future costs.
Why do we need to use life cycle costing?
Life cycle costing will be used in the design stage, when we decide to start the design of this new
product or not. So most of the figures are the budget which we receive from various sources such as
market research, past experience, and industry information.
It is the time when management has to decide to make this product or not. Managements may have a
few products to be selected for investment. We choose the highest profitable product.
Looking at the full life product helps us to see the full picture rather than one or two year profit which
could be misleading.
Characteristics of Life Cycle Costing:
a. Product life cycle costing involves tracing of costs and revenues of a product over several calendar
periods throughout its life cycle.
b. Product life cycle costing traces research and design and development costs and total magnitude of
these costs for each individual product and compared with product revenue.
c. Each phase of the product life-cycle poses different threats and opportunities that may require
different strategic actions.
d. Product life cycle may be extended by finding new uses or users or by increasing the consumption
of the present users.
Stages of Product Life Cycle Costing:
(i) Market Research:
It will establish what product the customer wants, how much he is prepared to pay for it and how much
he will buy.
(ii) Specification:
It will give details such as required life, maximum permissible maintenance costs, manufacturing costs,
required delivery date, expected performance of the product.
(iii) Design:
Proper drawings and process schedules are to be defined.
(iv)Prototype Manufacture:
From the drawings a small quantity of the product will be manufactured. These prototypes will be used
to develop the product.
(v) Development:
Testing and changing to meet requirements after the initial run. This period of testing and changing is
development. When a product is made for the first time, it rarely meets the requirements of the
specification and changes have to be made until it meets the requirements.
(vi) Tooling:
Tooling up for production can mean building a production line; building jigs, buying the necessary tools
and equipment’s requiring a very large initial investment.
(vii) Manufacture:
The manufacture of a product involves the purchase of raw materials and components, the use of labor
and manufacturing expenses to make the product.
(viii) Selling
(ix) Distribution
(x) Product support
(xi) Decommissioning:
When a manufacturing product comes to an end, the plant used to build the product must be sold or
scrapped.
Life cycle costing process:
Conducting a life cycle cost assessment helps you better predict how much your business will pay when
you acquire a new asset. To calculate an asset’s life cycle cost, estimate the following expenses:
1. Purchase
2. Installation
3. Operating
4. Maintenance
5. Financing (e.g., interest)
6. Depreciation
7. Disposal
Use of Life Cycle Costing (LCC) LLC concerns all cost regarding the investment decision, can be used
to evaluate
1. Complete building
2. Element parts
3. Systems
4. Components and material
Benefits of Product Life Cycle Costing:
(i) It results in earlier action to generate revenue or lower costs than otherwise might be considered.
There are a number of factors that need to be managed in order to maximize return in a product.
(ii) Better decision should follow from a more accurate and realistic assessment of revenues and costs
within a particular life cycle stage.
(iii) It can promote long term rewarding in contrast to short term rewarding.
(iv) It provides an overall framework for considering total incremental costs over the entire span of a
product.
Life Cycle Costing Process:
Life cycle costing is a three-staged process. The first stage is life cost planning stage which includes
planning LCC Analysis, Selecting and Developing LCC Model, applying LCC Model and finally
recording and reviewing the LCC Results. The Second Stage is Life Cost Analysis Preparation Stage
followed by third stage Implementation and Monitoring Life Cost Analysis.
The three stages are:
Life Cycle Costing Process:
LCC Analysis is a multi-disciplinary activity. An analyst, involved in life cycle costing, should be fully
familiar with unique cost elements involved in the life cycle of asset, sources of cost data to be collected
and financial principles to be applied.
He should also have clear understanding of methods of assessing the uncertainties associated with cost
estimation. Number of iteration may be required to perform to finally achieve the result. All these
iterations should be documented in detail to facilitate the interpretations of final result.
Stage 1: LCC Analysis Planning:

The Life Cycle Costing process begins with development of a plan, which addresses the purpose, and
scope of the analysis.
The plan should:
i. Define the analysis objectives in terms of outputs required to assist a management decision.
Typical objectives are:
a. Determination of the LCC for an asset in order to assist planning, contracting, budgeting or similar
needs.
b. Evaluation of the impact of alternative courses of action on the LCC of an asset (such as design
approaches, asset acquisition, support policies or alternative technologies).
c. Identification of cost elements which act as cost drives for the LCC of an asset in order to focus
design, development, acquisition or asset support efforts.
ii. Make the detailed schedule with regard to planning of time period for each phase, the operating,
technical and maintenance support required for the asset.
iii. Identify any underlying conditions, assumptions, limitations and constraints (such as minimum asset
performance, availability requirements or maximum capital cost limitations) that might restrict the
range of acceptable options to be evaluated. Identify alternative courses of action to be evaluated.
iv. Identify alternative courses of action to be evaluated. The list of proposed alternatives may be refined
as new options are identified or as existing options are found to violate the problem constraints.
v. Provide an estimate of resources required and a reporting schedule for the analysis to ensure that the
LCC results will be available to support the decision-making process for which they are required.
Next step in LCC Analysis planning is the selection or development of an LCC model that will satisfy
the objectives of the analysis. LCC Model is basically an accounting structure which enables the
estimation of an asset components cost.
Stage 2: Life Cost Analysis Preparation:
The Life Cost Analysis is essentially a tool, which can be used to control and manage the ongoing costs
of an asset or part thereof. It is based on the LCC Model developed and applied during the Life Cost
Planning phase with one important difference: it uses data on real costs.
The preparation of the Life Cost Analysis involves review and development of the LCC Model as
a “real-time” or actual cost control mechanism. Estimates of capital costs will be replaced by the actual
prices paid. Changes may also be required to the cost breakdown structure and cost elements to reflect
the asset components to be monitored and the level of detail required.
Targets are set for the operating costs and their frequency of occurrence based initially on the estimates
used in the Life Cost Planning phase. However, these targets may change with time as more accurate
data is obtained, from the actual asset operating costs or from the operating cost of similar other asset.
Stage 3: Implementing and Monitoring:
Implementation of the Life Cost Analysis involves the continuous monitoring of the actual performance
of an asset during its operation and maintenance to identify areas in which cost savings may be made
and to provide feedback for future life cost planning activities.
For example, it may be better to replace an expensive building component with a more efficient solution
prior to the end of its useful life than to continue with a poor initial decision.
Advantages and Disadvantages of Life Cycle Costing
Advantages of Life Cycle Costing:
1. Assess use of existing projects / components vs. new construction/installation
2. Comparison of alternates i.e. Project / design, product / component, materials
3. A management guide to the owner
4. Aids energy conservation
5. Combination of time, cost & quality
Disadvantages of Life Cycle Costing:
1. Financial problems may spoil maintenance schedules
2. Unexpected repair by design or construction failures
3. Repairs cost may change due to future difficulties (Ex. Increase of occupants)
4. Unexpected labor strikes, material shortages
5. Annual sinking fund method not suitable for short life projects
Purpose of the life cycle cost analysis
As mentioned, conducting a life cycle cost analysis helps you estimate how much an asset will cost you
over the course of its life.
Take a look at some of the reasons why knowing an asset’s total cost can guide your business decisions.
1. Choose between two or more assets
Using life cycle costing helps you make purchasing decisions. If you only factor in the initial cost of an
asset, you could end up spending more in the long run. For example, buying a used asset might have a
lower price tag, but it could cost you more in repairs and utility bills than a newer model.
Life cycle cost management depends on your ability to make a smart investment. When you are deciding
between two or more assets, consider their overall costs, not just the price tag in front of you.
2. Determine the asset’s benefits
How do you know if you should buy an asset? Generally, you weigh the pros and cons of your purchase.
But if you only consider the initial, short-term cost, you won’t know if the asset will benefit your
business financially in the long run.
By using life cycle costing, you can more accurately predict if the asset’s return on investment (ROI) is
worth the expense. If you only look at the asset’s current purchase cost and don’t factor in future costs,
you will overestimate the ROI.
3. Create accurate budgets
When you know how much an asset’s total price is, you can create budgets that represent your
business’s actual expenses. That way, you won’t underestimate your business’s costs.
A budget is made up of expenses, revenue, and profits. If you underestimate an asset’s cost on your
budget, you are overestimating your profits. Failing to account for expenses can result in overspending
and negative cash flow.

Life-cycle costing:
Life-cycle costing tracks and accumulates the actual costs and revenues attributable to each
product from inception to abandonment.
It enables a product’s true profitability to be determined at the end of the economic life.
Traditional cost accounting systems do not accumulate costs over a product’s entire life but focus
instead on (normally) twelve month accounting periods. As a result the total profitability of a product
over its entire life becomes difficult to determine.
As mentioned in the previous chapter, target costing places great emphasis on controlling any of the
costs that relate to any part of the product’s life.
Every product goes through a life cycle.
 1. Development.
The product has a research and development stage where costs are incurred but no revenue is generated.
During this stage, a high level of setup costs will be incurred, including research and development,
product design and building of production facilities.
2. Introduction.
The product is introduced to the market. Potential customers will be unaware of the product or service,
and the organization may have to spend further on advertising to bring the product or service to the
attention of the market.
Therefore, this stage will involve extensive marketing and promotion costs. High prices may be changed
to recoup these high development costs.
3. Growth.
The product gains a bigger market as demand builds up. Sales revenues increase and the product begins
to make a profit. Marketing and promotion will continue through this stage.
Unit costs tend to fall as fixed costs are recovered over greater volumes. Competition also increases and
the company may need to reduce prices to remain competitive.
4. Maturity.
Eventually, the growth in demand for the product will slow down and it will enter a period of relative
maturity.
It will continue to be profitable. However, price competition and product differentiation will start to
erode profitability.
The product may be modified or improved, as a means of sustaining its demand.
5. Decline.
At some stage, the market will have bought enough of the product and it will therefore reach 'saturation
point'.
Demand will start to fall and prices will also fall. Eventually it will become a loss maker and this is the
time when the organization should decide to stop selling the product or service.
During this stage, the costs involved would be environmental clean-up, disposal and decommissioning.
Theory of Constraints Definition:
Theory of Constraints is a broadly applicable approach to managing business operations within an
organization. Basically, the theory of constraints is a management philosophy designed to help
organizations achieve their goals.
The idea is to identify the goals of the organization, identify the factors that hinder the achievement of
those goals, and then improve the business operations by continuously striving to mitigate or eliminate
the limiting factors.
WHAT IS THE THEORY OF CONSTRAINTS?
The Theory of Constraints is a methodology for identifying the most important limiting factor (i.e.
constraint) that stands in the way of achieving a goal and then systematically improving that constraint
until it is no longer the limiting factor. In manufacturing, the constraint is often referred to as a
bottleneck.
The Theory of Constraints takes a scientific approach to improvement. It hypothesizes that every
complex system, including manufacturing processes, consists of multiple linked activities, one of which
acts as a constraint upon the entire system (i.e. the constraint activity is the “weakest link in the chain”).
A successful Theory of Constraints implementation will have the following benefits:
• Increased profit (the primary goal of TOC for most companies)
• Fast improvement (a result of focusing all attention on one critical area – the system constraint)
• Improved capacity (optimizing the constraint enables more product to be manufactured)
• Reduced lead times (optimizing the constraint results in smoother and faster product flow)
• Reduced inventory (eliminating bottlenecks means there will be less work-in-process)
Basics of Theory of constraints (TOC):
Core Concept
The core concept of the Theory of Constraints is that every process has a single constraint and that total
process throughput can only be improved when the constraint is improved. A very important corollary
to this is that spending time optimizing non-constraints will not provide significant benefits; only
improvements to the constraint will further the goal (achieving more profit).
The Five Focusing Steps
The Theory of Constraints provides a specific methodology for identifying and eliminating constraints,
referred to as the Five Focusing Steps. As shown in the following diagram, it is a cyclical process.

The Theory of Constraints uses a process known as the Five Focusing Steps to identify and eliminate
constraints (i.e. bottlenecks).
The Five Focusing Steps are further described in the following table.
Step Objective
Identify Identify the current constraint (the single part of the process that limits the rate at which
the goal is achieved).

Exploit Make quick improvements to the throughput of the constraint using existing resources
(i.e. make the most of what you have).

Subordinate Review all other activities in the process to ensure that they are aligned with and truly
support the needs of the constraint.

Elevate If the constraint still exists (i.e. it has not moved), consider what further actions can be
taken to eliminate it from being the constraint. Normally, actions are continued at this
step until the constraint has been “broken” (until it has moved somewhere else). In some
cases, capital investment may be required.

Repeat The Five Focusing Steps are a continuous improvement cycle. Therefore, once a
constraint is resolved the next constraint should immediately be addressed. This step is a
reminder to never become complacent – aggressively improve the current
constraint…and then immediately move on to the next constraint.
The theory of constraints is a management concept that postulates that all businesses are limited in
achieving their maximum success by one or more hindrances. It is used to identify those business
bottlenecks so that output is unencumbered and so that - ultimately therefore - financial performance is
improved.
Introduced by Eliyahu M. Goldratt in his 1984 book The Goal, the theory of constraints assumes the
position that a chain is not strong when it has a weak link. Therefore, the constraints - those weak links
- need to be identified and removed. This ensures that the weakness can no longer damage or hinder the
company’s progress and success.
Using the theory of constraints, a company can focus its efforts and attention on the business obstacles
and optimize processes so that it sees improved performance or output.
What is a constraint?
A constraint is anything that is hindering a company from achieving its goals. Typical constraints
include: time, capacity, materials, people and manpower, capital resources and money. And constraints
can come from any area of the business. While the theory originally centered on manufacturing, it’s
clear that business hindrances can be seen not only in operations, but also in a company’s functional
departments, such as HR, marketing, IT, sales, and accounting and finance.
The five steps for applying the theory of constraints
The theory states that it is ineffectual to improve the strong links; the weak links will still hamper the
organization. So it is imperative to focus on the constraints themselves. There are five steps to follow
in applying the theory of constraints as a process:
1. Identify the constraint. You cannot manage an issue until you know what it is, so employ an
audit process to pinpoint the bottlenecks.
2. Decide how to exploit and eliminate the constraint. This is done by systematically looking
at the issues and applying a process of improvement. All efforts should be focused primarily
on the constraint in order to maximise the speed at which income is generated.
3. Subordinate everything else to the constraint. If other areas are putting pressure on the
bottleneck, the pressure will increase and continue to handicap the operation, resulting in more
firefighting to deal with it. So the actions to fix the bottleneck must take priority.
4. Elevate the constraint. This is about adding capacity to the constraint so that more work can
be put through it now that it has been identified, exploited and other pressures have been
removed from it. In practice, this often means adding people or money or other resources.
5. Evaluate and check if the constraint is lifted. Sometimes solving one issue may create
another. So make an assessment for this and return to step one and repeat if there are new
bottlenecks. The initial constraint should also be monitored.
Introduction or Meaning of Throughput costing:
Throughput costing. Is a costing approach under which only direct materials are recorded as inventory
costs while all other manufacturing costs (including direct labor and variable factory overhead) are
expensed as period costs? Selling and administrative costs are expensed as period costs as well.
Definition of Throughput costing:
Throughput is defined as the amount of information or material passed put through or delivered in a
specific period of time. An example of throughput is twenty screens of copy being printed within a five
minute period.
Definition ‘A technique where the primary goal is to maximize throughput while simultaneously
maintaining or decreasing inventory and operating costs.’
What is TPAR?
The Taxable Payments Annual Report (TPAR) is an industry-specific report through which businesses
inform the ATO of the total payments made to contractors for services in that financial year. This
information is then used by the ATO to match the contractors' income declarations to improve their
compliance efforts.
TPAR explained
TPAR stands for taxable payments annual report. Put simply, this is an industry-specific report for
companies that need to report the total payments they’ve made to contractors for services. This amount
is reported to the ATO through the taxable payments annual report. The ATO will then use this
information to data match the annual income declared by contractors, helping to improve compliance.
For example, TPAR reports can help the ATO identify if a contractor hasn’t included all their income
on their tax return, failed to lodge tax returns/activity statements, quoted an incorrect ABN on their
invoices, or failed to register for GST when they’re required to do so. This ensures that all contractors
are meeting their tax obligations.
How is TPAR calculated?
Ratios
1. Return per factory hour = Throughput per unit / product time on bottleneck resource.
2. Cost per factory hour = Total factory costs / total time available on bottleneck resource.
3. Throughput accounting ratio (TPAR) = Return per factory hour/cost per factory hour.
Which industries are affected by TPAR?
As TPAR is an industry-specific document, not all businesses need to be concerned. If your business
provides the following services, even if it’s only part of the services you offer, you may be required to
submit a TPAR report:
● Building and construction services
● Road freight services
● Cleaning services
● Information technology (IT) services
 ● Mixed services
● Security, investigation, or surveillance services
● Courier services
In addition, federal, state, territory, and local government entities are obligated to report the payments
made to third parties for providing services.
What are the reporting requirements for TPAR reports?
You may need to report your company’s taxable payments. Reporting requirements vary depending on
the specific industry you’re operating within, but generally, a taxable payments report will be required
if the following statements apply to your business:
● You have an Australian Business Number (ABN)
● You have made payments to contractors for services that they’ve completed on your behalf
Do all payments need to be reported in your TPAR?
No, it’s important to note that not all payments need to be reported. Payments that you don’t need to
include on your taxable payments annual report include:
● Payment for materials only
● Payments within consolidated groups
● PAYG withholding payments
● Contractors who don’t provide an ABN
● Payments for private and domestic projects
● Incidental labour
● Invoices that are unpaid as of 30 June
What details need to be included in a TPAR report?
When you’re putting together your taxable payments report, you need to include all the payments you
made for the financial year. Payee details that you need to include are as follows:
● ABN (where known)
● Address
● Name (business name/individual’s name)
● Total amounts for gross amount paid, total GST paid, total tax withheld when ABN wasn’t
quoted
Government entities have a couple of additional reporting commitments:
● Whether a ‘statement by a supplier’ was provided
● Details of grants paid to organisations or people with an ABN, including the date the grant was
paid and the name of the grant