Chapter Two
Alternative Costing Methods
Course Name : Management Accounting - 1
Course Code : BAAC2204
Specialization : Accounting And Finance
Department of Business Studies
S h i n a s C o l l e g e o f Te c h n o l o g y
Outcome 2 :Explain and differentiate the various
alternative costing methods
CONTENTS
Activity Based Costing (ABC)
Life Cycle Costing
Target Costing
Activity Based
Costing
M.N. Arora, Cost and Management
Accounting – Theory, Problems
and Solutions , Himalaya
Publishing House
Essential Reading :
[Link]
[Link]?docID=588039&ppg=720
P. Periasamy, Textbook of Financial
Cost and Management Accounting
, Global Media
Suggested Reading :
[Link]
mp/[Link]?docID=3011183&ppg=5
21
Cost
Material Labor Expenses
Direct Indirect Direct Indirect Direct Indirect
Material Material Labor Labor Expenses Expenses
Overhead
The direct costs
Mainly include materials and labour,
They are chargeable to the end
products without difficulty
Convenient to handle.
The indirect costs
It also known as overhead.
Aggregate of all indirect cost is known as
Overheads
Which create problems for the cost
accountant in determining the accurate
product costs.
Introduction
This is a key costing method.
Comparisons of ABC with traditional
methods of overhead absorption are
particularly important.
Introduction
To determine the total cost of an end product, under the
traditional approach, the indirect costs are allocated and
apportioned.
Activity based costing is an upcoming and more refined
approach for charging indirect costs to products and computing
more accurate product costs
The traditional approach to allocate overhead
Traditionally, indirect costs are distributed
to end products in proportion to the
production volumes. (Labour intensive)
The traditional approach to allocate overhead
In traditional approach,
overhead are absorbed on the
basis of machine hours or
labour hours or direct wages,
etc.
The traditional approach to allocate overhead
The main steps in this approach are:
First, allocation and apportionment of overhead to
various production departments and service
departments.
Second, reapportionment of service departments'
overhead to production departments.
Third, absorption of production departments'
overhead by the end products.
Al Jaseera Company Produces two product TV and Smart Phone: Example - I
Production per Year Product Production per Year
TV 25,000
Smart Phone 5,000
Total 30,000
Each product requires 1 hour of direct labor, Total annual direct labor hours 30,000 , Direct labor
cost 12 OMR per unit for each product Expected annual manufacturing overhead costs OMR
900,000 Direct materials cost:
Product OMR
TV 40
Smart Phone 30
Required: Calculate unit Cost
Traditional System
Cost per unit
Smart
TV Phone
Direct Material 40 30
Direct Labor 12 12
Overheads 30* 30*
Cost per unit 82 72
*Pre determined overhead rate X Direct labor hour = 30 x1
900000/3
0000= 30
The traditional approach to allocate overhead
Problem of Under-costing and Over-
When a company produces a variety of products or
costing
services which place varying demands on resources,
traditional costing uses an average overhead rate for all
activities (like labour hour rate or machine hour rate) to
allocate costs to cost objects i.e., products or services.
Cost smoothing leads to under-costing of certain
products and over-costing of other products.
The traditional approach to allocate overhead
Problem of Under-costing and Over-
Where
costing one product is under-costed, it
results in other product being over-costed
because total amount of overhead
remain unchanged. This is known as
product cost cross - subsidization
Activity Based Costing
The activity based costing
system provides a better and
more logical distribution of
overhead resulting in accurate
costing.
Activity Based Costing
It is a new and scientific approach
Developed by Cooper and Kalpan (1988)
Assigning overhead to end products, jobs and
processes.
Aim To rectify the problem of inaccurate cost information due to
selection of wrong bases of indirect cost apportionment.
Activity Based Costing
Definition
In the words of Cooper and Kalpan, "ABC systems
calculate the costs of individual activities and
assign costs to cost objects such as product and
services on the basis of activities undertaken to
produce each product or service.".
Activity Based Costing
In this system, overheads are assigned to
activities or grouped into cost pools before
they are charged to cost objects, i.e., jobs
or products.
Activity Based Costing
According to C.I.M.A., London,
activity based costing is "cost
attribution to cost units on the basis
of benefits received from indirect
activities. i.e . ordering. setting up.
Assuring quality. etc."
Activity-based costing -Steps
1. Identify and classify the major activities
2. Creation of cost pool
3. Identify the cost driver
4. Compute the overhead rate
5. Assign overhead costs to products
Terms used in ABC
Activity: An activity may be defined as
a particular task or unit of work with a
specific purpose. Examples of activities
are – placing of a purchase order, setting
up of a machine, after sales service, etc.
Terms used in ABC
Cost object: It is an item for
which cost measurement is
required. For example. a product.
a service, a job or a customer etc.
are cost objects.
Terms used in ABC
Cost driver: It is a factor that
causes a change in the cost of an
activity. Cost driver is of two types
1. Resource cost driver
2. Activity cost driver
Resource cost driver
It is a measure of the quantity of resource
consumed by an activity. For example. number
of purchase orders placed will determine the
cost of purchasing the materials. Similarly, the
number of times machines are set up will
determine the cost of setting up of machines.
Resource cost driver is used to assign the cost of
a resource to an activity or cost pool.
Activity cost driver
It is a measure of the frequency and intensity
of demand placed on the activities by cost
objects. It is used for assigning activity costs
to cost objects consuming the activity.
Activity-based costing -Steps
1. Identify and classify the major
activities
2. Creation of cost pool
3. Identify the cost driver
4. Compute the overhead rate
5. Assign overhead costs to products
Identification of the main activities
1. Identify the major activities
2. The number of activities in an
organisation should neither be
too large or too small
Creation of cost pool
Cost pool is grouping of individual
cost items.
A cost pool or cost bucket should be
created for each activity.
Cost pool is like a cost centre
around which costs are
accumulated
Determination of the activity cost
drivers
The factors that influence the cost
of a particular activity is known as
cost driver.
Cost drivers signify the factors or
events that determine the cost of
activity
Calculation of the activity cost
driver rate
An overhead absorption rate is
calculated in traditional costing
system,
𝑻𝒐𝒕𝒂𝒍 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒚
𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒚 𝒄𝒐𝒔𝒕 𝒅𝒓𝒊𝒗𝒆𝒓 𝑹𝒂𝒕𝒆 ¿
𝑪𝒐𝒔𝒕 𝒅𝒓𝒊𝒗𝒆𝒓𝒔
Charging the costs of activities to
products
The costs of activities are traced to
products on the basis of demand by
products.
The cost drivers are used to
measure product demand of
activities.
Activity-based costing -Steps
1. Identify and classify the major activities
2. Creation of cost pool
3. Identify the cost driver
4. Compute the overhead rate
5. Assign overhead costs to products
Advantages of ABC
1. Accurate and reliable
2. Better pricing decision
3. Realistic approach
4. Control of costs
5. Greater cost efficiency
6. Useful cost driver rates
Accurate and reliable
ABC is a more accurate
and reliable system of
ascertaining product costs
Better pricing decision
It overcomes the problem of
under costing and over-costing.
Able to make more judicious
selling price decisions based on
accurate costs
Realistic approach
Distribution of overhead based
on activities is an objective and
realistic approach
Control of costs
Enables management to control
many fixed overhead by
exercising more control over
those activities which cause
these fixed overhead.
Greater cost efficiency
ABC helps to identify those
activities which are unnecessary
and may be weeded out and
thus achieving greater cost
efficiency..
Useful cost driver rates
ABC helps, through its cost
driver rates, in the modification
of existing products and also in
the development of new
products.
Al Jaseera Company Produces two product TV and Smart Phone: Example - I
Production per Year
Product Production per Year
TV 25,000
Smart Phone 5,000
Total 30,000
Each product requires 1 hour of direct labor, Total annual direct labor hours
30,000 , Direct labor cost 12 OMR per unit for each product Expected annual
manufacturing overhead costs OMR 900,000
Product OMR
Direct materials cost: TV 40
Smart Phone 30
Required: Calculate unit Cost
Activity cost pool Activity cost pool Estimated cost
Setting Up machine 300,000
Machining 500,000
Inspecting 100,000
Total 900,000
Cost Drivers
Cost Driver per
Activity cost pool Estimated cost Cost Driver per Activity product
Smart
TV
phone
Setting Up machine 300,000 1500 Setups 500 1000
Machining 500,000 50000 Machine Hours 30000 20000
Inspecting 100,000 2000 Inspections 500 1500
Solution
Activity cost pool Cost Drivers Estimated cost
Setting Up machine Number of Setup 1500 Setups
Machining Machine Hour 5000 Machine Hours
Inspecting Number of Inspections 2000 Inspections
Activity Based Estimated Overhead Per Activity
Overhead Rate
Expected use of Cost Drivers Per Activity
Overhead Rate
Activity Based
Activity cost pool Estimated cost Cost Driver per Activity
Overhead Rate
Setting Up machine 300,000 1500 Setups 200 Per Setup
Machining 500,000 5000 Machine Hours 10 Per Machine Hour
Inspecting 100,000 2000 Inspections 50 Per Inspection
TV
Activity cost pool Use of cost Driver Activity Based Overhead Rate Activity Based Overhead Rate
Setting Up
machine 500 200 100,000
Machining 30,000 10 300,000
Inspecting 500 50 25,000
Total cost 425,000
Unit Produced 25,000
Cost per
Unit 17
Smart Phone
Activity cost pool Use of cost Driver Activity Based Overhead Rate Activity Based Overhead Rate
Setting Up
machine 1,000 200 200,000
Machining 20,000 10 200,000
Inspecting 1,500 50 75,000
Total cost 475,000
Unit Produced 5,000
Cost per Unit
95
Comparison
Traditional Compariso
Product ABC Remarks
System n
TV 72 17 55 Over priced
Smart Phone 82 95 -13 Under priced
Overhead cost
Ordering
Activity and Setting up Assemblin Inspecting
Machining and Painting Supervising
Cost pool receiving machines g
material testing
Number
Number Direct
Cost of Machine Number Number Number
Purchas of labor
Drivers hours of Parts of Tests of Parts
e orders Setups hours
Product A Product B
Practical Problems
Cost Driver per product
Estimated Expected Use of cost
Cost Drivers
Overhead deriver Per activity
SJ HJ
Number of Purchase orders 200,000 2500 Orders 1000 1500
Setups 600,000 1200 Setups 500 700
Machine hours 2,000,000 800000 Hours 300000 500000
Parts 1,800,000 3000000 Parts 1800000 1200000
Tests 700,000 35000 Tests 20000 15000
Parts 300,000 3000000 Parts 1800000 1200000
Direct labor hours
6,800,000 200000 Hours 130000 70000
Practical Problems
Material
Products Quantity Prime cost Machine hours Setups
Moves
200,00
Indian A 700,000 50,000 700,000 100
0
Contem B 50,000 150,000 12,500 100,000 50
Total Value 850,000 62,500 800,000 150
Overhead cost
Cost of Maintanance of Machines 250,000
Material Handling cost 300,000
Setup cost 450,000
Solution
Total OH cost 1,000,000
OH Rate ( Mchine hr) 1,000,000/62,500
= 16
Indian A 16 x 50,000 800,000
Cote B 16 x 12,500 200,000
Total Cost
Indian A Contemp B
Prime Cost 700,000 150,000
Overhead 800,000 200,000
Total Cost 1,500,000 350,000
Unit Produced 200,000 50,000
Cost per Unit 7.50 7.00
ABC Approach
Activity Cost
Drivers
Maintanance
Material
Handling
Setup cost
Chapter Two
Alternative Costing Methods
Course Name : Management Accounting - 1
Course Code : BAAC2204
Specialization : Accounting And Finance
Department of Business Studies
S h i n a s C o l l e g e o f Te c h n o l o g y
Learning
Outcomes
Life Cycle
Costing
Life Cycle
Costing
Roger Hussey , and Audra Wei
Ming Ong, Strategic Cost
Essential Reading : Analysis , Business Expert
Press
[Link]
.com/lib/momp/[Link]
?docID=876652&ppg=140
Life cycle costing tracks
Introduct and accumulates costs
ion and revenues attributable
to each product over the
entire product life cycle.
Research and Development
Categories Cost
of Life Production and Construction
Cycle Costs Cost
Operation and Maintenance
Support Cost
Retirement and Disposal Cost
•It is future oriented, and it compels
managers to examine the long- term
Benefits of financial implications of the strategic
Life Cycle decisions they are making.
Costing •It also encourages managers to
examine and question the costs
incurred at every significant stage in
the life of the product.
The purposes for which organizations
could choose to use life- cycle costing are
Benefits of the acquisition of a system or project on
Life Cycle long- term budgets and operating results
Costing and the comparison among competing
suppliers of products and services.
Repair costs, maintenance, and warranties
are all other concerns that encourage
management to look at the life- cycle
costing.
Accumulated cost Research and
Development
Cost over product life - Removal
Life
Cycle
Phases of Life Cycle - 5 Phases
Cost
Development Introduction Growth Maturity Decline
Long Or
Different accros the product Short Life
Cycle
Dont Looking at accounting period
Life
Period to cover Life cost
Cycle
Cost Benefits of Life Cycle costing
Efficent Track Product Examine the long-
allocation of cost rather term financial
resources than period implications
Phases of Life Cycle - 5 Phases
Cost No revenue
and Loss
R&D Cost making stage
Testing Cost
Capital Investment
Training to staff
Development
In this stage incured Large % of Total cost
Phases of Life Cycle - 5 Phases
Introduction to
market -
Cost Products
Advertisement Cost Unknown
Marketing cost
Training cost
Product distribution
Introduction
Start to generate Revenue
Phases of Life Cycle - 5 Phases
Revenue
Building -
Cost Move to Profit
Inventory Holding
cost
Product distribution
Growth
Economise of scale
Phases of Life Cycle - 5 Phases
Demand Slow
Cost
Product
improvement cost
Maturity
Reduce Marketing
Phases of Life Cycle - 5 Phases
Low demad
Cost
Product Removal cost
Decline
Loss making stage
Illustration - 1
Cost Year 1 Year 2 Year 3 Year 4 Total
R&D 300 300
Design 200 200
Product 75 90 90 255
Marketing 70 50 30 150
Distribution 20 27 24 71
Customer service 15 23 30 68
Total Cost 1044
Chapter Two
Alternative Costing Methods
Course Name : Management Accounting - 1
Course Code : BAAC2204
Specialization : Accounting And Finance
Department of Business Studies
S h i n a s C o l l e g e o f Te c h n o l o g y
Learning objectives
Target Costing
Target Costing
Essential Reading :
Roger Hussey , and Audra Wei Ming Ong,
Strategic Cost Analysis , Business Expert
Press
[Link]
omp/[Link]?docID=876652&ppg=
140
Traditionally, companies price their
products or services using the cost
plus model.
Uses the average costs (variable and fixed)
Introducti to which a mark- up is added in the form
on of a percentage to give the market price.
This approach is only feasible if the
market is noncompetitive or only
slightly competitive
Prospective customers trace
alternative sources of supply, which
may be cheaper or of better quality.
Introducti Also the problem of competition from
companies choosing cost leadership
on as a strategy.
To remedy the deficiencies of the
cost- plus model, organizations turn
to target costing, which is often
referred to as price- led costing.
Target costing was developed by
Toyota in Japan during the 1960s.
This technique ensures that the
Definit product is introduced to the market
with a specific functionality, quality,
ion and selling price.
It is also planned that the product can
be produced at a life- cycle cost that
generates an acceptable level of
profitability.
Target costing involves the
establishment of target
costs for each product and
Definit each product- related
ion activity, starting with the
design of the product and
culminating with the sale of
the product.
Target costing is a reversal of the cost- plus
model, and we start with the market price.
Calculati The organization uses market research
information to determine the price
on of customers are willing to pay given the
Target product’s functionality and quality and the
alternatives provided by competitors.
Cost We then deduct the profit we wish to make,
and the balance is the target cost we must
achieve to be successful.
The target cost is the
maximum cost that is
Calculati allowable in the production,
on of distribution, and disposal of
Target the product:
Cost Target cost
= Target Selling Price –
Target Profit.
• Calculate the target cost that
satisfies the market price and
Process the organization’s target profit.
of • Evaluate the types of actions
Target that may be implemented in
different departments or areas
Costing to bring actual costs in line with
the target.
• Assess whether the reduction in
costs in one area may lead to a
consequential increase in costs in
Process other areas.
of • Set targets for each area in
Target discussion with managers.
• Monitor the cost reductions to
Costing ensure that the actions
implemented produce the
required results.
Target Costing
Traditional
cost Cost Plus method
Selecting a Target Price
Target Determine the Margin
Costing
Decide cost of product
Process / Steps Target Costing
Market Research
Set Target Questionnaires
Price
Competitor price
Steps Market Analysis
Target
Establish How much margin required
Costing Margin
How much your profit
Calculate Target Price - Margin
Cost
Targeted Cost
Target Costing
Actual Cost
is Very High
Actual Cost is more than
Targeted cost
Cost
Gap
Target Costing
Cost Cost Gap must be closed
Gap
Use Standard components
Improve Labour efficiency
Methods Cheaper Material / Labour
New Technology
Review the whole supply chain
Team Building
Target Costing
Intangible products
Not Suitable for
Service Industry Not design driven
Quality different
Suitability
Suitable for Tangible product
Manufacturing
company
Design
Target Costing – Formula
Where the profit margin is based on selling price,
target total cost can be calculated as follows:
Target
Selling Price – (Profit % × Selling Price)
cost
Target Costing – Formula
Where the profit margin is based on cost, target
cost can be found as follows:
Selling Price
Target
______________________
cost 1 + Profit percentage
Target Costing – Example - Question No 1
ALPHA is a Cloth manufacturer that operates in a very
competitive environment. It sells Cloths to different companies
that manufacture and market jeans under their own brands.
ALPHA can only charge OMR 2 per meter. If the company’s
intended profit margin is 15% on cost, calculate the target cost
per unit. If 30% of the cost per meter of Cloth is related to direct
materials, what’s the target cost per unit for direct materials.
Target Costing – Formula
Selling price OMR 2 per meter.
Profit margin is 15% on cost
= = OMR 1.74
Target
cost
Target Costing – Formula
If ALPHA wants to earn 15% on selling price
Target OMR 2 * (1 – 15%) = OMR1.70
cost
Chapter Two
Alternative Costing Methods
Course Name : Management Accounting - 1
Course Code : BAAC2204
Specialization : Accounting And Finance
Department of Business Studies
S h i n a s C o l l e g e o f Te c h n o l o g y
Practical Problems
CONTENTS
Activity Based Costing (ABC)
Life Cycle Costing
Target Costing
Problem 2
Particulars Soft Drink Fresh produce Packaged Food
Revenue 793,500 2,100,60 1,209,90
0 0
Cost of goods sold 600,000 1,500,00 900,000
0
Cost of Bottle returned 10,000 0 0
No of Purchase orders 360 840 360
No of deliveries 300 2,190 660
Hrs of Shelf stocking 540 5,400 2,700
time
Problem 2
Activity Total cost Cost allocation
Bottle Return 12,000 Soft drink
Ordering 156,000 1560 orders
Delivery 252,000 3150 deliveries
Shelf stocking 172,800 8640 Hrs
Customers support 307,200 1,536,000 item
sold
Total 900,000
Traditional Method
Particulars Soft Drink Fresh produce Packaged Food Total
ABC
OH Cost deriver QTY OH Rate
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