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UNIVERSITY OF EDUCATION, WINNEBA

SCHOOL OF BUSINESS
DEPARTMENT OF BANKING AND FINANCE

MANAGEMENT ACCOUNTING BAC 363


LECTURE NOTES ONE
SAMUEL KOFI ASIAMAH (MR.)

)
SPECIALIZED COST AND
MANAGEMENT ACCOUNTING
TECHNIQUES
• Costing Techniques
• Activity Based Costing
• Target Costing
• Life cycle Costing
• Throughput Accounting
• Environmental Accounting
COSTING TECHNIQUES-RECAP
• Costing: It is the process of determining the costs of products, services or
activities
• Direct Cost: A cost that can be traced to a product, service or department.
• Indirect Production Cost: It is a cost that cannot be directly linked in full to
the actual production of goods or provision of services. Example: Rent of
factory where five different products are manufactured.
• Indirect Non Production Cost: It is a cost incurred in a support function that is
not directly involved in the manufacturing process or provision of the main
service. Example: Marketing expenses of a television sets manufacturer
TRADITIONAL COSTING
SYSTEMS

Marginal Costing
• In marginal costing (variable costing), only variable costs of production are
allocated to products.
• The marginal production cost of an item is the sum of its direct materials cost,
direct labour cost, direct expenses cost (if any) and variable production
overhead cost.
• Fixed costs are treated as Period Costs regardless of the volume of
production and sale.
TRADITIONAL COSTING
SYSTEMS

Marginal Costing
• Is the accounting system in which variable costs are charged to cost units and
fixed costs of the period are written off in full against the aggregate contribution.
• The contribution concept lies at the heart of marginal costing. Contribution can be
calculated as follows.
Contribution = Sales price - Variable costs
• Is also the principal costing technique used in decision making
PER UNIT PRODUCT COST
CALCULATION- MARGINAL COSTING
GHS
Direct Material X
Direct Labour X
Other Direct Expenses X
Variable Production Cost X

Sales XX
Less :Variable Production Cost (X)
Gross contribution XX
Less : Variable non production cost (X)
Contribution XX
Less : Fixed non-production overhead (X)

Less : Variable non production cost (X)

Profit XX
TRADITIONAL COSTING
SYSTEMS

Absorption Costing:
• In absorption costing (full costing), all production costs are absorbed into
products.
• A form of costing in which the costs of products are calculated by adding an
amount for indirect production costs (overheads) to the direct costs of
production.
• Fixed production overhead costs are treated as a product cost.
PER UNIT PRODUCT COST
CALCULATION- ABSORPTION COSTING
GHS
Direct Material X
Direct Labour X
Other Direct Expenses X
Absorbed Production Overheads X
Full Production Cost X

Sales XX
Less : Full production cost of sale (X)
Less/Add: Under/Over absorbed Production overheads (X)/X
Gross Profit XX
Less : Fixed non-production overhead (X)

Less : Variable non production cost (X)

Profit XX
ABSORPTION COSTING

• Step 1: Allocate direct costs to a cost unit or cost centre.


• Step 2: Apportion general overheads amongst the cost centres, on a fair basis.
• Step 3: Re-apportion the costs of service cost centres’ amongst the production cost
centres on a fair basis.
• Step 4: Determine Absorption rate for each production cost centre using the formula:
Estimated Fixed Production Overheads / Budgeted Activity Level
• Step 5: Absorbed Production Overheads: Actual activity level x Absorption rate
• Step 6: Under/ Over Absorption: Absorbed Production Overheads – Actual Overheads
Expenditure
Under-absorbed: Absorbed production overheads < Actual overheads expenditure
Over-absorbed: Absorbed production overheads > Actual overheads expenditure
ABSORPTION COSTING

• Overhead absorption rate (OAR)= Budgeted Fixed Production Overheads


Budgeted Activity Level
Basis of Absorption rate:
• Production units
• Direct labour hours
• Machine hours
• Direct material cost
• Direct labour cost
• Prime cost
ABSORPTION COSTING

Let’s work an example:


Timbila Ltd supplied the following budgeted information for 2018:
Manufacturing overheads GHS60 000 Units to be produced 450 units
Direct labour hours 8 000 hours Machine hours 12 000 hours
Direct wages GHS16 000 Direct material used GH30 000

Required:
Use the above data to calculate six (6) different manufacturing overhead absorption
rates
ABSORPTION
COSTING
MARGINAL COSTING

LET’S WORK AN EXAMPLE


THE EFFECT OF ABSORPTION AND MARGINAL
COSTING ON INVENTORY VALUATION

• Marginal costing values inventory at the total variable production cost of a unit of
product. The unsold inventory is measured at variable cost of production
• Absorption costing values inventory at the full production cost of a unit of
product. The unsold inventory is measured at total cost of production.
• Inventory values will therefore be different at the beginning and end of a period
under marginal and absorption costing.
• If inventory values are different, then this will have an effect on profits reported in
the income statement in a period.
• Profits determined using marginal costing principles will therefore be different to
those using absorption costing principles.
THE EFFECT OF ABSORPTION AND MARGINAL
COSTING ON PROFIT DETERMINATION

Reconciling profits reported under the different methods


• When inventory levels increase or decrease during a period then profits differ
under absorption and marginal costing.
• If inventory levels increase, absorption costing gives the higher profit.
• If inventory levels decrease, marginal costing gives the higher profit.
• If inventory levels are constant, both methods give the same profit.
• Let’s work on some examples. ( Refer to Q4)
THE EFFECT OF ABSORPTION AND
MARGINAL COSTING ON PROFIT
DETERMINATION
• In profit determination, Absorbed Production Overheads is Actual activity level
multiply by Absorption rate.
• This could result in Under/ Over Absorption, which is the difference between
Absorbed Production Overheads and Actual Overheads Expenditure
• Under-absorbed: Absorbed production overheads < Actual overheads expenditure
• Over-absorbed: Absorbed production overheads > Actual overheads expenditure
• Add under-absorbed to cost of production
• Less over-absorbed from cost of production.
• Let’s work on some examples. ( Refer to Q4)
ARGUMENTS FOR ABSORPTION
COSTING OR MARGINAL COSTING
Advantages of marginal costing Advantages of absorption costing
• Contribution per unit is constant • Absorption costing includes an
unlike profit per unit which varies element of fixed overheads in
with changes in sales volumes inventory values (in accordance with
• There is no under or over absorption SSAP 9).
of overheads (and hence no
• Analysing under/over absorption of
adjustment is required in the income
statement). overheads is a useful exercise in
controlling costs of an organisation
• Fixed costs are a period cost and are
charged in full to the period under • In small organisations, absorbing
consideration overheads into the costs of products is
• Marginal costing is useful in the the best way of estimating job costs
decision-making process and profits on jobs
• It is simple to operate
ARGUMENTS AGAINST ABSORPTION
COSTING OR MARGINAL COSTING

Absorption Costing:
• It is more complex to operate than marginal costing and it does not provide
any useful information for decision making.
Marginal Costing:
• The closing inventory is not valued in accordance with accounting
standards and that fixed production overheads are not 'shared' out between
units of production, but written off in full instead.
TRADITIONAL COSTING SYSTEMS

• Typically used one rate to allocate production overhead to products.


• This rate was often based on per labour hour, or cost per machine hour
Problems with Traditional Costing System:
• Today’s Manufacturing Plants are more complex, often automated and often
make more than one product.
• Manufacturing processes and the products they produce are now more complex.
Solution to Traditional Costing System:
• Then multiple allocation bases should be used to allocate overhead expense.
• In such situations, managers need to consider using activity based costing (ABC).
ACTIVITY BASED COSTING (ABC)

• Activity-Based Costing (ABC) is the process of attributing costs to cost units on the
basis of how much cost per units have benefited from the indirect activities such as
ordering, machine set ups, order processing etc ( CIMA).
ABC Process:
• Identify the different activities within the organisation.
• Identify a distinct ‘fixed’ overhead cost, also termed as a Cost Pool.
• Identify the activity that causes this cost. This activity is the ‘Cost Driver’.

• For each cost pool, calculate an absorption rate per cost driver.
• For each product, charge the overheads cost based on the use of the relevant cost driver by
the product
ACTIVITY BASED COSTING (ABC)

• An activity is an event that incurs costs.


Classification of Activities:
▪ Unit Level Activities: These activities which are performed each time a single
product or unit is produced.
▪ Batch Level Activity: These activities which are performed each time a batch of
products or group of identical products are produced.
▪ Product Level Activities: These activities which are performed to support the
production of each different type of product.
▪ Facility Level Activities: Facility Level Activities are those which are needed to
sustain a factory's general manufacturing process.
ACTIVITY BASED COSTING (ABC)

• A Cost Driver is a unit of activity that creates demand for resources activity and
hence leads to the incurrence of cost.
• Is a factor that causes changes in the cost of activity within the organisation.
• The process of activity-based costing is based on the assumption that cost
behaviour is influenced by cost drives.
Types of Cost Drivers
• Resource cost drivers measures the quantity of resources consumed by an
activity.
• Activity cost drivers measure of the frequency of demand placed on activities
by cost unit.
ACTIVITY BASED COSTING (ABC)

• Examples of Cost Drivers

Cost Drivers Activity


Number of receiving orders Ordering
Number of deliveries Delivery
Number of purchasing orders Taking Order
Number of inspection Inspection
Number of material handling hours Product handling hours
LET’S WORK AN EXAMPLE

• An organisation manufactures 3 different products. In a year, its Fixed Production Overheads


comprise of:; Cost Pool Cost Driver
Machine Handling Costs GHS 20,000 500 machine hours

Production Scheduling Costs GHS 14,000 100 production runs


Total Fixed Overheads GHS 34,000 100 labour hours
Assuming that the manufacturing of Product A requires:

20 labour hours , 15 machine hours , 4 production run


What is the fixed overhead cost for product A using the traditional absorption costing as against
ABC?
ACTIVITY BASED COSTING (ABC)

Arguments for ABC:


• Pricing on mark-up basis for individual products will become fair as the cost of
production is assessed more accurately.

• Promoting or discontinuing products, activities or parts of business as there will be


better indication of where cost savings can be made.
Arguments against ABC:
• Cost drivers may not be very easy to identify or quantify.
• Cost of implementing this system may be more than benefits derived.
• It’s an adaptation of the Absorption costing method and decision making is more
effective based on Marginal Costing information.
ACTIVITY BASED
COSTING

LET’S WORK AN EXAMPLE


ACTIVITY BASED COSTING (ABC)

Advantages of ABC
• It brings accuracy and reliability of the costing data in determination of the cost of the
products.

• It facilitates cause and effect relationship to exercise effective cost control.


• It provides necessary cost information to the management to take decisions on any
matter, relating to the business.
• It is much helpful in fixing the cost and selling price of a product.
• It facilitates overhead costs allocate directly to the specific product.
• It enables to manage the activities rather than costs.
• It helps to remove all types of wastages and inefficiencies.
ACTIVITY BASED COSTING (ABC)

Essentials Factors of a Good Activity-Based Costing System


• Objectives of costing system and level of competition.

• Number of products manufactured.


• Product diversity and the business.
• Adaptation of cost management measures, standardization and technical aspects.

• Degree of sophistication and suitability to the firm.


• Determination of single or combined Cost Driver.
• Determination number of Activity Centre, Cost Pools and Cost Drivers.

• Determination of total overhead costs and economy


ACTIVITY BASED COSTING (ABC)

Activity Based Management (ABM)


• Extends the use of ABC from product costing to a comprehensive management
tool that focuses on reducing costs and improving processes and decision making.
• ABM classifies all activities as value-added or non-value-added.
• Value-added activities increase the worth of a product or service to the customer.
• Non-value added activities don’t increase the worth of a product.
• The objective of ABM is to reduce or eliminate non-value related activities (and
therefore costs
TARGET COSTING

• Traditionally the selling price of a product is determined by adding a profit mark-


up to the Product cost. But an organisation may not be able to find customers
who might want to buy at that price as the product may not have the features
customer’s value or the competitors’ products might be cheaper, or at least offer
better value for money
• Target costing is very much a marketing approach to costing as it involves setting
a selling price for the product by reference to the market.
• From this the desired profit margin is deducted to arrive at a target cost.
TARGET COSTING

Target Costing Process:


• Determine product specification and possible sales volume.
• Decide on a Target Selling Price at which the product can be successfully sold.
• Estimate Target Profit.
• Calculate Target Cost: Target Selling Price – Target Profit.
• Based on product specification and costs level, determine the estimated Production
Cost.
• Calculate Target Cost Gap: Estimated Production Cost – Target Cost.
• Make efforts to reduce the Target Cost Gap, before production commences.
TARGET COSTING

Closing the Target Cost Gap:


• Establishment of multifunctional teams consisting of marketing people, cost accountants,
production managers, quality control professionals and others.
• An emphasis is on the planning and design stage to ensure that the design is not needlessly
expensive to make.
• Reducing components
• Arranging cheaper labour/ training existing staff
• Acquiring new and efficient technology etc.
• The total target cost can be split into broad cost categories based on functions to ensure
better control over costs.
• Use value (the ability of the product or service to perform its function).
• Esteem value (the status that ownership or use confers).
TARGET COSTING

• Target Costing in Service Industries:


Because of the characteristics and information requirements, it is difficult to
use Target Costing in service industries. Examples of service businesses
include:
• (a) Mass service e.g. the banking sector, transportation (rail, air), mass
entertainment
• (b) Either / or e.g. fast food, teaching, hotels and holidays, psychotherapy
• (c) Personal service e.g. pensions and financial advice, car maintenance
TARGET COSTING

There are five major characteristics of services that distinguish services from manufacturing.
• Intangibility: Unlike goods there is no substantial material or physical aspects to a service.
• Inseparability/simultaneity: Many services are created at the same time as they are
consumed.
• Variability/heterogeneity: It is hard to attain precise standardisation of the service
offered.
• Perishability: Services are time bound.
• No transfer of ownership: Services do not result in the transfer of property but only
access to or a right to use a facility.
LIFE CYCLE COSTING

• Under traditional costing methods, only the current costs, comprising of marginal
costs plus a share of fixed costs, are considered. But other costs, without which the
goods could not have been made, such as Research & Development costs, are
ignored.
• All costs should be taken into account when working out the cost of a unit and its
profitability.
• Attention to all costs will help reduce the cost per unit and will help an organisation
achieve its target cost.
• Many costs will be linked.
• Costs are committed and incurred at very different times.
LIFE CYCLE COSTING

Stages of Life cycle (product life cycle)


• The development stage; where costs are incurred but no revenue is
generated.
• The introduction stage; the product is introduced to the market..
• The growth stage: At this stage, the product becomes well-known in the
market.
• The maturity stage: At this stage, demand for the product stabilises or the
rate of growth slows down.
• The decline / saturation stage: At this stage the demand for the product
starts to fall and marketing costs are cut down.
LIFE CYCLE COSTING
LIFE CYCLE COSTING

Benefits of Life cycle costing:


• The potential profitability of product can be assessed before major development of
the product is carried out and costs incurred and non-profit-making products can
be abandoned.
• Techniques can be used to reduce costs over the life of the product.
• Pricing strategy can be determined before the product enters production.
• Attention can be focused on reducing the research and development phase to get
the product to market as quickly as possible.
• By monitoring the actual performance of products against plans, lessons can be
learnt to improve the performance of future products.
THROUGHPUT ACCOUNTING

The theory of constraints


• The theory of constraints is applied within an organisation by following what are called
‘the five focusing steps.’ These are a tool developed to help organisations deal with
constraints, otherwise known as bottlenecks, within the system as a whole (rather than
any discrete unit within the organisation.) The steps are as follows:
• Step 1: Identify the system’s bottlenecks
• Step 2: Decide how to exploit the system’s bottlenecks
• Step 3: Subordinate everything else to the decisions made in Step 2
• Step 4: Elevate the system’s bottlenecks
• Step 5: If a new constraint is broken in Step 4, go back to Step 1, but do not let inertia
become the system’s new bottlenec
THROUGHPUT ACCOUNTING

• Throughput is calculated as ‘selling price less direct material cost.’


• This is different from the calculation of ‘contribution’, in which both
labour costs and variable overheads are also deducted from selling
price.
• It is an important distinction because the fundamental belief in
throughput accounting is that all costs except direct materials costs are
largely fixed.
• Let’s work on an example (Refer to Q5)
THROUGHPUT ACCOUNTING

• Difference between traditional costing and throughput accounting


Traditional Costing Throughput accounting

Labour costs and variable overheads are All costs other than materials are seen as
treated as variable costs. fixed in the short term.
Inventory is valued at total production cost. Inventory is valued at material cost only.

Value is added when an item is produced. Value is added when an item is sold.

Product profitability can be determined by Profitability is determined by the rate at


deducting a product cost from selling price. which money is earned.
EVIRONMENTAL ACCOUNTING

• Environmental accounting is becoming increasingly topical in the modern


business environment due to increased regulation and media coverage.
• The generation and analysis of both financial and non-financial information
in order to support environmental management processes
• The majority product or of environmental costs are already captured
within accounting systems. it is often difficult to pinpoint and allocate them
to a particular service
EVIRONMENTAL ACCOUNTING

Why environmental costs are important


• Identifying environmental costs associated with individual products and
services can assist with pricing decisions
• Ensuring compliance with regulatory standards
• Potential for cost savings
• Government support
• Reputation & goodwill
EVIRONMENTAL ACCOUNTING

Typical environmental costs:


• Consumables and raw materials
• Transport and travel
• Waste disposal
• Energy consumption
• Recycled material
• Water usage
• Pollution
EVIRONMENTAL ACCOUNTING

Methods of Environmental Accounting :


• Input/output analysis : This method operates on the principal that what
comes in must go out. Output is split across sold and stored goods and
waste.
• Environmental activity-based costing: In this method environment related
costs are attributed to joint environmental cost centers. Environmental cost
drivers are allocated to general overheads.
EVIRONMENTAL ACCOUNTING

Methods of Environmental Accounting :


• Flow cost accounting : In this method, material flows through an organization
are divided into three categories (Material, System and delivery, Disposal). The
values and costs of each material flow are calculated. This method focuses on
reducing costs and having a positive effect on the environment
• Life-cycle costing: In this method, environmental costs are considered from
the design stage right up to the last stage costs . This may influence the design
of the product itself, saving on future costs.