Tools for Business Decision Management Makers_4 pptx

Traditional versus activity-based costing Figure 5.1 With the traditional approach, overheads are first assigned to product cost centres and then absorbed by cost units based on an overhead recovery rate (using direct labour hours worked on the cost units or some other approach) for each cost centre. With activity-based costing, overheads are assigned to cost pools and then cost units are charged with overheads to the extent that they drive the costs in the various pools. Source: Adapted from Innes, J. and Mitchell, F., Activity Based Costing: A Review with Case Studies, CIMA Publishing, 1990. ACTIVITY-BASED COSTING 141 M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 141 CHAPTER 5 COSTING AND PRICING IN A COMPETITIVE ENVIRONMENT 142 Comma Ltd manufactures two types of Sprizzer – Standard and Deluxe. Each product requires the incorporation of a difficult-to-handle special part (one of them for a Standard and four for a Deluxe). Both of these products are made in batches (large batches for Standards and small ones for Deluxes). Each new batch requires that the production facilities are ‘set up’. Details of the two products are: Standard Deluxe Annual production and sales – units 12,000 12,000 Sales price per unit £65 £87 Batch size – units 1,000 50 Direct labour time per unit – hours 2 2 1 /2 Direct labour rate per hour £8 £8 Direct material cost per unit £22 £32 Number of special parts per unit 1 4 Number of set-ups per batch 1 3 Number of separate material issues from stores per batch 1 1 Number of sales invoices issued per year 50 240 In recent months, Comma Ltd has been trying to persuade customers who buy the Standard to purchase the Deluxe instead. An analysis of overhead costs for Comma Ltd has provided the following information. Overhead cost analysis £ Cost driver Set-up cost 73,200 Number of set-ups Special part handling cost 60,000 Number of special parts Customer invoicing cost 29,000 Number of invoices Material handling cost 63,000 Number of batches Other overheads 108,000 Labour hours Required: (a) Calculate the profit per unit and the return on sales for Standard and Deluxe Sprizzers using (i) the traditional direct-labour-hour based absorption of overheads; (ii) activity-based costing methods. (b) Comment on the managerial implications for Comma Ltd of the results in (a) above. Solution Using the traditional full (absorption) costing approach that we considered in Chapter 4, the overheads are added together and an overheads recovery rate deduced as follows: Overheads £ Set-up cost 73,200 Special part handling cost 60,000 Customer invoicing cost 29,000 Material handling cost 63,000 Other overheads 108,000 333,200 Example 5.3 M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 142 ACTIVITY-BASED COSTING 143 Overhead recovery rate = = = = £6.17 per hour The total cost per unit of each type of Sprizzer is calculated by adding the direct cost to the overheads cost per unit. The overheads cost per unit is calculated by multiplying the number of direct labour hours spent on the product (2 hours for each Standard and 2 1 /2 hours for each Deluxe) by the overheads recovery rate calculated above. Hence: Standard Deluxe Direct cost £ £ Labour 16.00 20.00 Material 22.00 32.00 Indirect cost Overheads (£6.17 per hour) 12.34 15.43 Total cost per unit 50.34 67.43 The return on sales is calculated as follows: Standard Deluxe £ per unit £ per unit Selling price 65.00 87.00 Total cost (see above) 50.34 67.43 Profit 14.66 19.57 Return on sales [(profit/sales) × 100%] 22.55% 22.49% Using the ABC costing approach, the activity cost driver rates will be calculated as follows: (a) (b) (c) (d) (e) Overhead Driver Standard Deluxe Total Costs Driver cost pool driver driver driver £ rate volume volume volume £ (a + b) (d/c) Set-up Set-ups per 12 720 732 73,200 100 batch Special part Special parts 12,000 48,000 60,000 60,000 1 per unit Customer Invoices 50 240 290 29,000 100 invoices per year Material Number of 12 240 252 63,000 250 handling batches Other Labour 24,000 30,000 54,000 108,000 2 overheads hours £333,200 54,000 £333,200 [(12,000 × 2) + (12,000 × 2 1 /2)] Total overheads Number of labour hours ‘ M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 143 Criticisms of ABC Although many businesses now adopt a system of ABC, its critics point out that ABC can be time-consuming and costly. Set-up costs as well as costs of running and updat- ing the ABC system must be incurred. These costs can be very high, particularly where the business’s operations are complex and involve a large number of activities and cost drivers. Furthermore, ABC information produced under the scenario just described may be complex. If managers find ABC reports difficult to understand, there is a risk that the potential benefits of ABC will be lost. Not all businesses are likely to benefit from ABC. Where a business sells products or services that all have similar levels of output and involve similar activities and CHAPTER 5 COSTING AND PRICING IN A COMPETITIVE ENVIRONMENT 144 The activity-based costs are derived as follows: (f ) (g) Overhead Total costs Total costs Unit costs Unit costs cost pool Standard Deluxe Standard Deluxe (a × e) (b × e) (f/12,000) (g/12,000) ££££ Set-up 1,200 72,000 0.10 6.00 Special part 12,000 48,000 1.00 4.00 Customer invoices 5,000 24,000 0.42 2.00 Material handling 3,000 60,000 0.25 5.00 Other overheads 48,000 60,000 4.00 5.00 Total overheads 5.77 22.00 The total cost per unit is calculated as follows: Standard Deluxe £ per unit £ per unit Direct cost: Labour 16.00 20.00 Material 22.00 32.00 Indirect cost See above 5.77 22.00 Total cost per unit 43.77 74.00 The return on sales is calculated as follows: Standard Deluxe £ per unit £ per unit Selling price 65.00 87.00 Total cost (see above) 43.77 74.00 Profit 21.23 13.00 Return on sales [(profit/sales) × 100%] 32.67% 14.94% The figures show that under the traditional approach the returns on sales appear broadly equal. However, the ABC approach shows that the Standard product is far more profitable. Hence, the business should reconsider its policy of trying to per- suade customers to switch to the Deluxe product. Example 5.3 continued M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 144 processes, it is unlikely that the finer measurements provided by ABC will lead to strik- ingly different results from those gained under the traditional approach. As a result, opportunities for better pricing, planning and cost control may not be great and may not justify the cost of switching to an ABC system. Measurement and tracing problems can arise with ABC, which may undermine any potential benefits. Not all costs can be easily identified with a particular activity and some may have to be allocated to cost pools. This can often be done on some sensible basis. For example, factory rent may be allocated on the basis of square metres of space used. In some cases, however, a lack of data concerning a particular cost may lead to fairly arbitrary cost allocations between activities. There is also the problem that the relationship between activity costs and their cost drivers may be difficult to determine. Identifying a cause-and-effect relationship can be difficult where a large proportion of activity costs are fixed and so do not vary with changes in usage. ABC is also criticised for the same reason that full costing generally is criticised: because it does not provide very relevant information for decision making. The point was made in Chapter 4 that full costing tends to use past costs and to ignore opportun- ity costs. Since past costs are always irrelevant in decision making and opportunity costs can be significant, full costing information is an expensive irrelevance. In con- trast, advocates of full costing claim that it is relevant, in that it provides a long-run average cost, whereas ‘relevant costing’, which we considered in Chapter 2, relates only to the specific circumstances of the short term. The use of ABC, rather than the tradi- tional approach to job (or product) costing, does not affect the validity of this irrelev- ance argument. Real World 5.2 shows how ABC came to be used at the Royal Mail. Real World 5.3 provides some indication of the extent to which ABC is used in practice. ACTIVITY-BASED COSTING 145 REAL WORLD 5.2 Delivering ABC Early in the 2000s the publicly-owned Royal Mail adopted ABC and used it to find the cost of making postal deliveries. Royal Mail identified 340 activities that gave rise to costs, created a cost pool and identified a cost driver for each of these. Roger Tabour, Royal Mail’s Enterprise Systems Programme Director, explained, ‘A new regulatory and competitive environment, plus a down-turned economy, led management to seek out more reliable sources of information on performance and profitability,’ and this led to the introduction of ABC. The Royal Mail is a public sector organisation that is subject to supervision by Postcomm, the UK government appointed regulatory body. The government requires the Royal Mail to operate on a commercial basis and to make profits. Source: www.sas.com. M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 145 CHAPTER 5 COSTING AND PRICING IN A COMPETITIVE ENVIRONMENT 146 REAL WORLD 5.3 ABC in practice A recent survey of 176 UK businesses operating in various industries, all with an annual turnover of more than £50 million, was conducted by Al-Omiri and Drury. This indicated that 29 per cent of larger UK businesses use ABC. The adoption of ABC in the UK varies widely between industries, as is shown in Figure 5.2. Al-Omiri and Drury took their analysis a step further by looking at the factors that appar- ently tend to lead a particular business to adopt ABC. They found that businesses that used ABC tended to be: l Large l Sophisticated, in terms of using advanced management accounting techniques generally l In an intensely competitive market for their products l Operating in a service industry, particularly in the financial services. All of these findings are broadly in line with other recent research evidence involving busi- nesses from around the world. Source: Al-Omiri, M. and Drury, C., ‘A survey of factors influencing the choice of product costing systems in UK organisations’, Management Accounting Research, December 2007. ABC in practice Figure 5.2 M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 146 ACTIVITY-BASED COSTING 147 Psilis Ltd makes a product in two qualities, called ‘Basic’ and ‘Super’. The business is able to sell these products at a price that gives a standard profit mark-up of 25 per cent of full cost. Management is concerned by the lack of profit. Full cost for one unit of a product is calculated by charging overheads to each type of product on the basis of direct labour hours. The costs are as follows: Basic Super ££ Direct labour (all £10/hour) 40 60 Direct material 15 20 The total overheads are £1,000,000. Based on experience over recent years, in the forthcoming year the business expects to make and sell 40,000 Basics and 10,000 Supers. Recently, the business’s management accountant has undertaken an exercise to try to identify activities and cost drivers in an attempt to be able to deal with the overheads on a more precise basis than had been possible before. This exercise has revealed the following analysis of the annual overheads: Activity (and cost driver) Cost Annual number of activities £000 Total Basic Super Number of machine set-ups 280 100 20 80 Number of quality-control inspections 220 2,000 500 1,500 Number of sales orders processed 240 5,000 1,500 3,500 General production (machine hours) 260 500,000 350,000 150,000 Total 1,000 The management accountant explained the analysis of the £1,000,000 overheads as follows: l The two products are made in relatively small batches, so that the amount of the finished product held in inventories is negligible. The Supers are made in very small batches because demand for them is relatively low. Each time a new batch is produced, the machines have to be reset by skilled staff. Resetting for Basic production occurs about 20 times a year and for Supers about 80 times: about 100 times in total. The cost of employing the machine-setting staff is about £280,000 a year. It is clear that the more set-ups that occur, the higher the total set-up costs; in other words, the number of set- ups is the factor that drives set-up costs. l All production has to be inspected for quality and this costs about £220,000 a year. The higher specifications of the Supers mean that there is more chance that there will be quality problems. Thus the Supers are inspected in total 1,500 times annually, whereas the Basics only need about 500 inspections. The number of inspections is the factor that drives these costs. l Sales order processing (dealing with customers’ orders, from receiving the original order to despatching the products) costs about £240,000 a year. Despite the larger amount of Basic production, there are only 1,500 sales orders each year because the Basics are sold to wholesalers in relatively large-sized orders. The Supers are sold mainly direct to the public by mail order, usually in very small-sized orders. It is believed that the number of orders drives the costs of processing orders. Self-assessment question 5.1 ‘ M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 147 The increasingly competitive environment in which modern businesses operate is lead- ing to greater effort being applied in trying to manage costs. Businesses need to keep costs to a minimum so that they can supply goods and services at a price that cus- tomers will be prepared to pay and, at the same time, generate a level of profit neces- sary to meet the businesses’ objectives of enhancing shareholder wealth. We have just seen how ABC can help manage costs. We shall now go on to outline some other tech- niques that have recently emerged in an attempt to meet these goals of competitive- ness and profitability. These can be used in conjunction with ABC. Total (or whole) life-cycle costing This method of costing starts from the premise that the total (or whole) life cycle of a product or service has three phases. These are: 1 The pre-production phase. This is the period that precedes production of the product or service for sale. During this phase, research and development – both of the product or service and of the market – is conducted. The product or service is invented/ designed and so is the means of production. The phase culminates with acquiring and setting up the necessary production facilities and with advertising and promotion. 2 The production phase comes next, being the one in which the product is made and sold or the service is rendered to customers. 3 The post-production phase comes last. During this phase, any costs necessary to cor- rect faults that arose with products or services that have been sold (after-sales ser- vice) are incurred. There would also be the costs of closing production at the end of the product’s or service’s life cycle, such as the cost of decommissioning production facilities. Since after-sales service will tend to arise from as early as the first product or service being sold and probably, therefore, well before the last one is sold, this phase would typically overlap with the manufacturing/service-rendering phase. Businesses often seem to consider environmental costs alongside the more obvious financial costs involved in the life of a product. The total life cycle is shown in Figure 5.3. Other approaches to cost management in the modern environment CHAPTER 5 COSTING AND PRICING IN A COMPETITIVE ENVIRONMENT 148 Required: (a) Deduce the full cost of each of the two products on the basis used at present and, from these, deduce the current selling price. (b) Deduce the full cost of each product on an ABC basis, taking account of the man- agement accountant’s recent investigations. (c) What conclusions do you draw? What advice would you offer the management of the business? The answer to this question can be found in Appendix B at the back of the book. Self-assessment question 5.1 continued M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 148 In some types of business, particularly those engaged in an advanced manufacturing environment, it is estimated that a very high proportion (as much as 80 per cent) of the total costs that will be incurred over the total life of a particular product are either incurred or committed at the pre-production phase. For example, a car manufacturer, when designing, developing and setting up production of a new model, incurs a high proportion of the total costs that will be incurred on that model during the whole of its life. Not only are pre-production costs specifically incurred during this phase, but the need to incur particular costs during the production phase is also established. This is because the design will incorporate features that will lead to particular manu- facturing costs. Once the design of the car has been finalised and the manufacturing plant set up, it may be too late to ‘design out’ a costly feature without incurring another large cost. OTHER APPROACHES TO COST MANAGEMENT IN THE MODERN ENVIRONMENT 149 The total life cycle of a product or service Figure 5.3 From the producer’s viewpoint, the life of a product can be seen as having three distinct phases. During the first the product is developed and everything is prepared so that produc- tion and marketing can start. Next comes production and sales. Lastly, dealing with post- production activities is undertaken. A decision taken at the design stage could well commit the business to costs after the manufacture of the product has taken place. Can you suggest a potential cost that could be built in at the design stage that will show itself after the manufacture of the product? After-sales service costs could be incurred as a result of some design fault. Once the manu- facturing facilities have been established, it may not be economic to revise the design; it may be better to deal with the problem through after-sales service procedures. Activity 5.3 M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 149 Total life-cycle costing seeks to focus management’s attention on the fact that it is not just during the production phase that attention needs to be paid to cost manage- ment. By the start of the production phase it may be too late to try to manage a large element of the product’s or service’s total life-cycle cost. Efforts need to be made to assess the costs of alternative designs. There needs to be a review of the product or service over its entire life cycle, which could be a period of 20 or more years. Traditional management accounting, however, tends to be concerned with assessing performance over periods of just one year or less. Real World 5.4 provides some idea of the extent to which total life-cycle costing is used in practice. Real World 5.5 shows how a well-known international carmaker uses total life-cycle costing. CHAPTER 5 COSTING AND PRICING IN A COMPETITIVE ENVIRONMENT 150 ‘ REAL WORLD 5.4 Total (whole) life-cycle costing in practice A survey of management accounting practice in the US was conducted in 2003. Nearly 2,000 businesses replied to the survey. These tended to be larger businesses, of which about 40 per cent were manufacturers and about 16 per cent financial services; the remainder were across a range of other industries. The survey revealed that 22 per cent extensively use a total life-cycle approach to cost control, with a further 37 per cent considering using the technique in the future. Though the survey relates to the US, in the absence of UK evidence it provides some insight to what is likely also to be practised in the UK and elsewhere in the developed world. Source: 2003 Survey of Management Accounting, Ernst and Young, 2003. REAL WORLD 5.5 Total life-cycle costing at Renault According to Renault, the French motor vehicle manufacturer: The life of a vehicle is long and comprises several phases: design: Creating a vehicle manufacturing: Extracting and producing materials, manufacturing and assembling the com- ponents, and then the whole vehicle distribution: Transition between the vehicle’s departure from the production plant and its pur- chase by a customer vehicle service life: The use by the motorist, the longest phase recycling. These phases make up the life cycle. Why the word ‘cycle’? Because the end of a vehicle’s service life is factored in right from the design phase. Source: www.renault.com. M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 150 [...]... to cater for a range of products and no single product decision will cause the business to amend it Required: (a) Prepare a summary of information that would help with the pricing decision for the new product Such information should include marginal cost and full cost implications after allocation of service department overheads (b) Explain and elaborate on the information prepared 5.8 A business manufactures... Specialist Ltd makes a very specialised machine that is sold to manufacturing businesses The business is about to commence production of a new model of machine for which facilities exist to produce a maximum of 10 machines each week To assist management in a decision on the price to charge for the new machine, two pieces of information have been collected: ‘ M05_ATRI3622_06_SE_C05.QXD 162 CHAPTER 5 5/29/09... quite a lot about what makes that business successful Businesses are under no statutory obligation to benchmark and are understandably reluctant to divulge commercially sensitive information to competitor businesses They may, however, benchmark internally, with one division or department comparing itself with another part of the same business They may also benchmark with businesses with which they are... Commodity B Demand for A reacts much more dramatically to price changes (stretches more) than does demand for B Elastic demand tends to be associated with commodities that are not essential, perhaps because there is a ready substitute It is very helpful for those involved with pricing decisions to have some feel for the elasticity of demand of the commodity that will be the subject of a decision The sensitivity... consider the strategic aspects of management accounting Costing quality control ‘ Such is the importance that their customers place on quality that businesses are forced to make sure that their output is of a high quality In the competitive environment in which most businesses operate, a failure to deliver quality will lead to customers going to another supplier Businesses, therefore, need to establish procedures... cost of £1,100, but each additional machine produced will increase the variable cost for the entire output by £100 a machine For example, if the output were three machines a week, the variable cost for each machine (for all three machines) would be £1,300 It is the policy of the business always to charge the same price for its entire output of a particular model What is the most profitable level of output... for the period In practice, this required profit is often set in relation to the amount of capital invested in the business In other words, businesses seek to generate a target return on capital employed It seems, therefore, that the profit loading on full cost should reflect the business s target profit and that the target should itself be based on a target return on capital employed Activity 5.9 A business. .. retailing and service businesses, where many businesses are quite small Source: Guilding, C., Drury, C and Tayles, M., ‘An empirical investigation of the importance of cost-plus pricing’, Management Auditing Journal, Vol 20, No 2, 2005 Pricing on the basis of relevant/marginal cost ‘ The relevant/marginal cost approach deduces the minimum price for which the business can offer the product for sale This minimum... business travellers, who are probably forced to travel, but for whom a Saturday stopover may be unattractive UK train operators often offer substantial discounts for off-peak travel, particularly through Apex tickets Similarly, hotels often charge very low rates for off-peak rooms A hotel mainly used by business travellers may well offer very low room rates for Friday and Saturday occupancy Relevant/marginal... – usually a continuing one – where a business, or one of its divisions, seeks to emulate a successful business or division and so achieve a similar level of success The successful business or division provides a benchmark against which the business can measure its own performance, as well as examples of approaches that can lead to success Sometimes the benchmark business will help with the activity, . 2,700 800 2,900 300 (200) 4 3 ,40 0 700 3,200 300 200 5 4, 000 600 3,500 300 500 6 4, 500 500 3,800 300 700 7 4, 900 40 0 4, 100 300 800 8 5,200 300 4, 400 300 800 9 5 ,40 0 200 4, 700 300 700 10 5,500 100. 72,000 0.10 6.00 Special part 12,000 48 ,000 1.00 4. 00 Customer invoices 5,000 24, 000 0 .42 2.00 Material handling 3,000 60,000 0.25 5.00 Other overheads 48 ,000 60,000 4. 00 5.00 Total overheads 5.77. 12. 34 15 .43 Total cost per unit 50. 34 67 .43 The return on sales is calculated as follows: Standard Deluxe £ per unit £ per unit Selling price 65.00 87.00 Total cost (see above) 50. 34 67 .43 Profit