Cost Evaluation Why what and how


Contemporary managerial accounting is affected by the growing importance of effective overhead cost management, the cause of which lies in several factors. First and foremost, there has been a proportional increase in the overheads faced by companies, changing from around a portion of 10% in the 1950?s to what it is today, potentially representing approximately 40% of a manufacturing business? total costs. Another factor holding sway over the bearing of effective overhead cost management is pressure from competitors, forcing firms to extend the efficiency of their operations. Organizations with huge overhead departments and inflated overhead costs could have difficulties reaching the necessary level of operational effectiveness. Furthermore, there is the factor of increasing diversity of operations. This means that each product and every customer could differ in how they consume overhead department services within an organization. In such cases, any company? costing system should provide useful information on product and client costs, as well as giving data on the relations between costs, company activities, and cost objects, these being products and customers.Cost is perhaps the most influential factor in the outcome of a product or service within many of today? industries. More often than not, reducing cost is essential for survival. To compete and qualify, companies are increasingly required to improve their quality, flexibility, product variety, and novelty while consistently reducing their costs. In short, customers expect higher quality at an ever-decreasing cost. Not surprisingly, cost reduction initiatives are essential within today? highly competitive market place. Since cost has become such an important factor of success, project development needs to be carefully considered and planned. Recent research demonstrates that companies unable to provide detailed, meaningful cost estimates, at the early development phases, have a significant higher percentage of programs behind schedule with higher development costs, than those that can provide completed cost estimates [Hoult et al. 1996]. Therefore, it is essential that the cost of a new project development be understood before it actually begins. It could mean the difference between success and failure.

The Need For Cost Evaluation

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Cost evaluation helps companies with decision-making, cost management and budgeting with respect to product development. It is a methodology used for predicting/forecasting/estimating the cost of a work activity or output [Stewart et al. 1995]. Cost estimates during the early stages of product development are crucial. They influence the go or no-go decision concerning a new development. If an estimate is too high it could mean the loss of business to a competitor. If the estimate is too low it could mean the company is unable to produce the product and make a reasonable profit. In this ever-increasing competitive market, cost engineering is becoming a necessity for survival and not a practice to do.

Cost Evaluation: Why, what and how?

Many authors agree that 70-80% of a product cost is committed during the concept phase [Stewart et al. 1995; NASA 2002a; Taylor 1997; Mileham et al. 1993]. Making a wrong decision at this stage is extremely costly further down the development process. Product modifications and process alterations are more expensive the later they occur in the development cycle. Thus, cost estimators need to approximate the true cost of producing a product, based on empirical data, with the purpose of satisfying both the customer and company. In traditional costing there are two main estimates: a first sight estimate, which is done early in the cost stage, and a detailed estimate, done to calculate costs precisely. The former of these cost-estimating methods is largely based around the experience of the estimator. For example, it is not uncommon for a first sight project estimate to be based upon a past similar project or purely on experience in costing. However, to attain this level of experience takes years of apprenticeship and considerable oversight from senior estimators. Although useful for a rough order of magnitude estimate, this type of estimating is too subjective in today? cost conscious culture and more quantified and justified estimates are required [Roy et al. 1999a, 1999b]. For detailed estimates, cost is based upon the number of operations, time per operation, labour cost, material cost and overhead costs in case of hardware cost estimating. Much of the information in a detailed estimate is based upon the internal synthetics (times or costs based upon expected rates of work for any particular task) of the company. To generate these estimates, it is necessary to have an understanding of the product, the methods of manufacture/process and relationships between processes.

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Detailed estimating goes through several iterations, since feedback from the relevant departments enables the estimates to be reviewed and improved. Thus, detailed estimating can be achieved only when a product is well defined and understood. Activity based costing (ABC) is a process for measuring the cost of the activities of an organisation [Dean 2003; Cokins 1998]. It is a quantitative technique used to measure the cost and performance of activities e.g. inspection, production processes and administration. Each activity within an organisation is first identified and then an average cost is associated. Once this is achieved, it is then possible to estimate the amount of activity a product is likely to need and then associate the relative costs. This makes ABC appealing since it combines estimates with hard data. This method follows similar processes to detailed estimating and also requires a detailed understanding of the product definition.

Cost control assessment of risk

The objective of a cost risk analysis is to predict the amount of uncertainties involved in the cost estimate of future projects. There will always be uncertainties, i.e. risks, involved in a project. If these uncertainties can be identified and quantified, effort can be made to successfully deal with the impact of them occurring. Risk management is a very broad term, meaning the management of any situation, which is controlled in one way or another by uncertainty. The aim of risk management is to minimise the negative impact of risk in a project and reduce uncertainties. In the context of cost, risk management uses cost risk analysis as a tool to identify risks and then mitigate the risks. By looking at the uncertain variables within a situation, a risk analysis can show which those that have the most effect on the solution and pinpoint where most effort should be targeted. The risk analysis makes sure that uncertainty within the variable can be accounted for before committing the project. Therefore, the outcome of the analysis can be used as a decision tool for the designer. That is, if the designer understands the risks involved with certain cost drivers, he can choose a different approach to lower the

risk. Thus, using risk assessment and risk analysis ensures that the consequences of risks to a programme cost and schedule are understood and taken into account for the commercial bid on programme price and duration. Since estimating is based on assumptions concerning the likely cost of an, as yet, unknown product outcome there is an increasing trend to combine the statistical techniques of parametric cost analysis with statistical risk analysis methods. Parametric estimating, because of its statistical approach, offers the cost analyst the advantage of being able to quantify the risk of an estimate. Risk management ensures that the goals of the producer and consumer materialist and that they both benefit. It provides confidence concerning final costs and identifies actions needed to keep cost and schedule on target (Heinmuller and Dilts 1997). One of the most important benefits of using risk assessment is to generate a distribution/range of costs, i.e. to move away from single point estimating, since a range of costs are much easier to estimate than a single cost [Forsberg et al. 2002]. Furthermore, once a risk analysis has been conducted the analyst can consider ways to reduce the risk, e.g. by avoidance, deflection or contingency, and then plan accordingly to control the reduction process.

Costing Methods

Costing is important because it provides a quantified basis for defining poverty reduction strategies and programs, as well as for forecasting resource gaps and needs, and for mobilizing additional resources, either internally or externally.

While it is usually not possible to obtain reliable cost estimates for the long-term, costing is essential for coordinating the national budget and aid allocations with the prioritized development goals. The price tag and the financing plan of the programs or projects can only be ascertained meaningfully within a short-to-medium time horizon.

Three elementary types of costing methods are generally used, differing in their means of allocating overhead costs to products, these being the traditional absorption costing method, plus the variable costing and activity-based costing methods. All of these have been written about at length by various authors (Drury- 2001, Kr?-2006). Traditional costing techniques, represented by the absorption costing method, were used for the purposes of overhead cost allocation in the last century. These are based on simplified procedures using principles of averages. In recent decades, such conventional concepts have become obsolete due to two major phenomena. The first is ever increasing competition in the marketplace, the necessity

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to reduce costs and the effect of having more detailed information on company costs. The other is the alteration in the cost structure of companies, undeniably a very important factor affecting the use of this method. In terms of the majority of overhead costs, traditional allocation concepts, based as they are on overhead absorption rates, can often provide misleading information on product costs.

The absorption method

Absorption costing are mostly related to primary activity overhead costs, the major disadvantages of this costing method are connected with overhead department costs. As overhead department costs usually have fixed characteristics, their allocation to a product may cause a distinct growth should installed capacity not be utilized. This means a rise in average fixed costs, with such an output of cost calculation resulting in incorrect decisions being made at managerial level. One potential solution to the problem of allocating fixed overheads is the variable costing method. This is based on allotting variable and fixed costs separately, where fixed costs are not assigned to cost objects. The method is very effective when short-term decisions are required. Some authors have stated that the

variable costing method is a means to providing useful, extra information for decision making (Drury, 2001). Generally, the most important limitations of the variable costing method are defined thus (Kr?, 2006)The construction of the method restricts managers to formulating short-term decisions which could clash with strategic objectives of the enterprises in question;Because fixed costs are not calculated, they are eliminated from consideration; Due to the fact that fixed costs are summarized, the causal relations between costs and objects are lost Consequently, the variable costing process might help managers avoid making inaccurate decisions based on full product costs, but could lead to overhead costs being overlooked. It is often stated by management that they cannot do anything as regards overhead department costs other than generate income to cover them.

Case Study (For Pharmaceutical)

Process Costing

Takes into account continuous process costing, based on an average cost for a quantity produced over a period of time.

Example: A medicine producing plant is continuous the cost of the a medicine can be calculated easily based on historical data, the final packaging may affect the price differently i.e. 100mg tablet will cost more than 500 mg medicine , for the weight of product contained within it.


Calculate the hourly process cost for the following job?

A press operates at 600 units per hour

Capital recovery is over 5 years which amounts to 3000 per year + $30 / hour material cost.

Determine the unit costs of the press based on

80 hours per week

Calculate costs per unit, total costs , total production.


For 80 hours

Hours worked (48weeks per yr x 5years) x70 per week = 16800 hours

Costs ($30 x 16800) + ($3000 x 5years) = $519,000

Produced units = 16800 x 500 = 10080000

Costs per unit = $435,000 / 10080000 = $0.05148 per unit

In the above example it can be seen the pharmaceutical company practiced process costing for their medicine as it provides the costing of the different processes required to perform the job. The second option would be the break-even analysis as it gives an idea that how much unit should be sold by a company in order to get a break-even where it cost is equal to revenue it gives help in pricing of the final product and also helps in developing the sales strategy. Activity based costing is also suitable as in winters there are higher demand for the coffee products and on the base of it company can divide its cost in terms of higher volumes activities that helps in minimizing the other processes cost. Manager knowledge about the product and costing techniques is very important as it gives clear idea about the implication of the technique and also the impact on the final prices of the product.

Task 3

Value Analysis can be defined as a process of systematic review that is applied to existing product designs in order to compare the function of the product required by a customer to meet their requirements at the lowest cost consistent with the specified performance and reliability needed. If a product was designed optimally and ?ight first time which is actually against the law of probability, then the product would offer the most value in providing the function sought by the customer in the most reliable way and lowest cost. The Value Analysis approach is therefore the means of maintaining the value proposition for the customer through periodic reviews that serve to continuously improve the process of ?esign to marketplace It is therefore a key strategic capability for any business that seeks to differentiate its products from the competition. At the very least, the VA process allows a company to correct design weaknesses after the product has entered production and therefore to cease paying for activities that add no value for the customer offer but costs which tend to be passed on to the customer. In essence, VA is used to maintain the fit between the product, low costs, and high perceived customer value.

VA exercises include:

Products with known problems that from the pilot production stage continue to be produced but require remedial, corrective actions, and engineering change requests.

Customer Demands. Most markets require suppliers to offer a range of products and to continuously increase this offering. To avoid an explosion in the number of unique parts associated each new product many companies have introduced standard components, platform strategies and supplier rationalization programmes. The ability to design

products is seen as key to maintaining the quality, cost and delivery performance of the product. Some customers, especially those in mature markets, need to continuously reduce the costs of products in order to compete against comparatively cheaper imports. The increasing trend, across Europe, for businesses to ?uy inrather than ?akeall the elements of a product means that new suppliers of materials must be educated in the VA process in order to use the specialist skills of the supplier to reduce the costs of supplied materials continuously.

Safety and Compliance Requirements for products in the market or being sold within markets that have different safety legislation implies that VA activities must be used to review the compliance of a product with the prevailing legislation and changes to that legislation.

The Improvement of Product Margins. VA is often used to combat the perpetual and expected price reductions between a supplier and a customer. Therefore as a protective measure many businesses employ VA to reduce costs and to protect their own profit margins.

Corrective Action. To redress known problems with existing product designs or to reduce the costs associated with failure (including warranty, complaints and poor quality within the factory and with the customer). In conditions where the market determines the price, any attempt to reduce costs or recover losses through redesign and improvement activities will provide a major return to the business throughout the life of the product. This total lifecycle saving can amount to a large financial saving.

There are many modern competitive trends and pressures that make the VA approach a valuable activity within any business. These pressures include:

Pricing Practice. The traditional approach to setting the price of a product has been to determine the costs of the product and then to add a ?arginto provide the profit (known as ?ost pluspricing). However in the modern competitive environment, the market tends to determine the acceptable price that can be commanded for a product. As

such, companies with high costs and a relatively fixed market price will command less profit if costs are not managed properly and reduced continuously. The VA process accommodates this need to manage and continuously seek ways of reducing product costs.

The Advent of E-Commerce. The new information technology available to customers means that product purchasing is now a global exercise. Therefore in order to maintain a relationship with an existing customer and to protect this relationship, enhancing the value and lowering the costs of existing products will be vital to competitiveness.

Reducing Complexity. The general trend in European industry is to rationalize the number of suppliers to a business and to reduce the vast number of parts that were traditionally bought and stocked. Therefore, the ability to redesign products to incorporate common parts will lead to financial savings in space and the costs of inventory.

Compliance with Quality Regulations. Most of the quality management systems, such as ISO9000 series, require companies to operate a formal design review process to ensure that the quality of the product can be assured. This is an element of the quality accreditation system that is monitored and audited by external agencies. As such, companies that fail to comply with these procedures will fail to qualify for the quality award and can lose business as a result.

New Technology and Materials. The discovery and invention of new processes and materials means that this form of innovation can be incorporated within existing product designs such that the reliability and quality of the product can be improved whilst simultaneously reducing costs. This market intelligence and the ability to take advantage

of innovation for product designs are vital to improving the performance of the product and the factory.

Environmentalism. The growing awareness of environmental issues is reshaping the buying behavior of customers and consumers in Europe. It is effectively redefining the esteem value of a product and can, through legislation, affect what materials can be used in the production of products and therefore environmental pressures serve to redefine the ?sevalue through changes in product specifications (for example CFC gases in refrigerators and aerosols). In addition many companies, notably vehicle producers, have begun to direct attention towards reducing the weight (and material content) of purchased parts to meet environmental and efficiency targets for themselves.

Managers focus is to reduce the per unit cost in order to gain the maximum benefit these benefit can be achieved through.

The methods through which cost reduction can be achieved are as follows:

Latest technological implementation.

Follow advanced accounting methods.

Supply chain program implementation.

Practicing JIT methodologies.

Control Variance in the production

Minimize cycle time.

Practice best and acclaimed accounting methods.

Provide training to managers with new costing methods.

Activity-based Costing

Activity-based costing (ABC) tries to assign overhead costs to cost objects more accurately than traditional cost systems. Therefore it is often argued that ABC can support medium- and long term decisions, such as make-or-buy, pricing and special orders decisions, or product portfolio decisions. ABC is even considered as a strategic cost system (see, e.g., Cooper and Kaplan, 1988). So far, however, it is not at all clear whether ABC is really an adequate instrument for decision making. Also it is an open question how the quality of decisions supported by ABC depends on the cost drivers of the underlying ABC system. The ABC literature defines an activity as a discrete task that a firm undertakes to make or deliver a product/service, and uses cost drivers to assign activity costs to products, services or customers related to these activities (Cooper, 1988; Ittner et al., 2002). Traditional costing systems use bases like direct labor and machine hours to allocate expenses, associated with indirect and support activities, to products and services. On the other hand, ABC segregates the expenses of indirect and support resources by activities, and then assigns those expenses based on the drivers of these activities (Cooper & Kaplan, 1991). Hence, ABC provides plant mangers with a more structured approach to evaluate the expenses associated with specific activities used to support a product. Researchers have claimed that, since ABC may provide greater visibility into business processes and their cost drivers, it may allow managers to eliminate costs related to non-value added activities and improve the efficiencies of existing processes (Carolfi, 1996). Improved information visibility may also enable the deployment of quality- related initiatives by identifying activities that are associated with poor product quality, and their cost drivers (Ittner, 1999; Cooper, Kaplan, Maisel, Morrissey, & Oehm, 1992). Hence, prior research suggests that ABC may be associated with adoption of process improvement activities, such as total quality management (TQM) programs (Ittner & Larcker, 1997a, 1997b; Anderson et al., 2002). On the other hand, Datar and Gupta (1994) claimed that increasing the number of cost pools and improving the specification of cost bases may increase the frequency of errors in product cost measurement. Banker and Potter (1993) and Christensen and Demski (1997) suggest that the ability of ABC to produce accurate cost estimates depends on other factors, such as the competitiveness of markets and the quality of the organization? information technology infrastructure. Noreen (1991) suggests that ABC implementation may provide beneficial results only under specific conditions. Similarly, empirical studies that have examined the impact of ABC on firm performance have also produced mixed results (Ittner & Larcker, 2001; Gordon & Silvester, 1999). Many of these studies rely on manager? beliefs regarding the success of ABC implementation, but they do not indicate whether ABC adopters achieved higher levels of operational or financial performance compared to non-adopters (Shields, 1995; McGowan & Klammer, 1997; Foster & Swenson, 1997). Other studies have suggested that many ABC adopters have abandoned their implementations, raising concerns about the potential impact of ABC on performance (McGowan & Klammer, 1997).