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Life-cycle costag estimates and accumulates costs over a product's entire life cycle in order to determine whether the profits earned during the manufacturing phase will cover
the costs incurred duing the pre- and post-manufacturing stages. Identifying the costs
incurred during the diferent stages of a product's life cycle provides an insight into
understanding and managing the total costs incurred throughout its life cycle. In particular,
life-cycle costing helps management to understand the cost consequences of developing
and making a product and to identify areas in which cost reduction eforts are likely to be
Figure illustrates a typical pattern of cost commitment and cost incurrence during
the three stages of a product's life cycle - the planning and design stage, the manufacturing
stage and the service and abandonment stage. Committed or locked-m costs are those
costs that have not been incurred but that will be incurred in the future on the basis of
decisions that have already been made. It is difficult to signiicantly alter costs ater they
have been committed. For example, the product design speciications determine a product's
material and labour inputs and the production process. At this stage costs become
committed and broadly determine the future costs that will be incurred during the
An understanding of life-cycle costs and how they are committed and incurred at diferent
stages throughout a product's life cycle led to the emergence of target costSeg, a technique
that focuses on managing costs during a product's planning and design phase.
Stage 1: Determine the target pice which customers will be prepared to pay for
Stage 2: Deduct a target proit margin rom the target pice to determine the target cost
Stage 3: Estimate the actual cost of the product.
Stage 4: If estimated actual cost exceeds the target cost investigate ways of diving
down the actual cost to the target cost.
The early adopters of acivity-based costing (ABC) used it to produce moe accurate product (or service) costs but it soon became appaent to the users that it could be extended beyond puely product costing to a range of cost management applications. The terms actiiviitty-ased mmannageinnieimt (ABM) or aictnvBty-Ibaised cost nmaimageiimeiiit (ABCM) ae used to descibe the cost management applicaions of ABC.
distinguishing feature of ABM reporting is that it oten reports information on aciviies
that cross departmental boundaies. For example, diferent producion departments and the
distribuion department might undertake customer processing acivities. They may resolve
customer problems by expediting late deliveries. The inance department may assess
customer credit worthiness and the remaining customer processing acivities might be
undertaken by the customer service department. Therefore the total cost of the customer
processing activity could be considerably in excess of the costs that are assigned to the
customer service department. However, to simplify the pesentaion it is assumed in
Exhibit 15.1 that the departmental and acivity costs are idenical but if the cost of the
customer order processing acivity was found to be, say, three times the amount assigned to
the customer service department, this would be important informaion because it may
change the way in which the managers view the acivity. For example, the managers may
give more attenion to educing the costs of the customer processing acivity.
It is apparent rom an examination of Exhibit 15.1 that the ABM approach provides more meaningful information. It gives more visibility to the cost of undertaking the acivities that make up the organizaion and may raise issues for management acion that are not highlighted by the traditional analysis. For example, why is £90000 spent on resolving customer problems? Attention-diecting informaion such as this is important for managing the cost of the aciviies.
Johnson (1990) suggests that knowing costs by activiies is a catalyst that eventually tiggers the acion necessary to become compeiive. Consider a situation where sales¬ persons, as a result of costing activiies, are informed that it costs £50 to process a customer's order. They theefore become awae that it is quesionable to pursue orders with a low sales value. By eliminating many small orders, and concentrating on larger value orders, the demand for customer-processing activiies should decease, and future spend¬ ing on this acivity should be reduced.
464 COST MANAGEMENT AND STRATEGIC MANAGEMENT ACCOUNTING
Pior to the introducion of ABM most organizaions have been unaware of the cost of
undertaking the activiies that make up the organizaion. Knowing the cost of acivities
enables those aciviies with the highest cost to be highlighted so that they can be
pioitized for detailed studies to ascertain whether they can be eliminated or performed
more efficiently. To identify and pioitize the potential for cost reduction many organiza¬
ions have fouia* it useful to classify aciviies as either value added or non-value added.
Deiniions of what constitutes value added and non-value added acivities vary. A
common deinition is that a valune added activity is an activity that customers perceive
as adding usefulness to the product or service they purchase. For example, painting a car
would be a value added acivity in an organizaion that manufactures cars. Other
deinitions are an activity that is being performed as eficiently as possible or an activity
that supports the primary objective of producing outputs.
In contrast, a aoM-vakiie added activity is an acivity where there is an opportunity for
cost reducion without reducing the product's service potential to the customer. Examples
of non-value added aciviies include inspecting, storing and moving raw mateials. The
cost of these aciviies can be reduced without reducing the value of the products to the
customers. Non-value added aciviies are essentially those activiies that customers should
not be expected to pay for. Reporting the cost of non-value added aciviies draws
management's attention to the vast amount of waste that has been tolerated by the
organization. This should pioitize those aciviies with the greatest potential for cost
reduction by eliminating or carrying them out more efectively, such as reducing mateial
movements, improving production lows and taking acions to reduce stock levels. Taking
acion to reduce or eliminate non-value added aciviies is given top pioity because by
doing so the organizaion permanently reduces the cost it incurs without reducing the value
of the product to the customer.
Kaplan and Cooper (1998) citicize the classiication of aciviies by simplisic value
added and non-value added categoies. They point out, that apart rom the extreme
examples similar to the ones illustrated above, people cannot consistently deine what
constitutes a value added or non-value added acivity. To reinforce this point they discuss
whether the activity of setting up a machine is value added or non-value added. One view
is that customers do not perceive performing set-ups as adding usefulness to products and
the acivity is non-value added. However, without set-ups a plant can only produce single
products. If customers value customized or diverse products, changing machine settings
rom the ability to produce diferent product vaieies creates value for customers. Kaplan
and Cooper also point out the demoivating impact when employees are informed that they
are performing non-value added acivities.
To overcome the above problems Kaplan and Cooper advocate that instead of using a
value added/non-value added classiication the following simple ive point scale should be
used to summaize an ABC project team's initial judgement about the current eiciency of
1. highly eicient, with little (less than 5%) apparent opportunity for improvement;
2. modestly eicient, some (5-15%) opportunity for improvement;
3. average eiciency, good opportuniies (15-25%) for improvement;
4. ineicient, major opportunities (25-50%) for improvement;
5. highly ineicient, perhaps should not be done at all; 50-100% opportunity for
By identifying the cost of acivities that make up their organizaion and classifying them
into the above ive categories, opportuniies for cost reduction can be pioitized. Cost
reducion can be achieved by either eliminating the activiies, performing them more
COST MANAGEMENT 465
eiciently with fewer organizaional resources or redesigning them so that they are performed in an enirely diferent and more cost eicient way. We shall consider how acivities can be redesigned later in the chapter.
Our discussion so far has related to the application of ABM during the manufacturing
or service phase of a product's life cycle. However, some organizaions have used their
acivity-based costing systems to influence future costs at the design stage within the target
costing process. For example, the Tektronix Portable Instruments Division assigned
mateial support expenses using a single cost diver-number of part numbers. The
company wanted to encourage design engineers to focus their attention on reducing the
number of part numbers, parts and vendors in future generaions of products. Product
timeliness was seen as a citical success factor and this was facilitated by designs which
simpliied parts procurement and production processes. The cost system moivated
engineers to design simpler products requiring less development time because they had
fewer parts and part numbers. The cost system designers knew that most of the mateial
support expenses were not incurred in direct proporion to the single cost diver chosen,
but the simpliied and imprecise cost system focused attention on factors deemed to be
most citical to the division's future success.
A survey of acivity-based costing applications by Innes and Mitchell (1995a) indicated
that many organizations use cost diver rates as a measure of cost eiciency and
performance for the activity concerned. The cost driver rate is computed by dividing
the activity costs by the cost diver volume. For example, if the cost of processing 10000
purchase orders is £100000, the cost per purchasing order is £10. Assume now that
improvements in procedures in the purchasing activity enable costs to be reduced to
£80000. If the same number of orders can be processed with fewer resources the cost of
processing an order will be reduced to £8. Reporting and focusing on cost diver rates can
thus be used to moivate managers to reduce the cost of performing acivities.
There is a danger, however, that cost diver rates can encourage dysfunctional
behaviour. An improvement in the cost diver rate can be achieved by splitting some
purchase orders and increasing the orders processed to, say, 12 000. Assuming that the cost
of the acivity remains unchanged at £100000 the cost per purchasing order will be
reduced rom £10 to £8.33 if all costs are ixed in the short term. The overall efect is that
the workload will be increased and, in the long term, this could result in an increase in
costs. Care should therefore be taken to avoid these dysfunctional consequences by using
cost diver rates as feedback informaion to guide employees in improving the eiciency of
performing activiies. If the measures are interpreted in a recriminatory or threatening
manner, there is a danger that they will lead to dysfunctional behaviour.
Business process re-engineering
BtmsDimess process jre-engimeernmg involves examining business processes and making substanial changes to how the organizaion currently operates. It involves the redesign of how work is done through aciviies. A business process consists of a collecion of activiies that are linked together in a co-ordinated manner to achieve a speciic objective. For example, mateial handling might be classed as a business process consisting of separate aciviies relating to scheduling production, storing mateials, processing purchase orders, inspecting mateials and paying suppliers.
The aim of business process re-engineering is to improve the key business processes in
an organization by focusing on simpliicaion, cost reduction, improved quality and
enhanced customer satisfaction. Consider the mateials handling process outlined in the
above paragraph. The process might be re-engineered by sending the production schedule
466 COST MANAGEMENT AND STRATEGIC MANAGEMENT ACCOUNTING
direct to nominated suppliers and entering into contractual agreements to deliver the mateials in accordance with the production schedule and also guaranteeing their quality by inspecting them pior to delivery. The end result might be the elimination, or a permanent reduction, of the storing, purchasing and inspection aciviies. These aciviies are non-value added activiies since they represent an opportunity for cost reduction without reducing the products' service potentials to customers.
A distinguishing feature of business process re-engineering is that it involves radical
and dramaic changes in processes by abandoning current practices and reinventing
completely new methods of performing business processes. The focus is on major changes
rather than marginal improvements. A further example of business process e-engineering
is moving rom a traditional functional plant layout to a just-in-time cellular product layout
and adopting a just-in-time philosophy. Adopting a just-in-time (JIT) system and
philosophy has important implicaions for cost management and performance reporting.
It is therefore important that you understand the nature of such systems and how they difer
rom tradiional systems, but rather than deviating at this point rom our discussion of cost
management the descipion of a JIT system will be deferred unil the end of the chapter.
Cost of quality
To compete successfully in today's global competiive environment companies are
becoming 'customer-diven' and making customer saisfacion an overiding pioity.
Customers are demanding ever-improving levels of service regarding cost, quality,
reliability, delivery and the choice of innovaive new products. Quality has become one
of the key compeitive variables and this has created the need for management accountants
to become more involved in the provision of informaion relating to the quality of products
and services and activiies that produce them. In the UK quality related costs have been
reported to range rom 5 to 15% of total company sales revenue (Plunkett et ai, 1985).
Eliminating infeior quality can therefore result in substanial savings and higher revenues.
Total qanaMiry maaiinmgeinmeioit (TQM), a term used to descibe a situaion where all
business functions are involved in a process of continuous quality improvement, has been
adopted by many companies. TQM has broadened, rom its early concentration on the
staisical monitoring of manufacturing processes, to a customer-oiented process of
continuous improvement that focuses on delivering products or services of consistent
high quality in a timely fashion. In the 1980s most European and Ameican companies
considered quality to be an addiional cost of manufacturing, but by the end of the decade
they began to realize that quality saved money. The philosophy of emphasizing producion
volume over quality resulted in high levels of stocks at each production stage in order to
protect against shortages caused by infeior quality at previous stages and excessive
expenditure on inspecion, rework, scrap and warranty repairs. Companies discovered that
it was cheaper to produce the items correctly the irst time rather than wasting resources by
making substandard items that have to be detected, eworked, scrapped or returned by
Management accounting systems can help organizaions achieve their quality goals by
providing a vaiety of reports and measures that moivate and evaluate manageial eforts
to improve quality. These will include inancial and non-inancial measures. Many
companies are currently not aware of how much they are spending on quality. Managers
need to know the costs of quality and how they are changing over time. A cost of quality
report should be prepared to indicate the total cost to the organizaion of producing
products or services that do not conform with quality requirements. Four categoies of
costs should be reported.
COST MANAGEMENT 467
1. FreveimtEOE costs are the costs incured in preventing the producion of products that
do not conform to speciicaion. They include the costs of prevenive maintenance,
quality planning and training and the extra costs of acquiring higher quality raw
2. Appraisal! costs are the costs incurred to ensure that mateials and products meet
quality conformance standards. They include the costs of inspecting purchased parts,
work in process and inished goods, quality audits and ield tests.
3. Innemmall failure costs are the costs associated with mateials and products that fail to
meet quality standards. They include costs incurred before the product is despatched to
the customer, such as the costs of scrap, repair, downtime and work stoppages caused
4. Extenal faioire costs are the costs incurred when products and services fail to
conform to requirements or saisfy customer needs ater they have been delivered.
They include the costs of handling customer complaints, warranty replacement, repairs
of returned products and the costs aising rom a damaged company reputation. Costs
within this category can have a dramaic impact on future sales.
Exhibit 15.2 presents a typical cost of quality report. Note that some of the items in the
report will have to be estimated. For example, included in the external failure costs
category is the forgone contibuion rom lost sales aising rom poor quality. This cost is
extremely dificult to estimate. Nevertheless, the lost contibution can be substantial and it
is preferable to include an estimate rather than omit it rom the report. By expressing each
category of costs as a percentage of sales revenues compaisons can be made with previous
peiods, other organizaions and divisions within the same group. Such compaisons can
highlight problem areas. For example, compaisons of external failure costs with other
companies can provide an indicaion of the current level of customer saisfaction.
The cost of quality report can be used as an attention-directing device to make the top management of a company aware of how much is being spent on quality-related costs. The report can also draw management's attenion to the possibility of reducing total quality costs by a wiser allocaion of costs among the four quality categoies. For example, by spending more on the prevention costs, the amount of spending in the internal and external failure categoies can be substanially reduced, and therefore total spending can be lowered. Also, by designing quality into the products and processes, appraisal costs can be reduced, since far less inspecion is required.
Prevenion and appraisal costs are sometimes referred to as the costs of qanaMty
coeformamice or compMamice and internal and external failure costs are also known as the
costs of Eoe-coefonmainice or nnoim-coinnipMaece. Costs of compliance are incurred with the
intenion of eliminating the costs of failure. They are discreionary in the sense that they do
not have to be incurred whereas costs of non-compliance are the result of production
imperfections and can only be reduced by increasing compliance expenditure. The optimal
investment in compliance costs is when total costs of quality reach a minimum. This can
occur when 100 per cent quality compliance has not been achieved. It is virtually
impossible to measure accurately all quality costs (particularly the lost contibuion
rom forgone sales) and determine the optimal investment in conformance costs. However, some people argue that a failure to achieve 100 per cent quality compliance is non-optimal and that a zero-defects policy is optimal. With a zero-defects policy the focus is on continuous improvement with the ultimate aim of achieving zero-defects and eliminating all internal and external failure costs.
A zero-defects policy does not use percentages as the unit of measurement because a
small percentage defect rate can result in a large number of defects. For example, a 1%
defect rate rom an output of 1 million units results in 10000 defective units. To overcome
468 COST MANAGEMENT AND STRATEGIC MANAGEMENT ACCOUNTING
Cost of quality
% of sales
Inspection of mateials received
Inspection of WIP and completed units Testing equipment
Internal failure costs
Downtime due to quality problems Retesting
External failure costs
Handling customer complaints
Foregone contibuion rom lost sales
(£000s) (£50 million)
400 2800 5.6
this problem the attainment of a zero-defects goal is measured in parts per million (PPM)
so that seemingly small numbers can be transferred into large numbers. Thus, instead of
reporting a 1 % defect rate, a measure of 10 000 PPM is more likely to create pressure for
action and highlight the trend in defect rates. Cost of quality reports provide a useful
summary of quality efforts and progress to top management, but at lower management
levels non-inancial quality measures provide more timely and appropriate target measures
for quality improvement. These measures will be discussed in the next chapter.