This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.
It is widely-noted in the normative literature that cost information can play a key role in determining selling prices (Drury, 2000; Horngren et al, 2000; Langfield-Smith et al, 1998). This would appear to be particularly the case for organizations that have some discretion in setting their selling prices or where a product or service is highly customized or a market leader. By way of contrast, for many firms prices are viewed as a function of market forces and there is minimal scope for discretion in price-setting. Also, small firms operating in an industry where prices are set by the dominant market leaders will have little influence over the prices of products or services. In these price-taking firms the scope for cost-plus pricing is likely to be limited. In such firms it is to be expected that cost information is viewed primarily as a key factor to be considered when attempting to optimise the output and mix of products and services in light of extant market prices. A literature search designed to uncover cost-plus pricing studies and covering periodical publications spanning the last two decades has revealed only two empirical studies with a specific focus on cost-plus pricing. These studies reported that cost-plus pricing, often using full costs, is widely-used. Mills (1988) in surveying 52 UK manufacturing and 42 service companies reported cost based methods reliant on full/absorption costing principles were the primary basis for determining prices under normal conditions. In the USA, (Govindarajan and Anthony, 1983) reported 74% of companies used some form of "full cost" as a basis for the mark-up when setting selling prices. Subsequent to the 1980's, the use of costs in pricing has commanded little more than cursory research attention as a part of surveys concerned with a breadth of costing and management accounting practices. For example, in Australia, (Joye and Blayney, 1990) reported pricing as the most important reason for allocating overhead costs and that product cost was an important determinant of price (ranking ahead of competitor and consumer factors). In the UK, (Bright et.al. 1993) reported that 90% of their survey respondents employed costing techniques and practices for product pricing. This product costing research had tended to focus on deriving empirical data relating to the use of different costing methods (typically variable or absorption costing), the accuracy of product costs, and the influence of financial accounting requirements on cost determination for decision-making as well as issues relating to ABC. The ABC research has tended to focus on usage levels, business applications, implementation problems and the identification of factors influencing success and failure of ABC. This interest in product costing research appears to have been triggered by two main factors. First, the environment in which product costing is undertaken has undergone substantial change. This includes changes in information technology, cost structures and the manufacturing and competitive environment. These changes have generated increased product costing interest amongst both academics and practitioners. Second, debate concerning product costing was initiated by several notable criticisms of traditional product costing systems (e.g., Cooper, 1990, Johnson and Kaplan, 1987; Kaplan, 1984, 1990) and the emergence of ABC systems.
Somewhat typifying much of the recent research into management and costing practices, (Chenhall and Langfield-Smith,1998) appraised the adoption and benefits of management accounting practices in Australian companies. They did not, however, examine pricing within the traditional and contemporary management accounting techniques they investigated, despite the fact that the scope of their inquiry included absorption costing, cost-volume-profitability analysis, ABC, target costing and product life cycle analysis. It is notable that in their review of research into product costing practice, (Brierley et. al. 2001) make reference to pricing and conclude:
"â€¦ there is a need to expand prior research to include an understanding of the relative importance of product costs for determining prices, and the circumstances under which product costs may be a less suitable basis for determining selling pricesâ€¦." (p. 232).
In light of the findings of our literature search and also (Brierley's, 2001) observation, it appears that further work concerned with the application of cost-plus pricing is warranted. Furthermore, little has been done to investigate the contingent factors affecting the application of cost-plus pricing. In order to address the relative paucity of recent research concerned with cost-plus pricing, this study had two specific objectives:
a) to appraise the relative importance of cost-plus pricing,
b) to develop and test hypotheses concerned with contingent factors that might affect
Strategic objective for most of the companies has been to find ways to enhance customer satisfaction. In the 1990s, companies also are going to need to know how well customers satisfy them that is, how profitable is the customer for the company? In increasingly competitive markets, it is critical to know customer, market, and channel of distribution profitability as well as product profitability.
While much of the current literature on advanced cost management and activity based costing has focused accountants on alternative cost methodologies, most of the attention has remained on product cost development The advanced costing techniques used to develop product costs are equally applicable to other cost elements, especially customers.
Advanced product cost systems often show highly volatile products with low volume and high scrap and rework to be under costed significantly. When the costs are compared to the product's revenue stream, product profitability may be negative. The first step is to identify ways to eliminate the product's non value added expenses. The second step is to evaluate the strategic benefit of the product in the product line. The decision to drop a product, however, is not made solely on the cost input Strategic, product life cycle and customer issues must be taken into consideration. In fact, the most frequently asked question after the development of new product costs is: Who purchases the product?
If a large, high profit customer purchases a product that is sold below manufacturing cost, the company will not necessarily discontinue the product because the decision making process is focused on customer profitability, not product profitability. An effective cost management system provides information relevant to the decision made. While accurate product cost information provides the foundation for customer profitability, as companies analyze the purchasing patterns, shipping policies, inventory carrying requirements, and other issues associated with different customers, opportunities become apparent. Many resources of the company are used in different ways by different customers, markets, and channels of distribution. Examples include:
Inventory and distribution support,
Inventory holding requirements,
Credit and collection support,
Accounts receivable (days),
Order entry and customer support, and
Current cost management practice is to classify these costs as period expenses that are managed in total and not assigned to any cost element. In fact, what little customer profitability analysis is done typically uses gross margin excluding sales, general, and administrative (S, G, & A) expenses. The costing activity for most management systems is to assign manufacturing costs to products excluding S, G, & A.
A second issue is that past cost accounting practices have focused on redeveloping product costs, not customer or activity costs. Although GARP does not preclude the assignment of sales, general, and administrative expenses to products, such expenses are rarely assigned to products or customers. Even manufacturing driven expenses such as cost accounting and senior manufacturing personnel often are treated as administrative expenses and are not assigned to products or product lines. Past practices do not motivate management accountants to determine the cost drivers for S, G, & A expenses.
Types of Costing applied to an engineering or manufacturing business
Firstly we need an appreciation of costing and information gathering
This is where past invoices over a period of time are collected and used to estimate future costs. Typically this is done over a one to 3 year period
are usually associated with a manufacturing company's costs of direct material, direct labour, and manufacturing overhead.
Rather than assigning the actual costs of direct material, direct labour, and manufacturing overhead to a product, many manufacturers assign the expected or standard cost. This means that a manufacturer's inventories and cost of goods sold will begin with amounts reflecting the standard costs, not the actual costs, of a product. Any differences from this are known as variances.
Where costs are collated and analyzed after the expenditure has happened.
Where costs are compared as they occur with estimated costs (ideal for repetitive costing)
What are the advantages and disadvantages of each type?
Where do we collect Costing information?
Purchase requisitions, Purchase order, Advice notes (shows item has been delivered), Invoice (charge for the goods sent, often received with 30 days credit)
Job cards, which include lost time, extra time and idle time.Clock Cards, When a person arrived on site, absent and lateness.
Stock requisitions, stock take sheets, Stock records, Kanban cards
These are normally invoiced each month or every 3 months via an invoice for services used. They include: Telephone. Advertising, heat and light, rent and rates,
Normally companies purchase products outright and write the value down over a number of years, recently however it has become more favorable to lease products, ie they pay monthly for an item that they use but may never own, (this eliminates initially high cost up front) this includes: Vans, Cars, Machinery etc.
Some companies now have automatic data systems which log time against products or operations of a machine, i.e. a power press has produced 500 items for 2 hours and then rested for 30 mins, this allows the production manager to work out up time of machine and efficiency rates.
Methods of Costing a Product
This is used where one offs or small quantities are produced the price is worked out on an individual basis for that job. The technique is simple using standard labour and material rates.
The labour used is usually highly skilled and multiskilled, machines are often standing idle which is reflected in the price.
Example of products include prototypes, press tools, jigs etc
A Bill of material is often used to help calculate costs.
As above but relates to much larger project which might have multiple inputs, ideal for complex or larger jobs,
Examples: Building a production line, Building a Bridge, building a stadium.
This uses a list of parts that go into an assembly (similar to a Bill of Material except no allowance is made for labor content) the cost of the parts is added up to crate an assembly cost.
Be careful how the cost of the individual item is generated, ie consider the stores do we base the cost on historical cost, latest cost or average cost, note some market prices are very volatile
Takes into account continuous process costing, based on an average cost for a quantity produced over a period of time.
Example: A coffee producing plant is continuous the cost of the coffee can be calculated easily based on historical data, the final packaging may affect the price differently i.e. 100g jars will cost more than Â½ kilo jars, for the weight of product contained within it.
Calculate the hourly process cost for the following job?
A press operates at 500 units per hour
Capital recovery is over 5 years which amounts to 3000 per year + £25 / hour material cost.
Determine the unit costs of the press based on
70 hours per week
Calculate costs per unit, total costs , total production.
For 70 hours
Hours worked (48weeks per yr x 5years) x70 per week = 16800 hours
Costs (£25 x 16800) + (£3000 x 5years) = £435,000
Produced units = 16800 x 500 = 8,400,000
Costs per unit = £435,000 / 8400,000 = £0.05178 per unit
A Bill of Material
This is breakdown cost of an assembly or sub assembly, typically is lists
Quantity used on assembly
The item description
Labour Hourly charge
In addition to this other information may be given
Purchasing details / blanket order numbers
Stage of assembly and part number
Often this document is computer driven and may have a number of methods of working out the cost i.e. LIFO, FIFO or Average Cost. Costs may be affected by number of suppliers, market fluctuations i.e. price of copper, Quantities purchased (economies of scale) etc.
There are a number of was of recovering costs of overheads or machine costs, this cost is attributed to an item manufactured or a batch of items, this is imperative if sales prices are to be calculated, an example of this is listed below:
Note: this is Costing Not sales prices, normally to work out a sales price we would calculate the cost using Marginal costing, add in the overhead apportioned cost then an allowance for profit.
In reality it is more complex than this as Overhead recovery is based on a known output. This may cause financial problems if the estimate is too low or too high.
This price does not take into account market conditions.
a. Marginal cost is the cost of
In Marginal Costing only the variable overheads are assigned to the product or
jobs. The fixed overheads then being recovered from the contribution to the expenses left when the direct costs and variable overheads are subtracted from the selling price.
This method is also known as differential costing or direct costing.
In absorption costing all overhead items are aggregated and the resulting total divided among all products or jobs by means of an agreed rate (the overhead recovery rate)
Analysis (VA) is considered to be a process, as opposed to a simple technique, because it is both an organized approach to improving the profitability of product applications and it utilizes many different techniques in order to achieve this objective. The techniques that support VA activities include 'common' techniques used for all value analysis exercises and some that are appropriate under certain conditions (appropriate for the product under consideration), see also chapter 3.2 . The VA approach is almost universal and can be used to analyze existing products or services offered by manufacturing companies and service providers alike. For new products, the Value Engineering (VE) approach, which applies the same principles and many of the VA techniques to premanufacturing stages such as concept development, design and prototyping. At the very heart of the VA process review is a concern to identify and eliminate product and service features that add no true value to the customer or the product but incur cost to the process of manufacturing or provision of the service. As such, the VA process is used to offer a higher performing product or service to the customer at a minimal cost as opposed to substituting an existing product with an inferior solution. This basic principle, of offering value at the lowest optimal cost of production, is never compromised. It is the principle that guides all actions within the VA process and allows any improvement ideas to be translated into commercial gains for the company and its customers. The VA process is therefore one of the key features of a business that understands and seeks to achieve Total Quality Management (TQM) in all that it does to satisfy customers. For many of the worlds leading companies, including names like Hewlett Packard, Sony, Panasonic, Toyota, Nissan, and Ford, the VA process of design review has provided major business returns. The key to
realizing these returns is knowledge, of the customer requirements, the costs of the product, and an indepth knowledge of manufacturing process and the costs associated with failures due to poor or inadequate product design. All these inputs to the VA process are vital if decisions regarding product and process redesign are to yield lower costs and enhanced customer value. The Value Analysis technique was developed after the Second World War in America at General Electric during the late 1940s. Since this time the basic VA approach has evolved and been supplemented with new techniques that have become available and have been integrated with the formal VA process. Today, VA is enjoying a renewed popularity as competitive pressures are forcing companies to reexamine their product ranges in an attempt to offer higher levels of customization without incurring high cost penalties. In parallel, many major corporations are using the VA process with their suppliers to extend the benefits of the approach throughout the supply chain. Businesses, big and small, will therefore benefit from understanding and applying the VA process. It is likely that those companies that do not take he time to develop this capability will face an uncertain future as the lessons and problems of the past are redesigned into the products of the future.
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.
The Focus of Value Analysis
The key focus of the VA approach is therefore the management of 'functionality' to yield value for the customer. If
you adopt this approach then the VA process is concerned with removing a specific type of cost. This cost is one that can be removed without negatively affecting the function, quality, reliability, maintainability or benefit required by the customer. As such, the target for all VA activities is to find these costs as opposed to simply reengineering a product design with no real purpose to the reengineering exercise. The VA approach is therefore formal and systematic because it is directed towards highlighting and dealing with these 'recoverable costs' of production. The objective is to create value for money as opposed to creating new products that do not provide customer satisfaction but are relatively inexpensive. The rules governing the application of the VA approach are therefore simple:
No cost can be removed if it compromises the quality of the product or its reliability,
as this would lower customer value, create complaints and inevitably lead to the withdrawal of the product or lost sales.
Saleability is another issue that cannot be compromised, as this is an aspect of the product that makes it attractive to the market and gives it appeal value.
Any activity that reduces the maintainability of the product increases the cost of ownership to the customer and can lower the value attached to the product.
In essence, the following diagram shows the process of VA and the development of knowledge about the costs of a product in such a way that the costs are gradually decomposed to a high level of detail. At this point, the recoverable losses associated with the current design can be assessed and targeted for reduction to yield, as a result, the same value
but at a reduced cost base. In the example, the current costs are decomposed into those related to materials and those related to conversion before analyzing, in greater detail, the materials costs and the opportunities to recover costs through redesign and the opportunities to recover transformation or conversion costs.
Why Use Value Analysis
In reality, a complex number of reasons exists that necessitate the structured approach of value analysis as a means of logical cost reduction. These reasons can be divided into two key sources, those that lie within the business and secondly those that are stimulated by the market for the product or service.
Within the business
Design related issues
The major reasons why VA exercises are conducted actually originate from the design process itself and the lack of control systems concerning reviews of product performance once the product has entered the production stage. Some of the problems associated with a lack of proper design review systems are listed below:
â€¢ The designer may not be aware of 'best practice' with which to develop an optimal design. The designer may also be unaware of the cost implications of one design over another due to insufficient information or a poor understanding of new materials and technologies that could be used to make the product. Therefore the review process allows
the opportunity to incorporate these new sources of cost reduction. The process also offers vital information feedback to the designer regarding the performance of the design in production.
â€¢ The designer may have produced a drawing that was intended for technology that has been replaced by the company since the product went into full production. The VA process also allows these changes to be incorporated formally.
â€¢ Traditional thinking and customary practice may have led the designer to believe that a particular solution was the best without questioning the line of logic. Instead, the belief that a traditional and proven solution will be adequate for a modern consumer can create products that do not entirely provide the value sought by the customer. The review forces the designer and other professional managers to assess the 'fit' between what the customer 'wants' and the solution provided by the company.
Activity Based Costing
ABC was introduced by Kaplan and Cooper of Harvard Business School as an alternative to traditional
accounting techniques in the 1980s (the earliest papers include Cooper and Kaplan (R. Cooper, R.S. Kaplan, 1990).
Many have since used this method for product costing in both manufacturing and business applications
(R. Cooper, R.S. Kaplan, 1990). The ABC method of accounting involves the breakdown of a system into individual activities and costing of the amount of time and resources spent on each activity in the manufacture of a product. A schematic diagram to illustrate this point is given in Fig. 1. Traditional accounting methods concentrate on
volume based costs systems and these methods are highly inaccurate in the modern manufacturing environment. Today much of the significant cost in producing an item are not volume related, for
example the cost of engineering, order processing, planning, quality control, etc. for high technology,
maket order products, or just in time delivery. ABC, however, takes into account the cost incurred
at the activity level and then attributes the cost to products according to the activities that a product
goes through. Even with a simple case ABC can be very complex and time consuming, that is why it is no widely applied in the manufacturing industry. It is recognized that ABC can be used to enhance rather than replace the accounting system when the company finds it too difficult to implement full scale ABC based accounting. In this case, ABC is used as a cost management tool by the operational departments to compliment the existing accounting practice. To the operational staff, implementing ABC using simulation models can be far more convenient, spontaneous, straightforward, and interactive than on an accounting software. Simulation models can provide the flexibility required by ABC to cope with the changes in combinations and permutations often encountered in a manufacturing system.