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Life-cycle costing estimates and accumulates costs over a products entire life cycle in order to find out whether the profits earned throughout the manufacturing period will cover
the cost incurred during the pre and post-manufacturing stages. Identifying the costs
incurred throughout the different 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 decrease efforts are likely to be
The early adopters of activity-based costing (ABC) used it to produce more accurate product (or service) costs but it soon became clear to the users that it could be extended beyond purely product costing to a range of cost management applications. The terms activity-based management (ABM) or activity based cost management (ABCM) are used to describe the cost management applications of ABC.
Stage1: Find out the target price which customers will be prepared to pay for the product.
Stage 2: Remove the target profit margin room from the target price to find out the target cost
Stage 3: Estimate the real cost of the product.
Stage 4: If estimated real cost exceeds the target cost examine ways of diving down the real cost to the target cost.
BUSINESS PROCESS RE-ENGINEERING:
Business process re-engineering involves examining business processes and making substantial changes to how the organization currently operates. It involves the redesign of how work is done through activities. A business process consists of a collection of activities that are linked together in a co-ordinate manner to achieve a specific objective. For example, material handling might be classed as a business process consisting of separate activities relating to scheduling production, storing materials, processing purchase orders, inspecting materials and paying suppliers.
The aim of business process re-engineering is to improve the key business processes in an organization by focusing on simplification, cost reduction, improved quality and enhanced customer satisfaction. Consider the materials handling process outlined in the above paragraph. The process might be re-engineered by sending the production schedule
COST OF QUALITY:
To compete successfully in today's global competitive environment companies are becoming 'customer-driven' and making customer satisfaction an overriding priority. Customers are demanding ever-improving levels of service regarding cost, quality, reliability, delivery and the choice of innovative new products. Quality has become one of the key competitive variables and this has created the need for management accountants to become more involved in the provision of information relating to the quality of products and services and activities that produce them.
COST MANAGEMENT AND THE VALUE CHAIN:
Coordinating the individual parts of the value chain together creates the conditions to improve customer satisfaction, particularly in terms of cost efficiency, quality and delivery. A firm which performs the value chain activities more efficiently, and at a lower cost, than its competitors will gain a competitive advantage. Therefore it is necessary to understand how value chain activities are performed and how they interact with each other. The activities are not just a collection of independent activities but a system of inter-dependent activities in which the performance of one activity affects the performance and cost of other activities.
It is also appropriate to view the value chain from the customer's perspective, with each link being seen as the customer of the previous link. If each link in the value chain is designed to meet the needs of its customers, then end-customer satisfaction should ensue. Furthermore, by viewing each link in the value chain as a supplier-customer relationship, the opinions of the customers can be used to provide useful feedback information on assessing the quality of service provided by the supplier. Opportunities are thus identified for improving activities throughout the entire value chain.
In order to identify the best way of performing activities and business processes organizations are turning their attention to benchmarking, which involves comparing key activities with world-class best practices. Benchmarking attempts to identify an activity, such as customer order processing, that needs to be improved and finding a non-rival organization that is considered to represent world-class best practice for the activity and studying how it performs the activity. The objective is to and out how the activity can be improved and ensures that the improvements are implemented.
JUST- IN -TIME SYSTEM:
Implementing a JIT system is a mechanism for reducing non-value added costs and long-run costs it is important that you understand the nature of such a system and its cost management implications.
The JIT approach involves a continuous commitment to the pursuit of excellence in all phases of manufacturing systems design and operations. The aims of JIT are to produce the required items, at the required quality and in the required quantities, at the precise time they are required. In particular, JIT seeks to achieve the following goals:
elimination of non-value added activities
batch sizes of one
A 100% on-time delivery service.
The above goals represent perfection, and are most unlikely to be achieved in practice. They do, however, offer targets, and create a climate for continuous improvement and excellence.
THE BALANCED SCORECARD AS A STRATEGIC MANAGEMENT SYSTEM:
According to Kaplan and Norton the objectives of the balanced scorecard are more than just an ad hoc collection of financial and non-financial performance measures; they are derived from a top-down process driven by the mission and strategy of the business unit.
Kaplan and Norton describe how innovative companies are using the measurement focus of the scorecard to accomplish the following critical management processes:
1. Clarifying and translating vision and strategy into specific strategic objectives and identifying the critical divers of the strategic objectives.
2. Communicating and linking strategic objectives and measures. Ideally, once all the employees understand the high level objectives and measures, they should establish local objectives that support the business unit's global strategy.
3. Planning, setting targets, and aligning strategic initiatives. Such targets should be over a 3-5 year period broken down on a yearly basis so that progression targets can be set for assessing the progress that is being made towards achieving the longer-term targets.
4. Enhancing strategic feedback and learning so that managers can monitor and adjust the implementation of their strategy, and, if necessary, make fundamental changes to the strategy itself. They approach strategy as choosing the market and customer segments the business unit intends to serve, identifying the critical internal processes that the unit must excel at to deliver value to customers in the targeted market segments, and selecting the individual and organizational capabilities required for the internal and financial objectives.
ESTABLISHING OBJECTIVES AND PERFORMANCE MEASURE:
Having explained the general principles of the balanced scorecard we shall now consider the process of establishing objectives and performance measures in each of the four scorecard perspectives (financial, customer, internal business process, and learning and growth).
THE FINANCIAL PERSPECTIVE:
At the strategic business unit level operating profit, return on investment, residual income and economic value added were discussed and such measures should be used for measuring the financial objective of the business unit. Other financial objectives include revenue growth, cost reduction and asset utilization. Typical financial objectives are to increase return on investment by 20% and/or to increase sales and operating income by 100% over the next five years.
THE CUSTOMER PERSPECTIVE:
In the customer perspective of the balanced scorecard managers should identify the customer and market segments in which the businesses unit will compete. Target segments may include both existing and potential customers. Managers should then develop performance measures that track the business unit's ability to create satisfied and loyal customers in the targeted segments. The customer perspective typically includes several core or generic objectives and measures that relate to customer loyalty and the outcomes of the strategy in the targeted segments. They include core objectives relating to increasing market share, customer retention, new customer acquisition, and customer satisfaction and customer profitability. Possible core measures for these objectives are following:
Customer retention and loyalty
Measuring value propositions
THE INTERNAL BUSINESS PERSPECTIVE:
In the internal business process perspective, managers identify the critical internal processes for which the organization must excel in implementing its strategy. The internal business process measures should focus on the internal processes that are required to achieve the organization's customer and financial objectives. Kaplan and Norton identify three principal internal business processes. They are:
Post-service sales processes.
THE LEARNING AND GROUTH PERSPECTIVE:
The fourth and final perspective on the balanced scorecard identifies the infrastructure that the business must build to create long-term growth and improvement. This perspective stresses the importance of investing for the future in areas other than investing in assets and new product research and development (which is included in the innovation process of the internal business perspective). Organizations must also invest in their infrastructure (people, systems and organizational procedures) to provide the capabilities that enable the accomplishment of the other three perspectives' objectives. Based upon their experiences of building balanced scorecards across a wide variety of organizations Kaplan and Norton have identified the following three principal categories, or enablers, for the learning and growth objectives:
information system capabilities;
Motivation, empowerment and alignment.
ANSWER # 2 :
RELEVANT AND IRRELEVANT COST AND REVENUE:
For decision-making, costs and revenues can be classified according to whether they are relevant to a particular decision. Relevant costs amid revenues are those future costs and revenues that will be changed by a decision, whereas irrelevant costs amid revenues are those that will not be affected by the decision. For example, if one is faced with a choice of making a journey by car or by public transport, the car tax and insurance costs are irrelevant, since they will remain the same whatever alternative is chosen. However, petrol costs for the car will differ depending on which alternative is chosen, and this cost will be relevant for decision-making.
Let us now consider a further illustration of the classification of relevant and irrelevant costs. Assume a company purchased raw materials a few years ago for £100 and that there appears to be no possibility of selling these materials or using them in future production apart from in connection with an enquiry from a former customer. This customer is prepared to purchase a product that will require the use of all these materials, but he is not prepared to pay more than £250 per unit. The additional costs of converting these materials into the required product are £200. Should the company accept the order for £250? It appears that the cost of the order is £300, consisting of £100 material cost and £200 conversion cost, but this is incorrect because the £100 material cost will remain the same whether the order is accepted or rejected. The material cost is therefore irrelevant for the decision, but if the order is accepted the conversion costs will change by £200, and this conversion cost is a relevant cost. If we compare the revenue of £250 with the relevant cost for the order of £200, it means that the order should be accepted, assuming of course that no higher-priced orders can be obtained elsewhere. The following calculation shows that this is the correct decision.
accept order Accept order
Materials 100 100
Conversion costs - 200
Revenue - (250)
Net costs UK) 50
The net costs of the company are £50 less, or alternatively the company is £50 better of as a result of accepting the order. This agrees with the £50 advantage which was suggested by the relevant cost method.
In this illustration the sales revenue was relevant to the decision because future revenue changed depending on which alternative was selected; but sales revenue may also be irrelevant for decision-making. Consider a situation where a company can meet its sales demand by purchasing either machine A or machine B. The output of both machines is identical, but the operating costs and purchase costs of the machines are different. In this situation the sales revenue will remain unchanged irrespective of which machine is purchased (assuming of course that the quality of output is identical for both machines). Consequently, sales revenue is irrelevant for this decision; the relevant items are the operating costs and the cost of the machines. We have now established an important principle regarding the classification of cost and revenues for decision-making; namely, that in the short term not all costs and revenues are relevant for decision-making.
These costs are the cost of resources already acquired where the total will be unaffected by the choice between various alternatives. They are costs that have been created by a decision made in the past and that cannot be changed by any decision that will be made in the future. The expenditure of £100 on materials that were no longer required, referred to in the preceding section, is an example of a sunk cost. Similarly, the written down values of assets previously purchased are sunk costs. For example, if a machine was purchased four years ago for £100000 with an expected life of five years and nil scrap value then the written down value will be £20 000 if straight line depreciation is used. This Witten down value will have to be Witten of, no matter what possible alternative future action might be chosen. If the machine was scrapped, the £20 000 would be written of; if the machine was used for productive purposes, the £20000 would still have to be written of. This cost cannot be changed by any future decision and is therefore classified as a sunk cost.
Sunk costs are irrelevant for decision-making, but they are distinguished from irrelevant costs because not all irrelevant costs are sunk costs. For example, a comparison of two alternative production methods may result in identical direct material expenditure for both alternatives, so the direct material cost is irrelevant because it will remain the same whichever alternative is chosen, but the material cost is not sunk cost since it will be incurred in the future.
Some costs for decision-making cannot normally be collected within the accounting system. Costs that are collected within the accounting system are based on past payments or commitments to pay at some time in the future. Sometimes it is necessary for decision making to impute costs that will not require cash outlays, and these imputed costs are called opportunity costs. An opportunity cost is a cost that measures the opportunity that is lost or sacrificed when the choice of one course of action requires that an alternative course of action be given up. Consider the information presented in It is important to note that opportunity costs only apply to the use of scarce resources.
Where resources are not scarce, no sacrifice exists from using these resources. In if machine X was operating at 80% of its potential capacity then the decision to accept the contract would not have resulted in reduced production of product A. Consequently, there would have been no loss of revenue, and the opportunity cost would be zero.
You should now be aware that opportunity costs are of vital importance for decision-making. If no alternative use of resources exists then the opportunity cost is zero, but if resources have an alternative use, and are scarce, then an opportunity cost does exist.
A company has an opportunity to obtain a contract for the production of a special component. This component will require 100 hours of processing on machine X. Machine X is working at full capacity on the production of product A, and the only way in which the contract can be fulfilled is by reducing the output of product A. This will result in a lost profit contribution of £200. The contract will also result in additional variable costs of £1000.
If the company takes on the contract, it will sacrifice a profit contribution of £200 from the lost output of product A, This represents an opportunity cost, and should be included as part of the cost when negotiating for the contract. The contract price should at least cover the additional costs of £1000 plus the £200 opportunity cost to ensure that the company will be better of in the short term by accepting the contract.
INCREMENTAL AND MARGINAL COSTS:
Incremental (also called differential) costs and revenues are the difference between costs and revenues for the corresponding items under each alternative being considered. For example, the incremental costs of increasing output from 1000 to 1100 units per week are the additional costs of producing extra 100 units per week. Incremental costs may or may not include fixed costs. If fixed costs change as a result of a decision, the increase in costs represents an incremental cost. If fixed costs do not change as a result of a decision, the incremental costs will be zero.
Incremental costs and revenues are similar in principle to the economist's concept of marginal cost and marginal revenue. The main difference is that marginal cost/revenue represents the additional cost/revenue of one extra unit of output whereas incremental cost/revenue represents the additional cost/revenue resulting from a group of additional units of output. The economist normally represents the theoretical relationship between cost/revenue and output in terms of the marginal cost/revenue of single additional units of output. We shall see that the accountant is normally more interested in the incremental cost/revenue of increasing production and sales to whatever extent is contemplated, and this is most unlikely to be a single unit of output.
Activity-based costing (ABC) is a model that defines activities in an Jessup and allot the cost of each activity resource to all goods and services according to the actual consumption by each it allocate more indirect costs into direct costs.
ABC uses the two stage allocation process.
In the first stage, ABC systems allocate costs to activities: (ABC systems tend to have more cost centres/cost pools)
In the second stage ABC systems use many second stage cost drivers.
ABC systems seek to use only cause-and-effect cost drivers whereas traditional systems often rely on arbitrary allocation bases. ABC systems tend to establish separate cost driver rates for support departments whereas traditional systems merge support and production centre costs.
Implementing an ABC system is a major task that requires considerable wealth. Once implemented an activity based costing (ABC) system is expensive to maintain. Data concerning several activity measures must be composed, checked, and entered into the system.
ABC produces information such as product margins, which are likelihood with the numbers produced by traditional costing systems. But managers are familiar to using traditional costing systems to run theirs operations and traditional costing systems are often used in presentation evaluations.
Activity based costing (ABC) data can be simply misinterpreted and must be used with care when used in manufacture decisions. Costs assign to products, customers and other cost objects are only potentially important. Before making any significant decision using activity based costing (ABC) data, managers must identify which costs are really related for the decisions at hand.
It may be difficult to set up and establish, particularly if an organization is using more traditional accounting methodologies.
Can be time consuming if all activities are to be cost.
May provide too much detail - obscuring the bigger picture.
It supports to recognize incompetent products, departments and behavior.
It supports to assign more capital on beneficial products, department and actions.
It supports to controlling the costs at an entity level and on a departmental level.
It supports to judgment out needless costs.
It supports setting up the price of a product or service systematically.
It boost the number of cost pools used to collect in direct costs such as over head costs, rather than collect all the costs only.
It change the basis used to assign indirect costs to products rather than conveying costs on the bases of simple measure such as volume, costs are assigned on the bases of activities that produce costs.
It changes the scenery of many indirect costs, reclassifying them into direct costs, so that they can be traced to particular activities.
Better considerate overhead.
Simple to understand for everyone.
Utilizes division cost relatively than just total cost.
Makes detectable waste and non-value added activities.
Supports performance of the management and scorecards of the organization.
Enables costing of processes and value streams.
Activity Based Costing (ABC) mirrors way work is done in proper way.
Facilitates into the benchmarking.