If you would like to explore the topics covered in this chapter in more depth, we recommend the following books: Atkinson, A., Kaplan R., Young, S. M. and Matsumura, E., Management Accounting, 5th edn, Prentice Hall, 2007, chapter 3. Drury, C., Management and Cost Accounting, 7th edn, Cengage Learning, 2007, chapters 3, 4 and 5. Hilton, R., Managerial Accounting, 6th edn, McGraw-Hill Irwin, 2005, chapters 2 and 3. Horngren, C., Foster, G., Datar, S., Rajan, M. and Ittner, C., Cost Accounting: A Managerial Emphasis, 13th edn, Prentice Hall International, 2008, chapter 4. Further reading CHAPTER 4 FULL COSTING 128 Full cost p. 94 Full costing p. 95 Cost unit p 95 Process costing p. 96 Direct cost p. 96 Indirect cost p. 96 Overheads p. 96 Common cost p. 96 Job costing p. 98 Absorption costing p. 98 Cost behaviour p. 99 Total cost p. 100 Overhead absorption (recovery) rate p. 101 Cost centre p. 110 Product cost centre p. 111 Service cost centre p. 111 Cost allocation p. 112 Cost apportionment p. 112 Batch costing p. 119 Cost-plus pricing p. 121 Variable costing p. 123 Key terms ‘ M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 128 Answers to these questions can be found in Appendix C at the back of the book. What problem does the existence of work in progress cause in process costing? What is the point of distinguishing direct cost from indirect cost? Why is this not necessary in process-costing environments? Are direct cost and variable cost the same thing? Explain your answer. It is sometimes claimed that the full cost of pursuing some objective represents the long-run break-even selling price. Why is this said, and what does it mean? 4.4 4.3 4.2 4.1 Exercises 4.4 to 4.8 are more advanced than 4.1 to 4.3. Answers to those exercises with coloured numbers can be found in Appendix D at the back of the book. Bodgers Ltd, a business that provides a market research service, operates a job-costing sys- tem. Towards the end of each financial year, the overhead recovery rate (the rate at which indirect cost will be absorbed by jobs) is established for the forthcoming year. (a) Why does the business bother to predetermine the recovery rate in the way outlined? (b) What steps will be involved in predetermining the rate? (c) What problems might arise with using a predetermined rate? Athena Ltd is an engineering business doing work for its customers to their particular require- ments and specifications. It determines the full cost of each job taking a ‘job-costing’ approach, accounting for overheads on a cost centre (departmental) basis. It bases its prices to customers on this full cost figure. The business has two departments (both of which are cost centres): a Machining Department, where each job starts, and a Fitting Department, which completes all of the jobs. Machining Department overheads are charged to jobs on a machine hour basis and those of the Fitting Department on a direct labour hour basis. The budgeted information for next year is as follows: Heating and lighting £25,000 (allocated equally between the two departments) Machine power £10,000 (all allocated to the Machining Department) Direct labour £200,000 (£150,000 allocated to the Fitting Department and £50,000 to the Machining Department; all direct workers are paid £10 an hour) Indirect labour £50,000 (apportioned to the departments in proportion to the direct labour cost) Direct materials £120,000 (all applied to jobs in the Machining Department) Depreciation £30,000 (all relates to the Machining Department) Machine time 20,000 hours (all worked in the Machining Department) 4.2 4.1 EXERCISES 129 REVIEW QUESTIONS EXERCISES M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 129 Required: (a) Prepare a statement showing the budgeted overheads for next year, analysed between the two cost centres. This should be in the form of three columns: one for the total figure for each type of overhead and one column each for the two cost centres, where each type of overhead is analysed between the two cost centres. Each column should also show the total of overheads for the year. (b) Derive the appropriate rate for charging the overheads of each cost centre to jobs (that is, a separate rate for each cost centre). (c) Athena Ltd has been asked by a customer to specify the price that it will charge for a par- ticular job that will, if the job goes ahead, be undertaken early next year. The job is expected to use direct materials costing Athena Ltd £1,200, to need 50 hours of machining time, 10 hours of Machine Department direct labour and 20 hours of Fitting Department direct labour. Athena Ltd charges a profit loading of 20% to the full cost of jobs to determine the selling price. Show workings to derive the proposed selling price for this job. Pieman Products Ltd makes road trailers to the precise specifications of individual customers. The following are predicted to occur during the forthcoming year, which is about to start: Direct materials cost £50,000 Direct labour cost £160,000 Direct labour time 16,000 hours Indirect labour cost £25,000 Depreciation of machine £8,000 Rent and rates £10,000 Heating, lighting and power £5,000 Indirect materials £2,000 Other indirect cost (overhead) elements £1,000 Machine time 3,000 hours All direct labour is paid at the same hourly rate. A customer has asked the business to build a trailer for transporting a racing motorcycle to race meetings. It is estimated that this will require materials and components that will cost £1,150. It will take 250 direct labour hours to do the job, of which 50 will involve the use of machinery. Required: Deduce a logical cost for the job, and explain the basis of dealing with overheads that you propose. Promptprint Ltd, a printing business, has received an enquiry from a potential customer for the quotation of a price for a job. The pricing policy of the business is based on the plans for the next financial year shown below. £ Sales revenue (billings to customers) 196,000 Materials (direct) (38,000) Labour (direct) (32,000) Variable overheads (2,400) Advertising (for business) (3,000) Depreciation (27,600) Administration (36,000) Interest (8,000) Profit (before taxation) 49,000 4.4 4.3 CHAPTER 4 FULL COSTING 130 M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 130 A first estimate of the direct cost for the particular job is: £ Direct materials 4,000 Direct labour 3,600 Required: (a) Prepare a recommended price for the job based on the plans, commenting on your method, ignoring the information given in the Appendix (below). (b) Comment on the validity of using financial plans in pricing, and recommend any improve- ments you would consider desirable for the pricing policy used in (a). (c) Incorporate the effects of the information shown in the Appendix (below) into your estimates of the direct material cost, explaining any changes you consider it necessary to make to the above direct material cost of £4,000. Appendix to Exercise 4.4 Based on historic cost, direct material cost was computed as follows: £ Paper grade 1 1,200 Paper grade 2 2,000 Card (zenith grade) 500 Inks and other miscellaneous items 300 4,000 Paper grade 1 is regularly used by the business. Enough of this paper to complete the job is cur- rently held. Because it is imported, it is estimated that if it is used for this job, a new purchase order will have to be placed shortly. Sterling has depreciated against the foreign currency by 25 per cent since the last purchase. Paper grade 2 is purchased from the same source as grade 1. The business holds exactly enough of it for the job, but this was bought in for a special order. This order was cancelled, although the defaulting customer was required to pay £500 towards the cost of the paper. The accountant has offset this against the original cost to arrive at the figure of £2,000 shown above. This paper is rarely used, and due to its special chemical coating will be unusable if it is not used on the job in question. The card is another specialist item currently held by the business. There is no use foreseen, and it would cost £750 to replace if required. However, the inventories controller had planned to spend £130 on overprinting to use the card as a substitute for other materials costing £640. Inks and other items are in regular use in the print shop. Bookdon plc manufactures three products, X, Y and Z, in two product cost centres: a machine shop and a fitting section; it also has two service cost centres: a canteen and a machine main- tenance section. Shown below are next year’s planned production data and manufacturing cost for the business. XYZ Production 4,200 units 6,900 units 1,700 units Direct materials £11/unit £14/unit £17/unit Direct labour Machine shop £6/unit £4/unit £2/unit Fitting section £12/unit £3/unit £21/unit Machine hours 6 hr/unit 3 hr/unit 4 hr/unit 4.5 EXERCISES 131 M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 131 Planned overheads are as follows: Machine Fitting Canteen Machine Total shop section maintenance section Allocated overheads £27,660 £19,470 £16,600 £26,650 £90,380 Rent, rates, heat and light £17,000 Depreciation and insurance of equipment £25,000 Additional data: Machine Fitting Canteen Machine shop section maintenance section Gross book value of equipment £150,000 £75,000 £30,000 £45,000 Number of employees 18 14 4 4 Floor space occupied 3,600 sq m 1,400 sq m 1,000 sq m 800 sq m All machining is carried out in the machine shop. It has been estimated that approximately 70 per cent of the machine maintenance section’s cost is incurred servicing the machine shop and the remainder servicing the fitting section. Required: (a) Calculate the following planned overhead absorption rates: (i) A machine hour rate for the machine shop. (ii) A rate expressed as a percentage of direct wages for the fitting section. (b) Calculate the planned full cost per unit of product X. Shown below is an extract from next year’s plans for a business manufacturing three products, A, B and C, in three product cost centres. ABC Production 4,000 units 3,000 units 6,000 units Direct material cost £7 per unit £4 per unit £9 per unit Direct labour requirements: Cutting department: Skilled operatives 3 hr/unit 5 hr/unit 2 hr/unit Unskilled operatives 6 hr/unit 1 hr/unit 3 hr/unit Machining department 1 /2 hr/unit 1 /4 hr/unit 1 /3 hr/unit Pressing department 2 hr/unit 3 hr/unit 4 hr/unit Machine requirements: Machining department 2 hr/unit 1 1 /2 hr/unit 2 1 /2 hr/unit The skilled operatives employed in the cutting department are paid £16 an hour and the unskilled operatives are paid £10 an hour. All the operatives in the machining and pressing departments are paid £12 an hour. 4.6 CHAPTER 4 FULL COSTING 132 M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 132 Product cost centres Service cost centres Cutting Machining Pressing Engineering Personnel Planned total overheads £154,482 £64,316 £58,452 £56,000 £34,000 Service cost centre cost incurred for the benefit of other cost centres, as follows: Engineering services 20% 45% 35% – – Personnel services 55% 10% 20% 15% – The business operates a full absorption costing system. Required: Derive the total planned cost of: (a) One completed unit of product A. (b) One incomplete unit of product B, which has been processed by the cutting and machining departments but which has not yet been passed into the pressing department. Consider this statement: ‘In a job costing system, it is necessary to divide up the business into departments. Fixed costs (or overheads) will be collected for each department. Where a particular fixed cost relates to the business as a whole, it must be divided between the departments. Usually this is done on the basis of area of floor space occupied by each department relative to the entire business. When the total fixed cost for each department has been identified, this will be divided by the number of hours that were worked in each department to deduce an overhead recovery rate. Each job that was worked on in a department will have a share of fixed cost allotted to it according to how long it was worked on. The total cost for each job will therefore be the sum of the variable cost of the job and its share of the fixed cost. It is essential that this approach is taken in order to deduce a selling price for the business’s output.’ Required: Prepare a table of two columns. In the first column you should show any phrases or sentences in the above statement with which you do not agree, and in the second column you should show your reason for disagreeing with each one. Many businesses charge overheads to jobs on a cost centre basis. Required: (a) What is the advantage that is claimed for charging overheads to jobs on a cost centre basis, and why is it claimed? (b) What circumstances need to exist for it to make a difference to the costing of a particular job whether overheads are charged on a business-wide basis or on a cost centre basis? (Note that the answer to this part of the question is not specifically covered in the chapter. You should, nevertheless, be able to deduce the reason from what you know.) 4.8 4.7 EXERCISES 133 M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 133 Costing and pricing in a competitive environment LEARNING OUTCOMES We saw in Chapter 1 that major changes have occurred in the business world in recent years, including deregulation, privatisation, the growing expectations of shareholders and the impact of new technology. These have led to a much more fast-changing and competitive environment that has radically altered the way that businesses need to be managed. In this chapter, we consider some of the management accounting techniques that have been developed to help businesses maintain their competitiveness in this new era. We begin by considering the impact of this new, highly competitive environment on the full-costing approach that we considered in Chapter 4. We shall see that activity-based costing (ABC), which is a development of the traditional full-costing approach, takes a much more enquiring, much less accepting attitude towards indirect cost (overheads). Some other recent approaches to costing that can help lower costs and, therefore, increase the ability of a business to compete on price will also be examined. Managers must approach pricing decisions with care because of the significant impact they can have on the profitability of a business. We shall see how, in theory and in practice, prices may be set in a competitive environment. In setting prices, managers are likely to be guided by product-costing information. We shall examine this point and, in so doing, pick up other points on relevant cost and cost–volume–profit relationships that were considered in Chapters 2 and 3. INTRODUCTION 5 When you have completed this chapter, you should be able to: l Describe the nature of the modern product costing and pricing environment. l Discuss the principles and practicalities of activity-based costing. l Explain how new developments such as total life-cycle costing and target costing can be used to manage product costs. l Explain the theoretical underpinning of pricing decisions and discuss the issues involved in reaching a pricing decision in real-world situations. M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 134 COST DETERMINATION IN THE CHANGED BUSINESS ENVIRONMENT 135 Costing and pricing products in the traditional way The traditional, and still widely used, approach to job costing and product pricing developed when the notion of trying to determine the cost of industrial production first emerged. This was around the time of the UK Industrial Revolution when indus- try displayed the following characteristics: l Direct-labour-intensive and direct-labour-paced production. Labour was at the heart of production. To the extent that machinery was used, it was to support the efforts of direct labour, and the speed of production was dictated by direct labour. l A low level of indirect cost relative to direct cost. Little was spent on power, personnel services, machinery (leading to low depreciation charges) or other areas typical of the indirect cost (overheads) of modern businesses. l A relatively uncompetitive market. Transport difficulties, limited industrial production worldwide and a lack of knowledge by customers of competitors’ prices meant that businesses could prosper without being too scientific in costing and pricing their output. Customers would have tended to accept what the supplier had to offer, rather than demanding precisely what they wanted. Since overheads at that time represented a pretty small element of total cost, it was acceptable and practical to deal with them in a fairly arbitrary manner. Not too much effort was devoted to trying to control overheads because the potential rewards of better control were relatively small, certainly when compared with the benefits from firmer control of direct labour and material costs. It was also reasonable to charge overheads to individual jobs on a direct labour hour basis. Most of the overheads were incurred directly in support of direct labour: providing direct workers with a place to work, heating and lighting the workplace, employing people to supervise the direct workers, and so on. Direct workers, perhaps aided by machinery, carried out all production. At that time, service industries were a relatively unimportant part of the economy and would have largely consisted of self-employed individuals. These individuals would probably have been uninterested in trying to do more than work out a rough hourly or daily rate for their time and to try to base prices on this. Costing and pricing products in the new environment As mentioned in Chapter 1, the world of industrial production has undergone funda- mental change. Most of it is now characterised by: l Capital-intensive and machine-paced production. Machines are at the heart of much production, including both the manufacture of goods and the rendering of services. Most labour supports the efforts of machines, for example, technically maintaining them. Also, machines often dictate the pace of production. According to evidence provided in Real World 4.2 (page 97), direct labour accounts on average for just 14 per cent of manufacturers’ total cost. l A high level of indirect costs relative to direct costs. Modern businesses tend to have very high depreciation, servicing and power costs. There are also high costs of personnel and staff welfare, which were scarcely envisaged in the early days of industrial Cost determination in the changed business environment M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 135 production. At the same time, there are very low (sometimes no) direct labour costs. Although direct material cost often remains an important element of total cost, more efficient production methods lead to less waste and, therefore, to a lower total material cost, again tending to make indirect cost (overheads) more dominant. Again, according to Real World 4.2, overheads account for 25 per cent of manufac- turers’ total cost and 51 per cent of service sector total cost. l A highly competitive international market. Production, much of it highly sophisticated, is carried out worldwide. Transport, including fast airfreight, is relatively cheap. Fax, the telephone and, particularly, the internet ensure that potential customers can quickly and cheaply find the prices of a range of suppliers. Markets now tend to be highly price competitive. Customers increasingly demand products custom made to their own requirements. This means that businesses need to know their product costs with a greater degree of accuracy than historically has been the case. Businesses also need to take a considered and informed approach to pricing their output. In the UK, as in many developed countries, service industries now dominate the economy, employing the great majority of the workforce and producing most of the value of productive output. Though there are many self-employed individuals sup- plying services, many service providers are vast businesses such as banks, insurance companies and cinema operators. For most of these larger service providers, the activ- ities very closely resemble modern manufacturing activity. They too are characterised by high capital intensity, overheads dominating direct costs and a competitive inter- national market. Cost management systems Changes in the competitive environment mean that businesses must now manage costs much more effectively than in the past. This, in turn, places an obligation on the cost management systems employed to provide the information that will enable man- agers to do this. Traditional cost management systems have often proved inadequate for the task and, in recent years, new systems have gained in popularity. We shall now take a look at some of these systems. In Chapter 4 we considered the traditional approach to job costing (deriving the full cost of output where one unit of output differs from another). We may recall that this approach involves collecting, for each job, those costs that can be clearly linked to, and measured in respect of, the particular job (direct costs). All indirect costs (overheads) are allocated or apportioned to product cost centres and then charged to individual jobs according to some formula. The evidence suggests that this formula is usually based on the number of direct labour hours worked on each particular job. In the past, this approach has worked reasonably well, largely because overhead recovery rates (that is, rates at which overheads are absorbed by jobs) were typically of a much lower value for each direct labour hour than the rate paid to direct workers as wages or salaries. It is now, however, becoming increasingly common for overhead recovery rates to be between five and ten times the hourly rate of pay, because over- heads are now much more significant. When production is dominated by direct labour Activity-based costing CHAPTER 5 COSTING AND PRICING IN A COMPETITIVE ENVIRONMENT 136 M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 136 ACTIVITY-BASED COSTING 137 paid, say, £8 an hour, it might be reasonable to have an overhead recovery rate of, say, £1 an hour. When, however, direct labour plays a relatively small part in production, to have an overhead recovery rate of, say, £50 for each direct labour hour is likely to lead to very arbitrary product costing. Even a small change in the amount of direct labour worked on a job could massively affect the total cost deduced – not because the direct worker is very highly paid, but because of the effect of the direct labour hours on the overhead cost loading. A further problem is that overheads are still typically charged on a direct labour hour basis even though the overheads may not be closely related to direct labour. Real World 5.1 provides a rather disturbing view of costing and cost control in large banks. An alternative approach to full costing The changes in the competitive environment discussed above have led to much closer attention being paid to the issue of overheads, what causes them and how they are charged to jobs. Historically, businesses have been content to accept that overheads exist and, therefore, for job (product) costing purposes they must be dealt with in as practical a way as possible. In recent years, however, there has been increasing recog- nition of the fact that overheads do not just happen; something must be causing them. To illustrate this point, let us consider Example 5.1. REAL WORLD 5.1 Bank accounts In a study of the cost structures of 52 international banks, the German consultancy firm, Droege, found that indirect cost (overheads) could represent as much as 85 per cent of total cost. However, whilst direct costs were generally under tight management control, overheads were not. The overheads, which include such items as IT development, risk control, auditing, marketing and public relations, were often not allocated between oper- ating divisions or were allocated in a rather arbitrary manner. Source: Based on information in A. Skorecki, ‘Banks have not tackled indirect costs’, ft.com, 7 January 2004. FT Modern Producers Ltd has a storage area that is set aside for its inventories of finished goods. The cost of running the stores includes a share of the factory rent and other establishment costs, such as heating and lighting. It also includes the salaries of staff employed to look after the inventories, and the cost of financing the inventories held in the stores. The business has two product lines: A and B. Product A tends to be made in small batches and low levels of finished inventories are held. The business prides itself on its ability to supply Product B in relatively large quantities, instantly. As a consequence, most of the space in the finished goods store is filled with finished Product Bs, ready to be despatched immediately an order is received. Example 5.1 ‘ M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 137 [...]... 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 opportunity costs Since past costs are always irrelevant in decision making and opportunity costs can be significant, full costing information is an expensive... 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... role In this section we are going to take a closer look at pricing We shall begin by considering some theoretical aspects of the subject before going on to look at some more practical issues, particularly the role of management accounting information in pricing decisions M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 155 PRICING Economic theory In most market conditions found in practice, the price... 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 5.4 Total (whole) life-cycle costing in practice A survey of management accounting practice in the US was conducted in 2003... 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 4:22 PM Page 162 COSTING AND PRICING... 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... 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... vice-president of European operations Lewis Booth, head of Ford Motor’s premium-brands group, told the Financial Times: ‘We want to get Land Rover to Jaguar quality levels.’ The problems owe something to the complexity of the vehicles, packed with electronic control units aimed at keeping them stable off road Land Rover, formerly owned by BMW and now up for sale by Ford, has seen a flurry of new vehicle launches... 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... account of the management 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 Other approaches to cost management in the modern environment The increasingly competitive environment in which modern businesses operate is leading to greater effort being . batches Other Labour 24,000 30 ,000 54,000 108,000 2 overheads hours 33 3,200 54,000 33 3,200 [(12,000 × 2) + (12,000 × 2 1 /2)] Total overheads Number of labour hours ‘ M05_ATRI3622_06_SE_C05.QXD 5/29/09. 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 33 3,200 Example 5 .3 M05_ATRI3622_06_SE_C05.QXD. E., Management Accounting, 5th edn, Prentice Hall, 2007, chapter 3. Drury, C., Management and Cost Accounting, 7th edn, Cengage Learning, 2007, chapters 3, 4 and 5. Hilton, R., Managerial Accounting,