Alternative Cost Accounting

1 Introduction

This chapter briefly explains four more recent developments in costing which are improvements on the traditional techniques that we have been dealing with in the previous chapters.

You will not be required to perform any calculations – they will come in a later examination – but you are required to be aware of the ideas.

2 Activity based costing (ABC)

ABC deals with the way we charge overheads to the different products that we make.

You will remember from an earlier chapter that the traditional way is to take the total overheads and calculate an absorption rate – often a rate per labour hour – and then to charge this to the individual products on the basis of the number of hours each product takes to make.

With ABC, we identify the area where overheads are being incurred and then decide what it the reason or cause for these overheads. For example, one area where overheads may be incurred is in the department that receives the raw materials for production. We may decide that the reason we are incurring these overheads is the number of deliveries received (we call this the cost driver).

We then charge the different products with this part of the overheads on the basis of the number of deliveries received for each of the products we are making.

Not only does this result in more accurate costings but more importantly we can then investigate whether it is possible to have fewer deliveries received (by ordering more raw materials each time) and therefore potentially reduce the total overhead and save costs.

3 Target costing

Target costing is particularly useful when a new product is being launched.

There are basically 4 steps involved:

First, we decide on a realistic selling price for the new product. We do this by looking at the prices competitors charge or maybe by using market research.

Secondly, we decide on our objective. For example, maybe we require all our products to generate a profit of 40% of the selling price.

Thirdly, we put the two together and calculate the maximum cost that we can allow in order to achieve our objective – this is the target cost.

For example, suppose we identify that a realistic selling price for our new product is $100, and we require a profit of 40% on selling prices. This would result in a target cost of $60.

Fourthly, we estimate the actual cost of production, and if this is above the target cost we look for ways of reducing the cost to the target cost.

The most important way of achieving this is by examining the design of the product and looking to see if we can change the design in ways that will reduce the costs without needing a reduction in the selling price.

4 Life-cycle costing

Traditional costing tends to budget costs over just the short term – usually over the coming year. However this can create problems. Many new products will have low sales initially, but sales will rise as the products become popular. If sales are low in the early years, then overheads per unit are likely to be high, giving high unit costs. Whereas in later years, when sales are higher, the overheads per unit are likely to be lower, giving lower unit costs.

Life-cycle costing tries to take account of all costs and all production over the entire life of the product which can lead to much more sensible decisions regarding, for example, the pricing policy.

5 Total quality management

Poor quality costs a company money. This can be for two reasons – firstly, if the workers are not performing well there is high wastage and excess labour costs if they work slowly. Secondly, if poor quality goods are delivered to customers then there is the cost of replacing faulty goods, or guarantee work, and of lost goodwill.

There is a much greater focus these days on improving quality and reducing the costs associated with poor quality. This can involve such things as employing better skilled workers, training employees better, and also the cost of greater quality control procedures to try and avoid delivering poor quality goods to the customers.

Total quality management involves getting the entire workforce motivated to improve quality, and assessing the costs and benefits involved in improving quality.