Other Costing Issues
1 Introduction
The costing methods in chapters 3 to 6 were designed for a factory making physical things, and they still work well there. This chapter deals with four issues that arise where they do not fit, or do not reach far enough:
costing a product that has no material content at all — a digital product (section 2);
the costing systems that modern products and supply chains need, and what distinguishes them from a traditional system (section 3);
the CGMA Cost Transformation Model, which sets out what an organisation has to change to become and stay cost-competitive (section 4);
the cost of quality, and environmental costing built on the same four categories (sections 5 and 6).
Syllabus
This chapter serves P1A3e digital costing and the “features of digital costing” topic, P1A3f the cost of quality framework, P1A3g environmental costing, and the “costing applied to digital cost objects” topic under P1A2b. The last two of those are the biggest single addition in the paper: the syllabus defines environmental costing in terms of the quality costing framework, so section 5 has to be read before section 6.
This lecture covers sections 2, 3 and 4 and is a good foundation for all three. Note what it does not reach. It predates the cost of quality framework (section 5) and environmental costing (section 6) and says nothing about either, and it does not give the “features of digital costing” list that section 3.2 sets out. It also declines to work through the CGMA model’s diagram — section 4 replaces that diagram with a table. Everything else in the recording is sound and the answer it gives to Example 1 is more complete than the printed one.
2 Digital products and digital cost objects
More and more of what organisations sell used to be delivered physically and is now delivered digitally: viewed, streamed or downloaded rather than manufactured, warehoused and shipped. Examples include:
online courses;
apps;
eBooks and audiobooks;
software, and software sold as a subscription service;
graphics, stock images and templates;
downloadable and streamed music.
A cost object is anything for which a cost is wanted — a product, a service, a customer, an activity, a project. A digital cost object is one with no physical form: a title, a licence, a subscriber, a download, a support ticket. The costing question is the same one; what changes is the shape of the costs behind it.
2.1 Why conventional standard costing fits digital products badly
The marginal cost is close to zero. A printed book consumes paper, ink and binding for every copy; the thousandth download of an eBook consumes a fraction of a cent of bandwidth. A costing system built to control a cost per unit has almost no cost per unit to control.
Almost the whole cost is incurred up front. Writing, recording, designing, coding and testing all happen before the first sale, and none of them can be attached to a unit of output in the way a material cost can.
The life of the product is uncertain. It may be superseded in a day or sold unchanged for years, and it may go on evolving through updates that are themselves paid for after the launch. A standard cost is set for a period; a digital product does not respect the period.
Overheads and their drivers are hard to identify. Platform, hosting, support and update costs are shared across every title and every customer, and rarely vary with anything as simple as a volume of output.
Prices and costs move without warning. A change of technology, or of platform commission, can change the economics of the product overnight, which is exactly what a standard fixed for a year cannot absorb.
None of that means digital products cannot be costed. It means the useful cost object is usually the title, the release or the customer over its whole life rather than the unit, and that the useful technique is life-cycle costing and activity-based analysis of the shared costs rather than a standard cost per unit.
Costing a digital product
Suggest some costs which might be involved in creating a digital audiobook — and can you suggest any costs which might be saved in comparison with the manufacture of physical books?
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3 Digital costing systems
Products have become far more complex, and costing systems have had to keep up. A car or an aircraft is assembled from thousands of components, bought from many suppliers, priced in several currencies, with specifications that differ from one customer to the next. Keeping track of the cost of one unit by hand stopped being possible a long time ago.
3.1 What a digital costing system does
A digital costing system collects cost data automatically and continuously rather than periodically, and does something with it:
it captures prices, quantities, lead times and exchange rates in real time, from suppliers’ systems and from sensors on the production line, rather than from month-end returns;
it computes the current cost of a complex product as those inputs move, instead of holding a standard cost fixed for a year;
it analyses the accumulated history to show how costs, supplier reliability and cost behaviour are changing, and flags the changes;
it forecasts the resources the business will need, and what they are likely to cost;
more advanced systems advise — on buying behaviour, on design changes, and on where efficiency can be gained;
and it presents all of it through an interface that a manager can use without being a costing specialist, with reports on cost breakdowns, overheads, drivers and cost behaviour.
Such systems are expensive to implement. Once established they save far more than they cost, largely because they make visible the things a periodic system averages away.
3.2 The features of digital costing
Pulling those together, digital costing is distinguished from traditional costing by these features:
Feature | What it replaces |
Real-time data capture | Periodic collection at a month end |
Automated capture from sensors, connected devices and other systems | Manual entry from documents and returns |
Very large data volumes, structured and unstructured | A small set of accounting records |
Fine granularity — a cost per order, per customer, per component, per transaction | A cost per product or per department |
Continuous re-costing as prices and rates move | A standard cost fixed for a period |
Integration across the supply chain — supplier prices, lead times, currencies | The organisation’s own ledger in isolation |
Predictive as well as historical: forecasting resource needs, prices and cost behaviour | Reporting what has already happened |
Anomaly detection, so an unexpected change is flagged as it occurs | A variance report after the period has closed |
Scenario and what-if analysis on demand | A single planned outcome |
Visual, self-service reporting for non-specialists | A finance-authored monthly pack |
The pattern behind the list is that digital costing moves costing from a periodic, backward-looking, internal, aggregated exercise to a continuous, forward-looking, supply-chain-wide and highly granular one. That is also where its risks lie: more data is not the same as better information, the drivers still have to be chosen by someone who understands the business, and a system that re-costs continuously can produce noise that a monthly report would have smoothed away.
3.3 Target costing
Some digital costing systems are built to operate a target costing approach, which reverses the traditional sequence. Instead of establishing a cost and adding a margin to arrive at a price, target costing starts from the price the market will bear, deducts the margin the organisation requires, and treats the remainder as a target cost that the product must be designed and made to meet.
Target cost = Target selling price − Required profit margin
The difference matters because of what each does to the incentive to reduce cost. Add a percentage margin to a cost and a cost reduction reduces the price and the profit with it, so there is little reason to pursue one. Fix the price first and every dollar taken out of the cost is a dollar of extra profit. A real-time costing system supports the approach directly, because it can show whether a design change actually brings the cost within the target.
Target costing is developed properly later in the CIMA syllabus; at P1 it is enough to know what it is and why the sequence is reversed.
4 The CGMA Cost Transformation Model
The CGMA Cost Transformation Model sets out six changes an organisation needs to make in order to achieve and retain cost competitiveness. They are not a sequence; they operate together.
Component | What it means in practice |
Creating a cost-conscious culture | Cost leadership is pursued deliberately: costs are benchmarked against competitors, and the commitment runs through every level of the organisation rather than sitting with the finance function. Technology is used wherever it can control cost. Lower costs can be taken as extra margin, or given away as a lower price to win volume. |
Understanding cost drivers | Investigating what actually causes costs, and how different variables change them — the activity-based costing analysis of chapter 4. Plans then aim at the drivers, not just at the costs: reducing the number of set-ups is more durable than instructing people to spend less on set-ups. |
Managing the risks that come from a cost-conscious culture | Cost reduction has a failure mode, and it is quality. Cutting too far damages the product, then customer satisfaction, then sales. Those risks are identified and mitigated like any other, which is the point at which this model meets the cost of quality in section 5. |
Connecting products with profitability | Making sure each product and service is individually profitable and makes a positive contribution, rather than judging the business in total. That depends entirely on how shared costs are allocated, so accurate individual product costs are a precondition, not a by-product. |
Maximising value from new products | Assessing profitability before production begins — which is target costing (section 3.3) — and designing products to be adaptable, so that one product can be varied to satisfy as many customer segments as possible. |
Incorporating sustainability | Considering the environmental impact of products and processes. Negative impacts such as unnecessary waste damage reputation and sales, and they cost money directly, because waste is material that was bought and then thrown away. Section 6 turns this component into a costing technique. |
5 The cost of quality
Quality costs money in two quite different ways: money spent to get the product right, and money lost because it was wrong. The cost of quality framework classifies both, so that the total can be seen and the balance between them managed.
The reason it is needed is that only some of these costs arrive in the accounts with a label on them. Scrap and warranty claims do. The cost of the machine that stood idle while a fault was investigated, the engineer’s time spent rectifying rather than producing, and above all the customer who did not come back, do not. An organisation that has never measured its cost of quality almost always underestimates it, and the four categories exist to make the missing parts visible.
5.1 The four categories
Category | Definition | Typical costs |
Prevention | Costs incurred to stop defects arising in the first place. | Quality engineering and designing quality into the product; supplier appraisal, selection and development; training operatives and inspectors; preventive maintenance; process capability studies; quality planning, systems and administration. |
Appraisal | Costs incurred to find defects before the product reaches the customer. | Inspection and testing of incoming materials, work in progress and finished goods; the test and measuring equipment itself, and its calibration; sampling; quality audits; supplier monitoring. |
Internal failure | Costs arising from defects found BEFORE delivery to the customer. | Scrap; rework and rectification; re-inspection and retesting of reworked items; downgrading, i.e. selling as a second at a reduced price; machine downtime and lost production caused by the failure; disposal of defective material and waste; failure investigation. |
External failure | Costs arising from defects found AFTER delivery to the customer. | Warranty claims and repairs; returns, replacements and refunds; product recall; customer compensation and product liability claims; the cost of running a complaints department; and — the largest of all, and the one no ledger records — lost repeat business and reputational damage. |
5.2 Conformance and non-conformance
The four categories group into two:
Made up of | Character | |
Cost of conformance | Prevention + appraisal | The cost of achieving quality. Discretionary, planned in advance, and controllable — management decides how much to spend. |
Cost of non-conformance | Internal failure + external failure | The cost of failing to achieve it. Not planned, not budgeted, and largely uncontrollable once the failure has occurred. |
The central relationship
Conformance costs and non-conformance costs move in opposite directions. Spending more on prevention and appraisal reduces failure — and spending nothing on them does not save money, it moves the money to the failure categories, usually with interest.
The traditional view held that there was an optimum somewhere in the middle: an acceptable quality level at which the rising cost of conformance and the falling cost of non-conformance together gave the lowest total, and that pushing beyond it cost more than it was worth.
The total quality management view is that the target is zero defects — get it right first time — for three reasons. Failure costs are systematically understated, because the lost customer never appears in the ledger. Prevention turns out to be far more effective, and far cheaper, than the traditional model assumed. And the earlier a defect is caught the less it costs: a widely used rule of thumb puts the ratio at roughly 1 : 10 : 100 for preventing a defect, catching it in the factory, and fixing it at the customer.
5.3 The cost of quality report
The framework becomes useful when it is reported. A cost of quality report sets out the four categories for the period in money and as a percentage of revenue, with the previous period beside them, so that management can see three things: the total, the split between conformance and non-conformance, and the direction of travel.
The characteristic profile of an organisation that has never measured it is heavy failure costs and almost no prevention spending. The characteristic profile after a few years of managing it is the reverse, with a total that is markedly lower than the one it started with.
A cost of quality report
Delta Co incurred the following costs last year, all of them connected with the quality of its products:
$ | |
Training operatives in quality procedures | 18,000 |
Inspection and testing of incoming materials | 26,000 |
Components scrapped at final inspection | 41,000 |
Warranty repairs carried out at customers’ premises | 37,000 |
Preventive maintenance of production machinery | 22,000 |
Reworking units rejected by the test department | 15,000 |
Product recall and customer compensation | 58,000 |
Salaries of the quality assurance department, which tests finished goods | 34,000 |
Revenue for the year was $2,500,000.
(a) Classify each cost into the four categories of the cost of quality framework, and total each category.
(b) Calculate the cost of conformance, the cost of non-conformance, and the total cost of quality as a percentage of revenue.
(c) Comment on what the report tells Delta Co’s management.
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6 Environmental costing
Environmental costs are the costs an organisation incurs because of the effect its activities have on the environment — and, more awkwardly, some of the costs its activities impose on other people. They are growing quickly, they are badly captured by conventional costing, and they are increasingly the subject of regulation that turns them into cash.
The difficulty is not that they are small. It is that they are invisible. Energy, water, waste disposal, effluent treatment, permits, compliance staff and environmental insurance almost always arrive in a general overhead account, are absorbed on a volume base such as machine hours or labour hours, and are therefore charged to products in proportion to how big the products are rather than in proportion to the environmental damage they cause. The product responsible for the waste is not the product charged with it.
6.1 Classifying environmental costs using the quality costing framework
The four categories of section 5 transfer directly, and this is the classification the syllabus asks for.
Category | Definition | Typical costs |
Environmental prevention | Costs incurred to prevent environmental damage arising. | Designing products and processes for lower impact (eco-design); substituting a hazardous or scarce input for a benign one; evaluating and developing suppliers on environmental criteria; training; obtaining and maintaining an environmental management system; redesigning a process to cut waste at source. |
Environmental appraisal (detection) | Costs incurred to establish what the organisation’s impacts are and whether it is complying with standards. | Monitoring emissions, effluent and discharges; testing and sampling; measuring energy, water and material use; environmental audits; independent verification of environmental reports; the monitoring equipment itself. |
Environmental internal failure | Costs of dealing with waste and emissions the organisation has created but has NOT released into the environment. | Treating, storing and disposing of hazardous waste; operating and maintaining abatement equipment such as filters and scrubbers; recycling and reprocessing scrap; permits and licences to hold or handle waste; the value of the material that became waste rather than product. |
Environmental external failure | Costs arising after the damage has reached the environment. | Cleaning up a spill or contaminated land; restoring habitat; fines, penalties and clean-up orders; compensation and legal claims; higher insurance; lost sales and reputational damage. And beyond those, the SOCIETAL costs borne by other people — the health effects of a discharge, the loss of a fishery — which the organisation does not pay for at all. |
Where the analogy breaks
With quality, most external failure costs come back to the organisation eventually, through warranty, recall and lost customers. With the environment, a large part of the external failure cost is borne by society and never enters the organisation’s ledger at all — unless regulation, a carbon price, a licence condition or a damaged reputation brings it in. That is precisely why environmental costs are understated even by organisations that are trying to measure them, and why the direction of regulation matters to a decision taken today.
6.2 Linking environmental costs to activities and outputs
Classifying the costs is the first half. The second is attaching them to the things that cause them, and there are three techniques worth knowing.
Environmental activity-based costing
The chapter 4 method, applied to environmental cost pools. Each pool is given a driver that measures the environmental activity rather than the volume of production — kilograms of hazardous waste, litres of effluent, kilowatt-hours, tonnes of CO₂ equivalent, number of deliveries, number of permits — and the cost is then traced to the products and processes in proportion to that driver. A useful refinement is to separate the pools that are genuinely environment-driven from those that merely correlate with output, because only the first group changes when the process is changed.
Input–output analysis
What comes in must come out, either as saleable product or as waste and emissions. Measuring the material inputs in physical units and comparing them with the physical output that was actually sold measures the material that was bought, paid for and then thrown away. The insight it produces is that waste is paid for twice — once as material, and again as disposal — and that the purchase price of the wasted material is usually much the larger of the two, and is completely invisible in the disposal account.
Flow cost accounting and life-cycle costing
Flow cost accounting traces material through each stage of the process and splits the cost attaching to it into material, system and delivery or disposal costs, so that the loss at each stage can be seen and valued. Life-cycle costing extends the boundary in the other direction, bringing in the costs of the end of life — take-back obligations, decommissioning, site restoration — at the point where the product is designed, which is the only point at which they can still be changed.
6.3 Implications for decision-making
Product mix and profitability. A product that looks profitable when environmental costs are absorbed on machine hours can be loss-making once its own waste and energy are traced to it. Nothing about the business changes; what changes is which product management believes is worth having.
Pricing. A cost-based price built on an averaged environmental overhead under-prices the damaging product and over-prices the clean one, which quietly grows the wrong half of the business.
Design and input choice. A cheaper input with a higher disposal cost, or a shorter life, may be dearer once the whole flow is costed. Most environmental cost is committed at the design stage and can be avoided only there.
Investment appraisal. Abatement equipment, process redesign and energy efficiency are justified by the disposal costs, permits, penalties and material losses they avoid — which have to be measured before they can be counted as a benefit.
Regulation and carbon pricing. The trend of regulation is to move societal costs onto the organisation that causes them. A decision taken today on today’s costs may be wrong within the life of the asset, so a sensitivity analysis on the price of emissions and disposal is worth doing (chapter 13).
Reporting and reputation. Customers, investors and lenders increasingly ask for these figures, and an organisation that cannot produce them pays for that in other ways.
Tracing environmental costs to products
Omega Co makes two products, Standard and Premium, in the same factory. Environmental costs of $360,000 a year are currently treated as general overhead and absorbed on machine hours.
An analysis of the $360,000, and of the activities that drive it, gives:
Cost pool | $ | Cost driver |
Hazardous solvent waste — treatment and disposal | 180,000 | litres of solvent waste |
Effluent monitoring and testing | 60,000 | litres of solvent waste |
Energy | 120,000 | machine hours |
360,000 |
Standard | Premium | Total | |
Output (units) | 60,000 | 10,000 | |
Machine hours | 30,000 | 10,000 | 40,000 |
Solvent waste (litres) | 3,000 | 21,000 | 24,000 |
Standard sells for $30 a unit and its other costs are $24 a unit. Premium sells for $95 a unit and its other costs are $76 a unit.
(a) Calculate the environmental cost per unit of each product on the present basis, and on the basis of the cost drivers above.
(b) Calculate the profit per unit of each product on each basis.
(c) State what management should do about the result.
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7 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Other Costing Issues
12 questionsAnswer the questions one at a time. Your progress is saved so you can leave and come back.
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