Module 16- New Developments in Management Accounting

16.1 Introduction

Increasingly companies are seeking to be more customer driven and have a quicker response to the market
Management accounting will have to change to reflect these new business paradigms
The shortcomings of traditional management accounting

They are still been driven by profit measurement and therefore by inventory valuation
Direct labor remains a popular method of overhead allocation, even though direct labor as a percentage of product cost is shrinking
Automated production lines have rendered the concept of fixed and variable costs obsolete
Traditionally overhead has been seen as a burden but as more companies differentiate on quality of service, increasing overheads has become almost a goal
the sheer complexity of business has increased exponentially – e.g products can be customized easily using CAD
Global competitive markets accentuate these problems – the demand for more accurate product costs is increasing

16.2 Target Costing

Up to now we have assumed that the customer is willing to purchase a product at a price which reflects the costs of production, distribution and a contribution to profit – this is naive
What do we do when the maximum selling price is well known and perhaps is below the internally calculated costs?
Target Costing is used when the selling price is known – e.g. a product in an extremely competitive market like the TV market
Once the target price is known, the desired profit margin can be deducted in order to determine the target cost beyond which the company would consider it uneconomic to produce and sell the product
Standard costs differ from Target costs in that they are set only when the output is stable and the detailed product specification is known and is unlikely to change
Target costs start as global figures and are set for an entirely new process
Target costs are usually lower than existing product costs and so a company must use Value Engineering to streamline its whole product process
Target costs are market focused – how much will the market pay for this and do they want it?
Costs are often saved in the design phase, e.g. fewer components usually means lower cost
Target costing involves a detailed examination of both direct costs involved in production (labor, materials etc.) and the overheads involved in the design, manufacture and distribution

Case Study

Puff sells 100,000 models of its ABX airbag to two car manufacturers who have asked for a 10% price reduction next year. Selling price = $100.

Currently each airbag costs $63 to manufacture, ie. $6.3M per year

Direct Material3,640,000

Direct Labor560,000

Machine Costs630,000

R&D costs422,800

Chemical and Explosive testing700,000

Recalibration Costs280,000

Ordering and facilitating costs67,200

6,300,000

The following are the principal activities and their drivers

ActivityDescription of ActivityCost DriverCost per Unit

of Cost Driver

Machine CostMachining of individualNone Fixed Cost

Components

R&DDesigning new productsNoneFixed Cost

Chemical &Each bad is tested forNo. of hours$3.50/hour

Explosivespeed of inflationtesting

RecalibratingReworking of devices thatNo. of bags$18.66/bag

fail the testrecalibrated

Ordering and Ordering of micro-devicesNo. of orders$224 per order

facilitatingand other componentsplaced

Each airbag contains ten components, each from a separate supplier. Currently 30 orders are placed per year with each supplier. Currently 50% of the airbags fail the test, which take two hours, and are then subject to recalibration.

Financial Controller: We need to reduce costs by $10/unit to maintain our current profit margin

R&D Manager: We can reduce the number of components from 10 to 8

Purchasing: We can drop the number of orders placed from 30 to 25. We can cut material cost per bag by $6 and direct labor to $1 less per bag

Chemical & Explosive Manager: We can reduce the number of hours it takes to test a bag from 2 hours to 1.75

Recalibration: Reducing components will reduce failure rate to 10%

Ans:

Savings

Direct Material$6 x 100,000$600,000

Direct Labor$1 x 100,000$100,000

Machine CostsNo change

R&D costsNo change

Chemical & Explosive test0.25 x $3.50x 100,000$87500

Recalibration40% x 100,000 x $18.66$764,400

Ordering and Faciltating((10x30) – (8x25)) x $224$24,000

$903,200

New cost total = $6,300,000 - $903,200 = $5,396,800

To drop our price to $53 => $53 x 100,000 = $5,300,000

Target not reached, perhaps look at why R&D and machine cost are fixed, e.g. machine costs should fall as number of components falls
R&D could be outsourced, resulting in short term savings

16.3 Life Cycle Costing

Life cycle costing does not stop at the usual annual accounting end of year, like investment appraisal it goes from the conception of a product to the moment the product is withdrawn and all services supporting that product cease
Life cycle costing gathers all cost and revenues of the entire life of a product so that its ultimate profitability can be measured
Conventional management accounting, because its annual-driven, tends to miss the upfront costs of product design, launch etc.

Case Study

A company is considering launching one of three possible software packages – all of which have a 3 year shelf life. Here are there budgeted sales figures

Packages Sold

Selling PriceYear 1 Year 2 Year 3

Risksave1200300040001000

Taxplan1500400020002000

ABCost1000200020002000

To avoid missing any costs, life cycle costing is to be used

Risksave ($000s)

Year 1 Year 2 Year 3

Sales Revenue360048001200

Costs

Design2000100

Software Dev,3000200

Manual authorship1200100

Production of packs500100200

Advertising & Distribution500200100

Customer training800200200

Taxplan ($000s)

Year 1 Year 2 Year 3 Year4 Year5

Sales Revenue600030003000

Costs

Design4000200100 100100

Software Dev,2000500500400300

Manual authorship1000100100100100

Production of packs1000600300

Advertising & Distribution500300300

Customer training100100100

ABCost ($000s)

Year 1 Year 2 Year 3

Sales Revenue200020002000

Costs

Design1000

Software Dev,1000

Manual authorship5000

Production of packs200200200

Advertising & Distribution200

Customer training100100100

Purchase of PC900

Soln:

Lifetime Income Statement

RiskSaveTaxplanABcost

Sales Revenue9600120006000

Costs

Design210045001000

Software Dev,320037001000

Manual authorship130014005000

Production of packs8001900600

Advertising & Distribution11001100200

Customer training1200300300

Purchase of PC--900

9400129004500

Profit / (loss)200(900)(1500)

ABCost is the most profitable
However before going with ABCost the firm may want to take a look at cutting costs for the other two since they have higher price and more market penetration
Taxplan suffer because it has ongoing support costs even after the product is removed from the shelves
Perhaps an over the wire upgrade

Life Cycle costing is often used with target costing – particularly with products that have a long life expectancy

16.4 Throughput Accounting

Today business are under pressure to reduce the response times between company and customer, and also to reduce inventory of both raw and finished goods (JIT)
Does the traditional methods of costing allow us to make fullest use of the latest technologies?
Throughput is defined as the rate at which money is earned

Scenario One

Plant supervisor under pressure to avoid having adverse cost variances this quarter
He must choose between two manufacturing alternatives
Alternative A uses a new machine with a low labor input, accountant views the high depreciation charge on this item as a production overhead to be loaded according to direct labor hours => less overhead because labor costs are low
Alternative B – use an older machine to do the task, this has a lower depreciation charge and so the supervisor likes this option as well

Throughput version of this Scenario

Fixed costs, like depreciation, should be excluded from performance measurement
Total factory costs – those which over the short term do not change with production – should be grouped together as one cost
An example of a total factory cost is direct labor – which has to be employed in the short term whether or not they are producing anything
Only material costs are excluded from total factory costs

Scenario Two

Supervisor is concerned at the idle time in his labor variances due to machine not been run all the time
He wants to fill this time by increasing production full capacity and filling inventory full of finished goods
So he can avoid questions about poor variances, while adding value to materials

Throughput version of Scenario Two

Value is added to a company not what products are made but when they are sold
This is contrary to the traditional financial view that rewards high closing inventory with a high profit figure
It is cheaper for a company to absorb total factory costs than total factory costs plus a build up of unwanted inventory
Inventory should be driven down (JIT)

Scenario Three

Two products have exactly the same cost structure but just differ in labor costs – X costs $100/unit in direct labor, Y costs $105/unit
Y takes 10.5 hours , X takes 10 hours
There is a bottleneck at machining, where of an available 200 hours per week, X takes up 4 while Y only 2
The manager decides that X is more profitable of the two because of the cheaper direct labor costs

Throughput version of Scenario 4

In throughput, profitability is defined as the rate at which cash is received from customers
Product Y can be produced at twice the rate of Product X at the bottleneck and so Y should be favored
The throughput ratio is calculated using return per factory hour and cost per factory hour:

Return per factory hour = Sales price – Material Cost

Time spent at the factory bottleneck per product

Cost per factory hour = Total Factory Cost

Total time at factory bottleneck

These two numbers are then combined to give a throughput accounting ratio

Throughput accounting ratio = Return per factory hour

Cost per factory hour

This is the rate at which products earn money for the business

Example

For products X and Y :

Selling price per unit$200

Direct Material per unit$50

Total Factory Cost$8000

Again, time at the bottleneck : X = 4 hours, Y = 2

X: Return per factory hour = 200-50/4 = $37.50/hour

Y: Return per factory hour = 200-50/2 = $75/hour

X: Cost per factory hour = 8000/200=$40

Y: Cost per factory hour = 8000/200=$40

X: Throughput Accounting Ratio = $37.50/$40 = 0.9375

Y: Throughput Accounting Ratio = $75/$40 = 1.875

Product Y shows the ability to generate more money in sales than is spent on production (Throughput Accounting Ratio > 1), X doesn’t

16.5 Costing for Competitive Advantage

Accountants are becoming more involved in strategic discussions and decisions – they often are able to rise above the feuds and vested interest
Management accountants can be involved in production planning - in this subject a number of issues are considered:

-production facilities

-labor skills

-sourcing of supplies

-introduction of JIT and total quality inspection

-the decision whether to make or buy specific components

-suppliers’ ability to cope with peak in demand

Production strategy could be expressed in on of the following terms of:

-% increase in output

-decrease in rejects

-buy in components

Management accounting can help in quantifying the various strategies under review

Example

Electric motor is a supplier of electric motors two white goods companies. Each say they need to 2100 motors between them per month an can guarantee that level for 12 months. Selling price is $80.

The limiting factor is supply of skilled machinists – availability is limited to 4500 hours/month. Electric Motor has used a subcontractor at peak demand time.

Option 1: Electric Motor should manufacture as many motors as it can and subcontract the balance to Sparks – Electric Motor would still have to test the motors - $3 per motor.

Option 2: Electric Motor should manufacture as many of the three separate components as it can and subcontract the remaining components to Sparks. Electric Motors would assemble and test [ignore assembly costs]

Production Info:

Three components:

Casing RotorResistor

Subcontract price $75$34$18$23

Parts for component432

Material cost per part$1.50$1.25$1

Machinist minutes per part151025

Machinist labor rate per hour $15

Variable Overhead 40% of labor costs

Fixed Overhead per month $20000

Solution

Limiting Factor = 4500 hours = 270,000mins

Machinist Labor per motor

Casing60 (4x15)

Rotor30

Resistor50

Total140 mins

Number of motors that can be built = 270,000/140 = 1928 motors

Number of motors that have to be subcontracted = 172

Option 1: cost profile

Electric Motor’s Cost Profile$$

Sales Price80

Direct Material 11.75

Direct Labor (2.33 hours x $15)35

Variable Overhead (40% of $35)14

Inspection and testing363.75

Contribution margin per month16.25

Total Contribution

1928 motors x 16.25 31330

172 x (80 – (75+3))344

31,674

Fixed Costs20,000

Profit11,674

Option 2 :

ComponentCasing RotorResistor

Direct Material63.752

Direct Labor3.7526.25

Variable Overhead1535

Total Variable Cost2714.2519.5

Buy in price341823

Contribution per component73.753.5

Limiting factor in minutes603050

Contribution per limiting factor$0.1167$0.125$0.07

Ranking213

Limiting factor for components

Rotor: 2100 units x 60126,000

Casing: 2100 x 3063,000

Resistor:1620 x 5081,000

270,000

So we need to subcontract 2100-1620= 480 resistors

Profitability of Option 2

Contribution of Internal components

Casing (7 x 2100)14700

Rotor7875

Resistors (1620 x $3.50)5670

28245

Contribution from subcon. (2100x(80-75))110500

Total Contribution38745

Less: inspection and testing 2100 x 36300

Fixed Costs2000026300

12445

1 Contribution comes from selling its motors externally & manufacturing components internally

Option 2 gives marginally more profit and so is preferred
The small difference may not be worth the effort of cheery picking components

Review Questions

c
c
a
c
d
a
c
d
a
b
c
a
c
Return per factory hour = sales-direct materials

Time Spent at bottle neck per product

300 – 75/3 = 75 =a

Cost per factory hour = Total Factory Cost/Total time at bottleneck

= 183000/2400 = $76.25 = d

Throughput accounting ratio = Return per factory hour/cost per factory hour

= 75/76.25 = 0.98 = a

Return per factory hour = 300 – 80/2 = $110

Throughput ratio = 110/76.25= 1.44 = b

c
TRUE

20.

V-01

Sales240,000

Variable96,000

Contribution144,000

Contribution of x02110,000

Contribution of Ql380,000

Total Contr.334,000

Less

V01 Fixed costs120,000

x02 fixed costs130,000

QL3 fixed80,000330,000

4,000 = a

21.

v01x02ql3

Sales240000300000280000820,000

Variable Costs - 180000144000324000

Contr12,000120,000136000268000

Fixed120,000130,00080,000330,000

Profit-62000 = c

22.

Limiting factor = 57000 direct labor hours

v01x-2ql3

Sales240,000300,000280,000

Variable Costs96,000180,000144,000

Contribution144,000120,000136,000

Limiting factor454

Contribution per

limiting factor36,00024,00034,000

Ranking 132

v01: 6000 x 4 = 24,000

ql3: 8000 x 4 = 32,000

57,000

Subcontract x2, ans: b

Case Study 16.1

Selling price = $200

60 components

unit production cost = $115, so old margin = 95

Sales units 5000

New selling price $180, so new production cost/unit = $95 => $475,000

savings in direct materials $15 x 5000 = 75000

increase in RD(10000)

savings in direct labor 10% of 800008000

machining costs2000

savings in purchasing2000

savings in testing10,000

$87,000

so new production costs = 488, not enough of a reduction

16.2