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Find more at http://www.downloadslide.com CHAPTER 11 Costing and performance evaluation in a competitive environment Introduction n recent years we have seen major changes in the business world, 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 in which businesses are 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 environment on the full-costing approach that we considered in Chapter 10. We shall see that activity-based costing, which is a development of the traditional full-costing approach, takes a much more enquiring, much less accepting attitude towards overheads. We shall also examine some recent approaches to costing that can help lower costs and, therefore, increase the ability of a business to compete on price. Management accounting embraces both financial and non-financial measures and, in this chapter, we shall consider the increasing importance of non-financial measures in managing a business. These include the balanced scorecard approach, which seeks to integrate financial and non-financial measures into a framework for the achievement of business objectives. Finally, we consider the idea of shareholder value, which has been a ‘hot’ issue among managers in recent years. Many leading businesses now claim that the quest for shareholder value is the driving force behind strategic and operational decisions. We consider what the term ‘shareholder value’ means and we shall look at one of the main methods of measuring shareholder value. I Learning outcomes When you have completed this chapter, you should be able to: ● Discuss the nature and usefulness of activity-based costing. ● Explain how new developments such as total life-cycle costing and target costing can be used to control costs. ➔ Find more at http://www.downloadslide.com 394 CHAPTER 11 COSTING AND PERFORMANCE EVALUATION IN A COMPETITIVE ENVIRONMENT ● Discuss the importance of non-financial measures of performance in managing a business and the way in which the balanced scorecard attempts to integrate financial and non-financial measures. ● Explain the term ‘shareholder value’ and describe the role of EVA® in measuring and delivering shareholder value. Remember to create your own personalised Study Plan Cost determination in the changed business environment Costing: 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 industry displayed the following characteristics: ● ● ● 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. A low level of indirect cost relative to direct cost. Little was spent on power, personnel services, machinery (leading to low depreciation charges) and other areas typical of the indirect cost (overheads) of modern businesses. 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 could add a margin for profit to arrive at the selling price (cost-plus pricing). 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/daily rate for their time and to try to base prices on this. Find more at http://www.downloadslide.com COST MANAGEMENT SYSTEMS Costing: the new environment In recent years, the world of industrial production has fundamentally changed. Most of it is now characterised by: ● ● ● 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 10.2 (page 353), direct labour accounts on average for just 14 per cent of manufacturers’ total cost. A high level of indirect cost 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 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 10.2, overheads account for 25 per cent of manufacturers’ total cost and 51 per cent of service sector total cost. A highly competitive international market. Production, much of it highly sophisticated, is carried out worldwide. Transport, including fast airfreight, is relatively cheap. Fax, 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 supplying services, many service providers are vast businesses such as banks, insurance companies and cinema operators. For most of these larger service providers, the activities very closely resemble modern manufacturing activity. They too are characterised by high capital intensity, overheads dominating direct costs and a competitive international 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 cost management systems to provide the information that will enable managers 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. The problem of overheads In Chapter 10 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 395 Find more at http://www.downloadslide.com 396 CHAPTER 11 COSTING AND PERFORMANCE EVALUATION IN A COMPETITIVE ENVIRONMENT 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 overheads are now much more significant. When production is dominated by direct labour 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 11.1 provides a rather disturbing view of costing and cost control in large banks. Real World 11.1 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 operating divisions or were allocated in a rather arbitrary manner. Source: Based on information in ‘Banks have not tackled indirect costs’, A. Skorecki, FT.com, 7 January 2004. Taking a closer look 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 recognition of the fact that overheads do not just happen; something must be causing them. To illustrate this point, let us consider Example 11.1. Find more at http://www.downloadslide.com ACTIVITY-BASED COSTING Example 11.1 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. Traditionally, the whole cost of operating the stores would have been treated as a part of general overheads and included in the total of overheads charged to jobs, probably on a direct labour hour basis. This means that, when assessing the cost of Products A and B, the cost of operating the stores has fallen on them according to the number of direct labour hours worked on manufacturing each one; a factor that has nothing to do with storage. In fact, most of the stores’ cost should be charged to Product B, since this product causes (and benefits from) the stores’ cost much more than Product A. Failure to account more precisely for the cost of running the stores is masking the fact that Product B is not as profitable as it seems to be. It may even be leading to losses as a result of the relatively high stores-operating cost that it causes. However, much of this cost is charged to Product A, without regard to the fact that Product A causes little of it. Activity-based costing ➔ Activity-based costing (ABC) aims to overcome the kind of problem just described by directly tracing the cost of all support activities to particular products or services. For a manufacturing business, these support activities may include materials ordering, materials handling, storage, inspection and so on. The cost of the support activities makes up the total overheads cost. The outcome of this tracing exercise is to provide a more realistic, and more finely measured, account of the overhead cost element for a particular product or service. To implement a system of ABC, managers must begin by carefully examining the business’s operations. They will need to identify: ● ➔ ● ● each of the various support activities involved in the process of making products or providing services; the costs to be attributed to each support activity; and the factors that cause a change in the costs of each support activity, that is the cost drivers. Identifying the cost drivers is a vital element of a successful ABC system. They have a cause-and-effect relationship with activity costs and so are used as a basis for attaching activity costs to a particular product or service. This point is discussed further below. 397 Find more at http://www.downloadslide.com 398 CHAPTER 11 COSTING AND PERFORMANCE EVALUATION IN A COMPETITIVE ENVIRONMENT Attributing overheads Once the various support activities, their costs and the factors that drive these costs, have been identified, ABC requires: ➔ ● ● ● An overhead cost pool to be established for each activity. Thus, the business in Example 11.1 will create a cost pool for operating the finished goods store. The total cost associated with each support activity to be allocated to the relevant cost pool. The total cost in each pool to then be charged to output (Products A and B, in the case of Example 11.1) using the relevant cost driver. The final step identified involves dividing the amount in each cost pool by the estimated total usage of the cost driver to derive a cost per unit of the cost driver. This unit cost figure is then multiplied by the number of units of the cost driver used by a particular product, or service, to determine the amount of overhead cost to be attached to it. Example 11.2 should make this last step clear. Example 11.2 The management accountant at Modern Producers Ltd (see Example 11.1) has estimated that the cost of running the finished goods stores for next year will be £90,000. This will be the amount allocated to the ‘finished goods stores cost pool’. It is estimated that each Product A will spend an average of one week in the stores before being sold. With Product B, the equivalent period is four weeks. Both products are of roughly similar size and have very similar storage needs. It is felt, therefore, that the period spent in the stores (‘product weeks’) is the cost driver. Next year, 50,000 Product As and 25,000 Product Bs are expected to pass through the stores. The estimated total usage of the cost driver will be the total number of ‘product weeks’ that the products will be in store. For next year, this will be: Product A B 50,000 × 1 week 25,000 × 4 weeks = = 50,000 100,000 150,000 The cost per unit of cost driver is the total cost of the stores divided by the number of ‘product weeks’, as calculated above. This is: £90,000/150,000 = £0.60 To determine the cost to be attached to a particular unit of product, the figure of £0.60 must be multiplied by the number of ‘product weeks’ that a product stays in the finished goods store. Thus, each unit of Product A will be charged with £0.60 (that is, £0.60 × 1), and each Product B with £2.40 (that is, £0.60 × 4). Benefits of ABC Through the direct tracing of cost to products in the way described, ABC seeks to establish more accurate costs for each unit of product or service. This should help managers in assessing product profitability and in making decisions concerning pricing and the appropriate product mix. Other benefits, however, may also flow from adopting an ABC approach. Find more at http://www.downloadslide.com ACTIVITY-BASED COSTING Activity 11.1 Can you think of any other benefits that an ABC approach to costing may provide? By identifying the various support activities’ costs and analysing what causes them to change, managers should gain a better understanding of the business. This, in turn, should help them in controlling costs and improving efficiency. It should also help them in forward planning. They may, for example, be in a better position to assess the likely effect of new products and processes on activities and costs. ABC versus the traditional approach We can see that there is a basic philosophical difference between the traditional and the ABC approaches. The traditional approach views overheads as rendering a service to cost units, the cost of which must be charged to those units. ABC, on the other hand, views overheads as being caused by activities, and so it is the cost units that cause these activities that must be charged with the costs that they cause. With the traditional approach, overheads are apportioned to product cost centres. Each product cost centre would then derive an overhead recovery rate, typically overheads per direct labour hour. Overheads would then be applied to units of output according to how many direct labour hours were worked on them. With ABC, the overheads are analysed into cost pools, with one cost pool for each cost-driving activity. The overheads are then charged to units of output, through activity cost driver rates. These rates are an attempt to represent the extent to which each particular cost unit is believed to cause the particular part of the overheads. Cost pools are much the same as cost centres, except that each cost pool is linked to a particular activity (operating the stores in Examples 11.1 and 11.2), rather than being more general, as is the case with cost centres in traditional job (or product) costing. The two different approaches are illustrated in Figure 11.1. ABC and service industries Much of our discussion of ABC has concentrated on the manufacturing industry, perhaps because early users of ABC were manufacturing businesses. In fact, ABC is possibly even more relevant to service industries because, in the absence of a direct material element, a service business’s total cost is likely to be largely made up of overheads (see Real World 10.2 on page 353). There is certainly evidence that ABC has been adopted more readily by businesses that sell services rather than products, as we shall see later. Activity 11.2 What is the difference in the way in which direct costs are accounted for when using ABC, relative to their treatment taking a traditional approach to full costing? The answer is no difference at all. ABC is concerned only with the way in which overheads are charged to jobs to derive the full cost. 399 Find more at http://www.downloadslide.com 400 CHAPTER 11 COSTING AND PERFORMANCE EVALUATION IN A COMPETITIVE ENVIRONMENT Figure 11.1 Traditional versus activity-based costing With the traditional approach, overheads are first assigned to product cost centres and then absorbed by cost units based on an overhead recovery rate (using direct labour hours worked on the cost units or some other approach) for each cost centre. With activity-based costing, overheads are assigned to cost pools and then cost units are charged with these elements to the extent that they drive the costs in the various pools. Source: Adapted from Activity Based Costing: A Review with Case Studies, J. Innes and F. Mitchell, CIMA Publishing, 1990. Example 11.3 provides an example of activity-based costing and brings together the points that have been raised so far. Find more at http://www.downloadslide.com ACTIVITY-BASED COSTING 401 Example 11.3 Comma Ltd manufactures two types of Sprizzer – Standard and Deluxe. Each product requires the incorporation of a difficult-to-handle special part (one of them for a Standard and four for a Deluxe). Both of these products are made in batches (large batches for Standards and small ones for Deluxes). Each new batch requires that the production facilities are ‘set up’. Details of the two products are: Annual production and sales – units Sales price per unit Batch size – units Direct labour time per unit – hours Direct labour rate per hour Direct material cost per unit Number of special parts per unit Number of set-ups per batch Number of separate material issues from stores per batch Number of sales invoices issued per year Standard 12,000 £65 1,000 2 £8 £22 1 1 1 50 Deluxe 12,000 £87 50 21/2 £8 £32 4 3 1 240 In recent months, Comma Ltd has been trying to persuade customers who buy the Standard to purchase the Deluxe instead. An analysis of overhead costs for Comma Ltd has provided the following information. Overhead cost analysis Set-up cost Special part handling cost Customer invoicing cost Material handling cost Other overheads £ 73,200 60,000 29,000 63,000 108,000 Cost driver Number of set-ups Number of special parts Number of invoices Number of batches Labour hours Required: (a) Calculate the profit per unit and the return on sales for Standard and Deluxe Sprizzers using both: ● the traditional direct-labour-hour-based absorption of overheads; and ● activity-based costing methods. (b) Comment on the managerial implications for Comma Ltd of the results in (a) above. Solution Using the traditional full (absorption) costing approach that we considered in Chapter 10, the overheads are added together and an overheads recovery rate deduced as follows: Overheads Set-up cost Special part handling cost Customer invoicing cost Material handling cost Other overheads £ 73,200 60,000 29,000 63,000 108,000 333,200 ➔ Find more at http://www.downloadslide.com 402 CHAPTER 11 ➔ COSTING AND PERFORMANCE EVALUATION IN A COMPETITIVE ENVIRONMENT Overhead recovery rate = = Total overheads Number of labour hours 333,200 54,000 [that is (12,000 × 2) + (12,000 × 21/2 )] = £6.17 per hour The total cost per unit of each type of Sprizzer is calculated by adding the direct cost to the overheads cost per unit. The overheads cost per unit is calculated by multiplying the number of direct labour hours spent on the product (2 hours for each Standard and 21/2 hours for each Deluxe) by the overheads recovery rate calculated above. Hence: Direct costs Labour Material Indirect cost Overheads (£6.17 per hour) Total cost per unit Standard £ 16.00 22.00 Deluxe £ 20.00 32.00 12.34 50.34 15.43 67.43 Standard £ per unit 65.00 50.34 14.66 22.55% Deluxe £ per unit 87.00 67.43 19.57 22.49% The return on sales is calculated as follows: Sales price Total cost (see above) Profit Return on sales [(profit/sales) × 100%] Using the ABC costing approach, the activity cost driver rates will be calculated as follows: Overhead cost pool Driver Set-up Set-ups per batch Special part Special parts per unit Customer invoices (a) Standard driver volume (b) Deluxe driver volume (c) Total driver volume (a + b) (d) Costs £ (e) Driver rate £ (d/c) 12 720 732 73,200 100 12,000 48,000 60,000 60,000 1 Invoices per year 50 240 290 29,000 100 Material handling Number of batches 12 240 252 63,000 250 Other overheads Labour hours 24,000 30,000 54,000 108,000 2