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M04_ATRI3622_06_SE_C04.QXD 128 CHAPTER 4 5/29/09 10:36 AM Page 128 FULL COSTING ‘ Key terms 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 Further reading 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. M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 129 EXERCISES REVIEW QUESTIONS Answers to these questions can be found in Appendix C at the back of the book. 4.1 What problem does the existence of work in progress cause in process costing? 4.2 What is the point of distinguishing direct cost from indirect cost? Why is this not necessary in process-costing environments? 4.3 Are direct cost and variable cost the same thing? Explain your answer. 4.4 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? EXERCISES 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. 4.1 Bodgers Ltd, a business that provides a market research service, operates a job-costing system. 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? 4.2 Athena Ltd is an engineering business doing work for its customers to their particular requirements 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 Machine power Direct labour Indirect labour Direct materials Depreciation Machine time £25,000 £10,000 £200,000 £50,000 £120,000 £30,000 20,000 hours (allocated equally between the two departments) (all allocated to the Machining Department) (£150,000 allocated to the Fitting Department and £50,000 to the Machining Department; all direct workers are paid £10 an hour) (apportioned to the departments in proportion to the direct labour cost) (all applied to jobs in the Machining Department) (all relates to the Machining Department) (all worked in the Machining Department) 129 M04_ATRI3622_06_SE_C04.QXD 130 CHAPTER 4 5/29/09 10:36 AM Page 130 FULL COSTING 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 particular 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. 4.3 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 Direct labour cost Direct labour time Indirect labour cost Depreciation of machine Rent and rates Heating, lighting and power Indirect materials Other indirect cost (overhead) elements Machine time £50,000 £160,000 16,000 hours £25,000 £8,000 £10,000 £5,000 £2,000 £1,000 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. 4.4 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) Materials (direct) Labour (direct) Variable overheads Advertising (for business) Depreciation Administration Interest Profit (before taxation) £ 196,000 (38,000) (32,000) (2,400) (3,000) (27,600) (36,000) (8,000) 49,000 M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 131 EXERCISES A first estimate of the direct cost for the particular job is: £ 4,000 3,600 Direct materials Direct labour 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 improvements 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: £ 1,200 2,000 500 300 4,000 Paper grade 1 Paper grade 2 Card (zenith grade) Inks and other miscellaneous items Paper grade 1 is regularly used by the business. Enough of this paper to complete the job is currently 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. 4.5 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 maintenance section. Shown below are next year’s planned production data and manufacturing cost for the business. Production Direct materials Direct labour Machine shop Fitting section Machine hours X 4,200 units £11/unit Y 6,900 units £14/unit Z 1,700 units £17/unit £6/unit £12/unit 6 hr/unit £4/unit £3/unit 3 hr/unit £2/unit £21/unit 4 hr/unit 131 M04_ATRI3622_06_SE_C04.QXD 132 CHAPTER 4 5/29/09 10:36 AM Page 132 FULL COSTING Planned overheads are as follows: Allocated overheads Rent, rates, heat and light Depreciation and insurance of equipment Machine shop Fitting section Canteen £27,660 £19,470 £16,600 Machine maintenance section £26,650 Total £90,380 £17,000 £25,000 Additional data: Gross book value of equipment Number of employees Floor space occupied Machine shop Fitting section Canteen £150,000 18 3,600 sq m £75,000 14 1,400 sq m £30,000 4 1,000 sq m Machine maintenance section £45,000 4 800 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. 4.6 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. Production Direct material cost Direct labour requirements: Cutting department: Skilled operatives Unskilled operatives Machining department Pressing department Machine requirements: Machining department A B C 4,000 units £7 per unit 3,000 units £4 per unit 6,000 units £9 per unit 3 6 1 /2 2 hr/unit hr/unit hr/unit hr/unit 2 hr/unit 5 1 1 /4 3 hr/unit hr/unit hr/unit hr/unit 11/2 hr/unit 2 3 1 /3 4 hr/unit hr/unit hr/unit hr/unit 21/2 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. M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 133 EXERCISES Product cost centres Planned total overheads Service cost centre cost incurred for the benefit of other cost centres, as follows: Engineering services Personnel services Service cost centres Cutting Machining Pressing Engineering Personnel £154,482 £64,316 £58,452 £56,000 £34,000 20% 55% 45% 10% 35% 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. 4.7 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. 4.8 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.) 133 M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 134 5 Costing and pricing in a competitive environment INTRODUCTION 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. LEARNING OUTCOMES 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 135 COST DETERMINATION IN THE CHANGED BUSINESS ENVIRONMENT Cost determination in the changed business environment 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 industry 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 fundamental 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 135 M05_ATRI3622_06_SE_C05.QXD 136 CHAPTER 5 5/29/09 4:22 PM Page 136 COSTING AND PRICING IN A COMPETITIVE ENVIRONMENT 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 manufacturers’ 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 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 the cost management systems employed 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. Activity-based costing 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 overheads are now much more significant. When production is dominated by direct labour M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 137 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. REAL WORLD 5.1 Bank accounts FT 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 A. Skorecki, ‘Banks have not tackled indirect costs’, ft.com, 7 January 2004. 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 recognition of the fact that overheads do not just happen; something must be causing them. To illustrate this point, let us consider Example 5.1. Example 5.1 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. ‘