Costing Methods — In some settings, costs may be captured by the job costing method. For example, a custom home builder would likely capture costs for each house constructed. The actual labor and material would be tracked and assigned to that specific home along with some amount of overhead , and the cost of each specific home can be expected to vary.
Some companies produce homogenous products in continuous processes. For example, consider production of paint or bricks used in building a home. How much does each brick or gallon of paint cost? These types of items are produced in continuous processes where costs are pooled together and output is measured in aggregate quantities.
It is difficult to identify specific costs for each unit. Yet, it is important to make a cost assignment. For these situations, accountants might utilize process costing methods. Next, think about the architectural firms that design homes.
They engage in many activities that drive costs but do not produce revenues. For example, substantial effort is required to train staff, develop clients, bill and collect, maintain the office, visit job sites, and so forth. The individual architects are probably involved in multiple tasks throughout each day; therefore, it becomes difficult to say exactly how much it costs to develop a specific set of blueprints!
The firm might consider tracing costs and assigning them to activities e. Then, an allocation model can be used to attribute selected activities to a job. Costing Concepts — In addition to alternative methods of costing, a good manager will need to understand different theories or concepts about costing. Overhead can include facilities depreciation, utilities, maintenance, and many other similar shared costs. With absorption costing, this overhead is schematically allocated among all units of output. In other words, output absorbs the full cost of the productive process.
Absorption costing is required for external reporting purposes under generally accepted accounting principles. Some managers are aware that sole reliance on absorption costing numbers can lead to bad decisions. As a result, internal cost accounting processes in some organizations focus on a direct costing approach.
With direct costing, a unit of output will be assigned only its direct cost of production e. Future chapters examine differences between absorption and direct costing. Successfully directing an organization requires prudent management of production. Because this is a hands-on process, and frequently involves dealing with the tangible portions of the business inventory, fabrication, assembly, etc.
Managerial accounting provides numerous tools for managers to use in support of production and logistics moving goods through production to a customer. This means that costs must be minimized and efficiency maximized, while seeking to achieve enhanced output and quality standards. In the past few decades, advances in technology have greatly contributed to the ability to run a lean business. Product fabrication and assembly have been improved through virtually error-free robotics. Accountability is handled via comprehensive software that tracks an array of data on a real-time basis.
B2B Business to Business A system that enables data interchange between companies; sometimes sufficiently robust to permit automatic inventory replenishment, etc. These developments ultimately enhance organizational efficiency and the living standards of customers who benefit from better and cheaper products. But, despite their robust power, they do not replace human decision making.
Managers must pay attention to the information being produced, and be ready to adjust business processes in response. M2M is also becoming known as IOT internet of things. Inventory — For a manufacturing company inventory may consist of raw materials, work in process, and finished goods.
The raw materials are the components and parts that are to be eventually processed into a final product. Work in process consists of goods that are actually under production. Finished goods are the completed units awaiting sale to customers. Each category will require special consideration and control. Failure to properly manage any category of inventory can be disastrous.
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Overstocking raw materials or overproduction of finished goods will increase costs and obsolescence. Conversely, out-of-stock situations for raw materials will silence the production line. Failure to have goods on hand might result in lost sales. Subsequent chapters cover inventory management. Responsibility Considerations — Enabling and motivating employees to work at peak performance is an important managerial role.
For this to occur, employees must perceive that their productive efficiency and quality of output are fairly measured. A good manager will understand and be able to explain to others how such measures are determined. These service departments have nothing to sell to outsiders, but are essential components of operation.
The costs of service departments must be recovered for a business to survive. It is easy for a production manager to focus solely on the area under direct control and ignore the costs of support tasks. Yet, good management decisions require full consideration of the costs of support services.
Many alternative techniques are used by managerial accountants to allocate responsibility for organizational costs. A good manager will understand the need for such allocations and be able to explain and justify them to employees who may not be fully aware of why profitability is more difficult to achieve than it would seem. In addition, techniques must be utilized to capture the cost of quality, or perhaps better said, the cost of a lack of quality. Finished goods that do not function as promised cause substantial warranty costs, including rework, shipping, and scrap.
There is also an extreme long-run cost associated with a lack of customer satisfaction. Understanding concepts of responsibility accounting will also require one to think about attaching inputs and outcomes to those responsible for their ultimate disposition. In other words, a manager must be held accountable, but to do this requires the ability to monitor costs incurred and deliverables produced by defined areas of accountability centers of responsibility. This does not happen by accident and requires extensive systems development work, as well as training and explanation, on the part of management accountants.
Managerial accounting provides theoretical models of calculations that are needed to support these types of decisions. Although such models are not perfect in every case, they certainly are effective in stimulating correct thought. The seemingly obvious answer may not always yield the truly correct or best decision. Therefore, subsequent chapters will provide insight into the logic and methods that need to be employed to manage these types of business decisions.
Things rarely go exactly as planned, and management must make a concerted effort to monitor and adjust for deviations. The managerial accountant is a major facilitator of this control process, including exploration of alternative corrective strategies to remedy unfavorable situations. In addition, a recent trend is for enhanced internal controls and mandatory certifications by CEOs and CFOs as to the accuracy of financial reports.
These certifications carry penalties of perjury, and have gotten the attention of corporate executives. This has led to greatly expanded emphasis on controls of the various internal and external reporting mechanisms. The controller is an important and respected position within most larger organizations. The corporate control function is of sufficient complexity that a controller may have hundreds of support personnel to assist with all phases of the management accounting process. In contrast, the chief financial officer CFO is usually responsible for external reporting, the treasury function, and general cash flow and financing management.
In some organizations, one person may serve a dual role as both the CFO and controller.
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Larger organizations may also have a separate internal audit group that reviews the work of the accounting and treasury units. Because internal auditors are reporting on the effectiveness and integrity of other units within a business organization, they usually report directly to the highest levels of corporate leadership. Steering, acceleration, and braking are not random; they are careful corrective responses to constant monitoring of many variables like traffic, road conditions, and so forth.
Clearly, each action is in response to having monitored conditions and adopted an adjusting response. Likewise, business managers must rely on systematic monitoring tools to maintain awareness of where the business is headed. Managerial accounting provides these monitoring tools and establishes a logical basis for making adjustments to business operations.
These standards represent benchmarks against which actual productive activity is compared. Importantly, standards can be developed for labor costs and efficiency, materials cost and utilization, and more general assessments of the overall deployment of facilities and equipment the overhead. Value engineering can be broken into stages. Ibusuki and Kaminski highlight three levels that focus on the product concept, the design phase and the production phase. The product concept phase involves a zero look. This considers new concepts and new functionalities that do not currently exist.
First look is concerned with the product design stages and primarily seeks to develop new products from existing concepts. First look identifies the main areas to target for a reduction of costs. This can include using existing products as a reference point to look for improvements. Second look picks up at the later design stages, detailed component design, and moves into the production stage. Tear down analysis can also be used to facilitate the understanding of functionality and costs if competitor products exit.
Value engineering techniques often include the use of checklists of functionalities along with their associated costs. It is not, however, a process of simply choosing functions from a list and deleting those that save money, as the requirements of the customer need to be taken into account, as well as the knock on effects of one function on another within the overall design, and the potential impact on quality.
Functional cost analysis as the name suggests is the process of mapping the functions of the product broken down into component parts, and assigning the cost to each element. The function is described in terms of verbs, that is, what activity or function is it that the product or the component needs to perform. This is then linked to the actual physical elements of the product. For example, in a household water tap, the basic function is to allow the free flow of water as and when desired.
There are several component parts that make up the tap. Each element performs a particular function within the design and has a cost attached to it. This could be materials and labour. If component parts are bought-in the suppliers also need to be involved in the process.
The parts are then assembled, packaged, stored, delivered, marketed and sold to customers. A table can be used that identifies the following elements: the functions, the parts, and the costs materials, labour and indirect costs which can be assigned using technique such as activity-based costing.
This forms the basis of a cost table that can be prepared with the help of the accountants. The marketing department will also have some input as certain elements will provide much more value to the customer than others. For example, those parts that are purely functional, that is, they have to be there to make the product work, may not be seen as a key selling point to the customer, but what customers value is the look, style, and finish of the product. Therefore, the handle design may have much more significance for the customer than the tap spindle, but the tap will not work without a spindle.
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This does not necessarily mean that the component parts can be made from a lower quality and hence less costly material, as this may affect the reliability of the product, which may be a factor valued by the customer. This illustrates that some of the functionality required by the customer is subjective.
For example, mobile phones include a camera, but the ease of use, and ease of handling the device when taking selfies are just as significant as the physical attributes and functions of the camera. Techniques such as functional cost analysis and value engineering enable a better understanding and consideration of the trade-off between product function and cost Iranmanesh and Thomson For example, the question would be, can the product be made from different materials that provide the desired reliability and quality?
The relative importance of various functions and attributes to the customer can be assigned based on a value 1 — 10 with 1 being not required, to 10 being of extreme importance. Or more loosely, it could be based on a simple scale of: not required, nice to have, or essential. The difficulty of understanding how components add value and contribute to the whole cannot be underestimated. Imagine how many parts there are in an Airbus A There are several thousand engineers involved in the design, so it can be a significant project undertaking and requires appropriate project management skills and leadership as well as the technical skills and knowledge.
Pronin et al. Overdesign can also occur through risk aversion, or believing that the component must perform under extreme situations. This emphasises the need to engender a team approach to value engineering and functional cost analysis, and to include review and critique sessions to guard against overdesign, but also to ensure that cost savings do not impact on the required functionality, reliability and quality of the product.
Reduce indirect costs. There may be scope to reduce the indirect costs that help to achieve the target cost. Techniques such as just-in-time management of inventory, production patterns, and improving the efficiency and effectiveness of activities such as machine set-up, maintenance and so on, can provide cost savings. Nor should we ignore the concept of continuous improvement Ellram, , which can provide significant benefits in achieving the target cost through the life cycle as well as increasing the cost accountability of all those involved.
Undertake overall net present value analysis over estimated life of product or reasonable time period. Where significant investment is required to produce the new product, or further investments to meet capacity requirements as the product grows, it is useful to undertake a net present value calculation feeding in the cost estimates and demand profile. This then takes account of the cost of capital and provides additional comfort that the product is viable in the long term. It is always worth remembering that the NPV calculation will include estimates, and sensitivity analysis should be undertaken to establish acceptable levels of error in the estimates for the future years.
Ensure cost management system in place to monitor ongoing costs and take corrective action where necessary. Target costing requires a good cost management system for monitoring the costs and taking corrective action in the future. The database of costs can be developed and improved over time as experience is gained of using the technique. This should also include supplier evaluation and the continuous monitoring of supplier performance to ensure that costs are managed throughout the whole value system. Not all new product launches are successful, and not all estimates will be accurate.
The experience of target costing exercises need to be fed back into future products so that the process can be continuously improved. Benefits of target costing. The increasing competitiveness of many markets today means that customers are always demanding new products, with better quality and functionality, without an increase in price Roy et al. Target costing means that an organisation needs to take a proactive approach to cost management, and to understand the cost drivers.
It helps to understand the trade-off between cost and functionality of a product Iranmanesh and Thomson, The organisation becomes much more customer focused as, rather than developing products in an internal vacuum, the customer needs are considered and a product developed to satisfy those needs at a price and cost acceptable to the consumer and organisation.
Indeed it could be said to be acceptable to all stakeholders, as suppliers will earn an acceptable profit, employees will be motivated with job security assured, and the shareholders receive an acceptable return. Target costing ensures the needs of the supply chain are considered. Helms et al.
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The whole supply chain needs to be involved Cooper and Slagmulder, However, the issue of supplier power and buyer power may come into play and the relative negotiating positions of the parties involved. Manufacturers of products have to have the needs of the retailers in mind when designing new products. The increasing awareness of sustainability issues has emphasised the need for organisations to work together through the development of new materials, packaging designs, and recycling systems, as well as new products.
Target costing fosters cooperation between internal functions of the organisation, as well as between members of the supply chain Monden and Hamada, Its introduction can enhance cooperation and awareness of the need to work together both internally and externally. When considering the value of different functionality, and the need for such functionality, it enhances the understanding of the non-value adding elements of a product. Some of them may be essential even though they do not add any value in the eyes of the customer.
This understanding can provide an insight into the areas where cost savings might be more productive, for example, reducing the non-value adding functionally or activities in the manufacture of the product. Careful monitoring and quality control of the component design can also help reduce costs in manufacture. The need to reduce the new product development time Gupta et al. If target costing is embraced as the way all products are developed within an organisation, that is, it becomes part of the normal culture, it can reduce the time to market for new products and improve the success rate for new product launches.
Target costing requires the development and maintenance of detailed cost data. This is not just a one off exercise to determine the initial cost, but entails monitoring of costs throughout the product life cycle. Only then can experience be gained of how costs behave and hence the learning fed into future cost estimates on other new products. If activity-based costing is used to help establish costs it requires the maintenance of the ABC system, which in itself requires the collection of a range of non-financial data. It can be difficult to establish the value of functionality to the customer and its associated cost.
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It is also difficult to estimate the pricing impact and costs over the life cycle of the product, hence forecasts may be wildly adrift of the actual outturn. If target costing is viewed by managers as a way of setting the budget it can have a demotivating impact if targets are not met. Rather, target costing should be seen as providing the impetus for continuous improvement of operations and cost savings. Many products are launched that have not met their target cost, but a program of continuously seeking to drive costs down without losing functionality, reliability or quality can be put in place to strive to ensure a contribution is made over the life of the product.
Reducing overhead costs and downstream costs, which are difficult to attribute to individual product lines, can also contribute to overall profitability. Implementation requires a willingness to cooperate within the organisation and with external partners. The design team is not always the same as those that have to live with the decisions and the options selected Yazdifar and Askarany, , and therefore, it is important to ensure that a wide range of views are represented in the team and that all employees are employed and motivated to reduce costs in line with the principles of target costing, that is, reducing costs without a reduction in functionality, reliability, or quality.
Therefore excellence in marketing research, as well as product innovation, is a key capability required within the organisation. As we have seen it should be an inclusive process if it is to be implemented effectively. Resources will need to be invested in the process and it should be seen as a long term project to implement the concept, as experience can be fed back into the process so that it contributes to organisational learning and the process becomes more valuable as experience grows.
It therefore requires the full commitment and support of senior managers within the organisation. End note. Target is gaining in popularity, but the level of detail can be off-putting, particularly for smaller organisations that do not have the appropriate skills and resources. The basic concept of market driven pricing and establishing an allowable cost target, can improve the chances of products being successful and improving overall profits.
Alfonso, P. Ansari, S. Bock, S. Cokins, G. Cooper, R. Crow, K. Davila, A. So, instead of setting change retroactively and only reacting to a specific situation, the management remains at the wheel and acts proactively differentiated pre-planning and targeted actions. Afterward, it is all about ensuring an adequate implementation of applicable measures to internalize and institutionalize the change properly. This sparks the initial motivation to get things moving. The relevance of those words needs to be highlighted and reasoned with, for example, poor sales statistics or desperate, actual financial figures.
If the company is still in calm waters, the management accountant identifies potential threats and develops scenarios. These show what could happen in the future—whether the organization will not initiate change and adapt to prospectively occurring developments. Only then will they start talking and thinking about the proposed change and can be convinced that there is no alternative to it. Therefore, it is important to keep employees motivated to participate in that change project constantly at a high level.
In that context, it would be counterproductive to only set long-term milestones or goals. Nothing produces more motivation than experiencing success. Management accountants can particularly contribute by providing adequate business reports that shed light on the realization of change management:.
Besides, to reward people who help to succeed in the change project, management accountants could—if supported and approved by the management—create or establish appropriate performance, compensation, and feedback systems that further enhance motivational and monetary incentives in the change stage. Besides, it cannot completely be ruled out that a supposed quick win in the change stage proves inappropriate and needs further change. As an example, just think of changing a production technique that at first seems to be cost-effective and successful overall.
But soon, the products show a serious production defect and product sales decline.
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Improvements become inevitable then. However, each small win provides an opportunity to identify what went right, and what wrong, and hence, needs improvement. Management accounting can accompany this transition from the change to refreeze stage while continuously analyzing the current situation. Again, management accountants report what supports or has supported the change process so far telling success stories about it, backed by operational figures, for example , which barriers need to be dismantled in favor of sustaining change, and whether the change sticks and is eventually stable.
Read on with Part 3: III. The management accountant taking on the role of a change agent. Raising awareness of predictive analysis by management accounting Dealing with change is and will be a major challenge for every company, no matter its size or its business operations. Radical vs. Management accountants can particularly contribute by providing adequate business reports that shed light on the realization of change management: Is the change project progressing as planned?
Which milestones and successes have already been achieved?