cma202 topic 5 - charles darwin...

CMA202TOPIC 5

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© Kevin J Clark CDU Slide 1 Last Revision 08/03/2015

Topic 05

Cost management, capacity costing andcapacity management

Chapter 7


LEARNING OBJECTIVES

• Distinguish between market-based and cost-based pricing

• Set output prices using the target-costing approach

• Distinguish between value- and non-value-added activities

• Apply the concepts of cost incurrence and locked-in costs

• Describe and apply various capacity concepts

• Select the appropriate capacity concept under differing circumstances

• Describe how attempts to recover the costs of capacity

(fixed costs) may lead to increases in price(s) and reduction

in demand.

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Cost management and pricing

• How companies price a product or service ultimately depends

on the demand and supply for it.

• Three influences on demand and supply:

o customers

o competitors

o costs.

Sidetrack: Consider briefly:• Porter’s Five Forces• Porter's Competitive Advantage Model


Porter’s Five Forces

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. Por

ter.

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ree

Pre

ss (

1980

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vant

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Porter's Competitive Advantage Model

Com

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ive

Str

ateg

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chni

ques

for

anal

yzin

gin

dust

ries

and

com

petit

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. Por

ter.

F

ree

Pre

ss (

1980

).C

ompe

titiv

e ad

vant

age:

cre

atin

g an

d su

stai

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sup

erio

r pe

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man

ce,

Mic

hael

Por

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Col

lier

Mac

mill

ian

(198

5)

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Cost management and pricing

• Market-based – price charged is based on what customers

want and how competitors react.

• Cost-based – price charged is based on what it costs to

produce, coupled with the ability to recoup the costs and still

achieve a required rate of return.

• Pricing decisions and customer-profitability analysis is further discussed in

Topic 11 [Chapter 9]


Cost management and pricing – web link

• Depending on the competitive situation, companies would gravitate

towards one approach or the other. For example;

o In a highly competitive market the market approach would normally be

utilised. These companies must accept the prices set by the market.

o If the market were less competitive, cost-plus pricing could be used. This

approach is useful for companies offering products or services that differ

from each other—legal services, income tax preparation, custom

jewellery, to name a few.

• The ‘How to build a pricing strategy’ process is described at:

http://www.virbusgame.eu/virbus/mediawiki/index.php/Pricing_Management


Target costing for target pricing

• Market-based pricing starts with a target price:

o Target price – estimated price for a product or service that

potential customers will pay

o Estimated on customers’ perceived value for a product or

service and how competitors will price competing products

or services.

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• Implementing target pricing and target costing:

1) develop a product that satisfies the needs of potential customers

2) choose a target price3) derive a target cost per unit:

– target price per unit minus target operating income (profit) per unit

4) analyse the costs5) apply value engineering to achieve target cost.





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• Value engineering

o Value engineering is a systematic evaluation of all aspects

of the value-chain, with the objective of reducing costs while

improving quality and satisfying customer needs.

o Value engineering looks for better ways to accomplish an

objective

o Managers must distinguish value-added activities and costs

from non-value-added activities and costs.


The Value-chain

A value chain is a chain of activities that a firm operating in a specific industry performs in order to deliver a valuable product or service for the market. Porter, Michael E. (1985). Competitive Advantage: Creating and Sustaining Superior Performance..



• Value-added costs – a cost that, if eliminated, would reduce the actual or

perceived value or utility (usefulness) customers obtain from using the

product or service.

• Non-value-added costs – a cost that, if eliminated, would not reduce the

actual or perceived value or utility customers obtain from using the product

or service. It is a cost the customer is unwilling to pay for.

• the distinction between value-added costs and non-value-added costs is

from the view of the customer.

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• Cost incurrence and locked-in costs

o Cost incurrence describes when a resource is consumed (or

benefit foregone) to meet a specific objective.

o Locked-in costs (designed-in costs) are costs that have not

yet been incurred but, based on decisions that have already

been made, will be incurred in the future.

• To manage activities (costs) well, a company must identify how design choices lock in costs before the costs are incurred.



• Cost incurrence and locked-in costs

o Design choices affect locked-in costs. Once the design of the product is

finalised, the cost of the product is determined to a large degree.. As the

product is manufactured, it becomes an incurred cost and can be

avoided only by a redesign or by not manufacturing the product.

o Since costs are incurred at all points in the value-chain, but frequently

locked in during the design phase, cost reductions can be most readily

attained through value-chain analysis and the use of cross-functional

teams



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• Value chain analysis and cross-functional teams

• There are five key aspects to the target pricing, target costing, and value-

engineering process:

• understanding customer requirements and competitor actions

• selecting a target price and determining a target cost

• anticipating how costs are locked in before they are incurred

• improving product and process designs and efficiency to achieve target costs and better quality

• using cross-functional teams to coordinate actions that need to be taken throughout the value chain.



• If it is not properly managed, value engineering and target

costing can have undesirable effects:

o Employees may feel frustrated if they fail to attain targets.

o A cross-functional team may add too many features just to

accommodate the wishes of team members.

o A product may be in development for a long time as alternative designs

are repeatedly evaluated.

o Organisational conflicts may develop as the burden of cutting costs falls

unequally on different business functions in the firm’s value chain.



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Target costing for target pricing – web links

• ‘Target Costing Approach to Pricing’ is an explanation with examples of the

process. It can be found at:

http://www.accounting4management.com/target_costing_pricing_products_an

d_services.htm#Example%20of%20Target%20Costing

• ‘Best Practices in Target Costing’. How Boeing, Caterpillar, DaimlerChrysler

and Continental Teves apply target costing can be found at:

http://www.imanet.org/PDFs/Public/MAQ/2003_Q1/2003MAQ_winter_bestpra

ctices.pdf


Target costing for target pricing – web link

• ‘Target Costing Vs. Cost-Plus in Pricing’, plus some related articles, can

be found at:

http://smallbusiness.chron.com/target-costing-vs-costplus-pricing-35302.html

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Life-cycle product budgeting and costing(briefly study this issue – it is dealt with in depth in CMA302)

• Product life cycle spans the time from initial R&D on a product to when

customer service and support are no long offered on that product.

• Life-cycle budgeting involves estimating the revenues and business

function costs of the value chain attributable to each product from its initial

R&D to its final customer service and support.

• Life-cycle costing tracks and accumulates business function costs of the

value chain attributable to each product from initial R&D to final customer

service and support.



• Life-cycle budgeting and pricing decisions:

o non-production costs are large

o development period for R&D and design is long and costly

o many costs are locked in at the R&D and design stages,

even if R&D and design costs are themselves small.



• Customer life-cycle costing:

o Customer life-cycle costs focus on the total costs incurred

by a customer to:

» acquire a product or service

» use a product or service

» maintain a product or service, and

» dispose of a product or service.

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Capacity costing and capacity management

• Capacity concepts

• Four different capacity concepts are used to calculate the budgeted fixed

manufacturing cost rate. They are:

• theoretical capacity

• practical capacity

• normal capacity utilisation

• master-budget capacity utilisation.



FOUR DIFFERENT MEASURES OF ACTIVITY LEVEL:

Capacity costing and capacity managementCapacity is not a hard number, but depends on many factors.

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• Theoretical capacity and practical capacity:

o Theoretical capacity is the level of capacity based on producing at

full efficiency all the time.

o Practical capacity recognises the need for unavoidable operating

interruptions, for example:

» scheduled maintenance time» shutdowns for holidays.

o Engineering and human resource factors are both important when

estimating theoretical or practical capacity.



• Normal capacity utilisation and master-budget capacity

utilisation:

o normal capacity utilisation is the level of capacity utilisation that

satisfies average customer demand over a period (say,

2 to 5 years). It includes seasonal, cyclical, and trend factors

o master-budget capacity utilisation is the level of capacity

utilisation that managers expect for the current budget period,

which is typically one year.



• Effect on budgeted fixed manufacturing cost rate• If budgeted fixed manufacturing overhead costs are $1,080,000, the

budgeted fixed manufacturing cost rates for each of the four capacity concepts are:

• The significant difference in cost rates (from $60 to $135) arises because of large differences in budgeted capacity levels under the different capacity concepts..

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• If budgeted variable manufacturing cost is $200 per unit, the

total budgeted manufacturing cost per unit for capacity

concepts is:


Capacity costing and capacity management – web link

• A summary of the article ‘Who is accounting for the cost of

capacity?’ in Management Accounting February, 1997, can be

found at:

http://maaw.info/ArticleSummaries/ArtSumBrauschTaylor97.htm


Choosing a capacity concept for capacity management

• Consider the effects of different capacity concepts on:

o product costing

o pricing

o performance evaluation

o external reporting

o requirements of the Australian Taxation Office

o forecasting chosen denominator-level concept.

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• product costing

o Theoretical capacity is rarely used to calculate budgeted fixed

manufacturing cost per unit because it is significantly different from the ‘real’

capacity available to a company.

o Practical capacity is frequently used to calculate budgeted fixed

manufacturing cost per unit. This approach sets the cost of capacity at the

cost of supplying the capacity regardless of demand.

o Practical capacity, then, highlights the cost of capacity acquired but not used

and may serve to direct managers’ attention toward more effective capacity

management.


Choosing a capacity concept for capacitymanagement

• Pricing:• using cost-based pricing, and selecting master-budget capacity utilisation

as the capacity concept, may lead to a downward demand spiral

o as demand drops, unit costs become increasingly higher resulting in an

increased reluctance to meet competitors’ prices

o as the company increases prices to cover fixed costs, demand drops

due to the higher price, resulting in another price increase to cover still

higher per-unit costs.



• in performance evaluation managers must guard against using a long-run measure such as

normal capacity usage for a short-run purpose such as annual bonuses. Master-budget

utilisation would be more effective in this situation.

• For external reporting purposes, the choice of capacity measure will affect the magnitude of

the production-volume variance. How this variance is disposed of at the end of the year will

impact the company’s operating income.

o The adjusted allocation-rate approach restates all amounts in the ledgers using actual rather than

budgeted cost rates. This has the effect of switching to actual costing at the end of the year.

o The proration approach spreads the balance over the accounts containing overhead—work-in-process,

finished goods, and cost of goods sold—in proportion to the balances in these accounts.

o The write-off to cost of goods sold approach simply writes the balance of the variance off to cost of

goods sold. This can be utilised when the balance is immaterial. This method is also the simplest to

utilise.

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More issues regarding capacity costs andcapacity concepts

• Costing systems, such as normal costing or standard costing, do not

recognise uncertainty the way managers recognise it.

• The fixed manufacturing cost rate is based on a numerator (budgeted fixed

manufacturing costs), and a denominator (some measure of capacity or

capacity utilisation). Challenging issues arise with the choices of both the

numerator and the denominator.

• Capacity costs also arise in non-manufacturing parts of the value chain.

• For simplicity it has been assumed that all fixed manufacturing costs had a

single cost driver. Activity-based costing systems have multiple overhead cost

pools, each with its own cost driver.

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