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Movement From Traditional to Modern Cost Accounting Methods in

Manufacturing Companies (*)

Hrvoje Perčević University of Zagreb, Croatia

Mirjana Hladika University of Zagreb, Croatia

AbstractSignificantchangesinbusinessenvironmentattheendof20thcenturyand

the beginning of 21st century enable the development and application ofmoderncost accounting methods which main purpose is to give required information tomanagement regarding the effectiveness of certain products, projects, activities,consumers, responsibility centres etc. Traditional cost accounting methods weredevelopedin themiddleof20thcenturydue to theautomationofproduction.Thefocusof traditionalcostaccountingmethodswasonmanufacturingcostandwaysof indirect manufacturing costs allocation to products or services. But, furtherdevelopmentoftechnology,changesinconsumer’spreferences,globalcompetitionface modern manufacturing companies with permanent challenges of survival attheglobalmarket.Traditionalcostaccountingmethodsarenolongerappropriateinmodern business conditions, because cost accountingmethods should indicate thepotential areas in companies where are possible cost savings. Therefore, moderncost accounting methods are focused on cost rationalization and cost reduction,since modern manufacturing companies cannot effect on market prices but caneffectontheircosts.Incurrentbusinessconditions,moderncostaccountingmethods

(*) Bu Araştırma, 19-22 Haziran 2013 tarihinde İstanbul’da yapılan 3rd International Conference on Luca Pacioli in Accounting History’de ve 3rd Balkans and Middle East Countries Conference on Accounting and Accounting History (3 BMAC) Konferansı’nda bildiri olarak sunulmuştur.

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aremore appropriatewhile they are focused on the total costs through thewholeproduct lifecycle.Thispaperdealswith themoderncostaccountingmethodsandtheirapplicationinmanufacturingcompanies.Theresultsareshowingthatmoderncostaccountingmethodsenablesmoreconfidentialdeterminationoftherealproductprofitability.Butitisalsoimportanttostatethatresearchresultsshowthatmoderncostaccountingmethodsshouldbeappliedtogetherwithtraditionalcostaccountingmethods. Traditional cost accounting methods give information regarding cost inshortterm,whilemodernmethodsareorientatedonlongerperiod(e.g.onthewholeproductlifecycle).

Key words: Traditional Cost Accounting Methods, Modern Cost AccountingMethods,ABC,TargetCosting,LifeCycleCosting,ProductProfitability.Jel Classificiation: M21,M4A,M51

1. IntroductionThebasicpurposeofcosting systems is todetermine thecostof a

productorservicebyassigningmanufacturingcoststoproductsorservicesthat company produces or provides. Costing system consist of differentaccountingmethods used in order to define the cost per unit.Accountingmethodsusedincostingsystemenabletheevaluationofproductsasaresultfrom themanufacturing process. It is important to point out that differentcosting systems differently affect the product evaluation. The choice ofcostingsystemwasbasedonthetypeoftheproductionprocess.Therefore,job order costingwas used in job order production,while process costingwasappliedinprocessormassproduction.Today,thesetwocostingsystemsareconsideredastraditionalcostingsystemswhicharenolongersuitabletouseinmodernoperatingconditions.Businessconditionsarechangingrapidlybecoming more and more complex. Manufacturing processes in modernproduction companies are almost fully automated and computerized. Theprocessofmanufacturingautomationandcomputerizationcausessignificantchangeinmanufacturingcoststructure.Themostimportantcostelementinmodernmanufacturingcoststructurebecomesindirectmanufacturingcosts

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(manufacturing overheads). This change in manufacturing cost structurefound traditional costing systems inappropriate for product evaluation.In order to avoid the inaccuracy of traditional costing systems in productevaluation,thenewcostingsystem,basedonactivities,hasbeendeveloped.ThiscostingsystemisknownasActivitybasedcosting.

2. The Types of Costing SystemsCosting systemcanbedefined as a systemused to assign costs to

costobjects(productsorservices).Themainpurposeofcostingsystemistoenable cost assignment.Cost assignment is theprocessof assigningdirectandindirectcoststoproductsorservicesinordertodeterminethecostofaproductorservice.

Each costing system consists of five basic elements:1

1. cost object – anything for which a measurement of cost isdesired.Usually,costobjectsareproductsorservicesthatcertaincompanymanufacturesorprovides.

2.direct costs of a cost object –thesearecoststhatcanbetracedtoaparticularproductorservice

3.indirect costs of a cost object –thesearecoststhatcannotbetracedtoaparticularproductorservice.Indirectcostsneedtobeallocatedtocostobjectsusingapropercostallocationmethod.

4.cost pool –agroupingofindividualcostitem.Thecostpoolsareformedwhencompanyusesmorecostallocationbases.InABCsystem,costpoolsareidentifiedactivitiestowhichindirectcostsareassigning.

5.cost allocation base –thefactorthatlinksinasystematicwayanindirectcost(orgroupofindirectcost)toaparticularcostobject.

1) Horngren, C.T., Datar, S.M., Foster, G. (2003), Cost Accounting – A Managerial Emphasis, Prentice Hall, New Jersey, p. 96-97.

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Thesefiveelementsareusingtodesignanadequatecostingsystem.There are three basic costing systems used in

manufacturing companies in order to determine the cost ofa particular product or to evaluate product profitability:2

1.jobordercosting,2.processcosting,3.activitybasedcosting.

The first two costing systems are known as traditional costingsystems.While the appliance of traditional costing systemsdependon thetypeofamanufacturingprocess,activitybasedcostingsystemcanbeappliedregardlessthetypeofmanufacturingprocess.Themainissueforcompaniesis:whenisconvenienttousetraditionalcostingsystemsandwhenactivitybasedcostingsystemshouldbeapplied?Toansweronthisquestiontheoperatingconditionsandthemanufacturingcoststructureshouldbeconsidered.

2.1. Cost allocation in traditional costing systemsThebasicdistinctionbetweenjobcostingandprocesscostingsystem

is indeterminationofcostobject.In jobcostingcostobject isa jobwhichconsistsofaunitormultipleunitsofdistinctproductsorservices.Inprocesscostingcostobjectismassesofidenticalorsimilarunitsofaproductorservice.Therefore,jobcostingcanbeappliedinmanufacturingwhichisinitiatedbyacustomer’sorder,whileprocesscostingcanbeusedinmassproductionwhichiscontinuallyperformingandisnotinitiatedbyacustomer’sorder.

Cost allocation is similar in job costing and in process costing. Inboth costing systems direct manufacturing costs are traced to products orservices.Thesecostsaredirectlyassignedtoparticularproductsorserviceswhich cause their appearance. Direct manufacturing costs include directmaterial costs and direct labour costs.Themain problemof every costingsystemisindirectmanufacturingcostsallocation.Becausethesecostscannot

2) Lucey, T. (1996), Costing, DP Publications, London, p. 175-176.

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bedirectlyidentifiedtoparticularproductorservice,indirectmanufacturingcostsneedtobeallocatedtoproductsorservicesonsomereasonablebaseswhich correctly present the relationship between indirect manufacturingcosts and certain product. This relationship is often very difficult toexpressbya singleallocationbase. It is important toemphasise that thereis no allocation basewhich can accurately provide indirect cost allocationto products. Chosen cost allocation base can be more or less objective,but it can’t be 100% accurate. Indirect manufacturing costs are usuallyassigned toproductsorservicesusing the followingcostallocationbases:3

1.directlabourhours,2.machinehours,3.directmaterialcosts,4.totaldirectcosts,5.quantityofproduction.

Indirect manufacturing costs are assigned to cost object by anoverheadallocationratewhichiscomputingonthechosencostallocationbase.4

total indirect manufacturing costsOAR=-------------------------------------------- cost allocation base Companiescanuseeitheroneormoreoverheadallocationratefor

assigningindirectmanufacturingcoststoproductsorservices.Itisconsideredthat themore overhead allocation rates are used the cost per unit ismoreaccurateand theproductprofitabilityevaluation ismore reliableandmoreobjectivefordecisionmaking.

3) Engler, C. (1988), Managerial Accounting, Irwin, Homewood, Illinois, p. 427

4) Lucey, T. (1996), Costing, DP Publications, London, p. 88

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Figure1.Costallocationintraditionalcostingsystems In traditional costing systems the indirectmanufacturing costs are

allocated to cost objects on arbitrary baseswhich could affect on productprofitabilityevaluation.Theimpactoftraditionalcostingsystemsapplianceon product profitability evaluation depends on certain conditions amongwhich ismanufacturingcost structureconsideredas themost important. Ifindirectmanufacturingcostsparticipatesignificantlyintotalmanufacturingcosts, traditional costing system may cause the wrong picture of productprofitability evaluation. Otherwise, traditional costing system can providerelativelyobjectiveproductprofitabilityevaluation.

2.2. Cost allocation in Activity Based Costing SystemActivity Based Costing system (ABC system) was designed in

order to correct thedeficienciesof traditional costing systems.The initialpurposeofABCsystemis toprovide the fairandaccuratecost allocation

Costallocationbase

Overheadallocationrate

COSTOBJECT–

Directmaterialcosts Directlabourcosts

Manufacturingoverheads

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andthereforeproductprofitabilityevaluationalso.Accordingtothat,ABCsystemfocusesattentiononindirectmanufacturingcosts.Theaimistodefinethemostappropriatewayforindirectmanufacturingcostsallocationtocostobjects.

The main assumption of ABC system is: productsconsume activities and activities consume resources.5 The moreactivities are set up, the more complex is ABC system. An activityis defined as any event, action, transaction or work sequence thatincurs cost when producing a product or providing a service.6

In ABC system direct manufacturing costs are also directly traced toproductsorservices,sothemainattentionispaidonindirectmanufacturingcosts which are allocated to activities instead to departments or jobs(like in traditional systems). Basically, the application ofABC system isgoing through twomain phases. In the first phase indirect manufacturingcosts are allocated to activity cost pools. It is important to determine thecorrelation between particular indirect manufacturing cost and identifiedactivity. Every indirect manufacturing cost must be assigned to properactivitywhichcausesitsoccurrence.ThesecondphaseinABCapplicationis assigning indirect manufacturing costs from activity cost pools toproducts using defined cost drivers.A cost driver is any factor or activitythat has a direct cause – effect relationshipwith the resources consumed.7

ABCsystemusesmultiplecostallocationbasestoassignindirectmanufacturingcosts to products or services. The usage of multiple allocation bases canprovideamoreaccurateandobjectiveproductprofitabilityevaluation.

5) Horngren, C.T., Datar, S.M., Foster, G. (2003), Cost Accounting – A Managerial Emphasis, Prentice Hall, New Jersey, p. 141.

6) Horngren, C.T., Datar, S.M., Foster, G. (2003), Cost Accounting – A Managerial Emphasis,Prentice Hall,New Jersey, p. 141 or Weygandt, J.J., Kieso, D.E.,Kimmel, P.D. (2005), Managerial Accounting, John Wiley & Sons, USA, p. 144.

7) Weygandt, J.J., Kieso, D.E., Kimmel, P.D. (2005), Managerial Accounting, John Wiley & Sons, USA, p. 144.

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Manufacturingoverheads

Figure2.CostallocationinABCsystem

Costdriversshouldcorrectlyshowtherelationshipbetweencertainactivity and cost objects. Otherwise, even this costing system can lead toproductcostdistortionandunreliableproductprofitabilityevaluation.ABCsystemisverycomplexandtakesmuchmoreeffortandresourcestoimplementthantraditionalsystems.ItsapplicationisjustifiedonlyifthebenefitsfromABCsystemexceedcostsof its implementation.So,whenmanagementofacompanydecidetoimplementABCsystemmustbesurethatABCsystemwillprovidethemoreusefulcostinformationforbusinessdecisionmakingthantraditionalsystems.

Activities

Costdrivers

COSTOBJECT–

Directmaterialcosts Directlabourcosts

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2.3. Traditional systems vs. ABC system – the impact on product profitability evaluation

Themain dilemmawhichmanymanufacturing companies face tois the choice of costing system. Traditional costing systems show certaindeficiencies inproductprofitabilityevaluationespeciallywhenchosencostallocation bases are not in direct correlation with indirect manufacturingcosts. Today’s manufacturing environment characterizes automated andcomputerizedmanufacturingprocesses,technologicalinnovationsandglobalcompetition.8Asaresultofthesechanges,indirectmanufacturingcostsaresignificantlyincreased,whiledirectlabourcostsaredramaticallydecreased.Intheseconditions,traditionalcostingsystemscannotprovideobjectiveandaccurateproductprofitabilityevaluationbecausetypicalcostallocationbasesintraditionalsystem(whicharedirectlabourhoursandmachinehours)arenolongerincorrelationwithindirectmanufacturingcostsappearance.Therefore,the new approach for cost allocation needs to be applied.ABC system ismoreappropriatecostingsysteminmodernmanufacturingconditions.Manysurveysconductedinmodernmanufacturingcompaniesworldwideindicatethe factors which directs toABC system application. These factors are:9

1.productlinesdiffergreatlyinvolumeandmanufacturing

complexity;2.productlinesarenumerous,diverseandrequiredifferingdegrees

ofsupportservices;3.overheadcostsconstituteasignificantportionoftotalcosts;4.themanufacturingprocessorthenumberofproductshaschanged

significantly–forexample,fromlabour-intensivetocapital- intensiveduetoautomation;

8) Ibid.

9) Ibid, p. 154

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5.productionormarketingmanagersareignoringdataprovided bytheexistingsystemandareinsteadusing“bootleg”costingdata orotheralternativedatawhenpricingormakingotherproduct decisions.

TheexistenceofoneormoreofthesefactorswouldbetheindicatorthatABCsystemshouldbeapplied.

One of the most important factors that will be considered moreclearlywhendecidingwhichcostingsystemtoapplyismanufacturingcoststructure.Recenttremendouschangesinmanufacturingcoststructure,which are provoked by permanent manufacturing process automation,significantly increased ABC system appliance in modern developedmanufacturingcompaniesworldwide.Asitisemphasised,themanufacturingprocess automation have increased indirect manufacturing costs whichbecame the most significant cost category in total manufacturingcosts. Simultaneously, direct labour costs have dramatically decreasedand today are considered as no longer an important cost category.The portion of direct labour costs in total manufacturing cost inmodern automated manufacturing companies is between 5 - 15%,10

while the portion of indirect manufacturing costs is often above 50%.Manufacturingcoststructureinmoderndevelopedmanufacturingsectorscanbeshownasitfollows:

Figure3.Manufacturingcoststructureinmodernautomated manufacturingsectors

10) Lucey, T. (1996), Management Accounting, Letts Educational, London, p. 37.

Directmanufacturing

costs

Indirectmanufacturing

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When indirect manufacturing costs take the significant portionof total manufacturing costs, more objective and more accurate productprofitabilityevaluationcanbeachievedbyusingABCsystem.But,ifdirectmanufacturingcoststakethesignificantportionoftotalmanufacturingcosts,then even traditional costing systems can provide relatively objective andaccurateproductprofitabilityevaluation.InthesecircumstancesusingABCsystem wouldn’t contribute to more objective and more accurate productprofitabilityevaluation.

3. Dynamic Approach of Cost ManagementDynamic approach of cost management enables the evaluation of

product profitability through the entire product life cycle. Therefore, thisapproachisorientedtothelongrundecisionsregardingpricingtheproduct,forming the adequateproductmix, eliminating thenon-profit product line,introducingthenewproductlineetc.But,inordertoprovidethemanagementwith relevant information regarding product profitability evaluation,accounting function in companies need to combineboth the static and thedynamicapproachof costmanagemente.g.needtocombineandcompareproductprofitabilityintheshortrunandinthelongrun.Onlytheinteractionofthesetwocostmanagementapproachescangivetheobjectiveandreliablepictureregardingproductprofitability.

While static cost management approach is based on traditionalcostaccountingmethodswhicharefocusedmainlyonmanufacturingcoststowardsthedeterminationofthemanufacturingcostperunit,dynamiccostmanagement approach involves modern managerial accounting methodsfocused on the total costs through the whole product life cycle. Modernmanagerialaccountingliteraturerecognizesseveralcostingmethodsfocusedonthewholeproductlifecycle.Themostimportantmethodsare:targetcosting,theoryofconstraints, life-cyclecostingandlong-termpricing11.Thesefour

11) Blocher, E.J., Chen, K.H., Cokins, G., Lin, T.W. (2005), Cost Management – A Strategic Emphasis, McGraw Hill – Irwin, New York.

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methods enable a comprehensive analysis of product cost and profitabilitythroughthewholeproductlifecycle.Target costingemphasizestheroleofproductdesigninreducingcostsinthemanufacturinganddownstreamphasesof theproduct life cycle.12 Theory of constraints includesmethodsused toidentifyandtomanage(oreliminateifpossible)bottlenecksinmanufacturingprocess in order to reduce manufacturing costs and to increase operatingincome13.Life-cycle costing tracksandaccumulatesallcostsattributable totheeachproductthroughitswholelifecycle14enablingacompleteevaluationofproductprofitability through its life cycle.Thus, long-term pricing useslife-cyclecostinginlong-termpricingdecisions.15

In further chapters of this paper, target costing and life-cyclecostingwill be analysed, because these twomethods aremost commonlyusedbymanufacturing companies, especially the oneswhere newproductdevelopment,manufacturingspeedandefficiencyareimportant.

3.1. The Characteristics and Implementation of Target Costing3.1.1. The Characteristics and Reasons of Target Costing

ApplicationTarget costing is a specific approach developed in Japan which

combinesmarketandaccountinginformation.Targetcostingcanbedefinedas the process of determining the maximum allowable cost for a newproductandthendevelopingaprototypethatcanbeprofitablymadeforthat

12) Ibid.

13) Horngren, C.T., Datar, S.M., Foster, G. (2003), Cost Accounting – A Horngren, C.T., Datar, S.M., Foster, G. (2003), Cost Accounting – A Managerial Emphasis, Prentice Hall, New Jersey.

14) Ibid.

15) Blocher, E.J., Chen, K.H., Cokins, G., Lin, T.W. (2005), Cost Management – A Strategic Emphasis, McGraw Hill – Irwin, New York.

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maximumtargetcostfeature16.Thisapproachisdevelopedduetothefactthatlargenumberofcompaniesoperatesonsuchmarketsinwhichtheycannotinfluence onmarket price.Market price is determined on the market andcompanieswhichoperateonthatmarketmustadjusttheircoststothatmarketprice.Therefore,inordertosustaindesiredlevelofprofitability,companiesinsuchbusinessconditionscanaffectonlyoncosts.So,costreductionbecomesoneofthemostimportantareasofmanagementinterest.Targetcostingisamethodofidentifyingtargetcostofaproductatanticipatedmarketpriceanddesiredprofitperproduct:17

Target cost = Anticipated market price – Desired profit Targetcost,determinedontheanticipatedmarketpriceanddesired

profitpreproduct,mustbemetinthelongrun.Therefore,accountingpracticeisdrivenbytherequirementsofthemarketplace.18Inordertoobtainthecostreductiontoatargetcostlevel,companieshavetwooptions:19

1.Byintegratingnewmanufacturingtechnology,usingadvancedcostmanagement techniques such as activity-based costing and seeking higherprofitability.

2.Byredesigningtheproductorservice.

Targetcostingasaspecificcostingmethodisemployedinthesecondoption.Design phase is the most important phase in a product life cycle,because in the design phase the number and types of product features are

16) Garrison, R.H., Noreen, E.W. (2000), Managerial Accounting, Irwin – McGraw Hill.

17) Ibid.

18) Lucey, T. (1996), Management Accounting, Letts Educational, London.

19) Blocher, E.J., Chen, K.H., Cokins, G., Lin, T.W. (2005), Cost Management – A Strategic Emphasis, McGraw Hill – Irwin, New York.

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determinedusingcostandmarketconsiderations.20Therefore,themajorityofproductcostsaredeterminedinthedesignphase.Onceaproductisdesignedandgoneintomanufacturingprocess,itisverydifficulttofindwaystoreducecosts.21

3.1.2. The Implementation of Target CostingTheimplementationoftargetcostinginvolvesfivesteps:22

1.Determinethemarketprice(MP);2.Determinethedesiredprofit(DP);3.Calculatethetargetcost(TC)atmarketpricelessdesiredprofit

(TC=MP–DP);4.Usevalueengineeringtoidentifywaystoreducecost;5.Usekaizencostingandoperationalcontroltofurtherreducecosts.

For many companies market prices are usually determined onthe market by the influence of supply and demand. In modern businessenvironment,companieshavealittleinfluenceonmarketpricesornothaveatall.Therefore,theymustadjusttothemarketpricesinsteadofinfluenceonit.Inordertomakethatadjustment,companiesdefinethedesiredlevelofprofitanddeterminedthetargetcostonthebasisofmarketpriceanddesiredprofit.Oncethetargetcostisdefined,companiesareseekingwaysandopportunitiestoreduceactualcoststotargetcosts.Intheprocessofreducingactualcoststo targetcosts,companiesconductvalueengineering(in thecaseofanewproduct)orkaizencostingandoperationalcontrol(inthecaseofredesignedproducts).

20) Ibid.

21) Garrison, R.H., Noreen, E.W. (2000), Managerial Accounting, Irwin – Garrison, R.H., Noreen, E.W. (2000), Managerial Accounting, Irwin – Garrison, R.H., Noreen, E.W. (2000), Managerial Accounting, Irwin – McGraw Hill.

22) Blocher, E.J., Chen, K.H., Cokins, G., Lin, T.W. (2005), Cost Management – A Strategic Emphasis, McGraw Hill – Irwin, New York.

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Value engineering is used in target costing to reduce product costbyanalyzingthetrade-offsbetweendifferenttypesofproductfunctionality(differenttypesofproductfeatures)andtotalproductcost23.Theinitialstepinvalueengineeringistoconductconsumeranalysisduringthedesignphaseoftheneworrevisedproductinordertoidentifyproductfunctionsthatarepreferredanddesiredbytheconsumers.Basically,valueengineeringidentifiesthemostpreferableproductfunctionsbyitsconsumersandseeksforwaystoreduceproductcostsbutmaintaintherequiredlevelofproductquality.Thisisalldoneinthedesignphaseofaproduct,whenmostoftheproductcostscan be changed.Therefore, in the design phase value engineering has thepurpose to identifyvalue-addedandnon-value-addedcosts.Avalue-addedcostisacostthat,ifeliminated,wouldreducetheactualorperceivedvalueorutilityconsumersobtainfromusingtheproduct24.Ontheotherhand,non-value-addedcostisacostthat,ifeliminated,wouldnotreducetheactualorperceivedvalueorutilityconsumersobtainfromusingtheproduct.Itisacostthattheconsumerisunwillingtopayfor25.Inthevalueengineeringprocess,companies are trying to reduce both the value-added and non-value-addedcost.

While value engineering is oriented to product cost reductionduringthedesignphase,kaizen costingandoperationalcontrolarefocusedonproduct cost reductionduring themanufacturingproductphase.Kaizencosting means continuous improvement in order to reduce cost and toimprovemanufacturingprocesses and thequality of a product and servicei.e.toimproveproductivityandeliminatewaste26.Ifthemajorityofproduct

23) Ibid.

24) Horngren, C.T., Datar, S.M., Foster, G. (2003), Cost Accounting – A Managerial Emphasis, Prentice Hall, New Jersey.

25) Ibid.

26) Horngren, C.T., Datar, S.M., Foster, G. (2003), Cost Accounting – A Horngren, C.T., Datar, S.M., Foster, G. (2003), Cost Accounting – A Horngren, C.T., Datar, S.M., Foster, G. (2003), Cost Accounting – A Managerial Emphasis, Prentice Hall, New Jersey.

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costs (approximately85%)are locked inafter thedesignphase, therestoftheproductcostscanbechangedduringthemanufacturingphaseandotherproductphases.Kaizencostingistheongoingsearchfornewwaystoreducecosts in the manufacturing process of a product with a given design andfunctionality.27Cost reduction at themanufacturing phase can be obtainedwiththedevelopmentofnewmanufacturingmethodsandbytheapplianceof new management techniques such as operational control, total qualitymanagement and theoryof constraints.28Target costing andkaizen costingare two complementary methods whose basic aim is to reduce productcostbykeeping thedesired levelofproductqualityand functionality.Themajordifferencebetweenthesetwomethodsis theproductphaseatwhichthemethodisoriented;targetcostingisorientedonthedesignwhilekaizencostingisfocusedprimarilyonmanufacturingprocesses.

Targetcostingenabledynamicproductprofitabilityevaluation,sinceitisorientedtothefuture.Inthedesignphase,themajorityofproductcostsaredefined.Afterthedesignphase,itisverydifficulttoreducecostsfurther.Kaizencostingcan influenceonapproximately15%of totalproductcosts.Targetcostingisthecrucialmethodforproductcostdetermination,becauseitdeterminestheproductcostsforallsubsequentproductphases.Therefore,itrepresentstheformoffeedforwardcontrol29.

3.2. The Purpose and Application of Life-Cycle Costing3.2.1. The Concept and Purpose of Life-Cycle CostingWhiletraditionalcostingmethodsarefocusedonmanufacturingcosts

andallocationofindirectmanufacturingcostsonproducts,life-cyclecostingconsidersallcostsassociatewiththeproductduringitslifecycle.Thepurposeoflife-cyclecostingistoidentifythe„real“costsofaproductandtoenable

27) Blocher, E.J., Chen, K.H., Cokins, G., Lin, T.W. (2005), Cost Management – A Strategic Emphasis, McGraw Hill – Irwin, New York.

28) Ibid.

29) Lucey, T. (1996), Management Accounting, Letts Educational, London.

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thelongtermevaluationofproductprofitability.Therefore,life-cyclecostingcreatesabasisfordynamicproductprofitabilityevaluation.

Life-cycle costing identifies main activities associated with thecertainproductandtracesallcostsassociatedwiththatproductsduringtheperformanceofeachactivity.ThehelpfultoolindeterminingthecostsofanactivityisActivity-BasedCosting.TheapplianceofABCinlife-cyclecostinghasthepurposetoconnecteachcostassociatedwiththeproducttothecertainactivity involved in product realization.Thereat,ABC is not focused onlyon indirectmanufacturingcosts,butonallcosts,manufacturingaswellasnonmanufacturingcosts.

In today’s business environment, managers are more interestedin the total costs over the entire life cycle of a product30, rather than onlyin manufacturing product costs. Life-cycle costing provides more usefulcost information regarding products that traditional costing method sinceit considers all cost during the entire product life cycle. Therefore, costinformationoflife-cyclecostingprovidesthequalitativebasisforlongtermdecisionmakingregardingproductpricing,evaluatingproductprofitability,formingtheproductmix,eliminatingthenon-profitproductetc.

3.2.2. The Application of Life-Cycle Costing in Evaluating Product Profitability

Life-cycle costing provides the information of costs of a productduringtheeachphaseintheproductlifecycle.But,inordertoevaluatetheproductprofitability,revenuesarealsomustbetracedovertheproduct lifecycle. So, when evaluating product profitability, two important and verydifferentviewsof theproduct lifecyclemustbeconsidered:31 thecost lifecycleandsaleslifecycle.Thecostlifecyclegivesinformationaboutcostsofaproductduringits lifecycle.Thesales lifecycleprovides informationregardingsalesandrevenuesearnedfromsellingtheproductonthemarket.

30) Blocher, E.J., Chen, K.H., Cokins, G., Lin, T.W. (2005), Cost Management – A Strategic Emphasis, McGraw Hill – Irwin, New York.

31) Ibid.

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Therefore,thesaleslifecycleisthesequenceofphasesintheproduct’slifeinthemarketfromtheintroductionoftheproducttothemarket,thegrowthinsalesandfinallymaturity,declineandwithdrawalfromthemarket32.Thesaleslifecycleisfocusedonlyonmarketphasesovertheproductlifecycleand thus recognizes the followingphases:33 introduction, growth,maturity,declineandwithdrawalfromthemarket.

Sincethesaleslifecycleincludesonlymarketphasesoftheproductlifecycleandcostlifecycleallproductphases,theproductlifecyclefromtheviewpointofcostlifecycleandfromtheviewpointofsaleslifecyclearedifferedi.e.theproductlifecycleislongerfromtheviewpointofthecostlifecyclebecauseitincludesintoconsiderationproductphasespriortoitsmarketphase.

The evaluation of product profitability can be determined duringthemarketphasesoftheproductlifecycle,becauseinthesephasesproductearns revenues. Inallphasesprior to themarketphases,productgeneratesonlycostsandthereforecreatesloss.Butthesecosts,occurredinthephaseofresearchanddevelopmentaswellasinthedesignphasecouldbecoveredby the revenues during themarket phases of the product. Therefore, it isveryimportanttocombinecostandsaleslifecycleofaproductinordertodetermine theappropriate long termproductpricingpolicy. It isnecessaryto cover all costs associatedwith the certain products.Therefore, researchanddevelopmentcostsanddesigncostsoccurredintheproductphasespriorto themarketphaseshouldbecoveredby revenueearned fromselling theproductduringitsmarketphases.Productprofitabilityshouldbeevaluateddynamically, during the whole product life cycle. Dynamical productprofitability evaluation enables the identification of the real contributionof a certainproduct to thecompany’s incomeandprofitability. Inorder toset up the appropriate price of a product in the certain product phase, thecorresponding costs need to be considered aswell as the situation on theproduct market. Usual pricing policy in the appropriate product phase isshowninthefollowingtable.

32) Ibid.

33) Ibid.

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Table1.PricingPolicyAccordingtotheSalesLifeCyclePhase

Sales Life Cycle Phase

Market Situation

Costs of a Product Pricing Policy

IntroductionLittlecompetition,Salesincrease

Highcosts(duetoR&Dcosts,manufacturingcostsandmarketingcosts

Highprice(becauseofdemandanddifferentiation)

Growth

Rapidsalesincrease,competitionincreases

Highcosts(duetodifferentiation,innovationandperformance)

Highprice(becauseofdemandanddifferentiation)

Maturity

Slowersalesincrease,competitiondeclines,requiredqualityandfunctionalityofaproduct

Costcontrol,qualitycostsoccurs

Pricefallsandissetbyacompetitivemarket

DeclineSalesdecline,competitiondeclines

Costcontrol,costreduction Lowprice

Source:Blocher,E.J.,Chen,K.H.,Cokins,G.,Lin,T.W.(2005),CostManagement–AStrategicEmphasis,McGrawHill–Irwin,NewYork.

Strategic (long term) pricing policy changes over the product lifecycle. In thefirstphase,price is set at the relativelyhigh level inorder torecover high research and development costs aswell as to take advantageof product differentiation and the new demand for the product.34 In the

34) Blocher, E.J., Chen, K.H., Cokins, G., Lin, T.W. (2005), Cost Management – A Strategic Emphasis, McGraw Hill – Irwin, New York.

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secondphase,price is still setathigh levelbecause thecompany is tryingto increase income and profitabilitywith the new product on the growingmarket.Inthethirdphase,pricebeginstofallandissetatthemarketlevel.In this phase company conducts cost control in order to keep the desiredlevel of profitability without jeopardising product quality. Finally, in thefourthphase,priceissetat therelativelylowlevel.Inthisphasecompanyistryingtoextendproductlife.Thekeypointforproductsurvivalisthecostreductionaswellastheeffectivedistributionnetwork.Targetcostingandlifecyclecostingareusedinthethirdandfourthphaseinordertoenablecostreductionsincethecompanyhasnolongerinfluenceontheproductprice.35

4. The Integration of Static and Dynamic Approach of Cost

ManagementInordertoobtainfairandobjectiveevaluationofproductprofitability,

bothstaticanddynamiccostmanagementapproachesneedtobecombined.Traditionalcostaccountingmethods(suchasjobordercostingandprocesscosting)weredevelopedinthetimeofindustrialrevolutionwhenthemostdesirable informationby themanagerswas informationofproductcost. Inthattime,themajorityoftotalcostsweredirectmanufacturingcosts,whiletheothercosts(indirectmanufacturingcosts,saleandadministrativecosts)didnot take thehighportion in total costs.So, traditional cost accountingmethodswere,andstillare,focusedprimarilyonmanufacturingcostsandthewaythat indirectmanufacturingcostsareallocatedonproductsorservices(cost object). Since indirect manufacturing costs were not significant, theallocationofindirectmanufacturingcostswerebasedoncertaincostallocationbase that links indirect manufacturing costs with manufacturing process(suchasdirectlabourhours,machinehoursetc.).But,businessconditionsanenvironmenthavesignificantlychangedduetotheinnovation,competition,automationofproductionprocesses,globalizationaswellasthechangesinconsumer’spreferencesanddesires.Today’sbusinessconditionsarecomplex

35) Ibid.

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and turbulent. Companies don’t have any or have a very small influenceonmarketpricesandarepermanentlyunderpressureofcostreductionandkeepingthedesirablelevelofproductqualityinordertosatisfyconsumer’spreferences.Thesenewbusinessconditionschangedthemanager’sneedsforinformationwhichledtothedevelopmentandimplementationofnewcostingmethods.Traditionalcostaccountingmethodscanprovidethestaticproductprofitabilityevaluationi.e.theycanprovidetheinformationregardingthecostofaproductinacertainaccountingperiod.Thisinformationissufficientformanagersinstaticbusinessenvironmentandforshort-termdecisionmaking.But,inmodernbusinessenvironment,thisinformationisinsufficient.Inordertoobtaincostoptimizationandmaintainthedesirablelevelofproductquality,managersrequireinformationabouttotalcostsnotonlymanufacturingcosts.Traditional costing methods, which are focused on manufacturing costsand determination of cost of a product, couldn’t provide appropriate costinformationinmodernbusinessenvironment.Thefirstsignificantchangeincosting systemswas done by the implementation ofABC (ActivityBasedCosting). Due to the automation of manufacturing processes, the coststructure of manufacturing companies has dramatically changed. Directlabourcostshavesignificantlydecreased36oreliminatedatall,butatthesametimetheportionofindirectmanufacturingcostshavesignificantlyincreased.The problem that occurredwas the following: how to achieve the reliableallocationofindirectmanufacturingcoststoproductsorservices?ThesolutioncameupwithABCmethod.ABCrequiresthatindirectmanufacturingcostsneed to be allocated on activities in themanufacturing and then allocatedfromtheactivitiestoproductonthebasisofproductconsumptionofcertainactivity.37Theallocationofcostsfromactivitiestoproductswerecarriedoutthrough the appropriate cost driver which linked the activity with certainproduct i.e.which indicated the product usage of certain activity. InABC

36) Lucey, T. (1996), Management Accounting, Letts Educational, London.

37) ) Horngren, C.T., Datar, S.M., Foster, G. (2003), Cost Accounting – A Managerial Emphasis, Prentice Hall, New Jersey.

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method, indirectmanufacturing costs are allocated to products or servicesthroughlargenumberofcostdrivers,notbyonecostallocationbaselikeintraditionalcostingsystems.Thatenabledthemorereliabledeterminationofproductcostsandbroughtbackmanager’sconfidenceincompany’scostingsystem.Evaluationofproductprofitabilitywith theapplianceofABCwasmoreaccurateandreliablethanwithtraditionalcostingmethods.ABCwasacertainrevolutionincostandmanagerialaccounting(andincostingsystemsofcompaniesaswell)anditwasalinkbetweenstaticanddynamicapproachofcostmanagementandproductprofitabilityevaluation.

The implementation of ABC was a first step to modern costmanagement and to dynamic evaluation of product profitability.ABCwasfirstlyfocusedonmanufacturingprocessandhadthepurposetoprovidetheobjectiveallocationofindirectmanufacturingcoststoproducts.InordertoapplyABCatthelevelofthewholecompany,allrelevantactivitieswithinthecompanyshouldbedeterminedandeverycostthatoccursinthecompanyshouldbelinkedorallocatedtocertainactivity(oractivities).ThepurposeofapplyingABCtowholecompanyistoidentifythecostofacertainactivityi.e. to identifywhichactivitiesgenerate thehighcosts.The informationofactivitycostsisveryusefulformanagerstryingtoreduceortooptimizecosts.TracingcoststoactivitiesenabledABM(ActivityBasedManagement).Duetotheinformationaboutthecostofacertainactivity,managerscandecidewhichactivityshouldbemaintainedwithinthecompanyandwhichshouldbeoutsourced.ABCi.e.ABMenablestheimplementationofmoderncostingmethods such as Target costing and Life-Cycle Costing. Modern costingmethods(costmanagementmethods)arefocusedonallcostsassociatedtoproduct or services, not only onmanufacturing costs. Due to themodernbusinessconditions,managersarenowinterestedintotalcostsofaproduct,manufacturingandnonmanufacturing.Staticproductprofitabilityevaluation,obtained with traditional costing methods, can be relevant for short termdecision making, not for long term. Managers require the information ofproductprofitability through thewholeproduct life,because thatway theycan evaluate which products have the greatest contribution to company’s

income. Static product profitability evaluation doesn’t provide the wholepicture about the product’s contribution to company’s income since it isoriented toonespecificaccountingperiod(usuallyoneyear).On theotherside,dynamicproductprofitabilityevaluationconsidersallcostsassociatedwithproductfromresearchanddevelopmenttowithdrawalfromthemarketandallrevenuesproductearnsthroughitslife,enablingthereforethemoreclearer andmore reliablepictureofproductprofitability and its impactoncompany’s income.But, staticanddynamicproductprofitabilityshouldbecombined.

Figure4.Staticvs.DynamicCostManagementApproach

Although static product profitability evaluation is focused onmanufacturingproducts,itcanindicatethephaseofaproductlifeinwhicha certain product is. Besides, static approach of cost management mustexistbecauseofexternalfinancial reporting.Dynamicproductprofitabilityevaluationprovidemanagementwiththeinformationofproductprofitabilitythroughitswholelifeenablingtheusefulbasisforlongtermdecisionmaking

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Static Cost Management

Approach

Job Order Costing Process Costing Activity Based

Costing

Static Product Profitability Evaluation

Dynamic Cost Management

Approach

Activity Based Costing / Activity

Based Management Target Costing

Life Cycle Costing

Dynamic Product

Profitability Evaluation

regarding theproductprices,productionquantity,productmixetc.Costingmethods used for dynamic product profitability evaluation are partially onABCwhichcanbeusedforboth,staticanddynamicevaluationofproductprofitability. In static costmanagement approach,ABC is used in order todetermine the appropriate cost of a product. In dynamic costmanagementapproachABC(orABM)isusedinordertodeterminethecostofacertainactivitywithin a companywhich afterwards can be used in target costingaswellasinlife-cyclecosting.Targetcostingdeterminesthetargetcostofaproductwhich includes the targetmaterialcost, target labourcost, targetindirectmanufacturingcost,targetsaleanddistributioncost.Targetindirectmanufacturing and nonmanufacturing costs can be determine accordingto activities and in such determinationABC/ABM has the key role. Thecomparison of actual activity cost (determined byABC/ABM) and targetactivitycostindicatewhetherthecostofactivityiswithinthetargetedlevel.ABC/ABMcanbeusedinlife-cyclecostingaswell.Sincelife-cyclecostingconsidersallcostassociatedwithproductswithinthewholeproductlife,thismethod requires the identification of all activities associatedwith productthroughitslifeandtracingcostaccordingtoidentifiedproductactivitieswithintheproductlife.ABCisausefultoolforidentificationofproductactivitiesandfortracingcostsassociatedwithcertainproductactivity.ThereforeABCenablesthemorequalitativeimplementationoflife-cyclecosting.

Staticanddynamiccostmanagementapproachislinkedandthereforecompatible.Dynamicproductprofitabilityevaluationcanbeprovidedonlyif static product profitability evaluation is based on appropriate costingmethods.Forthepurposeofdecisionmakingprocessregardingtheproductprices,productmix,eliminatingtheproductline,managersmustconsideredboth,staticanddynamicevaluationofproductprofitability.Accordingtothis,thecompanyshouldhaveimplementedandintegratedstaticanddynamiccostmanagementapproach.

Staticcostmanagementapproach(representedbyjobordercosting,process costing andABC) is focused primarily on manufacturing. Targetcosting as onemethod of dynamic costmanagement approach id focused

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primarilyondesign,becausein thisactivity themajorityofothercostsaredeterminedandthereforelockedin38.LifecyclecostingcombinedwithABC/ABMisfocusedonallactivitiesassociatedwithaproductduringitslife.

5. ConclusionThis paper is dealing with static and dynamic cost management

approachesand their impactonproductprofitabilityevaluation.Staticcostmanagement approach is based on traditional cost accounting methodsandABC whose focus was on manufacturing costs and ways of indirectmanufacturing costs allocation to products or services. The basic purposeof traditional cost accounting methods is the determination of cost of aproduct and evaluation of product profitability.When business conditionsandenvironmenthavechangedduetoautomation,innovation,competition,globalizationandchangesinconsumer’spreferenceswhichledtotheincreaseofindirectmanufacturingcosts,traditionalcostaccountingmethodsbecameinappropriate for product cost determination and therefore for productprofitability evaluation. In order to achieve more reliable product costs,ABCisintroduced.ABCtracesindirectmanufacturingcoststoactivitiesandthenallocatesthesecostsfromactivitiestoproductsaccordingtoidentifiedcostdrivers.ABCmethodaccomplisheditspurposeofreliableproductcostdetermination.Afterwardsthismethodisusedfordeterminationofactivitycosts within the whole company, which enables the implementation ofdynamiccostmanagementapproach.Dynamiccostmanagementapproachisrepresentedbytargetcostingandlifecyclecosting.Targetcostingdeterminesthe target cost of a product basedon anticipatedmarket prices.Life cyclecosting is focusedon all costs associatedwith aproduct during thewholeproductlife.

Inordertoobtainthequalitativeevaluationofproductprofitability,both, static and dynamic evaluation of product profitability should be

38) Horngren, C.T., Datar, S.M., Foster, G. (2003), Cost Accounting – A Managerial Emphasis, Prentice Hall, New Jersey.

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considered.Dynamic evaluationof product profitability considers all costsassociatedwithcertainproduct,manufacturingandnonmanufacturing.Staticevaluation of product profitability considers only manufacturing costs. Inmodern business environment, managers are interested in total costs of aproduct (manufacturing and nonmanufacturing costs).Dynamic evaluationof product profitability enables the identification of productwhich has thegreatestcontributiontocompany’sincome.Managersrequireinformationofproductcostsandrevenuesthroughthewholeproductlife.Therefore,theycandeterminetherealproductprofitability.Althoughstaticevaluationofproductprofitability refers to the particular accounting period, it is useful in ordertodeterminethephaseinwhichacertainproduct in.Thecompletepictureregardingproductprofitabilityevaluationcanbeachieveonlybyintegrationofstaticanddynamiccostmanagementapproachi.e.bycombiningthestaticanddynamicevaluationofproductprofitability.

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