FDM5 Strategic cost analysis 1 Strategic cost analysis 1

FDM5 Strategic cost analysis 1 Strategic cost analysis 1 The purpose of costing The ‘traditional approach’ – Marginal costing – Absorption costing Activity based costing Reading: Management Accounting for Business chapters 7 and 8

FDM5 Strategic cost analysis 1 The purpose of costing Provides information for decision making Provides a basis for pricing Allows organisations to distinguish between profitable and unprofitable activities Provides information for performance management

FDM5 Strategic cost analysis 1 Marginal costing Also referred to as variable or direct costing Considers only variable cost at product level Treats all overheads incurred as ‘period’ costs not related to specific product Avoids problem of how to share out overhead costs May be appropriate for short-term decision making Difficult to assess profitability of specific products – Especially where overheads are high proportion of costs Conflict with external reporting requirements

FDM5 Strategic cost analysis 1 Absorption costing Also known as ‘full costing’ Aim to estimate and report full cost of product or service – Measure direct costs – Share out overheads Absorption - process of recovering (paying for) production overheads Aim to recover (absorb) all overheads over total planned production Question is always: – How should the overheads be shared? – Most common method – sharing out overheads according to direct labour hours per product

FDM5 Strategic cost analysis 1 Issues with absorption costing Cost estimate depends on basis for absorption Makes assumptions about overhead usage Based on past costs Doesn’t accurately assess an increasingly large proportion of costs Doesn’t include non-manufacturing overheads – Cover by adding profit margin? – Use a different method of relating them to products?

FDM5 Strategic cost analysis 1 Alternative costing approaches Aim – understand costs better in order to manage and make decisions more effectively Activity based costing – alternative to absorption costing Lifecycle costing Target costing Kaizen costing Quality costs Environmental accounting

FDM5 Strategic cost analysis 1 Activity based costing – key concepts All overheads are variable in long run Some variable in short run Overheads do not necessarily vary with production quantity Activities consume resources Consumption of resources drives costs Direct labour and machine hours do not drive overheads in many cases The relationship between activities and products is essential for managing overheads Absorbing costs on volume basis may be misleading

FDM5 Strategic cost analysis 1 ABC – the steps Identify activities which consume resources and incur overheads – cost pools Allocate overheads to cost pools – no arbitrary apportionment Determine cost driver for activity / cost pool Collect data about actual activity for cost drivers Calculate overhead cost of products or services – Calculate overhead cost per unit of cost driver – Charge overhead costs to products or services on basis of activities used for each product or service

FDM5 Strategic cost analysis 1 Advantages of ABC Provides better understanding of what drives overhead costs Important when indirect costs high compared with direct costs Provides realistic information on significant proportion of total costs Enables overhead cost control through managing cost drivers Can be applied to all overheads, not just production costs Can be used in service businesses

FDM5 Strategic cost analysis 1 Disadvantages of ABC May be difficult to identify activities and cost drivers Based on simplification – may be difficult to allocate all costs to specific activities Can be difficult to understand May become very complex and expensive to implement

FDM5 Strategic cost analysis 1 How can ABC be used? Range of cost management applications Cost reduction Budgeting Performance measurement Benchmarking Process management and improvement Pricing