Welcome to Alternative Cost Accounting!
Hi there! If you’ve already studied Absorption Costing and Marginal Costing, you might be wondering: "Why do we need more ways to calculate costs?"
Well, the business world is changing. In the past, most costs were just labor and materials. Today, things are more complex—we have high technology, massive research costs, and global competition. This chapter introduces modern techniques designed to give managers more accurate information for making smart decisions. Don’t worry if some of these names sound intimidating; we’re going to break them down into simple, everyday ideas!
1. Activity-Based Costing (ABC)
Traditional costing (like Absorption Costing) often dumps all "overhead" costs into one big bucket and spreads them out based on something simple, like labor hours. But is that fair? If one product uses a complicated machine and another doesn't, should they both pay the same for "factory costs"?
Activity-Based Costing (ABC) says "No!" It tries to be more accurate by linking costs to the activities that actually cause them.
Key Terms to Know:
Cost Pool: A "bucket" where we group costs related to a specific activity (e.g., all costs related to "Setting up machines").
Cost Driver: The factor that causes the cost to change (e.g., the "Number of setups" is what drives the cost in that pool).
An Everyday Analogy:
Imagine you go out to dinner with three friends. Two friends order water and a side salad, but the third friend orders a steak and three expensive cocktails. If you split the bill equally (Traditional Costing), you are subsidizing the friend who ate the steak! ABC is like getting an itemized bill where everyone pays exactly for what they ordered.
How to do ABC (Step-by-Step):
1. Identify the major activities (e.g., Quality Inspections).
2. Assign costs to those activities to create Cost Pools.
3. Identify the Cost Driver for each activity (e.g., Number of inspections).
4. Calculate a Cost Driver Rate: \( \text{Cost Driver Rate} = \frac{\text{Total Cost in Pool}}{\text{Total Number of Drivers}} \)
5. Assign the costs to products based on how much of that driver they used.
Quick Review: ABC is more accurate for complex businesses with high overheads, but it can be expensive and time-consuming to set up!
2. Target Costing
In traditional costing, we usually say: "It costs \$10 to make, and we want a \$2 profit, so we will sell it for \$12." This is Cost-Plus Pricing.
\nTarget Costing flips this upside down. In a competitive market, the customers decide the price. If the market says a phone is worth \$500, you can't just charge \$600 because your costs are high.
\n\nThe Formula:
\n\( \text{Target Cost} = \text{Target Selling Price} - \text{Target Profit} \)
\n\nWhat is a "Cost Gap"?
\nIf your Estimated Cost to make the product is higher than your Target Cost, you have a Cost Gap.
\nExample: If the market price is \$100 and you want \$20 profit, your Target Cost is \$80. If your engineers say it will cost \$95 to make, your Cost Gap is \$15. You must find ways to close this gap (e.g., using cheaper materials or simplifying the design) before production starts.
Key Takeaway: Target Costing happens at the design stage. It’s much easier to change a product's cost while it's still a drawing on a computer than after the factory has started building it!
3. Life Cycle Costing
Most traditional systems only look at the cost of making a product. Life Cycle Costing tracks costs from the very beginning (cradle) to the very end (grave).
The Stages of a Product Life Cycle:
1. Design/Development: High costs, no revenue yet.
2. Introduction: High marketing costs, low sales.
3. Growth: Sales increase, profit starts to happen.
4. Maturity: Sales peak, costs are stable.
5. Decline: Sales fall, costs might include disposal or decommissioning.
Why use it?
Imagine buying a car. A "cheap" car might have a low purchase price but high fuel and repair costs. A "total life cycle" view helps you see that the "expensive" electric car might actually be cheaper over 10 years. Businesses use this to ensure a product is profitable over its entire life, not just during the manufacturing phase.
Did you know? Up to 80% of a product's total life cycle costs are "locked in" during the design stage. If you design a product that is hard to repair, you’ve already decided it will have high maintenance costs later!
4. Throughput Accounting
This technique is used in modern factories that use "Just-in-Time" (JIT) systems. It focuses on how quickly a business can turn raw materials into cash from sales.
The Golden Rule of Throughput:
In Throughput Accounting, we assume only Direct Materials are truly variable. Labor and other overheads are considered fixed (because we pay workers even if they are standing still).
Key Formula:
\( \text{Throughput} = \text{Sales Revenue} - \text{Direct Material Cost} \)
The "Bottleneck":
Every factory has a bottleneck—one machine or process that is slower than everything else. Throughput Accounting tells us that because the bottleneck limits the whole factory, we should focus on making the bottleneck as efficient as possible.
Memory Aid: Think of a bottle of water. No matter how wide the bottom of the bottle is, the water can only come out as fast as the neck allows. That's your bottleneck!
5. Environmental Accounting
Modern businesses can't ignore the planet. Environmental Accounting is about identifying and managing the costs of a business's impact on the environment.
Why is this tricky?
Environmental costs are often "hidden" in general overheads. For example, the cost of disposing of toxic waste might be buried in a "General Cleaning" budget. Environmental accounting pulls these costs out so managers can see them clearly.
Types of Environmental Costs:
1. Internal Costs: Costs the company pays directly (e.g., waste disposal fees, buying "green" materials).
2. External Costs: Costs the company imposes on society (e.g., air pollution) that they might not pay for yet, but might face through future taxes or fines.
Quick Summary: By tracking these costs, companies can improve their reputation, follow laws, and often save money by reducing waste.
Final Tips for the Exam
1. Don't mix up the formulas! Remember that Target Costing starts with the Price, while Throughput focuses on Materials.
2. Read the scenario: If the question mentions "many different activities" or "complex overheads," think ABC. If it mentions "the design stage," think Target Costing.
3. Stay Calm: These concepts are just tools to help managers make better decisions. If you understand the reason for the tool, the math becomes much easier to remember!