Life-cycle costag estimations and accumulates costs over a merchandise ‘s full life rhythm in order to find whether the net incomes earned during the fabrication stage will cover
the costs incurred duing the pre- and post-manufacturing phases. Identifying the costs
incurred during the diferent phases of a merchandise ‘s life rhythm provides an penetration into
apprehension and pull offing the sum costs incurred throughout its life rhythm. In peculiar,
life-cycle costing helps direction to understand the cost effects of developing
and doing a merchandise and to place countries in which cost decrease eforts are likely to be
Figure illustrates a typical form of cost committedness and cost incurrence during
the three phases of a merchandise ‘s life rhythm – the planning and design phase, the fabrication
phase and the service and abandonment phase. Committed or locked-m costs are those
costs that have non been incurred but that will be incurred in the hereafter on the footing of
determinations that have already been made. It is hard to signiicantly change costs ater they
have been committed. For illustration, the merchandise design speciications determine a merchandise ‘s
stuff and labor inputs and the production procedure. At this phase costs become
committed and loosely find the hereafter costs that will be incurred during the
An apprehension of life-cycle costs and how they are committed and incurred at diferent
phases throughout a merchandise ‘s life rhythm led to the outgrowth of mark costSeg, a technique
that focuses on pull offing costs during a merchandise ‘s planning and design stage.
Phase 1: Determine the mark pice which clients will be prepared to pay for
Phase 2: Deduct a mark proit border rom the mark pice to find the mark cost
Phase 3: Estimate the existent cost of the merchandise.
Phase 4: If estimated existent cost exceeds the mark cost investigate ways of plunging
down the existent cost to the mark cost.
The early adoptive parents of acivity-based costing ( ABC ) used it to bring forth moe accurate merchandise ( or service ) costs but it shortly became appaent to the users that it could be extended beyond puely merchandise bing to a scope of cost direction applications. The footings actiiviitty-ased mmannageinnieimt ( ABM ) or aictnvBty-Ibaised cost nmaimageiimeiiit ( ABCM ) ae used to descibe the cost direction applicaions of ABC.
separating characteristic of ABM coverage is that it oten studies information on aciviies
that cross departmental boundaies. For illustration, diferent producion sections and the
distribuion section might set about client processing acivities. They may decide
client jobs by hastening late bringings. The inance section may measure
client recognition worthiness and the staying client processing acivities might be
undertaken by the client service section. Therefore the entire cost of the client
processing activity could be well in surplus of the costs that are assigned to the
client service section. However, to simplify the pesentaion it is assumed in
Exhibit 15.1 that the departmental and acivity costs are idenical but if the cost of the
client order processing acivity was found to be, state, three times the sum assigned to
the client service section, this would be of import informaion because it may
alter the manner in which the directors view the acivity. For illustration, the directors may
give more attenion to evoking the costs of the client processing acivity.
It is evident rom an scrutiny of Exhibit 15.1 that the ABM attack provides more meaningful information. It gives more visibleness to the cost of set abouting the acivities that make up the organizaion and may raise issues for direction acion that are non highlighted by the traditional analysis. For illustration, why is & A ; lb ; 90000 spent on deciding client jobs? Attention-diecting informaion such as this is of import for pull offing the cost of the aciviies.
Johnson ( 1990 ) suggests that cognizing costs by activiies is a accelerator that finally tiggers the acion necessary to go compeiive. See a state of affairs where sales¬ individuals, as a consequence of bing activiies, are informed that it costs & A ; lb ; 50 to treat a client ‘s order. They theefore become awae that it is quesionable to prosecute orders with a low gross revenues value. By extinguishing many little orders, and concentrating on larger value orders, the demand for customer-processing activiies should die, and future spend¬ ing on this acivity should be reduced.
464 COST MANAGEMENT AND STRATEGIC MANAGEMENT ACCOUNTING
Pior to the introducion of ABM most organizaions have been incognizant of the cost of
set abouting the activiies that make up the organizaion. Knowing the cost of acivities
enables those aciviies with the highest cost to be highlighted so that they can be
pioitized for elaborate surveies to determine whether they can be eliminated or performed
more expeditiously. To place and pioitize the potency for cost decrease many organiza¬
ions have fouia* it utile to sort aciviies as either value added or non-value added.
Deiniions of what constitutes value added and non-value added acivities vary. A
common deinition is that a valune added activity is an activity that clients perceive
as adding utility to the merchandise or service they purchase. For illustration, painting a auto
would be a value added acivity in an organizaion that manufactures autos. Other
deinitions are an activity that is being performed every bit eficiently as possible or an activity
that supports the primary aim of bring forthing end products.
In contrast, a aoM-vakiie added activity is an acivity where there is an chance for
cost reducion without cut downing the merchandise ‘s service potency to the client. Examples
of non-value added aciviies include inspecting, hive awaying and traveling natural mateials. The
cost of these aciviies can be reduced without cut downing the value of the merchandises to the
clients. Non-value added aciviies are basically those activiies that clients should
non be expected to pay for. Reporting the cost of non-value added aciviies draws
direction ‘s attending to the huge sum of waste that has been tolerated by the
organisation. This should pioitize those aciviies with the greatest potency for cost
decrease by extinguishing or transporting them out more efectively, such as cut downing mateial
motions, bettering production depressions and taking acions to cut down stock degrees. Taking
acion to cut down or extinguish non-value added aciviies is given top pioity because by
making so the organizaion for good reduces the cost it incurs without cut downing the value
of the merchandise to the client.
Kaplan and Cooper ( 1998 ) citicize the classiication of aciviies by simplisic value
added and non-value added categoies. They point out, that apart rom the extreme
illustrations similar to the 1s illustrated above, people can non systematically deine what
constitutes a value added or non-value added acivity. To reenforce this point they discuss
whether the activity of puting up a machine is value added or non-value added. One position
is that clients do non comprehend executing set-ups as adding usefulness to merchandises and
the acivity is non-value added. However, without set-ups a works can merely bring forth individual
merchandises. If clients value customized or diverse merchandises, altering machine scenes
rom the ability to bring forth diferent merchandise vaieies creates value for clients. Kaplan
and Cooper besides point out the demoivating impact when employees are informed that they
are executing non-value added acivities.
To get the better of the above jobs Kaplan and Cooper advocate that alternatively of utilizing a
value added/non-value added classiication the undermentioned simple ive point graduated table should be
used to summaize an ABC undertaking squad ‘s initial opinion about the current eiciency of
1. extremely eicient, with small ( less than 5 % ) apparent chance for betterment ;
2. modestly eicient, some ( 5-15 % ) chance for betterment ;
3. mean eiciency, good opportuniies ( 15-25 % ) for betterment ;
4. ineicient, major chances ( 25-50 % ) for betterment ;
5. extremely ineicient, possibly should non be done at all ; 50-100 % chance for
By placing the cost of acivities that make up their organizaion and sorting them
into the above ive classs, opportuniies for cost decrease can be pioitized. Cost
reducion can be achieved by either extinguishing the activiies, executing them more
COST MANAGEMENT 465
eiciently with fewer organizaional resources or redesigning them so that they are performed in an enirely diferent and more cost eicient manner. We shall see how acivities can be redesigned subsequently in the chapter.
Our treatment so far has related to the application of ABM during the fabrication
or service stage of a merchandise ‘s life rhythm. However, some organizaions have used their
acivity-based bing systems to act upon future costs at the design phase within the mark
bing procedure. For illustration, the Tektronix Portable Instruments Division assigned
mateial support disbursals utilizing a individual cost diver-number of portion Numberss. The
company wanted to promote design applied scientists to concentrate their attending on cut downing the
figure of portion Numberss, parts and sellers in future generaions of merchandises. Merchandise
seasonableness was seen as a citical success factor and this was facilitated by designs which
simpliied parts procurance and production procedures. The cost system moivated
applied scientists to plan simpler merchandises necessitating less development clip because they had
fewer parts and portion Numberss. The cost system designers knew that most of the mateial
support disbursals were non incurred in direct proporion to the individual cost frogman chosen,
but the simpliied and imprecise cost system focused attending on factors deemed to be
most citical to the division ‘s future success.
A study of acivity-based costing applications by Innes and Mitchell ( 1995a ) indicated
that many organisations use cost frogman rates as a step of cost eiciency and
public presentation for the activity concerned. The cost driver rate is computed by spliting
the activity costs by the cost frogman volume. For illustration, if the cost of treating 10000
purchase orders is & A ; lb ; 100000, the cost per buying order is & A ; lb ; 10. Assume now that
betterments in processs in the buying activity enable costs to be reduced to
& A ; lb ; 80000. If the same figure of orders can be processed with fewer resources the cost of
treating an order will be reduced to & A ; lb ; 8. Coverage and concentrating on cost frogman rates can
therefore be used to moivate directors to cut down the cost of executing acivities.
There is a danger, nevertheless, that cost frogman rates can promote dysfunctional
behavior. An betterment in the cost frogman rate can be achieved by dividing some
purchase orders and increasing the orders processed to, state, 12 000. Assuming that the cost
of the acivity remains unchanged at & A ; lb ; 100000 the cost per buying order will be
reduced read-only memory & A ; lb ; 10 to & A ; lb ; 8.33 if all costs are ixed in the short term. The overall efect is that
the work load will be increased and, in the long term, this could ensue in an addition in
costs. Care should hence be taken to avoid these dysfunctional effects by utilizing
cost frogman rates as feedback informaion to steer employees in bettering the eiciency of
executing activiies. If the steps are interpreted in a recriminatory or threatening
mode, there is a danger that they will take to dysfunctional behavior.
Business procedure re-engineering
BtmsDimess procedure jre-engimeernmg involves analyzing concern procedures and doing substanial alterations to how the organizaion presently operates. It involves the redesign of how work is done through aciviies. A concern procedure consists of a collecion of activiies that are linked together in a coordinated mode to accomplish a speciic aim. For illustration, mateial handling might be classed as a concern procedure dwelling of separate aciviies associating to scheduling production, hive awaying mateials, treating purchase orders, inspecting mateials and paying providers.
The purpose of concern procedure re-engineering is to better the key concern procedures in
an organisation by concentrating on simpliicaion, cost decrease, improved quality and
enhanced client satisfaction. See the mateials managing procedure outlined in the
above paragraph. The procedure might be re-engineered by directing the production agenda
466 COST MANAGEMENT AND STRATEGIC MANAGEMENT ACCOUNTING
direct to nominative providers and come ining into contractual understandings to present the mateials in conformity with the production agenda and besides vouching their quality by inspecting them pior to bringing. The terminal consequence might be the riddance, or a lasting decrease, of the storing, buying and review aciviies. These aciviies are non-value added activiies since they represent an chance for cost decrease without cut downing the merchandises ‘ service potencies to clients.
A distinguishing characteristic of concern procedure re-engineering is that it involves extremist
and dramaic alterations in procedures by abandoning current patterns and reinventing
wholly new methods of executing concern procedures. The focal point is on major alterations
instead than fringy betterments. A farther illustration of concern procedure e-engineering
is traveling rom a traditional functional works layout to a just-in-time cellular merchandise layout
and following a just-in-time doctrine. Adopting a just-in-time ( JIT ) system and
doctrine has of import implicaions for cost direction and public presentation coverage.
It is hence of import that you understand the nature of such systems and how they difer
rom tradiional systems, but instead than diverting at this point rom our treatment of cost
direction the descipion of a JIT system will be deferred unil the terminal of the chapter.
Cost of quality
To vie successfully in today ‘s planetary competiive environment companies are
going ‘customer-diven ‘ and doing client saisfacion an overiding pioity.
Customers are demanding ever-improving degrees of service sing cost, quality,
dependability, bringing and the pick of innovaive new merchandises. Quality has become one
of the cardinal compeitive variables and this has created the demand for direction comptrollers
to go more involved in the proviso of informaion associating to the quality of merchandises
and services and activiies that produce them. In the UK quality related costs have been
reported to run rom 5 to 15 % of entire company gross revenues gross ( Plunkett et ai, 1985 ) .
Extinguishing infeior quality can therefore consequence in substanial nest eggs and higher grosss.
Entire qanaMiry maaiinmgeinmeioit ( TQM ) , a term used to descibe a situaion where all
concern maps are involved in a procedure of uninterrupted quality betterment, has been
adopted by many companies. TQM has broadened, rom its early concentration on the
staisical monitoring of fabrication procedures, to a customer-oiented procedure of
uninterrupted betterment that focuses on presenting merchandises or services of consistent
high quality in a timely manner. In the 1980s most European and Ameican companies
considered quality to be an addiional cost of fabrication, but by the terminal of the decennary
they began to recognize that quality saved money. The doctrine of stressing producion
volume over quality resulted in high degrees of stocks at each production phase in order to
protect against deficits caused by infeior quality at old phases and inordinate
outgo on inspecion, rework, bit and guarantee fixs. Companies discovered that
it was cheaper to bring forth the points right the irst clip instead than blowing resources by
doing deficient points that have to be detected, eworked, scrapped or returned by
Management accounting systems can assist organizaions accomplish their quality ends by
supplying a vaiety of studies and steps that moivate and evaluate manageial eforts
to better quality. These will include inancial and non-inancial steps. Many
companies are presently non cognizant of how much they are passing on quality. Directors
demand to cognize the costs of quality and how they are altering over clip. A cost of quality
study should be prepared to bespeak the entire cost to the organizaion of bring forthing
merchandises or services that do non conform with quality demands. Four categoies of
costs should be reported.
COST MANAGEMENT 467
1. FreveimtEOE costs are the costs incured in forestalling the producion of merchandises that
make non conform to speciicaion. They include the costs of prevenive care,
quality planning and preparation and the excess costs of geting higher quality raw
2. Appraisal! costs are the costs incurred to guarantee that mateials and merchandises run into
quality conformity criterions. They include the costs of inspecting purchased parts,
work in procedure and inished goods, quality audits and ield trials.
3. Innemmall failure costs are the costs associated with mateials and merchandises that fail to
meet quality criterions. They include costs incurred before the merchandise is despatched to
the client, such as the costs of bit, fix, downtime and work arrests caused
4. Extenal faioire costs are the costs incurred when merchandises and services fail to
conform to demands or saisfy client demands ater they have been delivered.
They include the costs of managing client ailments, warranty replacing, fixs
of returned merchandises and the costs aising rom a damaged company repute. Costss
within this class can hold a dramaic impact on future gross revenues.
Exhibit 15.2 nowadayss a typical cost of choice study. Note that some of the points in the
study will hold to be estimated. For illustration, included in the external failure costs
class is the forgone contibuion read-only memory lost gross revenues aising read-only memory hapless quality. This cost is
highly dificult to gauge. Nevertheless, the lost contibution can be significant and it
is preferred to include an estimation instead than exclude it rom the study. By showing each
class of costs as a per centum of gross revenues grosss compaisons can be made with old
peiods, other organizaions and divisions within the same group. Such compaisons can
high spot job countries. For illustration, compaisons of external failure costs with other
companies can supply an indicaion of the current degree of client saisfaction.
The cost of choice study can be used as an attention-directing device to do the top direction of a company aware of how much is being spent on quality-related costs. The study can besides pull direction ‘s attenion to the possibility of cut downing entire quality costs by a wiser allocaion of costs among the four quality categoies. For illustration, by passing more on the bar costs, the sum of disbursement in the internal and external failure categoies can be substanially reduced, and hence entire disbursement can be lowered. Besides, by planing quality into the merchandises and procedures, assessment costs can be reduced, since far less inspecion is required.
Prevenion and assessment costs are sometimes referred to as the costs of qanaMty
coeformamice or compMamice and internal and external failure costs are besides known as the
costs of Eoe-coefonmainice or nnoim-coinnipMaece. Costss of conformity are incurred with the
intenion of extinguishing the costs of failure. They are discreionary in the sense that they do
non hold to be incurred whereas costs of non-compliance are the consequence of production
imperfectnesss and can merely be reduced by increasing conformity outgo. The optimum
investing in conformity costs is when entire costs of quality reach a lower limit. This can
occur when 100 per cent quality conformity has non been achieved. It is virtually
impossible to mensurate accurately all quality costs ( peculiarly the lost contibuion
read-only memory forgone gross revenues ) and find the optimum investing in conformity costs. However, some people argue that a failure to accomplish 100 per cent quality conformity is non-optimal and that a zero-defects policy is optimum. With a zero-defects policy the focal point is on uninterrupted betterment with the ultimate purpose of accomplishing zero-defects and extinguishing all internal and external failure costs.
A zero-defects policy does non utilize per centums as the unit of measuring because a
little per centum defect rate can ensue in a big figure of defects. For illustration, a 1 %
defect rate rom an end product of 1 million units consequences in 10000 faulty units. To get the better of
468 COST MANAGEMENT AND STRATEGIC MANAGEMENT ACCOUNTING
Cost of quality
% of gross revenues
Inspection of mateials received
Inspection of WIP and completed units Testing equipment
Internal failure costs
Downtime due to quality jobs Retesting
External failure costs
Managing client ailments
Foregone contibuion read-only memory lost gross revenues
( & A ; lb ; 000s ) ( & A ; lb ; 50 million )
400 2800 5.6
this job the attainment of a zero-defects end is measured in parts per million ( PPM )
so that apparently little Numberss can be transferred into big Numberss. Therefore, alternatively of
describing a 1 % defect rate, a step of 10 000 PPM is more likely to make force per unit area for
action and highlight the tendency in defect rates. Cost of quality studies provide a utile
sum-up of quality attempts and advancement to exceed direction, but at lower direction
degrees non-inancial quality steps provide more timely and appropriate mark steps
for quality betterment. These steps will be discussed in the following chapter.