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Some snapshots from White Corp's event with our partner, the Chemical and Fertilizers Export Council, at the Ministry of Foreign Trade and Industry building, introducing TAWAR program to the members and giving a workshop about activity-based costing by white-corp team. TAWAR is a one-stop-shop solution tailored for manufacturing SMEs. Cost Accounting Facts: All people do Cost their products But They also mix up with pricing strategies Tracing product Activities is Not an Easy Job What we’re going to cover Comparison between ABC and traditional Costing Cost Volume profit Analysis Case Study Which Comes First “Cost or Price”? Relations among Sales Price, Cost, and Profit Costs + profits = sales price Sales price − profits = cost What do you notice when you look at these two equations? If you get the impression that they say the same thing, you have a knack for math. Mathematically, there is no difference between the two equations. However, if you are a business manager or someone fluent in finance concepts, you would recognize the equation’s algebraic similarity, but you would also insist that they are two completely different ways of thinking. How can we explain this? In the first equation costs + profits = sales price The method for determining the sales price is to add a profit margin onto costs. Specifically, we first identify and add up all the costs involved in manufacturing a planned commercial ­product. Then we tack on a profit margin to reach a sales price. We can call this the “cost up” method. The second equation sales price − profits = costs Set the sales price according to the market price. To do this, we first find out how much the planned product will likely fetch on the market and take that value as the sales price. Then we need to decide how big a profit margin is required. The total costs are what is left over when we subtract the profit from the sales (market) price. After that, we can go on to ask questions like, “What kind of materials can we use and still keep the costs within the equation’s total cost figure?” We can also work out our choices of production methods and labor resources in this way. As can be seen, anatomically speaking, these two factories are almost complete opposites In the latter case, the sales price is set according to the “going price” on the market. The company’s sales division is busy carrying out energetic marketing activities in sales promotion, distribution channels, and other areas. Meanwhile, all of the employees in the production division are equally busy with broad-reaching efforts to completely eliminate human errors, product defects, and waste. As a result, the company is able to maintain sales, suppress costs, and turn a good profit. When profits rise, so does employee morale. In addition, management is more willing to underwrite such initiatives as R&D, sales promotions, plant investment, and improvement activities. Here we have an example of a profitable factory, fueled by innovation. And remember, innovation is the key to success. Pricing strategies Cost-plus pricing: Calculate your costs and add a mark-up. Competitive pricing: Set a price based on what the competition charges. Price skimming: Set a high price and lower it as the market evolves. Penetration pricing: Set a low price to enter a competitive market and raise it later. Value-based pricing: Base your product or service’s price on what the customer believes it’s worth. The BreakevenPoint & CVP Break Even Point and Target Operating Income The breakeven point (BEP) is that quantity of output sold at which total revenues equal total costs—that is, the quantity of output sold that results in $0 of operating income. We have already seen how to use the graph method to calculate the breakeven point. we can calculate the breakeven point directly for any product Success rather than trying out different quantities and checking when operating income equals $0. Costing Structuring Cost accounting is a process of assigning costs to cost objects that typically include a company's products, services, and any other activities that involve the company. Cost accounting purpose: measure costs to enable performance analysis, decision-making and internal reporting Objectives: Determine selling prices and each product profit margin Costs controls and identify inefficiencies Types of costs: Direct Costs Indirect Costs Fixed Costs Variable Costs Fixed costs Fixed costs are those that remain constant regardless of the level of production or sales. These costs do not vary with changes in output or sales volume and must be paid even if no goods or services are produced. Examples include rent, insurance, salaries, loan payments, depreciation, and other overhead expenses. Variable costs Variable costs are those that change with the level of production or sales. These costs increase as output increases and decrease as output decreases. Examples include raw materials, labor, commissions, shipping fees, and other direct expenses related to producing a product. Direct costs Direct costs are those that can be easily traced to a specific cost object such as products. Examples include raw materials used in production, labor used to produce a product, spare parts used for machines, shipping fees for delivering products to customers, etc. Indirect costs Indirect costs are those that cannot be easily traced to a specific cost object but still contribute to overall business operations. Examples include rent for office space used by all departments in an organization; insurance premiums; salaries for administrative staff; loan payments; advertising expenses; utilities; etc. Direct costs are typically variable costs, which means the cost fluctuates based on the production volume. Indirect costs, on the other hand, tend to be fixed costs, so the expense amount is independent of the production volume. These types of expenses are necessary for running an organization but cannot be directly attributed to any product produced by the organization. Traditional costing How Traditional Cost Systems Allocate Most companies use ‘traditional’ cost systems Several choices for ways to allocate costs Allocate by the percentage: Simple Example : A factory produced 5 products and incurs $100,000 in indirect costs. Traditional Cost System Performance Can provide a ‘representative’ cost Presuming the allocation method makes sense (eg. using labor as a factor when there is a high labor content) Presuming the operation is not highly complex where a standard allocation method would not capture the cost adding requirements Presuming the operation has enough volume over which to distribute the overhead costs Highly relative Is it representative or accurate enough? How much more effort would be required to make it more accurate? The traditional costing system is an accounting method used to determine the cost of making products based on allocating overhead (or indirect costs). This system relies on calculating predetermined average overhead values per each product produced. And how much more would it cost to get that incremental accuracy? • How much of the overhead should be allocated to the different products? Of volume produced Of labor hours used Traditional costing– How it works Identify overhead costs Estimate the overhead costs for a specific time period Choose a cost driver to use in your calculations Estimate the figure for the cost driver Calculate the predetermined overhead rate Apply the overhead rate to your product Challenges & Risks Overhead Allocation Challenge • Because overhead (manufacturing OH in this case) is an indirect cost Not so easy when there is no direct relationship between the product and the indirect cost How can the firm decide to allocate the overhead costs to provide management with an informed assessment of the cost to produce a product or serve a customer? This is the challenge for the cost system. Activity based costing Activity-based costing (ABC) is a method of assigning costs to products or services based on the activities that are required to produce them. It is an accounting system that assigns costs to activities based on the resources they consume. ABC is used to identify and measure the cost of activities that are necessary for producing a product or service, and then assigns those costs to the product or service. Objectives: ABC is used by companies to better understand their costs and make more informed decisions about pricing, production, and other business operations. It helps companies identify areas where they can reduce costs and increase efficiency. ABC also helps companies allocate resources more effectively by providing a better understanding of how their activities are related to their costs. Activity based costing – How it works The ABC process begins with identifying all the activities involved in producing a product or service. This includes both direct and indirect activities such as research and development, marketing, customer service, manufacturing, distribution, etc. Once all the activities have been identified, each activity is assigned a cost based on its resource consumption. The total cost of each activity is then allocated to the products or services it supports. Traditional costing VS Activity based costing ABC can be used in conjunction with traditional costing methods such as job costing or process costing. However, ABC provides more detailed information about how resources are being used in production processes than traditional methods do. Considerations in Implementing Activity-Based Costing Systems Managers choose the level of detail to use in a costing system by evaluating the expected costs of the system against the expected benefits that result from better decisions. There are telltale signs of when an ABC system is likely to provide the most benefits. Here are some of these signs: Significant amounts of indirect costs are allocated using only one or two cost pools. All or most indirect costs are identified as output unit-level costs (few indirect costs are described as batch-level costs, product-sustaining costs, or facility-sustaining costs). Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity. Products that a company is well-suited to make and sell show small profits; whereas products that a company is less suited to produce and sell show large profits. Operations staff have substantial disagreement with the reported costs of manufacturing and marketing products and services. This allows companies to make more informed decisions about pricing, production processes, and other business operations. Traditional costing Short timeframe: When you have a deadline approaching, using traditional costing can save time. Indirect costs are lower than direct costs: This scenario can occur when production requires significantly more hands-on labor than machine labor or when a company produces only one product. Activity based costing Accuracy is key: When accuracy is crucial, activity-based costing is preferable because it looks at more factors related to overall costs, such as managerial, facility and administrative costs. Indirect costs are higher than direct costs: This situation occurs in companies that rely significantly on automated production processes rather than direct labor. Activity based costing Measure Each product's raw material cost based on its bill of material. Determine average monthly sales volume for each product. Calculate production time study for each product through each production process (activities). Analyze factory expenses and calculate Indirect costs to direct cost percentage. Determine each workstation utilization and absorption factor. Calculate direct cost for each machine (activity) per minute. Calculate each product's direct cost through activities and raw material cost. Allocate indirect cost (overhead costs) depending on activities and their costs. Absorption rate There are risks associated with allocating overhead without calculating work centers utilizations and know actual production volume will be produced What if the standard used is too low? Or too high? The result is that the overhead will be overallocated to some and under-allocated to other work centers