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527 STRATEGIC MANAGEMENT AND COSTING SYSTEMS CHAPTER 12

Process levels Activity drivers

Unit level direct labor hours, direct labor pesos, machine hours,unit of output

Batch level setup time, number of batches, material moves,orders processed, number of receipts, weight of material handled, number of inspections, or number of production orders

Product level design time, testing time, number of engineeringchange orders, number of categories of parts, designchanges, or number of products

Facility level square footage occupied, or any of those mentionedin the three levels

Group similar or homogenous activities in relation to specific activity driver.

Estimate costs based on their cost-driver or activity-driver.

The ABC process is included in the system of activity-based management (ABM). This system serves as a linkage of product costing and continuous improvement of processes which encompasses driver analysis, activity analysis, andperformance measurement.

ABC has its advantages and limitations, as presented below:

BENEFITS COSTS

Accuracy. Overhead is accumulated based onmultiple cost pools related to activities instead of in asingle pool.

Continuous improvement. Activities arecontinuously mapped, analyzed, and studied inrelation to a particular cost object thereby assisting inidentifying non-value adding activities. Theseadvantages result to a better cost control and moreefficient operations.

Costly to implement.

Product costing does not conform with GAAP.Example, ABC may classify research as product cost,and plant depreciation, insurance or taxes as periodcosts.

ABC is most applicable to those organizations with products or services thatVary significantly in volume, diversity of activities, and complexity of operations;Relatively high overhead costs; or Operations that have undergone major technological or design changes.


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CHAPTER 12 STRATEGIC MANAGEMENT AND COSTING SYSTEMS 528

Product-life cycle costingTraditionally, costs of units produced are computed based on the costs of materials, labor and overhead. The productioncosts are accumulated based on job-order costing and process costing. This model is now considered too shortsighted,not comprehensive, erratic and does not provide decision makers the overall and accurate picture of the entire costingprocess. Consequently, if the computed cost is incorrect, sales price tends to be incorrect. To address the weaknesses of the traditional coating systems and to capture the new ways of managing, the life-cycle costing was developed.

Life cycle-costing estimates and determines the total cost of a product over its life cycle. A product life cycle has five (5)stages, namely: pre-infancy (or start-up stage), growth stage, expansion stage, and maturity/decline stage, as shownbelow:

Growth rate Product life-cycle Time

Pre-infancy Infancy Growth Expansion Maturity/ Decline

The product life-cycle costing is related to quality based business cycle premise on the proposition that quality startsfrom effective listening to customers. It commences from research and development, to design engineering, production,marketing, channels of distribution, and customer services. This process is shown below.

Quality-based Business Cycle

Production

Design engineering Marketing

Research and Channels of Development distribution


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Customer Services


This new business cycle has four (4) groupings of costs: upward costs (e.g., research and development and designengineering), production costs, downward costs (e.g., marketing and channels of distribution), and post-sales servicescosts (e.g., customer services). Recent studies have shown that about 80 % of the total business cycle costs are alreadylocked-in even before the very first unit of product is produced. This pushes the issue that product costing should not beconfined within the production costs but should include all costs of doing business from research and development tocustomer services. In this approach, strategic costing should be more reliable and accurate leading to better strategicpricing and operating performance.

Life-cycle costing gets the average unit cost over the entire life span of a product. This would give managers an idea onthe long-term sales price of a product. As product costing fine tunes the business costs strategically, product pricing maybe made equally throughout the product life, or product pricing may be higher during the initial years of product life andgradually decreases as the product nears its maturity and decline. Or, still, product pricing may be initially set at a lower price and gradually increases as the product approaches growth and expansion. On top of all these, life-cycle costing isalso affected by the introduction of new technology or processes even before a product reaches its maturity stage. Thissituation also calls for consideration in strategic pricing.

Sample problem 3. Life-cycle costing

Rene Corporation is introducing a new model in one of its product lines. This model is expected to have a 3-year productlife and would incur the following costs and production (M = millions):

Upstream costs (e.g., research and development product design) P20 MProduction costs 40 MDownstream costs (e.g., marketing and channel of distribution) 20 MAfter-sales services costs 10 M

Total product costs P 90 M

Estimated production in units:Infancy period 1 MGrowth period 4 MExpansion period 8 MMaturity period 2 MTotal 15 M

Required: Determine The strategic sales price over the life of the model if:

1. Unit sales price is set at 200% of the total product costs.

2. unit sales price is set at 150% in the first year, 400% in the second year, and 120% in the third year.


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Solutions / Discussions:1. The life-cycle unit cost is P6.00 (eg, P90M / 15M). The unit sales price is P12.00 (eg, P6 x 200%).2. The sales price are:

First year P6 x 150% P 9.00Second year P6 x 200% 24.00Third year P6 x 120% 7.20

Statistical Control Techniques and Other Quantitative Techniques

Statistical control techniques are operations research models used to map up processes, monitor and evaluate qualityindicators, and provide intelligent alternative solutions. Statistical control techniques are numerical reports expressed in

statistical terms and presentations used to predict and monitor activities towards a more efficient and more effectiveoperations. These techniques include lines (eg, regression line, line graph, etc.), graphs (eg, bar graph, histograph, etc.),dispersion or deviations (eg, such as those expressed in x-graph, r-graph, etc.), and other related analysis that areconveniently used to identify and describe patterns and potential problems in the business operations.

The other quantitative techniques include Gantt Chart, PERT/CPM, Paretos Law, regression analysis, fish-bone analysis,linear and dynamic programming, and learning curve theory. Gantt Chart is used to trace project schedules and activitiesas to their sequence, parallel undertakings, and time of completion. PERT/CPM is used in estimating a project (or process) completion time and activity costs using probabilistic principles. Paretos Law is the 80-20 rule, which states, for example, that 80% of the problems in a particular process is contributed by 20% of the total activities, or vice-versa.Paretos Law is applicable in every conceivable business process and in all fields of managing such as human resources,financial management, marketing management, warehousing, logistics, legal department, accounting department, etc.

Learning curve theory

Productivity RateLearning Curve Theory

One of the applications of Paretos Law is thelearning curve theory which states that pro-ductivity rate marginally increases as emplo-yees gain experience in his work. Normally,efficiency increases by an average of 20% for every doubling .

0 Time


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There are two models used in the learning curve theory, the Wright Model and Crawford Model. The Wright Model statesthat each time the cumulative quantity of output doubles, the cumulative (or moving) average time to produce per unitdecreases by a certain percentage. The decrease I percentage to produce an additional unit is 20%. This rate changesacross industries between 60% and 85%.

The Crawford model (i.e., incremental-unit-time learning model) predicts the time required to produce the last unitsrequires getting the total of each units time to compute cumulative total time and cumulative average time per unit.

Sample problem 4. Learning curve theory applications: cumulative average time

To illustrate the learning curve theory using the Wright model, let us assume a 20% learning rate, and a worker initiallyneeds 20 hours to produce the first unit. The average direct labor cost is P30. analyze the effects of the learning curvetheory.

Solutions / Discussions:

The learning curve theory has the following effects:

a b C(axb) d E(cxd) F(e/a)

Units Moving averageLabor hours per unit

Estimated totalhours to produce

the units

DL costper hour

Total DLcost

Average DL costper unit

1248

1632

20.00(20 x 80%) 16.00(16 x 80%) 12.80(12.80 x 80%) 10.24(10.24 x 80%) 8.19( 8.19 x 80%) 6.55

20.0032.0051.2081.92

131.04209.60

P 30.0030.0030.0030.0030.0030.00

P 600960

1,5362.4583,9316,288

P 600480384307246197

Take note, as the number of units produced doubles, the average labor hours per unit decreases (i.e, from 20 hoursto 16 hours, to 12.8 hours, to 10.24 hours, etc.).

Also note that the average direct labor cost per unit decreases by 20% as number of output doubles (e.g., P600 x80% - P480; P 480 x 80% - P384, etc.).

Learning curve rate may be determined as follows:a. Based on average DLH per unit

Learning curve rate = 16 hrs / 20 hrs = 80%

b. Based on average DL cost per unitLearning curve rate = P480 / P600 = 80%


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Strategic Profitability Analysis

The application of the balanced scorecard as discussed in chapter 3 brings an extended analysis of profitability.

Evaluating the success of a strategy

Under the balanced scorecard philosophy, evaluating the success of a strategy involves the use of the StrategicProfitability Analysis (SPA). It dissects the change in profit into growth factor, price-recovery factor, and productivity factor.An example of such strategic analysis is given below:

Sample Problem 5. Strategic Profitability Analysis

Consider the following income statements of BS Company for the years ended 2006 and 2007:

2006 2007AmountChange

%Change

Revenues P 16,000,000 P 22,000,000 P 6,000,000 10 %Materials (9,600,000) ( 10,648,000) (1,048,000)Direct labor (4,000,000) (6,072,000) (2,072,000)Other expenses (2,000,000) (2,000,000) -Profit P 400,000 P 3,280,000 P 2,880,000

An analysis of related data are as follows:Quantity sold 400,000 440,000 40,000 F 10 %Unit sales price P40 P50 P10 FActual directMaterials quantity

800,000 lbs. 968,000 lbs.

Actual directmaterials price

P 12 P 11 P (1) F

DM productivityMeasure

( 400,000 / 0.50) 0.50

Standard DMQuantity based on2006 data

( 440,000 / 0.50) 880,000

DM growth Change (800,000- 880,000) 80,000 UFDM productivityVariance

(968,000-880,000) 88,000 UF

Actual DLH 200,000 264,000 64,000Actual DLR P 20 P 23 P 3 UFDL productivityMeasure

(400,000 / 200,000) 2 220,000

Standard DLH basedOn 2006 data

( 440,000 / 2)

DL Growth Change (200,000- 220,000) 20,000 UFDL Productivityvariance

(264,000-220,000) 44,000 UF


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Required: Account for the change in net profit in 2007 using the strategic profitability analysis.



The change in profit accounted for by itemizing the effects of the growth factor, price recovery factor, andproductivity factor, as follows:

Growth factor Sales growth factor 50,000 F x P40 P1,600,000 FDM growth factor 80,000 UF x P12 960,000 UFDL growth factor 20,000 UF x P20 400,000 UF P 240,000 F

Price-Recovery Factor Sales price-recovery factor P10 F x 440,000 4,400,000 FDM price-recovery factor P(1) F x 880,000 (880,000) FDL price-recovery factor P3 UF x 220,000 660,000 UF 4,620,000 F

Productivity Factor DM productivity factor 880,000 F x P11 968,000 UFDL productivity factor 44,000 UF x P23 1,12,000 UF 1, 980,000 UF

Increase in profit P 2, 880,000 F

The growth factor is computed as follows:Sales growth factor = (Sales this year Sales last year) x Unit sales price last year DM growth factor = (Standard DM quantity this year DM quantity last year) x Unit direct materials

priceDL growth factor = (Standard DL hours this year DL hours last year) x Unit direct labor rate last

year

The price-recovery factor is computed as follows:Sales price-recovery factor = (USP this year USP last year) x Actual quantity sold this year DM price-recovery factor = (actual UDM price this year Actual UDM price last year) x Standard

DM quantity this year DL price-recovery factor = (actual UDL rate this year Actual UDL rate last year) x Standard

DL hours this year

Productivity factor DM productivity factor = (actual DM quantity this year Standard DM this year) x Standard

Unit DM price this year DL productivity factor = (actual DL hours this year Standard DL hours this year) x unit

DL rate this year


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BACKFLUSH COSTING

JIT and Backflush Costing

The use of Just-in-time inventory system among small and medium-sized companies in the industrialized economies hasbrought the development of backflush costing.

In just-in-time, the trigger point is traced from the date a customer made an order. From their, machines and men areprepared, and materials are ordered. As materials are ordered, it is safe to assume that the same would be immediatelyused in the production process. This means that no materials inventory, or only a little materials inventory, would bemaintained by the enterprise. And since machines are maintained on their top operating conditions, men at their best

possible performance, and having an error-free production processes, the materials are certain to be converted intofinished goods and delivered to customers. To do all of these things, the applications of technology would be inevitable.This brings direct labor costs minimal and indirect to the product being produced. This makes direct labor cost more of afixed cost rather than a variable cost.

This new manufacturing set-up suggests that materials inventory and work-in-process inventory would be an insignificantcost in the production process. Backflush costing records until after the events have taken place, then costs are workedbackwards to flush out the manufacturing costs. So the accounting question is: at what point in the production and salesprocesses would material costs be summarized and recognized? The point where the materials costs are backflushed iscalled the trigger point.

The trigger points

There are three events that trigger the records kept in many backflush accounting systems:

Trigger point Events Comments

1 Sale of goods This is the true trigger point because satisfying customers initially happenswhen the right goods are delivered or sold to them. The completion of goods does not give value to the enterprise until and only when the goodsare delivered to the customers.

2Completion of production

This is only a secondary trigger point in a true backflush coating systembecause the quality of the JIT system is measured on the date the goodsare delivered to the customers and not on the dare of production.


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3Purchase of materials

In a true JIT system where there are absolutely no raw materials held onhand, this trigger point is irrelevant. However, while companies have not yetreached the dream of backflush environment, the use of the materialspurchases date and the date of sale or production would still be popular.


Sample Problem 6. Backflush costing- the trigger point is the date of sale

Aquatic Corporation applies the just-in-time philosophy in its materials procurement and production systems. Ituses backflush accounting and the following selected transactions occurred in one of its products in the month of January 2009:

Raw materials purchases, 12,000 lbs. @ P10, P126,000.

Standard costs per unit:Materials, 4 lbs. @ P10, P40.00Conversion costs, P20.00

Production costs with 3,000 unitsDirect materials used 11,400 lbs.Conversion costs P62, 000

Required: Record the foregoing transactions assuming that materials are backflushed at the date the goods aredelivered to customers.


The transactions are to be recorded as follows:

Transactions Accounts Dr. Cr.a. Raw materials purchases No entry

b. Incurrence of conversioncosts Conversion costs P62,000

Accounts payable, etc. P62,000

c. Finished goods completed No entry

d. Sale of goods to customers,materials are backflushed Cost of goods sold 188,000to cost of goods sold Conversion costs 62,000

Accounts payable 126,000

The backflushing of direct materials costs, and therefore the recording of the creditors account, is made at the date of sale. No finished goods inventory is maintained. Conversion costs are recorded at the date of incurrence.

Sample Problem 7. Backflush costing-the trigger point is the date of production.


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Aquatic Corporation applies the just-in-time philosophy in its materials procurement and production systems. Ituses backflush accounting and the following selected transactions occurred in one of its production I the month of January 2009.


Raw materials purchases, 12,000 lbs. @ P10, P126, 000.Standard costs per unit:

Materials, 4 lbs. @ P10, P40.00Conversion costs, P20.00

Production costs with 3,000 unitsDirect materials used 11,400 lbs.Conversion costs P62, 000

Sales, 3,000 units

Required: Record the foregoing transactions assuming that materials are backflushed at the date of completingthe goods produced.



Transactions Accounts Dr. Cr.a. Raw materials purchases No entry

b. Incurrence of conversioncosts Conversion costs P62,000

Accounts payable, etc. P62,000

c. Finished goods completed. Finished goods 126,000Materials are backflushed Accounts payable 126,000to finished goods

d. To close conversion costs to Cost of goods sold 62,000cost of goods sold Conversion costs 62,000

e. Transfer of finished goods to Cost of goods sold 126,000

costs of goods sold Finished goods 126,000

The backflushing of direct materials costs, and also the recording of the creditors account, is made at the date of completing the production. As such, finished goods inventory is maintained. Later, the finished goods inventory is alsobackflushed to cost of goods sold. Conversion costs are recorded at the date of incurrence.

Sample Problem 8. Backflush costing-trigger points are materials purchases and point of sale


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Aquatic Corporation applies the just-in-time philosophy in its materials procurement and production systems. Ituses Raw and In Process account to keep track of its materials and backflushed materials at the date goods arecompleted. The following selected transactions occurred in one of its products in the month of January 2009:


Raw materials purchases,Direct materials 12,000 lbs. @ P10, P126,000Indirect materials P4,400

Production costs with 3,000 unitsOther conversion costs P62,000

Beginning and ending balances:

Beginning balance Direct materialsConversion costs

TotalEnding balances Direct materials

Conversion costs

Total

RIP FG2,0009002,900(1500)(600)2100

3,1001,2004,300(4,200)(2,200)6,300

Required: Record the foregoing transactions using the companys backflush accounting system.



Transactions Accounts Dr. Cr.a. Raw materials purchases Raw and in process 130,400

Accounts payable 130,400

b. Incurrence of conversion Conversion costs 62,000costs Accounts payable, etc. 62,000

c. Finished goods completed No entry

d. Materials backflushed to Cost of goods sold 126,500cost of goods sold as Raw and In process 126,500follows:

DM, Beginning P 2,000


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DM, Purchases 126,000-DM, Ending 1.500DM used( to be backflushed) P 126,500

e. To close conversion costs Cost of goods sold 62,000to cost of goods sold Conversion costs 62,000

f. Adjustment to RIP account Cost of goods sold 300on conversion costs 300DM (900-600)


In this version of backflush accounting, raw materials purchases are immediately recognized on the date of receipt. Thedebit is made to the Raw and in Process account to impress that there is no materials stored in the warehouse,however, still in the process of production. The cost of materials used is backflushed at the date of sale. There is nofinished goods inventory account to be maintained. Conversion costs are recorded at the date of incurrence.

Sample Problem 9. Backflush costing-the trigger points are materials purchases and point of production

Aquatic Corporation applies the just-in-time philosophy in its materials procurement and production systems. It uses Rawand In process account to keep track of its materials and backflushed materials at the date goods are completed. Thefollowing selected transactions occurred in one of its products in the month of January 2007:

Raw materials purchases,Direct materials 12,000 lbs. @ P10, P126,000.Indirect materials P4,400

Production costs with 3,000 unitsOther conversion costs P62,000

Beginning and ending balances:

Beginning balance Direct materialsConversion costs

TotalEnding balances Direct materials

Conversion costsTotal

RIP FG2,0009002,900(1500)(600)2100

3,1001,2004,300(4,200)(2,200)6,300


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Required: Record the foregoing transactions using the companys backflush accounting system.


Transactions are to be recorded as follows:

Transactions Accounts Dr. Cr.a. Raw materials purchases Raw and In process P130,400

Accounts payable P130,400

b. Incurrence of conversion Conversion costs 62,000Costs Accounts payable, etc. 62,000


c. Finished goods completed Finished goods 126,500Materials to be backflushed Raw and in process 126,500Is computed as follows:

DM, Beginning P 2,000DM, Purchases 126,000-DM, Ending 1.500DM used ( to be backflushed) P 126,500

d. To close conversion costs Cost of goods sold 62,000to cost of goods sold Conversion costs 62,000

e. Transfer of Finished goodsto cost of goods sold,computed as follows:

FG, Beginning P 3,100+ Materials backflushed 126,500-FG, ending 1,500FG transferred to CGS P128, 100

f. Adjustment on RIP and FG Finished goods 1,000

balances on conversion costs Cost of goods sold 700DM (900-600) Raw and in process 300DL (1200-2200)

In this version of backflush accounting, raw materials purchases are also immediately recognized on the date of receipt.The debit is made to the Raw and in process account to impress that there is no materials stored in the warehouse,however, still in process of production. The cost of materials used is backflushed at the date of completing the production.Finished goods inventory account is maintained and is later transferred to the cost of goods sold account. Conversioncosts are recorded at the date of incurrence.


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Standard costing and backflush accounting

Standard costing may be used in the backflush accounting. If used, the variance between the actual conversion costs areto be closed to the cost of materials and conversion costs.


Throughput Accounting

The Theory of Constraints (TOC)

The concept behind the theory of constraints was first formulated and developed by Goldratt and Cox (1986) in their book,The Goal. In 1990 Goldratt refined the concepts and eventually gave it the name the Theory of Constraints.

The theory focuses on constraints or bottlenecks which hinder speedy production. This binding constraint in theproduction process dictates the pace of the manufacturing throughput rate. The idea is to remove or unclog the bottleneckto accelerate the production process from the point of procuring materials up to the point of delivering the goods to thecustomers.

The theory of constraints has a five-step procedure as follows:1. Identifying constraints 4. Increasing the capacity of the binding constraints2. Exploiting the binding constraints 5. Repeating the process when new binding constraints are identified.3. Subordinating everything else to the

Decisions made in the second step.

There could be as many bottlenecks that could be found in the production processes. The bottlenecks could be in terms of machine hours, direct labor hours, materials availability, market capacity, financial constraints and priorities, talents andtechnology. These bottlenecks impede the capacity of the enterprise to produce more goods and services. In case themarket could still accommodate, the constraints or the bottlenecks should be managed with an aim of allowing theproduction process to produce goods up to where they could meet customer demands. This means that if the presentbottleneck is machine hours, then efforts should be made to speed up the production process in the use of machine either by re-lay-outing the production process, training men to be more skilled, acquiring more durable materials, or acquisitionof more machines. In the process, creativity, innovations, and systems improvements would come into play. The


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processes of eliminating or unclogging the bottleneck should be made using the overriding criterion of benefit-costanalysis as the guiding principle.

Once the most constraining bottleneck is remedied, then another most constraining bottleneck that principally hinders thepotential of the production process would be identified. This would then be remedied, and the cycle goes on until themaximum capacity of the plant is attained. In such case, the overall plant becomes the bottleneck in responding tocustomer demands.

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