1. Course HM 004
, WS 2014 / 2015
Andreas Klingen

2. Content for Today Key Points Session 18.11.2014 Marginal Costs
Process Costs - ABC
Target Costing

3. Key Points Session 18.11.2014 Which Cost? Where? For What? “Raw data”
Inputs for planning,
control processes,
further processing
Cost elements
Cost center
Cost units

4. Marginal costs
Costs, which are incurred when a product is produced by one more unit.
Why is it important?
Determine the cost function and the marginal cost function

5. Marginal costs – cost functions
Example: linear cost function K (x) = 4 * x + € 3.
Mathematically, the marginal costs can be determined by the first derivative of the cost function. This means that if the company produces an additional unit, the cost of 4 €.
This derivation follows K '(x) = 4 €.

6. Marginal costs
The slope/shape of the total cost function determines the marginal cost function.
The marginal cost function of a linear cost function is constant
Non-linear cost functions?
The marginal cost function may show minima and maxima
Assumption: perfect competition
The marginal cost function of a progressive total cost function is increasing and a declining total cost function is decreasing

7. …back to cost accounting….
“Traditional”
Categories
Cost Element accounting
Cost Center accounting
Cost Unit accounting
“Systems”
Actual
Standardised
Plan
Process Costing

8. Activity-based costing
Developed by Cooper, Johnson and Kaplan in the mid-80s Also: Miller and Vollmann (1985)
Initial problem: steady increase in overhead rates when applying costing.
Goal: fair and equitable allocation of direct and indirect overhead costs to the products
The ABC is a full accounting system and the starting point more elaborate process costing systems.

9. Activity-based costing – Basic principle
Assign overhead costs not on arbitrary overhead rates / allocation keys, but according to the actual use;
“cost-by-cause” principle “polluter pays” principle
Internal corporate activity is seen as system of processes that run independently across divisions. It can not be captured by traditional cost accounting systems with their functionally oriented cost centers
Therefore, all processes must be precisely defined and often recur. In addition, they must be able to can be implemented with known processing methods.

10. Activity-based costing
Preconditions The processes must be clearly measurable on the use of and often occur in the company. Examples are in the logistics and procurement.
Objectives Improve the business processes / process management Optimal allocation of processes to new investments
ABC as decision tool. Anticipation of product purchases. It is thus possible to investigate different technologies for their benefits.
Better pricing due to accurate preliminary cost estimates

11. Activity-based costing - Process
Clear Definition of Scope
Create hypotheses about key processes their cost drivers
Activity analysis
All activities leading to the same “product” and have a common process variable are bundled into sub-processes
Accurate mapping of processes is key

12. Activity-based costing - Process
Identify cost drivers (e.g. number of orders in distribution)
Which fixed costs of the product can be determined?
Determine available capacity for each sub-process of a cost center (using available working time of the employee = “Man-Year” MY)
Allocation of costs to sub-processes = sub process costs
Bundling of sub-processes on the main processes
Result is an ABC process plan that can be established that records all processes that are triggered by the acquisition or production of a product.

13. Activity-based costing - Review
Advantages
Applied independently of overhead rates
The overheads are thus distributed according to consumption of materials.
In addition, economies of scale are considered
Disadvantages
Costly system. Cost incurred for personnel / process control
Process variables must be quantifiable and appropriate while easy to handle
Allocation Not all costs according comprehensible way In reality…even volume-independent costs need to be recognized

14. Activity based costing – basic example (1)
Activity analysis Identify the repetitive activities and their time requirements. The result of this first step is a so-called process list. In it, the sub-processes of the various cost centers are listed and grouped into main processes
Cost center Procurement
Buy raw
materials
Offer
preparation
Manage
Suppliers
Manage
Department
Main process: Buy supplies

15. Activity based costing – basic example (2)
Determine appropriate cost driver After determining the main processes the cost drivers can now be determined. The processes need to be reviewed if they are non-volume induced or non-volume neutral. The example of the procurement cost center indentifies the following sub-processes and cost drivers:
Sub process
Volume induced?
Cost driver
Buy raw materials Y
Number of invoices received
Offer preparation
Number of offers
Manage suppliers
Number of suppliers
Manage department N
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16. Activity based costing – basic example (3)
For all volume-induced sub-processes the process volume must be determined:
Sub-processes of procurement planned process volume Buy materials and supplies 1,200 Offers prepared 3,500 Manage suppliers Manage department
Based the planned process volumes the planned process cost can be determined
Buy materials and supplies Offers prepared Manage suppliers Manage department

17. Activity based costing – basic example (4)
Determine appropriate cost driver On the basis of the planned process volumes the required process cost can be determined. Process expense ratio = Process costs / Process volumes Levy rate = Volume induce processes / Cost of volume induced processes* Process expense ratio Overall cost rate = Process expense rate + levy rate

18. Activity based costing – basic example (5)
Process expense ratio
Levy
Total
Buy materials and supplies
250
21,27
271,27
Offers prepared 20
1,70
21,70
Manage suppliers
1000
85,10
1085,10
Manage department
250 = / ,27 = /( ) * ,27 = ,27

19. Activity based costing – basic example (6)
If the overheads are allocated internally, the costs incurred of the volume independent processes are not considered
To solve the problem of the allocation of overheads, an allocation key is “calculated”, which allocates the volume-independent processing costs to the volume induced processes

20. Target costing – Basic Concept
Target cost is the cost that can be incurred while still earning the desired profit
Selling price – desired profit = target cost
The customer sets the price
Profit must be achieved through cost control

21. Target Costing Characteristics
Contradicts the traditional approach: design product, determine cost, set price
Intense customer focus
What do they want?
How much will they pay for it?
Can we make a profit on it?
Cost control from the beginning
70-90% of costs are committed to at the design stage
Focus on product and process design to engineer out costs from the beginning
Saves costly changes later on

22. Target Costing Characteristics
Product, manufacturing process, delivery process designed simultaneously
Ensures the features customers demand, but within acceptable cost parameters
Eliminates the temptation to add other costly features
Customers may not value the added features
Forces consideration of manufacturability
Reduces the need for subsequent changes

23. Target Costing Characteristics
Cost control at all phases of the product life cycle
Design
Production
Delivery/setup
Customer’s cost of ownership
Service and repair
Disposal and recycling

24. Target Costing:Establish Cross-Functional Team
Marketing
Design/engineering
Manufacturing
Purchasing / Including suppliers
Distribution
Service/support
Cost accounting
Finance
Legal

25. Target Costing Process
Two stage process
Establish the target cost
Market research
Product planning, concept development stages
Achieve the target cost
Value engineering, continuous improvement
Design stage
Continuous improvement in later stages

26. Establishing the Target Cost
Determine the product and its market
Who is the target market?
What do they want?
What do competitors offer?
Introduce concept or prototype
Evolutionary or revolutionary?
Refine until it meets customer needs

27. Establishing the Target Cost
Determine the selling price
Must be acceptable to the customer
Must be able to withstand competition
Determine the required profit
Return on sales
Desired return
Historical return for similar products
Industry average for similar products
Return on sales will fluctuate over the life of the product
Price and costs fluctuate

28. Achieving the Target Cost
Total expected revenue throughout product life
Total desired profit throughout product life
Total target cost
Must include the features the customer wants while maintaining cost at or below target
Meet the customers needs, but not exceed them
Eliminating desired features will result in an undesirable product
Adding unwanted features will increase cost
Failing to keep cost at or below target will result in unacceptable profits

29. Achieving the Target Cost
Rank customer requirements
What does the customer want?
How important is each function to the customer?
What do we and our competitors currently offer?
Competitive evaluation
Do our current product features meet the customer needs
Are the customers’ needs met, unmet or exceeded?
What can we learn from our competitors’ products?

30. Achieving the Target Cost

31. Achieving the Target Cost
Determine the cost gap between current cost and allowable cost
Current cost is based on
Currently used components
Current suppliers
Current manufacturing processes
Current distribution network
Decompose the cost gap
Cost reduction goals are divided among the functions in the product’s life cycle
Design/engineering
Manufacturing
Sales/distribution
Service/support /General administration

32. Achieving the Target Cost
Value chain decomposition
Cost reduction targets are divided among internal and external activities
Internal costs
Labor, overhead, selling and administrative costs, etc.
External costs
Components and services acquired from suppliers, etc.
Often represent a large proportion of total cost

33. Achieving the Target Cost

34. Achieving the Target Cost
Perform value engineering to design out costs without sacrificing needed features
Perform a cost analysis of major components and activities
List components or activities and their functions
Calculate a cost breakdown
Determine the current cost of each component or activity and convert to percentage of total cost
Costs include materials, labor, overhead, etc.

35. Achieving the Target Cost

36. Achieving the Target Cost
Relate the components to customer requirements
Develop Quality-Function-Deployment matrix
Indicates which components have the greatest impact on customer requirements
Develop a functional ranking
Indicates the importance of each component to the custome
Based on the component’s contribution to providing the desired functions

37. Achieving the Target Cost

38. Achieving the Target Cost
Contribution weight assigned to the component * importance to the customer

39. Achieving the Target Cost
Identify components for cost reduction
Calculate a value index for each major component (exhibit 6)
Component cost as a percentage of total cost divided by the component’s relative importance to the customer
Index greater than 1
Disproportionately high cost in relation to its importance
Implies cost reduction should be considered

40. Achieving the Target Cost

41. Achieving the Target Cost
Generate cost reduction ideas
Eliminate, replace, combine, rearrange
Consider the process as well as the product
More efficient manufacturing processes
Better logistics
Test the ideas
Will they be effective?
Are they technologically feasible?
Do activities interact?
Estimate the achievable costs
Use activity-based costing, cost tables, etc.

42. Achieving the Target Cost

43. Organizational Impact
Positives
Customer focus
Cross-functional integration
Open sharing of information
Better process understanding
Negatives
Too much customer focus
Potential organizational conflict
Too much pressure to attain targets
Longer development times