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6. COSTING AND TACTICAL DECISIONS

6.1 LIFE CYCLE COSTING

Life Cycle Costing: a cost management approach where costs are accumulated and managed over a
product’s life cycle

Product life cycle: the time from the conceptions of a product through to its abandonment (cradle to grave)

Stages of product life cycle:

1. Product planning and initial concept

2. Product design and development
3. Production, and
4. Distribution and customer support

Life Cycle Budget: a budget that compares planned

costs with predicted revenues over each year of the
product’s entire life

ADVANTAGES AND DISADVANTAGES OF LIFE

CYCLE COSTING

+ Considering upstream and downstream costs

+ Facilitates cost management

 Recognizing the trade-off between pre-production costs and costs incurred once production begins
 Design in efficiencies rather than controlling costs incurred during production

+ Can be used to show costs and profitability over the entire life-cycle of a product

– Difficulties in deriving life cycle costs and budgets

 Difficult to derive forecasts
 Lack of information especially in traditional costing systems

6.2 TARGET COSTING

Target Costing: a system of profit planning and cost management that determines the life cycle cost at
which a proposed product must be produced to generate the desired level of profit given the producer’s
anticipated selling price

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BASIC FORMULA:

- Target Selling Price: anticipated

selling price for product, based on market considerations and strategic objectives for the product
o Customer consideration: what they are willing to pay
o Competitor considerations:
how they react to your price
o Strategies: Cost Leadership vs
Differentiation strategy
- Target Profit Margin: the return on
sales that the business requires to
make an acceptable profit on the product
- Target Cost: cost at which the product must be produced if it is to be sold at the target selling price
and generate the target profit margin
- Current cost: cost that the new product could be manufactured for, including upstream and
downstream costs, given
- Cost Reduction Objective: the degree of cost reduction required to achieve the target cost
i.e. the difference between the target cost and the current cost

DESIGN PHASE: VALUE ENGINEERING

Value Engineering: a systematic approach to analysing the product and process design to eliminate any
NVA elements to achieve target costs, while maintaining or increasing customer value

Two main methods of Value Engineering

1. Maintain ‘desired’ functionality while minimising costs

2. Increase the functionality while maintaining costs
o Must consider if the customer is willing to pay for a specific function
o If customers are indifferent they will eliminate the function

Note: Value Engineering  Design Phase, Value Analysis  Production Phase

SUMMARY: KEY FEATURES OF TARGET COSTING

- It is price led: it begins with the expected market price and works backwards to set the target cost
- Focuses on the customer and customer expectations: the product features and quality required to
meet customers’ expectations are established and taken as given when setting target cost and when
working to achieve the target cost
- Powerful tool when combined with Life Cycle Costing (LCC)
o “Design out costs”
- Cross-functional involving managers from across the value chain, for example:
o Procurement manager: knowledge of raw materials available
o Product engineer: the one designing the product

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o Manufacturing manager: knowledge of the level of skill employees possess and the
manufacturing technology, machine and equipment
o Sales manager: knowledge of customer demands
o Supplier: knowledge of raw materials and how to utilize those materials
- Costs can be reduced using Value Engineering

6.3 DECISION-MAKING PROCESS

1. Clarify the problem

2. Specify the decision criterion
3. Identify the alternative course of action
4. Collect information about the relevant costs and benefits:
5. Compare the costs and benefits of each alternative
6. Select a course of action
7. Evaluate decision effectiveness

Although Management accountants are part of all seven steps, they are mostly responsible for steps 4 and 5.

6.4 TYPES OF TACTICAL DE CISIONS

Tactical Decisions: are decisions that do not require large increases or decreases in capacity-related
resources and can be changed or reversed quickly

Contrasted with long-term decisions which tend to be more strategic in nature, and involve large increases (or
decreases) in capacity-related resources

Qualities of Tactical Decisions:

- Short term decisions

- Less ‘strategic’ in nature
- Do not usually involve significant increases or decreases in capacity-related resource
- Can change/reverse quickly
- However, some tactical decisions do have longer term implications

RELEVANT INFORMATION

Relevant Information: must satisfy the following criteria:

- Differs under competing courses of action

e.g. incremental revenue or costs, un/avoidable costs, and opportunity costs
- Relates to the future i.e. not sunk costs
- Strikes a balance between timeliness and accuracy (trade-off)
- Can be qualitative and not just quantitative

Identifying relevant information is important as gathering information can be costly for the firm.

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SOME TERMINOLOGIES

- Sunk Cost: costs that have already been incurred and are irrelevant to any future decisions
Opportunity Costs: potential benefit given up when the choice of one action precludes a different
action

- Incremental Revenue: additional revenue that arise from choosing one course of action over another
- Incremental costs or out-of-pocket-costs: additional costs that arises from choosing one course of
action over another

- Avoidable Costs: costs that will not be incurred in the future if a particular decision is made
- Unavoidable costs (irrelevant to the decision): costs that will continue to be incurred no matter which
decision alternative is chosen

FOUR TYPES OF TACTICAL DECISIONS:

Whether to:

1. Accept/reject a special order

2. To make or buy a product/service (Outsourcing)
3. Add or delete a product, service or department
4. Joint product: sell or produce further

1. ACCEPT/REJECT SPECIAL ORDERS

Accept/reject a special order: whether to supply a customer with a single, one-off order for goods or
services, at a special price

Relevant Information:

- Direct costs of producing the product for the special order

- Costs of acquiring specific equipment or other activities related to the special order
- Is there excess capacity
o If yes, then consider the incremental revenues less incremental costs
o If no, then consider then also consider the opportunity costs

Qualitative Considerations:

- Is this really a one-off special order?

- If we do not have excess capacity, is it cheaper to “rent” some extra capacity?
- What happens if existing customers find out about this “special price” Especially if this means we
cannot deliver the regular order
- Is this “new” customer likely to become a repeat customer?  improved relationship?

Note: allocated admin and marketing costs are assumed to be fixed costs unless stated otherwise

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2. MAKE OR BUY A PRODUCT/SERVICE (OUTSOURCING)

Make or Buy a Product/Service (Outsourcing): whether to produce a particular goods or services, or

purchase them from an external supplier

Relevant Information:

1. Avoidable costs
2. Opportunity costs or benefits from freeing up capacity
3. Qualitative factors

Two ways of presenting the analysis:

1. Total costs approach: calculate the cost of both make and buy decision and calculate the difference
2. Incremental cost approach: Consider only the relevant information which differ between make and
buy decisions

Qualitative Considerations:

- Outsourcing decisions are difficult to reverse and can have strategic implications
- Non-financial considerations
o Quality of the product
o Delivery responsiveness of supplier
o Ability of the supplier to respect confidential information
o Labour relations at the supplier
o Financial stability of the supplier

Always remember to consider:

- Opportunity costs
- Will we increase our level of excess capacity if we outsource? Can we somehow also reduce resource
supplied?

3. ADDING/DELETING A PRODUCT, SERVICE OR DEPARTMENT

Adding/Deleting a Product or Department: whether to eliminate a product (both goods and service) or
department

Key considerations for DELETING a product, service or department:

- Avoidable vs unavoidable Costs

- Customer may prefer “full service” suppliers and leave (e.g. car insurance)
- Deleting a department raises morale concerns
- Removing a product can lead to excessive idle capacities (at least in the short term)

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Key considerations for ADDING a product, service or department:

- Incremental revenue and costs  assuming that there is insufficient capacity, what incremental costs
would be relevant
- Opportunity costs
- Ability to produce the new product
- Impact on the firm’s competitive position

4. JOINT PRODUCTS: SELL OR PROCESS FURTHER

Joint Products: are two or more products produced simultaneously from the one production process. The
question is whether to sell the joint product or process it further

- Split-off point: the stage in the production process at which the joint products are identifiable as
separate products
- Joint Cost: all manufacturing costs incurred in the production of joint products
- Relative Sales Method: a method of allocating joint cost to joint products in proportion to their sales
value at the split-off point

Qualitative considerations

- Do we have the capabilities to process further

- Is the decision a long-term or one-off decision
- Do the customers want the unprocessed or processed product

6.6 PITFALLS IN USING ACCOUNTING DATA FOR TACTICAL DECISIONS

- The sunk cost trap  ignore them

- The unitised fixed cost trap  consider all total costs and how they will be affected by a decision
- The allocated cost trap  some costs allocated to departments are still unavoidable when
eliminating that department  identify the avoidable costs
- The opportunity cost trap  account for them

Also consider the escalation of commitment