2.2.

Product cost calculations

2.2.1. Accounting definitions
All revenues and costs have been organized into accounts. There must be an explicit account for each different type of revenue and expense in the company accounting system. The lowest-level accounts are normally consolidated first into head accounts and later into variable (i.e. direct) and fixed (i.e. indirect or overhead) costs. Variable costs change linearly with the output volume, whereas fixed costs remain constant. This is normally considered on an annual basis. If the reporting range is shorter, for example periodic, the role of the behavior of some direct costs become more and more like fixed. Typical direct costs are material costs, labor costs, freights and duties, and sales deductions. Traditional accounting has a historical background. However, remarkable changes have taken place in the industry between the time the system was developed and the 1990s (Atrill & McLaney 1997):

From direct labor-intensive and direct labor-paced to capital-intensive and machine-paced production, from a low level of overheads to a high level overheads relative to direct costs, and from a relatively uncompetitive to a highly competitive international market.

Many organizations produce mountains of cost data but provide management with little or no useful information on cost and performance. This leads to wrong decisions. In many organizations, the management doubt the traditional cost figures and often end up with unofficial cost analyses. (Walker 1999.) Financial accounting is organized to produce the kind of official financial statements required in the country where the companys financial statements are announced. In these statements, product costing is not required, and the financial departments do not need to pay attention to them. The three reports that together describe the financial state of the company are: 1. Profit and Loss statement (P/L). 2. Balance Sheet, i.e. Liabilities and Equity statement (L/E). 3. Cash Flow statement (C/F).

The P/L statement consolidates the companys revenues and expenses over a period (month, quarter, year) categorized in a standard form (list of accounts) and expressing the profit of the business period. The C/F statement presents the cash inflows and outflows over the period, and the L/E statement concludes the accumulated wealth at the end of the period. The definitions of these statements are presented in Appendix 1 (Atrill & McLaney 1997). Total cost has been defined in many ways. Atrill & McLaney (1997) present the concept of full costing in their book: Full costing is not concerned with variable cost, but with all the costs involved with achieving some objective, for example making a particular product. Monden (1989) emphasizes the total cost of the quality in Japanese automobile industries. The necessary steps in total cost management: 1. Plan a product that meets the customers demand for quality. 2. Determine a target cost under which the customers demand for quality is attainable using a blueprint based on value engineering (cost reduction in a narrower sense). 3. Determine which processes achieve the target cost in production performance. (Monden 1989.) In this text, total cost includes all meaningful expenses between the revenues and the bottom line in the P/L statement.

2.2.2. Challenges of product costing

The pricing of products depends notably on the competition in the market. In a weakly competed market, such as a closed market, the sales price can be calculated as follows: Sales price = cost + profit Since competition is not strong, the changes in the company costs and profit targets can be incorporated into the sales price. In modern open markets, competition is very strong and the pricing equation changes to Cost = sales price - profit The sales prices are defined by the market competition and the products competitiveness. Profit should never be bargained to ensure the companys survival in the long run. Thus, costs are the target function that can be influenced by the companies. (Lumijrvi et al. 1995.)

One basic difficulty in product costing is that products do not drive all the company expenses. For example, it would be very artificial to allocate general management costs, administration, general IT-support and human resource costs, etc. on products. Even within a factory, there are many questionable costs, not directly driven by the type, number or volume of products. In addition, there are costs that are driven by substantial material vendors and customers. In fact there is no single correct (product) cost figure (Walker 1999). Product costs are always calculated from the financial transaction data of the cost centers of the organization. Several methods exist, and each company uses a method of its own. The simplest product costing method is to use only the direct costs. In the early days, labor cost used to have more meaning. Everything was done manually, and output volume was directly dependent on the number of employees involved. When machines began to substitute labor in production, machine costs became less visible. Most machine costs are depreciation costs, which are not comparable to direct labor costs. It is possible to calculate the hourly cost of a machine by using deprecations and interest on invested capital plus operating and maintenance costs, but this not directly visible in the P/L statement. The following cases also easily remain as hidden costs in traditional accounting: 1. What is the (account) name for the costs of the unmanned hours of the factory? Depreciation and interests on the capital run every second (for 8760 hours a year), but manufacturing operates for 2000 6000 hours a year, depending on how many shifts are used. 2. What is the (account) name for the cost of the standing hours due to poor product demand, material shortage and machinery breakdown? 3. How do we visualize the costs of poor product quality, rework, repair, etc.? In the standard costing method, product cost is calculated based on BOM and the capacity demand of the product. Direct costs include the raw material (component) prices and the labor cost for the product-specific work time. Indirect costs are expressed in terms of multiplier factors and extras onto direct costs. This standard cost is used as an average target product cost and followed up by comparing with the actual cost calculated similarly. (Uusi-Rauva et al. 1994.) In practice, we can also find other types of standard costs. Ideal cost (theoretical cost) does not include any waste, scrap, inefficiency, delays, etc., representing an ideal situation that is never reached in real life. This standard is used to motivate efficiency and cost reduction efforts. Standard cost is sometimes called normal cost and used to point

out the everyday target level. Normal cost includes the allowable level of inefficiency, scrap, etc., reached on a good day. (Riistama & Jyrkki 1996.) Although the purpose of standard costing is to give targets for product manufacturing, these costs differ from the target costing method, which is used in the early development phases of a product (see Subsection 2.2.5). Standard costing is a simple and suitable method for actual cost follow-up, but may lead to inappropriate decisions when used incorrectly in future planning. The main problem is that standard product costing does not provide enough information to enable the user to control the overheads and other indirect costs related to the product. For example, the production overheads multiplier is typically expressed as an additional percentage of the product direct cost. This value is calculated recursively from the past accounting figures, allowing a typically growing trend for overheads when the figure is used as a standard for a new product. (Shank & Fisher 1999.) Attempts to create generic product costing methods have been under way for decades, resulting in, for example, activity-based costing. Still, there is disagreement as to how this method should and could be applied in company accounting. In a series of three articles, Schnoebelen (1993) describes the design and implementation of an advanced cost management system (ACMS). To provide maximum benefit, however, these new cost management concepts must be practically integrated into the business processes and operating systems (Schnoebelen 1993a). In conventional product costing methodologies only costs incurred in the manufacturing process are applied to products to determine the cost of manufacturing. The new thinking in cost management has forced accountants to break through the typical product costing barriers by applying all organizational costs in a more relevant and enlightening way. All organizational costs can be attached to cost objects (e.g., a process, product, customer etc.). The business objectives of the ACMS should include the following targets:

Improving the understanding of the organizational cost structure and behavior by products, business processes and business activities. Improving product costing to enhance product and customer profitability. Highlighting opportunities to reduce or avoid costs. Improving cost planning and simulation capabilities. Supporting the cost management information needs of nonmanufacturing and non-financial functions, including product design, engineering, purchasing and marketing. Better utilizing manufacturing and administrative resources. Improving performance reporting.

Providing a sound, fundamental cost accounting framework. Increasing the timeliness, efficiency, reliability and accessibility of financial information. (Schnoebelen 1993b.)

The system features that correspond to these objectives are illustrated in Table 4. A lot of attention has been given to the implementation of ACMS. Three different (concurrent, pilot and phase) approaches to implementation have been recognized and described. Data validity control is also considered a very important measure of system quality. (Schnoebelen 1993b.) Table 4. Integrated Advanced Cost Management System (ACMS) features (Schnoebelen 1993b)

In this text, product cost means the material plus direct labor costs and the overhead costs, including machine depreciations. The scope of the definition ranges from the factorys incoming material storage and to the semi-finished product inventory. Therefore, product cost is only a part of the product business case, which aims to describe the total costs of the product during the CE and PE processes.

2.2.3. Activity-based costing

One well-known advanced costing method is activity-based cost (ABC). The main advantage of ABC is the more direct assignment and traceability of costs. ABC was originally developed in manufacturing, but it is being adopted in other areas, such as services and the public sector. ABC adds value to the financial accounting system by incorporating operational and quality information with financial data and assigning this information

to objects, i.e. the initial drivers of the costs. The idea is illustrated in Fig. 15. ABC monitors the use and efficiency of the way the resources have been used in theactivities. Secondly, it also monitors the way in which these activities have been utilized to produce the objects, i.e. the products and services. An activity is an operative unit focusing on limited actions. Typical activities are selling, purchasing, assembling and packaging.

Figure 15. ABC costing from resources through activities to objects (Paasovaara 1996). All these activities inevitably utilize resources; people, materials and consumables, machines, money, facilities, etc. In each activity, the resources are spent on objects, i.e. products or services. Fig. 15 illustrates the cost drivers - the relationships between the resources, activities and objects. Theresource driver indicates how much resources an activity requires, and the activity driver defines how much an object utilizes an activity. In the literature, the names of the drivers vary, i.e. they are called input drivers, volume drives, level drivers, etc. The selection of correct drivers is an essential success factor for good calculation results. An incorrect driver may lead to erratic results. (Lumijrvi et al. 1995.) In proactive cost calculation, we estimate the resource costs for any activity. To avoid further confusion in this text, the following definition is used. Both resource and activity drivers may consist of two parts: driver quantity and driver value. Driver quantity indicates the numbers of occurrence, anddriver value indicates the rating of a transaction.

ABC can use several level drivers to allocate the overhead expenses on an object. The purpose is to use the most descriptive driver for the costs. The resource cost of unit level activities is divided by the number of transactions differently from the calculations on a batch or any higher level of activity (see Fig. 16).

Figure 16. Different levels of costs (Cooper 1990). This feature has been found useful in revealing the hidden costs of small batches in the Rautaruukki Raahe Steel works. (Pesonen 1992, Pesonen 1994). The ABC method was also demonstrated in the telecommunication industry, where the cost efficiency of generating new products was studied well before the products were launched. The study focused mainly on product variation costs during the manufacturing (Ojala 1997). The product cost is calculated based on the known activities, resource quantities and resource usage in an activity by object. If we can estimate the characteristics and volumes of the future products, it is also possible to estimate the cost roadmaps using ABC. The unit cost of an activity (i) for a product j as Unit cost (i, j) = cost driver value (i) * cost driver quantity (i, j) The addition of a discrete time parameter t into the formula results in cost roadmaps. Unit cost (i, j, t) = cost driver value (i, t) * cost driver quantity (i, j, t), where t is a discrete time variable (e.g. day, period, quarter, etc.), i is an activity, j is a product.

ABC analysis highlight for managers where their action will likely have the greatest impacts on profits (Cooper & Kaplan 1991). For example, the reduction of the product test time will also reduce the unit cost of the testing of the product. These changes can already be considered during the CE process using the cost roadmaps, provided that we have at least an estimate of the product cost driver quantities. During the PE process, the managers should attempt to re-evaluate the products and search for ways to reduce resource consumption. This might lead to a need to re-design the product with fewer components by implementing continuous improvement programs or adopting new technologies. Walker (1999) suggests integrating ABC with other techniques, such as:

Attribute-Based Costing (ABCII), which integrates market research, quality function and other techniques, (Limited factor) Contribution Analysis and On-Line Analytical Databases (OLAP).

Attribute-based costing separates the cost of products and services from the cost of various other external and internal cost objects. In short and medium term, (ABCII-based) contribution analysis a powerful technique for exploring profitability at the product, channel, market segment and customer levels. Limited factor contribution analysis gives an enhanced view of product profitability: In Table 5, product A appears to be more profitable when the percentage of sales contribution is used. If there were limited capacity hours available and demand for the product, the annual contribution of B would be over threefold compared to a situation where only B was sold. Table 5. An example of contribution analysis (Walker 1999).
Account Sales Direct costs Contribution Hours (per product) A 100 40 60 20 B 100 60 40 4 10

Contribution per hour 3

OLAP database systems provide the advantage that they enable data from different systems, such as spreadsheets, accounting, etc., to be automatically combined, processed, and presented (Walker 1999).

2.2.4. Theory of constraints

Noreen et al. (1995) analyzed the theory of constraints (TOC) and its implications for management accounting. Goldratt believes it is necessary to purge the term product cost from our vocabulary (Noreen et al. 1995). Goldratt argues that activity-based costing cannot give reliable answers to the question of what impact will this decision have on throughput, operating expenses and assets. Goldratt insists on this point because he believes that the term product cost is synonymous with fully allocated product costs in the minds of many managers. Goldratts theory has three building blocks: Throughput, operating expenses and assets (Goldratt 1990). Throughput is defined as the rate at which the system generates money through sales. Operating expenses are defined as all the money the system spends in turning inventory into throughput, andassets as all the money the system invests in purchasing things it intends to sell. Profit is measured by throughput minus operating expenses and profitability by profits divided by assets. (Goldratt & Cox 1992.) Accordingly, they motivate managers to apply the theory of constraints because many managers seem to focus their energies on cost reduction rather than on profit enhancement. This brings out the key strength of TOC its simplicity: Only the workload and the capacity of the bottlenecks are essential. TOC is defined as an analysis procedure of anything that limits the system achieving higher performance versus its goal. TOC thinking is based on the following continuous improvement procedure: 1. 2. 3. 4. 5. Identify the systems constraint(s). Decide on how to exploit the systems constraint(s). Subordinate everything else to the above decision. Elevate the constraint(s). If a constraint has been broken, go back to Step 1. Do not allow inertia to cause a system constraint. (Goldratt 1990.)

A comparison of the most frequently used accounting practices is illustrated in Table 6. Table 6. Comparison of variable costing with throughput accounting (Noreen et al. 1995).

The official definition of throughput is revenue minus total variable costs. However, some companies exclude all the other expenses, such as the variable selling and shipping costs, considering direct material the most significant factor. Thus, a simplified version of throughput accounting is also used. The visible difference between conventional and throughput accounting (Table 6) is the handling of direct labor, which is considered as a fixed cost. The variable cost nature of direct labor seems to be more a historical reminder than contemporary reality. In many companies, labor cost is, in practise, treated as a fixed cost. (Noreen et al. 1995.) TOC has been successfully applied also with ABC. Southwestern Ohio Steel has implemented a pricing model based on ABC and TOC. This model has been used to analyze and justify manufacturing cycle-time improvements. (Campbell 1995.) Fritzsch suggests that the conflicting viewpoints of product cost of TOC and ABC can be resolved using different time horizons. ABC is recommended for strategic planning and TOC for the short-term purposes. As the time horizons increase, the solutions produced by TOC begin to look more and more like those produced by conventional cost accounting techniques. Applications of ABC in strategic planning appear to be well documented. These implications seem obvious, but the writer does not verify his statements thoroughly. (Fritzsch 1997.)

2.2.5. Target cost management

CAM-I (Consortium for Advanced Manufacturing International) was established 1972 as an international non-profit-organization to carry out research and scholarship on management and manufacturing technology systems. CAM-I has launched an extensive study labeled as target cost management (TCM). The CAM-I study group made the following conclusions concerning the major changes needed:

An overall management system is required to set the targets and to channel the decisions of all those involved in product definition and development towards wider corporate goals. Product management must widen to incorporate both physical and service attributes measured in terms of customer value. Cost management must shift its focus from accounting for the sake of accounting to enable expenditures to be used as a planning tool for creative product and process design. Product profitability must be assessed and planned in the context of a comprehensive life cycle and the relationship of a broad market value chain. (CAM-I TCM Study Group statements 1994.)

The following quotations have been taken from a state-of-the-art review about target costing. Target costing is a cost management concept that has been developed and practiced in Japanese companies since the 1970s and has been described in English mainly by Japanese authors. Target costing is built on a comprehensive set of cost planning, cost management and cost control instruments which are aimed primarily at the early stages of product and process design in order to influence product cost structures resulting from the market-derived requirements. The target costing process requires the cost orients coordination of all product related functions. (Horvth 1993.) Japanese management accounting uses classification of predetermined and actual costs. Predetermined costs are the expected measures of the cost before production, while actual costs are calculated after production. Predetermined costs are divided into standard costs and estimated costs. Standard costs depend on statistical data and are utilized as an index for cost management. Estimated costs depend on the managers past experience or intuition (Makido 1992). Target costing, as it has been developed in Japan, was invented by Toyota in 1965. Thus, the use of target costing has a long tradition at Toyota. At Toyota, they talk about cost planning and cost control, i.e. influencing product costs during the design phase and keeping the running costs as low as possible. Reducing cost through continuous improvement, cost kaizen, is becoming relatively less important, because the efforts made throughout the company will inevitably lead to fewer opportunities to cut costs. (Tanaka T 1993.) For example, the lifetime target profit Ps of a new model (e.g. Celica) is calculated as follows: Ps = P% * Sa

where P% is the profit ratio of sales and Sa is the target sales. The sales target is calculated using the retail price Sa = Us * Qs where Us is the target retail price and Qs is the target production volume over the products life. Tanaka M (1989) claims that 80-90% of the life cycle cost is determined at the design phase of the product. Therefore, the present cost control system is focused on the design phase. The system consists of five stages: planning, concept design, basic design and manufacturing preparation. The phases are outlines below: STEP1: Planning Summarize the new product plan in a document that clarifies the design requirements: 1. Outline the products concept and mission. 2. Generate primary specifications for the products performance and design. 3. Schedule the products design, manufacturing and marketing. 4. Define product target cost, selling price and volume. STEP2: Concept design Formulate the basic concept of the new product based on the design requirements mentioned in step 1. 1. 2. 3. 4. Formulate the main functional areas. Assign the target cost to the functional area of the new product. Design the basic product concept under the target cost. Use a rough cost estimate to ascertain whether the basic product concept has been designed to fit the target cost.

STEP3: Basic design Make a general drawing of the product based on the previous steps:

1. Assign target cost to the top and middle functions of each functional area or main component of the new product. 2. Frame a general drawing under the target cost. 3. Use a rough estimate to ascertain whether the general drawing has been designed to fit the target cost. STEP4: Detailed design Write the products manufacturing specifications based on: 1. The detailed manufacturing specifications under the target cost. 2. A detailed cost estimate to ascertain whether the products manufacturing specifications have been designed to fit the target cost. STEP5: Manufacturing preparation Write the products manufacturing specifications based on: 1. The design of the manufacturing process, type and jig under the target cost. 2. The detailed cost estimate used to ascertain whether the manufacturing preparations for the product are accomplished within the target cost. (Tanaka M 1989.) Boer and Ettlie (1999) report a case where a car manufacturer could have prevented a $300 million mistake by using proactive target costing. The survey was conducted among the top-performing US R&D units and resulted in 126 questionnaires, of which 77 showed an orientation towards market-driven cost control. Xerox is mentioned as one the well-known practitioners of systematic proactive cost planning. (Boer & Ettlie 1999.) According to Shank & Fisher (1999), target costing seems to be applied mostly at the early stages of product development, but the case of Montclair Paper Mill shows how the target costing principle can be applied at a later stage of the product life cycle. The situation of Montclair Mill seemed gloomy: The mill was making $700 loss per every ton of paper sold. The management believed that the loss was related to the market price rather than their own manufacturing. The standard cost of $2900 per ton was thought to be based on a solid analysis and was taken for granted. The implementation of target costing was introduced with a new target of $1162 per ton, which equals a 60% cost reduction. The management

accepted the challenge, and after ta cost-driven analysis, four major reductions were accomplished: 1. Fiber cost: 60% cost reduction. 2. Paper machine cost: Yield from 47% -> 75%. 3. Dye costs: material savings of $250 per ton incorporated in the yield improvement at the paper machine resulted in an amazing $769 reduction per ton. 4. Conversion costs: Based on benchmarking, a reduction from $303 to $150 was challenged with the risk of possible outsourcing. During 18 moths, the cost dropped to $240, and the continuous improvement seemed to gain even more. Together, these produced the desired level of costing and a dramatic turnaround in the mind set. (Shank & Fisher 1999.) Cooper & Slagmulder (1999) gives a comprehensive review of the application of target costing. He emphasizes the strategic value of target costing in managing the companys future profits. According to their study of seven Japanese companies, the target costing discipline has been structured into three sections, as illustrated in Fig. 17.

Figure 17. Three main elements of the target costing process (Cooper & Slagmulder 1999). Successful application of this process (Fig. 17) requires a highly disciplined approach. Each of the main phases must be balanced to avoid unrealistic target setting. The process starts from the left, by setting the companys long-term sales and profits objectives, and continues through the product level targets to component level target costing. The role of the product chief engineer is remarkable in the fundamental decisions concerning product

and component target costing. The senior management tends to push down the product target costs as much as possible while the chief engineer must find the realistic limits in co-operation with the design teams and the suppliers. Once these have been decided on, the Cardinal Rule is applied to ensure that discipline is maintained throughout the design process. The Cardinal Rule of target costing is: The target cost must never be exceeded. The Cardinal Rule controls the process in three ways: 1. If the design does not reach the target costs, the offsetting saving must be found somewhere else. 2. The company does not launch any product exceeding the target costs. 3. The design transfer to manufacturing must be well controlled to achieve the target cost. As a conclusion, the early involvement of proactive product cost management has been highlighted as a major advantage of some leading Japanese companies in highly competitive markets. (Cooper & Slagmulder 1999.)