Part - I – Advanced Cost Concepts

1. Introduction
2. Application of incremental/differential cost techniques in managerial decisions
3. Target Costing
4. Life Cycle Costing
5. Cost control and cost reduction
6. Throughput accounting, Uniform costing, Target costing. Kaizen costing
7. Inter-firm comparison

Introduction
Accounting systems are designed to provide information to decision-makers. Accounting
language has two primary “variations”, Financial Accounting and Management accounting.
Cost accounting is a bridge between financial and management accounting.
Financial accounting: Financial accounting reports the financial performance of the
company mainly to external users. It reports financial position and income according to
GAAP. Data should be comparable across firms.

Management accounting: Management accounting provides information for internal

users (managers) who direct and control its operations. The reports are not governed
by GAAP.

Cost accounting: Cost accounting is defined as “a technique or method for determining

the cost of a product, service, project, process, or things. It integrates with financial
accounting by providing product costing information for financial statements and with
management accounting by providing some of the quantitative, cost-based information
managers need to perform their tasks.

Cost accounting has long been used to help managers understand the costs of running a
business. Modern cost accounting originated during the industrial revolution, when the
complexities of running a large scale business led to the development of systems for
recording and tracking costs to help business owners and managers make decisions.

Organizations that do not manufacture products may not require elaborate cost
accounting systems. However, even service companies need to understand how much
their services cost so that they can determine whether it cost-effective to be engaged in
particular business activities.

Note: This course focuses on the concepts and procedures of cost accounting
The Purposes of Cost Accounting Systems
Cost accounting systems provide information useful:
1. For managing the activities that consume resources.
2. For planning and control and for performance evaluation. Budgeting is the most
commonly used tool for planning and control and forces managers to: Look ahead,
translate strategy into plans, coordinate and communicate within the organization and
provide a benchmark for evaluating performance.
3. In addition, the cost information is reported on external financial statements as, for
example, inventories, cost of goods sold, and period expenses. The costs of products
and services produced and sold are needed for tax purpose.
4. Information about costs is also needed for a variety of management decisions (both
strategic and short-term decisions). For example, product pricing, product
discontinuance (shut-down), make (produce) or buy, acceptance of a special order.
5. Cost accounting is linked to tax accounting, financial accounting and managerial
accounting because both depend on cost accounting to provide cost information.

Cost Terms
An understanding of cost terms and concepts provides the foundation for the understanding of
cost accounting and management accounting. The terminology and concepts introduced in this
chapter will be used extensively throughout the remaining chapters in this course. Note that
since cost accounting is not for external reporting purposes, there is frequently a lack of
communication between companies, and no standard terminology developed. Many cost
accounting terms lack a uniform definition, and many practices may go by different names.
Cost
The monetary measure of economic resources (tangible or service) given up/sacrificed to attain
a specific objective/purpose such as acquiring a good or service.
1. One guiding principle is that the term cost is a relative term, dependent both on the
“cost object” chosen and the purpose for which cost is being calculated and reported.
2. “Cost” is often actually “estimated cost” due to difficulties involved in cost tracing and
allocation, relevant range issues, which cost method is used, and the cost-benefit
approach to measuring costs.
Expense
A cost that has given a benefit and is now expired. Expenses are incurred intentionally in the
process of generating revenues. E.g cost of goods sold, selling and administrative expenses.
Unexpired costs that can give future benefit are classified as assets.
Loss
Losses are unintentionally incurred in the context of business operation. E.g. losses resulting
from damage related to fire, flood, abnormal production waste, sale of productive asset below
book value.

Cost Object
To guide their decisions, mangers often want to know how much a particular thing costs. This
“thing” is called a cost object, anything for which a measurement of costs is desired. E.g.
products, services, projects, departments, division, branch, etc.

A. Different cost objects tend to be used in different industries. Using products as cost
objects in a manufacturing company makes sense because product cost information
can be used to determine product profitability and to make various strategic decisions.
Services are more appropriate cost objects for many other firms in the service industry.
On the other hand a retailer might find it more useful to treat departments as cost
objects.

B. Two steps (stages) to arrive at the cost of a cost object:

1. Cost accumulation: The collection of cost data (e.g. on wages or overhead) in
some organized way by means of an accounting system.
2. Cost assignment: The cost accumulated must be assigned to various cost
objects in order to provide managers needed information for decision making
purposes. It is a general term that includes:
i. Tracing accumulated costs with a direct relationship to the cost object
and
ii. Allocating accumulated costs with an indirect relationship to a cost
object

Cost Classification
vary with purpose and the same cost data cannot serve all purposes equally well. The word
cost is used in such a wide variety of ways that is advisable to use it with an adjective or phrase,
which will convey the meaning intended.
Now consider some ways of classifying costs:
A. Based on business function (R&D, Production (Manufacturing), Marketing, distribution,
Customer service). For purposes of contracting with government agencies design &
R&D costs are treated as product costs.
 B. Based on financial statement presentation (Capitalized, non-capitalized, inventoriable,
non-inventoriable: product vs. Period)
C. Based on assignment to cost object (direct vs. Indirect)
D. Based on whether or not the specified subunit can control or significantly influence
the cost ( controllable cost, uncontrollable cost)
E. Based on behaviour in relation to cost driver (variable vs. Fixed)
F. Based on aggregation (total vs. unit)
G. Based on economic characteristics of costs ( opportunity costs, sunk cost, incremental
cost, marginal cost)

2. Incremental Costing / Differential Costs

An incremental cost is the increase in total costs resulting from an increase in production or other
activity. For instance, if a company's total costs increase on machine from $32000 to $36000 as the
result of increasing its machine hours, output and revenue increases from $32000 to $ 40,000, the
incremental cost of the $4000 on machine increases revenue $8000.

• The incremental cost is also referred to as the differential cost. The incremental cost is the
relevant cost for making a short run decision between two alternatives.

• Differential costs are defined as the difference in total cost between any two acceptable
alternatives. Differential costs are also known as incremental costs.

• Differential cost is a broader term encompassing both cost increase and cost decreases
between alternatives.

• But Incremental cost is different from Marginal Cost (economists view), which is the cost of
producing one more unit during a specified time period.

• Differential costs can be either fixed or variable.

Differential Costing / Incremental Costing Techniques in Managerial Decisions:

It is a technique used for arriving at managerial decisions in which only cost and income differences
between alternative courses of action are taken into consideration. This technique is applicable to
situations where fixed costs alter. This technique emphasizes on comparing the incremental costs with
incremental revenues for taking a managerial decision. So long as the incremental revenue is greater
than incremental costs, the decision should be in favour of the proposal.

The areas in which the incremental costing analysis can be used for making managerial decisions are
1. Whether to process a product further or not.
2. Dropping or adding a product line.
3. Making the best use of the investment made.
4. Acceptance of an additional order from a special customer at lower than existing price.
5. Optimizing investment plan out of multiple alternatives.
6. Opening of new sales territory and branch.
7. Make or Buy decisions.
8. Submitting tenders
 9. Lease or buy decisions
10. Equipment replacement decision.

Problems on incremental costing

Problem 1 - Coleman Company owns a machine that produces a component for the
products the company makes and sells. The company uses 1,800 units of this
component in production each year. The costs of making one unit of this component are
Direct material $7
Variable manufacturing overhead 6
Direct labor 4
Fixed manufacturing overhead 5

The fixed overhead costs are unavoidable, and the unit cost is based on the present
annual usage of 1,800 units of the component. An outside supplier has offered to sell
Coleman this component for $18 per unit and can supply all the units it needs.

A. If Coleman buys the component from the outside supplier instead of making it, how
much will net income change? Should Coleman make or buy the component? Use the
incremental approach to justify your answer.

Ans:
Variable cost = $7 + $6 + $4 = $17
Incremental cost savings from not making component (1,800 x $17) $30,600
Incremental cost of buying component (1,800 x $18) (32,400)
Incremental decrease in net income due to buying component $(1,800)

Interpretation: Since net income decreases, Coleman should continue making the
component.

B. Suppose Coleman could rent the machine to another company for $5,000 per year.
How would your response change to part A? Use the incremental approach to justify
your answer.

Incremental cost savings from not making component (1,800 x $17) $30,600
Incremental Annual rent from machine 5,000
Total 35,600
Incremental Cost of buying component (1,800 x $18) (32,400)

Incremental Increase in net income due to buying component $3,200

Interpretation: Since net income increases, the company should choose to buy the
components.

Problem 2 - Tenchavez Company makes and sells 12,000 pairs of running shoes each
year. The cost of making one pair of these shoes is
Direct material $ 11
Variable manufacturing overhead 5
Direct labor 4
Fixed manufacturing overhead 7
The fixed overhead costs are unavoidable. Tenchavez allocates fixed overhead costs
based on its annual capacity of 15,000 pairs it is able to make. An overseas company
recently offered to buy 3,000 pairs of shoes at $21 per pair. Regular customers buy
shoes from Tenchavez at $30 per pair.

How much is incremental income if Tenchavez accepts the special order? Should
Tenchavez accept? Use the incremental approach to justify your answer.

Ans:

Variable cost = $11 + $5 + $4 = $20 per unit

Incremental revenue from special order (3,000 x $21) $63,000
Incremental cost to fill special order (3,000 x $20) (60,000)
Incremental income from accepting special order $ 3,000
Interpretation: Tenchavez should accept.

Problem 3 - Brislin Company makes and sells two products, Olives and Popeyes. The
income statement for the prior year, 2001, was as follows:
Olives Popeyes
Sales $16,000 $24,000
Variable cost of goods sold 6,000 10,000
Manufacturing contribution margin $10,000 $14,000
Fixed production 5,000 7,000
Variable selling and administration 2,000 5,000
Fixed selling and administration 1,000 3,000
Net income $2,000 ($1,000)
Brislin's fixed costs are unavoidable and are allocated to products on the basis of sales
revenue. If Popeyes are dropped, sales of Olives are expected to increase by 40
percent next year.
A. Use the incremental approach to determine if Popeyes should be dropped.

Ans:
Incremental revenue ($16,000* 40%) of Olives $ 6,400
Incremental revenue of Popeyes (24,000)
Incremental cost savings of Popeyes CGS +10,000
Incremental cost savings of Popeyes S&A cost +5,000
Incremental variable cost of Olives ($6,000*40%) (2,400)
Incremental s&a cost of Olives ($2,000*40%) (800)

Incremental decrease in income if Popeyes discountinued ($5,800)

Problem 4 - Monk Company manufactures widulators. Watson Company has

approached Monk with a proposal to sell the company a component use in its widulators
at a price of $12,000 for 4,000 units. Monk is currently making these components in its
own factory. The following costs are associated annually with this part of the process
when 4,000 units are produced:
Direct material $4,000
Direct labor 2,000
Manufacturing overhead (fixed & variable) 6,800
Total $12,800
All but $3,000 of the manufacturing overhead costs will continue if Monk discontinues
making the components. Monk will be able to eliminate machine rental of $1,800 per
year if the components are no longer manufactured.

A. How much are the incremental cost or savings if Monk outsources? Use the
incremental approach to justify your answer.

Of the $6,800, $3,000 is avoidable, and $3,800 will

continue.

Incremental cost to buy 4,000 components ($

12,000)
Incremental manufacturing savings if bought:
Machine rental $ 1,800
Direct materials 4,000
Direct labor 2,000
Overhead – avoidable portion 3,000
Total Incremental savings 10,800
Incremental cost of buying ($1,200)
components

B. What is the amount of avoidable costs if Monk buys rather than makes the
components?
$10,800 – from part A above….the costs that can be avoided if the alternative course of
action—buying—is taken.

C. Which costs/amounts from above are opportunity costs, if any?

$1,800......the rent savings are given up if the alternative action--buying--is undertaken.
Note that the cost of the products--whether bought or made is still a 'cost' for the
company.

D. Should Monk make or buy the components? Briefly justify your answer.
Monk should make the components. There is an additional cost of $1,200 if Monks buys
the components. Increases in costs are bad choices in decision making because the
cost must be passed on to the customer or absorbed as lower profits by the seller.

Problem 5 - Anheiser, Inc. has three divisions: Bud, Wise, and Er. Results of May,
2003 are presented below:

Bud Wise Er Total

Units sold 3,000 5,000 2,000 10,000
Revenue $70,000 $50,000 $40,000 $160,000
Less variable costs 32,000 26,000 16,000 74,000
Less direct fixed costs 14,000 19,000 12,000 45,000
Less allocated fixed costs 6,000 10,000 4,000 20,000
Net income $18,000 ($5,000) $ 8,000 $21,000
The variable costs are directly attributable to the products produced for the specific
departments. All of the allocated costs will continue even if a division is discontinued.
Anheiser allocates indirect fixed costs based on the number of units to be sold. Since
the Wise division has a net loss, Anheiser feels that it should be discontinued. Anheiser
feels if the division is closed, that sales at the Bud division will increase by 20%, and
that sales at the Er division will stay the same.

A. Prepare an incremental analysis showing the effect of discontinuing the Wise division
on the remaining divisions.

Bud
Incremental revenue
20%*$70,000 - $50,000 ($36,000)
Incremental variable costs savings
20%*32,000 - $26,000 19,600
Incremental direct fixed costs saved 19,000
Increase increase in profit if discontinued $2,600

B. Should Anheiser close the Wise division? Briefly indicate why or why not.
Yes. The profit increases by $2,600 when the division is eliminated. Direct fixed
costs and variable costs for the Wise division were relatively high compared to those for
the Bud and Er divisions. The increase in sales by 20% of the Bud division was enough
to offset the loss of the Wise division.
3. Target Costing
1. The concept of target costing had its origin in Japan in 1960s as a result of difficult
market conditions.
2. Target costing can be defined as a cost management tool for reducing the overall cost of
the product over its products life cycle. Target costing is a system under which a company
plans in advance for the price points, product costs, and margins that it wants to achieve
for a new product. If it cannot manufacture a product at these planned levels, then it
cancels the design project entirely.
3. Target costing is an approach in which companies set targets for its costs based on the
price prevalent in the market and the profit margin they want to earn. Keeping its costs
below the relevant targets helps the company generate profit.

Target cost = selling price – profit margin

Where the profit margin is based on cost, target cost can be found as follows:

Target cost = selling price

1 + profit percentage

For Example:
D&D is a denim manufacturer that operates in a very competitive environment. It sells denim
to different companies that manufacture and market jeans under their own brands. D&D can
only charge $2 per metre. If the company’s intended profit margin is 15% on cost, calculate
the target cost per unit. If 30% of the cost per metre of denim is related to direct materials,
what’s the target cost per unit for direct materials.
Solution
D&D wants to earn a margin of 15% on cost, so the following formula shall be used to set the
total target cost per unit.
Target cost per unit = selling price
(1 + profit percentage)
Target cost per unit = $2 per metre = $1.74
(1 + 15%)
 D&D has to keep its cost per unit below $1.74 in order to generate 15% profit margin
on cost.
 If 30% of the unit cost is related to direct materials, target cost for direct materials
shall be $0.52 (0.3*$1.74).
 If D&D wants to earn 15% on selling price, the total target cost per unit shall be
worked out as follows:
 Target cost per unit = $2 * (1 – 15%) = $1
The primary steps in the target costing process are:

1. Conduct research: The first step is to review the marketplace in which the company
wants to sell products. The design team needs to determine the set of product features that
customers are most likely to buy, and the amount they will pay for those features. The
team must learn about the perceived value of individual features, in case they later need
to determine what impact there will be on the product price if they drop one or more
features. It may be necessary to later drop a product feature if the team decides that it
cannot provide the feature while still meeting its target cost. At the end of this process,
the team has a good idea of the target price at which it can sell the proposed product with
a certain set of features, and how it must alter the price if it drops some features from the
product.
2. Calculate maximum cost: The Company provides the design team with a mandated gross
margin that the proposed product must earn. By subtracting the mandated gross margin
from the projected product price, the team can easily determine the maximum target cost
that the product must achieve before it can be allowed into production.
3. Engineer the product: The engineers and procurement personnel on the team now take
the leading role in creating the product. The procurement staff is particularly important if
the product has a high proportion of purchased parts; they must determine component
pricing based on the necessary quality, delivery, and quantity levels expected for the
product. They may also be involved in outsourcing parts, if this results in lower costs.
The engineers must design the product to meet the cost target, which will likely include a
number of design iterations to see which combination of revised features and design
considerations results in the lowest cost.
4. Ongoing activities: Once a product design is finalized and approved, the team is
reconstituted to include fewer designers and more industrial engineers. The team now
enters into a new phase of reducing production costs, which continues for the life of the
product. For example, cost reductions may come from waste reductions in production
(known as kaizen costing), or from planned supplier cost reductions. These ongoing cost
reductions yield enough additional gross margin for the company to further reduce the
price of the product over time, in response to increases in the level of competition.

The design team uses one of the following approaches to more tightly focus its cost reduction
efforts:

 Tied to components: The design team allocates the cost reduction goal among the various
product components. This approach tends to result in incremental cost reductions to the
same components that were used in the last iteration of the product. This approach is
commonly used when a company is simply trying to refresh an existing product with a
new version, and wants to retain the same underlying product structure. The cost
reductions achieved through this approach tend to be relatively low, but also result in a
high rate of product success, as well as a fairly short design period.
 Tied to features: The product team allocates the cost reduction goal among various
product features, which focuses attention away from any product designs that may have
 been inherited from the preceding model. This approach tends to achieve more radical
cost reductions (and design changes), but also requires more time to design, and also runs
a greater risk of product failure or at least greater warranty costs.

Objectives of target costing:

1. Downsizing the cost.
2. Making new products compatible to market needs.
3. Motivating the employees to attain target profit.

The process of target costing:

The process of target costing can be divided into three sections
1. The first section involves in market-driven target costing, which focuses on studying
market condition to identifying product’s allowable cost in order to meet company’s
long-term profit at expected selling price.
2. The second section involves in performing cost reduction strategies with the product
designer’s effort and creativity to identify the product-level target cost.
3. The third section is component-level target cost which decomposes the production cost
to functional and component levels to transmit cost responsibility to suppliers.

Application of target costing:

1. Target costing was developed independently in both USA and Japan in different time periods.

2. Target costing was adopted earlier by American companies to reduce cost and improve
productivity, such as Ford Motor from 1900s, American Motors from 1950s-1960s. Although the
ideas of target costing were also applied by a number of other American companies including
 Boeing, Caterpillar, Northern Telecom, few of them apply target costing as comprehensively
and intensively as top Japanese companies such as Nissan, Toyota, Nippondenso. Target
costing emerged from Japan from 1960s to early 1970s with the particular effort of Japanese
automobile industry, including Toyota and Nissan. It did not receive global attention until late
1980s to 1990.

3. Traditional cost-plus pricing strategy has been impeding the productivity and profitability for a
long time. As a new strategy, target costing is replacing traditional cost-plus pricing strategy by
maximizing customer satisfaction by accepted level of quality and functionality while minimizing
costs.

4. Profit margin may be based on cost or selling price.

5. In most of the industries competition is high which means that prices are determined by the
interaction of market demand and supply which the market participants i.e. producers can’t
change. However, they can control their costs. In target costing, companies leverage their ability
to monitor and control their cost to generate a profit.

6. Target costing can be contrasted with cost-plus pricing, in which companies set price by adding
a profit margin to whatever cost they incur.

7. Target costing is a more effective approach because it emphasizes efficiency in order to keep
costs low. Target costing is particularly useful in industries that have low profit margins and
high Competition.

Advantages of Target Costing

1. Induces for innovations

2. Reduces cost
3. Increase spirit of team work
4. Development of right products
5. Enhances the probability of market success
6. Alings the cost of futures with customer’s willingness to pay for them

4. Life Cycle Costing

Introduction :
1. At the start of any project, it is important to understand the costs involved. Traditional
methods simply look at start up costs, cash flow and profit or loss.
2. Life Cycle Costing topic is a strategic management accounting techniques. It considers
cost of an asset through out its life period.
Meaning:
• The process of identifying and documenting all the costs involved over the life of an
asset is known as Life Cycle Costing (LCC).
• Life-cycle cost analysis (LCCA) is a tool to determine the most cost-effective option
among different competing alternatives (Assets) to purchase, own, operate, maintain
and, finally, dispose of an asset or process.
 4.1.Estimating Life Cycle Costs: Simple Formula

The life cycle cost of an asset can be expressed by the simple formula:

Life Cycle Cost = initial (projected) capital costs + projected life-time operating costs +
projected life-time maintenance costs + projected capital rehabilitation costs + projected
disposal costs - projected residual value.

Or

LCC = Capital + Lifetime Operating Costs + Lifetime Maintenance Costs + Disposal Costs –
Residual Value
LCC differs asset to asset and product to product.
For example: LCC differs asset to asset and product to product.
A company is planning a new product. Market research information suggests that the product
should sell 10,000 units at RM21 unit. The company seeks to make a mark- up of 40% product
costs.
It is estimated that the lifetime costs of the product will be as follows:
1. Design and development costs 50,000 ETB.
2. Manufacturing costs ETB per unit 10 ETB.
3. Maintenance cost ETB 30,000.
4. End of life costs ETB 20,000.
Required: What is the original lifecycle costs per unit?
LCC = 50,000 + (10,000 units x 10) + 30,000 + 20,000.
= 200,000
10,000
= 20

4.2. Life Cycle Cost Analysis

A life cycle cost analysis involves the analysis of the costs of a system or a component over its
entire life span. Typical costs for a system may include:
1. Acquisition costs: (or design and development costs).
2. Operating costs:
• Cost of failures
• Cost of repairs
• Cost for spares
• Downtime costs
• Loss of production
3. Maintenance costs:
• Cost of corrective maintenance
• Cost of preventive maintenance
• Cost for predictive maintenance
 4. Disposal costs.
A complete life cycle cost projection (LCCP) analysis may also include other costs, as well as
other accounting/financial elements (such as, interest rates, depreciation, present value of
money/discount rates, etc.).

1. The asset life cycle begins with strategic planning, creation of the asset, operations,
maintenance, rehabilitation, and on through decommissioning and disposal at the end of the
assets life.

2. The life of an asset will be influenced by its ability to continue to provide a required level of
service. Many assets reach the end of their effective life before they become non-functional
(regulations change, the asset becomes non-economic, the expected level of service increases,
capacity requirements exceed design capability).

3. Technological developments and changes in user requirements are key factors impacting the
effective life of an asset.
4.3. The objectives of life cycle costing
1. To Minimize the total cost of ownership of the Utility’s infrastructure to its customers
given a desired level of sustained performance;
2. To Support management considerations affecting decisions during any life-cycle phase;
3. To Identify the attributes of the asset which significantly influence the Life Cycle Cost
drivers so that the assets can be effectively managed;
4. To identify the cash flow requirements for projects.

4.4. Estimating Future Costs

Knowing with certainty the exact costs for the entire life cycle of an asset is, of
course, not possible; future costs can only be estimated with varying degrees of
confidence. Future costs are usually subject to a level of uncertainty that arises from
a variety of factors, including:
1. The prediction of the utilization pattern of the asset over time.
2. The nature, scale, and trend of operating costs.
3. The need for and cost of maintenance activities.
4. The impact of inflation.
5. The opportunity cost of alternative investments.
6. The prediction of the length of the asset's useful life.

4.5. Life Cycle Cost Analysis Tool Structure

Users of the Tool should follow the flow chart through the various sequential steps
of creating a life cycle cost analysis profile. At each step the user is able to access
knowledge relevant to the particular step. The steps in the Tool are:
Step 1 – Define Project Basics
Step 2 – Develop LCCP Data for Each Project Option
Step 3 – Analyze Each Option
Step 4 – Document Analysis
Step 5 – Review and Finalize LCCP Projections
Useful of Life-cycle Costing Concept
Useful apply to low-technology issues, such as repair versus replace decisions Eg-the
New York State Throughway Authority uses life cycle concept to determine the point
at which it is more expensive to repair than to replace bridges (Morse, Davis &
Hartgraves third edition)
4.6. Cost Reduction in LCC

4.7. Advantages and Disadvantages of LCC

Advantages of LCC Improve forecasting
1. The application of LCC technique allows the full cost associated with a procurement to
be estimated more accurately. Improved awareness
2. Provide management with an improved awareness of the factors that drive cost and the
resources required by the purchase. Performance trade-off against cost
3. LCC technique not only focus on cost but also consider other factors like quality of the
goods and level of service to be provided.

Disadvantages of LCC Time Consuming

1. Life cycle costing analysis is too long because of changes of new technology.
2. Costly
3. The longer the project life time, the more operating cost will be incurred.
4. Technology always change day to day.
 5. Cost Control and Cost Reduction
Cost Control
Definition of Cost Control
1. Cost Control is a process which focuses on controlling the total cost through competitive
analysis. It is a practice which works / product to maintain the actual cost in accordance
with the established norms. It ensures that the cost incurred on an operation should not
go beyond the pre-determined cost.
2. Cost Control involves a chain of functions, which starts from
1. To preparation of the budget in relation to the operation.
2. To evaluating the actual performance.
3. To compute the variances between the actual cost & the budgeted cost.
4. To find out the reasons for the variances.
5. To implement the necessary actions for correcting discrepancies.
3. The major techniques used in cost control are standard costing and budgetary control. It
is a continuous process as it helps in analyzing the causes for variances which control
wastage of material.

Definition of Cost Reduction:

Cost Reduction is a process, aims at lowering the unit cost of a product manufactured or
service rendered without affecting its quality by using new and improved methods and
techniques.
• It ascertains substitute ways to reduce the cost of a unit. It ensures savings in per unit
cost and maximization of profits of the organization.
• Cost Reduction aims at cutting off the unnecessary expenses which occur during the
production, storing, selling and distribution of the product.
To identify cost reduction, the following are the major elements:
1. Savings in per unit cost.
2. No compromise with the quality of the product.
3. Savings are non-volatile in nature.
5.1. Tools And Techniques Of Cost Reduction
The following are the widely used techniques of cost reduction:
1. Just-In-Time (JIT) System:
The main aim of JIT is to produce the required items, at the required quality and quantity, at
the precise time they are required. JIT purchasing requires for the items where too much
carrying costs associated with holding high inventory levels. Purchasing system reduces the
investment in inventories because of frequent order of small quantities.
2. Target Costing:
Target costing refers to the design of product, and the processes used to produce it, so that
ultimately the product can be manufactured at a cost that will enable the firm to make profit
when the product is sold at an estimated market-driven price. This estimated price is called
target price.
3. Activity Based Management (ABM)
Activity based management is the use of activity based costing to improve operations and to
eliminate non-value added cost. The main goal of ABM is to identify and eliminate non-value
added activities and costs.
4. Life Cycle Costing
Life cycle costing estimates and accumulates costs over a product's entire life cycle in order to
determine whether the profits earned during the manufacturing phase will cover the costs
incurred during the pre-and-post manufacturing stage.
5. Kaizen Costing
Kaizen costing is the process of cost reduction during the manufacturing phase of an existing
product. The Japanese word 'Kaizen' refers to continual and gradual improvement through
small activities, rather than large or radical improvement through innovation or large
investment technology.
6. Business Process-re-engineering
Re-engineering is a complete redesign of process with an emphasis on finding creative new
ways to accomplish an objective. The aim of business process re-engineering is to improve the
key business process in an organization by focusing on simplification, cost reduction, improved
quality and enhanced customer satisfaction.
7. Total Quality Management (TQM)
Under the TQM approach, all business functions are involved in a process of continuous quality
improvement.
8. Value chain
Value chain analysis is a means of achieving higher customer satisfaction and managing costs
more effectively. The value chain is the linked set of value creating activities all the way from
basic raw materials' sources, component suppliers, to the ultimate end-use product or service
delivered to the customer.
9. Bench Marketing
Bench marketing is a continual search for the most effective method of accomplishing a task by
comparing the existing methods and performance levels with those of other organizations or
other sub - units within the same organization.
10. Management Audits
Management audits, also known as performance audits, can be used to facilitate cost reduction
in both profit and non-profit organizations. Management audits are intended to help
management to do a better job by identifying waste and inefficiency and recommending a
corrective action.

5. 2. Key Differences Between Cost control and Cost Reduction

1. The activity of maintaining cost as per the established norms is known as cost control.
The activity of decreasing per unit cost by applying new methods of production in such a
way that it does not affect the quality of the product is known as cost reduction.
2. Cost Control focuses on decreasing the total cost while cost reduction focuses on
decreasing per unit cost of a product.
3. Cost Control is temporary in nature, unlike Cost Reduction which is permanent.
4. The process of cost control is completed when the specified target is achieved.
Conversely, the process of cost reduction has no visible end as it is a continuous process
that targets for eliminating wasteful expenses.
5. Cost Control does not guarantee quality maintenance, however100% quality
maintenance is assured in case of cost reduction.
6. Cost Control is a preventive function as it ascertains the cost before its occurrence. Cost
Reduction is a corrective action.
 6. Throughput Accounting

INTRODUCTION:
Throughput Accounting (TA) is a principle-based and simplified management accounting
approach that provides managers with decision support information for enterprise
profitability improvement.
• TA was proposed by Eliyahu M. Goldratt as an alternative to traditional cost accounting
• TA is relatively new concept in management accounting
It is an approach that identifies factors that limit an organization from reaching its goal, and
then focuses on simple measures that drive behavior in key areas towards reaching
organizational goals.
Throughput accounting uses three measures of income and expense:
1. Throughput (T) is the rate at which the production system produces desired units.
When the desired units are money (in for-profit businesses), throughput is sales
revenues less the cost of the raw materials (T = S - RM) or throughput is net sales (S)
less totally variable cost (TVC), generally the cost of the raw materials (T = S – TVC).
Note that T only exists when there is a sale of the product or service. Producing
materials that sit in a warehouse does not count. ("Throughput" is sometimes referred
to as "Throughput Contribution" and has similarities to the concept of "Contribution"
in Marginal Costing which is sales revenues less "variable" costs).
2. Investment (I) is the money tied up in the production system. This is money associated
with inventory, machinery, buildings, and other assets and liabilities. In earlier TOC
documentation, the "I" was interchanged between "Inventory" and "Investment." The
preferred term is now only "investment." Note that TOC recommends inventory be
valued strictly on totally variable cost associated with creating the inventory, not with
additional cost allocations from overhead.
3. Operating expense (OE) is the money the system spends in generating desired units.
For physical products, OE is all expenses except the cost of the raw materials. OE
includes maintenance, utilities, rent, taxes, payroll, etc.

Organizations that wish to increase their attainment of The Desired Goal should therefore
require managers to test proposed decisions against three questions. Will the proposed
change:
 • Increase Throughput? How?
• Reduce Investment (Inventory) (money that cannot be used)? How?
• Reduce Operating expense? How?

The answers to these questions determine the effect of proposed changes on system wide
measurements:
• Net profit (NP) = Throughput - Operating Expense = T-OE
• Return on investment (ROI) = Net profit / Investment = NP/I
• Productivity (P) = Throughput / Operating expense = T/OE
• Investment turns (IT) = Throughput / Investment = T/I

7. Uniform costing system

Uniform costing is not a particular method of costing. It is adoption of common cost

accounting principles and methods by member companies in the same industry so that their
cost figures may be comparable. Uniform costing can be defined as the ‘use by several
undertakings of the same costing principle and practices’.
In other words, it is a technique or method of costing by which different firms in industry
apply similar costing system so as to produce cost data which have maximum comparability.
Standard costs may be developed and cost-control is secured in firm through mutual
comparison.
• Relative efficiency and inefficiencies in production may be identified and suitable steps
may be suggested to control and reduce the cost.
• The objectives of uniform costing are to standardize accounting methods and to assist
in determining suitable prices of products of firms which adopt this method.

7.1. objects of a uniform costing system

1. It provides reliable data for making inter-unit comparisons of cost performances.
2. It helps to arrive at the cost of production for the industry as a whole on a common
basis acceptable to all individual units or firm of the industry.
3. It provides data to compare the cost of production and the production efficiencies
between one firm and others.
4. It ensures that the product prices are based on authentic costing data.

7. 2. Application of Uniform Costing (Scope)

Application of Uniform Costing (Scope): Uniform costing may be applied in two different
situations.
(a) Common Control and Management:
Uniform costing may be applied when number of units or firm producing similar goods
and services are under a common control or controlled by the same group of
management.
(b) Trade Associations:
Uniform costing may be adopted by firms or units which are related to a trade
association. Different firm may form an association through which they may adopt
common costing method and practice.

7.3. Requisites of Uniform Costing

Uniform costing can be adopted if certain pre-conditions exists. The success of a uniform
costing system depends primarily on the cooperation extended by different units or firm
towards the working of the system. Every unit should agree to supply required accounting and
costing information without reservation to a central body formed by them for implementation
of the uniform costing scheme.
Following are pre-requisites of uniform costing:
1. Firms or units adopting uniform costing must be ready to provide and share accounting
and costing information freely.
2. They should adopt a common system of costing regarding classification, distribution and
absorption of costs. They must agree on a common technique of costing e.g.,
absorption costing, standard costing or marginal costing.
3. The firms must use a common terminology and procedure for cost ascertainment and
cost control.
4. There should not be any restriction from the Government in adopting uniform costing.
5. A central body or proper organisation must be set up for preparing comparative
statistics for the use of member units participating in the uniform costing.
6. Above all, the most important is that units or firms must have mutual trust, confidence
and cooperation.

7.4. Advantages and Disadvantages of Uniform Costing

Advantages:
1. It helps in installation of an ideal costing system.
2. Standard norms of operations are set for the industry as whole. Every member unit can
evaluate its performance against these standard norms and strive for betterment.
3. It helps in eliminating cut throat competition in the line of industry and ensures stability
4. It leads economy and efficiency for medium and large scale firms.
5. It assists in making effective cost control.
6. It provides a suitable basis for making inter firm comparison.
Disadvantages:
1. This technique assumes that all the undertakings in the industry are identical, which is
not possible.
2. The installation of uniform costing is quite expensive and the medium and small sized
units are not in a position to adapt it.
3. uniform costing encourages monopolistic trend in the industry. monopolistic trends
have their own economic and social evil.