18.
Approaches to management accounting

18.1 Introduction

Management accounting is concerned with the provision of information to internal managers within an organisation for planning, decision-making and control purposes. It is both forward-looking and historic. It is also flexible as it is not constrained by financial reporting rules. That means that management accounting data can be prepared as frequently as required, or not at all. It can also include data on both financial and non-financial performance.

Organisations all have a purpose or strategy that they are seeking to pursue, and which helps them to envision what success is in their field. These are often summarised in what is called a ‘mission statement’ – although other forms of wording are can be used. These, usually quite short, statements summarise what the goals of an organisation are.

Management accountants typically work with senior management to design a handful of metrics that reflect success for the organisation. These are usually called key performance indicators (KPIs) and reflect the practical steps that must be achieved if the mission statement of the organisation is to be fulfilled.

For example, a retail chain may seek to make its profit by being the number-one sportswear retailer for 15- to 20-year-olds. To do this it seeks to work with social media influencers to secure sales. KPIs will undoubtedly refer to sales volumes but also to issues such as:

• the number of social media views of its products
• the success of particular influencers
• the speed of product range turnover if that is key to success and attracting attention to the brand
• attention by sector, for example, based on gender or region
• gross margins earned by line – because profit is still a key focus.

On the other hand, a charity might seek to prevent extinction of certain species of animals through a captive breeding programme and set KPIs related to that, from fundraising to breeding success and publicity ratings, while in the public sector a council might seek to reduce road deaths by investing in road construction.

It is important to design appropriate measures to ensure that organisational behaviour is aligned with the strategic objectives. As part of the design process the management accountant will consider the external market conditions and, when appropriate, competitors’ strategies. Poorly designed metrics can drive undesirable behaviours within the organisation and lead to it being unable to achieve its goals.

It is a normal task of a management account to be involved in preparing plans to ensure that their organisation has sufficient resources to achieve its objectives. These usually include both financial and non-financial data.

At high level these are called strategic plans and will usually cover a period of several years.

A plan for a forthcoming period (usually a year) is commonly called a budget. This will set out detailed operational plans for the entity and will seek to then suggest the financial implications of those plans by forecasting:

• income statements, usually by month or four-week period
• capital expenditure
• cash flows, usually by month or four-week period
• future balance sheets, at least at the end of the period and maybe by month or four-week period
• data on KPI performance, usually by month or four-week period, and sometimes for shorter periods such as weeks.

It is important to note that the structure and disciplines of financial reporting are not ignored in management accounting, although it is possible that different accounting policies might be adopted in management accounting. Most commonly, management accounting has a cash flow focus, meaning that the fair value accounting that is commonplace in International Financial Reporting Standards reporting is frequently ignored in management reporting.

These budgets for the entity as a whole can be split further into what are often called functional budgets. These can be prepared for each senior manager within an organisation setting out the financial expectations set for them for the period in question. These might be set, for example, by country of operation, or by product or service grouping, or with regard to capital investment.

The association between a functional budget and a manager is important. The purpose of much management accounting is to set goals for managers with responsibility for key aspects of an organisation’s operations. This means management goals and accounting have to be aligned so that managers can be held to account for what they achieve.

The management reporting system of an organisation should be designed to ensure that managers have sufficient information to make decisions related to performance for their area of responsibility. It should also be designed to ensure that they receive regular reporting (usually monthly, but increasingly commonly, four-weekly) on their performance when compared to the expectation shown in a budget. With variance analysis – which compares actual and budgeted performance – it is possible to evaluate whether managers are on track to meet their plan, and areas where actual performance differs from the plan can be highlighted and required actions discussed.

These points being noted, this unit largely focuses on approaches to pricing and costing adopted by management accountants.

This activity will not necessarily relate to policies linked to the goal of profit maximisation. Organisations that are not profit-focused still need management accounts. All organisations do, however, need to understand the implications of the decisions they make, and in commercial organisations this will involve decision-making on optimal pricing to achieve profit objectives across the organisation as a whole.

This might require the exercise of judgement because, for example, an organisation may decide to cross-subsidise its products. An example of this is selling a mobile handset at a lower price than competitors to then enable sales of data at a higher price across the duration of a customer’s contract. It is important that issues like this are understood by the management accountant.

18.2 How can an organisation create value?

The aim of an organisation is to create value for interested parties. In a business this might be the owner or shareholders, in an NGO it could be the beneficiaries, and in the public sector it could be citizens. In many cases the organisation will operate in a competitive environment and must articulate its proposition clearly to its customers or service users. We focus on this situation in what follows.

In his book, Competitive Advantage (1985), Michael Porter introduced a framework that has shaped the way businesses think about strategy since then. Porter’s framework revolves around three key concepts: cost leadership, differentiation, and focus. These strategies are intended to create competitive advantage for those using them.

Cost leadership is a strategy aimed at becoming the lowest-cost producer in an industry. The assumption is that if a company can deliver superior performance at a lower cost than its competitors then it is bound to succeed. As a result, the object is to offer lower prices or maintain higher margins than competitors. This can be achieved by delivering:

• economies of scale by, for example, increasing production volume to reduce the per-unit cost of goods or services supplied
• operational efficiency by, for example, reducing waste
• technological superiority by, for example, using artificial intelligence
• cost control, whether from superior supply chain management or by controlling overhead costs.

Famous cost leaders include Lidl, Aldi, EasyJet and Ryanair.

Differentiation is a strategy that focuses on the creation of unique products or services that stand out from competitors. Key elements of differentiation include:

• product innovation, for example, by creating new or innovative products that meet customer needs in novel ways
• brand management to resonate with customers and convey quality
• enhanced customer experiences
• quality control to ensure that products meet or exceed customer expectations.

Companies seeking to differentiate their products can use legal protections such as copyrights, patents and trademarks to create barriers to market entry. This strategy can initially be viewed as being anti-competitive but the competitive advantage itself comes from making more profits compared to other companies that do not operate in a monopoly setting.¹ The danger of this is that it does not encourage innovation or strategies to improve efficiency while it continues to increase price. Examples of companies that have excelled by differentiation include Apple, Ferrari and Patagonia.

Focus involves a company identifying a particular market segment that it wishes to service particularly well. There are two variants within this theme. With cost focus, a company seeks to be the lowest-cost producer within a niche market. With differentiation focus, the company aims to offer unique products or services for the market that they serve.

Successful focus-based strategies require:

• market research to understand a market in great depth
• customisation, which requires tailoring products or services to a particular market
• specialisation, which means developing particular expertise in a market
• building strong customer relationships to encourage loyalty.

Companies that have successfully employed focus strategies include Rolls-Royce, which targets the luxury automobile market with bespoke vehicles, and leisure sector companies such as Saga, which specialises in holidays for older people.

There are other strategies used in organisations such as those described by Miles and Snow’s (1978). They describe four strategies in their book Organizational Strategy, Structure, and Process, each suggesting a unique approach to management:

• A defender strategy seeks to maintain a secure position in a stable product market. Defenders seek to protect their market share by improving existing operations.
• A prospector strategy, by contrast, describes a company always seeking new opportunities for growth. They typically invest in research and development to pioneer new products and markets. They are risk-takers.
• Analysers balance the characteristics of defenders and prospectors. They maintain core products while exploring new opportunities.
• Reactors respond to market conditions on an ad hoc basis. They lack of a coherent strategy.

Not all of these definitions will apply to all organisations. The reactor exposes itself to the highest risk.

Organisations can also consider adopting what are called ‘blue ocean’ and ‘red ocean’ strategies by W. Chan Kim and Renée Mauborgne (2005). These strategies explain how companies compete within their industries.

• In red ocean markets, companies compete in existing markets, seeking a larger share of existing demand. This can lead to fiercely competitive rivalries.
• A blue ocean strategy describes uncontested market spaces where these is new demand created by innovation. The term ‘blue oceans’ refers to new opportunities that avoid direct competition.

Companies might also need to consider the practical implications of using either a hybrid or pure strategy (Alnoor et al., 2022). The key point is that understanding the competitive environment in which a company operates and how it wishes to manage it will help to shape the organisation’s approach to understanding its costs and their relationship to its income-generation capacity.

18.3 Product, pricing and costing

18.3.1 Deciding what product to sell

The decision of what to sell should be driven by the company’s vision, mission and objectives. Some methodologies for determining these have already been discussed.

Any product that an entity decides to sell or service it decides to offer should be selected based on its ability to meet the needs of a customer, whether in a niche or mass market. Unless it does this it cannot succeed. Market research is required to determine this, with the complexity of that research depending very largely on the likely size of the market and the cost of bringing a product to market. If that cost is high, more market research is required to manage risks.

Competitor information can also be key. Analysing market information for price, interests, customer reviews for similar products, current trends, how these needs can be practically met and carefully considering available capital to enter a market is essential.

This is often harder for not-for-profit and public-sector organisations, but key metrics of success have still to be considered. Only when a potential product, with an associated specification, has been agreed upon can costing exercise to assist the determination of a product price be undertaken.

18.3.2 What price should a product be sold at?

Pricing a product or service is critically important but is only part of the overall picture. Indeed, when considering how to bring any product to market, McCarthy’s (1960) ‘marketing mix’ might be considered. This is composed of four Ps:

• product, which refers to product quality, design, branding, packaging and life cycle
• price, which refers to the cost of production, distribution and marketing as the variable expenditure that must be covered, as well as value perception in the marketplace, competitor’s prices, market conditions and whether price is used to be as a promotional tool in its own right, for example, as a loss leader for other products
• place, which refers to the distribution channels used to make the product available to customers, with an emphasis on creating availability
• promotion, which refers to the options available to enhance sales of the product, from advertising to marketing and policy placement and beyond.

18.3.3 What the management accountant should know

There are many models for product selection and pricing that the management of an entity might choose to adopt, whatever the product, service or facility that it is seeking to supply.

The role of the management accountant is to both help inform those decisions and to understand the consequences of them for their work. Unless they do, they might promote decision-making that is in conflict with the key organisational goals of the entity that they work for. The management accountant does not work in isolation; they work within the environment of the organisation that employs them, and they need to understand just what that is.

18.4 The importance of economics

The management accountant needs to understand not only theories about management but also economic theory on how prices are established.

This is particularly important when considering what is called the theory of price elasticity.²

Understanding a product or service’s price elasticity of demand will help determine a appropriate pricing strategy for it.

For example, if a product is distinctive, customers will purchase it irrespective of the price. In other words, PED is less than 1. This is referred to as ‘inelastic’ demand. Here the price strategy is known as ‘skimming’ or being a ‘price-maker’ and takes advantage of the customer’s lack of sensitivity to prices.

In a competitive market with price-sensitive customers, demand is considered ‘elastic’ and will vary in relation to price as customers freely switch between similar products. The organisation may not be able to set prices freely. It is the market that sets the price, and the company selling in that market is, in effect, a ‘price-taker’. A pricing strategy in this type of market is known as ‘penetration’ pricing as the organisation hopes to build a market share that will enable it to reduce its costs or build customer loyalty.

18.5 Some common pricing approaches

18.5.1 Cost-plus pricing

In this approach, the product or service cost is used as the starting point for pricing. A markup of, for example, 20% is added.

The formula is:

\[\text{Selling price} = \text{Product cost} × (1 + \text{Markup}\ \%)\]

In other words, using the 20% markup and product costs of £10:

\[\text{Selling price} = £10 × (1 + 0.2) = £12\]

18.5.2 Sales margin pricing

Another pricing approach seeks to achieve a consistent gross profit margin. In this case the formula they use might be:

\[\text{Selling price = Cost of sales}/(1 − \text{Gross profit margin}\ \%)\]

If the cost of sales is £7 and the required profit margin is 30% ,the result is:

\[\text{Selling price} = £7/(1 − 0.3) = £10\]

18.6 What makes up the cost of a product?

As we’ve seen, many organisations wish to know the cost of a profit or service that they supply when setting its price. Doing so helps them ensure that they are likely to sell it at a profit. Determining just what the costs are can, however, pose problems for many organisations.

As an example, consider a business that sells cakes from a van at events such as music festivals. Suppose that when they are planning prices to charge at an event, they assume that they:

• can buy cakes for £2 each from a bakery to then resell
• will pay a pitch fee of £1,000 for the weekend
• will sell 1,000 cakes over the weekend

This then suggests that:

\[\text{Cost per cake sold } = \text{ Cost of buying the cake } + \frac{\text{Cost of the pitch}}{\text{Number of cakes sold}}\]

In other words:

\[\text{Cost per cake sold} = £2 + (£1,000/1000) = £2 + £1 = £3\]

However, this only covers what are called the direct costs. A gross profit – meaning that the costs of sales might be covered – is earned if the sale price is set at £3, but this would not deliver a profit if there were overheads to cover. For example, the van the business uses has a cost. Suppose the van:

• cost £20,000 6 months ago and is expected to sell for £4,000 after 5 years of use, at a resulting net cost of £16,000
• will be used 40 weekends a year over that time, or 200 times in the 5-year period
• is expected to cost £4,000 per year for insurance, fuel and servicing.

In addition, what about labour costs? How these are treated might depend upon how staff are to be paid for the weekend. For example, are staff to be paid per cake they sell or per hour worked when selling cakes?

These questions highlight that there are differences between:

• Variable costs such as the cost of buying cakes, and labour if employees are paid per cake sold
• Semi-variable costs, which are avoidable if the event is not undertaken, such as the pitch fee, or employees’ labour if they are paid for the weekend as a whole
• Attributable fixed costs, such as the costs of the van.

There is a need to attribute the semi-variable and attributable fixed costs to units sold if the price charged is meant to cover both the direct costs of sales and a reasonable part of overheads so that a profit as a whole is to be earned.

The problem becomes more complex if coffee is sold as well as cakes, and the coffee is made to the customer’s order. Then variable costs might also include:

• disposable coffee cups
• coffee beans
• milk
• water, if it has to be identifiably paid for.

Now the pricing might also need to take into account differences between the products and in the product mix because, for example:

An Americano coffee requires only:

• a cup
• coffee beans (although the number will vary depending on the number of shots)
• water
• modest labour costs.

On the other hand, a cappuccino requires:

• a cup
• coffee beans
• water
• milk, in potentially variable quantities
• nutmeg or grated chocolate
• additional labour cost.

It can be hard to know precisely what the definition of the product offering might be and what the product mix might be.

As a consequence, product pricing will be approximate in many cases, and will have to be based on reasonable assumptions which should, ideally, be specified so that variances between expectation and actual performance can be tested after the event so that lessons can be learned. This is not a problem with management accounting: the iterative processes of learning inherent in this exercise is an integral aspect of the discipline.

The management accountant must balance these various issues to estimate a product cost. To do this, they must make some reasonable assumptions based on the information available. In this example, various calculations and decisions can be made, as follows.

18.6.1 Capacity constraints

We are provided with some further information about the event that clarify the constraints it imposes:

• The event being considered lasts for 2 days. It is likely that there will be 12 hours of sales time on the first day and 8 on the second, or 20 hours in all.
• It takes 2 minutes to make a coffee, but 2 can be prepared at once, so a sale can be made approximately every minute using the available equipment – 1,200 cups of coffee in all.
• However, there are quiet periods in any day. Realistically, selling more than 1,000 cups of coffee is very unlikely.
• Weather can affect sales at an event like the they plan to attend. It will not be feasible to sell fewer than 500 coffees over the 2-day event. If the business owners sold fewer than this, it would not be worth attending.
• The van has limited storage capacity. Selling more than 300 cakes a day is unlikely for that reason.
• These real constraints must be noted for the management accountant’s calculations to be useful.

18.6.2 Costing the coffee

Experience has shown that:

• Each disposable cup costs about 6p, or 8p with a lid, and 10p with a holder to prevent scalding.
• Reasonable coffee beans can be bought for around £12 per kilogram and make around 60 coffees, assuming double shots. That is 20p per coffee.
• Water is included in the pitch fee and can be ignored.
• Milk is sold by the pint in the UK, where this costing is being done, and costs around 40p a pint. On average coffees can be made with a fifth of a pint of milk, assuming all contain milk. Most do, so it is fair to allocate 8p per coffee for milk.
• Nutmeg or grated chocolate have a negligible cost that is assumed to be 1p a cup.
• Sugar costs 2p per sachet, but at most half of all customers use it, so the cost equates to 1p per cup.
• The marginal cost of a coffee is assumed to be 40p in total.
• Although this varies from coffee to coffee it is assumed that the variance is not significant enough to consider.

18.6.3 Pricing

Demand for cakes is price-elastic. If the price is £3 then 80% of coffee customers will buy a cake. If it is £4 then 50% will. Using the formula

\[\text{PED} = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in price}}\]

the percentage change in quantity demanded is \((80 − 50)/80 = 37.5\%.\)

The percentage change in price is \((4 − 3)/4 = 25\%.\)

This means the PED is 37.5/25 = 1.5, meaning that price is described as elastic.

There is, however, a problem: if 1,000 coffees are sold and 80% of customers buy a cake, but the van only has capacity for 600 cakes over 2 days, then a lot of sales are going to be missed because the cakes will be sold out.

Additionally, if it turns out to be a very wet day and only 500 coffees are sold, even if the price for a cake is £3, only 400 cakes will be sold. If 600 cakes have been ordered, there will be a lot of waste at significant cost, which is a risk the business owners would rather avoid.

In that case, it is decided to price cakes at £4, meaning that for every coffee sold, half a cake will be sold, at an average price of £2 per coffee. Maximum cake sales are now 500, which is within the van’s capacity. They decide on a £4 price, and order 500 cakes, and hope for good weather. This does, however, leave a real risk of waste arising, which is an issue noted in more detail below.

Market research shows that £3 is the minimum price people to expect to pay for a coffee at an event like the one that the business is attending. It also shows that at above average prices of £3.50, people complain, and significant numbers will not buy. The PED is very elastic above this price. Allowing for differing types of coffee on sale, the owners think that the average price of coffee sold on the day will be £3.25.

18.6.4 Summarising the costing

Pulling this data together, we get the following:

• Coffees will sell for £3.25.
• Each coffee has an average cake sale of £2 (half a £4 cake) associated with it.
• Revenue per sale is, then, expected to be £5.25.
• The cost to make a coffee is 40p.
• The cost of a sale of a £2 cake is £1.
• Marginal costs of a sale are, then, £1.40, excluding waste.
• Wasted cakes, if sales of cakes fall below the 500 ordered and costed for, cost £2 per cake.
• All other costs are either semi-variable (in that they could only be avoided by not going to the event) or are attributable (in that they contribute towards costs already incurred).
• Details of semi-variable costs:
  • Labour costs are paid at £12.50 per hour, irrespective of sales made and with 2 people working at all times, meaning labour costs for the 20 hours of opening at the weekend, plus 4 hours of set-up and getting the van back to base, are £600 (24 hours for each of 2 people, at £12.50 per hour).
  • The pitch fee is £1,000.
  • The direct costs of the van are £100 (£4,000 a year, divided by 40 planned events).
  • The total semi-variable costs are, then, £1,700.
• The attributable cost for the use of the van is £80 (£16,000 of total van cost over its life after allowing for sale proceeds, divided by 2,000 events over its life).
• Sales of fewer than 500 coffees can be ignored as the owners of the business are sure they will get at least that many, and sales of over 1,000 coffees can be ignored as they are very unlikely given the van’s capacity.

This data is used in the following exercises.

18.7 Costing

This exercise is deliberately detailed, and yet it relates to a very simple business with a very simple product mix and a very simple cost structure. What it demonstrates is how attuned to the reality of a business a management accountant has to be if they are to truly add value to the organisation that they work for. The management accountant is much more than a technician. It is their job to understand exactly how a business works.

Using the above data we can consider the various methods of costing used by management accountants.

18.7.1 Marginal costing

One method of costing is marginal costing. Using this method, variable costs are dealt with first, and then the fixed costs. Using the above example:

As this table shows, on a marginal cost basis sales always make a contribution towards the semi-variable and attributable costs of the event. Within the range of plausible potential sales, the risk of waste never threatens this. In fact, extrapolating the data shows that there will be a positive marginal contribution from sales, having allowed for variable costs including waste, until sales fall to around 200 coffees, and the owners have already decided they would not attend the event if the risk of this level of sales was significant.

The trouble with marginal costing is, however, that it does not really indicate profitability when semi-variable and attributable fixed costs can be reasonably allocated to the event.

As can be seen from the above table, these semi-variable and fixed costs are fixed across all levels of sales. As the table also makes clear, this means that these costs per unit sold fall very steadily as the number of coffee sales increases.

Expressed as costs per unit sold, the data looks like this:

Of course, the primary limitation of this approach is that costs are not truly fixed. In this example, if the van was successful, a second van might be added to the fleet simply to hold more cakes, for example, or the original van would be upgraded to one with a higher capacity. Perhaps more staff would be needed to sell the cakes and additional staff would be brought in who would require additional payment. Over time we would also expect fixed costs to increase at least in line with inflation (for example, rents). As a result, marginal costing is typically a short-term approach. Furthermore, variable costs may not remain constant as volumes increase.

18.7.2 Absorption costing

Absorption costing is an approach that aims to include the fixed costs into each unit. If done correctly this should enable the business and management accountant to address some of the limitations of marginal costing, but it requires a bit more work, and some assumptions to be made.

This technique can be explored using the example already noted. The key principle is that we predict volumes in advance, then using this we can simulate an artificial variable cost that absorbs fixed costs into each unit sold.

If the predictions that we could sell 1,000 coffees and 500 cakes are 100% correct, then in the example noted above the total semi-variable and attributable costs of £1,780 could be ‘absorbed’ as an additional cost of £1.78 for each coffee and cake combination sold, bringing the total cost per combination sold to £3.18. The £1.78 represents an overhead absorption rate (OAR) per unit.

The problem is that this OAR is only appropriate if 1,000 coffees and cakes are sold. If the unit sales change, so does the OAR. In the short term the OAR adds little value, and nor does absorption costing.

However, in a market where things like weather have less impact on sales and rents are fixed and not semi-variable like event pitch fees, absorption costing can be more useful, especially if sales volumes are more broadly predictable, as they are in many cases. Absorption costing can more easily suggest total unit costs and so the total profit made per sale, which helps decision-making.

The method of costing chosen has to suit the situation of a business. In the example used, marginal cost aids decision-making more than absorption costing.

18.7.3 Absorption costing of multiple products

It is unusual for a company to sell only one product, and multiple product lines mean that we cannot reliably and simply divide expected fixed costs by expected volume unless the products are virtually the same (different styles of coffee, for instance). If a company were to produce laptops and phones, then the different types of products should absorb fixed or indirect costs at different rates.

‘Traditional’ does not mean old-fashioned, as the absorption costing system remains in use. We generally use ‘traditional’ to mean simple methods and ‘advanced’ for more complex methods.

Absorbing costs at different rates is relatively straightforward; we just need to set an OAR based on something other than units. Using traditional absorption costing, this might be based on labour hours (the time staff spend on working on a product) or machine hours (the time the machines spend working on a product). Once the OAR is determined, we can then determine the costs of a job quite easily.

Suppose a new laptop is being developed by a company. The designers have told us that each unit will require £200 of materials and parts, it will take 4 hours of labour (at a cost of £20 per hour) to make, and 2 hours of machine time. The laptop will be made in the same factory used for other laptops, and all the fixed costs for that factory are absorbed based on an OAR of £50 per labour hour.

18.7.4 Job costing

When companies offer custom or bespoke products or services, we can use the job costing system to capture costs incurred in production. This involves recording costs incurred of a specific order from when materials needed to make the item are bought to when the item is delivered to the customer. The job costing system can also be used in the service sector, for example, in accountancy firms that provide bespoke services to clients.

Take a UK furniture retailer as an example. Different customers could order the same type of sofa but require different fabric to be used and some might want extra features added, such as extra storage, or a recliner, and so on. This means the costs of materials, labour and overheads may be different for each order.

The job costing approach assumes:

• marginal costs – for example, materials and time spent – can be accurately recorded
• OARs can be calculated for each type of activity undertaken
• these costs can then be combined to create a cost per job.

This method also assumes the fixed costs do not vary at different levels of production and that expectations for production quantities are accurate, yet this is seldom the case, which leads to over- or under-absorption of fixed costs.

18.7.5 Activity-based costing

An OAR can be very useful for capturing the total cost of a product or service. However, a criticism of the approach is that it is too simplistic. The link, for example, between factory rent and machine depreciation and the number of hours staff work is tenuous at best. By definition, fixed costs are based on time periods, not volumes.

Activity-based costing (ABC) is an approach that considers that costs are being ‘driven’ by activities, not functions, time or anything else. For example, the costs for a parcel delivery company are primarily driven by the number of deliveries, not the number of units in each package. It is even sufficiently flexible to incorporate sustainability-related costs that help organisations identify the ‘true’ cost of a product or service.

The idea is to consider each type of fixed cost in turn, identify what drives these costs, and then determine an overhead rate to be charged per unit of activity.

The steps involved in ABC are as follows:

1. Identify the activities involved in manufacturing the product or developing the service.
2. Identify the cost driver for each activity, that is, the ‘cost pool’.
3. Calculate the cost driver rate (overhead cost or cost driver activity).
4. Identify the cost driver usage by each product or service (activity level).
5. Calculate the overhead cost from the cost pool (cost driver rate times cost driver usage).
6. Calculate the total unit cost.

18.8 Should we set the price first?

Having explored some of the issues around determining costs, we can return to pricing.

These costing exercises assume, in the main, that the entity undertaking these exercises can set its own prices.

However, as was shown in the coffee van exercise, this is not always what happens. Either companies have to match the price of competitors, or those competitors only allow for a small range of choices to be made. These entities have no choice but start their pricing exercise with current market price of similar products or services. They then need to decide whether:

• they can differentiate their products to enable them to become price-makers rather than price-takers, or
• they need to treat the desired profit of their product as a cost and then determine a target cost for what they are selling – profit included, which, in other words, establishes the break-even point at which that product becomes viable. If a product is expected to cost more to make than this target cost, then it is not viable, and an alternative should be sought. The value of target costing is to identify products or services that will or will not be profitable before production even starts.

Example

Assuming a mobile phone manufacturer wants to make virtual reality headsets.

Similar virtual reality headsets are being sold in the market at £500.

If the company wants to make 30% profit margin on the selling price, the expected costs should be no more than £350.

If the company is in the position to set the price (possibly because the headset will have a feature that is unique to the market), then they simply need to add a desired profit on top of the costs to determine the selling price of the headset.

As the purpose of target costing is to design profitable products and services, all the associated costs need to be captured. These include research costs, prototyping costs, development costs and so on. It might also be the case that there are costs post-sale that will be incurred, such as warranty claims, customer support or environmental clean-up costs. When we start to consider all the costs of a product from start to finish, we consider the costs from the whole life cycle of a product.

Target costing ensures that a product can be sold at the current market price and still make the desired profit. If it cannot, then the company should return to the design stage to attempt to design or engineer a cheaper product. This is not about trying to make a product cheaply or cutting corners, but exploring more efficient ways to make the desired profit.

18.9 Summary

• An organisation needs to have a strategy before setting a price or determining costs. Mixing strategies is common in practice.
• Overhead costs need to be allocated fairly across products and services to establish the full cost.
• Fixed overheads are treated differently under marginal costing and absorption costing methods.
• The activity-based costing system reflects the activities involved in producing a range of products.
• If there is a similar product in the market, target costing might be more appropriate to achieve the desired profits.

Costing methods are limited by the assumption that fixed costs do not increase whereas in reality most costs considered fixed increase in steps, for example, through renting a new warehouse or investing in machinery.