5. Costing and pricing in a competitive environment
The traditional way: rendering a service to cost units
• Direct-labour-intensive and direct-labour-paced production
• A low level of indirect cost relative to direct cost
• A relatively uncompetitive market
Overheads represented a small element of total cost. Not too much effort was devoted to
trying to control overheads, because potential rewards of better control were relatively
small. It was reasonable to charge overheads to individual jobs on a direct labour hour
basis. Service industries were relatively unimportant.
The new environment:
• Capital-intensive and machine-paced production
• A high level of indirect cost relative to direct costs
• A highly competitive international market
Service industries now dominate the economy.
Changes in competitive environment à businesses must manage cost more effectively.
Traditional approach job costing = deriving the full cost of output where one unit of
output differs from another. The new environment = Overheads are now much more
significant. Even a small chance in the amount of direct labour worked on a job could
massively affect the total cost deduced. Businesses accepted that overheads exist and
they must be dealt with in a as practical way as possible.
Activity-based costing (ABC): overheads as being caused by activities. Overcome the
problem of overheads by directly tracing the cost of all support activities. Managers
need to identify:
• Each of the various support activities involved in the process of making products
or providing services.
• The costs to be attributed to each support activity.
• The factors that cause a change in the costs of each support activity (cost
drivers)
Identifying the cost drivers is a vital element of a successful ABC system. They have a
cause-and-effect relationship with activity costs and so are used as a basis for attaching
activity costs to a particular product/service.
ABC requires:
• An overhead cost pool to be established for each activity. There will be just one
cost pool for each separate cost driver.
• The total cost associated with each support activity to be allocated to the relevant
cost pool.
• The total cost in each pool to then be charged to output using the relevant cost
driver.
Final step = dividing the amount in each cost pool by the estimated total usage of the
cost driver to derive a cost per unit of the cost driver. This unit cost figure is then
multiplied by the number of units of the cost driver used by a particular product, or
service, to determine the amount of overhead cost to be attached to it.
, Benefits ABC:
• More accurate cost for each unit à help managers in assessing product
profitability and in making decisions concerning pricing and the appropriate
product mix.
ABC VS the traditional approach:
Traditional
• Overheads are apportioned to product cost centres.
• Typically overheads per direct labour hour.
ABC
• Overheads are analysed into cost pools.
• The overheads are charged to units of output, through activity cost drives rates,
which represent the extent to which each particular cost unit is believed to cause
the particular part of the overheads.
Cost pools are much the same as cost centres, except that each cost pool is linked to a
particular activity.
ABC is possibly even more relevant to service industries, because in the absence of a
direct material element, a service business’s total cost is likely to be largely made up of
overheads.
Criticisms of ABC:
• Time-consuming and costly.
• ABC reports can be difficult to understand by managers.
• Measurement and tracing problems (not all costs can be easily identified)
• Not all business can benefit from ABC (similar levels of output and involve similar
activities and processes don’t need finer measurements)
• Does not provide a very relevant information for decisions making (tends to use
past costs and to ignore opportunity costs)
Businesses must keep costs to a minimum so that they can supply goods and services at
a price that customers will be prepared to pay and, at the same time, meet the
businesses’ objectives of enhancing shareholder wealth.
Total/whole life-cycle costing:
1. The pre-production phase = period that precedes (voorafgaat) production of the
product/service. Research and development is conducted. Acquiring and setting
up the necessary production facilities and with advertising and promotion. Very
high proportion of the total costs will be incurred.
2. The production phase = being the one in which the product is made and sold or
service is rendered to customers.
3. The post-production phase = any costs necessary to correct faults that arose with
products or services that have been sold are incurred. Cost of closing production
(decommissioning product facilities).
Businesses often seem to consider environmental costs alongside the more obvious
financial costs involved in the life of a product.
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