Costing Method

1) BACK FLUSH ACCOUNTING 

Back-flush accounting is a costing short-cut. It relies on businesses having immaterial

amounts of work-in-progress and it is therefore particularly suitable for businesses
operating just-in-time inventory management. If the amount of work-in-progress is
negligible, what is the point in meticulously valuing it? Fretting that some products might
be 25% complete and others 60% complete, and then adding carefully calculated labour
and overheads to these (immaterial) items is a complete waste of time and effort. That
type of accounting is perhaps the modern-day equivalent of alleged ancient arguments
about how many angels could dance on the point of a needle. 

In back-flush accounting costs are not associated with units until they are completed or
sold. Backflush accounting is sometimes called delayed costing, which is a helpful
name, as costs are not allocated to production until after events have occurred.

Standard costs are then used to work backwards to flush out manufacturing costs into
production, splitting them between stocks of finished goods (if any) and cost of sales.
No costs, whether material or conversion costs, are allocated to work-in-progress. 

Basically, backflush accounting is when you wait until the manufacture of a product has
been completed, and then record all of the related issuances of inventory from stock
that were required to create the product. This approach has the advantage of avoiding
all manual assignments of costs to products during the various production stages,
thereby eliminating a large number of transactions and the associated clerical labor. 

Backflush accounting is entirely automated, with a computer handling all transactions.

The backflushing formula is:

Number of units produced × unit count listed in the bill of materials for each component
= Number of raw material units removed from stock  

Backflushing is a theoretically elegant solution to the complexities of assigning costs to

products and relieving inventory, but it is difficult to implement. Backflush accounting is
subject to the following problems:

•     Requires an accurate production count. The number of finished goods produced is

the multiplier in the backflush equation, so an incorrect count will relieve an incorrect
amount of components and raw materials from stock.

•     Requires an accurate bill of materials. The bill of materials contains a complete

itemization of the components and raw materials used to construct a product. If the
items in the bill are inaccurate, the backflush equation will relieve an incorrect amount of
components and raw materials from stock.
•     Requires excellent scrap reporting. There will inevitably be unusual amounts of
scrap or rework in a production process that are not anticipated in a bill of materials. If
you do not separately delete these items from inventory, they will remain in the
inventory records, since the backflush equation does not account for them.

•     Requires a fast production cycle time. Backflushing does not remove items from
inventory until after a product has been completed, so the inventory records will remain
incomplete until such time as the backflushing occurs. Thus, a very rapid production
cycle time is the best way to keep this interval as short as possible. Under a
backflushing system, there is no recorded amount of work-in-process inventory. 

Backflushing is not suitable for long production processes, since it takes too long for the
inventory records to be reduced after the eventual completion of products. It is also not
suitable for the production of customized products, since this would require the creation
of a unique bill of materials for each item produced.

The cautions raised here do not mean that it is impossible to use backflush accounting.
Usually, a manufacturing planning system allows you to use backflush accounting for
just certain products, so you can run it on a compartmentalized basis. This is useful not
just to pilot test the concept, but also to use it only under those circumstances where it
is most likely to succeed. Thus, backflush accounting can be incorporated into a hybrid
system in which multiple methods of production accounting may be used. 

2) THROUGHPUT COSTING 

Throughput accounting has a very direct relationship with decision-making and

performance management. It begins by focusing on what an organisation’s purpose is –
its goal – and seeks to help organisations attain their purpose by increasing their ‘goal
units’. The approach can be applied in both profit-seeking and not-for-profit
organisations, provided meaningful goal units can be identified.

For example, take a not-for profit organisation which performs a medical screening
service in three sequential stages: 1. Take an X-ray.

2.   Interpret the result.

3.   Recall patients who need further investigation/tell others that all is fine.

The ‘goal unit’ of this organisation will be to progress a person through all three stages.

The number of people who complete all the stages is the organisation’s throughput, and
the organisation should seek to maximise its throughput. However, there will always be
a limit to throughput, and the resource which sets that limit is called the ‘bottleneck
resource’. 

Adding more detail to the medical screening process above: 

Process Time/patient (hours) Total                hours

available/week
Take an X-ray 0.25 0.10 40

Interpret the result 0.20 20

Recall patients who need further 30

investigation/tell others that all is fine

You can easily see from this table that the maximum number of patients (goal units)
who can be dealt with in each process is:

X – rays: 40/0.25 = 160

Interpret results: 20/0.10 = 200

Recall etc: 30/0.20 = 150 

So, the recall procedure is the bottleneck resource. Throughput and the organization’s
performance cannot be improved until that part of the process can deal with more
people. Therefore, to improve throughput:

1.   Ensure there is no idle time in the bottleneck resource, as that will be detrimental to
overall performance (idle time in a non-bottleneck resource is not detrimental to overall
performance).

2.   See if less time needs to be spent on the bottleneck activity.

3.   Finally, increase the bottleneck resource available.

In the example above, increasing the bottleneck resource or the efficiency with which it
is used might be relatively cheap and easy to do because this is a simple piece of
administration whilst the other stages employ expensive machinery or highly skilled
personnel. There is certainly no point in improving the first two stages if things grind to a
halt in the last stage; patients are helped only when the whole process is completed and
they are recalled id necessary.  

3) TARGET COSTING 

Target costing is a pricing method used by firms. It is defined as "a cost management
tool for reducing the overall cost of a product over its entire life-cycle with the help of
production, engineering, research and design". 
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. With target costing, a management team has a powerful tool for continually
monitoring products from the moment they enter the design phase and onward
throughout their product life cycles. It is considered one of the most important tools for
achieving consistent profitability in a manufacturing environment.

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 margins 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. 

Of these methods, companies are more likely to use the first approach if they are
looking for a routine upgrade to an existing product, and the second approach if they
want to achieve a significant cost reduction or break away from the existing design. 

4) LIFE CYCLE COSTING 

The costs involved in making a product, and the sales revenues generated, are likely to
be different at different stages in the life of a product. For example, during the initial
development of the product the costs are likely to be high and the revenue minimal – i.e.
the product is likely to be loss-making.

If costing (and decision based on the costing) were only to be ever done over the short
term it could easily lead to bad decisions.

Life-cycle costing identifies the phases in the life-cycle and attempts to accumulate the
costs over the entire life of the product. 

The cost phases of a product can be identified as;- 

Phase               Examples of types of cost

Design              Research, development, design and tooling

Material, labour, overheads, machine set up, inventory, training, production

Manufacture machine maintenance and depreciation

Operation         Distribution, advertising and warranty claims

End of life        Environmental clean-up, disposal and decommissioning 

There are four principal lessons to be learned from lifecycle costing:

•       All costs should be taken into account when working out the cost of a unit and its
profitability.

•       Attention to all costs will help to reduce the cost per unit and will help an
organisation achieve its target cost.

•       Many costs will be linked. For example, more attention to design can reduce
manufacturing and warranty costs. More attention to training can machine
maintenance costs. More attention to waste disposal during manufacturing can

reduce end-of life costs. Costing Methods

1) BACK FLUSH ACCOUNTING 

Back-flush accounting is a costing short-cut. It relies on businesses having immaterial

amounts of work-in-progress and it is therefore particularly suitable for businesses
operating just-in-time inventory management. If the amount of work-in-progress is
negligible, what is the point in meticulously valuing it? Fretting that some products might
be 25% complete and others 60% complete, and then adding carefully calculated labour
and overheads to these (immaterial) items is a complete waste of time and effort. That
type of accounting is perhaps the modern-day equivalent of alleged ancient arguments
about how many angels could dance on the point of a needle. 

In back-flush accounting costs are not associated with units until they are completed or
sold. Backflush accounting is sometimes called delayed costing, which is a helpful
name, as costs are not allocated to production until after events have occurred.

Standard costs are then used to work backwards to flush out manufacturing costs into
production, splitting them between stocks of finished goods (if any) and cost of sales.
No costs, whether material or conversion costs, are allocated to work-in-progress. 

Basically, backflush accounting is when you wait until the manufacture of a product has
been completed, and then record all of the related issuances of inventory from stock
that were required to create the product. This approach has the advantage of avoiding
all manual assignments of costs to products during the various production stages,
thereby eliminating a large number of transactions and the associated clerical labor. 

Backflush accounting is entirely automated, with a computer handling all transactions.

The backflushing formula is:

Number of units produced × unit count listed in the bill of materials for each component
= Number of raw material units removed from stock  

Backflushing is a theoretically elegant solution to the complexities of assigning costs to

products and relieving inventory, but it is difficult to implement. Backflush accounting is
subject to the following problems:
•     Requires an accurate production count. The number of finished goods produced is
the multiplier in the backflush equation, so an incorrect count will relieve an incorrect
amount of components and raw materials from stock.

•     Requires an accurate bill of materials. The bill of materials contains a complete

itemization of the components and raw materials used to construct a product. If the
items in the bill are inaccurate, the backflush equation will relieve an incorrect amount of
components and raw materials from stock.

•     Requires excellent scrap reporting. There will inevitably be unusual amounts of

scrap or rework in a production process that are not anticipated in a bill of materials. If
you do not separately delete these items from inventory, they will remain in the
inventory records, since the backflush equation does not account for them.

•     Requires a fast production cycle time. Backflushing does not remove items from
inventory until after a product has been completed, so the inventory records will remain
incomplete until such time as the backflushing occurs. Thus, a very rapid production
cycle time is the best way to keep this interval as short as possible. Under a
backflushing system, there is no recorded amount of work-in-process inventory. 

Backflushing is not suitable for long production processes, since it takes too long for the
inventory records to be reduced after the eventual completion of products. It is also not
suitable for the production of customized products, since this would require the creation
of a unique bill of materials for each item produced.

The cautions raised here do not mean that it is impossible to use backflush accounting.
Usually, a manufacturing planning system allows you to use backflush accounting for
just certain products, so you can run it on a compartmentalized basis. This is useful not
just to pilot test the concept, but also to use it only under those circumstances where it
is most likely to succeed. Thus, backflush accounting can be incorporated into a hybrid
system in which multiple methods of production accounting may be used. 

2) THROUGHPUT COSTING 

Throughput accounting has a very direct relationship with decision-making and

performance management. It begins by focusing on what an organisation’s purpose is –
its goal – and seeks to help organisations attain their purpose by increasing their ‘goal
units’. The approach can be applied in both profit-seeking and not-for-profit
organisations, provided meaningful goal units can be identified.

For example, take a not-for profit organisation which performs a medical screening
service in three sequential stages: 1. Take an X-ray.

2.   Interpret the result.

3.   Recall patients who need further investigation/tell others that all is fine.
The ‘goal unit’ of this organisation will be to progress a person through all three stages.

The number of people who complete all the stages is the organisation’s throughput, and
the organisation should seek to maximise its throughput. However, there will always be
a limit to throughput, and the resource which sets that limit is called the ‘bottleneck
resource’. 

Adding more detail to the medical screening process above: 

Process Time/patient (hours) Total                hours

available/week
Take an X-ray 0.25 0.10 40

Interpret the result 0.20 20

Recall patients who need further 30

investigation/tell others that all is fine

You can easily see from this table that the maximum number of patients (goal units)
who can be dealt with in each process is:

X – rays: 40/0.25 = 160

Interpret results: 20/0.10 = 200

Recall etc: 30/0.20 = 150 

So, the recall procedure is the bottleneck resource. Throughput and the organization’s
performance cannot be improved until that part of the process can deal with more
people. Therefore, to improve throughput:

1.   Ensure there is no idle time in the bottleneck resource, as that will be detrimental to
overall performance (idle time in a non-bottleneck resource is not detrimental to overall
performance).

2.   See if less time needs to be spent on the bottleneck activity.

3.   Finally, increase the bottleneck resource available.

In the example above, increasing the bottleneck resource or the efficiency with which it
is used might be relatively cheap and easy to do because this is a simple piece of
administration whilst the other stages employ expensive machinery or highly skilled
personnel. There is certainly no point in improving the first two stages if things grind to a
halt in the last stage; patients are helped only when the whole process is completed and
they are recalled id necessary.  

3) TARGET COSTING 

Target costing is a pricing method used by firms. It is defined as "a cost management
tool for reducing the overall cost of a product over its entire life-cycle with the help of
production, engineering, research and design". 

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. With target costing, a management team has a powerful tool for continually
monitoring products from the moment they enter the design phase and onward
throughout their product life cycles. It is considered one of the most important tools for
achieving consistent profitability in a manufacturing environment.

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 margins 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. 

Of these methods, companies are more likely to use the first approach if they are
looking for a routine upgrade to an existing product, and the second approach if they
want to achieve a significant cost reduction or break away from the existing design. 

4) LIFE CYCLE COSTING 

The costs involved in making a product, and the sales revenues generated, are likely to
be different at different stages in the life of a product. For example, during the initial
development of the product the costs are likely to be high and the revenue minimal – i.e.
the product is likely to be loss-making.

If costing (and decision based on the costing) were only to be ever done over the short
term it could easily lead to bad decisions.

Life-cycle costing identifies the phases in the life-cycle and attempts to accumulate the
costs over the entire life of the product. 

The cost phases of a product can be identified as;- 

Phase               Examples of types of cost

Design              Research, development, design and tooling

Material, labour, overheads, machine set up, inventory, training, production

Manufacture machine maintenance and depreciation

Operation         Distribution, advertising and warranty claims

End of life        Environmental clean-up, disposal and decommissioning 

There are four principal lessons to be learned from lifecycle costing:

•       All costs should be taken into account when working out the cost of a unit and its
profitability.

•       Attention to all costs will help to reduce the cost per unit and will help an
organisation achieve its target cost.

•       Many costs will be linked. For example, more attention to design can reduce
manufacturing and warranty costs. More attention to training can machine maintenance
costs. More attention to waste disposal during manufacturing can reduce end-of life
costs.

•       Costs are committed and incurred at very different times. A committed cost is a
cost that will be incurred in the future because of decisions that have already been
made. Costs are incurred only when a resource is used.

•       Costs are committed and incurred at very different times. A committed cost is a
cost that will be incurred in the future because of decisions that have already been
made. Costs are incurred only when a resource is used.