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　　Chapter 1
　　Advanced costing method
　　Chapter learning objectives
　　Upon completion of this chapter you will be able to:
　　§ explain what is meant by the term cost driver
　　§ identify appropriate cost drivers under activity-based costing (ABC)
　　§ calculate costs per driver and per unit using (ABC)
　　§ compare ABC and traditional methods of overhead absorption based on production units, labour hours or machine hours.
　　§ explain the implications of switching to ABC on pricing, performance management and decision making.
　　§ explain what is meant by the term ‘target cost’ in both manufacturing and service industries.
　　§ derive a target cost in both manufacturing and service industries.
　　§ explain the difficulties of using target costing in service industries
　　§ explain the implications of using target costing on pricing, cost control and performance management.
　　§ describe the target cost gap.
　　§ suggest how a target cost gap might be closed.
　　§ explain what is meant by the term ‘life-cycle costing’ in a manufacturing industry
　　§ identify the costs involved at different stages of the life-cycle.
　　§ explain the implications of life-cycle costing on pricing, performance management and decision making.
　　§ describe the process of back-flush accounting and contrast with traditional process accounting.
　　§ explain, for a manufacturing business, the implications of back-flush accounting on performance management
　　§ *uate the decision to switch to back-flush accounting from traditional process control for a manufacturing business.
　　§ explain throughput accounting and the throughput accounting ratio (TPAR), and calculate and interpret, a TPAR.
　　§ suggest how a TPAR could be improved.
　　§ apply throughput accounting to a given multi-production decision making problem.
　　1 Activity based costing
　　1.1 Introduction – absorption cost
　　In F2 we saw how to determine a cost per unit for a product. Key issues of relevance here are the following:
　　Firms have the choice of two basic costing methods – marginal costing and absorption costing.
　　Under absorption costing it is necessary to absorb overheads into units of production using a suitable basis.
　　The main basis of absorption used in F2 questions is direct labour hours. This involves calculating an overhead absorption rate (OAR) for each production department as follows:
　　OAR =
　　To enable this, all overheads must first be allocated/apportioned/reapportioned into production departments, again using a suitable basis (e.g. rent on the basis of floor area).
　　Overhead expenses incurred/budgeted
　　Step 1: Overheads allocated or apportioned to cost centres using suitable bases Cost centres (usually departments)
　　Step 2: Service centre costs reapportioned to production centres
　　Step 3: Overheads absorbed into units of production using an OAR (usually on the basis of direct labour hours) output
　　Expandable text
　　The assumption underlying the traditional method of costing is that overhead expenditure is connected to the volume of production activity.
　　§ This assumption was probably valid many years ago, when production system were based on labour-intensive or machine-intensive mass production of fairly standard items. Overhead costs were also fairly small relative to direct materials and direct labour costs; therefore any inaccuracy in the charging of overheads to products costs was not significant.
　　§ The assumption is not valid in a complex manufacturing environment, where production is based on smaller customised batches of products, indirect costs are high in relation to direct costs, and a high proportion of overhead activities – such as production scheduling, order handling and quality control – are not related to production volume.
　　§ For similar reasons, traditional absorption costing is not well-suited to the costing of many services.