Unit 6 Cost Accumulation Systems

6.1 Job Order Costing

Job Order Costing is concerned with accumulating costs by specific jobs. This method is best
used when producing products with individual characteristics or tailored products. Special
recordkeeping is done by specific jobs. (Ex- cars manufacturer producing buses as special order)
Costs are traced and applied to individual jobs in a job order costing system.

1. Steps in Job Order Costing

Example

Raw Materials $20,000

Cash / AP $20,000

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 NO ENTRY

Work in Process (Job 15) $15,000

Direct Material $15,000
Direct Material (charged with the amounts actually used for production in the special job)

Direct Labor $12,000

Wages Payable $12,000

Work in Process (Job 15) $12,000

Direct Labor $12,000
Direct Labor (charged with the actual wages for production in the special job)

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 Work in Process (Job 15) $8,000
MOH Applied $8,000 (PREDICTED)
MOH (charged using an estimated rate)
It is necessary to recognize the MOH under Job-Order as products are customized and the
process varies from period to period. As the indirect costs are paid within the year, they are
collected in MOH Control. The WIP is not affected when the actual MOH costs are incurred
Manufacturing Overhead Control $5,000 (ACTUAL)
Tax Payable/Prepaid Insurance/Acc. Depr. $5,000

Overhead costs are absorbed by (applied to) a specific overhead Application Rate for that year.
At the beginning of the year, an estimation is made for the allocation base (DL hours or machine)
Application Rate = Estimated Total MOH
Estimated Total quantity of allocation base

$ Of Overhead Applied = Total quantity of allocation base x Application Rate

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 Finished Goods $35,000
Work in Process (Job 15) $35,000

Accounts Receivables $45,000

Sales Revenue $45,000
COGS $35,000
Finished Goods $35,000

SUMMARY

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 2. Over or Under Applied
At the end of the period, overhead control (actual) and overhead applied (estimated) are
compared for variances.
MOH Applied > MOH Actual = Over-Applied (CR)
MOH Applied < MOH Actual = Under-Applied (DR)
If the difference is immarterial, it is closed directly at COGS only. However, if the difference is
material then it is closed based on raitios of COGS, WIP and FG.

3. Spoilage
It is the output that does not meet the quality standards to be sold. There are 2 types of spoilages:
1) Normal Spoilage- expected amount of units in a period of production. It is treated
product cost (included in cost of goods produced).

a. If the normal spoilage is worthless

NO ENTRY (discarded)

b. If the normal spoilage can be sold, its value should not be included in COGS

Spoiled Inventory (fair value) XXX

Work in Process (Job 15) XXX

2) Abnormal Spoilage- is the spoilage above the expected amount in an ordinary course of
production. It is treated as period cost (not included in the cost of goods produced)

a. If the abnormal spoilage is worthless, must be discarded (costs included till

inspection)

Loss from Abnormal Spoilage XXX

Work in Process (Job 15) XXX

b. If the abnormal spoilage can be sold, its value should not be included in COGS,
(costs included till inspection). Loss is recorded in the Income Statement.

Spoiled Inventory (fair value) XXX

Loss from Abnormal Spoilage (difference) XXX
Work in Process (Job 15) XXX

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6.2 Process Costing

Process Costing is the method to assign costs to homogenous (similar) products that are
produced by continuous basis or mass production. (Ex- cars, petroleum extracts). Assign exact
amounts to these amounts is not cost effective, so averaging is used for FG and WIP.
Accumulating costs under this method is done by departments rather than projects. There will
be WIP by each department illustrating the continuous basis.

1. Steps in Accumulating Costs

Example

Raw Materials $2,000,000

Cash / AP $2,000,000

NO ENTRY as risks and rewards were not transfereed the customer.

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 Work in Process (Dept. A) $400,000
Raw Material $400,000

Direct Labor $120,000

Wages Payable $120,000
Work in Process (Dept. A) $120,000
Direct Labor $120,000

Work in Process (Dept. A) $240,000

MOH Applied $240,000

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Work in Process (Dept. B) $76,000
Work in Process (Dept. A) $76,000

Work in Process (Dept. A) $1,000,000

Raw Material $1,000,000

Finished Goods $2,170,000

Work in Process $2,170,000

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 2. Equivalent Units of Production (EUP)
At the end of a period, some units remain unfinished (WIP), in order for each department to
recognize costs, they must be in Equivalent Units of Production (EUP). EUP, is the number of
complete units that could have been produced using the consumed input.
Example

The main target is allocating the Total Costs $1,500,000 between Units Completed OR Ending
WIP.
3 things to consider in EUP
1) Total Costs- should be allocated to Units Completed OR Ending WIP

2) Method Used- FIFO OR WA

3) When to Allocate Costs-

a. Proportionally allocate Materials and Conversion costs
b. Specific Time during production for Materials and Conversion costs
c. Allocate Materials at Beginning and Conversion Costs Proportionally

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 1) FIFO (Material & Conversion Costs allocated Proportionally)

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 ❖ Step 1 Calculate the Physical Units

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

80% 0% 100% 40%

Total Beginning Costs $40,000

+Costs During May $460,000 (160,000 + 300,000)
Total Costs $500,000

❖ Step 2 Calculate Units Started and Completed

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

80% 0% 100% 40%

❖ Step 3 Determine where Costs were added

Materials and Conversions Costs are added proportionally and at the same time as
mentioned in the heading.

❖ Step 4 Calculate EUP for Materials & Conversion

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

80% 0% 100% 40%

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Beg WIP 100 Units x 20% = 20 Units
Started & Completed 300 Units x 100% = 300 Units
Ending WIP 200 Units x 40% = 80 Units
400 Units EUP

❖ Step 5 Costs incurred during the period only (FIFO)

Current Period Costs = Material Costs + Conversion Costs

$460,000 = 160,000 + 300,000

IGNORE Beginning Inventory Costs

❖ Step 6 Calculate Costs per equivalent unit for Material & Conversion

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

80% 0% 100% 40%

Costs this Period = $460,000 =$1,150 (Cost per EUP)

EUP 400

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 ❖ Step 7 Allocate Costs between Completed Units & Ending WIP
Completed Units
Cost of Beg WIP $40,000
Costs to Complete Beg WIP $23,000 (20 EUP X $1,150)
Started & Completed $345,000 (300 EUP X $1,150)
Costs of Units Completed $408,000

Ending WIP Units

Cost of Ending WIP Units $92,000 (80 EUP X $1,150)
OR
Total Cost = Completed Units + Ending WIP Units
500,000 = 408,000 + 92,000

2) Weighted Average (Material & Conversion Costs allocated Proportionally)

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 ❖ Step 1 Calculate the Physical Units

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

80% 0% 100% 40%

Total Beginning Costs $40,000

+Costs During May $460,000 (160,000 + 300,000)
Total Costs $500,000

❖ Step 2 Calculate Units Completed

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

80% 0% 100% 40%

❖ Step 3 Determine where Costs were added

Materials and Conversions Costs are added proportionally and at the same time as
mentioned in the heading.

❖ Step 4 Calculate EUP for Materials & Conversion

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

80% 0% 100% 40%

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Completed Units 400 Units x 100% = 400 Units
Ending WIP 200 Units x 40% = 80 Units
480 Units EUP

❖ Step 5 Costs incurred for Beginning & during the period (Weighted Average)

Total Costs = Beginning Costs + (Material Costs + Conversion Costs)

$500,000 = $40,000 + ($160,000 + $300,000)

❖ Step 6 Calculate Costs per equivalent unit for Material & Conversion

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

80% 0% 100% 40%

Total Costs = $500,000 =$1,042 (Cost per EUP)

EUP 480

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 ❖ Step 7 Allocate Costs between Completed Units & Ending WIP
Completed Units
Costs of Units Completed $416,800 (400 Units X $1,042)

Ending WIP Units

Cost of Ending WIP Units $83,200 (200 Units X 40% X $1,042)
OR
Total Cost = Completed Units + Ending WIP Units
500,000 = 416,800 + 83,200

3) FIFO (Material & Conversion Costs allocated at specific times)

❖ Step 1 Calculate the Physical Units

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

Materials 60% 0% 100% 90%
Conversion 20% 0% 100% 40%

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 Direct Materials Conversion Costs Totals
Beginning Costs $15,000 $25,000 $40,000
+ Costs during May $160,000 $300,000 $460,000
Total Costs $175,000 $325,000 $500,000

❖ Step 2 Calculate Units Started and Completed

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

Materials 60% 0% 100% 90%
Conversion 20% 0% 100% 40%

❖ Step 3 Determine where Costs were added

Materials and Conversions Costs are added at specific intervals as mentioned in the
heading.

❖ Step 4 Calculate EUP for Materials & Conversion

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

Materials 60% 0% 100% 90%
Conversion 20% 0% 100% 40%

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 Direct Material
Beg WIP 100 Units x 40% = 40 Units
Started & Completed 300 Units x 100% = 300 Units
Ending WIP 200 Units x 90% = 180 Units
520 Units EUP

Conversion Costs
Beg WIP 100 Units x 80% = 80 Units
Started & Completed 300 Units x 100% = 300 Units
Ending WIP 200 Units x 40% = 80 Units
460 Units EUP

❖ Step 5 Costs incurred during the period only (FIFO)

Current Period Costs = Material Costs + Conversion Costs

$460,000 = 160,000 + 300,000

IGNORE Beginning Inventory Costs

❖ Step 6 Calculate Costs per equivalent unit for Material & Conversion

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units = 400 Units 200 Units

Materials 60% 0% 100% 90%
Conversion 20% 0% 100% 40%
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 Direct Material
Costs of DM this Period = $160,000 = $308 (Cost per EUP Materials)
EUP 520

Conversion Costs
Costs of DM this Period = $300,000 = $652 (Cost per EUP Conversion)
EUP 460

❖ Step 7 Allocate Costs between Completed Units & Ending WIP

Completed Units
Direct Material
Cost of Beg WIP $15,000
Costs to Complete Beg WIP $12,300 (100-unit X 40% X $308)
Started & Completed $92,400 (300-unit X $308)
Costs of Units Completed DM $119,700

Conversion Costs
Cost of Beg WIP $25,000
Costs to Complete Beg WIP $52,100 (100-unit X 80% X $652)
Started & Completed $195,600 (300-unit X $652)
Costs of Units Completed CC $272,700

So, Total Costs of Completed Units (400) = $392,400

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 Ending WIP Units
Cost of Ending WIP Units Materials $55,440 (200-unit X 90% X $308)
Cost of Ending WIP Units Conversion $52,160 (200-unit X 40% X $652)
Ending WIP $107,600

OR
Total Cost = Completed Units + Ending WIP Units
500,000 = $392,400 + 107,600

4) Weighted Average (Material & Conversion Costs allocated at specific times)

❖ Step 1 Calculate the Physical Units

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

Materials 60% 0% 100% 90%
Conversion 20% 0% 100% 40%

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 Direct Materials Conversion Costs Totals
Beginning Costs $15,000 $25,000 $40,000
+ Costs during May $160,000 $300,000 $460,000
Total Costs $175,000 $325,000 $500,000

❖ Step 2 Calculate Units Completed

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

Materials 60% 0% 100% 90%
Conversion 20% 0% 100% 40%

❖ Step 3 Determine where Costs were added

Materials and Conversions Costs are added at specific intervals as mentioned in the
heading.

❖ Step 4 Calculate EUP for Materials & Conversion

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

Materials 60% 0% 100% 90%
Conversion 20% 0% 100% 40%

Direct Material
Completed 400 Units x 100% = 400 Units
Ending WIP 200 Units x 90% = 180 Units
580 Units EUP

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 Conversion Costs
Completed 400 Units x 100% = 400 Units
Ending WIP 200 Units x 40% = 80 Units
480 Units EUP

❖ Step 5 Costs incurred for Beginning & during the period (Weighted Average)
Direct Materials Conversion Costs Totals
Beginning Costs $15,000 $25,000 $40,000
+ Costs during May $160,000 $300,000 $460,000
Total Costs $175,000 $325,000 $500,000

❖ Step 6 Calculate Costs per equivalent unit for Material & Conversion

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units = 400 Units 200 Units

Materials 60% 0% 100% 90%
Conversion 20% 0% 100% 40%

Direct Material
Costs of DM this Period = $175,000 = $302 (Cost per EUP Materials)
EUP 580

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 Conversion Costs
Costs of DM this Period = $325,000 = $677 (Cost per EUP Conversion)
EUP 480

❖ Step 7 Allocate Costs between Completed Units & Ending WIP

Completed Units
Direct Material
Completed Units $120,800 (400-unit X $302)
Costs of Units Completed DM $120,800

Conversion Costs
Started & Completed $270,600 (400-unit X $677)
Costs of Units Completed CC $270,600

So, Total Costs of Completed Units (400) = $391,600

Ending WIP Units

Cost of Ending WIP Units Materials $54,360 (200-unit X 90% X $302)
Cost of Ending WIP Units Conversion $54,040 (200-unit X 40% X $677)
Ending WIP $108,400

OR
Total Cost = Completed Units + Ending WIP Units
500,000 = $391,600 + 108,400

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 5) FIFO (Materials added at beginning and Conversion added Proportionally)

❖ Step 1 Calculate the Physical Units

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

Materials 100% 0% 100% 100%
Conversion 20% 0% 100% 40%
❖ Step 2 Calculate Units Started and Completed

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

Materials 100% 0% 100% 100%
Conversion 20% 0% 100% 40%

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 ❖ Step 3 Determine where Costs were added
Materials are added in the beginning and Conversions Costs are added proportionally as
mentioned in the heading.

❖ Step 4 Calculate EUP for Materials & Conversion

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

Materials 100% 0% 100% 100%
Conversion 20% 0% 100% 40%
Direct Material
Beg WIP 100 Units x 0% = 0 Units
Started & Completed 300 Units x 100% = 300 Units
Ending WIP 200 Units x 100% = 200 Units
500 Units EUP

Conversion Costs
Beg WIP 100 Units x 80% = 80 Units
Started & Completed 300 Units x 100% = 300 Units
Ending WIP 200 Units x 40% = 80 Units
460 Units EUP

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 ❖ Step 5 Costs incurred during the period only (FIFO)

Current Period Costs = Material Costs + Conversion Costs

$460,000 = 160,000 + 300,000

IGNORE Beginning Inventory Costs

❖ Step 6 Calculate Costs per equivalent unit for Material & Conversion

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units = 400 Units 200 Units

Materials 100% 0% 100% 100%
Conversion 20% 0% 100% 40%
Direct Material
Costs of DM this Period = $160,000 = $320 (Cost per EUP Materials)
EUP 500

Conversion Costs
Costs of DM this Period = $300,000 = $652 (Cost per EUP Conversion)
EUP 460

❖ Step 7 Allocate Costs between Completed Units & Ending WIP

Completed Units
Direct Material
Cost of Beg WIP $15,000
Costs to Complete Beg WIP $0 (100-unit X 0% X $320)
Started & Completed $96,000 (300-unit X $320)
Costs of Units Completed DM $111,000

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 Conversion Costs
Cost of Beg WIP $25,000
Costs to Complete Beg WIP $52,160 (100-unit X 80% X $652)
Started & Completed $195,600 (300-unit X $652)
Costs of Units Completed CC $272,760

So, Total Costs of Completed Units (400) = $383,760

Ending WIP Units

Cost of Ending WIP Units Materials $64,000 (200-unit X 100% X $320)
Cost of Ending WIP Units Conversion $52,160 (200-unit X 40% X $652)
Ending WIP $116,240
OR
Total Cost = Completed Units + Ending WIP Units
500,000 = $383,760 + 116,240

6) Weighted Average (Materials added at beginning and Conversion added

Proportionally)

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 ❖ Step 1 Calculate the Physical Units

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

Materials 100% 0% 100% 100%
Conversion 20% 0% 100% 40%

❖ Step 2 Calculate Units Started and Completed

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

Materials 100% 0% 100% 100%
Conversion 20% 0% 100% 40%

❖ Step 3 Determine where Costs were added

Materials are added in the beginning and Conversions Costs are added proportionally as
mentioned in the heading.

❖ Step 4 Calculate EUP for Materials & Conversion

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units 400 Units 200 Units

Materials 100% 0% 100% 100%
Conversion 20% 0% 100% 40%

Direct Material
Completed 400 Units x 100% = 400 Units
Ending WIP 200 Units x 100% = 200 Units
600 Units EUP
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 Conversion Costs
Completed 400 Units x 100% = 400 Units
Ending WIP 200 Units x 40% = 80 Units
480 Units EUP

❖ Step 5 Costs incurred for Beginning & during the period (Weighted Average)
Direct Materials Conversion Costs Totals
Beginning Costs $15,000 $25,000 $40,000
+ Costs during May $160,000 $300,000 $460,000
Total Costs $175,000 $325,000 $500,000

❖ Step 6 Calculate Costs per equivalent unit for Material & Conversion

Beg. WIP Started = Completed Ending WIP

100 Units 500 Units = 400 Units 200 Units

Materials 100% 0% 100% 100%
Conversion 20% 0% 100% 40%

Direct Material
Costs of DM this Period = $175,000 = $292 (Cost per EUP Materials)
EUP 600

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 Conversion Costs
Costs of DM this Period = $325,000 = $677 (Cost per EUP Conversion)
EUP 480

❖ Step 7 Allocate Costs between Completed Units & Ending WIP

Completed Units
Direct Material
Completed Units $116,800 (400-unit X $292)
Costs of Units Completed DM $116,800

Conversion Costs
Started & Completed $270,800 (400-unit X $677)
Costs of Units Completed CC $270,800

So, Total Costs of Completed Units (400) = $387,600

Ending WIP Units

Cost of Ending WIP Units Materials $58,400 (200-unit X 100% X $292)
Cost of Ending WIP Units Conversion $54,160 (200-unit X 40% X $677)
Ending WIP $112,400

OR
Total Cost = Completed Units + Ending WIP Units
500,000 = $387,600 + 112,400

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 3. Spoilage in Process Costing
Normal Level of Spoilage is included in COGS; however, abnormal level of spoilage is
considered a Loss. In order to recognize the Loss under Process Costing, multi-step process must
be followed.
The manufacturer established inspection points, which excludes goods that do not meet the
standards at any time, this is opposite of Job-Order Process. The inspection arrangement inspects
the units when being transferred from one department to the other, which allows for each
department to calculate its own spoilage.
Entry (FIFO or WA)
Loss from Abnormal Spoilage XXX
WIP (Dept. A) XXX

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6.3 Activity Based Costing (ABC)

Activity Bases Costing is a response to a dramatic increase in MOH (fixed and variable) /
indirect costs as a result of technological advancements. ABC is an improvement over the Job
Order or Process Costing, used in internal reporting and management control.

1. Traditional (Volume-Based) Costing System

It is an inaccurate averaging or spreading of indirect costs over products or services that use
different amounts of resource “peanut-butter costing”. Under Traditional System, overhead is
accumulated using a single cost pool and spread evenly across all products. Direct materials and
direct labor are traced to the product.
The peanut butter costing results in product-cost-cross subsidizations, which is when mis-
costing one product will also mis-cost other products.
Example

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Benefits of Traditional System
✓ Easily implemented approach to calculate using one cost driver
✓ Comply with GAAP and Tax Authorities

Drawbacks of Traditional System

❖ Inaccurate product costing due to significant increase in overhead costs
❖ Leads to bad management decisions as it excludes certain non-manufacturing costs
❖ Inaccurate averaging or cost spreading of indirect costs among products (peanut-butter
costing)

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Peanut-Butter Costing Issue

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 2. Activity Based Costing
This method was utilized because of increase in automation resulted in increase in MOH costs
with increasing complexity. The ABC assigns cost of final product based on the activity that
drives/causes the cost.
Steps in Activity Based Costing
❖ Step 1 Activity Analysis

Activities are classified in a hierarchy based on the production process that takes place
a. Unit-Level Activity- performed for each unit produced

b. Batch-Level Activity- occurs for each group of output produced in batched

c. Product Sustaining Activity- activities that support the production of a specific

product, despite the level.

d. Facility Sustaining Activity- concerns overall operations and cannot be traced to the
product at any point.

❖ Step 2 Assign Resources of Cost

The indirect costs are assigned to resources identified (different classification)

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 ❖ Step 3 Allocate the Cost of Resources in the Multi-Cost Pool

Done based on the resource drivers/cause consumed by the activity

❖ Step 4 Identify the resource cost driver

Done by the entity level, depending on the cost driver (must be sensible) to each cost
pool

❖ Step 5 Calculate the Cost Per Resource Driver

It’s the dollar spent of resources per resource driver (Step 3 ÷ Step 4)

❖ Step 6 Identify the Cost Driver

The cost driver actually consumed is determined by the activity

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 ❖ Step 7 Allocate resource cost to final cost object

Advantages of Activity Based Costing System

❖ ABC is more useful when overhead costs are relatively high, and several products are
made
❖ It also improves the product costing, which enhances decision making
❖ The Process Value Analysis performed as a part of the ABC System provides information
to eliminate or reduce non-value adding activities
❖ It results in better cost control and efficient operations

Disadvantages of Activity Based Costing System

✓ It’s difficult to apply this system for the Facility Level Costs that are not accurately
assigned to products or services. These costs are treated as period costs. However, Unit,
Batch and Product Level Costs can be assigned to specific products
✓ Under this system, it doesn’t comply with GAAP (external users), ex ABC system
assigns Research costs as part of the product (capitalized), but GAAP assigns it as period
costs (expensed), but this method is used to report for internal users
✓ Initial costs of implementing this system are high and there might be little or no
advantage when implementing this system, in contrast to simple allocating of MOH
✓ If the company produces one product, then there is no advantage
✓ Its required to maintain separate accounting system for resource costs

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 3. Process Value Analysis
In order to design an ABC, an analysis of the firm’s activity and output must be analyzed. Under
this method of analysis, the firm must compare 2 items and eliminate the unnecessary process.
a. Value Adding Activity- enhances the customer satisfaction or assists the need
of the entity. Eliminating such activities will result in a loss in quantity,
quality, etc.

b. Non-Value Adding Activity- does not enhance customer satisfaction,

therefore, it can be eliminated, reduced, or redesigned without the loss in
quantity, quality, etc.
The process of eliminating unnecessary stages or improving the product cost is linked by
Activity Based Management (ABM). The ABM is made of driver analysis, activity analysis and
performance management.

Cost Driver
Drivers (resource and activity) must be chosen by cause-and-effect relationship. A cost object
may be job, product, process, activity or service (anything cost measured). Intermediate cost
object accumulates the costs temporary as the cost pool moves.

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6.4 Life Cycle Costing

A life-cycle approach to estimate a

product’s revenues and expense over its
entire sale life-cycle, beginning with R&D
till the decline phases.
a. R&D- no sales, costs are high
b. Introduction- few competitors
c. Growth- sales and competitors
increase
d. Maturity- sales growth decreases
and competitors are at highest level
e. Decline/Harvest- competitors decreases
This approach has a long-term view to the entire cost life-cycle, this is called Value Chain. This
is crucial as it assists management in pricing decisions because revenues must cover costs
incurred at each stage Of the Value Chain. Costs are incurred at 2 levels:
1) Before Production, such as R&D and product design are upstream costs
2) After Production, such as Marketing and Customer Service are downstream costs

Potential Benefits
Life-Cycle Costing coordinates between the costs at different value-chain stages. Ex if the firm is
at the upstream stage cost, the downstream costs can be reduced to reduce the price for the
customer or increase profits to the firm. Cost reduction can mainly be occurred at the upstream
or downstream stages but not the Manufacturing costs as it may affect the quality of the product.

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 1. Life Cycle VS Other Costing Methods
The Traditional Approach focuses on cost control, in contrast to Life-Cycle which focuses on
cost reduction during the production and pre-production (upstream and downstream) stages. The
Traditional Approach also treats the pre-production costs as period costs and ignores the
profitability on the product.
Traditional Method also ignores the After-Purchases costs, ex operating, support, repairs and
disposal.

Whole-Life Costing is related to Life-Cycle Costing.

Whole-Life Costing = Life-Cycle Costing + After Purchases Costs
The constant focus on reduction of whole-life costing can increase customer satisfaction, as the
management analysis the value-chain activities and it’s a powerful tool.

Life-Cycle and Whole-Life Costing are involved with Target Costing and Target Pricing. The
firm may determine its selling price with a specific Target Price.
Target Cost = Target Price - Profit Margin
The idea of cost reduction is achieved, in case the cost of producing a product is more that the
Target Cost, the firm will immediately be alerted of these losses.

Value-Engineering means reaching Target Cost Level. It is a systematic approach to assess all
aspects of the value-chain. The aim is to reduce costs without reducing the customer satisfaction.
This is why, it is crucial to differentiate between Value-Adding Activities which enhances in
customer satisfaction and Non-Value-Adding Activities, that doesn’t enhance customer
satisfaction. Value-Engineering seeks to reduce the Non-Value-Adding activities and their cost
driver. This method attempts to increase efficiency by reducing costs

Internal and External Reporting

For Internal Reporting (Life-Cycle), costs such as R&D are capitalized, as they represent
marketable products. Furthermore, this method also capitalized upstream and downstream costs.
For the External Reporting (GAAP) upstream and downstream costs are expensed, but the
Manufacturing costs are capitalized.

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The internal Income Statement for a product will report the Risk Reserve established which acts
as a contra-account to capitalized costs. The Risk Reserve consists of deferred (postpone)
product costs that may not be recovered

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