Chapter NO: 1 Target costing.

So far, we have seen how the total cost of a product is determined as

the sum of all direct costs and a share of the overheads using some
suitable basis for their absorption. This total cost is then used to
determine the selling price of the product.
Target costing is a contemporary approach to costing which works in
the opposite way, starting with market price (to achieve a specified
market share) and desired profit and working back to cost at which
the company ought to produce the product.
The most significant implication of target costing is that it often
results in the identification of a cost gap i.e. current costs are higher
than the target cost needed to reach target profit. Management then
needs to develop strategies to close this gap.
Alternative product designs and production methods should be
examined to determine if cost gap can be eliminated. As it is difficult
to reduce costs of production drastically with minor changes, it is
perhaps easier to design the product such that its cost of production
is equal to or less than the target cost
Thus target costing plays a significant role in the design phase.
Question practice.

1. ABC Ltd plans to launch a new product. The

expected selling price is ₹1,000 per unit.
The company requires a profit margin of 25% of
the selling price.

The estimated current cost of producing the

product is ₹800 per unit.

Required.

Calculate the target cost per unit.

Calculate the cost gap.

2.
Techniques to reduce costs could include.
 Simplification of design to reduce complexity
 Use of standardized components.
 Use of high efficiency machinery
 Training of staff to improve productivity and reduce waste.
 Increasing production volume to enjoy economic of scale
  Outsourcing some part of the production process
 Use of cheaper raw materials.

Advantages.
 Target costing re-emphasizes the need for cost control.
 Target costing provides way for better performance
management.
 Target costing encourages innovation, creativity and fosters out
of the box thinking.
 Target costing also impacts the pricing strategies of the
company as well as the mix of products sold.

Dis-advantages.
 Determination of market price may not be possible if there are
no similar products in the market.
 While target costing seeks to eliminate unwanted features and
complexities in design, measures to reduce costs may have
negative impact on quality / customer satisfaction.

Value analysis.
If you want to reduce cost without compromising the quality, is called
value analysis.
What is mean by value analysis ?
What is the things which creates value on our products. Those things
are not compromised when estimating the cost.

Target costing and service organization,

Normally target costing is not much suitable for service industry.

Japanese Target Costing after World War II.

After World War II, Japan’s economy was in ruins
 Severe shortage of raw materials.
 Strong competition from Western companies
 Low purchasing power of customers
The Core Problem.
Japanese companies could not use cost-plus pricing because.
 Customers would not pay high prices.

 International market prices were already fixed

 Inefficient production would make firms uncompetitive
Price was given by the market, not by the company.

Cost accountants reversed traditional thinking.

Target Cost = Market Price − Desired Profit.

80–90% of product costs are locked in at the design stage.

Cost accountants worked closely with.

 Engineers
  Designers
 Suppliers

Prevented high costs before production even started.

This approach helped:

 Toyota → dominate global auto markets

 Sony & Honda → deliver high quality at competitive prices
 Japan → rebuild its economy with limited resources

Cost accountants directly contributed to national economic recovery.

Life cycle costing.

Traditional costing systems are based on the accounting year and tend to dissect the
product`s life cycle in a series of annual section. This means that the product`s
profitability over its entire life is not assessed, but rather its profitability is
periodically calculated. This does not provide the full insight of the profitability and
viability of a product.

Life cycle costing in contrast considers the accumulation of costs and revenues over
the lifetime of a product to assess its overall profitability.
Products that may appear unprofitable in their early stages due to high unit costs
may in fact be viable if high production volumes & economies of scale are
considered.

Product life cycle stages

1. Development Stage
Costs at this point are largely research and development. For many
high technology products the majority of costs can be incurred at this
stage.
2. Introduction Stage.
At this point the product is introduced into the market. Heavy
expenditure on promotion and marketing is needed to increase
product awareness and gain market share. Production volume may be
quite low so unit costs remain high.
 3. Growth Stage
At this point sales volume begins to increase rapidly. As the product
grows in popularity less is spent on marketing. Unit cost also begins to
fall as economies of scale become possible.
4. Maturity
At this stage growth in sales begins to tall off. Sales volume remains
high and profits are good. A company may seek to extend the life of
the product by refreshing its look (face lift for cars, for example) or by
adding new features and partially redesigning the product. Marketing
expenditure remains low, though additional cost may be incurred to
market a revamped version of the product.
5. Decline
At this point demand for a product begins to fall and companies start
to consider product shut down and market exit. Whilst production
cost are low there may be significant costs associated with close
down including redundancy costs, disposal and environmental
cleanup costs in the event of polluting products.

Benefit of life cycle costing.

 Better decision making: As a result of the analysis of life-cycle costs and

revenues, better decisions can be made considering the viability of
producing and selling a product over its whole life.
 Well thought-out pricing strategies: Pricing decisions will incorporate
costs over the whole life of the product rather than period costs, thereby
help to obtain desirable margins and setting realistic prices.
 Control over Design and Development: The lifecycle model brings forth
the importance of design and development costs. It is believed that
 above 95% of the cost of a producing a product is determined at the
design stage. Hence lifecycle costing reinforces the need for proper
design of the product and similarly tight control over R & D and other
such expenditure.
 Improved performance reporting & evaluation: Life cycle costing
provides a better means of measuring the performance of organizations
and their managers from a product perspective rather than for a
particular period.

Lifecycle costs are the costs incurred on products and services from
their design stage, through development to market launch, production
and sales and their eventual withdrawal from the market. A product`s
life cycle costs might therefore be classified as follows:

Question practice,
ABC Ltd is planning to launch a new product. The following costs are expected
over the entire life of the product:
 Research and development cost: ₹3,00,000
 Design and testing cost: ₹1,50,000
 Manufacturing cost per unit: ₹400
 Marketing and distribution cost per unit: ₹100
 Expected total production and sales: 6,000 units
 End-of-life disposal cost: ₹60,000

Required:

 Calculate the life cycle cost per unit of the product.

 ABC costing.
Absorption costing.
Absorption costing is a method of costing where all production costs (both variable and
fixed) are absorbed into the cost of a product.

To calculate full product cost

It includes:

 Direct materials

 Direct labour

 Variable production overhead

 Fixed production overhead

Purpose of absorption costing.

 For inventory valuation
 For profit measurement.
 For pricing decisions
 For cost control and budgeting
Required:

Calculate full production cost per unit.

Normally costing of a product are done immediately after production,

For an example at jan 1. I made a single product, I required to determine full cost of the
product.

(Full cost= direct cost+ indirect cost.)

In the case of direct cost there is no issue regarding this, actual direct cost are readily
available.

In the case of OH and total level of activity , the exact total amount will known by at year
end,

At that time I will take budgeted OH and budgeted level of activity.

 Calculate full production per unit.

Marginal costing.
Marginal costing is a costing technique where only variable costs are charged to units
of production.
Fixed costs are treated as period costs and written off in full to the profit and loss
account.

This is main for decision making.

Product cost under marginal costing.

 Direct material
 Direct labour
 Direct expense
 Variable production OH.

ABC COSTING.

Is a costing system that identifies the major activities carried out in an organisation and
assigns overhead costs to products or services based on their actual consumption of those
activities, using appropriate cost drivers. This method provides more accurate product costs
by recognising that different products consume support resources in different proportions.

Allocate overhead of $9000, into product A and B, by using absorption costing and ABC
costing.

IN ABC COSTING OAR IS COST POOL/COST DRIVER.

WHAT IS COST POOL.?

A cost pool is a group of similar overhead costs that are collected together and
allocated to products or services using a common cost driver.

WHAT IS COST DRIVER.?

A cost driver is a factor or activity that causes a cost to be incurred and is used to
allocate overhead costs to products or services.

Number of production runs = number of machine set ups. This is always equal, in exams
you need number of production runs but there is no such a cost driver then you can take
number of machine set up vise versa.
 Dis advantages.

Time consuming and expensive

Implementing ABC requires detailed data collection and analysis, which takes
time and money.
Selection of cost drivers is difficult
It may not be easy to identify the most appropriate cost driver for each activity.
Some arbitrary apportionment still exists
ABC does not fully eliminate cost apportionment; some overheads are still
allocated on estimates.
High implementation and maintenance cost
The cost of setting up and running an ABC system may exceed the benefits.
Cost effective only when overheads are high
ABC is useful mainly when overhead costs form a large proportion of total
costs.
ABC is still a form of absorption costing
ABC costs are not variable costs and therefore are not relevant for short-term
decision making.
Limited benefit in some situations
If overheads are mainly volume-related or form a small part of total cost, ABC
adds little value.