Ken Garrett explains target costing and lifecycle costing, and gives examples as to how and when you would use these costing techniques Show
Target costing and lifecycle costing can be regarded as relatively modern advances in management accounting, so it is worth first looking at the approach taken by conventional costing. Typically, conventional costing attempts to work out the cost of producing an item incorporating the costs of resources that are currently used or consumed. Therefore, for each unit made the classical variable costs of material, direct labour and variable overheads are included (the total of these is the marginal cost of production), together with a share of the fixed production costs. The fixed production costs can be included using a conventional overhead absorption rate (absorption costing (AC)) or they can be accounted for using activity-based costing (ABC). ABC is more complex but almost certainly more accurate. However, whether conventional overhead treatment or ABC is used the overheads incorporated are usually based on the budgeted overheads for the current period. Once the total absorption cost of units has been calculated, a mark-up (or gross profit percentage) is used to determine the selling price and the profit per unit. The mark-up is chosen so that if the budgeted sales are achieved, the organisation should make a profit. There are two flaws in this approach:
Target costingTarget costing is very much a marketing approach to costing. The Chartered Institute of Marketing defines marketing as: ‘The management process responsible for identifying, anticipating and satisfying customer requirements profitably.’ In marketing, customers rule, and marketing departments attempt to find answers to the following questions:
Marketing says that there is no point in management, engineers and accountants sitting in darkened rooms dreaming up products, putting them into production, adding on, say 50% for mark-up then hoping those products sell. At best this is corporate arrogance; at worst it is corporate suicide. Note that marketing is not a passive approach, and management cannot simply rely on customers volunteering their ideas. Management should anticipate customer requirements, perhaps by developing prototypes and using other market research techniques. Therefore really important information relating to a new product is:
Of course, there will probably be a range of products and prices, but the company cannot dictate to the market, customers or competitors. There are powerful constraints on the product and its price and the company has to make the required product, sell it at an acceptable and competitive price and, at the same time, make a profit. If the profit is going to be adequate, the costs have to be sufficiently low. Therefore, instead of starting with the cost and working to the selling price by adding on the expected margin, target costing will start with the selling price of a particular product and work back to the cost by removing the profit element. This means that the company has to find ways of not exceeding that cost. Example:
This is a powerful discipline imposed on the company. The main results are:
Lifecycle costingAs mentioned above, target costing places great emphasis on controlling costs by good product design and production planning, but those up‑front activities also cause costs. There might be other costs incurred after a product is sold such as warranty costs and plant decommissioning. When seeking to make a profit on a product it is essential that the total revenue arising from the product exceeds total costs, whether these costs are incurred before, during or after the product is produced. This is the concept of life cycle costing, and it is important to realise that target costs can be driven down by attacking any of the costs that relate to any part of a product’s life. The cost phases of a product can be identified as:
There are four principal lessons to be learned from lifecycle costing:
The diagram shows that by the end of the design phase approximately 80% of costs are committed. For example, the design will largely dictate material, labour and machine costs. The company can try to haggle with suppliers over the cost of components but if, for example, the design specifies 10 units of a certain component, negotiating with suppliers is likely to have only a small overall effect on costs. A bigger cost decrease would be obtained if the design had specified only eight units of the component. The design phase locks the company in to most future costs and it this phase which gives the company its greatest opportunities to reduce those costs. Conventional costing records costs only as they are incurred, but recording those costs is different to controlling those costs and performance management depends on cost control, not cost measurement. A numerical example of target and lifecycle costingA company is planning a new product. Market research information suggests that the product should sell 10,000 units at $21.00/unit. The company seeks to make a mark-up of 40% product cost. It is estimated that the lifetime costs of the product will be as follows:
Required: Solution: (a)
(b) The original life cycle cost per unit = ($50,000 + (10,000 x $10) + $20,000)/10,000 = $17 This cost/unit is above the target cost per unit, so the product is not worth making. (c) Maximum total cost per unit = $15. Some of this will be caused by the design and end of life costs: ($50,000 + $15,000 + $20,000)/10,000 = $8.50 Therefore, the maximum manufacturing cost per unit would have to fall from $10 to ($15 – $8.50) = $6.50. Ken Garrett is a freelance lecturer and author Which cost is not considered in marginal costing?Marginal cost is the change in the total cost due to production of one extra unit while incremental cost can be both for increase in one unit or in total volume. In the Example 2 above, `1,220 is the incremental cost of producing one extra unit but not marginal cost for producing one extra unit.
What does the cost of product include under marginal costing?Under marginal costing, the cost of the product includes (C) Prime cost and fixed overheads. Marginal costing is a technique of costing that is concerned with marginal cost (MC). The marginal cost gives the change in the total cost that arises when the quantity of produce is increased.
Which of the following costs is not included while computing unit product cost under direct costing?Answer: Notice that the fixed manufacturing overhead cost has not been included while computing the cost of one bike under variable costing system.
Which one of the following is not an assumption of marginal costing?Solution(By Examveda Team) All factors, except one, are variable is NOT the assumption of the Marginal Productivity Theory of Distribution.
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