Costing Techniques

Costing Techniques Management Level – Paper P2 Advanced Management Accounting Lecture - 07 Vidya Rajawasam ACMA CGMA MBA

Costing Techniques In the previous lecture we have discussed • Modern Business environment and related business theories

Costing Techniques In this lecture we will discuss • Introduction to Costing Techniques • Target costing

Costing Techniques Background information The traditionaloverheadabsorptioncosting was designed and developed for companies involved in production activities and the techniques are lesssuitable for service and retail firms. The productcosts related to the R&D, marketing and administration expenses are not factored as product costs in the published financial accounts.

Costing Techniques Background information The traditionaloverheadabsorptioncosting was developed in lastcentury and at that time, the level of overheads were small compared to today's overhead costs. In those days the overhead costs accounted around 10% of average productcosts and the direct labour costs accounted around 50% of product cost.

Costing Techniques Background information Since the overheads were such a small part of totalcosts, any inaccuracies in the absorptioncosting process did not distort product costs. Furthermore, traditional absorption costing was notdesigned to make short term decisions related to product pricing, product profitability and newproduct development.

Costing Techniques Target costing Target Costing is a costmanagementprocess that is price led, customer focused, design centered and cross functional. It initiates cost management at the earliest stages of a product or service development and applies it throughout the related lifecycle by actively involving the entirevaluechain

Costing Techniques Target costing The targetcosting for a product or service is calculated based on the anticipatedsellingprice and arrive at the desiredprofit. The productdevelopment team is then given the responsibility of designing the product or service so that it can be made for nomore than the targetcost.

Costing Techniques Target costing The targetprofit requirement process should be driven by strategicprofit planning process rather than standard mark-up calculations. The target costing approach was developed because in reality many organizations actually have lesscontrol over price than they would like to think.

Costing Techniques Target costing It is the market that really determinesprice of the product and in target costing calculations are based on the marketprice. Most of a product costs are determined during the designphase and there is little that can be done to reducecostafter that phase.

Costing Techniques Target costing Research have shown that up to 90% of costs are builtin at the product design stage. The examples of costs related to the product design stage are; • Design specification and extra features. • Number of components incorporated into the product.

Costing Techniques Target costing Examples of costs; • Design of components Should consider productreliability and ease of manufacture. Whenever possible standardparts can be used since they are tested for reliability and reduce the inventory and handling costs.

Costing Techniques Target costing Examples of costs; • Type of packagingrequired. Includes the productpackaging, packing per case and packing per pallet. The main objective is to protect the product and minimize handing costs.

Costing Techniques Target costing Examples of costs; • The number of spareparts that needs to be carried. This is related to the number of components used in the product. Some of the parts needs to be held for up to 10 years or more. Which is a costly scenario.

Costing Techniques Target costing Target costing is something that companies should consider when they really need to deliver a product or a service that is costcompetitive, that is going to provide a profit. It works really well with morecomplexproducts rather than more basic and simple products.

Costing Techniques Target costing Target costing is an iterativeprocess which cannot be de-coupled from design. The pre-production stages can be categorized in variety of ways. Each stage has variouslevels of activities and those can be highlighted in the next slides, after the MCQ session.

Costing Techniques Review MCQs The traditional absorption costing has following drawbacks? • Not suitable for retail and service organizations. • Cannot make short term decisions with regard to costing activities. • Accuracy may vary according to a very large percentage of overheads activities. • Non of the above.

Costing Techniques Review MCQs What is true related to the target costing ? • Focuses on pro-active cost control • Driven by external market factors. • Too costly to implement • Does not require additional resources.

Costing Techniques Pre-production stages – Target costing Target costing is an iterativeprocess which cannot be de-coupled from design. The pre-production stages can be categorized in variety of ways. Each stage has variouslevels of activities.

Costing Techniques Pre-production stages 1) Conduct research. This is the first stage of the process and reviews the marketplace in which the company wants to sell products. The design team needs to determine the set of productfeatures that customers are most likely to buy, and the amount they will pay for those features.

Costing Techniques Pre-production stages 1) Conduct research. 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 productprice if they dropone or more features.

Costing Techniques Pre-production stages 1) Conduct research. At the end of this process, the team has a goodidea of the target price at which it can sell the proposeda product with a certain set of features, and how it must alter the price if it drops some features from the product.

Costing Techniques Pre-production stages 2) Calculate maximum cost. The company provides the designteam with a mandatedgrossmargin that the proposed product must earn. By subtracting the mandated gross margin from the projectedproductprice, the team can easily determine the maximum targetcost that the product must achieve before it can be allowed into production.

Costing Techniques Pre-production stages 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 highproportion of purchased parts; they must determine component pricing based on the necessary quality, delivery, and quantity levels expected for the product.

Costing Techniques Pre-production stages 3) Engineer the product. They may also be involved in outsourcing parts, if this results in lowercosts. The engineers must design the product to meet the costtarget, which will likely include a number of design iterations to see which combination of revised features and designconsiderations results in the lowestcost.

Costing Techniques Pre-production stages 4) Ongoing activities. Once a product design is finalized and approved, the team is reconstituted to include fewerdesigners and more industrialengineers. The team now enters into a new phase of reducingproductioncosts, which continues for the life of the product.

Costing Techniques Pre-production stages 4) Ongoing activities. For example, cost reductions may come from wastereductions in production (known as kaizen costing), or from plannedsuppliercostreductions. These ongoing cost reductions yield enough additional gross margin for the company to further reduce the price of the product over time, in response to increases in the level of competition.

Costing Techniques Calculation of target Cost

Modern Business Environment Difference between Target costing and standard costing (1) Target costing; supports Pull System. _________________________________________________________________________________ Standard Costing; supports Push System (2) Target costing; Technique is proactive, Starts before the design of the product. ___________________________________ Standard costing; Technique is reactive, Selling price determined by standard cost of the product.

Modern Business Environment Difference between Target costing and standard costing (3) Target costing; supports costreduction _________________________________________________________________________________ Standard Costing; supports costcontrol (4) Target costing; Driven by externalmarketprices, may not be attainable in the short term ___________________________________ Standard costing; Driven by internal massproduction and economies of scale

Costing Techniques Advantages of Target costing • Supports properplanning of production activities and also planning of marketing activities. • Supports the company win in the competition and marketshare. • The customers get qualityproducts by fulfilling their requirements at affordablecost.

Costing Techniques Advantages of Target costing • There is a commitment on the part of employees from top to bottom for quality production. • There is a possibility of productinnovation to achieve some competitive advantages. • It uses managementcontrolsystem to support and reinforce manufacturing strategies.

Costing Techniques Advantages of Target costing • It integrates the activities of supplier with the customers requirements to design the right product. • It helps to find the marketopportunities. Such marketopportunities are used to fix the possible targetsellingprice at the maximum.

Costing Techniques Advantages of Target costing • The cost of features of a product is based on the customers’ willingness to pay for them. • It reduces the period of productdevelopment cycle. • It reduces the costs of products significantly.

Costing Techniques Advantages of Target costing • The spirit of team work starts from the stage of conceiving the productidea and ends with distribution of products among the customers and passes through planning, developing, manufacturing and selling.

Costing Techniques Review MCQs What is the true statement related to breakdown of target cost? • Identifies the costs related to the development costs, manufacturing costs. • Provides information related to product discounts • Provides information related to work in progress. • Provides after sales service costs.

Costing Techniques Review MCQs The main difference between Target costing and standard costing ? • Target costing supports pull system of production and standard costing uses push system of production. • Standard costing methods are not frequently used in production. • Identifies the activities and costs related to distribution channels. • Non of the above

Costing Techniques Lecture Summary We have discussed the • Introduction to Costing Techniques • Target costing

Costing Techniques Management Level – Paper P2 Advanced Management Accounting Lecture - 07 Vidya Rajawasam ACMA CGMA MBA

Costing Techniques