Last updated: July 14, 2019
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In a highly competitive world today, companies have to devise innovative ways of reducing production costs while not compromising on the quality of goods and services. It is for this reason that there has been a shift from the traditional costing methods to, for example, a combination of Activity Based Costing and Target Costing.

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Integration of target costing and ABC

Most companies in the world today have adopted costing methods which are innovative and effective in reducing the product costs.

Some of these methods include the combination of Target Costing and Activity Based Costing. Kaizen costing-continuous improvement (identifying factors that add value and using them) can also be employed.

Target costing includes evaluating a product costs over its lifecycle i.e. from the design stage to the abandonment of the production of the product.

During this evaluation, accurate cost data of the various elements that contribute to cost structure of the product are needed. And this is where ABC comes in. Activity based management is applied to identify those factors that do not add value and their related costs (Chapman, S. C et al 2007:516 Vol.2)

ABC and Target Costing are both departures from traditional costing methods. The focus in activity based costing is the activities that are undertaken in the production process (Cost/activity drivers) while in target costing the company works to achieve the target sales, profit and costs.

The integration of Activity Based Costing and Target Costing therefore brings to the company the benefits of both methods. It is worthwhile also to note that the determination of component costs in Target Costing is actually achieved through Activity Based Costing.

As explained above, Activity Based Costing can be used to provide and determine the component costs therefore achieving and maintaining target costs, profitability and selling price. Target Costing involves the separation of the target cost in to individual ‘parts’ or components, which are, then analyzed separately using the information provided by Activity Based Costing (Kaplan, S & Cooper, R 1998:218)

Activity Based Costing involves the allocation of costs to cost/activity drivers. This is line with Target Costing in that, the process of allocation of costs to cost drivers enables the management of the company to keep tabs with the product costs while still in production and therefore costs can be controlled and managed. (Value based management .net 2008)

In Target Costing, the process of costing starts with the target selling price and target profit margin, which consequently helps in setting and determination of the target cost. The target costs are then split in to component costs, which have to be improved consistently through out the product’s life cycle in order to maintain the set targets of profitability, costs and selling prices. Activity Based Costing has the ability to enhance the continuous improvement process that is much needed in Target Costing.

Another potential benefit of integrating Activity Based Costing and Target Costing is the fact that ABC is able to identify and correctly determine the individual product or customers’ profitability and costs therefore helping the management to monitor the performance of the various products, marketing channels and customers.

Target Costing involves the process of product definition, setting of targets-selling price, profits and costs, achievement of the set targets and the continuous maintenance of competitive costs (Bird, H.M.B. et al 1999).

Product definition involves the designing of the product according to the target market and therefore customer needs are met through the production of quality goods at competitive prices.

The other benefit of product definition is it will avoid confusion among customers as to what price is charged to what product because the market segment is clearly defined.

Cost allocation and cost-cutting are performed at the earliest stage of a product life cycle in Target Costing. The benefit of this is that it enables the company to achieve and maintain the set cost targets.

Target costing ensures that most of the company’s costs are captured in the product cost early in the product’s life cycle. The benefit of this is that it enables the company to reduce all costs i.e. no additional costs at a later stage of the product life cycle is allocated. (Cooper & Slagmulder, 2002:36).

Cohesion among the various departments in the company is also achieved through the Cross-functional team approach used in Target Costing to set the component target costs.

Both Target Costing and Activity Based Costing use Kaizen costing i.e. continuous improvement and therefore customer satisfaction through provision of quality goods and services at affordable prices is achieved. (Boar, G. & Ettlie, J. 1999: 50)

Chances of design changes later on which may increase the product cost is avoided in Target Costing by producing goods which are customer focused.

(Braxton P.J et al, 2008, Slide 13)

Target costing and ABC during a products life cycle

Target costing involves the critical understanding of the various cost elements and their costs over a product’s life cycle. These cost data is provided by among others ABC.

In target costing a large portion of products costs are determined during the design stage of product development. Therefore it is important that the company is able to manage these costs early because as the product continues to “age” the ability to further reduce costs declines significantly.

The ability of the company to reduce costs over the products’ life cycle is best illustrated by the figure below. The figure also shows the cost of trying to reduce cost over the product’s life.

 

 

 

 

Graph

Cost reduction                                  cost of

Potential                                            reduction

 

 

 

 

 

 

Concept     devt.      intro.   Growth maturity   decline     withdrwl

Design phase    phase   phase    stage      stage          stage        /disposal

 

{Cokins 2002, page 15 exhibit 2}

 

 

 

Early stages (concept and design development)

The figure above clearly indicates that the potential of reducing the costs of a product are high, this means that the product cost can be reduced significantly during these stages. More over, it is cheap to reduce the costs at this stage because during so will not involve a lot of trade-offs. This is shown by the cost of reduction curve.

Beyond these two stages the ability to reduce the produce costs declines significantly while at the same time the cost of a cost reduction rises (Cokins 2002:16)

Introduction, growth and maturity phases

At this stage the company can reduce the product costs but the amount of costs that can be reduced are minimal. Plus the cost of reduction is almost the same as the cost reduced and therefore it will not make any business sense to try to reduce product costs at these stages.

Later stages (decline and withdrawal)

The amount of costs that can be reduced is minimal as illustrated by the curve. The cost of reduction is also high and it would be expensive and it will lend to losses. Therefore any attempted cost reduction will lead to higher costs.

At this stage, the customers will have adopted other novel products introduced into the market and therefore the selling price will have to be reduced thus meaning lower profit margins (Cokins 2002:17)

The unit cost

a)      In calculating the cost of each unit of cloth, activity based costing will be used.

The assumption made is that the first phase of activity based costing of allocating resources to costs is ignored because, no information on cost drivers is provided. Also the absorption rates are no provided.

Therefore the final phase of ABC is calculated as follows

The number of units is estimated to be 425,000 units

The target price is £18

The board of directors wishes to achieve a rate of return of 15% on assets used. The return on assets here is the amount of profits after tax but before interest that should be made by the company.

The working capital is equal to 25% of revenue =25%*425,000*18=£1,912,000

The total assets is equal to £19,912,000 and therefore the required rate of return of 15% is =19,912,000*15%=£2,986,875

The total revenue /sales =425,000*18=£7,650,000

Therefore the target cost should be =7,650,000-2,986,875=£4,663,125

The target unit cost is =4,663,125

425,000 units =£10.972

The assumption made is that working capital added to fixed assets is equal to total assets

Advise to the board of directors

b)      Currently, the component cost that make up the total cost is as follows

Direct materials=126,000

425,000 = 2.965

Direct labor=2,250,000

425,000 = 5.294

Contract negotiation costs=500,000

425,000 = 1.176

Cost of returns=700,000

425,000 = 1.647

Administration of bad debts=200,000

425,000=0.471

Staff welfare benefits =225,000

425,000 = 0.529

Stock control cost=525,000

425,000 = 1.235

Delivery problems costs=150,000

425,000 = 0.353

General administration costs=500,000

425,000 = 1.176

The current unit cost =£14.846

The target unit cost =£10.972

The current cost is off-target by 14.846-10.972=£3.874. The management, therefore, should devise ways of reducing component costs so as to reduce the total cost

The excess cost of £3.874 should be cut across all the components that make up the total cost

Some of the higher cost that could be reduced includes direct labor which can be re-negotiated, contract negotiation costs, cost of dealing with returns, stock control and general administration costs

A cross-functional team could identify the costs to be reduced and ensure that the target cost is achieved. The suggested cost reductions should not affect the overall product quality and thus compromise customer satisfaction and needs

The cost cutting measures can be effected at a higher percentage in components like general administration costs, delivery problems costs, administration of bad debts costs, contract negotiation costs, cost of dealing with returns and stock control costs

All the above cost can be reduced significantly without compromising on the quality of the product because they have no direct impact on the final product.

Strategic position analysis

According to Michael E. Porter, strategic position means doing things in a different way from the competitors or doing different things altogether.

Strategic positioning is one of the strategies of the strategies that a company can apply to gain competitive advantage. The other common strategy advocated by Porter is that of operational effectiveness.

Operational effectiveness is the ability of the company to perform its activities well on a sustainable basis thereby achieving competitive advantage.

It is every business interest to achieve competitive advantage and therefore be ahead of competitors in every aspect. It is basically wining the competition.

One of the methods that can be adopted in the evaluation of position is the 5- force analysis model.

The 5 forces model is analyzed in a horizontal and vertical basis. The horizontal analysis includes a look into the threat of substitute goods, threat of competitors and the threat of entry of new rivals {Decide-Guide.com 2007}.

Vertical analysis involves the look into the bargaining position of customers and suppliers as well

Horizontal Analysis

Threat of substitute products

Substitute products are those that customers can switch to. They are alternatives to the company’s goods. In understanding the threat of substitutes, the company should analyze the prices of these substitutes, costs incurred by buyers if they switch to substitutes, how different our product is from the substitute and the buyers’ tendency to buy the substitute.

The company can ensure that its products are differentiated, ensure that switch costs are high to ‘trap’ customers.

Threat of entry of new competitors

Most profitable industries always attract many new companies and it is important that the company ensures that it protects itself from threat of new entrants to maintain its profits.

The analysis of barriers to entry, capital requirement, government regulations are some of the factors to be considered. The existing companies can block new entrants by ensuring operational efficiency and thereby reducing costs and also utilizing their existing market share to stifle out competitors.

Threat of rivals within the industry

The analysis in this case includes the number of rivals, exit barriers. The company should ensure that it achieves competitive advantage reduce this threat.

 

Vertical Analysis

Bargaining power of suppliers

The number of suppliers, switching costs of suppliers, monopolies of supplies should be analyzed in this case to determine the strategic position of a company. The switching costs should not be high so as deter the company from sourcing materials from cheaper suppliers

Bargaining power of customers

It is often claimed that customer is the ‘boss’ and therefore should be treated in a nice way. The company should strive to retain the existing customers and seek for new ones by analyzing factors like volumes bought by customers, bargaining power of customers and ensuring that customers switching costs are high to reduce the number of customers buying from competitors.

Strategic position simply includes focusing on the customer needs and ensuring that they are satisfied. Wal-Mart, Inc has been the dominant retailer in the U.S.A by just focusing and ensuring that customers are satisfied.

It is all about identifying an ‘upper hand’ over competitors and maintaining that advantage. The advantage should be different from the rest of the companies

To achieve a strategic position, the management should ensure that the company’s activities complement each other in a well defined manner. (Winnipeg University, Slide 16)

 

 

References:

Albano, R. E., Bird, H. M. B. & Townsend, W. P. 2007. Target Costing. Delighting Your

Customers While Making a Profit. Focus Magazine. (Online), Available: http://www.focusmag.com/pages/targetcosting.htm 21/1/2008

Braxton, P. J. 2007. Target Costing Best Practices and Implications for CAIV

Implementation. The Society of Cost Estimating and Analysis (Online), Available: www.sceaonline.net/Files/EA-10%20Braxton_Target%20Costing%20CAIV.ppt.21/1/2008

Boer, G. & Ettlie J. 1999. Target costing can boost your bottom line. Strategic Finance

(July): 49-52.

Chapman, S. C., Hopwood, G. A., & Shields, D. M. 2007: Handbook of Management

Accounting Research.Pg 516

Cokins, G. 2002. Integrating target costing and ABC. Journal of Cost Management

(July/August): 13-22.

Cooper, R. 2002. Target costing for new-product development. Journal of Cost

Management (May/June): 5-12.

Cooper, R., & Slagmulder, R. 2002. Target costing for new-product

development: Component-level target costing. Journal of Cost Management (September/October): 36-43.

Decide- Guide.com. 2007. Porters Five Forces Model.Decide-Guide.com (Online)
Available:
http://www.decide-guide.com/porters-five-forces-model.html 21/1/2008

Kaplan, R. S & Cooper, R.1998. Cost and Effect: Using Cost Systems to Drive

Profitability and Performance.Pg.218

University of Winnipeg. 2008, Strategy according to Michael Porter (Online), Available:

http://www.uwinnipeg.ca/admin/vh_external/busandadmin/Strategy/Lectures/StrategyMichaelPorter.ppt 21/1/2008

Value Based Management.net .2008.ABC Method. ABC Methodology (Online) Available:

http://www.valuebasedmanagement.net/methods_abc.html