Cost Accounting

Target Costing and Lifecycle Costing Explained

Target Costing and Lifecycle Costing

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 calculate the cost of creating an item by integrating the costs of currently used or consumed resources. Therefore, for each unit created, the conventional variable costs of material, direct labour and variable overheads are included (the total of these being the marginal cost of production), coupled with a part 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 the organisation should profit if the budgeted sales are achieved.

target costing and lifecycle costing explained

Flaws in Traditional Costing System

There are two flaws in this approach:

  1. The product’s price is based on its cost, but no one might want to buy it at that price. The product might incorporate features that customers do not value and therefore do not want to pay for. Competitors’ products might be cheaper or at least offer better value for money. This flaw is addressed by target costing.
  2. The costs incorporated are the current costs only. They are the marginal costs plus a share of the fixed costs for the current accounting period. Other important costs may not be part of these categories, but without which the goods could not have been made.
    Examples include the research and development costs and any close down costs incurred at the end of the product’s life. Why have these costs been excluded, particularly when selling prices have to be high enough to ensure that the product makes an overall profit for the company? To make a profit, total revenue must exceed total costs in the long term. This flaw is addressed by lifecycle costing.

Target Costing

Target costing is a process that involves setting cost levels needed to meet the target price. Target costing effectively reduces manufacturing costs by focusing on the most efficient ways of manufacturing while minimising the manufacturing lead time. The target cost approach occurs at every point during the production process, starting with planning where savings are identified. It also focuses on production by identifying the necessary changes to the design, layout, and procedures to reduce costs.

Target 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:

  • Are customers homogeneous, or can we identify different segments within the market?
  • What features does each market segment want in the product?
  • What price are customers willing to pay?
  • To what competitor products or services do our customers compare ours?
  • How will we advertise and distribute our products?

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, and 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 other market research techniques.

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:
If a company expects a mark-up typically on the cost of 50% and estimates that a new product will sell successfully for $12, then the maximum cost of production should be $8:

Cost
100%
$8
+Mark-up
8%
$4
=Selling price
150%
$12

This is an assertive discipline imposed on the company. The main results are:

  • The establishment of multifunctional teams consisting of marketing people, cost accountants, production managers, quality control professionals and others. These teams are vital to the design and manufacturing decisions required to determine the price and feature combinations that are most likely to appeal to potential buyers of products.
  • An emphasis on the planning and design stage. This becomes very important to the cost of the product because if something is designed such that it is needlessly expensive to make, it does not matter how efficient the production process is; it will always be a struggle to make satisfactory profits.

Here are some of the decisions made at the design stage which can affect the cost of a product:

  • the features of the product
  • how to avoid ‘over design.’
  • the number of components needed
  • where the product can be made
  • what to make in-house and what to sub-contract
  • the quality of the product
  • the batch size in which the product can be made

You will see from this list that activity-based costing can also play an important part in target costing. By understanding the cost drivers (cost causers), a company can better control its costs.

For example, costs could be driven down by increasing batch size or reducing the number of components that have to be handled by stores. The concept of value engineering (or value analysis) can be important here. Value engineering aims to reduce costs by identifying those parts of a product or service which do not add value – where ‘value’ is made up of both:

  • use-value (the ability of the product or service to do what it sets out to do – its function), and
  • esteem value (the status that ownership or use confers)

Value engineering aims to maximise and esteem values while reducing costs. For example, if you are selling perfume, its packaging design is important. The perfume could be held in a plain glass (or plastic) bottle, and although that would not damage the use-value of the product, it would damage the esteem value.

The company would be unwise to try to reduce costs by economising much on the packaging. Similarly, suppose a company is trying to reduce the costs of manufacturing a car. There might be many components that cheaper or simpler ones could satisfactorily replace without damaging either use or esteem values.

However, some components will be vital to use value (perhaps elements of the suspension system) and others that endow the product with esteem value (the quality of the paint and the upholstery).

Lifecycle Costing

When aiming to earn a profit on a product, the total income derived from the product must surpass overall costs, whether these costs are incurred before, during or after the product is produced.

This is the concept of lifecycle costing, and it is crucial to know that target costs can be driven down by tackling any of the costs that correspond to any portion of a product’s life.

There are four principal lessons to be learned from lifecycle costing:

  • All costs should be considered when working out the cost of a unit and its profitability.
  • Attention to all costs will help reduce the cost per unit and help an organisation achieve its target cost.
  • Many costs will be linked. For example, more attention to design can reduce manufacturing and warranty costs. More attention to training can machine maintenance costs. More attention to waste disposal during manufacturing can reduce end-of-life costs.
  • Costs are committed and incurred at very different times. A committed cost is a cost that will be incurred in the future because of decisions that have already been made. Costs are incurred only when a resource is used.

Typically, the following pattern of costs committed and costs incurred are observed:

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 more considerable cost decrease would be obtained if the design had specified only eight units of the component. The design phase locks the company into most future costs, and this phase gives the company its most significant opportunities to reduce those costs.

Conventional costing records costs only as incurred, but recording those costs is different from controlling those costs and performance management depends on cost control, not cost measurement.

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