Activity Based Costing

• Activities can be defined as a named process, function, or task that occurs over time and has recognized results. Activities use up assigned resources to produce products and services. Inputs are transformed into outputs under the parameters set by controls performed by the organization’s employees and their tools.

Basis Of ABC

• Identifying major activities and their costs

• Determining the cost drivers

Basis Of ABC

• Resources are people and machines.• Resource drivers are the measure of the frequency and

intensity of the demands placed on resources by activity.• Activities are the processes performed by the people and

machine.• Activity drivers measure the frequency and intensity of

the demands placed on activities by cost objects enabling costs to be assigned to cost objects.

• Cost objects are the products and/or services produced.• Cost drivers are the factors that affect the cost of an

activity, e.g. poor quality.

How To Use ABC?

• ABC is used to determine the cost and benefits associated with reengineering processes and systems.

• This cost and benefit analysis will then become part of the overall business case for the project.

• ABC approach will account for– Activities or processes– Frequency and cost of the activity– The do-nothing scenario– Which process provides value

• Determine cost drivers for activities• Estimate application rates for each activity driver• Applying costs to products

Benefits Of ABC Over Absorption Costing

• More realistic product costs may be produced,• Management will be more aware of the link between

activity and cost behaviour• Cost reduction activities are more likely to be

successful• It may become apparent that costs are not driven

solely by output volumes• It facilitates the preparation of an activity-based budget• It helps in decision-making.• Identification of non-value adding activities helps the

management to control cost.

Target Costing

• Target costing is defined as ‘a market-based cost that is calculated using a sales price necessary to capture a predetermined market share.’

• Business entities need to stand on their feet, to eliminate inefficiencies, cut down costs and improve productivity.

• Fittest will survive.

Traditional Cost System VSProactive Cost Management

System• Traditional cost systems were designed in an era of benign

environment, when product life cycles were long.• In those days, when competition was not as keen, most price

decisions were based on cost-plus pricing• Proactive cost management system puts emphasis on resources

consumed in performing the organization’s significant activities.• This emphasis, sometimes called activity accounting• Traditional cost system utilizes a single basis• Rather than relying on a single basis to distribute costs, ABC

assigns costs to activities and product based on how the costs (resources) are actually consumed by the process or product

Basics Of Target Costing

• Most firms define competitors as ‘firms that make things similar to what we make’ which are the producers’ view of competition.

• In target costing, competitors are defined from the customers’ perspective: ‘I am about to make a purchase, so what are my options?’

• Target costing is a cost-management technique that lets a firm manage its costs by determining how much customers are willing to pay for a product

• Product strategy defines the customers that a firm wants to target, the features that these customers want in the product, and the prices they are willing to pay for each feature and for the product as a whole.

What Is Target Cost?

• A target cost is the maximum amount of cost that can be incurred on a product and still earn the required profit margin from that product.

• Target Cost = Sales Price – Desired Profit

Setting Target Costs

• Cost Reductions– Cost reductions are associated with a cost

leadership strategy

• Cost Adjustments– Cost adjustments are associated with

differentiation and time-to-market strategies.

Phases In Target Costing

• Planning Phase

• Development Phase

• Production Phase

Streamlining The Process

• Target costing is the true form of design for cost.

• Value engineering consists of generating ideas for cost reduction without compromising the features or extending the development period of the product.

• Computing overall target costs• Making it work• Calls for business process reengineering

Computing overall target costs

• Once a target cost has been calculated for a new product, the design team has to divide it up among the product’s various functions. How much can the team spend on one function as against all the others?

• For target costing to succeed, targets must not only be valid, managers must also see them as valid. The market analysis that yields the target prices, the financial analysis that generates the target costs, and the segregation procedures that allocate costs among components and sub- assemblies – all must be trusted. The target-costing process must, therefore, be highly transparent.

Benefits Of Target Costing

• The process of target costing provides detailed information on the costs

• Target costing reduces the development cycle of a product.

• The internal costing model, using ABC, can provide an excellent understanding of the dynamics of production costs

• The profitability of new products is increased by target costing

• Target costing is also used to forecast future costs

Life Cycle Costing

• The accumulation of costs for activities that occur over the entire life cycle of a product, from inception to abandonment, by the manufacturer and the customer are known as life cycle costing.

• The firm cannot regard a particular design successful unless they meet the functionality needs of the customer, the price demands of the distribution channel, the manufacturability requirements of the plant, and the financial projections of the firm.

Life Cycle Cost Analysis• Life cycle cost analysis (LCCA) is a method for assessing the

total cost of facility ownership.• It takes into account all costs of acquiring, owning, and disposing

of an asset or asset system.• Lowest life cycle cost (LCC) is the most straightforward and

easy-to interpret measure of economic evaluation.• Some other commonly used measures are net savings (or net

benefits), savings-to-investment ratio (or savings benefit-to-cost ratio), internal rate of return, and payback period.

• There are numerous costs associated with acquiring, operating, maintaining, and disposing of any asset.

Project Life Cycle Costing

• Project life cycle costing is a new concept which places new demands upon the management accountant.

• A key question for many accountants will be whether the costs of developing realistic life cycle costs will outweigh the benefits to be derived from their availability.

• Technology is concerned with pursuit of economic life cycle costs.

• It ensures that the assets produce the highest possible benefit for least cost.