Activity Based Costing – Target Costing

Activity Based Costing

Activity-Based Costing (ABC) is a costing model that identifies activities in an
organization and assigns the cost of each activity resource to all products and services
according to the actual consumption by each: it assigns more indirect costs (overhead)
into direct costs.
Activity Based Costing (ABC) is actually a method for developing cost
estimates in which the project is subdivided into discrete, quantifiable activities or a
work unit. The activity must be definable where productivity can be measured in units
(e.g., number of samples versus man-hours). After the project is broken into its
activities, a cost estimate is prepared for each activity. These individual cost estimates
will contain all labour, materials, equipment, and subcontracting costs, including
overhead, for each activity. Each complete individual estimate is added to the others
to obtain an overall estimate. Contingency and escalation can be calculated for each
activity or after all the activities have been summed. ABC is a powerful tool, but it is
not appropriate for all cost estimates.
In this way an organization can establish the true cost of its individual products and
services for the purposes of identifying and eliminating those which are unprofitable
and lowering the prices of those which are overpriced.
In a business organization, the ABC methodology assigns an organization's resource
costs through activities to the products and services provided to its customers. It is
generally used as a tool for understanding product and customer cost and
profitability. As such, ABC has predominantly been used to support strategic
decisions such as pricing, outsourcing and identification and measurement of process
improvement initiatives.

Methodology
Direct labor and materials are relatively easy to trace directly to products, but it is
more difficult to directly allocate indirect costs to products. Where products use
common resources differently, some sort of weighting is needed in the cost allocation
process. The measure of the use of a shared activity by each of the products is known
as the cost driver. For example, the cost of the activity of bank tellers can be
attributed to each product by measuring how long each product's transactions takes at
the counter and then by measuring the number of each type of transaction.

Activity Based Costing Definition

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 ABC can be defined by the following equation:
• C/A = HD + M + E + S
• where C/A = Estimated cost per activity
• H = Number of labour hours required to perform the activity one time
• D = Wages per labour hour
• M = Material costs required to perform the activity one time
• E = Equipment costs to perform the activity one time
• S = Subcontracting costs to perform the activity one time

Limitations
• Even in activity-based costing, some overhead costs are difficult to assign to
products and customers, for example the chief executive's salary. These costs
are termed 'business sustaining' and are not assigned to products and customers
because there is no meaningful method. This lump of unallocated overhead
costs must nevertheless be met by contributions from each of the products, but
it is not as large as the overhead costs before ABC is employed.
• Although some may argue that costs untraceable to activities should be
"arbitrarily allocated" to products, it is important to realize that the only

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 purpose of ABC is to provide information to management. Therefore, there is
no reason to assign any cost in an arbitrary manner.

Use of Activity Based Costing Methodology

• ABC methodology is used when a project can be divided into defined

activities.
• These activities are at the lowest function level of a project at which costs are
tracked and performance is evaluated. Depending on the project organization,
the activity may coincide with an element of the work breakdown structure
(WBS) or may combine one or more elements of the WBS. However, the
activities must be defined so there is no overlap between them. After the
activity is defined, the unit of work is established. All costs for the activity are
estimated using the unit of work.
• The estimates for the units of work can be done by performing detailed
estimates, using cost estimating relationships, obtaining outside quotes for
equipment, etc. All costs including overhead, profit, and mark-ups should be
included in the activity cost.
• It helps to identify inefficient product, department and activity
• It helps to allocate more resources on profitable product, department and
activity
• It helps to control the cost at individual level and on departmental level
• It helps to find unnecessary costs

Identification of Activities
• When defining an individual activity, the cost estimator must balance the need
for accuracy with the amount of time available to prepare the estimate. An
estimator may be able to develop an extremely accurate cost estimate by
defining smaller and smaller activities; however, the amount of time required
to prepare ABC estimates for each of these activities may not justify the
increased accuracy. The total estimated project cost may be sufficiently
accurate if 10 activities are used instead of 15. On the other hand, reliable cost
information may not be accessible if the activity categories are too general.
Since the activity is the basis for the estimate, it is very important that the
activity be selected correctly.

Application of activity based costing

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ABC can be a useful cost estimating tool for nonconventional and construction
projects. However, there are some activities that are more appropriately estimated
using other cost estimating techniques. For example, site security may always be
required at some facilities regardless of the number of employees at the facility or
work being conducted at the facility. ABC estimating is especially useful in instances
where the number of activities is uncertain or may change during the estimate process.

Target costing
Target costing is a pricing method used by firms. It is defined as "a cost management
tool for reducing the overall cost of a product over its entire life-cycle with the help of
production, engineering, research and design". A target cost is the maximum amount
of cost that can be incurred on a product and with it the firm can still earn the required
profit margin from that product at a particular selling price.
In the traditional cost-plus pricing method materials, labor and overhead costs are
measured and a desired profit is added to determine the selling price.
Target costing involves setting a target cost by subtracting a desired profit margin
from a competitive market price.
To compete effectively, organizations must continually redesign their products ( or
services) in order to shorten product life cycles. The planning, development and
design stage of a product is therefore critical to an organization's cost management
process. Considering possible cost reduction at this stage of a product's life cycle
(rather than during the production process) is now one of the most important issues
facing management accountants in industry.
Here are some examples of decisions made at the design stage which impact on the
cost of a product.
1. The number of different components
2. Whether the components are standard or not
3. The ease of changing over tools
Japanese companies have developed target costing as a response to the problem of
controlling and reducing costs over the product life cycle.

TARGET COSTING STEPS

1. Determine target selling price – As the first step, the company determines what
the market is willing to pay for a product. Three main players are taken into

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 consideration: customers, competitors, and a company’s senior management.
The company must understand the customer’s perceived value of a product as
well as their attitude for purchasing products. The company must take into
account competitors alternative and substitute products. This is because
customers are shoppers and will shop around for the best price and value.
Senior management must define and adjust strategies to meet the company’s
objectives.
2. Determine target profit margin – Profit margins must be set to satisfy the
expectations of both the company and its investors. Two approaches can be
used to determine the desired profit margin: baseline experiences and capital
budgeting using lifecycle analysis.
3. Calculate the allowable product cost – The maximum allowable product cost is
calculated as the net difference between the target selling price and the target
profit margin. In order for target costing to work, the maximum allowable
product cost must not be exceeded. If the maximum allowable product cost is
exceeded there will be undesirable outcomes. First, the company will increase
the price of the product in order to maintain the desired profit margin. This will
decrease sales volume and the optimal sales-price combination will not be
achieved. Second, investors will be dissatisfied.
It can be understood through the following diagram:

Target - costing principles

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Target costing can best be described as a systematic process of cost management and
profit planning. The six key principles of target costing are:

1. Price-led costing.
Market prices are used to determine allowable—or target—costs. Target costs
are calculated using a formula similar to the following:

Market price – required profit margin = target cost

2. Focus on customers.
Customer requirements for quality, cost, and time are simultaneously
incorporated in product and process decisions and guide cost analysis.
The value (to the customer) of any features and functionality built into the
product must be greater than the cost of providing those features and
functionality.
3. Focus on design.
Cost control is emphasized at the product and process design stage. Therefore,
engineering changes must occur before production begins,
resulting in lower costs and reduced “time-to-market” for new products.
4. Cross-functional involvement.
Cross-functional product and process teams are responsible for the entire
product from initial concept through final production.
5. Value-chain involvement.
All members of the valuechain —e.g., suppliers, distributors, service
providers, and customers—are included in the target costing
process.
6. A life-cycle orientation.
Total life-cycle costs are minimized for both the producer and the customer.
Life-cycle costs include purchase price, operating costs,
maintenance, and distribution costs.