MODULE 10

Cost Management

10.1. Target costing

Target costing is a system used by companies where product costs, desired profit margin and price are planned in advance.
The companies will keep production costs in line with the price point, it involves developing an “allowable” product cost
by analyzing market research to estimate what the market will pay (price point) for a product with specific characteristics.
When expressed in formula:
Target Cost= Estimated Selling Price — Acceptable Profit Margin — Expected Selling and Administrative Cost
TC = ESP — APM — S&A
The computed target cost will serve as an implied maximum per-unit target product cost which then is compared to an
expected product cost. If expected cost exceeds the target cost, company will work on several alternatives: it may change
the product design and/or production process to reduce costs, or lower its acceptable profit margin, or the company can
decide not to enter this particular product market at the current time because it cannot make the desired profit margin

Kaizen costing
When a company decides to enter a market, the target cost computed at the beginning of the product life cycle will change
over time. Kaizen costing involves ongoing efforts for continuous improvement to reduce product costs, increase product
quality, and/or improve the production process after manufacturing activities have begun. These cost reductions are
designed to keep the profit margin relatively stable as the product price is reduced over the product life cycle.

(See demonstration problem 1 in Cost Accounting Chapter 18 by Raiborn)

10. 2. Total Quality Management

Total quality management (TQM) is a “management approach of an organization, centered on quality, based on the
participation of all its members and aiming at long-term success through customer satisfaction, and benefits to all
members of the organization and to society.” The focus is to improve the quality of an organization's outputs, including
goods and services, through continual improvement of internal practices. It involves continuous process of reducing or
eliminating errors in the manufacturing/ production of goods or services.

Quality Costs

▪ Prevention Costs
These are costs incurred by companies to improve its product and service quality. These costs prevent product
defects that result from dysfunctional processing.
Types of prevention costs:
a) Quality planning and engineering: creation of the overall quality plan, the inspection plan, the reliability
plan, the data system, all activities of the quality assurance function, the preparation of manuals and
procedures used to communicate the quality plan, costs auditing the system.
b) New products review: evaluation of new designs, preparation of tests & experimental programs to
evaluate the performance of new products.
c) Product & process design: costs incurred during the design of the product or the selection of the
production processes that are intended to improve the overall quality of the product.
d) Process control: the cost of process control techniques, such as control charts, that monitor the
manufacturing process in an effort to reduce variation and build quality into the product.
e) Burn-in: the cost of pre-shipment operation of the product to prevent early failures in the field.
f) Training: the cost of developing, preparing, implementing, operating, and maintaining formal training
programs for quality.
 g) Quality data acquisition and analysis: the cost of running the quality data system to acquire data on
product and process performance. Includes cost of analyzing these data to identify quality problems.

▪ Appraisal Costs
These are incurred to monitor and compensate for mistakes not eliminated through prevention activities.
a) Inspection & test of incoming material: Costs associated with the inspection and testing of all vendor-
supplied material.
b) Product inspection & test: the cost of checking the conformance of the product throughout its various
stages of manufacturing.
c) Materials & Services consumed: The cost of operating a system that keeps the measuring instruments
and equipment in calibration.
d) Maintaining accuracy of test equipment: the cost of operating a system that keeps the measuring
instruments and equipment in calibration.
▪ Failure Costs
Internal failure costs are expenditures, such as scrap or rework, incurred to remedy defective units before they
are shipped to customers.

External failure costs are expenditures for items, such as warranty work, customer complaints, litigation, and
defective product recalls that are incurred after a faulty unit of product has been shipped to the customer.

10.3. Value engineering

Value engineering is a systematic evaluation of all aspects of the value chain, with the objective of reducing costs and
achieving a quality level that satisfies customers. To apply value engineering, determination of value-added and nonvalue-
added activities and its corresponding costs must be made by the management. A value-added cost is a cost that, if
eliminated, would reduce the actual or perceived value or utility (usefulness) customers experience from using the product
or service. A nonvalue-added cost is a cost that, if eliminated, would not reduce the actual or perceived value or utility
(usefulness) customers gain from using the product or service. It is a cost that the customer is unwilling to pay for.

10.4. Theory of Constraints

A constraint is anything that confines or limits the ability of a person or machine to perform a project or function, it affects
time and costs of the production process. Theory of constraints (TOC) can help management reduce cycle time; it indicates
that the flow of goods through a production process cannot be at a rate faster than the slowest constraint in the process.
The constraints may arise due to human, material, or machine factors. Constraints, also called bottlenecks, are points at
which the processing levels are sufficiently slow to cause the other processing mechanisms in the network to experience
idle time. For continuous improvement, efforts are made to manage the constraints in the production. Company should
make the best use of the time or productive capacity the constrained processes provide and limit the constraints’ impacts
on performance.

10.5. Life-Cycle Costing

Lifecycle costing is the maintenance of physical asset cost records over entire asset lives. Lifecycle costing is also applied
in outlining cost over the product’s life. Product lifecycle costing is the accumulation of a product’s costs over its whole
life, from inception to abandonment. Typically, costs are accumulated from research and development activities, design,
manufacturing, marketing, distribution, and disposal activities. The product life cycle is the process a product goes through
from when it is first introduced into the market until it declines or is removed from the market. The life cycle has four
stages - introduction, growth, maturity and decline.

In a product’s introduction stage, companies generally invest substantially in promotion and advertising to build demand
for the product and to get it into the hands of its target consumers. When the product gets successful entry, it enters the
growth stage where the product gets popular and the demand grows as a result the market expands. Production will also
increase and will seek improvement to the product features to maintain and expand further the market share. The most
profitable life of the product is when it enters the maturity stage. Maturity stage is where sales is maxed out and saturation
is reached, and competition with other products will be very high and the product sales and market share will tend to go
slower because of the competition. Businesses will attempt to keep its product in the market during the maturity stage as
long as possible, but when it cannot held on longer product sales will decline drastically and demand will deteriorate
making the product life decline.

To maximize the product’s profitability, designing costs out of the product, minimizing the time to market, and maximizing
the lifecycle factors should be minimized.

Reference used:
• Cost Accounting by Raiborn
• Cost Accounting by Horngren
 Learning Activities

Exercise 1:
Mosquito MoJo is developing a propane-powered mosquito zapper for campers. Market research has indicated that
potential purchasers would be willing to pay $145 per unit for this product. Company engineers have estimated that fi rst-
year production costs will amount to $120 per unit and selling and administrative expenses will be $20 per unit. On this
type of product, Mosquito MoJo would normally expect to earn $15 per unit in profits. Using the concept of target costing,
write a memo that (a) analyzes the prospects for this product and (b) discusses possible organizational strategies.

Exercise 2:
Research the topic of value engineering on the Internet, and write a brief report on a company or an organization’s
experiences using this technique.

Exercise 3:
Th e marketing department at Cleveland Furniture Mfg. has an idea for a new product that is expected to have a 6-year
life cycle. After conducting market research, the company found that the product could sell for $800 per unit in the fi rst
4 years of life and for $650 per unit for the last 2 years. Unit sales are expected to be as follows:

Per-unit variable selling costs are estimated at $140 throughout the product’s life; total fixed selling and administrative
costs over the 6 years are expected to be $3,700,000. Cleveland Furniture Mfg. desires a profit margin of 15 percent of
selling price per unit.

a) Compute the life cycle target cost to manufacture the product. (Round to the nearest cent.)
b) If the company expects the product to cost $430 to manufacture in the first year, what is the upper bound for
manufacturing cost in the following five years? (Round to the nearest cent.)
c) Refer to the original information. Assume that Cleveland Furniture Mfg. engineers indicate that the expected
manufacturing cost per unit is $340. What actions might the company take to reduce this cost?

Evaluation

What am I learning from this

module?

What am I finding hard or

challenging about the topic?

What was the most important

thing I learned from this
module?