TARGET COSTING AND

TOTAL QUALITY
MANAGEMENT

F.M.KAPEPISO
LEARNING OBJECTIVES
At the end of the lecture, you should be able to:
 Explain the total quality management (TQM) process

 Define the costs of quality and draw up a cost of

quality report
 Explain the meaning of target costing, tear down
analysis and value engineering
 Use target costing and other tools for cost
management and control
 INTRODUCTION
 Before the 1970s, barriers of communication and
geographical distance limited the extent to which
overseas organizations could compete in domestic
markets.
 Cost increases could often be passed on to customers & so
there were few efforts to maximize efficiency and
improve management practices or to reduce costs.
 During 1970s, however, overseas competitors gained
access to domestic markets by establishing global
networks for acquiring raw materials and
distributing high-quality, low priced goods.
 To succeed, organizations had to compete against the best
companies in the world
 QUALITY MANAGEMENT:

 Quality is defined as the extent to which a product or

service meets customer expectations by conforming to the
required design or specifications at the price customers
are willing to pay.
 In other words quality means the degree of excellence of
a thing (how well made it is, or how well performed if it is
a service, how well it serves its purpose and how well it
measures up against its rivals.
 The management of quality is the process of:
 Establishing standards of quality for a product or service
 Establishing procedures or production methods which ought to
ensure that these required standards of quality are met in a
suitably high proportion of cases
 Monitoring actual quality
 Taking control action when actual quality falls bellow
standards
 TOTAL QUALITY MANAGEMENT (TQM)

 Quality management becomes total (Total Quality Management

(TQM) when it is applied to everything a business does.
 TQM is an integrated and comprehensive system of planning and
controlling all business functions so that products or services are
produced which meet or exceed customer expectations.
 TQM is a customer-centric approach based on two basic principles
 The principle of get it right first time (cost of preventing mistake is less than
cost of correcting them once they occur)
 Continuous improvement (dissatisfaction with the status quo, employees
should believe that it is always possible to improve and get it more right each
time)
 It requires providing better quality products at the competitor’s price
or providing same quality products at lesser price.
 TQM is a wholesome approach that focuses on activities such as
reducing inventories and defects, streamlining production flow, co-
operating with suppliers, increasing flexibility and productivity of
workforce, providing excellent after sales service and focus on cause
rather than symptom of poor quality.
 COSTS OF QUALITY
 Cost of quality is the difference between the actual cost
of producing, selling and supporting, products or services
and the equivalent costs if there were failures during
production or usage.
 Cost of quality can also be defined as the sum of the
costs that arise from activities associated with
prevention, identification, repair, and rectification of
poor quality, and opportunity costs from lost production
time and lost sales as a result of poor quality
 The costs of quality are generally classified into:
 Costs of conformance- costs of achieving specified quality
standards
 Costs of non-conformance – the costs of failure to deliver
the required standard of quality
 COSTS OF QUALITY…
 Costs of conformance are further divided into: prevention
costs and appraisal costs
 Prevention costs – costs incurred prior to or during production in
order to prevent substandard or defective products or services from
being produced
 Appraisal cost – costs incurred in order to ensure that outputs
produced meet required quality standards. These occurs during
production but before product are delivered to customers.
 Costs of non-conformance are further divided into:
internal failure costs and external failure costs
 Internal failure costs – costs arising from inadequate quality
which are identified before the transfer of ownership from supplier
to purchaser (costs of fixing defects or problems that bring down
quality before the goods are delivered to customers)
 External failure costs – costs arising from inadequate quality
discovered after the transfer of ownership from supplier to
purchaser (costs of fixing quality problems that are found when the
product is in the hands of consumer)
 COST OF QUALITY REPORT
 Costs of quality report – shows the various categories
of quality costs expressed as a percentage of sales or
turnover. The table bellow gives examples of the
components of quality costs.
Typical quality costs
Prevention costs
 System development
 Quality engineering
 Quality training
 Quality cycles
 Statistical process control activities
 Supervision of prevention activities
 Quality data gathering, analysis, and reporting
 Quality improvement projects
 Technical support provided to suppliers
 Audits of the effectiveness of the quality system
Appraisal costs
 Test and inspection of incoming materials
 Test and inspection of in-process goods
 Final product testing and inspection
 Supplies used in testing and inspection activities
 Supervision of testing and inspection activities
 Depreciation of test equipment
 Maintenance of test equipment
 Plant utilities in the inspection area
 Field testing and appraisal at customer site
Internal failure costs
 Net cost of scrap
 Net cost of spoilage
 Rework labour and overhead
 Reinspection of reworked products
 Downtime caused by quality problems
 Disposal of defective products
 Analysis of the cause of defects in production
 Re-entering data because of keying errors
 Debugging software errors
External failure costs
 Cost of field servicing and handling complaints
 Warranty repairs and replacements
 Repairs and replacements beyond the warranty period
 Product recalls
 Liability arising from defective products
 Returns and allowance arising from quality problems
 Lost sales arising from a reputation for poor quality
 COST OF QUALITY REPORT…
 The cost of quality increases as one moves down the order of
prevention, appraisal, internal failure and external failure
costs.
 Total cost of quality is minimised when more emphasis is
placed on the earlier categories. This implies that more money
ought to be spent early on, such as on designing a quality
product and purchasing quality materials.
 Organisations that achieve and sustain competitive
advantage using TQM, therefore focus on prevention and
appraisal in order to eliminate internal and especially
external failure.
 Although cost of quality reports provide a useful summary of
the costs, effort and progress of quality. Lower levels of
management may also need non-financial measures
including:
 Number of customer complaints
 Number of warranty claims
 Number of defective units delivered to customers as a % of total unit
delivered
 COST OF QUALITY REPORT…
Example: Cost of quality report for the year ended 31 Dec
2000 Cost as % of
annual
turnover (10
Amount million)
Prevention costs
Design of quality control equipment 80 000,00 0,80
Quality control training 80 000,00 0,80
Total 160 000,00 1,60
Appraisal costs
Inspection of goods inwards 90 000,00 0,90
Inspection of WIP 100 000,00 1,00
Total 190 000,00 1,90
Internal failure costs
Scrap 150 000,00 1,50
Rework 200 000,00 2,00
Total 350 000,00 3,50
External failure costs
Returns 500 000,00 5,00
Contribution forgone on lost sales 400 000,00 4,00
Handling customer complaints 100 000,00 1,00
Total 1 000 000,00 10,00
Total quality costs 1 700 000,00 17,00
 COST OF QUALITY REPORT…
Uses of cost of quality report
 Quality cost information helps managers to see the
financial significance of defects. Managers are not aware
of the magnitude of their quality costs because these
costs cut across departmental lines and are not normally
tracked and accumulated by the cost system.
 Quality cost information helps managers to identify the
relative importance of the quality problems faced by the
firm. For example the report may show that scrap is a
major quality problem, so it helps manager to have a
better idea of where to focus efforts.
 Quality cost information helps managers to see whether
their quality costs are poorly distributed. In general,
quality costs should be distributed more torwards
prevention and appraisal activities and less towards
failures.
 EXERCISE 1
In response to intensive foreign competition, the management of Florex Company
has attempted over the past year to improve the quality of its products. A
statistical process control system has been installed and other steps have been
taken to decrease the amount of warranty and other field costs, which have been
trending upward over the past several years. Costs relating to quality and quality
control over the last two years are given below:
This year Last year
Inspection $900 000 $750 000
Quality engineering 570 000 420 000
Depreciation of test 240 000 210 000
equipment
Rework labour 1 500 000 1 050 000
Statistical process control 180 000 -
Cost of field servicing 900 000 1 200 000
Supplies used in testing 60 000 30 000
System development 750 000 480 000
Warranty repairs 1 050 000 3 600 000
Net cost of scrap 1 125 000 630 000
Product testing 1 200 000 810 000
Product recalls 750 000 2 100 000
Disposal of defective products 975 000 720 000

Sales have been flat over the past few years, at $75 000 000 per year. A great deal
of money has been spent in the effort to upgrade quality, and management is
anxious to see whether or not the effort has been effective.

REQUIRED Marks
(a) Prepare a quality cost report that contains data for both this year
and last year. Classify clearly each of the cost above in categories 20
and carry percentage computations to two decimal places.
(b) Prepare a written evaluation to accompany the reports you have
prepared in requirement (a) above. 5
TOTAL MARKS 25
 EXERCISE 2
Nawa group realises that its present performance reporting does not highlight quality
costs. The reports contain the information below, but the directors require this to be
reported in an appropriate format.

The following information is available in respect of the year ended 31 May:

1) Production data:
Units requiring rework 1 500
Units requiring warranty repair service 1 800
Design engineering hours 66 000
Inspection hours (manufacturing) 216 000

2) Cost data:
N$
Design engineering costs per hour 75
Inspection cost per hour (manufacturing) 40
Rework cost per heating system unit reworked 3 000
(manufacturing)
Customer support cost per repaired unit (marketing) 200
Transportation costs per repaired unit (distribution) 240
Warranty repair costs per repaired unit 3 200

3) Staff training costs amounted to N$150 000 and additional product testing costs
were N$49 000.
4) The marketing director has estimated that sales of 1 400 units were lost as a result
of bad publicity in trade journals. The average contribution per heating system unit
is estimated at N$6 000.

REQUIRED Marks
1.3. Prepare a cost quality report for Nawa group that shows its costs of 10
quality (using appropriate headings) for the year ended 31 May.
 ADAPTED: SUPP EXAM 2017
FANTASY designs and makes a single product, the X4, used in the telecommunications
industry. The organisation has a goods received store which employs staff who carry out
random checks to ensure materials are of the correct specification. In addition to the
random checks, a standard allowance is made for failures due to faulty materials at the
completion stage and the normal practice is to charge the cost of any remedial work
required to the cost of production for the month. Once delivered to the customer, any faults
discovered in the X4 during its warranty period become an expense of the customer
support department.
At the end of each month, management reports are prepared for the board of directors.
These identify the cost of running the stores and the number of issues, the cost of
production and the number of units manufactured, and the cost of customer support.

REQUIRED Marks
2.1. Briefly discuss why the current accounting system fails to highlight the cost of
quality. 5
2.2. Identify four categories (or classifications) of FANTASY’s activities where
expenditure making up the explicit cost of quality will be found and an example 16
of a cost found within each category.
2.3. Give two examples of a cost of quality not normally identified by the 4
accounting system.
TOTAL MARKS 25
 TARGET COSTING
Target Costing is the process of determining the
maximum allowable cost for a new product and then
developing a prototype that can be profitably made for that
target cost. It focuses attention on the product at design
stage
Stages involved in target costing
 Based on market analysis determine a target price that
customers willing to pay.
 Estimate a desired profit margin and deduct it from the target
price.
 The difference is called target cost.
 Estimate the actual cost of the product.
 Estimated cost > target cost, find out ways of reducing it to the
target cost.
 It may require stripping down product features, changing
production process etc.
 PRODUCT DESIGN:
 Research reveals that most of a products’ manufacturing
cost is already committed at product design stage, as
choices regarding product features, functions,
manufacturing processes are made at this stage.

 Therefore, product design plays an important role in

overall cost management and producing products that
are valued by customers.
 TEAR-DOWN ANALYSIS:
 To know about the secrets of its competitors.
 Also known as reverse engineering , is a process of
dissecting competitors’ product into components for the
purpose of critically evaluating its features.
 Allows a company to identify opportunities of product
improvement.
 To identify product’s distinguishing features such as
functionality, design, process used etc.
 Insights into the cost of the product and also suggests the
relative advantages or disadvantages of the competitors’
approach to product design.
 Based on findings of tear down analysis, company can
make appropriate choices to produce a product with
desired features and provide it at an attractive price tag
 VALUE ENGINEERING :
Value engineering ( also known as value analysis) is a
systematic interdisciplinary examination of factors affecting
the cost of a product or service in order to devise means of
achieving the specified purpose at the required standard of
quality and reliability at the target cost.
Steps in value engineering:
 Identify functions to be packaged in the product, cost of
providing those functions and how much customers are
willing to pay for those functions.
 Distinguish between value added and non-value added
activities.
 Identify specification of products’ functions
 Identify alternatives of providing those functions and the
cost of each alternative.
 Among these then best alternatives are taken to develop
the proposed product design.
 KAIZEN COSTING
 Kaizen Costing is a buzzword developed by Japanese
Companies that aims at continuous cost reduction.
 Once the product and process designs are finalized, the
attention shifts to manufacturing process efficiency
to achieve continuous smaller improvements.
 Kaizen costing focuses attention on things that managers
can do to reduce costs. Under Kaizen costing periodic
targets for cost reduction are set internally by senior
management.
 Cost reduction is achieved through activities such as
increased employee awareness and trainings to improve
motivation levels, and machine performance to reduce
waste etc.
 LIFE CYCLE COSTING (LCC)
 LCC is the maintenance of cost records that accumulate the costs
incurred over the lifespan of a product, service or physical asset.
 The concept of life cycle costing assumes vital role in industries
where huge initial research and development costs or end of product
life abandonment costs or clearing costs have to be incurred.
 This concept shifts attention from direct profit from manufacturing
phase to profit earned when entire life cycle costs are considered.
 This exercise may also result in choices that reduce overall cost
incurred during the product life cycle. Many times it may cause short
term losses but proves to be beneficial in long run as it might require
changes in the product or process design.
 A product with lower life cycle cost is always more profitable than a
product with lower production cost but comparatively higher pre or
post production costs.
 Life cycle costs include pre - production costs (such as research and
development), actual production costs, after sales service and
support costs and end of the life cycle clearing or abandonment costs.
 EXAMPLE:
Epifania CC is contemplating investment in one of the following
two projects that aim mining, processing and marketing semi-
precious stones.
Project 1 Project 2
Annual sales volume (Units) 30000 30000
N$ N$
Unit selling price 315 350
Costs:
Mining costs including royalty 3600000 3300000
Processing costs including bought in supplies 3000000 3150000
Other indirect costs (fixed) 1500000 2000000
 Fixed costs include straight line depreciation on fixed assets that cost
N$ 5 million and 7.5 million respectively for the two projects. The
estimated life of both projects is five years, and residual values of
both project assets are nil.
 Required:
 Which project will you prefer if manufacturing phase profit is the
basis of decision?
SUGGESTED SOLUTION
Project 1 Project 2
Annual sales volume (Units) 30000 30000

N$ N$
Total sales revenue 9450000 10500000
Costs:

Mining costs including royalty 3600000 3300000

Processing costs including bought in
3000000 3150000
supplies
Other indirect costs (fixed) 1500000 2000000
Total costs 8100000 8450000
Profit 1350000 2050000
It is obvious from the above table that Project 2 is more
profitable and should be preferred over project 1.
 EXAMPLE CONTINUED
Now consider the following additional information:
Project 2 is located in the vicinity of proclaimed
environmentally sensitive zone and requires restoration of
the site to the specifications set by Ministry of
Environment and Tourism. It will require an estimated
outlay of N$ 5500000 on restoration costs. While
restoration costs for project 1 are estimated to be 1350000.
The prospecting and research and development costs for
the two projects were N$ 520000 and N$ 985000
respectively.
Required:
Which product will you prefer if project life cycle costing is
the basis of decision? Ignore time value of money.
SUGGESTED SOLUTION

Project 1 Project 2
5 year revenues (revenue as
above X 5) 47250000 52500000
5 year costs (costs as above
X 5) 40500000 42250000

Pre - production costs

520000 985000

Restoration costs
1350000 5500000

Life Cycle Costs

42370000 48735000

Life cycle profit

4880000 3765000

Now your preference will be project 1 and not project 2.

 SUPPLY CHAIN MANAGEMENT:
 Supply Chain Management (SCM) involves the flows of materials,
information, and finance in a network consisting of customers,
suppliers, manufacturers and distributors. SCM moves focus from
being internally focused to being both internally and externally
focused with the objective of achieving greater customer satisfaction.
 It involves establishment of long-lasting, trust-based collaborative
relationship between organisations both upstream and downstream
of the supply chain, and also involves sharing information about
product development
 Supply chain is a network of organisations that are involved in
different processes and activities that produce value in the form of
products and services in the hands of the ultimate customer.
 PRACTICE QUESTION 1
Alcazarquirvir Lda manufactures and sells industrial grinders. The following table presents
financial information pertaining to quality in 2011 and 2012 (N$000):

2012 2011
Sales N$12,500 N$10,000
Line inspection 85.00 110.00
Scrap 200.00 250.00
design engineering 240.00 100.00
cost of returned goods 145.00 60.00
product-testing equipment 50.00 50.00
customer support 30.00 40.00
Rework costs 135.00 160.00
Preventive equipment maintenance 90.00 35.00
Product6-liability claims 100.00 200.00
Incoming materials inspection 40.00 20.00
Breakdown maintenance 40.00 90.00
product-testing labour 75.00 220.00
Training 120.00 45.00
warranty repair 200.00 300.00
supplier evaluation 50.00 20.00
Required: (15 + 13 + 2 marks)

i. Classify cost items in the table into prevention, appraisal, internal failure or external
failure categories.
ii. Calculate the ratio of each Cost of Quality category to sales in 2011 and 2012.
Comment on the trends in costs of quality between 2011 and 2012.
Give two examples of non-financial quality measures that Alcazarquivir could monitor as
part of a total-quality-control effort.
Thanks