BACT 302 MANAGEMENT ACCOUNTING

TOPIC:
TARGET COSTING
 TARGET COSTING
• It is a process which involves setting a target cost for a product
by subtracting a desired profit margin from a target selling
price.
• In a competitive market where organisations are continually
redesigning products and developing new products, target
costing can be an invaluable technique for helping the
organisation to make a satisfactory profit on the items that it
sells.
• In a competitive market, selling prices must be competitive. In
order to sell at a competitive price and make a required
amount of profit, the cost of production and sales must be kept
at a level that will provide the required profit at the chosen
selling price

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 TARGET COSTING
• Target cost is the cost at which a product must be produced and sold in
order to achieve the required amount of profit at the target selling price.
• Target costing is concerned with designing a product and its production
process so that it can be made and sold at a cost that delivers the
required profit at the chosen price.
• It focuses on getting the expected cost of a product down to a target cost
amount. Achieving a target cost will usually require some re-designing of
the product and the removal of unnecessary costs.
• Target costing is most effective at the product design stage, rand is less
effective for established products that are made in established
processes. At the design stage, it is easier and cheaper to make changes
that reduce costs.
• The aim of target costing is then to find ways of closing this target cost
gap, and producing and selling the product at the target cost

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 TARGET COSTING
• Implementing target costing The 7-steps below provide a useful summary of
the stages in the implementation of the target costing process.
• Step 1 Determine a product specification of which an adequate sales volume
is estimated.
• Step 2 Decide a target selling price at which the organisation will be able to
sell the product successfully and achieve a desired market share.
• Step 3 Estimate the required profit, based on required profit margin or return
on investment.
• Step 4 Calculate: Target cost = Target selling price – Target profit.
• Step 5 Prepare an estimated cost for the product, based on the initial design
specification and current cost levels.
• Step 6 Calculate: Target cost gap = Estimated cost – Target cost.
• Step 7 Make efforts to close the gap. This is more likely to be successful if
efforts are made to 'design out' costs prior to production, rather than to
'control out' costs after ‘live’ production has started.

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 TARGET COSTING
Deriving a target cost
• The target cost is simply the target price minus the required profit
• starting with a market-based target selling price,you subtract a desired profit
margin to get the target cost.

• Q1. Target costing A car manufacturer wants to calculate a target cost for a new
car,
• the price of which will be set at GHS17,950.
• The company requires an 8% profit margin on sales.
• What is the target cost?
Solution
• Profit required = 8% GHS17,950 = GHS1,436
• Target cost = GHS(17,950 – 1,436) = GHS16,514
• The car manufacturer will then need to carefully compile an estimated cost for
the new car.

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 TARGET COSTING
• Q2. Great Games, a manufacturer of computer games, is in the process of introducing a new
game to the market.
• The results of this research have been used to establish a target selling price of GHS60. This is the
price that the company thinks it will have to sell the product to achieve the required sales
volume.
• Cost estimates have been prepared based on the proposed product specification.
• Manufacturing cost GHS
• Direct material 3.21
• Direct labour 24.03
• Direct machinery costs 1.12
• Ordering and receiving 0.23
• Quality assurance 4.60
• Non-manufacturing costs
• Marketing 8.15
• Distribution 3.25
• After-sales service 1.30
The target profit margin for the game is 30% of the target selling price. Calculate the target cost of
the new game and the target cost gap

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 TARGET COSTING

Solution
GHS
Target selling price 60.00
Target profit margin (30% of selling price) 18.00
 Target cost (60.00 – 18.00) 42.00
 Projected cost 45.89
The projected cost exceeds the target cost by GHS3.89. This is
the target cost gap.
Great Games will therefore have to investigate ways to reduce
the cost from the current estimated amount down to the
target cost

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 TARGET COSTING

• Closing a target cost gap

• Reducing the number of components
• Using cheaper staff
• Using standard components wherever possible  Acquiring new,
more efficient technology
• Training staff in more efficient techniques
• Cutting out non-value-added activities
• Using different materials (identified using activity analysis etc)
NB.the most effective time to eliminate unnecessary cost and
reduce the expected cost to the target cost level is during the
product design and development phase, not after ‘live’ production
has begun.

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 TARGET COSTING

 Target costing in service industries

• It is problematic with services because target costing requires exact
and detailed specification of product design and make-up but services
are much more difficult to specify exactly due totheir characteristics
• (a) Intangibility-makes it difficult for services to be specified exactly
especially when provided by humans.What exactly does a customer
receive, for example, when he or she goes to a cinema? (b)
Variability/homogeneity- means a service can differ every time it is
provided, and a standard service may not exist. Hence it is difficult to
specify a cost , making target costing difficult
• For example, repairing a motor car, providing an accountancy service,
or driving a delivery truck from London to Paris are never exactly the
same each time.

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BACT 302 MANAGEMENT ACCOUNTING
TOPIC:
Throughput Accounting
 THROUGHPUT ACCOUNTING

Throughput accounting
Theory of constraints
Performance measures in throughput accounting
Throughput accounting ratio

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 Throughput accounting
Throughput
• Throughput = Sales – Material costs
• Throughput accounting (TA) is an approach to production
management which aims to maximise sales revenue less materials
cost(throughput), whilst also reducing inventory and operational
expenses.
• The basic concept in throughput accounting is that an organisation
should seek to maximise throughput by identifying and eliminating
bottlenecks. Hence it is based on the Theory of constraints (TOC).
• Theory of constraints (TOC) is an approach to production management
which aims to maximise sales revenue less material cost(throughput).
• It focuses on identifying and eliminating bottlenecks which act as
constraints to the maximisation of throughput.

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Throughput accounting is based on the following concepts, all
derived from the TOC.
• (a) Concept 1
• In the short run, all costs in the factory (with the exception of
materials costs) are fixed. These costs =Total Factory Costs
(TFC).
• (b) Concept 2 Ideal inventory level is zero.
• In a JIT environment, all inventory is a 'bad thing' and the ideal
inventory level is zero. Products should not be made unless a
customer has ordered them.

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 Throughput accounting
• Working on output just to add to work in progress or finished goods inventory
creates no profit, and so should not be encouraged.
• Work in progress should be valued at material cost only until the output is
eventually sold, so that no value will be added and no profit earned until the
sale takes place.
Concept 3 Profitability is determined by the rate at which sales are made-the rate
at which 'money comes in at the door'
• in a JIT environment, this depends on how quickly goods can be produced to
satisfy customer orders.
• Since the goal of a profit-orientated organisation is to make money, inventory
must be sold for that goal to be achieved.
• The bottleneck resource slows the process of making money. Making money
means maximising throughput

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• In the theory of constraints and throughput accounting,
• Throughput- Throughput is the money obtained from sales
minus the cost of materials that have gone into making them
• Inventory -is the amount of money the system has invested in
purchasing things that it intends to re-sell within its finished
products. Inventory has no value because it does not create
throughput until it is used to sell products.
• Operational expenses/ factory expenses-are all the other costs
of operations. -direct labour costs,overhead costs. In
throughput accounting, all operational expenses or factory
expenses are assumed to be ‘fixed’ costs.

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• Bottleneck factor/ ‘bottleneck resource’- is that which
prevents output and throughput from getting any higher, could
be:
• (a) A production resource, such as time available on a type of
machine, or the available amount of skilled employee time
• (b) A selling resource, such as the number of sales
representatives
• (c) The existence of an uncompetitive selling price
• (d) A need to deliver on time to particular customers
• (e) A lack of product quality and reliability
• (f) The lack of reliable material suppliers

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 Throughput accounting

Goldratt devised a five-step approach to summarise the key stages of TOC.

Step 1 Identify the constraint (bottleneck resource).
 Step 2 Decide how to exploit the constraint in order to maximise
throughput.
Step 3 Subordinate and synchronise everything else to the decisions made
in step 2.
 Step 4 Elevate the performance of the constraint.
 Step 5 If the constraint has shifted during any of the above steps, go back
to step 1. Do not allow inertia to cause a new constraint.
The overall aim of TOC is to maximise throughput/throughput
contribution’ (sales revenue – material cost) while keeping operational
costs (all operating costs except material costs) and investment costs
(inventory, equipment and so on) to the minimum.

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 Throughput accounting

• Key
  formulae:
• Throughput ($) = Sales revenue – Direct Material costs
• Total factory costs = ALL production costs (except materials)

• =

• Throughput accounting ratio=

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 Throughput accounting

• Interpretation of TPAR ratios:

• The TPAR ratio should be greater than 1 for the product to be
classed as financially viable. Priority should be given to the
products which generate the highest TA ratios.
• Products with a TPAR ratio less than one should be
discontinued.

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 Throughput accounting
Example 1. suppose that a factory manufactures a single product. Each unit of product
takes 2 hours to make on Machine X and output capacity is restricted by the available
time on Machine X, which is restricted to 500 hours per week. The product has a
material cost of GHS20 per unit and sells for GHS160 per unit. Total operating costs are
GHS30,000 per week.
Throughput per Machine X hour ;
• = GHS(160 – 20)/2 hours
• = GHS70
Factory cost per Machine X hour
• = GHS30,000/500 hours
• = GHS60
TA ratio
• = GHS70/GHS60
• = 1.17
• PRODUCT IS FINANCIALLY VIABLE.

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 Throughput accounting
• Example 2. Pi plc manufactures 2 products, A and B. The cost cards are as follows:
A B
• Selling price 25 28
• Materials 8 20
• Labour 5 2
• Other variable costs 7 2
• Fixed costs 3 2
• 23 26
• Profit $2 $2
• Machine hours p.u. 2 hrs 1 hr
• Maximum demand 20,000 units 10,000 units

The total hours available are 48,000.

(a) Calculate the optimum production plan and the maximum profit, on the assumption that in the short-term
only material costs are variable i.e. using a throughput accounting approach
(b) Calculate and Interpret the Throughput Accounting ratios (TPAR ratios)
(c) Suggest some business strategic reasons why management might decide NOT to withdraw an unprofitable
product from sale.
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 SOLUTION

A B
• Selling price 25 28
• Materials 8 20
• Throughput p.u. $17 $8
• Machine hrs p.u. 2 1
• Contribution per hour $8.50 $8
• (2) (1)

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 SOLUTION

Production Plan
• units hours
• A: 20,000 × 2hrs = 40,000
• B: 8,000 × 1hr = 8,000
• 48,000 hours
Profit
• $ A: 20,000 × $17 340,000
• B: 8,000 × $8 64,000
• 404,000
• less “fixed” costs:
• A: 20,000 × $15 (lab,vc,fc)
• B: 10,000 × $6 (lab,vc,fc) 360,000
• Profit $44,000

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 SOLUTION

• Cost
  per factory hour == $7.50
Throughput accounting ratios:
A: =1.13

B: = 1.07
Interpretation: Both products have a TPAR greater than 1 which means they are both
financially viable products (they return more per hour than the factory cost per hour).
However, Product A is more profitable than product B – which is why the production
plan we created prioritised resources to producing all of product A first.
 (c) Management should always consider other business strategic factors before
withdrawing a product from sale. For example, product may be a vital part of the
range that customers value. Alternatively, sale price may be deliberately low due to
pricing strategies such as introductory pricing, loss leadership or a price penetration
policy.

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