Chapter 19

Activity Based And

Target Costing
 Activity Based Costing
• Activity based costing (ABC) is an accounting
methodology that assigns costs to activities
rather than products or services.
• This enables resources and overhead costs to
be more accurately assigned to the products
and the services that consume them.
• ABC is based on the principle that ‘products
consume activities.’
 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.
 Other Concepts Related To ABC
• Activity Based Management
– It is a systematic method of planning, controlling,
and improving labour and overhead cost. ABM is
based on the principle activities consume costs.
• Activity Accounting
• It is a system that defines and reports the
activities, costs, activity, characteristics, and
outputs of each department, cost center, or
group of employees in an organization.
 Other Concepts Related To ABC
• Activity Based Budgeting
– It is a systematic method of planning and budgeting
the resources of an organization. In essence, ABB is
activity accounting in reverse, e.g. start ABB at
the bottom of the activity accounting spreadsheet.
Define the cost per output target and planned
activity workloads to determine headcount and
expense budgets.
 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 VS
Proactive 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