Methods of Establishment of cost

Target Costing Phases: Planning, Development and Production

Target costing is a market driven methodology.

There are the three phases of this methodology as under:

(i) Planning:

The products of all competitors are to be analysed with regard to price, sales, quality, technology, and service etc., and after that target cost is to be determined and then market share of one product is to be finalised.

(ii) Development:

Cost structure of the organisation is to be finalised after examining and studying various cost reductions measures and Activity based costing and then a suitable design has to be developed.

(iii) Production:

Production target are fixed and efforts are made to achieve it at the lowest cost without affecting the quality, technology design and its production techniques etc.

Target Costing Approaches (With Equations)

Target costing system has customer orientation. Under the target costing approach, before a firm launches a product (or a family of products), it determines the ideal selling price, establishes the feasibility of meeting that price, and then control costs to ensure that the price is met.

The target costing approach is radically different from the conventional approach for price fixation and cost management.

1. Conventional Approach:

The conventional approach is cost plus pricing. The approach is to design a product so that it can be produced at the lowest cost, and then a desired margin is added to the estimated cost to determine the selling price of the new product.

We may present this approach in an equation form as follows:

S = C + P

If the firm feels that the price is too high, it modifies the design to reduce the cost and consequently the required selling price. If the firm could not establish the expected selling price, the product is launched at the originally estimated selling price based on the original design.

The other conventional approach is to design a product so that it can be produced at the lowest cost, and then match the cost to the anticipated selling price.

The profit margin is determined as presented in the following equation:

P = S-C

If the profit margin is below an acceptable level, the product is redesigned, if possible, to reduce the cost until the desired profit margin is achieved.

In both the conventional approaches, the focus is on cost reduction and not on cost management. The cost reduction efforts start after the development stage. Both the approaches induce production efficiencies to apply after the product design stage. Therefore, the potential for cost reduction is limited.

A study estimated that at most 10% cost reduction is attainable. Conventional approaches do not compel managers to estimate how much the customer will pay for each element of functionality and quality. Each product used to be conceived as a package of functionality and quality without much scope for modification.

2. Target Costing Approach:

Under the target costing approach, firms work backward from customers’ need and willingness to pay. Target costing takes cost as the dependent variable, while conventional approaches take selling price or profit as the dependent variable.

The relationship between the variables can be presented as follows:

C = S-P

The target costing approach recognizes that there is a trade-off between price, cost, functionality, and quality. Managers examine this trade-off at the development stage of the product, and optimize on the product functionality and quality within the parameters of estimated selling price, target cost, target volume and target launch date.

Costing Types:

1. Job Costing:

Under this method costs are collected and accumulated for each job or work order or project separately. Each job can be identified separately and hence becomes essential to analyze the costs according to each job.

Normally production consists of distinct jobs or lots so that order number can identify costs. A job card is prepared for each job for cost accumulation. This method is suitable for Printers, Machine tool manufacturers, Foundries, and general engineering workshops.

2. Contract Costing:

Contract costing does not in principle differ from job costing. When the job is big and spread over long period of time, the method of contract costing is used. A separate account is kept for each individual contract. Civil engineering contractors, constructional and mechanical engineering firms, builders, etc use this method.

In contracts, when it is agreed to pay an agreed sum or percentage to cover overheads and profit to the contractors, it will be termed as ‘cost plus costing’. The term cost here refers to the prime cost. Usually government contracts are assigned in this basis.

3. Batch Costing:

This is an extension of job costing. A batch may represent a number of small orders or group of identical products passed through the factory in batch. Each batch is treated as a cost unit and cost is ascertained separately.

The cost per unit is determined by dividing the cost of the batch by the number of units produced in a batch. The manufacturers of biscuits, garments, spare parts and components mainly use this method.

4. Process Costing:

A process refers here to a stage of production. If a product passes through different stages, each distinct and well defined, then in order to ascertain the cost at each stage or process, the process costing is used. Under this method, a separate process account is prepared and all costs incurred in that process are charged.

Normally the finished product of one process becomes the raw material of the subsequent process and a final product is obtained in the last process. As the products are manufactured in continuous process, this is also known as continuous costing. Process costing method is generally followed in textile units, chemical industries, refineries, tanneries, paper manufacture, etc.

5. Operation Costing:

It is a further refinement of process costing. It is suitable to industries where mass or repetitive production is carried out or where the goods have to be stocked in semi-finished stage, to enable the execution of special orders, or for the convenient use in later operations. In this method, the cost unit is an operation. It is used in cycle manufacturing, automobile units, etc.

6. Unit Costing:

This is also known as single or output costing. This method is suitable for industries where the manufacture is continuous and units are identical. This method is applied in industries like mines, quarries, cement works, brick works, etc.

In all these industries there is natural or standard unit of cost, for example, tonne of coal in collieries, tonne of cement, one thousands of bricks, etc. The object of this method is to ascertain the cost per unit of output and the cost of each element of such cost.

Here the cost account takes the form of cost sheet or statement prepared for a definite period. The cost per unit is determined by dividing the total expenditure incurred during a given period by the number of units produced during that period.

7. Operating Costing:

This is suitable for industries, which render services as distinct from those, which manufacture goods. This is applied in transport undertakings, power supply companies, gas, water works, municipal services, hospitals, hotels, etc.

It is used to ascertain the cost of services rendered. There is usually a compound unit in such undertakings, for example, tonne-kilometres or passenger-kilometres in transport companies, kilo-watt-hour in power supply, patient-day in hospitals, etc.

8. Multiple Costing:

It is also called as composite costing. It represents the application of more than one method of costing in respect of the same product. This is suitable for industries where a number of component parts are separately produced and subsequently assembled into a final product. In such industries each component differs from others as to price, materials used, and manufacturing processes.

So it will be necessary to ascertain the cost of each component. For this purpose process costing may be applied. To ascertain the cost of the final product batch costing may be applied. This method is used in factories manufacturing cycles, automobiles, engines, radios, typewriter, aero plane and other complex products.