Activity-Based Costing (ABC)

Activity-Based Costing (ABC) is a method of allocating indirect costs (like overhead) to products or services
based on the activities they require. This approach ensures that costs are assigned more accurately
compared to traditional costing methods.

Simplified Process of Activity-Based Costing

1. Identify Activities:

 Determine the key activities involved in producing products or providing services.

2. Assign Costs to Activities:

 Accumulate the total costs for each identified activity.

3. Determine Cost Drivers:

 Identify the factors that cause costs for each activity (e.g., machine hours, number of
setups).

4. Calculate Activity Rates:

 Divide the total cost of each activity by its cost driver to find the rate (e.g., cost per machine
hour).

5. Assign Costs to Products/Services:

 Allocate costs to products or services based on their use of each activity.

6. Analyze and Interpret Data:

 Use the cost information to make informed decisions about pricing, budgeting, and process
improvements.

Benefits of Activity Based Costing Activity

1. Accurate cost determination: ABC leads to accurate and precise cost determination through proper
matching of overheads to products through cost drivers.
2. Detailed cost information for decision making: ABC provides segregated cost information for better
decision making especially relating to pricing, profit planning, product lines etc.
3. Cost Control: Managers are able to exercise cost control effectively by identifying value added and
non-value-added activities.
4. Budgeting and Performance Evaluation: Detailed breakdown of cost and identification of cost drivers
leads to realistic budgeting and comparison of actual performance with budgeted performance.
Limitations of Activity Based Costing ABC
1. Detailed measurements: ABC requires detailed analysis of tasks and grouping them into activities,
calculations relating to cost drivers for each activity, tracing of cost drivers to products and assignment
of costs to products. This is a continuous exercise requiring time, cost and effort.
 2. Difficulty in identification: Sometimes it is difficult to identify the cost driver for each activity and
managers may be forced to arbitrarily select allocation base which may lead to inaccurate cost
assignment.
3. Non-suitability for small organizations: Due to the complexity of ABC systems, it not suitable for
small organizations which may find traditional costing system more feasible.
Target Costing

Target Costing is a pricing method in which a company determines the desired profit margin and market
price for a product and then works backward to ensure that the product can be produced at a cost that
allows for this profit. It focuses on designing and producing products that meet customer needs at a price
they are willing to pay while achieving desired profitability.

Simplified Process of Target Costing

1. Determine Market Price:

 Research and establish the price customers are willing to pay for the product.

2. Set Target Profit Margin:

 Decide on the desired profit margin based on strategic objectives.

3. Calculate Target Cost:

 Subtract the target profit margin from the market price to find the maximum allowable cost
to produce the product.

4. Design to Cost:

 Develop product designs and production methods that meet the target cost while ensuring
quality and functionality.

5. Continuous Improvement:

 Implement cost-saving measures and process improvements to meet or stay below the
target cost throughout the product’s lifecycle.
Benefits of Target Costing
1. Cost Minimisation: Target costing involves determination of maximum costs and entails efforts to
meet that cost at all stages of value chain while meeting customers’ needs and wants. It also eliminates
defects, wastages and costly revisions after production.
2. Market orientation: Under Target costing, products are driven by market rather than business
capabilities. Target costing begins with thorough research of customers’ requirements, defining product
features, deciding the price they would be willing to pay and then trying to achieve the target margins
through continuous cost reduction.
3. Profitability: Target costing involves active simultaneous focus on costs and prices leading to
improved profitability.
4. Innovation: As management looks for alternative ways to attain target cost, it gives rise to innovation
which may also lead to a product differentiation and competitive edge to the company.
 Limitations of Target Costing
1. Burden on employees: In a bid to continuously reduce the costs, employees may be unduly
burdened and may also be penalized for failing to meet the targets.
2. Conflicts in the organization: Even though all the departments are equally involved in value
engineering, there is greater burden on the manufacturing department which may lead to
organisational conflicts. Also, problems of co-ordination may arise when there are multiple experts on
the team.
3. Compromise on Quality: It is possible that managers may resort to use of cheaper substitutes to
attain the target costs which may do more harm than good in the long run.
4. Inaccurate estimations: Since, target price is the basis for the entire process, failing to estimate it
with reasonable accuracy may lead to failure of the entire project.
In order to address these limitations, it is important that:
(1) There should be strong top management leadership and employee participation in implementing
target costing system.
(2) Team orientation and commitment among employees
(3) Realistic performance standards
(4) Specific cost goals for all departments rather than overall goal for the entire team.
Life Cycle Costing (LCC)
Life Cycle Costing (LCC) is a method of accounting that considers all costs associated with the life span of a
product or project, from initial development through to disposal. This approach helps in understanding the
total cost of ownership and making more informed financial decisions.

Stages of Product Life Cycle

1. Market research: This stage involves understanding of target market’s needs and wants, existing
products and how much the market would be willing to pay for the product.
2. Product features: This stage involves identification of basic product features related to functionality,
durability, performance, maintenance cost etc.
3. Design and Development: This stage involves drawing the product, processes, running, testing and
redesigning. The product goes through many iterations before the design is finalized and prototype is
market ready.
4. Market testing: The product is introduced on a small scale to gauge market reaction.
5. Production: Once the product passes the market test, it is produced on a mass scale.
6. Sales and Distribution: Finished products are shipped to the final consumers
7. Customer Support
8. Phasing Out: In this phase, further production is stopped and customer support for existing products is
also rolled back.
Benefits of Life Cycle Costing Product Life Cycle
1. Life Cycle Costing forces managers to see the long-term consequences of their decisions and make
decisions relating to design, pricing, life cycle wisely.
 2. Life Cycle Costing is a pro-active rather than reactive approach to maximise total operating income over
the life cycle of product. Prices can be lowered during the introduction stage and increased during the
growth stage to maximise life time revenue.
3. It generates cost consciousness in the organization as all costs from “cradle to grave” are analysed
beforehand and cost reduction efforts can be initiated early on.
4. Life Cycle Costing leads to more accurate determination of cost per unit.
Limitations of Life Cycle Costing
1. This method relies heavily on estimations and if market projections are wrong, the entire costing and
pricing will fail.
2. In a dynamic market, Life Cycle Costing may not be feasible as uncertainties render long range planning
futile.

Quality Costing

Quality Costing is a method used to quantify the costs associated with ensuring and improving quality
within an organization, as well as the costs resulting from failing to achieve quality. It focuses on
categorizing and analyzing these costs to improve overall efficiency and reduce waste.

Simplified Process of Quality Costing

1. Identify Quality Cost Categories:

 Prevention Costs: Costs incurred to prevent defects (e.g., training, process improvement).
 Appraisal Costs: Costs of evaluating products or services to ensure quality (e.g., inspections,
testing).
 Internal Failure Costs: Costs resulting from defects found before delivery to customers (e.g.,
rework, scrap).
 External Failure Costs: Costs incurred due to defects found after delivery to customers (e.g.,
returns, warranties).

2. Collect Cost Data:

 Gather data on all relevant costs within each category from various departments.

3. Analyze Quality Costs:

 Assess the collected data to understand the distribution and impact of quality-related costs
on the organization.

4. Implement Improvements:

 Identify areas where investing in prevention and appraisal can reduce internal and external
failure costs.

5. Monitor and Review:

  Continuously track quality costs and the effectiveness of quality improvement initiatives to
ensure ongoing efficiency.

Tools for Quality Costing (Shortened)

1. Pareto Analysis:

 Identifies major factors contributing to quality costs.

 Prioritizes issues to address first.

2. Fishbone Diagram (Cause-and-Effect Diagram):

 Identifies root causes of quality problems.

 Visualizes potential factors contributing to issues.

3. Flowcharts:

 Maps processes to identify points of defects or errors.

 Highlights areas for improvement.

4. Failure Mode and Effects Analysis (FMEA):

 Evaluates potential failures and their impacts.

 Prioritizes actions to reduce failures.

5. Control Charts:

 Monitors process performance over time.

 Identifies variations indicating quality problems.