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 organizations 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 organizations 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 products 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