Before discussing how cost accountants setup target costing; what is the so-called target costing? You may ask. Let me tell you in short words: target costing is a costing methodology that uses preset cost—that is charged into products—before it’s actually happened. The preset cost, in this particular method is called target cost.
Target costing is highly recommended to any company that designs its own products, since it can result in significant reductions in product costs even before they’re actually incurred, when the design is completed. But there is the downside; it requires extensive labor work of the cost accountants.
Unlike other costing methodologies where a cost accountant collects, populates, calculates and charges costs when they’re incurred in production—so that managers will find out what a product costs after it is too late to make any changes to the design, in target costing system a team of cost accountants are required to get involved since the product design process—with the intent of creating products that meet certain target cost. Using the target costs, all activities—in the production area—are driven into one direction; the margin goal. So, how cost accountants setup target costing? I am going to outline the setup—in a step-by-step manner, through this post. But before the steps, let’s have a look at cost accounting in general. Read on…
Please Forget GAAP for Better Cost Accounting Result
The only aspect of accounting that capable of providing company-related performance information to the management team is the cost accounting. Thus, cost accounting is crucial skill that any accountants should have.
A well organized cost accounting function can give valuable feedback regarding the cost trend, impact of product pricing, the performance of cost-and-profit centers, and production capacity. Such information can even—in some degree—contribute to the formulation of company strategy.
I am supposed to not even need to outline how important the accounting roles in real business life—accountants very well know about that. But in my personal experience in overseeing many different accounting departments found that many accountants rarely give due consideration to the multitude of uses to which cost accounting can be put.
Instead, they only think of how cost accounting will feed information into the financial statements. This is an obvious result of a strong tendency in business schools to train students in generally accepted accounting principles (GAAP) and how they are used to create financial statements.
At this particular post, let’s forget about GAAP for couple of minutes. Keep in mind that when doing cost accounting, you’re serving the management of the company—not the accounting standard setter nor the SEC, nor the other accounting standard bodies. Let’s realize that the primarily concerned of the cost accounting, is to help the management team to understand the company’s operations.
The truth is, cost accounting function works best without any oversight rules and regulations, because, in accordance with its stated purpose of assisting management, it tends to result in hybrid systems that are custom-designed to meet specific company needs.
You may find that a major requirement is to determine the incremental cost that it incurs for each additional unit of production, for an example—so that it can make accurate decisions regarding the price of incremental units sold (possibly at prices very close to the direct cost). If it were to use accounting standards, it would be constrained to use only a costing system that allocated a portion of overhead costs to product costs—even though these are not incremental costs.
Accordingly, the cost accounting system used for this specific purpose will operate in contravention of GAAP, because following GAAP would yield results that do not assist management.
Three Steps to Perform and Various Costing Methodologies to Use
The proper cost accounting information could be gotten through three major steps that a cost accountant should perform:
Step-1. Collecting the raw data – The first step in setting up a data collection system is to determine what types of data to gather.
Step-2. Processing the data—in accordance with a costing methodology; and followed by
Step-3. Reporting of the resulting information to management
The area that receives the most coverage is the processing function, for there are a number of different methodologies available, each of which applies to different situations. But before that, let’s cover how the cost data supposed to be collected so that fits the costing methodology that will be used.
One can simply collect every conceivable type of data available, but this will result in immensely detailed and cumbersome collection systems that are expensive and require a great deal of employee time to collect and record.
A better approach is to determine what types of outputs are required, which can then be used to ascertain the specific data items needed to create those outputs. This allows the cost accountant to ignore many types of data, simply because no one needs them.
However, the process of determining data requirements from projected outputs must be revisited on a regular basis, for changes in the business will require changes in the required cost accounting reports, and therefore changes in the types of data collected. Once the cost accountant knows what data to collect, there is still the issue of creating a data accumulation system.
There are several factors that will influence this decision. One is cost; if there are many employees who will be recording information continuously, then the unit cost of the data collection device cannot be too expensive, or else its total cost will exceed the utility of the collected data.
Having covered the data collection portion of cost accounting, cost accountants would move to the various costing methodologies that are available for processing the raw data into a format that is most useful for management consumption. Here are seven common costing methodologies that cost accountant can utilize in performing the second and third step—other than the target costing in brief (we are going to discuss target costing after these):
1. Job costing – This is a commonly used system that is primarily targeted at production situations where customized goods are produced for specific customers. It is very useful for tracking the exact cost of individual products, and is the only valid technique for accumulating costs for cost-plus contractual arrangements.
2. Process costing – This is also often used system, and is most common in situations in which large quantities of exactly the same product are created. Costs are collected in bulk for entire time periods, and then allocated out to the volume of entire production runs during that period. This results in a fair degree of accuracy when costs are averaged out and assigned to individual units.
3. Standard costing – This methodology has been installed in many companies as an adjunct to both the job costing and process costing systems. It is designed to set standard costs for all material and labor costs incurred by a company, against which actual results can be compared through variance analysis.
4. Direct costing – This is a favorite methodology for those managers who are constantly confronted with incremental costing and pricing decisions where the inclusion of overhead costs in a product’s total cost will yield inaccurate information. Thus, direct costing is an ideal approach for determining the lowest possible price at which to sell incremental units.
5. Throughput accounting – A variation on direct costing is throughput costing. This methodology holds that the only direct cost is direct materials, with even direct labor costs being thrown out when making most cost-related management decisions. The main tenet of throughput accounting is that a company must carefully manage the bottleneck operation in its production facility, so that the largest possible contribution margin is created.
6. Activity-based costing (ABC) – The ABC methodology is a much more accurate way to associate overhead costs with specific activities, which in turn can be assigned to product costs. Its main advantage is that it builds a direct correlation between the occurrence of an activity and related overhead costs, so that changes in the activity can reliably be expected to result in corresponding changes in the overhead costs.
7. By-product and joint product costing – This type of costing involves using some rational means for allocating costs to products for which there is no clearly attributable cost. The various methods for conducting these allocations are primarily used for valuing inventory for external reporting purposes.
Four Major Phases in Target Costing Setup
Three major steps a cost accountant should be performed in the cost accounting have been quickly covered. We have also, by far, covered 7 common methods—other than the target costing—that can be used for data collection purposes, what types of costing methodologies can be utilized to process this incoming data, and how the results can be reported to management.
Of the three areas covered, the most important is the proper use of the correct costing methodology, for this has a major impact on the type of information reported to management.
As it has been mentioned on the preface, target costing is the most proactive of all the methodologies, for it involves the direct intervention of the cost accounting staff in the product design process. This is opposed to the usual practice of accumulating costs after products have been designed and manufactured.
This costing system is highly recommended to any company that designs its own products, since it can result in significant reductions in product costs before they’re even approved when the design is completed. This technique, however, usually requires a great deal of cost accounting staff time, and can lengthen the product development process, but is well worth the effort.
And those can’t be achieved without solid knowledge of how to set up a proper cost accounting system—the target costing, in this particular case. You may not be able to get such insights from the accounting school, but you can always accumulate the knowledge by keep learning the subject, and the best way is by putting your feet into the field—conduct real cost accounting tasks.
As a start, here I summarized four major phases to go through in target costing setup with a simple graph (see explanations of each phases after the graph):
Here I outlined explanations for the above graph:
Phase-1. Conducts Market Research
Instead of designing-costing-selling products at certain price points, target costing works the other way round. Setting up target cost is started by knowing the “price point”.
To know the price point, the design team would need to conduct market research—before attempting to engineer a product—to determine the “price point” that a company is most likely to achieve if it creates a product with a certain set of features.
There are two types of research to be conducted to gain better knowledge of price point:
- Customer research; and
- Competitor research.
Once both researches are completed, the team should capable of determining:
- Customer’s requirements
- Product’s features
The elaborated researches should include information about the perceived value of certain features on a product, so that the design team can add or subtract features from the design with a full knowledge of what these changes will probably do to the final price at which the product will be sold.
Phase-2. Determine Margin and Cost Feasibility
On this phase, the cost accountant subtract from the prospective product price a gross margin that must be earned on the product; this can be a standard company-wide margin that must be earned on all new products, or perhaps a more specific one that management has imposed based on the perceived risk of the project.
At this points, however, the cost account should have been, at least, gained the initial margin goal and target cost.
By subtracting the required margin from the expected price, we arrive at the maximum amount that the product can cost. This total cost figure drives the next step on the next phases.
Phase-3. Meet Margin Goal and Target Cost (Design/Engineering Improvement)
On the phase-2, the team (consisted of designers, engineers and cost accountants,) in most cases, have not meet the target cost yet. On third phase, the team then uses value engineering to drive down the cost of the product until it meets its overall cost target.
Value engineering requires considerable attention to the elimination of production functions, a product design that is cheaper to manufacture, a planned reduction of product durability in order to cut costs, a reduced number of product features, less expensive component parts, and so on—in short, any activity that will lead to a reduced product cost.
This process also requires the team to confirm costs with the suppliers of raw materials and outsourced parts, as well as the processing costs that will be incurred internally.
The cost accountant plays a key role at this stage, regularly summarizing costing information and relaying it not only to the team members, but to the managers who are reviewing the team’s progress.
A standard procedure at this point is to force the team to come within a set percentage of its cost target at various milestones (such as being within 12% of the target after three months of design work, 6% after four months, and on target after five months); if the team cannot meet increasingly tighter costing targets, then the project will be canceled.
Once these design steps have been completed and a product has met its targeted cost level, the target costing effort is shifted into a different activity, which involves follow-on activities that will reduce costs even further after the product has entered its production phase.
Phase-4. Implement Continuous Improvement
This final step is used to create some excess gross margin over time, which allows the company to reduce the price of the product to respond to presumed increases in the level of competition.
The sources of those cost reductions can be either through planned supplier cost reductions or through waste reductions in the production process—famously known as “kaizen costing.”
The concepts of value engineering and kaizen costing can be used repeatedly to gradually reduce the cost of a product over time.
The market price of a product may follow a steady downward trend, which is caused by ongoing competitive pressure as the market for the product matures. To meet this pricing pressure with corresponding reductions in costs, the company initially creates Product A, and uses value engineering to design a pre-set cost into the product.
Once the design is released for production, kaizen costing is used to further reduce costs in multiple stages until there are few additional reductions left to squeeze out of the original design.
At this point, the design team uses value engineering to create a replacement Product B that incorporates additional cost savings (likely including the cost reduction experience gleaned from the kaizen costing stages used for Product A) that result in an even lower initial cost.
Kaizen costing is then used once again to further reduce the cost of Product B, thereby keeping the cost reduction process moving in an ever-downward direction.
While the technique seems to be very handy and ideal to be implemented, it, however, requires a great deal of cost accounting staff time, and can lengthen the product development process, but is well worth the effort. A key issue to remember is that a single costing system will not meet all of a company’s reporting needs. The result should be a mix of systems that are selected for specific purposes, and that can be changed to meet different information reporting requirements. On this post, I am going to cover the target costing.