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The second article on Section A of the F5 syllabus looks at target costing and life-cycle costing. These can be regarded as relatively modern advances in management accounting so it is worth first looking at the approach taken by conventional costing.
Typically, conventional costing attempts to work out the cost of producing an item incorporating the costs of resources that are currently used or consumed. Therefore, for each unit made the classical variable costs of material, direct labour and variable overheads are included (the total of these is the marginal cost of production), together with a share of the fixed production costs. As explained last month, the fixed production costs can be included using a conventional overhead absorption rate or they can be accounted for using activity based costing (ABC). ABC is more complex but almost certainly more accurate. However, whether conventional overhead treatment or ABC is used the overheads incorporated are usually based on the budgeted overheads for the current period.
Once the total absorption cost of units has been calculated, a mark-up (or gross profit percentage) is used to determine the selling price and the profit per unit. The mark-up is chosen so that if the budgeted sales are achieved, the organisation should make a profit.
There are two serious flaws in this approach:
1. The product’s price is based on its cost, but no-one might want to buy at that price. The product might incorporate features which customers do not value and therefore do not want to pay for and competitors’ products might be cheaper, or at least offer better value for money. This flaw is addressed by target costing.
2. The costs incorporated are the current costs only. They are the marginal costs plus a share of the fixed costs for the current accounting period. There may be other important costs which are not part of these categories, but without which the goods could not have been made. Examples include the research and development costs and any close down costs incurred at the end of the product’s life. Why have these costs been excluded, particularly when selling prices have to be high enough to ensure that the product makes a profit: total revenue must exceed total costs in the long term? This flaw is addressed by life-cycle costing.
Target costing is very much a marketing approach to costing. The Chartered institute of Marketing defines marketing as:
“The management process responsible for identifying, anticipating and satisfying customer requirements profitably.”