What is the difference between target costing and activity based costing?

Answer 1

Activity Based Costing

In an ABC structure, organizational departments that have served as cost centers, where costs are accumulated for allocation to products or services, are replaced by organizational activities through which costs are viewed. The heart of ABC is to trace and account for the pool of fixed overhead costs and show that they are really variable. The crucial aspect of ABC is its focus on the causality and variability with respect to operations and resource consumption in organizations.

This focus can be examined in detail using four categories of activities and consumption: unit-level expenses, batch-level expenses, product-level expenses, and facility-level expenses. Unit-level expenses very proportionately with the production volume in units. These costs are typically materials and supplies. Batch-level expenses are incurred as a batch of products is manufactured. These expenses are setups, quality inspection, and procurement. Product-level expenses are related to the activities performed to support specific products in a company's product line. These costs are typically seen when a company makes engineering and product design changes. Finally, facility-level expenses are common to various product lines, and cannot be logically attributed to specific products. Examples include the plant superintendent's salary and property tax on the plant.

If properly implemented, ABC can become a powerful tool for a company in costing products and services, evaluating performance, formulating pricing strategies, and making product and customer mix decisions. Recent studies have found the first benefit from ABC is the realigning of the involved organization's expenses from functional categories and departments to activities and business processes. The information gained from ABC was to be used to make decisions on outsourcing, eliminating nonessential activities, and improving efficiency.

The hardest part of ABC implementation was reported as identifying and measuring cost drivers. The identified drivers were used to connect activities to products, customers, or other cost objects. ABC reveals that low-volume, complex products tend to be more expensive than more traditional standard cost systems have indicated.

Additionally, pertinent actions are required to turn the ABC findings into actual cost reductions to improve the companies' bottom line performance. Usually, insufficient time exists for senior management to establish profit priorities. Simply, the radical changes brought on by ABC create a problem in that management is not able to respond quickly enough or use the information to the greatest advantage because it requires them to break with everything they know about their business. Meanwhile, the radical change is hindered by most companies being unprepared to make radical changes or being willing to make changes, but ill-equipped to make the necessary changes to take full advantage of the information.

ABC is only effective when the possible changes are identified in advance and then planned for before implementation. Companies need an explicit plan for line managers to execute desirable actions based on ABC. Thereby, desirable actions could be taken in the areas of costing products and services, evaluating performance, formulating pricing strategies, and making product and customer mix decisions. Without such an explicit plan, ABC may never reach beyond the finance or other group that developed the model. Target CostingTarget costing is a market-driven system of cost reduction, focused on managing costs at the development and design stages of a product. The Japanese believe that cost reduction activities, especially in automated plants, carried out in the production stage of a product have a limited effect. The effect is limited because processing methods, type of equipment, production flow, and other aspects of the production environment related to workers and quality are determined and fixed at the product planning stage in an automated plant.

Target costing reveals a direct link between the marketplace, corporate long-term profit goals, and cost management practices. The process begins with finding, through rigorous market research, a quality product that can appeal to potential customers. The expected price at which this product is most likely to appeal to customers is also determined by the new-product team. This sales price generally reflects not current, but future, market conditions and reflects the team's best efforts, although the price may change over that product's life cycle. Based on the company's long-term profit plans, the new product's target profit is calculated and is subtracted from the expected sales price to arrive at the allowable cost. By design, the allowable cost is too stringent to achieve through current technologies. The cost estimates are based on current engineering and production technologies. The target cost is set somewhere between the allowable cost and the current estimated cost.

In calculating the target profit, Japanese companies use the rate of return on sales (ROS) rather than return on investment (ROI). ROS is more technically convenient to relate profit to low-volume products. This practice reflects Japanese manufacturers' tendency to focus on the profitability of the portfolios of related products rather individual products. After the total target cost is set for a newly approved product plan, the engineering planners and cost management personnel divide the total target cost for the product into various product cost elements based on the engineering design and cost requirements. The achievement of the target cost requires intense value engineering (VE) activities and close cooperation among departments, such as engineering, production, and marketing.

Value engineering (VE) was first developed by General Electric and is geared toward producing innovative, yet cost effective, product features that will satisfy customers' needs. The features have already been determined based on rigorous market research. The sales price incorporates the appealing features based on the market research.For products and services under VE, functions are defined, and costs incurred to perform those defined functions are measured against the functions.

One of the primary reasons that Japanese managers find target costing so attractive is its compatibility with the management strategies they use to deal with the shortening product life cycles in today's market. They need to monitor the profit and cost performance in short intervals because they want to recover their investment in a short period of time. Target costing allows companies to translate the cost reduction strategy into a series of equivalent actions according to the relationships to the defined functions. This ability to translate the target into actions is very powerful because cost accounting is connected to products very closely, which workers find very easy to understand. The close connection is in contrast to the loose connection between cost accounting and various functions and products in standard cost systems.