Ken Garrett explains target costing and lifecycle costing, and gives examples as to how and when you would use these costing techniques
Target costing and lifecycle costing 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. 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 flaws in this approach:
- 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.
- 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. To make a profit, total revenue must exceed total costs in the long term. This flaw is addressed by lifecycle 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.’
In marketing, customers rule, and marketing departments attempt to find answers to the following questions:
- Are customers homogeneous or can we identify different segments within the market?
- What features does each market segment want in the product?
- What price are customers willing to pay?
- To what competitor products or services are customers comparing ours?
- How will we advertise and distribute our products? (There are costs associated with those activities too.)
Marketing says that there is no point in management, engineers and accountants sitting in darkened rooms dreaming up products, putting them into production, adding on, say 50% for mark-up then hoping those products sell. At best this is corporate arrogance; at worst it is corporate suicide.
Note that marketing is not a passive approach, and management cannot simply rely on customers volunteering their ideas. Management should anticipate customer requirements, perhaps by developing prototypes and using other market research techniques.
This really important information relating to a new product is: