Variable and target costing techniques
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Introduction
According to
Answers, (2010) cost is a monetary sacrifice that is incurred in the production
of an economic product. All organizations in the business world incur costs.
Costs are incurred during the performance of activities in the production
process. Due to the diverse nature of production, different costs are realized.
The management of any organization must take care of costs for it to realize
profits. Costs are classified into different categories depending on their
characteristics. Direct costs are those costs that can be easily traced and
assigned to the required cost object. An indirect cost is a cost on the other
hand is a cost that cannot be easily traced. This paper analyses the variable
costs and the target costs as they relate to the management of and organization
(Answers, 2010).
Variable Costing (Direct or Marginal Costing)
To evaluate
the inventories and costs of an organization, the variable and the absorption
costing methods are used. In this method, the variable costs of output are
usually classified as product costs, such costs include; direct labor and
direct material costs variable manufacturing overheads. Variable costing is a
costing technique in which the costs that are incurred in the organization in
the purchase of inputs comprise of only variable manufacturing costs.
Concerning the fixed factory overheads, they are deducted together with the
administrative and selling costs. This is done because administrative and
selling expenses are not part of the variable costs but are period costs.
This essay is an exam
Uses of Variable Costing
The internal
management is the one that makes use of variable costing. They use it it for:
- Valuation of the inventory and
the determination of income
- Carrying out the necessary or
relevant analysis of costs.
- Variable costing is used purposes
of analyzing the break-even point and the analysis of the
cost-volume-profit.
- Decision making - the management
uses the variable costing to make short term decisions.
As a
component of management accounting, variable costing is mainly used for
internal purposes only and not for external purposes or tax reporting.
Absorption costing is the alternative that is used by external user instead of
variable costing.
Basing on the
above, the management of SAC can use variable costing for internal use. They
can use variable costing for:
- Decision making: the tope
management of SAC can use the figures from the variable costing method to
make decisions in the short run.
- They figures from the variable
costing technique can be used to carry out a break-even analysis. This
will enable the firm to know the exact amount of input and output make the
firm realize profit or make losses.
- Cost analysis: the management of
SAC can use variable costing technique to evaluate the cost that it incurs
on the inventory purchases during the production.
- Income determination: through the
variable costing technique, the company will be able to evaluate the
inventory hence be in a position to work put the profit realized.
Comparison of variable costing and absorption
costing
Absorption
costing is the alternative costing technique that is used by external users.
This type of costing usually treats all production costs (fixed or variable) as
product costs. The allocation system in absorption costing is that each unit of
production is allocated a portion of fixed manufacturing overhead costs. This
is usually done together with manufacturing cost.
The major
distinction between variable costing and absorption costing is in relation to
the calculation of net income:
- In absorption costing, a large
net income is realized when sales are less than production while in
variable costing, a large net income is realized when sales are more than
production.
- The equity of production and
sales leaves net income equal in both methods of costing.
To reconcile
the differences in net incomes:
Difference in
net income = change in inventory X fixed factory overhead rate. This works only
when per unit fixed overhead rate is constant.
Advantages of variable costing
- Variable costing provides readily
available data for cost volume profit (CVP) analysis. This data is not
provided by the absorption costing's income statement.
- The changes that occur in
inventories don not affect the profit realized during that period. Profits
move in the same direction with sales.
- The assumption that all costs are
variable is important in variable costing but not in absorption costing.
This is because there are not fixed costs contained in product costs.
- Under the variable cost system
and the contribution margin approach, emphasis is laid on the fixed costs
unlike in absorption costing where fixed costs explicitly are on the
income statement (Accountingformanagement, 2010).
- With variable costing, it is
estimation of the profitability of the segments of the organization is
easier. Profitability of the segments in absorption costing is dependent
on the allocation of fixed cost.
- Variable costing is effective and
can work well with a standard costing and flexible budget.
- The net income realized under
variable costing is closer to the one in the cash flow statements. This is
advantageous to companies with cash flow problems
(Accountingformanagement, 2010).
Disadvantages
- Variable costing uses historical
data while the decision makers require focus on the future of the organization.
- The method oversimplifies costs
into fixed and variable costs yet they are complex
- This method does not realize that
in the long run all costs are variable.
- It fails to allocate fixed costs
to product neglecting their importance in production.
- Due to the methods poor
distinction of fixed and variable costs, the organization could realize
problems in the stock valuation (College accounting coach, 2010).
Target Costing
This is a
tool that is used in cost accounting to minimize the overall total cost of the
manufactured product. This too is often used by the management of organizations
to enable it meet the objectives of the organizations which include and not
limited to cost minimization. The target costing technique is more common in
firms in Japan like Toyota, Nissan, Daihatsu etc. This is method is preferred
by these firms because the increased diversity in tastes increases the assembly
oriented production. Due to this, assembling process, the life cycle of a
product is shortened. The shortened life cycle always diverts the
organization's focus to costs that are incurred at each stage of production
(designing, planning and the development phases).
According to
Sakurai, M (1989), unlike normal costing techniques which always consider all
costs of producing a product (administrative cost, marketing cost and
distribution cost), target costing approaches pricing of products proactively.
In target costing, the market sets the price which is a signal to the selling
price. To arrive at the product cost, the target income is subtracted from the
price set by the market. Target costing normally makes use of other costing
information. Through this, it jumps on the next best price. There is no time
wasted in redesigning and engineering the product (Sakurai, 1989).
The market
price that is feasible, revenue to be generated from the sales and the feasible
costs to be incurred are all determined by the meeting of the employees from
the many departments in the organization. Members from these departments in
their meeting minimize the cost of production by eliminating the
non-value-added costs in the production process while putting more emphasis on
the modification and the design of a product.
In this
method, major cost reductions are done during the product design and the
planning process. This is because these two stages are the major cost
contributors. As compared to the other costing methods, which reduce costs by
pricing and bargaining power, this method reduces production costs during the
developmental stages of a product. Through this method, there is an increase in
the upcoming of assembly oriented industries while the economic order quantity
is fading away. The methods used in target costing include just-in-time and
material requirement planning (Sakurai, 1989).
The
difference between target and other costing techniques is in the designing of
the products and the assigning of prices. Target costing sets target prices
that end up being adopted by the firm's management unlike in the other
traditional costing methods where the firm's management has the problem of
deciding the product price. Also, the difference arises in cost reduction.
Target costing emphasizes the reduction of costs through laying more emphasis
on the design stage of production while other cost methods reduce costs through
the reduction of production costs on the entire production process (Sakurai,
1989).
Application of Target Costing by SAC
Basing on the
fact that many organization including SAC have less control on the pricing of
the product, the market do determines the price. Since target costing gives an
estimate of the price, SAC management can also be leaving the market to decide
the estimate of the price that they can assign the company's product. The
market literally sets the price targets for the company. This can well be
achieved by adopting target costing technique.s essay is an example of a student's aimer
This
essay has been submitted to us by a student in order to help y
SAC can also
apply this method in the cost reduction of production. This can be done by the
company putting more emphasis on assembling than the current traditional way of
manufacturing. The management of SAC should focus on the product design rather
than the whole manufacturing process.
Advantages of Target Costing
- Target costing is more oriented
to customers than the traditional costing methods. This is because it
gives room to the market to estimate the target price of the firm's
product
- Through its functional decision
making team, it breaks the barriers between departments because the team
members are from the various departments of the organization.
- The organization's employees'
empowerment and awareness is enhanced through the implementation of the
functional team' decisions.
- There is improved partnership-
supplier relation ship (Accountingformanagement, 2010).
- The time to market the firm's
product is reduced
- Activities that do not add value
the product are reduced.
- Management decisions are arrived
at proactively (Accountingformanagement, 2010)
Limitations of the target costing method
- The implementation requires
cooperation form the company's employees. Where this fails, it cannot be
implemented.
- There is time wastage in frequent
meetings rather than doing productive work.
- A detailed list on cost data is
required for the effective implementation of the system.
- The use of the method encourages
assembling. This may jeopardized the quality of the product manufactured
(Accountingformanagement, 2010).
Conclusion
Any operating
firm must meet its objectives which include profit maximization and cost
minimization. Costing involves many techniques that are used by the management
of the organization to make far reaching decisions regarding the operation of
the firm and the going concern of the organization. Variable costing is a
costing technique where only variable costs are used in the determination of
the costs. This method is easier to use and is main used for internal purposes
of the organization. On the other hand, target costing is used by the
organizations that want to reduce the whole of their production costs.
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