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.

Uses of Variable Costing

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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

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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.

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

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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.