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CA FINAL

Set B - STRATEGIC COST & PERFORMANCE MANAGEMENT

Self-Paced Online Module

(Also Relevant for Paper 6 – Integrated Business Solutions)

- By CA Manan Pujara (AIR-37)

INDEX
Page
Par culars
No.
Chapter 1 - INTRODUCTION TO STRATEGIC COST MANAGEMENT
Tradi onal Cost Management & It’s Limita ons 1
Tradi onal Cost Management V/S Strategic Cost Management 2
Underneath Pillars of Strategic Cost Management 2
- Cost Driver Analysis 2
- Strategic Posi oning Analysis 3
- Value Chain Analysis 4
Value Shop Model or Service Value Chain 6
Organisa onal Context 6
1. Core Competencies Analysis / Gaining Compe ve Advantage 6
- Differen a on Advantage/ Low-Cost Advantage (Cost Leadership) 7
- Internal Cost Analysis 7
- Internal Differen a on Analysis 8
- Ver cal Linkage Analysis 8
2. Business Models 9
- Osterwalder’s Business Model Canvas 9
- Value Proposi on Canvas 10
External Environment Context 11
- Industry Profitability / Industry Structure Analysis (Porter’s 5 Forces Analysis) 12
- Market | Market Segments | Market Segmenta on Analysis 13
- Basis Of Compe on 14
- Industry Key Success Factors 15
- Core-Competencies Analysis 15
Informa on Technology The Strategic Context 15
- It/Is & Porter’s 5 Forces 16
- It/Is & Value Chain Analysis 17
The Role of Management Accountant As A Leader 17
Vision, Mission and Objec ves & SCM 19

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Chapter 2 - MODERN BUSINESS ENVIRONMENT

Cost Of Quality (COQ)
20
(Preven on | Appraisal | Internal Failure | External Failure Cost)
Total Quality Management (TQM)
22
(Six C of TQM | PDCA Cycle | Deming’s 14 Points Methodology)
Supply Chain Management 24
- Push Model | Pull Model 24
- Upstream and Downstream Flow 25
- Rela onship Marke ng (Six Markets Model) 26
- Customers Rela onship Management (CAP|CLV) 26
- The Use of Informa on Technology in Downstream Supply Chain Management 27
- Brand Strategy 27
Outsourcing 27
Service Level Agreements (SLA) 28
Gain Sharing Arrangements 28
Downsizing 29
Offshoring 29

Chapter 3 - LEAN SYSTEM AND INNOVATION

Lean System – Meaning 30
Just-In-Time (JIT) 30
- Kanban Card System 31
- Group machines into working cells 32
EOQ Formulas 33
Kaizen Cos ng 34
5’S 35
Total Produc ve Maintenance (TPM)
36
(8 Pillars | OEE)
Cellular Manufacturing/ One Piece Flow Produc on System 39
- Rank Order Clustering Algorithm 39
- Calcula on of Takt Time 40
Six Sigma
40
(DMAIC | DMADV)
Concept of Produc vity 42
Process Innova on 42
Business Process Re-engineering 43

Chapter 4 - SPECIALIST COST MANAGEMENT TECHNIQUES

Cost Control & Cost Reduc on 45
Target Cos ng 45
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Life Cycle Cos ng 48

Theory Of Constraints 51
- Goldra ’s Five-Step Method for Improving Performance 52
- Throughput Accoun ng 52
Environmental Management Accoun ng [EMA] 53

Chapter 5 - MANAGEMENT OF COST STRATEGICALLY FOR EMERGING BUSINESS MODELS

Change Drivers of Dynamic Business Environment 57
- Digital Technologies 57
- Business Ecosystems 59
- Hyper Compe on 59
- Transforma on and Disrup on 60
- Advanced Manufacturing 61
- Lean Start-Up 61
- Agile Organisa ons 62
- Start-Ups Vs Incumbents 63
- Intrapreneurship 64
- Innova on Hubs and Incubators 64
- Supply Chain Partnerships 64
Business Models 66
- Hyper Disrup ve Business Models
66
(Free | Subscrip on | Freemium | Digital Pla orm | Hypermarket Models etc)
- Models Relevant to Sustainability 68
- Models Relevant to Emerging Na onal Markets 68
Strategic Responses to New Business Models 69

Chapter 6 – STRATEGIC REVENUE MANAGEMENT

Basic Formulas 71
Cost Volume Profit Analysis (CVP Analysis) 72
Short-Run Decision Making 73
- Relevant Cost (RC) 73
- Product Mix Decision (Limi ng Factor) 76
- Make or Buy/Outsourcing Decision 80
- Keep or Drop Decision 81
- Sell or Further Process 82
- Minimum Pricing Decisions 83
Ethics & Non-Financial Considera on In Business 83
Decision Making Model 84
Pricing Policy 84
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Pricing Theory 84
Profit Maximiza on Model 85
Pricing Under Different Market Structures 86
Principles Of Product Pricing
86
(Price Customiza on | Price Sensi vity)
Structured Approach to Pricing Decisions 87
Sensi vity Analysis 87
Strategic Pricing of New Products
88
(Skimming | Penetra on Pricing)
Pricing Methods 89
- Cost Based (Mark-up pricing | Target Rate of return) 89
- Compe on-Based (Going Rate Pricing | Sealed Bid-Pricing) 89
- Value- Based (True Economic Value | Perceived Value) 90
Pricing and Product Life Cycle 91
Pricing of Services 91
Ethics & Non-Financial Considera on in Pricing 92
Price Adjustment Strategies
93
(Geographic Pricing | Discounted | Promo onal | Price Discrimina on | Product Mix Pricing)
Kano’s Performance A ributes 94

Chapter 7 – STRATEGIC PROFIT MANAGEMENT

Strategic Profitability Analysis
96
(Growth Component | Price Recovery Component | Produc vity Component)
Profitability Analysis Through Ac vity Based Cos ng 98
Direct Product Profitability 98
Customer Profitability Analysis 99
Ac vity Based Cost Management (ABM) 100
- Manufacturing Cycle Time | Manufacturing Cycle Efficiency 102
Ac vity Based Budge ng (ABB) 104
ABC: A Decision - Making Tool 105
Pareto Analysis 105

Chapter 8 – AN INTRODUCTION TO STRATEGIC PERFORMANCE MANAGEMENT

Performance Management and Its Link to Strategy 107
Role of Performance Management in Business Integra on Using Models Such as Value Chain
107
and Mckinsey’s 7S.
Value Chain/Value Chain Analysis & Performance Management 108
McKinsey’s 7S 109
- Types of Organisa onal Structures 110
The Effect of Organiza on Structure, Culture, and Strategy on Performance Measurement 113

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Strategic Performance Issues in Complex Business Structures 114

Behavioural Aspects 115
Predic ng and Preven ng Corporate Failure 116
- Quan ta ve Models (Altman Z score | PAS) 117
- Qualita ve Models (Argen 's A score) 120

Chapter 9 - STRATEGIC PERFORMANCE MEASURES IN PRIVATE SECTORS

Responsibility Centers and Its Performance 122
Interlinking Of CSF & KPI To Performance Measurement 122
Financial Performance Measures 123
- Gross Profit 123
- Return on capital employed (ROCE) 123
- Earnings Per Share (EPS) 124
- Net Present Value (NPV) 124
- Return on Investment (ROI) 125
- Residual Income (RI) 125
- Economic Value Added (EVA) 126
Non - Financial Performance Measures 127
- Balanced Scorecard 127
- Performance Pyramid 128
- The Building Block Model 129
- Performance Prism (PP) 130
Triple Bo om Line (TBL) 131
Role of Quality in Performance Measurement System 132

Chapter 10 - STRATEGIC PERFORMANCE MEASURES IN NOT-FOR-PROFIT ORGANISATIONS

Challenges for Measuring Performance in NPO and Way-Out 133
Models For Measuring The Performance Of NPO’s 133
- Adapted Balanced Scorecard 133
- Value for Money (VFM) Framework 134
Performance Measurement Process 134

Chapter 11 – PREPARATION OF PERFORMANCE REPORTS

Responsibility Accoun ng 135
Performance Report 135
Role of Performance Reports 135
Aspects Involved in the Prepara on of Performance Reports 135
Types of Performance Reports 136

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External Repor ng Frameworks that are Relevant to Strategic Performance Management 136
Analyse The Performance Reports to Take the Required Ac on 137

Chapter 12 - DIVISIONAL TRANSFER PRICING

U lity/Uses of Transfer Pricing 138
Transfer Pricing Methods 139
- Market Based Pricing (Shared Profit Rela ve to Cost) 139
- Cost Based Pricing ( Marginal | Standard | Full Cost) 139
- Bargained or Nego ated Pricing 140
Transfer Pricing and Goal Congruence (Examples) 141
Transfer Pricing Decision, Different Circumstances 143
- Different Capacity Levels (with Limi ng Factor) - Example 143
- Different Demand Levels (Example) 144
Proposals for Resolving Transfer Pricing Conflict
146
(Dual Rate | Two Part Transfer Pricing)
Interna onal Transfer Pricing 146

Chapter 13 – STANDARD COSTING

Material Cost Variances 148
Labour Cost Variances 149
Variable Overhead Cost Variances 150
Fixed Overhead Cost Variances 150
Sales Variances 151
Planning & Opera onal Variances 153
Market Size Variance & Market Share Variance 154
Interdependence Between Variances 154
Interpreta on of Variances 155
Inves ga on of Variances 155
Reconcilia on of Profits 156
Variance Analysis in Ac vity Based Cos ng 157
Relevant Cost Approach to Variance Analysis 158
Other Miscellaneous Concepts 158
Learning Curve Theory 160
Calcula on of Control Ra os 162
Modern Produc on Environment & Standard Cos ng 162

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Chapter 1 - INTRODUCTION TO STRATEGIC COST

MANAGEMENT
Ignores
Traditional Cost Management Competition,
Market
Traditional cost management system involves allocation Growth, and
of costs and overheads to the production and focusses Customer
Limited Focus Requirement
largely on cost control and cost reduction. Excessive
on Review
focus on cost
and
reduction
Improvisation
Strategic Cost Management Limitation of
A strategy is a set of actions taken by managers of a Traditional
company to increase the company’s performance. In the Cost
Management
modern business environment, it is not sufficient to Ignores
Dynamics of
control costs and a business must focus to manage cost Marketing
Short-Term
Outlook
strategically. The businesses today operate in an and
Economics
environment with stiff competition, increasing consumer
demands for quality products and technology revolution. Reactive
Approach
The ultimate objective of a business is to earn better
profits and create value for shareholders.

 Strategic cost management is the application of cost management techniques so that they
improve the strategic position of a business as well as control costs.
 It also involves integrating cost information with the decision-making framework to support the
overall organisational strategy.
 It is not limited to controlling costs but using cost information for management decision making.
 The basic aim of Strategic Cost Management is to help the organisation to achieve the sustainable
competitive advantage through product differentiation and cost leadership.

Example
The following information is extracted from the financial statements of a company producing products A
& B. If the company stops producing product B, the sale of A would fall down by 25%.

Particulars A B
Revenue 60 35
Cost of Sales 35 25
Gross Profit 25 10
Overheads 5 12
Net Profit 20 -2

Analysis
If the information provided above is approached using a traditional cost management technique, the
company might decide to stop production of B because it has a very high overhead cost and also results in
a loss of 2 lacs. It thus appears to be prudent to close down the production of B.
However, with additional information that sale of product A would fall down by 25% if B is not sold the
decision might change. The company would lose 5 lacs (25% of 20 lacs) because of reduced sales of A. The

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net loss for the company if it decides to stop production of B is 3 lacs (2 lacs of savings from B and 5 lacs
of loss of profits from A). Hence the decision to stop of production B is not prudent.

Basis of
Traditional Cost Management Strategic Cost Management
Difference
Allocation of Allocation will be w.r.t. relevant cost driver
cost Volume (per unit produced).
– Activity Based Costing.
Nature Reactive (risk averse) approach. Proactive and dynamic approach.
Product differentiation (apart from cost
Objective Cost control and reduction.
containment).
Risk taking approach and ability to
Risk Appetite Risk-averse approach.
adapt itself to changing environment.
Scope Internal business environment. Both internal and external.
Term Short term focus. Long span or perpetual focus.

UNDERNEATH PILLARS OF STRATEGIC COST MANAGEMENT

Strategic Cost Management primary revolves around three business themes - Value Chain analysis, Cost
driver analysis and Strategic positioning analysis.

Cost Driver Analysis

Cost
Cost is caused or driven by various factors which are Driver
interrelated. Cost is not a simple function of volume or output Analysis
as considered by traditional cost accounting systems.
Value
Chain
Based upon two distinct nature of supporting cost (overhead Analysis
cost), drivers can also be categories into two classes Strategic
Positioning
1. Resource drivers – Concerned with contribution of specific Analysis
quantum of resources, which caused cost. Eg - electricity
costs to produce products and the no. of machine hours
spent (machine hour is resource).

2. Activity driver – Concerned with cost incurred on the activities required to complete a specific task. Eg
- inspection costs and the number of inspections or the hours of inspection (Inspection is required
activity to ensure quality)

The Further Classification can be understood by the diagram :-

Operational Activities
& Drivers
Structural cost
Resource Drivers
drivers
Supporting Cost Organisational
(Overhead Cost) Activities & Drivers
Executional cost
Activities Drivers
drivers

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Structural cost drivers relate to business strategic choices about an organization’s underlying economic
structure, such as scale and scope of operations, use of technology, and complexity of products (it is not
necessary that more is better).

Executional cost drivers relate to the execution of the business activities, such as the utilization of
employees in terms of involvement, the provision of quality service, product design and manufacturing,
and links with suppliers and clients (higher is the better).
Structural activities Structural cost drivers
Plant construction Number of plants, scale, degree of work centralization
Employee grouping Number and type of work units
Complexity Number of product lines, number of unique processes, number
of unique parts, degree of complexity
Process selection and use Types of process, experience of usage
Executional activities Executional cost drivers
Employee utilization Degree of involvement
Quality service provision Quality management approach
Operation of plant layout Plant layout efficiency
Product design & manufacturing Product configuration

Operational activities are daily work activities done as a result of the structure and process adopted by
the company. Operational cost drivers refer to factors that drive the costs of operational activities. Can
be categories at Unit, Batch and Product level.

Unit-level activities Unit-level cost drivers

Grinding materials Grinding machine hours
Component assembly Labour assembly hours
Drilling holes Drilling machine hours
Materials use Material weight
Electricity use (Power) Number of kilowatt-hours
Batch-level activities Batch-level cost drivers
Equipment set up Number of setups
Finished products moved in batch Number of moves
Manufacturing products inspected in batches Inspection hours
Reworking products Number of detective units
Product-level activities Product-level cost drivers
Product design and/or redesign Number of change orders
Product line scheduling Number of different products
Product testing Number of procedures

Strategic Positioning Analysis

Strategic Positioning Analysis is a company’s relative position within its industry matters for performance.
Strategic positioning reflects choices a company makes about the kind of value it will create and how that
value will be created differently than rivals. The following factors affect the strategic position of a
company.

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Strategic positioning analysis includes the

study of

Environment in
Task Environment in
Culture, beliefs, and Stakeholders’ context of
context of capability
assumptions of the influence and competitors,
i.e., resources, core
organisation expectations markets,
competences
regulations, etc

Mission and Strengths and Opportunities and

Vision and Values
Objectives Weaknesses Threats

Mendelow’s Matrix and

Responses to each class of
stakeholders
(Stakeholder’s influence and
expectations) >>>>

Value Chain Analysis (Porter’s VCA)

“Value-chain analysis is a process by
which a firm identifies & analyses various
activities that add value to the final
product.”
The idea is to identify those activities
which do not add value to the final
product/service and eliminate such non-
value adding activities.
Resources must be deployed in those
activities that are capable of producing
products valued by customers.

Manufacturing Industry - Primary Activities include:

 Inbound Logistics: These are activities concerned with receiving, storing, and distributing the
inputs (raw materials) to the production process. The relationship with suppliers is a key
component in this process.

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 Operations: These activities involve transforming inputs into final product. Activities such as
machining, packaging, testing and equipment maintenance form part of Operations.
 Outbound Logistics: These activities involve collecting, storing and distributing the products from
the factory line to end consumers. This may include finished goods warehousing, delivery vehicle
operation, order processing and scheduling.
 Marketing and Sales: Marketing and Sales provide the means by which the customers are made
aware of the product. The activities include advertising, promotion, distribution channel selection,
sales force management and pricing policy.
 Service: This includes activities related to after sales service like Installation, repair and parts
replacement.

Retail Industry - Primary Activities include:

 Inbound Logistics: All activities related to delivery of product from Supplier to retail stores.
 Operations: These activities involving running of stores, managing inventory levels, designing
layout of stores etc.
 Outbound Logistics: These activities involve collecting, storing and distributing the products from
the store to end consumers. This may include finished goods warehousing, delivery vehicle
operation, order processing and scheduling.
 Marketing and Sales: Marketing and Sales provide the means by which the customers are made
aware of the product. The activities include advertising, promotion, distribution channel selection,
sales force management and pricing policy.
 Service: This includes activities related to after sales service like Installation, repair and parts
replacement, mainly it needs to handle return of customers.

Support Activities include:

 Procurement involves purchasing of raw material, supplies and other consumables required as
inputs for the primary activities.
 Technological Development includes technical knowledge, equipment, hardware, software and
any other knowledge which is used in the transformation of inputs to outputs.
 Human Resource Management includes activities around selection, recruitment, placement,
training, appraisal, rewards and promotion; management development; and labour/employee
relations.
 Firm Infrastructure consists of activities such as planning, finance, accounting, legal, government
affairs and quality management.

 It to identify those activities which do not add value to the final product/service
and eliminate such non-value adding activities
 The analysis of value chain helps a firm obtain cost leadership or improve
Benefits product differentiation.
 This helps Management in accurate decision making & also reducing costs.
 It helps to focus on core areas of business & facilitates development of
Performance matrix.
Limitations  It is difficult to apply in Service Industry

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 Complicated & sometimes Frustrating for Management since indepth analysis of

every process is required.
 Time Consuming & Expensive.
 Linear approach & ignores concept of Value Networks i.e improvement in one
may lead to fall in other process & all process must be considered together.
 Considers only financial factors, ignores non-financial factors.

VALUE SHOP MODEL OR SERVICE VALUE CHAIN

This concept aims to serve companies from service sector. In value shop principle, no value addition
takes place. It only deals with the problem, figure-out the main area requires its service and finally
comes with the solution. This approach is designed to solve customer problems rather than creating
value by producing output from an input of raw materials.

The model has the same support activities as Porter’s Value

Chain but the primary activities are described differently.

In the value shop they are:

 Problem finding and acquisition.

 Problem solving.
 Choosing among solutions.
 Execution and control/evaluation.

The management in a value shop focuses on areas like

problem and opportunity assessment, resource mobilization,
project management, solutions delivery, outcome
measurement, and learning.

ORGANISATIONAL CONTEXT

1. Core Competencies Analysis / Gaining Competitive Advantage

Core Competency is a distinctive or unique skill or technological knowhow that creates distinctive
customer value. A core competency is the primary source of an organisation’s competitive advantage. The
competitive advantage could result from Cost Leadership or Product Differentiation. In order to survive
and prosper in an industry, firms must meet two criteria:
(i) They must supply what customers want to buy & (ii) They must survive competition.

In order to attain superior performance and attain competitive advantage, a firm must have distinctive
competencies. Distinctive competencies can take any of the following two forms:

 An offering or differentiation advantage. If customers perceive a product or service as superior,

they become more willing to pay a premium price relative to the price they will have to pay for
competing offerings.

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Chapter 4 - SPECIALIST COST MANAGEMENT

TECHNIQUES
Cost Control Prerequisites of Cost Control -
It means regulating costs through comparing with  Effective delegation of authority and
the Targets. Target can be either be Internal responsibility
(Standard costing/ budgetary control) or External  Clearly defined targets
(Benchmarking). It’s a less dynamic process i.e can  Motivation to encourage individuals to reach
be applied only where standards can be set and established goals
savings achieved are not permanent in nature.  Timely and efficient reporting.
 Recommendations must be followed by action.
It’s a preventive measure that focuses on past &
 Effective follow-up system to check
present.
implementation of recommendation.

Cost Reduction
Cost reduction is a corrective measure which believes in reducing to cost permanently till the optimal level
rather any specified level such as standards or budget. It’s a dynamic process & can be applied in all areas
of business. It focuses on present & future. (Eg - Target Costing, Value Analysis, BPR, JIT, Kaizen).

Scope of Cost Reduction –

Some of the important area to reduce costs (using any technique) is as under:
(i) Product design
Its first stage of manufacturing hence its impact will be throughout manufacturing life of
a product.
Conclusions from Chart -
1. 80% cost is commited to design face only (refer life cycle cost commited line)
2. Ease of change is maximum during design phase
3. Cost incurred increases rapidly once manufacturing starts
Hence Cost reduction is most effective during design & development phase.

(ii) Organisation (iv) Production Plan Program &

It is not possible to measure the extent (iii) Factory Layout Equipment Method
of the cost reduction at organisation Effective utilisation of the facilities Efficient procedure and
level however, economies are bound available, by elimination of wastage programme ensuring proper
to be achieved if functions and of men & materials, necessity for utilisation of materials, manpower
responsibilities are defined and replacement of plants, introduction and resources, to check scope for
delegated properly and of new techniques etc should be reducing idle time so that there is
encouragement to employees is given considered with a view to reducing no waste of time and money due
for cost reduction suggestions costs to waiting for components, men,
material etc

TARGET COSTING

It is a structured approach to determining the cost at which a proposed product with specified
functionality and quality must be produced, to generate a desired level of profitability at its anticipated
selling price”. It is exactly opposite of cost-plus margin model.

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Cost-plus margin model : Cost + Profit = Sales (ignores price that consumes may pay/price change by
competitors)

Target Costing: Desired selling price (basis market condition) – Desired Profit = Cost (that must be achieved)

Steps of Target Costing

Step 1 - Re-orient culture of Step 2 - Identify the Step 3 - Establish the market-
Step 3A -
thinking and attitude, so market requirements driven target price basis
Determine the
that importance must be as regards design, market share, price charged by
volume of product
given to market driven utility, and needs etc competitors, the elasticity of
to be produced
prices and need of customer (Be customer oriented) demand and strategy.

Step 4A - Establish a
Step 3B - Establish the Step 4 - Determine the Step 5 - Establish the
balance between target
target profit margin target cost by reducing target costing process
cost and requirement
based on the long-term the desired/required (comprises the persons,
(target cost and
objectives and financing margin from market- their role & responsibilities
requirement both must be
aspects. driven target price. and tool & techniques)
fulfilled)

Step 6 - Brainstorm and analyze the alternatives to

identify the opportunity to reduce the cost through Step 6A - Establish product cost models
consideration of the multiple concepts and design (along with cost table) for each concept and
alternate for both the product and its manufacturing design alternate to support decision making
process at each stage of the development cycle.

Step 7 - Use the tools to closing down the Step 7A - Reduce the indirect cost Step 8 - Measure the
gap between cost as determined by product applications by Eliminating the non- results and maintain
cost model in step 6A and target cost locked value-added function to minimize the management focus on
in step 4A. cost reduction opportunities are cost & Use Activity Based Costing to further possibilities of cost
identified using Value Engineering/ Value understand how design decision reduction as a continuous
Analysis. impact these indirect costs improvement program
(These steps will give insight into the features of the target costing too)

Components of Target Costing System

Typically, the total target is broken down into its various components, each component is studied and
opportunities for cost reductions are identified. These activities are often referred to as Value Analysis
(VA) and Value Engineering (VE).

Value Analysis is a planned, scientific approach to cost reduction which reviews the material composition
of a product and production design so that modifications and improvements can be made which do not
reduce the value of the product to the customer or to the user.

Value Engineering is the application of value analysis to new products. Value engineering relates closely
to target costing as it is cost avoidance or cost reduction before production.

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The initial value engineering may not uncover all possible cost savings. Thus, Kaizen Costing is designed
to repeat many of the value engineering steps for as long as a product is produced, constantly refining the
process and thereby stripping out extra costs.
Even if minimal amount of cost reduction is required, one must conduct full range of Value engineering,
but before that, All existing variances should be removed (Eg – Adverse material/labour cost variance) to
ensure there is no difference between standard & actual cost. In next stage one must focus on challenging
standards with help of value analysis with deals with mix of following issues/Value Engineering steps :-
Can we eliminate Can we Can we Can we design the
Can we Can we Can we take Is there a
functions from minimize eliminate some product better for the
substitute combine supplier’s better
the production the durability or manufacturing
parts? steps? assistance? way?
process? design? reliability? process?

Principles of Target Costing

Leadership of Using and Attention to all
Focusing on Reduce the Cost of the Focus on the Stage of
Target Selling Developing a Stages of the Value
Customer Product Life Cycle Product Design
Price Teamwork Chain

Impact of Target Costing on Profitability

Strategic Selection of Selling Price Reduces Cost

• It improves profitability through precise targeting of • It places continuous emphasis on product costs
the correct prices at which the company feels it can throughout the life cycle
field a profitable product in the marketplace that will • Management is also aware of costing issues as it
sell in a robust manner. receives regular reports from the design team.

Most Useful Situations for Target Costing

Target costing is most useful in those situations where the substantial amount of product costs are locked
(committed) during the product design phase. This is a common feature of a product to be manufactured;
but rare in case of services. Companies, with following features expected to gain maximum from target
costing :-
 Assembly-oriented industries & Industries with diversification of the product lines.
 Companies in process of implementing management methods such as JIT, value engineering
 Use technologies of factory automation, including computer-aided design, flexible manufacturing
systems, office automation, and computer-aided manufacturing.

Pros of Target Costing Cons of Target Costing

Reinforces top-to-bottom commitment to process and The development process can be lengthened to a
product innovation, thus identifying issues to be considerable extent only (Lengthy process).
resolved to achieve competitive advantage.
Identifies market opportunities that can be converted More difficult to reach a consensus on the proper
into real savings. design because of too many opinions.
Proactive approach to cost management. Can result in finger-pointing in various parts of the
company.
Enhances the employee awareness and empowerment. Requirement of detailed cost data.
Fosters partnership with suppliers. May reduce the quality of products.

By Prof. CA Manan Pujara 47 | P a g e

CA Final - AIR 37
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 I Can Do it & I Will Do it…!!

Encourages adoption of value- added activities and Substantial portion of information is market-led, hence
elimination of non-value- added activities. highly dynamic in nature.
Tar. Costing takes market-driven approach towards cost Great amount of forecasting and estimation.

Note –
1. Target costing and E-commerce go hand in hand, especially when products offered are lacking
differentiation. Due to intense competition in Ecom business, the USP of the firm can be to offer quality
product at a cheaper rate. In other words, it has to adapt the price first and then arrive at target cost.
2. Functional Analysis - Its applied to the design of new products and breaks the product down into
functional parts. For example, a new chair may have the moveable feature. The value that the customer
places on each feature is considered and added to give a target cost. Thus, functional analysis aims to
increase profits by reducing costs through elimination of unnecessary features and/or by adding cost-
effective new features.
3. Additionally, achievement of Target Cost by compromising quality can lead to adverse situations like :
- Non-compliance of BS norms to meet targets can create environmental issues and lead to adverse
reputation.
- Using cheap material (eg – plastic instead of aluminium in bike) can lead to safety issues. Hence
company must spread awareness about safety.
- Complicated designs may not be repairable by mechanicals hence good network of service centers
should be created by the company.

LIFE CYCLE COSTING

Life Cycle Costing involves identifying the costs and revenue over a product’s life i.e. from inception to decline.
It aims to maximize the profit generated from a product over its total life cycle.

The life cycle of a product consists of four phases/

stages :-
1. Introduction
2. Growth
3. Maturity
4. Saturation and Decline.

[Practically there is 1 additional stage prior to

introduction stage i.e product development stage (where
R&D related activities takes place). Academically it is
merged with introduction stage]

Characteristics

By Prof. CA Manan Pujara 48 | P a g e

CA Final - AIR 37
Keep Smiling, Be Happy, Stay Motivated, All the Best…!!