CAIRO UNIVERSITY

FACULTY OF COMMERCE

PRE-MASTER ACCOUNTING

Traditional Costing System,

ABC, & Target Costing

Presented To,
Prof. Dr. Ahmed Farghaly

Presented By:
 Blal Akram Abd El-Fatah Badr
 Mohamed Ali Ali Elshiekh
 Tarek Mohamed Said Abd El-Satar

1
 Abstract
Activity-based costing (ABC) which has become an important aspect of manufacturing/service
organizations can be defined as a methodology that measures the cost and performance of
activities, resources and cost objects. It can be considered as an alternative paradigm to
traditional cost-based accounting systems.1 The target costing process is a price driven, customer
oriented profit planning and cost management system. It works, in a cross functional way, from
the design stage throughout all the product life cycle and it involves the entire value chain. The
process implementation needs a costing methodology consistent with the cost management logic.
The aim of the paper is to focus on Activity Based Costing (ABC) application to target costing
process.2

Introduction3
The traditional approach of mark-up or cost plus pricing may be adopted in a market where
demand exceeds supply and the number of competitors is limited. When the supply of the good
outstrips customer demand, prices set on a cost basis can render the product uncompetitive. In
such scenarios, pricing policies should be the related to external factors. To obtain margins that
adequately exceed costs, firms must revise their logic and begin to manage costs as a function of
an exogenous variable, i.e. the price that the market allows to be applied, then shift from the
logic of cost measurement to cost management. The opportunity to use target costing depends
not only on the characteristics of the market where the company operates but also on the
characteristics of the production process and the product. The methodology is used mainly in
manufacturing companies and is particularly suited, as Sakurai stated (Sakurai, 1989: 39-50), to
companies that manufacture a wide variety of products in small-medium volumes, those
implementing production characterized by a continuity in the production process with high
product differentiation, and to high technology firms. Whether the methodology is adopted or not
depends on the complexity of the product portfolio: target costing becomes more appealing when
products are differentiated, characterized by high quality and with short and contracting life
cycles.

1
Akyol, Derya Eren, Gonca Tuncel, and G Mirac Bayhan. "A comparative analysis of activity-based
costing and traditional costing." World Academy of Science, Engineering and Technology 3 (2005): 44-47.
2
Maria, Moisello Anna. "Cost Measurement And Cost Management In Target Costing." Annals of Faculty
of Economics 1.1 (2012): 533-547.
3
Maria, Moisello Anna. "Cost Measurement And Cost Management In Target Costing." Annals of Faculty
of Economics 1.1 (2012): 533-547.

2
 Background
1. Traditional Costing System4,
Historically, manufacturing and cost accounting became so linked because of the
necessity to determine profit on goods produced, sold and shipped. Early decisions made within
this relationship fostered a certain benchmark or standard upon which most of the manufacturers
in the earlier times will use as method. In the past, using direct labor as basis for the computation
of overhead costs to be charged on the products manufactured would make sense, since it has
contributed to the largest percentage of the cost that was expended in manufacturing products
such as, automobiles, trains, garments, etc. This procedure of allocating costs incurred in
production, other than direct materials and direct labor costs was known as the traditional costing
method.

Despite the fact that it is over 75 years old, most companies still use standard cost
systems to value inventory for financial statement purposes and for many other management
purposes as well. This standard cost system has some advantages for financial statement
purposes (e.g., for simplicity and consistency). However, in this modern times where the way we
do business have changed, insisting on the use of the traditional costing system would be
misleading as a tool to assist in making effective management decisions.

The traditional costing system worked well until the business environment changed.
About 20 years ago, most of the manufacturing firms began adopting changes in their operations,
which were not consistent to traditional costing method. Automated equipment and robotics are
just some of the many current discoveries that lessened the use of manpower, thus, minimizing
direct labor costs. Under the traditional costing system, adhering on the use of direct labor as an
allocation base for overhead or indirect costs distorts product cost computation.

The traditional cost accounting is becoming ineffective if not obsolete in the current
global competitive world of business. The business scenario in the olden times for which it was
developed and used is no longer the current business trend. Using standard cost, which is the one
being advocated by traditional costing system was designed for a company that had: 1)
homogeneous products, 2) large direct costs compared to indirect costs, 3) limited ability to
collect data and 4) low “below the line” costs. On the other hand, today’s companies typically
have 1) a wide variety and complexity of products and services, 2) high overhead costs compared

4
Manalo, MV. "Activity Based Costing vs. Traditional Cost Accounting." 2005.
<http://www.dlsu.edu.ph/research/centers/cberd/pdf/papers/Working%20Paper%20Series%202004-
11.pdf>

3
to direct labor, 3) an overabundance of data and 4) substantial non product (e.g., distribution
channels) costs that can dramatically affect true product cost.

Many manufacturing companies are still arbitrarily attaching overhead to products using
direct labor as the basis. These companies often allocate the largest cost (i.e., overhead) based on
the smallest cost (i.e., direct labor). Because of product variety and product line complexity,
using one homogeneous overhead rate which is being utilized under traditional costing system, is
no longer an appropriate average. Lastly, the modern business environment today, is now
characterized by high technology, high-speed, state-of-the-art data collection and reporting
systems. With the proper tools and equipment, gathering and manipulation of data in a multiple
complex ways is no longer an issue. As a result of these changes, the traditional system, with its
"one-size-fits-all" approach, is not an adequate tool for today's business conditions. Not only is
the traditional costing method unable to supply the necessary framework for measuring cost
accurately, it cannot also empower managers with sufficient information needed to manage the
company’s operations effectively and profitably.

B. Activity Based Costing5,

Far from being new, Activity-Based Costing (ABC) first surfaced as various commercial
businesses began experiencing difficulties in accounting for indirect and overhead costs.
Activity-Based Costing is a cost accounting method developed and pioneered by Roben Cooper,
Robert Kaplan, and H. Thomas Johnson, which traces overhead costs directly to cost objects, i.e.,
products, processes, services or customers and help managers make the right decisions regarding
product mix and competitive strategies (Roztocki, Valenzuela, Porter, Monk, Needy, 1999).

Cost management has become an integral component of organization’s business and

operational strategies. One of the popular techniques used in cost management is Activity-Based
Costing. Its important advantage is it helps managers make decisions. It corrects the limitations
of traditional costing by identifying all the work activities and their costs that enter into
manufacturing a product, delivering a service, or performing a process. It differs from traditional
costing because it traces cost directly when possible and all relevant manufacturing costs are
considered.

Activity based costing is a refinement of the traditional costing systems of allocating

manufacturing overhead to the units produced. As mentioned earlier, traditional costing systems
always use volume-related measures, e.g., direct labor hours or machine hours to allocate
overhead costs to products manufactured. On the other hand, ABC allocates overhead costs to
5
Manalo, MV. "Activity Based Costing vs. Traditional Cost Accounting." 2005.
<http://www.dlsu.edu.ph/research/centers/cberd/pdf/papers/Working%20Paper%20Series%202004-
11.pdf>

4
products on the basis of the resources consumed by each activity involved in the design,
production, and distribution of a particular product. This is accomplished by assigning costs to
cost pools that represent specific activities and allocating these costs using appropriate cost
drivers to the product. Cost drivers are those activities, which have a direct cause and effect
relationship to the occurrence of a particular cost. (Carter, Usry, 2002).

ABC is an accounting technique that allows an organization to determine the actual cost
associated with each product and service produced by the organization without regard to the
organizational structure. An important function of ABC is to define the activities of a company
as value adding or non-value adding activities. Value added activities are tasks undertaken by the
company for which the customers are usually willing to pay for the service. On the other hand,
non-value added activities create waste, result in delay, add costs to the products, or for which
cost customers are not willing to pay. ABC aids an organization in finding opportunities to
streamline or reduce the costs, or eliminates the entire activity, especially if there is no value
added aspect to it.

ABC enables managers to see whether the resources are being used effectively and which
activities contribute value to the product or service. The activities performed which need more
resources for efficiency can be justified by analyzing these activities. A major advantage of using
ABC is that it avoids or minimizes misrepresentations in product costing that result from random
allocations of indirect costs. It matches the actual total cost of the resources consumed to the
total output produced. ABC system could assist managers in identifying the value added
activities which they could further improve to meet customers’ demands and enhancing the
product quality and process simplification and efficiency.

ABC has become extremely popular in recent years. In fact, it is difficult to find an
academic or practitioner journal that does not include at least one article on activity-based
costing, Activity-Based Management (ABM), or activity-based budgeting. A powerful tool for
measuring performance, Activity-Based Costing is used to identify, describe, assign costs to, and
report on agency operations. Companies that adapted ABC believe that it is a more accurate cost
management system than traditional cost accounting. They say that ABC identifies opportunities
to improve business process effectiveness and efficiency by determining the “true” cost of a
product or a service.

Definitions of ABC,
❏ It is an economic model that identifies the cost pools or activity centers in an organization
and assigns costs to cost drivers based on the number of each activity used.6

6
Akyol, Derya Eren, Gonca Tuncel, and G Mirac Bayhan. "A comparative analysis of activity-based
costing and traditional costing." World Academy of Science, Engineering and Technology 3 (2005): 44-47.

5
 ❏ It is a costing methodology that identifies activities in an organization and assigns the
cost of each activity with resources to all products and services according to the actual
consumption by each. This model assigns more indirect costs (overhead) into direct
costs compared to conventional costing.7
❏ It is an accounting method that identifies the activities that a firm performs,
and then assigns indirect costs to products. An activity based costing (ABC)
system recognizes the relationship between costs, activities and products,
and through this relationship assigns indirect costs to products less arbitrarily
than traditional methods. 8

C. Target Costing9,
Target costing is not a new idea, even though only a small number of North American companies
fully embrace its elements. Henry Ford developed the first mass-produced automobile, the Model
T, in 1908 with the objective of increasing volume by continually lowering its price, and by 1913
was able to sell it for under $500. Obviously, to do that and make money, costs would have to be
tightly managed. Ford managed material costs via backward integration, labor costs by the use of
the assembly line and efficiency improvements, and other costs by frugal behavior. The “roaring
twenties,” and, later, the pent-up demand after World War II made it easier for Ford and other
companies to raise prices.

Even during the late 1950s and early 1960s, American Motors conceived, developed, and
introduced the Nash Rambler as a small, inexpensive alternative to the gas-guzzling monsters
then on the market. The car was successful, and American Motors was very profitable as a result,
at the end of 1962 the company had a debt-free balance sheet! Although some North American
companies (such as Boeing, Caterpillar, John Deere, and Northern Telecom) have used the
general ideas of target costing over the years, or applied it to a specific product (such as Ford’s
Taurus or Motorola’s pocket pager), few apply it as comprehensively and intensely as leading
Japanese companies (such as Toyota, Nissan, Nippondenso, and NEC).

It has only been recently that Japanese authors (such as Monden, Sakurai, and Tanaka) have
begun to describe how Japanese companies are applying target costing, as these companies strive
to be successful in their domestic market, and subsequently in the world markets. Some North
American companies (such as Ford, Chrysler, and Cummins Engine) are beginning to study the

7
"Activity-based costing - Wikipedia, the free encyclopedia." 2005. 4 May. 2014
<http://en.wikipedia.org/wiki/Activity-based_costing>
8
"Activity-Based Costing (ABC) Definition | Investopedia." 2008. 4 May. 2014
<http://www.investopedia.com/terms/a/abc.asp>
9
Costing, IT. "Implementing Target Costing - IMA." 1994.
<http://www.imanet.org/PDFs/Public/Research/SMA/Implementing%20Target%20Costing.pdf>

6
Japanese and establish target costing initiatives. Many more companies will when they realize
that price increases are no longer automatic and target costing is a powerful technique.

Because the idea of target costing has resulted from the highly competitive environment to which
most Japanese companies have been subjected for a number of years, each company has its own
unique approach.

As a result, there is no single, simple definition of target costing. Definitions range from
relatively narrow to broad.

Robin Cooper (1992), for example, says, “The object of target costing is to identify the
production cost of a proposed product so that, when sold, it generates the desired profit margin.”

Michiharu Sakurai (1989) says, “Target costing can be defined as a cost management tool for
deducing the overall cost of a product over its entire life cycle with the help of the production,
engineering, research and design, marketing, and accounting departments.”

Peter Horváth (1993) defines it as “a comprehensive cost planning, cost management, and cost
control concept...used primarily at the early stages of product design in order to influence
product cost structures depending on the market derived requirements. The target costing process
requires the cost-oriented coordination of all product-related organizational functions.”

Common to most definitions is a process founded on a competitive market environment; market

prices driving cost (and investment) decisions; cost planning, management, and reduction
occurring early in the design and development process; and cross-functional team involvement,
including the management accountant.

When prices are set by market forces or by a management decision to be a price leader, costs
must be lower than prices to make money. Therein lies the underlying concept of target costing:
Price - Profit Margin = Cost

Of course, this contrasts dramatically with the historical practice of many firms and industries,
where:
Cost + Profit Margin = Price

Since target costing is usually applied to new product planning, which frequently requires
investments in tooling, equipment, and other assets influencing costs, it can legitimately be said
that price drives both costs and investments.

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Objectives of Target Costing,

The fundamental objective of target costing is to enable management to manage the business to
be profitable in a very competitive marketplace. In effect, target costing is a proactive cost
planning, cost management, and cost reduction practice whereby costs are planned and managed
out of a product and business early in the design and development cycle, rather than during the
latter stages of product development and production.

Target costing obviously applies to new products. It also applies to product modifications or
succeeding generations of products.

The costs most typically emphasized in the target costing process are those most directly affected
by it: material and purchased parts, conversion costs (such as labor and identifiable overhead
expenses), tooling costs, development expenses, and depreciation. However, because target
costing is a comprehensive cost planning, management, and reduction process, as well as a
specific technique, all costs and assets that may be affected by early product planning decisions
should be considered. This would include more indirect overhead expenses through the
production stage, and beyond, such as service costs, and assets, such as inventory.

Target costing is intended to get managers thinking ahead and comprehensively about the cost
and other implications of the decisions they made.

Target costing is as much a significant business philosophy as it is a process to plan, manage,

and reduce costs. It emphasizes understanding the markets and competition; it focuses on
customer requirements in terms of quality, functions, and delivery, as well as price; it recognizes
the necessity to balance the trade-offs across the organization, and establishes teams to address
them early in the development cycle; and it has, at its core, the fundamental objective to make
money, to be able to reinvest, grow, and increase value.

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 The ABC in the Target Costing Process10

Activity-Based Costing (ABC) was introduced (Johnson and Kaplan, 1987: 183 208) in
response to the need for a costing tool based on the factors that give rise to indirect costs
as well as one able to express more objectively the causal relationship between products
and costs. The method is based on the assumption that production costs are incurred for
the implementation of activities which are performed in order to produce and sell
products. Therefore, ABC correlates costs to activities, then to products, through a two-
stage imputation methodology. The strength of ABC is due to its recognition that the
consumption of resources in the production process is related not only to the volume of
production, but largely to activities related to transactions that occur within the
organization (Cooper and Kaplan, 1988: 20-27).

The innovative contribution of ABC is twofold: on the one hand, through considering a
wide variety of cost drivers, it provides the analytical causal-functional determination of
the product cost of multi-product or multi-service companies. These have differentiated
outputs depending on their varied complexity; on the other, it is a tool to guide
management decisions because, by ordering activities by hierarchical logic, ABC
highlights relevant costs and makes it possible to determine the actual cost of a decision.

The Target Costing process would be effectively supported, by structuring the model in
order to keep - within the activities costs - the separation of costs according to their
dynamic in relation to changes in output (Woods, 1992: 53-57; Christensen and Sharpe,
1993: 38-42; Kee, 2001: 1-7, Moisello, 2008: 107-119), in order to enlighten the effect of
different solution on product cost structure and on capacity utilization both in the short
and the long term. Woods (1992: 53-57) proposes a partition of costs between variable
and fixed, while Christensen and Sharpe (1993: 38-42) suggest a more detailed
classification of the activity costs: variable costs in the short run, fixed costs and fixed
costs in the short term, which I assume in the model. The distinction between short-term
variable costs, fixed costs and fixed costs in the short-term depends on the time horizon
in which management can change the costs. The variable costs in the short-term change
in direct proportion to changes in cost drivers and are therefore related to the volume of
the driver. Decisions involving activities related to the units or batches have a short-term
impact. Decisions that affect the fixed costs in the short term, which is normally one year,
10
Maria, Moisello Anna. "Cost Measurement And Cost Management In Target Costing." Annals of Faculty
of Economics 1.1 (2012): 533-547.

9
involve cost drivers in the batch or product-support level. The fixed costs in the short
term, for example, vary with the number of batches, but not in relation to the number of
units in the batch. Decisions that affect the fixed costs imply a long-term time horizon.
These costs are normally linked to activities in support of the product, to support the
industrial structure or the business.

Since both fixed costs and fixed costs in the short term have the problem of unused
capacity that must be properly highlighted, the costing rates must be calculated on the
basis of the offered capacity but charged in relation to the used one. From an operational
standpoint the ABC model is flexible processing information on capacity because,
through the comparison of variable cost capacity and the capacity of the factors that result
in short and long-term fixed costs, it shows:

The size of the unused capacity in accordance with the following relations:

[1] measures the unused capacity manageable in the short as the difference between the
capacity of fixed costs in the short and the capacity of the variable costs, since the first
indicates the maximum available capacity taking into account that capacity constraints
can not be eliminated in the short term and the second expresses the short run used
capacity as the acquisition and, therefore, the availability of variable factors is modulated
by the planned use of their capacity.

[2] detects idle capacity that can be managed in the long run as the difference between the
capacity of fixed costs and variable costs capacity as the first expresses the long term
available capacity that is not constrained by capacity limits of short term fixed costs.
When the capacity of the short-term variable cost is equal to the capacity of short term
fixed costs

[3] shows the presence of capacity constraints in the short period because on the base of
[1] production capacity is fully used.

[4] shows a capacity constraint in the long run when the capacity of the variable costs
completely absorbs the available capacity of fixed costs.

The flexible model shows the extent of available resources and possible areas of
intervention, to optimise the management of production capacity through capacity
reductions or reallocation of resources to activities whose capacity is at saturation level.

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This pattern is also designed as compromise in the wider discussion around ABC
absorption versus direct costing that stresses the importance of highlighting the costs of
idle capacity (Aranoff, 2011: 6-10; Baxendale and Foster, 2010: 5-14; Sopariwala, 2009:
41-46).

Conclusions
Activity based costing, due to its ability to model the relationship between complexity,
use of activities and the indirect costs dynamic, can adequately support the target costing
process, both for the design of the product and for the redesign and reengineering
process, when indirect costs have a significant impact on the cost structure of the product
that is the object of the process. ABC performs to its maximum potential if structured
flexibly, with the separation of variable costs, fixed and fixed in the short because it
makes evident the effects of changes in the product or in the processes in terms of
capacity utilization and capacity constraints of the various activities. It also highlights the
time horizon to which excess capacity is related. The ABC methodology effectively
supports target costing both in determining the drifting cost and in the operational phase
of target cost alignment because the creation of activities maps and the identification of
value-added and non value-added activities highlights those on which cost containment
should be focused.11

11
Maria, Moisello Anna. "Cost Measurement And Cost Management In Target Costing." Annals of Faculty
of Economics 1.1 (2012): 533-547.

11