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6 01 15 SY LL AB US -2 FINAL : PAPER - STRATEGIC COST MANAGEMENT DECISION MAKING STUDY NOTES The Institute of Cost Accountants of India CMA Bhawan, 12, Sudder Street, Kolkata - 700 016 FINAL

First Edition : August 2016 Reprint : January 2018 Revised Edition : December 2018 Published by : Directorate of Studies The Institute of Cost Accountants of India (ICAI) CMA Bhawan, 12, Sudder Street, Kolkata - 700 016 Printed at : Jayant Printery LLP. 352/54, Girgaum Road, Murlidhar Temple Compound, Mumbai - 400 002. Copyright of these Study Notes is reserved by the Institute of Cost Accountants of India and prior permission from the Institute is necessary for reproduction of the whole or any part thereof.

Syllabus- 2016 Syllabus Structure A B C Cost Management Strategic Cost Management Tools and Techniques Strategic Cost Management - Application of Statistical Techniques in Business Decisions 20% 50% 30% A 20% C 30% B 50% ASSESSMENT STRATEGY There will be written examination paper of three hours OBJECTIVES On completion of this subject students should have developed skills of analysis, evaluation and synthesis in cost and management accounting and, in the process, created an awareness of current developments and issue in the area. The subject covers the complex modern industrial organizations within which the various facets of decision-making and controlling operations take place; the subject includes discussion of costing systems and activity based costing, activity management, and implementation issues in modern costing systems. Learning Aims The syllabus aims to test the student’s ability to: Identify the conventions and doctrines of managerial and cost accounting and other generally accepted principles which may be applied in the contemporary cost management models Identify major contemporary issues that have emerged in strategic cost management Discuss a number of issues relating to the design and implementation of cost management models in modern firms Application of Operation Research in Strategic Decision Making Skill set required Level C : Requiring skill levels of knowledge, comprehension, application, analysis, synthesis and evaluation Section A : Cost Management 1. Cost Management Section B : Strategic Cost Management Tools and Techniques 2. Decisions Making Techniques 3. Standard Costing in Profit Planning 4. Activity Based Cost Management – JIT and ERP 5. Cost of Quality and Total Quality Management Section C : Strategic Cost Management – Application of Statistical Techniques in Business Decisions 6. Application of Operation Research and Statistical Tools in Strategic Decision Making 20% 50% 30%

SECTION A: COST MANAGEMENT [20 MARKS] 1. Cost Management (a) Developments in Cost Management: (i) Life Cycle costing (ii) Target costing (iii) Kaizen Costing (iv) Value Analysis and Value Engineering (v) Throughput Costing (vi) Business Process Re-engineering (vii) Back-flush Accounting (viii) Lean Accounting (ix) Socio Economic Costing (b) Cost Control and Cost Reduction – Basics, Process, Methods and Techniques of Cost Reduction programme. SECTION B: STRATEGIC COST MANAGEMENT TOOLS AND TECHNIQUES [50 MARKS] 2. 3. Decision Making Techniques (a) Marginal Costing- Differential costing-CVP Analysis – Profit Volume Graphs – Contribution Approach (b) Decisions involving alternative choices – Optimum utilization of resources – Make or Buy – Evaluation of Orders – Multiple scarce resource problems- Product sales pricing . etc (c) Pricing Decisions and Strategies – New Product Pricing, Use of Costs in Pricing, Sensitivity Analysis in Pricing Decisions; Monopoly Pricing vs. Competitive Pricing; Bottom Line Pricing (d) Costing of Service Sector – methods, pricing, performance measurement (e) Transfer Pricing - Objectives, Methods ( Cost Based, Market Price Based, Negotiated Pricing), Advantages and Disadvantages, Criteria for setting Transfer Prices, Transfer Price in different situations, Situations causing Conflicts and resolving the Conflicts; (f) Relevant Cost Analysis : Relevant Cost, Irrelevant Costs - Sunk or Historical Cost, Committed Cost, Absorbed Cost, Situations where Fixed Costs become relevant for decision – making and its related implications (g) Profitability Analysis – Product wise / Segment Wise / Customer wise Standard Costing in Profit Planning (a) Variance Analysis - Investigation of Variances, Planning and Operating Variances, Controllable / Non-controllable Variances, Relevant Cost Approach to Variance Analysis; Variance analysis under marginal costing and absorption costing; Activity Ratios; Application of budgetary control and Standard Costing in Profit planning, Standard Costing Vs Budgetary Control, Reconciliation of Actual Profit with Standard Profit and /or Budgeted Profit. (b) Uniform Costing and Inter-firm comparison. 4. Activity Based Cost Management – JIT and ERP (a) Activity Based Cost Management - Concept , purpose, benefits, stages, relevance in decisionmaking and its application in Budgeting, Responsibility accounting, Traditional Vs. ABC System – comparative analysis

(b) JIT – introduction, Benefits, Use of JIT in measuring the Performance (c) ERP and its applications in strategic cost management (d) Bench Marking 5. Cost of Quality and Total Quality Managment (a) TQM - Basics, Stages, Principles, Control, Corrective actions (b) PRAISE-Steps, Problems, implementation (c) PARETO Analysis (d) Quality Costs SECTION C: STRATEGIC COST MANAGEMENT – APPLICATION OF STATISTICAL TECHNIQUES IN BUSINESS DECISIONS [30 MARKS] 6. Application of Operation Research and Statistical Tools in Strategic Decision Making (a) Learning Curve, (b) Linear Programming (Formulation only) (c) Assignment, (d) Transportation (e) Simulation (f) Network Analysis – CPM / PERT

Contents SECTION A – COST MANAGEMENT Study Note 1 : Cost Management 1.1 Life Cycle Costing 1 1.2 Target Costing 8 1.3 Kaizen Costing 14 1.4 Value Analysis and Value Engineering 15 1.5 Throughput Costing 21 1.6 Business Process Re-engineering 33 1.7 Back-flush Accounting 34 1.8 Lean Accounting 40 1.9 Socio Economic Costing 43 1.10 Cost Control and Cost Reduction – Basics, Process, Methods and Techniques of Cost Reduction Programme 47 SECTION B – STRATEGIC COST MANAGEMENT TOOLS AND TECHNIQUES Study Note 2 : Decision Making Techniquesti 2.1 Marginal Costing 2.2 Transfer Pricing 51 145 Study Note 3 : Standard Costing in Profit Planning 3.1 Variance Analysis 165 3.2 Uniform Costing in Profit Planning 226 3.3 Inter Firm Comparison 228 Study Note 4 : Activity Based Cost Management - JIT and ERP 4.1 Activity Based Cost Management 231 4.2 Just-In-Time (JIT) 245 4.3 Enterprise Resource Planning (ERP) 251 4.4 Bench Marking 254

Study Note 5 : Cost of Quality and Total Quality Management.1 5.1 Total Quality Management (TQM) 259 5.2 Praise Analysis 261 5.3 Six Sigma 263 5.4 Pareto Analysis 264 5.5 Quality Costs 267 SECTION C – STRATEGIC COST MANAGEMENT – APPLICATION OF STATISTICAL TECHNIQUES IN BUSINESS DECISIONS Study Note 6 : Application of Operation Research and Statistical Tools in Strategic Decisions Making 6.1 Learning Curve 281 6.2 Linear Programming 289 6.3 Assignment 296 6.4 Transportation 307 6.5 Simulation 327 6.6 Network Analysis – CPM/PERT 342

Cost Management Study Note - 1 COST MANAGEMENT This Study Note includes 1.1 Life Cycle Costing 1.2 Target Costing 1.3 Kaizen Costing 1.4 Value Analysis and Value Engineering 1.5 Throughput Costing 1.6 Business Process Re-engineering 1.7 Back-flush Accounting 1.8 Lean Accounting 1.9 Socio Economic Costing 1.10 Cost Control and Cost Reduction – Basics, Process, Methods and Techniques of Cost Reduction Programme 1.1 LIFE CYCLE COSTING Meaning of Life Cycle Costing (a) Life Cycle Costing; aims at cost ascertainment of a product, project etc. over its projected life. (b) It is a system that tracts and accumulates the actual costs snd revenues attributable to cost object (i.e.; product) from its inception to its abandonment. (c) Sometimes the terms; cradle-to-grave costing and womb-to-tomb costing convey the meaning of fully capturing all costs associated with the product from its initial to final stages. Meaning of Product Life Cycle (a) Product Life Cycle is a pattern of expenditure, sale level, revenue and profit over the period from new idea generation to the deletion of product from product range. (b) Product Life Cycle spans the time from initial R&D on a product to when customer servicing and support is no longer offered for the product. For products like motor vehicles, this time-span may range from 5 to 7 years. For some basic pharmaceuticals, the time-span be 7 to 10 years. Characteristic of PLCC (a) Involves tracing of costs and revenues of each product over several calendar periods throughout their entire life cycle. (b) Traces research, design and development costs and total magnitude of these costs for each individual product and compared with product revenue. (c) Assists report generation for costs and revenues. Phases in Product Life Cycle: The 4 identifiable phases in the product Life Cycle are — (a) Introduction (b) Growth (c) Maturity and (d) Decline. A comparative analysis of these phases is given below — THE INSTITUTE OF COST ACCOUNTANTS OF INDIA 1

Strategic Cost Management - Decision Making Particulars Introduction Growth Maturity Decline Phase 1 II III IV Sales Volumes Initial stages, hence low. Rise in sales levels at increasing rates. Rise in sales levels at decreasing rates Sales level off and then start decreasing Prices of products High levels to cover initial costs and promotional exps. Prices fall closer to Retention of high level prices except in cost, due to effect of competition. certain cases. Ratio of promotion expenses to sales Highest, due to effort needed to inform potential customers, launch products, distribute to customers etc. Total expenses remain the same, while ratio of S&D OH to sales is reduced due to increase in sales. Ratio reaches a normal level of sales. Such normal level becomes the industry standard. Reduced sales promotional efforts as the product is no longer in demand. Competiti on Negligible and insignificant Entry of a large number of competitors. Fierce Competition Starts disappearing due to withdrawal of products. Profits Nil, due to heavy initial Increase at a rapid costs pace Normal rate of profits since costs and prices are normalized. Decline profits due to price competition new products etc. Gap between price and cost is further reduced. in the growth stage, maintain the prices at high levels, in order to realize maximum profits. Price reduction will not be undertaken unless (a) the low prices will lead to market penetration, (b) the Firm has sufficient production capacity to absorb the increased sales volume, and (c) Competitors enters the market. Maturity Growth Sales Decline Introduction Time Benefits of PLCC (a) Results in earlier actions to generate revenue or to lower costs than otherwise might be considered. (b) Ensures better decision from a more accurate and realistic assessment of revenues and costs atleast within a particular life cycle stage. (c) Promotes long-term rewarding. (d) Provides an overall framework for considering total incremental costs over the life span of the product. 2 THE INSTITUTE OF COST ACCOUNTANTS OF INDIA

Cost Management Importance of Product Life Cycle Costing: Product Life Cycle Costing is considered important due to the following reasons — (a) Time based analysis: Life cycle costing involves tracing of costs and revenues of each product over several calendar periods throughout their life cycle. Costs and revenues can analysed by time periods. The total magnitude of costs for each individual product can be reported and compared with product revenues generated in various time periods. (b) Overall Cost Analysis: Production Costs are accounted and recognized by the routine accounting system. However non-production costs like R&D; design; marketing; distribution; customer service etc. are less visible on a product — by — product basis. Product Life Cycle Costing focuses on recognizing both production and non-production costs. (c) Pre-production costs analysis: The development period of R&D and design is long and costly. A high percentage of total product costs maybe incurred before commercial production begin. Hence; the Company needs accurate information on such costs for deciding whether to continue with the R&D or not. (d) Effective Pricing Decisions: Pricing Decisions; in order to be effective; should include market considerations on one hand and cost considerations on the other. Product Life Cycle Costing and Target Costing help analyze both these considerations and arrive at optimal price decisions. (e) Better Decision Making: Based on a more accurate and realistic assessment ot revenues and costs, at least within a particular life cycle stage, better decisions can be taken. (f) Long Run Holistic view: Product Life Cycle Costing can promote long-term rewarding in contrast to short-term profitability rewarding. It provides an overall framework for considering total incremental costs over the entire life span of a product, which in turn facilitates analysis of parts of the whole where cost effectiveness might be improved. (g) Life Cycle Budgeting: Life Cycle Budgeting, i.e., Life Cycle Costing with Target Costing principles, facilitates scope for cost reduction at the design stage itself. Since costs are avoided before they are committed or locked in the Company is benefited. (h) Review: Life Cycle Costing provides scope for analysis of long term picture of product line profitability, feedback on the effectiveness of life cycle planning and cost data to clarify the economic impact of alternatives chosen in the design, engineering phase etc. Illustration 1. Wipro is examining the profitability and pricing policies of its Software Division. The Software Division develops Software Packages for Engineers. It has collected data on three of its more recent packages - (a) ECE Package for Electronics and Communication Engineers, (b) CE Package for Computer Engineers, and (c) IE Package for Industrial Engineers. Summary details on each package over their two year cradle to grave product lives are Package Selling Price Number of units sold Year 1 Year 2 ECE 250 2,000 8,000 CE 300 2,000 3,000 IE 200 5,000 3,000 Assume that no inventory remains on hand at the end of year 2. Wipro is deciding which product lines to emphasize in its software division. In the past two years, the profitability of this division has been mediocre. Wipro is particularly concerned with the increase in R & D costs in several of its divisions. An analyst at the Software Division pointed out that for one of its most recent packages (IE) major efforts had been made to reduce R&D costs. THE INSTITUTE OF COST ACCOUNTANTS OF INDIA 3

Strategic Cost Management - Decision Making Last week, Amit, the Software Division Manager, decides to use Life Cycle Costing in his own division. He collects the following Life Cycle Revenue and Cost information for the packages Amount ( ) Particulars Package ECE Year 1 Revenues Package CE Year 2 Package IE Year 1 Year 2 Year 1 Year 2 5,00,000 20,00,000 6,00,000 9,00,000 10,00,000 6,00,000 R&D 7,00,000 - 4,50,000 - 2,40,000 - Design of Product 1,15,000 85,000 1,05,000 15,000 76,000 20,000 25,000 2,75,000 1,10,000 1,00,000 1,65,000 43,000 1,60,000 3,40,000 1,50,000 1,20,000 2,08,000 2,40,000 Distribution 15,000 60,000 24,000 36,000 60,000 36,000 Customer Service 50,000 3,25,000 45,000 1,05,000 2,20,000 3,88,000 Costs Manufacturing Marketing Present a Product Life Cycle Income Statement for each Software Package. Which package is most profitable and which is the least profitable? How do the three packages differ in their cost structure (the percentage of total costs in each category)? Answer: Life cycle Income Statement (in 000s) Particulars Package ECE Y1 Y2 Total 500 2,000 2,500 R&D 700 - Design 115 Package CE Y1 Y2 Total 100% 600 900 1,500 100% 700 28% 450 - 450 85 200 8% 105 15 25 275 300 12% 110 Marketing 160 340 500 20% Distribution 15 60 75 Cust. Service 50 325 1065 1,085 Revenues % Package IE % Y1 Y2 Total % 1,000 600 1,600 100% 30% 240 - 240 15% 120 8% 76 20 96 6% 100 210 14% 165 43 208 13% 150 120 270 18% 208 240 448 28% 3% 24 36 60 4% 60 36 96 6% 375 15% 45 105 150 10% 220 388 608 38% 2150 86% 884 376 1260 84% 969 727 1696 106% 350 14% 240 16% (96) -6% Costs Manufacturing Total Costs Profit Observation: Package ECE is most profitable, while package IE is least profitable. Illustration 2. A2Z p.l.c supports the concept of tero technology or life cycle costing for new investment decisions covering its engineering activities. The financial side of this philosophy is now well established and its principles extended to all other areas of decision making. The company is to replace a number of its machines and the Production Manager is torn between the Exe Machine, a more expensive machine with a life of 12 years, and the Wye machine with an estimated life of 6 years. If the Wye machine is chosen it is likely that it would be replaced at the end of 6 years by another Wye machine. The patter of maintenance and running costs differs between the two types of machine and relevant data are shown below: 4 THE INSTITUTE OF COST ACCOUNTANTS OF INDIA

Cost Management Exe Wye Purchase price 19,000 13,000 Trade-in value/brakeup/scrap 3,000 3,000 Annual repair costs 2,000 2,600 Overhaul costs (at year 8) 4,000 (at year 4) 2,000 Estimated financing costs averaged over machine life 10%p.a -Exe; 10% p.a. -Wye You are required to: recommend with supporting figures, which machine to purchase, stating any assumptions made. Solution: Computation of present value of outflows and equivalent annual Initial cost Exe machine WYE machine 19,000.00 Less : Scrap at the end of the life (3000x0.32) 960.00 Present value of total annual cost (2000x6.81) (4000X.47) 13,000.00 (3000X.56) 1,680.00 13,620.00 (2600x4.36) 11,336.00 1,880.00 (2000X.68) 1,360.00 18,040.00 Overhaul cost 11,320.00 33,540.00 Capital recovery factor (1/6.81) Equivalent annual cost 0.15 24,016.00 (1/4.36) 4,925.00 0.23 5,508.00 As the equivalent annual cost is less for exe machine, it is better to purchase the same. Illustration 3. Company X is forced to choose between two machines A and B. The two machines are designed differently, but have identical capacity and do exactly the same job. Machine A costs 1,50,000 and will last for 3 years. It costs 40,000 per year to run. Machine B is an ‘economy’ model costing only 1,00,000, but will last only for 2 years, and costs 60,000 per year to run. These are real cash flows. The costs are forecasted in rupees of constant purchasing power. Ignore tax. Opportunity cost of capital is 10%. Which machine Company X should buy? Answer: Compound present value of 3 years @ 10% 2.486 P.V. of running cost of Machine A for 3 years 40,000 x 2.486 99,440 Compound present value of 2 years @ 10% 1.735 P.V. of running cost of Machine B for 2 years 60,000 x 1.735 1,04,100 Statement Showing Evaluation of Machines A and B ( ) Particulars Cost of purchase Add: P.V. of running cost for 3 years P.V. of Cash outflow Equivalent present value of annual cash outflow Machine A Machine B 1,50,000 1,00,000 99,440 1,04,100 2,49,440 2,04,100 2,49,440 2,04,100 2.486 1.735 1,00,338 1,17,637 Analysis: Since the annual cash outflow of Machine B is higher, Machine A can be purchased. THE INSTITUTE OF COST ACCOUNTANTS OF INDIA 5

Strategic Cost Management - Decision Making Illustration 4. Computation of Equivalent Annual Cost and Identification of Year to Replace the Machine A & Co. is contemplating whether to replace an existing machine or to spend money on overhauling it. A & Co. currently pays no taxes. The replacement machine costs 90,000 now and requires maintenance of 10,000 at the end of every year for eight years. At the end of eight years it would have a salvage value of 20,000 and would be sold. The existing machine requires increasing amounts of maintenance each year and its salvage value falls each year as follows: Amount ( ) Year Maintenance Salvage Present 0 40,000 1 10,000 25,000 2 20,000 15,000 3 30,000 10,000 4 40,000 0 The opportunity cost of capital for A & Co. is 15%. When should the company replace the machine? (Notes: Present value of an annuity of 1 per period for 8 years at interest rate of 15% : 4.4873; present value of 1 to be received after 8 years at interest rate of 15% : 0.3269) Answer: Calculation of Equivalent Annual Cost of New Machine Amount ( ) Cost of New Machine 90,000 Add: Present value of annual maintenance cost for 8 years ( 10,000 4.4873) Less: Present value of salvage value at the end of 8th year ( 20,000 0.3269) 44,873 1,34,873 Total present value of life cycle costs of new machine Equivalent Annual cost 1,28,335/4.4873 28,600 Calculation of Equivalent Annual cost in continuing with Existing Machine 6,538 1,28,335 1st Year Amount ( ) P.V. of salvage value at the beginning of 1st year 40,000 Add: P. V. of Maintenance cost (10,00/1.15) Less: P.V. of salvage value at the end of the year (25,000/1.15) 8,696 48,696 21,739 26,957 Equivalent Annual cost at the end of 1st year (26,957 1.15) 2nd Year 31,000 Amount ( ) P.V. of salvage value at the beginning of 2nd year 25,000 Add: P. V. of Maintenance cost (20,00/1.15) 17,391 Less: P.V. of salvage value at the end of the 2nd year (15,000/1.15) 13,043 42,391 29,348 Equivalent Annual cost at the end of 2 nd 6 year (29,348 1.15) 33,750 THE INSTITUTE OF COST ACCOUNTANTS OF INDIA

Cost Management 3rd Year Amount ( ) P.V. of salvage value at the beginning of 3rd year 15,000 Add: P. V. of Maintenance cost (30,00/1.15) 26,087 41,087 Less: P.V. of salvage value at the end of the 3rd year (10,000/1.15) 8,696 32,391 Equivalent Annual cost at the end of 3rd year (32,391 1.15) 4th Year 37,250 Amount ( ) P.V. of salvage value at the beginning of 4th year 10,000 Add: P. V. of Maintenance cost (40,00/1.15) 34,783 44,783 Less: P.V. of salvage value at the end of the 4th year Nil 44,783 Equivalent Annual cost at the end of 4 year (44,783 1.15) th 51,500 Analysis: Since the equivalent annual cost of new machine is lesser than that of existing machine, it is suggested to replace the existing machine with new machine. The equivalent annual cost of existing machine is higher in all the four years as compared to new machine. Illustration 5. A company is considering the purchase of a machine for 3,50,000. It feels quite confident that it can sell the goods produced by the machine as to yield an annual cash surplus of 1,00,000. There is however uncertainly as to the machine working life. A recently published Trade Association Survey shows that members of the Association have between them owned 250 of these machines and have found the lives of the machines vary as under: No. of year of machine life 3 4 5 6 7 Total No. of machines having given life 20 50 100 70 10 250 Assuming discount rate of 10% the net present value for each different machine life is follows: Machine life NPV ( ) 3 4 5 6 7 (1,01,000) (33,000) 29,000 86,000 1,37,000 You required to advice whether the company should purchase a machine or not. Answer: Computation of NPV of an asset considering the probability of life of machine. Year 3 4 5 6 7 Probability (a) 20/250 50/250 100/250 70/250 10/250 NPV (b) (1,01,000) (33,000) 29,000 86,000 1,37,000 Expected value (a b) (8,080) (6,600) 11,600 24,080 5,480 26,480 So, Assets should be purchased. THE INSTITUTE OF COST ACCOUNTANTS OF INDIA 7

Strategic Cost Management - Decision Making 1.2 TARGET COSTING Target Costing. Target Costing: This technique has been developed in Japan. It aims at profit planning. It is a device to continuously control costs and manage profit over a product’s life cycle. In short, it is a part of a comprehensive strategic profit management system. For a decision to enter a market prices of the competitors’ products are given due consideration. Target Costing initiates cost management at the earliest stages of product development and applies it throughout the product life cycle by actively involving the entire value chain. In the product concept stage selling price and required profit are set after consideration of the medium term profit plans, which links the operational strategy to the long term strategic plans. Target Cost Planned Selling Price - Required Profit. From this, the necessary target cost can be arrived at. Target cost, then, becomes the residual or allowable sum. If it is thought that the product cannot generate the required profit, it will not be produced as such and aspects of the product would be redesigned until the target is met. Value engineering and value analysis may be used to identify innovative and cost effective product features in the planning and concept stages. Throughout the product’s life target costing continues to be used to control costs. After the initial start up stage target costs will be set through short-period budget. Thus all costs including both variable and fixed overheads are expected to reduce on a regular (monthly) basis. Target profit is a commitment agreed by all the people in a firm, who have any part to play in achieving it. Features of Target Costing Target Costing is defined as “a structured approach in 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.” The main features or practices followed in Target Costing are Step 1 Identify the market requirements as regards design, utility and need for a new product or improvements of existing product. Step 2 Set Target Selling Price based on customer expectations and sales forecasts. Step 3 Set Target Production Volumes based on relationships between price and volume. Step 4 Establish Target Profit Margin for each product, based on the company’s long term profit objectives, projected volumes, and course of action, etc. Step 5 Set Target Cost ( or Allowable cost) per unit, for each product. Target cost Target selling price less Target profit margin Step 6 Determine Current Cost of producing the new product, based on available resources and conditions. Step 7 Set cost reduction Target in order to reduce the Current Cost to the Target Cost. Step 8 Analyze the Cost Reduction Target into various components and identify cost reduction opportunities using Value Engineering (VE) and Value Analysis (VA) and Activity Based Costing (ABC) Step 9 Achieve cost reduction and Target profit by Effective Implementation of Cost Reduction decisions Step 10 Focus on further possibilities of cost reduction ie Continuous Improvement program. Steps in Target Costing Target Costing is viewed as integral part of the design and introduction of new products. It is part of an overall Profit Management Process, rather than simply a tool for cost Reduction and Cost Management. Step 1: Customer product Design Specification: (a) The customer requirements as to the functionality and quality of the product is of prime importance (b) The design specification of the new product is based on customer’s tastes, expectations and requirements. 8 THE INSTITUTE OF COST ACCOUNTANTS OF INDIA

Cost Management (c) Competitor’s products and the need to have extra features over competitor’s products are also considered. However the need to provide improved products, without significant increase in prices, should be recognized as charging a higher price may not be possible in competitive conditions. Step 2 & Step 3: Market - Target Selling Price and Production Volume: (a) The Target Selling Price is determined using various sales forecasting techniques. (b) The price is also influenced by the offers of competitors, product utility, prices, volumes and margins. (c) In view of competition and elasticity of demand, the Firm has to forecast the price volume relationship with reasonable certainty. Hence the Target Selling Price is market driven and should encompass a realistic reflection of the competitive environment. (d) Establishment of Target Production Volumes is closely related to Target Selling price, given the relationship between price and volume. (e) Target Volumes are also significant in computation of unit costs particularly Capacity Related Costs and Fixed Costs. Product Costs are dependent upon the production levels over the life cycle of the product. Step 4: Profitability - Target Profit Margin: (a) Since profitability is Critical for survival, a Target Profit Margin is established for all new products. (b) The Target Profit Margin is derived from the company’s long term business plan, objectives and strategies. (c) Each product or product line is required to earn atleast the Target Profit Margin. Step 5: Setting Target Costs: (a) The difference between the Target Selling Price and Target Profit Margin indicates the “Allowable Cost” for the product. (b) Ideally, the Allowable Cost becomes the “Target Cost for the product”. However, the Target Cost may exceed the Allowable Cost, in light of the realities associated with existing capacities and capabilities. Step 6: Computing Current Costs: (a) The “Current Costs” for producing the new product should be estimated. (b) The estimation of Current Cost is based on existing technologies and components, taking into account the functionalities and quality requirements of the new product. (c) Direct Costs are determined by reference to design specifications, materials prices, labour processing time and wage rates. Indirect Costs may be estimated using Activity Based Costing Principles. Step 7: Setting Cost Reduction Targets: (a) The difference between Current Cost and Target Cost

1. Cost Management Section B : Strategic Cost Management Tools and Techniques 50% 2. Decisions Making Techniques 3. Standard Costing in Profit Planning 4. Activity Based Cost Management - JIT and ERP 5. Cost of Quality and Total Quality Management Section C : Strategic Cost Management - Application of Statistical Techniques in Business .

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