Chapter 21 Cost Management by Ax2YAZF


									                           Chapter 2b Target Costing

Question 1 – Target Costing
Edward Co assembles and sells many types of radio. It is considering extending its
product range to include digital radios. These radios produce a better sound quality
than traditional radios and have a large number of potential additional features not
possible with the previous technologies (station scanning, more choice, one touch
tuning, station identification text and song identification text etc).

A radio is produced by assembly workers assembling a variety of components.
Production overheads are currently absorbed into product costs on an assembly labour
hour basis.

Edward Co is considering a target costing approach for its new digital radio product.


(a)   Briefly describe the target costing process that Edward Co should undertake.
                                                                              (3 marks)
(b)   Explain the benefits to Edward Co of adopting a target costing approach at such
      an early stage in the product development process.                      (4 marks)
(c)   Assuming a cost gap was identified in the process, outline possible steps Edward
      Co could take to reduce this gap.                                       (5 marks)

A selling price of $44 has been set in order to compete with a similar radio on the
market that has comparable features to Edward Co’s intended product. The board
have agreed that the acceptable margin (after allowing for all production costs) should
be 20%.

Cost information for the new radio is as follows:

Component 1 (Circuit board) – these are bought in and cost $4·10 each. They are
bought in batches of 4,000 and additional delivery costs are $2,400 per batch.

Component 2 (Wiring) – in an ideal situation 25 cm of wiring is needed for each
completed radio. However, there is some waste involved in the process as wire is
occasionally cut to the wrong length or is damaged in the assembly process. Edward
Co estimates that 2% of the purchased wire is lost in the assembly process. Wire costs

                                          P. 1
$0·50 per metre to buy.

Other material – other materials cost $8·10 per radio.

Assembly labour – these are skilled people who are difficult to recruit and retain.
Edward Co has more staff of this type than needed but is prepared to carry this extra
cost in return for the security it gives the business. It takes 30 minutes to assemble a
radio and the assembly workers are paid $12·60 per hour. It is estimated that 10% of
hours paid to the assembly workers is for idle time.

Production Overheads – recent historic cost analysis has revealed the following
production overhead data:

                    Total production overhead         Total assembly labour hours
Month 1                      620,000                              19,000
Month 2                      700,000                              23,000

Fixed production overheads are absorbed on an assembly hour basis based on normal
annual activity levels. In a typical year 240,000 assembly hours will be worked by
Edward Co.


(d)   Calculate the expected cost per unit for the radio and identify any cost gap that
      might exist.                                                          (13 marks)
                                                              (Total 25 marks)
                           (ACCA F5 Performance Management December 2007 Q1)

Question 2 – Target Costing and Learning Curve
Big Cheese Chairs (BCC) manufactures and sells executive leather chairs. They are
considering a new design of massaging chair to launch into the competitive market in
which they operate.

They have carried out an investigation in the market and using a target costing system
have targeted a competitive selling price of $120 for the chair. BCC wants a margin
on selling price of 20% (ignoring any overheads).

                                          P. 2
The frame and massage mechanism will be bought in for $51 per chair and BCC will
upholster it in leather and assemble it ready for despatch.
Leather costs $10 per metre and two metres are needed for a complete chair although
20% of all leather is wasted in the upholstery process.

The upholstery and assembly process will be subject to a learning effect as the
workers get used to the new design. BCC estimates that the first chair will take two
hours to prepare but this will be subject to a learning rate (LR) of 95%. The learning
improvement will stop once 128 chairs have been made and the time for the 128th
chair will be the time for all subsequent chairs. The cost of labour is $15 per hour.

The learning formula is shown on the formula sheet and at the 95% learning rate the
value of b is –0·074000581.


(a)   Calculate the average cost for the first 128 chairs made and identify any cost
      gap that may be present at that stage.                               (8 marks)
(b)   Assuming that a cost gap for the chair exists suggest four ways in which it could
      be closed.                                                             (6 marks)

The production manager denies any claims that a cost gap exists and has stated that
the cost of the 128th chair will be low enough to yield the required margin.

(c)   Calculate the cost of the 128th chair made and state whether the target cost is
      being achieved on the 128th chair.                                   (6 marks)
                                                               (Total 20 marks)
                            (ACCA F5 Performance Management December 2009 Q2)

                                           P. 3
Question 3 – Target Costing and Life Cycle Costing
GEEWHIZZ, a manufacturer of computer games, has developed a new game called
the Action Accountant (AA). This is an interactive 3D game and is the first of its kind
to be introduced to the market. GEEWHIZZ is due to launch the AA in time for the
peak selling season.

GEEWIZZ has been using a traditional absorption costing system to calculate costs
and price its products. The new management accountant believes that this is
inappropriate for this company and is arguing for a new approach to be adopted.


(a)   Discuss how the following techniques could have been applied to the AA.
      (i) Life cycle costing
      (ii)   Target costing
                                                                            (10 marks)

A few months later, GEEWHIZZ is in the process of introducing another new game,
the Laughing Lawyer (LL) and has undertaken market research to find out about
customers' views on the value of the product and also to obtain a comparison with
competitors' products. The results of this research have been used to establish a target
selling price of €55 and a projected lifetime volume of 200,000 games.

Cost estimates have also been prepared based on the proposed product specification.
Manufacturing cost                                         €
Direct material                                          3.21
Direct labour                                              4.23
Direct machinery costs                                     1.12
Ordering and receiving                                     0.23
Quality assurance                                          4.60
Design                                                    19.80
Non-manufacturing costs
Marketing                                                  8.15
Distribution                                               3.25
After-sales service and warranty costs                     1.30

The target profit margin for the LL is 30% of the proposed selling price.

                                          P. 4

(b)   Calculate the target cost of the LL and discuss the implications of the result.
      Explain the limitations of target costing for GEEWIZZ.               (7 marks)
(c)   Briefly explain how and why market research is used by companies such as
      GEEWHIZZ.                                                            (3 marks)
                                                                    (Total 20 marks)

                                         P. 5

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