Test your understanding 7
LMN Ltd makes and sells two products, X and Y. Both products are manufactured through two consecutive processes – assembly and finishing. Raw material is input at the commencement of the assembly process. An ABC approach is used in the absorption of product specific conversion costs.
The following estimated information is available for the period ending 31 December 20x5:
Product XProduct Y
Production/sales (units)12,0007,200
Selling price per unit$75$90
Direct material cost per unit$20$20
ABC variable conversion cost per unit
- assembly$20$28
- finishing$12$24
Product-specific fixed costs$170,000$90,000
Company fixed costs$50,000
LMN Ltd uses a minimum contribution/sales (C/S) ratio target of 25% when assessing the viability of a product. In addition, management wish to achieve an overall net profit margin of 12% on sales in this period in order to meet return on capital targets.
Explain how target costing may be used in achieving the required returns and suggest specific areas of investigation.
2.3 The difficulties of using target costing in service industries
Target costing was introduced by major Japanese manufacturers for use in a manufacturing environment where:
§ a new product was to be designed to meet the target cost
§ a substantial part of the production cost consisted of bought-in materials.
§ This environment facilitates use of a target cost approach since:
§ Professional design teams can alter the design specification of a new product until it matches their cost requirements.
§ Very large manufacturers such as Sony and Toyota are able to exert considerable pressure on (usually much smaller) suppliers to reduce their prices.
Service industries (e.g. banking, insurance, travel) provide a less favourable environment for the use of target costing:
§ It is much more difficult to make service comparisons than product comparisons, making it harder to determine a market driven price in the first place.
§ The introduction of new products and services in service industries usually occurs far less frequently than in manufacturing environment (e.g. Sony and Toyota introduce new models on a regular basis) and, in consequence, the equivalent of manufacturing design teams are rarely found in service industries.
§ Bought in materials are usually of modest significance so there is little scope for exerting pressure on external suppliers.
§ The major cost of any new product or service is salaries and unless lower cost delivery mechanisms (e.g. the internet) or radically different ways of working can be exploited there is limited scope for substantial cost reduction.
