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The aim of traditional absorption costing methods is to determine the full production cost per
unit. It is relatively easy to estimate the direct material and direct labor cost per unit. However, it
is much more difficult to estimate the production overhead per unit. It is an indirect cost and very
in nature it is difficult to know how much contained in each unit. So the absorption costing
method used the unit produce, machine hours or labor hours as bases of in the calculation of
overhead absorption rate (OAR) as activity level. The assumption of this method of costing is
that all overhead expenditures are connected to the volume produce.

The reason to the development of activity based costing


The production was much more labor intensive in traditional manufacturing

The production was much more a labor intensive as a result relatively mach more direct cost
proportion to overhead costs so a rough estimation of overhead cost per it make much difference.

Produce single and simple products in traditional manufacturing

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Target costing involve setting a target cost by subtracting a desired profit from competitive
market price.

The traditional cost plus pricing system

The cost of the product first established and then the required profit add to the cost to determine
the selling price of a product. This system ignores

1.Y The price that customer are willing to pay price of the product too high could result in lower
sales volume and profit.
2.Y The price charged by the competitors for similar product. If the competitor are charging less
than price for similar product then customers may decide to buy their product from
competitor companies.
3.Y The cost of the product is established but there is little incentive to control this cost.

Target costing

The first step is to establish a competitive market price. The company would consider how much
customers are willing to pay and how much competitors are charging for similar product and
then deduct their required profit from the selling price to determine the target cost after that must
take close the target cost gap from the current costs.
The steps used in deriving a target cost

1.Y Vstimate a selling price for a new product that considers how much competitors are
charged and how much customers are willing to pay. This selling price will enable a firm
to capture a required share of the market.
2.Y Reduce the first figure by the firm¶s required level of profit. This could take into accunt
the investment and on working capital requirement or could involve a target margin on
sales.
3.Y roduce a target cost figure for product designers to meet.
4.Y Reduce costs to provide a product that meets that target cost.

Closing the target cost gap

Target cost gap=Vstimated product cost ± target cost

It is the difference between what an organization thinks it can current make a product for and
what it needs to make it for in order to make a required profit.

Alternative product designs should be examined for potential areas of cost reduction that will not
compromise the quality of the products.

The implications of using target costing on pricing, cost control and performance
management

Pricing

Target costing is usually considered superior to cost plus pricing as it consider the demand for a
product or service as long as the estimate for demand at the target price are accurate and costs are
controlled then organization will chive its required return on investment.