Types of Strategic Costing and Their Relevance
Types of Strategic Costing and Their Relevance: Introduction
Strategic costing is the process of using cost information to support an organization’s long-term strategic objectives, competitive advantage, and value creation. Unlike traditional costing, which mainly focuses on determining product costs, strategic costing considers factors such as customer expectations, competition, product life cycle, quality, and business processes.
The major types of strategic costing include:
- Target Costing
- Activity-Based Costing (ABC)
- Life Cycle Costing
- Quality Costing
1. Target Costing
Meaning
Target costing is a market-oriented costing technique in which the company determines the allowable cost of a product based on the market price and desired profit.
Formula
Target Cost = Target Selling Price − Desired Profit
For example, if the expected market price of a product is ₹1,000 and the company wants a profit of ₹200:
Target Cost = ₹1,000 − ₹200 = ₹800
Therefore, the company must design and produce the product at a cost of ₹800 or less.
Features
- Market-oriented.
- Customer-focused.
- Begins with the selling price rather than the cost.
- Focuses on cost reduction during product design.
- Encourages cross-functional teamwork.
- Considers competitors and customer expectations.
Relevance of Target Costing
Target costing is relevant because it:
- Helps maintain competitive prices.
- Ensures the desired profit margin.
- Encourages cost reduction before production begins.
- Helps design products according to customer requirements.
- Reduces the possibility of producing products that are too expensive for the market.
- Supports long-term competitive strategy.
Example
If competitors sell a similar product for ₹5,000, a company cannot simply add its desired profit to a high production cost and expect customers to pay more. Target costing starts with the competitive market price and works backward to determine the maximum acceptable cost.
2. Activity-Based Costing (ABC)
Meaning
Activity-Based Costing (ABC) is a costing technique that assigns overhead costs to products or services based on the activities that cause those costs.
Traditional costing often allocates overhead using broad measures such as direct labour hours or machine hours. ABC recognizes that different activities consume resources differently.
Basic Process of ABC
Resources → Activities → Cost Drivers → Products/Services
For example:
- Purchasing → Number of purchase orders
- Quality inspection → Number of inspections
- Machine setup → Number of setups
- Material handling → Number of material movements
Features
- Focuses on activities.
- Uses appropriate cost drivers.
- Provides more accurate product-cost information.
- Identifies costly and inefficient activities.
- Helps management understand the causes of overhead costs.
Relevance of ABC
ABC is relevant because it:
- Improves the accuracy of product costing.
- Helps identify profitable and unprofitable products.
- Supports pricing decisions.
- Identifies activities that do not add value.
- Helps reduce unnecessary overhead costs.
- Improves resource allocation.
- Supports decisions such as outsourcing, product mix, and process improvement.
Example
Suppose Product A requires 10 machine setups while Product B requires only 2. Allocating all setup costs simply according to production volume may distort product costs. ABC assigns setup costs based on the actual number of setups, giving management better information.
3. Life Cycle Costing
Meaning
Life Cycle Costing considers the total cost of a product over its entire life cycle, rather than focusing only on manufacturing costs.
A product’s life cycle generally includes:
Research & Development → Design → Introduction → Growth → Maturity → Decline → Disposal
Costs can include:
- Research and development
- Product design
- Testing
- Production
- Marketing
- Distribution
- Customer service
- Warranty
- Maintenance
- Disposal
Features
- Takes a long-term perspective.
- Covers the entire product life.
- Helps identify costs early.
- Integrates product design and cost management.
- Focuses on total profitability rather than short-term production cost.
Relevance of Life Cycle Costing
It is relevant because:
- A large proportion of a product’s total cost may be determined during the design stage.
- Helps management identify cost-saving opportunities early.
- Supports pricing and profitability decisions.
- Helps determine whether a product will be profitable over its entire life.
- Encourages better product design.
- Helps manage warranty, service, and disposal costs.
- Supports decisions about product introduction, modification, and withdrawal.
Example
A company may manufacture a machine at a relatively low cost, but if it requires expensive maintenance and warranty support throughout its life, the total life-cycle cost may be high. Life cycle costing captures these costs.
4. Quality Costing
Meaning
Quality costing measures the costs associated with achieving, maintaining, or failing to achieve the required level of product or service quality.
Quality costs are generally classified into four categories:
A. Prevention Costs
Costs incurred to prevent defects from occurring.
Examples:
- Employee training
- Quality planning
- Supplier evaluation
- Process improvement
- Preventive maintenance
B. Appraisal Costs
Costs incurred to detect defects or ensure that quality standards are being met.
Examples:
- Inspection
- Testing
- Quality audits
- Product verification
C. Internal Failure Costs
Costs arising from defects discovered before the product reaches the customer.
Examples:
- Scrap
- Rework
- Retesting
- Production downtime
D. External Failure Costs
Costs arising from defects discovered after the product reaches the customer.
Examples:
- Warranty claims
- Product returns
- Repairs
- Customer complaints
- Compensation
- Loss of reputation and future sales
Relevance of Quality Costing
Quality costing is relevant because it:
- Helps reduce defects.
- Improves customer satisfaction.
- Reduces warranty and return costs.
- Identifies the cost of poor quality.
- Supports continuous improvement.
- Improves brand reputation.
- Helps balance prevention costs against failure costs.
- Can improve long-term profitability.
Important Principle
Spending more on prevention and appraisal can reduce much larger internal and external failure costs.
Comparison of Strategic Costing Techniques
- Main Focus: Target Costing (Achieving target cost) | ABC (Accurate allocation of overhead) | Life Cycle Costing (Total product cost) | Quality Costing (Cost of achieving/failing quality)
- Starting Point: Target Costing (Market price) | ABC (Activities) | Life Cycle Costing (Entire product life) | Quality Costing (Quality-related activities)
- Major Objective: Target Costing (Competitive cost and desired profit) | ABC (Accurate cost information) | Life Cycle Costing (Long-term profitability) | Quality Costing (Reduce cost of poor quality)
- Time Perspective: Target Costing (Mainly design/pre-production) | ABC (Ongoing operations) | Life Cycle Costing (Entire product life) | Quality Costing (Ongoing)
- Key Question: Target Costing (“What should the product cost?”) | ABC (“What activities cause the cost?”) | Life Cycle Costing (“What will the product cost over its life?”) | Quality Costing (“What does quality and poor quality cost us?”)
- Strategic Benefit: Target Costing (Competitive pricing) | ABC (Better resource allocation) | Life Cycle Costing (Long-term cost control) | Quality Costing (Better quality and customer satisfaction)
Overall Relevance of Strategic Costing
These techniques help management move from traditional cost control to strategic cost management.
Their combined contribution can be understood as:
Target Costing
↓
Determines the acceptable cost based on market conditions
ABC
↓
Identifies the activities causing costs
Life Cycle Costing
↓
Measures costs throughout the product’s life
Quality Costing
↓
Controls the cost of achieving and failing to achieve quality
Result:
Lower Costs + Better Quality + Competitive Prices + Higher Profitability + Long-Term Value Creation