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Cost Management

Cost management means planning and controlling what things cost. Standard costing sets the cost one item should have and measures variances (actual minus standard). Direct standard costing counts only variable costs in product cost. Target costing starts from the market price: target cost = price - desired profit. Activity-based costing shares overhead by the activities that cause it. Quality costing adds up prevention, checking and failure costs.

🎬 Step-by-step story

  1. Look at the blue, green and orange stack. It is the standard cost of one item: materials 40, labour 30, overhead 30. Total 100. This is what it SHOULD cost.
  2. Now the real cost stack stands beside it. Materials cost 52, not 40. Total is 112. The gap of 12 is the variance. Red means we spent more than planned.
  3. Target costing turns it around. The market will pay 120. We want 20 profit. So the cost must be only 100. Price minus profit is the target cost.
  4. Activity-based costing: the overhead pool of 40 is not split equally. The simple item uses little of the factory work, so it gets 10. The complex item uses a lot, so it gets 30.
  5. Quality costs: a little spent on prevention and checking is cheap. Mistakes found inside the factory cost more. Mistakes found by customers cost the most.
  6. Your turn. Move the slider for actual material cost. Watch the variance turn adverse (more spent) or favourable (less spent).

Tip: drag the 3D scene to turn it. Use two fingers to zoom.

🤔 Common doubts, cleared

Why do we set a standard when the real cost is different anyway?

The standard is a yardstick. Without it you cannot tell whether 112 is good or bad. See the two stacks side by side.

Is a favourable variance always good news?

No. Cheaper cloth may be poor quality. Ask why before you celebrate. Slide the cost lower in free play and think about the reason.

Why does target costing start from the price?

Because customers decide the price, not the firm. If we cannot cut cost to the target, we may not make the product. The purple profit slice is fixed first.

Why not share overhead equally among products?

The complex item uses far more of the factory activity. Equal sharing makes the simple item too dear and the complex item too cheap.

Is spending on prevention a waste?

No. The short prevention bars cost far less than the tall failure bars.

What is the difference between standard and direct standard costing?

Direct standard costing leaves out fixed overhead from the unit cost. Only the variable parts of the stack count.

Standard costing and variances

A standard cost is the cost we plan for ONE unit. It is set from past data and good estimates: how much material, how many labour hours, and what price and wage.

After production we compare the actual cost with the standard. The difference is the variance. If actual is more than standard, the variance is adverse (A). If actual is less, it is favourable (F).

Variances tell managers where to look. They are a signal, not a verdict.

Direct standard costing

In direct standard costing (also called variable standard costing), only the variable costs are put into the standard product cost: direct materials, direct labour and variable overhead. Fixed costs such as rent are not spread over units. They are written off as a cost of the period.

Why do this? Fixed cost does not change when output changes, so spreading it makes a unit look cheaper when you make more and dearer when you make less. Leaving it out gives a cleaner base for short-term decisions and for the contribution (price - variable cost).

Target costing

Normal costing asks "what does it cost, so what price?" Target costing asks the other way: "what price will customers pay, so what may it cost?"

Target cost = expected selling price - desired profit

If the current design costs more than the target, the team looks for savings in design, materials, process and suppliers until the gap closes. Most of a product's cost is fixed in the design stage, so the work starts early.

Activity-based costing (ABC)

Old methods share overhead using one number, such as labour hours. That is unfair when a product is complex. ABC follows cause and effect:

  1. List the main activities (set-ups, inspections, orders, deliveries).
  2. Collect the overhead of each activity in a cost pool.
  3. Find the cost driver (number of set-ups, inspections...).
  4. Rate = pool cost / total driver units.
  5. Charge each product: rate x driver units it uses.

Products that use more activities now carry more overhead, so prices and decisions become more honest.

Quality costing

Cost of quality has four parts. Prevention (training, good design) and appraisal (inspection, testing) are costs of good quality. Internal failure (scrap, rework found before sale) and external failure (returns, repairs, lost trust after sale) are costs of poor quality.

The usual finding: a rupee spent on prevention saves several rupees of failure cost. External failure is the most costly of all.

Try it: find your own variance

Plan a lemonade for 4 friends: 8 lemons at Rs 5 each, sugar Rs 10. Standard cost = Rs 50. Now make it and note the real spend. Is the variance adverse or favourable? Was it price (lemons dearer) or usage (you used 10 lemons)? In the 3D, move the slider and watch the red stack.

Key formulas and definitions

Worked examples

1. Standard price of wool is Rs 10/kg. The firm buys 500 kg at Rs 12/kg. Find the material price variance.

(12 - 10) x 500 = Rs 1,000. Actual price is higher, so it is ADVERSE.

2. For the actual output the standard quantity is 480 kg. The firm used 500 kg. Standard price Rs 10/kg. Find the usage variance.

(500 - 480) x 10 = Rs 200 ADVERSE. It used more wool than it should have.

3. Standard wage Rs 50/hour. Actual wage Rs 48/hour for 200 hours. Find the labour rate variance.

(48 - 50) x 200 = -Rs 400, so Rs 400 FAVOURABLE.

4. A bag sells in the market for Rs 1,500. The firm wants a profit of 20% of the price. Find the target cost.

Profit = 20% of 1,500 = 300. Target cost = 1,500 - 300 = Rs 1,200.

5. Set-up overhead pool is Rs 60,000 for 30 set-ups. Product A needs 5 set-ups, product B needs 25. How much overhead does each get?

Rate = 60,000 / 30 = Rs 2,000 per set-up. A: 5 x 2,000 = Rs 10,000. B: 25 x 2,000 = Rs 50,000.

6. A firm spends: prevention 5,000; appraisal 3,000; internal failure 8,000; external failure 14,000. What share of total quality cost is failure cost?

Total = 30,000. Failure = 8,000 + 14,000 = 22,000. Share = 22,000 / 30,000 = 73% (about).

Common mistakes

Practice quiz

1. A standard cost is:
2. Actual cost 112, standard cost 100. The variance is:
3. Target cost equals:
4. In ABC, overhead is shared using:
5. Which is the costliest quality cost?

Practice: answer these yourself

Type or choose your answer, then press Check. Use a hint if you are stuck; the full solution appears after you answer.

Frequently asked questions

What is standard costing in simple words?

You decide in advance what one item should cost, then compare with the real cost. The difference is called variance and shows where to improve.

How is target costing different from cost-plus pricing?

Cost-plus adds profit to the cost to get a price. Target costing starts from the price customers accept, subtracts profit, and forces the cost down to that level.

Why is activity-based costing more accurate?

It charges overhead according to the activities each product really uses, not a single rate such as labour hours.

Where this is taught

Japan高校（専門学科）1〜3年Management Accounting

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