Alternative costing principles - Target and life-cycle costi...

Learning Outcomes

After reading this article, you will be able to explain the rationale and principles of alternative costing approaches, focusing on target costing and life-cycle costing. You will distinguish these methods from traditional costing techniques, understand their purpose, process, and benefits, and identify when each method is appropriate for managing product costs and profitability in line with ACCA exam requirements.

ACCA Management Accounting (MA) Syllabus

For ACCA Management Accounting (MA), you are required to understand alternative costing methods used in modern organisations. When preparing for the exam, focus on:

• Explaining target costing and life-cycle costing as alternative cost management techniques
• Differentiating target costing and life-cycle costing from traditional costing techniques
• Recognising the practical application and limitations of each method
• Identifying in which situations each method is most suitable for product cost management

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is determined first in target costing?
   1. Allowable product cost
   2. Required profit margin
   3. Market price
   4. Actual production cost
2. Which of the following best describes life-cycle costing?
   1. Considers only manufacturing costs
   2. Tracks all costs from product design to withdrawal
   3. Ignores marketing expenses
   4. Focuses only on distribution costs

3. True or false? In target costing, a business sets the selling price by adding a markup to the estimated cost of production.

4. State one key difference between life-cycle costing and traditional absorption costing.

Introduction

Modern product environments often require organisations to look beyond traditional cost management. With competitive markets, shorter product lives, and significant costs arising in R&D or after sales, standard costing systems may fail to give an accurate picture of total product costs or the right basis for decision making. Alternative approaches—such as target costing and life-cycle costing—offer better tools for planning, controlling, and optimising profitability over the entire life of a product.

Key Term: absorption costing
A costing method where direct costs and a share of overheads are allocated to products, usually using a volume-based measure such as labour or machine hours.

ALTERNATIVE COSTING PRINCIPLES: WHY THEY ARE NEEDED

Traditional absorption costing assigns costs mainly based on production activity (e.g. number of units or hours). However, as products and processes grow more complex, a large proportion of costs may not relate directly to volume—such as design, setup, or support costs. These can be overlooked if only production costs are considered.

Target costing and life-cycle costing provide more effective control for modern product costing challenges:

• Target costing is market-focused, setting a maximum allowable cost based on future selling prices and desired profit.
• Life-cycle costing considers all costs incurred over the entire product life, not just during manufacturing.

TARGET COSTING

Target costing is used mainly during the development and design phase of a product. It ensures that products can be produced at a cost which makes them profitable—given the price customers are willing to pay.

Key Term: target costing
A technique where a business determines the target cost for a product by subtracting the required profit from a competitive market price.

The target costing process

1. Determine the expected market price: What are customers prepared to pay?
2. Deduct the required profit margin: Management sets a target profit per unit.
3. Calculate the target cost: Target cost = Market price – Required profit
4. Design to meet the target: Product design, engineering, and sourcing processes are modified to ensure the cost does not exceed the target.
5. Review and refine: The process is repeated as necessary to achieve the target.

Key Term: required profit margin
The minimum profit set by management for each unit sold, based on business objectives and investment needs.

Worked Example 1.1

A company plans to launch a new fitness tracker. Market research suggests a realistic price of $80 per unit. The business wants a profit margin of 20% on sales.

Question: What is the maximum allowable cost per unit?

Answer:
Required profit = $80 × 20% = $16
Target cost = $80 – $16 = $64
The highest permissible cost is $64 per unit.

Features and benefits of target costing

• Focuses managers on cost control early, when most design choices are made
• Encourages teamwork between marketing, design, and operations
• Improves chances of meeting profit objectives at market-driven prices
• Reduces the risk of making loss-making products

Limitations of target costing

• May force lower product specifications to meet tight cost targets
• Can create pressure for suppliers to reduce their prices
• Not suitable where there is little information about customer willingness to pay or competitive prices

Exam Warning

Students often mistake target costing for traditional cost-plus pricing. In target costing, the sales price comes from external market analysis—not by adding a mark-up to estimated costs.

LIFE-CYCLE COSTING

Life-cycle costing analyses and manages all costs linked to a product, from conception to withdrawal. Many important decisions that affect long-term profitability are made before manufacturing even begins.

Key Term: life-cycle costing
A technique that records and manages a product’s total costs across all stages—design, development, production, support, and withdrawal.

Product life-cycle stages

1. Development: Market research, design, and concept testing. High initial costs, no revenue.
2. Introduction: Launch; often high marketing and promotional expenditure.
3. Growth: Sales and production volumes increase, costs may fall due to learning or scale effects.
4. Maturity: Sales stabilise; competition may increase, margin pressure rises.
5. Decline: Demand falls, product is phased out; may face end-of-life costs such as disposal or decommissioning.

Key Term: product life cycle
The full sequence from initial idea through launch, growth, maturity, and eventual withdrawal of a product.

Purpose and uses of life-cycle costing

• Allows management to measure profitability over the whole product life, not just per year
• Captures all relevant costs, including development, marketing, support, and end-of-life
• Informs decisions on pricing, investment appraisal, and resource allocation

Worked Example 1.2

A company introduces a kitchen appliance. Initial development costs are $120,000. Production costs are $45 per unit; marketing, customer support, and withdrawal costs total $75,000 over the product’s three-year life. Annual sales are forecast at 5,000 units, with a selling price of $70, for three years.

Question: What is the total life-cycle profit?

Answer:
Total costs:
Development: $120,000
Production: 5,000 units × $45 × 3 years = $675,000
Other (marketing, support, withdrawal): $75,000
Total = $870,000
Total revenue:
5,000 units × $70 × 3 years = $1,050,000
Life-cycle profit: $1,050,000 – $870,000 = $180,000

Why life-cycle costing matters

• Many product costs are committed before launch (e.g. design, setup)
• Some costs (maintenance, disposal) may occur after sales peak or end
• Only by viewing costs over the full life can profit be planned and managed accurately

Benefits and limitations of life-cycle costing

Benefits:

• Encourages long-term profit planning
• Supports investment decisions (e.g. whether to design for cheaper maintenance)
• Exposes hidden or overlooked costs

Limitations:

• Long-term predictions for sales or costs may be uncertain
• Requires co-operation between many business areas (design, marketing, operations)

Worked Example 1.3

A company launches office printers. Traditional costing included only production and distribution costs in the selling price, ignoring three years of included warranty repairs. In practice, after-sales support costs led to an overall loss on the product.

Question: How might life-cycle costing have changed the company’s pricing?

Answer:
If life-cycle costing had been applied, warranty and repair costs would have been estimated and included when setting the initial price or profit target. This might have justified a higher price, a more robust design, or a decision not to launch at all.

COMPARISON: TARGET AND LIFE-CYCLE COSTING VS TRADITIONAL COSTING

WHEN TO USE EACH COSTING METHOD

• Use target costing when launching new products in price-competitive markets or where early-stage cost control is critical.
• Use life-cycle costing for products with significant non-production costs, long lifespans, or substantial after-sales or environmental costs.
• Use traditional costing for reporting or where manufacturing overheads closely track production volume.

Revision Tip

Practice distinguishing between cost-plus and target costing in exam questions—a common area of confusion.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain why alternative costing methods are important in modern organisations
• Describe and apply the purpose and steps of target costing
• Explain the principle and application of life-cycle costing
• Compare and contrast alternative and traditional costing methods
• Identify when to use target costing, life-cycle costing, or traditional costing in business scenarios

Key Terms and Concepts

• absorption costing
• target costing
• required profit margin
• life-cycle costing
• product life cycle