Target costing

Traditionally, in the commercial sector, unit product costs have been ascertained in order to (among other things) facilitate pricing decisions. Target costing, which is largely of Japanese origin, puts this into reverse by starting with the “right price” (given market conditions and competitors’ prices) and deriving from this a unit product cost which will generate an acceptable level of profit. This approach, known as target costing, has many definitions but, perhaps, the clearest is as follows.

A cost management tool for reducing the overall cost of a product over its entire life-cycle with the help of production, engineering, research and design.

Thus, a target cost is the maximum amount of cost that can be incurred on a product such that the organisation can still earn the required profit margin from selling that product at the market price.

The target cost for a product is calculated by subtracting the target profit from a predetermined selling price based on customers’ views about willingness to pay. Once this cost is established, the organisation needs to be able manufacture the product for that amount.

One option available to the manufacturer would be to conduct a value engineering exercise in order to redesign the product so that its value to the customer is enhanced, while its costs are reduced. Value engineering is a complete audit of a product or service that takes place while that product or service is still on the drawing board. In some cases, it could lead to a complete redesign. At the same time cognisance would need to be taken of any statutory requirements or customer preferences in undertaking this exercise.

A well-known example of target costing being used in this way concerned the manufacture of the low-priced automobile, the Tata Nano in India. The initial objective of the company was to develop a product for people who want to move from two-wheeler to four-wheeler at affordable price – this implied being able to supply a car at around 1,000,000 Indian rupees. The car was to be developed in relation to three main factors: cost, safety and compliance with regulatory requirements. Thus, the car had to be developed on the basis of low cost, safety, low on emissions and fuel efficient and needed to be seen as a truly people’s car.

At first thought target costing might not seem appropriate to public services since most public services do not have a market price let alone deduct a profit margin to get a target price. However, this is not necessarily true for a number of reasons.

First, in some situations, public service organisations do work in a competitive market where there is a ruling price and so target pricing can be as applicable here as in the commercial sector. Take for example the delivery of a programme of short courses at a college. Using a form of target costing, the following approach could be applied:

• Identify or estimate the likely price the client is prepared to pay for the programme.

• Identify the target cost envelope for the course programme taking account of the financial surplus required.

• Identify the current costs of delivering such courses at the college.

• Make changes to current approaches to course delivery to get inside the cost envelope. In doing this, client requirements and professional standards need to be maintained.

Second, even where there is no competitive market, public service organisations do have to deliver services in an environment of scarce resources, particularly during a period of austerity. In Chapter 2 on operations management, it was noted that a key aspect of operations management, which precedes service delivery, was that of service design. Thus, a form of target costing could be used to design (or redesign) services that will fit the resources available rather than the other way around.

There are many situations where the same public services show large-scale cost variations across different providers with no obvious reason for the differences. One example of this concerns imaging services in hospitals (Prowle 2007) which suggested large-scale variations in imaging procedure costs between different hospitals for the same type of imaging scan (e.g. CT, X-ray, ultrasound). In this situation a target costing approach might be used in order to reduce imaging costs:

• Establish the costs of delivering imaging activities at different hospitals.

• Establish the quality of imaging work being achieved.

• Choose a target cost in line with comparable hospitals but with some efficiency savings.

• Review existing operational processes (stages, staffing, timing etc.) applied in undertaking imaging scans.

• Identify process changes which would reduce costs while maintaining quality standards.

• Implement and monitor the revised changes.

Target costing would probably be seen as alien to many public service professionals as normal practice is to identify client needs and then use the resources available to meet those needs, probably using what might be seen as traditional approaches. Target costing turns this on its side by first identifying the resources that should be spent delivering a service (based on comparisons with others etc.) and designing a service to meet client needs based around this cost envelope.

Life-cycle costing (LCC)

In the commercial sector, conventional product costing methods such as absorption costing or activity-based costing were designed to ascertain the cost of manufacturing a product or providing a service. However, many other costs which are involved in developing, launching and supporting a product or service during its life cycle are ignored. Some costs, such as design, development and setting up the production/delivery process, are incurred prior to manufacture. Other costs are incurred after manufacture, such as distribution and after-sales service. There may also be costs involved in the eventual dropping of the product at the end of its life cycle.

Conventional accounting systems account for such costs on a calendar/time basis to which they relate, they are treated as expenses in the income and expenditure account of the period in which they are incurred. In order to understand the true costs of a product or service, however, such costs should be tracked and assigned to the product/service from the beginning to end of its life. Revenues earned during its life cycle can also be tracked and, by comparing these with the accumulated costs, the true longer-term profitability of the product can be evaluated.

With regard to public services, incorporating LCC into decision making will provide public service organisations with the opportunity to demonstrate the best value for money across the asset life cycle. Key cost aspects concern:

• Acquisition

• Use

• Maintenance

• End-of-life disposal

Life-cycle costing in public services can be defined as an assessment which considers all agreed projected significant and relevant cost flows over a period of analysis. The projected costs are those needed to achieve defined levels of performance, including reliability, safety and availability. The use of LCC is essential to demonstrate that decisions have moved beyond just considering the initial cost of a service which does not reflect the financial and non-financial gains that are offered by using environmentally and socially preferable assets as they accrue during the operations and use phases of the life cycle.

Typical LCC analyses are therefore are based on:

• purchasing costs and all associated costs such as delivery, installation, commissioning and insurance;

• operating costs, including utility costs such as energy and water use and maintenance costs;

• end-of-life costs such as removal, recycling or refurbishment and decommissioning.

Now LCC methods have been well known in the public sector for many years, but such life-cycle approaches may often be seen as clashing with the short-term funding approaches of many public services which force short-term considerations. For example, the pressure to minimise initial capital costs of a new building in spite of the fact that higher capital costs may generate lower LCCs through factors such as improved energy utilisation. The current emphasis on slowing climate change and achieving sustainability demands much stronger consideration should be given, in future, to costing on a life-cycle basis than has been traditionally the case. Hence, LCC has been incorporated into this chapter as a contemporary management accounting issue.

Quality costing

In recent years, the quality of products and services has been of increasing strategic importance to companies. With the increased emphasis on quality, however, has come the need to manage the costs of achieving quality. This applies to public services as well as the commercial sector, and public service organisations may wish to address this issue.

Albright and Roth (1992) developed a framework for managing quality costs, based on their observation that “Quality costs are incurred to ensure that quality standards are met or because quality standards are not met”. Accordingly, they proposed a framework for analysing quality costs, which can inform management of the problem areas and action priorities through the regular provision of a cost of quality report. In the cost of quality report, costs are analysed into four distinct categories as shown below.

• Prevention costs – costs associated with personnel engaged in designing, implementing and maintaining the quality system. Subcategories include quality engineering, design and development of equipment, quality training, quality planning, quality reporting, supplier evaluation and selection, quality audits.

• Appraisal costs – costs associated with measuring and evaluating products, components and purchased materials to assure conformance with quality standards and performance requirements. Subcategories include inspection and testing of incoming materials and of finished products before despatch.

• Internal failure costs – these occur when products, components and materials fail to meet quality requirements prior to transfer of ownership to the customer or client. Subcategories include scrap, rework, failure analysis, re-inspection and machine down time due to defects and so on.

• External failure costs – these occur when the product does not perform satisfactorily after the transfer of ownership to the customer/client. Subcategories include complaints, rejects and returns, repairs, warranty costs and ultimately the loss of customer goodwill, and sales and market share that may result (adapted from Hoque 2006).

Ultimately, money invested in prevention and appraisal activities should reduce internal and external failure costs by an amount that significantly exceeds this investment. The cost of quality report should, over time, inform management whether this trend is occurring so that they can assess the overall effectiveness of their quality programme.

Quality costing is often thought of in relation to material goods but it also has applicability in relation to services and by extension also has potential applicability in relation to public services. Quality has many dimensions in relation to public services but the costs of delivering that quality just cannot be ignored. With information on quality costing, it is possible to consider a number of key issues such as:

• Can the costs associated with quality assurance be reduced without having any major impact on quality levels?

• If quality levels are a problem in the organisation, should we be enhancing quality assurance approaches? How should that be done and what would be the associated costs?

What is EMA?

At the outset we need to distinguish between environmental accounting and EMA. Environmental accounting is a broader term that encompasses the provision of environment-related information mainly for external readers. It focuses on reports required for shareholders and other stakeholders. EMA is a subset of environmental accounting which focuses on information required for decision making by managers within the organisation.

The International Federation of Accountants (IFAC 2005) defined EMA as:

The management of environmental and economic performance, through the development and implementation of appropriate environment-related accounting systems and practices. While this may include reporting and auditing in some companies, environmental management accounting typically involves lifecycle costing, full cost accounting, benefits assessment, and strategic planning for environmental management.

Traditional management accounting practice focusses on providing information, both financial and non-financial, on the activities of an organisation in order to assist with strategic and operational decisions. EMA goes beyond that and is a part of management accounting that focuses on matters such as the cost of energy and water, the disposal of waste and effluent, the consumption of materials, transportation costs and carbon footprint. It is important to note, at this point, that the focus of EMA is not purely on financial costs. It includes consideration of matters such as the costs versus benefits of buying from suppliers who are more environmentally aware, or the effect on the public image of the organisation of failure to comply with environmental regulations etc.

Such management information requirements could include the following:

• Identifying and estimating the costs of environment-related activities

• Identifying and monitoring the use and cost of resources such as water, electricity and fuel, so that such costs can be reduced

• Making sure environmental considerations form part of capital investment decisions

• Assessing the likelihood and impact of environmental risks

• Including environment-related indicators as part of routine performance monitoring

• Benchmarking activities against environmental best practice

Thus, EMA involves the identification, collection, analysis and use of two types of management information for internal decision making:

• Physical information on the use, flows and rates of energy, water and materials (including wastes)

• Monetary information on the environment-related costs, earnings and savings

Defining environmental costs

Organisations will vary considerably in the way they define their environmental costs, as their cost structures will vary between sectors and organisations. Hence, it is difficult to come up with a standard definition. In broad terms, a useful over-arching approach to defining organisational costs is that provided by the US Environmental Protection Agency (EPA 1998). Their approach was to consider the way in which an organisation intended to use the information. They made a distinction between four types of costs:

• Conventional costs – raw material and energy costs having environmental relevance

• Potentially hidden costs – costs captured by accounting systems but then losing their “environmental” identity in general overheads

• Contingent environmental costs – costs to be incurred at a future date – for example, clean-up costs

• Image and relationship costs – costs that, by their nature, are intangible, for example, the costs of preparing environmental reports

Other models may be available but in public services it is for each sector to come up with its own approach to categorising environmental costs.

Identifying environmental costs

Much of the information needed to prepare environmental management accounts can be found in the financial systems of a public service organisation. A review should reveal the costs of materials, utilities and waste disposal. However, many costs with environmental impacts will be found within the category of “general overheads”. Identifying them could be a lengthy process, particularly in a large organisation, but some attempt needs to be undertaken possibly by a sampling exercise. If this is not done, then the fact that environmental costs are often “hidden” in this way makes it difficult to identify opportunities to cut environmental costs and yet it is crucial that to try to do so. It is equally important to allocate environmental costs to the activities, processes, products or services which give rise to them. Only by doing this can an organisation make well-informed decisions. Possible approaches are discussed in the next section.

Accounting for environmental costs

A number of accounting techniques have been identified by the United Nations Division for Sustainable Development (UNDSD 2003) as being appropriate for the process of accounting for environmental costs. These are discussed below:

• Inflow/outflow analysis – this technique records and contrasts material inflows with outflows and, on the basis that what comes in must go out the causes of any differences are analysed. For example, if 500 kg of materials have been issued for production and only 400 kg have been used in production, then the 100 kg difference must be accounted for in some way. Some of it might be scrap and the rest might be waste. By accounting for outputs in this way, both in terms of physical quantities and, at the end of the process, in monetary terms, organisations are forced to focus on environmental costs.

• Flow cost accounting – this technique links material flows to the organisational structure. It looks at the physical quantities, the costs and the value of these flows and divides them into three categories: material, system and delivery/disposal. The values and costs of each of these three flow categories are then calculated and examined. This makes material flows more transparent. The aim of flow cost accounting is to reduce the quantity of materials which, as well as having a positive effect on the environment, should have a positive effect on an organisation’s total costs in the long run.

• Activity-based costing – the activity-based costing approach has already been discussed, at length in Chapter 7. In an environmental accounting context, activity-based costing distinguishes between environment-related costs, which can be attributed to joint cost centres, and environment driven costs, which tend to be hidden in general overheads.

• Life-cycle costing – this approach has already been discussed earlier in this chapter and is a technique which requires the full environmental consequences, and, therefore, costs arising from production of a product to be taken account across its whole life cycle, literally “from cradle to grave”.

Controlling environmental costs

Once environmental costs have been defined, identified and accounted for, organisations can consider the vital task of identifying how to control them.

The size and mix of environmental costs will vary substantially from sector to sector and so it is difficult to be prescriptive about how this should be approached. Key items in public services are

• Energy and utilities

• Transport and travel

• Consumables

Each of these costs is considered in turn below.

• Energy and utilities – these are often a huge cost in many public service organisations. They are also major contributors to global warming. Such costs can often be reduced significantly at very little cost by identifying inefficiencies and wasteful practices in the organisation. Environmental management accountants may help to identify opportunities in this area.

• Transport and travel – transport (and especially air travel) is also one of the major contributors to global warming. Transport can involve people and goods. Public sector organisations need to examine the number of journeys made by staff, the travel mode and the degree of necessity of the journeys. In the Internet age, it may be easy to utilise social media applications (e.g. Skype, Zoom) or home working for many activities rather than making physical journeys. Similarly, public service organisations need to analyse their pattern of purchases for physical goods and where these goods were sourced from. Consideration might be given to reducing their carbon footprint by sourcing goods more proximate to their base. Again, EMA can often help in doing this. A particular issue in purchasing considerations is whether the public authority can set off savings in environmental costs against a possibly higher purchase price.

• Consumables – public services do not generally produce goods and so there are not usually large amounts of raw materials, work in progress etc. associated with production. However, there will be large financial and environmental costs associated with consumable items such as stationery, foodstuffs, clothing, building materials, medications etc. The key mantras in relation to these items are the three Rs of reduce, reuse and recycle, and many public service organisations now have various policies and procedures in place to implement these matters. These involve designated responsibilities for environmental matters, procedures for reducing environmental costs, measurement devices and frequent reports on progress.

Lean

Lean is an approach to operations management that focuses on cutting out waste whilst ensuring quality. This approach can be applied to all aspects of an organisation from design through production to distribution. It originated in the manufacturing plants of Japan (particularly Toyota) but has now been adopted well beyond that in many large and sophisticated manufacturing activities. Many public services have also attempted to adopt lean practices most notably the NHS.

Lean aims to cut costs by making the organisation more efficient and responsive to external needs. The lean approach sets out to remove or minimise activities that do not add value to the operational process, such as holding of stock, repairing faulty product and unnecessary movement of people and product around the organisation.

Some key aspects of waste to be looked at include

1. Over-production – making more than is needed which leads to excess volumes of finished goods.

2. Waiting time – equipment and people standing idle waiting for a production process to be completed or resources to arrive.

3. Transport – moving resources (people, materials) around unnecessarily often due to poor layout.

4. Stocks – often held as an acceptable buffer but should not be excessive.

5. Motion – a worker who appears busy but is not actually adding any value.

6. Defects – output that does not reach the required quality standard – often a significant cost to an uncompetitive business.

The concept of lean is an incredibly powerful one for any organisation. Why? Because waste = cost. Less waste therefore means lower costs.

A big problem is that lean is often seen, merely, as a collection of techniques to be utilised including:

• Time-based management

• Simultaneous engineering

• Just-in-time production

• Cell production

• Kaizen (continuous improvement)

• Quality improvement and management

However, this is a serious error. Experience shows that the successful implementation of lean requires a major cultural change in the organisation which encourages employees, at all levels, to focus on identifying waste and taking remedial actions. The various tools shown above assist in this process.

The lean approach to managing operations is really about:

• Doing the simple things well

• Doing things better

• Involving employees in the continuous process of improvement and as a result, avoiding waste

Lean approaches have been employed in many parts of the public sector and in many countries in the world including defence, healthcare, police, higher education, central government and local government. Much has also been written about how lean should be applied in public services and how successful it is seen as being. It is probably true to say that the degree of success of lean in public services is mixed and that the reasons for this are debatable. It is beyond the scope of this book to address these matters in any detail, but it seems one main reason for the failure of lean in public services is that, as quoted earlier, there was a too strong focus on the use of techniques and a weaker focus on developing a lean culture.

Theory of constraints (TOC)

The theory of constraints (TOC) is a management philosophy that was introduced in 1984 with the publication of The Goal by Eli Goldratt, an Israeli academic and business management expert. Basically, TOC says that a small number of constraints prevent any production system from achieving more of its goals. There is always at least one constraint, and the TOC uses what is called a focusing process to identify that constraint, and then restructuring in order to address it. Think of it like the old axiom, “A chain is no stronger than its weakest link”. The TOC works to find that link and lessen its vulnerability. That applies to processes, organisation, individual team members, whatever or whoever is a risk to the successful completion of the project.

The TOC was initially developed and applied in manufacturing industry where product production involved the flow of raw materials and work in progress through various manufacturing stages leading to a final product. Within these production processes, bottlenecks would occur at various stages in the process leading to the production of finished goods being held up. The TOC is concerned with identifying those bottlenecks and optimising the whole production process.

However, TOC also has great applicability in relation to a wide variety of service industries where the provision of services involves a flow through various stages in the service delivery process and where bottlenecks can occur. Indeed, the TOC creator Eli Goldratt simply defined it as, “A thinking process that enables people to invent simple solutions to complex problems”. The TOC has also had a lot of applicability in public services where the process of delivering the service might suffer a bottleneck which inhibits service delivery. One example of this shown in Figure 13.1 concerns planned hospital surgery and shows how the patient might flow through the system.

Clearly the aim of the hospital is to treat as many patients as possible. However, in a flow system like the above, it is often the case that a bottleneck is caused by insufficiency of capacity, in one of the above stages, meaning that a patient transfer cannot take place and so the operation cannot commence until the bottleneck is cleared. This inhibits the total number of operations that can take place.

Management accounting aspects

There are some similarities between lean and TOC but a considerable difference in the main focus of each. Also, there are approaches to TOC which involve linkages to the six-sigma methodology.

However, there are some management accounting approaches which have been developed associated with these operational process developments and these are outlined below.

Big data analytics

In recent years the approach known as BDA has become of increasing importance in all organisations. Big data is a field that involves analysing and systematically extracting information from large datasets that are too large or complex to be dealt with by traditional data-processing application software.

The importance now given to BDA has come about because of two main causes:

• Amount of data – the huge proliferation in the amount of data actually being collected largely as a consequence of the digitisation of data making it easy to collect. This can be further considered as:

  • Volume – the overall quantity of generated and stored data.

  • Variety – the variety of data including text, images, audio, video.

  • Velocity – the speed at which the data are generated and processed.

• Processing power – the availability of advanced software to analyse large volumes of data.

Basically, BDA involves utilising this advanced software to analyse, in a reasonable period of time, the massive volumes and variety of data (which is now available through the digital revolution) available in order to derive information about the issues being studied. Now organisations of any reasonable size will already hold a wide variety of financial and non-financial data within its data banks. However, BDA goes beyond this and also utilises the much larger pool of data which can be found in external repositories.

BDA can be seen as having three main functions in an organisation:

• Descriptive – this involves converting past and current data into usable information in the form of reports, charts, pivot tables and graphs. The idea is to identify patterns by using statistical measures (e.g. the mean, correlation, range, standard deviation) to make informed decisions. Visualising tools may also be used here such as different types of charts, scorecards, frequency distributions, clustering, Pareto analysis.

• Predictive – this involves going beyond merely descriptive characteristics of data, by using data from the past and current performance to be able to make relevant predictions for the future. It analyses past performance and makes it possible to come up with relevant forecasts for the future by examining historical data in detail, detecting patterns or relationships and then extrapolating these relations forward in time. Items such as cause-and-effect relationships, the balancing of financial and non-financial, of internal and external measures can be considered. However, the most important assumptions are that data must be relevant, reliable and timely for decision-makers to be able to use. Such forecasts will inevitably be wrong, but it is better to make some prediction knowing the risks of error than to make no forecast at all.

• Prescriptive – this involves using experimental design and optimisation to identify the best possible alternative courses of action given different scenarios, criteria and objectives. Many problems simply involve too many choices or alternatives for a human decision-maker to effectively consider (bounded rationality). Prescriptive analytics uses optimisation to identify the best – and most likely – alternatives to minimise or maximise some objective.

Artificial intelligence and machine learning

Artificial intelligence (AI) is the branch of computer sciences that emphasises the development of intelligent machines that think and work like humans. For example, some current aspects of AI include speech recognition, problem-solving, learning and planning. However, AI is not limited to just IT or technology industry but is being extensively used in other areas such as medical, business, education, law and manufacturing.

Machine learning (ML) is an application of AI that involves systems with the ability to automatically learn and improve from experience without being explicitly programmed to do so. ML focuses on the development of computer programs that can access data and use it to learn for themselves. The process of learning begins with observations or data, such as examples, direct experience or instruction, in order to look for patterns in data and make better decisions for the future based on the examples provided. The primary aim is to allow the computers learn automatically without human intervention or assistance and adjust actions accordingly.

The implications of technology for management accounting

There are many aspects of management accounting practices in public services where AI, ML and BDA can and will have a significant impact, including

• More accurate costing of service activities as a consequence of using a wider variety of cost drivers and a larger data pool;

• Improved cost allocation procedures through using ML algorithms to decide the best approaches;

• Improved financial forecasting by taking account of errors in previous forecasts;

• More accurate budget setting by taking account of errors made in previous budget setting exercises;

• Improved budget variance analysis by taking account of a wider variety of factors than has traditionally been the case;

• Improved forecasting of future demands for public services;

• More sophisticated performance analysis and reporting.

Now these impacts will take place at different speeds within different organisations but they will eventually happen. They will, clearly, have a major impact on the role and work of the management accountant.

A major transformation is taking place in public and private sector organisations, regarding the role of the finance department and its staff. This is illustrated diagrammatically in Figure 13.2.

This implies that, in the future, the roles and focus of management accountants will increasingly be on the provision of analytical services to the organisation. Transactional services will have a reduced focus as a consequence of outsourcing and/or the use of shared services as a delivery medium. While the pace of change will vary from place to place, technological developments mean that such change is inevitable.

In future, public service organisations will expect its management accountants to be champions of evidence-based decision making, translating analytical insights into public service insights and ensuring these are used to improve future prospects and performance. This provides a huge opportunity for public service management accountants to use their combination of accounting and analysis skills with an understanding of the organisation and the services it delivers. Consequently, these technologies will hugely impact on the role and work of the management accountant. If we turn to the role of the public service management accountant of the future, four possible roles can be delineated:

• Data scientist – management accountants could evolve into data scientists directly involved in the design and utilisation of new technologies. However, to become a data scientist they must be prepared to invest (and many do) in extensive professional development to complement their accounting skill set with greater expertise in advanced analytical techniques.

• Data manager – management accountants generally have a good understanding of their organisation’s information systems. As providers of financial information, they also have a focus on data quality. Thus, they are well placed to be effective at identifying the overall information needs of the organisation and to determine the data necessary to inform decisions or manage performance. Thus, some management accountants may choose to develop their careers in this area as project managers, information managers etc.

• Data champion – management accountants are already involved in organisational decision making and trying to ensure that decisions are properly structured, informed and considered on the basis of the evidence and value to various stakeholders involved. In public services, decision making is often influenced by political issues and the views of different groups of service professionals rather than the evidence. Thus, management accountants can be seen as champions of evidence-based decision making by championing the use of information already available and the extraction of additional information using new technologies.

• Finance business partner – this has already been discussed earlier in this book. Management accountants come into contact with all aspects of the organisational activities and are well positioned to partner with line managers, service professionals, IT professionals and data scientists’ experts to support value creation in the organisation. This involves participation in data analytics exercises and the interpretation and communication of the findings to interested parties.

At the very least we can be confident that management accountants will need

• An awareness of these technologies,

• An understanding of their capabilities,

• Expertise to utilise them,

• An awareness of their limitations.

Thus, management accountants in any public service organisation must continually develop their skill sets to remain relevant to employers’ needs. They must ensure that their continuing professional development enables them to ride the new waves of technology so that their professional skills are recognised by employers and that they are engaged to help their organisation to succeed.