Managerial Accounting — Strategic Cost Management and the Balanced Scorecard: Target Costing, Cost of Quality and the BSC

The last chapter of managerial accounting goes beyond calculating costs after the fact to tools that manage costs in advance by linking them to strategy. They grew out of two concerns: most of a product’s cost is already fixed at the design stage, and performance cannot be seen fully in financial figures alone.

1. Target costing

Traditional pricing adds a margin to cost. Target costing works the other way: it deducts the target profit from the price the market will accept to set an allowable cost, and then designs the product to meet it.

Target cost

\text{Target cost} = \text{Target selling price} - \text{Target profit}

If competing products sell for ₩500,000 and the target profit margin is 20% of the selling price, the target cost is ₩400,000.

If Company BT’s current design is estimated to cost ₩460,000, it must cut ₩60,000. It uses value engineering to lower costs through common parts, simpler processes and joint design with suppliers. Target costing rests on the premise that 70–80% of cost is locked in at the design stage. Once production starts, kaizen costing lowers costs further by steadily accumulating small improvements.

2. Life-cycle costing

A product’s cost is not only in production. Gathering costs across the whole life cycle — R&D, design, production, marketing, distribution, customer service and disposal — shows the product’s profitability. A product with heavy R&D spending may be profitable on production cost alone yet loss-making over its whole life cycle. Consumers, for their part, look at the total cost of ownership, adding energy and maintenance costs during use to the purchase price.

3. Cost of quality

The cost of quality divides quality-related costs into four categories.

Classification of the cost of quality
Category	Content	Examples
Prevention costs	Costs of keeping defects from arising	Quality training, design reviews, supplier evaluation
Appraisal costs	Costs of finding defects	Inspection, testing, quality audits
Internal failure costs	Costs of defects found before shipment	Rework, scrap, production stoppages
External failure costs	Costs of defects found after reaching customers	Warranty repairs, returns, recalls, lost reputation

BT’s annual cost of quality is prevention ₩1 million, appraisal ₩2 million, internal failure ₩4 million and external failure ₩8 million: ₩15 million in total. Suppose spending ₩2 million more on prevention halves failure costs. The new cost of quality is $300 + 200 + 200 + 400 = 1{,}100$ (₩11 million), ₩4 million less. The heart of quality cost management is that spending on prevention and appraisal is an investment that reduces failure costs. External failure costs also include hard-to-measure costs such as lost customers, so the real effect may be larger.

4. The balanced scorecard (BSC)

The balanced scorecard proposed by Kaplan and Norton uses measures from four perspectives together, to address the problem that future performance cannot be managed with financial measures alone.

The four perspectives of the balanced scorecard
Perspective	Question	Example measures
Financial	How do we look to shareholders?	ROI, EVA, revenue growth
Customer	How do we look to customers?	Customer satisfaction, repeat purchase rate, market share
Internal process	What must we excel at?	Defect rate, on-time delivery, time to market for new products
Learning and growth	How will we keep improving?	Employee capabilities, information system availability, number of suggestions

The four perspectives are linked by cause and effect. Employee training (learning and growth) lowers the defect rate (internal process); better quality raises customer satisfaction and repeat purchases (customer); and in the end revenue and profit grow (financial). A picture of this causal chain is a strategy map. Only by watching leading indicators (training hours, defect rate) together with lagging ones (ROI) can you manage whether today’s investment turns into tomorrow’s financial performance.

Check your understanding

Company BU sets a new product’s market price at ₩300,000 and its target operating margin at 15% of the selling price. The current design is estimated to cost ₩270,000. What are the target cost and the required cost reduction? And if BU’s cost of quality is prevention ₩500,000, appraisal ₩1.5 million, internal failure ₩3 million and external failure ₩5 million, and raising prevention costs by ₩1 million can cut both failure costs by 40%, what is the net saving?

The target cost is $30 \times (1 - 15\%) = 25.5$ (₩255,000), so costs must fall by ₩15,000 per unit. Failure costs fall by $(300 + 500) \times 40\% = 320$ (₩3.2 million); deducting the ₩1 million increase in prevention costs leaves a net saving of ₩2.2 million. Total cost of quality falls from ₩10 million to ₩7.8 million.

References

Robert Kaplan and David Norton, The Balanced Scorecard: Translating Strategy into Action
Robin Cooper and Regine Slagmulder, Target Costing and Value Engineering
Charles Horngren, Srikant Datar and Madhav Rajan, Cost Accounting: A Managerial Emphasis, ch. 12, 19