Lee, J. Y., R. Jacob and M. Ulinski. 1994.

Activity-based costing and

Japanese cost management techniques: A comparison. Advances In
Management Accounting (3): 179-196.
Summary by Charles Hart
Master of Accountancy Program
University of South Florida, Summer 2003
ABC Main Page | Japanese Management Main Page | Target Costing Main Page
This article compares activity based costing (ABC) with Japanese cost management techniques, a
combination of target costing and kaizen costing.
At the heart of this article is the question, how do we deal with the problems that conventional cost
accounting systems create or cannot deal with? ABC is a cost accounting concept that views costs
through a prism of organizational activities; not organizational departments. Target costing is
market-driven system of cost reduction, focused on managing costs at the developmental and design
stages of a product. Kaizen costing relies on setting cost reduction targets and attaining the targets
through continuous improvement activities in the manufacturing phase.
Activity Based Costing
In an ABC structure, organizational departments that have served as cost centers, where costs are
accumulated for allocation to products or services, are replaced by organizational activities through
which costs are viewed. The heart of ABC is to trace and account for the pool of fixed overhead
costs and show that they are really variable. The crucial aspect of ABC is its focus on the causality
and variability with respect to operations and resource consumption in organizations.
This focus can be examined in detail using four categories of activities and consumption: unit-level
expenses, batch-level expenses, product-level expenses, and facility-level expenses. Unit-level
expenses very proportionately with the production volume in units. These costs are typically
materials and supplies. Batch-level expenses are incurred as a batch of products is manufactured.
These expenses are setups, quality inspection, and procurement. Product-level expenses are related
to the activities performed to support specific products in a companys product line. These costs are
typically seen when a company makes engineering and product design changes. Finally, facility-
level expenses are common to various product lines, and cannot be logically attributed to specific
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products. Examples include the plant superintendents salary and property tax on the plant.
If properly implemented, ABC can become a powerful tool for a company in costing products and
services, evaluating performance, formulating pricing strategies, and making product and customer
mix decisions. Recent studies have found the first benefit from ABC is the realigning of the involved
organizations expenses from functional categories and departments to activities and business
processes. The information gained from ABC was to be used to make decisions on outsourcing,
eliminating nonessential activities, and improving efficiency.
The hardest part of ABC implementation was reported as identifying and measuring cost
drivers. The identified drivers were used to connect activities to products, customers, or other cost
objects. ABC reveals that low-volume, complex products tend to be more expensive than more
traditional standard cost systems have indicated.
Additionally, pertinent actions are required to turn the ABC findings into actual cost reductions to
improve the companies bottom line performance. Usually, insufficient time exists for senior
management to establish profit priorities. Simply, the radical changes brought on by ABC create a
problem in that management is not able to respond quickly enough or use the information to the
greatest advantage because it requires them to break with everything they know about their
business. Meanwhile, the radical change is hindered by most companies being unprepared to make
radical changes or being willing to make changes, but ill-equipped to make the necessary changes to
take full advantage of the information.
ABC is only effective when the possible changes are identified in advance and then planned for
before implementation. Companies need an explicit plan for line managers to execute desirable
actions based on ABC. Thereby, desirable actions could be taken in the areas of costing products
and services, evaluating performance, formulating pricing strategies, and making product and
customer mix decisions. Without such an explicit plan, ABC may never reach beyond the finance
or other group that developed the model.
Target Costing
Target costing is a market-driven system of cost reduction, focused on managing costs at the
development and design stages of a product. The Japanese believe that cost reduction activities,
especially in automated plants, carried out in the production stage of a product have a limited
effect. The effect is limited because processing methods, type of equipment, production flow, and
other aspects of the production environment related to workers and quality are determined and fixed
at the product planning stage in an automated plant.
Target costing reveals a direct link between the marketplace, corporate long-term profit goals, and
cost management practices. The process begins with finding, through rigorous market research, a
quality product that can appeal to potential customers. The expected price at which this product is
most likely to appeal to customers is also determined by the new-product team. This sales price
generally reflects not current, but future, market conditions and reflects the teams best efforts,
although the price may change over that products life cycle. Based on the companys long-term
profit plans, the new products target profit is calculated and is subtracted from the expected sales
price to arrive at the allowable cost. By design, the allowable cost is too stringent to achieve through
current technologies. The cost estimates are based on current engineering and production
technologies. The target cost is set somewhere between the allowable cost and the current estimated
cost.
In calculating the target profit, Japanese companies use the rate of return on sales (ROS) rather than
return on investment (ROI). ROS is more technically convenient to relate profit to low-volume
products. This practice reflects Japanese manufacturers tendency to focus on the profitability of
the portfolios of related products rather individual products. After the total target cost is set for a
newly approved product plan, the engineering planners and cost management personnel divide the
total target cost for the product into various product cost elements based on the engineering design
and cost requirements. The achievement of the target cost requires intense value engineering (VE)
activities and close cooperation among departments, such as engineering, production, and
marketing.
Value engineering (VE) was first developed by General Electric and is geared toward producing
innovative, yet cost effective, product features that will satisfy customers needs. The features have
already been determined based on rigorous market research. The sales price incorporates the
appealing features based on the market research. For products and services under VE, functions are
defined, and costs incurred to perform those defined functions are measured against the functions.
One of the primary reasons that Japanese managers find target costing so attractive is its
compatibility with the management strategies they use to deal with the shortening product life cycles
in todays market. They need to monitor the profit and cost performance in short intervals because
they want to recover their investment in a short period of time. Target costing allows companies to
translate the cost reduction strategy into a series of equivalent actions according to the relationships
to the defined functions. This ability to translate the target into actions is very powerful because
cost accounting is connected to products very closely, which workers find very easy to understand.
The close connection is in contrast to the loose connection between cost accounting and various
functions and products in standard cost systems.
Kaizen Costing
While target costing is a critical means of managing the costs in a new product design and
development stage, Kaizen costing supports continuous improvement activities in the manufacturing
phase. It is an alternative to ABC and combined with target costing, Kaizen costing helps Japanese
manufacturers accomplish their objective of cost reduction in the full cycle of design-development-
production cycle.
Kaizen costing functions in the same way as a budgetary control system but is usually located
outside the regular cost accounting system. In the standard cost accounting system, the focus is on
meeting standards. Kaizen costing , in contrast, mandates the setting of a cost reduction target
amount and the attainment of the target amount through continuous improvement activities. These
improvement activities, which should lead to cost reductions, are clearly specified for each
organizational unit and for each accounting period.
The cost reduction process in each period follows the annual budgeting process that represents the
current years portion of a manufacturing long-term program. Each organizational unit prepares
projections and plans that become an integral part of their annual profit budget. For example,
projections would cover:
production, distribution, and sales plan,
projected parts and materials costs, and
fixed expense plan.
Using the contribution approach, the budgeted contributed margin (BCM) is calculated as
follows:
BCM = budgeted sales expected variable costs
Expected changes from manufacturing variable costs are used to adjust the BCM. Expected fixed
costs from the personnel plan, facility investment plan, and fixed expense plan are deducted from
the adjusted BCM to calculate budgeted operating profit. The budgeted operating profit is assigned
to each department. Performance of each department is measured on the basis of the difference
between actual profit and budgeted profit. After the total target reduction amount has been
determined, the cost reduction target is decomposed and assigned along the hierarchical organization
in each plant: from plant top management to department, to section, to subsection, and all the way
to each manufacturing process.
The decomposition of the cost reduction target, which is performed at each organizational level of
the plant before cost targets are assigned, is closely related to the objectives of each level of the
organization. The target decomposition is performed in connection with each organizational levels
established objectives on manufacturing productivity, product quality, and cost. Kaizen costing is
not affected by the financial accounting focus of the standard costing system used by Japanese
manufacturers. The close link is rather with the profit planning process of the whole organization.
This link allows Kaizen costing to function effectively in cost management without being tied to the
endless ritual of analyzing and explaining standard cost variances that cannot be easily translated
into actual tasks performed by employees.
Comparison
Comparison Between ABC and Kaizen Costing
ABC Kaizen Costing
Control location Within cost system Outside of cost system
Feedback time frame Long term Short term
Connection between cost Connection is made Connection through cost
system and strategic
decisions
through cost accounting accounting is not critical
Primary focus on costs Fixed costs Variable costs
Relate transactions to cost
accounting
Transactions are directly
related to cost accounting
Transactions are not
directly related to cost
accounting
Use cost drivers and
performance measures
Use activity cost drivers
and performance measures
Use performance measures
Nature of methodology Comprehensive cost
accounting and
management methodology
Tool for motivation and
enforcement



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