UNIT – 3

PROJECT EXECUTION AND COSTING CONCEPTS

1.PROJECT EXECUTION

Project execution is the phase of project management where the details of a project charter are carried out
to deliver products or services to clients or internal stakeholders. It involves taking action on the
strategies outlined in the project plan to get the project finished.

2.PROJECT COST CONTROL

Cost control is the process of measuring cost variances from the baseline and taking appropriate action,
such as increasing the budget allocated or reducing the scope of work, to correct that gap. Cost control is
a continuous process done throughout the project lifecycle.

3.BAR CHART

Bar charts are a graphical representation of data that can be used to enhance project management. They
can help you:

 Track progress: Monitor task schedules to see which tasks are behind schedule, on track, or
completed

 Analyze resource utilization: Gain insight into resource use in project tasks and phases

 Compare projects: Quickly compare projects and their progress

 Identify trends over time: Display different data sets and identify trends over time

Bar charts use the length of each bar to represent the value of each variable. For example, bar charts can
show variations in categories or subcategories scaling width or height across simple, spaced bars, or
rectangles.

In project management, bar charts are also known as Gantt charts. Each activity is represented by a bar,
and the position and length of the bar reflects the start date, duration, and end date of the activity. Gantt
charts can help project team members understand task progress, and can also help project teams focus
work at the front of, or at the tail end of a task timeline.

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 4.NETWORK DIAGRAM

A network diagram is a graphical representation of a project and is composed of a series of connected

arrows and boxes to describe the inter-relationship between the activities involved in the project. Boxes
or nodes represent the activity description, and arrows show the relationship among the activities.

What is a project network?

A project network is a graph that shows the activities, duration, and interdependencies of tasks within
your project.

What is a project schedule network diagram in project management?

A project schedule network diagram visualizes the sequential and logical relationship between tasks in a
project setting. This visualization relies on the clear expression of the chronology of tasks and events.

Most often, a project network diagram is depicted as a chart with a series of boxes and arrows. This
network diagram tool is used to map out the schedule and work sequence for the project, as well as track
its progress through each stage — up to and including completion. Because it encompasses the large tasks
that need to occur over the project’s duration, a network diagram is also useful in illustrating the scope of
the project.

Benefits of the project management network diagram

A network diagram allows a project manager to track each element of a project and quickly share its
status with others. Its other benefits include:

 Visual representation of progress for stakeholders

 Establishing project workflows

 Tracking dependencies and potential bottlenecks

Research also shows that depicting data in a visual way can improve comprehension and enhance
retention — meaning that a network diagram can boost performance and productivity while reducing
stress among your team members.

Types of project network diagrams: Arrow diagram and precedence diagram

There are two main types of network diagrams in project management: the arrow diagramming method
(ADM), also known as “activity network diagram” or “activity on arrow”; and the precedence
diagramming method (PDM), also known as “node network” or “activity on node.”

Arrow diagram method (ADM)

The ADM, or activity network diagram, uses arrows to represent activities associated with the project.
It’s important to note that, due to the ADM’s limitations, it is no longer widely used in project
management. However, it’s still useful to understand ADMs, so that you can recognize these diagrams if
they arise in your work environment.

In ADM:

 The tail of the arrow represents the start of the activity and the head represents the finish.

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  The length of the arrow typically denotes the duration of the activity.

 Each arrow connects two boxes, known as “nodes.” The nodes are used to represent the start or
end of an activity in a sequence. The starting node of an activity is sometimes called the “i-node,”
with the final node of a sequence sometimes called the “j-node.”

 The only relationship between the nodes and activity that an ADM chart can represent is “finish to
start” or FS.

Occasionally, “dummy activities”—arrows that do not represent a direct relationship—need to be

included in ADM network diagrams. In the diagram below, activity C can only occur once activities A
and B are complete; in the network diagram, you’ve connected activity A to activity C. Perhaps we’re
talking about tiling a floor (activity C): It can only begin once the concrete is poured (activity A) and the
permits are obtained (activity B). Since activities A and B are not directly related—A doesn’t lead to B,
and B doesn’t lead to A—you’ll need to draw a dummy activity between B and C to show that C is
dependent on B being completed.An ADM chart also does not have a way to encapsulate lead and lag
times without introducing new nodes and activities.

Precedence diagram method (PDM)

PDM network diagrams are frequently used in project management today and are a more efficient
alternative to ADMs. In the precedence diagramming method for creating network diagrams, each box, or
node, represents an activity—with the arrows representing relationships between the different activities.
The arrows can therefore represent all four possible relationships:

 “Finish to Start” (FS): When an activity cannot start before another activity finishes

 “Start to Start” (SS): When two activities are able to start simultaneously

 “Finish to Finish” (FF): When two tasks need to finish together

 “Start to Finish” (SF): This is an uncommon dependency and only used when one activity
cannot finish until another activity starts

In PDM, lead times and lag times can be written alongside the arrows. If a particular activity is going to
require 10 days to elapse until the next activity can occur, for example, you can simply write “10 days”
over the arrow representing the relationship between the connected nodes.

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 5. Project commissioning mechanical and process

Commissioning in project execution, particularly in mechanical and process engineering projects,

involves a series of activities aimed at ensuring that systems, equipment, and processes are installed,
tested, and operated according to design specifications and functional requirements. Here's an overview
of commissioning activities in mechanical and process engineering projects:

1. Pre-Commissioning Activities:

 System Readiness Check: Verify that all systems, equipment, and components are installed
correctly and ready for testing.

 Documentation Review: Review equipment manuals, operating procedures, and other

documentation to ensure completeness and accuracy.

 Safety Precautions: Establish safety protocols and procedures for commissioning activities,
including training for personnel involved.

2. Functional Testing:

 Equipment Testing: Perform functional tests on individual equipment and systems to ensure they
operate correctly and meet performance specifications.

 Interlock Testing: Test interlocks and safety systems to verify proper operation and compliance
with safety standards.

 Process Testing: Conduct initial tests on process systems to validate functionality and identify
any issues or discrepancies.

3. Instrumentation and Control Systems:

 Calibration: Calibrate instrumentation and control devices to ensure accuracy and reliability.

 Control Loop Testing: Test control loops to ensure proper functioning of feedback and control
mechanisms.

 Alarm Testing: Test alarm systems to ensure they activate appropriately in case of abnormal
conditions.

4. Performance Testing:

 Load Testing: Subject systems and equipment to load testing to verify performance under normal
operating conditions.

 Efficiency Testing: Measure and evaluate the efficiency of mechanical systems, such as pumps,
compressors, and turbines.

 Process Simulation: Conduct simulations or mock runs to test the entire process and identify any
operational issues.

5. System Integration Testing:

 Integration Testing: Test the integration of different systems and subsystems to ensure seamless
operation and communication.

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  Interface Testing: Verify interfaces between mechanical and process systems to ensure
compatibility and functionality.

6. Safety and Emergency Procedures:

 Emergency Shutdown Testing: Test emergency shutdown procedures and systems to ensure
they function correctly in case of emergencies.

 Safety System Testing: Verify the operation of safety systems, such as fire suppression, gas
detection, and emergency ventilation.

7. Operational Readiness:

 Operator Training: Provide training for operators and maintenance personnel on the operation
and maintenance of systems and equipment.

 Procedure Development: Develop standard operating procedures (SOPs) and maintenance

procedures for ongoing operations.

 Documentation and Handover: Complete all documentation and prepare for the formal
handover of the system to operations.

8. Final Acceptance and Handover:

 Client Acceptance Testing: Conduct final acceptance testing with the client or end-users to
demonstrate compliance with requirements.

 Punch List Resolution: Address any outstanding issues identified during testing and verification.

 Formal Handover: Complete the formal handover of the system to the client or end-users,
including documentation, training, and support.

9. Post-Commissioning Support:

 Initial Operation Support: Provide support during the initial period of operation to address any
issues or concerns.

 Performance Monitoring: Monitor system performance and address any performance deviations
or optimization opportunities.

 Lessons Learned: Conduct a post-commissioning review to identify lessons learned and areas for
improvement in future projects.

6. Cost Behaviour

Cost behavior in project execution refers to how costs change in response to changes in activity levels
within a project. Understanding cost behavior is crucial for effective project management, as it helps in
budgeting, forecasting, and decision-making. There are primarily three types of cost behavior:

1. Fixed Costs: These costs remain constant regardless of changes in activity levels within the
project. Fixed costs are incurred even if there is no activity. For example, rent for a project office,
salaries of permanent staff, insurance premiums, etc. In project management, fixed costs are often
associated with overhead expenses that do not directly vary with project output.

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 2. Variable Costs: Variable costs change proportionally with the level of activity or output in the
project. As activity increases, variable costs increase; as activity decreases, variable costs
decrease. For example, the cost of materials, labor hours, and subcontractor fees are often variable
costs in a project.

3. Semi-Variable Costs: Also known as mixed costs, semi-variable costs have elements of both
fixed and variable costs. They have a fixed component that remains constant within a certain
range of activity and a variable component that changes with activity levels. For instance, utility
bills might have a fixed portion (base fee) plus a variable portion (based on consumption).

7. Profit Planning Marginal Costing

1. Profit Planning: Profit planning involves setting targets for sales, costs, and profits over a
specified period, typically a financial year. It's a proactive process where businesses analyze their
market, costs, and other factors to establish achievable goals. Profit planning helps in resource
allocation, performance evaluation, and strategic decision-making. It involves creating a
comprehensive plan that aligns the company's objectives with its financial capabilities and market
conditions.

2. Marginal Costing: Marginal costing, also known as variable costing, is a costing technique where
only variable costs are considered when determining the cost of producing goods or services.
Fixed costs are treated as period costs and are not allocated to products. In marginal costing, the
contribution margin (sales revenue minus variable costs) is used to cover fixed costs and generate
profit. Marginal costing provides insights into the profitability of individual products and helps in
making short-term pricing and production decisions.

8. Distinction between Marginal Costing and Absorption Costing

What is Marginal Costing?

Marginal costing definition: Marginal Costing is a decision-making technique for determining the
total cost of production.

In marginal costing, variable cost is treated as product cost and fixed cost as period cost. And this type of
costing is also known as variable costing. This technique accounts for the variable costs associated with

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the extra units produced. In this technique, fixed expenses are not considered because they do not vary
due to ongoing changes.

Marginal costing example:

Let’s look at an example to understand better “marginal costing.” Assume there is a shoe factory that
produces 100 “Black shoes,” and to produce 100 black shoes costs ₹5000. To make one more black
would cost ₹800. This is the marginal cost: the cost of producing one more unit of a good or service.

Using this technique, management can easily decide, or this technique will also assist management in
understanding whether increasing production to 101 or 102 will be financially beneficial.

What is Absorption Costing?

Absorption costing definition: Absorption costing is calculating product costs considering fixed and
variable costs.

Absorption costing is GAAP compliant, and contribution per unit is considered. The cost of an abortion is
primarily used for external reporting to the government, tax authorities, and shareholders.

Abortion costs include direct manufacturing costs, such as direct labor and materials, and fixed overhead
costs incurred during the production process, such as utility costs. Let’s go through an example to
understand the term “absorption costing” in a better way.

Absorption costing example:

Assume a company produces 5,000 toys with variable costs (a variable cost is a business expense that
varies based on the amount a company produces or sells) of ₹60 direct materials, ₹110 direct labor, and
₹40 variable overhead per unit. The fixed overhead is ₹100,000 in addition to the per-unit costs.

To calculate the toy cost using absorption costing, add the per-unit costs together (direct labor, direct
materials, variable overhead). Following that, per-unit costs must be obtained from the fixed overhead for
the per-unit overhead to be applied to the per-unit cost. The absorption costing per unit is final when the
overhead is added to the per-unit costs.

Hence, absorption cost per unit: (direct materials + direct labor + variable overhead) + (fixed overhead /
number of units) = (60+110+40 = ₹210) + (100,000/5000 = ₹20). So, the absorption cost per unit is
₹230.

Key Difference Between Absorption Costing and Marginal Costing

Here are the key differences between marginal costing and absorption costing:

 While absorption costing is challenging to implement, marginal costing is simple.

 In absorption costing, contribution per unit is considered, whereas net profit per unit is considered
in marginal costing.

 Absorption costing emphasizes overhead recovery, whereas marginal costing emphasizes

calculating each unit’s contribution.

 The primary consideration is given to the cost of each unit in absorption costing. However, the
cost of producing the next unit is prioritised in marginal costing.

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  In absorption costing, variable and fixed costs are factored into the product’s price. In contrast,
only variable costs are considered product costs in marginal costing, while fixed costs are
classified as period costs.

9. Break-even Analysis

A break-even analysis is an economic tool that is used to determine the cost structure of a company or the
number of units that need to be sold to cover the cost. Break-even is a circumstance where a company
neither makes a profit nor loss but recovers all the money spent.

The break-even analysis is used to examine the relation between the fixed cost, variable cost, and
revenue. Usually, an organisation with a low fixed cost will have a low break-even point of sale.

Importance of Break-Even Analysis

 Manages the size of units to be sold: With the help of break-even analysis, the company or the
owner comes to know how many units need to be sold to cover the cost. The variable cost and the
selling price of an individual product and the total cost are required to evaluate the break-even
analysis.

 Budgeting and setting targets: Since the company or the owner knows at which point a company
can break-even, it is easy for them to fix a goal and set a budget for the firm accordingly. This
analysis can also be practised in establishing a realistic target for a company.

 Manage the margin of safety: In a financial breakdown, the sales of a company tend to decrease.
The break-even analysis helps the company to decide the least number of sales required to make
profits. With the margin of safety reports, the management can execute a high business decision.

 Monitors and controls cost: Companies’ profit margin can be affected by the fixed and variable
cost. Therefore, with break-even analysis, the management can detect if any effects are changing
the cost.

 Helps to design pricing strategy: The break-even point can be affected if there is any change in
the pricing of a product. For example, if the selling price is raised, then the quantity of the product
to be sold to break-even will be reduced. Similarly, if the selling price is reduced, then a company
needs to sell extra to break-even.

Components of Break-Even Analysis

 Fixed costs: These costs are also known as overhead costs. These costs materialise once the
financial activity of a business starts. The fixed prices include taxes, salaries, rents, depreciation
cost, labour cost, interests, energy cost, etc.

 Variable costs: These costs fluctuate and will decrease or increase according to the volume of the
production. These costs include packaging cost, cost of raw material, fuel, and other materials
related to production.

Uses of Break-Even Analysis

 New business: For a new venture, a break-even analysis is essential. It guides the management
with pricing strategy and is practical about the cost. This analysis also gives an idea if the new
business is productive.

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  Manufacture new products: If an existing company is going to launch a new product, then they
still have to focus on a break-even analysis before starting and see if the product adds necessary
expenditure to the company.

 Change in business model: The break-even analysis works even if there is a change in any
business model like shifting from retail business to wholesale business. This analysis will help the
company to determine if the selling price of a product needs to change.

Break-Even Analysis Formula

Break-even point = Fixed cost/-Price per cost – Variable cost

Example of break-even analysis

Company X sells a pen. The company first determined the fixed costs, which include a lease, property
tax, and salaries. They sum up to ₹1,00,000. The variable cost linked with manufacturing one pen is ₹2
per unit. So, the pen is sold at a premium price of ₹10.

Therefore, to determine the break-even point of Company X, the premium pen will be:

Break-even point = Fixed cost/Price per cost – Variable cost

= ₹1,00,000/(₹12 – ₹2)

= 1,oo,000/10

= 10,000

Therefore, given the variable costs, fixed costs, and selling price of the pen, company X would need to
sell 10,000 units of pens to break-even.

10. Cost-Volume-Profit Analysis

What Is Cost-Volume-Profit (CVP) Analysis?

Cost-Volume-Profit (CVP) analysis is a cost accounting method used to analyze the relationship between
cost, volume, and profit. It helps to determine the impact of cost, volume, and pricing changes on a
company’s profitability. Companies use it to determine the breakeven point, the point at which total
revenue equals total costs, and to project how changes in costs, volumes, and prices will affect a
company’s future profit. This information is useful for pricing, production, and cost control decisions.

Components of CVP Analysis

The CVP analysis contains different components, which involve various calculations. These components
are:

Fixed costs: These don’t fluctuate with sales or product production changes. Examples of fixed costs
include rent and advertising.

Variable costs: These are the costs that change as the quantity of products changes. Examples of variable
costs include raw materials and direct labor.

Contribution margin is the difference between the total variable costs and a company’s total revenue.

Contribution ratio: This is the contribution margin expressed as a percentage.

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Sales volume: The number of products businesses sell during a specific period.

Breakeven point: This is when the total costs and revenue are equal, meaning the business is neither
losing nor profiting.

Selling price: The amount a customer pays for the product.

Benefits of Cost-Volume-Profit Analysis

The benefits of Cost-Volume-Profit (CVP) analysis are:

Profit Planning

CVP analysis is instrumental in profit planning. It helps businesses forecast the impact of various
operational and pricing strategies on profits, allowing them to make informed decisions. Companies can
identify the most lucrative strategies by understanding the interplay between costs, volume, and profit,
enhancing their profitability and financial stability.

Pricing Strategies

It plays a crucial role in developing effective pricing strategies. CVP analysis provides insights into the
cost structure and profitability at different price levels, enabling businesses to set prices that maximize
profits while ensuring competitiveness. This insight is vital for achieving both revenue and profit
objectives.

Decision Making

CVP analysis enhances decision-making capabilities by clearly understanding the financial implications
of various operational choices. It allows businesses to evaluate the potential profitability of different
decisions, ensuring that they choose options that bolster their financial position and contribute positively
to their long-term success.

Risk Assessment

It aids in risk assessment by helping businesses understand the sensitivity of profits to changes in costs
and sales volume. This understanding allows companies to anticipate and mitigate risks related to cost
fluctuations and market demand, enhancing their resilience and adaptability in a dynamic business
environment.

Cost Control

CVP analysis contributes to effective cost control by highlighting the impact of costs on profitability. It
enables businesses to identify and prioritize areas where cost-reduction efforts will have the most
significant positive effect on profits, ensuring efficient resource allocation and optimal financial
performance.

Limitations of Cost-Volume-Profit (CVP) Analysis

The limitations of Cost-Volume-Profit (CVP) analysis are:

Simplistic assumptions: It assumes a linear relationship between cost, volume, and profit. It may not
always be accurate in a complex business environment.

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Ignores non-linear costs: CVP analysis assumes that costs are constant per unit. But many costs are
variable or semi-variable and change with volume.

Does not consider all costs: This method only considers direct and fixed costs. It may not accurately
reflect the total cost structure of a company.

Ignores external factors: CVP analysis does not consider external factors such as market changes,
competition, or economic conditions that can impact a company’s profitability.

Limited long-term predictions: It only provides short-term predictions and may not accurately predict a
company’s future performance over a longer period.

Limited use for service industries: Organizations mainly use it in manufacturing industries. Hence, it
may not be suitable for service-based businesses where cost structures and production processes differ.

11. Various decision-making problems

Costing concepts are crucial for decision-making in various aspects of business operations. Here are some
decision-making problems where costing concepts play a significant role:

1. Product Pricing Decisions: Costing concepts help in determining the selling price of products or
services. By analyzing the costs associated with production, distribution, and marketing,
businesses can set prices that cover costs while ensuring competitiveness and profitability.

2. Make or Buy Decisions: In situations where a company needs certain components or products,
costing concepts help in evaluating whether to produce them internally (make) or purchase them
from external suppliers (buy). This decision involves comparing the costs of in-house production
(including direct materials, labor, and overheads) with the costs of outsourcing.

3. Special Order Decisions: When a business receives a special order for a product at a price lower
than the regular selling price, costing concepts assist in assessing whether accepting the order
would be profitable. By analyzing the incremental costs and contribution margin associated with
the special order, managers can make informed decisions.

4. Product Mix Decisions: Costing concepts help in determining the optimal product mix to
maximize overall profitability. By analyzing the contribution margin of each product and
considering factors such as demand, production capacity, and resource constraints, managers can
decide on the most profitable product mix.

5. Capacity Utilization Decisions: Costing concepts assist in evaluating the impact of operating at
different levels of capacity utilization on costs and profitability. By analyzing the fixed and
variable costs associated with different levels of production, managers can make decisions
regarding production volume, pricing strategies, and resource allocation.

6. Cost Control Decisions: Costing concepts aid in identifying areas of cost inefficiency and
implementing cost control measures. By comparing actual costs with budgeted costs and
analyzing variances, managers can pinpoint areas where costs are exceeding expectations and take
corrective actions.

7. Investment Decisions: Costing concepts help in evaluating the financial feasibility and potential
returns of investment projects. By estimating the costs and benefits associated with investment

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 alternatives, such as capital expenditures or new ventures, managers can make informed decisions
regarding resource allocation and strategic investments.

8. Performance Evaluation: Costing concepts are used to evaluate the performance of departments,
products, or projects. By comparing actual costs and revenues with budgeted or standard costs,
managers can assess performance, identify areas of improvement, and make strategic adjustments.

12. Pricing strategies: Pareto Analysis, Target costing, Life Cycle Costing.

PRICING STRATEGIES:

A pricing strategy is an approach businesses use to determine what prices they should charge for their
products and services. It involves analyzing the market and customer demand, understanding customer
needs, evaluating production costs, and setting competitive prices that maximize profits.

Pareto Analysis:

Pareto analysis, also known as the 80/20 rule or the law of the vital few, is a decision-making technique
used to identify and prioritize the most significant factors contributing to a particular outcome. It is based
on the principle that a large proportion of the effects (typically around 80%) come from a small
proportion of the causes (approximately 20%).

Here's how Pareto analysis works:

1. Identify the Problem or Outcome: First, you need to define the problem or outcome you want to
analyze. This could be anything from identifying the most significant sources of defects in a
manufacturing process to determining the main drivers of customer complaints.

2. Collect Data: Gather data related to the problem or outcome. This could include factors,
variables, or categories that may contribute to the outcome. Ensure that the data is comprehensive
and accurately reflects the situation.

3. Determine Frequency or Impact: Analyze the data to determine the frequency or impact of each
factor. This could involve counting occurrences, measuring the magnitude of the effect, or
assigning scores or weights to each factor.

4. Rank the Factors: Rank the factors from highest to lowest based on their frequency or impact.
The factors with the highest frequency or impact will be at the top of the list, while those with the
lowest frequency or impact will be at the bottom.

5. Calculate Cumulative Percentages: Calculate the cumulative percentage of the total frequency
or impact as you move down the ranked list of factors. This helps visualize the cumulative
contribution of each factor to the total.

6. Plot the Data: Create a Pareto chart, which is a bar chart that displays the factors on the x-axis
and their frequencies or impacts on the y-axis. The bars are arranged in descending order of
frequency or impact, and a cumulative percentage line is added to the chart to show the
cumulative contribution.

7. Identify the Vital Few: Identify the "vital few" factors that contribute the most to the outcome.
These are typically the top 20% of factors that account for approximately 80% of the total
frequency or impact. Focus on addressing or improving these factors first, as they will have the
greatest impact on achieving the desired outcome.
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Target costing:

What is target costing?

Target costing is a strategy that companies can use to plan the prices of their new products before they
manufacture them. This strategy allows companies to determine whether they can manufacture new
products and reach their profit goals. If a company determines through target costing that a product isn't
workable, it can cancel the product plan. For products that are workable, they can plan their costs early in
their life cycle. The formula for target cost is as follows:

Target cost = selling price - profit margin

Throughout a product’s life cycle, a company can continue to use the target cost as a reference to ensure
that products remain profitable. Target costing is especially useful in industries with high levels of
competition, including construction, health care and consumer goods. Target costing is a useful strategy
because market supply and demand are the leading factors behind product pricing. Because suppliers
have little control over the price of products in these industries, they can shift their focus to their
production costs to ensure that they continue to make a profit.

Benefits of target costing

Target costing can have many benefits for companies, including:

Ensuring profit capability

Target costing can be an effective method of setting a price for a product if you have a minimum amount
of profit required on your product or service to make it a feasible offering, Target costing allows you to
find a sale price that meets your profitability needs. This allows you to only move forward with those
projects that have the potential to meet your profit targets.

Tracking manufacturing costs

Target costing puts an emphasis on the value that customers place on your product or service. Using this
information, you can assess your manufacturing processes to identify whether your current structure
enables you to provide your product or service at that price point while maintaining effective profitability.
If a target costing analysis shows an insufficient profit at a price point, you can then assess your
manufacturing process to identify any areas you can make savings to hit your desired manufacturing cost
for the target.

Staying customer-focused

The target costing process can also help your company to stay customer-focused, as target costing bases
the cost of the product on the customer's expected price. This can help customers feel like your company
values them, which can make them more likely to stay engaged. Target costing can also allow customers
to buy products at affordable prices.

How to calculate target cost

If you're interested in using target costing for your company, follow these steps:

1. Research your market conditions

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Analyze the market into which you’re releasing your product or service. It's important to understand who
your potential customers are, what they’re looking for and what their financial capabilities are. This
provides you with valuable information you can use later in your calculations to create more accurate
estimations.

2. Establish the product's target price

Set your ideal sale price for your product or service. Calculating a target price relies on a range of
variables that can differ based on industry, market and company goals. For example, a product aimed at
affluent consumers may merit a higher price, or a company seeking to build public awareness may choose
a lower price point to increase total sales and begin developing a loyal customer base.

3. Determine your target profit margin

Set your target profitability for the product or service to meet your financial goals. As with your sale
price, there are many factors that can determine your ideal profit margin. Important considerations
include your financial capabilities, your company’s short- and long-term goals and any financial
obligations for the company.

4. Calculate the target cost

Subtract your desired profit margin per sale from your target sale price. The resulting value is your target
cost. This represents the acceptable financial cost to produce one sale of the product at the target price in
order to meet your desired profit margins.

Example of target costing

Here’s an example of effective target costing for reference:

ABC Cosmetics is interested in producing a new mascara product, and the company uses a target costing
strategy to find the target cost per unit of their new mascara.

First, ABC Cosmetics performs market research and finds that customers pay a maximum of $9 on
average for mascara in the current market. This means ABC's target price for its new product is $10. The
company's desired profit margin on the new mascara product is 20% of the target price, which equals $2.
By subtracting the profit margin from the target price, ABC Cosmetics calculates a target cost per unit of
$8. After calculating the target cost of the new mascara product, the company creates a plan to
manufacture the products while aligning with the target cost per unit.

Life cycle costing:

Life cycle costing (LCC) is a cost management technique that involves assessing and considering all costs
associated with a product or project over its entire life cycle, from inception to disposal. This
comprehensive approach allows businesses to make more informed decisions by considering not only the
initial acquisition or production costs but also the costs incurred throughout the product's or project's life
span.

Here's how life cycle costing typically works:

1. Identification of Costs: The first step in life cycle costing is to identify all relevant costs
associated with the product or project over its entire life cycle. These costs can be categorized into
different phases, including acquisition, operation, maintenance, and disposal.

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 2. Cost Estimation: Once the costs are identified, they need to be estimated for each phase of the
life cycle. This involves forecasting expenses such as initial purchase or production costs,
installation costs, operating costs (e.g., energy, maintenance, labor), and disposal costs (e.g.,
recycling, disposal fees).

3. Discounting and Present Value: Since costs incurred in the future are not as valuable as costs
incurred today, life cycle costing typically involves discounting future costs to their present value.
This helps in comparing costs incurred at different points in time on an equal basis.

4. Analysis and Decision Making: Once all costs are estimated and discounted to their present
value, businesses can analyze the life cycle costs to make informed decisions. This may involve
comparing different alternatives, such as different product designs, materials, or maintenance
strategies, to identify the most cost-effective option over the entire life cycle.

5. Sensitivity Analysis: Sensitivity analysis is often conducted to assess the impact of variations in
key assumptions or variables on the life cycle costs. This helps in understanding the level of
uncertainty associated with the cost estimates and making more robust decisions.

6. Continuous Monitoring and Review: Life cycle costing is not a one-time exercise but rather an
ongoing process. As the project or product evolves, actual costs may differ from the initial
estimates. Therefore, it's essential to continuously monitor and review the life cycle costs to
ensure that decisions remain cost-effective and aligned with organizational objectives.

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