SAPexperts | What Are Target Costs in Cost Center Accounting and Why Should You Calculate Them

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Home > Financials > Articles > What Are Target Costs in Cost Center Accounting and Why Should You Calculate Them?

What Are Target Costs in CostCenter Accounting and WhyShould You Calculate Them?

by Janet Salmon, Solution Manager, SAP AG

March 15, 2004

SAPexperts/FinancialsMany reports that monitor cost center performance areincomplete because they account for the planned outputrather than the actual output of the cost center. The author demonstrates how to use adjusted costs called targetcosts. Calculating target costs will provide you with areport that more accurately reflects the performance of your cost centers.

Ask most people to define Cost Center Accounting (CO-OM-

CCA) and they will tell you that it is the process of assigningexpenses to cost centers and monitoring these figures over

time. Ask them how they monitor cost center performance and

these people will tell you that they compare the actual costs

with the planned costs for the period and analyze the variance.

They typically work with reports like the one shown in Figur e 1,

with a line-by-line explanation of the over/under absorption on

the cost center. (For information on reports in Business

Information Warehouse [BW], see the sidebar, "Analyzing

Target Costs in Business Information Warehouse.")

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Figure 1

Plan/actual comparison for cost center group(click on image for full- screen

However, while everyone is familiar with this sort of report, it

has its limitations. To understand how their cost centers are

performing, some companies go a step further and adjust their

planned costs to reflect the actual output of the cost center.

They then compare these adjusted costs — SAP calls them

target costs — with their actual costs to calculate variances.

This gives them a more accurate picture of how efficiently their

cost centers have been working, because it accounts for

variations in cost center output. Using five cost centers in a

fictitious manufacturing company, I will show you why

companies use target costs instead of planned costs to judge

their cost centers' performance and what impact this business

requirement has on their planning process.





Target Costs

In a nutshell, target costs reflect the output rate of the cost

center. If the cost center's output is higher than planned, then it

probably spent more than planned. If the cost center's output is

lower than planned, then it probably incurred fewer costs.

Some costs — the fixed costs — are unaffected by the change

in output. The term "target costs" is best understood by lookingat the German word "Sollkosten." These are the costs that

should have ("Soll") been incurred to achieve a given output.

Do not be misled by the fact that the term sounds like "target

costing" — working back from a market price (the target) to

arrive at the product costs. Calculating target costs is all about

looking backward at what was planned and adjusting this plan

to reflect the actual output. This brings us to the crux of the

matter. Calculating target costs has a major impact on

planning. You need to plan:

What the cost center output is: in SAP terms, the activity

types to be performed and the quantities of that activity(output) to be provided

What the cost center spends to perform this activity:SAP differentiates here between activity- dependentcosts and activity-independent costs

How the output of this cost center is to be used: howmuch of each activity flows to other cost centers,business processes, and orders in the course of theplanning period

This is a much more detailed form of cost center planning than

many organizations currently perform, but it provides a way to

establish the targets for the cost center and to measurewhether these targets were achieved. This form of planning

also presupposes that the activity flow is reconciled — supply

reflects demand — and that the flow of activities will be valued

with a price that is calculated by dividing the planned costs

either by the planned activity or (more rarely) the planned

capacity for the cost center.

Activity Types

The activity type describes the output of the cost center. In

manufacturing companies, it is standard practice to calculatethe number of machine hours or labor hours expected for the

period based on the quantities in the production plan and the

number of maintenance hours, quality control hours, and so

on, that will be required to provide these machine hours. It is

becoming increasingly common to find Activity- Based Costing

(ABC) methodologies being used by service companies to

determine the number of labor hours required to provide

certain services. What matters is that all cost center allocations





should use activity types. If you use assessment cycles to clear

some of the cost centers at period close, you will have no

activity quantities and consequently no target costs for these

cost centers.

In my example, the service cost center's energy, quality, and

repairs provide the following activity types to two production

cost centers: kilowatt hours, quality hours, and repair hours.

The production cost centers provide machine hours to the

production orders processed by them.

Activity-Dependent and -IndependentCosts

To calculate target costs properly, you need to plan the activity

output (number of hours) for your cost center and to distinguish

in your plan between activity-dependent and activity-

independent costs. The activity-independent — or fixed —

costs are expenses like salaries and facilities that are incurredeven if the cost center is idle. The activity-dependent costs are

expenses like energy, direct labor, and external processing,

that change with respect to the output of the cost center. These

costs can either be totally variable (as might be the case for

external processing) or a mixture of fixed and variable costs

(as might be the case for direct labor costs).

In Figure 2, you can see that the fixed costs for the cost center

quality control are Salaries and Office & Building, the costs for

External procurement vary with the number of quality hours

worked, and that Direct labor costs is a mixture of fixed and

variable costs. To plan activity output and/or capacity, choose

Accounting>Controlling> Cost Center

Accounting>Planning> Activity Output/Prices>Change.

Choose a planning layout that allows you to enter the activity

quantity and/ or capacity for each activity type on the cost

center. For more information on planning layouts, see the

sidebar, "Setting up Planning Layouts." To plan the costs to

provide this output, choose Accounting> Controlling>Cost

Center Accounting> Planning>Cost and Activity

Inputs>Change. Choose a planning layout that allows you to

enter first the fixed costs on the cost centers by cost element

and then the activity-dependent costs on the cost centers by

cost element and activity type.





Figure 2

Planned costs for quality control cost center before reconciliation (click on image for full-screen

Activity Usage

The information planned so far would be sufficient to calculate

an activity price and target costs for the quality control cost

center in isolation. However, you have not yet planned which

cost centers will use quality control hours. You also need to

plan the activity allocation for quality control — 1,200 hours to

PC production and 600 hours to chip production. Figure 2

shows the planned costs (activity-dependent and activity-





independent) for a quality control cost center, the planned

output (1,500 hours), and the planned usage of this output in

chip production and PC production.

To plan activity input, choose Accounting>Controlling>Cost

Center Accounting>Planning>Cost and Activity

Inputs>Change. Choose a planning layout that allows you to

enter both the sender cost centers and activity types (quality in

my example) and the receiver cost centers and activity types

(chip and PC production in my example).

Plan Reconciliation

If you look closely at Figure 2, you see that the activity usage

planned — 600 hours to chip production and 1,200 hours to

PC production — is higher than the output planned for the

quality cost center — 1,500 hours. The plan reconciliation

function takes account of this discrepancy and adjusts the

planned cost center output from 1,500 to 1,800 hours to reflect

the demand from the production cost centers. It also adjusts

the activity-dependent costs accordingly. Thus, the variable

costs for External procurement are now EUR 108,000

instead of EUR 90,000 and the variable costs for direct labor

are now EUR 36,000 instead of EUR 30,000. This is illustrated

in Figure 3.





Figure 3

Planned costs for quality cost center after reconciliation (click on image for full-screen)

To run plan reconciliation, choose

Accounting>Controlling>Cost Center Accounting>

Planning>Planning Aids> Plan Reconciliation. If you do notrun this transaction, plan reconciliation takes place

automatically when you calculate activity prices.

Activity Prices and Capacity

The price indicator for the activity type determines whether the

activity price for a cost center is based on the planned quantity

or the capacity. Price indicator 1 means that the activity price is

calculated by dividing the costs by the planned activity. Price





indicator 2 means that the activity price is calculated by

dividing the costs by the planned capacity.

The activity price is used to assign costs from the quality

control cost center to the production cost centers based on the

quantities confirmed. This price is analyzed when variances

are calculated. If the cost center has not operated at the rate

planned, the price includes fixed costs that are too high or low

and these appear as a fixed-cost variance for the quality cost

center. If the activity price is changed — for example, by using

a manual correction — variance analysis reveals an output

price variance on the quality control cost center and input price

variances on the production cost centers.

Some companies do not calculate their activity prices in R/3 at

all, but instead calculate them manually and upload them from

a spreadsheet. In this case, the price indicator 3 is used. This

does not affect your ability to calculate target costs and

variances.

Calculating Target Costs

Let's assume now that actual costs have been incurred and

activities have been posted to production. If the quality control

cost center had provided 150 hours of activity in January as

planned, the report you saw in Figure 1 would provide ample

explanation. However, if the operating rate for the cost center

is different, the target/actual comparison provides a better

reflection of the business for the period in question, because it

adjusts the planned costs to reflect the fact that 160 hours of

activity were actually provided in January. The variableplanned costs is adjusted to reflect the higher amount of

activity.

If you compare Figure 1 to Figure 4, you can see that the

totals have changed. In Figure 1 the total planned costs were

EUR 29,000 and in Figure 4 the total target costs are EUR

29,800. All cost elements containing activity-dependent costs

— in this case, external procurement and direct labor — have

been affected by switching from planned costs to target costs.

Thus, the planned/actual comparison shows a variance of EUR

3,000 for External procurement and no variance for Direct

labor costs, whereas the target/actual comparison shows a

variance of EUR 3,600 for External procurement and EUR

200 for Direct labor costs. Only the activity-independent costs

— Salaries and Office & Building — remain the same.





Figure 4

Target/actual comparison for cost center group (click on image for full-screen)

Running variance analysis gives you an even more detailed

explanation of the source of each variance. By double-clicking

on each report line, you can see the categories of variance for

each activity type. Figure 5 shows the operating rate, the

planned quantity, and the actual quantity.




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Figure 5

Variance analysis with detail of quality costcenter (click on image for full-screen)

The control costs are the actual costs assigned to thecost center for the period (in Product Cost Controllingthey have been cleansed of any scrap or work inprocess, but in CO-OM-CCA they are all input costs).

The target costs are the planned costs adjusted toreflect the operating rate (in this example, 106.67percent).

The actual costs allocated are the costs assigned fromrepairs to production using the planned activity price for the cost center.

SAP distinguishes between input variances (those resulting

from changes in the costs coming in to the cost center) and

output variances (those resulting from changes to the output of





the cost center or the activity price).

The input variances are:

Input price variances occur as a result of changes to theactivity prices for other cost centers or material pricechanges

Input quantity variances occur as a result of using adifferent quantity of activity from other cost centers

Resource-usage variances occur if an activity is used from another cost center than wasoriginally planned

Remaining variances is a catch-all for any unassignedvariances

The output variances are:

Output price variances occur if the activity price ischanged for any reason

Fixed cost variances occur if the operating rate changesresult in an over- or undercharging for the fixed costs inthe activity price. In my example, the production costcenters were overcharged for the fixed part of theactivity price (salaries and building costs).

Remaining variances is a catch-all for any unassignedvariances

Managing Cost Center Performance

Companies that use target costs extensively judge their cost

center managers not on their ability to stay within a budget, but

by their ability not to exceed their target costs. They expend a

great deal of energy planning activity inputs and outputs

because they believe it reflects the business they plan to do in

the next planning time frame. They know that the business

environment will change, but they use the target costs to reflect

the fact that their cost center had more or less work than they

had anticipated at the time of planning.

Companies running ABC can use the same functions to

analyze both cost center costs and process costs. In this case,

as well as planning the outputs of their cost centers, these

companies plan the process outputs based on the quantities of

activity required to meet their sales plan and then adjust the

planned process costs to reflect the actual process output for the period. The notion of detailed output planning and the

"flexing" of the planned costs to reflect actual output is central

to SAP's approach to CO-OM-CCA and ABC. Unfortunately,

the significance of the target costs often gets lost in translation,

meaning that companies miss out on an effective method of

managing cost center performance.

Analyzing Target Costs in Business Information





Warehouse

The reports shown in this article have been accessed directly

from SAP's R/3. Similar reports are available within Business

Information Warehouse (BW).

To build reports like those shown in Figures 1 and 4, you

should use InfoCube 0CCA_C11 (CO-OM-CCA: costs and

allocations). This InfoCube contains the totals on the cost

center. To provide the base data for Figure 1, use InfoSource

0CO_OM_CCA_9 for the actual costs (value type 010) and

InfoSource 0CO_OM_CCA_1 for the planned costs (value

type 020). To provide the base data for Figure 4, create an

additional InfoPackage for InfoSource 0CO_OM_CCA_1 and

select the target costs (value type 030). Schedule this

package to load monthly, when the calculations in R/3 are

complete.

To build reports like those shown in Figures 2 and 3, use

InfoSource 0CO_OM_CCA_2 to extract the costs per activity

type to InfoCube 0CCA_C02 (CO-OM- CCA: Costs andallocations by activity type) and InfoSource

0CO_OM_CCA_3 to extract the activity quantities and

capacity to InfoCube 0CCA_C04 (CO-OM-CCA: activity

quantities and prices).

To build reports like that shown in Figure 5, you should also

use InfoCube 0CCA_C11. If you intend to build your own

queries, you should activate the restricted key figures for this

InfoCube to save you from having to define key figures for

each of the variance categories I mentioned.

Setting up Planning Layouts

The screens in which you enter data during planning are

configurable, so you may find that suitable planning

layouts do not exist in your productive system if your

organization is not doing the sort of detailed planning that I

have described. To set up suitable planning layouts,

choose the IMG menu path Planning>Manual

Planning>User-Defined Planning Layouts>Create

Planning Layouts for Cost Element Planning or Create

Planning Layouts for Activity Type Planning. These

transactions take you to Report Painter, where you can

position the fields you need in a planning layout that meets

your planners' needs. In my example, I entered the activity

quantities and capacities in layout 1-201 (activity

types/prices), the costs to provide the output in layout 1-

101 (cost elements) and the activity input in layout 1-102

(activity input) — all of which are standard settings. At a

customer site I would probably copy layout 1-102 and

create separate layouts for activity-dependent and activity-





Janet Salmon

Janet Salmon joined SAP AG in 1992. After six

months of training on R/2, she began work as a

translator, becoming a technical writer for the

Product Costing area in 1993. As English

speakers with a grasp of German costing

methodologies were rare in the early 1990s, she

began to hold classes and became a product

manager for the Product Costing area in 1996,

helping numerous international organizations set

up Product Costing. More recently, she has

worked on CO content for SAP NetWeaver

Business Warehouse, Financial Analytics, and

role-based portals. She is currently chief product

owner for management accounting and the

author of the SAP PRESS book titled Controlling

with SAP – Practical Guide. She lives in Speyer,

Germany, with her husband and two children.

You may contact Janet via email at

[email protected].

See more by this author

independent costs, because I find that leaving fields blank

(for activity- independent costs) in the selection screen is

confusing.

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SAPexperts | What Are Target Costs in Cost Center Accounting and Why Should You Calculate Them