Kaizen Costing Explained: Definition, Formula & Example

Kaizen costing is a core strategic cost management technique covered in ACCA Performance Management (PM) and CIMA's management accounting syllabus, and it regularly trips students up because it's easy to confuse with the similarly-named target costing. The two are related but operate at completely different stages of a product's life — understanding that distinction is usually the key to answering exam questions correctly.

What is kaizen costing?

Kaizen costing is a cost-management discipline that sets continuous, period-by-period cost-reduction targets during a product's actual production phase, rather than fixing a single static standard cost. Instead of accepting the current cost as the baseline going forward, kaizen costing uses the previous period's actual cost as the new starting point, then applies a further reduction target on top of it — the cost bar keeps moving lower throughout the production run.

Kaizen costing vs target costing

This is the distinction most exam answers get wrong. Target costing operates during the design phase, working backward from a competitive market price to determine the maximum allowable cost before the product is ever manufactured — it's about engineering cost out of a product before production starts. Kaizen costing operates during production itself, pursuing incremental, ongoing cost reductions through shop-floor improvements to a product that's already being made. In short: target costing sets the entry cost; kaizen costing keeps lowering the cost curve after production has begun.

Where the concept comes from

Kaizen costing emerged from Japanese manufacturing practice, most closely associated with Toyota's production system. The management accountant Yasuhiro Monden formalised it in the management accounting literature, documenting how continuous cost reduction operates as part of a broader lean production philosophy — "kaizen" itself is a Japanese term generally translated as "continuous improvement."

How reduction targets are typically set

Management usually sets kaizen cost-reduction targets as a modest annual percentage — often around 3% — allocated evenly across the reporting periods within the year. These targets cascade forward: if a quarter falls short of its target, the shortfall carries into the following period's baseline, maintaining consistent pressure for ongoing cost improvement rather than allowing a single missed target to disappear.

A worked example

Consider a component costing €40.00 per unit at the start of the year, with a 3% annual reduction target distributed across four quarters (roughly 0.75% per quarter). Through specific shop-floor improvements — better material yield, shorter machine setup times, fewer defects — the business targets a unit cost of around €38.80 by year-end, saving approximately €30,000 per quarter across the full production volume. Each quarter's actual achieved cost then becomes the new baseline for the next quarter's target, rather than resetting back to the original €40.00 figure.

Why this matters beyond the exam

Kaizen costing reflects a genuinely different mindset from traditional standard costing, where a cost standard is set once and variances are simply measured against it. Kaizen costing assumes that cost reduction is a continuous, expected part of operating a production process — it embeds the idea that today's cost should always be lower than yesterday's, which fits naturally with lean manufacturing and total quality management approaches that many manufacturers now use alongside it.

How this shows up in exam questions

ACCA PM and CIMA exam questions on kaizen costing typically test two things: whether you can correctly distinguish it from target costing in a scenario (the giveaway is usually whether the question describes activity happening before or during production), and whether you can work through a straightforward percentage-reduction calculation across multiple periods, tracking how the baseline cost shifts each time. A common trap is applying the reduction percentage to the original starting cost every period instead of the previous period's already-reduced cost — since kaizen costing compounds, each period's target should be calculated against the most recent actual cost, not the original baseline from the start of the year. Getting this compounding mechanic right is usually the difference between a partially correct and a fully correct exam answer.

FAQs

Can kaizen costing and target costing be used together? Yes, and in practice they often are — target costing establishes the initial allowable cost before production, and kaizen costing then drives further reductions once production is underway, working together across the product's full lifecycle.

Does kaizen costing apply outside manufacturing? While it originated in manufacturing, the underlying principle of continuous, incremental cost reduction has been adapted by some service businesses, though the technique is most commonly examined and applied in a manufacturing context.

What happens if a kaizen cost target can't realistically be met? This is a genuine practical limitation of the technique — kaizen costing assumes continuous improvement is always achievable, which isn't realistic indefinitely, and businesses eventually reach diminishing returns where further percentage reductions become increasingly difficult to find.

Kaizen costing is best understood as a mindset as much as a technique — a formalised expectation that costs should keep falling throughout a product's production life, achieved through the accumulation of many small, continuous improvements rather than one large redesign.