STRATEGIC COST MANAGEMENT IN GENERAL

INTRODUCTION

Cost management is the development and use of both financial information (costs and revenues) and
non-financial information (customer retention, productivity, quality and other critical success factors
[CSF]) within the organization to manage the firm and make it more competitive and successful.

Cost Management Information

Cost information serves all management functions, and is useful in all organizations: business firms,
governmental units, and not-for-profit organizations; merchandising, manufacturing, and service
firms; large and small firms in all types of industries.

Information a manager needs to manage effectively include both financial and nonfinancial and these
are developed under the direction of the controller for the Chief Financial Officer (CFO) of the
organization. Financial information alone shows a short-term focus

Cost management information is developed and used within the organization’s information value
chain, from stage 1 through stage 5 as shown below

Stage 1 Stage 2 Stage 3 Stage 4 Stage 5

Business 1.
Information Knowledge Decisions
events Data

At lower stages of the value chain, management accountants gather and summarize data (stage 2)
from business events (stage 1) and then transform the data to information (stage 3) through analysis
and use of the management accountant’s expertise. At stage 4, the information is combined with other
information about the organization’s strategy and competitive environment to produce actionable
knowledge. At stage 5, management accountants use this knowledge to participate with management
teams in making strategic decisions that advance the firm’s strategy.

Cost information is used in a variety of ways:

 to manage production costs
 to manage stocking, distribution and customer service
 to know the cost of new products and services, cost of finding a new way to produce the
product or to provide the service
 to determine prices
 to change product or service offerings to improve profitability
 to update manufacturing facilities in a timely fashion
 to determine new marketing methods or distribution channels

Cost management focus

 Prior business environment: financial reporting and cost analysis; common emphasis on
standardization and standard costs; the accountant as financial accounting expert and
financial scorekeeper
 Contemporary business environment: cost management as a stool for the development and
implementation of business strategy; the accountant as a business partner.

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Cost Management vs. Financial Reporting
 Financial reporting
 External users
 Emphasis on accuracy and compliance
 Cost management
 Internal users
 Emphasis on usefulness and timeliness, key characteristics of decision-relevant
information

It is a real challenge for the controller to reconcile these potentially conflicting roles.

Four Functions of Management

Cost management information is assembled to aid management in the following functions:
 Strategic management: Cost management information is needed to make sound strategic
decisions about choice of products and manufacturing methods, marketing techniques,
evaluating customer profitability
 Planning and decision-making: to support recurring decisions about replacement of assets,
managing cash flow, budgeting raw materials purchases, scheduling production, pricing
 Management and operational control: to provide a fair and effective basis for identifying
inefficient operations and to reward and motivate effective managers
 Preparation of financial statements: to provide accurate accounting for assets, in compliance
with reporting requirements (of Financial Reporting Standards Council, Securities and Exchange
Commission and other governmental regulatory bodies) for the preparation of financial reports
or statements

The Strategic Focus of Cost Management: Kaplan’s Phases for Developing Cost Management Systems

Stage One Cost-management systems are basic transaction reporting systems.

Stage Two Cost-management systems focus on external reporting–decision-

usefulness of cost-management data is limited.

Stage Three Cost-management systems track key operating data and relevant cost
information for decision-making.

Stage Four Strategically relevant cost-management information is an integral part of

the system.

Strategic cost management describes cost management specifically focused on strategic issues. This
seeks answers to questions such as:
• Who are our most important customers and how do we deliver value to them?
• What substitute products exist in the market? How do they differ from ours?
• What is our most critical capability? What do we do best?
• Will adequate cash be available to fund the strategy or is outside financing needed

Contemporary Management Techniques

1. The Balanced Scorecard and the Strategy Map
 The Balanced Scorecard (BSC)
 An accounting report that addresses a firm’s performance in four areas:
financial, customer, internal business processes, and innovation and learning

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  The Strategy Map
 The strategy map is a method, based on the balanced scorecard, which links the
four perspectives in a cause-and-effect diagram.

2. The Value Chain

 An analysis tool used to identify the specific steps required to provide a competitive
product
 Helps identify steps that can be eliminated or outsourced

3. Activity-Based Costing and Management

 Activity-Based Costing (ABC) improves the tracing of costs to individual products
and customers.
 Activity-Based Management (ABM) improves operational and management control.

4. Business Intelligence
 An approach to strategy implementation in which the management accountant uses
data to understand and analyze business performance.

5. Target Costing
 Target Cost = Market-determined price – Desired Profit
 A method that has resulted from intensely competitive markets.

6. Life-Cycle Costing
 Costs should be monitored throughout a product’s life cycle – from research and
development to sales and service.

7. Benchmarking
 Process by which a firm identifies its CSFs, studies the best practices of other firms in
achieving these CSFs, and institutes change based on the assessment results

8. Business Process Improvement

 This technique involves managers and workers committing to a program of
continuous improvement in quality and other CSFs.

9. Total Quality Management (TQM)

 A technique by which management develops policies and practices to ensure the
firm’s products and services exceed customer’s expectations.

10. Lean accounting uses value streams to measure the financial benefits of a firm’s progress in
implementing lean manufacturing.

11. The Theory of Constraints (TOC) helps firms improve cycle-time (i.e., the rate at which raw
materials can be converted to finished products).

12. Enterprise Sustainability means the balancing of the company’s short and long term goals in
all three dimensions of performance – social, environmental, and financial.

13. Enterprise risk management is a framework and process that firms use to managing the risks
that could negatively or positively affect the company’s competitiveness and success.

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Competitive Strategies
 A firm succeeds by implementing a set of policies, procedures, and approaches to business
called strategy
 Strategy must have a long-term focus and adapt to the changing environment
 Cost management information should be used to develop and monitor strategic information

Michael Porter: Strategic Positioning

• Cost Leadership—outperform competitors by producing at the lowest cost, consistent with
quality demanded by the consumer
1. A cost leader is one who
 Makes sustainable profits at lower prices
 Has a relatively large market share and avoids niche or segment markets
 Focuses almost exclusively on cost reduction
2. A cost leader can remain competitive only as long as the consumer sees that the product
or service is (at least nearly) equivalent to competing products that cost somewhat more.
• Differentiation—creating value for the customer through product innovation, product features,
customer service, etc. that the customer is willing to pay for.
1. It enables the firm
 to charge higher prices and
 to outperform the competition without reducing costs significantly.
2. Strategy may backfire because of the entity’s tendency to undermine its strength
 by attempting to lower its costs or
 by ignoring the necessity of having a continuous and aggressive marketing plan
to reinforce its perceived difference.

VALUE-CHAIN ANALYSIS
• An analysis for better understanding the details of the organization’s competitive strategy
1. CSFs (critical success factors such as product innovation, quality, skill development) must
be implemented in each and every phase of operations
2. Helps a firm better understand its competitive advantage by analyzing what processes
add value (processes that do not add value can be deleted or outsourced)
• Will include upstream (prior to manufacturing or operations) and downstream activities

 Value-chain analysis has two steps:

 Identify the value-chain activities at the smallest level possible
 Develop a competitive advantage by reducing cost or adding value
 To develop a competitive advantage, a firm must consider the following:
 What is our competitive advantage (strategy)?
 Where can we add value for the customer?
 Where can we reduce costs?
 Are any of our processes linked (linkages exploited)?

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Example: Value-Chain Analysis in Computer Manufacturing
 Computer Intelligence Company (CIC) manufactures computers for small businesses. The
company has an excellent reputation for service and reliability as well as a growing customer
list. It competes on differentiation.
 The company is considering two options:
1. Option One is to continue functioning as is.
2. Option Two includes two separate outsourcing decisions: (a) the purchase or
manufacture of parts, and (b) providing service internally or outsourcing it. It is
important to consider company strategy in outsourcing decisions

Value Activity Option One – Current Option Two – Potential

Acquiring raw CIC is not involved at CIC is not involved at this

materials this step step

Manufacturing CIC is not involved at CIC is not involved at this

computer chips and this step; cost is P200 step; cost is P200
other parts

Manufacturing CIC purchases P300 of CIC manufactures these

components, some of parts for each unit parts for P190 per unit plus
which CIC can make P55,000 monthly

Assembling CIC’s costs are P250 CIC’s costs are P250

Marketing, CIC’s costs are P175,000 CIC contracts out these

distributing, and per month services for P130 per month
servicing

Is there any way to add value for the customer while reducing costs?

 Results of Value-Chain Analysis

Marketing, distributing,
Manufacturing and servicing

Option One 600 x P300 = P180,000 P175,000 per month

Option Two 600 x 190 + P55,000 = P78,000 per month

P169,000

Savings with Option Two P11,000 P97,000 per month

a. CIC can save P108,000 (P11,000 + P97,000) per month by manufacturing the parts and
contracting out marketing, distributing, and servicing
b. The main factor driving the decision is company strategy, which in this case is quality and
customer service
 For a firm pursuing a differentiation strategy, the best option is not necessarily the
one which provides the most savings (savings is a secondary consideration)
 From a strategic viewpoint, Option One is preferred over Option Two

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COST PLANNING FOR THE PRODUCT LIFE CYCLE

 Four costing methods:

1. Target costing
2. Theory of constraints (TOC)
3. Life-cycle costing
4. Strategic pricing
 All involve the entire product life cycle:
 Managers now need to look at costs upstream (before manufacturing) and downstream (after
manufacturing).

TARGET COSTING
 Target costing: a costing method in which the firm determines the allowable (i.e., “target”) cost
for a product or service, given a competitive market price and a targeted profit
 Two options for reducing costs to achieve the target-cost level:
 By integrating new manufacturing technology using advanced cost management
techniques, (such as ABC), and seeking higher productivity
 By redesigning the product or service
 Implementing Target Costing
 Determine the market price.
 Determine the desired profit1
 Calculate the target cost as market price less desired profit.
 Use “value engineering” to reduce cost.
 Use kaizen costing and operational control to further reduce costs.

1 For example, expressed as a percent of peso-sales.

Value Engineering
 Analyze trade-offs between product functionality (features) and total product cost
 Perform a consumer analysis during the design stage of the new or revised product to
identify critical consumer preferences
 To implement value engineering, managers must distinguish between value-added and non-
value-added costs. A value-added cost is a cost that, if eliminated, would reduce the value of
the product in the eyes of the customer. A non-value-added cost is one that, if given a choice,
the customer would not pay for.
 In performing value engineering, a distinction must be made between cost incurrence and
when costs are locked in. Cost incurrence describes when a resource is consumed to meet a
specific objective. When direct materials are placed into production, the cost has been
incurred. Locked-in costs or designed-in costs are costs that have not been incurred, but are
based on decisions that have already been made, and will be incurred in the future.
 Design choices affect locked-in costs. Once the design of the product is finalized, the cost of
the product is determined to a large degree. If the design of the product requires four screws,
the cost of four screws is a locked-in cost. As the product is manufactured it becomes an
incurred cost and can be avoided only by a redesign or by not manufacturing the product.
 Because costs are incurred at all points in the value chain, but frequently locked in during the
design phase, cost reductions can be most readily attained through value-chain analysis and
the use of cross-functional teams. By forming a team of representatives from all segments of the
value chain, the product can be designed to reduce costs while retaining features that
customers value.

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  The key steps in value engineering are:
 Understanding customer requirements and value-added and non-value-added costs
 Anticipating how costs are locked in before they are incurred
 Using cross-functional teams to coordinate redesign products and processes to reduce
costs while meeting customer needs

Cost reduction methods

 Functional analysis refers to the examination of the performance and cost of each major
function or feature of the product. For firms that can add and delete features easily, this
method can be used. Benchmarking is often used in this step to determine which features give
the firm a competitive advantage. Its goal is to provide a desired level of performance
without exceeding the target cost.
 Design analysis
 Useful when the firm cannot add and delete features easily
 The design team prepares several possible designs of the product, each having
similar features with different levels of performance and different costs.
 Accountants work with the design team to choose one design that best meets
customer preferences while not exceeding the target cost.
 Cost tables contain computer-based databases (costs and cost drivers). Firms that
manufacture parts of different size from the same design can estimate the difference in cost
and material usage for increasing or decreasing size
 Group technology is a method of identifying similarities in the parts of products a firm
manufactures so the same parts can be used in two or more products, thereby reducing costs

Kaizen
Kaizen (step five) refers to using continuous improvement & operational control to reduce costs in the
manufacturing stage of the product life-cycle. It is achieved through:
 Streamlining the supply chain
 Lean manufacturing
 Improving manufacturing methods and productivity programs
 Employing new management techniques
 Used extensively in the time period between product redesigns

Benefits of Target Costing

 Increases customer satisfaction (design is focused on customer value)
 Reduces costs (more effective and efficient design)
 Helps the firm achieve desired profitability on new and redesigned products
 Reduces “surprises” of the type, “We did not expect it to cost that much...”
 Can improve overall product quality
 Facilitates coordination of design, manufacturing, marketing, and cost managers throughout
the product cost and sales life-cycles

MEASURING AND IMPROVING SPEED

Today, many strategic initiatives focus on improving the speed of operations. Time is an increasingly
important strategic factor. Proper time management can increase revenues and decrease costs.

In order to manage time, it must be measured properly. Two operational measures of time are
frequently utilized: customer-response time and on-time performance.

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Customer-response time is how long it takes from the time a customer places an order for a product
or service to the time the product or service is delivered to the customer. Components of customer-
response time include:

 Receipt time is how long it takes marketing to specify to manufacturing the exact
requirements of the customer order.
 Manufacturing cycle time (also called manufacturing lead or throughput time) is how long it
takes from receipt of the order by manufacturing to the time the finished good is produced.
 Delivery time is how long it takes to deliver a completed order to a customer.

Customer-response time – illustrated:

Manufacturing cycle efficiency (MCE) is a measure of company response time efforts. It is calculated
by dividing value-added manufacturing time or processing time by manufacturing cycle time. MCE
separates manufacturing cycle time into:
 Processing time
 Inspection time
 Materials handling time
 Waiting time, and so on
 Most firms would like to see MCE close to one.
 Constraints are activities that slow a product’s total cycle time

On-time performance delivery of a product or service by the time it is scheduled to be delivered. On-
time performance increases customer satisfaction, but there is a trade-off between on-time
performance and customer response time

THE THEORY OF CONSTRAINTS (TOC)

The Theory of Constraints is a specialized version of variable costing for use in short-run optimization
decisions. A distinction between TOC and variable costing is that TOC focuses on only the purely
variable costs (materials cost) and does not consider direct labor to be purely variable. TOC deals
heavily with the improvement of constraints or bottlenecks in a production system.

A constraint is anything that confines or limits a person or machine’s ability to perform a project or
function
 human constraints
 bottlenecks

A bottleneck is an operation where the work to be performed approaches or exceeds the capacity
available to do it. In simpler terms, it is an operation that has a limited capacity.

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According to Dr. Eliyahu Goldratt, the “Flow of goods through a production process cannot be at a
faster rate than the slowest bottleneck in the process.” The theory of constraints
 Describes methods to maximize operating income when faced with bottleneck (BO) and non-
bottleneck operations (NBO).
 It defines three (3) measures:
1. Throughput contribution or margin = revenues minus the direct materials costs of
goods sold
2. Operating expense / costs = all costs of operations (other than direct materials)
incurred to earn throughput contribution. Operating expenses include conversion
costs, salaries and wages, rent, utilities, depreciation, etc.
3. Assets / investments = sum of materials costs, WIP and FG inventories; R&D costs;
and costs of equipment & buildings

 Focuses on purely variable costs (DM) and does not consider DL to be purely variable
 When applied to manufacturing costs, uses one form of variable costing
 Objective: increase throughput contribution while decreasing investment & operating costs
 Considers short-run time horizon and assumes that operating costs are fixed costs
 Complements the long-run strategic-cost-management focus of ABC.

TOC focuses on improving speed at the constraints, to decrease overall cycle time.

Methods to relieve bottlenecks

 Eliminate idle time at the bottleneck operation.
 Process only those parts or products that increase throughput contribution, not parts or
products that will remain in finished goods or spare parts inventories.
 Shift products that do not have to be made on the bottleneck operation to non-bottleneck
processes, or to outside processing facilities.
 Reduce setup time and processing time at bottleneck operations.
 Improve the quality of parts or products manufactured at the bottleneck operation.

Five steps in TOC

1. Identify the constraint.
2. Determine the most profitable product mix given the constraint.
3. Maximize the flow through the constraint.
4. Add capacity to the constraint.
5. Redesign the manufacturing process for flexibility and fast cycle time.

TOC Example

HPI Process, Incorporated manufactures both the second generation (HPI-2) and the third generation
(HPI-3) of hearing aids. Prices are competitive at P600 and P1,200, respectively, and are not expected
to change. The monthly number of orders for HPI-2 is 3,000 units and for HPI-3 is 1,800 units.
New customers are told they may have to wait three weeks or more for their orders, and management
is concerned about the need to improve speed in the manufacturing.

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Step 1: Identify the Constraint
 Develop a flow diagram, which shows the sequence and time of each process
 Use the flow diagram to identify the constraint for HPI (see example, next slide)
 There is difficulty maintaining adequate staffing in all process areas except process 5
 The constraint occurs in process 4, perform final assembly and test; the other four
processes have slack time

Step 2: Determine the most profitable product mix given the constraint
 The most profitable mix provides the maximum total profits for both products.
 First, using throughput margin determine the most profitable product given the
constraint
 Throughput margin = selling price less materials cost
 In the example, the relevant measure of profitability is throughput margin per minute in final
assembly and testing.

As can be seen, HPI-3 has a higher throughput margin. In the absence of constraints, this product
would be more profitable, but with the time constraint in process 4, HPI-2 is the more profitable
product.

HPI-2 HPI-3
Price P600 P1,200
Materials cost 300 750
Throughput margin P300 P450
Constraint time (Process 4) 30 60
Throughput per minute P10 P7.50

HPI will produce all 3,000 units (total demand) for HPI-2 since it is the more profitable, and
the remaining capacity will be used to produce HPI-3. HPI-2 will use 1,500 (3,000 units x 0.5
hour per unit) hours of the 2,400-hour capacity. The 900 hours remaining allow for
production of 900 units of HPI-3.

HPI-2 HPI-3
Total demand in units 3,000 1,800
Units of product in optimal mix 3,000 900
Unmet demand — 900

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Step 3: Maximize the flow through the constraint
 Look for ways to speed the flow by simplifying the process, improving product design,
reducing setup, and reducing other delays.
 Objective is to balance the flow of production through the system (processes prior to and
including the constraint) by carefully timing and scheduling those activities.
 Another method to use is Takt time (total time available to meet expected customer demand).
 Example: If a manufacturing plant operates 8 hrs. per day; after allowing for break time, 400
minutes of manufacturing time are available per day. If average customer demand is 800
units, the Takt time is 30 seconds per unit, that is, 30 seconds per unit. Takt time is used to
balance the flow of product through the processes.

Takt time = 400 minutes ÷ 800 units = 30 seconds per unit

Step 4: Add capacity to the constraint

Adding new machines or additional labor is a long-term measure that can improve flow
through the constraint.

Step 5: Redesign the manufacturing process for flexibility and fast cycle-time
This step involves the most complete strategic response to the constraint because simply
removing one or more minor features of a product might speed up the production process
significantly.

Theory of constraints vs. Activity-based costing

TOC ABC

Main Short-term focus: through put Long-term focus; analysis of all

Objective margin analysis based on materials product costs
and materials-related costs

Resource Included explicitly, a principal focus Not included explicitly

constraints of TOC

Cost drivers No direct utilization of cost drivers Develop an understanding of cost

drivers at all levels

Major Use Optimization of production flow and Strategic pricing and profit planning
short-term product mix

LIFE-CYCLE COSTING
A normal budget cycle is a one-year period. However, companies sometimes need to consider target
prices and costs over a multiple year product life cycle. The product life cycle spans the time from
initial R&D on a product to the point where customer support and service are no longer offered for
that product.

The product life cycle model depicts the stages through which a product class (not each product)
passes from the time an idea is conceived until production is discontinued. Companies must be aware
of where their products are in their life cycles because, in addition to the sales effects, the life cycle
stage can have a tremendous impact on costs and profits.

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The product life cycle involves the following stages:
1. Development stage
Production methods, materials and conversion operations are selected. Many of the product’s
quality, cost, and environmental impacts are set with the decisions made in this stage. During the
product introduction stage, costs can be substantial and are typically related to engineering
change orders, market research, and advertising/promotion. Sales are usually low and prices are
often set in relation to the market prices of similar or substitute goods, if any are available.

 Development (R&D) costs expensed as incurred in financial accounting

 Decisions made during the development stage represent 80% to 90% of product’s total life-
cycle costs
 Substantial costs including engineering changes, market research, advertising, and promotion
 Sales price matches similar or substitute goods
 Sales low

2. Introduction stage
 Substantial costs including engineering changes, market research, advertising, and promotion
 Sales low
 Sales price matches similar or substitute goods

3. Growth stage
 Increased sales
 Quality may improve
 Prices stable

4. Maturity stage
 Sales stabilize or decline slowly
 Firms compete on selling price
 Costs at lowest level

5. Decline stage
 Waning sales
 Dramatic price cuts
 Cost per unit increases

Life-cycle budgeting is the process in which managers estimate revenues and business function costs
of the entire value chain. Life-cycle costing tracks and accumulates business function costs across the
value chain from a product’s R&D to final customer service and support.

Life-cycle costing provides a more complete perspective of product costs and profitability than
pricing based on manufacturing costs only…
 Managers need to be concerned with costs outside the manufacturing process because
upstream and downstream costs can account for a significant portion of total life-cycle costs.
 The most crucial way to manage these costs is at the design stage of the product and the
manufacturing process. Decision-making at the design stage is critical because decisions at
this point commit a firm to a given production, marketing, and service plan, and lock in most
of the product’s total life cycle costs.

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These factors make life-cycle budgeting important:
 The development period for R&D is long and costly. These costs must be recovered over the
life span of the product.
 Many costs are locked in at the R&D and design stages. Poorly designed products require
higher marketing and customer service costs.

A different approach to life-cycle costing is customer life-cycle costing. The approach considers the
cost of ownership of the product for the customer from the initial purchase to ultimate disposal.

 Life-cycle costing provides a more complete perspective of product costs and profitability
than pricing based on manufacturing costs only…
 Managers need to be concerned with costs outside the manufacturing process
because upstream and downstream costs can account for a significant portion of total
life-cycle costs.
 The most crucial way to manage these costs is at the design stage of the product and
the manufacturing process.
 Decision-making at the design stage is critical because decisions at this point commit a firm to
a given production, marketing, and service plan, and lock in most of the product’s total life cycle
costs.

Life-Cycle Costing Example

According to the “traditional” product-line statements below, ADI-1 appears to be the more
profitable product.

Analytical Decisions, Incorporated

Product Line Income Statement

ADI-1 ADI-2 Total

Sales P4,500,000 P2,500,000 P7,000,000
Cost of sales 1,240,000 1,005,000 2,245,000
Gross profit P3,260,000 P1,495,000 P4,755,000
R&D (2,150,000)
Selling & distribution (1,850,000)
Income before tax P755,000

However, when upstream and downstream (i.e., life-cycle) costs are considered, ADI-2 is actually
more profitable.

ADI-1 ADI-2 Total

Sales P4,500,000 P2,500,000 P7,000,000
Cost of sales 1,240,000 1,005,000 2,245,000
Gross profit P3,260,000 P1,495,000 P4,755,000
R&D (1,550,000) (600,000) (2,150,000)
Selling & distribution (1,450,000) (400,000) (1,850,000)
Income before tax P260,000 495,000 P755,000

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STRATEGIC PRICING

Strategic pricing decisions require information from:

 The cost life-cycle
 The sales life-cycle

The cost information for pricing is commonly based on one of four methods:
1. Full manufacturing cost plus markup
2. Life-cycle cost plus markup
3. Full cost and desired gross margin percent
4. Full cost plus desired return

The sales life cycle is the life-cycle of a product or service from the viewpoint of sales volume
achieved. Important cost management issues arise in each stage of the life-cycle. The sales life cycle is
the sequence of the following:
 Introduction of the product or service to the market
 Growth in sales
 Maturity
 Decline
 Withdrawal from the market

Strategic pricing depends on the position of the product or service in the sales life-cycle.

Phase 1 Pricing is set relatively high to recover development costs and take advantage
Introduction of new-product demand

Phase 2 Pricing is likely to stay relatively high as the firm attempts to build
Growth profitability

Phase 3 The firm becomes more of a price taker than a price setter and attempts to
Maturity reduce upstream and downstream costs

Phase 4 The firm becomes more of a price taker than a price setter and attempts to
Decline reduce upstream and downstream costs

End of Handout 1

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