Strategic CostManagement

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Cost-reduction, it is said, is atrue path to sustainablecompetitive advantage. Yet theexercises of the early 90s havehardly yielded benefits promised.The price of cost-reduction asstop-start vs strategic:

law of recurring costsstaff and expenses reduced,workload doesnt fall at samrate, behaviours dont chancosts elsewhere drift up,offsetting savings

wrong costs eliminatedmany employees dontunderstand real costs becaustandard costing systems atheir allocation processes;usually easiest costs cut f

costs cut outside stratein response to crisis, short-needs, weakening the stratestrength of an organisationone-time reductions neithefollowed up nor maintaine

mistrust because top-dviewed as sensitive, not suiemployee involvement; resecosts cannot be reducedeffectively, continuously unemployees want them reduc

Strategic perspective

Three main themes underpinstrategic cost management:

value chain analysisbreak down a firms relevantactivities in order to understand

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At USF&G, a major USinsurance company, middlemanagement task forceswere formed not just tofind the answers but also to

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Harley Davidson ensuthe true cost of everycomponent is knownemployees at every leallows them to manacosts as part of their

Blue Circle have trainpeople to ask and ansquestions: Is there valadded to my activitieAre there unnecessarcomplexities? What athe true cost implicatiof this decision? TEL: +44 (0)1737 767181 FAX: +44 (0)

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the behaviour of costs; toobtain sustainable advantfirm must either:

O perform one or moreactivities in the chaithe same quality levcompetitors, but at lcost; or

O perform its value chactivities at a higherquality level, but at greater cost

cost driver identificatcost drivers cause costs toincurred by an activity orevent; some are within a control (executional) and are not (structural); any gactivity may be due to secost drivers acting togeth

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value engineeringinvolves developing a strto achieve a lower relativposition through controllcost drivers, or reconfiguthe value chain; for eachactivity the key question

O can we reduce costsactivity, holding val(revenues) constant?

O can we increase valthis activity, holdingconstant?

O can we reduce assetthis activity, holdingand revenues consta

Undertake detailed examof designs and processes identify candidates forimprovement; a good staat process complexity. Nocost reduction efforts:

O must not erode comdifferentiation, and

O must be tested forsustainability

make tough decisions.Norman Blake: Theircharge was to look at we could be most costeffective not what ayour recommendationreducing costs? I askethem to justify the valevery cost in the compsuperstructure. Succesachieved by givingdecision-making powecosts to those who wobe implementing the p

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Internal analysis

Standard costing (comparesactual costs against a standard)is under pressure due to:

rapid changes in coststructures

inconsistency with just-in-time

lack of focus on continuousimprovement

Though standard costing isuseful for control, performaassessment, new tools gaincurrency:

1. Cost of Quality (Ccan be assessed in 4 catego

prevention costs: to ensdefects do not occur egpreventative maintenanc

appraisal costs: inspectiensure customer requiremare met eg testing

internal failure costs: torectify defective outputbefore it reaches thecustomer eg rework

external failure costs: odelivering defective goodthe customer eg returns

Research: firms tend to spein the wrong place: more ointernal, external failures aappraisal, than prevention;of thumb: for every 1 speprevention, 10 can be savappraisal, failure costs. But

quality costs are variabthe way up but fixed oway down ie not easy toreduce: may be able to cdefects by 25%, but maybe able to reduce reworkworkforce by 25%

companies have learnedneutralise poor quality customers not always anto receive better qualitybecause they have builtinfrastructure to cope witdefects, shortfalls in serv

2. Managing Cycle Timetime between starting andfinishing the production of anorder; composed of:

processing time: time spentworking on the product

wait time: time spentbetween production stages

move time: time spentmoving between stages

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3. Target Costingan evolution of Japanese kaizencosting; arrived at as follows:

set long-term sales goalsmust be realistic, not wishfulthinking; at Toyota the salesdivision proposes sales,production volumes based onpast sales levels, market trends,and competitors productofferings

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inspection time: ensuoutput is of required q

In customers eyes only tprocessing time adds valuhence ideally, manufactucycle efficiency (MCE):

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Research: MCE ratio is of

The terminology of costs in itself can be daunting. Many different flavours of cost measurement exist, depending on views ofcost by product, business unit, project, process, or customer. Here are some basic cost definitions and terms that managersneed to be aware of:

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Know Your Costs

Measure What it meansabsorption costing includes both fixed and variable overheads in product costsactivity-based costing (ABC) costs are assigned to activities, then allocated to products consuming the activities

actual cost based on historical data, including storage and deliveryaverage/unit cost total cost of producing a quantity of product divided by number of units producedavoidable cost costs no longer incurred if company discontinues an activity, productcarrying cost

controllable costcost allocationcost centrecost drivercost objectcost of capitalcost of goods soldcost poolcost-plus pricingcost structuredifferential costdirect costdiscretionary costdistribution costeconomic order quantityengineered costexperience curveexternal failure costfixed costincremental costindirect costinternal failure costjoint costkaizen costingmarginal costmixed costnormal costingopportunity costprevention costsprime costsproduct costproduct life-cycle costingstandard coststep-down methodstep costsunk costtarget cost

total cost curvetransfer pricevariable cost9TEL: +44 (0)1737 767181 FAX: +44 (0)1737 767868 e-mail subs@bulletpoint.co.uk www.bulletpointonline.com Bulletpoint - March 2000

extra cost of producing one additional unitcost with both fixed and variable componentallocates to products actual direct labour, material, and overheads by formulapotential benefit given up when one action is chosen above another

costs of preventing defective productscosts of direct material and direct labourcost of a product until it is sold, at which point it becomes an expenseaccumulation of costs from product concept to discontinuancepre-determined estimate of producing one unit; benchmark for actual costwhere service dept costs allocated first to service depts, then to production deptsfixed or variable, but move in jumps, usually large for fixed, small for variablecosts incurred in the past and unalterable by current or future decisionsprojected long-term product cost; target selling price less target profit

graphs relationship between total cost and total quantity produced and soldprice at which products, services are transferred between a firms divisionschanges in direct proportion with either inputs or outputscost of holding stock from purchase to use

cost that is substantially controlled or influenced by a particular individual process of assigning costs, usually overheads, by formula eg volume, resource usea responsibility centre whose manager is accountable for its costsitem(s) that have the highest bearing on, or causing an activitys costcritical item, activity or process whose costs need to be separately measuredcost of acquiring resources either through debt or issuing stocktotal cost of finished goods actually sold in a particular period collection of costs for different cost objectswhere price equals cost plus percentage mark-uprelative proportion of a products, firms variable vs fixed costsdifference in a cost item under two decision alternativescost traceable to a product, dept, usually direct labour and materialsnot essential for operations, but critical to maintain profitability, growthcost of storing and transporting finished goods; includes salaries, selling coststhe order size that minimises inventory holding and ordering costscost that results from a definitive physical relationship with an activitygraph showing how costs decline as cumulative production output increasesincurred because defective products have been solddoes not change in total as activity, volume changesamount by which the cost of one action exceeds that of anothercost that cannot be traced to one product, department, processcost of correcting defects found prior to saleincurred in a joint production process before products are separatedprocess of continual cost reduction during the manufacturing phase of a product

10 TEL: +44 (0)1737 767181 FAX Bulletpoint - March 2000

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External analysis

Cost performance should also bemonitored vs competitors andother best practise firms. Somemethods:

product teardowndisassembling and analysingproducts to identify materialsthey contain, parts they use,and the way they function andare manufactured; not jucompetitors products butproducts that contain parwhich perform similar buidentical functions, eg trumaker tearing down passvehicles to see how fuel systems function

roundtableswith other firms who are direct competitors, but wsimilar processes; all firmbenefit from rich exchangideas; can be formal, eg sassociation, or informal tuniversities, industry grou

benchmarkingshould go beyond productoperating, management skmost powerful: estimate cactivities and processes asperformed by a perfectly lenterprise; even the best fthey have some way to goachieve waste-free standaencourages out-of-the-bothinking

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Benchmarking ROI

in a recent benchmarking study Florida Power & Light found thatit ranked quite high on customer service, but that its costs werehigh for the industry; as a result the utility initiated several stepsto cut costs without impairing customer service

AMP, a manufacturer of electronic connectors, benchmarkedsupplier management practices against Federal Express, Frito-Layand American Airlines; results after re-engineering:

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Cost-stripping

Isuzu applies productteardown in all stages oproduct developmentprocess. The company eight different teardowmethods, some designereduce a vehicles direcmanufacturing cost andothers intended to reduthe investment requireproduce vehicles throuincreased productivity.

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competitive cost analysisrequires intensive informationgathering from various sourceusing multi-functional teams;includes:

O careful screening of pubinformation

O tearing down competitoproducts

O identifying suppliers andcosts of parts sourced frthem

O analysing cost andefficiency of labour forc

O assessing capacityutilisation of assetsemployed

O supplier base cut by O cycle time reduced byO quality increased fromO late shipments decrea

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ReferenceThe Cost Management Toolband Boosting Profits Lianabe

Develop Profitable New ProdRegine Slagmulder Sloan Man

Manage Your Costs by ManaManagement Accounting June

Managerial Accounting Rona

Practical Issues in Cost DriveDale Geiger Government Acco

Strategic Cost ManagementManagement Accounting July

Target Costing as a StrategicSloan Management Review Fa

* Indicates booksom

Tool John K Shank, Joseph Fisher ll 1999e

or future cost-reductionprogrammes

... understanding all of whjust may make the differenbetween survival andcompetitive demise.

s and further readingox: A Managers Guide to Controlling Cl Oliver Amacom 2000*

ucts with Target Costing Robin Cooper,agement Review Fall 1999

ging Your Cycle Times Tony Brabazon 1999

ld W Hilton Irwin McGraw-Hill 1999*

r Selection for Managerial Costing Sysuntants Journal Fall 1999

Robin Cooper, Regine Slagmulderichce

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Competitor info will containgaps to be filled with estimatesbased on logical assumptions;analysis needs to go beyondsimple estimates of competitorsproduct costs and:

highlight any value(dis)advantages on productquality, customer service

provide insights intostrategies and future plans,quantifying impact of current

/3 50% 92% to 98%

sed from 30% to 10%