Strategic Cost Management - CBSbutler



Strategic Cost Management Cost-reduction, it is said, is a true path to sustainable competitive advantage. Yet the exercises of the early ’90s have hardly yielded benefits promised. The price of cost-reduction as stop-start vs strategic:

law of recurring costs

staff and expenses reduced, but workload doesn’t fall at same rate, behaviours don’t change; costs elsewhere drift up, offsetting savings

Strategic perspective

value chain analysis


perform one or more activities in the chain at the same quality level as competitors, but at lower cost; or


perform its value chain activities at a higher quality level, but at no greater cost

wrong costs eliminated

costs cut outside strategy

in response to crisis, short-term needs, weakening the strategic strength of an organisation; one-time reductions neither followed up nor maintained

mistrust because top-down

viewed as sensitive, not suited to employee involvement; research: costs cannot be reduced effectively, continuously unless employees want them reduced

Costs in truth

Harley Davidson ensures the true cost of every component is known by employees at every level; allows them to manage costs as part of their job Blue Circle have trained people to ask and answer questions: Is there valueadded to my activities? Are there unnecessary complexities? What are the true cost implications of this decision?

At USF&G, a major US insurance company, middle management task forces were formed not just to find the answers but also to make tough decisions. CEO Norman Blake: ‘Their charge was to look at how we could be most cost effective – not ‘what are your recommendations for reducing costs?’ I asked them to justify the value of every cost in the company’s superstructure. Success was achieved by giving decision-making power on costs to those who would be implementing the plan.’

break down a firm’s relevant activities in order to understand the behaviour of costs; to obtain sustainable advantage a firm must either:

many employees don’t understand real costs because of standard costing systems and their allocation processes; usually ‘easiest’ costs cut first

The right language

Three main themes underpin strategic cost management:

cost driver identification

cost drivers cause costs to be incurred by an activity or event; some are within a firm’s control (executional) and some are not (structural); any given activity may be due to several cost drivers acting together

value engineering

involves developing a strategy to achieve a lower relative cost position through controlling cost drivers, or reconfiguring the value chain; for each value activity the key questions are:

Cost drivers at H-P


Some of the cost drivers used by Hewlett-Packard in circuit-board production:

can we reduce costs in this activity, holding value (revenues) constant?


can we increase value in this activity, holding costs constant?


can we reduce assets in this activity, holding costs and revenues constant?

no. components placed on a board’s surface

no. components inserted through holes

mins required to place hand-loaded vs autoplaced components

• • • •

no. unique parts no. prod’n scheduling hrs

Undertake detailed examination of designs and processes to identify candidates for improvement; a good start: look at process complexity. Note, any cost reduction efforts:

no. mins of set-up time


no. mins of test and rework time

must not erode competitive differentiation, and


must be tested for sustainability

TEL: +44 (0)1737 767181 FAX: +44 (0)1737 767868 e-mail [email protected] © Bulletpoint - March 2000


dossier Internal analysis Standard costing (compares actual costs against a standard) is under pressure due to:

rapid changes in cost structures

inconsistency with just-intime

lack of focus on continuous improvement

Though standard costing is still useful for control, performance assessment, new tools gaining currency:

1. Cost of Quality (COQ) can be assessed in 4 categories:

• • •

prevention costs: to ensure defects do not occur eg preventative maintenance appraisal costs: inspecting to ensure customer requirements are met eg testing internal failure costs: to rectify defective output before it reaches the customer eg rework

external failure costs: of delivering defective goods to the customer eg returns

Research: firms tend to spend £ in the wrong place: more on internal, external failures and appraisal, than prevention; rule of thumb: for every £1 spent on prevention, £10 can be saved in appraisal, failure costs. But:


quality costs are variable on the way up but fixed on the way down ie not easy to reduce: may be able to cut defects by 25%, but may not be able to reduce rework dept workforce by 25%

2. Managing Cycle Time

3. Target Costing

time between starting and finishing the production of an order; composed of:

an evolution of Japanese kaizen costing; arrived at as follows:

processing time: time spent working on the product

wait time: time spent between production stages

move time: time spent moving between stages

must be realistic, not wishful thinking; at Toyota the sales division proposes sales, production volumes based on past sales levels, market trends, and competitors’ product offerings

inspection time: ensuring output is of required quality

In customers’ eyes only the processing time adds value, hence ideally, manufacturing cycle efficiency (MCE): processing time processing+wait+move+inspection time


Research: MCE ratio is often <10%; more than 80% of cycle time is spent waiting, meaning huge investments tied up in work-in-progress, and non value-adding activities.

Cycle time savings Consider a firm that has an average mfg cycle time of 15 working days and an annual Cost of Goods Sold of £10m. The average value of Work-in-Process is £10m x(15/365) = £410,959. If the cycle time could be reduced to 12 days, the avge value of WIP would shrink to: £10m x (12/365) = £328,767

companies have learned to neutralise poor quality ie customers not always anxious to receive better quality because they have built infrastructure to cope with defects, shortfalls in service

TEL: +44 (0)1737 767181 FAX: +44 (0)1737 767868 e-mail [email protected] © Bulletpoint - March 2000

set long-term sales goals

structure product lines for maximum profitability to satisfy as many customers as possible, but not contain so many products that customers confused; by detecting clusters of mindsets, eg ‘value seeker’ ‘aggressive enthusiast’, Nissan identifies niches containing enough potential car buyers to warrant a tailored model

set target selling price

can raise selling prices only if the ‘perceived value’ exceeds the product’s predecessor and also competing products; if managers at Topcon, a maker of ophthalmic instruments, believe their product has more functionality than competing products, they raise its price, and reduce if less

set target profit margin

to achieve long-term profit objectives; ensure margins are realistic, comparing to predecessor product and changes in market conditions; must offset entire life-cycle costs of the product

set allowable target cost

by subtracting target profit margin from target selling price; then decompose down to component level; suppliers must find ways to deliver (perhaps incentivised) at target prices set by customers; if Nissan accepts a cost-reduction idea, it awards the supplier a significant percentage of the component contract for a specified time eg 50% for 12 months

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


What it means

absorption costing activity-based costing (ABC)

includes both fixed and variable overheads in product costs costs are assigned to activities, then allocated to products consuming the activities

actual cost average/unit cost avoidable cost carrying cost

based on historical data, including storage and delivery total cost of producing a quantity of product divided by number of units produced costs no longer incurred if company discontinues an activity, product cost of holding stock from purchase to use

controllable cost cost allocation cost centre cost driver cost object cost of capital cost of goods sold cost pool cost-plus pricing cost structure differential cost direct cost discretionary cost distribution cost economic order quantity engineered cost experience curve external failure cost fixed cost incremental cost indirect cost internal failure cost joint cost kaizen costing marginal cost mixed cost normal costing opportunity cost

cost that is substantially controlled or influenced by a particular individual process of assigning costs, usually overheads, by formula eg volume, resource use a responsibility centre whose manager is accountable for its costs item(s) that have the highest bearing on, or causing an activity’s cost critical item, activity or process whose costs need to be separately measured cost of acquiring resources either through debt or issuing stock total cost of finished goods actually sold in a particular period collection of costs for different cost objects where price equals cost plus percentage mark-up relative proportion of a product’s, firm’s variable vs fixed costs difference in a cost item under two decision alternatives cost traceable to a product, dept, usually direct labour and materials not essential for operations, but critical to maintain profitability, growth cost of storing and transporting finished goods; includes salaries, selling costs the order size that minimises inventory holding and ordering costs cost that results from a definitive physical relationship with an activity graph showing how costs decline as cumulative production output increases incurred because defective products have been sold does not change in total as activity, volume changes amount by which the cost of one action exceeds that of another cost that cannot be traced to one product, department, process cost of correcting defects found prior to sale incurred in a joint production process before products are separated process of continual cost reduction during the manufacturing phase of a product extra cost of producing one additional unit cost with both fixed and variable component allocates to products actual direct labour, material, and overheads by formula potential benefit given up when one action is chosen above another

prevention costs prime costs product cost product life-cycle costing standard cost step-down method step cost sunk cost target cost

costs of preventing defective products costs of direct material and direct labour cost of a product until it is sold, at which point it becomes an expense accumulation of costs from product concept to discontinuance pre-determined estimate of producing one unit; benchmark for actual cost where service dept costs allocated first to service depts, then to production depts fixed or variable, but move in jumps, usually large for fixed, small for variable costs incurred in the past and unalterable by current or future decisions projected long-term product cost; target selling price less target profit

total cost curve transfer price variable cost

graphs relationship between total cost and total quantity produced and sold price at which products, services are transferred between a firm’s divisions changes in direct proportion with either inputs or outputs

TEL: +44 (0)1737 767181 FAX: +44 (0)1737 767868 e-mail [email protected] © Bulletpoint - March 2000


dossier External analysis Benchmarking ROI

Cost performance should also be monitored vs competitors and other best practise firms. Some methods:

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

AMP, a manufacturer of electronic connectors, benchmarked supplier management practices against Federal Express, Frito-Lay and American Airlines; results after re-engineering: O supplier base cut by 1/3 O cycle time reduced by 50% O quality increased from 92% to 98% O late shipments decreased from 30% to 10%

product teardown

disassembling and analysing products to identify materials they contain, parts they use, and the way they function and are manufactured; not just competitors’ products but also products that contain parts which perform similar but not identical functions, eg truck maker tearing down passenger vehicles to see how fuel systems function

Cost-stripping Isuzu applies product teardown in all stages of its product development process. The company uses eight different teardown methods, some designed to reduce a vehicle’s direct manufacturing cost and others intended to reduce the investment required to produce vehicles through increased productivity.

competitive cost analysis requires intensive informationgathering from various sources using multi-functional teams; includes: O

careful screening of public information


tearing down competitors’ products


identifying suppliers and costs of parts sourced from them


analysing cost and efficiency of labour force


assessing capacity utilisation of assets employed

Competitor info will contain gaps to be filled with estimates based on logical assumptions; analysis needs to go beyond simple estimates of competitors’ product costs and:

highlight any value (dis)advantages on product quality, customer service

provide insights into strategies and future plans, quantifying impact of current or future cost-reduction programmes

... understanding all of which just may make the difference between survival and competitive demise.


with other firms who are not direct competitors, but with similar processes; all firms benefit from rich exchange of ideas; can be formal, eg supplier association, or informal through universities, industry groups

Develop Profitable New Products with Target Costing Robin Cooper, Regine Slagmulder Sloan Management Review Fall 1999

Management Accounting June 1999

benchmarking should go beyond products to operating, management skills; most powerful: estimate costs of activities and processes as if performed by a perfectly lean enterprise; even the best find they have some way to go to achieve waste-free standards; encourages ‘out-of-the-box’ thinking


References and further reading The Cost Management Toolbox: A Manager’s Guide to Controlling Costs and Boosting Profits Lianabel Oliver Amacom 2000*

Manage Your Costs by Managing Your Cycle Times Tony Brabazon Managerial Accounting Ronald W Hilton Irwin McGraw-Hill 1999* Practical Issues in Cost Driver Selection for Managerial Costing Systems Dale Geiger Government Accountants Journal Fall 1999

Strategic Cost Management Robin Cooper, Regine Slagmulder Management Accounting July 1998

Target Costing as a Strategic Tool John K Shank, Joseph Fisher Sloan Management Review Fall 1999 * Indicates books

TEL: +44 (0)1737 767181 FAX: +44 (0)1737 767868 e-mail [email protected] © Bulletpoint - March 2000


Strategic Cost Management - CBSbutler

dossier Strategic Cost Management Cost-reduction, it is said, is a true path to sustainable competitive advantage. Yet the exercises of the early ’90...

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