Cost Planning and Analysis For Competitive Advantage

Cost Planning

Continuous improvement

• Involves a constant effort to eliminate waste, reduce response time, simplify the design of both products and processes and to improve the quality and performance of activities that in turn will result in an increase in customer satisfaction

• Japanese manufacturers identified two approaches to continuous improvement:

• Target Costing
• Setting of a target cost to challenge product designers to produce products within tight cost targets
• A cost management tool for reducing the overall cost of a product over its entire life-cycle with the help of production, engineering, research and design
• Four basic steps of Target Costing: 
• (1) Define the Product 
• (2) Set the Price and Cost Targets 
• (3) Achieve the Targets 
• (4) Maintain Competitive Costs
• Happens before production
• Competitive Market Price - Desired Profit = Target Cost
• CIMA - Target Costing Discussion Paper


• Kaizen Costing
• Continuous improvement in ALL aspects of a company's performance, at every level. These improvements are through small incremental amounts rather than through large innovations
• Setting of continuously more challenging cost targets to encourage a continuous drive for increased efficiencies
• Yashihuro Moden defines kaizen costing as "the maintenance of present cost levels for products currently being manufactured via systematic efforts to achieve the desired cost level."
• Happens during production
• CIMA - Kaizen Costing Discussion Paper

Value Analysis

• Systematic interdisciplinary examination of the factors affecting the cost of a product or service, in order to devise means of achieving the specified purpose most economically at the required standard of quality and reliability
• AIM: Improve profitability by reducing costs without necessarily increasing prices, comprising the quality or usefulness of the product
• Focus: To meet customer needs, while reducing costs
• Value Analysis is a planned, scientific approach to cost reduction which reviews the material composition of a product and production design so that modifications and improvements can be made which do not reduce the value of the product to the customer or to the user. (i.e. quality for purpose should not be compromised.)

Functional analysis

• Analysis of the relationships between product functions, their perceived value to the customer and their cost provision
• Product functions -- represent the end benefits for customers. A mobile phone may offer a variety of functions: phone calls, music player, surfing the net, sending/receiving texts, camera and so on
• Breakdown the product into its many functions and places and price or value on each of these functions which reflects the amount the customer is willing to pay.
• Function 1 + Function 2 + Function 3 = Selling price of the product

Value Analysis Functional Analysis Value Engineering - CIMA

Value Chain - The Philosophy of Continuous Improvement

• Principle
• Excellence in manufacturing is necessary for success, but it will not work alone. A firm must appreciate the relationship between all the factors in the value chain -- the sequence of business factors by which value is added to the organization's products and services

• World-class manufacturing
• The philosophy of continuous improvement and first class performance that underpins those organizations that get the 'value chain right.'
• 7 Keys to World-Class Manufacturing
• 1)  Reduce lead times
• 2)  Speed time-to-market
• 3)  Cut operations costs
• 4)  Exceed customer expectations
• 5)  Manage the global enterprise
• 6)  Streamline outsourcing processes
• 7)  Improve business performance visibility
• Just-in-time concept
• A system where the objective is to produce products as required for use of by a customer, rather than for stock. It is a 'pull' system, responsive to demand.

Just-In-Time (JIT)

• Production system which is driven by demand for finished products whereby each component on a production line is produced only when needed for the next stage of production so there is little work in progress, and finished goods produced only when required by customers so there is little finished goods inventory.
• JIT Purchasing - a purchasing system in which material purchases are contracted so that the receipt and usage of material, to the maximum extent possible, coincide, reducing material inventories
• Features of JIT system:
• Workers are multi-skilled and flexible and can easily adapt to changing demands
• Reduces stockholdings as one of the outcomes
• Aiming of 'zero defects', since any defect will mean late delivery to customers
• Pull principle -- producing to customer demand
• Just-in-time production method is also called the Toyota Production System. To meet JIT objectives, the process relies on signals or Kanban (看板 Kanban?) between different points in the process, which tell production when to make the next part.

Total Quality Management (TQM)

• Quality - best viewed from the customer's perspective - is the product 'fit for purpose'? Failure to meet the customer's requirements will put a firm out of business
• Cost of failing to deliver quality:
• Appraisal costs - costs of measuring conformity with requirements, e.g. quality control inspections
• Prevention costs - cost of ensuring that defects do not occur in the first place
• Internal failure - e.g. costs of reworking failed products
• External failure - e.g. product replacement, lost sales due to impact on reputation

• Features of TQM
• Focus on continuous improvement
• Workforce training
• Focus on product design
• High quality information feedback systems to facilitate improvements
• Use of performance measures
• Focused on meeting customer needs
• Workforce coordination and use of initiative
• Emphasis on prevention not detection
• Constant change is expected and normal

• TQM functions on the premise that the quality of products and processes is the responsibility of everyone who is involved with the creation or consumption of the products or services offered by an organization. In other words, TQM capitalizes on the involvement of management, workforce, suppliers, and even customers, in order to meet or exceed customer expectations. Considering the practices of TQM as discussed in six empirical studies, Cua, McKone, and Schroeder (2001) identified the nine common TQM practices as cross-functional product design, process management, supplier quality management, customer involvement, information and feedback, committed leadership, strategic planning, cross-functional training, and employee involvement.

Business Process Re-engineering (BPR)

• Involves examining business processes and radically redesigning these processes to achieve cost reduction, improved quality and customer satisfaction.
• About major changes to how business processes opearate

Gain Sharing Arrangements

• Involves those employees or suppliers who are involved in solving a problem or making an improvement, sharing in the benefits generated
• Key features:
• Knowledge sharing between staff in the organization and with the external parties (e.g. suppliers) who are working towards the solution
• Contracts with suppliers and unions of the terms for gain sharing
• Accurate measurement of results to facilitate calculation of benefits

Cost Analysis

The Overhead Problem

• Absorption Costing
• Originally designed for production companies to deal with production costs. It is less suitable for service and retail organization
• Overheads were then only a small part of the overall costs and inaccuracies in absorption were small and insignificant
• Never intended for use in short-term decision making, and a number of modern activity-based approaches have subsequently been developed

• Direct Product Profitability
• Modern way of absorbing overheads in retail organizations
• Traditionally, bought-in cost was deducted from selling price to give gross margin. This was of little use for cost control and decision making. 
• DPP deducts 1) buy-in price 2) indirect costs - based on the way the goods are used or created
• DPP Calculation:



• Advantages of DPP:
• Cost analysis resulting in a more, accurate cost unit
• Pricing decisions, now based on more accurate cost units
• Management of warehouse space, by understanding the costs of stan's each product
• Rationalism of product range based on accurate profitability estimates
• Merchandising decisions

Activity-based costing (ABC)


In traditional costing systems, product costings can be inaccurate resulting in poor pricing decisions. This is because they tend to use labour or machine hours - an outdated approach, as most overheads do not vary directly with hours

• Traditional Costing
• Costs are gathered together, based on where they are incurred, i.e., cost centers and the cost objects are costed based on absorption rates

• ABS Costing
• Costs are gathered together, based on resource cost drivers into cost pools or cost activities, and the cost objects are costed, based on activity cost drivers

Absorbing overheads using ABC

• Identify and collect overhead costs
• Pool costs based on activities which have consumed resources
• Allocate overheads to products based on cost drivers (e.g. quality control overhead may be allocated on the basis of the no. of inspections

Example:

• Machine overhaul overhead amounts to $180,000 in one year. 
• The cost driver has been identified as the number of set-ups, and 450 were carried out in the year
• Charge out rate for set-ups is $180,000/450 = $400 per set-up
• A product range requiring 75 set-ups = $400 X 75 = $30,000
• If 25000 units of the product were produced, then the overhead per unit is $30,000/2500 = $12

Usefulness of ABC

• Production overheads are high in relation to direct costs
• Product range is diverse
• Products use differing amounts of the overhead resources (e.g. complex versus simple products)
• Consumption of overhead resource is not primarily driven by volume

Activity-based Management (ABM)


A system of management which uses activity-based cost information for a variety of purposes, including cost reduction, cost modelling and customer profitability analysis. AIM: use the information to ensure that the customer needs are met using a minimum of resources.

Advantages


Duplication - Identifies where activities are duplicated, causing waste

Overhead Control - Used to monitor overhead causing activities and thereby control overhead costs

Non Value Added - Helps to identify a non-value-added expenditure

Empowers Managers - Flags up changes in activity or resource consumption - empowers managers to view fixed costs as potentially variable


Customer Profitability Analysis

• Different customers and customer groups will make use of different activities to varying degrees, e.g. amount of time used for product advice
• ABC permits the creating of customer profiles and the analysis of customer profitability recognizing where customers cause additional costs to the company
• Information can be used to target profitable customers and review the business model currently offered to less profitable ones, e.g. start changing for advice above a certain basic service level

Distribution Channel Profitability


Overview

• Channel - point of purchase which may be direct (i.e. sales team) or indirect (i.e. through retailers). A company selects is a critical driver of business profitability
• The method of channel distribution chosen can account for a significant proportion of total cost and choosing the wrong channel can result in significant losses.
• It is just important for companies to cost channels as it is to cost products and customers.
• Activity-based costing information makes it possible to cost these channels by creating cost pools for activities and understanding the affect of different channels on the cost drivers, e.g. selling to retailers will result in fewer deliveries than selling directly to customers.

Strategic Activity Management


This recognizes that individual activities are part of a wider process, which help to achieve the overall strategic aims.

ABC information can be used to assist strategic decisions, such as

• Add-Value or Non-Value Added
• Mass production to smaller lots
• Changes in activities and components affect the suppliers and the value chain.

Using ABS in service industries and activities

ABC can be used by all types of organization, such as retail, service and government departments, and in all areas of the business. The key difference from manufacturing organizations are the types of cost pools, and the cost drivers used.

Problems with implementing ABC/ABM

Bureaucratic - many cost pools and significant recording of costs. In turn this is time consuming and costly

Lack of enthusiasm -- Finance staff might not understand ABC or understand the business well enough to make ABC work effectively

Complex IT - which be be expensive and time consuming to implement


Pareto Analysis


Overview

• Based on the observed phenomenon that 80% of population's wealth is owned by 20% of the people
• Approximation of the principle holds true in many business situations, e.g. relationship between
• Contribution and revenue
• Customers and profit
• Stock items and stock value