Concepts of Strategic Cost Management PDF

Concepts of Strategic Cost Management in different stages of Value Chain 1.1 A strategy is an integrated set of choices for actions which positions a firm in an industry so as to generate superior financial ret...

Concepts of Strategic Cost Management in different stages of Value Chain 1.1 A strategy is an integrated set of choices for actions which positions a firm in an industry so as to generate superior financial returns over the long run. Here ‘integrated set of choices’ create the environment internal to the firm, whereas ‘industry’ provides the external environment and the ‘long run’ replicates the competitive dynamics. Strategic Cost Management (SCM) A firm’s strategy aims to match its own capabilities with the available opportunities. In other words, strategy defines as to how an organisation creates value for its customers while distinguishing itself from its competitors. In general, businesses follow one of two broad strategies, i.e.., either Cost Leadership or Product Differentiation. Low-Cost-Carriers (Airlines) are known to provide quality products or services at low prices by toeing the cost leadership strategy. Electronic giants such as Apple are known to garner premium prices by following product differentiation strategy. Strategic Cost Management (SCM) refers to the cost management that specifically focuses on strategic issues such as: (a) the company’s cost, productivity, or efficiency advantage relative to competitors or (b) the premium prices a company can charge over its costs for distinctive product or service features. Strategic Cost Management, thus, plays a vital role in formulating beneficial strategies relevant for the firm by providing information about the sources of competitive advantage. Strategic Cost Management (SCM) may be stated as the process of identifying, accumulating, measuring, analysing, interpreting, and reporting cost information useful to both internal and external groups concerned with the way in which an organisation utilises its resources to achieve its strategic objectives. As such, Strategic cost management needs to be perceived as the application of cost management techniques with a view to enhance the strategic posture of a firm and reduce the costs. It is a process of combining the decision-making structure with the cost information, in order to reinforce the business strategy as a whole. It measures and manages costs to align the same with the company’s business strategy. Strategic Cost Management may be divided into four stages, viz. (i) Formulation of Strategies (ii) Communication of Strategies across the entire organisation. (iii) Implementation of the tactics to execute the strategies. (iv) Controlling the activities to track the achievement. The Institute of Cost Accountants of India 5 Strategic Cost Management In Strategic Cost Management (SCM), primary importance is given to constant improvement in the product or service to deliver better quality to its target customers. SCM, therefore, encompasses every facet of the value chain of an organisation. The need for SCM may be summarised as: (i) It is an updated form of cost analysis, in which the strategic elements are clearer and more formal. (ii) It helps in identifying the cost relationship between value chain activities and its process of management to gain competitive advantage. (iii) It is used to analyse cost information with a view to develop relevant tactics to garner a sustainable competitive advantage. (iv) It provides a better understanding of the overall cost structure in the quest for gaining a sustainable competitive advantage. (v) It uses cost information specifically to govern the strategic management process – formulation, communication, implementation and control. SCM has three important pillars, viz., strategic positioning, cost driver analysis and value chain analysis. 1. Strategic Positioning Analysis: It determines the company’s comparative position in the industry in terms of performance. 2. Cost Driver Analysis: Cost is driven by different interrelated factors. In strategic cost management, the cost driver is divided into two categories, i.e.., structural cost drivers and executional cost drivers. It examines, measures and explains the financial impact of the cost driver concerned with the activity. 3. Value Chain Analysis (VCA): VCA is the process in which a firm recognizes and analyses, all the activities and functions that contribute to the final product. VCA depicts the manner in which customer-value accrues along the activity chain that results in the final product or service. In a nutshell, strategic cost management is not just about controlling the costs but also using the information for strategic decision making. The fundamental objective of strategic cost management is to gain a sustainable competitive advantage by way of cost leadership and product differentiation. Value Chain Developed by Michael Porter in 1985 and used throughout the world, the value chain is a powerful tool for disaggregating a company into its strategically relevant activities in order to focus on the sources of competitive advantage, that is, the specific activities that result in lower costs or higher prices. A company’s value chain is typically part of a larger value system that includes companies either upstream (suppliers) or downstream (distribution channels), or both. This perspective about how VALUE – COST = PROFIT value is created forces managers to consider and see each activity not just as a cost, but as a step that has to add some increment of value to the finished product or service. Manufacturing companies create value by acquiring raw materials and using them to produce Figure 1.1 something useful. Retailers bring together a range 6 The Institute of Cost Accountants of India  Introduction to Strategic Cost Management of products and present them in a way that is convenient to customers, sometimes supported by services such as trial rooms or personal shopper advice and insurance companies offer policies to customers that are underwritten by larger re-insurance policies. Here, they are packaging these larger policies in a customer-friendly way, and distributing them to a mass audience. In other words, the value that is created and captured by a company as reduced by the costs incurred is the profit margin. Expressed as a formula the equation would read as: Value Created and Captured – Cost of Creating that Value = Profit Margin The more value an organisation creates, the more profitable it is likely to be. As more and more value is provided to the customers, competitive advantage creeps in. Understanding how a company creates value, and looking for ways to add more value, are critical elements in developing a competitive strategy. Thus, the value chain is a set of activities that an organisation carries out to create value for its customers. Porter proposed a general-purpose value chain that companies can use to examine all of their activities, and see how they are connected. The way in which value chain activities are performed determines costs and affects profits. Elements in Porter’s Value Chain Rather than looking at departments or accounting cost types, Porter’s Value Chain focuses on systems, and how inputs are changed into the outputs purchased by consumers. Using this viewpoint, Porter described a chain of activities common to all businesses, and he divided them into primary and support activities, as shown below. Primary Activities: Primary activities relate directly to the physical creation, sale, maintenance and support of a product or service. They consist of the following: ~ Inbound Logistics: These are all the processes related to receiving, storing, and distributing the inputs internally. The supplier relationships are a key factor in creating value here. ~ Operations: These are the transformation activities that change inputs into outputs that are sold to customers. Here, operational systems create value. ~ Outbound Logistics: These activities deliver the product or service to the customer. These are the things like collection, storage, and distributing the outputs. They may be internal or external to the organisation. ~ Marketing and Sales: These are the processes that are used to persuade clients to purchase from the firm instead of its competitors. The benefits being offered, and how well they are communicated to the customers, are sources of value here. ~ Service: These are the activities related to maintaining the value of the product or service to customers, once it has been purchased. Support Activities: Support activities support the primary functions stated above. Each support, or secondary, activity can play a role in each primary activity. For example, procurement supports operations with certain activities, but it also supports marketing and sales with other activities. ~ Procurement (Purchasing): This is what the organisation does to get the resources it needs to operate. This includes finding vendors and negotiating best prices. ~ Human Resource Management: This is how well a company recruits, hires, trains, motivates, rewards, and retains its workers. People are a significant source of value, so businesses can create a clear advantage with good HR practices. ~ Technological Development: These activities relate to managing and processing information, as well as protecting a company’s knowledge base. Minimizing information technology costs, staying current with The Institute of Cost Accountants of India 7 Strategic Cost Management technological advances, and maintaining technical excellence are sources of value creation. ~ Infrastructure: These are a company’s support systems, and the functions that allow it to maintain daily operations. Accounting, legal, administrative, and general management are examples of necessary infrastructure that businesses can use to their advantage. Activities Primary Marketing Services Profit Margin and Sales Activities Support Human Resource Technological Procurement Infrastructure Management Development Figure 1.2 Companies use these primary and support activities as “building blocks” to create a valuable product or service. Value chain analysis (VCA) Value chain analysis (VCA) is a process where a firm identifies its primary and support activities that add value to its final product and then analyse these activities to reduce costs or increase differentiation. Value chain analysis relies on the basic economic principle of advantage - companies are best served by operating in sectors where they have a relative productive advantage compared to their competitors. Simultaneously, companies should ask themselves where they can deliver the best value to their customers. Conducting a value chain analysis prompts a firm to consider how each step adds or subtracts value from its final product or service. This, in turn, can help it realize some form of competitive advantage, such as: Cost reduction, by making each activity in the value chain more efficient and, therefore, less expensive Product differentiation, by investing more time and resources into activities like research and development, design, or marketing that can help the product stand out Typically, increasing the performance of one of the four secondary activities can benefit at least one of the primary activities. Five Steps to developing a value chain analysis (Illustrative) Step 1: Identify all value chain activities Identify each activity that plays a part in creating your company’s finished product. For example, it is not enough to write down that you have a product design team. You need to dig deeper and ask: How many designers are on that team? How much time does each activity on that team require? What raw materials are they using? Once you’ve identified each primary activity in detail, you’ll need to do the same for each support activity. This step will take a considerable amount of time and, if possible, shouldn’t be a one-person task. Instead, encourage cross-collaboration internally so each department can outline its logistics, operational costs and services. 8 The Institute of Cost Accountants of India  Introduction to Strategic Cost Management Step 2: Calculate the cost of each activity Remember to calculate cost drivers such as rent, utilities and staff. By having an accurate picture of every single cost (and what activities increase or decrease costs), it’s easier to see how much revenue you’re actually generating. Once each activity has been mapped out, you can delineate which parts of your value chain are costing your business the most money. According to the Financial Times, a value chain analysis on a £2.50 cup of coffee revealed that only 1penny/pence goes to the actual coffee grower. The rest of the £2.49 is made up of additional supplies like: Milk, Stirrers, Transport, Rent, Staff and Taxes. Using this value chain analysis example, we learn that the most critical component (coffee) is one of the least expensive parts of the cost breakdown. Rent and staff are the most expensive. Having this information, the company can choose their next steps wisely. If they want to reduce rent costs, they can attempt to negotiate their contract. Failing that, they can relocate to a less expensive location. While that may draw less foot traffic, the low-cost option could potentially boost their profit margin. If they want to reduce staff costs, they could evaluate how many people are scheduled per shift and perhaps cut staff hours during less busy times. Alternatively, if they cannot streamline their process or lower costs in any way, they could try to boost their perceived value. They could do this by creating and promoting unique items, or sourcing new ingredients (at a similar cost) that increase sales or engagement. It’s easy to see why detailed, accurate calculations can make or break the effectiveness of your value chain. Step 3: Look at what your customers perceive as value Know that customers tie value directly to a product’s price tag, in other words, perception greatly impacts product margins. Research shows that although branded and non-branded painkillers have the exact same health outcome, the former is better perceived by consumers. Because customers believe it is more valuable to their health, they’re willing to pay more for the brand name. To determine what your end customers perceive as valuable, you need to dig into their psychology. Collecting quantitative and qualitative data can help you identify statistical patterns in your customer’s buying behaviour. Identifying these qualities will also help your sales representatives down the line with prospecting and qualifying ideal customers. Understanding why and how your customers make purchasing decisions boils down to understanding their intent and what they perceive as valuable. As Rory Sutherland’s TED Talk highlights, the same product can mean very different things to different people. He explains that when it comes to selling a product, there’s no such thing as an objective value. Rather, the value that people place on products comes from factors such as societal influence and group-think. People often make decisions based on actions that their friends, family and close social groups take. For example, if people in your social circles start to buy noise-cancelling headphones to wear at work, you may begin to think of them as valuable, even if you didn’t want to buy them before. Knowing what your customers, and their social circles, desire opens up the opportunity to market your product in a way that motivates them to buy it. Step 4: Look at your competitors’ value chains The best way to determine value is through market analysis. Although it’s unlikely you will have access to your competitors’ infrastructure and operational breakdowns, you can use benchmarks as a starting point. This process is called competitive benchmarking. You can choose to use competitive benchmarking in one of three main ways: (i) Process benchmarking: Comparing your process structure and operations against how your competitors carry out tasks. (ii) Strategic benchmarking: Comparing your high-level business strategy to your competitors’ to determine what emulates success. The Institute of Cost Accountants of India 9 Strategic Cost Management (iii) Performance benchmarking: Comparing outcomes, such as revenue, organic traffic, social media performance, reviews and ratings and so on. First, you need to determine your competitive benchmarking goals; then, you can conduct research, make a comparison and determine value. As SmartInsights’ Dave Chaffey explains, you need a baseline to review the marketing effectiveness of competitors. For example, the sales and marketing value chain of online companies can be expansive. By breaking down the rough costs of your competitor’s online sales and marketing efforts, you can calculate whether your spending is too high. McKinsey recommends using a competitor-insight loop to build insight into your competitors’ strategic planning and decision-making processes. The key to making this process successful is to tap into the latest data from a competitor’s frontline workforce, such as a blog or shared database, and identify value gaps. Step 5: Decide on a competitive advantage At this stage, you will have a clear understanding of your internal costs, what changes you can make and how they stack up to your competitors. If you choose cost advantage, you need to find a way to optimize and cut the cost of primary and support activities in your value chain. You might choose to outsource talent, replace certain human activities with automation or look for cheaper delivery services or distribution channels. As more and more people start working remotely, you may even get rid of office space. Any cost cuts you make in the chain can lower the cost of your final product. The more you can push your product prices down, the larger your cost advantage will be compared to competitors. If you choose competitive differentiation, you must capitalize on increasing the value perception of those products that your customers and end users are most willing to pay for. You can cater to your customers’ most basic desires and needs by recognizing their pain points and repositioning your products as the ultimate solution. For example, your sales team can highlight your product differentiation during the sales pitch or closing stage in the pipeline by: Mentioning the unique benefits your product has that your competitors’ products don’t Presenting a case study from a customer that reinforces your position and highlighting relevant data or ROI (Return on Investment) Listing other businesses in the prospect’s industry that have used your product or service and had a positive experience Example of Apple When Steve Jobs began building Macs in the 80s in his garage, he wasn’t doing it for customers — it was for himself. “We were the group of people who were going to judge whether it was great or not,” he said in an interview years later. “We weren’t going to go out and do market research.” Just over a decade later, Jobs famously quipped: “People don’t know what they want until you show it to them.” These admissions give us a unique understanding of the mindset behind a very successful brand. While Jobs was insistent on making products that he loved, the company spent massive amounts of money on its internal creative processes — a support activity in their value chain. These investments were made possible because of tight control over the cost of Apple’s primary activities such as operations, logistics and support. This is what Apple’s value chain analysis tells us about how the company became so successful. Apple’s Primary Activities 1. Inbound logistics: Apple’s supply chain is enormous. Its top 200 suppliers provide the company with 10 The Institute of Cost Accountants of India  Introduction to Strategic Cost Management 98% of procurement expenditures for materials, manufacturing and product assembly. To manage the sheer volume of suppliers and inbound logistics, they must run a tight supply chain management ship. As such, the suppliers are held to strict quality standards and to streamline this process, the company launched the Apple Procurement Program, which states: “Our business environment is competitive and fast-paced. Our suppliers must understand this dynamic and be agile and flexible in responding to changing business conditions. Above all, Apple values innovation. We appreciate suppliers who truly understand and share in our challenges, and who help us find the best possible solutions.” Every year, the list of suppliers is revisited. Suppliers that meet Apple’s standards and provide a more competitive product are added to the list to ensure optimization of their value chain. 2. Operations: Apple takes advantage of lower labour and raw material costs in Japan and China, overall manufacturing costs are also cut. Outsourcing helps them keep overall manufacturing costs low. 3. Outbound logistics: Apple’s business model allows for products to be purchased online and from the company’s stores. Because the company has hundreds of retail stores, it can capitalize on keeping any retail margins made through Apple sales. Brand name recognition also means that non-Apple outlets stock the products in large numbers. A Communications Of The ACM article estimates that Apple gives retailers a 25% wholesale discount. Using this estimate, Apple was left with a gross profit of $80 for the 30GB 5th Gen iPods sold through non-Apple outlets. For any sale made through Apple’s online or customer-facing stores, they also pocketed a $45 retail margin. 4. Marketing and sales: Apple’s marketing and sales efforts are identifiable for its design, quality and innovation. In 2015, the company boosted its marketing budget to $1.8 Billion, explaining that an “ongoing investment in marketing and advertising is critical to the development and sale of innovative products and technologies”. Apple’s approach to marketing and sales reflects its chosen competitive advantage: ‘highlighting value’. As SeedX Inc Founder Jacqueline Basulto points out, Apple reflects its perceived value not only in the cost of its products but also in its advertising. 5. Service: Most products sold by Apple are initially covered by a 1-year warranty and 90 days of support from staff. Customers can book appointments for technical repairs or general product assistance. They also staff their stores with trained Apple technicians who offer guided, interacted demos to customers. Allowing store visitors to engage with products, in turn, helps encourage them to buy. Apple’s Support Activities 1. Research and development: Apple invests heavily in research and development. In 2019 alone, more than $16 billion was pumped into its R&D program to continue research into products that can maintain Apple’s competitive advantage. The investment paid off: in 2020, the company released 28 new or refreshed products onto the market. 2. Human Resource Management: Apple was crowned the most admired company for HR in 2019, reflecting its reputation on hiring and paying well. The company is known for recruiting top candidates and even poaching talent from other companies to get the best people working for them. Summing up, conducting a value chain analysis is one of the most powerful processes a business can undertake. The detail involved in the analysis can uncover where your company spends its money, how well your operations are working and how you can outmanoeuvre your competitors. In fact, without a detailed value chain analysis, it’s impossible to see where you can lower costs and how to decide what competitive advantage will work best for your product. At the same time, a value chain analysis is invaluable in identifying wasteful activities in your product production. By sizing up your competitors and tightening up your development process, you can take steps to add value to your product and ultimately your bottom line. The Institute of Cost Accountants of India 11 Strategic Cost Management Example of Pizza Hut As another example, let’s look at the value chain of Pizza Hut: Primary activities Inbound logistics: This includes all of the sourcing activities to procure and standardize all of the produce, ingredients and materials to bake pizza’s fast, consistently, and delicious – in house. They capitalize on economies of scale, and use massive global purchase orders to source the best prices on raw products for their restaurants. Operations: By targeting areas where there is an affinity for Italian food, Pizza Hut operates in a huge number of countries globally with a licensing model where stores are managed by a local franchise owner. Outbound logistics: There are two models that Pizza Hut capitalizes on, in store dining and their home delivery service. Marketing and Sales: There is a large investment in marketing to drive additional sales, and compete with the other fast-food chains. Service: The entire goal of Pizza Hut is to offer value to their customers in affordable and convenient pizza that everyone can enjoy. Support activities Infrastructure: Again, this includes every other activity that is required to keep the stores in business, such as finance, legal, etc. Human Resources: To keep the costs down staff are typically junior, and unskilled. Technological development: The process they have created to have unskilled chefs cooking the pizza is their biggest asset. Breaking down the complicated method into simple steps that can be repeated again and again for consistently great pizza. Procurement: The purchasing and activities required to produce the pizza, the raw food, and all of the buildings, and equipment needed to cook and deliver the pizzas. Based on these activities, Pizza Hut is leading the market in producing pizza that is both affordable, and can be delivered to your door in under 30 minutes (in most cities). This convenience is what sets them apart from many other competing options for meals, like going out to dinner or preparing a meal at home yourself, and they use a strong campaign and marketing focus to entice customers to use them over similar competitors in the fast-food delivery industry. Doing a value chain analysis is a fantastic way of following a process to review all of the ways you can generate value for your customers. When you review all of these in detail, you’ll find that you come across many different ways you can satisfy your customers even more. Very soon you be excelling in all the things that really matter to your customers. That’s when you’ll have real success! Value Innovation Value innovation is a process in which a company introduces new technologies or upgrades that are designed to achieve both product differentiation and low costs. The changes implemented through value innovation create new or improved elements for the product or service, but also result in cost savings by eliminating or reducing unnecessary aspects during the product lifecycle. Value innovation places equal emphasis on ‘Value’ as also ‘Innovation’. Value innovation, thus, can improve on existing services and lowers the costs of that service for both the company and their customers. 12 The Institute of Cost Accountants of India  Introduction to Strategic Cost Management Value innovation was first outlined in a 1997 article in Harvard Business Review by W. Chan Kim and Renée Mauborgne, who would later write the book Blue Ocean Strategy in 2005. Value innovation is a key principle of “blue ocean strategy,” a business approach that focuses on creating new market spaces instead of fighting competitors existing market share. Instead of competing for market share, value innovation is designed to create new markets. The goal of value innovation is to create new demand and change the market enough to render the competition irrelevant in that market. Red Ocean vs Blue Ocean Strategy Red oceans are all the industries in existence today – the known market space, where industry boundaries are defined and companies try to outperform their rivals to grab a greater share of the existing market. Cutthroat competition turns the ocean bloody red. Hence, the term ‘red’ oceans. Blue oceans denote all the industries not in existence today – the unknown market space, unexplored and untainted by competition. Like the ‘blue’ ocean, it is vast, deep and powerful –in terms of opportunity and profitable growth. The creation of blue ocean enables driving costs down while simultaneously pushing value up. Fundamental differences between Red Ocean Strategy and Blue Ocean Strategy In order to sustain themselves in the marketplace, red ocean strategists focus on building advantages over the competition, usually by assessing what competitors do and striving to do it better. Here, grabbing a bigger share of a finite market is seen as a zero-sum game in which one company’s gain is achieved at another company’s loss. They focus on dividing up the red ocean, where growth is increasingly limited. Such strategic thinking leads firms to divide industries into attractive and unattractive ones and to decide accordingly whether or not to enter. Blue ocean strategists recognize that market boundaries exist only in managers’ minds, and they do not let existing market structures limit their thinking. To them, extra demand is out there, largely untapped. The crux of the problem is how to create it. This, in turn, requires a shift of attention from supply to demand, from a focus on competing to a focus on creating innovative value to unlock new demand. This is achieved via the simultaneous pursuit of differentiation and low cost. Under blue ocean strategy, there is scarcely an attractive or unattractive industry per se because the level of industry attractiveness can be altered through companies’ conscientious efforts. As market structure is changed by breaking the value-cost trade-off, so are the rules of the game. Competition in the old game is therefore rendered irrelevant. By expanding the demand side of the economy new wealth is created. Such a strategy, therefore, allows firms to largely play a non–zero-sum game, with high pay-off possibilities. The table below summarizes the distinct characteristics of competing in red oceans (Red Ocean Strategy) versus creating a blue ocean (Blue Ocean Strategy). Red Ocean Strategy Blue Ocean Strategy Compete in existing market space Create uncontested market space Beat the competition Make the competition irrelevant Exploit existing demand Create and capture new demand Make the value-cost trade-off Break the value-cost trade-off Align the whole system of a firm’s activities with Align the whole system of a firm’s activities its strategic choice of differentiation or low cost in pursuit of differentiation and low cost The Institute of Cost Accountants of India 13 Strategic Cost Management Blue ocean strategies reflect an entrepreneur’s dream to have an unexplored market allowing innovators to create and introduce new products that capture a large share of the market. A blue ocean shift means moving the business, the team and the organisation from cutthroat markets to wide-open new markets in a way that the team owns and drives the process. To successfully shift from red oceans of bloody competition to blue oceans of new market space depends on three key components: having the right perspective, a clear roadmap with market-creating tools, and building people’s confidence at every level to drive and own the process. Examples of Blue Ocean Strategies A blue ocean is specific to time and place. Ford, Apple and Netflix may be quoted as examples of creating blue oceans by pursuing high product differentiation at a relatively low cost. Ford Motor Co.: In 1908, Ford Motor Co. introduced the Model T as the car for the masses. It only came in one color and one model, but it was reliable, durable, and affordable. At the time, the automobile industry was still in its infancy with approximately 500 automakers producing custom-made cars that were more expensive and less reliable. Ford created a new manufacturing process for mass-production of standardized cars at a fraction of the price of its competitors. The Model T’s market share jumped up from 9% in 1908 to 61% in 1921, officially replacing the horse-drawn carriage as the principal mode of transportation. Apple Inc.: Apple Inc. found a blue ocean with its iTunes music download service. While billions of music files were being downloaded each month illegally, Apple created the first legal format for downloading music in 2003. It was easy to use, providing users with the ability to buy individual songs at a reasonable price. Apple won over millions of music listeners who had been pirating music by offering higher-quality sound along with search and navigation functions. Apple made iTunes a win-win-win for the music producers, music listeners, and Apple by creating a new stream of revenue from a new market while providing more convenient access to music. Netflix: Netflix is a company that reinvented the entertainment industry in the 2000s. Rather than entering the competitive marketplace of video rental stores, Netflix created new models of entertainment; first by introducing mail-order video rentals, and later by pioneering the first streaming video platform paid for by user subscriptions. Following their success, many other companies have followed in Netflix’s footsteps. As a result, any new company trying to launch a video subscription model will find itself facing a red ocean rather than a blue one. 14 The Institute of Cost Accountants of India