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AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA LEARNING OBJECTIVES  At the end of this unit, you should be able to: 1. Di...

AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA LEARNING OBJECTIVES  At the end of this unit, you should be able to: 1. Differentiate traditional cost management and strategic cost management. 2. Identify and describe the components of strategic cost management. 3. Understand the relevant factors that are analyzed in strategic positioning analysis. 4. Differentiate structural costs from executional costs. 5. Define value chain and identify its primary and support activities. 6. Understand how value chain analysis is applied by understanding its three frameworks of industry structure analysis, core competency analysis and segmentation analysis. 7. Determine the contribution of the management accountant to the overall strategic management of a business entity. 8. Define product life cycle and apply basic concepts of life cycle costing. CONTENTS I. Introduction to Strategic Cost Management II. Life-cycle Costing A. Traditional versus Strategic Cost A. Product Life Cycle, Defined Management: 1. Traditional Cost Management B. Phases in Product Life Cycle 2. Strategic Cost Management C. Product Life Cycle Costing, Characteristics B. Components of Strategic Cost Management and Benefits 1. Strategic Positioning Analysis 2. Cost Driver Analysis 3. Value Chain Analysis C. The Role of the Management Accountant INTRODUCTION to Strategic Cost Management A. Traditional Cost Management versus Strategic Cost Management TRADITIONAL STRATEGIC 1. Time Span Short-term Long-term 2. Focus Internal Both internal and external 3. Cost Driver Based on volume of the Each value activity has a separate cost driver. It is Concept product not based on volume but on activities associated with the manufacturing of the product 4. Objective Score keeping, attention Cost leadership or product differentiation. directing and problem solving. 5. Cost Primary objective is cost Primary objective is cost containment – cost Reduction reduction. reduction and value improvement at the same time. 6. Approach Risk-averse Risk taking and ability to adapt itself with changing environment. TRADITIONAL Cost Management involves allocation of costs and overheads to production, and focuses largely on cost control and cost reduction. The underlying assumption is that with reduced direct and indirect costs, a firm could earn better profits. It involves comparing actual results with the standard expectations (typically through a budget or with standard costs) and analyzing the differences. This process is also known as variance analysis. A corrective action would be taken to ensure future outcomes are within budgeted outcomes. A traditional cost management system suffers from the following limitations: o Excessive focus on cost reduction - The focus is on cost control and reduction. However, a broad cost reduction program doesn't work effectively in today’s business environment. If a company targets to reduce the marketing spend by, say, 20% across the all product categories, it is likely that the sales of profitable products is also impacted. AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA  A broad-based cost reduction could lead to inferior quality of products and services which might drive away customers resulting in lower sales and profitability.  The expectations of modern customers are quite different. An excessive focus on cost reduction could impact the quality of product and services, and alienate the customers. o Ignores dynamics of marketing and economics - Traditional cost management system has internal focus and does not look at the external factors such as competition, market growth and customer requirement. Traditional cost accounting systems rely on accounting data which can be misleading at times. Financial statements can be a great reporting tool but might not be able to assist in strategic decision making as it focuses on historical costs. o Limited focus on review and improvisation of existing processes and activities. o Reactive approach to costs already incurred o Short-term outlook, often with a focus on saving costs on an annual basis. STRATEGIC Cost Management In the modern business environment, it is not sufficient to control costs. A business must focus on managing cost strategically. Businesses today operate in an environment with stiff competition, increasing consumer demands for quality products and technology revolution. The ultimate objective of a business is to earn better profits and create value for shareholders. This can be achieved by superior performance as compared to the competitors which results in distinctive competitive advantages. Note: A strategy is a set of actions taken by managers of a company to increase the company’s performance. Strategic cost management is the application of cost management techniques so that they improve the strategic position of a business as well as control costs. It also involves integrating cost information with the decision-making framework to support the overall organizational strategy. Strategic cost management lays a greater focus on continuous improvement to deliver superior quality product to the customers. Strategic cost management must be an integral part of the value chain. It needs to include all aspects of the production, purchase, design, manufacturing, delivery and service. Necessity of Strategic Cost Management o It is implemented with a broader context where the strategic elements become more explicit and formal, thus strengthening the strategic position of the company. o Cost data are analyzed and used strategically to develop alternate measures to gain sustainable competitive advantages. o It is the managerial use of cost information explicitly directed to the four stages of strategic management – formulation, communication, implementation and control. o It helps in overall recognition of cost relationships among the activities in the value chain and the process of managing these relationships to the company’s competitive advantage. B. COMPONENTS of Strategic Cost Management  Strategic Cost Management primary revolves around three business themes: 1. strategic positioning analysis, 3. value chain analysis 2. cost driver analysis I. STRATEGIC POSITIONING ANALYSIS Strategic positioning analysis determines a company’s relative position within its industry with regard to its performance. Strategic positioning reflects choices a company makes about the kind of value it will create and how that value will be created differently than rivals. Strategic positioning analysis is concerned with impact of external and internal environment on the overall strategy of a company. It is important to take account of the future and to assess whether the current strategy is a suitable fit with the strategic position. The factors that affect the strategic position of a company are 1. organization value, cultures and systems 3. the internal environment. 2. the external environment AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA 1. Organization values, culture and systems Organizational culture is a system of shared meaning held by members that distinguishes the organization from other organizations. Key characteristics of an organizational culture include: Innovation and risk taking. The degree to which employees are encouraged to be creative and adventurous as they go about their tasks. Attention to detail. The degree to which employees are expected to exhibit precision, analysis, and attention to detail. Outcome orientation. The degree to which management focuses on results or outcomes rather than on technique and process. People orientation. The degree to which management decisions take into consideration the effect of outcomes on people within the organization. Team orientation. The degree to which work activities are organized around teams rather than individuals. Aggressiveness. The degree to which people are aggressive and competitive rather than easygoing. Stability. The degree to which organizational activities emphasize maintaining the status quo in contrast to growth. These organizational cultures should be integrated as part of a firm’s mission-vision statement. A mission statement is a statement of the company’s reason to be. It seeks to answer the question - “Why does the company exist?”. A company’s mission statement must be customer focused and not product focused. A vision statement declares what the firm wants to be. A good vision statement must motivate employees and managers to works towards the common organization goals. The action- oriented statement to implement the mission-vision statement is the objective or goal statement. It specifies what needs to be done in order to attain the company’s mission or vision. Goals must be specific and measurable as well as challenging and realistic. A company’s strategy is directed towards achieving a sustained competitive advantage that will pave the path towards organization goals. Strategic cost management, one of the means towards that goal, hence should be aligned with the vision, mission and objectives of the company. 2. EXTERNAL environment using the PESTEL Framework The PESTEL analysis is an acronym for a tool used to identify the macro (external) forces facing an organization. The letters stand for Political, Economic, Socio-cultural, Technological, Environmental and Legal. Truthfully, not all of these categories will affect a business equally. Depending on the organization, it can be reduced to PEST or some areas can be added (e.g. Ethical) Before any kind of strategy or tactical plan can be implemented, it is fundamental to conduct a situational analysis. The PESTEL analysis forms part of that and should be repeated at regular stages to identify changes in the macro-environment. Organizations that successfully monitor and respond to changes in the macro-environment are able to differentiate from the competition and create a competitive advantage. Political - These determine the extent to which government and government policy may impact an organization or a specific industry. This would include fiscal, monetary and trade policies being advocated by the government entities. Economic - These factors impact the economy and its performance. These include conditions of the general market, consumers, labor force, costs and inflation, GDP and GNP, and foreign exchange rates. Socio-cultural - These factors focus on the social environment and emerging trends. This helps a marketer to further understand their customers’ needs and wants. Factors include changing family demographics, education levels, cultural trends, attitude changes and changes in lifestyles. Technological - These factors consider the rate of technological innovation and development that could affect a market or industry. Factors could include changes in digital or mobile technology, automation, and research and development. There is often a tendency to focus on developments only in digital technology, but consideration must also be given to new methods of distribution, manufacturing and logistics. AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA Environmental - These factors relate to the influence of the surrounding environment and the impact of ecological aspects. With the rise in importance of environmental sustainability, this element is becoming more important. Factors include climate, recycling procedures, carbon footprint, waste disposal and sustainability. Strategic cost management topic for this is the Environment Management Accounting. Legal - Political factors do cross over with legal factors; however, the key difference is that political factors are led by the government as they execute the law, whereas legal factors must be complied with regardless of implementation. Relevant law should be gathered & reviewed for compliance regularly. A PESTEL analysis helps an organization identify the external forces that could impact their market and analyze how they could directly impact their business. It’s important when undertaking such an analysis that the factors affecting the organization are not just identified but are also assessed – for example, what impact might they have on the organization? 3. Internal environment Resources - factors that enable a company to create value for customers. They can be tangible (land, buildings, inventory, machinery, money etc.) or intangible (employee’s skills, brand, patent, technology etc.). The more difficult a resource is to imitate, the more valuable is the resource for the company. The algorithms used by Google to deliver search results are not easily imitated by competition. Similarly, the secret formula of concentrates used by soft drinks manufacturers like Coca Cola are hard to copy. Competencies - the company’s ability to coordinate resources and put them to productive use. Availability of resources by themselves does not guarantee core competency and success. Capabilities stem from organizational structure, processes and control systems. II. COST DRIVER ANALYSIS Cost is caused or driven by various factors which are interrelated. Cost is not a simple function of volume or output as considered by traditional cost accounting systems. Cost driver concept is explained in two broad ways in strategic cost management parlance - Structural cost drivers and Executional cost drivers. STRUCTURAL cost drivers are the organizational factors which affect the costs of a firm’s product. These factors drive costs of an organization in varied ways. The scale and scope of operation of a company will impact the costs. A larger scale of operations is likely to give an advantage of economies of scale. The usage of technology and complexity of operations also determine the costs of various activities within a firm. The experience or learning curve also impacts the costs being incurred by a firm. The product development process could be costlier earlier and cheaper in later stages of a lifecycle. A simple volume-based cost allocation would not be appropriate in such cases. o Favorable location, number of locations o Number of plants, scale, degree of centralization o Management style and philosophy o Numbers of product lines, of unique processes, and of unique parts o Scope, buying power, selling power o Sales volume in units or monetary amounts o Number of different customers o Types of process technologies, experience o Debt level, debt capacity, favorable tax status o Cumulative volume in the activity, time in operation EXECUTIONAL cost drivers are based on firm’s operational decision on how the various resources are employed to achieve the goals and objectives. These cost drivers are determined by management style and policy. o Employee morale level, turnover rates, degree of involvement o Quality management approach, employee training level, return merchandise rates, customer satisfaction ratings o Plant layout efficiency; throughput time, ability to convert from one product/service to another o Product configuration, capacity utilization AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA o Lead-time from product concept to production, R&D cost compared to competitor In case of a strategic analysis, volume is not the most appropriate way to explain costs. It is more relevant to explain costs based on strategic choices and executional skills. All costs drivers might not be important at all times. A company must focus on those cost drivers which is of strategic importance. Cost driver analysis will be further discussed in the topic Activity-Based Costing. III. VALUE CHAIN ANALYSIS Value-chain analysis is a process by which a firm identifies and analyzes various activities that add value to the final product. The idea is to identify those activities which do not add value to the final product/service and eliminate such non-value adding activities. The analysis of value chain helps a firm obtain cost leadership or improve product differentiation. Resources must be deployed in those activities that are capable of producing products valued by customers. The idea of a value chain was first suggested by Michael Porter (1985) to depict how customer value accumulates along a chain of activities that lead to an end product or service. The various activities undertaken by a firm can be broadly classified into primary activities and supporting activities. Primary activities are those which are directly involved in transforming of inputs (Raw Material) into outputs (Finished Products) or in provision of service. Supporting activities (also known as secondary activities) allow the smooth operation of the primary activities. Though, supporting activities are not directly involved in creation of product, it doesn't mean that they are of less importance as compared to primary activities. A. PRIMARY Activities: 1. Inbound Logistics: These are activities concerned with receiving, storing, and distributing the inputs (raw materials) to the production process. The relationship with suppliers is a key component in this process. 2. Operations: These activities involve transforming inputs into final product. Activities such as machining, packaging, testing and equipment maintenance form part of the operations activity. 3. Outbound Logistics: These activities involve collecting, storing and distributing the products from the factory line to end consumers. This may include finished goods warehousing, delivery vehicle operation, sales order processing and scheduling. 4. Marketing and Sales: Marketing and Sales provide the means by which the customers are made aware of the product. The activities include advertising, promotion, distribution channel selection, sales force management and pricing policy. 5. Service: This includes activities related to after sales service like Installation, repair and parts replacement. AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA B. SUPPORT Activities: 1. Firm Infrastructure consists of activities such as planning, finance, accounting, legal, government affairs and quality management. 2. Human Resource Management includes activities around selection, recruitment, placement, training, appraisal, rewards and promotion; management development; and labor/ employee relations. 3. Technological Development includes technical knowledge, equipment, hardware, software and any other knowledge and improvements which ae used in the transformation of inputs to outputs. 4. Procurement involves purchasing of raw material, supplies and other consumables required as inputs for primary activities. A value chain gives managers a deeper understanding of what the organization does and helps them identify key processes of the business. The various processes can be analyzed to identify those activities which do not add value to consumers. Such non-value activity can be eliminated to reduce costs and improve profits of the business as a whole. STRATEGIC FRAMEWORKS FOR VALUE CHAIN ANALYSIS Value chain analysis requires internal information (for internal value chain) and external information (for industry value chain). The value chain analysis requires strategic framework for organizing varied information. The generally accepted strategic framework for value chain analysis are the following: 1. Industry structure analysis using Porter’s Five Forces Model, 3. Segmentation analysis. 2. Core competency analysis which looks from a resource-based perspective, I. INDUSTRY STRUCTURE ANALYSIS (Porter’s Five Forces Model) An industry might not yield high profits just because the industry is large or growing. The five forces suggested by Porter’s play an important role in determining profit potential of the firms in an industry. Michael Porter developed a five factors model as a way to organize information about an industry structure to evaluate its potential attractiveness According to Porter, the factors which influence profitability are: Among the five forces, supply chain factors which include bargaining power of suppliers and of buyers contribute to vertical competition. The threat of new entrants, the threat of substitute products and services, and intensity of rivalry amongst firms create horizontal competition. 1. Bargaining power of buyers: The bargaining power of buyers generally determines the ability of buyer to push the price down. This happens when the buyers are concentrated or when the volume purchased by buyers is very high. In other words, when the bargaining power of buyers is high, they would be in a position to dictate terms to the firm. A buyer also has higher bargaining power if the cost of switching suppliers is very low. A higher bargaining power results in lower profitability. Large companies have a high bargaining power when they buy from small suppliers. AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA 2. Bargaining power of suppliers: The bargaining power of supplier is relatively higher when the input is important to the buying firm or when there are very few suppliers of the input. The suppliers could also dictate terms if the input supplied is not replaceable or when an alternate input is not available. Microsoft dominates the operating system business of computers and laptops and can dictate terms to its buyers as buyers do not have multiple options to choose from. The profitability of companies can shrink if their suppliers have a higher bargaining power. 3. Threat of substitute products or services: When multiple and close substitutes are available in the market for a particular product, customers are likely to switch suppliers easily. A firm in such a case must resort to competitive pricing to retain its customers. When few substitutes exist for a product, consumers are willing to pay a potentially high price. If close substitutes for a product exist, then there is a limit to what price customers are willing to pay. The problem becomes severe if substitutes are available at much cheaper price. A company should strive to build its brand and customer loyalty to thwart the threat of substitutes. Substitutes could be from within the industry or from a different industry. The paper industry faces threats from entities in the e-book market. When more people switch to public transport as trains, the demand for vehicles comes down. 4. Threat of new entrants: The threat of new entrants largely depends on the barrier to entry and perceived profitability in an industry. If an industry is profitable and the barriers to entry are low, new firms could enter the industry leading to excess supplies and reduced prices. Some examples of barriers to entry are intensive capital requirement, sophisticated technology, legal factors, and limited access to raw material and labor, among others. Industries which require a huge amount of capital or sophisticated technical knowhow might not have a high threat of new firms entering into the industry. The airline industry is a case where very few new firms enter the business because of the capital requirements. Another barrier to entry could be legislation which restricts newer firms to start the business, like in the case of telecommunication industry. Certain industries (for example medicines) are largely driven by patents and new firms might find it difficult to enter the industry. An industry where threat of new entrants is low is more profitable than an industry where new entrants can easily enter the industry. 5. Intensity of competition/ rivalry amongst firms: Some markets are more competitive than others. In highly competitive industries, firms resort to cut-throat competition to win more customers. The competitive rivalry is higher when an industry has high number of firms and is lower when there are few large players dominating the market. The intensity of competition is generally higher in the following cases: Extra capacity exists in the industry Difficulty in differentiation in the products. High exit barriers - This is a case where the exit costs are high and hence firms must continue in the industry despite excess capacity at industry level. Higher fixed costs - Firms would want to produce as much as possible to keep the unit costs low leading to surplus capacity. Since these five forces are ever-changing, Porter’s framework needs to be employed as a dynamic analytical tool. This is because competition is a dynamic process; equilibrium is never reached and industry structures are constantly being reformed. The five forces analysis helps a firm to better understand the industry value chain and its competitive environment. II. CORE COMPETENCIES ANALYSIS Core Competency is a distinctive or unique skill or technological knowhow that creates distinctive customer value. The core competencies are a function of the collective skillset of people, organization structure resources & technological knowhow. A core competency is the primary source of an organization’s competitive advantage. The competitive advantage could result from cost leadership or product differentiation. AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA  Sources of Core Competencies 1. Resources: Factors that enable a company to create value for customers. They can be tangible (land, buildings, inventory, machinery, money etc.) or intangible (employee’s skills, brand, patent, technology etc.). The more difficult a resource is to imitate, the more valuable the resource is for the company. The algorithms used by Google to deliver search results are not easily imitated by competition. Similarly, the secret formula of concentrates used by soft drinks manufacturers like Coca Cola are hard to copy. 2. Capabilities: The company’s ability to coordinate resources and put them to productive use. Availability of resources by themselves does not guarantee core competency and success. Capabilities stem from organizational structure, processes and control systems.  Core Competency Test Resources and capabilities produce core competencies for businesses when they have the following characteristics: 1. Provides end-product benefits 3. Difficult for competitors to imitate 2. Has access to a wide variety of markets  Tips in Utilizing Core Competencies in Business The value chain approach to core competencies for competitive advantage may be used in several ways. Some of them are shown below: Validate core competencies in current businesses regularly: Assess the continued existence of the resources and capabilities. Test whether they still have the aforementioned characteristics. Leverage competencies to the value chains of other existing businesses: A core competency in one segment of business can be used in another existing/new business. An excellent distribution network in one business can be used to launch another product. Example - If a bank has wide network of branches in its banking business, the same network can be used to launch and sell insurance products. Use core competencies to reconfigure the value chains of existing businesses: While firms may manage their existing value chains better than their competitors, sophisticated firms work harder on using their core competencies to reconfigure the value chain to improve payoffs. Otherwise, competitors may exploit opportunities Use core competencies to create new value chains: With strong core competencies in its existing businesses, an organization can seek new customers by developing new value chains. For example, FedEx transferred its expertise in the delivery of small packages to contract new business with L.L. Bean for overnight distribution.  Results of Core Competency: Competitive Advantage The ultimate objective of a for-profit company is to achieve superior performance in comparison to their competitors. A company which attains superior performance gets a definitive competitive advantage. The company’s profitability is improved with superior performance which leads to the maximization of shareholder’s wealth. In order to attain superior performance and attain competitive advantage, a firm must have distinctive competencies. Distinctive competencies can take the form of (1) product differentiation, (2) cost leadership or (3) market niche focus with a combination of one of the first two. AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA 1. Product DIFFERENTIATION – an offering or differentiation advantage. If customers perceive a product or service as superior, they become more willing to pay a premium price relative to the price they will have to pay for competing offerings. Example: Customers of Apple pay a higher price for its products. It occurs when customers perceive that a business unit’s product offering is of higher quality, involves fewer risks and/or outperforms products offered by competitors. In other words, customers perceive the product or service offered by a business to be superior. For example, differentiation may include a firm’s ability to deliver goods and services in a timely manner, to manufacture goods of better quality, to offer the customer a wider range of goods and services, and other factors that provide unique customer value. A differentiation advantage can be achieved by adopting the following techniques: Superior Quality: The customers are offered a better-quality product in the similar price range. The quality of product or service offering is such that the company becomes a preferred choice of its customers. Superior Innovation: The company continuously offers innovative products ahead of its competition. Superior Customer Responsiveness: The company produces products or provides services which are aligned with customer’s expectation. The company also focuses on overall customer service and works towards parameters like reducing waiting time, on time delivery etc. Once a company has successfully differentiated its offering, management may exploit the advantage in one of two ways viz., either; increase price until it just offsets the cost of improvement in customer benefits, thus maintaining current market share; or price below the “full premium” level in order to build market share. Companies like Apple charge premium prices from its customers because customers perceive Apple’s product to be different from others. 2. COST Leadership – Relative low-cost advantage, under which customers gain when a company’s total costs undercut those of its average competitor. A firm enjoys a relative cost advantage if its total costs are lower than those of its competitors. This relative cost advantage enables a business to do one of the following: Charge a lower price than its competitors for its product or services in order to gain market share and still maintain current profitability; or Match with the price of competing products or services and increase its profitability. A company may choose a strategy in which it can lower its cost and thereby gain a competitive advantage. Many sources of cost advantage exist - access to low-cost raw materials; innovative process technology; low-cost access to distribution channels or customers; and superior operating management. A company might also gain a relative cost advantage by exploiting economies of scale in some markets. Example - A refinery which has superior technology can process low grade crude to produce oil. Since low grade crude is cheaper than what the competitors pay for high grade crude, the company might be in a position to charge lower price & gain additional market share or charge higher price and earn better profits. A disadvantage of this strategy is that competitors might find way to lower their costs as well. Hence, a company which pursues a cost leadership strategy must continuously improve its cost structure. Another risk associated with cost leadership strategy is that managers might try to lower costs by compromising the quality of products. 3. Market NICHE Focus – By understanding the dynamics of a particular market and the unique needs of customers within it, this strategy develops uniquely low-cost or well-specified products for the target market. Because they serve customers in their market uniquely well, they tend to build strong brand loyalty amongst their customers. This makes their particular market segment less attractive to competitors. As with broad market strategies, it is still essential to decide whether you will pursue cost leadership or product differentiation once you have selected a focus strategy as your main approach: Focus is not normally enough on its own. However, the key to making a success of a generic market niche focus strategy is to ensure that you are adding something extra as a result of serving only that market niche. AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA It's simply not enough to focus on only one market segment because your organization is too small to serve a broader market (if you do, you risk competing against better-resourced broad market companies' offerings). The company must look at its value chain, which consists of all of its functions ― production, marketing, R&D, customer service, information systems, materials management, human resources ― to determine each one’s role in lowering the cost structure, increasing customers’ perceived utility through differentiation of its product or service and/or catering to needs of its specific market.  Value Chain Assessment Approach for Core Competencies The value chain model can be used by businesses to assess its competitive advantage. Companies must not only focus on the end product/ service but also on the process/ activities involved in creation of these. The value chain approach can be used to better understand the competitive advantage by applying (1) Internal cost analysis, (2) internal differentiation analysis, and/or (3) vertical linkage analysis. 1. Internal Cost Analysis Organizations can use the value chain analysis to understand the cost of processes and activities, and identify the source of profitability. The following steps are generally used to carry out an internal cost analysis: Step 1: Identify the firm’s value-creating processes. Step 2: Determine the portion of the total cost of the product or service attributable to each value creating process. Step 3: Identify the cost drivers for each process: The company identifies the factors which drive costs. Step 4: Identify the links between processes. Step 5: Evaluate the opportunities for achieving relative cost advantage. These steps will be applied in Activity-based Costing. 2. Internal Differentiation Analysis Companies can also use value chain analysis to create and offer superior differentiation to the customers. The focus is on improving the value perceived by customers on the companies’ products and service offering. The firms must identify and analyze the value creating process and carry out a differentiation analysis. Step 1: Identify the customer’s value creating processes: The company must identify various activities in its value chain which are undertaken to deliver products/ services to its customers. Differentiation comes from the way various activities are performed and the way in which value chain is structured. Step 2: Evaluate differentiation strategies for enhancing customer value: The company seeks to evaluate various strategies which could enhance the customer value. Strategies which a company can implement to enhance the customer value are: Providing superior features in a product - e.g. Premium cars, Phones etc. Using effective marketing and distribution channels - e.g. on time delivery. Excellent customer service - e.g. timeliness of repairs at effective cost, cleanliness at hotels etc. Having a superior brand image - e.g. Apple, Google, Tata Offering better quality product at competitive prices. Step 3: Determine the best sustainable differentiation strategies: The activities which could enhance differentiation must be identified. A company must identify those strategies which could create sustainable product/ service differentiation. The selection of strategy must be according to the availability of resources. 3. Vertical Linkage Analysis A company generates competitive advantage not only through linkages of internal processes within a firm but also through linkages between a firm’s value chain and that of a suppliers or users. A vertical linkage analysis includes all upstream and downstream activities throughout the industry. The analysis encompasses activities beginning at source of raw material and ending at the final delivery of AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA products to the customers. A company must have an understanding of not only its internal value chain but also of the industry value chain. A company might not carry out all activities in the entire value chain of an industry. Hence, it might not be in a position to obtain information relating to costs and revenues for each process being carried out in the industry. However, such information is necessary for a firm to carry out a vertical linkage analysis. A company must identify the cost drivers for each of the process in the value chain of the industry as done in the case of the internal value chain analysis. A company must identify and evaluate the opportunities for sustainable competitive advantages after carrying out an industry value chain analysis. Example - A company manufactures cars using various components like chassis, steering wheel, tires, axles etc. The company does not manufacturer all the components in-house and are purchased from third party suppliers. The company focusses on assembly line which is its core competency. However, certain parts, which are critical to the car are manufactured in-house. This is a strategic choice to gain a competitive advantage. In another case, a company could identify that there is virtually no competition in a particular process of the value chain. In such a case, it is less likely that the company might get a competitive price for the components it purchases. If there is only a single battery manufacturer, the car company might end up paying higher price. Such a situation could lead to a competitive disadvantage. A company might also carry out negotiations with its suppliers after an analysis of industry value chain. This generally happens when the company observes that certain section of value chain is charging excessive margin. Similar to internal cost analysis, this would be discussed and applied in Activity-based Costing. III. SEGMENTATION ANALYSIS A single industry might be a collection of different market segments. Motor vehicle industry, for example, can be seen as a composite of tire, glass, battery, metals etc. Not all firms in an industry participate in all segments. The structural characteristics of different industry segments need to be examined. This analysis will reveal the competitive advantages or disadvantages of different segments. A firm may use this information to decide to exit the segment, to enter a segment, reconfigure one or more segments, or embark on cost reduction/ differentiation programs. Step 1: Identify segmentation variables and categories: An industry might be divided into multiple segments depending upon the nature and complexity of the industry. The segmentation could be based on the nature of products or geographies or customers. Step 2: Construct a segmentation matrix: After the segments are identified, a segmentation matrix (generally two way) can be created. ITC could create a matrix based on the nature of products (Cigarettes, Hotels, Textile, Paper etc.) and geographies (North, East, West and South). Another way could be to create a matrix using products and distribution channel (wholesale, retail, direct). Step 3: Analyze segment attractiveness: The segmentation matrix could be used to evaluate profitability and performance of each of the segment. The interrelationship between various segments (say distribution channels, similar products) must also be considered while analyzing segmental attractiveness. For very similar segments, a responsibility accounting report may suffice. Step 4: Identify key success factors for each segment: Each segment identified must be assessed with a relevant measure of performance. It could be quality of product, service, timeliness of delivery etc. A single performance measure across all segments is not advisable. A measure which suits the service segment will not suit the manufacturing segment. Step 5: Analyze attractiveness of broad versus narrow segment scope: The company must identify whether it wants to be in a broad segment or a narrow one. Narrower segments could be risky for business as a single segment could be vulnerable to the competition. Multiple segments help a company to spread costs across the various segments. The company might also be in a position to use the competency of one segment in other segments. Some firms might abandon certain segments because of lack of profitability. The competitive advantage of each segment may be identified in terms of low cost and/or differentiation. AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA C. ROLE of the Management Accountant The management accountant is traditionally considered the resident expert on cost analysis; cost estimation; cost behavior; standard costing; profitability analysis by product, customer or distribution channel; profit variance analysis; and financial analysis. Today, management accountants must also bring skills in value chain analysis, life cycle costing (also taken in this unit), relevant costing (unit 2), capital budgeting (unit 3), responsibility accounting (unit 4), activity-based costing and management (unit 5), balance scorecard application (unit 6), and environmental management accounting (unit 7), among others. Strategic cost management is a team effort. Management accountants need to collaborate with engineering, production, marketing, distribution and service professionals to focus on the strengths, weaknesses, opportunities and threats identified in the strategic position, cost driver and value chain analysis results. By championing the use of strategic cost management, the accountant contributes to the firm’s growth and survival, and enhances the firm’s value. AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA LIFE-CYCLE COSTING The overall strategic cost management tool that will be discussed is life-cycle costing. It aims at cost ascertainment of a product or project over its projected life. It is a system that tracts and accumulates the actual costs and revenues attributable to product from its inception to its abandonment. It is loosely used interchangeably with the terms cradle-to-grave costing and womb-to-tomb costing to describe a system that fully captures all costs associated with the product from its initial to final stages. Product Life Cycle, Defined Product life cycle is a pattern of expenditure, sale level, revenue and profit over the period from new idea generation to the deletion of the product from product range. It spans the time from initial R&D on a product to when customer servicing and support is no longer offered for the product. For products like motor vehicles, this time-span may range from 5 to 7 years. For toys, the timespan be 7 to 10 months. Phases in Product Life Cycle The four identifiable phases in the product life cycle are (1) introduction, (2) growth, (3) maturity and (4) decline. A comparative analysis of these phases is given below: Particulars Introduction Growth Maturity Decline Phase 1 2 3 4 Sales Volume Initial stages, hence Rise in sales level at increasing Rise in sales Sales level off and low rates levels at then starts decreasing rates decreasing Prices of High levels to cover Retention of high level of Prices fall closer Gap between products initial costs and prices except in certain cases to cos, due to price and cost is promotional the effect of further reduced expenses competition Ratio of Highest, due to Total expenses remain the Ratio reaches a Reduced sales promotion effort needed to same while ratio of sales and normal ratio to and promotional expense to inform potential distribution and overhead sales, becomes efforts; the sales customers, launch costs to sales is reduced due industry product is no products, distribute to increase in sales (capacity standard longer in demand to customers etc. are maximized and fixed costs are spread over higher number of units) Competition Negligible and Entry of a large number of Fierce Starts insignificant competitors competition disappearing due to withdrawal of products Profits Nil, due to heavy Increases at a rapid pace Normal rate of Declining profits initial costs profits since due to price costs and prices competition, new are normalized products etc. In the growth stage, maintaining high prices are suggested to realize maximum profits. Price reduction will not be undertaken unless (a) the low prices will lead to market penetration, (b) the firm has sufficient production capacity to absorb the increased sales volume, and (c) competitors enter the market. AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA Product Life Cycle Costing, Characteristics and Benefits It Involves (1) tracing of costs and revenues of each product over several calendar periods throughout their entire life cycle, (2) tracing research, design and development costs and total magnitude of these costs for each individual product and compared with product revenue, and (3) serving as a tool in assisting in report generation for costs and revenues. Product life cycle costing is considered important due to these reasons: Pre-production costs analysis: The development period of R&D and design is long and costly. A high percentage of total product costs may be incurred before commercial production begin. Hence; the company needs accurate information on such costs for deciding whether or not to continue the product. Overall Cost Analysis: Production costs are accounted and recognized by the routine accounting system. However non-production costs like R&D, design, marketing, distribution and customer service are less visible on a product-by-product basis. Product life cycle costing focuses on recognizing both production and non- production costs. Effective Pricing Decisions: In order to be effective, pricing decisions should include market considerations on one hand and cost considerations on the other. Product life cycle costing and target costing help analyze both these considerations and arrive at optimal price decisions. Life Cycle Budgeting: Life cycle budgeting, i.e., life cycle costing with target costing principles, facilitates scope for cost reduction at the design stage itself. Since costs are avoided before they are committed or locked in, the entity benefits. Review: Life cycle costing provides scope for analysis of long-term picture of product line profitability, feedback on the effectiveness of life cycle planning and cost data to clarify the economic impact of alternatives chosen in the design, engineering phase etc. Better Decision Making: Based on a more accurate and realistic assessment of revenues and costs, at least within a particular life cycle stage, better decisions can be taken. Long Run Holistic view: Product life cycle costing can promote long-term rewarding in contrast to short- term profitability rewarding. It provides an overall framework for considering total incremental costs over the entire life span of a product, which in turn facilitates analysis of parts of the whole where cost effectiveness might be improved. ILLUSTRATION 1. Life Cycle Costing Wipro is examining the profitability and pricing policies of its Software Division. The Software Division develops Software Packages for Engineers. It has collected data on three of its more recent packages - (a) ECE Package for Electronics and Communication Engineers, (b) CE Package for Computer Engineers, and (c) IE Package for Industrial Engineers. Summary details on each package over their two-year cradle to grave product lives are as follows: Package Selling Price Number of units sold Year 1 Year 2 ECE 250 2,000 8,000 CE 300 2,000 3,000 IE 200 5,000 3,000 Last week, Amit, the Software Division Manager, decides to use Life Cycle Costing in his own division. He collects the following Life Cycle Revenue and Cost information for the packages (in pesos): Particulars ECE CE IE Year 1 Year 2 Year 1 Year 2 Year 1 Year 2 Revenues 500,000 2,000,000 600,000 900,000 1,000,000 600,000 Costs R&D 700,000 - 450,000 - 240,000 - Design of Product 115,000 85,000 105,000 15,000 76,000 20,000 Manufacturing 25,000 275,000 110,000 100,000 165,000 43,000 Marketing 160,000 340,000 150,000 120,000 208,000 240,000 Distribution 15,000 60,000 24,000 36,000 60,000 36,000 Customer Service 50,000 325,000 45,000 105,000 220,000 388,000 REQUIRED: Present a product life cycle income statement for each software package. Which package is most profitable and which is the least profitable? How do the three packages differ in their cost structure (the percentage of total costs in each category)? AE 313 Introduction to Strategic Cost Management Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA SUGGESTED ANSWER: Life Cycle Income Statement (in thousands of pesos) Particulars Package ECE Package CE Package IE Y1 Y2 Total % Y1 Y2 Total % Y1 Y2 Total % Revenues 500 2,000 2,500 100% 600 900 1,500 100% 1,000 600 1,600 100% Less: Costs R&D 700 - 700 28% 450 - 450 30% 240 - 240 15% Design 115 85 200 8% 105 15 120 8% 76 20 96 6% Manu. 25 275 300 12% 110 100 210 14% 165 43 208 13% Marketing 160 340 500 20% 150 120 270 18% 208 240 448 28% Distribution 15 60 75 3% 24 36 60 4% 60 36 96 6% Cust. Service 50 325 375 15% 45 105 150 10% 220 388 608 38% Total Costs 1065 1085 2150 86% 884 376 1260 84% 969 727 1696 106% Profit 350 14% 240 16% (96) -6% Analysis: Package CE is most profitable while IE is the least. ILLUSTRATION 2. Equivalent Annual Cost of Capital Investments ABC Corporation supports the concept of life cycle costing for new investment decisions covering its engineering activities. The company is to replace a number of its machines and the Production Manager is torn between the E-Machine, a more expensive machine with a life of 12 years, and the Y-Machine with an estimated life of 6 years. If the Y-Machine is chosen it is likely that it would be replaced at the end of 6 years by another Wye machine. The pattern of maintenance and running costs differs between the two types of machine and relevant data are shown below: E Y Purchase price P 19000 P 13000 Salvage value 3000 3000 Annual repair cost 2000 2600 Overhaul cost (at the end of 8th year for E and 4th year for Y) 4000 2000 Useful Life in years 12 6 Implicit interest rate 10% 10% REQUIRED: Recommend with supporting figures, which machine to purchase, stating any assumptions made. SUGGESTED ANSWER: Amount PVF PV of CF Purchase price P 19000 1 P 19000 Salvage value -3000 0.318631 (955.89) Annual repair cost 2000 6.813692 13627.38 Overhaul cost (at the 8th year) 4000 0.466507 1866.03 PVF of Net Cash Outflow - E P 33537.52 Divided by: PVFA - 12 years, 10% 6.813692 Equivalent Annual Cost of Equipment P 4922.08 Amount PVF PV of CF Purchase price P 13000 1 P 13000.00 Salvage value -3000 0.564474 (1693.42) Annual repair cost 2600 4.355261 11323.68 Overhaul cost (at the 4th year) 2000 0.683013 1366.027 PVF of Net Cash Outflow - Y P 23996.28 Divided by: PVFA - 6 years, 10% 4.355261 Equivalent Annual Cost of Equipment P 5509.72 E-Machine has a lower equivalent annual cost; hence it should be purchased instead of Y-Machine. *Note that with additional information, the above illustrations can be further analyzed with respect to tax implications and the financing costs. These will be taken under the topic Capital Budgeting. AE 313 EXERCISES Environmental Management Accounting Prepared by: Maybel Kua Edited by: Joseph R. Mendoza 16 | P a g e