MODULE 3

Management Advisory Services 2

SESSION TOPIC 3 : Strategic Cost Management

LEARNING OUTCOMES:
The following specific learning objectives are expected to be realized at the end of the session:
1. Discuss and give appreciation to the strategic cost management

KEY POINTS

Strategic cost management

CORE CONTENT
Introduction:
This module covers the discussion of
a. Total quality management
b. Just-in-time production system
c. Continuous improvement
d. Business process re-engineering
e. Kaizen costing
f. Product life cycle costing
g. Target costing

IN-TEXT ACTIVITY
Strategic Cost Management Definition
Strategic cost management is the process of reducing total costs while improving the strategic position of a business. This
goal can be accomplished by having a thorough understanding of which costs support a company's strategic position and
which costs either weaken it or have no impact. Subsequent cost reduction initiatives should focus on those costs in the
second category. Conversely, it may be useful to increase costs that support the strategic position of the business.

It is almost never worthwhile to cut costs in strategically important areas, since doing so reduces the customer experience
and therefore will eventually lead to a decline in sales. Consequently, management needs to be involved in cost reduction
activities, so that they can provide input regarding how certain costs must be incurred in order to support the competitive
position of the firm.

Strategic Cost Management Techniques

1. Activity Based Costing (ABC):

ABC is a natural outgrowth of today’s competitive and complex environment. ABC provides a closer approximation of the
cost of a product than that provided by the traditional volume based costing method. The main principle of ABC states that
activities cause costs and to control costs, the activities must be controlled.

Under ABC system, the activities are identified, the expenses related to each activity are clubbed together to get activity-
wise expenses, a cost driver for each activity is selected and finally the cost of the product is worked out.

Traditional cost accounting measures what it costs to do a task whereas ABC records the cost of not doing also. The
system monitors activities more closely, relates costs to activities and bring in cost effectiveness. This system of costing
makes a great impact in the service sector also.

ABC is a primary source of information for Activity Based Management (ABM). ABM is basically a top down approach
wherein the top management exploits information derived from ABC and passes the decision to the operational level
towards continuous improvement and excellence.

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2. Target Costing (TC):
As customers become more demanding and seek great value, importance of effective cost management becomes even
more. Much of the Indian manufacturing in the past was occurring in a cost plus environment, aided by extensive
government regulations. The operating practice was to fix a price as: Price = Cost + Profit. But in the global market the
customer will dictate the price and features that he will be looking for.

Target costing is a new attempt in which cost is the difference between the price expectation of the customers and margin
expectations of the corporation entities. Cost = Price – Target Profit. Management Accountant will have to work closely
with design and engineering personnel to achieve this target.

3. Total Quality Management (TQM):

Total Quality Management is a term first coined by the U.S. Naval Air Systems Command to describe its Japanese-style
management approach to quality improvement.

TQM is a set of management practices throughout the organization, geared to ensure that the organization consistently
meets or exceeds customer requirements. TQM places strong focus on process measurement and controls as means of
continuous improvement.

Total Quality is a people-focused management system that aims at continual increase in customer satisfaction at
continually lower real cost. In a TQM effort, all members of an organization participate in improving processes, products,
services and the culture in which they work.

4. Benchmarking:
Benchmarking is the process of determining who is the very best, who sets the standard, and what that standard is. In
other words, Benchmarking refers to the search for the best practices that yields the benchmark performance, with
emphasis on how you can apply the process to achieve superior results.

Often Benchmarking is used to evaluate performance. Benchmarking represents “best practice” available inside or outside
the organization.

5. Business Process Reengineering (BPR):

Business Process Reengineering, when fully implemented, will reduce a lot of clerical work and maintenance of records.
Thus Purchasing, Material Receipts, Accounts Payable procedures and documentation will be virtually eliminated. Instead
annual contracts with a few reliable suppliers to whom payments for quantities consumed in production will be made.

These improvements are made possible by the rapid strides made in Information Technology. Government support and
the attitude of Business Executives at the top level will determine the pace of acceptance of these recent developments.

It can be noted that the above system and practices would lead in overall improvement in the performance of the
organization, reduction in cost of production and improvement in productivity. As such the above singularly and
collectively play a very vital role in the financial control of an organization.

6. JIT Inventory Control System:

Originally developed in Japan and successfully implemented. Under this system, a company should maintain a very
minimal level of inventory and rely mostly on suppliers to provide parts and components “Just in Time” to meet assembly
requirements.

JIT philosophy is dedicated to the elimination of waste because stocks of raw materials and finished goods are reduced
leading to minimum holding cost of inventory.

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However, this system may not be applicable in the present Indian situation because of unreliable transport arrangement,
not so excellent relations with suppliers and distance of supply sources from the factory. Over emphasis on safety stock
will come in the way of its implementation.

7. Balanced Score Card:

The balanced score card is a strategic cost management technique for communicating and evaluating the achievement of
the strategy of the organization. It has been developed by Kaplan and Norton. This technique has been adopted by rapidly
growing organizations as a mechanism to help effectively manage their performance and strategy.

Traditional financial measures such as ROI, RI, value added, EPS, variance analysis etc. deal with past performance and
are inadequate for evaluating current information needs of large growing companies.

Traditional performance measures have the following drawbacks:

1. Performance measures lay too much emphasis on financial aspects.

2. Measures are not customer oriented and do not take care of the requirements of customers.

3. Departmental performance measures are not linked to the organization’s strategic objectives and as a result fail to
achieve the overall objectives of the organization.

4. Sometimes performance measures are irrelevant to the situation.

5. Traditional performance measures are mainly developed to meet the requirements of the organizations who are
operating in a seller’s market. But now a day’s business enterprises are operating in a buyer’s market where there is
acute competition.

For survival in the market, the organization must come up to the expectations of customers and must deliver defect free
product on time at a low price. organizations must develop performance measures that take care of customers
expectations.

Prior to 1980s management accounting, control systems used to focus mainly only on financial performance measures.

Only those items were included which could be expressed in monetary terms and motivated managers to focus
excessively on cost reduction and ignore other important variables (such as quality, delivery, after sales service, etc.)
which were necessary to compete in the global market that emerged during the 1980s.

Consideration of non-financial measures plays a very important role these days in achieving success of financial terms.
Thus, a mix of non-financial measure and financial measures emerged to cope with the requirements of customers.
Performance measurement systems much achieve a balance which supports progress against pre-determined objectives.

According to Kaplan and Norton previous system that incorporated non-financial measurements used ad hoc collection of
such measures more like checklists of measures for managers to keep track of and improve than a comprehensive
system of linked-measurement. The need to integrate financial and non-financial measures of performance led to the
emergence of the balanced scorecard (BSC).

Four persecution of BSC as developed by Kaplan and Norton are given below:
1. Customer perspective, i.e., how to customers view us. This perspective lays emphasis on the ability of the organization
to provide quality goods and services promising delivery in time and ensuring that goods and services are provided at low
cost and low cost of ownership keeping in view the overall satisfaction of customers.

2. Internal business process perspective (i.e. to satisfy our shareholders and customers at what business must we
excel?). The organization should make efforts to excel at the business which will satisfy customers and provide a good
return to shareholders.

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3. Learning and growth perspective (i.e. can we continue to improve and create values?) In order to meet the new
changes in the market and coming up to the exceptions of customers, employees should be willing or asked to take on
dramatically new responsibilities and may be ready to acquire new skills, technologies and organizational designs that
were not available in the past.

4. Financial perspective (i.e. how do we look to shareholders?). This perspective lays emphasis on profitability and market
value of the organization so that shareholders are duly compensated. The purpose of balanced scorecard is to strike a
balance in these four perspectives and to achieve the overall best for the organization.

Balanced Scorecard is a Performance metric used in strategic management to identify and improve various internal
functions and their resulting external outcomes. The balanced Scorecard attempts to measure and provide feedback to an
organization in order to assist in implementing strategies and objectives.

It is a set of performance targets and results relating to four dimensions of performance—financial, customer, internal
process and innovation. As a structure, balanced scorecard methodology breaks broad goals down successively into
vision, strategies, tactical activities, and metrics.

As an example of how the methodology might work, an organization might include in its mission statement a goal of
maintaining employee satisfaction. This would be the organization’s vision. Strategies for achieving that vision might
include approaches such as increasing employee-management communication.

Tactical activities undertaken to implement the strategy could include, for example, regularly scheduled meetings with
employees. Finally, metrics could include quantifications of employee suggestions or employee surveys. So this technique
helps to take proper action to create the desired future results.

8. Kaizen Costing:
Kaizen refers to continual and gradual improvement through small betterment activities, rather than large or radical
improvement made through innovation or large investment in technology. It is the process of cost reduction during the
manufacturing phase of an existing product. Kaizen costing is most consistent with the saying “slow and steady wins the
race.”

It is a Japanese term for making improvements to a process through small, incremental amounts rather than through large
innovations. It is a planning method used during the manufacturing cycle with an emphasis on reducing variable costs in
one period below the costs in a base period.

9. Six Sigma:
Six Sigma originated at Motorola in the early 1980s in response to a CEO-driven challenge to achieve tenfold reduction in
product-failure levels in five years. It is a multifaceted approach to process improvement, reduced costs, and increased
profits. With a fundamental principle to improve customer satisfaction by reducing defects, its ultimate performance target
is virtually defect-free processes and products.

The Six Sigma methodology, consisting of the steps: Identifying the Process—Define- Measure-Analyse-Improve-
Control,” is the roadmap to achieving this goal. Within this improvement framework, it is the responsibility of the
improvement team to identify the process, the definition of defect, and the corresponding measurements, improvement
and control.

The primary objective of Six Sigma is to improve customer satisfaction, and thereby profitability by reducing and
eliminating defects. Defects may be related to any aspect of customer satisfaction high product quality, schedule
adherence, cost minimisation etc.

10. Life Cycle Costing (LCC):

A life cycle cost analysis calculates the cost of a system or product over its entire life span. This also involves the process
of Product Life Cycle Management so that the life cycle profits are maximised.

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The analysis of this system includes cost for planning, research & development, production, operation, maintenance, cost
of replacement and disposal or salvage. This concept provides important information for pricing and also helps in
managing cost incurred throughout lifecycle of a system or product.

Process of LCC:
LCC involves identifying the individual costs relating to the procurement of the product or service. These can be either
“one-off” or “recurring” costs.

Examples of one-off costs include:

(i) Procurement;
(ii) Implementation and acceptance;
(iii) Initial training;
(iv) Documentation;
(v) Facilities;
(vi) Transition from incumbent supplier(s);
(vii) Changes to business processes; and
(viii) Withdrawal from service and disposal

Examples of recurring costs include:

(i) Retraining;
(ii) Operating costs;
(iii) Service charges;
(iv) Contract and supplier management costs;
(v) Changing volumes;
(vi) Cost of changes;
(vii) Downtime due non-availability;
(viii) Maintenance and repair; and
(ix) Transportation and handling.

It is important to understand the difference between these cost groupings because one-off costs are sunk costs once the
acquisition is made whereas recurring costs are time dependent and continue to be incurred throughout the life of the
product or service.

Furthermore, recurring costs can increase with time for example through increased maintenance costs as equipment
becomes old. These types of costs incurred will vary according to the goods or services being acquired.

11. Theory of Constraints (TOC):

During the 1980s Goldratt and Cox (1984) advocated a new approach to production management called optimized
production technology (OPT). OPT is based on the principle that profits are expanded by increasing the throughput of the
plant. The OPT approach determines what prevents throughput being higher by distinguishing between bottleneck and
non-bottleneck resources.

A bottleneck might be a machine whose capacity limits the throughput of the whole production process. The aim is to
identify bottlenecks and remove them or, if this is not possible, ensure that they are fully utilized at all times. Non-
bottleneck resources should be scheduled and operated based on constraints within the system, and should not be used
to produce more than the bottlenecks can absorb.

The OPT philosophy therefore, advocates that non-bottleneck resources should not be utilized to 100% of their capacity,
since this would merely result in an increase in inventory. Thus, idle time in non-bottleneck is not considered detrimental
to the efficiency of the organization.

If it were utilized, it would result in increased inventory without a corresponding increase in throughput for the plant. The
process of maximising profit when faced with bottleneck and non-bottleneck operations is known as theory of constraint
(TOC).

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The process involves five steps:
(i) Identify the system’s bottleneck;
(ii) Decide how to exploit the bottlenecks;
(iii) Subordinate everything else to the decision in step (ii);
(iv) Elevate the system’s bottlenecks;
(v) If, in the previous steps a bottleneck has been broken go back to step (i).

12. Activity Based Management (ABM):

The adopters of activity based costing (ABC) used it is produce more accurate product or service costs but it soon
became apparent to the users that it could be extended beyond purely product costing to a range of cost management
applications.

The term activity based management (ABM) or activity based costing management (ABCM) are used to describe the cost
management applications. To complement an ABM system only first three stages of the five stages for designing an
activity-based product costing system are required.

They are:
(i) Identifying the major activities that take place in the organization;
(ii) Assigning costs to cost pools/cost centres for each activity;
(iii) Determining the cost driver for each major activity.

ABM rules business as a set of linked activities that ultimately add value to the customer. It focuses on managing the
business on the basis of activities that make up the organization. ABM is based on the premise that activates consume
costs.

Therefore, by managing activities costs will be managed in the long-term. The goal of ABM is to enable customer needs to
be satisfied while making fewer demands on organizational resources.

ABC also provides information on the cost of activities why activities are taken and how will they are performed. ABM is
much broader concept than ABC. It refers to the management philosophy that focuses on the planning execution and
measurement of the activities as the key to competitive advantage.

From the above we can conclude that Strategic Cost Management helps to find lower cost solutions but this also requires
proper supply chain management. Globalized market place and consumer’s increased demands on availability put higher
pressure on companies supply chain.

If supply chain is efficient, then end consumers will be better served. If supply chain is on top, it not only helps to gain new
consumers but also helps to retain old ones.

The major responsibility of purchasing is to ensure that the price paid for an item is fair and reasonable because price has
a direct-impact on the end consumer’s perception of value provided by the organization.

So evaluation of supplier’s cost to provide the product and services is an ongoing challenge within all industries. Price
analysis focuses simply on a seller’s price perspective, giving less consideration to actual cost of production.

On the other hand cost analysis, lays emphasis on each individual cost element (i.e. material, labour, overhead, other
administrative costs and profits) and final cost of product. This analysis determines a fair and reasonable price and
develop plan to achieve future cost reduction.

So price and cost management should be considered from total supply chain perspective. Strategic cost management
requires that purchasing and logistics system should adopt a series of new initiatives that can deliver results of the bottom
line.

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SESSION SUMMARY
 Strategic cost management (SCM) deals with measuring and managing costs and aligning them to the business
strategy
 Strategic cost management is a continuing process, since the strategy of a firm may change over time. Thus, certain
costs may be sacrosanct when one strategy is being used, but can be readily eliminated when the strategy shifts.

SELF-ASSESSMENT
Assignment : Case study of strategic cost management
Quiz : Problem on strategic cost management

REFERENCES
Refer to the references listed in the syllabus of the subject.

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