Contemporary cost management models

Contemporary cost management models

1. Value chain analysis

   • Value-added activity
     • Increases worth of products
     • Increases customers' WTP
       • May buy greater quantities
     • Eliminate non-value-added activities to create value
       • Some non-value-added activities essential for firms' existence
       • Concentrates on expense items when reducing cost, without understanding impacts of existing processes, leading to vaue destruction
     • Some activities more valuable to customers than others
     • 5-point rating scale of value of activities
       • 1: Add no value, eg. manufacturing defective products
         • Discard to eliminate these activities
       • 3: Not perceived as valuable to customers but neccesary for operations, eg. online banking to reduce time to pay employees
         • Review how objective can be achieved
       • 5: Highest value
         • Proceed with caution if reducing costs to preserve value
     • Value-added less cost = profit margin
       • Costs must be managed to remain below value-added
   • Porter
     • Advocated VCA to gain competitive advantage
       • Optimisation
         • Firms can choose optimal solution after considering trade-offs between activites
       • Coordination
         • Between activities to enhance value
     • Activities are interlinked; understanding linkages to better manage costs
     • Primary activities
       • Directly concerned with creation/delivery
       • Inbound / outbound logistics
       • Marketing and sales
       • Service
     • Support activites
       • Support primary activities, some more critical than others for differing organisations to remain competitive
       • HR management
       • Technology development
   • Steps
     • 1: Define activities, considering disaggregation into individual value activities
       • Separate if significant in size or growth in cost, or if they have different cost behaviours, or if performed differently by competitors
     • 2: Determine cost drivers (cause for cost)
       • Shank: Two categories of cost drivers
         • Structural, don't necessarily reduce cost due to diseconomies of scale
           • E.g., scale, scope, experience, technology
         • Executional, increasing them decreases costs because benefits exceed costs
           • E.g., work force involvement, capacity utilisation, TQM
     • 3: Identify opportunities for cost reduction / enhanced differentiation

2. Activity-based management

   • Uses activity-based costing information, more accurate than traditional abosrption costing
     • OHs allocated to activity cost centres, costs incurred by these allocated to cost objects using activity cost drivers
       • Higher number of cost centres, so more accurate determination of cost drivers / cause of cost
         • More accurate pricing decisions
       • Makes non-value added activites more visible
     • OHs allocated to cost centres (departments), costs incurred allocated to cost objects using volume-based allocators eg direct labour, machine hours
       • May be unaware of an undesirable, significant cost
   • Steps of traditional absorption costing
     • 1: Assign all manufacturing OHs to production and service cost centres
     • 2: Reallocate costs assigned to service cost centres to production cost centres
     • 3: Compare separate OH rates for each production cost centre
     • 4: Assign cost centre OHs to products or other cost objects
   • Steps of ABC
     • 1: Identify major activities that take place in firm
     • 2: Assign costs to cost centres
     • 3: Determine cost drivers for each major activity; calculate cost driver rate
       • Annual cost / cost driver volume
     • 4: Assign cost of activities to products according to demand for activities
       • Cost driver volume * cost driver rate
   • Operational ABM
     • Efficiency; doing things right
     • 5-point scale on current efficiency of activity, 1 highly efficient with little opportunity for improvement, 5 50-100% opportunity
     • Directs attention to activities and cost drivers improving processes and reducing costs
     • Start with activities with largest costs, with little value added and highly inefficient
       • Higher chance of benefits
     • Comparing cost driver rate to industry average
       • If higher, investigate to improve process and reduce costs
   • Strategic ABM
     • Effectiveness; doing the right thing
       • Selling the right products to the right people at the right prices
     • Lead to operational adjustments
     • Profitability analysis of cost objects
     • Investigate all activities with an OH consumption rate higher than the highest overall OH per unit, starting with the highest cost activitiy
       • May indicate a need to adjust SP but only do that after a business-orientated analysis due to factors of changing SP

3. Life cycle costing

   • Focuses on costs over product's entire life cycle
   • Profits earned during manufacturing stage need to cover those incurred pre- and post- (period costs)
     • Concentrates on manufacturing stage
   • Withdraw products if cost savings exceed contribution loss
     • So that competitors don't gain market share whilst a mature product declines
   • Accurate feedback on product development
   • Better info for DM as product profitability is more understood

4. Target costing

   • ABC costing system used to reduce likelihood of incorrect decisions due to cause-and-effect cost drivers
   • Cost management should commence in the planning and design phase because 80-90% of costs are in this phase
     • Design, production method etc. locked in before production
   • Customer-oriented approach
     • Aiming to produce at a SP customers are WTP
   • Aims to reduce life cycle costs of new products whilst ensuring quality, functionality and reliability
   • Iterative, multidisciplinary approach
     • People from different disciplines have different skills and ideas
   • Steps
     • 1: Determine price customers are WTP
     • 2: Determine target cost
       • SP - (investment / profit as % of sales)
     • 3: Compare estimated actual cost with target
       • To reduce estimated annual costs below target cost:
         • Tear-down analysis
           • Examine competitors' products to identify opportunities for reduction in cost
           • Dismantle to identify design, material, functionality
         • Value engineering
           • Systematic interdisciplinary examination of factor affecting the cost of a product
           • Achieve target costs without sacrificing value propositions
           • Decompose products into attributes, eg. style, then determine price customers are WTP for each attribute
             • If costs of function exceed benefits to customers, reduce costs of increase benefits to enhance perceived value
   • Benefits
     • Max impact on cost management because carried out in planning / design phase
     • Emphasis on meeting target cost promotes cost consciousness
       • Strengthens competitive position due to selling at price customers are WTP whilst having desirable profit margins

5. Kaizen costing

   • Focuses on production processes, applied during the manufacturing stage
   • Promotes process-orientated thinking
     • Reducing process costs by small incremental amounts
       • Continuous improvement achieved through employee empowerment
   • Cost reduction doesn't cease once the target costs are met like target costing
   • Cost-reduction targets measured in terms of ratio of target reduction to standard cost base, applied monthly
     • Employees have failed if target not met
   • Cost variance analysis involves comparing kaizen cost-reduction targets with actual cost-reduction amount
   • Improvement, sought after by everyone, are small but always possible
     • Have a cumulative effect
   • Consider culture before adopting kaizen
     • Need commitment by staff from all levels, hard in a highly centralised culture
   • Demands rapid implementation of improvements with follow up to ensure they are sustained
     • Investigations if target reductions aren't met
   • Standard costing used for cost control, assuming stability in current manufacturing processes, aiming to meet pre-determined cost performance standards

6. Benchmarking

   • Learn from the best
   • Comparison of key activities with best practices found within and outside the firm
   • External benchmarking
     • Identify an activity that needs improving
     • Find a non-rival organisation considered to represent world-class best practice for the activity
     • Study how it performs the activity and implement improvements
   • Internal benchmarking
     • Different business units performing the same activities compared
     • The unit representing best practice becomes the target to achieve
   • Advantages
     • Cost beneficial; to avoid mistakes other companies have made and duplicate effort
     • Benchmark company need not be in the same industry due to focus on activities; easy to find
   • Disadvantages
     • Finding the right organisation difficult because they have different cultures
     • Gaining access to organisation difficult without an arrangement

7. Process and enterprise maturity model

   • Process redesign only if organisation is ready
     • Depends on level of maturity measured through process enablers and enterprise capabilities
     • More extensive process redesign = higher process performance
   • Less radical than BPR; no need to go straight to perfection
     • Redesign takes place over time
   • 5 process enablers
     • Characteristics essential for any process to perform well
       • Are interdependent
     • Design: well specified
       • Low: design only needs to be primary functional
       • High: End-to-end documentation of process design
     • Performers: people who execute skill
       • Low: name processes they execute
       • High: describe how their work affects inter-enterprise performance
     • Owner: responsibility over results
       • Low: individual informally in charge of improving
       • High: needs to be a member of the enterprises most senior DM body
     • Infrastructure: aligned, information and management system support processes to not impede performance
       • Low: rewards linked to functional excellence
       • High: reinforce importance of inter and intra- enterprise collaboration, personal learning and organisational change
     • Metrics: track performance over time
       • Low: basic cost and quality metrics
       • High: metrics derived from enterprise' strategic goals
   • 4 enterprise capabilities
     • Need to be at a high level of maturity to support a more extensive process redesign
     • Leadership: maturity depends on how well senior mgmt understand + and - of a process redesign focus
     • Culture: values of customer focus, teamwork, willingness to change
       • Mature if all employees assume personal accountability
     • Expertise: skills in process redesign, more skilled employees
     • Governance: mechanisms for managing complex process, high maturity if process model used for trategy development
   • Process performance
     • 0: Process works erratically
     • 1: Reliable, predictable, stable
     • 2: Delivers superior results, implements from all ends of organisation
     • 3: Delivers optimal performance integrated with other internal processes
     • 4: Best in class, extending to suppliers / customers
       • High performance; integrated across value chain; all process enablers of highest maturity
   • Benefits
     • Comprehensive to evaluate maturity of business processes
       • Ensures extent of redesign matches the organisation's readiness
     • Flexible; applies to any industry
     • Easy to administer; doesn't require consultants
     • Provides a list of factors for troubleshooting when high-performing processes break down

8. Business process re-engineering

   • Popular in the 1990s
   • Identified non-value-added activities within long-established business processes, affecting competitiveness
   • Since activities are linked, look holistically, questioning assumptions underlying business processes
     • Missed opportunity to revamp processes when change occured
   • Examine business processes to radically redesign, improving quality and cost reduction
     • Questioning the need for activities, not improving them
     • Causes for failure
       • Disruption caused, depending on extent of redesign
       • Employee resistance
         • Uncomfortable with change
         • Tend to involve large employee layoff