Specialist Cost Management Techniques: Comprehensive Study Guide

Specialist Cost Management Techniques: Learning Outcomes and Overview

• Core Learning Objectives:
  • Identify costs involved at various stages of the product life cycle.
  • Derive and evaluate life cycle costs and target costs.
  • Advise on business issues regarding the management of environmental costs.
• Profit Enhancement Mechanisms:
  • Profit is the gap between sales and cost.
  • Improvement strategies include: increasing sales, reducing costs, or maintaining costs through control.
  • In competitive environments, increasing sales is difficult; therefore, cost reduction and cost control are the primary available tools.

Cost Control and Cost Reduction

• Cost Control:
  • Definition: Regulation of the cost of operation through executive action.
  • Process: Setting targets (yardsticks) for cost centers, comparing actual performance against targets, and continuous regulation.
  • Types of Targets:
    • External: Based on external benchmarking.
    • Internal: Established in-house using techniques like Standard Costing and Budgetary Control.
  • Prerequisites of Cost Control (Crowningshield and Gorman):
    • Effective delegation of authority and assignment of responsibility for specific costs.
    • An agreed plan with clearly defined objectives and goals.
    • Motivation (financial or non-financial) to reach established goals.
    • Timely and efficient reporting.
    • Recommendations followed by immediate action.
    • Effective follow-up systems to judge implementation.
• Cost Reduction:
  • Definition: Real and permanent reduction in unit cost without impairing the utility or intended use of the product/service.
  • Nature: A continuous effort focusing on economics (standardization) and savings in manufacture, administration, and distribution.
  • Concept Insights:
    • Requires a cost reduction team guided by a well-defined program.
    • Must use a cost/benefit approach.
    • Requires change management as improvements are permanent.
  • Scope of Cost Reduction:
    • Product Design: Crucial phase where over $80\%$ of production costs are committed. Savings found through cheaper substitutes, higher yield, reduced operation time, and standardization.
    • Organisation: Defining functions, delegating responsibility, and improving communication to remove overlapping tasks and friction.
    • Factory Layout and Equipment: Elimination of wastage of men/materials and maximizing facility utilization.
    • Production Plan and Method: Minimizing manpower/material waste, reducing idle capacity, and improving maintenance/purchase controls.
  • Standardization Example (Automobiles): Using the same door handle or wiper across different car models to achieve economies of scale and easier inventory control.

Differences Between Cost Control and Cost Reduction

• Objective: Cost Control aims at maintaining costs within a specified level; Cost Reduction aims at reducing costs to an optimal level.
• Nature of Savings: Cost Control may result in temporary savings; Cost Reduction provides real and permanent savings.
• Retention of Utility: Cost Reduction strictly retains utility and quality; Cost Control focuses on regulation, where quality maintenance is not always guaranteed.
• Process: Cost Control uses standards/budgets as yardsticks and remedies variances; Cost Reduction challenges established standards continuously through dynamic analysis.
• Applicability: Cost Control is limited to items with set standards; Cost Reduction is universally applicable and focuses on present and future costs.

Target Costing: Definition, Principles, and Methodology

• Definition: A structured approach to determining the cost at which a product with specified functionality/quality must be produced to generate a desired profitability at an anticipated selling price.
• Contrast with Traditional Logic:
  • Traditional (Cost-Plus): $Cost + Profit \, Margin = Selling \, Price$. Ignores competitor pricing and customer willingness to pay.
  • Target Costing: $Anticipated \, Selling \, Price - Desired \, Profit \, Margin = Target \, Cost$.
• Steps in Target Costing:
  • Step 1: Re-orient culture to market-driven thinking.
  • Step 2: Identify market requirements (design, utility, needs).
  • Step 3: Establish market-driven target price based on competition and demand elasticity.
  • Step 3A/3B: Determine production volume and target profit margin based on long-term objectives.
  • Step 4: Calculate Target Cost ($Price - Margin$) and allocate it to subsystem assemblies.
  • Step 5-6: Establish the process and brainstorm alternatives to identify cost-reduction opportunities at each development stage.
  • Step 7: Close the gap between the product cost model and target cost using Value Engineering (VE) and Value Analysis (VA).
  • Step 7A: Re-engineer indirect processes using Activity Based Costing (ABC) to eliminate non-value-added functions.
  • Step 8: Measure results and maintain focus on continuous improvement.
• Ansari, Bell, and Swenson Model (6 Principles):
  1. Leadership of Target Selling Price.
  2. Focusing on Customer.
  3. Using and Developing Teamwork.
  4. Reducing Cost of the Product Life Cycle.
  5. Focus on the Stage of Product Design.
  6. Attention to all Stages of the Value Chain.
• Case Study: Kowloon Toy Company (KTC):
  • Target Selling Price: $₹100$.
  • Royalty: $15\%$ ($₹15$).
  • Target Profit: $25\%$ ($₹25$).
  • Target Cost calculation: $₹100 - ₹15 - ₹25 = ₹60$.
  • Current Cost Structure: Component H1 ($₹8.50$) + Component H2 ($₹7.00$) + Labour ($0.40 \, hr \times ₹60 = ₹24$) + Overheads ($₹13.50$) + Other Material ($0.6 \, kg \div 96\% \times ₹16 = ₹10$) = $₹63$.
  • Required Cost Reduction: $₹63 - ₹60 = ₹3$ per toy.

Target Costing: Implementation Realities

• Pros:
  • Reinforces innovation and manufacturing strategies.
  • Proactive approach and enhanced employee awareness.
  • Elimination of non-value-added activities and reduced time to market.
  • Allows intelligent trade-offs between features and functionality.
• Cons:
  • Lengthened development process through repeated design iterations.
  • Potential conflicts (“finger-pointing”) between departments regarding cost-cutting burdens.
  • Difficulties in reaching consensus in cross-functional teams.
  • High cost of detailed data development.
  • Risk of reduced quality from cheap components.
• Case Scenario: Zingaroo Bike (Kaveri Ltd):
  • Product: $99.2 \, cc$ engine, $8 \, bhp$ power, $8 \, Nm$ torque, $88 \, kmpl$ efficiency.
  • Strategy: Low-cost strategy for middle-class families.
  • Challenges: Increasing input costs, environmental pollution concerns, safety issues (aluminum/plastic frame), and servicing network.
  • Solutions suggested: Kaizen Costing for continuous refinement, compliance with BS emission norms, meeting safety standards, and establishing service centers.

Components of Target Costing: Value Engineering and Value Analysis

• Value Analysis (VA): Planned approach to cost reduction for existing products without reducing value.
• Value Engineering (VE): Application of value analysis to new products; happens before production.
• Critical VA/VE Questions:
  • Eliminate functions? Remove non-value-added activities from the process.
  • Eliminate excessive durability? Example: designing a vacuum for $100 \, lbs$ impact instead of $1 \, ton$.
  • Minimize design? Use fewer parts (Design for Manufacture and Assembly).
  • Design for process? Ensuring a laser cartridge fits only when correctly aligned to prevent assembly errors.
  • Substitute parts? Using less expensive, modern materials.
  • Combine steps? Process centering to reduce transfer/queue time.
  • Supplier assistance? Leveraging supplier expertise in material technology.
• Kaizen Costing Connection: Repeats VE steps throughout the production phase for small, continuous savings.

Life Cycle Costing (LCC)

• Definition: A system that accumulates actual costs and revenues attributable to a cost object from inception (R&D) to abandonment.
• Stages of Product Life Cycle:
  1. Introduction: Market launch, minimal awareness, high distribution/promotion costs, low/negative profits. Strategy: Raising awareness, price skimming or penetration.
  2. Growth: Rapid sales increase, rising competition, strategy shifts to retention and brand loyalty. Strategy: Improve features, maximize availability.
  3. Maturity: Sales increase at a diminishing rate, intense price competition, laggard buyers enter. Strategy: Maximize profits, defend market share, sales incentives.
  4. Decline: Sales volume drops due to substitutes or changing tastes. Strategy: Phase out items, reduce expenditure, milk the brand.
• LCC Math Example (Learning Curve):
  • Great Eastern Appliances Ltd 'Kitchen Care' product.
  • Learning Curve: $80\%$ ($index \, b = -0.3219$). First unit time: $30 \, hours$.
  • Average time for 250 units: $Y_{250} = 30 \times 250^{-0.3219} = 5.073 \, hours$.
  • Total time for 250 units: $5.073 \times 250 = 1,268.25 \, hours$.
  • Time for 250th unit: $(30 \times 250^{-0.3219} \times 250) - (30 \times 249^{-0.3219} \times 249) = 1,268.25 - 1,264.67 = 3.58 \, hours$.
  • Total time for lifetime (1000 units): $(750 \times 3.58) + 1,268.25 = 3,953.25 \, hours$.
• Benefits of LCC:
  • Earlier actions for revenue generation/cost lowering.
  • Accuracy in assessing long-term profitability.
  • Framework for total incremental costs.
  • Provides feedback on planning effectiveness.

Theory of Constraints (TOC) and Throughput Accounting

• Founders: Goldratt and Cox (1980s).
• Core Principle: Profits are expanded by increasing plant throughput. Bottleneck resources should be fully utilized; non-bottlenecks should not be fully utilized to avoid inventory buildup.
• Operational Measures:
  1. Throughput (T): Rate at which the organization generates money through sales. $T = (Sales \, Revenue - Unit \, Level \, Variable \, Expenses) \div Time$.
  2. Investment (I): Money tied up in materials, facilities, and equipment.
  3. Operating Expense (OE): Money spent turning Investment into Throughput (e.g., labor, maintenance).
• Goldratt’s Five-Step Method:
  1. Identify system bottlenecks.
  2. Exploit the bottlenecks (ensure $100\%$ utilization).
  3. Subordinate everything else (align non-bottleneck schedules to the bottleneck).
  4. Elevate the bottleneck (increase capacity/efficiency).
  5. Repeat for new constraints.
• Throughput Accounting (TA) Ratio:
  • $\text{TA Ratio} = \frac{\text{Throughput per Bottleneck Minute}}{\text{Factory Cost per Bottleneck Minute}}$.
  • A ratio $> 1$ indicates the product is profitable.

Environmental Management Accounting (EMA)

• Definition: Process of collection and analysis of environmental cost information for internal decision-making. Integrates management accounting with environmental practice.
• Application Areas: Product pricing, budgeting, investment appraisal, and performance targeting.
• Environmental Cost Classifications:
  • Generic: Internal costs (out-of-pocket waste disposal, taxes) and External costs (carbon emissions, soil erosion borne by society).
  • US EPA Classification: Conventional, Potentially Hidden, Contingent (fines), and Relationship/Image (reporting costs).
  • Hansen and Mendoza (Quality-based):
    1. Prevention Costs: Designing policies, pollution control R&D.
    2. Appraisal Costs: Monitoring, testing, and audits.
    3. Internal Failure Costs: Recycling scrap, disposing of toxics.
    4. External Failure Costs: Cleaning contaminated soil, reputation damage.
• EMA Methodologies:
  1. Input-Output Analysis: Recording inflows and balancing them with productive and unproductive (waste) outflows. Waste often represents $40\%$ to $90\%$ of environmental costs.
  2. Flow Cost Accounting: Tracing material flows in physical and monetary terms through organizational structures (material, system, and delivery/disposal costs).
  3. Life Cycle Costing: Accounting for full environmental costs over the whole life of the product.
  4. Activity Based Costing (ABC): Tracing environment-driven costs (hidden in overheads) to products via environmental impact drivers.
• Pros and Cons:
  • Pros: Improved revenue (popular with eco-conscious consumers), cost reductions (efficiency), and improved corporate image.
  • Cons: Compliance costs, diversion of top management focus, and significant failure costs if mismanagement occurs.
  • Practical Example (Xerox): Introduced standardized packaging (‘totes’) for photocopier leases, reducing disposal costs and improving logistics efficiency.