tutorial 1 - strategic cost management and value creation

question 1

the question is about activity based management [ABM] and its potential impact on aspect windows, a company manufacturing different types of products

aspect currently uses a traditional costing system, which absorbs overheads based on direct labour hrs instead of allocating them based on cost drivers. the CEO is concerned about falling net profit margins despite revenue growth, and wants to know whether AB, could help improve profitability

a. how ABM might help improve aspect’s strategic performance

what is ABM?

ABM applied activity based costing [ABC] principles to improve efficiency by analysing activities, identifying cost drivers, and reducing non-value added activities

how can ABM help aspect?

  • better cost allocation:

    • ABC identifies overhead costs based on activities rather than using direct labour hrs

    • procurement, customer admin, and product design costs will be better allocated, making product profitability clearer

  • product profitability analysis:

    • the conservatories business has high costs [procurement, customer service, efficiency and redesigning due to leaks]

    • ABM can identify these costs and help aspect decide whether to improve efficiency or discontinue conservatories]

  • cost reduction without quality loss:

    • ABM identifies non-value added activities [e.g. excessive procurement time, rework due to design flaws]

    • cutting these reduces costs without compromising quality

  • strategic decision making

    • helps aspect determine which products to focus on [e.g. discontinuing conservatories or standardising materials]

    • assists in evaluating the future move into large windows for commercial buildings, which will be highly customised

conclusion:

ABM can improve aspect’s strategic performance by providing clear cost visibility, improving pricing, and identifying areas for cost reduction. it will help aspect focus on profitable products and customers

b. problems of using ABM for aspect’s products

ABM has limitation and challenges that aspect must consider:

challenges of using ABM for aspect’s products

  • difficulties in identifying cost drivers:

    • overheads for procurement, customer service, and product design are complex

    • it may be hard to determine what drives each cost [e.g. how much of procurement costs relate to different products types]

  • ABM is less useful for standardised products:

    • windows [84% of total contribution] are highly standardised

    • overhead costs for design and customer administration are low for this segment, making ABM less beneficial

  • interdependencies between products:

    • discontinuing conservatories may reduce sales of glasshouses, as customers like matching designs

    • this could reduce contribution from glasshouses by up to £166,000

      • glasshouses sold = 3,800 units

      • conservatories sold = 650 units

      • ratio of conservatives to glasshouses = 650/3800 = 17.1%

        • potential loss of 17.1% of glasshouse sales if conservatories are discontinued

      • total contribution from glasshouses = 969,000

      • potential contribution loss = 17.1% x 969,000 = 166,000

challenges of using ABM for aspects customers

  • limited influence over large customers

    • aspect sells windows to a few large construction companies, meaning they cannot stop trading them or increase prices

  • complexity of customer profitability analysis [CPA]

    • glasshouses are sold through 40 retailers

    • each retailer has different order sizes, trade discounts, and customer service needs

    • identifying profitability per customers requires complex data collection, which aspect may struggle with

implementation issues

  • high setup costs:

    • aspect has basic information systems, and implementing ABM requires data collection software and training

  • resistance to change:

    • employees may resist adopting ABM due to unfamiliarity

conclusion:

while ABM provides better cost allocation and strategic insights, it has implementation challenges - especially for highly standardised products [windows] and large customers [construction companies] where pricing and order control are difficult

c. does ABM contribute to value creation?

how ABM helps create value

  • identifying and eliminating non value added activities:

    • reducing unnecessary procurement efforts for special materials

    • avoiding rework costs by improving conservatory design upfront

  • better pricing strategies:

    • conservatories require custom materials - aspect could charge a premium for customer finishes to cover costs

  • improved customer satisfaction:

    • identifying issues like leaking conservatories allows for proactive design improvements

  • informed decision making:

    • if conservatories are loss making, aspect can redesign or discontinue them

challenges to value creation

  • if ABM is costly to implement - aspect must ensure the benefits outweigh the costs

  • not all activities are easily classified as value added or non value added

conclusion:

ABM contributes to value creation by optimising operations, improving pricing, and reducing inefficiencies. however, it requires investment in data collection and system upgrades

d. linking ABM to CPA

what is CPA?

CPA allocates overheads to customers to assess which customers are most profitable

how ABM and CPA work together?

  • CPA uses ABM principles to allocate costs

    • overheads like customer support and order processing can be assigned to retailers/customers based on actual usage

  • glasshouses example

    • aspect sells to 40 retailers with different discounts, order sizes, and support needs

    • CPA can identify which retailers are less profitable and whether minimum order sizes should be imposed

  • pricing and cost control

    • CPA helps determine whether trade discounts should be adjusted

    • customers requiring high service levels [e.g. more order processing time] could be charged higher prices

how CPA helps in value creation

  • helps aspect decide which customers to prioritise

  • enables better pricing strategies [e.g. charging higher prices to customers with high service demands]

  • identifies areas to cut costs without losing revenue

conclusion:

CPA, when combined with ABM, provides clear insights into customer profitability, allowing aspect to make data driven decisions on pricing, discounts, and customer service


question 2

wales ltd. is planning to introduce digital radios and is considering using a target costing approach to ensure the product is profitable. the company has:

  • set a selling price of £44 to compete in the market

  • a desired profit margin of 20%, meaning the target cost per unit = 80% of £44

  • various cost components that need to be analysed

a. briefly describe the target costing process that wales ltd. should undertake

the target costing approach follows these steps:

  1. identify customer needs and required product features

    • wales ltd. must analyse customer preferences to determine which features to include [e.g. station scanning, text display]

  2. set the competitive selling price

    • the price of £44 has been set based on competitor analysis

  3. determine the target cost

    • target cost = selling price - desired margin

    • target cost = £44 × 80% = £35.20 per unit

  4. estimate current product cost and compare to target cost

    • if actual cost > target cost, a cost gap exists

  5. close the cost gap using cost reduction strategies

    • apply value engineering and supply chain improvements to reduce costs while maintaining product quality

b. benefits of target costing at the early stage

  • customer-centric approach:

    • ensures that only features valued by customers are included

  • cost control from the beginning

    • identifies cost issues before production starts, avoiding costly redesigns later

  • reduces time to market

    • minimises delays caused by late stage cost cutting adjustments

  • higher profitability

    • helps achieve the desired 20% margin by controlling costs early

  • better competitive positioning

    • ensures wales ltd. can price competitively while maintaining profitability

c. ways to reduce a cost gap

if the actual cost exceeds the target cost, wales ltd. can take the following actions:

  • value engineering

    • remove features that do not significantly increase customer value but add to cost

    • simplify circuit board design or use alternative components

  • supply chain optimisation

    • negotiate better bulk pricing on materials

    • reduce wastage of wiring through better training or automation

  • labour cost improvements

    • reduce idle time through better workforce scheduling

    • introduce automation to reduce labour costs

  • overhead cost management

    • use ABC to understand and reduce non-essential overheads

    • increase production efficiency to to spread fixed costs over units

d. cost per calculation and cost gap analysis

step 1 - calculate the target cost

  • selling price per unit = £44

  • desired profit margin = 20%

  • target cost per unit = £35.20 [see earlier]

step 2 - calculate cost per unit for each component

component 1 - circuit board

  • information from question:

    • cost per unit = £4.10

    • delivery cost per batch = £2,400

    • batch size = 4,000 units

  • delivery cost per unit = 2400/4000 = £0.60

  • total cost per unit [incl. delivery] = 4.10 + 0.60 = 4.7

  • cost of circuit board = £4.70 per unit

component 2 - wiring

  • info from question:

    • required wire per radio = 25 cm [converted to meters = 0.25m]

    • cost per meter of wire = £0.50

    • wastage factor = 2% wire loss, meaning for every 100m purchased, only 98m is usable

  • adjustment for wastage = [100/98]

  • cost per unit = 0.25 × 0.50 x [100/98] = 0.13

  • cost of wiring = £0.13 per unit

other materials

  • given and total cost = £8.10

step 3 - calculate assembly labour cost

  • info from question:

    • labour rate per hour = £12.60

    • time per unit = 30 minutes [0.5 hrs]

    • idle time factor = 10% idle time, so only 90% of paid time is productive

  • adjustment for idle time = [100/90]

  • labour cost per unit = 0.5 × 12.6 x [100/90] = 7

  • labour cost = £7.00

step 4 - calculate prod. overheads

variable overhead [using high-low method]

  • info from question:

    • month 1 overhead = 620,000 for 19,000 hrs

    • month 2 overhead = 700,000 for 23,000 hrs

  • inc. in overhead = 700 - 620 = 80,000

  • inc. in hrs = 23 - 19 = 4,000 hrs

  • variable cost per hr = 80,000/4,000 = £20.00 per hr

  • variable OH per unit = 0.5 × 20 = £10.00

    • each radio takes 30 min [0.5 hrs] to assemble

    • OH costs are allocated per hr, but we only use half an hr per unit

    • to allocate the correct proportion of OH per unit, we multiply by 0.5

fixed overhead [absorption calculation]

  • info from question:

    • normal annual activity = 240,000 assembly hrs

  • total variable OH for month 1 = 19,000 × 20 = 380,000

    • total assembly hrs x variable cost per hr

  • fixed OH per month = 620,000 - 380,000 = 240,000

    • total OH - variable OH —— must do this as total OH include both variable and fixed

  • annual fixed OH = 240,000 × 12 = 2,880,000

  • fixed OH absorption rate = 2,880,000/240,000 = £12.00 per hr

    • the 240K is from the normal annual activity

  • fixed OH per unit = 0.5 × 12 = £6.00

step 5 - calculate total cost per unit

  • 4.7 + 0.13 + 8.1 + 7 + 10 + 6 = £35.92

step 6 - calculate cost gap

  • cost gap = total cost per unit - target cost per unit

  • cost gap = 35.92 - 35.20 = £0.72 per unit

wales ltd. must reduce costs by £0.72 per unit to meet the target cost and achieve the 20% margin