Cost management

• Traditional management accounting control techniques tend to focus on cost containment whereas cost management concentrates on cost reduction.

• Traditional management accounting control techniques are routinely applied on a continuous basis whereas cost management tends to be applied on an ad hoc basis.

• Many of the approaches that fall within the area of cost management do not rely exclusively on accounting techniques

Cost management

• Traditional management accounting procedures have focused primarily on the manufacturing stage of a product ’s life cycle.

• LCC focuses on costs over the product ’s entire life cycle to determine whether profits earned during the manufacturing phase will cover the costs incurred during the pre-and post-manufacturing stages.

• A large proportion of a product ’s costs can be committed or ‘locked in ’during the planning and design stage

• Cost management can be most effectively exercised during the planning and design stage.

Life-cycle costing (LCC)

4

The Cost Life Cycle

• “Cost life cycle” refers to the following sequence of activities:

– R&D– Design– Manufacturing (or providing the service)– Marketing/distribution– Customer service

• It is the life-cycle of a product or service from the viewpoint of costs incurred

5

Upstream Activities Downstream Activities

R&D Design Manufacturing Marketing

and Distribution

Customer Service

The Cost Life-Cycle (continued)

Design decisions account for much of total product life cycle costs

6

The Sales Life-Cycle

• Sales life cycle is the sequence of phases in the product’s or service’s life:

– Introduction of the product or service to the market

– Growth in sales

– Maturity

– Decline

– Withdrawal from the market

• It is the life-cycle of a product or service from the viewpoint of sales volume achieved

7

The Sales Life-Cycle

Introduction

Growth Maturity

Decline

Time

Sale

s

Important strategic cost management issues arise in each stage of the life-cycle.

Futuristic Software Inc, a computer software company is developing a new accounting package, “Future Accounting”. The following are the budgeted amounts for Future Accounting Package over a six-year product life-cycle.

Life-cycle costing (LCC)

Year 1 and 2 $ Research and Development costs 360,000 Design costs 240,000

Year 3 to 6 One-Time Setup Costs

Variable Cost per package

Production costs $ 150,000 $ 37.50 Marketing costs 105,000 36 Distribution costs 75,000 24 Customer-service costs 120,000 45 To be profitable, Futuristic Software Inc must generate revenues to recover costs of

all six-business functions taken together and, in particular, its high non-production costs. Futuristic Software Inc wants to decide between three alternative selling prices i.e., $350, $430 and $550, so as to maximize life-cycle operating income. Sales volumes at these prices have been estimated at 7,500 units, 6,000 units and 3,750 units respectively. Identify which option maximizes life-cycle operating income.

Life-cycle costing (LCC)Alternative Selling Price/

Sales-Quantity Combination A B C

Selling price per package $350 $430 $550 Sales quantity in units 7,500 6,000 3,750

A. Life-cycle revenues $2,625,000 $2,580,00

0 $2,062,50

0 B. Life-cycle costs : R & D costs $360,000 $360,000 $360,000 Design cost of product/ process $240,000 $240,000 $240,000 Production costs (w1) $431,250 $375,000 $290,625 Marketing costs (w2) $375,000 $321,000 $240,000 Distribution costs (w3) $255,000 $219,000 $165,000 Customer-service costs (w4) $457,500 $390,000 $288,750 Total life-cycle costs C. Life-cycle operating income (A -B) $2,118,750 $1,905,00

0 $1,584,37

5 $506,250 $675,000 $478,125

Workings1. Production costs-

For A, $150,000 + (7,500 units x $37.50/package) = $431,250For B, $150,000 + (6,000 units x $37.50/package) = $375,000For C, $150,000 + (3,750 units x $37.50/package) = $290,625

2. Marketing Costs-For A, $105,000 + (7,500 units x $36/package) = $375,000For B, $105,000 + (6,000 units x $36/package) = $321,000For C, $105,000 + (3,750 units x $36/package) = $240,000

3. Distribution costs-For A, $75,000 + (7,500 units x $24/package) = $255,000For B, $75,000 + (6,000 units x $24/package) = $219,000For C, $75,000 + (3,750 units x $24/package) = $165,000

4. Customer-service costs-For A, $120,000 + (7,500 units x $45/package) = $457,500For B, $120,000 + (6,000 units x $45/package) = $390,000For C, $120,000 + (3,750 units x $45/package) = $288,750

Life-cycle costing (LCC)

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Target Costing

• Target costing: a costing method in which the firm determines the allowable (i.e., “target”) cost for a product or service, given a competitive market price and a targeted profit

• Two options for reducing costs to achieve the target-cost level:– By integrating new manufacturing technology using

advanced cost management techniques, (such as ABC), and seeking higher productivity

– By redesigning the product or service

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Implementing Target Costing

Determine the market price Determine the desired profit1

Calculate the target cost as market price less desired profit

Use “value engineering” to reduce cost Use kaizen costing and operational control to further

reduce costs

1For example, expressed as a percent of sales dollars

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Value Engineering

Value engineering (step 4):

– Analyze trade-offs between product functionality (features) and total product cost

– Perform a consumer analysis during the design stage of the new or revised product to identify critical consumer preferences

14

Value Engineering (continued)

For firm’s that can add and delete features easily, functional analysis (examining the performance and cost of each major function or feature of the product) can be used

– Benchmarking is often used in this step to determine which features give the firm a competitive advantage

– Goal: provide a desired level of performance without exceeding the target cost

15

Value Engineering (continued)

Design analysis:

– Useful when the firm that cannot add and delete features easily

– The design team prepares several possible designs of the product, each having similar features with

different levels of performance and different costs– Accountants work with the design team to choose one

design that best meets customer preferences while not exceeding the target cost

16Value Engineering (continued)

Other cost-reduction methods:

– Cost tables: computer-based databases (costs and cost drivers)

• Firms that manufacture parts of different size from the same design can see the difference in cost and material usage for each size

– Group technology is a method of identifying similarities in the parts of products a firm manufactures so the same parts can be used in two or more products, thereby reducing costs

17

Kaizen

Kaizen (step five): using continuous improvement & operational control to reduce costs in the manufacturing stage of the product life-cycle

– Achieved through:

• Streamlining the supply chain• Improving manufacturing methods and productivity

programs• Employing new management techniques

– Used extensively in the time period between product redesigns

18Benefits of Target Costing

– Increases customer satisfaction (design is focused on customer values)

– Reduces costs (more effective and efficient design)– Helps the firm achieve desired profitability on new and

redesigned products– Can decrease the total time required for product

development– Reduces “surprises” of the type, “We did not expect it to

cost that much...”– Can improve overall product quality– Facilitates coordination of design, manufacturing,

marketing, and cost managers throughout the product cost and sales life-cycles

An example of target costing

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Target Costing Example

HPI is performing a target costing analysis of a hearing aid (HPI-2), which sells for $750 (cost = $650) and has

30% of the market. However, a competitor has introduced a new model that incorporates a computer

chip that improves quality. Its cost is $1,200. A consumer analysis indicates that cost-conscious

consumers will remain loyal to HPI as long as price does not exceed $600. HPI wants to maintain the

current rate of profit, $100 per hearing aid.

HPI must therefore reduce its cost to $500 ($600 -$100) to meet its profit goal

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Target Costing Example (continued)

Design analysis options (see page 366 in your text):

– Alternative A: reduce R&D, replace parts, and change inspection procedure–savings = $150– Alternative B: replace parts and change inspection procedure–savings = $150– Alternative C: increase R&D to develop a computer chip

type hearing aid, replace parts, change inspection procedure, renegotiate new supplier contract–savings = $150

22

Target Costing Example (continued)

Management chooses alternative C because:

– Of the increase in R&D expenditures

– The increase in R&D will improve the firm’s competitive position in the future

– The move is strategically important: the new technology may be dominant in the future

• Kaizen costing is applied during manufacturing stage whereas target costing is during planning stage.

• Kaizen costing focuses on production processes whereas target costing focuses on the product.

• Kaizen costing aims to reduce costs of processes by a pre-specified amount relying on employee empowerment.

Kaizen Costing

• Quality is now one of the key competitive variables.

• Management accountants are now placing greater emphasis on the provision of information relating to the cost of quality.

• Cost of quality reports prepared periodically:1. Prevention costs2. Appraisal costs3. Internal failure costs4. External failure costs

• Increasing attention is also being given to continuous improvement with the aim of zero defects.

• Non-financial measures and statistical quality control tools also play a key role in improving quality and reducing internal and external failure costs.

Cost of quality

Cost of quality report

Cost of quality report (contd.)

A company started a quality improvement programme in July 2010. At the end of first quarter of 2011 management of the company desires to compare the results with the first quarter of previous year to assess the financial impact of quality improvement programme. Statistics for 1st quarters of both years are as under:

Example Cost of quality

Rs ‘000’

Cost 2010 2011Jul Aug Sep Jul Aug Sep

Process engineering 66 74 83 116 146 183 Training 393 431 477 633 765 911 Sales lost 1476 1209 993 734 632 576 Sales return 807 632 491 339 285 252 Inspection 42 47 53 72 89 110 Rework 474 380 300 218 185 167 Quality assurance 186 195 206 239 263 288 Scrap 528 435 357 267 231 210 Testing 48 51 56 68 78 90 Customer complaint 117 104 90 75 68 65 Prepare a ‘Cost of Quality Report’ showing monthly and quarterly results of twoyears that classifies into the following:

Example Cost of qualityCost of Quality Report

  2010 2011Cost Elements Jul Aug Sep Jul Aug Sep

Process engineering 66 74 83 116 146 183Training 393 431 477 633 765 911Quality assurance 186 195 206 239 263 288Prevention Cost 645 700 766 988 1,174 1,382Inspection 42 47 53 72 89 110Testing 48 51 56 68 78 90Appraisal Cost 90 98 109 140 167 200Rework 474 380 300 218 185 167Scrap 528 435 357 267 231 210Internal Failure Cost 1,002 815 657 485 416 377Sales lost 1,476 1,209 993 734 632 576Sales return 807 632 491 339 285 252Customer complaint 117 104 90 75 68 65External Failure Cost 2,400 1,945 1,574 1,148 985 893Total Cost 4,137 3,558 3,106 2,761 2,742 2,852