AC 4104 – Pillars of

Strategic Cost
Management
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 PILLARS OF STRATEGIC COST MANAGEMENT
 1. Cost Driver Analysis
 Cost Driver – are the causal factors used in the estimation of the cost. Is any factor that causes a change in total
cost. It is the cause, and the cost incurred is the effect of it.
 Cost to be Estimated Cost Driver
 a. Fuel expenses for a delivery truck Miles driven
 b. Maintenance cost in a manufacturing plant Machine hours, labor hours
 c. Product design cost Number of design elements, design changes

 Activity-Based Cost Drivers – are identified using activity analysis – a detailed description of the specific activities
performed in the firm’s operations.
 Activity Possible Cost Drivers
 Provide ATM service Number of ATM transactions, number of customers
 Provide cashier service Number of customers
 Process loan applications Number of loan applications processed
 Volume-Based Cost Drivers – the cost driver is the amount produced or quantity of service provided.
Management accountants commonly call this volume, or volume of output, or simply output.
 Good examples of volume-based costs are direct material cost and hourly direct cost – these costs
increase with each unit of the volume of output.
 The three (3) cost drivers, namely: (1) the output of completed units; (2) the quantity of direct
materials; and (3) the hours of direct labor – are all volume-based cost drivers and are proportional to
each other.
 Cost – is incurred when a resource is used for some purpose.
 Cost pools – are the meaningful groups into which costs are often collected or assigned. Costs can be
grouped in many different ways, including by type of cost (labor cost in one pool, material costs in
another; by source (department 1, department 2); or by responsibility (manager 1, manager 2). For
example: a product engineering department or an assembly department might be treated as a cost pool.
 Cost object – is any product, service, customer, activity or organizational unit to which costs are
assigned for some management purpose. Costs objects play a key role in decision making, performance
measurement and strategy implementation.
 Cost assignment – is the process of assigning resource costs to cost pools and then from cost pools to cost objects.
There are two (2) types of assignment: (1) direct tracing, and (2) allocation. Direct tracing is used for assigning
direct costs, and allocation is used for assigning indirect costs.
 Direct cost – can be conveniently and economically traced directly to a cost pool or a cost object. For example:
the cost of materials required for a particular product is a direct cost because it can be traced directly to the
product.
 In a manufacturing company, the material cost is accumulated in cost pools (manufacturing departments) and then
is traced to each product manufactured, which is the cost object. For a direct cost, the cost driver is the number
of units of that object. Total direct cost increases directly in proportion to the number of objects.
 Indirect costs – cannot be conveniently or economically traced directly from the cost to the cost pool or from the
cost pool to the cost object. For example: the cost of supervising manufacturing employees and the cost of
handling materials are costs that generally cannot be traced to individual products and therefore are considered
indirect costs.
 Since indirect costs cannot be traced to a single cost pool or cost object, the assignment for indirect cost is made
by using cost drivers. For example, if the cost driver for material handling cost is the number of parts, the total
cost of material handling can be assigned to each product on the basis of each product’s number of parts relative
to the total number of parts in all products. Similarly, a department with large number of employees should bear a
large portion of the cost of supervision.
 Cost allocation – is the assignment of indirect costs to cost pools and cost objects. It is a form of cost
assignment in which direct tracing is not economically feasible, so cost drivers are used instead.
 Allocation bases – are the cost drivers used to allocate costs.
 Direct material cost – includes the cost of materials in the product and a reasonable allowance for scrap
and defective units.
 Indirect material cost – refers to the cost of materials used in manufacturing that are not physically part
of the finished product. Examples include supplies used by manufacturing employees, such as rags and
small tools, or materials required by the machines, such as lubricants; direct materials that are a very
small part of material cost, such as glues and nails are often not traced to each product but are included
instead in indirect materials.\
 Direct labor cost – includes the labor used to manufacture the product or to provide the service plus
some portion of non-value-added time that is normal and unavoidable (coffee breaks and personal time).
 Indirect labor costs – include supervision, quality control, inspection, purchasing and receiving, materials
handling and other manufacturing support costs. For example in a restaurant where the cost object is
each meal served, the food and food preparation costs are direct costs for each meal served, but the cost
of purchasing, handling and storing food items are indirect costs
 The Flow of Cost Assignment
 Resource Cost Cost Driver Cost Pool Cost Driver Cost Object
 Direct Cost
 Electric motor Direct trace Assembly department Direct trace Dishwasher and WM
 Packing material Direct trace Packing department Direct trace Dishwasher and WM
 Final inspection Direct trace -------------- Dishwasher and WM
 Indirect Costs
 Supervision Allocation base: Assembly and Allocation base: Dishwasher and
 No of employees packing depts. Direct labor hours washing machine
 in the department for each product
 Materials Allocation base: Assembly and Allocation base: Dishwasher and
 Handling Weight of materials packing depts. Number of parts washing machine
 in the product
 Overhead (or factory overhead in a manufacturing firm) – are all indirect costs commonly combined
into a single cost pool such as indirect materials, indirect labor, and other indirect items.
 Prime costs - refer to direct materials and direct labor that are combined into a single amount.
 Conversion cost – refers to direct labor and factory overhead combined into single amount.
 Cost Drivers and Cost Behaviors
 Cost drivers provide two important roles for the management accountant:
 1. enabling the assignment of costs to cost objects
 2. explaining cost behavior: how total cost change as the cost driver changes.
 Four types of cost drivers:
 1. activity-based cost drivers – are developed at a detailed level of operations and are associated with
a given manufacturing activity (or activity in providing a service, such as: machine setup, product
inspection, materials handling, or packaging.
 2. volume-based cost drivers – are developed at an aggregate level, such as an output level for the
number of units produced.
 3. structural cost drivers – involve strategic and operational decisions that affect the
relationship between these costs drivers and total cost. These are strategic in nature and involve
plans and decisions that have a long-term effect with regards to issues such as scale, experience,
technology and complexity.
 4. executional cost drivers – also involve strategic and operational decisions. These are factors
the firm can manage in the short-term to reduce costs, such as workforce empowerment, design
of the production process, and supplier relationship.
 Workforce empowerment. Are the employees dedicated to continual improvement and quality?
This workforce commitment will lower cost.
 Design of the product process. Speeding up the flow of product through the firm can reduce the
costs. Innovation in manufacturing technology can reduce manufacturing costs significantly.
 Supplier relationships. Can the cost, quality, or delivery of materials and purchased parts be
improved to reduce overall costs? Maintain a low-cost advantage partially through agreements
with the suppliers to provide products or parts that meet the company’s explicit requirements as
to their quality, timeliness of delivery, and other features.
 Fixed and Variable Costs
 Variable cost – is a cost that changes in total in response to changes in one or more costs drivers.
 The cost drivers can be activity-based or volume-based though typically management accountants in practice
use the term variable costs in connection with volume-based cost drivers.
 Fixed cost – is that portion of the total cost that does not change with the volume of a designated cost driver
within the relevant range.
 Total fixed costs and unit variable costs are expected to remain approximately constant within the relevant
range.
 Relevant range – refers to the range of volumes or activity within which the expected behavior of cost is valid.
Example: A company, with its current facilities and personnel is capable of producing 100,000 units and incurs
total fixed costs and expenses of P1,000,000. The relevant range for this amount of fixed costs and expenses is
from 0 to 100,000 units. Beyond that, the company must increase its production/sales capacity by acquiring
additional fixed assets and/or hire additional employees and these will give rise to additional fixed charges.
 Step cost – is one that varies with the cost driver but does so in steps. For example: if a warehouse clerk can
fill 100 orders in a day, 10 clerks will be needed to process approximately 1,000 orders, as demand exceeds
1,000 orders, an 11th clerk must be added.
 Unit cost (or average cost) – is the total cost of manufacturing resources consumed (materials, labor and
overhead) divided by the number of units of output. It is a useful concept in setting prices and in
evaluating product profitability.
 To properly interpret unit cost, we must distinguish unit variable cost from unit fixed costs.
 Unit variable costs – do not change as output changes.
 Unit fixed costs – do change as output changes.
 Product Costs and period Costs
 Product costs – for manufacturing firms, include only the costs necessary to complete the product: direct
materials, direct labor, and factory overhead.
 Direct materials – the materials used to manufacture the product, which becomes a physical part of it;
Direct labor – the labor used to manufacture the product; Factory overhead – the indirect costs for
materials, labor and facilities used to support the manufacturing process.
 Period costs – are all non-product expenditures for managing the firm and selling the products. They are
expense in the period in which they are incurred. In manufacturing or merchandising firm, period costs
are also referred to as operating expenses or selling and administrative expenses.
 Cost Estimation
 Cost estimation – is the development of a well-defined relationship between a cost object and
its cost drivers for the purpose of predicting the cost.
 Cost estimation facilitates strategic management in three (3) important ways:
 1. It helps predict future costs using previously identified activity-based, volume-based,
structural, or executional cost drivers.
 2. Cost estimation helps identify the key cost drivers for a cost object.
 3. The cost drivers and cost-estimating relationships are useful in planning and decision making.
 Six (6) steps of cost estimation:
 Step 1: Define the cost object for which the related costs are to be estimated.
 Step 2: Determined the cost drivers.
 Step 3: Collect consistent and accurate data on the cost object and the cost drivers.
 Step 4: Graph the data.
 Step 5: Select and employ an appropriate estimation method (High-low method and Regression analysis)
 Step 6: Evaluate the accuracy of the cost estimate.
 High-low method – uses algebra to determine a unique estimation line between representative high and low
points in the data.
 *Y = a + (b x X)
 where: Y = the value of the estimated maintenance cost
 a = a fixed quantity that represents the value of Y when X = zero
 b = the unit variable cost per operating hour
 X = the cost driver, the number of operating hours of operations
 b = Variable cost per hour
 = Difference between costs for high and low points_______
 Difference for the value of the cost driver for the high and low points
 Illustration: (High-low Method)
 The firm shows the maintenance costs and additional operating hours information as follows:
 January February March April May June July
 Total operating hours 3,451 3,325 3,383 3,615 3,423 3,410 3,500
 Maintenance costs P22,843 P22,510 P22,706 P23,032 P22,413 P22,935 P23,175
 Required: Suppose that 3,600 operating hours are expected in August, compute the estimated
maintenance costs in August.
 b = P 23,032 – P22,510 = P1.80 per hour
 3,615 - 3,325
 Using April data: a = Y – (b x X) = P23,032 – (P1.80 x 3,615) = 16,525
 Using February data: a = Y – (b x X) = P22,510 – (P1.80 x 3,325) = 16,525
 So the estimation equation using the high-low method is: Y = P16,525 + (P1.80 x X)
 Maintenance cost in August = P16,525 + (P1.80 x 3,600) = P23,005
 Regression Analysis
 Regression Analysis – is a statistical method for obtaining the unique cost-estimation equation that
best fits a set of data points.
 Least squares regression – is a cost estimation method that minimizes the sum of the squares of
the estimation errors; it is widely viewed as one of the most accurate methods for estimating costs.
 Dependent variable – is the cost to be estimated.
 Independent variable – is the cost driver used to estimate the value of the dependent variable.
 Simple regression – has a single, independent variable.
 Multiple regression – is used to describe regression applications having two or more independent
variables.
 In contrast to the high-low method, the amount of estimated error is considered explicitly in the
simple regression estimate, which is:
 Y = a + bX + e
 Where: Y = the amount of the dependent variable, the cost to be estimated
 a = a fixed quantity, also called the intercept, which represents the amount of Y when X = 0
 b = the unit variable cost, also called the coefficient of the independent variable, that is, the
increase in Y (cost) for each unit increase in X (cost driver)
 X = the value of the independent variable, the cost driver for the cost to be estimated
 e = the estimation error, which is the amount by which the regression prediction (y = a + bX) differs
from the data point.
 Illustration: The firm shows three months of data on supplies expense and production levels:
 Month Supplies Expense (Y) Production Level (X)
 1 P250 50 units
 2 310 100
 3 325 150
 4 ? 125
 Required: Compute the estimated supplies expense in month 4.
 b = P325 – P250 = P0.75
 150 – 50
 The regression for the data is determined by a statistical procedure that finds
the unique line through the three (3) data points that minimizes the sum of
the squared error distances. The regression line (see Exhibit 8.3B) is:
 Y = P220 + P0.75X
 Thus, the estimated value for supplies expense in month 4 is:
 Y = P220 + (P0.75 x 125) = P313.75
 Next slide: Exhibit 8.3A shows Supplies Expense Data for Regression
Application and Exhibit 8.3B shows the Regression Line for Supplies Expense
with Units of Output as the Cost Driver (a = P220)
 2. Strategic Positioning Analysis
 Strategic positioning analysis – is a company’s relative position within its industry with regard to matters
related to performance. It depicts the choices that a company makes about the type of value it shall create and
how that value would be created differently than competitors.
 SWOT Analysis – is as systematic procedure for identifying a firm’s critical success factors: its internal strength
and weaknesses and its external opportunities and threats.
 Strengths and weaknesses are most easily identified by looking inside the firm at its specific resources:
 a. Product lines. Are the firm’s products and services innovative? Are the products and services too wide or too
narrow? Are there important and distinctive technological advantages?
 b. Management. What is the level of experience and competence?
 c. Research and development. Is the firm ahead of or behind competitors? What is the outlook for important
new products and services?
 d. Operations. How competitive, flexible, productive and technologically advanced are the current operations?
What plans are there for improvements in facilities and processes?
 e. Marketing. How effective is the overall marketing approach, including promotions, selling, and advertising?
 f. Strategy. How clearly defined, communicated, and effectively implemented is the strategy?
 Opportunities and threats are identified by looking outside the firm. Opportunities are important
favorable situations in the firm’s environment. Demographic trends, changes in regulatory matters, and
technological changes in the industry might provide significant advantages or disadvantages for the firm.
 In contrast, threats are major unfavorable situations in the firm’s environment. These may include the
entrance of new competitors or competing products, unfavorable changes in government regulations, and
technological change that is unfavorable to the firm.
 Opportunities and threats can be identified most easily by analyzing the industry and the firm’s competitors:
 a. Barriers to entry. Do certain factors, such as capital requirements, economies of scale, product
differentiation, and access to selected distribution channels, protect the firm from new-comers?
 b. Intensity of rivalry among competitors. Intense rivalry can be the result of high entry barriers,
specialized assets, rapid product innovation, slow growth in total market demand, or significant over
capacity in the industry. How intense is the overall industry rivalry facing the firm?
 c. Pressure from substitute products. Will the presence of readily substitutable products increase the
intensity level of the firm’s competition?
 d. Bargaining power of customers. The greater the bargaining power of the firm’s customers,
the greater the level of competition facing the firm. The bargaining power of customers is
likely higher if switching costs are relatively low and its products are not differentiated.
 e. Bargaining power of suppliers. The greater the bargaining power of a firm’s suppliers, the
greater the overall level of competition facing the firm. The bargaining power of suppliers is
higher when a few large firms dominate the group of suppliers and when these suppliers have
other good outlets for their products.
 SWOT analysis guides the strategic analysis by focusing attention on the strengths, weaknesses,
opportunities, and threats critical to the company’s success. It also serves as a means for
obtaining a greater understanding and perhaps consensus among managers regarding the
factors that are crucial to the firm’s success.
 A final step in the SWOT analysis is to identify quantitative measures for the critical success
factors (CSFs), that is, the CFS the critical process in the firm that delivers value to the
customer. The objective of at this step is to determine the quantitative measures that will
allow the firm to monitor its progress toward achieving its strategic goals.
 Critical Success Factors How to Measure the CSF
 1. Financial factors
 1.1 Profitability Earnings from operations, earnings trend
 1.2 Liquidity Cash flow, asset, inventory and receivables turnover
 1.3 Sales level of sales in critical product groups, sales forecast accuracy
 1.4 Market value Sale price
 2. Customer factors
 2.1 Customer satisfaction Customer returns and complaints, customer survey
 2.2 Dealer and distributor Coverage and strength of dealer and distributor channel relationships
 2.3 Marketing and selling Trends in sales performance, training market research activities
 2.4 Timeliness of delivery On-time delivery performance, time form order to customer receipt
 2.5 Quality Customer complaints, warranty expense
 Portfolio Analysis
 Portfolio analysis is an examination of the components included in a mix of
products with the purpose of making decisions that are expected to improve
overall return. The term applies to the process that allows manager to recognize
better ways to allocate resources with the goal of increasing profits.
 Example: The company manufactures and markets 55 models of women shoes.
The General Manager realized that sales increased but profitability steadily
decreased over the past two years. He did not know what happened and he asked
a management accountant to conduct a portfolio analysis.
 The study provided some interesting results. The top 5 models represented 17% of
total sales. However, those 5 are not profitable at all because product costs were
too high. At the same time, other models were highly profitable but their sales
were negligible within the overall portfolio.
 Cost Leadership – is a competitive strategy in which a firm outperforms competitors in producing
products or services at the lowest cost.
 The cost leader makes sustainable profits at lower prices, thus undermining the profitability of
competitors. The cost leader has a relatively large market and tends to avoid segment markets by
using the price advantage to attract a large portion of the broad market. Cost advantages usually
from productivity in the manufacturing process, in distribution or in overall administration.
 A potential weakness of the cost leadership strategy is the tendency to cut costs in a way that
undermines demand for the product or service, for example, by deleting key features.
 Product Differentiation – is a competitive strategy in which a firm succeeds by developing and
maintaining a unique value for the product or service as perceived by customers.
 It is sometimes called as product leadership to refer to the innovation and features in the
product. A weakness of the differentiation strategy is the firm’s tendency to undermine its
strength by attempting to lower cost or by ignoring the necessity of having a continual aggressive
marketing plan to reinforce the differentiation. If the customer begins to believe that the
difference is not significant, then lower-cost rival products will appear more attractive.
 3. Value-Chain Analysis
 Value-chain analysis – is strategic analysis tool used to better understand the firm’s competitive
advantage, to identify where value to customer can be increased or costs reduced, and to better understand
the firm’s linkages with supplier, customers and other firms in the industry.
 Value-chain analysis has two (2) steps:
 Step 1. Identify the value-Chain Activities. The firm identifies the specific value activities that firms in the
industry must perform in the process of designing, manufacturing, and providing customer service. The
development of a value-chain depends on the type of industry.
 Value activities – are activities the firms in the industry must perform in the process of designing,
manufacturing, and providing customer service.
 Step 2. Develop a Competitive Advantage by Reducing Cost or Adding Value. The firm determines the
nature of its current and potential competitive advantage by studying the value activities and cost drivers
identified earlier. In doing so, the firm must consider the following:
 1. Identify competitive advantage ( cost leadership or differentiation). The analysis of value activities can
help management better understand the firm’s strategic competitive advantage and its proper positioning in
the overall industry value chain.
 2. Identify opportunities for added value. The analysis of value activities can help identify
activities in which the firm can add significant value for the customer. For example, banks have
developed online computer technologies to provide an opportunity to reduce processing costs
further; food processing plants and packaging plants are now commonly located near their largest
customers to provide faster and cheaper delivery.
 3. Identify opportunities for reduced costs. A study of its value activities can help a firm
determine those parts of the value chain for which it is not competitive. For example, the brand
name manufacturers have found that outsourcing some of the manufacturing to other firms reduces
the cost and can improve speed, quality and competitiveness.
 Porter’s Value Chain – is a useful strategic management tool and works by breaking an
organization’s activities down into strategically relevant pieces, so that one can see a fuller picture
of the cost drivers and sources of differentiation, and make changes appropriately.
 The idea of the value chain is based on the process view of organizations, the idea of seeing a
manufacturing (or service) organization as a system, made up of sub-systems each with inputs,
transformation processes, and outputs. How value chain activities are carried out determines costs
and affects profits.