STRATEGIC COST MANAGEMENT THREE KEY THEMES The emergence of Strategic Cost Management (SCM) results from a blending of three underlying themes, each taken from the strategic management literature: 1, Value Chain Analysis 2. Strategic Positioning Analysis 3. Cost Driver Analysis ‘As shown in the earlier note Strategic Cost Management: Definition and Overview these three themes are what differentiates Strategic Cost Management from Cost and Management Accounting, Each of these three themes is developed and illustrated in this note. Each represents a stream of research and analysis in which cost information is cast in a light very different from that-in which it is viewed in conventional Management Accounting. This note presents an overview of each of these themes THE VALUE CHAIN ANALYSIS CONCEPT ‘The first theme that underlies the work in strategic cost management concerns the focus of cost management efforts. Stated in question form: How do we organize our thinking about cost management? In the SCM framework, managing costs effectively requires a broad focus, preferably external to the firm, Professor Michael Porter has called this type of focus- external- the valve chain, The value chain for any firm in any type of business is the linked set of value-creating activities all the way from the stage of basic raw material sources and component suppliers, through to the ultimate end~ use product delivered into the final consumers’ hands. This focus is external to the firm, seeing each firm in the context of the overall chain of value-creating activities of which it is only a part, from basic raw material components to end-use consumers. For the specialty chemicals or resins refiner, his value chain includes from the crude oil supplier to automotive parts and CKD supplier of VWON and VWON itself to the final person who buys a Santana GLS car with a metallic paint. In contrast, the traditional management accounting often adopts a focus that is largely intemal to the firm- its purchases, its processes, its functions, its products, and its customers, Another way of saying this is that management accounting takes a value-added perspective, starting with payments to suppliers (purchases), and stopping with charges to customers (sales). It's key theme (the benefits or se if drenvs aitention to), is fo maximize the difference (the value added) between purchases and sales ‘The value chain concept is fundamentally different from the value-added concept. From a strategic perspective, the value-added concept has two big problems; it starts too late and it stops too soon. Starting cost analysis with purchases misses all the opportunities for expfoiting linkages with the firm's suppliers. Such opportunities can be dramatically important to a firm, Consider the following example case A few years ago, one of the major US automobile companies began to implement Just-in-Time (JIT) management concepts in its assembly plants. Manufacturing costs represented 30% of sales for the auto firm. It was believed that applying JIT concepts could eliminate 20% of these costs because assembly 1costs in Japanese auto plants were known to be more than 20% below those in US plants. As the firm began to manage its factories differently to eliminate waste and the need for inventory buffers, its assembly costs began to drop noticeably. But, atthe same time, the firm experienced dramatic problems with its major suppliers. They began to demand price increases that more than offset the assembly plants’ cost savings. The auto firm's first response was to chide its suppliers that they, too, needed to embrace JIT concepts for their own operations ‘A value chain perspective revealed a much different picture of the overall situation. Of the auto company's sales, 0% was purchases from parts suppliers; of this amount, 37% was purchases by the parts suppliers and 63% was suppliers’ value added. Thus, suppliers were adding more manufacturing value to the auto than the assembly plants (63% x 50% = 31.5%, versus 30%). The reason, once identified, was very simple, The assembly plants experienced huge and uncertain variability in their production schedules. For every dollar of manufacturing cost the assembly plants saved by moving toward JIT management concepts, the suppliers’ plants spent much more than one dollar extra because of schedule instability Because of its narrow value-added perspective, the auto company had overlooked the impact of its ‘changes on its suppliers’ costs. Management had ignored (or did not know) the idea that JET involves a partnership with suppliers. Management did not realize that a major element in the success of JIT for a Japanese auto assembly plant is schedule stability for its supplier firms. The failure to adopt a value chain perspective doomed this major effort by a leading US firm. The lack of awareness of supply chain cost analysis concepts, on the part of this company's mariagement accountants, proved to be a very costly oversight. Should those management accountants have been exposed to value chain concepts somewhere in their accounting education? In addition to starting too late, value-added analysis has another major flaw; it stops too soon Stopping cost analysis at sales misses all the opportunities for exploiting linkages with the firm's customers. Customer linkages can be just as important as supplier linkages Exploiting customer linkages is the key idea behind the concept of life cycle costing. Life cycle costing deals explicitly with the relationship between what a customer pays for a product and the total cost the customer incurs over the life cycle of using the product. A life cycle costing perspective on the custo- mer linkage in the value chain can lead to increased profitability. Explicit attention to post-purchase costs by the customer can lead to more effective market segmentation and product positioning, Also, designing a product to reduce post-purchase costs of the customer can be a major weapon in capturing competitive advantage, In many ways, the lower life cycle cost of imported Japanese autos helps to explain their success in the US market Consider one further example. In 1992, the US suppliers of paper to envelope converters suffered a loss in profit because they were caught unaware by a significant shift in the value chain of the envelope converter. The shift from sheet-fed to roll-fed envelope finishing-machines dramatically changes the raw material specifications for envelope paper. Roll-fed machines are much more expensive to buy but much less expensive to operate. For large orders, they represent substantial overall savings for the envelope converter. Roll-fed machines were only introduced in the United States about 1980, but they now produce more than 60% of all domestic envelopes. The business issue here is how the change in the ‘customers’ value chain should be reflected in paper prices. Now that manufacturing costs along the value chain have changed (in response to changed customer requirements), how should prices change? Jn the paper industry, where management accounting does not include value chain analysis or life cycle costing, Fewinder-sitter costs are seen as just a small part of mill overhead. The overhead cost is 2allocated to all paper production on a per-ton basis. For a large, modern paper mill, rewinder-sitter cost is no more than 1% or 2% of total cost. The impact on total average cost per ton is less than $10. Also, very little of this cost varies with incremental production because the mill always keeps excess capacity in such a small department, It is common sense to make sure that $300 million paper machines are never slowed down by a bottleneck at a $2 million rewinder-slitter. ‘An extemal value chain perspective would look at the savings from narrow rolls for the customer and the extra costs to the paper mill and set a price differential somewhere in between. An internal mill costing perspective, however, sees no cost issues at all. The lack of a value chain perspective contributed to the lack of concer about product costing issues. The result is an uneconomic price, the impact of which is buried in a mill management accounting system that ignores value chain issues. Should the management accountants in the paper companies have been exposed to value chain concepts somewhere in their management accounting education? WHAT IS THE SUPPLY CHAIN OF MERCEDES-BENZ Ecstasy, meet Mercedes EVER since an engineer, Henry Royce, tesined up wit an aftecrat Chaos ls, 1904, tno motor crs have-been emiems ol enghaoing oxcelonce and Brienness, Now Pale Rojee Motor fs aling fo two German companies, Damier ene and SHH, about alaboraton fo develop a nev mode, Rels Royce's parent he Vickers angieehg grep cannot aor he 250m (USS230M)f woul fake {0 develop a much-needed new model The news has brouBt plenty of predctabie, msguged nlses about another pla of Bish Inds fang no ereign hands ‘Yet tho “Sp of Ecstasy” the winged fue that adorns Rots-Royoes, i lest Bish tha she cots. Long before anyone intone a word avout lot! sourcing, Mr Reyce was grabbing technaogy Vom abroad. His esl engine was adapted om a French sig. 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Ard for ab BMW's new Bish bent. kracenty bought Rover: Mercedes iso srangerf 2 branaintermingig. (eaming up wih Sutzerana's Si, th maker af the Swaten wate, fo make te Swatchmobie, 9 new compact lownvcar The gueston of wheter Ecstasy wl pow spot zd green wal sap has ao et oubled he Ros negotiator A THE STRATEGIC POSITIONING ANALYSIS CONCEPT The second major theme underlying the work in strategic cost management (SCM) concerns the perceived uses of management accounting information, Stated, again, in question form: What role does ‘cost management play in the firm? ‘The theme of SCM can be stated very succinctly. In SCM, the role of cost analysis differs in important ways depending on how the firm is choosing to compete. Following Professor Michael Porter's delineation of basic strategic choices, a business can compete either by having lower costs (cost leadership) or by offering superior products (product differentiation). That these two approaches demand very different conceptual frameworks have been widely accepted in the strategy literature, And, although strategic positioning does not involve simple either/or choices in practice, the implications for strategic management have been frequently amplified. But, the implications of strategie positioning for management accounting, are not as well explored. Since differentiation and cost leadership involve different managerial mindsets, they also involve different cost analysis perspectives 3