Performance Evaluation

Week 8 Cost Management

Objectives

To distinguish the difference between traditional management accounting control systems and cost management Review different approaches to cost management This area will be continued next week

21.1a

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

Aim is to reduce cost but increase customer satisfaction

Drury 2008

Life cycle costing

Is the profiling of cost over a products life, including the pre-production stage. Tracks and accumulates the actual costs and revenues attributable to each product from inception to abandonment. Enables a products true profitability to be determined at the end of its economic life.
Slide 4

21.1b

Life-cycle costing (LCC)

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 (see Figure 21.1 on sheet 21.2).

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

Drury 2008

Product Lifecycle
volumes

Maturity Growth Decline

Introduce Develop

Sales revenue Profit

time
Slide 6

21.2
Decisions made on materials and labour in the design phase are hard to change at a later date

Drury 2008

Lifecycle Impact
Shorter product lifecycles Clear Planning needed

80% cost incurred before product reaches market

Slide 8

Need to ensure return can be achieved in the timescale

Implications of Lifecycle costing

Pricing decisions can be based on total lifecycle costs rather than simply the costs for the current period. Decision making - a timetable of life cycle costs helps show what costs need to be recovered. Control - Lifecycle costing reinforces the importance of tight control over locked-in costs, such as R&D. Performance reporting - Life cycle costing costs to products over their entire life cycles, to aid comparison with product revenues generated in later periods.

Slide 9

Lifecycle costing - Summary

All costs and revenues measured throughout product life Price to manipulate demand / Product Life Cycle stage
For example if a product is coming to the end of its life then the price may be dropped to stimulate demand.

Slide 10

Lifecycle costing example

Units manufactured and sold Year 1 2000 Year 2 15000 100,000 80,000 430 45 Year 3 20000 Year 4 5000

R &D C osts 2,500,000 Marketing costs 150,000 P roduction cost per unit 555 C ustomer services cost per unit 55 Disposal of specialist equipment

45,000 390 45

10,000 450 45 250,000

The company is looking to set a sales price of 500 per unit. R equired: C alculate the cost per unit across the whole lifecycle and comment on the sales price.

Lifecycle example solution

L ifec yc le c os ts R &D C os ts 2,500 + 100 Marketing cos ts 150 + 80 + 45 +10 P roduction cos t per unit s ee below C us tomer s ervices cos t per unit D is pos al of s pecialis t equipment T otal number of units 000's C os t per unit 000's 2,600 285 17,610 1,910 250 22,655 42 539.40

Working s P roduction cos ts per unit Units T otal cos ts T otal C us tomer s ervices C us tomer s ervices per unit Units T otal cos ts T otal

555 430 390 2000 15000 20000 1,110,000 6,450,000 7,800,000

450 5000 2,250,000 17,610,000

55 2000 110,000

45 15000 675,000

45 20000 900,000

45 5000 225,000 1,910,000

21.3a

Target costing
Focuses on managing costs during a product/services planning and design phase. Involves the following stages: 1. Determine the target price which customers will be prepared to pay for the product. 2. Deduct a target profit margin from the target price to determine the target cost. 3. Estimate the actual cost of the product. 4. If estimated actual cost exceeds the target cost investigate ways of driving down the actual cost to the target cost.

Drury 2008

21.3a

Target costing
Iterative process involving: 1. Tear-down analysis

Examine a competitors product for ideas on cost savings

2.

Value analysis and functional analysis

Eliminate any extras that customers are not willing to pay for

It is important that target costing is supported by an accurate costing system using appropriate cause-and-effect cost drivers.

Drury 2008

Target costing
Traditionally:
mark-up (2nd) selling price (3rd) The focus is internal

Cost (1st)

Slide 15

Target costing
Target costing:
Profit (2nd) The focus is external

target cost (3rd)

selling price (1st)

Slide 16

Example
If target profit is 1.5m, units sold 40000 and Selling price is 67.50 what is the target cost?

Target price Target profit (w)

/unit 67.50 37.50

Target cost

30.00

(w)Target profit per unit = 1,500,000 / 40,000 = 37.50

Slide 17

Target Costing

Estimated cost

Target cost

Cost Gap

How do companies close a cost gap?

Slide 18

Car manufacturing activity:

A mid range car manufacturer has a cost gap with their latest four door saloon model. The selling price less the profit margin is far less than the cost of the car.
What can they do to reduce this gap?

Target costing - Summary

Selling price set with reference to market Desired profit subtracted to calculate target cost Cost gaps closed via design & development of product
Slide 20

21.3b

Kaizen Costing
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.

Making continuous small changes to processes to improve them rather than huge innovative changes

Drury 2008

21.5a Activity-based management (ABM)

Involves the following stages: 1. Identifying the major activities that take place in an organization. 2. Assigning costs to cost pools/cost centres for each activity. 3. Determining the cost driver for each activity.

ABM focuses on managing the business on the basis of the activities that make up the organization by managing the activities costs are managed in the long term.
Traditional control reports analyze costs by types of expenses for each responsibility centre whereas ABM analyses costs by activities (See sheet 21.6 for an illustration). Knowing the cost of activities is a catalyst for triggering action to become competitive.

Drury 2008

21.5b

Activity-based management (ABM) - contd.

1. 2. Activity cost information is useful for prioritizing those activities that need to be studied more closely. Activities can be classified: As value-added or non-value-added. According to a scale similar to that advocated by Kaplan and Cooper. Activity-based systems can also be used to manage costs at the design stage using behavioural drivers. Surveys also suggest that many organizations use cost driver rates as measures of cost efficiency

Example Cost of purchasing activity = 100,000 Orders processed =10,000 Cost per order = 10 (Used for relative, trend and budget comparisons).
Drury 2008

21.6

Example
Customer order processing activity Traditional analysis (customer order processing department) Salaries Stationery Travel Telephone Depreciation of equipment 000 s 320 40 140 40 40 580 120 190 100 80 90 580

ABM analysis Preparing quotations Receiving customer orders Assessing the credit-worthiness of customers Expediting Resolving customer problems
Why are we spending 90k resolving problems we cant see this in the traditional method

Drury 2008

Tutorial Preparation

May 2012 Q5
Strategic management accounting includes techniques that are different from the traditional view. Critically evaluate the use of target costing and lifecycle costing in a mobile phone manufacturer.

25 Marks