Strategic Cost Management: Top 12 Techniques

The following points highlight the top twelve techniques involved in strategic cost management. The techniques are: 1. Activity Based Costing (ABC) 2. Target Costing (TC) 3. Total Quality Management (TQM) 4. Benchmarking 5. Business Process Reengineering (BPR) 6. JIT Inventory Control System 7. Balanced Score Card 8. Kaizan Costing 9. Six Sigma 10. Life Cycle Costing (LCC) 11. Theory of Constraints (TOC) and Others.

Strategic Cost Management: Technique # 1. Activity Based Costing (ABC):

ABC is a natural outgrowth of today’s competitive and complex environment. ABC provides a closer approximation of the cost of a product than that provided by the traditional volume based costing method. The main principle of ABC states that activities cause costs and to control costs, the activities must be controlled.

Under ABC system, the activities are identified, the expenses related to each activity are clubbed together to get activity-wise expenses, a cost driver for each activity is selected and finally the cost of the product is worked out.

Traditional cost accounting measures what it costs to do a task whereas ABC records the cost of not doing also. The system monitors activities more closely, relates costs to activities and bring in cost effectiveness. This system of costing makes a great impact in the service sector also.

ABC is a primary source of information for Activity Based Management (ABM). ABM is basically a top down approach wherein the top management exploits information derived from ABC and passes the decision to the operational level towards continuous improvement and excellence.

Strategic Cost Management: Technique # 2. Target Costing (TC):

As customers become more demanding and seek great value, importance of effective cost management becomes even more. Much of the Indian manufacturing in the past was occurring in a cost plus environment, aided by extensive government regulations. The operating practice was to fix a price as: Price = Cost + Profit. But in the global market the customer will dictate the price and features that he will be looking for.

Target costing is a new attempt in which cost is the difference between the price expectation of the customers and margin expectations of the corporation entities. Cost = Price – Target Profit. Management Accountant will have to work closely with design and engineering personnel to achieve this target.

Strategic Cost Management: Technique # 3. Total Quality Management (TQM):

Total Quality Management is a term first coined by the U.S. Naval Air Systems Command to describe its Japanese-style management approach to quality improvement.

TQM is a set of management practices throughout the organisation, geared to ensure that the organisation consistently meets or exceeds customer requirements. TQM places strong focus on process measurement and controls as means of continuous improvement.

Total Quality is a people-focused management system that aims at continual increase in customer satisfaction at continually lower real cost. In a TQM effort, all members of an organisation participate in improving processes, products, services and the culture in which they work.

Strategic Cost Management: Technique # 4. Benchmarking:

Benchmarking is the process of determining who is the very best, who sets the standard, and what that standard is. In other words, Benchmarking refers to the search for the best practices that yields the benchmark performance, with emphasis on how you can apply the process to achieve superior results.

Often Benchmarking is used to evaluate performance. Benchmarking represents “best practice” available inside or outside the organisation.

Strategic Cost Management: Technique # 5. Business Process Reengineering (BPR):

Business Process Reengineering, when fully implemented, will reduce a lot of clerical work and maintenance of records. Thus Purchasing, Material Receipts, Accounts Payable procedures and documentation will be virtually eliminated. Instead annual contracts with a few reliable suppliers to whom payments for quantities consumed in production will be made.

These improvements are made possible by the rapid strides made in Information Technology. Government support and the attitude of Business Executives at the top level will determine the pace of acceptance of these recent developments.

It can be noted that the above system and practices would lead in overall improvement in the performance of the organisation, reduction in cost of production and improvement in productivity. As such the above singularly and collectively play a very vital role in the financial control of an organisation.

Strategic Cost Management: Technique # 6. JIT Inventory Control System:

Originally developed in Japan and successfully implemented. Under this system, a company should maintain a very minimal level of inventory and rely mostly on suppliers to provide parts and components “Just in Time” to meet assembly requirements.

JIT philosophy is dedicated to the elimination of waste because stocks of raw materials and finished goods are reduced leading to minimum holding cost of inventory.

However, this system may not be applicable in the present Indian situation because of unreliable transport arrangement, not so excellent relations with suppliers and distance of supply sources from the factory. Over emphasis on safety stock will come in the way of its implementation.

Strategic Cost Management: Technique # 7. Balanced Score Card:

The balanced score card is a strategic cost management technique for communicating and evaluating the achievement of the strategy of the organisation. It has been developed by Kaplan and Norton. This technique has been adopted by rapidly growing organisations as a mechanism to help effectively manage their performance and strategy.

Traditional financial measures such as ROI, RI, value added, EPS, variance analysis etc. deal with past performance and are inadequate for evaluating current information needs of large growing companies.

Traditional performance measures have the following drawbacks:

1. Performance measures lay too much emphasis on financial aspects.

2. Measures are not customer oriented and do not take care of the requirements of customers.

3. Departmental performance measures are not linked to the organisation’s strategic objectives and as a result fail to achieve the overall objectives of the organisation.

4. Sometimes performance measures are irrelevant to the situation.

5. Traditional performance measures are mainly developed to meet the requirements of the organisations who are operating in a seller’s market. But now a day’s business enterprises are operating in a buyer’s market where there is acute competition.

For survival in the market, the organisation must come up to the expectations of customers and must deliver defect free product on time at a low price. Organisations must develop performance measures that take care of customers expectations.

Prior to 1980s management accounting, control systems used to focus mainly only on financial performance measures.

Only those items were included which could be expressed in monetary terms and motivated managers to focus excessively on cost reduction and ignore other important variables (such as quality, delivery, after sales service, etc.) which were necessary to compete in the global market that emerged during the 1980s.

Consideration of non-financial measures plays a very important role these days in achieving success of financial terms. Thus, a mix of non-financial measure and financial measures emerged to cope with the requirements of customers. Performance measurement systems much achieve a balance which supports progress against pre-determined objectives.

According to Kaplan and Norton previous system that incorporated non-financial measurements used ad hoc collection of such measures more like checklists of measures for managers to keep track of and improve than a comprehensive system of linked-measurement. The need to integrate financial and non-financial measures of performance led to the emergence of the balanced scorecard (BSC).

Four persecution of BSC as developed by Kaplan and Norton are given below:

1. Customer perspective, i.e., how to customers view us. This perspective lays emphasis on the ability of the organisation to provide quality goods and services promising delivery in time and ensuring that goods and services are provided at low cost and low cost of ownership keeping in view the overall satisfaction of customers.

2. Internal business process perspective (i.e. to satisfy our shareholders and customers at what business must we excel?). The organisation should make efforts to excel at the business which will satisfy customers and provide a good return to shareholders.

3. Learning and growth perspective (i.e. can we continue to improve and create values?) In order to meet the new changes in the market and coming up to the exceptions of customers, employees should be willing or asked to take on dramatically new responsibilities and may be ready to acquire new skills, technologies and organisational designs that were not available in the past.

4. Financial perspective (i.e. how do we look to shareholders?). This perspective lays emphasis on profitability and market value of the organisation so that shareholders are duly compensated. The purpose of balanced scorecard is to strike a balance in these four perspectives and to achieve the overall best for the organization.

Balanced Scorecard is a Performance metric used in strategic management to identify and improve various internal functions and their resulting external outcomes. The balanced Scorecard attempts to measure and provide feedback to an organisation in order to assist in implementing strategies and objectives.

It is a set of performance targets and results relating to four dimensions of performance—financial, customer, internal process and innovation. As a structure, balanced scorecard methodology breaks broad goals down successively into vision, strategies, tactical activities, and metrics.

As an example of how the methodology might work, an organisation might include in its mission statement a goal of maintaining employee satisfaction. This would be the organisation’s vision. Strategies for achieving that vision might include approaches such as increasing employee-management communication.

Tactical activities undertaken to implement the strategy could include, for example, regularly scheduled meetings with employees. Finally, metrics could include quantifications of employee suggestions or employee surveys. So this technique helps to take proper action to create the desired future results.

Strategic Cost Management: Technique # 8. Kaizan Costing:

Kaizan refers to continual and gradual improvement through small betterment activities, rather than large or radical improvement made through innovation or large investment in technology. It is the process of cost reduction during the manufacturing phase of an existing product. Kaizen costing is most consistent with the saying “slow and steady wins the race.”

It is a Japanese term for making improvements to a process through small, incremental amounts rather than through large innovations. It is a planning method used during the manufacturing cycle with an emphasis on reducing variable costs in one period below the costs in a base period.

Strategic Cost Management: Technique # 9. Six Sigma:

Six Sigma originated at Motorola in the early 1980s in response to a CEO-driven challenge to achieve tenfold reduction in product-failure levels in five years. It is a multifaceted approach to process improvement, reduced costs, and increased profits. With a fundamental principle to improve customer satisfaction by reducing defects, its ultimate performance target is virtually defect-free processes and products.

The Six Sigma methodology, consisting of the steps: Identifying the Process—Define- Measure-Analyse-Improve-Control,” is the roadmap to achieving this goal. Within this improvement framework, it is the responsibility of the improvement team to identify the process, the definition of defect, and the corresponding measurements, improvement and control.

The primary objective of Six Sigma is to improve customer satisfaction, and thereby profitability by reducing and eliminating defects. Defects may be related to any aspect of customer satisfaction high product quality, schedule adherence, cost minimisation etc.

Strategic Cost Management: Technique # 10. Life Cycle Costing (LCC):

A life cycle cost analysis calculates the cost of a system or product over its entire life span. This also involves the process of Product Life Cycle Management so that the life cycle profits are maximised.

The analysis of this system includes cost for planning, research & development, production, operation, maintenance, cost of replacement and disposal or salvage. This concept provides important information for pricing and also helps in managing cost incurred throughout lifecycle of a system or product.

Process of LCC:

LCC involves identifying the individual costs relating to the procurement of the product or service. These can be either “one-off” or “recurring” costs.

Examples of one-off costs include:

(i) Procurement;

(ii) Implementation and acceptance;

(iii) Initial training;

(iv) Documentation;

(v) Facilities;

(vi) Transition from incumbent supplier(s);

(vii) Changes to business processes; and

(viii) Withdrawal from service and disposal

Examples of recurring costs include:

(i) Retraining;

(ii) Operating costs;

(iii) Service charges;

(iv) Contract and supplier management costs;

(v) Changing volumes;

(vi) Cost of changes;

(vii) Downtime due non-availability;

(viii) Maintenance and repair; and

(ix) Transportation and handling.

It is important to understand the difference between these cost groupings because one-off costs are sunk costs once the acquisition is made whereas recurring costs are time dependent and continue to be incurred throughout the life of the product or service.

Furthermore, recurring costs can increase with time for example through increased maintenance costs as equipment becomes old. These types of costs incurred will vary according to the goods or services being acquired.

Strategic Cost Management: Technique # 11. Theory of Constraints (TOC):

During the 1980s Goldratt and Cox (1984) advocated a new approach to production management called optimized production technology (OPT). OPT is based on the principle that profits are expanded by increasing the throughput of the plant. The OPT approach determines what prevents throughput being higher by distinguishing between bottleneck and non-bottleneck resources.

A bottleneck might be a machine whose capacity limits the throughput of the whole production process. The aim is to identify bottlenecks and remove them or, if this is not possible, ensure that they are fully utilized at all times. Non-bottleneck resources should be scheduled and operated based on constraints within the system, and should not be used to produce more than the bottlenecks can absorb.

The OPT philosophy therefore, advocates that non-bottleneck resources should not be utilized to 100% of their capacity, since this would merely result in an increase in inventory. Thus, idle time in non-bottleneck is not considered detrimental to the efficiency of the organisation.

If it were utilized, it would result in increased inventory without a corresponding increase in throughput for the plant. The process of maximising profit when faced with bottleneck and non-bottleneck operations is known as theory of constraint (TOC).

The process involves five steps:

(i) Identify the system’s bottleneck;

(ii) Decide how to exploit the bottlenecks;

(iii) Subordinate everything else to the decision in step (ii);

(iv) Elevate the system’s bottlenecks;

(v) If, in the previous steps a bottleneck has been broken go back to step (i).

Strategic Cost Management: Technique # 12. Activity Based Management (ABM):

The adopters of activity based costing (ABC) used it is produce more accurate product or service costs but it soon became apparent to the users that it could be extended beyond purely product costing to a range of cost management applications.

The term activity based management (ABM) or activity based costing management (ABCM) are used to describe the cost management applications. To complement an ABM system only first three stages of the five stages for designing an activity-based product costing system are required.

They are:

(i) Identifying the major activities that take place in the organisation;

(ii) Assigning costs to cost pools/cost centres for each activity;

(iii) Determining the cost driver for each major activity.

ABM rules business as a set of linked activities that ultimately add value to the customer. It focuses on managing the business on the basis of activities that make up the organisation. ABM is based on the premise that activates consume costs.

Therefore, by managing activities costs will be managed in the long-term. The goal of ABM is to enable customer needs to be satisfied while making fewer demands on organisational resources.

ABC also provides information on the cost of activities why activities are taken and how will they are performed. ABM is much broader concept than ABC. It refers to the management philosophy that focuses on the planning execution and measurement of the activities as the key to competitive advantage.

From the above we can conclude that Strategic Cost Management helps to find lower cost solutions but this also requires proper supply chain management. Globalized market place and consumer’s increased demands on availability put higher pressure on companies supply chain.

If supply chain is efficient, then end consumers will be better served. If supply chain is on top, it not only helps to gain new consumers but also helps to retain old ones.

The major responsibility of purchasing is to ensure that the price paid for an item is fair and reasonable because price has a direct-impact on the end consumer’s perception of value provided by the organisation.

So evaluation of supplier’s cost to provide the product and services is an ongoing challenge within all industries. Price analysis focuses simply on a seller’s price perspective, giving less consideration to actual cost of production.

On the other hand cost analysis, lays emphasis on each individual cost element (i.e. material, labour, overhead, other administrative costs and profits) and final cost of product. This analysis determines a fair and reasonable price and develop plan to achieve future cost reduction.

So price and cost management should be considered from total supply chain perspective. Strategic cost management requires that purchasing and logistics system should adopt a series of new initiatives that can deliver results of the bottom line.

Strategic cost management approaches require that supply chain team work together to identify process improvement that reduces costs across the supply chain. E.g. team based value engineering efforts, on-site supplier development, cross enterprise cost reduction projects, joint brainstorming efforts on new products, supplier suggestion programmes, and supply chain redesign efforts.

Organisations should use various techniques of Strategic Cost Management for reducing and controlling cost in today’s competitive world.

One of the basic things an organisation relies on for its long-term sustainability is cost management and giving it a strategic emphasis has led to the evolution of a new stream of management known as strategic cost management which is crucial in modern business environment.

The strategic cost management itself involves a number of techniques that are useful in improving the efficiency and long-term competitiveness of the firm. Strategic Cost Management not only leads to incremental performance improvement but also to transformational change across the value chain.

It is viewed as part of business process to influence decisions on pricing and profitability across several dimensions: product, customer, region, and distribution channel. Strategic Cost Management helps to find lower cost solutions but it should also be kept in mind that this also requires proper supply chain management.