Management Accounting – Strategic Cost Management MAS

Atty. Abrahm A. Apepe, CPA

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MAS 08 STRATEGIC COST MANAGEMENT

The application of cost management techniques so that those techniques may reduce costs and improves the
strategic position of the firm. It involves the recognition of the importance of cost relationships among the various
activities in the value chain and managing those relationships to the firm’s advantage.

Total Quality Management (TQM)

This is a management approach that aims to improve product quality by reducing and eliminating errors,
streamlining activities, and continuously improving production process. In this system, a cost of quality report that
summarizes the cost incurred to prevent, detect and correct quality problems is prepared. This report should
include details about the following quality costs:
1. Prevention costs – incurred to keep quality problems from happening in the first place
2. Appraisal or inspection costs – incurred to identify defective products before they get to the customer
3. Internal failure costs – results from the defect that are caught during the inspection process.
4. External failure costs – occur when a defective product is discovered only after the product has made
its way into the customer’s hand

Exercise 1. Total quality management. CUP Company is currently analyzing all costs associated with their
products. The following data has been provided:

Scrap costs Php47,000

Rework costs 90,000
Warranty claims 84,000
Quality training 38,000
Product quality audits 40,000
Inspection of incoming materials 55,000

Required: Determine the following:

1. Prevention costs. Php38,000
2. Appraisal or inspection or detection costs. Php95,000
3. Internal failure costs. Php137,000
4. External failure costs. Php84,000

Just-In-Time (JIT) Production System

The objective of JIT is to reduce carrying costs by eliminating inventories and increasing the deliveries
made by suppliers. Ideally, shipments of raw materials are received just in time to be incorporated into the
manufacturing process. The focus of quality control under JIT is the prevention of quality problems. Quality control
is shifted to the supplier. JIT companies typically do not inspect incoming goods; the assumption is that receipts
are of perfect quality. Suppliers are limited to those who guarantee perfect quality and prompt delivery.

This approach eliminates non-value-added activities, reduce costs and improve quality. Under this system,
a company purchases materials and manufactures products at just the right time and in just the right quantity to
fill customer orders. It is a demand-pull system in which materials and products are pulled through the
manufacturing system based on customer demand.

JIT-Lean Production Environment

implement a just-in-time approach to inventory management and to eliminate waste of
materials, labor, factory space, and machine usage, the factory is reorganized to permit what is often
called LEAN PRODUCTION. Plant layout in a JIT-lean production environment is not arranged by
functional department or process but by manufacturing cells (work cells). Central support

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departments are reduced or eliminated, space is saved, fewer and smaller factories may be required, and
materials and tools are brought close to the point of use.

This is based on a manufacturing philosophy that combines purchasing, production, and inventory control
into one function. The goal is to minimize the level of inventories that are held in the plant at all stages of
production, including raw materials, work-in-process, and finished goods inventories while meeting customer
demand in a timely manner with high-quality products at the lowest possible cost.

“Demand-pull system” vs. “Push system”

In a “push system”, a department produces and sends all that it can to the next step for further processing,
which means that the manufacturer is producing something without understanding consumer demand
resulting to useless stocks of inventory.

In a “demand-pull system”, nothing is produced until the next process in the assembly line needs it.
Ultimately, this means that nothing will be produced until a customer orders it, and then it will be produced
very quickly. This requires close coordination between workstations so that the flow of goods will be smooth
in spite of the low levels of inventory.

The JIT system

1. Purchasing – inventory is purchased so that it will be delivered just as needed for production (or
sales, if merchandising).

2. Quality - the inventory must be of the required quality because there is no extra stock to use in place
of any defective units that are delivered.

3. Supplier – they are chosen carefully, and a long-term relationship is maintained. Since very little
inventory is held, a supplier that does not deliver direct materials on time or delivers direct materials
that do not meet quality standards can cause the company to not be able to meet its own scheduled
deliveries.

4. Benefits vs. Costs and Shortcomings

• Lower carrying costs for inventory;
• Greater emphasis on improving quality by eliminating the causes of rework, scrap, and
waste;
• Reduces inventory levels and enables the company to respond quickly to changes in
customer demand;
• Less downtime – the machine needs to be stopped only during the actual setup activities;
• Less floor space required than traditional factories – they do not need to store large amounts
of inventories;

5. Costs and shortcomings

• The reduced level of inventory carries with it an increased risk of stockout costs and can
lead to more frequent trips for parts and material inputs from sister facilities or suppliers.
• If the products produced have large and/or unpredictable market fluctuations, a JIT system
may not be able to reduce or eliminate overproduction and associated waste.
• JIT implementation is not appropriate for high-mix manufacturing environments, which
often have thousands of products and dozens of work centers.

Business Process Reengineering (BPR)

It is applied to restructure the organizational process that is brought about by rapidly changing technology
and today’s competitive economy. In applying BPR, management starts with a clean sheet of paper and redesigns
processes to accomplish its objectives. Operations that have become obsolete are discarded. It involves analyzing

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and radically redesigning the workflow which means, old procedures are thrown out and new ways of getting the
work done are invented.

Objectives
1. Simplification of the business process;
2. Elimination of non-value-added activities;
3. Reduction of opportunities for errors; and
4. Cost reduction.

Outcome vs. Tasks

In reengineering, the work should be organized around outcomes, not tasks. You must think about what you
want to accomplish, then think of ways to accomplish it rather than thinking of tasks to be done.

The process begins with the customer, not with the company’s product or service. Ask yourself how you
could organize the way work is done to provide the best quality and the lowest-cost goods and services to
the customers.

Priority of processes to be reengineered -The processes should first be identified, then prioritized according
to:
1. Which processes are the most dysfunctional;
2. Which will have the greatest impact on customers; and
3. For which ones reengineering is most feasible.

Use of technology - The use of technology should not be to make old processes work better, but to break
the rules and create new ways of working.

What happens after BPR?

The value-chain activities; quality management takes over and focuses on continued improvement and
refinement of the new process. Also, internal controls for the reengineered process must not be neglected.
When a process is reengineered, internal controls must also be reengineered.

Kaizen Costing

Kaizen is the Japanese term for improvement, and it is used in business to mean continuous
improvement or slow but constant incremental improvements being made in all areas of business operations.
Kaizen needs to be a part of the corporate culture. It requires the conscious effort to think about ways that tasks
could be done better.

In relation to other management principles

Principles Application of Kaizen
Activity-based
management; Activity-
Improve the quality and/or reduce the cost of a business process.
based costing; Business
process reengineering
Determine what its ideal standard costs are. Using kaizen principles, the
company figures out how it can manufacture the product for the target cost.
The standard is achieved through development of new manufacturing
Target costing
methods and techniques that entail continuous improvement or the on-
going search for new ways to reduce costs.

Kaizen anticipates continuous improvements in the production process, a

Budgeting
budget developed on kaizen principles will incorporate planned

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 Management Accounting – Strategic Cost Management MAS
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improvements, resulting in decreasing costs of production over the budget
period.

Product Life Cycle Costing

In life-cycle costing, a company does not determine the production cost in the short-term sense
of the production of one unit. Rather, the company takes a much longer view to the cost of production and
attempts to allocate all the research and development, marketing, development, after-sale service and
support costs and any other cost that is associated with this product during its life cycle. The life cycle of the
product is also called its value chain.

For example, the research and development (R&D) costs associated with a product also need to
be covered by the sales price. If the company fails to consider the large costs of R&D, it runs the risk of the
sales price covering the costs of the actual production of that unit, but not the costs of R&D.

The process of a company looking at all the costs hopefully enables it to determine the ultimate
value of developing a better product. Aside from R&D costs, there are also after-sale costs such as warranties
and repair work and product support expense.

Three categories and the types of costs included

1. Upstream costs (before production)
a. Research and development; and
b. Design – prototyping (first model), testing, engineering, quality development
2. Manufacturing costs
a. Purchasing; and
b. Direct and indirect manufacturing costs
3. Downstream costs (after production)
a. Marketing and distribution; and
b. Services and warranties.

However, remember that under GAAP financial reporting, the upstream costs are expensed as
they are incurred. However, for internal decision-making purposes, it is important that the company treat
these as product costs that will need to be recovered.

Exercise 2. The value chain. Match the following functions whether they appear in “Research and
development (R&D)”, “Customer service”, “Production”, “Marketing”, “Distribution” or “Design of products,
services or processes”

1. Generation of, and experimentation with, ideas related to new A. Research and development
products, services or processes
2. Detailed planning and engineering of products, services or B. Design of products,
processes services or processes
3. Acquisition, coordination, and assembly of resources to produce a C. Production
product or deliver a service
4. The manner by which companies promote and sell their products D. Marketing
or services to customers or prospective customers
5. The delivery of products or services to customers E. Customer service
6. The after-sale support provided to customers F. Distribution

Ans: (1) A; (2) B; (3) C; (4) D; (5) F; and (6) E.

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Stages in the Product Life Cycle
• Introduction Stage – This is characterized by slow sales growth and lack of profits because of the high
expenses of promotion and selective distribution to generate awareness of the product and encourage
customers to try it. During this stage, only a few, basic products are being produced, and the strategy is
to increase marketing efforts.

• Growth Stage – During this stage, the opportunity for cost reductions is at its maximum because
production volume is increasing at a high rate. Thus, fixed costs are being spread over more units of
production, and the benefits of the learning curve are being realized.

• Maturity Stage – In this stage, sales growth declines and competitors are most numerous.

• Decline Stage – The first symptom of the decline stage of a product’s life cycle triggers such other
effects as price cutting, narrowing of the product line, and reduction in promotion budgets.

Target Costing

A proactive approach to cost management that managers can use to determine what costs should be for
the company to earn an acceptable profit across a product’s life cycle. The product life cycle represents the life of
the product from its infancy, through design, development, product introduction, growth, maturity and eventual
decline. With target costing, the price is set by the market based on what the company believes consumers will be
willing to pay for the product or service

Target costing begins with a target price, which is the expected market price given the company’s
knowledge of its customers and competitors. Subtracting the unit target profit margin determines the long-term
target cost. If this cost is lower than the full cost, the company may need to adopt comprehensive cost-cutting
measures.

Exercise 3. Target costing. ABC Enterprises currently sells a piece of luggage for Php200. An aggressive
competitor has announced plans for a similar product that will be sold for Php170. ABC’s marketing department
believes that if the price is dropped to meet competition, unit sales will increase by 10%. The current cost to
manufacture and distribute the luggage is Php130, and ABC has a profit goal of 30% of sales. If ABC meets
competitive selling prices, what must happen to the company’s manufacturing and distribution cost?

Required:
1. If ABC meets competitive selling prices, what must happen to the company’s manufacturing and
distribution cost? Costs must decrease by Php11.

-END-

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