STRATEGIC FINANCIAL MANAGEMENT

UNIT – 4

STRATEGIC COST MANAGEMENT

Strategic Cost Management is an approach that organizations use to control and

optimize their costs while aligning them with their overall strategic objectives. It involves
analyzing and managing costs in a way that supports the company's long-term goals and
competitive advantage. This may include activities such as cost reduction, cost allocation,
cost forecasting, and cost-benefit analysis. The aim is to make informed decisions about
resource allocation, pricing, and operational efficiency to enhance the organization's strategic
position in the market.

TECHNIQUES OF STRATEGIC COST MANAGEMENT

TRADITIONAL TECHNIQUES

1. Cost Reduction: Traditional cost management programs primarily focus on cost reduction
and cost control by allocating production overheads and costs.

2. Standard Costing: Standard costing is a traditional technique that involves setting

standard costs for materials, labor, and overheads and comparing them with actual costs.

3. Variable Costing: Variable costing is a traditional technique that involves allocating only
variable costs to products or services.

MODERN TECHNIQUES

1. Activity-Based Costing (ABC): Activity-based costing is a modern technique that assigns

costs to specific activities or processes based on their use of resources.

2. Value Chain Analysis: Value chain analysis is a modern technique that helps to identify
the activities that add value to the product or service and those that do not.

3. Lifecycle Costing: Lifecycle costing is a modern technique that considers the total cost of
ownership of a product or service over its entire lifecycle, from design to disposal.

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4. Target Costing: Target costing is a modern technique that involves setting a target cost for
a product or service and then designing the product or service to meet that cost.

5. Benchmarking: Benchmarking is a modern technique that involves comparing the

company's performance with that of its competitors or industry standards.

6. Total Quality Management (TQM): Total quality management is a modern technique

that focuses on improving the quality of products or services while reducing costs.

7. World-class manufacturing: World-class manufacturing is a modern technique that

involves implementing best practices in manufacturing to reduce costs and improve quality.

8. Product teardown analysis: Product teardown analysis is a modern technique that

involves disassembling a product to identify its components and their costs.

9. Offer Cost Management Training: Cost management training is a modern technique that
involves training employees on cost management techniques to help them identify and reduce
costs.

CHARACTERISTICS OF STRATEGIC COST MANAGEMENT

Strategic Cost Management (SCM) is an approach that focuses on managing costs in a

way that aligns with an organization's overall strategic objectives.

1. Alignment with Strategy: SCM is closely tied to an organization's strategic goals and
objectives. It involves identifying cost drivers and cost reduction opportunities that align with
the company's long-term strategy.

2. Cost Differentiation: SCM recognizes that not all costs are equal. It emphasizes the need
to differentiate between costs that directly contribute to value creation (value-added costs)
and those that do not. Value-added costs are preserved, while non-value-added costs are
targeted for reduction.

3. Continuous Improvement: SCM is a continuous process. It involves regularly reviewing

and optimizing costs to ensure they remain in line with the strategic direction of the
organization. This may involve cost reduction initiatives and process improvements.

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4. Cost Drivers Identification: SCM focuses on identifying the key cost drivers within an
organization. Understanding what factors influence costs allows for targeted cost
management efforts.

5. Cost-Volume-Profit Analysis: SCM often employs techniques like cost-volume-profit

(CVP) analysis to understand how changes in volume, price, or cost affect profitability. This
analysis aids in decision-making.

6. Cross-Functional Collaboration: Effective SCM requires collaboration across different

functions of an organization, such as finance, operations, marketing, and supply chain
management. This ensures that cost management efforts are coordinated and holistic.

7. Value Chain Perspective: SCM looks at the entire value chain of an organization, from
suppliers to customers. It seeks opportunities for cost reduction and value creation at every
stage of the value chain.

8. Risk Management: SCM also considers risk factors that could impact costs. It involves
strategies to mitigate and manage risks that could affect cost structures.

9. Performance Measurement: Metrics and key performance indicators (KPIs) are used to
monitor the effectiveness of SCM efforts. These metrics help track cost reductions,
profitability improvements, and alignment with strategic goals.

10. Long-Term Orientation: SCM is not just about short-term cost-cutting but also about
ensuring that cost management efforts contribute to the sustainability and competitiveness of
the organization over the long term.

STRATEGY FORMULATION

Strategy formulation in cost management system involves the development of a cost

management strategy that aligns with the business objectives and takes into account the
environmental analysis. The strategy aims to reduce costs while simultaneously strengthening
the chosen strategic position.

1. Identifying Organizational Objectives:

The first step is to identify the long-term objectives of the organization.

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2. Environmental Analysis:

The second step is to analyze the internal and external environment of the
organization, including competitors, customers, suppliers, and other factors that may impact
the organization.

3. Strategy Formulation:

The third step is to develop a strategy that aligns with the organizational objectives
and takes into account the environmental analysis.

4. Strategy Implementation:

The fourth step is to implement the strategy, which involves allocating resources,
setting timelines, and establishing performance metrics.

5. Strategy Evaluation & Control:

The final step is to evaluate the effectiveness of the strategy and make any necessary
adjustments to ensure that it is delivering the expected results.

ALTERNATE STEPS INVOLVED IN STRATEGY FORMULATION

1. Understanding the project and its scope: To ensure effective cost management during
strategy execution, there needs to be a clear and concise definition of the project and the
scope of work that will be carried out.

2. Evaluating the Organizational Environment: The next step is to evaluate the general
economic and industrial environment in which the organization operates.

3. Formulating business cost strategies: Start with critically reviewing all the current
strategies of the business. A critical review of all the current strategies will help the company
to figure out the gaps between the current strategies.

4. Identifying costs: The first step in cost reduction is identifying all the costs incurred in
running the business.

5. Cost Analysis and Evaluation: The next step is to analyze and evaluate the costs
identified in the previous step.

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6. Planning the tactics and methods to execute the planned strategies: Once the cost
management strategies are finalized, the company needs to plan the methods and tactics that
can be used to implement the strategy.

7. Execution: This includes identifying and executing tactics in furtherance of the identified
strategies.

8. Continuous evaluation and control: Once the project is over, a review is carried out
comparing initial estimates with actual costs. This information is then later used to guide
future project planning and can contribute to determining how successful the project was
done.

COST MANAGEMENT SYSTEM DESIGN

Cost management system design involves the development of a set of formal methods
for planning and controlling an organization's cost-generating activities relative to its short-
term objectives and long-term strategies.

CHARACTERISTICS:

1. Dynamic:

A cost management system must be dynamic to keep up with the continually evolving
organization and business competition.

2. Focus on Short-term Objectives and Long-term Strategies:

An effective cost management system must provide managers with the information
needed to achieve profitability in the short run and maintain a competitive position in the
long run.

3. Technical Details of the Business:

The design of a cost management system should take into account the technical
details of the business.

4. Suitable Costing Technique:

The selection of a suitable costing technique is essential in designing a cost

management system.

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5. Method of Overhead Accounting:

The method of overhead accounting is an essential factor in designing a cost

management system.

6. Suitable Forms:

Designing suitable forms is necessary to ensure that the cost management system is
effective.

PROCESS

Designing a cost management system is a crucial step for organizations to track and
control their expenses effectively.

1. Define Objectives and Scope:

• Identify the specific goals and objectives of the cost management system.
• Determine the scope of the system, including what costs it will track (e.g., direct,
indirect, fixed, variable) and for which departments or projects.

2. Gather Requirements:

Collect requirements from stakeholders, including finance teams, department heads,

and executives, to understand their needs and expectations.

3. Select Costing Method:

Choose a costing method that suits your organization's operations. Common methods
include job costing, process costing, activity-based costing (ABC), and standard costing.

4. Data Collection and Integration:

• Identify the sources of cost data, such as accounting systems, payroll records, and
invoices.
• Implement systems to collect and integrate data efficiently into the cost management
system.

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5. Design Cost Categories:

Create a structured framework for categorizing costs, such as direct costs (e.g., raw
materials), indirect costs (e.g., utilities), and overhead costs (e.g., rent).

6. Allocate Costs:

• Develop a methodology for allocating indirect and overhead costs to specific

products, projects, or departments.
• Ensure accurate allocation methods to avoid distortions in cost analysis.

7. Cost Reporting and Analysis:

• Design reports and dashboards that provide relevant cost information to stakeholders.
• Implement tools and software for data analysis and visualization to aid decision-
making.

8. Budget Integration:

Integrate the cost management system with the budgeting process to align cost control
with financial planning.

9. Cost Control Measures:

Develop cost control measures and benchmarks to monitor cost variances and take
corrective actions as needed.

10. Documentation and Training:

• Document the cost management system's design, processes, and procedures for future
reference.
• Train relevant staff members on how to use the system effectively.

11. Testing and Validation:

Conduct testing and validation to ensure that the cost management system accurately
captures and reports costs.

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12. Continuous Improvement:

Establish a system for ongoing review and improvement of the cost management
system to adapt to changing business needs and technology.

13. Compliance and Auditing:

• Ensure that the cost management system complies with relevant accounting standards
and regulations.
• Prepare for regular internal and external audits.

14. Monitoring and Feedback:

Continuously monitor the performance of the cost management system and gather
feedback from users to make necessary adjustments.

15. Scale and Adapt:

As the organization grows or changes, be prepared to scale the system and adapt it to
new requirements.

16. Communication and Transparency:

Maintain clear communication with stakeholders about cost management goals,

processes, and outcomes to foster transparency and accountability.

The design of a cost management system should align with the organization's strategic
objectives and provide valuable insights to support informed decision-making and cost
optimization. It's an iterative process that requires ongoing maintenance and improvement to
remain effective.

FUNCTIONS

1. Planning and Controlling Budget: Cost management system design involves planning
and controlling the budget of a business.

2. Developing a System of Constant Targeted Impact: Cost management system design

involves the development of a system of constant targeted impact on the structure of costs
and their composition and behavior.

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3. Maintaining Effective Financial Control of Projects: Cost management system design
includes the processes required to maintain effective financial control of projects, such as
evaluating, estimating, and budgeting.

4. Improving Business Performance: Cost management system design plays a major role in
improving business performance by helping managers, analysts, and business owners to make
informed decisions based on careful cost analysis.

5. Resource Planning: Cost management system design involves resource planning, which
includes identifying the resources required for the project and estimating their costs.

6. Estimation: Cost management system design involves estimation, which includes

estimating the costs of the resources required for the project.

7. Budgeting: Cost management system design involves budgeting, which includes

developing a budget for the project based on the estimated costs.

8. Control: Cost management system design involves control, which includes monitoring the
actual costs of the project and comparing them to the budgeted costs.

ALTERNATE STRATEGIES

1. Design to cost:

This is an organizational methodology for integrating cost management with decision-

making at the design stage. It aligns organizational thinking about cost management,
functional design, and customer needs/marketplace pricing to create an effective costing
strategy.

2. Target costing:

This is a cost management method focused on establishing cost requirements from the
beginning. These requirements serve as a baseline for making decisions in the product
development process. This cost-focused approach enables product development teams to save
time and reduce costs in the long run.

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3. Design-to-value:

This is a cost management method that focuses on creating value for customers while
keeping costs low. It involves identifying the features that customers value most and
designing products that meet those needs while minimizing costs.

4. Relevant cost analysis:

This is a management accounting technique that helps managers decide between

different courses of action. It involves preparing one income statement that includes keeping
the product and one income statement that assumes discontinuing the product. For each item
on the income statement, the company determines if the income or cost item will change
under the two scenarios.

5. Cloud cost management:

This is a cost management system design that helps businesses manage their cloud
infrastructure costs. It involves analyzing and reporting on cloud infrastructure costs based on
different factors, such as account, cloud provider, and region. Cloud cost management teams
can also prioritize software development projects and purchase reserve capacity right from
the platform's portal.

6. Examine your facility costs:

This strategy involves examining facility costs to identify areas where costs can be
cut. Businesses can evaluate their energy consumption, rent, and other facility-related
expenses to reduce costs.

7. Re-evaluate your inventory and supplies costs:

This strategy involves examining the cost of supplies and materials to determine if
there is too much material in stock. Businesses can also review their suppliers to ensure they
are getting the best quality and service at the lowest costs.

8. Consider outsourcing:

Outsourcing can be a good option for tasks that take a lot of time and resources or
may be prone to errors. Businesses can outsource tasks like accounting, IT, and customer
service to reduce costs.

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9. Constant strategic cost management:

This strategy involves constantly reviewing and adjusting cost management strategies
to ensure businesses are making decisions at the right time to give them a competitive edge
over their competitors.

10. Renegotiating contracts:

Renegotiating contracts with ISPs, suppliers, and other service providers is an

effective cost reduction strategy. Renegotiating contracts with providers enables companies
to reduce current fees by 10 to 30% on average.

COST MANAGEMENT SYSTEMS

In simple terms, a Cost Management System is a structured way a company keeps

track of its expenses and spending. It helps the company understand where and how money is
being used in its operations. This system allows businesses to control costs, make informed
financial decisions, and optimize their resources to be more efficient and profitable. It's like a
financial toolkit that helps a company manage its money effectively.

OBJECTIVES OF COST MANAGEMENT SYSTEMS

The objectives of cost management systems are to ensure that an organization

effectively controls and optimizes its costs while achieving its strategic goals.

1. Cost Control:

To monitor and control costs to ensure that they remain within budgeted limits. This
helps prevent overspending and ensures financial stability.

2. Cost Reduction:

Identify opportunities to reduce costs without compromising the quality of products or

services. This objective aims to improve the organization's profitability.

3. Cost Allocation:

Accurately allocate costs to products, projects, or services to determine their true

profitability. This helps in making informed pricing and resource allocation decisions.

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4. Cost Planning:

Develop comprehensive cost budgets and forecasts to guide financial planning and
resource allocation. This includes short-term and long-term cost projections.

5. Performance Evaluation:

Evaluate the performance of various departments, products, or projects based on their

cost efficiency. This can help in identifying areas for improvement.

6. Decision Support:

Provide decision-makers with accurate cost information to support strategic decisions,

such as product development, pricing strategies, and make-or-buy choices.

7. Process Improvement:

Identify inefficiencies in processes and operations that lead to higher costs. Implement
process improvements to reduce wastage and enhance productivity.

8. Compliance:

Ensure compliance with relevant accounting standards and regulations, such as

Generally Accepted Accounting Principles (GAAP) or International Financial Reporting
Standards (IFRS).

9. Risk Management:

Assess the impact of cost fluctuations and cost drivers on the organization's financial
stability and take proactive measures to mitigate risks.

10. Resource Optimization:

Allocate resources efficiently to maximize output while minimizing costs, ensuring

that the organization operates at its optimal capacity.

11. Cost Transparency:

Foster transparency in cost reporting, making cost information accessible and

understandable to all relevant stakeholders.

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12. Customer Profitability Analysis:

Determine the profitability of different customer segments to focus efforts on high-

value customers and products.

13. Continuous Improvement:

Continuously review and refine cost management practices to adapt to changing

business conditions and improve cost-effectiveness.

PROCESS OF COST MANAGEMENT SYSTEMS

Cost management is a critical aspect of business operations that involves planning,

controlling, and monitoring expenses to optimize resources and achieve financial goals.

1. Setting Objectives: The first step in cost management is defining clear financial objectives
and targets. This could include cost reduction, cost containment, cost optimization, or
achieving specific profit margins.

2. Cost Identification: Identifying and categorizing costs into various types, such as fixed
costs (e.g., rent, salaries) and variable costs (e.g., raw materials, utilities), is essential. This
helps in understanding where money is being spent.

3. Cost Estimation: Estimating future costs is crucial for budgeting and planning. Historical
data, market research, and industry benchmarks are often used to make these estimates.

4. Budgeting: Developing a comprehensive budget involves allocating resources to different

cost centers or departments. This provides a framework for spending throughout the fiscal
year.

5. Cost Control: Implementing measures to control costs involves monitoring expenses

against the budget and taking corrective actions if actual costs deviate significantly from the
planned figures. This might include renegotiating contracts, reducing discretionary spending,
or finding more cost-effective suppliers.

6. Variance Analysis: Regularly comparing actual costs to budgeted costs allows for
variance analysis. Positive variances (spending less than budgeted) are often desirable, while
negative variances (overspending) require attention and adjustment.

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7. Cost Reduction: Identifying opportunities for cost reduction without compromising
product or service quality is a continuous process. This might involve process improvements,
automation, or renegotiating supplier contracts.

8. Cost Allocation: Allocating costs to products, services, or projects accurately is vital for
pricing decisions and assessing profitability. Activity-based costing (ABC) is one method
used for more precise allocation.

9. Performance Measurement: Key performance indicators (KPIs) are used to evaluate the
effectiveness of cost management efforts. These could include metrics like cost-to-revenue
ratios, return on investment (ROI), or gross margin percentages.

10. Continuous Improvement: Cost management is an ongoing process. Regularly

reviewing and refining cost management strategies ensures that the organization remains
competitive and financially healthy.

11. Cost Reporting: Generating and sharing cost reports with relevant stakeholders, such as
executives and department heads, helps in decision-making and accountability.

12. Technology Integration: Many organizations use cost management software and
financial tools to streamline the process, improve accuracy, and provide real-time insights
into cost data.

13. Compliance and Ethics: Ensuring that cost management practices adhere to legal and
ethical standards is crucial. This includes transparency in financial reporting and adherence to
accounting principles.

BROKEN COST SYSTEMS

A broken cost system, in simple terms, is a financial system within a company that is
not working correctly. It fails to provide accurate and reliable information about the costs
associated with producing goods or delivering services. This can lead to financial problems,
incorrect pricing, and poor decision-making within the organization. In essence, a broken cost
system is like a broken compass that doesn't point the company in the right financial
direction.

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 CAUSES AND SYMPTOMS OF BROKEN COST SYSTEM

CAUSES

1. Inaccurate Data Entry:

Errors in recording financial data, such as incorrect input of costs or expenses, can
lead to a broken cost system.

2. Outdated Cost Allocation Methods:

Using outdated or inappropriate methods for allocating costs to products or services

can result in distorted cost information.

3. Lack of Integration:

When various departments or systems within an organization do not communicate

effectively, it can lead to inconsistencies and inaccuracies in cost data.

4. Failure to Reflect Changes:

If the cost system does not adapt to changes in the business environment, such as new
products or production processes, it can become ineffective.

5. Inadequate Training:

Insufficient training of employees responsible for cost accounting can result in

mistakes and misinterpretation of cost data.

SYMPTOMS

1. Variance Discrepancies:

Large and unexplained variances between budgeted and actual costs are a clear
symptom of a broken cost system.

2. Inconsistent Profit Margins:

If profit margins vary widely across products or services without a clear explanation,
it may indicate a problem with cost allocation.

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3. Delayed Financial Reporting:

Difficulty in generating timely and accurate financial reports can be a sign of

underlying cost system issues.

4. High Overhead Costs:

If overhead costs are disproportionately high compared to direct costs, it might signal
problems in cost allocation methods.

5. Lack of Cost Visibility:

When managers and decision-makers lack access to detailed and relevant cost
information, it hinders effective cost control and strategic planning.

Addressing these causes and symptoms is crucial for maintaining an effective cost accounting
system within an organization.

REMEDIES OF BROKEN COST SYSTEM

Remedying a broken cost system is crucial to ensure accurate financial information

and effective cost management.

1. Identify and Correct Data Errors:

Audit the cost data to identify and rectify any errors or discrepancies in data entry.
Implement data validation checks to minimize future errors.

2. Update Cost Allocation Methods:

Review and update cost allocation methods to ensure they accurately reflect the cost
drivers for different products or services. Consider adopting activity-based costing (ABC) if
appropriate.

3. Integration of Systems:

Ensure seamless integration between various departments and systems that handle
financial data. This integration promotes consistency and reduces the risk of data
discrepancies.

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4. Regular System Audits:

Conduct regular audits of the cost system to identify weaknesses, inconsistencies, and
areas for improvement. Address any issues promptly to maintain data accuracy.

5. Training and Education:

Provide training and education to employees involved in cost accounting and

management. Ensure they understand the cost system's principles and best practices.

6. Adaptability:

Ensure that the cost system can adapt to changes in the business environment, such as
new products, markets, or cost structures. Modify the system as needed to accommodate
these changes.

7. Clear Documentation:

Document cost accounting policies and procedures comprehensively. This

documentation should be readily available to all relevant staff and regularly updated.

8. Use Technology:

Leverage modern accounting software and technology to streamline cost data

collection, analysis, and reporting. Automation can reduce errors and improve efficiency.

9. Standardization:

Standardize cost reporting formats and terminology to enhance consistency and

comparability across different departments or business units.

10. Performance Metrics:

Implement key performance indicators (KPIs) related to cost management. Regularly

monitor these metrics to track cost performance and identify deviations.

11. Cross-Functional Teams:

Create cross-functional teams involving finance, operations, and other relevant

departments to collaboratively manage costs and address cost-related issues.

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12. Benchmarking:

Compare your organization's cost performance to industry benchmarks or competitors

to identify areas where cost improvements are needed.

13. Cost Transparency:

Foster transparency by sharing cost information with relevant stakeholders, including

management, employees, and investors, as appropriate.

14. Continuous Improvement:

Establish a culture of continuous improvement in cost management. Encourage

employees to seek out cost-saving opportunities and regularly review cost control strategies.

15. External Review:

In cases of severe cost system issues, consider bringing in external consultants or

auditors to conduct a comprehensive review and provide recommendations for improvement.

Remedying a broken cost system requires a multifaceted approach that addresses both
technical and organizational aspects. The goal is to create a cost management system that
provides accurate, timely, and actionable cost information to support effective decision-
making and cost control.

COST OF QUALITY

Cost of Quality (COQ) is a method for calculating the costs that companies incur to
ensure that products meet quality standards, as well as the costs of producing goods that fail
to meet quality standards. It is a means to quantify the total cost of quality-related efforts and
deficiencies. The principle of COQ is similar to the idea of preventive maintenance, where
investing in upfront quality costs can prevent more costly repairs down the road.

There are two main categories within the definition of COQ:

1. Cost of Conformance
2. Cost of Non-Conformance

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1. Cost of Conformance:

These costs are incurred in an effort to keep defective products from falling into the
hands of customers. The Cost of Conformance is made up of Prevention costs and Appraisal
costs.

Prevention costs: These arise from efforts to keep defects from occurring at all, such as
training, quality planning, and process control..

Appraisal costs: These arise from detecting defects via inspection, test, audit, and other
means, such as testing equipment and inspection labor.

2. Cost of Non-Conformance:

These costs are incurred as a result of defects in products. The Cost of Non-
Conformance is made up of Internal Failure costs and External Failure costs.

Internal Failure costs: These are costs associated with defects found before the customer
receives the product, such as scrap, rework, and downtime.

External Failure costs: These are costs associated with defects found after the customer
receives the product, such as warranty claims, product returns, and lost sales.

The Cost of Quality can be represented by the sum of two factors: the Cost of Good Quality
and the Cost of Poor Quality. The goal of calculating the cost of quality is to create an
understanding of how quality impacts the bottom line, and to evaluate investments in quality
based on cost improvement and profit enhancement.

FUNCTIONS

1. Definition:

COQ is a technique that defines and measures where and what amount of a company's
resources are being used for prevention activities and maintaining product quality as opposed
to the costs resulting from internal and external failures.

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2. Cost Improvement:

By analyzing the costs of producing and maintaining quality products, companies can
identify areas for improvement in their quality operations and reduce the overall cost of
quality.

3. Profit Enhancement:

The goal of calculating the cost of quality is to create an understanding of how quality
impacts the bottom line. By evaluating investments in quality based on cost improvement and
profit enhancement, companies can make informed decisions about quality-related
investments.

4. Cost of Good Quality (CoGQ):

The Cost of Good Quality includes Prevention costs, which are costs incurred from
activities intended to keep failures to a minimum, and Appraisal costs, which are costs
incurred from detecting defects via inspection, test, audit, and other means.

5. Cost of Poor Quality (CoPQ):

The Cost of Poor Quality includes Internal Failure costs, which are costs associated
with defects found before the customer receives the product, and External Failure costs,
which are costs associated with defects found after the customer receives the product.

6. Cost-Benefit Analysis:

As absolute perfection is usually not achievable, costs of quality are subject to a cost-
benefit analysis. This analysis helps companies find the right balance between quality and
cost.

7. Project Quality Management:

Cost of quality is an important concept in both project quality management as well as

project cost estimation.

8. Practical Considerations:

The concept of cost of quality may look a bit theoretical at first sight. However, there
are certain practical considerations stemming from this concept.

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PROCESS (or) STEPS

1. Define the Scope:

The first step in the COQ process is to define the scope of the analysis. This involves
identifying the products or services that will be included in the analysis, as well as the
specific quality-related costs that will be considered.

2. Identify the Costs:

The next step is to identify the different types of costs associated with quality. These
costs can be classified into four main categories: Prevention costs, Appraisal costs, Internal
Failure costs, and External Failure costs.

3. Collect Data:

Once the costs have been identified, the next step is to collect data on each of the cost
categories. This may involve reviewing financial records, conducting surveys, or analyzing
production data.

4. Calculate the Costs:

After the data has been collected, the costs can be calculated for each of the cost
categories. This involves adding up the costs associated with each category to determine the
total cost of quality.

5. Analyze the Results:

The final step in the COQ process is to analyze the results of the cost analysis. This
involves identifying areas where quality-related costs can be reduced, as well as evaluating
the return on investment for quality-related initiatives.

MERITS OF COST OF QUALITY:

1. Improved Decision Making: Measuring the cost of quality helps companies make
informed decisions about quality-related investments, which can lead to significant cost
savings, greater client satisfaction, and higher project profitability.

2. Increased Awareness: Cost of quality analysis increases awareness among employees

about the importance of quality and the costs associated with poor quality.

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3. Better Resource Allocation: By analyzing the costs associated with quality, companies
can allocate resources more effectively to improve quality and reduce costs.

4. Improved Customer Satisfaction: By investing in quality, companies can avoid defects,

build customer loyalty, and improve customer satisfaction.

5. Enhanced Reputation: Quality costs can improve product or service reliability, which
enhances customer confidence and leads to a positive perception of the brand.

DEMERITS OF COST OF QUALITY:

1. Limited Scope: One of the significant disadvantages of quality costing is that it has a
limited scope. Quality costing only measures the cost of poor quality, and not the benefits of
good quality.

2. Time-Consuming: Collecting data and analyzing the cost of quality can be a time-
consuming process, which can be a disadvantage for companies with limited resources.

3. Costly: Implementing quality initiatives can be expensive, and businesses must balance
quality and cost to ensure economic viability.

4. Resistance to Change: Employees may resist changes to quality processes, which can
make it difficult to implement quality initiatives.

5. Inaccurate Data: The accuracy of the data collected for cost of quality analysis depends
on the quality of the data collection system and the training of employees.

LONG – TERM PROFITABILITY

Long-term profitability refers to the ability of a business to generate sustainable

profits over an extended period of time.

MERITS (or) FUNCTIONS:

1. Sustainable Growth: Long-term profitability ensures sustainable growth for a business,

which is essential for its survival and success.

2. Attracting Investors: Investors are more likely to invest in businesses that have a track
record of long-term profitability, as it indicates a stable and reliable source of income.

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3. Better Decision Making: Focusing on long-term profitability helps businesses make better
decisions about investments, resource allocation, and strategic planning.

4. Customer Loyalty: Businesses that prioritize long-term profitability tend to focus on

building relationships with customers, which can lead to increased customer loyalty and
repeat business.

5. Ethical Business Practices: Long-term profitability encourages businesses to adopt

ethical business practices, which can improve their reputation and attract more customers.

DEMERITS:

1. Short-Term Sacrifices: Achieving long-term profitability often requires short-term

sacrifices, such as investing in research and development or reducing profit margins.

2. Time-Consuming: Building long-term profitability takes time and effort, which can be a
disadvantage for businesses that need to show immediate results.

3. External Factors: External factors such as changes in the market, economic conditions, or
competition can impact a business's ability to achieve long-term profitability.

4. Risk: There is always a risk associated with long-term investments, and businesses must
balance the potential rewards with the potential risks.

5. Limited Resources: Businesses with limited resources may find it challenging to invest in
long-term profitability initiatives, which can put them at a disadvantage compared to larger
competitors.

ACTIVITY BASED COSTING

Activity-Based Costing (ABC) is a costing method that identifies activities in an

organization and assigns the cost of each activity to all products and services according to the
actual consumption by each. ABC is an accounting method that identifies the activities which
a firm performs and then assigns indirect costs to cost objects.

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 PRINCIPLES

Activity Based Costing, often referred to as 'ABC,' is a strategic evaluation process

aimed at gaining insights into your current business costs. In this approach, there are five
fundamental principles that serve as the foundation for any ABC exercise:

1. Strategic Alignment: Linking to Business Planning:

ABC is not a mere accounting exercise; it's a strategic tool. It should be directly
connected to your organization's strategic business planning. The information generated by
your ABC model should guide and inform strategic decisions.

2. Comprehensive Organizational Inclusion:

An effective ABC exercise encompasses the entire organization. The resulting model
should be capable of meeting various cost-related demands. Flexibility is crucial, as these
demands may evolve, especially in response to government policies. Engaging operational
areas is vital to secure their support, as the complete model becomes the cornerstone for
enhancing financial performance.

3. Pilot and Refine:

Before full-scale implementation, it's advisable to "crawl before you walk." In other
words, pilot the ABC methodology to test and refine it. This approach ensures that your
model effectively addresses strategic business questions and other cost-related requirements,
reducing the risk associated with investing in a cost model prematurely.

4. Integration into Day-to-Day Operations:

To achieve long-term success, the ABC model should be institutionalized and

seamlessly integrated into daily operations. This is realized when the model gains official
endorsement and enjoys participation from across the organization. Costing becomes a
routine task for cost managers, fostering a culture of financial awareness.

5. Simplicity, Completeness, and Utility:

The ABC model should adhere to the principle of "do it once and do it right." It
should be simple, yet comprehensive, covering all relevant aspects. Most importantly, it must

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be useful, providing actionable insights and contributing significantly to the organization's
financial management.

Activity Based Costing is a strategic approach to understanding and managing business costs,
guided by these five core principles. When executed effectively, it can drive informed
decision-making, enhance financial performance, and become an integral part of an
organization's daily operations.

FUNCTIONS

1. More Accurate Cost Information: ABC provides more accurate cost information by
activity, customer, product, or any other cost object, which can help businesses make better
decisions about resource allocation and pricing.

2. Improved Cost Management: ABC enables businesses to improve their cost management
and pricing strategies by singling out specific activities that are raising production costs and
require improvements.

3. Better Pricing Decisions: ABC provides a more accurate method of product/service

costing, leading to more accurate pricing decisions.

4. Enhanced Profitability: ABC helps businesses identify areas for improvement and
optimize profitability by assigning costs to activities that are the real cause of the overhead.

5. Flexible Modeling: ABC provides flexible modeling without relying on IT, which can
help businesses update models easily and without the need to rebuild.

6. Automated Calculation: ABC enables automated calculation of net margin across

unlimited entities, customers, products, and channels, which can help businesses identify
areas for improvement and optimize profitability

ACTIVITY BASED MANAGEMENT

Activity-based management (ABM) is a procedure that originated in the 1980s for

analyzing the processes of a business to identify strengths and weaknesses. Specifically,
activity-based management seeks out areas where a business is losing money so that those
activities can be eliminated or improved to increase profitability. ABM analyzes the costs of
employees, equipment, facilities, distribution, overhead and other factors in a business to
determine and allocate activity costs.
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 Activity-Based Management (ABM) is a management approach that focuses on
identifying and analyzing the activities performed by an organization to improve profitability.

ABM is used to determine the profitability of every aspect of a business, so that those
areas can be upgraded or eliminated. The information used in an ABM analysis is derived
from activity-based costing, where general overhead costs are assigned to cost objects based
on their use of activity drivers. A cost object is anything about which a business wants to
collect cost information, such as processes, customers, products, product lines, and
geographic sales regions.

FUNCTIONS

1. Identifying Problem Areas: ABM helps businesses identify problem areas by analyzing
and evaluating their business activities through activity-based costing and value-chain
analysis.

2. Improving Profitability: ABM helps businesses improve profitability by identifying and

analyzing the activities performed by an organization to improve profitability.

3. Enhancing Efficiency: ABM helps businesses enhance efficiency by identifying and

eliminating non-value-added activities and focusing on value-added activities.

4. Better Decision Making: ABM provides more accurate cost information by activity,
customer, product, or any other cost object, which can help businesses make better decisions
about resource allocation and pricing.

5. Strategic Planning: ABM helps businesses with strategic planning by analyzing the
profitability of an activity, which allows the company to obtain a strategic picture of which
products and customers to develop and/or pursue in order to boost sales and profitability.

6. Cost Reduction: ABM helps businesses reduce costs by identifying and eliminating non-
value-added activities and focusing on value-added activities.

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 TARGET COSTING

Target costing is an approach to determine a product's life-cycle cost which should be

sufficient to develop specified functionality and quality, while ensuring its desired profit. It
involves setting a target cost by subtracting a desired profit margin from a competitive market
price. The primary objective of target costing is to manage the business to be profitable in a
highly competitive marketplace.

Target costing is a proactive cost planning, cost management, and cost reduction
practice whereby costs are planned and managed out of a product and business early in the
design and development cycle, rather than during the later stages of product development and
production.

FUNCTIONS

1. Setting Targets for Costs According to Market Conditions: Target costing is a

management technique wherein prices are determined by market conditions, taking into
account several factors, such as homogeneous products, level of competition, no/low
switching costs for the end customer, etc. When these factors come into the picture,
management wants to control the costs, as they have little or no control over the selling price.

2. Customer Focus: Target costing helps businesses focus on customer needs and
preferences, which can lead to the development of products that better meet customer needs.

3. Improved Profitability: Target costing helps businesses improve profitability by setting a

target cost that is based on a competitive market price and desired profit margin.

4. Proactive Cost Management: Target costing is a proactive cost management practice that
helps businesses plan and manage costs early in the design and development cycle.

5. Better Decision Making: Target costing provides more accurate cost information, which
can help businesses make better decisions about resource allocation and pricing.

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TYPES OF TARGET COSTING

1. Market-Driven Target Costing:

This type of target costing is based on the market conditions and the expected selling
price of the product.

2. Product-Level Costing:

This type of target costing targets the cost of a specific product.

3. Customer-Level Costing:

This type of target costing targets the cost of serving a specific customer.

4. Component-Level Costing:

This type of target costing targets the cost of a specific component of a product.

5. Life-Cycle Costing:

This type of target costing involves reducing the total cost of the product over its
complete lifecycle, through production, engineering, research, and development.

7 KEY PRINCIPLES OF TARGET COSTING

1. Price-Led Costing:

Target costing sets the target cost by first determining the price at which a product can
be sold in the marketplace. Subtracting the target profit margin from this target price yields
the target cost, that is, the cost at which the product must be manufactured.

2. Focus on the Customer:

To be successful at target costing, management must listen to the company’s

customers. What products do they want? What features are important? How much are they
willing to pay for a certain level of product quality? Management needs to aggressively seek
customer feedback, and then products must be designed to meet those needs.

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3. Focus on Product Design:

Target costing focuses on product design to identify areas for improvement and
optimize profitability.

4. Focus on Process Design:

Target costing focuses on process design to identify areas for improvement and
optimize profitability.

5. Cross-Functional Teams:

Target costing involves cross-functional teams that work together to identify and
eliminate non-value-added activities and focus on value-added activities.

6. Lifecycle Cost Reduction:

Target costing involves reducing the total cost of the product over its complete
lifecycle, through production, engineering, research, and development.

7. Value Chain Orientation:

Target costing involves analyzing the value chain to identify areas for improvement
and optimize profitability.

Target costing is a management technique that involves setting a target cost for a product
based on the competitive market price and desired profit margin. The seven key principles of
target costing include price-led costing, focus on the customer, focus on product design, focus
on process design, cross-functional teams, lifecycle cost reduction, and value chain
orientation. By following these principles, businesses can gain more accurate cost
information, understand profitability, model flexibly, automate calculations, and practice
sustainable cost management. These strategies can help businesses optimize resource
allocation, reduce waste, and improve operational efficiency, leading to long-term
profitability.

NOTE: ABC, ABM, TC MERITS AND DEMERITS ARE

SIMILAR AS COST OF QUALITY (COQ)

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