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Strategic Cost Management
Strategic Cost Management
Strategic Cost Management
Abstract (Summary)
The article then discusses what really makes ABC a strategic costing
technique. In doing this, the article highlights the significance of the
philosophy underpinning the use of ABC as a strategic costing technique.
Introduction
Part 1 of this series discussed strategic cost management in the context of the
philosophy that informs the manner in which costing techniques are used in
order to realise benefits from any cost management initiatives. The purpose
of part 1 was to establish the context within which strategic costing
techniques such as activity-based costing are used. In this article, ABC is
discussed with the objective of demonstrating why and how it is superior to
traditional costing techniques, how it can be used as a strategic costing
technique and how it is integrated within an organisation's strategy.
The rationale behind ABC is that the provision of products and service
requires the performance of activities. The performance of activities in turn
consumes (uses) resources. It is the consumption (use) of resources that
generates costs, most of which are overheads (indirect costs). However,
where a company produces several products or services, assigning these
costs to the different products and services is often not easy, because such
costs arise from the consumption of common resources.
The cost caused by the use of the common resources cannot easily be traced
to a particular product or service, thus making the costing of products and
services difficult. Yet, many companies require accurate product and service
costs to establish (1) what should be charged to customers (in cases of cost
plus pricing), (2) how profitable products and services are, and (3) how best
to provide such products and services in a cost-effective way.
(i) Overhead costs are first assigned to activities that have consumed the
resources that gave rise to these costs.
(ii) The costs assigned to activities are then assigned to the various products
and services that have consumed those activities.
Benefits of ABC
It is important to point out the fact that, for most products and services, the
assumption made by the traditional costing methods that only one cost driver
explains why overhead costs are increasing in the cost structure is not valid.
ABC is superior to the traditional costing methods because it captures every
form of diversity that causes overhead costs in products and services, as
shown in figure 1 opposite.
Figure 1 (on next page) demonstrates that there is no one cost driver that
explains why companies incur overhead costs. Thus the overhead costs, as
shown in the company's accounting records (as recorded in the general
ledger), arise from, or are caused by, a number of cost drivers, such as the
complexity of the process that generates a product or service, volume of
output and degree of product/ service customisation. The more complex the
process, the higher the number of activities that need to be performed, and
thus the more the costs incurred in the provision of such a product or service.
An objection that is frequently raised is that many overhead costs are fixed
in nature and will not decline in line with reduced usage of the resource to
which that fixed cost is attached. A typical example is that of the rental cost
of the premises from which a factory or warehouse operates. The rental cost
is incurred regardless of the activities carried out, or distribution of space
within the factory/warehouse premises. However, charging rental costs to
products based on the space and time consumed by that product, would have
the following effects, provided proper accountability structures are in place:
Departments and staff responsible for sales would de-emphasise the products
that consume above average space in the factory/warehouse as the increase
in cost charged to the product impacts unfavourably on the profitability of
that product
The converse would also occur, with products (or services) that are less
resource intensive receiving increased emphasis, provided that sales staff are
incentivised on the basis of profit, and not volume or revenue. This change
in behaviour leads to more profitable use of the warehouse space by
changing the mix of activities from unprofitable products and services to
more profitable ones. By influencing the organisational attention away from
less profitable to more profitable products and services, a company
invariably increases its return on the assets (warehouse space in this
example).
As such, the cause and effect relationship between many of these costs and
the activities that actually drive them is not evident, due to the activity
driving costs of one functional area falling within the ambit of another
functional area of the organisation (see the third part of this series for more
discussion of this issue). The point that we want to make is that a costcutting
philosophy that adopts a silo approach cannot support the effective
implementation of ABC. As a technique that relies of process and activity
visibility, ABC requires a cost management philosophy in order for its
potential benefits to be realised.
The first question is concerned about the extent to which cost information
generated by ABC is more accurate than that produced by the traditional
costing system. The second question centres on the usefulness of ABC
information in supporting strategy, given constraints imposed by the
organisation's strategic options.
* Strategic considerations.
[Reference]
[Author Affiliation]
Dr Richard Chivoka PhD, MSc, BCom, is an Associate Professor, Department of
Accounting at the University of Cape Town and Carol Cairney CA(SA) is a lecturer,
Department of Accounting at the University of Cope Town.
[Photograph
]
[Author Affiliation]
Dr Richard Chivaka is an Associate Professor in the Dept of Accounting at UCT. He
is Director of the Honours & Masters degree programme in Strategic Cost
Management. His research interests include strategic cost management, costing
systems design (ABC Et ABM), supply chain management and value chain analysis.