SMART MANAGER

Cost management

Addressing the challenge

of falling prices
Through the last three articles, the second stage of customer value creation, ie, operations and delivery cycle have
been explored. There are four aspects that are considered to be critical for sustaining the cost management initiative
at this stage. These include sustaining the current cost levels (cost control), questioning the current cost levels (cost
reduction), aligning the business processes to the customer value (using lean principles) and addressing the challenge
of falling prices (Kaizen costing). The first three was addressed in the last three articles. This article addresses the
fourth aspect, ie, addressing the challenge of falling prices. Read on…

M Hariharan

W
ith increasing competition and
constant demands from the
customer, there is a constant
pressure on prices in today’s
marketplace. The basic equation of cost
management is S – P = C, where C is the
allowable cost. On the other hand, input
prices go up as it depends on
the investors who shuffle
their portfolio among
shares, commodities,
metals, etc.
Therefore, it is
important to
focus on
the cost
continuously for sustaining the current
profitability. Quality initiatives also help in
sustaining the current profitability effectively.
Though quality tools are not cost reduction
methods; these could lead to reduction of cost.
Kaizen
Kai (change) + Zen (good) = Kaizen
meaning improvement. Moreover, Kaizen means
continuous improvement in personal life, home
life, social life, and working life. When applied
to the workplace, Kaizen means continuous
improvement involving everyone - managers
and workers alike – Imai.
Kaizen is a process involving gradual, orderly
and continuous improvement. It focusses on
eliminating waste in all systems and processes
of an organisation. It involves everyone
in an organisation who works together to
make improvements ‘without large capital
investments’. When applied on a long-term basis,
it can bring about dramatic improvement in
the bottomline.

Local optimisation leading to global

suboptimisation
Kaizen, like any other quality initiative
improves the operating performance of an
organisation. However, any improvement that
focusses at a micro level without understanding
the overall improvement can be detrimental to
the overall growth.

62 Modern Plastics & Polymers ● June-July 2006


! of the existing model of product. It is
?
Õ ..
. .
Process A Process B
200 MT/Hr 100 MT/Hr
Process A in-change is more efficient and improves productivity
Process A is measured based on MT per hour or cost per MT
Figure 1: Local optimisation leading
to overall suboptimisation
Figure 1 represents local optimisation
leading to overall suboptimisation. Process
B works on the output of Process A. Ideally,
Process A should produce only 100 MT/hr
to meet the requirements of Process B.
However, if the in-charge of Process A
manages to improve the productivity
of Process A, imagine the impact of the
same! Hence, the ‘work-in-progress’ tag
will increase for Process B. If another
dimension is added to this problem – in
case these processes produce variety of
products – Process A, which is measured
in terms of tonnes per hour will try to pull
ahead orders irrespective of the market
requirement. So, any improvement in
productivity at Process A and reduction
of setup time can lead to overall sub-
optimisation. These improvements can
make sense, when there is a potential cost
reduction possible.
Any Kaizen initiative that fails to focus
on the overall impact has the potential to
lead a situation where local optimisation
leads to global suboptimisation. There are
a few CEOs who lament that everybody
in their firm has improved, but they
still continue to make losses. Further, if
everyone is improving in a firm, it may
lead to overall sub-optimisation.
Kaizen costing – quantifying
improvement efforts
Businesses must continually improve
to stay competitive. One of the main
purposes of the whole management
accounting system is to influence the
behaviour of a firm’s employees to achieve
corporate goals. Kaizen costing is the
system to support the cost reduction
process in the manufacturing phase
Modern Plastics & Polymers ● June-July 2006
about beating the current cost levels
rather than matching standards and
explaining variances. Kaizen costing
system has specific cost-improvement
activities for each department and each
accounting period but not everywhere.
Information provided by Kaizen costing
allows the management to zero-in on
where improvements can be made.
Kaizen costing aims to achieve cost
reductions, to improve customer service
and improve bottom line.
Aims
Kaizen costing (KC) is for the existing
products whereas target costing (TC)
is for new products (Figure 2). TC is
Product specification
Price targets
Profit targets
Cost targets
Major product/process changes
Does
No
design meet
the TC?
Figure 2: Address of target costing and Kaizen costing
applied in the design stage of the PLC as
cost reduction is primarily through the
improvements in product design. KC is
applied during the manufacturing stage
as cost reduction is primarily through
increased efficiency of production process.
KC is in essence a technique for
profit management. Its objective is to
help ensure that each product earns
an adequate profit across its life. It
complements TC by extending the
discipline that TC creates in product
development process.
Quantifying improvement
The question arises, ‘Can the impact
of all improvements to the bottomline
be quantified?’ The author does not
SMART MANAGER
think so! For eg, consider a bank that
is improving its ‘time taken to search
and provide the account opening
form to the customer’. This is a form of
improvement. But can this be quantified
in terms of financial impact? This
improvement cannot be quantified and
said for sure that the employee cost
will come down by so much amount.
How then can this improvement be
quantified? In this case, it is important to
measure the time taken for the process
before the improvement procedure and
the time taken after the improvement.
Setting a target to achieve this would
be better. These improvement areas
are identified based on the customer
value proposition with the firm’s efforts
Target costing
Kaizen costing
Start production
Minor product/process changes
Product scrapping
Yes
directed towards this. But, the author
suggests that any effort to quantify this
improvement in terms of the financial
impact will be in vain.
Then what are the kinds of
improvements that can be quantified?
z Establish ‘standard cost’ for the
current period
Rs. 100
z Establish ’target cost reduction
amount’ (Kaizen cost) for the period
Rs. 10
z Compare the actual cost with the
standard cost
Rs. 96
z Compare the actually rationlised
amount Rs. 4
z Variance is the difference between
target cost reduction amount and Rs. 6
the actually rationalised amount
Figure 3: Steps in Kaizen costing
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 SMART MANAGER
Group cost reduction objective
Direct material
cost reduction
objective by
product
Not individual material wise
Figure 4: Period Specific KC — establishing specific cost reducion targets
Any improvement that directly improves
revenue, reduces cost and optimises
investment can be quantified in financial
terms. In the above example, this effort
could lead to improvement in sales,
reduction in storage space as well as
reduction in future cost of manpower,
as the existing resource is utilised better.
However, the impact is indirect and not
directly traceable. Hence, quantifying this
improvement is not feasible.
Steps in Kaizen costing
Kaizen costing is a method that
incorporates Kaizen savings before the
savings accrue, in the budget for current
year. Normally, where Kaizen initiatives
are taken, the improvements are included
in the following year’s budget. There are
many companies that incorporate cost
reduction targets in their annual budgets.
But how is Kaizen costing different?
As far as the concept of incorporating
anticipated cost targets are concerned,
Kaizen costing is same as this method.
However, the point of difference is two
fold. First, KC continues from where TC
signs off, ie, cost reduction targets are
based on the cost targets imputed into
the life cycle cost of the product. Second,
the method of identifying the cost
reduction targets – Kaizen cost (Figure 3).
64
fluctuate and are influenced by factors
that will not continue in the current year.
If a standard costing system is in
place, the standard cost established for
the system can be considered. Here again,
this number has to be updated based on
current and anticipated practices.
Establishing Kaizen cost – target
cost reduction amount
Kaizen costing follows three
approaches to quantify and track
improvements. These include:
z Period-specific: Reducing direct costs
Direct labour of production processes and support
cost reduction processes
Purchased parts
objective by
cost reduction z Item-specific: Reducing direct costs of
product line
objective by item
products and components
z Overhead-specific: Reducing indirect
costs
Period-specific Kaizen costing
Establishing standard cost The objective of period specific KC
Normally, many Japanese companies is to find ways to perform production
take the previous year-end actual cost and associated support processes more
as the standard cost. This is because, efficiently. In the case of production
it is presumed that the cost has been processes, it should find ways to produce
the most efficient cost improved over a products so that they consume less
period of time. material & labour and trigger fewer
However, this method may not be overhead activities. Improving process
appropriate, where the current costs capability stability, reduction of
Product specific
Kaizen costing
Selling price
Aggressive Kaizen falling faster than
Failure to
savings imputed manufacturing
Achieve cost
in life cycle
TC
profitability
Feed forward
Feedback
Figure 5: Product specific KC — triggers
Modern Plastics & Polymers ● June-July 2006

Component specific
Kaizen costing
All products that
contain the item
report low
profitability
Tear-down identifies
Prior cost reduction
cost reduction
opportunity
Figure 6: Component specific KC — triggers
set-up time, reducing process wastages,
reduction of cycle time are some
examples of addressing improvements in
production processes. As the targets are
to be given before the budget is prepared,
improvements in Process A (Figure 1) will
be carefully considered.
For support processes, it should
find ways to perform them so that they
consume fewer resources. For example,
improving material movements, storage
practices, planning of buffer stock,
maintenance scheduling are areas of
support services. As pressure mounts on
selling prices, period specific KC acts as
the primary cost-reduction mechanism.
This is because, sustainable cost reduction
is possible only through addressing the
processes at the post design level.
Under period specific KC, the
starting point is establishing the cost-
reduction objectives for each group
of firm’s production facilities. Then it is
decomposed to material, labour and
purchased parts level. It can be top down,
where the top management establishes
the overall reduction percentage and this
percolates down to the group level and
departmental levels. Alternatively, one
can use a bottom up approach, where the
departments give their achievable cost
reduction targets, approved or modified
by the top management.
The group cost reduction objective
is further broken up into direct material,
Modern Plastics & Polymers ● June-July 2006
Material and other
input costs increase
insufficient excessively
direct labour and purchased parts. The
material level cost reduction is addressed
through item specific KC.
Item-specific Kaizen costing
The objective of item specific KC is
to maintain the profitability of a given
product. It is initiated under two primary
conditions: when a new product is
launched above its target cost or, when
the selling price of a long-term, mature
product is falling faster than its cost.
This is the second area where Kaizen
costing is different from other methods of
incorporating the cost reduction targets.
It continues from where target costing
signs off.
There are two levels of item-specific
KC: product specific KC and component
specific KC.
Product-specific KC is akin to TC.
In TC, functionality is variable, ie, the
primary difference lies in the ability to
change product functionality, where the
Table 1: Standard costing vs Kaizen costing
Standard costing
z Cost-control system
z Stability in current processes
z Goal is meeting cost peformance sandards
z Standards are set annually or semi-annually
z Cost variance analysis involves comparing actual to
standard costs
z Cost variance investigation occurs when standards
are not met
SMART MANAGER
product and customer value proposition is
redefined. However, in product specific
KC, functionality is fixed; ie, the
functionality of the product cannot be
changed. But, it does not mean that the
material content and the process cannot
be changed, yet the customer should not
perceive the change.
Product-specific KC is applied under
three circumstances (Figure 5)
z Failure to achieve target cost: The
product is launched with the promise
of achieving the target cost. But on
launch, the promised level was not
achieved. This is a planning failure and
here Product Specific KC is done more
as a feed back mechanism to achieve
the originally planned target cost
z Aggressive Kaizen savings imputed
in life cycle profitability: While
designing the product, the top
management allowed the product
to be launched at a higher target
cost, to ensure a strategic product
to survive the initial years of launch.
Here, product specific KC acts as a feed
forward mechanism to achieve the
promised cost levels over the life cycle
of the product
z Selling price is falling faster than
manufacturing cost: This happens
due to intensified competition and
supplier power. It is not a planning
failure but extraneous factors
impacting the profitability of the
product. Here again, product specific
KC acts as a feed forward mechanism
Thus, KC forces the firm to focus on
specific products and product lines for
achieving cost reduction, instead of
spreading the efforts thin and wide.
Component-specific KC is similar to
component level TC. When cost target
Kaizen costing
z Cost-reduction/management system
z Continuous improvement
z Goal is to achieve cost reduction standards
z Cost reduction targets are set and applied monthly
and continous improvement (Kaizen) methods are
applied all year long to meet targets
z Cost variance analysis involves target Kaizen costs
versus actual cost reduction amounts
z Cost variance investigaion occurs when targets cost
reduction amounts are not attained
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 SMART MANAGER
is set for the component, the design
engineers have to find ways to achieve
that cost.
But lesser freedom is given to change
the design of the rest of the product. The
function should not change as the value
proposition for the customer is frozen at
the design stage.
Component-specific KC is applied
under four triggers (Figure 6):
z All products that contain the
item report low profitability: In
any discrete manufacturing firm,
components tend to get standardised
across different products. Tear
down analysis to identify common
components used across products can
throw those products that contain
these components as a possible cost
reduction candidate
z Tear down analysis identifies
cost reduction opportunity:
Comparing parts used by competitors,
standardising components across
product lines, material replacement,
alternative sourcing of parts comes
out of this analysis
66
z Prior cost reduction insufficient:
With the constantly falling selling
prices and the investor expectation
increasing, it is identified that the prior
cost reduction is insufficient
z Material and other input costs
increase excessively: Steel prices
going up forcing manufacturers to
address those steel parts is a classic
example
Overhead-specific Kaizen costing
Overhead-specific Kaizen costing
addresses causes of excessive complexity
across products and periods. The overhead
costs can be addressed based on the
methods that were discussed in the last
three articles.
Writings on Kaizen costing
There is not much material on Kaizen
costing. Besides, a few articles written
by Japanese authors like Monden, the
one book that addresses Kaizen costing
elaborately is ‘Inter-organisational Cost
Management’ by Robin Cooper and
Regine Slagmulder.
Conclusion
Kaizen costing is a budgetary control
system that incorporates Kaizen savings
before the savings arise. It focusses on
specific processes, products, components
and complexities to achieve cost
reduction targets. It ensures that the
customer value is not sacrificed in an
attempt to achieve cost reduction. It is not
a cost control system but a cost reduction/
cost management methodology (Table 1).
The next article of our series will focus
on understanding customer relationship
through the eyes of cost management. It will
include the ways to understand customer
and enhance the profitability. „
M Hariharan is the director
of Savoir Faire Management
Services, Mumbai. He has been
helping firms across sectors in
identifying their core problem,
aligning their processes
according to customer needs
and enable sustenance of the
efforts. He preaches what he practices and has
successfully trained more than 5,000 executives
on these aspects. Email: sfgroup@vsnl.com
Modern Plastics & Polymers ● June-July 2006