Cost Management:

Strategic versus Conventional Approaches

Constantine Konstans, Ph.D., CPA, CMA, CIA CFE
Professor of Accounting and Information Management University of Texas at Dallas
These materials are drawn heavily from Shank and Govindarajan Strategic Cost Management

EXHIBIT 1

The Management Accounting versus the Strategic Cost Paradigm

Management Accounting In terms of products, customers, and functions Strongly internal focus Value added is a key concept Strategic Cost Management In terms of the various stages of the overall value chain of which the firm is a part Strongly external focus Value-added considered a dangerously narrow concept

What is the most useful way to analyze costs?

What is the objective of cost analysis?

Although the three objectives are always Three objectives all apply present, the design of cost management without regard to the systems changes dramatically depending strategic context: score on the basic strategic positioning of the keeping, attention directing, firm, i.e., a cost leadership or product and problem solving. differentiation strategy. Cost is primarily a function of output volume: variable cost, fixed cost, step cost, mixed cost Cost is a function of strategic choice about the structure of how to compete and managerial skill in executing the strategic choices: in terms of structural cost drivers and executional cost drivers
2

How should we try to understand cost behavior?

EXHIBIT 2

Contrasting Cost Management Paradigms: Conventional Cost Management vs Strategic Cost Management
Conventional Cost Management Strategic Cost Management Standard cost system with normal allowance No allowance for scrap, waste, rework; zero for scrap, waste, rework; zero defect standard defect is the concept is not practical. Overhead variance analysis; maximize production volume (not quality) to absorb overhead. Overhead absorption is not the key; standard costs and variance analysis are deemphasized, in general

Variance analysis on raw material price; procedure from multiple suppliers to avoid unfavorable price variance; low price/lowquality raw materials No emphasis on nonfinancial performance measure

No control on raw material price; certify vendors who can deliver right quantity, right quality, and on time

Heavy use of nonfinancial measures(part-per-million defects, percentage yields, scrap, unscheduled machine down-times, first-pass yields, number of employee suggestions)
3

EXHIBIT 2 (Continued)
Contrasting Cost Management Paradigms: Traditional Cost Management vs Strategic Cost Management
Conventional Cost Management No tracking of customer acceptance Strategic Cost Management Systematic tracking of customer acceptance (customer complaints, order lead time, on-time delivery, incidence of failures in customers locations) Quality costing as a diagnostic and management control tool

No cost of quality analysis

CONTROL PHILOSOPHY The goal is to be in the top tier of the The goal is kaizen reference group

The annual target is to meet the standards Industry norms set the floor The annual target is to beat last years performance Standards are to be met, not exceeded Each achievement level sets a new floor for future A regularly exceeded standard is not achievement tough enough
4

SCMs Three Underlying Themes

Value

Chain Analysis Cost Driver Analysis Strategic Positioning Analysis

Value Chain Analysis

(concerned with the focus of Cost Management efforts)

Strategic

View a linked set of value-creating activities from basic raw material sources to the final consumer. External focus identifies places in activity chain to enhance customer value or reduce costs in order to achieve sustainable competitive advantage. View a linked set of value-creating activities taking place within the boundaries of an organization. Objective is to maximize value added, i.e., the difference between sales and purchases.
6

Conventional

EXHIBIT 3 Value Chain in the Paper Products Industry

Silvaculture and Timber Farming
Competitor B

Logging and Chipping

Competitor C

Pulp Manufacturing
Competitor D

Paper Manufacturing
Competitor E

Converting Operations Distribution End-Use Customer

Competitor F

Competitor G
7

Competitor A

EXHIBIT 4 A Summary of Value Chain Versus Conventional Management Accounting

Conventional Management Accounting Focus Perspective Internal Value added Value Chain Analysis in the SCM Framework External Entire set of linked activities from raw material suppliers to ultimate end-used customers

Cost driver concept

A single fundamental cost driver pervades the literaturecost is a function of volume Applied too often only at the overall firm level

Multiple cost drivers Structural drivers(e.g., scale, scope, experience, technology, complexity) Executional drivers(e.g., participative management, total quality management) Each value activity has a set of unique cost drivers

Cost reduction approached Cost containment is a function of the cost driver(s) Cost via responsibility centers regulating each value activity containment or product cost issues Exploit linkages with suppliers philosophy Exploit linkages with customers Exploit linkages within the firm
8

EXHIBIT 4 (Continued)

A Summary of Value Chain Versus Conventional Management Accounting

Conventional Management Accounting Value Chain Analysis in the SCM Framework Identify cost drivers at the individual activity level; develop cost/differentiation advantage either by controlling those drivers better than competitors or by reconfiguring the value chain

Insights for None are readily apparent. This is a major reason strategic why strategy consulting decisions firms typically throw away conventional reports as they begin their cost analysis For each value activity, ask strategic questions pertaining to make versus buy and forward versus backward integration
Quantify and assess supplier power and buyer power; exploit linkages with suppliers and buyers

Strategic Positioning Analysis

(concerned with role of Cost Management in the firm)

Firms

choose to compete either through cost leadership or product differentiation Strategy chosen influences cost management perspective

10

Exhibit 5
Differences in Cost Management Caused by Differences in Strategy
Primary Strategic Emphasis Product Differentiation Role of engineered product costs in assessing performance Importance of such concepts as flexible budgeting for manufacturing cost control Perceived importance of meeting budgets Importance of marketing cost analysis Importance of product cost as an input to pricing decisions Not very important Moderate to low Cost Leadership Very important High to very high

Moderate to low Critical to success low

High to very high Often not done on a formal basis high

Importance of competitor cost analysis

low

high
11

Cost Driver Analysis

(concerned with analyzing cost behavior in a manner supportive to strategic choices)

Understanding

cost behavior requires identifying the cost drivers present in any given situation Understanding cost behavior depends on understanding the complex interplay among the relevant cost drivers in any given situation

12

Conventional Approach to Cost Driver Analysis

Level and Behavior of Costs Total Cost

Output Volume
13

Cost Driver Categories

Structural

-- related to strategic choices that drive costs Executional related to an organizations ability to execute successfully

14

Structural Cost Drivers

(Related to organizational choices) Scale:

Investment size in manufacturing, R&D, and marketing Scope: Degree of vertical integration Experience: Previous repetitions of current work Technology: Process technologies used at each step in value chain Complexity: Broadness of product line

15

Executional Cost Drivers

(Related to organizational skills)
Work

Force Involvement: participation; empowerment; commitment to continuous improvement Capacity Utilization: given scale choices on plant construction Plant Layout Efficiency: compared to current norms Product Configuration: design or formulation effectiveness Exploiting Linkages with Suppliers/Customers: in relation to the value chain
16

Cost Driver Analysis Some Key Ideas

Volume

is usually not the best way to explain cost behavior More useful to explain cost position in terms of structural choices and executional skills Not all strategic cost drivers operable or equally important all the time but some are probably very important in every instance

17

Linkages Among Value Chain Analysis, Strategic Positioning Analysis and Cost Driver Analysis
Understanding

the value chain helps define the optimal positioning strategy Understanding the value chain and positioning strategy helps identify the relevant cost drivers

18