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Decision Making

Cost Concepts

Decision Making
• Decision making is the process of choosing among alternatives available which result in -The judicious utilization of input resources to get optimum return on investment -On going economic value addition to the stake holders

Types of Decisions
• Pricing Related • Product Mix Related • Investment Related • Operation Related

Levels in Decision Making
• Corporate Planning • Business Unit • Operating Level

Corporate Level
• Corporate Level -Markets -Products -Customers -Joint Ventures -Mergers & Acquisition -Investments

Business Unit • Business Unit -Asset Deployment -Quality -Procurement -Delivery -Funding -Man Power Deployment .

Operating Level • Operating Level -Productivity Related -Supply Chain Related -Maintenance -Quality -Delivery -After Sales Service .

Role Of Cost In Decision Making • Fixation of selling price • Make or buy decision • Investment in a project • Determination of sales mix • Choosing between two alternatives .

and/or waste reduction or elimination.Cost Advantage • Superiority achieved by an organization over its competitors through factors such as access to cheaper inputs. skilled workforce. efficient processes. favourable location. superior technology. .

. distribution network and customer support. product offerings.What is Competitive Advantage • An advantage that a firm has over its competitors • allowing it to generate greater sales or margins and/or retain more customers • types of competitive advantages are the firm's cost structure.

Achieving a high asset turnover • Fixed costs are spread over a larger number of units of the product or service • Experience curve effect • Create an entry barrier to potential competitors .Strategies for Cost Leadership 1.

Strategies for Cost Leadership 2. Achieving low direct and indirect operating costs • Offering high volumes of standardized products • Limited and standard components • Increasing asset capacity utilization • Extensive distribution of costs .

Strategies for Cost Leadership 3. Control over supply chain • Bulk buying and vendor cost minimization • Application of inventory-control techniques • Preferential access to raw materials • Backward integration .

Cost as a Competitive Advantage Benefits • • • • • Lures price sensitive customers Ensures stable market share Helps outperform competition Stability of enterprise Reduction of advertising and promotional costs .

Cost as a Competitive Advantage Demerits • • • • Misconception that low price=low quality Fail to cater to value-seeking customers Quality-price mismatch Limited R&D activity .

The goal is to deliver maximum value for the least possible total cost. • Value-chain analysis looks at every step a business goes through.Concept of Value Chain • A value chain is a chain of activities for a firm operating in a specific industry. . from raw materials to the eventual end-user.

Porter’s Value Chain .

• Service Secondary/Support activities are: • The infrastructure of the firm • Human resource management • Technology development • Procurement .The primary value chain activities are: • Inbound Logistics • Operations • Outbound Logistics • Marketing & Sales.

coordinate and optimize linkages between activities in the value chain.Value Chain Analysis • Value chain analysis is used to analyze. by focusing on the interdependence between these activities. • Improving quality by providing better understanding of customer requirements • Reducing time • Reducing cost .

Identify opportunities for reducing costs and/or improving value.Stages in Value Chain Analysis 1. Identify cost drivers. 2. 3. . Identify linkages and interrelationships in the value chain. 5. Compare costs by activity. Identify the value chain activities and disaggregate the firm into separate activities. Establish the relative importance of different activities in the total cost of the product. 4. 6.

Cost Advantage and the Value Chain • • • • • • Interrelationships among business units Degree of vertical integration Timing of market entry Firm's policy of cost or differentiation Geographic location Institutional factors Differentiation and the Value Chain • • • • Policies and decisions Linkages among activities Timing Location .

Cost Driver Concept Cost drivers are factors that determines the cost of an activity. They are usually assessed together as multiple drivers rather than singly. . Cost drivers are analyzed as part of activity based costing and can be used in continuous improvement programs.

. complexity of products. .Categories of Cost Driver Concept • Structural cost drivers: Structural cost drivers that are derived from the business strategic choices about its underlying economic structure such as scale and scope of operations. plant layout. • Executional cost drivers: Executional cost drivers that are derived from the execution of the business activities such as capacity utilization. use of technology. etc. work-force involvement. etc.

Examples of Cost Drivers • • • • • Number of purchase orders Number of machine hours Number of direct labour hours Number of batches of material Number of machine operators .

The machine set up expenses of company x is Rs 40.Computation of Cost Driver Rates • Cost driver rate = Activity cost Activity volume Eg.000 and its total number of machine set up hours is 40 hours .Calculate the cost driver rate? .

Continuation • SolutionCost driver rate = Machine set up expenses Total number of machine Set up hours = 40.000 40 Cost driver rate = Rs 1000 per hour .

AVC & AFC • Total variable costs increase as the cost driver increases. • Total fixed costs remain constant as the cost driver increases.TFC. • Average variable costs remain constant as the cost driver increases. • Average fixed costs decrease as the cost driver increases. .Impact of Cost Drivers on TVC.

Advantages of Cost Driver Concept • Improving enterprise performances • Improving employee and manager awareness • Periodically reviewing cost • Controlling costs with better calculations • Eliminating cost .

Strategic Positioning Concept • Strategic positioning concept is the key to create and sustain competitive advantage. • Basic consumer concepts – Consumer value – Product – Customer sacrifice .

• Differentiation strategy: – Differentiation strategy focuses on features / benefits offered to customer. – Competitive advantage can be created by providing something to customers that is not provided by competitors. .Basic General Strategies • Cost leadership: – The objective of cost leadership is to provide the same or better value to the customers at a lower cost than offered by competitors.

– Alternative 2: selecting segment where the firm’s core competencies in the segment are superior to competitors. – There are 2 possibilities in using this strategy. .• Focus strategy: – A focusing strategy is selecting a market or customer segment in which to compete. – Alternative 1: Selecting the markets that appear attractive and then develop the capabilities to serve .

– Competitive advantage is tied to cost. .Strategic Positioning • Strategic positioning is the process of selecting the optimal mix of general strategies. • Role of cost management: – The effective cost management helps in reducing the costs while simultaneously strengthening the chosen strategic position. • The mix is selected with an objective of creating competitive advantage.

• There are two basic concepts of quality :- 1) Characteristics of a product/service 2) Performance of a product/service .Quality • Quality is the total features and characteristics of a product/service performed account to specifications to satisfy customers.

Quality Cost • It is the cost incurred to prevent or the cost arising as a result of producing a low-quality products These are categorized into four groups:1) Prevention cost 2) Quality appraisal (Direction) cost 3) Internal failure cost 4) External failure cost .

.Illustration • Compute the total cost of Modi Xerox ltd. The revenue from sale of 20. quality in terms of cost of conformance quality.000 machinery are 70 crore.

40.50.00.000 3.000 hrs 2.50.20.40.0% 2.Analysis of activity based cost of quality of photocopying machines of Modi Xerox Ltd Cost of quality activity (1) a) Prevention cost:Design Engineering Process Engeenering TOTAL b) Appraisal costs:Rs 400/hr 300/hr 20.47.000 1.1 % 1.1% Rate (2) Quantity (3) Total cost (4) % of revenue (4/ 70 crore)% Solution Inspection TOTAL 200/hr 1.000 2.00.000 1.00.000 hrs 22.4% .4% 3.5oo hrs Rs 80.000 67.

6% 3.2% 0.6% 250/hr 1.200/hr 550/hr 6.3% 4.50.00.000 2.00.000 18.Cost of quality c) Internal failure cost Rework Total d) External failure cost Customer support Transportation Warranty repair Total Total (a+b+c) Rate Quantity Total cost % 500/hr 50.00.00.000 0.50.000 hrs 15.00.000 3.000 10.000 hrs 1.000 3.000 3.000 hrs 2.2% 14.50.30.500 hrs 60.00.7% 5.00.63.3% .

Target and Life Cycle Costing Target Costing and Lifecycle Costing can be regarded as relatively modern advances in Management Accounting .

the classical variable costs of material. direct labour and variable overheads are included together with a share of the fixed production costs .Conventional Costing Attempts to work out the cost of producing an item incorporating the costs of resources that are currently used or consumed For each unit made.

The fixed production costs can be included using a conventional overhead absorption rate or they can be accounted for using activity-based costing (ABC Analysis) Once the total absorption cost of units has been calculated. a mark-up is used to determine the selling price and the profit per unit .

or at least offer better value for money  Other important costs are ignored like R&D.Flaws in The Approach  The product’s price is based on its cost. Close Down Costs . but no-one might want to buy at that price  The product might incorporate features which customers do not value and therefore do not want to pay for  Competitors’ products might be cheaper.

anticipating and satisfying customer requirements profitably .Target Costing Target costing is very much a marketing approach to costing. The management process responsible for identifying.

Basic Question for Marketers • Are customers homogeneous or can we identify different segments within the market? • What features does each market segment want in the product? • What price are customers willing to pay? • To what competitor products or services are customers comparing ours? • How will we advertise and distribute our products? .

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the costs have to be sufficiently low . but the company cannot dictate to the market.There will probably be a range of products and prices. customers or competitors If the profit is going to be adequate.

Cost 100% Rs. then.12. if a company normally expects a mark-up on cost of 50% and estimates that a new product will sell successfully at a price of Rs.8.8 + Mark-up = 50% Rs.For example.4 Selling price 150% Rs. the maximum cost of production should be Rs.12 .

design.Life Cycle Costing The total cost throughout the life of a product including planning. acquisition and support costs and any other costs directly attributable to owning or using the asset .

Overheads. Production Machine Maintenance & Depreciation Distribution. Advertising Cost. Design and Tooling Manufacturing Material. Training. Warranty Claims Operation End of Life Environmental Clean Up. Labour. Machine Setup.Phase Design Examples of Types of Cost Research and Development. Inventory. Disposal .

Four Principle Lessons to Learn • All the costs should be taken into account when working out the cost/unit and profitability • Attention to all costs will help reduce the cost/unit and will help an organization to achieve its target cost • Many costs are linked • Costs are committed and incurred at different times .

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The company seeks to make a mark-up of 40% product cost.000 units at Rs. 20.000 Manufacturing costs Rs. 2.00/unit.000 The company estimates that if it were to spend an additional Rs. Market research information suggests that the product should sell 10. It is estimated that the lifetime costs of the product will be as follows: 1. 50. 10/unit End of life costs Rs.000 on design. . 3.15.A Numerical Example of Target & Life Cycle Costing A company is planning a new product. manufacturing costs/ unit could be reduced.21. Design and development costs Rs.

What is the original lifecycle cost per unit and is the product worth making on that basis? 3. what is the maximum manufacturing cost per unit that could be tolerated if the company is to earn its required mark-up? .Required: 1. If the additional amount were spent on design. What is the target cost of the product? 2.

000 + (10.Solution The target cost of the product can be calculated as follows: Cost + 100% Rs. so the product is not worth making.000 = Rs.000 x Rs. 15 Mark-up = 40% Rs. .21 The original life cycle cost per unit = (Rs. 17 This cost/unit is above the target cost per unit. 20.6 Selling Price 140% Rs.000)/10. 10) + Rs. 50.

Maximum total cost per unit = Rs.50) = Rs.50 Therefore. Some of this will be caused by the design and end of life costs: (Rs. 50. 15.000 = Rs.8. 20. 15.000 + Rs. 15 – Rs.6.000)/10.000 + Rs. the maximum manufacturing cost per unit would have to fall from Rs.50 .8.10 to (Rs.

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