Airline Finance - Chapter - 8 PDF

STRATEGIC COST
MANAGEMENT IN THE
AIRLINE INDUSTRY
By: Anton van der Merwe and Christopher Jackiw
Originally published as “Strategic Cost Management in the Airline Industry” from the
Handbook of Airline Finance, McGraw-Hill Companies, Inc., 1999.
Strategic Cost Management in a Complex Service Industry 1
The Utopian vision of strategic management is a strategy that is pursued by everyone

throughout the enterprise and successfully executed, with management at all levels
leading and acting in unison. This vision is more easily attainable when the enterprise is
able to standardize and integrate business processes and has the capability to use the same
data, in concert, from the highest level to the minutest level of detail in the organization.
Until recently, this level of process and data integration was not possible. But real-time
integrated systems now make this level of integration a reality, so achieving the Utopian
vision a real possibility. It is important for an enterprise to achieve this vision since it is
only through repeatedly being successful in executing strategy that the enterprise can
ultimately maximize shareholder wealth. The strategic cost management system (SCMS)
can play a key role in maximizing shareholder wealth by providing relevant data for
supporting decision making and information for maximizing long-term profit, and by
accommodating essential business processes.
This chapter is essentially an argument for a management accounting system with

a strategic focus to assist the enterprise to maximize shareholder wealth. On the subject
of management accounting, it should be noted that management accounting is a discipline
in transition1. At this time innovative concepts abound. None of these concepts should
be ignored when one is covering this subject; their omission here is owing to a lack of
space and nothing more. Similarly, those concepts mentioned or introduced here should
also not be construed as deemed more important than others. The concepts explored in
this chapter were, however, considered more relevant in highlighting a practical approach
to aiding the accommodation and execution of a strategy using management accounting
principles on existing information technology (IT) and functionality.
What we will initially discuss in this chapter applies to any enterprise. The broad
principles are definitely generic, although the detailed examples are more specific to the
airline industry. This chapter is broken down into four sections. First we look at the two
basic requirements the enterprise needs to meet to be able to successfully execute
enterprise strategy: the efficient conversion of inputs to products and services and the
ability to effectively cope with a changing environment.
Next we highlight the importance of the management processes of planning,

controlling, and taking corrective actions to be effective in executing enterprise strategy.
Accommodating these management processes and providing relevant information for
making decisions about appropriate corrective actions lead into the next section of the
chapter.
In the next section we use detailed airline examples to illustrate the mechanics of
calculating and allocating costs, and we look at the underlying philosophies that should
constitute the foundation of the SCMS.
The chapter concludes with a limited representation of a possible Enterprise

Resource Planning (ERP) cost model for an airline, as well as practical illustrations of
how to use of the information provided by the proposed strategic cost model to make
decisions.
The Two Basic Elements Required to Successfully Execute

Enterprise Strategy
Two elements are essential for the successful execution of strategy. The first is an
enterprise’s ability to mine the market for and invest in the right resources and to
effectively convert these resources input into sellable output. This process must be
optimized. The efficient and effective execution of the desired value chain configuration
will be referred to as optimized execution.
Second, an enterprise must react appropriately and in a timely manner to changes

in both the internal and the external environment and also strive to be proactive in
preempting change. The organization’s ability to appropriately evaluate, respond to,
adapt to, or preempt change within the shortest possible time will be referred to as
integrated organizational response.
Optimized Execution
As we have said, the conversion process consists of changing input resources into
products and services for use by the consumer. Optimizing the conversion process entails
analyzing and evaluating the entire conversion effort within the parameters of
organizational strategy. An analysis for the “entire conversion effort” must consist of
studying the internal and external components of conversion, from the resource market
and suppliers to the consumers of the finished goods or services provided.
The value chain is traditionally thought of as the group of processes/activities

within the enterprise. At first glance optimized execution might sound like Porter’s Value
Chain2, and in an ideal environment perhaps the value chain does extend beyond the
organization’s four walls, into the resource market, and to suppliers and consumers. This
expanded value chain concept has been suggested in the consumer products industry for
years. But to expand the value chain to this degree the enterprise has to share
information internally as well as with its suppliers and its consumers.
Evaluating the Macro and Micro Conversion Process
In Figure 8-1 one can see that according to the traditional definition, the conversion
process is contained within the enterprise walls. To achieve optimized execution, the
enterprise must extend its view of the conversion process beyond the traditional
enterprise, or “micro” view, to the “macro” view of conversion. The “macro” view,
shown in Figure 8-1, takes into account the suppliers/resources, the products and services
provided, and the customers and markets served.
The micro view is shown in more detail in Figure 8-2. The diagrams also
highlight that clear inputs and outputs exist for each of the views. For each input and
output, in turn, there are specific optimization requirements in which the SCMS has an
important role to play. Once an enterprise delves into each of these four areas, the
particular optimization requirements and solutions will be revealed.
In order to evaluate and present the opportunities of the SCMS, we will break
down each analytical area, either macro or micro, into input and output components of
analysis. For each of these resulting four components we will look at the optimization
requirements and highlight the demands of the SCMS.
Su p
p li e
rs Enterprise
Micro View
Activity
Target
Products/ Market/
Resources Resource
Product/
Service Market
Activity
Services
Segment
Customers
r s
tu re
u fa c
M an
Purchasing,Conversion,
Input Support, Distribution, Output
Marketing, Sales & Service
Figure 8-1 The Enterprise Conversion Process – The Macro View.
Macro Conversion Optimization Optimizing the macro component of the

conversion process requires the ability to evaluate the environment in terms of resources
and resource alternatives as well as markets and market variations. As stated earlier, both
input and output perspectives need to be evaluated; further, for each component of the
analysis we need to determine efficiency (“doing activities right”) and effectiveness
(“doing the right activities”).
Input Output Input Output
Resource Product
Customer
Secondary
Resource Activity
Market
Segment
Primary Service
Activity
Resource
Primary
Customer
Resource Activity
Tier 1 Tier 2
Figure 8-2 The Micro View of Conversion.
Macro Input In terms of macro-input efficiency, the enterprise must have the ability to
source the market and identify new technologies, techniques, resources, and methods that
will enhance the enterprise’s conversion process. The enterprise must be a “first finder”
and act quickly to bring these innovations to light, for evaluation by the enterprise, and
commercialize them ahead of its competitors. A similar set of activities/processes to find
new and existing suppliers and manufacturers to provide new raw materials and finished
components must also be in place.
This evaluation of overall resource efficiency, in relation to the new options

available, should occur on a continuous basis. The SCMS must facilitate this
optimization analysis by supplying information on fully burdened resource costs for all
individual resources/resource pools. Fully burdened resource costs reflect a particular
resource pool and include the costs normally associated with the resources plus all costs
for internal services that are needed to support the resources in providing their output.
Detailed examples will be given later in the chapter. Included in this function is the
determination of the fixed and proportional costs (that is, the nature of costs) of resources
required to support capital replacement and resource outsourcing decisions. The SCMS
must also provide insight into the internally consumed resources and costs of all macro-
input activities/processes performed in determining the optimum solution from the
resource market (that is, prospecting the resource market).
When evaluating macro-input effectiveness, the focus is on the ability of the

enterprise to choose the right technology and input alternatives to maximize the
organization’s limited investment resources. The input goal is for the enterprise to invest
in resource alternatives that will provide for the lowest possible overall input costs
without sacrificing output quality.
To support optimization in the area of macro-input effectiveness, the SCMS must

provide for the evaluation of all business processes/activities, to enable the measurement
of process relevance. It must also provide the ability to optimize for the lowest possible
overall input cost (that is, to provide life cycle cost information, including costs for
research, evaluation, and acquisition and fully burdened operating costs of an
asset/resource).
Macro Output Macro-output decisions involve the outbound products and the markets
for those products and services. The macro-output efficiency component of the output
analysis refers to the enterprise’s ability to mine the market on a continuous basis,
exposing new markets for existing products as well as discovering the demand for new
and improved products. The goal is for the enterprise to be able to take advantage of
market and product opportunities ahead of its competitors.
The SCMS must provide vital information, on a per unit and cumulative basis, on
product revenues, cost and profit as well as on related down stream activities/business
processes so that management will be able to evaluate the profit potential for these new
opportunities. The SCMS must also provide for the valuation of all macro-output
business processes/activities, based on resources consumed, to ensure that the enterprise
can measure costs and can optimize for the lowest possible overall output cost.
In terms of macro-output effectiveness, the enterprise must be able to be effective

in applying and maintaining the appropriate product/service, and product/service mix in
the right target markets and market segments.
The SCMS must provide information, on a per unit and cumulative basis, for
product revenues, cost, and profit, and the system should present these in multi-
dimensional views that reflect the enterprise’s market segmentation. Each of these views
should accurately reflect full and proportional product costs as well as gross margins and
contribution margins. This information will aid in maximizing profitability and in
supporting specific strategies, for example, market penetration or product discontinuance.
Micro Conversion Optimization The study of the micro view of the enterprise
conversion process takes on a similar but more specific and focused analysis. Whereas
the macro view looks at the interaction of the enterprise with its external environment,
the micro view focuses within the enterprise. This analysis focuses on resources, the
outputs they provide into activities, and the resources and activities consumed by
products and services (both internal and external). Figure 8-2 depicts the two logical tiers
of inputs and outputs of the micro conversion process. When we look at internal
resources we see a variety of consumption patterns. For example, resource-to-resource
consumption, activity-to-resource consumption, and resource-to-product consumption.
The role of the SCMS is segmented along lines similar to the breakdown of the macro
view.
The micro view of conversion optimization, although similar in many ways to the
macro optimization scheme, contains many more permutations. The view can be limited
to a specific process/activity, or it can be broadened to include a group of processes

representing a chain of events. As a result of the varying levels of detail, many
components of analysis have to be considered. Optimization entails evaluating internal
resources, secondary activities, and primary activities.
Micro Input Micro-input efficiencies can take on many forms. Input in the micro view
may be internal resource pools (tier 1) or activities either direct or indirect (tier 2). For
either input, the analysis is similar to that used in the macro environment. Is the
organization harvesting knowledge internally and ensuring the internal processes are
being performed in an optimal manner?
The organization’s internal resources are limited. Is the enterprise making the
most with these limited resources? In the tier 1, to address this question, the analysis may
be as simple as evaluating each resource pool and weighting the total inputs into the
resource pool against the output that the enterprise gains from the resource pool. The
SCMS must supply information on fully burdened resource output rates for evaluation of
overall resource efficiency. In the tier 2, the answer to the question lies in the quantity of
inputs (activities and or resources) required to produce products and services.
In evaluating Micro-input effectiveness the enterprise analyzes the value chain

configuration for its relevance when measured against strategy and the ongoing process
of adapting to changes in the internal and external environments. In other words,
management asks, Are the resources doing the right things? Does the internal
organization need and value the things that are being done? In this regard the SCMS
must assign a value to resources, activities, and supply product input details and costs.
To make the evaluation possible, the SCMS must accommodate all the activities and their
costs, making the business process transparent, for the purposes of improving processes,
evaluating the relevance of processes, and potentially eliminating unnecessary or
irrelevant processes.
Micro Output To optimize micro output, management looks to evaluate how well the
internal processes are being completed from the internal consumer’s perspective. The
internal consumer may be other activities or the end product or service. Micro-output
efficiency analysis addresses the specific activities executed by a resource pool, whether
those activities involve support, producing a product/service, distribution, marketing, or
serving the customer.
In the micro-output area the SCMS must supply information on resource output,
for example, resource utilization, resource capacity management information, and the
cost of excess idle capacity. Specific output units must be provided so that efficiency can
be measured, whether the output units were consumed to execute supporting activities or
to produce products and services. In this regard standard product costs are an important
measure of efficiency.
In evaluating micro-output effectiveness the enterprise looks at its ability to

produce the right products and services according to the strategic plan; therefore the
SCMS must supply product cost and quantity information. Additionally, the system
should enable the enterprise to evaluate “how” products and services are created,
produced, and delivered to the right markets at the right time (that is, are the outputs from
the micro conversion process the right outputs?). Relevant information in this instance
would be, for example, profitability by each class of passenger, segment, flight, route,
and geographical area. Effectiveness can also be measured by inventory turnover, excess
inventory, or excess/idle product capacity, and so forth.
Before concluding this section on optimized execution and its demands on the
SCMS, we must consider the different levels of management, taking into consideration
the various hierarchical levels of the value chain. Undoubtedly, information at the micro
level is necessary so that the enterprise can optimize operations. At the same time there
is also the need for more strategically oriented, aggregated information for top
management, as pointed out by Porter3, in his discussion of the overall value chain and its
ten major cost drivers. Therefore, the SCMS should be required to provide for alternative
activity/business process cost views. These alternative cost roll-ups can address dual
information requirements. On the one hand, activity-based costing (ABC) standards at
the micro level facilitate the detailed analysis of the micro and macro conversion views of
the enterprise. On the other hand, an aggregated value chain view of costs with multiple
drivers per process enables high-level strategic analysis of the value chain based on, for
example, economies of scale, location, interdependencies, and so forth.
In summary, through pursuing optimized execution an organization can be

effective and efficient in both its internal execution and its interaction with the business
environment based on a given strategy. An enterprise’s vision and strategy demand both
an internal optimization for given a configuration of the value chain as well as an external
optimization to extend the value chain concept to suppliers and consumers. In this sense
the traditional value chain shows its limitations in that it is essentially focused inward on
execution.4 The extended value chain, or the combination of the macro and micro views,
is necessary for true optimization.
Integrated Organizational Response
The second element required for an enterprise to be successful in implementing strategy

is the ability to react to but more importantly to preempt change in a timely and relevant
manner. The groundwork for such a forward-looking, proactive enterprise is laid
primarily by undertaking an integrated organizational planning process, that is, a process
consisting of integrating strategic, tactical and operational planning. The organization
must also have relevant and timely control, to highlight deviations from the plan so that
appropriate corrective actions will be triggered. Although engaging in the management
processes of planning, controlling and taking corrective action is key to achieving a
proactive organization, this is not the only work that needs to be done. Scrutinizing
managerial and organizational behavior is another important element.
The successful execution of strategy is not achieved in one step; it is a process.

The enterprise in itself is dynamic and subject to change just as the business environment
is. Management must therefore continuously communicate the enterprise’s vision, lead
in line with it, motivate workers, monitor operations and costs, and take the necessary
corrective action to ensure achievement of organizational objectives and strategy.
Everybody in the enterprise must have the same overall goals. There needs to be
alignment in terms of personal, departmental and corporate goals. Managers, as the

leaders in the enterprise, play a crucial role in this regard. Through their leadership,
managers, individually and collectively, shape and signal acceptable behavior.
A mechanism commonly used to shift focus and change behavior is Key

Performance Indicators (KPIs). A comprehensive, interrelated hierarchy of KPIs must be
developed to embody strategy, supply appropriate measures of performance throughout
the organization, and successfully motivate people through rewarding the right behavior.
Organizational Strategy
KPI s
Organizational
Planning and
Control
s KP
I Is
KP
Performance Reward
Measurement System
Figure 8-3 The Building Blocks of Integrated Organizational Response.
The KPIs must fulfill the following criteria if they are to help managers work together to
achieve goals within the enterprise:
 The establishment of KPIs must emphasize the principles of the downward-cascading

organizational planning model, that is, first strategic planning, then tactical planning,
and then operational planning.
 Key Performance Indicators must be specific to every individual managerial position.
 The KPIs must be controllable measures that individual managers accept and can be
held accountable for.
 The measurement of performance according to KPIs must be the primary driver of the
reward system of the enterprise.
Singleness of purpose and the congruence of goals therefore require the integration of the
enterprise strategy, the performance measurement system, the reward system and the
organizational planning and control processes.
The management processes of planning, controlling, and taking corrective actions

will be covered in the next section. With regard to integrated organizational response, the
management processes of planning and control are the key integrators of enterprise
strategy, performance measurement, and the reward system, as is illustrated in Figure 8-3.
The management planning and control process is also where standards are set that will
determine the enterprise’s response to changes in the business environment.
In summary, optimized execution of the value chain takes a broader view of

conversion and divides it into a micro and macro view. The aim is to optimize both of
these views, and in the process to place specific demands on the SCMS to supply
information that will make achieving optimized execution possible. Integrated
organizational response has as its vision the integration of various organizational and
management elements in an attempt to ensure an appropriate and timely response to
changes in the business environment. Management processes play a key role in both of
these elements. For optimized execution the standards define acceptable and
unacceptable deviations from company operating policy. For integrated organizational
response the management processes are the primary means for internalizing the
integration of strategy, performance measurement, and the reward system in the

organization.
Management Processes in the Strategic Cost Management System
It is interesting to note that in the earlier part of this century great strides were made in
the automation of manufacturing. The ERP system has similarly ushered in, although
much more quietly, the automation of business processes throughout the organization,
particularly in the back offices. But there seems to be a distinct shortcoming in
businesses’ failing to recognizing the need for explicit and integrated accommodation of
management processes. Before we look at management processes and their ideal place in
the strategic cost management system, it would serve us well to consider current practice
in two closely related subjects: the general state of current cost systems and the planning
and control roles managers currently fulfill in organizations. We will also consider the
consequences of these practices.
In practice one finds that organizational planning/budgeting systems are often

modified general ledgers that poorly accommodate planning, never mind that they do not
in g
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on tr lann in
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Top
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Management
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M an St rat e
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St
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Co P
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Middle
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Management
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Op
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al
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Operational
rat
Management
e
Op
Empirical Management Simplified Organizational Structure Normative Management

Structure
Figure 8-4 The Types of Management Structures.

reflect the full spectrum of management processes. Costing systems are often separate
from planning systems (ABC systems of the last decade are a good example); they are
stand-alone and in effect, actual cost systems only. Integrated activity-based budgeting
(ABB) systems are also not a reality yet5. The result is that the execution of management
processes is not optimized. Worse still, the relevance of data for making decisions is low
and data are dispersed, making it difficult for information to trigger the right actions.
Second, as far as managerial roles are concerned, one finds in practice that the
different levels of management devote varying amounts of time to planning and control
activities (see the left side of Figure 8-4).6 As can be seen in Figure 8-4, under the
empirical management structure, a disproportionate amount of time is spent on
operational issues and activities. As a result the organization is too internally focused
and is largely reactive to changes in the external environment.
On the other hand, under the normative management structure (pictured on the
right side of the diagram) there is an ideal division of time for each level of management
along three tiers of planning and control: strategic, management/tactical, and operational.
Within this normative management structure, top management is involved in operational
planning and control only in exceptional cases, as represented by the shaded triangle on
the right-hand side of Figure 8-4. The normative management structure also strives to
entrench a forward-looking, proactive enterprise whose managers can address change at
the earliest possible opportunity to ensure the successful execution of company strategy.
An organizational planning and control model based on normative management

principles will therefore encourage strategic, tactical, and operational planning and
control at the right levels in the enterprise and with the desired focus. Such a model will
also contain mechanisms for management to preempt change and actively seek to
influence the business environment, bridge performance gaps, and keep the organization
focused on achieving strategy.
Figure 8-5 represents an example of what such an organizational planning and

control model would look like (adapted from Schutte). 7 Following are the features of this
planning and control model:
Summarized
Strategic Plan Strategic Corporate
Bridge of
- Critical Gap Strategic
Performance
Assumptions Action
Statement
Plans Corporate
- Strategic
Level
Guidelines
- Targets Corporate
Gap Financial Plan
Analysis
Review
Unit
Assumptions
Unit
Mechanistic Action Plans Bridge of Financial Business
Forecast Performance Plan Unit/
Statement Department
Analytical Level
Forecast
Review
Functional/
SWOT Division
Action Plans Level
Analysis
Figure 8-5 An Example of the Organizational Planning and Control Model.
 Management processes are not viewed as distinct steps---planning, controlling, and

taking corrective action---but rather as one continuous, dynamic process of re-
planning, controlling, and taking corrective action.
 Managers are not only challenged to be proactive and outward looking; they are
expected to make the intellectual tasks of planning and making action plans or taking
corrective actions as their primary entrepreneurial outputs, providing innovative and
new ways for the enterprise to respond to changes.
 The Bridges of Performance Statement for action plans and corrective actions is
introduced at each level in the organization. A Bridge of Performance Statement
contains the monetary expression of each manager’s entrepreneurial action plans and
corrective actions. The monetary expression of these plans and actions consists of
quantified statements of what the dollar impact will be of each plan or action to
bridge the performance gap that is being addressed. The summary Bridge of
Performance Statement reflects all the action plans and corrective actions that will be
taken by the various levels of the organization, to ensure that the strategy is achieved.
The traditional management process of static planning, controlling (explaining

variances), and taking corrective actions (trying to make do with less or to scrounge
money somewhere else) is now replaced by a more dynamic process. Through a
continuous process of dynamic re-planning, controlling and taking corrective actions in
all three tiers of management, the organization fosters an external focus and a proactive
culture. The Bridges of Performance Statement is pivotal, because it is a quantified plan
with assigned responsibilities and time lines. It drives a proactive organizational attitude
and the entrepreneurial actions necessary to close gaps, work toward the realignment of
the organization, and achieve the organization’s strategy.
What are the implications of the normative management structure for the SCMS? To
answer this question we have to consider management planning and control in more
detail.
Planning
When we introduced KPIs, we argued for a very strong link between KPIs and
organizational planning and control. In this section, we are discussing the planning
component in more detail, but with a stronger focus of converting the strategic plan into a
monetary plan. It should be noted that we are not arguing for overtly quantitative KPIs.
Key Performance Indicators should be a sound balance of both qualitative and
quantitative measures that fully represent the enterprise strategy.
We focus on the monetary expression of the strategic plan here for the following
reasons:
 The monetary planning or re-planning process is still the primary intellectual event in
an enterprise and should be exploited as such.
 Management accounting is about computing cost and profit and should thus
accommodate the planning for these areas.
 If the SCMS is to accommodate the management processes of planning and control,

the organization’s monetary strategic plan provides an excellent basis for
accomplishing this.
 There is a need to periodically revisit and set standards periodically to keep the cost
model and measures for performance up to date.
Second, although we recognize the need for different planning horizons for different
purposes, for example, five-year strategic plans and day-to-day operational planning, the
focus here will be on planning that will reflect strategy for an appropriate time horizon.
In line with the recognition that the management processes are a continuum, an
appropriate time horizon should also be a moving window, which can be shorter or
longer than the traditional fiscal year. An appropriate time horizon must be established
after managers consider factors such as structural changes taking place in the industry,
economic trends, the competitive environment, and so forth. The primary aim of medium
term planning, the focus here, is to enable control and an integrated organizational
response to change. The longer-term strategic plan should serve as the more static
measure of how the enterprise is progressing along the path to achieving its strategy.
Within the framework just defined, monetary planning or re-planning is no longer just
a process whereby some dollar amount is agreed to for the planning period; rather it
becomes the first proactive step in focusing the enterprise on the road ahead. Therefore,
every plan will include entrepreneurial action plans and corrective actions that are
quantified and valuated in Bridges of Performance Statement, with explicit
responsibilities and time lines assigned to manage their accomplishment.
The organizational planning process is depicted in Figure 8-6. This is the process
whereby the vision, mission, and purpose objectives are converted into an investment in
resources with the desired quantity, quality, technology, skill, and training. Much is
being made of this cascading planning process in literature today, in particular the need
for ABB. However this is a question of method that we will return to later in the chapter.
Vision, Mission and

Purpose Objectives
Top
Management Resource Focus
Middle Resource Acquisition

Management Resource Application
Operations Resource Utilization

Management
Capacity
Location Skill Scale
Initial Inherent Cost Characteristics
Figure 8-6 The Organizational Planning Process.
Here we want to highlight the output from the organizational planning process, that is, the
establishment of the invested resource base, which has the following implications for
management accounting:
 First, once this process has taken place, a number of the macro cost drivers of the
value chain will be determined, for example, economies of scale and location.
 The initial inherent nature of cost, which the enterprise will have to deal with in
executing the desired value chain, is locked down. The initial inherent nature of cost
for the individual resources/resource pools are defined as the fixed and proportional
characteristics of the costs given the capacity, skill, technology, and so forth that are
invested in.
 Initial capacity will be determined.
Finally, recognizing that change is inevitable, the futility of establishing a stagnant

dollar budget, for the purposes of effective control, becomes readily apparent. There is,
therefore, a need for the SCMS to convert planned activities and planned outputs into the
appropriate monetary values. The ability to adjust the monetary valuation for different
planning scenarios to determine likely outcomes, and to determine the deviation of actual
outcomes, should also be supported. Thus the SCMS must have a cost model based on
quantity structures where value follows quantity, and it must have quantity standards
reflecting causal relationships.
As regards quantity structures and quantity standards, it is important to note that the
resource drivers typically used in ABC will not suffice; for example, Full-Time
Equivalents (FTEs; that is, full-time productive people) will not suffice. Using FTEs as
resource drivers is a method of dividing a pool of dollars into portions; it is not a
quantity-based driver. Using a quantity structure to allocate the planned costs for a
passenger-handling department to its activities will be done using standard staff hours per
activity. Costs will be charged to the passenger-handling activity on a per hour basis, and
planned capacity information will be available for the passenger handling department.
More detailed examples of the quantity structure approach will be given in the section
where we deal with the basic building blocks of the SCMS.
Control
Within the normative management approach, control no longer involves measuring

performance against a static budget. Instead, if the control process is to sensibly support
performance measurement, the cost model must be able to adjust to the fluctuations of the
business environment. This means that the SCMS must be able to calculate authorized
expenses and profits, taking into account fluctuations in all relevant factors, for example,
product/service volume, mix, actual activity levels, increased complexity, and so forth.
Authorized reporting, therefore, is the practice whereby a particular budget associated
with a particular level of activity/output is adjusted up or down based on the fluctuation

(up or down, respectively) of the actual level of activity/output. Authorized expense then
is a new plan/budget calculated as relevant for the actual level of activity/output.
For example, consider the individual meal preparation time for two classes of
passengers. Product A, a business-class meal, requires 30 minutes of preparation time.
Product B, a coach meal, requires 12 minutes of preparation time. If the planned product
mix was 100 Product A and 800 Product B for the month, total planned meal preparation
time would be 12,600 minutes. But if the actual product mix is 120 of Product A and 770
of Product B, a reduction in total volume (from 900 to 890), the meal preparation expense
will increase to a dollar amount representative of 12,840 meal preparation minutes.
Assuming that one minute costs $1 and that all costs are proportional, a static budget
would compare actual meal preparation expenses with the $12,600 initially calculated.
But the authorized expense that would be calculated for the actual level of activity
incurred would be $12,840, a more relevant measure, since meal preparation actually
increased even though total meals produced decreased.
To facilitate this quantity-based approach and the calculation of authorized

expense, ERP systems with their real-time and integrated capabilities are ideally suited.
Tight integration means that operational system quantities are readily available to the
SCMS. Flight hours, cycles, the number of passengers per class, and other cost driver
data and consumption data are potentially available to support the calculation of
authorized expenses. Real-time operation of ERP systems ensures that standard costs and
profits are available immediately and authorized expenses can be calculated as soon as
the operational quantities are posted.
Also authorized reporting, as opposed to static budget, more accurately reflects the
current course of the enterprise. In this regard, it is important to note that because of the
various factors mentioned above, for example, changes in passenger mix and producing
more complex products and fewer simple products, different tiers of cost drivers in the
SCMS will react differently to these changes. For example, if sector lengths decrease and
there is no change in total flight hours, not only will direct maintenance costs increase
owing to an increase in cycles, but so will maintenance planning costs. Consider Figure
8-7, which shows five potential levels of fluctuations that might occur in an airline SCMS
under two scenarios. With causal relationships identified between the quantity-based
drivers, and costs at the different levels compounded with variance analysis, the course of
the enterprise can be influenced. Note that the scenarios pictured in the diagram are
obvious simplifications and that multiple layers with their own drivers actually exist.
Authorized reporting, because it utilizes the quantity-based drivers behind these cost
Figure G: Levels of Potential Fluctuations for an Airline

Scenario 1 Scenario 2
Flight profitability is down - Flight Profitability Area: Flight profitability is up owing

owing to competitive Flight AZ999 + to better yield management
pressure, for example, fewer
passengers
+ Flight Cost Area:

Flight costs are lower
owing to lower Flight AZ999 - Flight cost is Higher
owing to higher fuel
maintenance costs costs
The aircraft type cost is lower,

Aircraft type cost higher owing
owing to a utilization pattern Aircraft Type Cost Area:
change: longer average sectors + - to utilization pattern change:
and total flight hours are
Aircraft Type A7X7 shorter average sectors and total
flight hours decrease
unchanged
The hangar maintenance Hangar Maintenance The hangar maintenance

expense is higher owing - + expense is lower owing to
to bad troubleshooting
Cost Area: Hangar 2 less frequent larger checks
Less maintenance planning Maintenance Overhead Cost Maintenance planning costs

activity is required owing to a + Area: Planning Group A7X7 + are lower owing to fewer
utilization pattern change checks being performed
Figure 8-7 Levels of Potential Fluctuation for an Airline.
movements, will calculate the expected costs at each level and provide valid performance
measurement yardsticks at all levels.
The scenarios depicted in Figure 8-7 not only highlight the need to establish the
causal relationships between the quantity-based drivers and costs at the different levels;
they also show the need for variance analysis. Through variance analysis it will be
possible to identify controllable and uncontrollable variances and determine which areas
within the organization are responsible for the variances. For example, the variance in
fuel price might not be the responsibility of route management, but bad trouble shooting
should be the responsibility of maintenance. In line with the classification of the input
and output areas we have already discussed, variances must be separated into input-side
and output-side variances. More specifically, price, quantity, resource usage, volume, lot
size, mix, and remaining variance categories must be supported.
It should be noted at this time that there are other factors that will influence the
effectiveness of the control process, for example, the handling of major maintenance
expenses. These factors will be addressed later when we discuss the potential
enhancement of the decision relevance of information for making decisions.
Taking Corrective Action
In the management planning and control process, standards need to be established for the
appropriate managers to respond to changes in the business environment, that is, to take
corrective action when necessary. Strategic cost management system design plays an
Vision, Mission, and

Purpose Objectives Decisions
Top Resource Focus Shifts

Management
Excess Idle Capacity

Middle Resource Outsourcing
Management Resource Realignment
Resource Redeployment
Operations Resource Optimization

Management Resource Short-term Application
Skill
Figure 8-8 Levels of Management and Decision Making in an Organization

important role in decision support for managers; it ensures that information will be
available on an ongoing basis and that it will be tailored to meet individual managers’
needs. In this regard we will briefly consider managerial roles and the continuous nature
of the management process as they apply to taking corrective action.
As we saw in the section on organizational planning, the three tiers of

management have different responsibilities in converting the enterprise vision, mission,
and purpose objectives into a resource base that can execute strategy. Naturally when it
comes to taking corrective actions, responsibilities should align with the managers and
their planning outputs. Figure 8-8 gives examples of typical decisions/corrective actions
and the levels of management responsible for each of these decisions.
As one can see, information needs for different levels of management could be in
conflict. For example, in making an outsourcing decision, middle management may need
to consider fewer costs as being fixed, although more costs should be considered as being
fixed in normal operations by operational managers. Therefore the SCMS should address
these varying demands by supplying the necessary information.
The second aspect to consider is the continuous nature of the management

processes of dynamic re-planning, controlling and taking corrective action, as depicted in
Figure 8-9. Decision making as the primary intellectual task throughout this process is
also the primary entrepreneurial output and the focal point of management. Since
information is the primary input into decision-making, it is imperative that the SCMS
provide information that is relevant for decision-making purposes, in addition to fulfilling
the requirements already identified.
The relevance of the information supplied for decision-making purposes can be

characterized as follows:
 The information reflects a timing dimension of costs and profits relevant to the
decision at hand.
 The information is supplied in views that align with organizational responsibility, and
it is relevant for measuring performance and taking corrective actions.
 Costs between internal suppliers and consumers are charged based on causal
relationships.
 The initial inherent nature of cost is accurately reflected.
 The changing nature of cost based on consumption is accurately accounted for. By

this we mean, in cases where services consumed are not proportional to the
consumers’ own output level, all costs for such services must become a fixed cost.
Detailed examples of this principle will be given in the next section.
 Casual relationships are expressed in a flexible quantity structure to accommodate

authorized reporting, relevant variance calculation, and the appropriate corrective
actions.
Strategy
Figure 8-9 The Continuum of Management Processes.

The capability of the proposed cost model to provide relevant information for decision
making will be explored in the last section through decision scenarios.
The Basic Building Blocks of the SCM Model
We have identified the need to optimize execution, the need to preempt and adjust to
change, the centrality of the management processes, and the inevitable decisions that
must follow to keep the enterprise on track. Two basic building blocks constitute the
foundation of the SCMS and satisfy these needs: the mechanics used to do the
calculations and cost charges, for example, ABC or a more traditional full-absorption
approach, such as direct conversion cost plus a percentage for overheads. Second, the
philosophical approaches adopted to enhance the relevance of information, for example,
the timing of expense, the normalization of expense, or the incorporation of industry-
specific characteristics in the strategic cost model.
In this section we will first propose the mechanics for satisfying the demands on
the information to be supplied by the SCMS, and then we will look at the philosophical
approaches available to enhance, in particular, the relevance of information for making
decisions. The development of the strategic cost model will be based on the storyboard
shown in Figure 8-10, which is a limited representation of an airline with the
departments, products, and consumption flows of services indicated by the arrows.
The Mechanics for a Strategic Cost Management System
The resources of the enterprise are the basis of the SCMS mechanics. There are many
reasons why resources are important, for example, for purposes of departmental learning
and optimization and resource specialization. Resources are also paramount in planning,
in that resources and their costs are the outputs from the strategic enterprise planning
process, as we have already indicated. Resources are the basic building blocks of the
value chain, as we saw in the section on micro efficiency, and therefore they are key
elements in execution optimization, as well as in changing and adapting the organization
to meet its strategy. For these reasons, resources will be the foundation for the proposed
strategic cost model.
We have already pointed to the need for an entirely quantity-based cost model and
the need for resource costs to be fully burdened, in both their fixed and their proportional
components, these being some of the requirements to be fulfilled by the SCMS.
In explaining the details of the SCMS mechanics and highlighting how these
requirements are met, we will build the cost model from the ground up, starting with such
Flight
Profitability
- Jet Fuel
- Landing and Parking Flight: ZZ999
- Business Class Aircraft Types:
- Coach Class - A7X7
- A7Y7
Cabin Crew
Catering
Hangar
Maintenance
Apron
Handling
Purchasing
Human
Resources
Figure 8-10 A Limited Storyboard.
basic concepts as the origin of the quantity structure, the initial inherent nature of costs,
fully burdened resource costs, and the changing nature of cost on consumption. Having
laid the foundation, we will expand the cost model into a model consisting of a standard
cost system, capacity management, and ABB.
The Origin of the Quantity Structure and the Initial Inherent Nature of Costs
Resource Consumption Accounting (RCA) is an approach to the calculation and

assignment of resource costs based entirely on a quantity structure and direct causal
relationships. This approach results in fully burdened resource costs and specific
treatment of the nature of costs.
The quantity structure approach starts with the quantity of resource output. For
each resource pool, this output is used to calculate the resource output rate. As we
indicated in discussing micro input, the resource output rate is an important parameter in
determining the initial efficiency of converting inputs into outputs for each
resource/resource pool. The resource output quantity and output rate together are the
mechanism whereby costs are charged to the consumers of resources.
Resource Consumption Accounting also recognizes that the resource pool is the
primary determinant of the initial inherent nature of costs. That is to say, once the airline
has decided to invest in a specific mix of resources involving a specified level of skill and
technology, the nature of the costs required to achieve the strategy is fairly well locked
down. Take, for example, the option of using a highly automated cargo-handling system
as opposed to a labor-intensive cargo-handling department.
Given these two basic principles, the annual plan for the Purchasing Department
in the storyboard could be as reflected in Table 8-1. The expenses shown in this example
are only those expense accounts for which the department is directly responsible. We will
classify these as primary expenses. Primary expenses are then further broken down and
classified into their fixed and proportional components. The resource output rate for the
inputs is also shown in the table.
Table 8-1 The Initial Inherent Nature of Costs and Resource Output
Purchasing Department Planned Resource Output: 8,000 Purchasing Man-Hours
Primary Expenses Fixed Proportional Total
Supervisory Salary $ 60,000 - $ 60,000
Purchasing Clerk Salaries - $ 152,000 $ 152,000
Office Supplies - $ 8,000 $ 8,000
Depreciation – Furniture $ 20,000 - $ 20,000
$ 80,000 $ 160,000 $ 240,000
Resource Unit Output Rate $10 $ 20 $ 30
It is important to recognize that this approach will result in the determination of

very specific rates for each individual resource pool. This means that purchasing
departments in different locations will have not only different rates but also different
ratios of fixed and proportional costs. For example, because of relatively high social
costs in Europe, not only will purchasing in Europe be more expensive, but its fixed cost
component will be higher than, for example, the same type of purchasing function in
Asia.
RCA and ABC The quantity structure approach also serves as a perfect compliment to
ABC. Consider Table 8-2, which is an example of the airline’s Catering Department,
showing the planned primary costs and the activities that Catering performs, namely,
“Prepare Business Class Meal” and “Prepare Coach Class Meal”. Note first of all how
the quantity structure is used to allocate costs from the Catering Department to its
activities. Note also how the inherent nature of the Catering Department’s costs is
transferred to its activities, since with each unit of resource output consumed, for a given
level of invested capacity, a fixed and a proportional component of cost is incurred on
every activity. More specifically, the number of Catering hours (0.5 hours), needed to
prepare a business-class meal (Activity 1) is multiplied by the resource output fixed rate
($ 12.00 per hour) to arrive at the fixed cost for the activity: $ 6.00. The resource output
proportional rate ($ 19.00 per hour) is also multiplied by the consumption quantity (0.5
hours), resulting in the $ 9.50 of proportional costs assigned to the activity. Note that we
are assuming, at this stage, that quantities being consumed by the processes/activities are
not fixed; that is to say, if an activity is eliminated, all of the resource output hours
consumed will become available to perform other activities. This assumption is an
obvious simplification and will be revisited later when we consider the changing nature
of costs on consumption.
Table 8-2 Charging Costs, Using a Quantity Structure, Quantities Consumed,

and Rates
Catering Department Planned Resource Output: 12,000 Catering Man-Hours
Chefs’ Salaries - $ 228,000 $ 228,000
Fringe Benefits $ 60,000 - $ 60,000
Depreciation – Equipment $ 4,000 - $ 4,000
$ 144,000 $ 228,000 $ 372,000
Resource Unit Output Rate $ 12 $ 19 $ 31
Catering Activities
Process/Activity 1: Prepare Business-Class Meal Quantity: 1
Resource Output Quantity Required Activity Fixed Costs Activity Proportional Costs
0.5 catering man-hours $ 6.00 $ 9.50
Process/Activity 2: Prepare Coach Meal Quantity: 1
Resource Output Quantity Required Activity Fixed Costs Activity Proportional Costs
0.2 catering man-hours $ 2.40 $ 3.80

Fully Burdened Resource Costs A requirement for the SCMS is that it should
supply fully burdened resource costs, so that the enterprise can optimize in the area of
macro input. The SCMS should support outsourcing decisions, capital replacement
decisions, and the valuation of products and services with the fully burdened resource
cost information.
Figure 8-11, is a graphic representation of the step-down method - the dominant

method of cost allocation in today’s advanced cost management arena. This step-down
method of allocation generally does not recognize the fact that processes/activities should
Departments/ Cost Centers
$ $ $
Cost Flow
Process/ Process/ Process/

Activity Activity Activity
$ $ $ $
Cost Cost
Object Object
Figure 8-11 The Step-Down Allocation Method.
be allocated back to the resource pools, that is, the real consumers of support activities.
An appropriate example from the storyboard (see Figure 8-10) would be, for instance, if
the Purchasing Department had to purchase furniture or office supplies for the Human
Resources Department. Within the step-down logic, the cost of this purchase order is not
charged back to the Human Resources Department, but some allocation relationship is
derived to allocate the costs to products/services directly.
Table 8-3 Fully Burdened Resource Costs
Hangar Maintenance Planned Resource Output: 40,000 Hangar Maint.Hours
Supervisory Salary $100,000 - $ 100,000
Technicians’ Wages - $ 600,000 $ 600,000
Uniforms and Clothing $ 3,000 - $ 3,000
Depreciation Tools $ 10,000 - $ 10,000
Secondary Expenses Fixed Proportional Total
Human Resource (HR) Costs $3,000 $ 12,000 $ 15,000
Purchasing Costs $ 4,000 $ 28,000 $ 32,000
$ 120,000 $ 640,000 $ 760,000
Resource Unit Output Rate $3 $ 16 $ 19
Table 8-3 shows the fully burdened resource costs for a resource pool of aircraft
maintenance technicians. Note that the costs from the Human Resources Department and
the Purchasing Department, that is, the services that maintenance consumes, are charged
to this resource pool to obtain its fully burdened resource costs. These consumption-
based charges are classified as secondary costs. The method of cost allocation in
resource consumption accounting is therefore not a step-down method but rather an
iterative method of allocation, since all resource pools will reflect support and reciprocal
services as secondary consumptions.9 The secondary costs, for the moment, reflect the
fixed and proportional components of the resources supplying the services (the
calculation details are not shown in the table).
Resource Consumption Accounting and the Changing Nature of Costs
We demonstrated earlier how fixed costs are transferred from the supplying activity or
resource to the consumer (refer to the section on ABC and the secondary-cost examples).
An important factor in determining the type of cost that must be accommodated by the
SCMS is that the nature of costs can change upon consumption. The initial nature of
costs is determined by the characteristics of the invested resources, that is, the supplying
resource pool. But in cases where the service consumed is not related to the output of the
consuming resource or activity, the quantity of service consumed, and thus the costs for
that particular service, must be considered as fixed to the consumer.
An example, mentioned before, is that of the Purchasing Department buying

furniture for the Human Resources Department. Clearly, this expense does not relate to
the output of the Human Resources Department, in terms of human resources man-hours,
in the same way that the purchase of office supplies would, the latter being proportional
to the output generated by the Human Resources Department. Table 8-4 shows how the
nature of cost changes at consumption in the case of furniture purchased for the Human
Resources Department. First the costs, as incurred on the purchasing activity/process, are
shown, and then the costs, after consumption by the Human Resources Department, are
shown.
Using the Purchasing Department information from Table 8-1, five purchasing
man-hours are charged to the activity “Purchase Asset”. Note that the five hours
consumed by the activity is proportional, but that $50 of fixed cost (5 hours x $10
resource output fixed rate) and (5 x $ 20) results in the fixed and proportional costs for
the activity, respectively.
Table 8-4 The Changing Nature of Costs on Consumption
Purchasing Activity
Process/Activity 1: Purchase Asset Qty: 1
Fixed Resource Output Proportional Resource Activity Activity

Quantity Required Output Quantity Fixed Proportional
Required Costs Costs
5.0 purchasing man- $ 50 $ 100

-
hours
Human Resources Planned Resource Output: 10,000 Human Resource Hours
Proportional
Primary Expenses Fixed Cost Total Cost
Cost
Supervisory Salary - - $ 30,000 - $ 30,000
Human Resources Clerk

Salaries - - - $ 90,000 $ 90,000
Depreciation: Furniture - - $ 8,000 - $ 8,000
Fixed Prop. Proportional

Secondary Expenses Fixed Cost Total Cost
Qty. Qty. Cost
Purchase Orders: Assets 10 - $ 1,500 - $1,500
$ 39,500 $ 90,000 $ 129,500
Resource Unit Output Rate $ 3.95 $9 $ 12.95

The ten purchase orders, planned for equipment to be provided to the Human Resources
Department, are planned as a fixed quantity consumption, because the purchase orders
will be raised regardless of the level of output of the Human Resources Department.
Note that using the fixed-quantity consumption method results in all of the costs for
purchasing becoming fixed for the Human Resources Department and being included as
such in the human resources output rate. The purchasing cost for the Human Resources
Department is calculated as follows: 10 purchase orders (fixed) multiplied by the hours
per purchase order (5) multiplied by the resource output rate fixed ($10) for purchasing,
or 10 x 5 x 10 = $500. We add this result to the ten purchase orders (fixed) multiplied by
the hours per purchase order (5) multiplied by the resource output rate proportional ($20)
for purchasing, or 10 x 5 x 20 = 1,000. After adding the results of the previous equation
we get $1,500, the total fixed purchasing expenses. Thus we illustrate how value follows
quantity.
The Need for a Standard Costing System The enterprise must be able to
effectively plan and control its path to achieve its strategy. The SCMS must be based on
a standard cost approach. Standards should be quantity standards, and values should
follow quantities. The reasoning behind the standard cost approach for the SCMS was
given earlier in the chapter.
Another reason for the use of a standard costing approach is the need for
timeliness. Although real-time ERP systems strive to enhance the timely availability of
information, it is not practically possible. Quantities are fairly well available to the
SCMS at the time that they are posted in the logistics modules, but expenses cannot be
gathered with such consistency. Within the ERP system the monthly payroll run is still a
periodic processing event. Normal expenses are still received only after the service or
product has been consumed; for example, the monthly invoicing for jet fuel or the invoice
for landing and parking fees comes in after the fuel was uploaded and landing and
parking have occurred. The situation gets worse when charges for reciprocal services or
code-share revenues arrive at the airline via an IATA clearinghouse.
Timely monetary reflections of the airline’s activities and outputs can be provided
by a standard cost system that uses the real-time quantities available via the ERP system.
On a real-time basis, managers can evaluate the impact of actual activity and output
levels on planned profit and costs. They can take appropriate steps at an early stage to
address any deviations. Yet they will be able to make a detailed variance analysis of
actual expenses only after all relevant expenses have been collected.
Capacity Management Another important requirement that is fulfilled by the

combination of the quantity structure approach and the standard cost system is that of
capacity management. A primary responsibility of middle management is the monitoring
and realignment of the deployed resource base (refer to Figure 8-8). Excess/idle capacity
information is an important input into this process.
The proposed SCMS will not only enable middle managers to monitor resource
utilization during the process of execution; it will also help them to make capacity
management decisions during the planning stage. In cases where resource skill or
technology dictates the use of practical capacity during planning, the financial
implications of this decision will be known up front. For example, when aircraft
maintenance technicians will not be fully used for a planning period, the decision is made
not to reduce the number of technicians. This decision is rightfully based on the fact that
these highly skilled personnel require four to six years of training to work independently
and can therefore not be replaced at will. A resource output rate based on practical
capacity, as the resource pool output quantity, and the planned product consumptions of
this resource will result in the resource pool showing a dollar amount of costs that are to
be under-recovered. This amount is a clear expression of the financial implication of the
decision.
In a similar vein, excess/idle capacity variances during execution will be an

indication to middle management that changes have occurred in the business environment
and must be addressed. It is important to note that the use of the quantity structure and
standards in white-collar areas, such as human resources and purchasing, provides for an
effective tool to apply capacity management principles in these historically elusive areas.
The presence of excess/idle capacity variances in the SCMS means that

activities/processes are not fully burdened with expenses for a given accounting period,
as would be the case in most existing ABC systems. Although not allocating this
variance bodes well for the accuracy of product costs and the relevance of information for
making decisions, it does have an implication for alternative strategic cost rollups. The
total costs of all activities/processes are now no longer a reflection of total enterprise
expenses. The excess/idle capacity variance must therefore be added into the relevant
macro level of the value chain to ensure that all costs are included in the strategic cost
analysis.
Finally, attempts have been made to incorporate capacity management into activity-
based costing.10 But the proposed strategic cost model takes the RCA view and bases it
on the following considerations:
 The invested resource base is the output from the strategic planning process, and at
this time initial capacity has been determined.
 The primary capacity measure in the model is the resource output quantity, which is
established through the quantity structure approach.
 The domain of capacity management is wholly contained within the resource base.
Within this view activities/processes have no capacity in and of themselves; they are
individually and collectively consumers of capacity output. The consumption quantities
that activities/processes consume reflect resource utilization, not capacity. Utilization
and capacity can always be equal only in a closed and perfectly balanced system.
The Quantity Structure and Activity-Based Budgeting
For the cascading organizational planning process, shown in Figure 8-6, one needs a
reliable method for calculating both the resource quantities and the associated dollars
necessary to support a given strategy. This planning process is typically a reverse flow of
the standard cost model; the quantity-based cost model is ideally suited to this process
because it is geared to generating accurate planned dollar values.
For example, Table 8-5 gives details, as per the storyboard (see Figure 8-10) of
the cabin crew and their utilization on the two aircraft types for the current period and the
current flight timetable. Note that the A7Y7 is a larger airplane that requires more cabin
crew per flight. The total expense for the cabin crew is $4,000,000.
Table 8-5 Basic Data for an Activity-based Budgeting Example

Aircraft Type:
Aircraft Type:
Cabin Crew Utilization A7X7 (10,000 Flight
A7Y7 (5,000 Flight Hours)
Hours)
Cabin Crew Time 80,000 hours (40 FTEs) 120,000 hours (60 FTEs)
Basis of the Calculation

Aircraft Type: A7X7
$ 1,600,000
Cabin Crew 40 FT Es Qty: 10,000
$ 4,000,000 60 F
TEs
Aircraft Type: A7Y7
$ 2,400,000
Qty: 5,000
Activity-Based Budgeting Result Aircraft Type: A7X7

$ 1,280,000
Cabin Crew D olla rs Qty: 8,000
$ 5,120,000 Do l l a
rs
Aircraft Type; A7Y7
$ 3,840,000
Qty: 8,000
Figure 8-12 Activity-Based Budgeting without a Quantity Structure.

In Figures 8-12 and 8-13 we show the differences in deriving a budget using activity-
based budgeting without a quantity structure versus using resource consumption
accounting with a quantity structure. Using the current approach to ABB, the budget that
would be generated for 8,000 planned flight hours for both aircraft types is shown in
Figure 8-12. In the top half of the diagram the FTEs from Table 8-5 are used to split the
$4,000,000 of cabin crew expense between the two aircraft types. This results in the
values $1,600,000 and $2,400,000 as shown. These numbers are then used to calculate a
new budget, given the planned flight hours. Because it is common practice to consider
all costs in ABC as variable, the calculated costs for A7X7 and A7Y7 will be $ 1,280,000
and $ 3,840,000 respectively (refer the bottom half of Figure 8-12). The total calculated
planned expense for cabin crew is then $5,120,000.
Table 8-6 Fully Burdened Resource Costs for the Cabin Crew
Cabin Crew Planned Resource Output: 200,000 Cabin Crew Hours
Primary Expenses Fixed Cost Proportional Cost Total Cost
Supervisory Salaries $ 190,000 - $ 190,000
Crew Salaries - $ 2,900,000 $ 2,900,000
Uniforms and
Clothing $ 200,000 - $ 200,000
Secondary Expenses Fixed Cost Proportional Cost Total Cost
Human Resources
Costs $ 170,000 $ 60,000 $ 230,000
Aviation Medical $ 320,000 $ 40,000 $ 360,000
Facilities Costs $ 120,000 - $ 120,000
$ 1,000,000 $ 3,000,000 $ 4,000,000
Resource Unit Output $ $5 $ 15 $ 20

On the other hand, using resource consumption accounting and the quantity
structure, one would first come up with the resource pool plan. Cost would be classified
as primary and secondary as well as fixed and proportional. The plan for the cabin crew
is shown in Table 8-6. (Note that because of the complexity of the table, the detailed
Basis of the Calculation

Aircraft Type: A7X7
$ 1,600,000
o urs
Cabin Crew 80,000 H Qty: 10,000
$ 4,000,000 120,0
00 H
ours
Aircraft Type: A7Y7
$ 2,400,000
Qty: 5,000
Activity-Based Budgeting Result Aircraft Type: A7X7

ours
Cabin Crew 64 ,00 0 H Qty: 8,000
Planned Qty: 256,000
192,
000 H
ours
Corresponding Value: Aircraft Type; A7Y7
$ 4,840,000
Qty: 8,000
Figure 8-13 Resource Consumption Accounting Using a Quantity Structure.

secondary quantities are not shown here. But these consumption quantities would be
assigned to the cabin crew resource pool using the quantity-based principles previously
introduced.)
Next, using the resource output quantity as the primary consumption link, we
arrive at the dollar value for each aircraft type (see the top half of Figure 8-13). Note that
we are assuming no planned excess/idle capacity, and thus the amounts calculated are the
same as when FTEs were used. Given the planned utilization for each aircraft type, new
demand for cabin crew hours is calculated as 64,000 hours for the A7X7 and 192,000 for
the A7Y7, which results in total planned cabin crew hours of 256,000 as shown in the
bottom half of Figure 8-13.
The hours demanded are converted to the dollar amount that would be required
using the resource pool unit standards. Total hours (256,000) multiplied by the
proportional cost rate ($15) gives the total planned proportional expense ($3,840,000).
Add to this the $1,000,000 of fixed costs and we arrive at the total planned expense for
cabin crew: $4,840,000. This number is $280,000 less than the amount calculated using
activity-based budgeting with no quantity structure.
The following limitations of this example should be noted. The example

highlights only the error that current ABB practices will cause owing to the fact that fixed
primary and secondary costs of the resources are ignored. The error would be even larger
if the example had included fixed quantity consumptions on the activities/processes.
Second, both scenarios used the same total expense for cabin crew ($4,000,000).
Because, in practice, resource consumption accounting includes the secondary costs and
an iterative method of allocation, this method will give a more accurate reflection of total
cabin crew costs. Further, it would be possible to use the secondary quantities calculated
(detail not shown in Figure 8-6) for the Human Resources Department, the Aviation
Medical Department, and the Facilities Department to derive their budgets in a similar
fashion. The process of deriving these support budgets will, like the process used for cost
charging, be iterative.
Philosophical Approaches Affect the Relevance of Management

Information
The mechanics of the SCMS are just one of the basic building blocks of the system. The
other is the philosophies adopted with respect to each of the following: the timing of
expense, the allocation of fixed costs, the normalization of expense, and the consideration
of industry-specific characteristics.
As alluded to in the introduction to this chapter, the information that the SCMS
supplies is essential for the maximization of profit over the life of particular assets that
are deployed, over the life cycle of a product, or the strategic horizon under
consideration. The product information supplied, for example, must reflect the inherent
characteristics of applicable assets and the full and marginal costs and profits of products.
Therefore the information needs to be transparent and should intuitively highlight the
underlying principles of applicable assets, the nature of costs, and the appropriate time
line. The choices the enterprise makes with regard to the following four areas are crucial
to successfully executing strategy.
The Timing of Costs The aggregate nature and lack of relevance of financial
information for management decisions are well documented. Although the need for
financial information and the rules governing financial accounting are well recognized,
the SCMS clearly has a management focus. Enterprise Resource Planning systems now
afford companies the best of both worlds by allowing the sharing of common data and by
providing additional functionality to satisfy management accounting needs. The example
that will be used here to highlight the opportunities provided by ERP systems and the
influence of the timing dimension on cost information is depreciation.
Depreciation constitutes a large portion of airline expense and therefore has a

major impact on the cost of a ticket11. Figure 8-14 depicts the operating costs of an
aircraft. The shaded area between years 0 and X represents the operating costs and
depreciation costs while financial depreciation is in force. From year X onward the
airplane is fully depreciated, and the shaded area represents operating expense without
depreciation. For the sake of simplicity and because operating expense is not key to this
illustration, operating expense is assumed to be constant over the life of the airplane. The
two horizontal dashed lines represent the price the market will bear for a coach ticket on
two flights, ZZ999 at $410 and flight ZZ998 at $190.
Using financial depreciation for decision making in this instance would bring about the
following circumstances:
 Flights with a ceiling price below that of the initial expense of the equipment, up until
year X, would likely not be provided; that is, both flight ZZ999 and ZZ998 would not
be provided.
 After year X both flights are likely to be provided since as of that point they would
appear profitable.
600
Flight ZZ999 Price $ 410

400
Dollars

200
0 X Z
Years
Figure 8-14 Product/Service Costs with Financial Depreciation.
Simply stated, using financial depreciation results in inadequate information for making
strategic decisions.12 It is important to recognize that it is very difficult to determine
which products will be truly profitable in the long run.
We would propose that the SCMS should use cost depreciation. Cost depreciation is
calculated as the replacement value of the airplane divided by its economic life, for
example, year Z in the diagram. In Figure 8-15 we show the operating cost for the
airplane depicted in Figure 8-14, but figuring in cost depreciation. The following points
should be noted regarding the potential use of cost depreciation:
600

400
Dollars
200
0 X Z
Years
Figure 8-15 Product/Service Costs with Cost Depreciation.
 Current IT functionality is able to simultaneously support financial depreciation for

the general ledger and cost depreciation for the SCMS, while maintaining all required
integrity.
 The argument is often raised that the lives and costs involved are too difficult to
estimate. It should, however, be borne in mind that on a period-by-period basis, for
example annually, the lives and values should be adjusted to reflect the latest insights.
In this sense, the graph in Figure 8-15 is not a true reflection of the new cost curve.
From a purely capital cost perspective the curve will in fact increase periodically by
small increments.
As Figure 8-15 illustrates, the longer-term view of product profitability shows that
Flight ZZ999 could be operated profitably with the airline type under consideration, but
Flight ZZ998 could not. The use of financial depreciation-based cost information could
potentially lead to inconsistent product and profitability decisions. If this statement is
true, there is a whole range of other implications that follows as a result of this
information, namely:
 New, more efficient equipment will potentially be underutilized or not utilized to its
fullest potential.
 Potentially profitable products/opportunities will be turned away, for example, Flight

ZZ999 in Figure 8-14 from year 0 to year X.
 Older, fully depreciated but less efficient equipment will be utilized more since it
does not negatively impact currently “profitable” products, for example, Flight
ZZ998 from year X to year Z in Figure 8-14.
 Practices like those mentioned in the preceding items have a negative impact on the
operating expense of the enterprise. The identification of this situation was also
alluded to earlier when we discussed macro input and mentioned the need for
determining the “life cycle cost” of an asset.
Finally, it is worth noting that depreciation is not the only big-ticket financial cost that
could be handled in a more decision-oriented way using the SCMS. Interest on capital is
another item that is highly relevant to this industry.
The Allocation of Fixed Costs A traditional full absorption approach to cost

accounting would allocate all fixed costs at the product level13, that is, to the class of
passenger in the storyboard (see Figure 8-10). Because we are proposing a standard cost
approach, the liquidation of the excess/idle capacity variance is the primary fixed cost
that must be considered for allocation in the SCMS.
We would propose a stepped allocation of this variance as represented by the

simplified stepped contribution report in Table 8-7. Two excess/idle capacity variances
are allocated in this example. The variance for cabin crew staff is allocated to the Flight
Business level. The variance for the Human Resources Department is allocated to the
Enterprise Result level.
The variance for excess/idle capacity is allocated in the stepped recovery method for
the following reasons:
 In line with the principles of controllable and uncontrollable variance identification,

the excess/idle capacity variance should not be spread out among the lowest-level
products, that is, passenger classes.
 For the sake of visibility and to clearly delineate responsibility for the variance, it is
allocated to an appropriate, higher level in the stepped recovery report.
 Not spreading the variance to the individual product level enhances the relevance of
the data for decision making.
Table 8-7 Product Stepped Gross Margin Report
Business-Class Passengers: Planned Actual

Passenger Revenues (50,000) (45,000)
Passenger-Related Costs:
Meals 500 480
Cabin Crew 2,000 2,000
Passenger Handling 2,500 2,400
Gross Margin 1: Business-Class Passengers (45,000) (40,120)

Flight ZZ999:
Passenger Class Margins (150,000) (165,000)
Flight-Related Costs:
Jet Fuel 15,000 16,000
Landing and Parking 8,000 8,000
Aircraft Maintenance 6,000 6,000
Gross Margin 2 : Flight ZZ999 (121,000) (135,000)
Route: Europe/Asia:
Flight Margins (2,250,000) (1,975,000)
Route-Related Costs:
Lounge Costs 55,000 50,000
Marketing Costs 800,000 910,000
Gross Margin 3 : Route Europasia (1,395,000) (915,000)
Flight Business:
Route Margins (10,800,000) (6,300,000)
Flight Business-Related Costs:
Flight Business Overhead 1,700,000 1,500,000
Excess Capacity – Cabin Crew - 100,000
Gross Margin 4 : Flight Business (9,100,000) (4,700,000)
Enterprise Result:
Business Units’ Margins (27,900,000) (18,100,000)
Enterprise-Related Costs:
Corporate Overhead 3,000,000 3,200,000
Excess Capacity – Human - 80,000
Resources Department
Enterprise Operating Result (24,900,000) (14,820,000)

Normalized Expenses The same principles we have mentioned in relation to

accounting for the cost of assets also apply to certain expense items in the airline
industry. The cost for major aircraft maintenance is an expense that would have a similar
effect on margins. Figure 8-16 represents the typical actual cost curve for a modern
jetliner14 . Clearly, from perspective of managing the margins, the spikes in costs shown
in the graph cannot be afforded. From an organizational planning and control
perspective, it should be noted that these cost spikes are also not related to the ongoing
activities and outputs that form the basis of planning and authorized reporting
Cost
Introduction Mature Aging
Years in Operation
Figure 8-16 Actual Cost Curve for Typical Jetliner.
We therefore propose that major maintenance expenses be charged to flight

costing as a normalized expense. Costs that could be included in the maintenance
category are, for example, the costs of major airframe checks, engine overhauls, landing
gear overhauls, and Auxiliary Power Unit (APU) overhauls. The total maintenance
charges to flight costing will then be broken down into a regular maintenance charge per
flight hour, a regular maintenance charge per cycle, and a standard major maintenance
charge per flight hour. This smoothed cost curve for total maintenance cost is
represented by the horizontal dotted line in Figure 8-16.
Apart from the benefits for managing margins, the process of normalizing
expenses has some very specific implications for organizational planning and control.
Planning must now be done for two time horizons. First of all, a long-term plan must be
established for major maintenance costs to be incurred per category. This information is
used to determine the standard major maintenance rate by dividing the total planned costs
Flight
Profitability
Major
Maintenance
- Jet Fuel Reserve
- Landing and Parking Flight: ZZ999
- Business Class
- Coach Class
Aircraft Types:
- A7X7
Cabin Crew - A7Y7
Catering
Hangar
Maintenance Major
Maintenance
Apron
Events
Handling
Purchasing
Human
Resource
Figure 8-17 A Revised Storyboard Representing an SCMS Model.
by the planned flight hours. These calculations and standards should be updated on a
periodic basis. This rate is charged to the cost of the flight and used to build a reserve for
future major maintenance expenses. Regarding the acceptability of this practice for
financial accounting purposes, it should suffice to say that current ERP functionality
allows for parallel treatment of the major maintenance expenses to satisfy both financial
and management accounting demands in cases where the airline does not have to
capitalize the reserve.
Second, since major maintenance will now be controlled for each period as actual
events occur, management needs to determine the planned number of each type of major
maintenance event. These events are individually budgeted and controlled when they
occur, and at completion the costs are accounted for against the reserve that has been
built using the standard rate.
The normalization of large expense items will necessitate an adjustment to the

storyboard (Figure 8-10) to more accurately reflect our proposed SCMS model. The
revised storyboard is shown in Figure 8-17.
Adjustments for Industry-Specific Characteristics
We indicated previously that the invested resources determine the initial inherent nature
of costs. But at least one other factor need to be considered in this regard - the inherent
operating cost characteristics of the resources/assets.
It is a well known fact in the airline industry that operating costs are to a large
extent a function of equipment utilization patterns, the operating environment, and fleet
age, and so forth, for example, the fuel efficiency of the equipment.15 The airline industry
is, of course, not unique in this regard; these factors holds true for any transportation
enterprise. But because of the cost of the equipment used in the airline industry, this
industry is more sensitive to these factors than most.
We have not been oblivious to this fact as we have gone along in this chapter. As
far as the influence of equipment utilization patterns, operating environments, and fleet
age, among other considerations, on the inherent nature of costs is concerned, there is
clearly a need to evaluate the specific airline’s position. This process must take into
consideration the utilization pattern, the status of the equipment in terms of the overall
equipment life curve and cost curve, and it must adjust the fixed and proportional nature
of the costs of certain assets. This also implies the need to make periodic adjustments to
standards as the fleet ages or as utilization patterns change.
In conclusion, it is important to note that the primary purpose of the SCMS is to

accommodate the management processes of planning and control, and the provision of
information that is relevant for making decisions within the time frame that the strategy
must be achieved. The reflection of the proportionality of costs is therefore driven
primarily by the strategic view, but within the framework of the airline’s position in
terms of industry-specific cost characteristics. Both views must be combined in the
SCMS to enable accurate planning and valid control measures as provided by authorized
reporting.
Evaluating the Output of the Proposed SCMS Model
In this section we illustrate how the output from the SCMS can be used in everyday
management tasks and decisions. We present three examples: an outsourcing decision,
illustrating how middle management will use information from the SCMS; an authorized
report for a resource pool that incurred a higher than planned activity level; and, finally,
to illustrate the support of more strategically oriented decisions, entry into a new market
using data from the SCMS.
An Outsourcing Decision and the Alternate Views of the Nature of Costs
As we have pointed out already, the information demands of different levels of

management could result in conflicting information needs. This is well illustrated when
we compare the information typically supplied by the management accounting system
with the information needs of managers who need to make an outsourcing decision. For
decisions of this kind, middle managers must consider fewer costs fixed than what they
are typically presented with.
It is important to realize that the proposed SCMS model is based on what is

considered to be a viable strategic plan. No organization plans for failure. Adjustments
to the resource base, for example, outsourcing, can therefore only be incremental steps to
the plan, triggered by change in the environment. The embodiment of the plan,
optimizing execution and enabling control, is a primary objective of the SCMS. The
SCMS must therefore supply data with primarily an operational flavor.
But on those occasions when outsourcing decisions must be made, the SCMS
should also supply information that is relevant for making this kind of decision. Consider
Table 8-8, an example of the fully burdened resource costs for the Catering Department
of an airline; note that this is an expansion of Table 8-1, which showed only the primary
expenses. The view is often held that all costs are variable at this level of decision
making. We would propose that this is not the case, and in this regard the classification
of costs into their primary and secondary categories is crucial. In particular, the
secondary costs should be more carefully considered.
The classification of primary fixed and proportional costs, although essential for
making short-term operating decisions, is not relevant in the case of outsourcing
decisions. If the catering function is to be outsourced, clearly all of the primary expenses
will no longer be incurred, and therefore middle management will need to consider none
of these costs to be fixed.
But this is not the case for the secondary expenses. In the event that catering is
outsourced, the proportional secondary expenses will result in excess/idle capacity for the
providers of these services. For the Human Resources Department, Water and Energy
Department, and the Facilities Department, subsequent management actions are required
to ensure that the resultant excess/idle capacity is addressed and the cost savings realized.
It is more difficult to turn the secondary fixed costs, highlighted in Table 8-8, into cost
savings. These costs typically include fixed costs, not only those from the suppliers of
service - in this instance Human Resources Department, the Water and Energy
Department, and the Facilities Department - but also the fixed costs for those services
that suppliers of the service consume in providing their service. Those making the
outsourcing decision therefore cannot be oblivious to these costs, which will clearly not
go away when the Catering Department is outsourced. As this scenario illustrates, the
SCMS can supply information that is relevant to tactical management in cases where
these managers are required to take corrective actions, as well as information that is
relevant to operational decisions.
Table 8.8
Catering Department Planned Resource Output: 12,000 Catering Man-Hours
Chefs’ Salaries - $ 228,000 $ 228,000
Fringe Benefits $ 60,000 - $ 60,000
Depreciation – Equipment $ 4,000 - $ 4,000
Secondary Expenses Fixed Proportional Total
Human Resources $ 40,000 $ 15,000 $ 55,000
Water and Energy $ 8,000 $ 25,000 $ 33,000
Facilities $ 20,000 - $20,000
$ 212,000 $ 268,000 $ 480,000
Resource Unit Output Rate $ 17.67 $ 22.33 $ 40.00
Finally, this scenario highlights another interesting point about the nature of costs
- namely, that there is never really a business for which all costs would be variable, an
approach generally maintained in ABC today. For any given strategy, considering the
investment base and support services being provided, certain fixed costs will always be
present. The conclusion on the nature of cost within any going concern would therefore
have to be that the only time all costs would be variable would be if it is the enterprise’s
strategy to go out of business.
Organizational Control with Authorized Reporting
A primary objective of the SCMS is to enhance organizational control by providing valid

yardsticks for performance measurement in spite of changes in the business environment.
Table 8-9 shows the original plan and actual expense for the period for the Apron
Handling Department. Note that this table covers ground-handling equipment and does
not include labor costs; the latter would be treated as a separate resource pool with its
own output in the SCMS.
The rates charged by the secondary services in this example are shown in Table 8-
10. Note that the actual output level for the period was higher than planned. A fair
amount of the input variances shown here should therefore be attributed to the increase in
volume from 10,000 hours to 11,000 hours. This distinction is provided by the
authorized report shown in Table 8-11.
The total input variance for apron-handling equipment is now $ 4,780 as opposed
to $11,750 in Table 8-9, and this variance is the responsibility of the apron-handling
supervisor. Functionality typically allows for the primary cost variances to be broken
down into price, quantity, resource usage and remaining variance (details not shown in
the table). Note that authorized secondary costs are based on authorized secondary
quantities. The monetary secondary cost variances shown reflect the quantity variances
only. Since the SCMS is a standard cost system, no price variances for secondary costs
are provided.
Table 8-9 Planned Output and Costs To Be Used for Authorized Reporting
Plan/Actual/Variance Report Output: Equipment Hours
Department: Apron Handling Planned Quantity: 10,000 Actual Quantity: 11,000
Primary Costs Plan Plan Actual Variance

Fixed Prop.
Oil and Lubricants 100 1,000 1,270 170
Diesel Fuel - 5,000 6,000 1,000
Consumables 50 200 260 10
Depreciation 25,000 - 25,000 -
Secondary Costs Quantities
Plan Plan Actual

Fixed Prop.
Maintenance 10 1,000 1,377 10,250 15,000 34,425 9,175
Plan & Schedule - 400 433 6,000 8,000 15,155 1,155
Purchasing - 100 112 500 1,500 2,240 240
41,900 30,700 84,350 11,750
Table 8-10 Secondary Service Outputs and Rates
Proportional
Service Description Output Fixed Rate
Rate
Equipment Maintenance Hours 10 15
Equipment Plan and Scheduling Hours 15 20
Equipment Purchasing Purchase Orders 5 15

Table 8-11 Authorized Report for Apron Handling
Authorized Report Output: Equipment Hours
Department: Apron Handling Planned Quantity: 10,000 Actual Quantity: 11,000
Primary Costs Authorized Actual Variance
Oil and Lubricants 1,200 1,270 70
Diesel Fuel 5,500 6,000 500
Consumables 270 260 (10)
Depreciation 25,000 25,000 -
Secondary Costs Quantities
Authorized Actual
Maintenance 1,200 1,377 30,000 34,425 4,425
Plan and Schedule 440 433 15,400 15,155 (245)
Purchasing 110 112 2,200 2,240 40
79,570 84,350 4,780
Considering Entry into a New Market
The following scenario illustrates how the information that the SCMS provides enables
the evaluation of macro output efficiency.
A regular scheduled airline wants to get into the no-frills travel business. The
company has identified a popular vacation destination as a potential target market into
which to introduce its product, initially to be offered from the airline’s primary hub only.
It is also estimated that some traffic will be attracted from the large retired population in
the state, with travel patterns complimentary to vacation travelers. The plan is to serve
the route with older aircraft with a single-class configuration that is being phased out of
normal scheduled operations. Management also wants to ensure that the business
remains profitable once the airplanes come up for replacement, particularly since this is a
very price-sensitive market.
Market research has indicated that the route is not very thick. The airline has,
however, proven that with its name, image, and safety record in the market, it is normally
able to attract passengers fairly quickly on new routes. Initial route density is estimated
at one thousand passengers per week. This translates to a 60 percent load factor on an
initial service offering of two flights per day. It is also assumed that current support
service capacity will be able to absorb this initial level of increase in throughput without
any incremental investment. It is estimated that route density will increase to two
thousand passengers per week. The ceiling price on this service is currently $ 79. The
thought is to follow an aggressive market penetration strategy, the two major prongs
being aggressive pricing and a corresponding advertising campaign to raise market
awareness. Management has asked the management information analyst (MIA) to
prepare an estimate of the product costs for this venture. The MIA used data form the
airline’s newly implemented SCMS to provide the information shown in Table 8-12.
The analysis of the data shows that the flight will not make an overall profit.
Given the initial route density, the full-cost column indicates a loss of $2,120. Although
the flight would make a contribution to fixed costs, it was decided that this was not going
to be incremental business since this venture would have dedicated airplanes. Break-
even occurs at a load factor of 86 percent (99 passengers) - a level that is attainable
should the route density increase as forecasted. But the information supplied by the MIA
was based on the assumption that increase in traffic would not require any additional
investment in support areas. After investigating capacity utilization in maintenance,
cabin crew, flight crew and apron handling, the airline decides not to pursue the venture
any further since the incremental investment that would be required to facilitate a fully
developed route would increase the fixed costs to a level where the venture would no
longer be profitable.
Table 8-12 Profitability of the Venture at Initial Route Density
Estimated Product Profitability Report: Flight ZZ1111
Passenger Information: Marginal Cost Full Cost
# of Passengers 70 70
Passenger Revenues ($ 5,530) ($ 5,530)
Passenger Related Costs
- Passenger Handling $ 210 $ 560
- Cabin Crew $ 280 $ 770
Passenger Contribution Margin ($5,040)

Passenger Gross Margin ($ 4,200)
Flight Information:
Flight Related Costs

- Fuel $ 2,500 $ 2,500
- Landing and Parking $ 800 $ 800
- Maintenance $ 350 $ 790
- Flight Crew $ 60 $ 200
- Apron Handling $ 100 $ 280
- Interest - $ 250
- Depreciation - $ 1,500
Flight Contribution Margin (1,230)

Flight Gross Margin 2,120
Conclusion
Clearly managers need a system that can accommodate their processes and that has the
ability to supply information that supports them in guiding the enterprise to achieving its
strategy. Such a system should thus utilize a common set of data and supply information
that is relevant to all managerial levels for decision making. The ability to immediately
support decisions at all levels of management is critical in maximizing the enterprise’s
efficiency and effectiveness.
A primary objective of the proposed SCMS is that it supports proactive decision

making better than what traditional prescriptive reporting does. Changing to this new
system means migrating the organization from historic reporting to the ability to address,
adjust to, and even preempt change in the business environment. Achieving this vision
means converting from the traditional management accounting view into a strategic cost
management view. The power of real-time integrated systems makes this vision and the
maximizing of shareholder wealth attainable.
Endnotes
1. D.H. Drury and C.S. McWatters, “Management Accounting Paradigms in
Transition,” Journal of Cost Management 12, no. 3 (1998): 32-40.
2. Michael E. Porter, Competitive Advantage. Creating and Sustaining Superior

Performance (New York: The Free Press, 1998), p. 37.
3. Ibid., p. 70.
4. Drury and McWatters, “Management Accounting Paradigms in Transition,” pp. 32-

40.
5. Robin Cooper and Robert S. Kaplan, “The Promise-and Peril- of Integrated Cost
Systems,” Harvard Business Review (July- August 1998): 109-119.
6. Grant F. Schutte, Integrated Management Systems (Durban, South-Africa:

Butterworths, 1981), p. 13.
7. Ibid., p. 96.
8. Wolfgang Kilger, Flexible Plankostenrechnung und Deckungsbeitragsrechnung

(Wiesbaden, Germany: Gabler, 1993), p. 946.
9. A. van der Merwe, “Plaut Activity-based Costing: An Evaluation of Its Relevance in

Multi-Product Companies” (an empirical research project presented as a thesis for the
master’s degree in business leadership at the School of Business Leadership,
University of South-Africa), p.75.
10. Robert S. Kaplan, ABC Seminar Presentation. Frankfurt, Germany, June 11, 1996.
11. The Airplane Economics Group, BOEING. Airframe Maintenance Cost.

Methodology and Application. (BCAG Marketing Department) (Seattle, Wash.:
BCAG, 1994), p. 8.
12. John K. Shank and ijay Govindarajan, Strategic Cost Analysis: The Evolution from
Managerial to Strategic Accounting (Homewood, Ill.: Richard D. Irwin, 1989), p.
131.
13. Charles T. Horngren and George Foster, Cost Accounting. A Managerial Emphasis
(New Jersey: Prentice-Hall, 1987), p. 107.
14. Jean-Pierre Poubeau, Direct Maintenance Costs: Art or Science? Maintenance Costs
Group, Airbus Industrie, France, p. 17.
15. The Airplane Economics Group. BOEING. Airframe Maintenance Cost.

Methodology and Application, p.4.

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STRATEGIC COST

By: Anton van der Merwe and Christopher Jackiw

The Utopian vision of strategic management is a strategy that is pursued by everyone

This chapter is essentially an argument for a management accounting system with

Next we highlight the importance of the management processes of planning,

The chapter concludes with a limited representation of a possible Enterprise

The Two Basic Elements Required to Successfully Execute

Second, an enterprise must react appropriately and in a timely manner to changes

The value chain is traditionally thought of as the group of processes/activities

Evaluating the Macro and Micro Conversion Process

Figure 8-1 The Enterprise Conversion Process – The Macro View.

Macro Conversion Optimization Optimizing the macro component of the

Input Output Input Output

Figure 8-2 The Micro View of Conversion.

components must also be in place.

This evaluation of overall resource efficiency, in relation to the new options

When evaluating macro-input effectiveness, the focus is on the ability of the

To support optimization in the area of macro-input effectiveness, the SCMS must

In terms of macro-output effectiveness, the enterprise must be able to be effective

to a specific process/activity, or it can be broadened to include a group of processes

In evaluating Micro-input effectiveness the enterprise analyzes the value chain

In evaluating micro-output effectiveness the enterprise looks at its ability to

In summary, through pursuing optimized execution an organization can be

Integrated Organizational Response

The second element required for an enterprise to be successful in implementing strategy

The successful execution of strategy is not achieved in one step; it is a process.

alignment in terms of personal, departmental and corporate goals. Managers, as the

A mechanism commonly used to shift focus and change behavior is Key

Figure 8-3 The Building Blocks of Integrated Organizational Response.

 The establishment of KPIs must emphasize the principles of the downward-cascading

 Key Performance Indicators must be specific to every individual managerial position.

The management processes of planning, controlling, and taking corrective actions

In summary, optimized execution of the value chain takes a broader view of

integration of strategy, performance measurement, and the reward system in the

Management Processes in the Strategic Cost Management System

In practice one finds that organizational planning/budgeting systems are often

Empirical Management Simplified Organizational Structure Normative Management

Figure 8-4 The Types of Management Structures.

An organizational planning and control model based on normative management

Figure 8-5 represents an example of what such an organizational planning and

Figure 8-5 An Example of the Organizational Planning and Control Model.

 Management processes are not viewed as distinct steps---planning, controlling, and

The traditional management process of static planning, controlling (explaining

 If the SCMS is to accommodate the management processes of planning and control,

Vision, Mission and

Middle Resource Acquisition

Operations Resource Utilization

Figure 8-6 The Organizational Planning Process.

 Initial capacity will be determined.

Finally, recognizing that change is inevitable, the futility of establishing a stagnant

Within the normative management approach, control no longer involves measuring

with a particular level of activity/output is adjusted up or down based on the fluctuation

To facilitate this quantity-based approach and the calculation of authorized

Figure G: Levels of Potential Fluctuations for an Airline

Flight profitability is down - Flight Profitability Area: Flight profitability is up owing

+ Flight Cost Area:

The aircraft type cost is lower,

The hangar maintenance Hangar Maintenance The hangar maintenance

Less maintenance planning Maintenance Overhead Cost Maintenance planning costs

Figure 8-7 Levels of Potential Fluctuation for an Airline.

Taking Corrective Action

Vision, Mission, and

Top Resource Focus Shifts