Cost management

Cost management
Traditional management accounting control techniques tend to focus on
cost containment whereas cost management concentrates on cost
reduction.
Traditional management accounting control techniques are routinely
applied on a continuous basis whereas cost management tends to be
applied on an ad hoc basis.
Many of the approaches that fall within the area of cost management do
not rely exclusively on accounting techniques

Life-cycle costing (LCC)

Traditional management accounting procedures have focused primarily
on the manufacturing stage of a product s life cycle.
LCC focuses on costs over the product s entire life cycle to determine
whether profits earned during the manufacturing phase will cover the
costs incurred during the pre-and post-manufacturing stages.
A large proportion of a product s costs can be committed or locked in
during the planning and design stage
Cost management can be most effectively exercised during the planning
and design stage.

The Cost Life Cycle

Cost life cycle refers to the following sequence
of activities:
R&D
Design
Manufacturing (or providing the service)
Marketing/distribution
Customer service

It is the life-cycle of a product or service from the

viewpoint of costs incurred

The Cost Life-Cycle

(continued)

R&D

Design

Upstream Activities

Marketing
Customer
Manufacturing
and
Service
Distribution

Downstream Activities

Design decisions account for much of total product life cycle

costs

The Sales Life-Cycle

Sales life cycle is the sequence of phases in the
products or services life:
Introduction of the product or service to the market
Growth in sales
Maturity
Decline
Withdrawal from the market

It is the life-cycle of a product or service from the

viewpoint of sales volume achieved

Sales

The Sales Life-Cycle

Growth

Introduction

Maturity
Decline

Important
strategic cost
management
issues arise in
each stage of
the life-cycle.

Time

Life-cycle costing (LCC)

Futuristic Software Inc, a computer software company is developing a new
accounting package, Future Accounting. The following are the budgeted amounts
for Future Accounting Package over a six-year product life-cycle.
Year 1 and 2

Research and Development costs

Design costs
Year 3 to 6
Production costs
Marketing costs
Distribution costs
Customer-service costs

One-Time Setup
Costs
$ 150,000
105,000
75,000
120,000

360,000
240,000
Variable Cost per
package
$ 37.50
36
24
45

To be profitable, Futuristic Software Inc must generate revenues to recover costs of

all six-business functions taken together and, in particular, its high non-production
costs.
Futuristic Software Inc wants to decide between three alternative selling prices i.e.,
$350, $430 and $550, so as to maximize life-cycle operating income. Sales
volumes at these prices have been estimated at 7,500 units, 6,000 units and 3,750
units respectively. Identify which option maximizes life-cycle operating income.

Life-cycle costing (LCC)

Alternative Selling Price/
A
Selling price per package
Sales quantity in units
A. Life-cycle revenues

Sales-Quantity Combination
B
C
$350
$430
$550
7,500
6,000
3,750

$2,625,000

$2,580,00 $2,062,50
0
0

B. Life-cycle costs :
R & D costs
Design cost of product/ process
Production costs (w1)
Marketing costs (w2)
Distribution costs (w3)
Customer-service costs (w4)
Total life-cycle costs C.
Life-cycle operating income (A -B)

$360,000
$240,000
$431,250
$375,000
$255,000
$457,500
$2,118,750
$506,250

$360,000
$240,000
$375,000
$321,000
$219,000
$390,000

$360,000
$240,000
$290,625
$240,000
$165,000
$288,750

$1,905,00 $1,584,37
0
5
$675,000 $478,125

Life-cycle costing (LCC)

Workings
1. Production costsFor A, $150,000 + (7,500 units x $37.50/package) = $431,250
For B, $150,000 + (6,000 units x $37.50/package) = $375,000
For C, $150,000 + (3,750 units x $37.50/package) = $290,625
2. Marketing CostsFor A, $105,000 + (7,500 units x $36/package) = $375,000
For B, $105,000 + (6,000 units x $36/package) = $321,000
For C, $105,000 + (3,750 units x $36/package) = $240,000
3. Distribution costsFor A, $75,000 + (7,500 units x $24/package) = $255,000
For B, $75,000 + (6,000 units x $24/package) = $219,000
For C, $75,000 + (3,750 units x $24/package) = $165,000
4. Customer-service costsFor A, $120,000 + (7,500 units x $45/package) = $457,500
For B, $120,000 + (6,000 units x $45/package) = $390,000
For C, $120,000 + (3,750 units x $45/package) = $288,750

11

Target Costing
Target costing: a costing method in which the
firm determines the allowable (i.e., target) cost
for a product or service, given a competitive
market price and a targeted profit
Two options for reducing costs to achieve the
target-cost level:
By integrating new manufacturing technology using
advanced cost management techniques, (such as
ABC), and seeking higher productivity
By redesigning the product or service

12

Implementing Target Costing

Determine the market price
Determine the desired profit1
Calculate the target cost as market price
less desired profit
Use value engineering to reduce cost
Use kaizen costing and operational control to further
reduce costs
For example, expressed as a percent of sales dollars

13

Value Engineering
Value engineering (step 4):
Analyze trade-offs between product functionality
(features) and total product cost
Perform a consumer analysis during the design stage
of the new or revised product to identify critical
consumer preferences

14

Value Engineering (continued)

For firms that can add and delete features easily,
functional analysis (examining the performance and
cost of each major function or feature of the product)
can be used
Benchmarking is often used in this step to determine
which features give the firm a competitive advantage
Goal: provide a desired level of performance without
exceeding the target cost

15

Value Engineering (continued)

Design analysis:

Useful when the firm that cannot add and delete

features easily
The design team prepares several possible designs of
the product, each having similar features with different
levels of performance and different costs
Accountants work with the design team to choose one
design that best meets customer preferences while not
exceeding the target cost

16

Value Engineering (continued)

Other cost-reduction methods:
Cost tables: computer-based databases (costs and
cost drivers)
Firms that manufacture parts of different size from the
same design can see the difference in cost and material
usage for each size

Group technology is a method of identifying similarities

in the parts of products a firm manufactures so the
same parts can be used in two or more products,
thereby reducing costs

17

Kaizen
Kaizen (step five): using continuous improvement &
operational control to reduce costs in the
manufacturing stage of the product life-cycle
Achieved through:
Streamlining the supply chain
Improving manufacturing methods and productivity
programs
Employing new management techniques

Used extensively in the time period between product

redesigns

Benefits of Target Costing

18

Increases customer satisfaction (design is focused on

customer values)
Reduces costs (more effective and efficient design)
Helps the firm achieve desired profitability on new and
redesigned products
Can decrease the total time required for product
development
Reduces surprises of the type, We did not expect it to
cost that much...
Can improve overall product quality
Facilitates coordination of design, manufacturing,
marketing, and cost managers throughout the product
cost and sales life-cycles

An example of target costing

20

Target Costing Example

HPI is performing a target costing analysis of a hearing
aid (HPI-2), which sells for $750 (cost = $650) and has
30% of the market. However, a competitor has
introduced a new model that incorporates a computer
chip that improves quality. Its cost is $1,200. A
consumer analysis indicates that cost-conscious
consumers will remain loyal to HPI as long as price
does not exceed $600. HPI wants to maintain the
current rate of profit, $100 per hearing aid.
HPI must therefore reduce its cost to $500 ($600 $100) to meet its profit goal

21

Target Costing Example (continued)

Design analysis options (see page 366 in your text):

Alternative A: reduce R&D, replace parts, and change

inspection proceduresavings = $150
Alternative B: replace parts and change inspection
proceduresavings = $150
Alternative C: increase R&D to develop a computer chip
type hearing aid, replace parts, change inspection procedure,
renegotiate new supplier contractsavings = $150

22

Target Costing Example (continued)

Management chooses alternative C because:
Of the increase in R&D expenditures
The increase in R&D will improve the firms competitive
position in the future
The move is strategically important: the new technology
may be dominant in the future

Kaizen Costing
Kaizen costing is applied during manufacturing stage whereas target costing is
during planning stage.
Kaizen costing focuses on production processes whereas target costing focuses
on the product.
Kaizen costing aims to reduce costs of processes by a pre-specified amount
relying on employee empowerment.

Cost of quality

Quality is now one of the key competitive variables.

Management accountants are now placing greater emphasis on the provision

of information relating to the cost of quality.

Cost of quality reports prepared periodically:

1. Prevention costs
2. Appraisal costs
3. Internal failure costs
4. External failure costs

Increasing attention is also being given to continuous improvement with the

aim of zero defects.

Non-financial measures and statistical quality control tools also play a key role
in improving quality and reducing internal and external failure costs.

Cost of quality report

Cost of quality report (contd.)

Example Cost of quality

A company started a quality improvement programme in July 2010. At the end of
first quarter of 2011 management of the company desires to compare the results
with the first quarter of previous year to assess the financial impact of quality
improvement programme. Statistics for 1st quarters of both years are as under:
Rs 000
2010
2011
Cost
Jul
Aug
Sep
Jul
Aug
Sep
Process engineering
66
74
83
116
146 183
Training
393
431
477
633
765
911
Sales lost
1476
1209
993
734
632 576
Sales return
807
632
491
339
285 252
Inspection
42
47
53
72
89
110
Rework
474
380
300
218
185 167
Quality assurance
186
195
206
239
263 288
Scrap
528
435
357
267
231 210
Testing
48
51
56
68
78
90
Customer complaint
117
104
90
75
68
65
Prepare a Cost of Quality Report showing monthly and quarterly results of two
years that classifies into the following:

Example Cost of quality

Cost Elements
Process engineering
Training
Quality assurance
Prevention Cost
Inspection
Testing
Appraisal Cost
Rework
Scrap
Internal Failure Cost
Sales lost
Sales return
Customer complaint
External Failure Cost
Total Cost

Cost of Quality Report

2010
Jul
Aug
Sep
66
74
83
393
431
477
186
195
206
645
700
766
42
47
53
48
51
56
90
98
109
474
380
300
528
435
357
1,002
815
657
1,476 1,209
993
807
632
491
117
104
90
2,400 1,945 1,574
4,137 3,558 3,106

Jul
116
633
239
988
72
68
140
218
267
485
734
339
75
1,148
2,761

2011
Aug
146
765
263
1,174
89
78
167
185
231
416
632
285
68
985
2,742

Sep
183
911
288
1,382
110
90
200
167
210
377
576
252
65
893
2,852