Cost Management

Professor Bala V. Balachandran

J.L. Kellogg Distinguished Professor

of Accounting and Information Systems

References: Strategic Activity Based Accounting : By B.V. Balachandran 1994

Acknowledgements: Ernst & Young, Cap Gemini Grant

 Cost Management

Strategic Management

BUSINESS
Information Distribution
Systems Management

EXCELLENCE

Operations
Cost Management
Management

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 Cost Management

Uses of Cost Information

Inventory Performance
Product Costing
Valuation Measurement

Cost Accounting Cost control & Incentives & / or

Management Bonus

Cost Management

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 Cost Management

Introductory Table (see SABA)

Winning Products Losing Products
1 2 3….15 16 17 18
Selling Price Per $100 $120 …. …. $73 $80
Unit

Cost Per Unit $70 $96 …. …. $77 $85

Margin / Unit $30 $24 …. …. ($4) ($5)
Return on Sales 30% 20% …. …. (5.5%) (6.25%)

Current Volumes 3 mill 1.5 mill …. …. 1.2 mill 2 mill

in Millions

Profit 90 36 …. …. (4.8) (10)

contribution

Selling General and Administrative Expenses for the Company $1.3 Billion
Current Net Income (Company wide) ($ 11 mil)
Incremental Volume ½ million……sourcing out 2 mill at $ 78 / unit
Expected increase in Profit next year by outsourcing worst product at $ 78 and increasing best product
volume by ½ mill is : 10+4+15-.5 = 28.5 million

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 Cost Management

DO YOU HAVE ONE OR MORE OF THE FOLLOWING SYMPTOMS?

1. Declining profitability for no obvious reason; revenues increase but profits

decrease

2. Winning sales in products that the company is least well configured for, and
vice versa

3. Growth in support costs relative to direct costs (super variable costs)

4. Managers having little faith in existing product costing system

5. Obsolete allocation mechanisms (e.g. exclusive use of single driver e.g. labor)

6. Constant need for special studies

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 Cost Management

Current Systems may not:

• Identify the true total product cost because of unnecessary allocation and
complexity

• Identify and report cost of quality

• Provide cost and performance information to support strategic goals

• Measure or reward desired performance

• Focus on cost prevention of potential non-value added costs

• Identify and isolate non-value added activities

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 Cost Management

AVERAGE COSTING OR “PEANUT BUTTER” APPROACH TO

PRODUCT / CUSTOMER COSTING

Entrée Dessert Drinks Total

Goober 11 0 4 15
Rudy 20 8 14 42
Laura 15 4 8 27
Big Red 14 4 6 24
Total ($) 60 16 32 108
Average ($) 15 4 8 27

• How many “undercosted” customers are hidden?

• How many customers or products are “undercosted” in most organizations?

• Note for every “undercoated” product there is one “overcoated” product!

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 Cost Management

Bala’s Fine Dining

Wow! I cant believe a
sandwich costs $27
here. This must be an We should “go
expensive restaurant! dutch” every time.
It’s a thing these
guys didn’t learn
ABC Costing from
Bala.

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 Cost Management

PRODUCT / CUSTOMER PROFITABILITY ANALYSIS

$ per unit
Traditional Traced ABC Revenue less Reported Actual Profit
cost cost variable Profit / / (Loss)
allocation production (Loss)
cost
(assumed)

Goober 27 15 20 (7) 5
Rudy 27 42 35 8 (7)
Laura 27 27 30 3 3
Big Red 27 24 29 2 5
Total ($) 108 108 114 6 6

Note : Revenue less variable product cost should cover fixed overhead per unit. Any excess
(shortfall) is gross profit (loss) per unit

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 Cost Management

WHY ARE ACTIVITIES SO IMPORTANT FOR ANALYSIS?

• They are actionable; they are what the company does

• They consume resources which are consumed by products and processes

• They can be easily understood by diverse groups of people and their cost can
be tracked and measured by beneficiary

• They link planning and control and integrate financial and non-financial
performance measures

• They highlight cross-departmental interdependencies

• They facilitate understanding of cost drivers

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 Cost Management

BENEFITS OF ACTIVITY ANALYSIS

• Managers better understand the workload profile of their area

• Clarifies customer / supplier relationship, including cross-departmental

dependencies ( Total Value Chain)

• Cases a review of existing organizational procedures and responsibilities and

clarifies the causes and effects of activities

• Fosters plans for improvement with many linkages

• Establishes basis for tracing costs and implementing activity accounting

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VALUE CHAIN PERSPECTIVE OF BUSINESS FUNCTIONS

Pre-Manufacturing

Prototype Test
Product Research and Product /
and Design
Conception Development Process Design
Modify

Operations and
Manufacturing

Customer Service Distribution and Sales Marketing

Post-Manufacturing

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 Cost Management

IDENTIFICATION OF ACTIVITIES TIES CUSTOMER VALUE TO THE

ACTIVITIES
Concentration on Cost Drivers / Cost Prevention

Lead time = Process time + Inspection time + Move time + Queue time + Storage

= Value Added + = Non-Value Added

• Machine • Incoming Inspection
• Assembly • Set-up
• Order Processing • Rework
• Data Entry • In-process Queue
• Others • Material Moves
• Others

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 Cost Management

Identification of Activities Ties Customer Value to the Activities

Cycle Efficiency = Value Added Time

(Value Added + Non-Value-Added Time)

• Typical : Less that 10% for discrete manufacturing

Less than 5% for administration process

Greater than 30% for process

• Therefore : Majority of lead time adds cost, but no value

Money Value of Time?

Velocity Costing?

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 Cost Management

Process Value Analysis

Reasons for Non-Value-Added Time
• Number of labor transactions • Number of vendors

• Number of material moves • Number of units scrapped

• Number of total part numbers • Number of engineering

change notices
• Number of setups
• Number of process changes
• Number of products
• Number of units revoked
• Average number of options
• Number of direct labor
• Money value of time employees

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