A6010

STRATEGIC COST
MANAGEMENT
(Alternative Costing Methods)
 Relevant Reading

• Essential Reading – Drury, Management Accounting for

Business, 6th Edition, Ch 14, p 382 – 400
• Recommended Reading: Drury, Management Accounting for
Business, 6th Edition, Ch 5
 AGENDA
• Alternative costing methods to cost
management
– Activity-Based Management
– Life cycle costing
– Target costing
• Supporting techniques to cost management
– Reverse engineering
– Value engineering
– Kaizen costing
 What is Costing

“System of computing cost of production or of

running a business, by allocating expenditure to
various stages of production or to different
operations of a firm.”
ALTERNATIVE COSTING SYSTEMS

In this lecture we will consider 3 major alternatives to

Absorption (Traditional) Costing:
1. Activity Based Costing & Activity Based Management
2. Life Cycle Costing
3. Target Costing
ALTERNATIVE COSTING SYSTEMS
• ABC is not a method of costing, but a technique for managing the organisation better. It is
a one-off exercise which measures the cost and performance of activities, resources and
the objects which consume them in order to generate more accurate and meaningful
information for decision-making.

• ABM is the application of ABC data to manage product portfolios and

business processes better.

• ABM is a discipline that offers the organisation the opportunity to improve

the value of its products and services.
CIMA
 THE GOAL OF ABM
• Improve efficiency and effectiveness of the
organisation business processes by: Analysing and
costing activities.
• Resources are traced to activities to enable
evaluation and management of activities.
ACTIVITY BASED MANAGEMENT (ABM)
& ABC RELATIONSHIP
• The focus of ABC is on accurate information about the true cost of products,
services, processes, activities, distribution channels, customer segments,
contracts, and projects.
• ABM makes the cost and operating information useful by providing value
analysis, cost drivers, and performance measures to initiate, drive or support
improvement efforts and to improve decision making.
• It focuses managerial attention on business activities for-
• Improved customer value, cost control and profitability
• ABC is the information system and source for ABM
• Put simply ABM is ABC in action.
ACTIVITY BASED MANAGEMENT

Management Analysis Tools

ABM
e.g. completed projects,
Purchase orders, customer,
Finished product.
ABM - PROCESS VALUE ANALYSIS (PVA)
PVA focuses on accountability for activities rather than costs and involves
1. Driver analysis: identification of factor/root causes of activity costs
2. Activity analysis: identifying, describing, and evaluating organisation activities;
leading to 4 outcomes
– A list of what activities performed in the organisation
– Number of people involved in the performance of activities
– Time and resources required to perform each activity
– Evaluation of the value adding contributions of each activity
ABM - PROCESS VALUE ANALYSIS (PVA)
Activity Analysis leads to:
• Identification of Value-added activities / costs i.e.
– Activities that are essential for remaining in business +contribute to customer value
• Identification of Non-Value-added activities / costs i.e.
– All activities other than those essential for remaining in business e.g. scheduling, moving, waiting,
inspecting and storing.
• Required Actions.
– Activity elimination of non-value-adding activities
– Activity selection among a set of competing options
– Activity reduction – control of time and resources required for approved activities
– Activity sharing – the use of economies of scale to increase efficiency in the use of approved activities.
Hanson.Mowen.Guan (2009)
ABM - PROCESS VALUE ANALYSIS (PVA)
PVA focuses on accountability for activities rather than costs and
involves
3. Evaluation of activity performance via:
– Financial measures – value and nonvalue activity costs; trends in activity costs;
benchmarking, capacity utilisation, financial efficiency, etc.
– Nonfinancial/ Activity based performance measures – Time reductions, quality
improvements, cost reductions, trend measurements.
 FINANCIAL & ACTIVITY BASED REWARDS
Financial bases: Activity-Based Rewards
1. Financial performance basis 1. Multidimensional performance basis
2. Individual rewards 2. Group rewards
3. Salary increases 3. Salary increases
4. Promotions 4. Promotions
5. Bonus and profit sharing 5. Bonus, profit sharing and gains sharing
Hanson.Mowen.Guan (2009)
Life Cycle Costing
(LCC)
 Life Cycle
Costing (LCC)
Life Cycle Costing (LCC)
• Definition – a technique used to evaluate the total cost of a product or
service throughout its entire life cycle, from planning, design, acquisition,
support costs to disposal or end of life.
• Life Cycle Stages– There are five distinct phases in a product's life-
cycle:
1. Planning and development;
2. Introduction and growth;
3. Maturity;
4. Decline
5. Abandonment or renewal.
Life Cycle Costing (LCC)

(Armstrong & Kotler, 2013)

Product Life Cycle Stages
• Development
– Clearly major expenditures on R and D
– Moving to purchase of capital equipment etc
• Introduction
– Marketing to introduce the product to the market
– Production costs begin
– How should we price the product - penetration or skimming
• Growth
– Production costs continue
– Perhaps further capital spending
– Depending on competition may be high profits
– Some opportunity for minor cost reductions
Product Life Cycle Stages
• Maturity
– Product becomes cash cow, discretionary spending curtailed
– Competitors enter market, pressure on prices
• Decline
– Product looking ‘dated’
– Demand declining, maybe attempt to revamp product
• Withdrawal
– Product removed from market to be replaced by ?
– After sales support may need to continue beyond withdrawal
 Life Cycle Costing (LCC)
• LC Cost – The life-cycle cost includes the following costs:
• Design cost
• Development costs
• Introduction costs
• Manufacturing costs
• Selling and logistical costs
• Service and warranty costs
• Abandonment costs.
Life Cycle Costing Process
• Cost identification – identify and categorize the costs associated with
each stage of the product or service life cycle.
– Including design, manufacturing, distribution, maintenance, usage, and disposal.
• Time Value of Money - costs and benefits accruing in different time
periods are adjusted to their present value for better comparison of cost
and benefits.
• Cost Estimation - estimate the costs for each stage of the life cycle
involving, historical cost data, market research, and industry benchmarks.
Life Cycle Costing Process
• Benefits Assessment:– quantify the benefits associated with each
stage of the product or service life cycle.
– e.g. increased revenue, cost savings, improved efficiency, or environmental benefits.
• Sensitivity Analysis :– analyse the sensitivity of costs and benefits to different
variables or assumptions for better appreciation of potential impacts of e.g.
changes in product life span, maintenance costs, disposal costs, market demand,
etc.
• Continuous monitoring & improvements: - LCC is not a one-time activity
but an ongoing process. Regularly monitor and update the costs and benefits
associated with each stage of the life cycle.
Purposes of Life Cycle Costing
1. To determine if operating profits earned during the product's active or
manufacturing phase will cover the costs incurred in the planning and
abandonment phases;
2. At the planning period, identify and significant nonmanufacturing costs for a
given product design (e.g. warranty or product environmental costs) and to
initiate changes to the product design to eliminate or reduce those costs;
3. To support cost comparisons among different product designs.
4. To identify the nature and timing of costs for effective planning and control of
those costs.
 Why LCC is Important
1. Spending an additional Pound(£) in better design can often save several
pound (£) in manufacturing and post-sales activities (Drury, 2017).
2. It can cost 100 times more to correct a software defect during its operating
stage than to prevent or catch the bug in the design phase (Atkinson et al.,
2012).
3. The concept surpasses the purely economic cost calculation by taking into
account hidden costs and potentially external costs over the life cycle of the
product (Klöpffer, 2003)
4. This concept is very much in line with United Nations‘ Sustainable
Development Goals (SDGs) (Lam et al., 2018; Soni et al. 2016 )
 Life Cycle Costing
Atkinson (2011), discusses the costs of each life cycle stage of some interesting products ….
 LCC Activity 1
A manufacturing company which produces a range of products has developed a budget for the life cycle
of a new product “Alpha”. The information in the following table relates exclusively to product “Alpha”:

Lifetime Per unit

Total
Design costs £750,000
Direct manufacturing costs £20
Depreciation costs £540,000
Decommissioning costs £30,000
Machine hours 4
Production and sales units 300,000

The company’s total fixed manufacturing overheads are budgeted to be £36 million each year and total
machine hours are budgeted to be 48 million hours. The company absorbs overheads on a machine hour
basis. What is the budgeted life cycle cost per unit for product “Alpha”?
 LCC Activity 1
£'000
Budgeted annual production overhead 36,000
Budgeted annual machine hours 48,000
OAR per machine hr (£36,000/48,000) = 0.75
Overhead absorption per unit of Alpha - 4hrs x £0.75 = 3.00
 LCC Activity 1
Life Cycle Costing £'000

Design cost 750

Depreciation 540
Decommisioning costs 30
Direct manufacturing costs (£20 x 300,000) 6,000
Production overhead absorption (£3 x 300,000) 900
8,220
Budgeted production units (300,000) 300
LCC per unit of Alpha (£8,220,000 / 300,000) = 27.40
 Target
Costing
Target Costing
 Successful
target costing
 TARGET COSTING
• A target cost is ‘a product cost estimate derived by subtracting a desired profit
margin from a competitive market price.’
CIMA Official Terminology2

• A ‘cost management tool for reducing the overall cost of a product over its
entire life cycle with the help of the production, engineering, R&D, marketing,
and accounting departments’.
Sakura (1989)
• In short, it is a strategic management technique used to determine the cost at
which a product or service should be offered in order to meet specific profit
goals.
 TARGET COSTING
• Developed in Japan in early 1970’s for the manufacturing industry for
the following reasons:
• Demand for more diversified products
• Short product life cycles
• Increased autonomation and decreased labour input made standard costing
less relevant.
• It was discovered major part of product cost ( about 80%) is determined at
design stage
• Planning stages of new products became more important
• Lesson: Manage costs from the design stage forward, and launch products at prices
to attract customers and forestall imitation
 TARGET COSTING STAGES
1. Analyse the market and understanding customer needs and preferences. This
involves conducting market research, gathering customer feedback, and assessing
competitor prices.
2. Establish a selling price for the new product+ sales volume from an analysis of the
market, and a target profit.
3. Determine the target cost by subtracting the profit from the selling price.
4. Determine the costs involved in designing, developing, producing, marketing, and
delivering the product or service e.g. materials, labour, and overhead costs,
research and development expenses, marketing costs, and administrative expenses.
 TARGET COSTING STAGES
4. Value analysis: Examining each product or service component to identify
opportunities for cost reduction without compromising quality or performance.
o This can be achieved through design simplification, process
improvements, supplier negotiations, or alternative material sourcing.
5. Continuous improvement: An ongoing process. Regularly review and reassess
costs, identifying areas of inefficiency, and implementing corrective actions – e.g.
redesigning products, streamlining processes, or exploring new technologies to
reduce costs further.
6. Cross-functional teamwork: Successful implementation requires collaboration
from departments - design, engineering, production, procurement, marketing, and
finance.
 TARGET COSTING ADOPTION
• Tani et al. (1994) reported that 61 per cent of their sample of 180 listed Japanese
manufacturing firms used some form of target costing
• In the USA, Ernst & Young and the Institute of Management Accountants (IMA)
(2003) reported that 26 per cent of IMA member firms employed target costing.
• In a comparative study of the implementation of target costing in UK, Australian
and New Zealand companies Yazdifar and Askarany (2012) reported similar
adoption rates for each country with approximately 18 per cent of companies
adopting target costing
 TARGET COST

• Selling Price £516

• Less Target Profit £200
• Target Cost = £316
SUPPORTING
TECHNIQUES
SUPPORTING COSTING TECHNIQUES
1. Reverse Engineering
2. Value Analysis or Engineering
3. Kaizen Costing
4. Value Chain Analysis
5. Benchmarking
 Reverse Engineering
A process in which a products is deconstructed to extract design
information from them. Also known as Tear Down analysis
• Primarily supports Target Costing
• Take a competitor’s product & strip it down to see how it compares to
yours.
• Identify opportunities for –
– Product performance improvement
– Manufacturing cost reduction
– Refining features
– Replacing a product with a new version
Drury (2016)
 Value Analysis
A systematic and structured approach to improving the value of a product,
process, or system while reducing costs.
o Primary aim- Achieve desired functionality, quality, and performance at an
optimal cost. Supports Target Costing.
o Identify improved designs that will reduce or eliminate costs while improving
functionality + quality. Eliminate unnecessary functions that increase the cost
of the product
o Considers several things including – material, transportation, plant &
equipment, processes, sourcing, and delivery standards.
o Key: Adjust cost/benefit to achieve higher Value
Drury (2016) + other sources
 Kaizen Costing
This is a cost management approach focusing on continuous improvement
and cost reduction throughout an organisation.
o Primary objective: identify and eliminate wase and inefficiencies in
the processes, lowering costs while maintaining or improving quality.
o Small incremental steps. Not radical improvement
o Promotes cross-functional collaboration and cooperation.
o Value analysis is key. Applied at the manufacturing stage of the
product life cycle.
Drury (2016)
 Value Chain Analysis
The value chain is a set of linked activities that an
organisation carries out in order to deliver a product or
service to its Customers.

Porter (1985)
 Value Chain Analysis
• Aim – Analyse all business activities that help to create a product or service
from start to finish + identify improvement opportunities.
• Linking these activities cheaper than the competition will create a
completive advantage.
• Effective and efficient linking of these activities can enhance Customer
satisfaction, such as:
– Cost Efficiency – offer lower price to consumers
– Quality of products
– Delivery time
• Each chain in link seen as ‘Supplier – Customer’ relationship
 Benchmarking
• Compare key activities & processes with the Best Practice
found inside and outside the organisation.
– Internal Benchmarking – compare within our organisation
– External Benchmarking – compare outside the organisation
• Measures metrics such as:
– Cost
– Productivity
– Cycle time
• Widely used in Public sector organisations
(Drury, 2016)
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• Atkinson, A., Kaplan, R., Matsumura, E.M., 2011, Managerial Accounting: Information for Decision Making and Strategy
Execution with MyAccountingLab, Pearson
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Media, pages 484 – 499
• Defra, 2011, Guidance on Applying the Waste Hierarchy, Defra
• Drury, C., 2015, Management and Cost Accounting 9th Edition, Cengage Learning
• Drury, C., 2016, Management Accounting for Business 6th Edition, Cengage Learning
• Ellen MacArthur Foundation, 2015, Renault, Ellen MacArthur Foundation
https://www.ellenmacarthurfoundation.org/about/partners/global/Renault, retrieved 29/09/2016
• Hilton, 2008, Managerial Accounting: Creating Value in a Dynamic Business Environment, McGraw-Hill International Edition,
pages 222-225
• Infomine.com, 2016, Spot Gold Price and Gold Price Chart, Infomine.com,
http://www.infomine.com/investment/metal-prices/gold/1-day-spot/, retrieved 28/09/2016
• Porter, M., 1985, Competitive Advantage: Creating and Sustaining Superior Performance, The Free Press
• Rienmann, M., 2016, When remanufacturing meets innovation in a closed –loop supply chain, unpublished
• Slack, N., 2013, Operations Management seventh edition, Pearson