Notes: UNIT - 5

UNIT - 5

Objective:
To make the students aware of various Neo cost concepts developed in the modern era of complex business activities.

UNIT OVERVIEW

Topics covered: Neo concepts for decision making: Concept, distinctive features of Activity Based Costing, Cost drivers, Cost of activities, Cost object such as product, service and customer. Cost management: Concept, Strategies and Applications. Value Chain Analysis, Target Costing and Life cycle costing.
How Activity-Based Costing Works
1. ABC is a management tool that provides better allocation of resources.
2. ABC principles are applicable to both appropriations and revolving funds.
3. ABC relates total cost (resources consumed) to work accomplished (outputs produced).
4. The ABC or unit cost goal is a financial benchmark that represents an expectation of the maximum total cost incurred in the production of an output.
5. ABC aligns costs to outputs thereby increasing cost visibility, and is useful in forecasting financial baselines.
ABC focuses on the activities of a production cycle; it is based on the premise that outputs (products or services) require activities to produce, and that activities consume resources. It recognizes the causal relationship of cost drivers to activities. An output is defined as something "put out" at the end of a production process. It can be a good or service, and it must be measurable or quantifiable.
As a rule, outputs are:
produced to satisfy customer requirements;
distinctly quantifiable, measurable, and auditable;
consistent from fiscal period to fiscal period to allow cost comparisons;
incorporated into existing or modified financial management systems; and
separately identifiable so costs can be more easily allocated.
DoD activities are generally more complex than the example cited above, and often involve the production of more than one output. For example, a distribution depot handles millions of items, some of which require different resources to receive, store, and issue them. In these cases, DoD unit cost methodology uses output measures that are aggregated. To determine an organization's outputs, it must look at its core activities or processes—the things that it does. For example, an output at the Defense Finance Accounting Service (DFAS) might be a paid invoice.
In addition, unit cost activities also often fall into the service category as opposed to the manufacturing category. This can make the identification of outputs more difficult, as there is not always a physical product provided to the customer. For example, a research and development activity may be "employed" by one of the military services to test a specific missile system in addition to its basic research mission. Though it could be argued that a tested missile is a valid output, the diversity of services available to customers requires that a more common output be identified. In this case, direct labor hours expended in accomplishment of a task has been adopted as a surrogate or proxy output measure.

The Unit Cost Formula
The ABC system uses cost drivers to assign the costs of resources to activities. ABC can use unit cost as a way of measuring an output. Unit cost is the "average total cost" of producing one unit of output. It is calculated by dividing the total cost of production by the total number of units of output produced. For example, if an automobile manufacturer produces 50 vehicles for a total cost of $1,250,000, then the cost per unit (vehicle) is $25,000. But unlike a company like General Motors, which calculates the unit cost for an automobile in order to determine an adequate selling price and profit margin, DoD providers normally do not build in a profit margin. Their goal is an accumulated operating result (AOR) of zero.

ABC's Basic Benefits
v Enables determination of total production costs traced to outputs.
v Targets areas needing management attention.
v Encourages the consideration of alternative methods of production.
v Highlights operational efficiency and inefficiency.
v Identifies financial benchmarks for activity performance.
v Generates more information to measure and reward performance, and prioritizes activities for cost reductions.
v Provides a common managerial framework among support activities.

Comparison between Traditional costing and ABC

Traditional
ABC
Salaries $100
Clean door $40
Equipment $80
Paint door $75
Supplies $20
Inspect door $75
Overhead $45
Send door to assembly $55
TOTAL $245
TOTAL $245


Steps for Performing Activity Based Costing

Analyze Activities
Gather Costs
Trace Costs to Activities
Establish Output Measures
Analyze Costs

These steps should be performed by the core BPI team - which the FAA identifies as a small group of people, committed by top management to work on a BPI project full time if available, or part time on the effort with possible support from BPI contractors. This process can take anywhere from a few days to a few months, depending on level of detail, complexity of an organization's processes, and commitment of team resources.






Analyze Activities
First the scope of the activities to be analyzed must be identified. It is suggested that the program include at least a half-dozen organizational units having a common functional orientation, and preferably also a common budget somewhere in the reporting chain. The depth and detail of analysis will be determined by activity decomposition, since activity decomposition is complete when one common or homogeneous primary output per activity is reached. Any prior work captured in IDEF0 models and their related definitions is considered here. This is where the core team can use activity models as a basis for selecting and interviewing key people associated with the business process.

A determination then is made if an activity is value or non-value added; also if the activity is primary or secondary, and required or not needed. Value added is determined if the output of the activity is directly related to customer requirements, service or product, as opposed to an administrative or logistical outcome that services the providing organization. For instance, if the output of an activity were an inventory report or update for products (for which there are customers), the output would be non-value added, but necessary to the organization, i.e., "overhead." A major goal of reengineering is to reduce non-value added activities and eliminate those that are not necessary. Primary activities directly support the organization's mission while secondary activities support primary activities. Required activities are those that must always be performed while discretionary activities are performed only when allowed by the operating management.

Gather Costs
In this step costs are gathered for the activity producing the products or services provided as the outcome. These costs can be salaries, expenditures for research, machinery, office furniture, etc. These costs are used as the baseline activity costs. When documents for the costs incurred are not available, cost assignment formulas may be used.

Trace Costs to Activities
In this step the results of analyzing activities and the gathered organizational inputs and costs are brought together, which produces the total input cost for each activity. A simple formula for costs is provided - outputs consume activities that in turn have consumed costs associated with resources. This leads to a simple method to calculate total costs consumed by an activity - multiply the percent of time expended by an organizational unit, e.g., branch, division, on each activity by the total input cost for that entity. Here we are not calculating costs, just finding where they come from.

Establish Output Measures
In this step the actual activity unit cost is calculated. Even though activities may have multiple outputs, only one is identified as the primary output. Activity unit cost is calculated by dividing the total input cost, including assigned costs from secondary activities, by the primary activity output volume; the primary output must be measurable and its volume or quantity obtainable. From this, a bill of activities can then be calculated which contains or lists a set of activities and the amount of each activity consumed. The amount of each activity consumed is extended by the activity unit cost and is added up as a total cost for the bill of activity.

Analyze Costs
In the final step, the calculated activity unit costs and bills of activity are used to identify candidates for improving the business processes. Managers can use the information by stratifying, for a Pareto analysis, the activity costs and identifying a certain percentage of activities that consume the majority of costs. The thing to keep in mind is that the identification of non-value added activities occurs through this process with a clarity that allows us to eliminate them, and at the same time permits the product or service to be provided to the customer with greater efficiency.



Reference:

v www.isixsigma.com
v www.altavista.com


Total Cost Management for Competitiveness


v What is Total Cost Management or Cost Management?

v Issues addressed by TCM.

v Some Tools and Techniques of TCM.

v The areas of focus for cost reduction also include.

v The areas of focus for cost reduction also include.

v TCM techniques and their overview (e.g. ABC).


Value chain analysis
Introduction
Value Chain Analysis describes the activities that take place in a business and relates them to an analysis of the competitive strength of the business. Influential work by Michael Porter suggested that the activities of a business could be grouped under two headings:
(1) Primary Activities - those that are directly concerned with creating and delivering a product (e.g. component assembly); and
(2) Support Activities, which whilst they are not directly involved in production, may increase effectiveness or efficiency (e.g. human resource management). It is rare for a business to undertake all primary and support activities.
Value Chain Analysis is one way of identifying which activities are best undertaken by a business and which are best provided by others ("out sourced").
Linking Value Chain Analysis to Competitive Advantage
What activities a business undertakes is directly linked to achieving competitive advantage. For example, a business which wishes to outperform its competitors through differentiating itself through higher quality will have to perform its value chain activities better than the opposition. By contrast, a strategy based on seeking cost leadership will require a reduction in the costs associated with the value chain activities, or a reduction in the total amount of resources used.
Primary Activities
Primary value chain activities include:
Primary Activity
Description
Inbound logistics
All those activities concerned with receiving and storing externally sourced materials
Operations
The manufacture of products and services - the way in which resource inputs (e.g. materials) are converted to outputs (e.g. products)
Outbound logistics
All those activities associated with getting finished goods and services to buyers
Marketing and sales
Essentially an information activity - informing buyers and consumers about products and services (benefits, use, price etc.)
Service
All those activities associated with maintaining product performance after the product has been sold

Support activities include:
Secondary Activity
Description
Procurement
This concerns how resources are acquired for a business (e.g. sourcing and negotiating with materials suppliers)
Human Resource Management
Those activities concerned with recruiting, developing, motivating and rewarding the workforce of a business
Technology Development
Activities concerned with managing information processing and the development and protection of "knowledge" in a business
Infrastructure
Concerned with a wide range of support systems and functions such as finance, planning, quality control and general senior management



Steps in Value Chain Analysis:
Value chain analysis can be broken down into a three sequential steps:
(1) Break down a market/organisation into its key activities under each of the major headings in the model;
(2) Assess the potential for adding value via cost advantage or differentiation, or identify current activities where a business appears to be at a competitive disadvantage;
(3) Determine strategies built around focusing on activities where competitive advantage can be sustained
Reference:

v www.tutor2u.net
v www.google.com
v www.indiainfoline.com




Target Costing


THE TARGET COSTING PROCESS
Essentially, companies use target costing to establish concrete and highly visible cost targets for their new products. To maximize cost control and enhance profit improvement, most companies set relatively aggressive targets. The process begins when top management establishes a target cost for a new product, for example, a Chrysler Neon or a Caterpillar Excavator. A cost estimating group will then decompose the target cost for the product as a whole into cost targets for subassemblies and individual component parts--engine, transmission, seats, and so on.
Frequently a "gap" exists between the target cost and cost projections for the new product based on current designs and manufacturing capabilities. Closing the gap through cost reduction is central to the target costing process. This is accomplished through cross-functional target costing teams, which analyze the product's design, raw material requirements, and manufacturing processes to search for cost savings opportunities. The cross-functional teams employ a variety of management tools and initiatives to help them achieve their objectives. The following section describes some of these tools and initiatives and other characteristics of successful target costing companies.

TARGET-COSTING PRINCIPLES
Target costing can best be described as a systematic process of cost management and profit planning. The six key principles of target costing are: (1)
1. Price-led costing. Market prices are used to determine allowable--or target--costs. Target costs are calculated using a formula similar to the following: market price - required profit margin = target cost.
2. Focus on customers. Customer requirements for quality, cost, and time are simultaneously incorporated in product and process decisions and guide cost analysis. The value (to the customer) of any features and functionality built into the product must be greater than the cost of providing those features and functionality.
3. Focus on design. Cost control is emphasized at the product and process design stage. Therefore, engineering changes must occur before production begins, resulting in lower costs and reduced "time-to-market" for new products.
4. Cross-functional involvement. Cross-functional product and process teams are responsible for the entire product from initial concept through final production.
5. Value-chain involvement. All members of the value chain--e.g., suppliers, distributors, service providers, and customers--are included in the target costing process.
6. A life-cycle orientation. Total life-cycle costs are minimized for both the producer and the customer. Life-cycle costs include purchase price, operating costs, maintenance, and distribution costs.

The following ten steps are required to install a comprehensive target costing approach within an organization.
Re-orient culture and attitudes. The first and most challenging step is re-orient thinking toward market-driven pricing and prioritized customer needs rather than just technical requirements as a basis for product development. This is a fundamental change from the attitude in most organizations where cost is the result of the design rather than the influencer of the design and that pricing is derived from building up a estimate of the cost of manufacturing a product.

Establish a market-driven target price. A target price needs to be established based upon market factors such as the company position in the market place (market share), business and market penetration strategy, competition and competitive price response, targeted market niche or price point, and elasticity of demand. If the company is responding to a request for proposal/quotation, the target price is based on analysis of the price to win considering customer affordability and competitive analysis.

Determine the target cost. Once the target price is established, a worksheet (see example below) is used to calculate the target cost by subtracting the standard profit margin, warranty reserves, and any uncontrollable corporate allocations. If a bid includes non-recurring development costs, these are also subtracted. The target cost is allocated down to lower level assemblies of subsystems in a manner consistent with the structure of teams or individual designer responsibilities.





TARGET COSTING STEPS AT CATERPILLAR
Once companies have the tools and systems in place to support target costing, they often develop a standardized approach for achieving their target costing objectives. Caterpillar offers a good illustration to highlight the target costing process for one of its new products. For this particular vehicle, management set the target cost at 94.6% of a comparable model, creating an initial gap of 5.4%. The cost of the comparable model is based on current manufacturing capabilities. Therefore, to achieve the target, costs must be reduced by 5.4%.Current costs for a comparable model 100.0%Target cost for new product 94.6%Cost gap 5.4%
A cost improvement team is then assembled from product design, manufacturing engineering, production, marketing, and purchasing to determine how to close the gap. Initially, the group evaluates component part substitutions that would reduce costs but still provide the product features and benefits necessary to satisfy customer requirements. The group also considers opportunities to reduce costs through efficiency improvements. Table 1 shows that the cost improvement team identified 4.6% in "known" savings through an initial evaluation of cost savings opportunities.
Having reduced the gap by 4.6%, the team must find an additional 0.8% in savings to achieve the 5.4% cost reduction target. At this stage, the cost improvement team surveys the operational groups to identify potential cost savings opportunities. The responses to the questionnaire do not recommend specific solutions, but they do identify where improvement opportunities are more likely to be successful (see Table 2). Each "yes" response on the questionnaire indicates an opportunity for cost reduction, and the component part category (cab, engine, hydraulics, etc.) that has the largest number of positive responses is viewed as having the greatest potential for saving money. Table 2 highlights a sample questionnaire, and a tally of the responses indicates the extent to which each part category will be targeted for cost reduction. In this case, hydraulics will be responsible for achieving the highest percentage (50%) of the cost savings that are needed. Therefore, the cost of hydraulics must be reduced by .4% (.50 * .08).
Table 3 illustrates the final step in the process. It takes the adjusted costs column from Table 1 and subtracts the additional savings that are required for each component part category. The right-hand column in Table 3 illustrates the target cost for the new vehicle, broken down to the component level. To recap, Caterpillar began with current costs for a comparable product (100%) and, after deducting known savings based on existing technology (Table 1) and potential savings based on an analysis of the questionnaire (Table 2), established cost targets for each component of the new vehicle.

Reference:
v www.findarticles.com
v www.npd-solusions.com
v www.altavista.com


LIFE CYCLE COSTING

In the past, comparisons of asset alternatives, whether at the concept or detailed design level, have been based mainly on initial capital costs. However, with growing pressure to achieve better outcomes from assets, ongoing operating and maintenance costs must be considered as they consume most resources over the asset’s service life.
Life Cycle Costing is a process to determine the sum of all the costs associated with an asset or part thereof, including acquisition, installation, operation, maintenance, and refurbishment and disposal costs. It is therefore pivotal to the asset management process.
Life Cycle Costing incorporates both Life Cost Planning which occurs during development or manufacture and implementation of that plan by Life Cost Analysis as the asset is used or occupied.
Life Cycle Costing forms an input to evaluation processes such as Value Management, Economic Appraisal and Financial Appraisal.
Understanding Life Cycle Costing

An example of stainless steel-
Life Cycle Costing (LCC) has long been used in planning for reliability and maintenance for complex engineering systems in defence, airline, railway, offshore platform, power station, and other applications.
A basic attribute of stainless steel is the ability to provide long-term performance with a minimum of downtime and cost associated with maintenance. As a result LCC is of particular importance to the stainless industry.
Whilst the mathematics of LCC can be quite complex the International Chromium Development Association (ICDA) has developed an IBM or compatible PC program on floppy disk which can be easily applied to most examples.
The Australian Stainless Steel Development Association can make this program available to any interested party on request.
LCC analysis provides a more secure basis for comparing and selecting material options than the traditional method of judgments based on comparing acquisition costs alone. This particularly applies to situations where the initial cost is high and downtime for unplanned maintenance is costly.
In circumstances where stainless is being considered or introduced into new fields of applications, comparisons are often made with materials of a lower initial cost such as coated carbon steel or plastics.
Here the reasoning should progress well beyond the simple initial cost comparison and take account of the long term cost assessments associated with maintenance replacement and operating stoppages.
LCC is the tool to make this assessment and the ICDA program makes it easy.
Calculating LCC
In the LCC calculation, consideration is given only to relevant costs which are directly or indirectly affected by the material options being considered. Besides the cost of material, these include costs of installation, operation, maintenance, stoppages, replacements and possibly the residual value at the end of the service life. The time intervals at which the various costs arise during the selected life cycle period must also be taken into account.
Before the various cost items can be put together, those that arise every year and those that occur at certain time intervals during the service life must be converted into present values.
Again the complexities of the mathematics are catered for by the PC program.
Examples are the best way of demonstrating LCC principles and application and two are offered to illustrate the point.
The first is from Swedish practice and features roofing.
The building industry is one of the most rapidly expanding markets for stainless steel and roofing is a major growth application. A method based on seam welding 0.4 mm strips of cold rolled stainless steel was invented in Sweden in the 60s and has since found favour in Europe and Japan. An LCC calculation was carried out based on these material options:
galvanised and plastic coated carbon steel, double folded edges
0.4 mm stainless steel strip, seam-welded and single folded edges (type 316 for coastal areas or polluted atmospheres, otherwise type 304)
In this example the LCC period is 50 years and a real interest rate of 3% is used (comparative figures are given per sq metre):
The LCC result shows that stainless steels are less costly than galvanised and plastic coated steel. Galvanised carbon steel requires replacement after about 20 years. The calculation does, however, not take into account the risk of damage to building substructures each time the covering is replaced. The stainless steel alternative is the only one which is virtually maintenance free.

Reference:
v www.gamc.nsw.gov.au
v www.indisinfoline.com
v www.khoj.com