Cost management lecture slide summary

Lecture 1 Reasons for US growth 1977-­‐2007: end of cold war; China; spread of Internet; Financial deregulation and easy. Business inputs: land; material; labour; capital; enterprise; technology. Business decisions bound inputs with outputs Output: goods, service, information and data. Economically viability; financial variability; Efficiency ($, lowest cost) and Productivity (volume term) Economic efficiency: technical efficiency (values at production possibility frontier) and allocation efficiency (selecting the point, opportunity costs) Business decisions comprise from: -­‐ -­‐ -­‐ -­‐ -­‐ Economic: micro (price, supply & demand, cost) and macro (inflation, tax) Finance: capital structure (WACC) and capital budget (company value over market) Management Marketing: 5P’s (price, place, people, product, promotion) Accounting: financial (FS, reporting) and cost accounting ()

Cost types: a) Direct (labour, material) b) Overheads (burden/indirect costs) allocated based on direct labour or machine hours c) Nonmanufacturing (period costs): G&A and selling expenses Prime costs = Direct labour + Direct materials Conversion costs = COGS – Direct material -­‐> Direct labour + Overheads Value chain: Direct Material + Direct Labour +Direct Expenses = Prime Costs +Factory Overheads = Factory Costs +Office Overheads = Cost of Production + S/D Overheads = Cost of Sales +Profit = Sales Advanced value chain:

[Opening – Closing] Raw Material +Purchases + Inward Transport =Value of Material Consumed + Direct Wages + Direct Expenses = Prime Cost +Factory Overheads + [Opening – Closing] Stock of WIP

= Factory Costs + Administrative Overheads = Cost of Production + [Opening – Closing] Stocks of Finished Goods = COGS +Profit = Sales Cost or management accounting is the process relating to recording, classifying, and summarizing costs for the determination of costs of products or services, planning, controlling, and the provision of information to management for decision-­‐making. Aim is to understand how costs and revenue interact.

Cost-­‐Volume-­‐Profit (CVP) analysis: Price-­‐Volume-­‐VC-­‐TFC-­‐Mix of products Break even point in units = Fixed costs / (Price-­‐VC) OR TFC/T Contrib x (Sales) Shut down should be considered only when contribution per unit is negative. Contribution ratio = Unit contribution / Sales Price Operating leverage [over FC] = Contribution margin / Net operating income If sales volume > the Point (where profit from labor intense = profit from capital intense), then Capital intense [otherwise labor intense in order to mitigate high income volatility at capital intense process, as its operating leverage is high]. Traditional income statement = Sales – COGS – Selling & Admin expenses Contribution income statement = Sales – Variable costs – Fixed costs

Lecture 2 The relevant financial inputs for decision-­‐making are future cash flows, which will differ between the various alternatives being considered. Cash flow that is the same for all alternatives is irrelevant. Decisions based on relevant cash flows: price, product mix, PPE acquisition, outsourcing, and discontinued operations. Cost-­‐Plus Pricing: (Average VC + % allocation of FC) * (1 + Markup %) Problems: inelastic to price, require precise estimate of the demand Absorption costing: allocate overheads based on appropriate allocation base (lh) Full costing [good for single product manufacturing]: Sum of total costs / Number of units produced à No blanket (same for all) overhead rate Direct vs. Indirect 70/30 Activity Based Costing (ABC): It assigns more indirect costs (overheads) into direct costs. When overheads are small part of costs – use traditional costing. The cost driver is a factor that creates or drives the cost of the activity. Interview and survey employees to identify principle activities and estimate percentage of time spent on activities. Use percentages to assign costs to activities. Interviews should be repeated periodically. Deal idle and unused time. Analyzing overheads to identify cost drivers is time consuming and costly Variable costing: treat fixed costs, including fixed overheads, as period expenses.

Lecture 3 Identify activities as value added or non-­‐value added. Develop a scoring structure to assign a high value or low value added as perceived by customer. Identify opportunities to improve value added activities and reduce or eliminate non-­‐value added activities. The cost of unused capacity should not be assigned to products produced or customers served during a period. Issues with ABC include: • • • • Lack of senior management commitment Delegating the project to consultants / Poor ABC model design Individual and organizational resistance to change People feel threatened

MSDA (Mark, Sell, Distr and Adm) expenses: If managers only use financial performance metrics, they may take actions that improve short-­‐term financial performance but damage long-­‐term customer relationships. Both financial and nonfinancial metrics are needed to manage performance with customers. Customer profitability = Profit from this customer / Total profit for the year Establish a learning curve to deal with unprofitable customers Customer profitability analysis helps identify effective and ineffective customer-­‐ related activities. These activities include simplifying complicated order process, consolidating many small orders into fewer larger ones, and training customers to minimize costs by eliminating numerous changes to their orders. When companies rank products, they generally find that the top-­‐selling 20% of products generate 80% of the sales. The 80–20 rule applies well to sales revenues but it doesn’t apply to profits.

High Cost-­‐to-­‐Serve Customers • • • • • • Order custom products Small order quantities Unpredictable order arrivals / Customized delivery Large amounts of pre-­‐sales support Large amounts of post-­‐sales support Pay slowly

Low Cost-­‐to-­‐Serve Customers • • • • • • • Order standard products High order quantities Predictable order arrivals / Standard delivery Electronic processing with zero defects Little to no pre-­‐sales support No post-­‐sales support Pay on time

Companies have many options to increase customer profitability • • • • Process improvements Deploy menu-­‐based pricing to allow customers to select the features and services they are willing to pay for Enhance the customer relationship to lower cost to serve Use more discipline in granting discounts and allowances

Activity-­‐based pricing prices orders, not products Companies can transform unprofitable customers into profitable ones by managing customer relationships • • Persuade them to use a greater scope of products and services Establish minimum order sizes

The critical parameters for calculating Lifetime Customer Value are: • • • • Initial acquisition cost Profits or losses earned each year Additional costs to retain the customer Duration of the relationship

Don’t focus only on financial measures. Use surveys. Promote royalty Customers often remain with their current supplier because of lack of inertia, high switching costs, or lack of an alternative supplier Cost based drivers: labor hours, machine hours, labor dollars ABC is based on four steps:

1. Identify and classify the activities related to the product or service. 2. Estimate the costs of these activities 3. Calculate a cost driver rate for each activity 4. Assign activity cost to products

Lecture 4 The Balanced Scorecard (BSC) provides a system (mission, vision, and strategy) for measuring and managing all aspects (customer, financial, learning/growth, and process) of a company’s performance (through objective, measurement, target, and initiatives). Casual relationship: learning/growth -­‐> improved process quality/timing -­‐> increase in customer loyalty -­‐> higher financial returns a) Financial performance is improved through: revenue growth (higher price; new customers; new markets; higher market share; loyalty) or increase productivity (cost cutting; improved efficiency). b) The value proposition is the unique mix of product performance, price, quality, availability, ease of purchase, service, relationship, and image offered to the targeted customers (e.g. cost leader, best buy price, etc.): • • Defines the company’s strategy Communicates what the company expects to do for its customers better or differently from its competitors

d) Learning/growth perspective: IT, HRM and Org culture (climate, knowledge sharing, and commitment to common goals) Types of cost drivers: a) Basic cost drivers: regulations, service demand/supply, customer related activities, geography, technology, operating environment b) Management cost drivers: Customers service standards, Industrial and customer agreements, Staff Mix, Skills and competencies c) Process drivers: Support and indirect labor, Overtime levels, Staff and resource utilization, The business process d) Price related cost drivers