AC 4104 - STRATEGIC

COST MANAGEMENT
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 OVERVIEW OF STRATEGIC COST MANAGEMENT
 Strategy – is a set of policies, procedures and approaches to business that produce long-term
success. It is a set of goals and specific action plans that if, achieved, provide the desired
competitive advantage.
 Strategic Management – involves the development of a sustainable competitive position.
 Strategic cost Management – involves the development of cost management information to
facilitate the principal management function which is strategic management.
 Cost Management Information – is the information that the manager needs to effectively
manage the firm, profit oriented as well as not-for-profit organization. This includes financial
information about cost and revenues as well as relevant nonfinancial information about
productivity, quality and other key success factors for the firm.
 Cost management – is the practice of accounting in which the accounting develops and uses
cost management information. It is emphasizing only on financial information which could
lead manager to stress cost reduction (a financial measure) while ignoring or even lowering
quality standards (a nonfinancial measure). This decision could be a critical mistake which
could lead to the loss of customers and market share in the long run.
 Management Accountant’s Role in Strategic Cost Management
 Management Accounting – involves the application of appropriate techniques and concepts
to economic data so as to assist management in establishing plans for reasonable economic
objectives and in the making of rational decision with a view towards achieving these
objectives. It is the process of identification, measurement, accumulation, analysis,
preparation, interpretation and communication of financial information, which is used by
management to plan, evaluate and control activities within an organization.
 Management accountants – are concerned with providing information to managers, that is,
people inside the organization who direct and control the operations. They are accounting
professionals who develop and analyze cost management and other information.
 Administrative functions that must be performed by management accountant to provide a
system which allows management to receive the necessary information:
 a. Planning – which involves setting of goals for the firm, evaluating the various ways to meet
the goals and picking out what appears to be the best way to meet the goals.
 b. Controlling – which involves the evaluation of whether actual performance
conforms with plan goals; and
 c. Decision making – which involves determination of predictive information
(e.g. relevant costs) for making important business decisions.
 Relationship Between Cost Accounting and Cost Management
 Cost accounting – is a systematic set of procedures for recording and
reporting measurements of the cost of manufacturing goods and performing
services. It includes methods for recognizing, classifying, allocating,
aggregating and reporting such costs and comparing them with standard costs.
 Cost Management – needs the output of cost accounting and its purpose is to
provide managers with information which aids decision. The accounting
report should be tailored to the needs of the decision and the decision
maker.
 Strategic Decision Making and the Cost Management Accountant
 Basic Cost Management Perspectives:
 a. Strategic Management Perspective – The enterprise generates profits by
attracting customers willing to pay for the goods and services it offers. . The key
to company’s success is creating value for customers while differentiating itself
from the competitors. Customer value fall into three (3) broad categories, namely:
customer intimacy, operational excellence, and product leadership.
 b. Enterprise Risk Management Perspective – is a process use by an entity to
identify those risks and develop responses.
 c. Corporate Social Responsibility (CSR) Perspective – is a concept where
business organizations consider the needs of all stakeholders when making
decisions. They are responsible not only not only for creating strategies that
produce financial results that satisfy shareholders but also to serve other
stakeholders such as customers, suppliers, employees among others whose interest
are tied to the company’s performance.
 d. Process Management Perspective – Most companies organized themselves as functional
departments such as Marketing Department, Research and Development Department, and the
Accounting department. Effective managers, however, understand that business processes,
more than functional departments serve the needs of the company’s most important
stakeholders – its customers. A business process is a series of steps that are followed in order
to carry out some tasks in a business. The term value chain is often used to describe how an
organization’s functional departments interact with one another to form a business process. A
Value chain consists of the major business functions that add value to a company’s products
and services.
 e. Leadership Perspective – To achieve success, organizational leaders must able to unite the
behaviors of the fellow employee who have diverse needs, beliefs and goals to the workplace.
Leaders need to understand how the following factors influence human behavior:
 1. Internal motivation –refers to motivation that comes from within one’s self. A leader who
is perceived by employees as credible and respectful of their values to the company can
increase the extent to which those employees are intrinsically motivated to pursue strategic
goals.
 2. External incentives – such as bonus compensation are given by many organizations to
highlight important goals and to motivate employees to achieve them.
 3. Cognitive Bias – leaders should be aware that all people (including themselves) should
possess cognitive bias or distorted thought processes such as promoting false assertion that
can adversely affect planning, controlling and decision making. To reduce if not totally
eliminate cognitive biases, a leader may routinely appoint independent team of employees to
assess the credibility of recommendation set forth by other individuals and groups.
 F. An Ethics Perspective – without fundamental trust in the integrity of the business, the
economy would operate much less efficiently. Therefore for the benefit of everyone,
including profit-making companies, it is vitally important that the business be conducted
within the ethical framework that builds and sustain trust. Professional management
accountants have developed and implemented a set of Ethical Standards for practitioners
 Advantages of Strategic Cost Management
 Strategic Cost Management provides number of benefits to different organizations. It has
provided the business with an improved understanding of its sources of profits. Some benefits
are given below:
 1. It has developed a framework for reviewing the strategic allocation of resources across the
business based on core business processes and activities.
 2. It has improved the business understanding of its cost drivers leading to improved articulation of
its strategic plans in cost terms.
 3. It has enabled the business to assess, at a high level, how activity-based techniques can be
deployed at different levels in the business to improve its cost management process, such as in
budgeting and in process improvement.
 Uses of Cost Management Information
 Cost management information is needed for each of the following management functions, namely:
 1. Strategic Management. Involves the development of a sustainable competitive position in which
the firm’s competitive advantage spells continued success. It involves identifying and implementing
these goals and action plans. Management must make sound strategic decisions regarding the choice
of products, manufacturing methods, marketing techniques and channels and other long-term
issues.
 The strategic emphasis requires an integrated approach which combines skills from all business
functions, namely: marketing< production< finance and accounting/controllership, is necessary in a
dynamic and competitive environment
 Due to increasing strategic issues, cost management has moved from a traditional role of product
costing and operational control to a broader strategic focus: strategic cost management.
 2. Planning and Decision-making. Cost management information is needed to support
recurring decision such as replacing and maintaining equipment, managing cash flows,
budgeting raw material purchases, scheduling production, pricing and managing distribution
of products to customers, etc.
 Planning and decision-making involves budgeting and profit planning, cash flow
management and other decision related to the firm’s operation such as deciding whether to
lease or buy a facility, whether to replace or just repair an equipment, when to change a
marketing plan or when to begin new product development.
 3. Management and Operational Control. Cost management information is needed to
provide a fair and effective basis for in identifying inefficient operations and to reward and
motivate the most effective in managing.
 Operational control – takes place when mid-level managers (e.g., product managers,
regional managers) monitors the activities of operating-level managers and employees such
as product supervisors, department heads.
 Management control – is the evaluation of mid-level managers by upper-level managers such
as Controller or the Chief Financial officer (CFO).
 4. Reportorial and Compliance to Legal Requirements. Reportorial and compliance
responsibilities require management to comply with the financial reporting requirements to
regulatory agencies such as the SEC, BIR and other relevant government authorities and
agencies.
 The financial statement preparation role has recently received a renewed new focus and
interest as accounting scandals have shown how crucial and important accurate financial
information is for investors. Financial statement information also serves the other three
management functions as this information is often an important part of planning and decision
making, control and strategic management.
 Traditional Cost Management
 Traditional cost management is an accounting method used to determine the cost of making
products to make profit, and it is based on allocating overhead (or indirect) manufacturing
costs. This system relies on calculating predetermined overhead rates and applying the rates
to a given metric.
 Traditional costing system use estimated overhead rates for specific cost driver. A cost driver
is an element of the manufacturing process that may incur costs, such as: managerial
expenses. Packaging, machine hours, etc.
 The traditional costing system in accounting is the allocation of factory overhead to products
which is based on the volume of consumed production resources. Companies using this
method will apply overhead to either the number of machine hours used or the direct labor
hours which were consumed.
 Under traditional costing, one would add an average overhead rate to the direct costs of
manufacturing goods or providing services. It is applied on the basis of cost driving, reflecting
what is required to produce finished products.
 Limitations of Traditional Cost Management
 The following are the disadvantages of the Traditional Cost System:
 1. It offers limited accuracy, even in the best of situations.
 2. It wants to ignore unexpected circumstances
 3. It is not always a helpful system
 4. Its simplicity may be too simple
 5. It does not account for non-manufacturing cost
 Ethical Standards for Practitioners of Management Accounting and Financial Management
 Practitioners of management accounting and financial management have responsibility to:
 1. Competence. (a) Maintain an appropriate level of professional competence by ongoing
development of their knowledge and skills; (b) Perform their professional duties in
accordance with relevant laws, regulations, and technical standards; (c) Prepare complete
and clear reports and recommendations after appropriate analysis of relevant and reliable
information.
 2. Confidentiality. (a) Refrain from disclosing confidential information acquired in the
course of their work except when authorized, unless legally obligated to do so; (b) Inform
subordinates as appropriate regarding the confidentiality of information acquired in the
course of their work and monitor their activities to assure the maintenance of that
confidentiality; (c) Refrain from using or appearing to use confidential information acquired
in the course of their work for unethical or illegal advantage either personally or through
third parties.
 3. Integrity. (a) Avoid actual or apparent conflict of interest and advise all appropriate
parties of any potential conflict; (b) Refrain from engaging in any activity that would
prejudice their ability to carry out their duties ethically;
 (c) Refuse any gift, favor, or hospitality that would influence or would appear
to influence their actions; (d) Refrain from either actively or passively
subverting the attainment of the organization’s legitimate and ethical
objectives; (e) Recognize and communicate professional limitations or other
constraints that would preclude responsibility judgment or successful
performance of an activity; (f) Communicate unfavorable as well as favorable
information and professional judgment or opinions; and (g) Refrain from
engaging in or supporting any activity that would discredit the profession.
 4. Objectivity. (a) Communicate information fairly and objectively; and (b)
Disclose fully all relevant information that could reasonably be expected to
influence an intended user’s understanding of the reports, comments, and
recommendations presented.
 Implementing Strategy
 Balanced Scorecard – translates an organization’s mission and strategy into a set of
performance measures that provides the framework for implementing the strategy.
 The balance scorecard the non-financial objectives that an organization must achieve to
meet its financial objectives. It measures an organization’s performance from four (4)
perspectives:
 1. Financial perspective. Measures of profitability and market value among others, as
indicators of how well the firm satisfies its owners and stockholders.
 2. Customer Satisfaction. Measures of quality service and low cost, among others, as
indicators of how well the firm satisfies its customers.
 3.Internal Business Processes. Measures of the efficiency and effectiveness with which the
firm produces the product or service.
 4. Innovation and Learning. Measures of the firm’s ability to develop and utilize human
resources to meet the strategic goals now and into the future.
 Strategy map – is a method based, based on the balanced scorecard, that links the various
perspectives in a cause-and-effect diagram.
 Value Chain – is an analysis tool organizations use to identify the specific steps required to provide
a competitive product or service to the customer.
 Activity Analysis – is used to develop a detailed description of the specific activities performed in
the firm’s operations minimizing or eliminating non value added activities.
 Activity-Based Costing (ABC) – is used to improve the accuracy of cost analysis by improving the
tracing of costs to products or to individual customers.
 Activity-Based-Management – used activity analysis and activity-based costing to help managers
improve the value of products and services and increase the organization’s competitiveness. It focus
more on the efficiency and effectiveness of key business processes and activities.
 Target Costing – is a technique in which the firm determines the desired cost for the product or
service, given a competitive market price so the firm can earn a desired profit.
 *Target cost = Competitive price – Desired Profit
 Value Engineering – is used in target costing to reduce product cost by analyzing the trade-offs
between (1) different types and levels of products functionality and (2) total product cost.
 Functional Analysis – a common type of value engineering in which the performance and
cost of each major function or feature of the product is examined.
 Cost Smoothing – involves averaging of costs to eliminate high and low costs but it does not
reduce the total amount of indirect costs.
 Cost Driver – is the measure of the use of shared activity by each of the products. It is the
unit of an activity that causes a change in the cost of an activity. Michael Porter defines cost
driver as “structural determinants of the cost of an activity, reflecting any linkages or
interrelationships that affect it.
 Life-Cycle Costing – is a management technique used to identify and monitor the costs of
products through its life cycles. The lifecycle consists of all steps from product design and
purchase of raw materials to delivery and service of finished product.
 RD -> Design -> Production -> Marketing and Distribution -> Customer Service
 Benchmarking – is a process by which a firm identifies its critical success factors, studies the
best practices of other firms (or other business units within a firm) for achieving these
critical success factors, and then implements in the firm’s processes to match or beat the
performance of those competitors.
 Cost Leadership – is a competitive strategy in which a firm outperforms competitors in
producing products or services at the lower cost.
 Differentiation – is a competitive strategy in which a firm succeeds by developing and
maintaining a unique value for the product or service as perceived by consumers.
 Decision Making – is the process of studying and evaluating two or more available
alternatives leading to a final choice.
 Avoidable cost – cost that can be eliminated (in whole or in part) as a result of choosing one
alternative over another in decision-making situation. All costs are considered avoidable
except sunk costs and future costs that do not differ between alternatives at hand.
 Relevant costs – are expected future costs which differ between the decision alternatives.
These are costs that will be increased or decreased as a result of a decision.
 Opportunity costs – are the profits lost by the diversion of an input factor from one use to
another. They are net economic benefits given up when an alternative is rejected.
 Out-of-pocket costs – involve either an alternative or near-future cash outlay and are usually
relevant to decisions. Frequently, variable costs fall into this classification.
 Absorption costing – (also known as full, traditional, conventional and normal costing) is a method of
product costing in which all manufacturing costs, fixed and variable are treated as product inventoriable
costs.
 Variable costing – (or direct costing) is a method of inventory costing in which all variable manufacturing
costs are included as variable costs. All fixed manufacturing costs are excluded from inventoriable costs,
fixed manufacturing costs are instead treated as costs of the period in which they are incurred.
 Super-variable costing – is a variation in variable costing in which direct labor and manufacturing overhead
costs are considered to be fixed. It classifies all direct labor and manufacturing overhead costs as fixed
period costs and only direct materials as variable production cost.
 Budget – is a financial plan of the resources needed to carry out tasks and meet financial goals. It is a
detailed plan for the acquisition and use of financial and other resources over a specific period of time.
 Budgeting – is the process of preparing one or more budgets.
 Capital budgeting – is the process of deciding whether or not to commit resources to projects whose costs
and benefits are spread over several time periods. It is used to describe actions relating to the planning and
financing capital outlays. It is a process of evaluating proposed major projects such as purchases of new
equipment, construction of a new factory, and addition of new products and planning for resource
requirements.
 Strategic budgeting – are planned spending on initiatives and projects that lead to long-term value and
competitive advantage for the organization.
 Master budget – is an overall financial and operating plan for a coming fiscal period and the
coordinated program or achieving the plan. It is an aggregation of all subunit budgets into an integrated
plan of action for the budget period. It is a comprehensive budget for a specific period and consists of many
interrelated operating and financial budgets.
 Activity-based budgeting – is an extension of the traditional form of activity-based costing. It starts with
the budgeted output and segregates costs required for the budgeted output into homogenous activity cost
pools such as unit, batch, product-sustaining, customer-sustaining, and facility-sustaining activity pools.
 Incremental Budgeting – is a budgeting approach whereby the previous budget will act as a starting point
for the following year’s budget. The new budget is making changes from the current budget. The current
budget will adjust and add or subtract from the current amounts to have budgeted new quantities.
 Zero-Base Budgeting – is a budget process that requires managers to prepare budgets from zero base.
 Kaizen Budgeting – is a budgeting approach that explicitly demands continuous improvements in the
budget.
 Sales Budget – it shows what product will be sold in what quantities at what prices, is the foundation on
which all other short-term budgets are built.
 Quality – is a standard of something as measured against other things of a similar kind; the degree of excellence of something.
The ultimate test for a quality product or service is whether the product or service meets or exceeds customers’
expectations.
 Total Quality Management (TQM) – is the unyielding and continually improving effort of everyone in an organization to
understand, meet and exceed the expectation of customers.
 Costs of Quality – are costs associated with quality of performance and these costs are broken down into four broad groups
namely: Prevention costs, Appraisal costs, Internal failure costs, and External failure costs.
 Customer-response time – is the duration from the time a customer places an order for a product or service to the time the
product or service is delivered to the customer.
 On-Time Performance – refers to situations in which the product or service is actually delivered by the time it is scheduled to
be delivered. It increases customer satisfaction.
 Just –In-Time (JIT) Production – also called lean production is a demand-pull manufacturing system because each component
in a production line is produced as soon as and only when needed by the next step in the production line.
 Decision tree – is an analytical tool used in a problem in which a series of decisions has to be made at various time intervals,
with each decision influenced by the information that is available at the time it is made.
 Learning Curves - reflect the increased rate at which people performs tasks as they gain experience. The time required to
perform a given task becomes progressively shorter
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 Sensitivity Analysis - `describes how sensitive the linear programming optimal solution is to change
in any one number. It answers the what-if questions about the effect of change in prices or variable
costs; changes in value; addition or deletion of constraints, such as available machine hours; and
changes in industrial coefficients, such as the labor-hours required in manufacturing in a specific
unit.
 Linear Programming – is a mathematical technique that permits the determination of the best or
optimum use of the available resources, namely: money, personnel, materials, facilities and time. It
is valuable aid to management because it provides a systematic and efficient procedure which can
be used a guide in decision making.
 PERT (Program Evaluation and Review Techniques) – is a systematic procedure for using network
analysis systems for planning, measuring progress against schedule, evaluating changes to schedule,
forecasting future progress, and predicting and controlling costs.
 Economic Order Quantity (EOQ) Model – shows that the minimum total cost occurs at the point
where the two costs functions are equal. The EOQ or Optimal Q answers the question how much to
order.
 Reorder Point (ROP) – is the quantity level that automatically triggers a new order. This answers
the question “When to order”.
 Safety Stock – is the quantity of goods that are carried as a protection against possible stockouts.
 SWOT Analysis – is a strategic planning and strategic management technique used to help a
person or organization identify strengths, weaknesses, opportunities, and threats related to
business competition or project planning.
 Structural Cost Drivers – are strategic in nature and involves plans and decisions that have a
long-term with regard to issues such as scale, experience, technology, and complexity.
 Executional Cost Drivers – are factors the firm can manage in the short-term to reduce
costs, such as workforce empowerment, design of the production process, and supplier
relationships.
 Value Chain Analysis – is a process where a firm identifies its primary and support activities
that add value to its final product and then analyze these activities to reduce costs or
increase differentiation.
 Cost-Volume-Profit Analysis – a simplified model used to find out how changes in variable
and fixed costs affect a firm’s profit.
 Strategic Positioning Analysis – is a company’s relative position within its industry with
regard to matters related to performance. It depicts the choices that a company makes
about the type of value it shall create and how that value would be created differently from
competitors,
 Cost Management Concepts and Techniques for Control and Strategic Performance Measurement
 Performance Evaluation – is the process by which managers at all levels gain information about the
performance of tasks within the firm and judge that performance against pre-established criteria as
set out in budgets, plans and goals.
 Strategic Investment Unit (SIU) – also known as responsibility center is a specific unit of an
organization assigned to a manager who is held accountable for its operations and resources.
 Strategic Business Unit ( SBU) – is a unit within the organization which has control over costs,
revenues, profits and/or investment funds.
 Strategic Performance Measurement – also known as responsibility accounting is a system used by
top management to evaluate SIU managers.
 Cost SBU – is the unit within the organization wherein the manager is responsible for minimizing
costs subject to some output constraints.
 Profit SBU – is the unit or segment within the organization wherein the manager is responsible for
the generation of revenues and control of costs incurred in that SBU.
 Investment SBU – is the unit or segment within the organization where the manager is responsible
for the control of revenues, costs and investments made in that SBU.
 Transfer Price – is the price charged when one segment of a company provides goods or
services to another segment of the company. It is the value assigned to goods and services
transferred between segments within the company.
 Financial Measures – capture important aspects of both manager performance and
organization sub-unit performance such as: Return of Investment (ROI); Residual Income (RI);
Economic Value Added (EVA); and Return on Sales (ROS).
 Managing Productivity and Marketing Effectiveness
 Total Productivity – a productivity measure that includes all input resources used in
production. It is the ratio of output to input.
 *Productivity = Output / Input
 Partial Productivity – measures the relationship between the output and one or part of the
required input resources used in producing the output. The higher the ratio is the better.
 *Partial productivity = Number of units or value or output manufactured
 Number of units or cost of a single or part of the input resources
 Sales Price Variance – is the difference between the actual peso amount received from all the units
sold and the peso amount the firm would have received had the firm sold these units at the
budgeted selling price per unit. I measures the impact of deviations of the actual selling prices from
the master budgeted selling prices on contribution margin and operating income.
 *Sales Price Variance = (Actual selling price per unit – Budgeted selling
 price per unit) x Actual number of units sold
 Sales Volume (Activity) Variance - is the difference between the budgeted contribution margin for
the actual total units sold and the budgeted contribution margin for the budgeted units (master
budget contribution margin). It measures the effect on contribution margin and operating income
when the quantity sold for one or more products differs from the quantity in the master budget for
the period.
 *Sales Volume Variance = (Number of units sold – Number of units in the master
 budget) x Budgeted contribution margin per unit
 Capital Investment Decisions
 Payback period – measures the length of time required to recover the amount of initial investment.
It is the time interval between time of the initial outlay and the full recovery of the investment.
 *Payback Period = Net Investment / Annual cash returns
 Accounting Rate of Return (ARR)- also known as book value rate of return, measures
profitability from the conventional accounting standpoint by relating the required investment
to the future annual net income.
 *AAR = Average Annual Net Income / Net Investment or Average Investment
 Net present Value (NPV) – is the excess of the present value of cash inflows generated by
the project over the amount of the initial investment.
 *NPV = PV of cash inflows based on minimum desired discount rate – PV of investment
 Discounted Rate of Return / Internal Rate of Return (IRR) – is the rate which equates the
present value of the future cash inflows with the cost of investment which produces them.
 Discounted Payback Period – a method that recognizes the time value of money in a
payback context. This is used to compute the payback in terms of discounted cash flows
received in the future that is, the periodic cash flows are discounted using an appropriate
cost of capital rate.