Strategic Cost Management

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Chapter 13

• Strategic Cost Management
• IDIS 424
• Spring 2004

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Cost-related Concepts

• A cost driver is any factor that affects costs.
  A change in the cost driver will cause a change
  in the total cost
• Cost management are actions that managers take to
  satisfy customers while continuously reducing and
  controlling costs

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Cost Behavior

• Cost behavior refers to the way costs change with
  respect to a change in an activity level or cost
  driver
• Typical cost behavior patterns include
• Fixed costs
• Variable costs
• Mixed costs
• Semifixed costs
• Semivariable costs

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Cost Behavior Patterns

• Fixed costs are costs that do not change with
  changes of a cost driver
• Variable costs are costs that increase directly
  and proportionately with changes of a cost driver
• Mixed costs are costs that have both a fixed and
  a variable component

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Cost Behavior Patterns

• Semifixed costs are costs that increase with the
  level of activity, but by intermittent jumps,
  rather than continuously
• Semivariable costs are costs that increase with
  increasing levels of activity, but not at a
  constant rate. Can be separated into costs that
• increase at an increasing rate
• increase at a decreasing rate

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Cost Behavior Patterns

• Fixed Costs
• Variable Costs
• Semifixed Costs
• Semivariable Costs

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Total Cost

• Total cost is the sum of all costs
• Total costs increase as the volume of production
  or service increases, while the cost to produce
  each unit or provide each service decreases

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Total Cost

• Total cost specifics
• Total fixed costs do not change with volume
  increases or decreases
• Unit fixed costs decrease as volume increases
• Total variable costs increase with volume
• Unit variable costs may or may not change with
  volume changes

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Cost-related Concepts

• Direct costs are costs that are related to the
  cost object and can be traced to it in an
  economically feasible manner
• Direct materials (e.g., raw materials, purchased
  components, expendable packaging associated with
  a given product)
• Direct labor (e.g., all labor traceable to a
  given product)

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Cost-related Concepts

• Indirect costs are costs related to the cost
  object but cannot be traced to it in an
  economically feasible way. Indirect costs are
  allocated to the cost object using a cost
  allocation method (e.g., overhead costs)
• Indirect costs may have both a fixed and a
  variable component

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Overhead Cost Assignment

• Three common overhead assignment approaches
  include
• Overhead cost per direct labor hour
• Overhead as a percent of direct labor cost
• Overhead per machine hour

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SGA Expenses

• SGA expenses that are associated with supporting
  the interface between buyer and the supplier as
  well as those expenses that are not directly
  related to the organizations primary operations
  but are required to support these operations

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SGA Expenses

• SGA will typically include
• Sales salaries and commissions
• Advertising
• Administrative salaries
• Research and development
• SGA is usually presented as a percentage of
  annual net sales

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Prices, Profit, and Revenue

• Price is the amount that a buyer is willing to
  pay for a given product or service
• Profit is the difference between the total cost
  to produce a product or service and the selling
  price
• Revenue (sales revenue) is the product of price
  multiplied by the quantity sold

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Cost-related Concepts

• Sunk costs are those costs already committed to a
  project or decision
• An economic cost is the value of a good when
  employed in an alternative use. For example,
  specialized tooling used for a discontinued
  project that has no other alternative use or
  scrap value has an economic cost of zero

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Cost-related Concepts

• Differential costs refer to cost differences
  between two or more decision alternatives
• Controllable costs are those costs under the
  direct control of a manager. A manager should be
  accountable for only those cost items that he or
  she has the ability to control

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Cost-related Concepts

• Discretionary costs include any cost that can be
  avoided in the short term
• Continued cost avoidance, however, can result in
  the deterioration of a firms competitiveness or
  contribute to higher long-run costs

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Cost-related Concepts

• Relevant costs include only those costs having a
  direct impact on a decision
• Relevant costs have three necessary
  characteristics
• They must be differential (costs associated with
  two or more decision alternatives are different
  or unique)
• Future oriented (costs will not occur until after
  the decision is made concerning how to proceed)
• Quantifiable

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Price/Cost Management

• Price analysis examines price proposals without
  examining elements of cost and profit
• Cost analysis addresses actual or future costs

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Goals of Price/Cost Management

• Develop accurate price/cost information to
  enhance negotiating effectiveness
• Drive continuous price/cost improvement
• Effectively beat out the competition
• Determine type of supplier relationship

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Approaches
Price/Cost Management Approaches
Market Based Pricing
Cost Based Pricing
Non-collaborative
Collaborative
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Approaches

• Market-Based Pricing
• The price the buyer pays is not linked to the
  supplier's cost structure
• Cost-Based Pricing
• The price the buyer pays is directly linked to
  the supplier's cost structure
• Hybrid
• Some elements of cost may be known by the buyer

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Market-based Pricing

• Based on supply and demand
• Suppliers and buyers determine the price
  according to what either suppliers are asking or
  buyers will offer

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Market-based Pricing Approaches

• Market testing
• Initial price determined by competitive bid, and
  on-going negotiations thereafter
• Quantity discounts
• Volume consideration linked to price
• Longer term agreements linked to price
• Price change control
• Ceilings established on future price changes
• Reverse price analysis

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Reverse Price Analysis
Hypothetical Price 20 Profit / SGA
Allowance (15) - 3 Subtotal 17 Direct
Material - 4 Subtotal 13 Direct
Labor - 3 Manufacturing Burden
10 X TOTAL VOLUME TOTAL FIXED
COST (Will vary as volume changes)
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Cost-based Pricing - Non-collaborative

• Market-testing - initial contact through bid and
  on-going negotiations
• Target pricing - established ceiling cost to
  achieve a competitive position in the market for
  the finished product
• Supplier uses target price as a basis for
  accepting the order

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Cost-based Pricing - Collaborative

• Cost identified - margin or ROI negotiations
• Identification of cost drivers
• Targeted goals
• Establishment of value added / non-value added
  costs
• Continuous cost improvement (collaborative)

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Supplier Pricing Issues

• Pricing objectives
• Long-term versus short-term
• Price leader versus follower
• Establish entry barriers
• Pricing Strategy
• Cost based pricing (cost fixed markup)
• Market based pricing (penetration, skimming,
  floor pricing)

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Pricing Strategies

• Demand (skimming) pricing
• Introduction and growth of life cycle
• What the market will bear
• Works under conditions of no competition
• Cost-plus (penetration) pricing
• Maturation stage of life cycle
• Minimum acceptable price
• Appeals to a mass market with objective of sales
  increase

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Pricing Strategies

• Survival pricing
• Price remaining capacity at marginal cost
• Market share pricing
• Used to take market share from competitors
• Social responsibility pricing
• Forgoes sales and profits - puts society first
• Rule-of-Thumb (myopic) pricing
• DM DL 40
• Buy-in (foot in the door, low ball) pricing
• Cover VC only

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Pricing Variables

• External
• Nature of the product (life cycle)
• Sellers market characteristics
• Buyers control variables
• Internal
• Sellers internal characteristics
• Management orientation
• Accounting and costing methods

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Measures of Price Management Effectiveness

• Types of measures include
• Percent improvement of price paid over inflation
• Percent improvement of price paid vs. prior year
• Target prices achieved
• Ratio of actual price change improvement to
  comparable market index change

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Problems with Traditional Cost Accounting

• Standard product costs
• No recognition of tradeoffs
• Product cost structures
• Allocation of overhead fixed
• Budgeting and control
• Labor efficiencies / machine utilization

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Assigning Indirect Costs
Supervision 1000
Cooling Fluids 2000
Rags 200
Electricity 1500
Direct labor-related cost pool 2500 (2500/500
hrs)5/hr
Material weight-related cost pool
2200 (2200/220 kg) 10/kg
15/kg
Direct material
Products P1 and P2 Total Cost 425
Direct labor
10/hr
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Cost Behaviors

• Fixed Costs
• Variable Costs
• Semifixed Costs
• Semivariable Costs

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Which supplier would you rather do business with?

• High Fixed Costs Low Fixed Costs

Revenues
Revenues
Breakeven
Breakeven
VC
VC
FC
FC
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Relationship Between Sales and Costs

• As a suppliers sales increase. . .
• Fixed costs __________
• Average fixed costs _______
• Average variable costs ________
• Total variable costs __________
• Total costs __________
• Average total costs _________

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Production Cost Schedules
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Average Cost Curve
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Total Cost Curve
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Price Reductions
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What Happens to Profit?
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Price/Cost Management

• Price analysis examines price proposals without
  examining elements of cost and profit
• Cost analysis reviews actual or future costs
• COST PROFIT PRICE

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Goals of Price/Cost Management

• Develop accurate price/cost information to
  enhance negotiating effectiveness
• Drive continuous price/cost improvement
• Effectively beat out the competition
• Determine type of supplier relationship

45
Approaches

• Market-Based Pricing
• The price the buyer pays is not linked to the
  supplier's cost structure
• Cost-Based Pricing
• The price the buyer pays is directly linked to
  the supplier's cost structure
• Hybrid
• Some elements of cost may be known by the buyer

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Market-based Pricing

• Based on supply and demand
• Suppliers and buyers determine the price
  according to what either suppliers are asking or
  buyers will offer

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Framework for Cost Management
High Risk Low
Unique Products
Critical Products
Generics
Commodities
Low High Value (Cost, Service, Administration)
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Generics

• Low Value, Low Risk
• Strategies
• Standardize / consolidate
• Critical Factors
• Reduce cost of acquisition
• Metrics
• Total Delivered Cost Reduction
• Percent of CGS Improvement
• Transportation cost reduction

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Commodities

• High Value, Low Risk
• Strategies
• Leverage preferred suppliers
• Critical Factors
• Reduce cost of materials
• Metrics
• Price change improvement to market index

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Unique Products

• High Risk, Low Value
• Strategies
• Preferred suppliers
• Critical Factors
• High costs when cost/quality problems occur
• Metrics
• Unit price cost reduction - Actual to actual
  prices for same items
• Target prices achieved, Should cost
• Total Delivered Cost Reduction

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Critical Products

• High Risk, High ValueStrategies
• Strategic supplier partnerships
• Critical Factors
• High costs when cost/quality problems occur
• Metrics
• Target prices achieved
• Unit price cost reduction - Actual to actual
  prices for same items
• Joint cost savings sharing