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Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA
LEARNING OBJECTIVES
At the end of this unit, you should be able to:
1. Differentiate traditional cost management and strategic cost management.
2. Identify and describe the components of strategic cost management.
3. Understand the relevant factors that are analyzed in strategic positioning analysis.
4. Differentiate structural costs from executional costs.
5. Define value chain and identify its primary and support activities.
6. Understand how value chain analysis is applied by understanding its three frameworks of industry
structure analysis, core competency analysis and segmentation analysis.
7. Determine the contribution of the management accountant to the overall strategic management of
a business entity.
8. Define product life cycle and apply basic concepts of life cycle costing.
CONTENTS
I. Introduction to Strategic Cost Management II. Life-cycle Costing
A. Traditional versus Strategic Cost A. Product Life Cycle, Defined
Management:
1. Traditional Cost Management B. Phases in Product Life Cycle
2. Strategic Cost Management C. Product Life Cycle Costing, Characteristics
A broad-based cost reduction could lead to inferior quality of products and services which might
drive away customers resulting in lower sales and profitability.
The expectations of modern customers are quite different. An excessive focus on cost reduction
could impact the quality of product and services, and alienate the customers.
o Ignores dynamics of marketing and economics - Traditional cost management system has internal
focus and does not look at the external factors such as competition, market growth and customer
requirement. Traditional cost accounting systems rely on accounting data which can be misleading at
times. Financial statements can be a great reporting tool but might not be able to assist in strategic
decision making as it focuses on historical costs.
o Limited focus on review and improvisation of existing processes and activities.
o Reactive approach to costs already incurred
o Short-term outlook, often with a focus on saving costs on an annual basis.
A company’s strategy is directed towards achieving a sustained competitive advantage that will pave
the path towards organization goals. Strategic cost management, one of the means towards that
goal, hence should be aligned with the vision, mission and objectives of the company.
Before any kind of strategy or tactical plan can be implemented, it is fundamental to conduct a
situational analysis. The PESTEL analysis forms part of that and should be repeated at regular stages to
identify changes in the macro-environment. Organizations that successfully monitor and respond to
changes in the macro-environment are able to differentiate from the competition and create a
competitive advantage.
• Political - These determine the extent to which government and government policy may impact an
organization or a specific industry. This would include fiscal, monetary and trade policies being
advocated by the government entities.
• Economic - These factors impact the economy and its performance. These include conditions of
the general market, consumers, labor force, costs and inflation, GDP and GNP, and foreign
exchange rates.
• Socio-cultural - These factors focus on the social environment and emerging trends. This helps a
marketer to further understand their customers’ needs and wants. Factors include changing family
demographics, education levels, cultural trends, attitude changes and changes in lifestyles.
• Technological - These factors consider the rate of technological innovation and development that
could affect a market or industry. Factors could include changes in digital or mobile technology,
automation, and research and development. There is often a tendency to focus on developments
only in digital technology, but consideration must also be given to new methods of distribution,
manufacturing and logistics.
AE 313 Introduction to Strategic Cost Management
Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA
• Environmental - These factors relate to the influence of the surrounding environment and the impact
of ecological aspects. With the rise in importance of environmental sustainability, this element is
becoming more important. Factors include climate, recycling procedures, carbon footprint, waste
disposal and sustainability. Strategic cost management topic for this is the Environment
Management Accounting.
• Legal - Political factors do cross over with legal factors; however, the key difference is that political
factors are led by the government as they execute the law, whereas legal factors must be complied
with regardless of implementation. Relevant law should be gathered & reviewed for compliance
regularly.
A PESTEL analysis helps an organization identify the external forces that could impact their market and
analyze how they could directly impact their business. It’s important when undertaking such an analysis
that the factors affecting the organization are not just identified but are also assessed – for example,
what impact might they have on the organization?
3. Internal environment
• Resources - factors that enable a company to create value for customers. They can be tangible
(land, buildings, inventory, machinery, money etc.) or intangible (employee’s skills, brand, patent,
technology etc.). The more difficult a resource is to imitate, the more valuable is the resource for
the company. The algorithms used by Google to deliver search results are not easily imitated by
competition. Similarly, the secret formula of concentrates used by soft drinks manufacturers like
Coca Cola are hard to copy.
• Competencies - the company’s ability to coordinate resources and put them to productive use.
Availability of resources by themselves does not guarantee core competency and success.
Capabilities stem from organizational structure, processes and control systems.
• EXECUTIONAL cost drivers are based on firm’s operational decision on how the various resources are
employed to achieve the goals and objectives. These cost drivers are determined by management
style and policy.
o Employee morale level, turnover rates, degree of involvement
o Quality management approach, employee training level, return merchandise rates, customer
satisfaction ratings
o Plant layout efficiency; throughput time, ability to convert from one product/service to another
o Product configuration, capacity utilization
AE 313 Introduction to Strategic Cost Management
Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA
The idea of a value chain was first suggested by Michael Porter (1985) to depict how customer value
accumulates along a chain of activities that lead to an end product or service.
The various activities undertaken by a firm can be broadly classified into primary activities and supporting
activities. Primary activities are those which are directly involved in transforming of inputs (Raw Material)
into outputs (Finished Products) or in provision of service. Supporting activities (also known as secondary
activities) allow the smooth operation of the primary activities. Though, supporting activities are not directly
involved in creation of product, it doesn't mean that they are of less importance as compared to primary
activities.
A. PRIMARY Activities:
1. Inbound Logistics: These are activities concerned with receiving, storing, and distributing the inputs
(raw materials) to the production process. The relationship with suppliers is a key component in this
process.
2. Operations: These activities involve transforming inputs into final product. Activities such as
machining, packaging, testing and equipment maintenance form part of the operations activity.
3. Outbound Logistics: These activities involve collecting, storing and distributing the products from
the factory line to end consumers. This may include finished goods warehousing, delivery vehicle
operation, sales order processing and scheduling.
4. Marketing and Sales: Marketing and Sales provide the means by which the customers are made
aware of the product. The activities include advertising, promotion, distribution channel selection,
sales force management and pricing policy.
5. Service: This includes activities related to after sales service like Installation, repair and parts
replacement.
AE 313 Introduction to Strategic Cost Management
Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA
B. SUPPORT Activities:
1. Firm Infrastructure consists of activities such as planning, finance, accounting, legal, government
affairs and quality management.
4. Procurement involves purchasing of raw material, supplies and other consumables required as inputs for
primary activities.
A value chain gives managers a deeper understanding of what the organization does and helps them identify
key processes of the business. The various processes can be analyzed to identify those activities which do not
add value to consumers. Such non-value activity can be eliminated to reduce costs and improve profits of
the business as a whole.
Among the five forces, supply chain factors which include bargaining power of suppliers and of buyers
contribute to vertical competition. The threat of new entrants, the threat of substitute products and
services, and intensity of rivalry amongst firms create horizontal competition.
1. Bargaining power of buyers: The bargaining power of buyers generally determines the ability of buyer
to push the price down. This happens when the buyers are concentrated or when the volume
purchased by buyers is very high. In other words, when the bargaining power of buyers is high, they
would be in a position to dictate terms to the firm. A buyer also has higher bargaining power if the cost
of switching suppliers is very low. A higher bargaining power results in lower profitability. Large
companies have a high bargaining power when they buy from small suppliers.
AE 313 Introduction to Strategic Cost Management
Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA
2. Bargaining power of suppliers: The bargaining power of supplier is relatively higher when the input is
important to the buying firm or when there are very few suppliers of the input. The suppliers could also
dictate terms if the input supplied is not replaceable or when an alternate input is not available.
Microsoft dominates the operating system business of computers and laptops and can dictate terms
to its buyers as buyers do not have multiple options to choose from. The profitability of companies can
shrink if their suppliers have a higher bargaining power.
3. Threat of substitute products or services: When multiple and close substitutes are available in the
market for a particular product, customers are likely to switch suppliers easily. A firm in such a case
must resort to competitive pricing to retain its customers. When few substitutes exist for a product,
consumers are willing to pay a potentially high price. If close substitutes for a product exist, then there
is a limit to what price customers are willing to pay. The problem becomes severe if substitutes are
available at much cheaper price. A company should strive to build its brand and customer loyalty to
thwart the threat of substitutes.
Substitutes could be from within the industry or from a different industry. The paper industry faces threats
from entities in the e-book market. When more people switch to public transport as trains, the demand
for vehicles comes down.
4. Threat of new entrants: The threat of new entrants largely depends on the barrier to entry and
perceived profitability in an industry. If an industry is profitable and the barriers to entry are low, new
firms could enter the industry leading to excess supplies and reduced prices. Some examples of barriers
to entry are intensive capital requirement, sophisticated technology, legal factors, and limited access
to raw material and labor, among others.
Industries which require a huge amount of capital or sophisticated technical knowhow might not have
a high threat of new firms entering into the industry. The airline industry is a case where very few new
firms enter the business because of the capital requirements. Another barrier to entry could be
legislation which restricts newer firms to start the business, like in the case of telecommunication
industry. Certain industries (for example medicines) are largely driven by patents and new firms might
find it difficult to enter the industry. An industry where threat of new entrants is low is more profitable
than an industry where new entrants can easily enter the industry.
5. Intensity of competition/ rivalry amongst firms: Some markets are more competitive than others. In
highly competitive industries, firms resort to cut-throat competition to win more customers. The
competitive rivalry is higher when an industry has high number of firms and is lower when there are few
large players dominating the market. The intensity of competition is generally higher in the following
cases:
• Extra capacity exists in the industry
• Difficulty in differentiation in the products.
• High exit barriers - This is a case where the exit costs are high and hence firms must continue in the
industry despite excess capacity at industry level.
• Higher fixed costs - Firms would want to produce as much as possible to keep the unit costs low
leading to surplus capacity.
Since these five forces are ever-changing, Porter’s framework needs to be employed as a dynamic
analytical tool. This is because competition is a dynamic process; equilibrium is never reached and industry
structures are constantly being reformed. The five forces analysis helps a firm to better understand the
industry value chain and its competitive environment.
Once a company has successfully differentiated its offering, management may exploit the advantage
in one of two ways viz., either; increase price until it just offsets the cost of improvement in customer
benefits, thus maintaining current market share; or price below the “full premium” level in order to build
market share. Companies like Apple charge premium prices from its customers because customers
perceive Apple’s product to be different from others.
2. COST Leadership – Relative low-cost advantage, under which customers gain when a company’s total
costs undercut those of its average competitor.
A firm enjoys a relative cost advantage if its total costs are lower than those of its competitors. This
relative cost advantage enables a business to do one of the following:
• Charge a lower price than its competitors for its product or services in order to gain market share
and still maintain current profitability; or
• Match with the price of competing products or services and increase its profitability.
A company may choose a strategy in which it can lower its cost and thereby gain a competitive
advantage. Many sources of cost advantage exist - access to low-cost raw materials; innovative process
technology; low-cost access to distribution channels or customers; and superior operating management.
A company might also gain a relative cost advantage by exploiting economies of scale in some
markets.
Example - A refinery which has superior technology can process low grade crude to produce oil. Since low
grade crude is cheaper than what the competitors pay for high grade crude, the company might be in a
position to charge lower price & gain additional market share or charge higher price and earn better profits.
A disadvantage of this strategy is that competitors might find way to lower their costs as well. Hence,
a company which pursues a cost leadership strategy must continuously improve its cost structure.
Another risk associated with cost leadership strategy is that managers might try to lower costs by
compromising the quality of products.
3. Market NICHE Focus – By understanding the dynamics of a particular market and the unique needs of
customers within it, this strategy develops uniquely low-cost or well-specified products for the target
market. Because they serve customers in their market uniquely well, they tend to build strong brand
loyalty amongst their customers. This makes their particular market segment less attractive to
competitors.
As with broad market strategies, it is still essential to decide whether you will pursue cost leadership or
product differentiation once you have selected a focus strategy as your main approach: Focus is not
normally enough on its own. However, the key to making a success of a generic market niche focus
strategy is to ensure that you are adding something extra as a result of serving only that market niche.
AE 313 Introduction to Strategic Cost Management
Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA
It's simply not enough to focus on only one market segment because your organization is too small to
serve a broader market (if you do, you risk competing against better-resourced broad market
companies' offerings).
The company must look at its value chain, which consists of all of its functions ― production, marketing,
R&D, customer service, information systems, materials management, human resources ― to determine
each one’s role in lowering the cost structure, increasing customers’ perceived utility through
differentiation of its product or service and/or catering to needs of its specific market.
Step 2: Evaluate differentiation strategies for enhancing customer value: The company seeks to
evaluate various strategies which could enhance the customer value. Strategies which a company
can implement to enhance the customer value are:
• Providing superior features in a product - e.g. Premium cars, Phones etc.
• Using effective marketing and distribution channels - e.g. on time delivery.
• Excellent customer service - e.g. timeliness of repairs at effective cost, cleanliness at hotels
etc.
• Having a superior brand image - e.g. Apple, Google, Tata
• Offering better quality product at competitive prices.
Step 3: Determine the best sustainable differentiation strategies: The activities which could enhance
differentiation must be identified. A company must identify those strategies which could create
sustainable product/ service differentiation. The selection of strategy must be according to the
availability of resources.
products to the customers. A company must have an understanding of not only its internal value chain
but also of the industry value chain.
A company might not carry out all activities in the entire value chain of an industry. Hence, it might
not be in a position to obtain information relating to costs and revenues for each process being carried
out in the industry. However, such information is necessary for a firm to carry out a vertical linkage
analysis. A company must identify the cost drivers for each of the process in the value chain of the
industry as done in the case of the internal value chain analysis. A company must identify and evaluate
the opportunities for sustainable competitive advantages after carrying out an industry value chain analysis.
Example - A company manufactures cars using various components like chassis, steering wheel, tires, axles
etc. The company does not manufacturer all the components in-house and are purchased from third party
suppliers. The company focusses on assembly line which is its core competency. However, certain parts,
which are critical to the car are manufactured in-house. This is a strategic choice to gain a competitive
advantage.
In another case, a company could identify that there is virtually no competition in a particular process
of the value chain. In such a case, it is less likely that the company might get a competitive price for
the components it purchases. If there is only a single battery manufacturer, the car company might
end up paying higher price. Such a situation could lead to a competitive disadvantage. A company
might also carry out negotiations with its suppliers after an analysis of industry value chain. This generally
happens when the company observes that certain section of value chain is charging excessive
margin.
Similar to internal cost analysis, this would be discussed and applied in Activity-based Costing.
This analysis will reveal the competitive advantages or disadvantages of different segments. A firm may use
this information to decide to exit the segment, to enter a segment, reconfigure one or more segments, or
embark on cost reduction/ differentiation programs.
Step 1: Identify segmentation variables and categories: An industry might be divided into multiple segments
depending upon the nature and complexity of the industry. The segmentation could be based on the
nature of products or geographies or customers.
Step 2: Construct a segmentation matrix: After the segments are identified, a segmentation matrix
(generally two way) can be created. ITC could create a matrix based on the nature of products (Cigarettes,
Hotels, Textile, Paper etc.) and geographies (North, East, West and South). Another way could be to create a
matrix using products and distribution channel (wholesale, retail, direct).
Step 3: Analyze segment attractiveness: The segmentation matrix could be used to evaluate profitability
and performance of each of the segment. The interrelationship between various segments (say distribution
channels, similar products) must also be considered while analyzing segmental attractiveness. For very
similar segments, a responsibility accounting report may suffice.
Step 4: Identify key success factors for each segment: Each segment identified must be assessed with a
relevant measure of performance. It could be quality of product, service, timeliness of delivery etc. A single
performance measure across all segments is not advisable. A measure which suits the service segment will
not suit the manufacturing segment.
Step 5: Analyze attractiveness of broad versus narrow segment scope: The company must identify whether
it wants to be in a broad segment or a narrow one. Narrower segments could be risky for business as a single
segment could be vulnerable to the competition. Multiple segments help a company to spread costs across the
various segments. The company might also be in a position to use the competency of one segment in other
segments. Some firms might abandon certain segments because of lack of profitability. The competitive
advantage of each segment may be identified in terms of low cost and/or differentiation.
AE 313 Introduction to Strategic Cost Management
Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA
LIFE-CYCLE COSTING
The overall strategic cost management tool that will be discussed is life-cycle costing. It aims at cost
ascertainment of a product or project over its projected life. It is a system that tracts and accumulates the
actual costs and revenues attributable to product from its inception to its abandonment. It is loosely used
interchangeably with the terms cradle-to-grave costing and womb-to-tomb costing to describe a system that
fully captures all costs associated with the product from its initial to final stages.
In the growth stage, maintaining high prices are suggested to realize maximum profits. Price reduction will not
be undertaken unless (a) the low prices will lead to market penetration, (b) the firm has sufficient production
capacity to absorb the increased sales volume, and (c) competitors enter the market.
AE 313 Introduction to Strategic Cost Management
Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA
Last week, Amit, the Software Division Manager, decides to use Life Cycle Costing in his own division. He
collects the following Life Cycle Revenue and Cost information for the packages (in pesos):
Particulars ECE CE IE
Year 1 Year 2 Year 1 Year 2 Year 1 Year 2
Revenues 500,000 2,000,000 600,000 900,000 1,000,000 600,000
Costs
R&D 700,000 - 450,000 - 240,000 -
Design of Product 115,000 85,000 105,000 15,000 76,000 20,000
Manufacturing 25,000 275,000 110,000 100,000 165,000 43,000
Marketing 160,000 340,000 150,000 120,000 208,000 240,000
Distribution 15,000 60,000 24,000 36,000 60,000 36,000
Customer Service 50,000 325,000 45,000 105,000 220,000 388,000
REQUIRED: Present a product life cycle income statement for each software package. Which package is
most profitable and which is the least profitable? How do the three packages differ in their cost structure
(the percentage of total costs in each category)?
AE 313 Introduction to Strategic Cost Management
Prepared by: Maybel Kua, CPA Edited by: Joseph R. Mendoza, CPA
SUGGESTED ANSWER:
Life Cycle Income Statement (in thousands of pesos)
Particulars Package ECE Package CE Package IE
Y1 Y2 Total % Y1 Y2 Total % Y1 Y2 Total %
Revenues 500 2,000 2,500 100% 600 900 1,500 100% 1,000 600 1,600 100%
Less: Costs
R&D 700 - 700 28% 450 - 450 30% 240 - 240 15%
Design 115 85 200 8% 105 15 120 8% 76 20 96 6%
Manu. 25 275 300 12% 110 100 210 14% 165 43 208 13%
Marketing 160 340 500 20% 150 120 270 18% 208 240 448 28%
Distribution 15 60 75 3% 24 36 60 4% 60 36 96 6%
Cust. Service 50 325 375 15% 45 105 150 10% 220 388 608 38%
Total Costs 1065 1085 2150 86% 884 376 1260 84% 969 727 1696 106%
Profit 350 14% 240 16% (96) -6%
REQUIRED: Recommend with supporting figures, which machine to purchase, stating any assumptions made.
SUGGESTED ANSWER:
Amount PVF PV of CF
Purchase price P 19000 1 P 19000
Salvage value -3000 0.318631 (955.89)
Annual repair cost 2000 6.813692 13627.38
Overhaul cost (at the 8th year) 4000 0.466507 1866.03
PVF of Net Cash Outflow - E P 33537.52
Divided by: PVFA - 12 years, 10% 6.813692
Equivalent Annual Cost of Equipment P 4922.08
Amount PVF PV of CF
Purchase price P 13000 1 P 13000.00
Salvage value -3000 0.564474 (1693.42)
Annual repair cost 2600 4.355261 11323.68
Overhaul cost (at the 4th year) 2000 0.683013 1366.027
PVF of Net Cash Outflow - Y P 23996.28
Divided by: PVFA - 6 years, 10% 4.355261
Equivalent Annual Cost of Equipment P 5509.72
E-Machine has a lower equivalent annual cost; hence it should be purchased instead of Y-Machine.
*Note that with additional information, the above illustrations can be further analyzed with respect to tax
implications and the financing costs. These will be taken under the topic Capital Budgeting.
AE 313 EXERCISES Environmental Management Accounting