Transforming Cost Management into a Strategic Weapon

Tom Freeman Program Director, The Consortium for Advanced Manufacturing International (CAM-I)

The lowest-cost producers of the highest-quality products will cope best with the present slump. They will soon start growing and profiting again. Some never stopped Costs, especially, are a decisive factor. Most automakers now are competitive in terms of product quality. But the big differentials remain in cost structures Cost management is going to be for the automobile industry in the 1990s what quality control was in the 1970s and 80s. (S. Toyoda & T. Toyoda, Toyota Annual Report, October 1993, p.1.)

Introduction
This is a tremendously exciting time in the evolution of strategic cost and resource management. Since the emergence of activity-based costing as a mainstream performance improvement tool in 1986, several cost management methods have been developed or documented by CAM-I and others. Among these advances are Target Costing, Capacity Management, Process-Based Management, and improved performance measurement and reward systems including the balanced scorecard. As a result of these developments, the components of an integrated cost planning and management approach are becoming visible. Rather than an internally focused and tactical control system, effectively understanding and managing costs is increasingly being used by companies as a strategic weapon. The purpose of this paper is to develop a conceptual model of the organization and to demonstrate how effective understanding of activities and their resulting costs plays a key strategic role along the various performance dimensions of the organization. The Cost Management Systems (CMS) program of CAM-I has worked for the past ten years to develop leading-edge research and industry best practices in cost management methods. It has become increasingly clear as our thinking has evolved that individual management techniques are more effective when they are developed and framed within the context of a larger system of hierarchical relationships and processes. The purpose of this conceptual model is to provide a framework that helps the reader to understand the elements of this larger system. It will also focus on the relationships among various elements of the model, and to provide a communication platform that can be used to highlight areas where more effective subordination and integration is needed. This paper will focus on a few of the more significant developments that have been made by U.S. manufacturers who are using an integrated cost management approach to achieve strategic advantage. A conceptual model for understanding the fundamental dimensions of the enterprise where cost management systems can focus will be introduced and briefly discussed. Two of the underlying requirements for integration and strategic leverage, activity based decision support systems and a process-based view of the organization will be discussed. The remainder of the discussion will focus on approaches that have been developed and implemented by leading edge U.S. companies to better understand customer and product profitability, enhance revenues, plan and manage profitability, and measure and manage capacity. Each of these techniques, both individually and in combination, has significant strategic implications for the firm. No firm that we are aware of has fully integrated a system of management that incorporates all of these approaches. However many organizations are implementing these techniques concurrently as they move toward a more robust and responsive approach to strategic cost and resource management.

Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

The Business Hierarchy

The first critical relationship that affects strategic cost management initiatives is the business hierarchy. Figure 1 - The Business Hierarchy
The CAM-I CMS Framework Market Data Flow

business hierarchy of needs

market/customer strategy
Planning Activities

(why)
(what) (how) (resourc es)
Control Activities

product / service process inputs

Accounting Data Flow

Source: Alan Vercio, Texas Instruments, 1995. This layered model demonstrates the relationships that should guide the deployment of management strategy and initiatives. The top layer represents the presence of the customer in effective business strategy. By considering customer demands, businesses will be able to address the critical "why" questions involved in strategy development. For example, "Why should we be developing new products and/or services?" "Why should we pursue new markets?" "Why should we launch a new quality campaign?" This layer represents the introduction of the voice of the customer into the management process. The ability to transition from this layer to the next is based on the ability to translate the voice of the customer into product capability requirements. The customer can be a real customer in todays environment, or a perceived customer in tomorrows environment. The second layer of the hierarchy is the product/service dimension. This represents the important "what" decisions that must be addressed by business strategy. "What products and services will we develop?" "What capabilities will we provide to the customer?" "What levels of functionality will we deliver?" This component, in combination with the voice of the customer, represents the traditional business and market planning and management activities of the organization. The ability to transition from this layer is based on the ability to translate product capability requirements into manufacturing and/or service delivery process requirements. The process layer of the model addresses "how" work gets done in the organization, specifically how the factors of production (materials, labor, facilities, and innovation) are converted into viable products and services that satisfy customer demands. This level of the business hierarchy is synonymous with the traditional role of operations management in the organization. The final transition point is the translation of manufacturing requirements into specific resource requirements. The inputs or resource layer of the hierarchy is representative of the specific factor inputs that are required to execute the business strategy. This layer represents the development or acquisition of resource inputs that can be applied in the process layer with the greatest possible degree of productivity. Only through the effective subordination and integration of each of these levels of the business hierarchy can effective business strategy and management be accomplished. Planning activities drill down from top to bottom, while managers exercise control over resources, processes and products/services within the specific 2 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

layer(s) for which they are accountable. The CMS program has developed leading-edge research and case studies on a number of these management tools that will be described in the following pages.

The Underlying Requirements for Strategic Leverage A Process-based View of the Organization
In 1994, it seemed that every company was involved in a large-scale process-reengineering project. Almost four years later, the teams have mostly disbanded and moved back into functional responsibilities, the process maps have been folded, rolled or neatly bound and put away, and the months of meetings and interviews are starting to seem like a distant memory. But by virtue of returning to business as usual, there is a nagging feeling that something was missed, that there was something that was left undone. And it feels very much like the performance improvements that were identified through reengineering are slipping away. Why is this happening? It is happening because most organizations that embraced process reengineering only made the easy changes the technical, structural and system changes that were leading directly to dysfunctional workflow and results. They failed to make the deeper changes the cultural, political and behavioral changes that begin to solidify the organizations commitment to continuous improvement, and insure long-term benefits. Organizations can influence change on three levels as described below. Figure 2 - Three Layers of Change

Three Layers

Operational Changes

Process Structure

Technology Structure

Organization Structure

More Concrete Easiest to Change

Managerial Changes

Reward Structure

Measurement Systems

Management Methods

Cultural/Value Changes

Organizational Culture

Political Power

Individual Belief Systems Less concrete More difficult to change

Source: Ardenus and Stalich, Business Reengineering Survival Guide (adapted). Reengineering largely focused on operational changes work flow, system enablers, departmental structure, information flow, etc. The more robust applications improved the performance measurements of the organization. But very few efforts dramatically changed the way the organization perceives itself with respect to its customers and processes. One-time improvement efforts such as reengineering can simply not have this type of impact due to their duration and focus. This is precisely the role that process management and continuous process improvement can play. They form a complementary system when used in conjunction with process reengineering, and become the foundation for other far-reaching improvement initiatives such as ABC/M, target costing, and capacity measurement and management. Consider Figure 3:

3 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

Figure 3 - The Complementary Roles of Reengineering and Process Management

Process Management

Process Re-engineering
Intensive Revolutionary Tops down Systems solutions Dramatic improvements

Process Improvement
Ongoing Evolutionary Bottoms up People solutions Incremental changes

We Need Both To Be Successful We Need Both To Be Successful

Source: GTE Process Management Steering Team, 1996. By making a commitment to continuous improvement, organizations can begin to impact the third layer of change that affects the organizational culture, political power and belief systems that underlie behavior and subsequently, performance. What Does Being a Process-Centered Organization Mean? Functionally focused organizations are often ineffective and inefficient when work must be coordinated across traditional functional boundaries. This is due to the fact that the needs of the customer are often secondary to the goals of each functional area, thereby creating functional silos and limiting the creation of value within the company. Worse still, the customer may be ignored and decide to go elsewhere. In contrast to a functional focus, a process-focused organization requires that every executive, manager and process performer constantly consider the needs of the customer in everything that is done. Boundaries between functions are torn down as the organization creates core processes that involve personnel, technology and information across numerous functions for the purpose of adding value to the goods and services that a company creates, thereby maximizing customer satisfaction. A process-focused approach enables organizations to attain a competitive advantage through the integration of otherwise disconnected initiatives. What are the Steps toward Becoming a Process-Centered Organization? There is a natural migration path that companies who primarily manage by department or function may follow if they wish to pursue a process-focused management approach. There are distinct levels of maturity that the organizations will attain as they pursue this objective. Texas Instruments (see Figure 4) has developed an excellent depiction of the levels of process maturity.

4 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

Figure 4 - The Texas Instruments Metric and Process Maturity Model

TI Metric & Process Maturity Model

Metric Description
Metric driven actions are simulated during the strategy setting process to ensure organization alignment before the metric is put into production. Metrics in the enabling processes and centers of excellence are aligned with the integrated business processes. Metrics enhance communication across the core processes and focus on the investment decision process where 80%+ of the life cycle costs are committed. Process metrics have been added and integrated with result metrics. Metric alignment between the strategy and daily activities in the core processes is established. Metrics are adhoc and primarily results oriented.

Summary Level Summary

Process Description
Process management has enabled the enterprise to be a learning, agile, and forward looking organization. Enabling process management subordinated to business processes is implemented, in control, and in managements unconscious thinking. Business processes establish a common language or translator with each other business process. This enables inter-business process excellence (eg. DFM). Business process management which begins and ends with the customer, is established, in control, and in managements conscious thinking.

Optimizing

5 4 3 2 1

Holistic

Total Alignment

Enabling Processes Integrated

Horizontal Alignment

Core Processes Integrated

Vertical Alignment

Customer Focus

Initial

Initial

Few processes are defined. Process management is not a strategic thrust.

Copyright 1996 Texas Instruments Inc.

Source: Emery Powell, Texas Instruments, 1996. The levels in TIs maturity model describe the attributes of organizations at different levels of maturity. But what is the high-level development process that leads to the result? CAM-I has developed a seven-part migration model to assist companies who are trying to migrate toward process management. These are the basic components of the approach. 1. Create the Vision management at all levels must understand and communicate the attributes of a process-based organization. Jack Welch described the vision as boundarylessness. Every organization has to create a language and set of metaphors that describe the way that they wish to interact with one another, and particularly with their customers. This process is tied directly to the organizations strategic intent. GTE expressed its strategic intent as follows To be the easiest company for our customers to do business with. This provides a directive for all process improvement initiatives to center upon specifically, remove the impediments to world-class customer service from the processes. Without such a vision, improvement initiatives cannot be defined. Create Process Clarity Does the organization have an explicit set of named business processes that are customer-focused and cross functional? It is too easy to simply redefine a departmental role (such as sales) as a process. This is rarely correct. Processes should be viewed from the customers perspective from the time they request a product or service until it is delivered. Many organizations who have undergone extensive reengineering still do not have a set of globally-recognized named business processes. Create Process Awareness does every employee from the executive to job performer level know what business process(es) they are a part of and what are the performance objectives and standards for that process? Roles must be communicated in terms of the output of the process rather than in terms of departmental accountability. Figure 5 represents Chryslers process structure. 5 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

2.

3.

Figure 5 - Chrysler's Value Chain

Chryslers Value Chain

PRODUCT CREATION
PERFORM RESEARCH DEVELOP PRODUCT STRATEGY DEVELOP PRODUCT CONCEPT DEVELOP MAJOR PRODUCT ELEMENTS VALIDATE MAJOR PRODUCT ELEMENTS DEVELOP PRODUCT METHODS

VOLUME PRODUCTION
IMPLEMENT PRODUCT METHODS OBTAIN PRODUCT ORDER MANUFACTURE COMPONENTS OBTAIN COMPONENTS ASSEMBLE PRODUCT DISTRIBUTE FINISHED PRODUCT

CUSTOMER ACCEPTANCE
FACILITATE PURCHASE EXPERIENCE OBTAIN SERVICE MATERIAL SERVICE PRODUCT/ CUSTOMER STIMULATE OWNER LOYALTY ASSESS CONSUMER PREFERENCE

SUPPORT

Source: George Millush, Chrysler Corporation, 1996. Establish Cross-Functional Process Ownership and Control is there a system in place with accountabilities and infrastructure that formally supports coordination of results and performance levels for the end-to-end process. This is an area of major concern in that many critics of the process-centered approach suggest that functional organizations or departments must be removed from the organization chart and replaced with process-based structures. This is simply not true, nor is it desirable. Process owners and process team members ideally wear two hats. They maintain their functional expertise, while concurrently acting as members of a process team with accountability for the results of the end-to-end process. Figure 6 is a process ownership responsibility system that was developed by GTE Telephone Operations.

6 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

Figure 6 - GTE Telephoe Operations' Process Accountability Structure

P r o c e s s M a n a g e m e n t R o le s A n d R e s p o n s ib ilitie s
Process Executive
C h a m p ion Process M anagem ent F o r m u la t e P r o c e s s V i s i o n C h a m p ion Process Across Enterprise Identify Critical Process Business Issues Balance Process Focus/Functional Focus Process Perform ance M easures/Targets R esource/Capital A llocation/R e a llocation Appoint/Support Process Cham pions Approve G a p C losure Plans

Process Panel
P r o v i d e A l ig n m e n t A c r o s s S u b p r o c e s s e s Integrates Process Im provem ents CrossFunctionally R eallocates R esources to Fund A ction Plans Provides C lear Line of Sight to Custom er N eeds L ink Subprocess Perform ance to Process Perform ance

Process C h a m pion
Identifies C ritical S u b p r o c e s s Business Issues D efines Scope of Project C reates Perm anent Process Team Serves on Process Panel C h a m p i o n s S u b p r o c e s s /T e a m M a n a g e W hite Space of Process/Subprocess Provide Team R ew ards/Recognition

Perm anent Process Team

B ring Subject M atter E x p e r tise to T eam C onduct R oot C ause Analysis D esign Im provem ents and M easures D evelop/Recom m end Process Im provem ents/G a p C losure Ideas M aintain/Update Process D ocum entation Advocate/M aintain Process Focus Throughout the E n terprise

Process Team L eader

C oordinate Long-Term V ision and M igration Plan for Each Process C reate Q uantum L eaps for Processes Advocate/M aintain E n terprise Process Focus L ink W ith C ontinuous Process Im p r o v e m ent T eam s
6

4.

5.

6.

Migration an initial migration to a process-centered approach includes creating process teams, assessing the current process, identifying improvement opportunities, developing the improvement plan, implementing the process improvements, and evaluating and certifying the results. This is an encapsulated version of the continuous improvement cycle. Establishing Process-Based Performance Measurements Does the organization have a set of performance measurements that reflects its strategic intent and supports the objectives of its core processes? In most cases, bad performance measures are the root cause of poorly aligned organizational behavior. For example, time or efficiency based measures in an order entry department can cause chaos in a fulfillment process if there is no emphasis on error-free input. While costs are driven down in the department, rework results later in the process. Performance measures must support the process objective. Continuous Process Management Are the tools and management systems of the organization well developed and aligned in order to optimize process and organizational performance? Approaches like ABM, capacity management, and target costing are based on the assumption that effective structures exist to support continuous improvement. The process infrastructure can be the platform upon which these and other initiatives are launched and supported.

There is No Silver Bullet Organizations who are looking for a quick cure will not find it in process-based management. Rather it is a systematic approach to improving performance that must be undertaken as a way of doing business, not as one-time improvement opportunity. An example of the commitment to process improvement undertaken by Texas Instruments is outlined in Figure 7.

7 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

Figure 7 - Texas Instruments Business Excellence Roadmap

Core Process #1 Improvement Vertical Metric Alignment 1 | 2 | 3 | 4 | 5

Business Excellence Road Map

Customer Focus Order Fulfillmant Product Development Business Mgnt Strategy Dev. Manufacturing Capability

Core Process #n Improvement Vertical Metric Alignment 1 | 2 | 3 | 4 | 5 Concurrent Effort

Core Process Integration Horizontal Metric Alignment 1 | 2 | 3 | 4 | 5

HR Legal Finance Supply Quality

Concurrent Effort Support Process(s) Improvement Vertical Metric Alignment 1 | 2 | 3 | 4 | 5 Support Org. Process(s) Integration Enterprise Metric Alignment 1 | 2 | 3 | 4 | 5

1991

1994

1996

2000 --- Long Range Timing ---

2004

"As Is"
(Ad Hoc)

--- Enterprise Process ---

" To Be"
(Optimising)

Source: Emery Powell, Texas Instruments, 1996. When viewed in this context, becoming a process-centered organization defines the vision for business excellence that enables strategic intent. The commitment is substantial, in both time and effort. But the result is a competency that can sustain the organization against most competitive challenges.

8 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

Activity-Based Decision Support Systems

The use of cost management techniques as a strategic weapon is also based upon the availability of activitybased decision support systems. These tools range from activity analysis at the most basic level to fully integrated activity based costing and management systems that are supported by the organizations operational and accounting software. The foundation of effective cost management strategy is an understanding of the organizations activities and the associated costs and results. Further, the organization must understand the activities that are performed by its suppliers and customers and the impacts on product and service effectiveness and profitability. An understanding of the activities that impact the organization and their resulting costs and benefits enables a wide range of analyses and evaluations. Performance improvement is usually accomplished through a critical evaluation of the trade-off between the benefits of performing an activity and the resultant cost. Cost management activities are based upon one or more views of cost which have distinct levels of detail and different purposes. Strategic leverage can be achieved by developing analyses at both the strategic and operational levels of the organization. Traditional cost management activities have been based largely on the financial view. Figure 8 - Three Views of Cost View of Cost Users of Information Strategic Business/strategic planners Sourcing groups Capital budgeting Cost engineers Activity-based product costing Target costing Make vs buy analysis Investment justifications Life cycle costing Product line aggregation Information detail based on type of decision Ad hoc, as needed Usually a special study Operational Front-line managers Process improvement teams Quality teams Key performance information Value/non-value added identifiers Manage daily activity Financial Financial controllers Tax managers Treasury Tax authorities Shareholder reporting Inventory valuation Preparation of tax reports Lenders monitoring condition Immediate Possibly hourly or daily High Often companywide data May be on legal entity basis Periodic, usually monthly Probably quarterly or annually if other needs were met Mostly financial

Uses

Level of Aggregation

Very detailed Work unit level

Reporting Frequency

Type of Measures

Combination of physical and financial Time Focus Future Source: R. Steven Player, Arthur Andersen, L.L.P.

Mostly physical

Current

Historical

By evaluating their performance on each of these levels, organizations are better understand the impacts of strategy, customer and supplier behavior, and internal process performance on their effectiveness and 9 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

profitability. Without a clear understanding of activities and the associated costs, the analyses described in the remainder of the paper are not feasible.

Customer Focused Techniques Customer Profitability

One of the most powerful applications of cost management as a strategic weapon is in the development of a product and marketing plan based upon superior knowledge of the profit potential of individual customers, products, and distribution channels. Further, understanding the implications of possible combinations of products, customers and distribution channels and their relative costs and performance trade-off provides an organization with a significant advantage over its competitors who do not have access to this information. Consider the situation of Hewlett Packards North American Distribution Organization (HPNADO) in the summer of 1995. Figure 9 - The Hewlett Packard Story Hewlett-Packard's Business Environment Hewlett Packard, with revenues of $25 billion per year, is a world leader in manufacturing PCs, computer systems, printers, scanners, and workstations. It has four product distribution centers worldwide, with HP-NADO alone distributing 21 product lines through six customer resale channels. In 1994, HP-NADO distributed nearly $7 billion in product through five depots to more than 300 principal resellers nationwide. HP-NADO needed more accurate business information to influence and assist its management and business partners making operational and strategic business decisions. In Hewlett-Packard's manufacturing process, outside suppliers ship raw materials and parts to primary manufacturing plants. These plants produce standardized versions of various elements of Hewlett-Packard's product lines. The products are then shipped to HP-NADO and other depots for customization to specific geographic markets, packaging, and shipping to Hewlett-Packard's main reseller channels. Because potential customization steps number in the hundreds or thousands and the volume of products is huge, keeping records of the "backend" costs to make products and service customer market channels can become a monumental operation. Hewlett-Packard was using a traditional costing process that spread these overhead charges across the entire organization, but the company needed a means to generate more accurate business information about HP-NADO's costs. Management needed to know how the costs influence the company's profitability (the strategic view of costs) and how the costing process could be used to identify opportunities for cost reduction selected areas (the operational view of costs).1 Using an activity based analysis which comprised both a product profitability model and a customer profitability model, Hewlett Packard was able to develop the relative cost of each of its major customers and customer segments, products and product segments, and distribution channels. The availability of this data provided remarkable insights into the companys customer and product profitability. They discovered that customer behavior generated wide degrees of variability in profitability, even when the customers purchased the same products or product lines. Their least profitable customers generated multiple inquiries related to order status or product availability. They also submitted numerous unnecessary billing inquiries. Conversely, the most profitable customers generated very few additional order fulfillment or billing demands, possibly due to higher levels of integration and information sharing via electronic data interfaces.
1

Marino, Chris et al. 1995. Hewlett Packard Knows What It Takes and What It Costs, As Easy as ABC, (Issue 21). 10 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

Figure 10 - Strategic Implications for Hewlett Packard Data could now be looked at in terms of the three views of costs: financial, operational, and strategic. The model linked data from the storyboard sessions with various company business groups, activities, business processes, product lines, and customer segments. It revealed opportunities to drill into and analyze the data to see how activities and costs flowed through all levels of the organization. To demonstrate how the SAM (Strategic Activity Management) information could be used to target and achieve operational improvements, the team identified three areas to reengineer. Overall, the three pilots identified more than $2 million in potential savings for Hewlett-Packard. Thus, while the SAM model's primary purpose was to produce strategic cost information, the annual cost savings generated by the pilots provided a significant short-term return on the costs invested. The model's strategic value was even more far reaching. From the data, management learned that 51 customers accounted for 85 percent of Hewlett-Packard's orders. The model proved to be a powerful tool for analyzing customer and channel profitability; developing contract discount structure; analyzing costs of key services; determining the impact of outsourcing distribution functions and certain products; performing benchmarking of key areas; and justifying investment decisions.2 One Hewlett Packard executive remarked, I feel like we have just invented the microscope this information was here all along, but now we have the tools to see it. As a result of its ABM analysis, Hewlett Packard took dramatic steps to rationalize its product and customer profitability. The mix of products offered through specific distribution channels was altered to optimize the profitability of the product/channel combinations. Additionally, Hewlett Packard fired customers. Specifically, those customers whose behaviors caused unusual levels of order fulfillment or billing support were migrated to distribution systems such as retail which were better positioned to service their needs, or in some cases were diverted to purchase competing products.

Ibid. 11

Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

Revenue Enhancement
Activity based methods, including understanding the cost of activities throughout the value chain can also be strategically focused in order to enhance revenue generation. Only by truly understanding the cost of performing activities and the value that those activities generate for the customer can an organization optimize its product and service offerings. Consider the case of TTI, a Fort Worth, Texas based distributor of passive computer components. Figure 11 - The TTI Case TTIs cavernous 270,000-square foot warehouse on the northern outskirts of Fort Worth is stocked with 90,000 different kinds of capacitors and resistors over 330 million individual pieces worth about $55 million. Another 25,000 products worth about $15 million are housed in a smaller facility. Nobody comes close to that depth of inventory, (CEO Paul Andrews) says, adding that he prefers TTI to be tall and thin rather than fat and wide. His strategy has paid off with annual sales growth running at 31 percent for the past five years. Pretax profits of about 15 percent are about twice the industry norm. To sustain that growth, TTI must attract customers who buy by the billions. They historically or as Mr. Andrews disdainfully say, notoriously have bought directly from the component manufacturer. Five years ago, TTI set its sights on these giants with minimal results. Mega-customers didnt bother to study their paper-swirling process and just-incase stocking practices, because, after all these arent the latest and greatest $1,000 Pentiums theyre buying. Why worry about items that represent less than 5 percent of the total cost? Mr. Andrews is only too happy to enlighten them. Model Building Three years ago, guided by Arthur Andersens Steve Player, TTI designed a simple computer model that lets customers fiddle with the figures and see how much money is actually being spent on shuffling purchase orders, handling parts, eating obsolete inventory and temporarily halting production when parts are missing. Closing a line for an hour because its out of parts typically costs a PC manufacturer about $100,000 in lost production, Mr. Andrews says. And it doesnt matter whether the missing-in-action part is worth 10 cents or $100. Rather than run that risk, many companies build black holes of extra inventory in the cheap stuff, he says. That too is dangerous. In a world where product life cycles are counted in months, not years, theres plenty of opportunity to get burned by stocking too much of what you needed last week but dont today. In most cases, after they go through the checklist, says Mr. Andrews, theyll find its costing them 15 to 25 percent in manpower, capital, obsolescence and shutting lines. TTI promises to eliminate those costs by moving purchasing and inventory control into its mighty mainframe. No paper to push, no salesman to call. No inventory to handle until its needed on the line. Its not shifting work, Mr. Andrews says, its getting rid of it. For example, Richardson-based Alcatel feeds its parts forecast for the next few months into TTIs computer, which automatically ships and delivers the necessary capacitors and resistors just in time for their assembly into telecommunications modules being built. Capital and factory floor space have been freed up by 50 percent says Frank OReilly, senior director of operations at Alcatel. This year, TTI expects to generate $100 million in sales with 70 customers via its automated replenishment program.3

Hall, Cheryl. Invisible Ink. The Dallas Morning News, September 15, 1996. 12

Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

By developing a superior understanding of its customers activities and the associated cost and performance implications, TTI was able to transform a typical cost of service analysis into a strategic revenue enhancement tool. The critical issue is whether or not companies can view their business as a value chain that links the organization to both its customers and suppliers. If this view is taken, the entire activity system can be optimized based on the best capabilities of the participants to reduce costs and generate superior performance and value.

Product/Service Focused Techniques Target Costing as an Integration Strategy

Most of our organizations are engaged in a variety of cost and productivity improvement initiatives. These might include efforts like activity-based costing and management, TQM, continuous process improvement (or Kaizen) and demand flow planning. Others may be engaged in good old-fashioned cost reduction by brute force - which is systematically reducing headcount until a break point is reached. Unfortunately, these improvement initiatives only influence about 20% of the total costs of delivering a product or service. Consider the following diagram:

Figure 12 - Cost Relationships: Committed vs. Incurred

100 80 Costs 60 40 20 0
PRODUCT CONCEPT DESIGN AND DEVELOPMENT PRODUCTION DISTRIBUTION SERVICE DISPOSITION

Committed Costs

Incurred Costs

PRODUCT DEVELOPMENT CYCLE

Source: CAM-I Target Cost Core Group, S. Ansari and J. Bell The majority of our cost reduction efforts focus on production, distribution, service and disposition. After all, this is where the cost is incurred. Unfortunately, by the time a product or service leaves the design and development phase of the product development cycle, over eighty percent of the life cycle costs of the product or service are committed. Once the product is designed and the production process is developed and set in motion, less than twenty percent of the life cycle cost of the product can be influenced without a product or process redesign effort. Therefore, the kaizen or continuous improvement initiatives of an organization are only influencing a relatively small subset of its total costs.

World-class competitors are redesigning the way future products and processes are deployed - they are implementing cost and profit planning. They are developing and advocating Target Costing, a process for designing costs out of a product or service. 13 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

Target costing is a management method that allows firms to provide customers with products that they want, when they want them, at a price they can afford, and still earn adequate financial returns. Target costing is strategic in nature and, if done properly, it creates a culture of excellence in an organization that provides continuing strategic advantage. It is more than a narrow focus on improving operating efficiencies or meeting cost budgets. Six key principles within (target costing) represent a way of thinking about cost management that is quite different from traditional approaches to cost management and profit planning. They are: Price-led costing Customer focus Focus on design of products and processes Cross-functional teams Life cycle cost reduction Value chain involvement4

The following illustration is a summarized version of the target costing process model.

Figure 13 - The Target Costing Process Model

VOICE OF THE CUSTOMER VOICE OF THE CUSTOMER
Market Research

ESTABLISH TARGET COSTS ATTAIN TARGET COSTS

Product Strategy & Profit Plan Product Concept & Feasibility Product Design & Development Production and Logistics

Competitive Strategy

Competitive Intelligence

EXTENDED ENTERPRISE PARTICIPATION EXTENDED ENTERPRISE PARTICIPATION

Source: CAM-I Target Cost Core Group, S. Ansari and J. Bell In a sense, target costing is an unfortunate name for this process. It actually encompasses far more than establishing a cost target. The process is based on understanding what features customers want in a product and what they are willing to pay for these features, what product features competitors are likely to offer, and finally what life cycle cost must be attained to insure an adequate return. To mistake target costing for a finance-driven cost reduction exercise would be a tremendous mistake. However, we find that finance is a major participant in the redesign of the product development processes through the use of target costing. Notice that many steps in the target costing summary model require substantial support from the finance organization.

CAM-I Target Cost Core Group, S. Ansari and J. Bell: Target Costing: The Next Frontier in Strategic Cost Management; Irwin Professional Publishing; 1996 14 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

Figure 14 - Inputs to the Target Costing Process

MARKET RESEARCH

COMPETITORS ACTIONS

SHAREHOLDERS
$

PRODUCT CHARACTERISTICS NEW PRODUCT DEVELOPMENT

LESS

TARGET PRICE

REQUIRED PROFIT

TARGET COST
PRODUCT & PROCESS DESIGN CONTINUOUS IMPROVEMENT AND COST REDUCTION

Source: CAM-I Target Cost Core Group, S. Ansari and J. Bell Finance must help establish the target profit, evaluate the target price, establish and defend the target cost, and assist in evaluating feature/function tradeoffs throughout the design process. It is important to note that this is a fundamental shift in the way that prices and profit targets are established. Consider the following example: Figure 15 - Impacts of Target Costing on Cost Management
In The Past Today

Cost + Profit

Price - Margin Target Cost

Scope of Application

Variable Operating Costs Fixed Costs

Price

Life-cycle Costs Cost of Future Products Enterprise & Support Costs

Source: John Dutton, Arthur Andersen, LLP; 1996. Establishing and achieving target costs has a direct impact on the cost structure and performance of the entire value chain. The success of the target costing process will depend to a large degree on the ability of the Finance organization to translate operating performance into financial terms and assess the implications for future products and services. This fundamental shift in the product pricing and profit planning strategy of the organization requires the full support of the finance organization, as an educator, facilitator, and finally translator of product and process attributes into financial results. The strategic implications of target costing are far-reaching. As quality becomes more constant, the ability of firms to deliver products that customers desire, at a price they are willing to pay more quickly than their competitors will be the distinguishing characteristic of successful enterprises. Target costing insures that firms who do this also attain a life cycle cost target that supports long-term profitability. This ability will be one of the fundamental strategic weapons of world class competitors.

15 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

Process Focused Techniques Capacity Measurement and Management

The measurement and management of productive capacity is not a new issue for manufacturing, merely one that has received very little meaningful consideration during the past seventy years. Measuring and managing the sources and uses of capacity and the associated costs last received significant attention in the 1910-1920 time frame through the work of H. L. Gantt and Alexander Church. During subsequent decades, capacity issues at the plant level lost a significant amount of visibility. Beginning with DuPont and General Motors, organizations developed increasingly complex hierarchical organization structures. The development of increasingly complex and diverse product lines combined with functional specialization decreased the visibility of enterprise-wide capacity issues. Following the stock market crash of the early-1930s the focus of the accounting community shifted predominantly to the recording and reporting of financial results to the external financial community. Education, reporting practices, and statutory requirements diminished the emphasis on measurement and management of internal resources and the associated costs. Following World War II, economic issues also diminished the focus on capacity issues. Increasing affluence, increasing demand, a lack of global competition and the resulting heavy capitalization further diminished the need to aggressively measure and manage capacity and the resulting costs of non-productive capacity utilization. Why the Renewed Focus on Capacity Management? Beginning in the 60s and 70s, economic issues once again mandated a focus on effective capacity management. Increased global competition, the associated pressures on costs and resource utilization, and the resulting improvement initiatives have caused capacity measurement and management to regain visibility and re-emerge as a strategic cost and resource management initiative. Total Quality Management (TQM) began the development of the tools commonly used to measure process variability and the associated idleness and non-productive uses of organizational capacity. Just-in Time Inventory (JIT) heightened the need for removing the causes of process variability and imbalance. JIT also forces aggregate measurement of productivity and resource demand at the process level. Business Process Reengineering (BPR) heightened organizations awareness of the need to design organizations and manage results at the process level. Measurement of end-to-end process results began to re-emerge along with process-level accountability structures and improvement teams. Theory of Constraints (TOC) reemphasized the need to focus on optimizing throughput by measuring and managing the time-based economics of line and machine productivity. The Development of the CAM-I Capacity Model The development of the model was guided by a fundamental management axiom:
You Can't Manage What You Don't Communicate You Can't Communicate What you Don't Measure You Can't Measure What You Don't Define You Can't Define What You Don't Understand

The research was spearheaded by Alan Vercio of Texas Instruments and an interest group comprised of members of industry, academia, and consultancy. The group set out to address a set of fundamental questions: 16 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

n n n n n

What are the sources of idle capacity? How much unused capacity is assigned to product cost? How large of a threat is the hidden unused capacity? Who is responsible for capacity management? How are manufacturing activities communicated in a common language? How can we obtain more capacity without buying it?

At the beginning of the project, the member companies all lacked an effective tool set for understanding and communicating capacity issues, particularly the financial implications which are critical to strategy development. The CAM-I Capacity Model provides such a tool set. The model is a closed-loop system based on time. That is, all metrics are based on a 24 hour day. Figure 16 - The Closed Loop Model

Source: The CAM-I Capacity Model Interest Group

By defining capacity in this way, idle capacity resulting from policy decisions such as operating schedules, legal or contractual issues, or unmarketable production capability are always visible. The model, actually defines three summary categories of capacity utilization: Productive, Non-productive and Idle.
n

Idle Marketable (Idle) and not marketable (excess) Off Limits: Legal, Contractual, Management policy Nonproductive Standby, Waste, Maintenance, and Setup Process Balance & Variability; Scrap, Rework and Yield Scheduled & Unscheduled Maintenance: Time, Volume, Changeover Productive Good Production New Product Process Development

These broad categories can then be broken down further into sets of activities using a number of drill down and reporting templates. An industry-standard time template is presented in the following diagram: 17 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

Figure 17 - The CAM-I Capacity Model Summary Template

Rated Capacity Summary Model Traditional Model Theoretical

Industry Specific Model Not Marketable

Strategy Specific Model Excess Not Usable Management Policy Contractual Legal Idle But Usable Process Balance Variability Scrap Rework Yield Loss Scheduled Unscheduled Time Volume Change-Over

Idle

Off Limits Marketable

Practical Scheduled

Rated Capacity Nonproductive

Standby W aste Maintenance

Set-Ups

Process Development Productive Product Development

Good Products

Source: The CAM-I Capacity Model Interest Group Different templates are defined for different applications and audiences. The reporting tools developed by the research group include: Economic and Time Template Summary Template Drill-Down Template Strategic Template Responsibility Template Product Cost Template Equivalent Unit Template

Models and Templates can be built-up from existing ABC models. In fact, the data necessary to populate the reporting templates requires that an organization develop an activity-based view of its processes. The focus on capacity issues is a logical next step for companies who have developed advanced activity-based information systems. Models are equally relevant to manufacturing, assembly, and service and support processes. The CAM-I Capacity Model has a variety of implications. It creates a common language for communicating capacity issues. It establishes the framework for an effective accountability and performance measurement system to address capacity. It creates a linkage to investment plans and financial results. It provides the opportunity for a linkage to other productivity improvement approaches such as Theory of Constraints and Total Quality Management. It provides a behavioral model that demonstrates the effects of customer, supplier, and employee behavior on capacity utilization and the resulting process and product costs. 18 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

Finally, the model clarifies the accountability system needed for effective capacity planning and utilization. Where previously capacity management issues were largely the responsibility of the Operations Team, the CAM-I model proposes shared accountability between the Operations Team and the Business Team. Figure 18 - The Capacity Management Responsibility Model
The Manufacturing Team is responsible for reducing nonproductive activities and increasing idle capacity The Business Team is responsible for reducing idle capacity and increasing productive capacity. Manufacturing Team Productive Nonproductive Idle Business Team

Source: The CAM-I Capacity Management Interest Group As stated by Robert Kaplan, Management decisions that continually add new products, services, and customers often require additional capacity to be supplied throughout the organization. Many improvement initiatives such as TQM, re-engineering, and activity-based management usually lead not to immediate cost savings or revenue enhancements but idle capacity. Using activity-based results, in conjunction with an effective set of capacity measurement and communication templates, management can quantify sources of non-productive and idle capacity, as well as the associated costs to the organization, its shareholders and its customers. From a strategic perspective, capacity utilization has a fundamental impact on the cost structure of an organization. Consider the case of two similar sized manufacturing facilities. Factory A runs one 8-hour shift, 5 days per week. Factory B runs three 8-hour shifts 7 days per week. Each has identical per-hour unit outputs. Due to the idle capacity when Factory A is not running, the fixed overhead must be borne by a unit base that is only 24% of the output base of Factory B (40 hours vs. 168 hours per week). Therefore, the per-unit fixed cost of Factory A will be 4.2 times higher than that of Factory B. This is a simple example based on policy, but similar relationships exist for capacity differentials due to non-productivity, waste, and idleness due to demand variability.

Integration Systems
The challenge that is currently being faced by leading-edge organizations is the development of an integration system which effectively combines the approaches described in this paper with the other key management initiative to create a holistic approach to performance improvement. Too often, organizations are adopting improvement methods without understanding the linkage of the approach to their overall business strategy or to the other initiatives that they may be pursuing or considering. The results are suboptimal uses of scarce resources and limited results. Confusion resulting from conflicting improvement techniques is one of the most pervasive problems we encounter in our member companies. Toward that end, CAM-I has embarked on a number of new research projects to explore the issues surrounding integration. These projects include knowledge management, the conceptual design project, and our International Study of Best Practices in Target Costing.

19 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

Notes
1. 2. 3. 4. Alan Vercio of Texas Instruments first presented the Business Hierarchy at a meeting of the CAM-I interest group chairs on February 5, 1995. The discussion of Process-based Management was first published in As Easy as ABC, Issue 31. The discussion of Target Costing was first published in As Easy as ABC, Issue 28. The discussion of Capacity Management was first published in As Easy as ABC, Issue 29

20 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.

References
CAM-I Capacity Management Interest Group and Thomas Klammer: Capacity Measurement and Improvement; Irwin Professional Publishing; 1996. CAM-I Process Management Interest Group, Dennis Daly and Tom Freeman: The Road to Excellence: Becoming a Process-Based Company; The Consortium for Advanced Manufacturing - International; 1997. CAM-I Target Cost Core Group, S. Ansari and J. Bell: Target Costing: The Next Frontier in Strategic Cost Management; Irwin Professional Publishing; 1996. Hall, Cheryl. Invisible Ink. The Dallas Morning News, September 15, 1996. Marino, Chris et al. 1995. Hewlett Packard Knows What It Takes and What It Costs, As Easy as ABC, (Issue 21). Metrics Management Guide, Texas Instruments; 1997.

21 Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing International. All rights of reproduction in any form reserved.