 STRATEGIC COST MANAGEMENT

 By A Aruldoss Vithakan


04/06/11 1
 Strategic Management
• Traditional Management accounting is based on
comparing actual results against pre set
standard (Typically budget), identifying and
analysing variances and taking remedial
action to ensure that future outcomes confirm
with budgeted outcomes.
• Existing activities are not reviewed.
• They are based on cost containment rather than
cost reduction.
• But strategic management is focuses on cost
reduction and continuous improvement.
•
04/06/11 2
 Cost Management And Strategy-
• Wall Mart- TheAn Overview
world’s largest retail Chain- has
grown to that stage by scrupulously following
their mission-”We exist to provide value to the
customer”
• They achieved such a growth by following a
stringy of using extensively the technology
and opportunity oriented management style
that values change and experimentation
• It focus on friendly customer service and
aggressive efforts to grow the business
globally.

04/06/11 3
 Strategic Cost Management:
Basic Concepts
Strategic decision making is choosing among
alternative strategies with the goal of selecting
a strategy, or strategies, that provides a
company with reasonable assurance of long-
term growth and survival.
The key to achieving this goal is to gain a

competitive advantage.
Strategic cost management is the use of cost

data to develop and identify superior strategies

that will produce a sustainable competitive
advantage.
•
04/06/11 4
 General Strategies
• There are three general strategies that
have been identified:
ücost leadership
üproduct differentiation
üfocusing
•

04/06/11 5
 General Strategies
• A cost leadership strategy happens when
the same or better value is provided to
customers at a lower cost than a
company’s competitors.
• Example: A company might redesign a
product so that fewer parts are needed,
lowering production costs and the costs
of maintaining the product after
purchase
04/06/11 6
 General Strategies
• A differentiation strategy strives to
increase customer value by increasing
what the customer receives (customer
realization).
– Example: A retailer of computers
might offer on-site repair service, a
feature not offered by other rivals in
the local market.


04/06/11 7
 General Strategies
A focusing strategy happens when a firm


selects or emphasizes a market or customer

segment in which to compete.
 Example: Paging Network, Inc., a
paging services provider, has
targeted particular kinds of
customers and is in the
process of weeding out the
nontargeted customers.


04/06/11 8
 COST MANAGEMENT SYSTEM

• Cost management is focusing on not on the measurement per

se but on the identification these measures that are critical
to future success of the firm.
• Phases of the development of the cost management system:
1. CMS are basic information reporting system.
2. Focus on external financial reporting objectives are reliable
financial reporting, accordingly the usefulness of CMS is
limited.
3. CMS track key operating data and develop more accurate and
relevant cost information.
4. Strategically relevant cost management information is integral
part of the system.

04/06/11 9
 CONTEMPORARY MANAGEMENT
TECHNIQUES
• Bench marking.
• Total quality management (TQM).
• Activity based costing and management.
• Reengineering.
• The theory of constraints (TOC)- eliminate
obstacles/constraints to effectively improve the cycle
time.
• Mass customization-a larger number of smaller
production units in manufacturing and specially
deigned marketing and service functions.
• Just-in Time system
•
•
04/06/11 10
• Computer aided design and manufacturing.
• Automation
• Target costing.
• Life cycle costing.
• The value chain.
• Balanced score card
 \Financial performance
 -customer satisfaction.
 -internal business processes.
 -Innovation and training

04/06/11 11
 COSTING FOR DECISION
MAKING
• Managerial decision making is the process of making
choices.
• Relevant information has to be used for evaluating
alternatives and making decisions.
• Relevant information implies relevant costs( refers to
increase or decrease in cost expected from a
particular decision or course of action) and relevant
revenue (refers to increase or decrease in revenue
expected from a particular decision or course of
action)

04/06/11 12
 COST ANALYSIS FOR DECISION
MAKING
• Fixed and variable cost analysis
• Differential cost and incremental revenue analysis
• Cost benefit analysis
• Opportunity costing technique
• Cost effectiveness analysis
• Sunk cost
• Relevant cost analysis
• Engineered cost, committed cost and managed
cost
• Learning curve effect
04/06/11 13
 COST ANALYSIS FOR DECISION
MAKING
• Order getting & order filling costs.
• Target costing.
• Life cycle costing.
• Cost estimating
• Bench marking
• Quality cost analysis.


04/06/11 14
 COSTS FOR DECISION MAKING<
PLANNING ANF CONTROL
• Opportunity cost- it is the cost of opportunity lost.It is
the benefit given uo or sacrificed when one alternative
is chosen over another
• Sunk costs- cost already incurred.
• Relevant costs are costs which is a s result of a
decision /course of action ot the difference between
various alternatives.
• Differential cost: It is the total costs between any two
alternatives and it is equal to: Additional variable
expenses incurred in respect of additional output
+increase in fixed cost, if any.

04/06/11 15
Example : A printer is planning to replace an old


machine purchased at Rs.1,50,000. The old

machine is 3 years old and being depreciated at
Rs.50000 per year. There is two machines in the
market suitable at a cost of Rs.250000 with
operating cost of Rs. 50000 and the other
alternative is priced at Rs.280000 with an
operating cost of Rs.45000.
1. What are the incremental cost ,if any, in the
alternative choice of the equipment?
2. What are the sunk costs , if any, in this solution?

04/06/11 16
• Solution:
 Option A Option B DifferntialCost
Purchase Price 250000 2800000 30000
Operating Cost 50000 450000 5000
Depreciation of old Equipment 15000 15000
Differential cost = 30000-5000 =25000

Rs.15000 is sunk cost since it is already incurred and the equipment is only 3

years old and also in current use.

• Imputed Cost: Imputed costs are not generally accounted for in
normal accounting process. These costs are not actually incurred but
they are relevandto the activity. Internally generate funds when
invested interest is anopayable But there is an opportunity cost in that
such funds could have earned interest if invested outside the company.

04/06/11 17
• Out –of-Pocket cost : If a company
accepts a special order, it may
necessitate consideration of out-of-
pocket costs that need not be incurred in
case the order is not accepted. For
example if a restaurant takes special
order involving additional transport cost,
such cost is considered as out of pocket
cost.
04/06/11 18
RELEVANT COSTING-DECISION MAKING
PROBLEMS
• Relevant information.
• Relevant revenues
• Relevant cost
Some Decision making Types:

1. Make or buy
2. Drop or add a product
3. Sell or process further
4. Operate or shut down
5. Special orders
6. Replace or retain
7. Buy or lease

04/06/11 19
 Make or Buy Decision
• When a company has unused capacities the following
alternatives are considered:
 -To maximize production e capacity utilisation and
finaancialresources available to them they may consider
producing required raw materials or sub assemblies OR
 - to buy them from outside suppliers
• Such decision also depends on other than financial gain
such as – strategic importance/quality/reliability of
supplies etc.

04/06/11 20
 Drop or Add A product
• The decision to eliminate non profitable product is
tob primarily based on its impact on future
income if the firm.
• therefore one has to develop appropriate cost and
profit measures either to drop or add a product.
• It is also necessary to evaluate how the sales of
other products will get adversely affected if one
product is removed.
• A customer may buy a highly profitable product
since the unprofitable product is also available
from the same company.

04/06/11 21
 SELL OR PROCESS FURTHER

• It is a decision to sell a product at spin oo point or to

process further.
• Further process adds value tom the product and will get
more price.
• Further process may incur additional cost.
• Therefore the increase in revenue should be more than
the additional cost incurred.

04/06/11 22
• There are generally two conditions prevail :
 a)Additional process may call for additional
equipment and/or fixed costs.
 b) Company already processes beyond spin-
off point and invested in equipments and
required personnel.
•

04/06/11 23
 OPERATE OR SHUTDOWN

• A company may face a situation that even when they are

operating at lesser percentage of installed capacity
they expect further fall in sales volume or reduction in
profit margin due to:
• Reduction in demand.
• Economic slow down
• Stiff domestic or international competition.
• Political instability
• Increase in cost of inputs
•

04/06/11 24
 SPECIAL ORDERS

• Such an option is considered by a company when they

have surplus or unutilized production capacity is
avilable.
• Special orders should not affect existing sales of the
product.
• Pricing for special order may not take into account fixed
costs unless incurred for such orders a sotherwise the
firm may lose the order.
• Contribution approach may be an useful technique in
pricec determination for special orders.

04/06/11 25
 Replace or Retain

• It is capital investment decision to be taken

carefully.
• Differential cost and benefits are critical inputs
for making this decision.
• Relevant cost and relevant revenue are to be
considered.
• Replacement cost to include cost of equipment
at site, cost of capital, training cost of
operators etc.

04/06/11 26
 Assignment-1 (due on 12nd jul2009)
1.A firm needs an assembly component. If it needs to produce an


equipment costing 4 lakhsis needed which will lost for 4 years with
no salvage value. Manufacturing costs are in each year is 6 L , 7L,
8L and 10 L. IN case of buying it cost 9L, 10L, 11L and 14 L in each
of the four years. The new machine would occupy space of an
existing machine used for production which would be hired to
produce an item generates cash flow of Rs. 2 L per year in each of
the 4 years. I t is impossible to find room for both machines and
there are no external effects. The cost of capital is 10% and the
present value for each of the 4 years are;00-1; 1-0.909; 2-0.826;
3.0.751; 4- 0.683
• Should the firm make the component or buy. (10 Marks)

04/06/11 27
2.Based on the following data you are required to advice the
management the area of cultivation which would maximize the
profits of the company:
Particulars Apple Lemons Oranges Peaches
Selling Price/unit1 15 15 30 45
Yield/acre(Boxes) 500 150 100 200
Cost/acre(Materials) 270 105 50 150
Labour-Cultivation 300 225 150 195
Pick-up & Packing 1.50 1.50 3 4.50
Transport cost 3.00 3.00 1.50 4.50

04/06/11 28
 Additional Information:
1. Total fixed cost per season is210000
2. Following limitations are indicated:
 -out of available 450 acres300 acres are suitable only for
cultivation of oranges and lemons. And the balance 150 acres is
suitable for all fruits.
 -As the produce is hypothecated to bank acres are to be
ademarcatedonly in acres and not in fractions.
 -Marketing strategy calls for production of minimum of 18000
boxes of all fruits.
• You are required to advice cultivation plan and estimate the profit for
your plan.


04/06/11 29
 Value Chain Analysis
(concerned with the focus of Cost Management efforts)
• Strategic View– a linked set of value-creating activities
from basic raw material sources to the final consumer.
External focus identifies places in activity chain to
enhance customer value or reduce costs in order to
achieve sustainable competitive advantage.
•
• Conventional View– a linked set of value-creating
activities taking place within the boundaries of an
organization. Objective is to maximize value added,
i.e., the difference between sales and purchases.
•

04/06/11 30
 Value Chain Analysis

• A strategic analytical tool used to identify where

value to customers can be increased or costs
reduced.
• To enable better understanding of the linkages
with suppliers, customers and other.
• Value chain in PC Industry:
 Personal Computers---Software—Peripherals—
service
Operating

 Margins 5 20 10 15
(revenue-

 Cost)

04/06/11 31
 STEPS INVOLVED IN VALUE
ANALYSIS
• Identify the value chain activities
• Develop a competitive advantage by reducing cost or
adding value.
• Identify competitive advantage (cost leadership or
differentiation.
• Identify opportunities for added value.
• Identify opportunities for reduced cost.
• Exp[lain linkges among activities in the value chain

04/06/11 32
 Value Chain for a Computer Manufacturing Industry
Step-1 Design Research & Product design
Development
Step-2 Raw Materials Mining,, developing Silicon, plastics &
acquisition
Step-3 Materials & refining process
Conversion various materials
Desired components
assembled into parts Conversion process
Step-4 Intermediate and parts
Boards and
assembly
Step-5 Computer Final assembly components
Completed computer
Manufacturing
Step-^ Wholesaling, Moving products Truck, rail & air
Warehousing &
Step-7 Retail sales Making sale Cash Received
Distribution
Step-8 Customer Provide service Serviced units &
Service customer Satisfaction

04/06/11 33
 BALANCED SCORECARD

• BSC provides a system for measuring and

managing all aspects of the Company’s
performance.
• Score card balances traditional financial
measure of success, such as profits and
returns on capital with non financial measures
of drivers of future financial performance.
•

04/06/11 34
 STRATEGY MAP CONNECTING THE
FOUR PERSPECTIVES
Financial Perspective
 Return on Investment


 Customer Perspective Customer Loyalty



 On the Delivery


 Internal Perspective Process Process

 quality Cycle Time


 Learning & Growth Employees Process

Improvement
 Skills

04/06/11 35
 ILLUSTRATIVE EXAMPLE OF LOW COST
AIRLINE
Financial
 Profits, Return
 On Assets


 Grow Revenues Fewer

aircrafts


 Customer Attract, retain

 More customers


 On time services Lowest prices

 Internal Fast Ground Turnout
 Learning Trained motivated Ground Crew
•
04/06/11 36
 BALANCED SCORE CARD- AN EXAMPLE

• Strategy: To be leading organisation in the

industry through constant innovation
and adoptive to our environment. We
will measure success in terms of
value creation for our shareholders and
customers by the learning and growth
of our employeesand by our good
competitive citizenship.

04/06/11 37
 BALANCED SCORE CARD- AN EXAMPLE

OBJECTIVE INITIATIVE PERMANENT TARGET

FINANCIAL PERSPECTIVE MEASURE
Increase in Develop new Return on Assets 25%
Shareholders
Provide product Sales
growth Increase Percentage 30%
wealth
CUSTOMER PERSPECTIVE increase in ales
Increase in Increase Percentage 10%
Market share
Increase in Advertising
Increase quality Market share
Satisfied through 99%
Customer service survey
Satisfaction

04/06/11 38
 BALANCED SCORE CARD- AN EXAMPLE
OBJECTIVE INITIATIVE PERMANENT TARGET
MEASURE
INTERNAL BUSINESS PERSPECTIVE
Reduce through put time
Reduce non-value Average through 4 Hrs
added activities put time
Reduce defects Develop employee Percentage defects0.01%
quality.
Provide timely delivery
Streamliner Delivery Percentage
Process 30%
increase in timely
LEARNING & GROWTH PERSPECTIVE delivery

Develop multi-skilledProvide
workforce
Employee Effective increase 80%
Training in productivity
Provide good information
Hire system
new Effective and 20%
employees in smooth flow of IS
Reduce
04/06/11
computing
employees turnover
Better & higher Percentage 10% 39
compensation decrease in
 Silvaculture and Timber Farming
Competitor B

Logging and Chipping

Competitor C

Pulp Manufacturing
Competitor D

Paper Manufacturing

Competitor G
Competitor A

Converting Operations

Competitor E
Competitor F
Distribution

04/06/11 End-Use Customer 40

 Conventional Value Chain Analysis
Management Accounting in the SCM Framework
Focus Internal Value added External
Perspective Entire set of linked activities from raw material
suppliers to ultimate end-used customers

Cost driver A single fundamental cost Multiple cost drivers

concept driver pervades the Structural drivers(e.g., scale, scope, experience,
literature—cost is a technology, complexity)
function of volume Executional drivers(e.g., participative
Applied too often only at management,
the overall firm level total quality management)
Each value activity has a set of unique cost drivers

Cost Cost reduction approached Cost containment is a function of the cost driver(s)
containment via responsibility centers regulating each value activity
philosophy or product cost issues Exploit linkages with suppliers
Exploit linkages with customers
Exploit linkages within the firm
04/06/11 41
 Conventional Management Value Chain Analysis
Accounting in the SCM Framework
Insights for None are readily apparent. Identify cost drivers at the individual activity
strategic This is a major reason level; develop cost/differentiation advantage
decisions why strategy consulting either by controlling those drivers better than
firms typically throw away competitors or by reconfiguring the value chain
conventional reports as they
begin their cost analysis
For each value activity, ask strategic questions
pertaining to make versus buy and forward
versus backward integration

Quantify and assess supplier power and buyer

power; exploit linkages with suppliers and
buyers

04/06/11 42
 Differences in Cost Management Caused by Differences in Strategy
Primary Strategic Emphasis
Product Differentiation Cost Leadership
Role of engineered product costs in Not very important Very important
assessing performance

Importance of such concepts as Moderate to low High to very high

flexible budgeting for manufacturing
cost control

Perceived importance of meeting Moderate to low High to very high

budgets

Importance of marketing cost analysisCritical to success Often not done on a formal

basis

Importance of product cost as an low high

input to pricing decisions

Importance of competitor cost low high

04/06/11
analysis 43
 ABC Costing Technique

• Focuses on activity than on products

produced.
• Costs are first traced to activities then to
Products.
• ABC assumes that activities are responsible
for incurrence of costs and products create
demand for activities..
• Costs are charged to products based on
usage of activities. Traditional system
traces costs to products and ABC traces
costs to activities.
•
04/06/11 44
 ABC PROCESS

 Resources (or)
 Factors of Production Activities Products
Step: 1. Identify main activities

Step: 2. Identify the factors which determine

the cost of the activities.

Step:3.Collect cost of each activity.

Step:4. Support O/H to the products based

on usage of each activity.

04/06/11 45
 Cost Management
Cost management is a
misnomer
It is revenue and cost
management
The objective is to enhance
value to the firm
Price is external and cost is
internal
04/06/11 46
Contemporary Cost Management
Techniques
Manage cost at the point of commitment
and not at the point of incidence
Trace cost and revenue to cost objects
as
much as possible
Cost management should be all
pervasive
Cost management should be made a
culture within the organisation
04/06/11 47
 Survival triplet

Cost/Price

Survival Zone

Quality
Attributes

04/06/11 48
 COST DRIVERS

• Business Definition for: Cost Driver

• a factor that determines the cost of an activity.
Cost drivers are analyzed as part of activity
based costing and can be used in continuous
improvement programs. They are usually
assessed together as multiple drivers rather
than singly. There are two main types of cost
driver: the first is a resource driver, which refers
to the contribution of the quantity of resources
used to the cost of an activity; the second is an
activity driver, which refers to the costs incurred
by the activities required to complete a
particular task or project.

04/06/11 49
 COST DRIVER ANALYSIS

04/06/11 50
 Cost Drivers

• Manage cost drivers to manage costs

• Location of cost drivers might be different
from the location of cost incidence
• Map cost drivers

04/06/11 51
 Examples of Transaction based cost drivers
Support Department cost(cost
pool)
Production scheduling
Material Handling
Set up costs
Finished goods handling and
dispatch of goods
Purchasing cost
Raw material stock handling
Invoicing
04/06/11
Possible cost drivers
Of production run nos.
of production runs nos
Of production runs nos
Of production runs nose and
number
Number ofofdestinations and
purchase orders
deliver ordesr
Of orders received
Number of invoices
52
 CLASSIFICATION OF ACTIVITIES IN A
MANUFACTURING ORGANISATION
1. Unit level activities- activities performed when
each unit is produced.
2. Batch level activities-. activities performed when
each batch is produced.
3. Product level activities- activities to support
production of each different types of products ;
maintenance and operation of equipments and
testing / engineering charges.
4. Facility level cost-general manufacturing process.
These activities are common to variety of
products

04/06/11 53
Cost Driver Analysis
(concerned with analyzing cost behavior in a manner supportive to strategic
choices)

Understanding cost behavior requires

identifying the cost drivers present in any
given situation
Understanding cost behavior depends on
understanding the complex interplay among
the relevant cost drivers in any given
situation

04/06/11 54
Cost Driver Categories

Structural -- related to strategic

choices that drive costs
Executional – related to an
organization’s ability to execute
successfully

04/06/11 55
Structural Cost Drivers
(Related to organizational choices)

Scale: Investment size in manufacturing,

R&D, and marketing
Scope: Degree of vertical integration
Experience: Previous repetitions of current
work
Technology: Process technologies used at
each step in value chain
Complexity: Broadness of product line

04/06/11 56
 Executional Cost Drivers
(Related to organizational skills)

Work Force Involvement: participation;

empowerment; commitment to continuous
improvement
Capacity Utilization: given scale choices on
plant construction
Plant Layout Efficiency: compared to current
norms
Product Configuration: design or formulation
effectiveness
Exploiting Linkages with
Suppliers/Customers: in relation to the value
chain
04/06/11 57
Cost Driver Analysis – Some Key Ideas

Volume is usually not the best way to explain

cost behavior
More useful to explain cost position in terms of
structural choices and executional skills
Not all strategic cost drivers operable or
equally important all the time but some are
probably very important in every instance

04/06/11 58
Linkages Among Value Chain Analysis, Strategic Positioning
Analysis and Cost Driver Analysis

Understanding the value chain

helps define the optimal positioning
strategy
Understanding the value chain and
positioning strategy helps identify
the relevant cost drivers

04/06/11 59
 Advantages of ABC

• Brings accuracy and reliability in product cost determination.

• ABC provides realistic product cost where advanced manufacturing
environment and technologies were to support overhead costs.
• ABC identifies real cost behaviour and helps in reducing cost.
• Uses multiple cost drivers most of which are transaction based and
not volume based.
• Traces cost to areas of managerial responsibility, processes,
customers,depart,ent beyond product cost.
• Improve manager’s decision making.
• Provides reliable and correct product cost.
• Provides cost for cost driversand information on transaction volume.

04/06/11 60
 De-merits of ABC
• More complex in nature.
• Difficult to implement.
• ABC has different level of activity for different organisation.
ABC in Service Organisation:

• Unlike in manufacturing organation, in sevice organisation costs are

mostly fixeed and indirect and therfore ABC seems irrelevent.
•

04/06/11 61
 Activity Levels
Activit level Reason for activity Examples of activity
Unit level Performed for each -Raw material cost
Batch Level unit of product
Performed for each -Cost
Cost ofofprocessing
inserting a
Product Level produced
Performed ortosold
unit of product support component
sales of
Cost order
product
Facility Level produced
each ortosold
different
Performed Utilities
product -cost cost of
of maintenance.
inspection
development
Cost of
that can be
maintain general mfg. operations
produced Special M/C
Cost of non
facilities specialisecd equiment

04/06/11 62
 Product Differentiation
• In form-size, colour, shape, physical structure, design, coating, action
time.
• Features.
• Performance quality
• Conformance quality.
• Durability.
• Reliability.
• Style.
• Service differentiation.
• Ordering ease
• Installation.
• Customer training.
• Maintenance &repair
• Customer consulting
•
04/06/11 63
 Positioning Analysis

• Organizational analysis
• Organizational structure design / structure
alignment
• Staffing studies
• Job analysis / job description projects
• Long-range organization planning


04/06/11 64
 Positioning Analysis
• Strategic positioning analysis (SPA) is developed as a
specific analytical approach consisting of a product
portfolio analysis,
• Shift-share analysis and a Diversification analysis.
• The SPA describes the performance of ports and
traffic categories within ports in terms of market
share, growth rate, diversification and value added.
• The SPA needs to be used taking into account the
port's position with regard to value-added created
by the different traffic categories.
• By using this integrative instrument, indications on the
overall strategic position of ports are provided and
will benefit strategy formulation and decision-making
on port development.
•
04/06/11 65
 Positioning Analysis

• Predicting Relative Competitive Position of an

Organization
• Commonly used methods for analyzing
competitive strength including SWOT (Strength,
weakness, Opportunity ,Threat)VRIO
( Valuable, Rare, Imitable , Organization
ready)portfolio models and competitor ranking-
key success factors (KSF).
• A method for predicting relative competitive
position of an organization is proposed to
determine a numerical relative strength score for
a firm.
04/06/11 66
 Positioning Analysis
• To achieve maximum profitability a firm must find a way to
achieve meaningful competitive advantage over its
competitors.
• Unequal command of valuable resources forms the basis of
competitive advantage for a firm.
• Competitive advantage is connected to relative competitive
strength which is the net value of a firms strengths and
weaknesses comparative to benchmarks usually the
strengths and weaknesses of key industry rivals.
• Competitive analysis involves the organization looking both
inward to its internal environment as well as outward to its
competitors and other forces in the external environment.
The analysis will generally include the following elements:
identifying potential competitors, economic growth of the
country, financial markets, capital markets, customer etc.

04/06/11 67
The Strategic Management Process

Strategic Strategy Competitive

Objectives
Choice Implementation Advantage

Internal
Analysis

Business Level Corporate Level

Strategy Strategy

How to Position a Which Businesses

Business to Enter?
in the Market?
04/06/11 68
 Business Level Strategies
Two Generic Business Level Strategies

Cost Leadership:
• generate economic value by having lower costs
than competitors
Example: Wal-Mart

Product Differentiation:
• generate economic value by offering a product
that customers prefer over competitors’ product
Example: Harley-Davidson
04/06/11 69
 Understanding Cost Advantage

Managers need to understand who has

the cost advantage in their market

• it could be the focal firm

• develop a strategy to exploit the advantage

• it could be a competitor

• develop a strategy to either capture the

advantage or compete on some other basis
04/06/11 70
 Sources of Cost Advantage

Economies of Scale
• average cost per unit falls as quantity increases
-until the minimum efficient scale is reached

• are a cost advantage because competitors may

not be able to match the scale because of capital
requirements (barrier to entry)

• international expansion may allow a firm to have

enough sales to justify investing in additional
capacity to capture economies of scale
04/06/11 71
 • are an advantage for those who do not have
diseconomies of scale

• are a risk of international expansion

04/06/11 72
 Learning Curve Economies

• a firm gets more efficient at a process with experience

• the more complicated/technical the process,

the greater the experience advantage

• international expansion may propel a firm down the

experience curve because of higher volumes

Example: Fuel Injectors

04/06/11 73
 Differential Low-Cost Access to Productive Inputs

• may result from:

• history—being in the right place at the right time
• being first into a market—esp. foreign markets
• natural endowment—owning a mineral deposit
• locking up a source—buying all of its output

Example: Quantity Carpet Buys

04/06/11 74
 Cost-leadership Strategy
• Do everything to achieve a CA through producing
products or services at a lower unit cost (lowering
cost structure)  charge a lower price.
•
• Increase efficiency and lower costs – the
manufacturing and materials management
functions are the center of attention
•
• A low-level of product differentiation – it means that
you do not want to be the industry leader in
differentiation.
•
• Target the average customer – Scale and Focus,
not Product Variety
 - ignores the different market segments –
focuses on mass market.
04/06/11 75
 Technology Independent of Scale

• may allow small firms to become cost competitive

• advantage typically accrues to the ‘owner’ of the

technology—may or may not be the ones who actually
use the technology

• size of the advantage depends both on how valuable

and protectable the technology is

Example: Vegetable Inspection

04/06/11 76
 Policy Choices

• firms get to choose how they will serve the market

• we’ll offer level of quality that is inexpensive to
produce
• firms can make policy choices that give people
incentives to reduce cost at every opportunity

Example: Deccan Airways

04/06/11 77
 Cost Leadership & Competitive
Advantage

• Valuable

• Rare

• Costly to Imitate

• Organized (Implemented Appropriately)

04/06/11 78
 Value of a Cost Advantage
Entry Buyers
• increases capital • lowers incentives
requirements for buyers to
for entrants vertically
integrate

Rivalry

Substitutes • competitors rationally Suppliers

avoid price competition

• limits • increases
attractiveness importance of the
of substitutes focal firm to the
supplier

04/06/11 79
 Rareness of a
Cost Advantage The rareness of a source of cost advantage
depends heavily on the industry life cycle:

Generally…
Emerging Mature
Economies of Scale Not Rare Rare
Diseconomies of Scale Rare Rare

Learning Curve Economies Rare Not Rare

Differential Input Access Rare Rare

Technology Rare Not Rare

04/06/11
Rare Rare
80
 Imitability of Sources of Cost Advantage

Conditions largely determine if a source of cost

advantage will be costly to imitate

Low Cost Conditions

Unbalanced Industry Capacity and Demand

Non-Proprietary Technology

Highly Observable Technology

Transactional Exchange

(A cost advantage can be easily imitated)

04/06/11 81
Implementing a Cost Leadership Strategy

High Cost Conditions

Balanced Industry Capacity and Demand

Path Dependence (Historical Uniqueness)

Protected Technology

Highly Unobservable Technology (Causal Ambiguity)

Relational Exchange (Social Complexity)

(A cost advantage cannot be easily imitated)

04/06/11 82
 A strategy is only as good as its
implementation

Strategy is implemented through organizational

structure and control:

• structure: 1) the division of management

responsibilities, and 2) the establishment of
reporting relationships

• control: policies intended to influence behavior—align

the interests of the individual with the interests of the
organization
04/06/11 83
 Organizational Structure

Three Organizational Structures

Simple

Functional

Multi-Divisional

04/06/11 84
 Simple Structure
Owner / Manager

• Owner/Manager makes all major decisions

directly and monitors all activities

• difficult to maintain this structure as the firm

grows in size and complexity
04/06/11 85
 Functional Structure (U-Form: Unitary)

• divides management responsibilities by function

• marketing • procurement • HR
• finance • production • logistics
• accounting • R&D • etc.

• CEO is the only executive with enterprise-wide

perspective
• CEO is responsible for strategy & coordination
of functions
04/06/11 86
 Functional Structure

Chief Executive Officer

Human
Finance Accounting Marketing Resources

Production R&D

04/06/11 87
 Multi-Divisional Structure (M-Form)

• functions are replicated in each division as appropriate

• this structure makes sense when the firm is involved

in more than one business or has grown large enough
to justify geographic divisions

• CEO balances coordination & competition among

divisions
04/06/11 88
 Chief Executive Officer

Corporate
Corporate Corporate Strategic Corporate
Human
R&D Finance Planning Marketing
Resources

Division Division Division

Finance Production R&D Accounting

Marketing Human
Resources
04/06/11 89
 The Functional Structure and Cost
Leadership

• specialization within functions facilitates cost reduction

• CEO can use this structure to:
• ensure best cost reduction practices are
shared among divisions
• allow and encourage decision-making by those
who are in the best positions to do so—those
close to decisions
• ensure that functions are coordinating efforts in
pursuit of a common strategy
04/06/11 90
 Organizational Controls
Policies intended to influence behavior by aligning
the interests of the individual with the interests of
the organization

Management Controls
Formal Informal
• budgeting policies • culture
• credit policies • attitudes
• spending policies • leadership styles
• travel policies
• purchasing policies
04/06/11 91
 Compensation Policies

• stock options • non-monetary awards

• vacations
• bonuses based on:
• parking places
• cost reduction • office decor
• financial performance

Compensation Policies Should Reinforce

Formal and Informal Management Controls
04/06/11 92
 Organizational Controls and Cost Leadership

• management controls and compensation

policies can be focused on cost reduction

• supply contracts that stipulate cost reductions

over time
• tight credit policies
• austere travel policies (e.g., no first class)
• bonuses tied to cost reduction targets

Example: Wal-Mart & Southwest Airlines

04/06/11 93
 Summary

Business Level Strategy

Cost Leadership Product Differentiation

Cost Advantages
Competitive Advantage
Depends on Meeting
Economies of Scale VRIO Criteria

Diseconomies of Scale
Emphasis on
Learning Curve Economies Organization
(Implementation)
Differential Input Access

Technology
Structure &
Policy Choices Control
04/06/11 94
 Advantages and Disadvantages of
Cost-leadership Strategy

• Advantages
 - charge a lower price yet make the same
level of profit.
 - win in the price war.
 - low-cost as an entry barrier.
 - protected from rivals.
 - less affected by powerful buyers and
suppliers.
 - room to reduce its price to compete with
substitute products.
•
04/06/11 95
• Disadvantages
 - technological advancement makes the low
cost advantage outdated.
 - imitation ability of competitors.
 - lose sight of changes in customers’ tastes
•

04/06/11 96
 Differentiation Strategy
• Do everything to achieve a CA through producing
products or services that are unique to customers 
charge a premium price.
•
• Achieved in 3 principal ways – quality, innovation, &
responsiveness to customers
•
• Try to differentiate along as many dimensions as
possible – the bases of differentiation are endless
(prestige, status,…)
•
• R&D, Sales, & Marketing functions are center of
attention.
•
04/06/11 97
• Serve many market segments (i.e., a broad
 Advantages and Disadvantages of
Differentiation Strategy

• Advantages
 - Premium price.


 - Protected from rivals. (i.e., brand loyalty,

customer loyalty..)


 - Brand loyalty as an entry barrier.



 - Less affected by powerful buyers and

suppliers.
•
04/06/11 98
• Disadvantages
 - Substitutes can be a possible threat.


 - Difficult to maintain a product’s uniqueness

in customers’ eyes for a long time.

04/06/11 99
 Focus Strategy
• Try to achieve a CA by serving the needs of a specific
market segment or niche (i.e. geographically, product
line, customer type,..).
•
• Pursue a focus strategy through either a low-cost
approach or a differentiation
 - focused cost-leadership
 - focused differentiation (i.e., a specialized
differentiator)
•
• Try to build market share in one or a few market
segments and, if successful, then begin to serve more
segments.
•
•04/06/11
Pursue any distinctive competency 100

 Advantages and Disadvantages of
Focused Strategy
• Advantages
 - Exploration of a gap in the market 
customer loyalty.


 - Stay close to its customers and respond to

their changing needs.
 (faster in innovations).


 - In general, a focused firm is O.K. against

the threats of five forces.
•
04/06/11 101
• Disadvantages
 - Cost disadvantage relative to low-cost
leader b/c of a small volume.


 - Susceptible to attack from a broad

differentiator.


 - Technological change or changes in

customers’ tastes can make a niche market
disappear.
•
04/06/11 102
 Just-in time system
• The star recognition of Japan's distinguishing features.
• The most distinctive feature of Japan is the lack of natural
resources,
 which makes it necessary to import vast amounts of materials
including food.
• The second distinctive feature is that Japanese concept of work,
such
 as consciousness and attitude, differed from that held by the
European and
 American workers. The Japanese traits include: (
• 1) group consciousness, sense of equality, desire to improve, and
diligence born from !L long history of' a homogeneous race;
• (2) high degree of ability resulting from higher education
 brought by desire to improve;
• (3) centering their daily living around work.

04/06/11 103
• Upon recognition of the matters related above, Toyota planned and
followed the following two basic concepts:
• Attain low cost production is "reduction of cost through elimination of
waste".
• This involves making up a system that will thoroughly eliminate
waste by assuming that anything other than the minimum amount
of equipment, materials, parts, and workers (working time) which
are absolutely essential to production are merely surplus that
only raises the cost.
• The second recognition of Japanese diligence, high degree of
ability, and favoured labour environment is " to make full use of
the workers' capabilities". In short, treat the workers as human
beings and with consideration. Build up a system that will allow
the workers to and with consideration. Build up a system that will
allow the workers to display their full capabilities by themselves
•
•
04/06/11 104
•
• Cost cutting by through removal of waste
• Just in time production:
• shorten the lead time from the entry of
materials
• to the completion of vehicle. by maintaining
the conformity to changes by having " all
processes produce the necessary parts at
the necessary time and have on hand only
the minimum stock necessary to hold the
processes together".
• In addition, by checking the degree of
04/06/11
inventory quantity and production lead time
105
• Withdrawal by subsequent processes: The first
requirement of just-in-time production is to enable
all processes to quickly gain accurate knowledge
of , timing and quantity required'.
• In order to materialize the first requirement, Toyota
adopted a reverse method of " the following process
withdrawing the parts from the preceding process "
instead of the "the preceding process supplying the
parts to the following process ".
• The reason for this is as follows: Just-in-time
production is production of parts by the various
processes in the necessary amounts at necessary
timing for assembling a vehicle as a final product of
the company.
•
04/06/11 106
• One piece production and conveyance:
The second requirement of justin-time
production is that all processes
approach the condition where each
process can produce only one piece,
can convey it one at a time, and in
addition, have only one piece in stock
both between the equipment and the
processes.
• This means that no process for any
04/06/11 107
reason is allowed to produce extra
• Leveling of production: Provided that all
processes perform small lot process varies
considerably, the processes within the
company as well as the production and
conveyance, if the quantity to be withdrawn
by the subsequent subcontractors will
maintain peak capacity or holding
excessive inventory at subcontractors will
maintain peak capacity or holding
excessive inventory at all times.
• Therefore, in order to make a just-in-time
production possible, the prerequisite will be
to level the production at the. final
04/06/11assembly line (the most important line that108

gives out the production instructions to all

• Elimination of waste from over-producing:
The underlying concept in
• just-in-time production systems is that
thevalue of existence of inventory is
disavowed. .
• In the conventional production control
system, existence of inventory of
troubles and bad causes. We consider
that virtually most of the stock
 on hand is the result of ' over-producing' 109
04/06/11
• Jidoka: The term' Jidoka' as used at
Toyota means' to make the equipment
or operation stop whenever an abnorm
al or defective condition arises '.
• In short, its distinctive feature lies in the
fact that when an equipment trouble or
machining defect happens, the
equipment or entire line stops, and any
line with workers can be stopped by
them.
04/06/11 110
•
• The reasons for' Jidoka ' being so important are as
follows:
• (1) To prevent making too much. If the equipment is
made to stop
 when the required amount is produced, making too
much cannot arise.
• Consequently, the just-in-time production can be
accurately carried
 out.
• (2) Control of abnormality becomes easy. It will only'
be necessary to
 make improvements by directing attention to the
stopped equipment
• and the worker who did the stopping. This is an
04/06/11
important requirement when making up the system111
of ' full utilization of workers'
• Full utilization of workers' capabilities
• This is Toyota's second basic concept of making
the best use of Japan's
 favoured labour environment and excellent
workers. It has built up a system of respect for
human, putting emphasis on the points as follows:
• (1) elimination of waste movements by workers;
• (2) consideration for workers' safety; and
• (3) self-display of workers' capabilities by
entrusting them with greater responsibility and
authority.
• Elimination of 'Waste movement by workers:
Workers may realize
04/06/11 112
• their work worthy only if the labour of diligent
• Considerations to workers' safety:
• Self-display of workers' ability:
• Aim of Kanban System
• A production control system for just-in-
time production and making full use of
workers' capabilities is the Kanban
System
• . Utilizing Kanban System, workshops of
Toyota have no longer relied upon an
04/06/11electronic computer. 113
• The reasons to have employed
KanbanSystem instead. of computerized
system are as follows:
• (1) Reduction of cost processing information.
• (2) Rapid and precise acquisition of facts.
• (3) Limiting surplus
• 3.2 Description of Kanban system
• (I) In the Kanban System, a form of order
card called Kanban is used. These come in
two kinds, one of which is called'
04/06/11
conveyance Kanban ' that is carried when 114
going from one process to the preceding
• , production Kanban' and is used to order
production of the portion withdrawn by the
subsequent process.
• These two kinds of Kanban are always attached to
the containers holding parts.
• (2) When content of a container begins to be
used, conveyance Kanban is removed from the
container. A worker takes this conveyance
Kanban and goes to the stock point of the
preceding process to pick up this part.
• He then attaches this conveyance Kanban to the
container holding this part.

04/06/11 115
• (3) Then, the' production Kanban '
attached to the container is removed
and becomes a dispatching information
for the process. They produce the part to
replenish it withdrawn as early as
possible
• (4) Thus, the production activities of the
final assembly line are connected in a
manner like a chain to the preceding
processes or to the subcontractors and
04/06/11 116
materialize the just-in-time production of
• In the past, economic assessment of
alternative
 designs, constructions, or other
investments has been
 based on initial (first) cost which ignores
the total cost
 incurred for the investment throughout its

lifetime.
• The concept of life cycle costing provides
04/06/11an 117
 LIFE CYCLE COSTING

• Life Cycle Costing (LCC) also called Whole Life Costing is a

technique to establish the total cost of ownership. It is a

structured approach that addresses all the elements of this cost

and can be used to produce a spend profile of the product or

service over its anticipated life-span. The results of an LCC

analysis can be used to assist management in the decisionmaking

process where there is a choice of options. The accuracy

• of LCC analysis diminishes as it projects further into the future,

so it is most valuable as a comparative tool when long term

assumptions apply to all the options and consequently have the

same impact.

This briefing provides general guidance on LCC.

04/06/11 118
 Product life Cycle

04/06/11 119
• The life cycle costing can be defined as
follows:
an economic assessment of alternatives

designs,
construction, or other investment

considering all
significant costs of initial costs and

ownership costs
over economic life of each alternative,

expressed in
04/06/11 120
Introduction Growth Maturity Saturation Decline
Small number Imitators/cust Increase in Pressure for Technology
of innovative
Prefer security omers
Market competitive
Market new
Profitproduct
fall Change in
customers
of tried brands
Difficulties unwilling
Product to leadership
in broadened products
Cost Intensified fashion/
Reduced
effective
Technical change
improvement under
Distributors economies
Prices soften marketing tastes
profitability
distribution
problems
Limited sincrease. pressure
used up effort
Capacity prolong

04/06/11 121
 Product Life Cycle and Cost control

• The life cycle costing analysis can not be carried

 out without considering the followings:
• A - Total Costs
• B - The concept of the time value of money
• A - Total Costs
- Initial costs

- Owner costs

• Initial costs. They include the followings:

- initial construction costs

- design costs

-and costs

-finance costs
04/06/11 122
 Product Life Cycle and Cost control

• Product life cycle costing is the process of enhancing control over

manufacturing costs during different product life stages .
• It is therefore necessary to track and measure cost at every stage.LCC
used to provide long term profitability of the product
• What are product life cycle cost?
1. Acquisition Cost- Research. Design testing, production, construction or
purchase of capital equipment.
2. Transportation and handling costs.
3. Equipment maintenance cost.
4. Operation costs.
5. Training costs.
6. Inventory costs.
7. Technical costs.
8. Retirement and disposal costs.
9.
10.
04/06/11 123
11.
 Product life cycle cost iceberg

Design. Make,,
Commission & Install
Visible

Wages, Electricity,
Invisible Cosumables

Maintenance, spares,
wages.

04/06/11 124
•
•
• Life cycle cost: sum of money expended in terms
of labor, materials, use of equipment, etc to
produce a product or service during the life
cycle
• Management related costs: research and
development
• Design related costs

04/06/11 125
• Design related costs (Cost Breakdown Structure)
• Production and construction cost
• Manufacturing management, manufacturing, quality control,
initial logistic support …

• Operation and support cost (the most significant and

the most difficult to predict)

• Product operation, product distribution, product maintenance,

inventory inventory…

• Retirement and disposal cost (difficult to assess

quantitatively)

• Disposal of non non-repairable, product retirement, documentation

•

04/06/11 126
 PRICING STRATEGIES

• Traditional economic theory of pricing is based on the following

assumptions:


Business man point of view From Customer point of

Maximisation of total profit Fully
view aware of quality and
Knows what proportion knows
price present situation and
Knows
products the
arecost for each
produced and Distribute
hence he isexpenditure
not tom
influenced
Knows
level of how
outputmuch he can derive maximum
sold
sell and at what price by past event or future
satisfaction
expectations

04/06/11 127
• Elasticity of Demand: The price, Income and cross elasticity of demand are
discussed below:
• Price elasticity of demand=% change in rate of purchases/ % change
in price.
• This depends on various factors such as:
 -diminishing marginal utility.
 -essential/ non-essential commodities.
 -Availability of complementariness.
 -availability of substitutes.
 -Income group of customers.
 -Habits and preferences of customers.
Cross elasticity of demand=% change in quantity of X demanded -/

%change in price of Y
Income elasticity of demand=% change in quantity demanded/ % change

in income

04/06/11 128
• Types of market:
• Pure competition.
• Monopoly-single seller or product
• Monopolistic– Many firms sell differentiated product of the same basic
product.
• Oligopoly- where price by one firm has an influence on other competitors.
• Price determination in imperfect market conditions: The macro-economic
theory suggests that the firm should seek the price which maximises the
profit thereby obtain most efficient use of economic resources held by
them.
PRICING POLICY refer to the framework of rules and constraints within which

pricing decisions are made. Aims and objectives of pricing policy are:
• Maximisation of profit
• Promotion of long range welfare of the firm.
• Adoption of price to the diverse strategies and competitive environment.

04/06/11 129
• Flexibility to vary price to changes .
• Stabilisation of prices and margin.
• Pricing the goods based on average cost.
• Internal and external factors influencing product price policy.
•
Internal Factors External factors
Corporate objectives and goals Competition pricing strategy
Cost structures-Direct & Role and importance of
Existing
Indirect price Pressure from suppliers price
distributor
Historical practice and Price sensitivity to demand
Degree of market knowledge
precedent Motivation of customers
pressure from within- Salesman Government policies
Levels of R&D different market conditions like
domestic and export market

04/06/11 130
 Role of Cost in Pricing

• Cost is the fundamental element in pricing of a product.

• Higher the cost higher the price.
• Cost of sales promotion, distribution etc also push up the price
upwards.
• Cost is considered as the floor below which a company normally will
not fix the price.
• If cost cannot be recovered in the price the company will have to
consider whether to retain such a product in the production line.
• What are relevant cost for pricing decision?
• Though in the long run all costs are to be considered , in the short
run direct costs are relevant.
• In a multi product division direct cost is relevant cost, but the pricing
should result in contribution towards common costs and to the
realisation of profit.
•
04/06/11 131
 Cost based Pricing

• Full cost pricing- This is most conventional and popular method of

costing of a product or service.. Indirect taxes like Excise duty,
forwarding charges are to be included in the price.
•

04/06/11 132
 Target Costing

• Target cost is the cost that can be incurred

while still earning the desired profit
– Selling price – desired profit = target cost
• The customer sets the price
– Profit must be achieved through cost control
• Contradicts the traditional approach: design product, determine cost,
set price
• Intense customer focus
– What do they want?
– How much will they pay for it?
• Can we make a profit on it?
• Want answers to these questions before committing to the project

04/06/11 133
• Cost control from the beginning
– 70-90% of costs are committed to at the
design stage
– Focus on product and process design to
engineer out costs from the beginning
• Saves costly changes later on
• Product, manufacturing process, delivery
process designed simultaneously
– Ensures features customers demand, but
within acceptable cost parameters
– Eliminates the temptation to add costly
features
• Customers may not value the added features
04/06/11 – Forces consideration of manufacturability 134

• Reduces the need for subsequent changes

• Cost control at all phases of the product
life cycle
– Design
– Production
– Delivery/setup
– Customer’s cost of ownership
• Emphasizes future sales instead of current
cost savings
– Service and repair
– Disposal and recycling


04/06/11 135
 Cross Functional Team

• Marketing • Distribution
• Design/engineering • Service/support
• Manufacturing • Cost accounting
• Purchasing • Finance
– Including suppliers • Legal


04/06/11 136
 Target Costing Process

Two stage process

Establish the target cost
Market research
Product planning, concept development
stages
Achieve the target cost
Value engineering, continuous
improvement
Design stage
Continuous improvement in later
04/06/11 stages 137
 Establishing the Target Cost

• Determine the product and its market

– Who is the target market?
– What do they want?
– What do competitors offer?
• Introduce concept or prototype
– Evolutionary or revolutionary?
– Refine until it meets customer needs

04/06/11 138
• Determine the selling price
– Must be acceptable to the customer
– Must be able to withstand competition
– Techniques
• Existing price +/- value of features added or
deleted
• Consensus of focus group
• Price predicted to achieve a desired market
share

04/06/11 139
• Determine the required profit
– Return on sales
• Desired return
• Historical return for similar products
• Industry average for similar products
– Return on sales will fluctuate over the life
of the product
• Price and costs fluctuate
• Unit price, cost and profit are almost
meaningless because they fluctuate
04/06/11 – Life cycle totals are more meaningful 140
• Total expected revenue throughout product life
- -Total desired profit throughout product life
 Total target cost
Achieving the Target Cost

• Must include the features the customer

wants while maintaining cost at or below
target
– Want to meet the customers needs, but not
exceed them
• Eliminating desired features will result in an
undesirable product
• Adding unwanted features will increase cost
04/06/11 – Failing to keep cost at or below target will 141
result in unacceptable profits
 EXHIBIT 1
CUSTOMER REQUIREMENT RANKINGS

Less Ranking More Raw % of Total Competitive

Customer Requirement Important Important Score Raw Score Comparison
1 2 3 4 5 1 2 3 4 5
Multiple speeds 4 4 14.8%
Horizontal oscillation 3 3 11.1%
Vertical oscillation 1 1 3.7%
Light weight 4 4 14.8%
Adjustable height 1 1 3.7%
Airflow capacity 4 4 14.8%
Quietness 5 5 18.5%
Compact size 3 3 11.1%
Looks nice 2 2 7.4%

Total 27 100%

Us
Competitor
Both

04/06/11 142
• Rank customer requirements (exhibit 1)
– What does the customer want?
• How important is each function to the
customer?
– What do we and our competitors currently
offer?
• Competitive evaluation (exhibit 1)
– Do our current product features meet the
customer needs?
» Are the customers’ needs met,
unmet or exceeded?
04/06/11
– What can we learn from our competitors’
143
products?
• Determine the cost gap between current
cost and allowable cost
– Current cost is based on
• Currently used components
• Current suppliers
• Current manufacturing processes
• Current distribution network
• Etc.


04/06/11 144
• Decompose the cost gap(Exibit 2)
– Life cycle decomposition
• Cost reduction goals are divided among the
functions in the product’s life cycle
– Design/engineering
– Manufacturing
– Sales/distribution
– Service/support
– General administration
– Etc.


04/06/11 145
 – Value chain decomposition
• Cost reduction targets are divided among
internal and external activities
– Internal costs
» Labor, overhead, selling and
administrative costs, etc.
– External costs
» Components and services
acquired from suppliers, etc.
» Often represent a large
proportion of total cos

04/06/11 146
 EXHIBIT 2
COST GAP BREAKDOWN BY LIFE CYCLE AND VALUE CHAIN

Value Chain
Life Cycle Internal Costs External Costs Total Costs
Target Current Gap Target Current Gap Target Current Gap
Research and development $ 0.30 $ 0.50 $ 0.20 $ 0.30 $ 0.50 $ 0.20
Manufacturing 4.00 5.00 1.00 $ 13.00 $ 15.00 $ 2.00 17.00 20.00 3.00
Marketing and distribution 1.50 2.00 0.50 4.50 5.00 0.50 6.00 7.00 1.00
Service and support 0.25 0.50 0.25 0.25 0.50 0.25
General administration 0.75 1.00 0.25 0.75 1.00 0.25

Total $ 6.80 $ 9.00 $ 2.20 $ 17.50 $ 20.00 $ 2.50 $ 24.30 $ 29.00 $ 4.70

04/06/11 147
• Perform value engineering to design out
costs without sacrificing needed features
– Perform a cost analysis of major
components and activities
• List components or activities and their
functions
• Calculate a cost breakdown (exhibit 3)
– Determine the current cost of each
component or activity and convert to
percentage of total cost
» Costs include materials, labor,
overhead, etc.
04/06/11 148
EXHIBIT 3
COMPONENT COST BREAKDOWN

Percent of
Component Function Cost total cost
Motor Turns blade $ 8 40%
Transmission Provides oscillation capabilities 4 20%
Speed control/switch Controls blade speed 3 15%
Body Houses motor, transmission, speed control 2 10%
Blade Moves air 1 5%
Blade guard Protects blade from contacting objects 2 10%

Total $ 20 100%

04/06/11 149
 – Relate the components to customer
requirements (exhibit 4)
• Develop Quality-Function-Deployment
matrix
– Indicates which components have the
greatest impact on customer
requirements
– Develop a functional ranking (exhibit 5)
• Indicates the importance of each
component to the customer
– Based on the component’s contribution
to providing the desired functions
04/06/11 150
 EXHIBIT 4
QUALITY-FUNCTION-DEPLOYMENT (QFD) MATRIX

Components
Customer Requirements Speed Blade
Motor Transmission control Body Blade guard
Multiple speeds
Horizontal oscillation
Vertical oscillation
Light weight
Adjustable height
Airflow capacity
Quietness
Compact size
Looks nice

Strong correlation
Moderate correlation
Weak correlation

04/06/11 151
E X H IB IT 5
C O M P O N E N T C O N T R IB U T IO N T O C U S T O M E R R E Q U IR E M E N T S

C o m p o n e n ts
C u s t o m e r R e q u ir e m e n ts S peed B la d e
M o to r T r a n s m is s io n c o n tr o l Body B la d e g u a rd
M u ltip le s p e e d s 4 0 X 1 4 .8 = 5 . 9 2 6 0 X 1 4 . 8 = 8 .8 8
H o r iz o n t a l o s c illa tio n 8 0 X 1 1 .1 = 8 .8 8 2 0 X 1 1 .1 = 2 .2 2
V e r t ic a l o s c illa tio n 8 0 X 3 .7 = 2 .9 6 2 0 X 3 .7 = 0 .7 4
L ig h t w e ig h t 7 0 X 1 4 .8 = 1 0 .1306 X 1 4 .8 = 1 .4 8 2 0 X 1 4 .8 = 2 .9 6
A d ju s t a b le h e ig h t 1 0 0 X 3 .7 = 3 .7 0
A ir f lo w c a p a c ity 5 0 X 1 4 .8 = 7 . 4 0 5 0 X 1 4 .8 = 7 .4 0
Q u ie tn e s s 4 0 X 1 8 .5 = 7 . 4 0 6 0 X 1 8 .5 = 1 1 .1 0
C o m p a c t s iz e 5 X 1 1 .1 = 0 . 5 65 X 1 1 .1 = 0 .5 6 3 0 X 1 1 . 1 = 3 .3330 X 1 1 .1 = 3 .3330 X 1 1 .1 = 3 . 3 3
L o o k s n ic e 5 0 X 7 .4 = 3 .7 0 5 0 X 7 . 4 = 3 .7 0

T o ta l c o n tr ib u t io n p e r c e n t a g e 3 1 .6 4 % 1 3 .8 8 % 8 .8 8 % 1 6 .6 5 % 2 1 .8 3 % 7 .0 3 %

04/06/11 152
• Contribution weight assigned to the
component * importance to the customer
(exhibit 1)
– Identify components for cost reduction
• Calculate a value index for each major
component (exhibit 6)
– Component cost as a percentage of total
cost divided by the component’s relative
importance to the customer
– Index greater than 1
» Disproportionately high cost in
relation to its importance
» Implies cost reduction should be
04/06/11 considered 153
EXHIBIT 6
CALCULATION OF VALUE INDICES FOR COMPONENTS

Percent of Contribution
Component Total Cost Percentage Value Action
(Exhibit 3) (Exhibit 5) Index Implied
Motor 40% 31.64% 1.26 Reduce cost
Transmission 20% 13.88% 1.44 Reduce cost
Speed control 15% 8.88% 1.69 Reduce cost
Body 10% 16.65% 0.60 Improve
Blade 5% 21.83% 0.23 Improve
blade guard 10% 7.03% 1.42 Reduce cost

04/06/11 154
 – Generate cost reduction ideas
• Eliminate over-engineering
• Eliminate, replace, combine, rearrange
– Seek ways to accomplish the goal at
less cost
• Consider the process as well as the product
– More efficient manufacturing processes
– Better logistics
– Etc.


04/06/11 155
 – Test the ideas
• Will they be effective?
• Are they technologically feasible?
• Is there a domino effect?
– Construct a component interaction
matrix (exhibit 7)
– Do activities interact?
– Estimate the achievable costs
• Use activity-based costing, cost tables, etc

04/06/11 156
E X H IB IT 7
C O M P O N E N T IN T E R A C T IO N M A T R IX

Speed B la d e
C o m p o n e n t M o t o r T r a n s m is s iocno n t r o l Body B la d e g u a rd
M o to r X X
T r a n s m is s io n X X
S p e e d c o n tro l X
Body X X X X
B la d e X
B la d e g u a r d X X

04/06/11 157
 Organizational Impact

• Positives • Negatives
– Customer focus – Too much customer
– Cross-functional focus
integration – Potential
– Open sharing of organizational
information conflict
– Better process – Too much pressure
understanding to attain targets

– Longer development
times


04/06/11 158
 Divisional Performance Management

Advantages of divisionalisation:
• Top management gets free time to concentrate on strategic
planning and management.
• Improves decision making process.
• Specific decisions can be made on the spot.
• Managers will have quick response to changesin the environment.
• Managers gain experience in decision making.
• Helps in good labour management.
Disadvantages:

• Competition among decisions may enhance profitabilty of one

decision at the cost of another decision.
• Duplication of costs and assets.
• Top management loose some control.
•

04/06/11 159
 Responsibility Centre

• Cost centre: Managers are responsible to control cost but bot

responsible for revenue..
• Revebue centre: managers are responsible for generating sales
revenue but do not have control over cost (e.g) Marketing
Managers.
• Project centre: Project managers has responsibility both for cost and
revenue.
• Investment Centre: Responsible for planning , sourcing and
deployment of funds in selected investment portfolio.
Responsibility Accounting: Accounting is done in such a way as to how

the Managers of Responsibility centre have performed . This

system assumes the following:
1. Area of responsibility well defined.
2. Managers are charged with items of work and responsibility over
which they are exercising significant direct control.


04/06/11 160
3. Managers are actively participating in establishing goals and
budgets. ,
1. Goals defined should be attainable with efficient and effective
participation of all.
2. Good MIS and control mechanism.
3. Competent managers
Responsibility performance reporting’ report should be:

• Fit the organaisation structure.

• Prompt and timely.
• Issued regularly.
• Easy to understand.
• Sufficient but not excess detail.
• Compare performance with targets
•
04/06/11 161
1.
• Must be analytical and brings out criical decision inputs.
• Stated in physical terms.
• Highlight departmental effectiveness , lapses, problems, issues etc.
• Responsibility report to cost centre:


ITEM ACTUAL BUDGETE VARIAN

D CE
Foreman :Direct material
Direct Labour
Indirect Exps
Prodn.Manager
Part/Assembly/Cleaning Sections
Gene. Manager
Prodn/sales Department
04/06/11 162
 REPORTS SHOWING THE EVALUATION OF A DEPARTMENT
AS DIFFERENT RESPONSIBILTY CENTRE; COST CENTRE
BASIS
BUDGET ALLOTED ACTUAL
OUTPUT (IN UNITS) 10000 12500 12500
Direct materials 400000 500000 515000
Direct labour 250000 312500 325000
Repairs & maintenance 100000 125000 120000
Consumable stores 75000 93750 95000
Tools 25000 31250 30000
Power & fuel 150000 187500 180000
Total variable cost 1000000 1250000 1260000
Fixed cost
Repairs & Maintenance 100000 100000 100000
Supervision 100000 100000 110000
Factory rent 50000 50000 50000
Depreciation 100000 100000 100000
Administration 250000 250000 265000
Total04/06/11
Fixed Cost 600000 600000 625000163
TOTAL COST 1600000 1850000 1885000
• Excess variance=185000-1885000=35000(A)
• Volume variance=[{600000/10000}*12500] -60000o= 150000(F)
• Total overhead variance= 35000-150000= -115000
• Verification:
• Actual overhead 1885000
• Standard or budgeted o/h 2000000
• Total O/H variance 115000
Cost of Production on hire (12500*150) =1875000

Actual cost = 1885000

Profit variance 10000


04/06/11 164
 RESPONSIBILITY CENTRE BASIS
BUDGET ACTUAL VARIANCE
CONTROLLABLE
Direct material 500000 510000 1000 (a)
Direct labour 312500 325000 12500 (a)
Repairs & Maintenance 225000 220000 5000 (f)
Consumable stores 93750 95000 1250 (a)
Tolls 31250 30000 1250 (a)
Power & fuel 187500 180000 7500 (f)
Supervision 100000 110000 10000 (a)
1450000 1470000 20000 (a)
NON-CONTROLLABLE
Factory rent 50000 50000
Depreciation 100000 100000
Administration
04/06/11 250000 265000 15000 (a)165
400000 415000 15000 (a)
 Residual income

• Residual income business is based on generation of cash without doing

physical labor. Residual income provides you with the tool to earn
money easily even after not working directly. Internet at present
comes up with several residual income opportunities to help you
generate them and at last earn money via others effort. There are
several online business opportunities, which you can easily pursue
to have residual income.
• If you wish to start up your own online business, then you need not be
the computer expert or genius. You just need to have right
knowledge and right residual income opportunities. Though there are
several options on internet for residual income business, only few
guarantees to be authentic and trustworthy. When speaking about
online residual income opportunities, two things come up in the
mind. The first opportunity is to opt for online network marketing and
the other one is Affiliated Marketing.

04/06/11 166
 ECONOMIC VALUE ADDED

• The goal of Financial Management is to maximize the shareholder's

value. The shareholder's wealth is measured by the returns they
receive on their investment. Returns are in two parts, first is in
the form of dividends and the second in the form of capital
appreciation reflected in market value of shares of which market
value is thee dominant part.
• There exist very measures like return on Capital Employed, Return
on Equity, earnings per share, Net Profit margin, and Operating
profit margin to evaluate the performance of the business. The
problem with theses measures is that they lack a proper
benchmark for comparison. The shareholders require at least a
minimum rate of return on their vestment depending on the risk in
the investment. To overcome these problems the concept of EVA
vas developed.

04/06/11 167
• Evolution of EVA:
• It was Stern Stewart & Co. who devised an accounting method
called Economic Value Added (EVA), which measures whether
the company is generating adequate profits to reward, its
shareholders. EVA is the registered trademark of Stern Stewart &
Co. It is the financial performance measure that captures the true
economic profit of an enterprise. It is also one of the measures
most directly linked to the creation of shareholder wealth over
time.
•

04/06/11 168
• Concept of EVA:
• The company creates shareholders value only if it generates returns in
excess of its cost of capital. The excess of returns over cost of capital is
simply termed as Economic Value Added. To put in a simple terms EVA
is the profits generated by any economic entity over its cost of capital
employed. The entity can be a company, country or the entire human
civilization. If the difference between the above two parameters is
positive than the entity is said to be creating wealth for its stakeholders.
A negative EVA on the other hand indicates the company is a destroyer
of value.
• EVA is just a way of measuring an operation's real profitability. EVA holds a
company accountable for the cost of capital it uses to expand and
operate its business and attempts to show whether a company is
creating a real value for its shareholders.

04/06/11 169
• Calculation of EVA:
• EVA is essentially the surplus left after
making an appropriate charge for the
capital employed in the business. It can
be calculated in the following way.
• EVA = NOPAT – (TCE x WACC)
Where,
NOPAT = Net operating profit after tax
TCE = Total capital employed
04/06/11
WACC= Weighted average cost of 170
capital
• In determining the WACC, cost of debt is taken as after tax cost and
cost of equity is measured on the basis of capital asset pricing
method. Under Capital asset pricing model, cost of equity Ke is given
by the following:
• Ke = Rf + bi (Rm- Rf)
Where
Rf = Risk free return
Rm = Expected market rate of return
bi = Risk coefficient of particular investment
• For example an investment of Rs 1,000 in a soaps and detergent shop
produces 7% return, while the similar amount invested elsewhere
earns returns of 15%. EVA can be defined as a spread between a
company's return on capital employed and cost of capital (similar to
the opportunity cost of investing elsewhere) multiplied by the
invested capital. The EVA from this case would be
• EVA = (7%-15%) * Rs 1,000 = (Rs 80)
•
04/06/11 171
• An accountant measures the profit earned while an economist looks
at what could have been earned. Although the accounting profit
in this example is Rs 70 (7% * Rs 1,000), there was an
opportunity to earn Rs 150 (15% * Rs 1,000). So in this case the
company can be called as a destroyer of wealth.
• Thus, the litmus test behind any decision to raise, invest, or
retain a Rupee must be to create more value than the
investor might have achieved with an otherwise alternative
investment opportunity of similar risk.
• EVA Example:
• Now consider this example based on the formula explained above.
You can put different balance sheet and profit figures to know
your own EVA.

04/06/11 172
Particulars (Rs m)
Equity Capital 500
Reserves 7,500
Net worth 8,000
12.5% debentures 2,000
Capital employed 10,000
Weight of equity 0.8
Weight of debt 0.2
NOPAT (as per definition) 1,500.0
Return on tax free government 11.0%
bonds
Beta * * 1.1

04/06/11 173
Market premium * 15.0%
Corporate tax rate * 33.0%
Cost of borrowings * 12.5%
Cost of equity 15.4%
Cost of debt 8.4%
WACC 14.0%
NOPAT as a % of capital 15.0%
employed
Cost of Capital 1,400
EVA 100

04/06/11 174
 TRANSFER PRICING

• In divisionalised companies where profit centres are created, there

is likely hood of inter divisional transfer of goods or services.
• This calls form transfer pricing/..
• Normally transfer price is set up for intermediate products and
services that are supplied by selling division to buying division.
• Transfer price refers to the amount used in accounting for transfer of
goods or services from one responsibility centre to another or
from one company to another which belongs to the same group.
• Transfer pricing is a mechanism for distributing revenue between
different divisions which jointly develop, manufacture and market
products and services.

04/06/11 175
• Transfer pricing systems are designed to accomplish the following
objectives:
• to provide each division with relevant information required to make
optimal decisions for the organisation as a whole;
• to promote goal congruence – that is, actions by divisional
managers to optimise divisional performance should
automatically optimise the firm's performance; and
• to facilitate measuring divisional performances.
• The fundamental principle is that the transfer price should be similar
to the price that would be charged if the product were sold to
outside customers or purchased from outside vendors.
•

04/06/11 176
 Methods of pricing

• Cost based-
 -Actual cost
 -Marginal cost
 -Standard cost
 -Cost Plus ( cost +profit)
• Market-based transfer pricing system provides optimal results when the
market for the intermediate product is perfectly competitive and the
selling division can sell its output either to insiders or outsiders and
as long as the buying division can obtain all its requirements from
either outsiders or insiders.
• In such a situation the company as a whole has no additional cost of
providing autonomy to divisions. For example, if division A decides to
sell its product at the market price of Rs. 100 per unit and division B
decides to buy the same product from market at the market price,
net cash flow to the firm will be zero.
•


04/06/11 177
• If competitive prices are not available or it is too costly to obtain
market prices, transfer prices may be determined based on the
cost plus a profit. Cost-based transfer prices should be used only
as a second option to market-based transfer prices because it
involves complex calculations and results are less than
satisfactory.
• For multinational corporations, it may be advantageous to
arbitrarily select prices such that most of the profit is made in a
country with low taxes, thus shifting the profits to reduce overall
taxes paid by a multinational group.
• However, most countries enforce tax laws based on the arm's length
principle as defined in the OECD (Organisation for Economic Co-
operation and Development) Transfer Pricing Guidelines for
Multinational Enterprises and Tax Administrations, limiting how
transfer prices can be set and ensuring that that country gets to
tax its "fair" share. In India, the OECD principle was adopted in
2001.
•
04/06/11 178
•
• Applying transfer pricing rules based on
the arm's length principle is not easy,
even with the help of the OECD's
guidelines. It is not always possible –
and certainly takes valuable time – to
find comparable market transactions to
set an acceptable transfer price.
• The revenue authority and the MNCs
should work together in good faith to
implement regulations effectively. The
04/06/11 179
question of ethics cannot be ignored
 Role of Costing in Budgeting

• Role of Cost Accounting

• Balance sheets and profit and loss statements do not reveal how
profitable one product is versus another, or whether one plant
produces more efficiently than another.
• Although the stockholder or investment analyst may care little about
details of efficiency and cost since to them the overall profit of the
business is sufficient, management must take a different point of
view. Naturally, management is interested in maintaining the
overall position of the company.
• The overall position of a company can include such measures as
how successfully it competes, how it is perceived by its
customers, competitors, and investors, and its capacity for future
growth.
•
•
04/06/11 180
• In cost accounting the total expenditures in operating a
business are broken down on per item or per unit
basis, as for example the cost of producing a gallon of
gasoline, a ton of coal, a dozen shirts, or a
refrigerator.
• The same idea can be extended to cost per production
order, as when a special product is made for a
customer, or extended to cost per activity or operation,
such as the cost of drilling ½ inch holes, or plating
sheet metal of a certain size and quality.
•
•
•
04/06/11 181
• Cost accounting provides information for the following
purposes:
• 1. Cost determination
• The costs and expense of a business are recorded, classified,
and
 allocated to various jobs, departments, products, or services.
• 2. Costs for pricing
 Once costs are determined, the information also serves as a
guide
 regarding prices to be quoted to customers. Even though
selling prices are governed only partly by the costs of
production, in the long run the selling price must atleast equal
the costs of production, or there will be serious consequence
to the profit and loss statement

04/06/11 182
•
• Cost for managerial decision
• In a sense, both cost determination and cost
for pricing provide bases for managerial
decisions. Although managerial decision
making actually becomes much more
complex than the statement above implies,
cost information may be helpful in making
decision that have to do with
• (a) whether to add a new product, or to drop
one that is now being produced
• (b) Whether to manufacture a certain unit, or
04/06/11buy it on the outside, and 183
• Cost control
• One of the more essential purposes of
cost accounting is control of
expenditures. Such control leads to
efficiency in the use of labor, materials
machines and plants.
• Although to a large extent selling prices
are determined by competition, the
profit-making capacity of a business is
04/06/11
guided by the efficiency with which costs 184
are controlled.
• Cost control
• One of the more essential purposes of
cost accounting is control expenditure.
Such control leads to efficiency in the
use of labor, materials machines and
plants.
• Although to a large extent selling prices
are determined by competition, the
profit-making capacity of a business is
04/06/11
guided by the efficiency with which costs
185
are controlled.
• Basic Cost Elements
• There are three basic cost elements
-direct material cost, direct labor cost,
and overhead. Overhead will be further
subdivided as to whether it results from
factory operation, sales effort, or general
administration.
• Figure below shows in chart form the
derivation of basic cost elements.
•
04/06/11 186
04/06/11 187
 Obtaining Unit Costs

• Let us consider how these cost figures are

obtained, particularly on per unit or per-
product basis.
• Direct material and direct labor present little
difficulty. One can generally measure the
amount of direct material used per unit of
product.
• Because material costs can be determined
from vendors’ invoices and if product yields
are known, the direct material dollars per
unit can easily be obtained.
• Most factories require their employees to
04/06/11
keep time records. From these records the188
number of direct labor hours spent on any
• Common bases for the allocation of
overhead costs are
• 1. Number of employees
• 2. Direct labor costs
• 3. Direct labor hours
• 4. Direct material costs
• 5. Machine hours
• 6. Floor area
7. Prime Costs
•04/06/11 189
• Past versus Future Costs
• We have speaking of cost determination
and cost allocation strictly in the
historical sense.
• In other words, our discussion so far has
looked at cost after the accounting
period is over and products have been
stored in the warehouse; and we have
then tried to determine costs on a per
04/06/11
unit basis. Such figures are interesting 190
and helpful to some extent, but they are
• In managing operations, we need
sufficient information about what future
costs should be so that bids may be
placed on jobs, selling prices may be
estimated ahead of time, and a basis for
corrective action may be provided.
• The use of standard costs is helpful both
in predictive work as well as in control
Total cost of a product= Direct material+

direct labour+ Prime cot overhead+ Selling

04/06/11 191
& Distribution O/H + Administration O/H
 ROLE OF COSTIING IN BUDGETING

• Objectives
• To inculcate cost consciousness and accountability among the t
leaders/scientific community.
• To enable the optimal utilization of resources at various stages of
implementation .
• To obtain cost data on each PRODUCT
• For facilitating course corrections in the total cost estimates of the
products as well as decisions concerning reallocation of
resources.
• To provide information to the management to monitor the flow of
financial inputs in relation to physical outputs.
• To realistically project the future requirements of the organsation
in the budgetary process.
• To serve as an aid for better management in planning, monitoring
and reviewing of the programmes, projects and activities of the
laboratories.
•

04/06/11 192
• Methodology
• The system of budgeting and cost accounting has to be an integral
part of the planning process, resources allocation, monitoring
and evaluation within the laboratory organisation. This will
require the following steps to be undertaken.
• Role and functions of the PME Cell in the costing context..
• Role and functions of the PME Cell would inter-alia be as follows :-
• PME Cell shall constitute a focal point for implementation of the
process of t budgeting and cost accounting.
• They will maintain project folder for each of the products
containing the initial product proposal, authorisation, its code
number, recommendations of internal Committee, , periodical
progress reports both physical as well as financial and
completion reports of the projects etc.
•
•
04/06/11 193
• To provide assistance to the project team/project, leader in calculating the
cost of inputs - manpower material, capital and other items.
• To assist the management in preparing annual plan, five-year plan, duly
correlated With traditional budget and compilation of other relevant
information for decision making to different projects/activities and to
notify approved allocation to the concerned project leaders
/coordinators accordingly.
• To Assist the management in the allocation of resources.
• To coordinate with different Divisions namely Accounts, Stores, Purchase,
Administration, Technical Services Division and R&D Divisions for the
compilation of project-wise budget, cost accounting review and
monitoring.
• To prepare monthly summary reports of cost data of all the projects and
its reconciliation with the expenditure shown in the conventional
accounts and furnish it to the concerned authorities.
• To attend to such other functions as and when assigned by the Director.
•

04/06/11 194
• Financial aspects of a project would include the following
elements: -
• Direct Cost:
• Cost of manpower ( % time involved per (Profonna -1) person
proposed to be deployed
• Additional manpower required, if any (Proforma-II)
• Cost of Materials - Consumables and non- consumables -
(Proforma-III)
• Special capital equipment (Proforma-IV)
• Works and services specifically needed (proforma -V)
• Others (Misc./Contingencies etc.)
•

04/06/11 195
• Indirect Cost:
• Estimated cost of other allowances not covered under direct
charges.
• General & divisional overheads-expenses covering infrastructural
facilities costs, contingencies, maintenance etc.
• Role of Finance & Accounts Section
• 1. Finance and Accounts Division will be required to
ensure that all the bills passed by them contain classification
both conventional as well as project wise/cost centre wise with
Code Number.
• 2. Similarly while making posting of bills in the classified
abstract, expenditure relating to specific projects will be
signified by (p) under the Conventional Budget head. This will
facilitate the apportioning of expenditure to the projects and
general O.H. by PME Cell. F&A.0 will personally ensure that
information/records needed by PME Cell for compilation of cost
accounts are made available to them within the prescribed time
schedule. He would be extended all facilities and cooperation
in this regard
•
04/06/11 196
• Cost Accounting
• As already mentioned, PME Cell will act as a focal point for
project cost accounting. Total expenditure of the project will be
accounted under the following heads : (Profonna-XIV).
• Salary - research personnel cost
• Other allowances
• Consumables - General Stores
• Consumables - Project Stores
• Capital equipment
• Works& Services
• Service charges like computer charges, Workshop charges etc.
• Facility utilization charges (Depreciation)
• Overhead charges
• Any other

04/06/11 197
 COST FLOWS USING A GENERAL LEDGER
(ON STD.COST BASIS)

04/06/11 198
 COST FLOWS USING A GENERAL
LEDGER (ON ACTIVITY BASED COST
BASIS)

04/06/11 199
 BUDGET FORMULATION PROCESS
Strategic
Goals

SHORT TERM CAPITAL BUDGET

OBJECTIVES
Operating
SALES budget
BUDGET

Selling & admin

PRODUCTION budget
BUDGET

DIRECT FACTORY O/H

DIRECT
LABOUR BUDGET
MATERIALS BUDGET
BUDGET

Financial Budget

04/06/11 CASH BUDGET 200

06/04/2011 200
• Concept of Budgets and Budgetary Control
• A budget is a detailed plan of operations for some specific
future period. It acts as a business barometer
• It is a statement defining objectives to be attained in a future
period and the course to be followed to achieve them.
• It may express its targets either in rupees or in physical units
or both.
• It is prepared for a definite period well in advance.
• Laying down the objectives to be achieved by the business;
• Formulating the necessary plans to ensure that the desired
objectives are achieved;
• Relating the responsibilities of executives to the budgets or
particular sections
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• Continuous comparison of actual results with the budget
• Investigating into the deviations to establish the causes;
• information to management relating the variances
• Corrective action of the management to prevent
recurrence of variances.
• Nature of Budgets and Budgetary Control
• A business budget is a plan covering all phases of
operations for a definite period in future. It is a formal
expression of policies, plans, objectives and goals laid
down in advance by top management for the
undertaking as a whole and for every subdivision
thereof.
• Budgetary control is achieved through the carrying out of
the operational plan which is the budget.
•
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• Objectives of Budgetary Control
• Planning: A budget is a plan of the policy to be pursued during the
defined period
• Coordination "is the orderly arrangement of group effort to provide
unity of action in the pursuit of a common purpose".
• Control: Planning generates the need for control
– Budgeting system integrates key managerial functions
as it links top management's planning function with the
control function performed at all levels in the
managerial hierarchy. Budgetary control makes every
manager becomes cost conscious
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 Budgetary Control as a Management
Tool
• Its advantages to management can be summarised as
follows:
• establishment of divisional and departmental
responsibilities.
• coordinates the various divisions of a business facilitatating
smoother operation
• forces management to give timely and adequate attention to
the effect of expected trend of general business conditions
• helps in carrying out a uniform policy.
• facilitates management by exception and the timely correction
of significant deviations from the targets set.
• is looked upon with favour by credit agencies as indicative of
sound management.
• guards against undue optimism leading to over expansion
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• . Plant
• Insufficiency due to a)Shortage of supply(b)
Lack of capital. (c) Lack of space,
(d)Bottlenecks in certain key processes
• iv. Sales
• Consumer demand.
• Insufficient advertising.
• Shortage of good salesmen.
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 » Organisation for Budgetary Control
• Installation of budget centres
• Preparation of Organisation Chart
• Establishment of budget committees
• Budget Period
• Determination of the Key Factor
• The sequence of preparation of budgets is determined by the Key Factor or the
Principal Budget Factor
• Following are the key factors which can possibly affect budgeting:
– i. Materials -Shortage due to non availability.
(b)Shortage due to restrictions imposed by
licenses, quotas etc
• Labour
• General shortage. (b)Shortage of certain grades of labour
•
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• Management
• Overall paucity of capital.
• Limited availability of expertise - technical and managerial.
• Flogging research effort in respect of methods of production, production
design, etc.
• The Key factors should be correctly defined
• Budget Manual
• As the budgetary system gets into stride, it becomes essential to
systematize the procedure for the preparation of various budgets.
Generally the practice is to arrange this by means of a budget manual
• Preparation of Budgets
• The top management should define the objectives and policies in clear
terms. The goals set should be realistic and attainable. Then the budget
estimates are prepared by the executives in charge of different functions.
The budget programme should be comprehensive, covering all activities
of the undertaking.
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