Improving Bottom-line through improving Cost Competency Prof. Shailesh Gandhi Indian Institute of Management, Ahmedabad India.

Improving Bottom-line through improving Cost Competency

Prof. Shailesh GandhiIndian Institute of Management,

Ahmedabad

India

Perspective on Bottom-line

What is the meaning of bottom-line? Is it a performance metric or set of metrics? How is it to be calculated?

How does a performance metric like bottom-line fit into overall organisational performance measurement and management system?

Tracking organizational performance requires design and implementation of a Performance Management System (PMS).

PMS is an integral mechanism for implementation of organizational strategy.

PMS Framework

Strategy formulation/review process in a company is triggered by changes in external and/or internal environment (industry context). The changes in external environment come from economic, political, social and global dimensions. The changes in internal environment arise due to change of a leader, mergers, acquisitions, etc.

Strategy Formulation/Revi

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Strategy Implementation

Goal/ObjectiveStrategies

FRAMEWORK FOR PERFORMANCE MANAGEMENT SYSTEM

PMS Framework (Contd.)

Strategy execution involves a series of coordinated decisions and investments over time leading an organization towards an established goal.

It involves appropriate organization structure and culture, skilled human resources, and alignment of control/business processes.


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Organization Structure

Human/Resources

Control/Processes

OrganizationCulture




How does the organization ensure that its strategies are successful/have been working as expected?

It needs to periodically measure its actual performance across selected performance measures/metrics and compare with the target values.

It does so by designing and implementing appropriate PMS.


The design of PMS requires identification of performance measures and setting target values for them.

Performance measures are current and future Key Performance Indicators/Key Result Areas. If they are improved over a period then the organization is said to have successfully implemented its strategy.


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Human/Resources

Control/Processes

OrganizationCulture

Performance Management

System



Performance measures/Metrics

Key Performance Indicators


Target values of selected performance measures are set during the budgeting process.

A budget is a 1-year slice of the strategic/long range plan.

Budgeting is a critical part of “control/process”.


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Human/Resources

Control/Processes

OrganizationCulture


System


Data on ActualPerformance



Target Values


Budgeting

Wal-MartIndustry Industry ContextContext

Competitive Competitive StrategyStrategy

KPIKPI

Strategy Strategy ExecutionExecution

PerformancePerformance

Extremely ToughExtremely Tough

EDLPEDLP

Everyday Low CostEveryday Low Cost

Structure, Controls, Structure, Controls, People, CulturePeople, Culture

????????


Comparison of actual performance with the target values leads to variance analysis.

Variance analysis involves the following steps: (1) Computation of variance (2) Identification of organizational unit(s)

which caused it (3) Reasons for that variance – controllable

and uncontrollable (4) Corrective action – feedback to budgeting

system and strategy formulation/review


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Human/Resources

Control/Processes

OrganizationCulture


System


Data on ActualPerformance



Target Values


Budgeting

Variance Analysis

Feedback toBudgeting orStrategyReview

PMS – Choice of Measures

The choice of measures for PMS is a difficult exercise especially the choice between financial and non-financial measures.

Choice of Measures – Financial Measures

Historically, companies have used several variants of profit (surplus) as financial performance measure such as: A) Contribution B) Gross Profit C) Operating Profit (EBITA) C) Controllable Profit (Profit of Strategic

Business Unit before allocation of corporate overheads)

D) ROI/ROCE E) EVA (Economic Value Added)

Defining Bottom-line

From the previous list, the following are examples of bottom-line indicators:

Operating profit - EBIT/EBITA (Earnings before interest and tax)

RONOA (Return on Net Operating Assets)

ROI/ROCE (Return on Investment/capital employed)

EVA (Economic Value Added)

Cost competency and improving bottom-line measures

Bottom-line measures are influenced by operating efficiency, asset utilisation efficiency and cost of capital associated with capital structure decisions.

The operating efficiency is influenced by control over revenue determinants and cost determinants.

The asset utilisation efficiency is influenced by control over both current and non-current assets.

The cost of capital is influenced by the capital structure.

Review the following diagrams:

How Value Creation is measured

Creation ofValue

TSR TSR

(Total Return (Total Return to to

Shareholders)Shareholders)

TSR TSR

(Total Return (Total Return to to

Shareholders)Shareholders)

EVA EVA

(Economic (Economic Value Added)Value Added)

EVA EVA

(Economic (Economic Value Added)Value Added)

Op. EBITDA / Op. EBITDA / Op. EBITDA- Op. EBITDA-

MarginMargin

Op. EBITDA / Op. EBITDA / Op. EBITDA- Op. EBITDA-

MarginMargin

EconomicEconomicPerformance Performance

(Stakeholder (Stakeholder benefits)benefits)

EconomicEconomicPerformance Performance

(Stakeholder (Stakeholder benefits)benefits)

Outside-in view Internal view

No “easy” calculation, soft assessment consisting

of multiple factors

Dividend paymentsto shareholders+ share price

appreciation

Company result afterconsideration of all

costs of capital,incl. cost of equity

Key operationalindicator focused on

cash-generation/efficiency

Net SalesVolume

x

DistributionCost

ProductionCost ofGoods Sold

Gross profit

-

-Op. EBITAMargin

/

Marketing &Sales Exp.

Admin. Exp.

Op. EBITA

-

-

List price

DiscountsRebates

Net Price

-

Operating EBITA Margin tree

Return on Net Operating Assets (RONOA) Tree

RONOA

NOA

OperatingProfit

NWC

OperatingPPE

Costs

SalesPrices

Volumes

CurrentAssets

Current OperatingLiabilities

Production

Distribution

Marketing and Sales

Administration

Areas for developing cost competency

The following areas emerge from the previous diagrams that provide opportunities for cost competency: Production Distribution Sales & Marketing Administration Asset utilisation and Capital structure –

borrowing cost Understanding cost hierarchy also helps

in developing cost competency as shown:

Level Effect on Example

1. Cost at unit level

Every unit of production

Raw material cost

2. Cost at batch level

Every batch Cost of granulation, cost of in-process quality control

3. Cost at product level

Every product line Development costs, free samples

4. Cost at customer level

Specific customers Cost of special packing, development costs

5. Cost at facility level (general operations level)

All products using the common facility

Insurance, plant administration

Cost competency (Contd.)

In the process of developing cost competency, an organisation attempts to answer the questions like:

How can we find and correct the root causes of excess working capital?

What techniques can improve how we manage inventory, payables, and receivables?

How can we improve forecast accuracy and product design to minimize inventory levels?

Which processes can we rethink or simplify to eliminate costs?

What facilities could we consolidate to minimize funds tied up in fixed assets?


Tools in practice: Value-based cost reduction: eliminating

unnecessary or redundant activities and streamlining those that are necessary

Process redesign: measure factors such as time, cost, errors, and volume to identify inefficient processes and redesign them for major cost savings and performance improvement.

Fixed asset optimisation Working capital management


Activity-based costing and Activity-based pricing

Life-cycle costing: sum of all recurring and one-time (non-recurring) costs over the full life span or a specified period of a good or service

Target costing: a system under which a company plans in advance for the price points, product costs, and margins that it wants to achieve for a new product. A powerful tool for continually monitoring products from the moment they enter the design phase and onward throughout their product life cycles.

Thank You

Improving Bottom-line through improving Cost Competency Prof. Shailesh Gandhi Indian Institute of Management, Ahmedabad India.

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