Strategic Cost Management – A Profitability Tool, Bp, Fla, November 20, 2010

Strategic Cost Management – A

Profitability Management Tool

Presented to Finance Leaders AssociationNovember 20, 2010

Buffalo Grove, Illinois Barrett Peterson, C.P.A.

Manager, Accounting Standards, Procedures & Analysis

TTX

Political risks – laws, regulations, changes in officials Global financial system

Central bank actions and agreements; the impossible trinity “Hot capital “flows

Global trade Wage rates and wage arbitrage – outsourcing/off-shoring Comparative advantage Emerging consumer markets’ growth rates

Commodity distribution and economic power Oil Gas Coal Rare earths minerals Cadmium [think batteries] Fresh Water – a problem now and growing

Strategic Cost Management – Global Drivers

Quantitative Easing 2 and U.S. long-term interest rates:

advantage commodity prices U.S. Health care act [including 1099 political error] US deficit reduction committee chairmen’s “proposal” U.S. new consumer protection agency U.S. near term legislative prospects and the budget Basel III increased capital requirements

Swiss capital requirement increases Turkey capital increases aimed to reduce “hot capital” Bank capital {equity and near equity} requirements

Global Trade G-20 “rebalancing” and trade discussions South Korea trade agreement Commodity prices, including “rare earths”

Strategic Costs – Select Current Considerations

Product and Service Design Product Line Planning Process Design and Planning Capacity Management Market Segment Decisions Sales and Marketing Channel Decisions Logistics and Distribution Outsourcing

The Role of Strategic Cost Management – Impacted

Decisions

Single product entities can use just about any

costing method reliably Entities with few products with little difference

in resource consumption patterns can use simple cost allocation methods: Activity Based Costing will add little or no value

Cost Management Simplification

Price is an input unit measure

Driven by units acquired Usually denominated as amount per unit

acquired Cost is an output measure

Usage inefficiency can drive waste, reducing output volume, and dramatically increasing cost both directly and by slow-down

Quality can affect waste and customer perception of price, perhaps lowering price realization, reducing margin [“increased cost”]

Cost –Key Reminder: Cost is not equal to resource price

Cost objects – key for today

Resources Processes Products

Cost Management Objectives Effectiveness – doing the right things Efficiency – doing things right Economy – maximizing margin [can include cost

reductions, or improving revenues]

Strategic Cost Management Key Aspects

Resource Elements

People – employees, consultants, advisors Facilities, owned or leased Equipment, owned or leased Materials Services – insurance, banking, etc. Capital – Equity, debt, leasing, hedging, etc.

Cost of Business – Elements & Drivers

Cost Management Resources - People

Cost Management Resources – Facilities, Equipment

Cost Management Resources – Technology Improvement

Cost Management Resources - Capital

Drivers

Product Design, including features [market segments], appearance, materials, packaging, and expected life

Process Design Technology – Operations, Support Functions Logistics Requirements Marketing and Sales Methods Capital Markets Value Chain Position Cultural Expectations and customs Legal Compliance

Tax Regulation Financial Reporting Conduct and Social Responsibility

Cost of Business – Elements & Drivers

Cost Management - Drivers

Products Product Lines Processes Customers Distribution Channels Facilities Departments Individual Machines

Cost Accounting Objects

Strategic/Long-Term

Target Costing Activity Based Management (ABM)

Intermediate Activity Based Costing/Management (ABC/M) Marginal Analyses – direct costing

Tactical/Short-term Margin Oriented – Grenzplankostenrechnung

(GPK) Full Absorption – Traditional or ABC

Cost & Profit Management Time Frames

Economic Trade-off based

Target Costing Life Cycle Costing

Allocation Based Methods Traditional Product Based Allocation – Fixed vs. Variable Driver Based Allocation

Resource Consumption Accounting Activity Based Costing (ABC) applied to product objects Theory of Constraints (TOC) “Costed” resource consumption analysis [“Pure RCA]

Allocation Free or Limited – Direct/Attributable Costing Oriented Marginal Analyses [Direct/Attributable Costing] Grenzplankostenrechnung (GPK) [marginal plus fixed]

Cost Practices & Techniques

Full absorption focused

Traditional – organization structure centered, organized around organizational, often “siloed”, departments

Process /Activity focused – relies on assigning costs directly when possible, and using process drivers to allocate indirect cots

Production Management focused Marginal costing and process focused – GPK,

although GPK also contains a strong cost center focus

Cost Practices & Techniques

The Importance of Strategic Cost Management

External Financial Reporting – GAAP: focused on

aggregate inventory levels and consistency to inform investment decisions by investors

Income Tax Compliance – generally similar focus as external financial reporting plus “full absorption” to establish tax liability

Profitability Management – Product, Channel, Customer or Customer Class Focused

Performance Management – Operating Function, Department, Process, Channel, Customer or Customer Class Focused

Costing Method Objectives

External parties

Capital provision determinations – costing at entity level aggregation is all that is needed

Tax compliance – aggregate compliance at the tax paying entity/group level to establish tax liability

Entity management Allocations of resources among entities, products,

geographic operating areas Planning and controlling performance

management Profit maximization/optimization

Costing Method Customers

Assignment to accounting/management periods – some

large costs are inherently imprecise as to period; depreciation; loss contingencies; pensions; facility variable rentals and escalation provisions; hedging costs.

Assignment within accounting periods become increasingly difficult as the level of the costing object becomes smaller in size or time duration, as with products.

Allocation techniques sufficient for entity level results are not reliable for more detailed levels at which management must plan and operate – the driver of “drivers”.

The Cost Management Challenge – Assigning/Allocating

Costs

Direct costing always works, but many large

dollar costs are often not direct, particularly at the product or product line level , introducing a level of uncertainty to detail level decisions.

Time horizon improves the relative amount of costs that are direct, but longer horizons provide reduced tactical flexibility.

Direct margin analyses, at multiple levels, enables comparison of long horizon planning and tactical decision making.

The Cost Management Solution to Assigning/Allocating Costs

GAAP – ASC 330 [formerly FAS 151 & ARB 43]

Production [manufacturing]or acquisition [retail] costs

Full absorption Consistency

IRS – Full Absorption [of production costs] focused Code section 471 – Inventory Code section 472 – LIFO [elimination

considered] Code section 263 – UNICAP [some costs in

addition to production costs]

Inventory Costs – GAAP & IRS

Product [Inventory] and Product Line

Direct Costs Identification of and allocation of indirect costs Determine need, if any, to “tie” to financial reporting

Profitability Management Operations Performance Management

Product design Production Operations Logistics, including Warehouse and Material Handling

Product Costing – Today’s Focus

What do these have in common?Close is sufficient

Product Costing Method

Product Design – Coordination with

Manufacturing and Marketing/Sales Product Mix/Product Line Variations Process Design Complexity

Product Design Manufacturing Techniques Logistics and Material Handling Choices

Regulation and Compliance Manufacturing Technology and Performance Distribution and Logistics

Product Cost Drivers

Utilization Factors

Number of shifts – hours/day of use Time paid not worked – holidays, vacations

Operations Performance Factors Set-Up vs. Run Time Speed/Quality Control of Set-Up and Run - Throughput Maintenance – time used vs. production failure costs Waste Driven Slowing of Production Process Loss of time [slowdown, rework]

Waste Defective Material Production Losses

Costs Drivers to Analyze/Reflect

Assign costs directly as much as possible Determine costs pools for variable type indirect costs for

cost management and control Define around key drivers for allocation based on resource

consumption Include costs which reasonably attach to the pool category Consider two [or three] allocation layers,” indirect” indirect

functions like tools, patterns, printing plates Determine if “reciprocal” relationships will be used

Consider collecting assigning fixed type indirect costs separately using best available allocation basis

Establish Operating Departments for management responsibility evaluation – variable and fixed indirect costs

Effective Cost Accounting

Effective Cost Accounting - Drivers

Machine hours Direct labor hours Material costs Pallets handled Printing plates used Tool forms used Patterns used QC tests performed Cubic feet of

compressed air Mixing tank hours

Mixing tank hours Labels issued KWH used Orders processed Space used Miles traveled Warehouse

insertions/extractions Maintenance labor hours Chiller hours

“Methods” – Resource Consumption

Accounting (RCA), Grenzplankostenrechnung (GPK)

Based on consumption of resources (drivers) Applied to indirect costs The big differences in “pure” application – will

not “tie” to conventional financial reporting Replacement cost depreciation , w/o added

output Capital charge based largely on the

depreciation [capital] consumed or similar measures

Cost Accounting Methods – Resource Consumption Methods

GPK in its fundamental form is a marginal costing

system Use “margin” level definitions, with differing levels of

allocation of indirect and fixed costs Product margins Contribution to production costs, including production

functions’ depreciation Most useful for production scheduling Use for channel scheduling Calculate direct costs for both production or

manufacturing and for warehousing, distribution, and logistics

Cost Related Decisions and Marginal Costing

Use, carefully, throughput measures –

profitability, not optimization, is the business objective Minimize down time – set-up, maintenance,

materials not ready Speed and efficacy of machine operation

Optimize margin dollars per month Be very aware of system constraints [bottlenecks]

& consider Theory of Constraints – margin dollar optimization will usually require optimizing the constraint process, not all processes

Cost Measurement & Performance Management

Direct [final] departments – product volume variable costs

only Separate each process containing different

cost/operations/unit output characteristics Identify relevant output units

Fixed costs are separately collected and not assigned to products

Indirect [primary] departments – variable costs only Separate departments with different cost incurrence or

output patterns Identify application basis or bases To extent possible organize indirect cost pools with the

department structure

Product Cost System Design Considerations – RCA/GPK

General design aspects –

Consider replacement cost depreciation as more realistic despite not readily reflecting potential process improvements such as faster set-ups, or increased throughput speed and accuracy/quality

Minimize design complexity by not allocating costs from one indirect department to another indirect department, unless significant to the product

Consider a cost of capital charge, as a function of replacement cost depreciation

Derive a “full absorption” estimate by using percentage reduction for capital charge and replacement cost depreciation ratio to recorded depreciation [by included processes]

Product Cost System Design Considerations – RCA/GPK

Best used for –

Product pricing decisions Outsourcing evaluations Product design evaluation Manufacturing process improvements

Cost Design System – RCA/GPK

Similar to GPK, except that the system is “full

absorption” focused and thus assigns depreciation – usually actual book depreciation – to direct and indirect departments

Costs are the sum of: Direct costs Direct operating departments costs – including

fixed costs - assigned by a relevant driver Indirect departments costs – including fixed

costs - assigned by one or more drivers consumed by the product or the direct process

Cost System Design – Activity Based Costing (ABC)

Target Costing – cost management and

planning, follows six principles: Price-led costing Customer focus Focus on design of products and processes [point

at which most life cycle costs are effectively committed]

Cross-functional teams [for comprehensive perspective]

Life cycle cost reduction Value chain involvement

Costing – Other Important Applications

Attempts to address:

What are the sources of idle capacity? How much unused capacity is assigned to

product cost? How large of a threat is the hidden unused

capacity? Who is responsible for capacity management? How are manufacturing activities

communicated in a common language? How can we obtain more capacity without

buying it?

Costing – Capacity Management

Productive

Good production New product Process development

Non-productive Standby, waste, maintenance, and setup Process balance & variability; scrap; rework and yield Scheduled & unscheduled maintenance: time, volume,

changeover Idle

Marketable (idle) and non-marketable (excess) Off limits; legal, contractual, management policy

Costing – Capacity Management – Categories of Capacity

Utilization

Hydrox Laboratories: production and purchasing

Production planning and scheduling Waste reduction through process improvement Capital to improve quality – capping equipment Bulk purchasing of hydrogen peroxide Components purchasing

Hydrox Laboratories: logistics – per pallet shipping cost reduction by altering truck load factor [per pallet, LTL, truckload]

Graphic Direct Printing press speed Scheduling by cut-off and color similarity Personalization sizing test [MWWWWM] Sorting and envelop filling speed improvements with more

experienced personnel

Cost and Margin Management Examples

www.goldratt.com www.tocc.com www.cam-i.org www.bpminstitute.org www.supplychainmetric.com www.rcainstitute.org http://

www.focusedmanagement.com/knowledge_base/articles/fmi_articles/middle/German_Cost_Accounting_pt2.pdf

Google text string: GPK accounting Google text string: Resource consumption accounting

Cost Management Resources