Managing Costs for enhancing profitability

Product Costing

Financial Accounting

Product costs are used to value inventory and

to compute cost ofgoods sold.

Managerial Accounting and

Cost ManagementProduct costs are used

for planning, control, directing, and

management decision making.

Shift from “Cost-led Pricing” to “Price-led Costing”

Cost structure of individual products and departments

Cost structure of the entire value chain not only our operations

Cost structure of the individual business processes

Convert business costs into value for our customers

Typical Company Value Chain

DistributionAnd

OutboundLogistics

Operations

PurchasedSupplies

andInboundLogistics

Sales and Marketing

ServiceProfit

Margin

Product R&D, Technology, Systems Development

Human Resources Management

General Administration

Primary Activities and Costs

Support Activities and Costs

Competitive PositioningCost Position

High Cost Position

Low Cost Position

Pro

du

ct

Dif

fere

nti

atio

n

Low

High

Product Differentiati

on

Stuck in The

Middle

Differentiation &

Cost Leadership

Overall CostLeadership

0102030405060708090

AverageCompetitor

Low CostStrategy

DifferentiationStrategy

$

Cost

Price

Profit

Cost Leadership Strategy

Relatively standardized products

Lowest competitive price

Cost Leadership Strategy Building economies of scale Tightly controlling production costs and

overhead Minimizing costs of sales, R&D and

service Building efficient manufacturing facilities Monitoring costs of activities provided by

outsiders Simplifying production processes

Differentiation Strategy Nonstandardized products

Customers value differentiated features more than they value low cost

Cost Measures

Measurements are the key …If you can’t measure it, you can’t control it …If you can’t control it, you can’t manage it …If you can’t manage it, you can’t improve it !!!

Determining whether to add or drop product lines.

Determining product pricing.

Deciding whether or not to outsource a product or activity (make or buy, perform ourselves or outsource the activity).

To facilitate redesign of a product.

To facilitate redesign of an internal activity.

To perform customer profitability analysis.

Cost Information

Target Costing Process of cost management and profit

planning Price-led costing

Target Cost=Market Price-Reqd Profit Focus on Customers

Value>cost Focus on design Cross functional involvement Value chain involvement

Strategic Objective Employee Motivation

• Cost data traditionally used to FIX BLAME• Leads to short-run decision emphasis• Cost data can be used to focus on how to work

better, not who to blame

Total Product Cost• Manufacturing cost plus all costs of getting

product/service to customer

Something to remember

Cost minimisation is a sign of management success. Cost cutting is a sign of management failure.

Cost and Cost Terminology

A cost object is anything for which a separatemeasurement of costs is desired.Example – product, project, dept

Different Cost for Different Decisions

Traceability of cost objects Direct costs and indirect costs

How cost behave as volume varies Fixed costs, variable costs &

mixed costs

Direct and Indirect Costs

Direct CostsExample: Felt, plastic

Indirect CostsExample: Power

COST OBJECT

Example: DUSTER

COST OBJECT

Example: DUSTER

Traditional Product Costing

Resources

Direct materials

Direct labor

Direct expenses

Overhead

Products

Traced directlyAllocated UsingDL hours, sales

value, production volume

Elements of Product Cost Direct Material Direct Labour Direct Expenses

Indirect Material Indirect Labour Indirect Expenses

Prime Cost

+Factory (Works or Manufacturing Overhead)

=Total Factory(Works or Manufacturing) Cost

Factory Cost = Cost of Goods Sold

Cost of Goods Sold + Selling expenses +Adm Expenses + Interest + Profit = Sales

Cost SheetJob Number A - 143 Date Initiated 3-4-X2

Date CompletedDepartment B3 Units CompletedItem Wooden Box

Direct Materials Direct Labor Manufacturing OverheadReq. No. Amount Ticket Hours Amount Hours Rate Amount

Cost Summary Units ShippedAmount Date Number Balance

Direct Materials 0.00Direct Labor 0.00Manufacturing Overhead 0.00Total Cost 0.00Unit Cost

Product Costs

Cost SheetCoated Grey Back Board - cost sheet

Direct Materials Manufacturing OverheadReq. No. Amount Ticket Hours Amount Req. No. Amount Hours Rate Amount

Raw Materials 7268Power and fuel 1958

Repairs and maintenance 979

Chemicals Consumables 849Pulp mill 556 Others 872

Stock preparation 1681 Coating 2232Packing Cost 600Total 12337 Total 1958 Total 2700

Cost SummaryAmount Date Number Balance

Direct Materials 12337Direct Labor 0.00Direct Expenses 1958Total Direct Costs 14295Manufacturing Overhead 2700Other Overhead

Salaries and wages 1922Admin cost 1682Depreciation 1802

Total Cost 22400

Product Costs

Direct Labor Direct Expenses

Units Shipped

A Co applies overhead based on direct- labor hours. Total estimated overhead for the year is Rs 640,000. Total estimated labor cost is Rs 1,400,000 and Total estimated labor hours are 160,000.What is the Co’s predetermined overhead rate?

Overhead Application Example

Rs 640,000

160,000 direct-labor hours (DLH)POHR =

POHR = Rs 4.00 per DLH

For each direct labor hour worked on a job, Rs 4.00 of factory overhead will be applied to the job.

Overhead Application Example

POHR =Budgeted manufacturing overhead cost

Budgeted amount of cost driver (or activity base)

Direct and Indirect CostsExample

Direct Costs:Assembly Department Rs75,000Finishing Department Rs55,000Indirect Costs:Maintenance Department Rs40,000Personnel Department Rs20,600

Assume that Maintenance Department costs areallocated equally among the production departments.

How much is allocated to each department?

Direct and Indirect Costs Example

AllocatedRs20,000

MaintenanceRs40,000

AssemblyDirect Costs

Rs75,000

FinishingDirect Costs

Rs55,000

Rs20,000

Relationships of Types of Costs

Direct

Indirect

Variable Fixed

Price-Volume-Profit AnalysisAn Example

Price-Volume-Profit AnalysisAn Example

Present Sales Price 5.00Present Variable costs 2.00

Contribution MarginPresent Fixed costs 150,000

Unit VolumePresent 150,000

Expected with price reduction 170,000 Profit

PresentExpected with price reduction

•What is the present profit•If the sales price is reduced by 10%, what will happen to profits (with no change in unit volume)?•If the sales price is reduced by 10%, what will happen to profits (with an increase in volume to 170,000 units)?

EFFECT OF TECHNOLOGY ON PRODUCT PROFITABILITY

PRODN/SALESEXISTING TECHNOLOGY

150 250 350REVENUES 1500 2500 3500 VARIABLE COSTS 750 1250 1750 FIXED COSTS 1000 1000 1000NOI -250 250 750

IMPROVED TECHNOLOGY150 250 350

REVENUES 1500 2500 3500 VARIABLE COSTS 450 750 1050 FIXED COSTS 1540 1540 1540NOI -490 210 910

SALES 40% 40%NOI 200% 333%

DOL 5 8.325

Activity-Based Costing

Not all products or services share equally in activities.

The more complex a product’s manufacturing operation, the more activities and cost drivers it is likely to have.

Activity-Based Costing System

Overhead Costs

Products

Assem-bling

Cost Pool

Number of

Parts

Inspecting and

Testing Cost Pool

Number of

Tests

Painting Cost Pool

Number of

Parts

Super-vising

Cost Pool

Direct Labor Hours

Ordering and

Receiving Materials Cost Pool

Number of POs

Setting Up

Machines Cost Pool

Number of

Setups

Machining Cost Pool

Machine Hours

Value Added Time

VAT comes from the processing time and includes cost of direct materials and conversion costs.

Value-Added versus Nonvalue-Added Activities

Value-added activities increase the worth of a product or service to customers.

They involve resource usage and related costs that customers are willing to pay for.

Value-added activities are the functions of actually manufacturing a product or service.

Examples include engineering design, machining, assembly, painting, and packaging.

Value-Added versus Nonvalue-Added Activities

Nonvalue-added activities are production- or service-related activities that simply add cost to, or increase the time spent on, a product or service without increasing its market value.

Examples include the repair of machines, storage of inventory, moving of materials, maintenance, and inspections.

WAT

WAT consists of Set-up time (SUT), Inspection time (IT), Movement time (MT), Waiting time for the warehouse (WT), Storage time until sale (ST), which includes warehouse and distribution costs and other waste added cost (OT) denominated time like rebates, discounts, special deals or zero percent finance and sale returns.

Often Collection time (CT) is also included in the WAT.

WAT

WAT (= SUT + IT + MT + WT + ST + OT + CT) has to be minimized without unduly destabilizing the business, scale and scope.

Direct Labour

Direct Labour

SpaceSpace

Support Labour

Support Labour

InventoryInventory

Defects Defects

Capital Equipment

Capital Equipment

30-80%30-80%

20-60%20-60%

30-70%30-70%

50-80%50-80%

30-70%30-70%

50-80%50-80%

Direct Material

Direct Material

20-60%20-60%

How organizations save on major cost drivers

Value-Added Analysis

Planning Time

Move Time

Wait time

Setup Time

Process Time

Move Time

Inspection time

Total Production Cycle Time

Only the Process Time is Value-Added

Value-Added Analysis in Manufacturing

95% 5%

Non-Value-Added

Value Added

97.5% 2.5%

Non-Value-Added

Value Added

Company Concentrating on Improving Value-Added Performance

50% 50%

Non-Value-Added

Value AddedValue Added Management

Target

World Class Manufacturer

What is benchmarking ?

Benchmarking is a continuous process of measuring products , services , and practices against the toughest competitors or those companies recognized as industry leaders ( Best in class ).

The search for industry best practice and use them to achieve superior performance.

Benchmarking involves

Learning

Share information

Adopting best practices to improve the performance.

Why should we benchmark ?

The Basic purpose is to promote excellence , generate new levels of performance, and new standards in the organization.

To know as to how does your company rate to others in the industry.

To improve products , numbers , processes. Fast learning Competitive advantage.

Who should we benchmark with ?

Internal Benchmarking.

Benchmarking with competitors.

Best in Industry.

Cross Industry.

Benchmarking Costs ofKey Value Chain Activities

Focuses on cross-company comparisons of how certain activities are performed and the costs associated with these activities

Purchase of materials Payment of suppliers Management of inventories Training of employees Processing of payrolls Getting new products to market Performance of quality control Filling and shipping of customer orders

Procure Products

Identify appropriate

Products

Buy Products

Documentation

Product Design benchmarking

START Define Scope

of analysis

List the asslysTo be

benchmarked

Identify the current cost

View / Describe asslys.

Identify Prod differences.

View the Benchmarking

Product

List all visible Diff for

Function,valueProduct design.

Drive CR ideas

Br.down Diff into customerRelevant Features

Less customerRelevant

Features.

Assessment of Scope Compression Prod available

Assessment of own prod v/s benchmark

Cost reduction ideas

How applicable is CR in your company. Have you in last three years taken an

initiative which yielded 15 to 20% CR Are you able to reduce cost by 5%

consistently (beyond industry decline) Have you discussed with your supplier on

his economics and “should be the cost” Do you re-evaluate your supplier base to

explore better prices Is your SCM team the best and closely

integrated with other key functions .

How applicable is CR in your company Have you in last 5 years pursued an

initiative to reduce the mfg cost by 5 % Do you have a clear KPI based tracking

mechanism for cost Do you know the level of the costs in the

plant Do you have at least 10 important cross-

functional initiatives on going at any time in your plant.

3.55.9

28.7

65.5

10.5

32.5

4.53.5

0

10

20

30

40

50

60

70

Localisation. Better Buying. IndirectPurchase.

Logistics.

Val

ue

in M

i R

s.

05-06 Actual 05-06 Plan

Sr. Description. 05-06 Plan 05-06 Actual

1 Localisation. 32.5 28.7

2 Better Buying. 10.5 65.5

3 Indirect Purchase. 4.5 5.9

4 Logistics. 3.5 3.5

Total 51.01 103.51

Cost Performance – Year 2005-06

Achievement - 203%

Cost Performance Plan – Year 2006-07

Localisation.

Better Buying.

Indirect Purchase.

Logistics.

18.5 Mi Rs

29.4 Mi Rs

3 Mi Rs

4 Mi Rs Plan for Year 2006-07

Business Plan - Rs. M 38.0

Target - Rs.M 54.90

Plan till Oct - Rs.M 27.6

Actual till Oct - Rs.M 35.3

Total CR Plan – Rs. M 54.9

CR Avenues & Performance - TYA

Activity-Based Costing Activity-based costing (ABC) allocates

overhead to multiple activity cost pools and assigns the activity cost pools to production by means of cost drivers.

In ABC, an activity is any event, action, transaction, or work sequence that causes the incurrence of cost of a product or a service.

A cost driver is any factor or activity that has a direct cause/effect relationship with the resources consumed.

Activity-Based Costing ABC allocates overhead in a two-stage

process: Overhead is allocated to activity cost

pools, each of which is a distinct type of activity,

Overhead in the cost pools is assigned to products using cost drivers which represent and measure the number of individual activities undertaken or performed to produce products or render services.

Unit Costs under ABCActivity-based costing involves the following

steps:1 Identify the major activities that pertain to the

manufacture of specific products and allocate manufacturing overhead costs to activity cost pools.

2 Identify the cost drivers that accurately measure each activity’s contributions to the finished product and compute the activity-based overhead rate.

3 Assign manufacturing overhead costs for each activity cost pool to products using the activity-based overhead rates (cost per driver).

Computing Overhead Rates

Availability and ease of obtaining data relating to the activity cost driver is an important factor that must be considered in its selection.

The activity-based overhead rate is computed as shown below:

Estimated Overhead per

Activity

Expected Use of Cost Drivers per

Activity

Activity-based Overhead Rate =

Benefits of ABC The primary benefit of ABC is more

accurate product costing because ABC leads to more cost pools used to assign overhead costs to products.

ABC leads to enhanced control over overhead costs. Many overhead costs can be traced directly to activities. Thus, managers become more aware of their responsibility to control the activities that generate costs.

Benefits of ABC ABC leads to better management

decisions. More accurate product costing helps in setting selling prices and in deciding to whether make or buy components.

Activity-based costing does not, in and of itself, change the amount of overhead costs.

Limitations of ABC ABC can be expensive to use. ABC

systems are more complex than traditional costing systems.

Some arbitrary allocations continue. Certain overhead costs remain to be allocated by means of some arbitrary volume-based cost driver.

Activity-Based Management Activity-based management (ABM) is

an extension of ABC from a product costing system to a management function that focuses on reducing costs and improving processes and decision making.

A refinement of activity-based costing used in ABM is the classification of activities as either value-added or nonvalue-added.

Activity-Based Management Activity-based management (ABM) is

an extension of ABC from a product costing system to a management function that focuses on reducing costs and improving processes and decision making.

A refinement of activity-based costing used in ABM is the classification of activities as either value-added or nonvalue-added.