Using costs in decision making

timer Asked: Jan 28th, 2021

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Cost behaviour is relevant to the management function of planning, control and decision making. Identify and discuss briefly one example (you may pick any company), where knowledge of cost behaviour is relevant to the management function.

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Target costing Target costing Process: Step Example 1. Estimate the market price. Customers will pay $40 for a Guru2. 2. Estimate the cost of developing and producing the item → the as-if cost. The Guru2 will cost $32 per unit to produce, based on the current design specifications. 3. Determine the required investment and profit per unit and subtract the profit needed from the market price to determine the target cost. The Guru2 will require an investment of $10 million. Based on anticipated demand, the target profit is $10 per unit to achieve required ROI. Therefore, the target cost is $30 per unit. 4. Compare the as-if cost to the target cost and revise design if needed to reduce as-if cost to below target. As-if cost of $32 exceeds target cost of $30; revise design to reduce cost to target. Capacity resource planning Capacity: The upper limit of work that can be performed during a set period of time To ADD capacity To REDUCE capacity Add additional shifts Eliminate shifts Schedule overtime or work on weekends Reassign personnel temporarily Add new equipment or personnel Decrease the length of shifts Change layout or flow of work Subcontract / outsource work Outsourcing as a means to increase capacity and reduce costs • Core competencies should not be outsourced • Risks must be understood and mitigated Offshoring → outsourcing overseas Benefits Challenges • cost reductions compared to local materials/labour • quality concerns and transportation costs managing at a distance; loss of control • time zone advantage • cultural issues/political risks/currency risk • increased flexibility/options • reputational risks and ethical concerns • negative employee morale Improving efficiency and effectiveness • Organizations need to do more with less. • Many models are used; … examples: o o Just in time (JIT) Business process re-engineering (BPR) • Models are ongoing or iterative and aimed at continual improvements. Just-in-time (JIT) production • Concept was developed by Toyota in Japan • “Pull” system • JIT eliminates disruptions and waste: o product defects o processing waste o inventory o unnecessary transporting o waiting time • JIT is not an easy process to implement Business process re-engineering (BPR) • BPR involves completely rethinking and redesigning an organization’s business processes. • Examines underlying assumptions about how and why things are done. • The goal is to achieve dramatic results. • Often involves many departments or multiple activities on the value chain. • BPR is a big undertaking; it requires commitment to see it through and strong change management. Customer relationship management (CRM) • CRM is used to manage relationships with current and future customers. • uses technology to synchronize sales, marketing, customer support and service. • includes data warehousing and analytics to track and forecast results. • aided by social media data. • available SaaS (Software as a Service) for smaller organizations. Enterprise resource planning (ERP) • ERP integrates departments and functions into a single IT system • Enterprise-wide data available for analysis and decision-making • Core areas targeted for ERP solutions: o accounting/finance o production and materials management o human resources • ERP has high benefit, but also high cost/commitment Example ERP product… SAP enterprise resource planning systems Setting cost reduction targets • Selling expenses decline 25% • Channel expenses decline 10% • Advertising expenses decline 5% Overall energy reduction → cost reduction • 4G energy-saving base stations • Smart power saving technology • Green data centers • Recycled packaging • Waste recycling Air Canada Cost Structure Operating Costs Non-operating Costs • • • • • • Aircraft fuel Labour costs Airport and navigation fees Food, beverages, and supplies Aircraft Maintenance Depreciation • Interest expense • Foreign exchange gain/loss • Pension and Other Employee Future Benefits Labor cost Labour cost is the second largest cost. Need to pay pilots, flight attendants, baggage handlers, dispatchers, customer service representatives and others to operate. Challenges • Labor-Strike, work disruption, flight delays • Airline can not operate properly; damage to reputation STRATEGIC COST Introduction This week, you will learn about a variety of management tools and models that help organizations strategically manage costs and resources and achieve quality. These models represent approaches that reflect underlying business philosophies, meaning that they are not stand-alone tools but rather reflect the overall way of doing business, which is an important part of an organization’s culture. TOPIC 5.1: TOOLS FOR STRATEGIC COST AND CAPACITY MANAGEMENT A key part of managing performance relates to managing profits, which in turn means managing revenues, expenses and capacity levels. In Week 3, you studied strategies to support an organization’s value proposition. These strategies determine how much an organization focuses on revenues versus expenses in managing profits and whether the company will be a high- or low-volume producer. For example, companies pursuing differentiation and niche strategies will prioritize increasing revenues, while those striving to be price leaders or cost leaders will focus on cost cutting and high volume output. Regardless of the strategy chosen, however, cost and capacity management are important to long-term performance and sustainability. This topic looks at some of the practices or approaches commonly used to plan and manage costs and capacity. 5.1-1 Target costing Some companies set their prices using a cost-plus approach: they determine their costs and add a percentage markup based on their target profit margin to calculate the price. In other situations, however, the price is set based on what the market will bear. If prices are marketdriven, companies must use careful cost management to achieve profit targets: starting with the target price set by the market, they subtract their targeted profit to calculate the maximum allowable cost. This approach is called target costing. Target costing is a planning tool, rather than an operational tool, since it is used to determine the product’s design and the design of the process that will be used to make the product. The rationale for target costing is the realization that, on average, 80% of a product’s costs are committed at the time the product and its manufacturing process are designed. Therefore, it is easier to reduce product costs during the planning stage than after the product is designed and its manufacturing system has been put in place. The target costing approach involves the following steps: 1. Estimate the price the market will set for a proposed product with specific attributes. This might involve evaluating the price for similar products or questioning prospective customers using customer panels. This price is called the target price. For example, imagine that market research indicates customers will be willing to pay $40 for a new gardening tool called the Guru2, developed by Garden Genies Ltd. 2. Estimate the cost of developing and producing the proposed product. This actual expected cost is called the as-if cost. For example, assume that Garden Genies expects the Guru2 to cost $32 per unit to produce, based on the current design specifications. 3. Determine the required investment level in the product, based on the product and process design. This allows the organization to identify the target profit per unit that will provide the required return on investment. The organization deducts the target profit from the target price to compute the target cost. The target cost therefore reflects the maximum allowable cost that will result in the required return. For example, assume that the Guru2 will require an investment of $10 million, and that, based on anticipated demand, the company would need to make $10 in profit per unit to achieve the required ROI. Given a target price of $40 per unit, if the company needs $10 per unit profit, the target cost is $30 per unit. 4. Compare the product’s as-if cost to the target cost. If the as-if cost is greater than the target cost, the product development team reformulates the product and process design to reduce the product’s as-if cost. If reducing the as-if cost changes the target price the customer is willing to pay, this must be taken into account. The product and process redesign continues until the as-if cost is equal to or less than the target cost. For example, Garden Genies has determined that it needs a target cost of $30, but the as-if cost is $32. This means that the expected costs are too high, so the development team will need to re-evaluate the design specifications and processes. Imagine that the team determines that it can reduce the as-if cost by $5 per unit by using plastic rather than metal for two of the components on the Guru2. This will reduce quality slightly — so customers would only pay $38 per unit — but it would not be expected to decrease demand. The new target cost would be $38 – $10 = $28; the new as-if cost would be $32 – $5 = $27. The team would conclude that Garden Genies can produce the Guru2 at slightly below the target cost, so this formulation of the design and processes is expected to be successful. During the iterative planning process, when the organization develops a tentative product and process design and computes the resulting target profits and target costs, cost-reduction targets are delegated to each of the product’s components. For example, assume the Guru2 has 40 components that comprise 90% of the product’s estimated as-if cost. When Garden Genies is looking for ways to reformulate the Guru2 and reduce costs, it needs to consider what proportion of the as-if cost reduction will be assigned to each of the components. Delegating cost-reduction targets this way is difficult, mainly because different components may have significantly different potentials for cost reduction, and in many cases, the design of the components will affect not only the costs of those components but also the costs of other components and assembly costs. For example, using plastic instead of metal for some components may also change the tools used to assemble the Guru2. Common methods used at this stage include value engineering (which compares the value to the cost of each component or each product feature) and design for manufacturing assembly (which considers the manufacturing cost of each design). 5.1-2 Capacity resource planning Capacity is the upper limit of work that an operating unit can perform during a set period of time. An operating unit may be a plant, a department, a work centre, a machine or even a staff member. Capacity can be stated on the basis of output (such as units per hour) or on the basis of input (such as hours per shift). Capacity is generally broken down into two types: design capacity and effective capacity. Design capacity refers to the maximum rate of output that can be achieved under ideal operating conditions. Effective capacity is always less than design capacity and takes into account hours of work with rest periods, product mix and scheduling, and routine maintenance. Effective capacity is also called practical capacity, and design capacity may be termed theoretical capacity. Capacity planning decisions are made each year in conjunction with the capital and master budget preparation. The organization begins the process by forecasting demand over a one- to five-year period; this in turn will identify the capacity requirements to meet that demand. The firm compares these capacity requirements to its existing levels and generates alternatives to bridge any capacity gaps. The alternatives are then subject to standard financial evaluation techniques such as net present value analysis, payback and break-even. After considering both financial and non-financial analysis, the company will implement the chosen alternative. A number of strategies can be used to either increase or decrease capacity. Strategies for increasing capacity:  Add additional shifts (second or third daily shift).  Schedule overtime or work on weekends.  Add new equipment or personnel.  Change layout or flow of work.  Subcontract work. Strategies for decreasing capacity:  Eliminate shifts.  Reassign personnel temporarily.  Decrease the length of shifts. Capacity requirements planning (CRP) is the process of determining the amount of resources (such as machines and labour) needed to achieve the planned production for a given period. The inputs into CRP include forecasted demand, operational lead times, processing time and inventory buffers. The output from the CRP process is a load profile for each major resource, which identifies under- or overloaded resources. The firm can then adjust capacity or product flow to ensure that it will have enough capacity to meet the demand forecast for the period. CRP also helps identify bottleneck operations that limit the plant’s overall capacity. Three basic strategies can be employed to manage overall capacity:  Capacity lead strategy: an aggressive strategy where capacity is increased in anticipation of increased demand. It may be employed if the company’s objective is to win customers from competitors. This strategy can be problematic if costs have been committed to but demand does not increase.  Capacity lag strategy: a conservative strategy where capacity is only increased after demand increases. This may result in the firm having to turn away customers or deal with back orders.  Average capacity strategy: a moderate strategy where capacity is increased to meet average expected demand. This shares the risks of both of other strategies, but to a lesser extent in each direction. 5.1-3 Outsourcing as a means to increase capacity and reduce costs In Week 3, you learned about outsourcing from a strategic perspective. You revisit the idea now in terms of the impact on capacity and cost management. Recall that outsourcing refers to hiring an external provider to perform activities that traditionally have been performed internally. The overall goal of outsourcing is to increase efficiency and reduce costs by having the activities performed by experts with economies of scale, thereby allowing the organization to focus on its own core competencies. Outsourcing can be used to free up resources and increase overall capacity, but care is needed in determining what activities to outsource. As discussed in Week 3, core competencies should not be outsourced, because outsourcing removes the activities from the organization’s control and greatly reduces internal team members’ knowledge and competence in that particular area. For example, imagine a public practice firm whose competitive advantage stems from its ability to attract and retain top quality employees. One of the ways it achieves this is by requiring every manager to spend a certain amount of time each week on recruiting, training and employee engagement activities. This takes away from the time the managers can devote to client service. If the firm decides to outsource its human resources function, this may increase managers’ capacity to perform client service functions, but it may also jeopardize recruiting and employee engagement, which will eventually put its long-term success at risk. Using outsourcing as a means of cost management can be a good strategy in some situations, but it must be done carefully. One particular type of outsourcing is offshoring, which refers to the use of overseas service providers for outsourced activities. Offshoring has the added benefit of taking advantage of different time zones around the world to increase productivity and responsiveness, in effect increasing capacity by adding another shift. Offshoring has disadvantages as well, including the potential for even more loss of control than with local outsourcing providers, transportation costs, negative employee morale if staff feel they are being replaced by offshore employees and quality problems. The company’s reputation also becomes tied to the supplier. For example, many companies took advantage of advanced communication technologies in the last decade to outsource their help desks to overseas teams. Some companies suffered reputational issues, as customers were frustrated by dealing with individuals who did not understand the customer’s environment, needs or specific technologies being used. This prompted some organizations to revert back to using local support teams and to emphasize in their marketing that they serve customers from North America. In addition, offshoring presents numerous ethical challenges; companies must work to avoid potential harm to human health, the environment or the livelihood needs of the local people and to comply with various labour laws and human rights. Political, currency, and economic risks further complicate offshoring decisions. Overall, careful risk assessment and mitigation are required before undertaking any major outsourcing initiative, regardless of the potential for cost savings. TOPIC 5.2: IMPROVING EFFICIENCY AND EFFECTIVENESS Managing capacity and costs requires organizations to focus on ways to do more with less. Management uses a variety of models to pursue increased efficiency and effectiveness. As you explore a few of these models below, note that they overlap and are not mutually exclusive. Organizations may draw on and integrate several of these concepts in their quest for success, and they may use the names of the models interchangeably. Most of these models aim to achieve ongoing improvement through small continual advances or larger steps of improvement. As such, they are iterative management models rather than one-time activities. 5.2-1 Business process management The business process management (BPM) approach optimizes business processes, thereby improving efficiency and flexibility. Processes are seen as important assets to be understood and managed with a view to enhancing efficiency and value. BPM originally focused on automation through technology, but it has broadened over time to include human interaction and to synergize the benefits of both human efforts and technology. An organization using BPM aims to continuously improve business effectiveness and efficiency while working to innovate and use new technologies to optimize processes and accommodate change. BPM relies on process mapping (also known as process modelling or flow charting). This mapping provides a visual representation of a process by documenting the activities (often referred to as events or steps) used to make a product (good or service). The goal of process mapping is to break down processes to make them more understandable so that effectiveness and efficiency can be improved. Process mapping is attributed to Frank Gilbreth, who developed the original ideas in the 1920s by modelling bricklayers’ tasks and determining best practices to improve the efficiency of their work. Gilbreth’s original model focused on a visual approach that was limited to simply drawing the process. This was later adapted by adding times, quality and cost data to each of the documented activities. The following is an example of a generic process map. In an actual implementation, each process would be identified specifically rather than with the generic term process. For example, the box opposite the customer might be labelled “Take and transmit customer order to sales.” Process mapping is fundamental to many tools and models accountants ...
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