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Estimate the market price.
Customers will pay $40 for a Guru2.
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.
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.
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
The upper limit of work that can be performed
during a set period of time
To ADD capacity
To REDUCE capacity
Add additional 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
cost reductions compared to
quality concerns and transportation costs
managing at a distance; loss of control
time zone advantage
cultural issues/political risks/currency risk
reputational risks and ethical concerns
negative employee morale
Improving efficiency and effectiveness
• Organizations need to do more with less.
• Many models are used; … examples:
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:
• 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:
production and materials management
• 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
Airport and navigation fees
Food, beverages, and supplies
• Interest expense
• Foreign exchange gain/loss
• Pension and Other Employee Future Benefits
Labour cost is the second largest cost.
Need to pay pilots, flight attendants,
baggage handlers, dispatchers,
customer service representatives and
others to operate.
• Labor-Strike, work disruption,
• Airline can not operate properly;
damage to reputation
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
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.
Strategies for decreasing capacity:
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
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
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
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
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
Process mapping is fundamental to many tools and models accountants ...