Chap 4 - Cost Management Techniques

Question 1

What is the meaning of cost control and what are the various types of cost control targets that can be set by an organization?

Answer 1

• Cost control implies regulation of the cost of operation through the action of executives. It involves setting up the targets (yardstick) for managers who are responsible for cost centres and comparing their performance against such targets. Therefore, Cost Control involves continuous comparisons of actual with the standards or budgets to regulate the former.

Question 2

What are some Prerequisite of Cost Control?

Answer 2

Effective delegation of authority and assignment of responsibility for costs; simply means cost centre must be designated against the name of the manager responsible for it.
▪ An agreed plan that sets up objectives and goals to be achieved with clarity; simply means clearly defined targets.
▪ Motivation (may be finance linked or non-financial) to encourage individuals to reach the goals established and agreed.
▪ Timely and efficient reporting.
▪ The recommendations must be followed by action.
▪ An effective system of follow-up to judge the effective implementation of recommendation

Question 3

What is the meaning of cost reduction? and how different is it from cost control which we saw previously?

Answer 3

• Cost reduction is the real and permanent reduction in the unit cost of goods manufactured or service rendered without impairing the utility for the intended use. Therefore, cost reduction is continuous effort to reduce cost through economics (standardization of product or component) and savings in costs of manufacture, administration, selling and distribution. It believes in reducing to cost till the optimal level rather any specified level such as standards or budget(This last part is where we have the points of differences between the two systems)

Question 4

What are the various areas of scope of cost reduction and how it can be achieved?

Answer 4

• Product Design -
• Efficient designing for a new product or improving the design for an existing product can reduce the cost in the following manners:
• Cheaper substitute, higher yield and less quantity and varieties of materials, cause a reduction in cost.
  ▪ Reduced time of operation and increased productivity reduce cost.
  ▪ Standardization and simplification in variety increases productivity and reduces costs.
• Organisation
• Factory Lay Out Equipment
• Production Plan Programme and Method
• See 4.4 and 4.5 for detailed excerpts of these points

Question 5

How standardization of the components is an effective method of cost reduction when compared to the other methods?

Answer 5

• Standardisation of component means using the same type of component for more than one product or all the product which any manufacturer is producing.
• Benefits are economies of scale, ease in inventory control and Ease for an operator who use this component for various purposes

Question 6

What are the primary differences between cost control and cost reduction? - main points in relation how standards and budgets are used or not used in these systems is of critical importance?

Answer 6

Question 7

What is the meaning of target costing? when does this concept actually applied in the product life cycle of the product? and what are the various new types of cost that goes into determining target cost for the product?

Answer 7

• Target costing can be defined as “a structured approach to determining the cost at which a proposed product with specified functionality and quality must be produced, to generate a desired level of profitability at its anticipated selling price”.
• Target costing initiates cost management at the earliest stages of product development and applies it throughout the product life cycle by actively involving the entire value chain.
• target costing is capable to take into account initial design and engineering the costs, as well as cost of manufacturing, distribution, sales, and services.

Question 8

What are few limitations of cost plus pricing concepts, which can be overcome by the target costing?

Answer 8

The limitation includes-

▪ The ignorance of the price charged by competitor,

▪ The ignorance to the price which customer ready to pay and

▪ Cost control.

Question 9

What are the various important steps in target costing?

Answer 9

• Step 1– Re-orient culture of thinking and attitude - so that importance must be given to market driven prices and need of customer can be prioritized rather a just technical requirements.
• Step 2– Identify the market requirements - as regards design, utility, and need for a new product or improvements in the existing products. (Be customer-oriented while determining the requirements)
• Step 3– Establish the market-driven target price
• Step 3A– Determine the volume of product to be produced that will be produced at the established market-driven target price.
• Step 3B– Establish the target profit margin (for each product), based on the long-term objectives and considering the financing aspects
• Step 4– Determine the target cost by reducing the desired/required margin from market-driven target price.
• Step 4A– Establish a balance between target cost and requirement - The requirement is to be customer oriented.
• Step 5– Establish the target costing process (comprises the persons, their role & responsibilities and tool & techniques to be involved in the process of target costing).
• Step 6– Brainstorm and analyses the alternatives to identify the opportunity to reduce the cost through consideration of the multiple concepts and design alternate for both the product and its manufacturing process at each stage of the development cycle.
• Step 6A– Establish product cost models (along with cost table) for each concept and design alternate to support decision making.
• Step 7– Use the tools to closing down the gap between cost as determined by product cost model in step 6A and target cost locked in step 4A. Analysis of cost reduction target can be performed to identify cost reduction opportunities (both in design and layout of product and processes) using Value Engineering/ Value Analysis.
• Step 7A – Reduce the indirect cost applications – Re-engineer the indirect process by eliminating the non-value-added function to minimize the cost
• Step 8 – Measure the results and maintain management focus on further possibilities of cost reduction as a continuous improvement program

Question 10

What are the six main principles of target costing?

Answer 10

• target costing depends on achieving appropriate profit through planning, analyzing and studying both profitability and cost at the same time. It includes six main principles (as premise or dimension of target cost), which are enlisted below-
  ▪ Leadership of Target Selling Price.
  ▪ Focusing on Customer.
  ▪ Using and Developing a Teamwork.
  ▪ Reduce the Cost of the Product Life Cycle.
  ▪ Focus on the Stage of Product Design.
  ▪ Attention to all Stages of the Value Chain.

Question 11

what are the important points in relation to pros and cons of target costing system?

Answer 11

• Pros
• process and product innovation - Top down commitment.
• identify market opportunities that can be converted into real savings to achieve the best value rather than simply the lowest cost.
• Proactive approach to cost management
• employee awareness and empowerment
• Encourages the adoption of value- added activities with higher pay-off and elimination of non-value- added activities to residual level
• enhances product life by reducing the time to market
• market-driven approach towards cost, in which value is defined not only by what customers demand but also by what they are willing to pay for.
• Cons:
• The development process can be lengthened to a considerable extent only.
• A large amount of mandatory cost-cutting can result in finger-pointing in various parts of the company
• Representatives from a number of departments on the design team can sometimes make it more difficult to reach a consensus on the proper design because there are too many opinions regarding design issues.
• Resolving out is difficult and requires a strong team manager, as well as a long-term commitment on the part of a company to weed out those who are not willing to act in the best interests of the team
• Effective implementation require the development of detailed cost data
• Use of target costing may reduce the quality of products due to the use of cheap components which may be of inferior quality
• Based upon innovation, also involves the great amount of forecasting and estimation. Substantial portion of information is market-led, hence highly dynamic in nature.

Question 12

What is the impact of target costing on profitability?

Answer 12

• It all depends on the commitment of the management to it’s use by constantly involving the management accountants in all the stages of PLC.
• It places continuous emphasis on product costs throughout the life cycle of every product, and the management is completely aware of costing issues since it receives regular reports from the management accounting members of all design teams.
• It improves profitability through precise targeting of the correct prices at which the company feels it can field a profitable product in the marketplace that will sell in a robust manner. This is opposed to the more common cost-plus approach under which a company builds a product, determines its cost, tacks on a profit and then does not understand why its resoundingly high price does not attract buyers

Question 13

What are the situations in which the target costing can prove to be more useful in comparison to alternative uses?

Answer 13

Target costing is most useful in those situations where the substantial amount of product costs are locked (committed) during the product design phase(That is in manufacturing or assembly oriented industries)

but rare in case of services. In the services area, such as consulting, the bulk of all activities can be reconfigured for cost reduction when services are being provided directly to the customer - See the example of fast food restaurant where design cost is not locked in the initial phase and it can be modified as and when it is needed.

Question 14

What is the main difference between value analysis and value engineering in the target costing process?

Answer 14

Value Analysis is a planned, scientific approach to cost reduction which reviews the material composition of a product and production design so that modifications and improvements can be made which do not reduce the value of the product to the customer or to the user(Value analysis is cost avoidance or cost reduction of a product already in production; both adopt the same approach i.e. a complete audit of the product.)

Value Engineering is the application of value analysis to new products. Value engineering relates closely to target costing as it is cost avoidance or cost reduction before production.

Question 15

What are the various issues that needs to be dealt with when doing Value analysis or value engineering steps?

Answer 15

• Can we eliminate functions from the production process? - This involves a detailed review of the entire manufacturing process and determines the non- value-added activities. eliminate one or more activities from the original set of functions and be sure enough that eliminating these activities will not hamper the value- added activities in any manner.
• Can we eliminate some durability or reliability? - It is possible to design an excessive degree of sturdiness into a product, However, this concept can be taken too far, resulting in a visible reduction in durability or reliability, so any designs that have had their structural integrity reduced must be thoroughly tested to ensure that they meet all design standards.
• Can we minimize the design? - This involves the creation of a design that uses fewer parts or has fewer features. This approach is based on the assumption that a minimal design is easier to manufacture and assemble. Proper trade off between price and the quality is needed here.
• Can we design the product better for the manufacturing process? -Also, known as design for manufacture and assembly, this involves the creation of a product design that can be created in only a specific manner(Example for this is toner cateridge used for printers.
• Can we substitute parts?- This approach encourages the search for less expensive components or materials that can replace more expensive parts currently used in a product design. Note that this change might affect some other parts of the product already manufactured into the product design.
• Can we combine steps? - This is also known as process centering. By combining steps in this manner, we can eliminate some of the transfer and queue time from the production process, which in turn reduces the chance that parts will be damaged during these transfers.
• Can we take supplier’s assistance? These organizations are particularly suited to contribute information concerning enhanced types of technology of materials, since they may specialize in areas that a company has no information about.
• Is there a better way? -Though this step sounds rather vague, it really strikes at the core of the cost reduction issue—the other value engineering steps previously mentioned focus on incremental improvements to the existing design or production process, whereas this one is a more general attempt to start from scratch and build a new product or process that is not based in any way on preexisting ideas.

Question 16

What is the main difference between value analysis and functional analysis in target costing scenario?

Answer 16

• Value Analysis - It is a planned, scientific approach to cost reduction which reviews the material composition of a product and production design so that modifications and improvements can be made which do not reduce the value of the product to the customer or to the user. (i.e. quality for purpose should not be compromised.) - It is important to note that here the company does not see what functions of the product creates the most value to the customer.
• Functional Analysis - is applied to the design of new products and breaks the product down into functional parts, Thus, functional analysis aims to increase profits by reducing costs through elimination of unnecessary features and/or by adding cost-effective new features that are so attractive to customers that the product becomes more lucrative.

Question 17

What is the meaning of product life cycle? and what are the various stages in the product life cycle?

Answer 17

• Life cycle costing is a system that identifies and accumulates, the actual costs and corresponding revenues, attributable to cost object, from its inception to abandonment. Life cycle costing aims to maximize the profit that a product able generated over its life, using the strategies which are the best compliment to the features of each stage of the life cycle.
• The life cycle of any product consists of four phases, which are
  ▪ Introduction (market development or launch) - R&D phase is merged with this phase.
  ▪ Growth
  ▪ Maturity
  ▪ Decline

Question 18

What are the characteristics and strategies of the Introduction stage of the product life cycle?

Answer 18

Strategies
▪ Attracting customers by raising awareness of the product through promotion activities.
▪ Inducing customers to try and buy the product.
▪ Strengthening or expanding channel and supply chain relationships.
▪ Building on the availability and visibility of the product that boost channel intermediaries to support the product.
▪ Setting price in alignment with the competitive realities of the market.

Question 19

What are the characteristics and strategies of the Growth stage of the product life cycle?

Answer 19

Strategies
▪ Establish a clear brand identity through promotional campaigns.
▪ Maintain control over product quality to assure customer satisfaction.
▪ Maximize availability of the product through strong distribution channel.
▪ Find the ideal balance between price and demand as per price elasticity.
▪ Overall strategy shifts from acquisition to retention of customers, from motivating product trial to generating repeat purchases and building brand loyalty.

Development of long-term relationships with customers and partners for the maturity stage.
▪ Value-based pricing strategies may be considered.
▪ Leverage the product’s perceived differential advantages to secure a strong market position.

Question 20

What are the characteristics and strategies of the Maturity stage of the product life cycle?

Answer 20

Strategies
▪ Strong marketing efforts are needed to win over the competitor’s customers.
▪ Product features may be improved or enhanced to differentiate product from that of the competitors.
▪ Prices may have to be reduced to attract the price-sensitive consumers.
▪ Various sales promotion incentives are necessary for the consumers as well as dealers to maintain their interest in the product.
▪ Distribution becomes more intensive and incentives may be offered to encourage product over competing products.

Question 21

What are the characteristics and strategies of the Decline stage of the product life cycle?

Answer 21

Question 22

What is the overall life cycle characteristics when compared with the PLC concepts and what are the various strategies that can be undertaken?

Answer 22

Very Important and a good summary chart

Question 23

What are the benefits of using product life cycle costing?

Answer 23

▪ The product life cycle costing results in earlier actions to generate revenue or to lower costs than otherwise might be considered. There are a number of factors that need to manage in order to maximise return on a product.
▪ Better decisions should follow from a more accurate and realistic assessment of revenues and costs, at least within a particular life cycle stage.
▪ Product life cycle thinking can promote long-term rewarding in contrast to short-term profitability rewarding.
▪ It provides an overall framework for considering total incremental costs over the entire life span of a product, which in turn facilitates analysis of parts of the whole where cost effectiveness might be improved.
▪ It is an approach used to provide a long-term picture of product line profitability, feedback on the effectiveness of life cycle planning and cost data to clarify the economic impact of alternatives chosen in the design, engineering phase etc.
▪ It is also considered as a way to enhance the control of manufacturing costs. The thrust of product life cycle costing is on the distribution of costs among categories changes over the life of the product, as does the potential profitability of a product. Hence it is important to track and measure costs during each stage of a product’s life cycle.
▪ Product life cycle costing traces research and design and development costs etc., incurred to individual products over their entire life cycles, so that the total magnitude of these costs for each individual product can be reported and compared with product revenues generated in later periods.

Question 24

What is the basic premise behind the pareto principle? and what is the 80:20 rule and where and all can it be applied successfully?

Answer 24

• The key feature of any strategy is, achieving the objectives with a scarce set of resources. Hence in all circumstance, it is important to prioritise the application of the resource (effort) to those causes which has higher significance
• But a question arises here → is focusing only on ‘Vital Few’ will solve the problem to a larger or acceptable level? - This is what the Pareto principle largely argues - How?
• Pareto showed that approximately 80% of the land in Italy was owned by 20% of the population and this phenomenon gain popularity as ‘80:20 rule’
• How can we apply this to our subject? - in the context of quality control and improvement. Juran suggested the bulk of the quality problems are due to a few of the possible sources (such can be identified with Pareto analysis and graphically shown through Pareto Chart). Hence, correction of the same after isolation can help organizations to attain significant improvement in quality (because they have a higher probability of payoff).

Question 25

What are the pros and cons of Pareto Analysis?

Answer 25

Pros – Pareto Analysis is a control mechanism. It is a creative way of looking at the causes of problems to clearly establish top priorities and to identify targets along with its pay-off. One can advocate the use of Pareto analysis due to the following benefits-
▪ Breakdown big problem into smaller pieces by looking at different sort of root causes.
▪ Identification of significance of each cause/factor.
▪ Prioritise where to focus and apply efforts.
▪ Ensure optimal use of scare resources.
▪ Act as a control mechanism.
Cons – Pareto Analysis involves data and its classification, presentation, and analysis; these factors itself become the sources of shortcoming. Major limitations are-
▪ Possibility of exclusion of important problems which may be small initially (now), but may grow with time.
▪ Lack of understanding of ‘how it should be best applied to particular problems’, simply the wrong identification of causes.
▪ Effectiveness of Pareto Analysis is purely based upon the data/information

Question 26

What are the applications of Pareto Analysis in real life business?

Answer 26

• Pricing of a Product - Thus, a firm can adopt more sophisticated pricing methods for a small proportion of products that jointly accounts for approximately 80% of total sales revenue. For the remaining 80% of the products which the firm may use a cost based pricing method.
• Customer Profitability Analysis - Again, it is often found that approximately 20% (vital few) of customers helps to generate 80% of the profit and vice-versa, decision making such as whether to continue serving the same customer group, what is the extent of promotion expenses to be incurred.
• ABC Analysis- Stock Control - The outcome of such analysis is that by concentrating on a small proportion of stock items that jointly accounts for 80% of the total value, a firm may well be able to control most of the monetary investment in stocks.
• Application in Activity Based Costing -In Activity Based Costing it is often said that 20% of an organisation cost drivers are responsible for 80% of the total cost pool.
• Quality Control -Pareto analysis seeks to discover from an analysis of defect reports or customer complaints which “vital few” causes are responsible for most of the reported problems. Often, 80% of reported problems can usually be traced to 20% of the various underlying causes.

Question 27

What is environmental management Accounting(EMA)? and why is it gaining importance among organisations these days?

Answer 27

• EMA is the process of collection and analysis of the information relating to environmental cost for internal decision making. EMA identifies and estimates the costs of environment-related activities and seeks to control these costs.
• Previously companies used to make mere disclosures known as external environment reporting was made, later more refined EMA came into picture to bring in more accountability to the companies.
• The major areas for application of EMA are:
• Product Pricing
• Budgeting
• Investment Appraisal
• Calculating Costs and
• Savings of Environmental Projects, or Setting Quantified Performance Targets.

Question 27

What is environmental management Accounting(EMA)? and why is it gaining importance among organisations these days?

Answer 27

• EMA is the process of collection and analysis of the information relating to environmental cost for internal decision making. EMA identifies and estimates the costs of environment-related activities and seeks to control these costs.
• Previously companies used to make mere disclosures known as external environment reporting was made, later more refined EMA came into picture to bring in more accountability to the companies.
• The major areas for application of EMA are:
• Product Pricing
• Budgeting
• Investment Appraisal
• Calculating Costs and
• Savings of Environmental Projects, or Setting Quantified Performance Targets.

Question 28

What is the meaning of environmental costs and what are it’s classifications?

Classification 1 - Generic Classification

Answer 28

the environmental costs are costs connected with the actual or potential deterioration of natural assets due to economic activities.

Question 29

What is the meaning of environmental costs and what are it’s classifications?

Classification 2 - United states Environmental protection agency(US EPA)

Answer 29

Question 30

What is the meaning of environmental costs and what are it’s classifications?

Classification 3 - Hansen and Mendoza

Classification 4 - The United Nations Division for Sustainable Development

Answer 30

• _Environmental Prevention Costs(_Similar to TQM costs)

1. Evaluating and picking pollution control equipment
2. Creating environmental policies
3. Environmentally driven R & D
4. Site and feasibility studies
5. Investment in protective equipment

• Environmental Appraisal Costs

1. Monitoring, testing, inspection and reporting
2. Improved systems and checks in order to prevent fines/ penalties
3. Regulatory compliances
4. Performing contamination tests
5. Audit of environmental activities

• Environmental Internal Failure Costs

Costs incurred from activities that have been produced but not discharged into the environment. Examples include

• Recycling scrap
• Disposing toxic material
• Back end costs such as decommissioning costs on project completion
• Environmental External Failure Costs

Costs incurred on activities performed after discharging waste into the environment. These costs have adverse impact on the organisation’s reputation and natural resources. Examples include

• Cleaning up contaminated soil.
• Restoring land to its natural state

Classification 4 -

Costs incurred to protect the environment i.e. measures taken to prevent pollution, and
▪ Costs of wasted material, capital, and labor i.e. inefficiencies in the production process.

Question 31

What are the methods of identification, allocation and controlling of environment cost which is divided into 3 phases?

Answer 31

• To manage the environmental cost, we need to start with the process of identification of environment cost; which involves an intense review of the general ledger containing costs of materials, utilities, energy, water, and waste disposal, etc. Since the portion of environmental costs is generally ‘hidden’ in general overheads of the company, hence it becomes difficult for management to identify opportunities to cut environmental costs; but it is crucial for them to do so.
• Techniques for identification and allocation of environmental costs - See image

Question 32

What are the methods of identification, allocation and controlling of environment cost which is divided into 3 phases?

Techniques explanation

Answer 32

• Input-Output Analysis - This technique involves the preparation of records for material inflows and then balances these inflows with the quantum of outflows relying on principle ‘what enters in the production system, must move out, either at a productive output or unproductive output (waste)’.
• By accounting for outputs in this way, both in terms of physical quantities and, at the end of the process, in monetary terms too, businesses are forced to focus on environmental costs.
• Flow Cost Accounting

1. In the flow cost accounting, the organisational structure is also considered apart from material flows. Material losses incurred at various stages of production are also recorded. Further to bring transparency apart from the quantity of material, the cost per unit and value in total also recorded.
2. The material flows are divided into three categories, material, system (cost of in-house handling), and delivery and disposal (costs of flows leaving the company).

Life Cycle Costing:

Lifecycle costing has a feature of full cost accounting, because it takes into account the costs and revenues of a product over its whole life rather than one accounting period; hence therefore, the full environmental cost associated of producing a product will be taken into account irrespective of the fact who born it.

Activity Based Costing (ABC):

Activity Based Costing is technique, which basically deals with the allocation of cost pool to the cost centres using cost drivers on the basis of consumption or benefit received.