Chapter-6

Emerging Concepts in Cost Management

Introduction
Life Cycle Costing
· Life Cycle Costing Methodology
· Objectives of Life Cycle Costing
· Impact of Analysis Timing on Life Cycle Costs
· Selecting Potential Project Alternatives for Comparison
Target Costing
· Price/Cost Relationship in a Competitive Environment
· Objectives of Target Costing
· The Role of Management Accountant
· Developing the Target Cost
· Target Costing Process Tools
Value Chain Analysis
· Competitive Advantage and Customer Value
· The Role of Management Accountant
· Value Chain and Analysis Activities Tools
· Value Chain Analysis Impact
Traditional Cost Management
· Role of Management Accounting
· The Traditional Accounting Control System
· The Development of the Traditional Cost Accounting System
· The failure of Traditional Cost System
· Traditional Management Accounting v/s Value Chain Analysis
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INTRODUCTION
The initial capital outlay cost is, however, only a portion of the
costs over an asset’s life cycle that needs to be considered in making the
right choice for asset investment. The process of identifying and
documenting all the costs involved over the life of an asset is known as
Life Cycle Costing (LCC). This tool has been developed to assist
managers in decision making based on performing a systematic
assessment of the life cycle costs.

The total cost of ownership of an asset is often far greater than the
initial capital outlay cost and can vary significantly between different
alternative solutions to a given operational need. Consideration of the
costs over the whole life of an asset provides a sound basis for
decision-making. With this information, it is possible to1:
· Assess future resource requirements (through projection of
projected itemized line item costs for relevant assets);
· Assess comparative costs of potential acquisitions (investment
evaluation or appraisal);
· Decide between sources of supply (source selection);

· Account for resources used now or in the past (reporting and

auditing);
· Improve system design (through improved understanding of
input trends such as manpower and utilities over the expected
life cycle);

1. Young S.M. and Selto F. (1991), “New manufacturing practices and cost management: A review
of the literature and directions for future research”, Journal of Accounting Literature, (10):
265-298.
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· Optimize operational and maintenance support; through more

detailed understanding of input requirements over the expected
life cycle);
· Assess when assets reach the end of their economic life and if
renewal is required (through understanding of changes in input
requirements such as manpower, chemicals, and utilities as the
asset ages).

LIFE CYCLE COSTING

The Life Cycle Costing process can be as simple as a table of

expected annual costs or it can be a complex (computerized) model that
allows for the creation of scenarios based on assumptions about future
cost drivers. The scope and complexity of the life cycle cost analysis
should generally reflect the complexity of the assets under investigation,
the ability to predict future costs and the significance of the future costs
to the decision being made by the organization.2

A life cycle cost analysis involves the analysis of the costs of a

system or a component over its entire life span. Typical costs for a
system may include3:
· Acquisition costs (or design and development costs).

· Operating costs:
— Cost of failures
— Cost of repairs

2. Van der Merwe A. (2007), “Management accounting philosophy II: The cornerstones of
restoration”, Cost Management (September/October):26-33.
3. Young S.M. and Selto F., op.cit., p.298.
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— Cost for spares

— Downtime costs
— Loss of production
· Maintenance costs:
— Cost of corrective maintenance
— Cost of preventive maintenance
— Cost for predictive maintenance
· Disposal costs

A complete Life Cycle Cost Projection (LCCP) analysis may also

include other costs, as well as other accounting/financial elements (such
as, interest rates, depreciation, present value of money/discount rates,
etc.).

For the purpose of this tool, it is sufficient to say that if one has all
the required cost values (inputs), then a complete LCCP analysis can be
performed readily in a spreadsheet, since it really involves summations
of costs for several options and computations involving discount rates.
With respect to the cost inputs for such an analysis, the costs involved
are either deterministic (such as acquisition costs, disposal costs, etc.) or
probabilistic (such as cost of failures, repairs, spares, downtime, etc.).
Most of the probabilistic costs are directly related to the reliability and
maintainability characteristics of the system.4

The Life Cycle Cost analysis allows the utility to examine projected
life cycle costs for comparing competing capital and project solutions

4. Ibid.
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and allows for appropriate comparison of alternatives of different capital

values, and lengths of time.

Source: Stenzel C. and Stenzel J., “Essentials of Cost Management”, Wiley, 2012.

Fig. 6.1 : An LCCP analysis Procedure

Given the condition of the Utility’s assets, the amount of capital

available from the budget, and historical evidence, the project manager
must decide which project alternatives will incur the least life cycle costs
over the life cycle of the assets involved while delivering performance at
or above a defined level. As a result, this analysis will enable the Utility
to:
· Make decisions for capital and investments based on least life
cycle costs,
· Rank each of the projects based on total cost of ownership,

· Combine the costing data with the Project Validation and Risk
Reduction scores to prioritize the projects,
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· Make more informed decisions, and

· Allow better reporting to key stakeholders.

A thorough Life Cycle Cost analysis yields a higher level of

confidence in the project decision, which is part of the Project Validation
calculation. Combined with a Risk Reduction analysis to identify the
risk reduction of various alternatives considered, the information from
Life Cycle Cost preparation is summarized in a business case, providing
a consistent approach to the review of projects.5

Life Cycle Costing Methodology

The life cycle of an asset is defined as the time interval between the
initial planning for the creation of an asset and its final disposal. This life
cycle is characterized by a number of key stages6:
· Initial concept definition;

· Development of the detailed design requirements, specifications

and documentation;
· Construction, manufacture or purchase;

· Warranty period and early stages of usage or occupation;

· Prime period of usage and functional support, including

operational and maintenance costs, with the associated series of
upgrades and renewal;
· The disposal and cleanup at the end of the asset’s useful life.

5. Stenzel C. and Stenzel J. (2003), “From Cost to Performance Management”, John Wiley and
Sons, New York.
6. Drucker P.F. (1994), “Cost control and management”, in Management Controls: New Directions
in Basic Research (eds C.P. Bonini, R. Jaedicke and H. Wagner), McGraw-Hill, p.174.
 237

Source: Stenzel C. and Stenzel J., “Essentials of Cost Management”, Wiley, 2012.

Fig. 6.2 : Asset Life Cycle

As shown in Fig. 5.2, there are day-to-day, periodic and strategic

activities that may occur for any asset. The asset life cycle begins with
strategic planning, creation of the asset, operations, maintenance,
rehabilitation, and on through decommissioning and disposal at the end
of the assets life. The life of an asset will be influenced by its ability to
continue to provide a required level of service. Many assets reach the
end of their effective life before they become non-functional (regulations
change, the asset becomes non-economic, the expected level of service
increases, capacity requirements exceed design capability).
Technological developments and changes in user requirements are key
factors impacting the effective life of an asset.
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Objectives of Life Cycle Costing

Life cycle costing (the terms “life cycle costing” and “life cycle
cost projections” are used interchangeably in this Tool) analysis can be
carried out during any phase of an asset’s life cycle. It can be used to
provide input to decisions regarding asset design, manufacture,
installation, operation, maintenance support, renewal/refurbishment and
disposal.

The objectives of life cycle costing are7:

· Minimize the total cost of ownership of the Utility’s
infrastructure to its customers given a desired level of sustained
performance;
· Support management considerations affecting decisions during
any life-cycle phase;
· Identify the attributes of the asset which significantly influence
the Life Cycle Cost drivers so that the assets can be effectively
managed;
· Identify the cash flow requirements for projects.

Estimating Life Cycle Costs : The life cycle cost of an asset can be
expressed by the simple formula:

Life Cycle Cost = Initial (projected) capital costs + projected life-time

operating costs + projected life-time maintenance costs
+ projected capital rehabilitation costs + projected
disposal costs - projected residual value

7. Cooper R. and Kaplan R.S. (1998), “The Design of Cost Management Systems: Text Cases and
Readings”, Prentice Hall, p.176.
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The prominent role of projected costs versus historic (actual) costs

in analyzing life cycle costs; due to its forward looking “best guess”
nature, life cycle costing is at least as much “systematic art” as it is
analytical technique.

Impact of Analysis Timing on Life Cycle Costs

A major portion of projected life cycle costs stems from the

consequences of decisions made during the early phases of asset
planning and conceptual design.

Source: Cooper and Kaplan, “The Design of Cost Management Systems: Text Cases and Readings”,
Prentice Hall,1998.

Fig. 6.3 : Level of Cost Reduction

It is the early decisions made during the design of an asset,

definition of operations and maintenance requirements, and setting of the
operating context of the asset that commit a large percentage of the life
cycle costs for that asset.
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Fig. 6.3 provides an indication of the level of cost reduction that

can be achieved at various stages of the project. It shows that as a project
moves from strategic planning that the majority of decisions have been
made that provide the majority of the cost to the project.

The best opportunities to achieve significant cost reductions in life

cycle costs occur during the early concept development and design phase
of any project. At this time, significant changes can be made for the least
cost. At later stages of the project many costs have become “locked in”
and are not easily changed. To achieve the maximum benefit available
during this stage of the project it is important to explore the following:
· A range of alternative solutions;

· The cost drivers for each alternative;

· The time period for which the asset will be required;

· The level and frequency of usage;

· The maintenance and/or operating arrangements and costs;

· Quantification of future cash flows;

· Quantification of risk.

The concept of the life cycle of an asset provides a framework to

document and compare alternatives.8

Selecting Potential Project Alternatives for Comparison

The intervention (or treatment) alternatives available to be
considered include:

8. Cooper R. and Kaplan R.S., op.cit., p.184.

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· Do Nothing : The Do Nothing option is literally not investing

any money on any form of maintenance or renewal, including
that recommended by the design engineer or vendor. This
alternative is generally intended to set a conceptual baseline for
asking the question: “What value does what we do now or what
we plan to do add to extending the life / functionality /
reliability of the asset over doing nothing at all?” Another way
of looking at the core question posed here is, “Why should we
continue to do what we do or are anticipating doing?” There are
rather rare occasions when “Do Nothing” is a valid applied
approach such as when an asset is due to be replaced or shut
down in short order and additional maintenance/capital
investment is irrelevant to keeping it running for the short
period before it is to be decommissioned.
· Status Quo : The Status Quo option is defined as maintaining the
current operations and maintenance behavior - typically that
defined by the manufacturer or the design engineer. It is the
realistic baseline case against which other alternatives are
compared.
· Renewal (Major Repair, Rehabilitation or Replacement) :
Assessment of different rehabilitation or replacement strategies
requires an understanding of the costs and longevity of different
asset intervention strategies. Each strategy is costed for the
expected life of that strategy, converted to an equivalent present
worth, adjusted for varying alternative life lengths, and
compared to find the least overall cost.
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· Non-Asset Solutions : In certain circumstances the non-asset

solution (providing the same level of service without a major
additional investment) can be a viable alternative.
· Change Levels of Service : Most life cycle costing assumes a
constant Level of Service across options being compared. When
such is not the case (which is not infrequent in reality),
comparisons across alternatives with different levels of service
(that is, different levels of benefit) must introduce a projected
benefits section for each alternative in addition to the cost
projections. This, of course, takes the analysis into the realm of
benefit cost analysis.
· Dispose : Disposal of the asset is retiring the asset at the end of
its useful life. Perhaps the function or level of service originally
desired from the asset is no longer relevant.9

It is unlikely that all seven of the alternatives listed above are

feasible for each analysis; rather than waste money on obviously
irrelevant options, the practitioner is encouraged to reduce the analyzed
set to only those that are thought to be feasible.

The Effect of Intervention

A single intervention option for the entire life cycle is not likely to
be the best approach to maximizing the life extension for an asset.
Multiple strategies and options will need to be studied to determine the
optimal strategy or combination of strategies for maximum life

9. Coad A.F. and Cullen J. (2006), “Inter-organisational cost management: Towards an

evolutionary perspective”, Management Accounting Research (December): 342-369.
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extension. Optimal Renewal Decision Making uses life cycle cost

analysis as a core Tool for determining the optimum intervention
strategy and intervention timing.10

Estimating Future Costs

Knowing with certainty the exact costs for the entire life cycle of an
asset is, of course, not possible; future costs can only be estimated with
varying degrees of confidence. Future costs are usually subject to a level
of uncertainty that arises from a variety of factors, including11:
· The prediction of the utilization pattern of the asset over time;

· The nature, scale, and trend of operating costs;

· The need for and cost of maintenance activities;

· The impact of inflation;

· The opportunity cost of alternative investments;

· The prediction of the length of the asset’s useful life.

The main goal in assessing life cycle costs is to generate a

reasonable approximation of the costs (consistently derived over all
feasible alternatives).

As rehabilitations and or replacement of assets occur during the life

cycle, adjust both operations and maintenance costs appropriately. Both
maintenance and operations costs are likely to materially increase as the
asset ages. The pattern of increase will vary by asset type and
operational environment on many assets, as the asset ages, it requires an

10. Ibid.
11. Young S.M. and Selto F., op.cit., p.290.
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increasing number of visits per year by the maintenance team, longer

time while at the asset to execute the work order, and often a higher level
of maintenance staff to be deployed; these costs are both real and
material and can be simply “modeled” in a spreadsheet. The timing of
the rates of increases in the flow of costs over time are instrumental in
determining total life cycle costs and can substantially impact the
outcome of the investment decision. It is therefore important to:
· Be systematic, realistic and detailed in estimating the future
flow of real costs
· Document in a notes section what the assumptions are inflation
is likely to occur but should be taken into account in the
discounting of future costs.

The Management of Cash Flow

The application of Life Cycle Cost analysis to find that alternative

with the lowest life cycle costs is important, but there will also likely be
organizational cash flow issues that need to be considered. There will
always be competing demands for the available cash resources of the
organization at any given time. Management of cash flow is simplified if
the pattern is predictable over the long term. It is conceivable that the
lowest cost solution might not be the best solution from the aggregate
cash flow perspective.

Life cycle analysis provides a sound basis for projecting cash

requirements which can assist the Chief Financial Officer in managing
the cash cycles of the organization.
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The Life Cycle Cost Projection Tool

The web based LCCP Tool developed as part of this WERF project
is perceived as being at the forefront of life cycle costing analysis
practices in the global jewellery industry. The focus of the establishment
of this Tool has been on making it web based and enabling its’ usage by
utility asset managers in the US - many of whom may be unfamiliar with
the concept of life cycle costing in a formal methodological framework.

The Tool is designed to be interactive where a utility manager can

either follow the LCCP process on a sequential step by step basis or,
where a utility manager already understands the concepts of LCC, the
Tool can be used to provide more detailed information on a particular
aspect of the analysis.12

LCCP Tool Structure

Users of the Tool should follow the flow chart through the various
sequential steps of creating a life cycle cost analysis profile. At each step
the user is able to access knowledge relevant to the particular step. The
steps in the Tool are13:

Step 1 - Define Project Basics

Step 2 - Develop LCCP Data For Each Project Option

Step 3 - Analyze Each Option

Step 4 - Document Analysis

Step 5 - Review and Finalize LCCP Projections

12. Ansari S. and Lawrence C. (1999), “Cost Measurement Systems: Traditional vs. Contemporary
Approaches”, McGraw Hill, New York, p.124.
13. Ibid.
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The Tool has been structured to enable the user to sequentially

follow a process to assist in preparing life cycle cost projections for
several alternatives.

TARGET COSTING

Introduction

Target costing is not a new idea, even though only a small number
of North American companies fully embrace its elements. Henry Ford
developed the first mass-produced automobile, the Model T, in 1908
with the objective of increasing volume by continually lowering its
price, and by 1913 was able to sell it for under $500. Obviously, to do
that and make money, costs would have to be tightly managed. Ford
managed material costs via backward integration, labour costs by the use
of the assembly line and efficiency improvements, and other costs by
frugal behavior. The “roaring twenties,” and, later, the pent-up demand
after World War II made it easier for Ford and other companies to raise
prices.

Even during the late 1950s and early 1960s, American Motors
conceived, developed, and introduced the Nash Rambler as a small,
inexpensive alternative to the gas-guzzling monsters then on the market.
The car was successful, and American Motors was very profitable-as a
result, at the end of 1962 the company had a debt-free balance sheet.
Although some North American companies (such as Boeing, Caterpillar,
John Deere, and Northern Telecom) have used the general ideas of target
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costing over the years, or applied it to a specific product (such as Ford’s

Taurus or Motorola’s pocket pager), few apply it as comprehensively and
intensely as leading Japanese companies (such as Toyota, Nissan,
Nippondenso, and NEC).

It has only been recently that Japanese authors (such as Monden,

Sakurai, and Tanaka) have begun to describe how Japanese companies
are applying target costing, as these companies strive to be successful in
their domestic market, and subsequently in the world markets. Some
North American companies (such as Ford, Chrysler, and Cummins
Engine) are beginning to study the Japanese and establish target costing
initiatives. Many more companies will when they realize that price
increases are no longer automatic and target costing is a powerful
technique. Because the idea of target costing has resulted from the
highly competitive environment to which most Japanese companies have
been subjected for a number of years, each company has its own unique
approach. As a result, there is no single, simple definition of target
costing. Definitions range from relatively narrow to broad.

Robin Cooper (1992), for example, says, “The object of target

costing is to identify the production cost of a proposed product so that,
when sold, it generates the desired profit margin.”

Michiharu Sakurai (1989) says, “Target costing can be defined as a

cost management tool for deducing the overall cost of a product over its
entire life cycle with the help of the production, engineering, research
and design, marketing, and accounting departments.”
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Peter Horváth (1993) defines it as “a comprehensive cost planning,

cost management, and cost control concept used primarily at the early
stages of product design in order to influence product cost structures
depending on the market derived requirements. The target costing
process requires the cost-oriented coordination of all product-related
organizational functions.”

Common to most definitions is a process founded on a competitive

market environment; market prices driving cost (and investment)
decisions; cost planning, management, and reduction occurring early in
the design and development process; and cross-functional team
involvement, including the management accountant.

Objectives of Target Costing

The fundamental objective of target costing is very straight

forward. It is to enable management to manage the business to be
profitable in a very competitive marketplace. In effect, target costing is a
proactive cost planning, cost management, and cost reduction practice
whereby costs are planned and managed out of a product and business
early in the design and development cycle, rather than during the latter
stages of product development and production.

Target costing obviously applies to new products. It also applies to

product modifications or succeeding generations of products. NEC, for
example, uses the point of time at which no further cost reductions can
be realized as a cue to begin developing its next generation of products.
The foundations of target costing-market-based prices, price-based costs,
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and cross-functional participation-may also be used for existing

products, although costs are more difficult to reduce once a product is in
production.

The costs most typically emphasized in the target costing process

are those most directly affected by it: material and purchased parts,
conversion costs (such as labour and identifiable overhead expenses),
tooling costs, development expenses, and depreciation. However,
because target costing is a comprehensive cost planning, management,
and reduction process, as well as a specific technique, all costs and
assets that may be affected by early product planning decisions should
be considered. This would include more indirect overhead expenses
through the production stage, and beyond, such as service costs, and
assets, such as inventory. Target costing is intended to get managers
thinking ahead and comprehensively about the cost and other
implications of the decisions they made.

Although the initial emphasis of target costing may be cost

planning, management, and reduction, a number of other benefits result
from its application. First, it requires a strong market and customer
orientation. Product requirements are defined by market and customer
needs, and competition. Target costing starts with an understanding of
the market and an intent to meet customer needs in terms of product
features, quality, timeliness, and price.

Second, the cross-functional participation central to the process

yields a sense of understanding and teamwork frequently absent in a
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more typical, sequential design and development process.

Market-oriented design and development, and concurrent engineering
and manufacturing, are aspects of the target costing process that
facilitate cross-functional understanding.

Finally, the market understanding, cross-functional team

participation, and use of some of the tools (such as value engineering)
can actually accelerate the product design, development, production, and
introduction cycle by avoiding delays resulting from recycling, as one
area’s functional objectives conflict with others.

Target costing is as much a significant business philosophy as it is a

process to plan, manage, and reduce costs. It emphasizes understanding
the markets and competition; it focuses on customer requirements in
terms of quality, functions, and delivery, as well as price; it recognizes
the necessity to balance the trade-offs across the organization, and
establishes teams to address them early in the development cycle; and it
has, at its core, the fundamental objective to make money, to be able to
reinvest, grow, and increase value.14

Scope
Target costing is intended to accomplish two goals. First, it
introduces the concept of target costing, which has been used by a
number of leading Japanese automotive, electronic, and other
companies, and is beginning to be used by some North American
companies as they penetrate very competitive markets. Second, it

14. Ibid.
 251

describes the steps that a firm would take to implement target costing. It
is generally addressed to senior managers, and more specifically to
management accountants. It is developed to help make the management
accountant a key contributor to both the introduction and application of
target costing to the firm’s managerial process.15

Target costing assumes an organization with some awareness of

target costing and an interest in introducing target costing practices into
the firm’s managerial process. It is, of necessity, both descriptive and
prescriptive. It defines target costing terms, concepts, and processes, and
presents a plan for building a strong commitment to implement target
costing. The statement prescribes a sequence of steps that a firm would
take to implement target costing, and management and the management
accountant’s role in that effort.

The concept, techniques and case study included in target costing

are structured to apply to16:
· Businesses that produce a product or service;

· Large and small organizations;

· Enterprises in all business sectors;

· All stages in an enterprise’s value chain; and

· All costs and investments, whether related directly or indirectly

to a specific product or services.

15. Berliner C. and Brimson J.A. (1998), “Cost Management for Today’s Advanced
Manufacturing”, Harvard Business School Press, p.173.
16. Abernethy M.A., Millis A.M., Brownell P. and Carter P. (2001), “Product diversity and costing
system design choice: Field study evidence”, Management Accounting Research, (September):
261-279.
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Today, many management accountants are asked to do much more

than just traditional transactional accounting. One of the most significant
of these new responsibilities is target costing, which for many companies
is a dramatically different approach to cost planning, management, and
reduction. Target costing will help management accountants:
· to understand the relationship of target costing to the
organization’s strategic and financial goals;
· to understand the phases of the target costing process;

· to recognize the benefits of target costing;

· to comprehend their roles and responsibilities in the target

costing process; and
· to appreciate the organizational and management accounting
challenges in implementing target costing.

Competitive Market Environment

In markets where there are a limited number of sellers, and demand

exceeds supply, sellers can mark up their costs to achieve prices that
result in profits. That is, they may use a “cost plus” approach to pricing.
The global markets and increased competition many companies face
today preclude such historical cost-based pricing practices. In
competitive markets, and especially in markets where supply exceeds
demand, prices are driven by market forces. This does not mean that all
products become commodities, however, sellers must take greater
account of the presence of strong competitors, alternative products and
services, and their prices. If a company wants to achieve higher market
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penetration, it may choose to lower prices while increasing quality or

offering additional services. One of the benefits of target costing is that it
forces an increased understanding of markets, competition, and customer
needs in terms of products, quality, timeliness, and price.17

Price/Cost Relationship in a Competitive Environment

Price-Driven Costs: Companies are in business to make money.
When prices are set by market forces or by a management decision to be
a price leader, costs must be lower than prices to make money. Therein
lies the concept of target costing18:

Price - Profit Margin = Cost

Of course, this contrasts dramatically with the historical practice of

many firms and industries, where:

Cost + Profit Margin = Price

This transformation of terms looks very simple. In reality, viewing

costs as a derivative of prices and profit margin, rather than the other
way around, requires a major shift in mindset. It should be pointed out,
too, that margins cannot be arbitrarily set, but are influenced by one’s
potential cost position. Not all companies can be the lowest cost
producer. Setting an unattainable margin could lead to an unattainable
cost objective.

Fig. 6.4 presents the price and cost relationships in a market- or

management-driven price and cost environment. The Japanese
17. Brewer P.C. (1997), “Managing transitional cost management systems”, Journal of Cost
Management, (November/December): 35-40.
18. Brinker B. (2000), “Guide to Cost Management”, John Wiley & Sons, New York, pp.145-48.
 254

commonly refer to this relationship as “price down - cost down,” or

simply “cost down.”

Source: Brinker B., “Guide to Cost Management”, John Wiley & Sons, New York, 2000.

Fig. 6.4 : Price-Cost relationship in a Competitive Environment

Since target costing is usually applied to new product planning,

which frequently requires investments in tooling, equipment, and other
assets influencing costs, it can legitimately be said that price drives both
costs and investments.

Early Cost Planning: Another important element of target costing is

the realization that most costs are determined by early product and
process-design decisions. Trying to reduce costs once a product reaches
production is very difficult. Therefore, focusing on costs during the early
design stages to ensure that the target profit and cost can be realized is
critical. That means product designs, material choices, specifications and
tolerances, buy versus make decisions, process designs, and investment
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decisions need to be thought through before product design and

development decisions are finalized.

Cross-Functional Team Involvement: Finally, achieving the

necessary degree of agreement and compromise between any of the
functions (marketing, design and development, procurement, process
engineering, manufacturing, and accounting) involved with the product
delivery cycle requires the establishment of cross functional teams
specifically charged with addressing the inevitable trade-offs that will
arise. This basic unit, which cuts across the organization and works
together from the concept stage to production release or beyond, is
charged with effecting the product development and target costing
assignment. Done well, the result can be new and modified products that
are developed and produced quickly, satisfy the marketplace, and yield
the desired profits.

In all likelihood, target costing will not happen instantly. The idea
may initially meet with resistance. The concept of prices driving costs is
a major mindset change for managers once able to rise prices when costs
rose. Organizing in cross-functional teams, although more popular of
late, is still foreign to many managers. For them to believe that a set of
different views brought together early in the design process can be more
efficient and effective than a sequential process will require some
demonstration. The market success of companies such as Toyota, Sony,
and NEC should give managers and management accountants the
incentive to implement target costing methodologies.
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The Role of Management Accountant

The role of management accountant in many companies such as

electric, electronics, jewellery etc., is changing from historian and
controller to a more proactive, strategic, business partner and decision
maker. Active involvement in target costing reinforces this shift in
perspective and responsibility for the management accountant.

Target costing cannot be undertaken without the full support of

senior management and the support and involvement of the other areas
of the business, including marketing, product development,
procurement, process development, and manufacturing. Once that
support has been obtained, management accountants should be
committed to the firm’s target costing process.19

Since management accountants are trained in gathering, analyzing,

measuring, and reporting information, their expertise is a fundamental
element to a successful target costing effort. Having management
accountants involved in the target costing process also gives credibility
to the financial implications of the various tradeoffs and decisions made
during the target costing process. Thus, the management accountant can
be responsible for holding the whole process together. Management
accountants should be involved in all stages of the target costing process.

The first step in the target costing process is to establish the target
price. This involves assessing the market and individual customers’
wants and/or needs, and what they might pay for the tentative new

19. Berliner C. and Brimson J.A., op.cit. pp. 188-91.

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product; evaluating competing products, their prices, and estimated

costs; and agreeing among the team members as to an appropriate target
price. Evaluating customers’ benefit/cost trade-offs and performing
competitive price and cost comparisons are central financial analyses
management accountants are qualified to perform. Companies such as
Caterpillar have performed detailed cost analyses of their competitors’
products. If management’s pricing strategy is “preemptive”-that is, to
lower prices to gain additional market penetration-the management
accountant is also able to analyze the price, volume, cost, and profit
relationships of such actions.

The second step in the target costing process is to establish the

target profit margin. The starting point is the firm’s overall strategic and
financial goals, including return on sales (ROS), capital, and equity.
These need to be disaggregated to product lines, and eventually to
individual products. Not all product lines or products will have the same
target margins. Some will have to be higher to support a higher level of
investment directed toward those product lines or products; some may be
lower because they require lower investment, or competitive prices and
costs will not support a higher margin. As with the target price, setting
the target margin requires business understanding and financial analysis
skills that the management accountant brings to the process.

A very important role of the management accountant is to help to

determine what the proposed product’s current costs would be, assuming
similar product specifications and manufacturing processes to those
 258

presently used by the firm. Unfortunately, many companies’ existing

product cost determination (cost accounting) systems do not provide
accurate up-to-date information. Direct material costs may be reasonably
identified with specific products. Conversion costs, overhead, and even
nonmanufacturing costs (such as outbound freight and product specific
sales costs) may be more difficult to identify with specific products.
More companies are using activity-based costing (ABC) to improve their
understanding of their existing costs. The management accountant has an
important responsibility to introduce ABC to the firm and apply it to the
firm’s existing products and detailed processes, so a foundation for
target costing can be established.

Once the allowable cost has been established and the current cost
determined, the amount of cost reductions can be calculated. The target
costing team’s work really begins at this point, as it considers the
possible trade-offs and makes the numerous decisions necessary to
deliver a product that meets the markets’ requirements at a price and a
cost that achieves the firm’s profit objectives. The myriad of design
alternatives, buy versus make decisions, proposed manufacturing
processes, and capital investment requirements all have cost implications
that must be calculated, then tracked, separately and collectively.
Management accountants assume a central role in this analysis and
tracking process.

An important role for the management accountant is to create a

systematic framework of financial and nonfinancial measures to assure
that, as the target costing process unfolds, progress against the targets
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may be easily tracked, to make sure the targeted objectives are being
reached. Such tracking systems are especially critical if many new
products are being introduced and their significance on the firm’s
financial performance is great. Individual project costs, the cost impact
of asset requirements, the ability to achieve the target cost and profit,
and cash flows must all be tracked. In the case of multiple projects, their
aggregate impact on the firm’s overall profit, return, and cash should
also be monitored.

Once a product reaches the production stage and it is being sold,

there are still opportunities for the management accountant to contribute
to the target costing process. First, actual costs should be tracked and
related to allowable costs to determine whether allowable costs are being
met. This information can be used in future target costing projects.
Second, there may be more cost reduction opportunities to be achieved
in the production phase. The Japanese call such initiatives to continue to
pursue cost reductions during production “kaizen costing” or
“continuous improvement costing.”

Management accountants can and should play a number of

important roles in the target costing process. They can become familiar
with the process, talk with other management accountants who are
already involved, visit companies already using target costing, and then
take the lead in introducing target costing into their firms, such as the
financial leadership of Moonglow Electronics did. This can include
sharing their knowledge of target costing with senior management and
other functional areas of the firm. Management accountants can
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champion the initiation of a target costing project. Then they can be an

active part of a cross-functional target costing team, contributing their
financial analysis skills to the effort. As target costing takes effect, the
management accountant will have made another significant contribution
to the long-term success of the firm.

The Target Costing Process

Just as there is no single definition of target costing, there is no

single target costing process. Each company has evolved its own
organizations and practices. Nevertheless, all companies share a series of
general steps20:
· Establishing the target price in the context of market needs and
competition;
· Establishing the target profit margin;

· Determining the cost that must be achieved;

· Calculating the probable cost of current products and processes;

and finally
· Establishing the target cost-the amount by which costs must be
reduced.

Once the target cost has been calculated, companies take the
following steps to achieve it:
· Establishing a cross-functional team, which is involved in the
implementation process from the earliest design stages;
· Using tools such as value engineering in the design process; and

20. Young S.M. and Selto F., op.cit., pp.290-92.

 261

· Pursuing cost reductions using “kaizen costing” once production

has started.

This sequence of steps, and the intensity with which it is applied, is

quite different from a “cost plus” approach, which although becoming
more difficult to achieve, is still used by a number of companies. In this
more historic approach the sequence of steps is:
· Assessing market needs;

· Evaluating competing products;

· Developing new products;

· Deciding whether to buy or make products or components of

products;
· Calculating how much to invest in new processes;

· Setting up the new process;

· Manufacturing the new product;

· Costing the product; and

· Setting the price.

Using this approach, one decision leads to another. Prices are based
on the preceding steps in the process. When costs increase, prices are
often also increased to maintain or improve profit margins.

In today’s more global competitive marketplace, prices need to be

set early in the new product planning process and based on market and
competitive conditions, or management’s own pricing and market
penetration objectives. Costs must permit an acceptable profit and return
on capital. New product development, procurement, manufacturing
 262

processes, investments, and other cost drivers must be managed together,

in the context of market- or management-driven prices.

In the following paragraphs, the sequence of steps involved in a

successful target costing process will be discussed. This should serve as
a useful model for companies considering or just getting started with
target costing.21

Developing the Target Cost

Establishing the Target Price : The first step in the target costing
process is to establish the proposed new product’s target price. This
involves a number of considerations: what the market wants and needs
now and in the future; what the customers want and how much they
really are willing to pay for alternative features; and what the
competitive offerings are and may be in the future. Obviously, the best
way to determine current and future wants and needs is to ask current, or
prospective, customers. Companies such as Toyota, Sony, and (more
recently) Ford spend a great deal of time employing sophisticated market
research techniques, including surveys and focus groups, to ascertain
what functions and features customers want and how much they might
be willing to pay for them.

Conjoint, or trade-off, analysis can be used in conjunction with

focus groups to explore customers’ evaluations of various product
features. Instead of asking customers to react directly to the product’s
proposed price, ask them to indicate what price they would pay for
certain features. This simulates a real buying situation. This approach
21. Text of Footnote
 263

can provide the relative contribution of each product feature to total

product utility. This becomes especially useful as the target costing
process unfolds and the costs of providing those features can be
determined.

The target price is based on the market needs assessment, the

competitive analysis, and the company’s preliminary plans to deliver a
new or modified product with certain functions, features, aesthetics, and
other characteristics. The principal point is that companies employing
target costing base their target price on market and competitive
conditions, and on their long-term pricing and market penetration
objectives.

Determining the Current Cost and Target Cost : If the proposed

product is a modification of an existing product, a firm has a cost basis
from which it can determine what the potential costs of the proposed
new product might be if the new product’s specifications and method of
manufacture are similar. The next step in the target costing process, then,
is to determine what the new product’s costs would be, using existing
product specifications and manufacturing processes. This is frequently
called the “engineered costs.” Sakurai uses the terms “drifting costs” and
“current costs.”

Realizing the Target Cost : The process of achieving the cost

objectives is founded on three fundamental precepts. First, it is essential
to use a cross-functional team of participants who are affected by, and
can affect, the product and process specification process. Second, the
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team’s participation early in concept design and development will

greatly affect product life cycle costs. Finally, using value engineering
techniques and other tools to arrive at a product and process design is
central to achieving the target cost.

Monitoring the Target Costing Process : As the target costing

process unfolds, it is important to track how well the objectives -both
non-financial and financial, are being achieved. Are the customers’
wants and needs being satisfied? This may necessitate continued input
from existing and potential customers via surveys, focus groups, and
other means. Are competitors behaving as expected? If not, what are the
implications of their actions? Is the target price still valid? If not, what is
the impact on allowable and target cost objectives?

The allowable and target cost figures are aggregated numbers, and
may be disaggregated along traditional lines-primary building blocks,
subassemblies- or along functional dimensions, ultimately to
components. As the project team works together, it is important to track
the gains and shortfalls against the target reductions and allowable costs.
Some companies maintain detailed status boards aggregating where they
stand against major building block or function targets, broken down to
individual components. In this way, the team knows at all times where it
stands against the objectives and where additional opportunities must be
found.

Maintaining an accurate assessment of current costs is also

important, as they serve both as the foundation for the target cost
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determination, and as a report on how well the allowable costs are being
achieved. For those companies whose cost accounting systems use
methodologies that spread large pools of costs across a number of
products relatively evenly, or in other ways fail to relate costs to the
products that cause them, activity-based costing (ABC) can be
particularly effective for both assigning costs to products more
accurately, and then tracking actual costs. As the definition of the costs
to be included in target costing becomes more comprehensive, including
shared manufacturing and nonmanufacturing costs, the application and
22
benefits to be derived from ABC become greater.

Target Costing Process Tools

Target costing is as much a significant mindset change regarding

the relationship of prices and costs, a discipline, and an integrative
approach to decision making, as it is the application of a set of
techniques and tools. However, a number of techniques and tools
facilitate an effective and efficient target costing process.

Market Assessment Tools : Three externally-oriented analyses-

(i) market assessment tools, (ii) industry and competitive analysis, and
(iii) reverse engineering, provide a firm with a foundation for defining
the proposed new product and establishing its target price.

The first step in determining the target cost is to assess the market
and customers’ wants and needs in regard to the proposed product. A

22. Eldenburg L.G. and Wolcott S.K. (2010), “Cost Management: Measuring, Monitoring and
Motivating Performance”, 2nd Edition, John Wiley & Sons, pp.137-143.
 266

first step to satisfying customers is to find out what they want. This can
be accomplished either indirectly (via current or prospective customer
surveys) or directly (by using focus groups that bring together groups of
current or potential customers to ask them what they like and dislike
about existing products, what they want from new products, and what
they might be willing to pay for the various product features). Although
getting to know what the customer wants and needs, or may want and
need in the future, seems so obvious, many companies do not do it well.
Rather, they continue to develop products from an internal perspective.
One of the best ways to determine market wants and needs is to ask
former customers or noncustomers. These sources can provide insights
regarding the shortcomings of existing or proposed products that are
very different from the views of existing customers. If satisfied, the
company can open up new markets.

Japanese companies have for years made a very strong effort to

ascertain customers’ needs and their reactions to current products. For
example, the Japanese automobile companies have emphasized
reliability, fit and finish, quietness of the ride, and little pleasantries such
as electric mirrors and drink cup holders to gain market share. North
American companies are beginning to do more of that. Prior to the
development and introduction of its highly successful Taurus, Ford
extensively surveyed existing and prospective customers about what
they wanted and did not like in a new car. The Taurus has been one of
the most successful cars in the company’s history. Boeing builds
mock-ups of its cabins and asks its airline customers, and their
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customers, to evaluate them; Caterpillar puts stereo radios into the cabs
of its heavy equipment because that’s what operators wanted; Gillette
introduced a totally new design for its women’s razor; Thermos
introduced a highly successful electric grill after extensive market
review and evaluation.

Financial Planning and Analysis : The determination of the target

profit margin relies heavily on the comprehensive and detailed financial
planning and statement analysis. Every firm has relationships between
prices, volumes, and revenue; costs, and investments, in the aggregate
and for specific product lines and individual products. The management
accountant must understand these relationships to be able to relate them
to a proposed product. Based on the results of the externally oriented
analysis- which is used to help establish the target price, a thorough
understanding of the product line involved and related existing products,
and how the proposed new product may be similar and different in terms
of product design and processing, both the firm’s cost structure, and
what is realistic in terms of competitive cost structures- a target margin
can be set.

Product Cost Analysis : Organizations must also be able to

determine the product costs and related investments for their firm’s
product lines and products in order to estimate the cost of the proposed
new product under existing and proposed product and process
characteristics. One technique that has been promulgated in the last few
years is activity-based costing (ABC), which is intended to result in a
more accurate determination of product costs. Rather than rely on very
 268

general rules for assigning costs to products, such as average material

scrap rates and direct labour-based overhead rates, ABC takes into
consideration product, process, and other differences to more accurately
relate the costs that a business incurs to the specific products that drive
them. The Institute of Management Accountant’s Statement on
Management Accounting, Implementing Activity-Based Costing, deals
specifically with ABC.

Identifying costs with specific cost-incurring activities-such as

procurement, receiving, material handling, setups, and inspection, which
is a fundamental early step in the ABC process-provides high visibility
to potentially wasteful activities. This step in the ABC process is
frequently called activity-based management (ABM) and serves as a
useful aid to kaizen costing.

Key suppliers also can play an important role in product design,

development and costing.

Working closely with their customer, the key suppliers can

demonstrate additional ways by which alternative product design or
processing decisions can favorably, or adversely, affect the supplier’s
costs. Therefore, working with the suppliers early in the process and
even including them on the target costing team can add to a better
understanding and optimization of product costs.

Japanese companies most closely identified with target costing

(such as Toyota, Nissan, Nippondenso, and NEC) do not seem to use
ABC techniques. Initially, that might seem to contradict the previous
paragraphs. In fact, understanding the evolution of Japanese
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manufacturing and costing practices makes it more understandable.

These leading Japanese companies have emphasized total quality
management (TQM) and just-in-time (JIT) manufacturing for a number
of years. Both lead to very organized “lean production” environments. In
a flow line or cellular manufacturing environment, a high proportion of
product costs may be directly identified to them. ABM is a useful
approach to understand a sequence of activities, differentiate between
value and non value, and eliminate the wasteful activities. Leading
Japanese companies are past the point of ABM. Similarly with ABC, it
is an analytical approach to better identify costs to products in situations
where that is difficult. Toyota, and others, by rearranging their factories
contend that they can identify a high proportion of their costs directly to
relatively homogeneous product families, and, thus, do not require ABC.
The story of Harley-Davidson closely follows the Japanese model. By
making their factories flow better, and by utilizing other JIT practices
such as “pull” manufacturing, they focused on simplification and waste
elimination first. Japanese companies do know their costs well, and use
“cost tables” extensively in their target costing efforts.23

Parties involved in Target Costing

· Customers: Ask company’s customers if they have done
business with your competitors. Find out about their whole
buying experience: the price they paid, how they were treated,
the service they received. That’s great information, and they are
likely to be willing to share.
23. Hussein M. (1999), “Tracking and Controlling Costs: 25 Keys to Cost Management”,
Lebhar-Friedman Books, pp.201-8.
 270

· Suppliers: A supplier might be tougher, but it’s still worth a try.

Suppliers may keep information on current clients confidential,
but you might be able to get some data on a competitor who is a
former client. A supplier can tell you what your competitor
bought, how much, and possibly for what price, and maybe why
the competitor stopped buying from them. Essentially, you’re
getting data on your competitor’s supply costs.
· Company Publications: Companies publish information for a
variety of reasons. In some cases, they provide information to
comply with industry rules or regulations. Corporations publish
a glossy annual report for shareholders. Publicly traded
companies must file Form 10-K with the Securities and
Exchange Commission (SEC). This report may contain data
that’s helpful to your analysis. Look online.
· The Print Media: Many companies issue press releases to
announce new products and services. Information appears in the
general press and in industry journals. CEOs give interviews,
too.
· The Internet: The Internet is the print media “writ large.” Read
company websites. See what analysis, industry experts, and
journalists have to say about the company.
· Reverse Engineering: An excellent way to gather information
about a competitor and their products is through reverse
engineering. You get their product and literally take it apart to
see how the product was designed and assembled.
 271

· Intelligent Guessing: Some experienced clients can make very

shrewd guesses about how competitors of a company are cutting
corners to lower cost. A lawnmower manufacturer may say,
“Oh, I bet they’re using a low-quality blade.” A restaurant
owner may say, “My guess is that they use salad mix from a big
bag instead of tearing the lettuce.” Use your experience.24

VALUE CHAIN ANALYSIS

Introduction

The idea of a value chain was first suggested by Michael Porter

(1985) to depict how customer value accumulates along a chain of
activities that lead to an end product or service.

Porter describes the value chain as the internal processes or

activities a company performs “to design, produce, market, deliver and
support its product.” He further states that “a firm’s value chain and the
way it performs individual activities are a reflection of its history, its
strategy, its approach to implementing its strategy, and the economics of
the activities themselves.”

Porter describes two major categories of business activities:

primary activities and support activities. Primary activities are directly
involved in transforming inputs into outputs and in delivery and
after-sales support. These are generally also the line activities of the
organization. They include:
· Inbound logistics - material handling and warehousing;
24. Young S.M. and Selto F., op.cit., p.298.
 272

· Operations - transforming inputs into the final product;

· Outbound logistics - order processing and distribution;

· Marketing and sales - communication, pricing and channel

management; and
· Service - installation, repair and parts.

Support activities support primary activities and other support

activities. They are handled by the organization’s staff functions and
include:
· Procurement - purchasing of raw materials, supplies and other
consumable items as well
· As assets;

· Technology development - know-how, procedures and techno-

logical inputs needed in every value chain activity;
· Human resource management - selection, promotion and
placement; appraisal; rewards; management development; and
labour/employee relations; and
· Firm infrastructure - general management, planning, finance,
accounting, legal, government
· Affairs and quality management.

John Shank and V. Govindarajan (1993) describe the value chain in

broader terms than does Porter. They stated that, “the value chain for any
firm is the value-creating activities all the way from basic raw material
sources from component suppliers through to the ultimate end-use
product delivered into the final consumers hands.” This description
 273

views the firm as part of an overall chain of value-creating processes.

According to Shank and Govindarajan, the industry value chain starts
with the value-creating processes of suppliers, who provide the basic
raw materials and components. It continues with the value-creating
processes of different classes of buyers or end-use consumers, and
culminates in the disposal and recycling of materials.25

Scope
This guideline is addressed to managers, and more specifically to
management accountants, who may lead efforts to implement value
chain analysis in their organizations. The concepts, tools and techniques
presented apply to all organizations that produce and sell a product or
provide a service.

This guideline can help in:

· Link value chain analysis to organizational goals, strategies and
objectives;
· Broaden management awareness about value chain analysis;

· Understand the value chain approach for assessing competitive

advantage;
· Comprehend useful strategic frameworks for value chain
analysis; and
· Appreciate the organizational and managerial accounting
challenges.

25. Hutchinson R. (2013), “Cost accounting and simulation: Toward a post-structuralist

understanding”, Advances in Management Accounting, (22): 159-184.
 274

Competitive Advantage and Customer Value

In order to survive and prosper in an industry, firms must meet two

criteria: they must supply what customers want to buy, and they must
survive competition. A firm’s overall competitive advantage derives
from the difference between the value it offers to customers and its cost
of creating that customer value.

Competitive advantage in regard to products and services takes two

possible forms. The first is an offering or differentiation advantage. If
customers perceive a product or service as superior, they become more
willing to pay a premium price relative to the price they will pay for
competing offerings. The second is a relative low-cost advantage, which
customers gain when a company’s total costs undercut those of its
average competitor.

The Value Chain

Low-Cost Advantage : A firm enjoys a relative cost advantage if its

total costs are lower than the market average. This relative cost
advantage enables a business to do one of two things: price its product or
service lower than its competitors in order to gain market share and still
maintain current profitability; or match the price of competing products
or services and increase its profitability. Many sources of cost advantage
exist: access to low-cost raw materials; innovative process technology;
low-cost access to distribution channels or customers: and superior
operating management. A company might also gain a relative cost
advantage by exploiting economies of scale in some markets.
 275

Source: Brinker B., “Guide to Cost Management”, John Wiley & Sons, New York, 2000.

Fig. 6.5 : The Value Chain

The relationship between low-cost advantage and differentiation

advantage is illustrated in Fig. 6.6.

Fig. 6.6 : Competitive Advantage Through Low Cost and/or Differentiation

 276

The Value Chain Approach for Assessing Competitive Advantage :

Most corporations define their mission as one of creating products or
services. For these organizations, the products or services generated are
more important than any single step within their value chain. In contrast,
other companies are acutely aware of the strategic importance of
individual activities within their value chain. They thrive by
concentrating on the particular activities that allow them to capture
maximum value for their customers and themselves.

These firms use the value chain approach to better understand

which segments, distribution channels, price points, product
differentiation, selling propositions and value chain configurations will
yield them the greatest competitive advantage.

The way that the value chain approach helps organizations assess
competitive advantage is through the following types of analysis:
· Internal cost analysis - to determine the sources of profitability
and the relative cost positions of internal value-creating
processes;
· Internal differentiation analysis - to understand the sources of
differentiation (including the cost) within internal value-creating
processes; and
· Vertical linkage analysis - to understand the relationships and
associated costs among external suppliers and customers in
order to maximize the value delivered to customers and to
minimize cost.
 277

These types of analysis are not mutually exclusive. Rather, firms

begin by focusing on their internal operations and gradually widen their
focus to consider their competitive position within their industry.

The value chain approach for assessing competitive advantage is an

integral part of the strategic planning process. Like strategic planning,
value chain analysis is a continuous process of gathering, evaluating and
communicating information for business decision making. By
stimulating strategic thinking, the analysis helps managers envision the
company’s future and implement decisions to gain competitive
advantage.

Superior relative cost position offers equivalent customer value for

a lower price. Superior relative differentiation position offers better
customer value for an equivalent price. Organizations that fail to gain
competitive advantage through low cost or superior differentiation, or
both, are “stuck-in-the-middle.” For instance, several American bicycle
makers, including Schwinn, Huffy, Murray and Columbia, found
themselves in this position during the 1980s. These companies lacked a
cost advantage and failed to foresee the emerging mountain bike market.
By contrast, Cannondale captured market share after introducing its
large-diameter frame bicycle.26

The Role of Management Accountant

The management accountant is traditionally considered the resident
expert on cost analysis; cost estimation; cost behavior; standard costing;

26. Brinker B. (2000), “Guide to Cost Management”, John Wiley & Sons, New York, pp.145-48.
 278

profitability analysis by product, customer or distribution channel; profit

variance analysis; and financial analysis.

Today, management accountants must also bring skills in

activity-based costing, benchmarking, re-engineering, target costing,
life-cycle costing, economic value analysis, total quality management
and value chain analysis. Value chain analysis is a team effort.
Management accountants need to collabourate with engineering,
production, marketing, distribution and service professionals to focus on
the strengths, weaknesses, opportunities and threats identified in the
value chain analysis results.

By championing the use of value chain analysis, the management

accountant enhances the firm’s value and demonstrates the value of the
finance staff to the firm’s growth and survival.

Limitations of Value Chain Analysis

Value chain analysis is neither an exact science nor is it easy. It is
more art than preparing precise accounting reports. There are several
limitations to the implementation and interpretation of value chain
analysis. First, the internal data on costs, revenues and assets used for
value chain analysis are derived from one period’s financial information.
For long-term strategic decision-making, changes in cost structures,
market prices and capital investments from one period to the next may
alter the implications of value chain analysis. Organizations should
ensure that the value chain analysis is valid for future periods.
Otherwise, the value chain analysis must be repeated under new
conditions.
 279

Identifying stages in an industry’s value chain is limited by the

ability to locate at least one firm that participates in a specific stage.
Breaking a value stage into two or more stages when an outside firm
does not compete in these stages is strictly judgmental.
Finding the costs, revenues and assets for each value chain activity
sometimes presents serious difficulties. There is much experimentation
underway that may provide better approaches. Having at least one firm
operate in each value chain activity helps identify external prices for
goods and services transferred between value chains. For intermediate
products or services with no external or competitive market information,
transfer prices must be estimated on the basis of the best information
available.
Isolating cost drivers for each value-creating activity, identifying
value chain linkages across activities, and computing supplier and
customer profit margins present serious challenges. The use of full cost
assumes that the full capacity of the value chain activity’s facilities is
used to derive the costs. Plant and manufacturing personnel and vendors
of equipment are good sources for capacity information. They can also
be helpful in estimating the current or replacement cost of the assets.27
Despite the calculational difficulties, experience indicates that
performing value chain analysis can yield firms invaluable information
on their competitive situation, cost structure, and linkages with suppliers
and customers.

27. Hutchinson R., op.cit. pp.178-181.

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Value Chain and Analysis Activities Tools

· Increasing attention is now being given to value chain analysis
as a means of increasing customer satisfaction and managing
costs more effectively.
· It is the linked set of value creating activities all the way from
basic raw material sources for components suppliers through to
the ultimate end-use product or service delivered to the
customer.
· Coordinating the individual parts of the value chain together
creates the conditions to improve customer satisfaction,
particularly in terms of cost efficiency quality and delivery.
· A firm, which performs the value chain activities more
efficiently, and at a lower cost, than its competitors will gain a
competitive advantage. Therefore it is necessary to understand
how value chain activities are performed and how they interact
with each other.
· The activities are not just a collection of independent activities
but a system of interdependent activities in which the
performance of one activity affects the performance and cost of
other activities.
· It is also appropriate to view the value chain from the
customer’s perspective with each link being seen as the
customer of the previous link. If each link in the value chain is
designed to meet the needs of its customers, then end-customers,
satisfaction should ensure.

Fig. 6.7 : Value chain and activities tools

 281

Customer relationship, the options of the customers can be used to

provide useful feedback information on assessing the quality of service
provided by the supplier. Opportunities are thus identified for improving
activities throughout the entire value chain.

Value Chain Analysis Impact

1. Need for Education, Training and Awareness : Management

Accountants should bring the importance of customer’s value to the
forefront of management’s strategic thinking. They should take the
initiative to bring the value chain message to major players in the firm
through seminars, articles, value chain examples and company-specific
applications.

2. Exploring for Information : VCA requires expertise in internal

operations and information and also demands a great deal of external
information. Management accountants most seek relevant cost and
non-cost information from sources outside the organization.

3. Creativity : Management accountant musts integrate databases

and potential sources of timely information on competitive forces
confronting the business. This calls for innovation and creativity in
gathering and analyzing information for management decisions.

4. System Design : Designing internal and external information

systems to assist managers in planning monitoring and improving value
creating processes is another challenge facing management accountants.

5. Cooperation : Management accountants should solicit support

from all senior managers for allocating resources to develop and
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improve value chain-orients information systems. The management

accountant should ensure that the top management is committed to value
chain analysis and the organizational changes necessary for its
successful implementation.28

TRADITIONAL COST MANAGEMENT

Meaning

Traditional cost management produces information for internal

users. Specifically, cost management identifies, collects, measures,
classifies, and reports information that is useful to managers for
determining the cost of products, customers, and suppliers, and other
relevant objects and for planning, controlling, making continuous
improvements, and decision making.

Cost management has a much broader focus than that found in

traditional costing systems. It is not only concerned with how much
something costs but also with the factors that drive costs, such as cycle
time, quality, and process productivity. Thus, cost management requires
a deep understanding of a firm’s cost structure. Managers must be able
to determine the long- and short-run costs of activities and processes as
well as the costs of goods, services, customers, suppliers, and other
objects of interest.

28. Institute of Management Accountants (2000), “Designing an Integrated Cost Management

System for Driving Profit and Organizational Performance”, Institute of Management
Accountants.
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Today’s cost accountant must understand many functions of a

business’s value chain, from manufacturing to marketing to distribution
to customer service. This need is particularly important when the
company is involved in international trade. Definitions of product cost
vary. The company’s internal accountants have moved beyond the
traditional manufacturing cost approach to a more inclusive approach.
This newer approach to product costing may take into account the costs
of the value-chain activities defined by initial design and engineering,
manufacturing, distribution, sales, and service. An individual who is
well schooled in the various definitions of cost and who understands the
shifting definitions of cost from the short run to the long run can be
invaluable in determining what information is relevant in decision
making.

Objectives
· Discuss the role of management accounting in an organization.

· List the basic elements of a traditional accounting control

system.
· Explain the variances obtained through a traditional cost
accounting system.
· Describe the changes that have occurred in manufacturing over
the past twenty years.
· Explain why traditional cost systems fail.

· List the factors that may indicate that a company’s

cost-accounting system is obsolete.
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Today’s business environment is much more competitive than

yesterday’s- from both a national and an international perspective.
Customers want high-quality products at low prices. Scientific and
technological progress within a global environment means not only that
the players in the game change but also that the game itself changes. The
current leading player in the game may find that all of a sudden new and
stronger competitors are taking the game over or that the game is not
being played anymore- that it has been replaced by a new game.

Continuing to be a major player requires constant adjustments. The

products must be improved or new products must be produced.
Productivity must be improved so that costs are reduced and prices
remain competitive. Research and development activities are essential.
Distribution costs must be reduced. Unproductive activities must be
curtailed or, better yet, eliminated. Management philosophies such as
just-in-time and total quality management may need to be implemented
to stay abreast of competitors.

James Brimson (1991) states that to maintain a competitive

advantage, companies must have an information system that provides
answers to the following questions:

1. What are the influence able (and directly traceable) costs and
profits for each major product line and customer?

2. What are the Cost behavior patterns of each activity,

including its capacity, and how much can volume be
increased or decreased before costs change?
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3. What is the waste (nonviable-added) component of cost, and

what are the best methods for performing an activity?

4. How does overhead cost vary with changes in business? What

costs are avoidable if volume declines?

5. How do the current Cost structure, capacity utilization, and

nonfinancial performance trends compare with those of
competitors?

6. How can low cost be designed into new and existing

products?

Activity-based costing, which is the subject of this course, is

designed to allow analysis of a company’s activities in terms of cost and
performance.29

Role of Management Accountant

An accounting system may be either a major information system

within the organization or a subsystem of a management information
system. Information can be defined as data that have the potential to be
useful for influencing decisions-that is, the information is not random.
All these systems and subsystems operate to aid the organization in
achieving its purpose.

An accounting system aids an organization in the achievement of

its purpose by providing information on whether actual achievements
have matched financial and nonfinancial expectations. An accounting

29. Institute of Management Accountants (2000), “Designing an Integrated Cost Management

System for Driving Profit and Organizational Performance”, Institute of Management
Accountants.
 286

system serves not only the organization but also a larger

system-society-through the issuance of reports to stockholders,
government agencies, and other outside parties. Accounting systems are
dichotomous. One phase of an accounting system serves primarily
external users and is called financial accounting. The other phase serves
primarily decision makers within the organization (internal users) and is
called management accounting. Financial, quantitative, and no
quantitative information is provided to decision makers by management
accounting systems. Each group of users has its own special needs, and
those needs are dealt with in different ways.

The term management refers not only to the group of people who
plan, direct, and control the activities of an organization, but also to the
function itself. Managers do provide the focus for the organization, but
the necessities of management itself require that information flow to and
from all levels of the organization. Management’s needs are not confined
to any particular time, place, or group.

It is not enough to say that management accounting is internal

accounting. Management accounting exists to help an organization
achieve its purpose. It does not stand on its own; it is a service for
meeting the needs of management. These needs must be determined
before the process of management accounting can be defined.

In a very real sense, every organization has its own purpose, its
own set of goals and objectives. While accountants are free to debate
what the goals of an organization should be, they should not make
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assumptions about the goal of the organization they serve. It is the

function of managers to establish goals and objectives; it is the function
of accountants to help in achieving them.

A number of possible conditions can affect the work of

management accounting. Different goals require different decision
models, which can be affected by the environment. It may be assumed
that the organization operates in a particular environment and that this
circumstance is then reflected in the decision process used. Should the
actual environment be either significantly more stable or more volatile,
the models may not meet the organization s needs. Therefore, the
applicability of the models being used must be reevaluated periodically.

The management accountant must know the organization very well

before any attempt is made to meet its needs/Research, not assumptions,
should be the basis for what the management accountant does. In fact,
this research should be a constant process. The task of learning what
purpose and needs really are is not simple, and both purpose and needs
may change. Accountants can never know these things perfectly, but
they can learn them reasonably well.

A good accounting system can be readily adapted to meet changing

demands. If, for example, the environment becomes more volatile, the
users of the system still should be able to use the system in a meaningful
way. Sometimes processes that are commonly used as basic operating
procedures must be bypassed to meet the current necessities. At times, a
department within an organization may require changes in the way if
 288

alone, is served by the accounting system. In such a circumstance, the

accounting subsystem for that department must be able to be changed
without changing the entire system.

The accounting system must serve a multitude of needs. Some of

these needs are structured and consist of routine reports for internal and
external purposes; some are unstructured and respond to special needs.
The structured needs can be met by deliberate planning. The
unstructured needs must be met by maintaining an appropriate data base
and establishing a means of using that base to meet a variety of requests.
A data base contains material at an elementary level to allow for the
creation of the needed information. It may be stored in a single location
or in various locations.

Information relates to a decision, but the decision is made by

someone other than the designer of the accounting system. The
accountant may summarise what is and is not information but only
careful study can verify whether the data are useful for making a
decision. Information lies in the perception of the user. Therefore, it is
important to realize that the accounting system is not only an
information system but also a communication system. Unless data are
available to be communicated, they cannot become information.30

The Traditional Accounting Control System

The traditional accounting control system has the following basic

elements:
30. Ibid.
 289

1. Defining the goal of the sub unit (e.g., a division of a

company or a functional activity within a governmental unit)

2. Delineating the performance indicators established to

ascertain whether operations have been carried out effectively
(e.g., market share, rate of return on investment, or budget
overruns)

3. Establishing standards of performance

4. Performing the activity

5. Measuring the results of the operations performed

6. Comparing the actual results with the standards in order to

measure deviations or variances in performance

7. Communicating the results and analyzing significant

variances.

The goal or goals of the sub unit must be congruent with those of
the total unit. When they are progress toward the standards of the
performance indicators of the subunit enhances the overall operations of
the organization. Obviously, those performance indicators must truly
measure desired performance.

Standards may be developed through such processes as time and

motion studies, statistical studies, and subjective estimates of the
relationships between various inputs and outputs. Some standards are
more difficult to estimate than others, which means that performance
evaluation may vary considerably in accuracy. A deviation from standard
may reflect a problem with the standard rather than with performance.
 290

Performance evaluation can be no better than the standards used and, of

course, the accuracy of the data collected.

Debate arises about the efficacy of the use of data intended for
financial reports as part of the control mechanism. Accounting for
internal purposes does not have to be bound by generally accepted
accounting principles. The sophistication of available computer
technology allows data to be collected, analyzed, and reported for a
variety of purposes.

Accounting systems have been dominated by the demands of the

external users; it is not certain whether this domination results in the best
data for management purposes. Basic differences in purpose and
philosophy abound, and those differences affect cost and other data
critical in each area. Historical costs, for example, have no direct
relevance for decision making and, under some environmental
conditions, little indirect relevance. Control mechanisms must deal with
the realities of both the segments under observation and the relationships
of those segments to the whole system. The purpose of financial
accounting is to provide information to external users such as investors
and creditors about the overall performance and financial condition of
the organization. Financial accounting has little need for the detailed
relationships necessary in control and does not really address itself to
system relationships.

Traditional cost accounting systems were designed at a time when

the two main components of manufacturing cost were direct materials
 291

and direct labour. Manufacturing overhead was a relatively minor

component. Direct materials and direct labour are used directly to
produce a particular product. Indirect materials and indirect labour,
considered to be part of manufacturing overhead (or burden), are used in
manufacturing several products-examples include supplies and the cost
of labour employed in machine setups or maintenance.

Manufacturing overhead is applied to production based for the most

part on direct labour hours and/or machine hours. Excessive direct
labour hours or machine hours result in over applied manufacturing
overhead. The manufacturing costs are then allocated to cost of goods
sold and inventories. Unit costs are computed by dividing total
manufacturing costs for a product by the number of units produced.
These unit costs are important (although not the only factor) for
determining the selling prices of these products.

Although manufacturing overhead rates could be computed at the

end of each period based on actual overhead costs and actual direct
labour (or machine) hours, the total unit costs of each product would not
be known on a timely basis. Consequently, overhead costs are applied on
the basis of predetermined rates using budgeted overhead cost and
budgeted direct labour (or machine) hours. These predetermined
amounts are set on a yearly basis to avoid the volatility in overhead rates
due to seasonal variations or changes in the volume produced due to
increases or decreases in demand.
 292

When the business entity is divided into areas of management

responsibility-that is, cost centers, profit centers, and investment
centers-accounting reports are designed to facilitate comparisons
between actual and budgeted amounts for each organizational unit.
Management by exception, in which the variances of significant amounts
are highlighted, is an important part of this system.

With the accounting system setup in terms of standard costs, a

conversion to actual costs must be made for purposes of presentation in
the financial statement. Theoretically, these variances need to be
apportioned among work-in-process inventory, finished goods inventory,
and cost of goods sold. Often, however, the variances are closed to only
cost of goods sold.

Development of the Traditional Cost Accounting System

Cost accounting systems were developed to meet the needs of

businesses that produced a small number of products, used the same or
similar manufacturing processes on each one, and utilized direct labour
as the major input. The same production processes were repeated over
and over again. Costs were kept low due to increased output, high
productivity and efficiency through high utilization of labour, and
numerous inspections for defective units. Inventory levels were at rather
high levels, because increased output meant lower setup costs and less
idle time for the plant’s workers.
 293

Materials were purchased in large amounts to obtain quantity

discounts. These materials were requisitioned as needed. The workers
made the product and, when it was completed, transferred it to the
warehouse holding the finished goods inventory. Materials and labour
were the direct costs of production; both were considered to the variable
costs. Technology was fairly stable. Overhead costs were minor in
amount and could be allocated to production on the basis of direct labour
hours. Not all the overhead costs were variable- for example,
depreciation was an allocated cost, power had a fixed cost element, and
repairs were made as needed-but they were relatively small in
magnitude.

A cost accounting system had to be developed to meet the

company’s financial reporting needs. In 1934, the Securities and
Exchange Commission (SEC) began requiring annual reports that were
presented in conformity with generally accepted accounting principles.
The amount of cost of goods sold was needed for the income statement;
the inventory cost-direct material and supplies, work in process and
finished goods-was needed for the balance sheet. Nobody seemed to
question whether the cost accounting system developed to meet these
external needs was equally capable of meeting the company’s internal
need.31

31. Johnson H.T. (2002), “A former management accountant reflects on his journey through the
world of cost management”, Accounting History, (May): 9-21.
 294

The Failure of Traditional Cost System

Products cost are crucial to the profit-making ability of a company.
The cost of a product is vital information for setting selling prices and
for determining the marketing effort required. Knowing a product’s cost
is also important for deciding whether or not to meet or beat a reduction
in prices by competitors. Evaluating product profitability is not a
difficult task if only one or a very few products are produced. If product
variety is abundant, however, the task becomes far more difficult.
Manufacturing products requiring special specifications may result in
sales to certain customers, but the costs of these products must be
determined accurately so that profitability can be ascertained. Landing
orders that actually produce losses does not augment the company’s
overall well-being.

Incorrect cost information can cause a number of problems. Five of

these problems, discussed by Peter Turnery (1991), are as follows32:

1. Product designs that unnecessarily raise costs or miss

opportunities to reduce part counts or use common parts-for
example, a universal three-hole circuit could replace the
one-hole and two-hole circuits in a manufacturing process,
but the cost system says the three-hole circuit requires more
direct labour than the other two and is therefore more
expensive.

2. Acquiring the wrong type of equipment, thereby designing

processes in ways that reduce flexibility and quality and raise

32. Ostrenga M.R. and Probst F.R. (1992), “Process value analysis: The missing link in cost
management”, Journal of Cost Management, (Fall): 4-13.
 295

costs-for example, two or three small, mobile machines is

better than one large, stationary machine in terms of
scheduling, inventory levels, quality of products, materials
handling effort, maintenance, and supervision.

3. Centralizing functions to reduce cost but instead reduce

service and quality-for example, centralizing lending
operations in the main office rather than at numerous branch
offices increases communication costs.

4. Cutting costs across the board but finding that the quality of
products and services declines and, as new people are hired,
costs proceed to increase.

Moving production to foreign countries but finding that costs

increase instead of decrease and quality goes down-for example, the
price required by an outside supplier includes transportation costs, but
there are still additional costs for longer lead time and incorrect
forecasting as compared to a JIT system in conjunction with local
suppliers of materials, higher procurement and expediting costs,
increased storage costs, and lower levels of quality requiring varying
levels of rework.

Traditional Management Accounting V/s Value Chain Analysis

Traditional management accounting and value chain analysis differ

in a number of ways as shown in the Table 6.1.33

33. Yoshikawa T., Innes J., Mitchell F. and Tanaka M. (1993), “Contemporary Cost Management”,
Chapman and Hall, p.210.
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Table 6.1
Traditional Management Accounting V/s Value Chain Analysis
Traditional Management
Value Chain Analysis
Focus Accounting
Internal External
Perspective Seeks cost reduction in value added Seeks competitive advantage based
process i.e. sale price less cost of on entire set of linked activities from
Raw materials. suppliers to end-use customers.
Number of cost A single cost driver is adopted. Cost Multiple cost drivers (e.g. scale,
Drivers is generally based on volume of scope, experience, technology and
production and sales. complexity) Execution drivers (e.g.
participative management and plant
layout)
Use of cost Driver Application at the overall firm level A set of unique cost drivers is used
(cost volume-profit analysis) for each value activity.
Cost Containment Seeks adhoc cost reduction View lost containment as a function
Philosophy solutions by focusing on variance of the cost drivers regulating each
analysis, performance evaluation value activity.
based on cost and quantities data. Exploit linkage with suppliers
Exploit linkage with customers
Exploit process linkage within the
firm Spend to save
Cost preference Focus on control of manufac-turing Focus on gaining advantage and not
costs only on cost control and reduction.
Nature of data Internal information External and internal information

Benchmarking Partially present Inter firm Focus on full-fledged bench-marking”

comparison, if any, is generally
restricted to cost and not
operational information.
Insights for strategic Limited to some extent
decisions
learning from competitors”, but
exploiting one’s own strengths to gain
advantage.
Identify cost drivers at the individual
activity level, and develop cost
/differentiation advantage either by
controlling those drivers better than
competitors by reconfiguring the
value chain; Quantity and asses
“Supplier power” and “buyer power”,
and exploit linkage with suppliers and
buyers.

*****