Tag: Strategic cost Management

Strategic cost management is the process of reducing total costs while improving the strategic position of a business. This goal can be accomplished by having a thorough understanding of which costs support a company’s strategic position and which costs either weaken it or have no impact. Subsequent cost reduction initiatives should focus on those costs in the second category. Conversely, it may be useful to increase costs that support the strategic position of the business.

It is a process of combining the decision-making structure with the cost information, in order to reinforce the business strategy as a whole. It measures and manages costs to align the same with the company’s business strategy.

It is almost never worthwhile to cut costs in strategically important areas, since doing so reduces the customer experience and therefore will eventually lead to a decline in sales. Consequently, management needs to be involved in cost reduction activities, so that they can provide input regarding how certain costs must be incurred in order to support the competitive position of the firm.

Strategic cost management is a continuing process, since the strategy of a firm may change over time. Thus, certain costs may be sacrosanct when one strategy is being used, but can be readily eliminated when the strategy shifts.

Philosophies

In short, Strategic cost management is the development of cost management information for strategic management purpose. Strategic cost management can be defined as “scrutinizing every process within your organisation, knocking down departmental barriers, understanding your suppliers’ business, and helping improve their processes.”

Michael Porter in competitive advantage prepared the way for a strategic emphasis in cost management by developing a framework for identifying a firm’s competitive strategy.

Porter’s concepts of cost leadership and differentiation have had a strong influence on management education. These concepts provide the basis on which the strategic approach to cost management is based because they explain what a firm should do to succeed.

Thus, there are two steps in Strategic Cost Management: first, to identify (using Porter’s framework) what managers must do to make the firm succeed, and second, to develop cost management methods and practices to facilitate management’s efforts.

Need for SCM

• It is an updated form of cost analysis, in which the strategic elements are clearer and more formal and improves the overall position of the company.
• It is used to analyse cost information, and use it to develop various measures to achieve a sustainable competitive advantage.
• It provides a better understanding of the overall cost structure in the quest of gaining a sustainable competitive advantage.
• It uses cost information specifically to govern the strategic management process; formulation, communication, implementation and control.
• It helps in identifying the cost relationship between value chain activities and its process of management to gain competitive advantage.

Importance

Strategic cost management has become an essential area now a day. While formulating the strategy for the accomplishment of organisational overall objectives, different cost drivers should be clearly identified. Identification of key cost drivers helps companies to focus on key activities that will constitute almost 90% of the total costs.

In view of this, the importance of strategic cost management should not be underestimated. This implies that an organisation should be installing appropriate framework of strategic cost management to reduce its costs in key areas on which the success of organisation is mainly dependent. Strategic cost management is understood in different ways in literature.

Objectives of Strategic Cost Management:

Strategic Cost Management provides number of benefits to different organisations. It has provided the business with an improved understanding of its sources of profits.

(i) It has enabled the business to assess, at a high level, how activity-based techniques can be deployed at different levels in the business to improve its cost management process, such as in budgeting and in process improvement.

(ii) It has developed a framework for reviewing the strategic allocation of resources across the business based on core business processes and activities.

(iii) It has improved the businesses understanding of its cost drivers leading to improved articulation of its strategic plans in cost terms.

There are three important components of strategic cost management:

1. Strategic Positioning Analysis: It determines the company’s comparative position in the industry in terms of performance.

Strategic positioning analysis is an approach for researching what future environments might be like in your internal corporate structure as well as your external environment and determining how you can use the choice of business strategies to get from your current situation to these desirable goals.

Analysis of the status-quo often involves using some fairly standard strategic management tools such as:

• SWOT analysis: Strengths and weaknesses within your firm; opportunities and threats within the external competitive market.
• Product/market matrix: Establishing what new markets, product changes, product lines or market variations could prove profitable.
• Portfolio analysis: Establishing which of your projects are potential cash cows, stars, wildcats or dogs.

2. Cost Driver Analysis: Cost is driven by different interrelated factors. In strategic cost management, the cost driver is divided into two categories, i.e. structural cost drivers and executional cost drivers. It examines, measures and explains the financial effect of the cost driver concerned with the activity.

Cost driver analysis is concerned with determining what the actual drivers of activity costs are within your operations. The most popular type of analysis for this is activity-based costing (ABC) which aims to establish what indirect causes can be related to specific activities.

This has a bearing on strategic cost management since cost drivers can actually be determined by both structural cost drivers and executional cost drivers.

• Structural cost drivers relate to strategic management choices the company undertakes in relation to actual structure of their operations (scale and scope) as well as the complexity of their products and technologies used. A more complex working environment (products, technologies and production) leads to higher structural costs.
• Executional cost drivers relate to the actual operational processes and norms within operation. The effective use of staff, process layouts, just-in-time processes, etc. all have a bearing on the cost of executing activities within the firm.

3. Value Chain Analysis: The process in which a firm recognizes and analyses, all the activities and functions that contribute to the final product. It was propounded by Michael Porter (1985), to show the way a customer value assembles along the activity chain that results in the final product or service.

Value chain analysis is an approach used to determine the series of activities involved in creating and building value within your operations. It requires a systematic approach to examining each different element in your primary activities as well as support activities.

The operations of the organization may actually be split out into both primary as well as support activities.

• Primary activities: Inbound logistics, operations, outbound logistics, marketing & sales and service.
• Support activities: Procurement, technology development, human resources management and firm infrastructure.

Strategic cost management initiative is taken at the top and a dedicated team should be involved in the whole process of formulation, implementation and monitoring process.

A control standard is a target against which subsequent performance will be compared. Standards are the criteria that enable managers to evaluate future, current, or past actions. They are measured in a variety of ways, including physical, quantitative, and qualitative terms. Five aspects of the performance can be managed and controlled: quantity, quality, time, cost, and behavior.

Organization should have its own policy regarding recording and reporting of following information:

• Choice of strategic positioning, cost leadership or product differentiation;
• Choice of cost drivers, structural or executional;
• Cost reduction strategies with reference to value analysis;
• Value chain related activities;
• Periodic evaluation report;
• Strategic cost management framework for the firm
• List of tools applied by the firm as a part of strategic cost management.
• Any other types of reporting as required.

Effective control systems tend to have certain qualities in common. These can be stated thus:

1. Suitable: The control system must be suitable to the needs of an organisation. It must conform to the nature and needs of the job and the area to be controlled. For example, the control system used in production department will be different from that used in sales department.
2. Simple: The control system should be easy to understand and operate. A complicated control system will cause unnecessary mistakes, confusion and frustration among employees. When the control system is understood properly, employees can interpret the same in a right way and ensure its implementation.
3. Selective: To be useful, the control system must focus attention on key, strategic and important factors which are critical to performance. Insignificant deviations need not be looked into. By concentrating attention on important aspects, managers can save their time and meet problems head-on in an effective manner.
4. Sound and economical: The system of control should be economical and easy to maintain. Any system of control has to justify the benefits that it gives in relation to the costs it incurs. To minimize costs, management should try to impose the least amount of control that is necessary to produce the desired results.
5. Flexible: Competitive, technological and other environmental changes force organizations to change their plans. As a result, control should be necessarily flexible. It must be flexible enough to adjust to adverse changes or to take advantage of new opportunities.
6. Forward-looking: An effective control system should be forward-looking. It must provide timely information on deviations. Any departure from the standard should be caught as soon as possible. This helps managers to take remedial steps immediately before things go out of gear.
7. Reasonable: According to Robbins, controls must be reasonable. They must be attainable. If they are too high or unreasonable, they no longer motivate employees. On the other hand, when controls are set at low levels, they do not pose any challenge to employees. They do not stretch their talents. Therefore, control standards should be reasonable they should challenge and stretch people to reach higher performance without being demotivating.
8. Objective: A control system would be effective only when it is objective and impersonal. It should not be subjective and arbitrary. When standards are set in clear terms, it is easy to evaluate performance. Vague standards are not easily understood and hence, not achieved in a right way. Controls should be accurate and unbiased. If they are unreliable and subjective, people will resent them.
9. Responsibility for failures: An effective control system must indicate responsibility for failures.

Detecting deviations would be meaningless unless one knows where in the organisation they are occurring and who is responsible for them. The control system should also point out what corrective actions are needed to keep actual performance in line with planned performance.

10. Acceptable: Controls will not work unless people want them to. They should be acceptable to chose to whom they apply, controls will be acceptable when they are:

• Quantified
• Objective
• Attainable
• Understood by everyone

Features

Allows for Risk Management

Risk management can be considered as a subset or a specific form of strategic management. Risk is the probability of a future loss and risk management involves formulating various strategies to combat the risks making risk management a form or variety of strategic management.

Strategic management in this form allows for identifying and eliminating the risks posed by various hazards to the business.

Conscious Process

Strategies are a product of the developed conscience and intellect that we humans proudly possess and employ. Strategic management implies the usage of the brain and the heart and is not a routine ever-continuing process. It requires great skill and experience to be carried out effectively and requires a full application of one’s conscience.

Requires Foresight

The future is uncertain. We cannot predict what will happen. However, on the basis of the information that is available to us, we will be able to presume certain things about the future.

For instance, a discovery that the item XYZ causes cancer can allow us to make a very reasonable presumption that the item XYZ will be banned in the near future. This presumption thus allows us to not make any investment in anything directly related to XYZ.

Drives Innovation

The development of strategy is not a simple process and requires making the best out of often very restrictive situations. This drives innovations and allows managers to approach problems from different angles and solve problems more efficiently. After all, necessity is the mother of all inventions.

Strategic Management as a process is quite complicated and requires years of experience and inherent skills to be carried out efficiently. The process is pervasive and is central to any business. It is a discipline in itself and requires more study for enthusiasts wanting to pursue management.

Goal-Oriented Process

The process of Strategic Management is a goal-oriented process. The process is done with the intention and goal of analyzing the various elements through SWOT analysis and other tools and to develop a plan or strategy that effectively allows the business to maneuver itself around every hurdle and make use of its strength.

This process also plays the role of making all other functions of the business goal-oriented as well.

Facilitates decision making

Strategic Management plays an integral role in making important decisions. Whenever a manager has to make a decision he has to think about the bearing of such a decision on the overall strategy and the business’ trajectory.

Thus, the strategies developed to act as a guide to making efficient and accurate decisions.

Primary Process

Strategic Management is the primary process in any business. The strategies that the business has to apply in its activities is developed at the initial stage itself and only after the creation of the strategy that other processes commence by making the strategy as its basis.

Pervasive Process

Strategic Management is a pervasive process seen in all levels of the business.

The core strategies are formulated for the entire business by the top-level management and strategies to efficiently achieve the overall goal so laid down by the top-level management is developed through the various lower business units.

Dependent on Personal Qualities

The above two considerations make it amply clear that Strategic Management is heavily dependent on the personal qualities of the managers occupying the top-level positions.

These personal qualities including skills and experience obtained over years of employment and observation cannot be imparted by training or coaching classes and require practical exposure for extended periods of time unless the person is born with the talent of strategizing (which is rare).

Distribution Cost or the Distribution expenses are the costs that a company incurs to make its goods or services available to the end-users or resellers. It is a broad accounting term that covers several types of expenses.

Total distribution cost (TDC) analysis requires some assumptions. These include current observed rates and transit times for standard air freight, full containerload (FCL), and less-than containerload (LCL) service.

For any company which is involved in distribution, distribution cost is a major bottleneck. There are many different distribution expenses which must be taken care of. Furthermore, these expenses are not consistent and may change from time to time thereby changing the distribution cost as well.

If the shipper is a distributor and it further sells to the retailer and the retailer sells to the end user then all the separate distribution costs at each stage would be included in the total distribution cost. Moreover, in some cases the manufacturer has a production unit at one place and the “product pick up place” by the forwarder at another place. The cost of moving the product from the place of production to the pickup point is also included in distribution cost.

There are other types of costs as well that that are included in the distribution’s costs. Handling cost of inventory at all points for example production place, storehouse, sales point is part of distribution cost. Packing costs are also part of distribution costs. Distribution managerial cost such as the salary expense of distribution manager and his/her office expenses are also part of distribution costs.

Freight cost is usually the most important component of distribution costs. If the product is manufactured and sold in same country then freight cost refers to the “Trucking” or such transport fare to deliver the product.

If the product is sold internationally then it may include “Air Freight, Less than container load (LCL), Day-Definite LCL or Full container load (FCL).” In case the product is transported by air the cost would be higher and if it is transported through LCL the cost would be lower but there is one further point to contemplate i.e. “Transit Time”. The transit time for LCL is longer and the transit time for moving by air is smaller. Covering all ends there is a need for comparative analysis between the product demand urgency and transport cost. If the product is urgently needed and the shipper is losing sales revenue then it is optimum to reduce transit time and increase the freight expense.

Distribution expenses: The individual expenses made by the company for various reasons is known as Distribution expenses. These are individual or repeated transactions happening over time. An example may include; Rent, Salaries, Administrative expenses etc. All these are individual transactions or repeat transactions and these transactions can be called distribution expenses.

Distribution cost: The combination of all distribution expenses made by a company is known as Distribution cost. So, continuing the above example; the total of rent, salaries, and administrative expenses will be considered as distribution cost. In terms of Formula

[The sum of all Distribution Expenses] = Distribution cost

1) Sales returns

If a dealer or a retailer rejects a material, then the material comes back to the manufacturer provided it is in the returns policy of the company. This returned material may have come back due to cosmetic conditions (it was damaged or dented) or it may have come back due to performance issues. In any condition, the returned product is a cost to the company.

2) Direct Selling Expenses

Any expense made towards selling the product to the target customer is a direct selling. Many manufacturers, wholesalers, and distributors carry out direct selling in the regions that they want to expand. They also would like to know the distribution cost of that region. Thus, they consider all direct selling expenses as the primary expense made by the firm.

3) Commercials & Accountancy

It is a government requirement to present all your sales and purchases as well as balance and profit sheets to the government to determine profit earned by your firm. Furthermore, these statements are also important for the firm itself to note the growth year on year as well as to determine the performance and future potential. Thus, commercials and accounts are documented precisely in any firm.

4) Advertising & Sales promotion expenses

If a company wants to establish itself in a new region, it needs to have OOH advertising, it needs to run in-store branding, it needs to run ads in local newspapers or local channels. Thus, the company will be spending a lot towards advertising and promotions which are various forms of distribution expenses.

5) Product and Packaging expenses

The product packaging was good but was not strong. As a result, the packaging suffered a huge wear and tear by the time it reached the customer and the customers returned the product.

6) Shipping and Delivery

With the rise of E-commerce, delivery is a huge focus area for all manufacturers. The stock must be in the market, whether it is on an E-commerce portal or in a retail outlet or with the distributor. Everyone knows that if there is no stock on display, the sale will not happen and this creates friction between the different distribution channels.

7) Trade discounts

Besides sales promotion exercises like advertising and marketing, a company launches several trade promotional exercises as well. This includes giving discounts to retailers, distributors, and suppliers on achieving certain targets.

8) Market research

When reputed companies like Samsung, LG or Sony want to establish themselves in a new market, they buy market research reports from the likes of IMRB or Nielson. These reports may cost hundreds or thousands of dollars. Not only in a new market, even in an old market, a company might want to conduct a satisfaction survey or a survey of new ideas regarding distribution.

9) Credit, Outstanding and Overdue

A distributor who operates in a regional market needs the huge amount of money to conduct business. To arrange this money, the distributor takes a loan from the banks. This is known as an Overdue account. Hypothetically, If the distributor takes 1 lakh from the bank, within 30 days he should give back 1 lakh + 1% interest. Thus, a dealer suffers a loss when his money does not come back from the market in time.

10) Warehousing and handling within warehouse

Warehousing is a major cost of distribution. When a company expands to newer markets, it needs to have new warehouses in each new territory. Domino’s or McDonald’s practically have warehouses for every 3-4 towns so that they can supply to local retail outlets very fast. Because of Domino’s and McDonald’s handle frozen goods (burgers or fries), their expenses are even higher because they need cold rooms and cold chains to deliver the products.

NOTE: Warehousing cost is different from transportation and delivery cost which is calculated separately.

Under these assumptions, the analysis shows:

• Standard LCL would minimize transport-related costs, but would incur by far the highest inventory-related expenses due to long and highly variable transit times.
• Using full containerload (FCL) rather than LCL reduces inventory-related costs but to do so would spend more than the inventory-related savings on transport-related costs due to the wasted space in 20-ft. containers occupied by only 2,500 metric tons of freight.
• Switching to air freight to minimize inventory-related costs would incur the highest transport-related expenses, leading to the highest overall total distribution costs.
• Day-definite LCL could minimize total distribution costs (sum of transport and inventory related costs). Compared to LCL, the shipper would spend about $600,000 more on transportation to use day-definite LCL service ($1.8 million vs. $1.2 million per year) but would capture approximately $825,000 in inventory related cost savings ($1.3 million vs. $2.2 million per year).