Strategic

Cost
Management
Prepared by
Douglas Cloud
Pepperdine University

13-1
 Objectives
1. Explain what strategic cost management is and
After studying this
how it can be used to help a firm create a
chapter, you should
competitive advantage.
be able to:
2. Discuss a value-chain analysis and the strategic
role of activity-based customer and supplier
costing.
3. Tell what life-cycle cost management is and how
it can be used to maximize profits over a
product’s life cycle.
Continued
13-2
 Objectives
4. Identify the basic features of JIT purchasing
and manufacturing.
5. Describe the effect JIT has on cost
traceability and product costing.

13-3
 Strategic Cost Management:
Basic Concepts
Strategic decision making is choosing among
alternative strategies with the goal of selecting a
strategy, or strategies, that provides a company with
reasonable assurance of long-term growth and survival.
The key to achieving this goal is to gain a competitive
advantage.
Strategic cost management is the use of cost data to
develop and identify superior strategies that will
produce a sustainable competitive advantage.

13-4
 Strategic Cost Management:
Basic Concepts
Competitive advantage is the process of creating better
customer value for the same or lower cost than that of
competitors or creating equivalent value for lower cost
than that of competitors.
Customer value is the difference between what a
customer receives (customer realization) and what the
customer gives up (customer sacrifice).
The total product is the complete range of tangible and
intangible benefits that a customer receives from a
purchased product.

13-5
 General Strategies

There are three general strategies that

have been identified:
 cost leadership
 product differentiation
 focusing

13-6
 General Strategies

A cost leadership strategy

happens when the same or
better value is provided to
customers at a lower cost
than a company’s
competitors.

Example: A company might redesign a product so

that fewer parts are needed, lowering
production costs and the costs of
maintaining the product after purchase.
13-7
 General Strategies
A differentiation strategy strives to increase
customer value by increasing what the customer
receives (customer realization).
Example: A retailer of computers might
offer on-site repair service, a
feature not offered by other
rivals in the local market.

13-8
 General Strategies

A focusing strategy happens when a firm selects or

emphasizes a market or customer segment in which to
compete.
Example: Paging Network, Inc., a paging
services provider, has targeted
particular kinds of customers and is
in the process of weeding out the
nontargeted customers.

13-9
 Industrial Value Chain

The industrial value

chain is the linked set of
value-creating activities
Fundamental to a value-
from basic raw materials
chain framework is the
to the disposal of the
recognition that there exist
finished product by end-
complex linkages and
use customers.
interrelationships among
activities both within and
external to the firm.

13-10
 Internal and External Linkages
There are two types of linkages that must be analyzed
and understood: internal and external linkages.
Internal linkages are relationships among activities
that are performed within a firm’s portion of the
value chain.
External linkages describe the relationship of a
firm’s value-chain activities that are performed with
its suppliers and customers. There are two types:
supplier linkages and customer linkages.

13-11
 Oil Exploration
Firm B
Oil Production

Oil Distribution
Firm C
Firm A
Oil Refining

Gas Distribution

Service Stations

Value Chain for End-Use Customer

the Petroleum
Industry Product Disposal
13-12
 Organizational Activities and Cost Drivers

Organizational activities are of two types: structural

and executional.
executional
Structural activities are activities that determine the
underlying economic structure of the organization.
Executional activities are activities that define the
processes and capabilities of an organization and
thus are directly related to the ability of an
organization to execute successfully.

13-13
 Organizational Activities and Cost Drivers

Structural Activities Structural Cost Drivers

Building plants Number of plants, scale, degree of
centralization
Management structuring Management style and philosophy
Grouping employees Number and type of work units
Complexity Number of product lines, number of
unique processes, number of unique parts
Vertically integrating Scope, buying power, selling power
Selecting and using process Types of process technologies,

technologies experience

13-14
 Organizational Activities and Cost Drivers

Educational Activities Educational Cost Drivers

Using employees Degree of involvement
Providing quality Quality management approach
Providing plant layout Plant layout efficiency
Designing and producing
products Product configuration
Providing capacity Capacity utilization

13-15
 Operational Activities
Operational activities are day-to-day activities
performed as a result of the structure and processes
selected by the organization.
Examples: Receiving and inspecting incoming
parts, moving materials, shipping
products, testing new products,
servicing products, and setting up
equipment.

13-16
Organizational and Operational
Activity Relationships
Organizational Activity
(Selecting and using process technologies)

Operational Driver Structural Cost Driver

(Number of moves) (JIT: Type of process technology)

Operational Activity
(Moving material)

13-17
 Internal Value Chain
Design

Service Develop

Distribute Product

Market

13-18
 Internal Linkages: An Example

Design engineers have been told that the number of parts

is a significant cost driver and that reducing the number
of parts will reduce the demand for various activities
downstream in the value chain. They plan to reduce the
price by per-unit savings. Currently 10,000 units are
produced. The data of the new design and its effects on
demand are given in slide 13-20.

13-19
 Internal Linkages: An Example

Activities Activity Driver Capacity Demand Demand

Material usage Number of parts 200,000 200,000 80,000
Assembling parts Direct labor hours 10,000 10,000 5,000
Purchasing parts Number of orders 15,000 12,500 6,500
Warranty repair Number of defective
products 1,000 800 500

13-20
 Internal Linkages: An Example
Additionally, the following activity cost data are provided:
Material usage: $3 per part used; no fixed activity cost.
Assembly: $12 per direct labor hour; no fixed activity cost
Purchasing: Three salaried clerks, each earning a $30,000
annual salary; each clerk is capable of processing 5,000
purchase orders annually. Variable activity costs: $0.50
per purchase order processed for forms, postage, etc.
Warranty: Two repair agents, each paid a salary of
$28,000 per year; each repair agent is capable of
repairing 500 units per year. Variable activity costs: $20
per product repaired.
13-21
Internal Linkages: An Example
Cost Reduction from Exploiting Internal Linkages

Material usage: (200,000 – 80,000)$3

$360,000
Labor usage: (10,000 – 5,000)$12

60,000
Purchasing: [$30,000 + $.50(12,500 – 6,500)]

33,000
Warranty repair: [($28,000 + $20(800 – 500)]

34,000
13-22
Step Cost Behavior: Purchasing Activity
Cost

$90,000

60,000

30,000

5 6.5 10 12.5 15 20
Number of Purchase Orders (in thousands)
13-23
Activity-Based Supplier Costing

Reworking rate = $200,000/1,000

Reworking rate = $200 per failed component
800 + 190 + 5 + 5
Expediting rate = $50,000/50
Expediting rate = $1,000 per late delivery
30 + 20

13-24
 Activity-Based Customer Costing
Large Ten
Customer Smaller Customers
Units purchased 500,000 500,000
Orders placed 2200
Manufacturing cost $3,000,000 $3,000,000
Order-filling cost allocated* $303,000 $303,000
Order cost per unit $0.606$0.606
*Order-filling capacity is purchased in blocks of 45 (225 capacity), each block costing $40,400; variable
order-filling activity costs are $2,000 per order; thus, the cost is [(5 x $40,400) + ($2,000 x 202)]

13-25
 Product Life Cycle Viewpoints

There are three basic views of the product life cycle:

 Marketing viewpoint
 Production viewpoint
 Consumable life viewpoint

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 Marketing Viewpoint

Units of
sales

Introduction Growth Maturity Decline

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 Production Viewpoint
Cost Commitment Curve
Life Cycle
Cost %

100

75

50

25

Research Planning Design Testing Production Logistics

13-28
 A Life Cycle Costing Example
Suppose that engineers are
considering two new
product designs for one of
its power tools. Both
designs reduce direct
materials and direct labor
content over the current
model. The anticipated
effects of the two designs
on manufacturing,
logistical, and postpurchase
activities costs are listed on
slide 13-30.
13-29
 A Life Cycle Costing Example
Cost Behavior
Functional-based system:
Variable conversion activity rate: $40 per direct labor hour
Material usage rate: $8 per part
ABC system:
Labor usage $10 per direct labor hour
Material usage: $8 per part
Machining: $28 per machine hour
Purchasing activity: $60 per purchase order
Setup activity: $1,000 per setup hour
Warranty activity: $200 per returned unit
Customer repair cost: $10 per hour

13-30
 A Life Cycle Costing Example
Traditional costing (overhead allocated by direct labor
hours)
Design A
Design B
Direct materials $ 800,000
$ 480,000
Conversion costb 2,000,000
3,200,000
Total manufacturing cost $2,800,000
a $ 3,680,000
$8 x 100,000 parts; $8 x 60,000 parts
Units
b
$40produced
x 50,000 direct labor hours; $40 x80,000
10,000
direct labor
hours  10,000
Unit cost $ 280
$ 368
13-31
 A Life Cycle Costing Example
ABC Costing (Overhead allocated by direct labor
hours)
Design A Design B
Classification
Direct materials $ 800,000 $ 480,000
Manufacturing
Direct labora 500,000 800,000
Manufacturing
Machiningb 700,000 560,000
Manufacturing
Purchasingc 18,000 12,000 Upstream
Setupsd 200,000 100,000
Manufacturing
Warrantye 80,000 15,000 Downstream
Total product costs $2,298,000 $1,967,000
Units productd  10,000  10,000
Unit cost $ 230 $ 197
Postpurchase costs $ 80,000 $ 15,000
13-32
 Role of Target Costing
A company is considering the production of a new
trencher. Current product specifications and the
targeted market share call for a sales price of $250,000.
The required profit is $50,000 per unit. The target cost
is computed as follows:
Target cost = $250,000 – $50,000
= $200,000

13-33
 Target-Costing Model
Market Share Target Price Product
Objective Functionality
Target Profit

Target Cost

Product and Process

Design

NO Target cost
met?
YES
Produce Product
13-34
 Traditional Manufacturing Layout

Product A A A  
Lathes Abrasive Welding
Product B B Grinders B Equipment

Department. 1 Department 2 Department 3

Each process passes

through departments Finished Product A
that specialize in one
process. Finished Product B

13-35
 JIT Manufacturing Layout
Cell A Cell B

Grinder Grinder
 
Lathe Welding Lathe Welding

Product Finished Product Finished

A Product B Product
A B
13-36
 Traditional Inventory Systems
 Push-through system
 Significant inventories
 Large supplier base
 Short-term supplier contracts
 Departmental structure
 Specialized labor
 Centralized services
 Low employee involvement
 Supervisory management style
 Acceptable quality level
 Driver tracing dominates
13-37
JIT Inventory Systems
 Pull-through system
 Insignificant inventories
 Small supplier base
 Long-term supplier contracts
 Cellular structure
 Multiskilled labor
 Decentralized services
 High employee involvement
 Facilitating management style
 Total quality control
 Direct tracing dominates
13-38
 Backfushing Compared with
Traditional Cost Flow Accounting
Transaction: Raw materials were purchased on
account for $160,000.
Traditional Journal Entry
Materials Inventory 160,000
Accounts Payable 160,000

Back-Flush Journal Entry

Raw Materials and In-Process Inv. 160,000
Accounts Payable 160,000
13-39
 Backfushing Compared with
Traditional Cost Flow Accounting
Transaction: All materials received were issued into
production.
Traditional Journal Entry
Work-in-Process Inventory 160,000
Materials Inventory 160,000

Back-Flush Journal Entry

No entry

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 Backfushing Compared with
Traditional Cost Flow Accounting
Transaction: Actual direct labor cost, $25,000.
Traditional Journal Entry
Work-in-Process Inventory 25,000
Wages Payable 25,000

Back-Flush Journal Entry

Combined with overhead; See next entry.

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 Backfushing Compared with
Traditional Cost Flow Accounting
Transaction: Actual overhead costs, $225,000.
Traditional Journal Entry
Overhead Control 225,000
Accounts Payable 225,000

Back-Flush Journal Entry

Conversion Cost Control 250,000
Wages Payable 25,000
Accounts Payable 225,000
13-42
 Backfushing Compared with
Traditional Cost Flow Accounting
Transaction: Conversion costs applied, $235,000.
Traditional Journal Entry
Work-in-Process Inventory 235,000
Overhead Control 235,000

Back-Flush Journal Entry

No entry.

13-43
 Backfushing Compared with
Traditional Cost Flow Accounting
Transaction: All work was completed for the month.
Traditional Journal Entry
Finished Goods Inventory 395,000
Work-in-Process Inventory 395,000

Back-Flush Journal Entry

Finished Goods Inventory 395,000
Raw Materials and in-Process Inv. 160,000
Conversion Cost Control 235,000
13-44
 Backfushing Compared with
Traditional Cost Flow Accounting
Transaction: All completed work was sold.
Traditional Journal Entry
Cost of Goods Sold 395,000
Finished Goods Inventory 395,000

Back-Flush Journal Entry

Cost of Goods Sold 395,000
Finished Goods Inventory 395,000

13-45
 Backfushing Compared with
Traditional Cost Flow Accounting
Transaction: Variance is recognized.
Traditional Journal Entry
Cost of Goods Sold 15,000
Overhead Control 15,000

Back-Flush Journal Entry

Cost of Goods Sold 15,000
Conversion Cost Control 15,000

13-46
 End of

Chapter

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13-48