MADM Cost Management

8/8/2019 MADM Cost Management

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Management Accounting-

Decision MakingStage-5

Cost Management Techniques

Rizwan Ahmad Malik

FCMA, LLB, CFE



Learning Curve

The learning Curve theory states thatcumulative average time per unitproduced is assumed to decrease by aconstant percentage every time total

output of product doubles. This effect isdue to learning curve which can bequantified in the form of %age like 80%,90% etc. The learning curve effect stopsat certain point where steady statestarts.



Learning Curve

Definition³The mathematical expression of

phenomenon that when complex and

labor intensive procedures are repeated,unit labor times tend to decrease at

constant rate. The learning curve

mathematically models this reduction in

unit production time.´



Learning Curve

80% Learning Curve

No of

Units

Per Unit

Time

Total

Time

Per Unit

Avg Time

Incremental

Time Total

Incremental

Time Per

Unit

Hrs Hrs Hrs Hrs Hrs

1 100 100 100 0 0

2 80 160 80 60 60

4 64 256 64 96 48

8 51.2 409.6 51.2 153.6 38.4

16 40.96 655.36 40.96 245.76 30.72

This is the marginaltime which actually

reduces with

learning curveeffect. Focus on it



Learning Curve

The Learning Curve Formula

Y= a Xb

Y= cumulative average time per unit to produce X units

a = time required for 1st Unit

X= the cumulative number of units

b = learning co-efficient/ index of learning

Log (learning rate)/ Log 2Std Value of b 90%= - .1520 85% = - .2345 80% = - .321970%= -.5145



Learning Curve

Illustration 1

A company is preparing a quotation for a newproduct. The time taken for the 1st unit of product

was 30 minutes and the company expects an85% learning curve. The quotation is to bebased on the time taken for final unit within thelearning period which is expected to end after

the company has produced 200 units.Calculate time per unit to be used for thequotation.



Learning Curve

Illustration 1- Solution

We know that Y= a Xb and where b is = - .2345

Y= 30*200 - .2345 = 8.66

For 200 units = 200*8.66= 1732 minutes

For 199 units = 199*8.66= 1725.33 minutes

Time for 200th unit is = 6.67 minutes

Note that learning period ends at 200 units and steady state starts.



Learning Curve

Important to know about Learning Curve The theory is applicable only on Labor usage.

The theory is not applicable on materials and OHs.

The theory is based on the double production of units each time. For checking average time per unit at any given quantity for

specific learning curve, the formula is used.

Remember the terms, Average time and cumulative average

time.



Experience Curves

An experience curve is a term applied to thecorporate embodiment of the shop floor,managerial and technological learning

effects within an organization and itexpresses the way in which the averagecost per unit of production changes over time due to technological and organizationalchanges as well as changes to factory size,product design, materials used and so on,and not just learning by labor.



Experience Curves

Application of Experience Curves

Needs a stable work conditions

Not always applicable

Not Applicable in case of product with fast pace of

technological developments

Change in production techniques is a hindrance.



Product Life Cycle CostingP

rofiling of cost, sales revenue, profit over a product¶s lifecycle covering all stages of life cycle which are Introduction,Growth, Maturity and Decline.

(Another stage is ³ saturation´ which comes after maturity.)

Introduction- high promotional cost, low sales revenue, -ve

profits, small customer base, customer security for trying,G rowth- sales rise, profits +ve, promotion cost sustain,distribution cost lower than introduction phase,

Maturity- longest stage, sales increase at decreasing rate, or sales, promotion required to sustain and replace the satisfied customers who left, competitors are in now, price competitionmay arise.

Decline Phase- technical advancement, taste and fashionchange, cost control necessary otherwise losses may jumpinto. No promotions required, reduced production, identify thezero profit level before going in to losses phases again.



Product Life Cycle CostingMain Cost Elements Design Research &

Development Cost

Technology Cost

Manufacturing cost

Production Cost

Distribution Cost Marketing Cost

Inventory Cost

Retirement & DisposalCost

Does not include Capital

Investments

Product life cycle costing is way to distribute thecost among life cycle

phases of product which

enhances the control and monitoring over the lifecycle. It is important totrack and accurately measure the cost. Product

life cycle costing approach is used to provide a long term picture of the product line profitability.



Product Life Cycle Costing

Factors to consider for Life Cycle Costing

Product Life Cycle Stages

Breakeven Time

Launching Time

Total Life Span

Extending the life span by extending life cycle stage

Customer life cycle

M

arketing strategies «..




Product Life Cycle Costing-

Product life cycle costing can be divided into three major

heads to better identify costs

Upstream Cost- Research & Development, Design,

engineering, prototyping, testing and engineering

Manufacturing Cost- Procurements, Direct

Manufacturing Cost, Indirect Manufacturing Costs,

Down Stream Cost- Marketing and distribution, packing,

shipping, promotions, service, warranties,Industries with high DSC are retail, cosmetics etc.

Industries with high USC are software, technical

equipments etc.

Industries with both high DSC & USC are auto, pharma etc.




Performance Measure

Intro Growth Maturity Decline

Cash User User Generator Generator

ROC NA NA + VE +VE

Growth low high Peak Low

Profit NA NA/ OperationalOperational no loss noprofit /Loss/

Strategy Invest Invest/ Earn Earn only Wind Up fast



Project Life Cycle Costing

Project Life cycle costing isDetermining cost associated with the acquiring, using,caring for and disposing of physical assets, includingthe feasibility studies, research design, development,production, maintenance, replacement and disposal of such assets.

Project life cycle costing takes into accountAcquisition cost

Transportation and handling

Operation CostTraining Cost

Tools, Parts & inventory cost

Retirement and disposal cost



Project Life Cycle Costing

F or accurate project costing we need to identify the Visible Costs and Hidden Cost, Accurate

measurement of costs needs to see below the ice

berg and ignoring the tip of the iceberg. Visible

costs covers only capital cost which is easily measurable, the cost below the iceberg, hidden

costs are operating cost and maintenance cost

which need to be accurately measured.



Value Analysis

A systematic inter-disciplinary examination of factors

affecting the cost of a product or service in order to

devise means of achieving the specified purpose

most economically at the required standard of quality

and reliability. By this analysis Value must beenhanced or at least must be same but at reduced

cost. Value analysis helps to design products which

meet customer needs at the lowest cost while

assuring standard of quality and reliability.

Objectives- Cost Elimination, Cost Reduction,

Product Quality Improvement, Product Esteem Value

Enhancement.



Value Analysis

Value added & Non Value Added Activities

An activity may increase the worth of a product or service

to the customer; in this case the customer is willing to pay

for that activity and it is considered as Value added

activity. Some activities which simply increase the timespent on a product or service but do not increase its

worth to the customer; these activities are non value

added activities. The time and effort spent on non-value

added activities creates only additional cost that areunnecessary and if such activities are eliminated costs

would decrease without having an adverse effect on

quality or service.



Value Analysis


Primary/ Core Activity is that adds value directly to a product.

Support Activity or Secondary Activity is that which supports anyprimary activity in adding value.

Discretionary/ Diversionary Activities is an activity which do not add

value directly or indirectly.



Value Analysis


We can assess whether an activity adds value or not by

checking

1- Whether this activity is encouraged by customer

2- Whether the organization would be closer to its goals

by doing this activity.

Ex amples of Non Value Added ActivitiesCustomer Complaints

Performing Multiple Inspections

In House transfer of goods



Value Analysis

Cost Value is cost of producing and selling an item.

Exchange Value is market value of a product or

service.

Use Value is what the product does, product it fulfills.

Esteem Value is the prestige the customer attached

to the product.

Value analysis involves the systematic investigation

of every source of cost and technique of production

with the aim of getting rid of all unnecessary costs.An unnecessary cost is an additional cost incurred

without adding use, exchange or esteem value.



Variable Cost Analysis

Short Term Variable Cost- that vary with the volume of production

Long Term Variable Cost- that are fixed in the short term and do

not vary with the volume of production but\ vary with different

levels of activity. Variable Costs like set up cost, inventory

handling, work scheduling do not increase with volume of

production. They are fixed in short term but vary in long termaccording to range of production levels, complexity, set up

change, limited edition lots etc. Assume that if a single type of

product is produced, such costs can be avoided.

Volume Cost- falling behavior Producing a small number of products in large volumes. ?

Variety Cost- rising behavior

Producing a large number of products in small volumes. ?



Activity Based Costing

ABC Costing- An approach to the costing and monitoring of

activities which involves tracing resource consumption and

costing final outputs. Resources are assigned to activities and

activities to cost objects based on consumption estimates. The

latter use cost drivers to attach activity costs to outputs.

Cost Drivers- Any factor which causes a change in the cost of an

activity. An activity may have multiple cost drivers associated with

it. Few Examples

Cost Driver

Set Up Cost No of Production runs

Inspection Cost No of Inspections

Dispatch Cost No of orders delivered




Resource Cost Driver- A resource cost driver is a measure of

quantity of resources consumed by an activity. It is used to assign

the cost of a resource to an activity or cost pool.

An example of resource cost driver is area, which can be used to

assign office occupancy costs to purchase, accounts and other

departments.Activity Cost Driver- An activity cost driver is a measure of

frequency and intensity of demand placed on activities by cost

objectives. It is used to assign activity costs to costs objects.

An example of activity cost driver is number of customer orders,

the number of orders measuring the consumption of order entryactivities by each customer.




In traditional absorption costing overheads are first related to cost

centres and then to cost objects (products). In ABC overheads are

first related to activities or grouped into cost pools and then

related to cost objects. The two processes are same but only

difference is that ACB uses activities instead of cost centres

(functional departments).

Absor ption Costing focuses on cost recovery

ABC Costing focus on highlighting inefficiencies by focusing activities.

Primary Activities are those activities performed directly for theproducts, services or customers.

Support Activities create the environment that enables the primary

activities to be performed e.g the activities of the human resource

departments.




Steps in Activity Based Costing

Step 1 Identify Activities

Step 2 Relate Overheads to the activities and create cost

pools.

Step 3 Determine the activity cost drivers that will be used

to relate the OHs collected in the cost pools to cost

objects.

Step 4 Activity Cost driver rate= total cost/activity driver

Step 5 Use cost driver rate to level of activities used by

different cost objects.



Activity Based CostingIllustration- Data

ProductsOutput

Units

Material

CostLabor Hrs Mach Hrs

No of Prod

Runs

A 300 20 2 1 3

B 400 80 3 2 8

C 600 20 4 2 8

D 500 80 3 3 524

Labor Cost 50 per hr Total Lb Hrs

Variable Cost 30,800 Per Hr 5.40

Set Up Cost 15,600 Per Run 650.00 600

Scheduling Cost 20,000 Per Run 833.33 1,200

Material Handling Cost 12,500 Per Run 520.83 2,400

78,900 Total Ohs 13.84 per hr 1,500

5,700




Traditional Costing

A B C D

No of Units 300 400 600 500

No of Runs 3 8 8 5

Material Cost 20 80 20 80

Total 6,000 32,000 12,000 40,000

Labor Cost/ Unit 100 150 200 150

No of Hrs 600 1,200 2,400 1,500 5,700

Total 30,000 60,000 120,000 75,000

Ohs 8,305 16,611 33,221 20,763 78,900

Total Cost 44,305 108,611 165,221 135,763 453,900

Per Unit Cost 148 272 275 272



Activity Based CostingABC Costing

No of Units 300 400 600 500

No of Runs 3 8 8 5Material Cost 20 80 20 80

Total 6,000 32,000 12,000 40,000

Labor Cost/ Unit 100 150 200 150

No of Hrs 600 1,200 2,400 1,500

Total 30,000 60,000 120,000 75,000

Over Heads

Variable Cost 3,242 6,484 12,968 8,105

Based on Hrs 5.40 5.40 5.40 5.40

Set Up Cost 1,950 5,200 5,200 3,250

Based on No of Runs 650.0 650 650 650

Scheduling Cost 2,500 6,667 6,667 4,167Based on No of Runs 833 833 833 833

Material Handling Cost 1,563 4,167 4,167 2,604

Based on No of Runs 521 521 521 521

Total Cost 45,255 114,518 161,002 133,126

Per Unit Cost 150.84868 286.29386 268.33626 266.25219

Diff 3.16 14.77 (7.03) (5.27)



Activity Based Pricing

Using the same parameters as in ABC Costing, Pricing can be

done in a better way.

When a business produces a large number of standard products

and a number of variant products which are refined versions of

basic product. Such variant products in fact need minor additional

workings but get a better price. Traditional Costing based pricing

may result in undesirable profit margins leading to low ranking

whereas the product would be profitable if assessed under ABC

Costing. Keeping in view above, pricing may be adjusted for maximization of profit by focusing on high margin products.



Other Techniques

Kaizen Costing

Tear Down Analysis (ReverseEngineering)

BPR (Business Process Re-engineering) Benchmarking

- Internal

- Functional- Competitive

- Strategic



Other Techniques

Manufacturing Cycle TimeThe length of time between starting and finishing

the production consisting of Processing Time,

Waiting Time, Moving Time, Inspection Time.

Manufacturing Cycle Efficiency

= Processing Time

Manufacturing Cycle Time

A reduction in MCT reduces the average value of

WIP engaged in production processes.



Other Techniques

Backflush Costing³A method of costing, associated with JIT

Production systems, which applies cost to output

of a process. Cost do not mirror the flow of

products through the production process, but areattached to the output produced (finished goods

stock and cost of sales), on the assumption that

such backflushed costs are a realistic measure of

actual costs incurred.´



Other Techniques

Theory of ConstraintsA bottleneck resource or binding constraint is anactivity within an organization which has lower capacity than preceding or subsequent activities

thereby limiting throughput.The theory of constraints focuses on such bindingconstraints which are hindrance in maximizing theprofitability by eliminating the effect of suchbinding constraints.

Example, Two Process A & B, B has restrictedcapacity but A works at its full capacity, this shallresult in stock piling, Labor may not attracted for more production at Process A.



Other Techniques

Theory of ConstraintsWe need to govern overall flow of work kee ping in view

bottleneck resource.

Where a bottleneck exists and it cannot be eliminated, then

production must b

e limited to the ca pacity of b

ottleneck resource in order to avoid unnecessary build u p of work in

progress.

Bottleneck Resources other than Production

Non Existence of Com petitive Selling Price

Product Delivery Issues Product Quality and Reliability Issues

U n-reliable material su ppliers



Other Techniques

Throughput Contribution

The rate at which profit is generated

through sales

TC = Sales ± Direct Material Cost

Conversion Costs, all operating expenses

Investments, Capital Investment



Other Techniques

Basic Underlying Concepts of Throughput AccountingMost Costs are constant only variable isMaterials.

Comparison with marginal costing, labor is fi x ed or variable, In

marginal costing labor is variable but taken fi x ed in TA.

Ideal Inventory Level is zero

Products should not be made, until customer is waiting for it.

Inventory investment must be zero other than buffer stock. Idle

capacity is acceptable other than for bottleneck operation.

Profitability is determined by the rate at which sales are made.How quickly the materials are converted to products using resources

and quickly sent to customers for earning sales.



Other Techniques

Return per Time Period The rate at which organization can generate profits.

= Sales Revenue ± Material Cost

Time Period It shows value added by the organization during a particular time period

Return per Time Period on bottleneck resources

= Sales Revenue ± Material Cost

Time Period on Key bottleneck resource

Product ranking for preferred production canb

e carried out b

ased onthrough put contri bution per unit of bottleneck resource, as better decision making.



Other Techniques

T A- Ratio

= through put contri bution per time period

conversion cost per time period

Alternatively

= (Sales ± material cost) per time period

(labor + overhead cost) per time period

Inter pretation- Higher Ratio, Higher Profit



Other Techniques

TA Ratio - Example

Atlas Bravo Cameron

Sales Price 500 600 350Bottleneck Hrs 2 3 2

Material Cost 235 230 175

Conversion Cost 150 330 160

385 560 335Profit 115 40 15

TA Contribution 265 370 175

TA Contr. per Hr 132.50 123.33 87.50

TA Ratio 1.77 1.12 1.09



Other Techniques

Total Quality Management

An integrated and comprehensive system of planning

and controlling all business functions so that products

or services are produced which meet or exceed

customer expectations. TQM is a philosophy of business behavior, embracing principles such as

employee involvement, continuous improvement at all

levels and customer focus as well as being collection

of related techniques aimed at improving quality such

as full documentation of activities, clear goal setting

and performance measurement from customer

perspective.



Other Techniques

Total QualityM

anagement ± Key IngredientsGet it right, first Time

Continuous Improvement

Quality Assurance Procedures

Material Purchases Ins p

ection, In p

rocess Ins p

ection, Out p

ut Ins p

ectionInternal Customers and Internal Suppliers

Employees Quality Awareness

Customer Responses

Competitive BenchmarkingEveryone¶s work

Synergy

Feed back and Feed forward Controls

Recognition & Rewarding```



Other Techniques

Cost of QualityThe difference between the actual cost of producing, selling and

supporting products or services and the equivalent costs if there

were no failures during production or usage.

Cost of Prevention- cost incurred to prevent defective goods

being produced.

Cost of Appraisal- costs incurred in order to ensure that outputs

produced meet required quality standards.

Cost of Internal Failure- the cost arising from in-adequate quality

which are identified before transfer to customer.

Cost of External Failure- the cost arising from inadequate quality

discovered after transfer of ownership from supplier to purchases.



Other Techniques

Quality Cost Concepts

Cost of Conformance- Cost of achieving specified quality

standards.

To achieve 0% defects, cost of conformance must be high

Cost of Non-Conformance- Cost of failure to deliver the

required standard of quality.

Cost of Non-conformance shall rise if defects rises.



Other Techniques

Institute of Cost & Management Accountants- Management Accounting & Decision Making 47

Rs

Defects

Cost of Conformance

Costs of Non-Conformance



Other Techniques

Quality Cost ConceptsTraditional View & TQM View

Traditional view suggests that there is an optimal level

of quality effort that minimizes total quality costs and

there is a point beyond which spending more onquality yields a benefit that is less than additional cost

incurred. (Law of Diminishing Returns)

TQM View suggests that poor quality is unacceptable

and objective is to reach zero defect level irrespectiveof the Cost/ Benefit view.



Externally Oriented Management

Accounting TechniquesThe Value Chain

The sequence of business activities by which from the

perspective of the end user, value is added to the

products and services produced by an organization.

The Activities are the means by which an organizationcreates value in its products, Activities can be divided

in to Primary & Support Activities.

Organization Infrastructure, Human Resource

Management, Technology Development, Procurement,Logistics, Operations, Marketing & Sales, Services etc.




Accounting Techniques

The ultimate value an organization creates is measured

by the amount customers are willing to pay for its

products and services above the cost of carrying out

value activities.

Organization if profitable if the realized value to

customers exceeds the collective cost of performing

the activities.





The Value Chain Analysis

Draw a Value Chain of all the Processes

Establish Cost Drivers, Structural or Executional

Focus on Drivers Focus on Cost reduction

Focus on Value to Customer at each Process

Identify Cost Reduction Measures





Supply Chain

A supply chain is the network of facilities and

distribution options that performs the

functions of procurement of materials,

transformation of these materials in to

intermediate finished products and then

distribution of these finished goods to

customers.





Supply Chain Management

Supply Chain Management or Pipeline Management or

Value Stream Management views all the buyers and

sellers in this chain as a part of continuum, and theaim should be to look at the supply chain as a whole

and seek to optimize the functioning of the entire

chain. In other words, a company should look beyond

its immediate suppliers and its immediate customers to

add value for example by improving efficiency andeliminating waste.





Supply Chain Management

Production Planning & Co-ordination (PPC)

Material Management & Co-ordination (MMC)

Inbound Logistics

Outbound Logistics

Effective Resource Utilization

Procurement Procdures

Supplier Relation Management

Inventory Levels Optimization

Others«.





Other Concepts

Outsourcing

Partnering

Project/ Product Specific, Long term

Pain/ Gain Sharing Arrangements





Direct Product Profitability (DPP)

This involves the attribution of costs other than

purchase price to each product line. The cost

attribution process utilizes a variety of different basisfor allocating cost.

Direct product profit is in fact contribution a product

category makes to fixed cost and profits. It is

calculated by deducting attributed direct product cost

from product gross margin.

Applicable in Retail, FMCG Industry etc.





Customer Profitability

An Analysis of revenue streams and service cost

associated with specific customers or customer

groups.Factors

Sales Effort

Quantitative Analysis

No of Deliveries Product Handling

Post Sale Service




Accounting TechniquesCustomer Categories

Cost to

Supply

high Demanding Service Conscious

Low Price Conscious Accepting

Low High

Willing Price





Other Concepts

Customer Pareto Analysis80/ 20 Princi ple, Customer G rou ps, bad debts, high turnover low volume

customer, low turnover high volume customer.

Product Pareto Analysis80/ 20 Princi ple, Product Mix and Customer G rou ps, U nit Level Analysis,

Batch Level Analysis, Product Sustaining Analysis, Net Product

sustaining margins, Contri bution to plant sustaining

Distribution Channel ProfitabilityProduct Costs & Administrative or Activity Costs

Determine Product Cost, find out margins, check product mi x , check

activity costs, determine net gain of the channel.

MADM Cost Management

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