Managing Costs for enhancing profitability Product Costing Financial Accounting Product costs are...
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Transcript of Managing Costs for enhancing profitability Product Costing Financial Accounting Product costs are...
Managing Costs for enhancing profitability
Product Costing
Financial Accounting
Product costs are used to value inventory and
to compute cost ofgoods sold.
Managerial Accounting and
Cost ManagementProduct costs are used
for planning, control, directing, and
management decision making.
Shift from “Cost-led Pricing” to “Price-led Costing”
Cost structure of individual products and departments
Cost structure of the entire value chain not only our operations
Cost structure of the individual business processes
Convert business costs into value for our customers
Typical Company Value Chain
DistributionAnd
OutboundLogistics
Operations
PurchasedSupplies
andInboundLogistics
Sales and Marketing
ServiceProfit
Margin
Product R&D, Technology, Systems Development
Human Resources Management
General Administration
Primary Activities and Costs
Support Activities and Costs
Competitive PositioningCost Position
High Cost Position
Low Cost Position
Pro
du
ct
Dif
fere
nti
atio
n
Low
High
Product Differentiati
on
Stuck in The
Middle
Differentiation &
Cost Leadership
Overall CostLeadership
0102030405060708090
AverageCompetitor
Low CostStrategy
DifferentiationStrategy
$
Cost
Price
Profit
Cost Leadership Strategy
Relatively standardized products
Lowest competitive price
Cost Leadership Strategy Building economies of scale Tightly controlling production costs and
overhead Minimizing costs of sales, R&D and
service Building efficient manufacturing facilities Monitoring costs of activities provided by
outsiders Simplifying production processes
Differentiation Strategy Nonstandardized products
Customers value differentiated features more than they value low cost
Cost Measures
Measurements are the key …If you can’t measure it, you can’t control it …If you can’t control it, you can’t manage it …If you can’t manage it, you can’t improve it !!!
Determining whether to add or drop product lines.
Determining product pricing.
Deciding whether or not to outsource a product or activity (make or buy, perform ourselves or outsource the activity).
To facilitate redesign of a product.
To facilitate redesign of an internal activity.
To perform customer profitability analysis.
Cost Information
Target Costing Process of cost management and profit
planning Price-led costing
Target Cost=Market Price-Reqd Profit Focus on Customers
Value>cost Focus on design Cross functional involvement Value chain involvement
Strategic Objective Employee Motivation
• Cost data traditionally used to FIX BLAME• Leads to short-run decision emphasis• Cost data can be used to focus on how to work
better, not who to blame
Total Product Cost• Manufacturing cost plus all costs of getting
product/service to customer
Something to remember
Cost minimisation is a sign of management success. Cost cutting is a sign of management failure.
Cost and Cost Terminology
A cost object is anything for which a separatemeasurement of costs is desired.Example – product, project, dept
Different Cost for Different Decisions
Traceability of cost objects Direct costs and indirect costs
How cost behave as volume varies Fixed costs, variable costs &
mixed costs
Direct and Indirect Costs
Direct CostsExample: Felt, plastic
Indirect CostsExample: Power
COST OBJECT
Example: DUSTER
COST OBJECT
Example: DUSTER
Traditional Product Costing
Resources
Direct materials
Direct labor
Direct expenses
Overhead
Products
Traced directlyAllocated UsingDL hours, sales
value, production volume
Elements of Product Cost Direct Material Direct Labour Direct Expenses
Indirect Material Indirect Labour Indirect Expenses
Prime Cost
+Factory (Works or Manufacturing Overhead)
=Total Factory(Works or Manufacturing) Cost
Factory Cost = Cost of Goods Sold
Cost of Goods Sold + Selling expenses +Adm Expenses + Interest + Profit = Sales
Cost SheetJob Number A - 143 Date Initiated 3-4-X2
Date CompletedDepartment B3 Units CompletedItem Wooden Box
Direct Materials Direct Labor Manufacturing OverheadReq. No. Amount Ticket Hours Amount Hours Rate Amount
Cost Summary Units ShippedAmount Date Number Balance
Direct Materials 0.00Direct Labor 0.00Manufacturing Overhead 0.00Total Cost 0.00Unit Cost
Product Costs
Cost SheetCoated Grey Back Board - cost sheet
Direct Materials Manufacturing OverheadReq. No. Amount Ticket Hours Amount Req. No. Amount Hours Rate Amount
Raw Materials 7268Power and fuel 1958
Repairs and maintenance 979
Chemicals Consumables 849Pulp mill 556 Others 872
Stock preparation 1681 Coating 2232Packing Cost 600Total 12337 Total 1958 Total 2700
Cost SummaryAmount Date Number Balance
Direct Materials 12337Direct Labor 0.00Direct Expenses 1958Total Direct Costs 14295Manufacturing Overhead 2700Other Overhead
Salaries and wages 1922Admin cost 1682Depreciation 1802
Total Cost 22400
Product Costs
Direct Labor Direct Expenses
Units Shipped
A Co applies overhead based on direct- labor hours. Total estimated overhead for the year is Rs 640,000. Total estimated labor cost is Rs 1,400,000 and Total estimated labor hours are 160,000.What is the Co’s predetermined overhead rate?
Overhead Application Example
Rs 640,000
160,000 direct-labor hours (DLH)POHR =
POHR = Rs 4.00 per DLH
For each direct labor hour worked on a job, Rs 4.00 of factory overhead will be applied to the job.
Overhead Application Example
POHR =Budgeted manufacturing overhead cost
Budgeted amount of cost driver (or activity base)
Direct and Indirect CostsExample
Direct Costs:Assembly Department Rs75,000Finishing Department Rs55,000Indirect Costs:Maintenance Department Rs40,000Personnel Department Rs20,600
Assume that Maintenance Department costs areallocated equally among the production departments.
How much is allocated to each department?
Direct and Indirect Costs Example
AllocatedRs20,000
MaintenanceRs40,000
AssemblyDirect Costs
Rs75,000
FinishingDirect Costs
Rs55,000
Rs20,000
Relationships of Types of Costs
Direct
Indirect
Variable Fixed
Price-Volume-Profit AnalysisAn Example
Price-Volume-Profit AnalysisAn Example
Present Sales Price 5.00Present Variable costs 2.00
Contribution MarginPresent Fixed costs 150,000
Unit VolumePresent 150,000
Expected with price reduction 170,000 Profit
PresentExpected with price reduction
•What is the present profit•If the sales price is reduced by 10%, what will happen to profits (with no change in unit volume)?•If the sales price is reduced by 10%, what will happen to profits (with an increase in volume to 170,000 units)?
EFFECT OF TECHNOLOGY ON PRODUCT PROFITABILITY
PRODN/SALESEXISTING TECHNOLOGY
150 250 350REVENUES 1500 2500 3500 VARIABLE COSTS 750 1250 1750 FIXED COSTS 1000 1000 1000NOI -250 250 750
IMPROVED TECHNOLOGY150 250 350
REVENUES 1500 2500 3500 VARIABLE COSTS 450 750 1050 FIXED COSTS 1540 1540 1540NOI -490 210 910
SALES 40% 40%NOI 200% 333%
DOL 5 8.325
Activity-Based Costing
Not all products or services share equally in activities.
The more complex a product’s manufacturing operation, the more activities and cost drivers it is likely to have.
Activity-Based Costing System
Overhead Costs
Products
Assem-bling
Cost Pool
Number of
Parts
Inspecting and
Testing Cost Pool
Number of
Tests
Painting Cost Pool
Number of
Parts
Super-vising
Cost Pool
Direct Labor Hours
Ordering and
Receiving Materials Cost Pool
Number of POs
Setting Up
Machines Cost Pool
Number of
Setups
Machining Cost Pool
Machine Hours
Value Added Time
VAT comes from the processing time and includes cost of direct materials and conversion costs.
Value-Added versus Nonvalue-Added Activities
Value-added activities increase the worth of a product or service to customers.
They involve resource usage and related costs that customers are willing to pay for.
Value-added activities are the functions of actually manufacturing a product or service.
Examples include engineering design, machining, assembly, painting, and packaging.
Value-Added versus Nonvalue-Added Activities
Nonvalue-added activities are production- or service-related activities that simply add cost to, or increase the time spent on, a product or service without increasing its market value.
Examples include the repair of machines, storage of inventory, moving of materials, maintenance, and inspections.
WAT
WAT consists of Set-up time (SUT), Inspection time (IT), Movement time (MT), Waiting time for the warehouse (WT), Storage time until sale (ST), which includes warehouse and distribution costs and other waste added cost (OT) denominated time like rebates, discounts, special deals or zero percent finance and sale returns.
Often Collection time (CT) is also included in the WAT.
WAT
WAT (= SUT + IT + MT + WT + ST + OT + CT) has to be minimized without unduly destabilizing the business, scale and scope.
Direct Labour
Direct Labour
SpaceSpace
Support Labour
Support Labour
InventoryInventory
Defects Defects
Capital Equipment
Capital Equipment
30-80%30-80%
20-60%20-60%
30-70%30-70%
50-80%50-80%
30-70%30-70%
50-80%50-80%
Direct Material
Direct Material
20-60%20-60%
How organizations save on major cost drivers
Value-Added Analysis
Planning Time
Move Time
Wait time
Setup Time
Process Time
Move Time
Inspection time
Total Production Cycle Time
Only the Process Time is Value-Added
Value-Added Analysis in Manufacturing
95% 5%
Non-Value-Added
Value Added
97.5% 2.5%
Non-Value-Added
Value Added
Company Concentrating on Improving Value-Added Performance
50% 50%
Non-Value-Added
Value AddedValue Added Management
Target
World Class Manufacturer
What is benchmarking ?
Benchmarking is a continuous process of measuring products , services , and practices against the toughest competitors or those companies recognized as industry leaders ( Best in class ).
The search for industry best practice and use them to achieve superior performance.
Benchmarking involves
Learning
Share information
Adopting best practices to improve the performance.
Why should we benchmark ?
The Basic purpose is to promote excellence , generate new levels of performance, and new standards in the organization.
To know as to how does your company rate to others in the industry.
To improve products , numbers , processes. Fast learning Competitive advantage.
Who should we benchmark with ?
Internal Benchmarking.
Benchmarking with competitors.
Best in Industry.
Cross Industry.
Benchmarking Costs ofKey Value Chain Activities
Focuses on cross-company comparisons of how certain activities are performed and the costs associated with these activities
Purchase of materials Payment of suppliers Management of inventories Training of employees Processing of payrolls Getting new products to market Performance of quality control Filling and shipping of customer orders
Procure Products
Identify appropriate
Products
Buy Products
Documentation
Product Design benchmarking
START Define Scope
of analysis
List the asslysTo be
benchmarked
Identify the current cost
View / Describe asslys.
Identify Prod differences.
View the Benchmarking
Product
List all visible Diff for
Function,valueProduct design.
Drive CR ideas
Br.down Diff into customerRelevant Features
Less customerRelevant
Features.
Assessment of Scope Compression Prod available
Assessment of own prod v/s benchmark
Cost reduction ideas
How applicable is CR in your company. Have you in last three years taken an
initiative which yielded 15 to 20% CR Are you able to reduce cost by 5%
consistently (beyond industry decline) Have you discussed with your supplier on
his economics and “should be the cost” Do you re-evaluate your supplier base to
explore better prices Is your SCM team the best and closely
integrated with other key functions .
How applicable is CR in your company Have you in last 5 years pursued an
initiative to reduce the mfg cost by 5 % Do you have a clear KPI based tracking
mechanism for cost Do you know the level of the costs in the
plant Do you have at least 10 important cross-
functional initiatives on going at any time in your plant.
3.55.9
28.7
65.5
10.5
32.5
4.53.5
0
10
20
30
40
50
60
70
Localisation. Better Buying. IndirectPurchase.
Logistics.
Val
ue
in M
i R
s.
05-06 Actual 05-06 Plan
Sr. Description. 05-06 Plan 05-06 Actual
1 Localisation. 32.5 28.7
2 Better Buying. 10.5 65.5
3 Indirect Purchase. 4.5 5.9
4 Logistics. 3.5 3.5
Total 51.01 103.51
Cost Performance – Year 2005-06
Achievement - 203%
Cost Performance Plan – Year 2006-07
Localisation.
Better Buying.
Indirect Purchase.
Logistics.
18.5 Mi Rs
29.4 Mi Rs
3 Mi Rs
4 Mi Rs Plan for Year 2006-07
Business Plan - Rs. M 38.0
Target - Rs.M 54.90
Plan till Oct - Rs.M 27.6
Actual till Oct - Rs.M 35.3
Total CR Plan – Rs. M 54.9
CR Avenues & Performance - TYA
Activity-Based Costing Activity-based costing (ABC) allocates
overhead to multiple activity cost pools and assigns the activity cost pools to production by means of cost drivers.
In ABC, an activity is any event, action, transaction, or work sequence that causes the incurrence of cost of a product or a service.
A cost driver is any factor or activity that has a direct cause/effect relationship with the resources consumed.
Activity-Based Costing ABC allocates overhead in a two-stage
process: Overhead is allocated to activity cost
pools, each of which is a distinct type of activity,
Overhead in the cost pools is assigned to products using cost drivers which represent and measure the number of individual activities undertaken or performed to produce products or render services.
Unit Costs under ABCActivity-based costing involves the following
steps:1 Identify the major activities that pertain to the
manufacture of specific products and allocate manufacturing overhead costs to activity cost pools.
2 Identify the cost drivers that accurately measure each activity’s contributions to the finished product and compute the activity-based overhead rate.
3 Assign manufacturing overhead costs for each activity cost pool to products using the activity-based overhead rates (cost per driver).
Computing Overhead Rates
Availability and ease of obtaining data relating to the activity cost driver is an important factor that must be considered in its selection.
The activity-based overhead rate is computed as shown below:
Estimated Overhead per
Activity
Expected Use of Cost Drivers per
Activity
Activity-based Overhead Rate =
Benefits of ABC The primary benefit of ABC is more
accurate product costing because ABC leads to more cost pools used to assign overhead costs to products.
ABC leads to enhanced control over overhead costs. Many overhead costs can be traced directly to activities. Thus, managers become more aware of their responsibility to control the activities that generate costs.
Benefits of ABC ABC leads to better management
decisions. More accurate product costing helps in setting selling prices and in deciding to whether make or buy components.
Activity-based costing does not, in and of itself, change the amount of overhead costs.
Limitations of ABC ABC can be expensive to use. ABC
systems are more complex than traditional costing systems.
Some arbitrary allocations continue. Certain overhead costs remain to be allocated by means of some arbitrary volume-based cost driver.
Activity-Based Management Activity-based management (ABM) is
an extension of ABC from a product costing system to a management function that focuses on reducing costs and improving processes and decision making.
A refinement of activity-based costing used in ABM is the classification of activities as either value-added or nonvalue-added.
Activity-Based Management Activity-based management (ABM) is
an extension of ABC from a product costing system to a management function that focuses on reducing costs and improving processes and decision making.
A refinement of activity-based costing used in ABM is the classification of activities as either value-added or nonvalue-added.