LECTURE 11 INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING

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1 LECTURE 11 INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING Deficiencies of Traditional Management Accounting Thus far covered cost accounting referred to as traditional management accounting techniques. Commonly acknowledged limitations of traditional management accounting and the new techniques that have resulted include: o Traditional systems were set up in a direct-labour-intensive manufacturing environment. Consequently, using overhead allocations based on direct-labour (or other volume-related bases) in a highly automated environment leads to inaccurate, non-representative product costs, and potentially bad business decisions. The problem is exacerbated because in an automated environment overhead is typically a higher percentage of manufacturing cost than in a traditional environment. (Activity based costing and management) o Product costs have included manufacturing costs only. A wider view recognises that much of the product's cost occurs in the design and development stage, and further that additional expense here can lead to savings in other areas. (Activity based costing, life-cycle costing, value-chain analysis) o The requirements of external reporting have dominated management accounting in the past. While it is still necessary to provide information for inventory valuation, in addition relevant information for decision-making is needed. (Cost concepts such as opportunity costs, relevant costs, marginal costs) o Management accounting in the past has been reactive. A firm made a decision to produce a product, and the management accountant was then called on to provide the costing for that product. In today's competitive environment, it is necessary for management accounting to take a more proactive role. Consequently, the strategic role of the management accountant is becoming increasingly important as the accountant provides management with information to enable the firm gain a sustainable competitive advantage. (Target costing, strategic cost management focus, marketing issues) o In the past, management accounting systems have focused on cost control (as evidenced by the emphasis placed on variance analysis). Today's systems still include cost control via traditional measures such as variance analysis, but also emphasise the reduction and elimination of non-value adding costs. (Value added, customer profitability analysis, total quality management, continuous improvement, business process re-engineering, just-in-time inventory) o Traditionally performance evaluation has focused on accounting measures, e.g. return on investment; achieving favourable variances etc. These accounting measures are primarily of interest to the principal stakeholder, viz. the owners/shareholders. While bottom-line profit is still important, it is recognised that there is a need to focus on other critical success factors for the firm (such as quality, customer satisfaction etc.) Consequently for certain decisions, non-financial indicators are required in addition to financial measures. (Non-financial performance indicators, balanced scorecards, benchmarking, best practice) o Past management accounting information systems have focused on accumulating data internal to the firm. The challenge in today's global market and highly competitive environment is to be able to supplement internal data with data from external sources (market-related information, customer information, competitor information). o Almost exclusive focus on manufacturing firms. The majority of accountants will be working in nonmanufacturing firms, and consequently techniques need to be adapted to the service industry. Value Engineering Value engineering includes value chain analysis, and involves analysing products, processes and costs with the objective of changing the way firms do things, and therefore reducing cost while at the same time maintaining customer satisfaction. o It is important that any changes should not remove activities (and therefore costs) resulting from what customers value, therefore value engineering revolves around the concept of value-added and nonvalue added activities and costs. A feature of the target costing technique. Value Chain Analysis An analysis of the firm's value chain provides potential for cost reduction. A firm gains competitive advantage is by performing all value chain functions (not just the production function, which has been the focus of most weeks of the course) more efficiently than its competitors. Furthermore, analysis of the value chain also yields cost reduction opportunities relating to:

2 o Linkages in the chain. For example, spending more in the design stage may mean savings greater than that amount in later stages. o The extended value chain. Strategies can be extended back to suppliers (e.g. setting contracts for supply of materials), or forward to customers (not just customer service, which is part of the value chain, but consulting customers in advance of production to find out what they value). o Re-engineering the way things are done. For example, instead of transporting A to B, move B to A. (Business process re-engineering) Value-added and non-value added A value added activity is an activity which, if eliminated, would reduce the worth of a product or service to the customer. The activity adds value for the customer, and the customer is willing to pay for the activity. A non-value-added activity increases the time spent producing the product, creates additional cost, but does not increase the worth of the product to the customer. o Elimination of the activity means that costs would decrease without affecting the market value or the quality of the product. Lecture Example Determine whether the following activities from the clothes-dryer assembly product line are value-added or non-value added. (a) (b) (c) (d) (e) (f) (g) (h) Time-consuming moving of component parts from warehouse to assembly line. Assembling the tumbler unit. Expediting materials to the door-assembly area because of stock-balance error. Assembling the dial-presentation component. Inserting the owner's manual and instruction guide in the dryer package. Reworking faulty latches on doors. Testing the operating capabilities of the assembled unit. Packaging the clothes dryer in a breakage-resistant box. Costs of Quality Measurement of quality in traditional systems has focused on items such as: o the planning and control of production costs (variance analysis) o accounting for spoilage (which assumes that some level of spoiled product is acceptable and consistent with efficient production, and aims to control abnormal spoilage). Some of today's firms strive for total quality management (TQM) production, which says that the only acceptable level of spoilage is zero. Costs of Quality There are four costs of quality for a firm: (1) prevention costs (2) appraisal costs (3) internal failure costs (4) external failure costs A cost advantage is sought by a TQM firm based on the principle that prevention costs are less than correction costs. In other words, costs incurred in the prevention stage will be more than compensated for by savings in the costs of failure. o TQM firms will be hoping to see the amounts spent in the four areas above decreasing as the firm moves from (1) to (4) to the ultimate stage when the only cost incurred is (1). The employment of quality as a strategic tool for competitive advantage involves recognition of issues such as the following: o Expenditure on prevention costs has not been attractive in the past because of the short-term focus of traditional systems. Cost-savings lag cost-increases sometimes by lengthy periods. o Actual costs of poor quality in the past are probably higher than is recognised because of the multiplier effect on external failure costs. The firm may know the amount of goods that had to be replaced, but do not know how much lost custom has resulted because dis-satisfied customers o Firms may be slow to change because of the funds already committed to "fixing" the problem (eg. inspection systems, reworking etc.). Short-term profitability can be improved by incurring costs in the wrong area, ie. by continuing to "fix" rather than "prevent".

3 Continuous Improvement A TQM environment is characterised by "continuous improvement". o For example, a firm may start its quality improvement by focusing on problem areas - "on time delivery". Initially the firm will select performance measures to address that problem. The measure may be "percentage of on-time deliveries", and the target may be "70%". As things improve, the target moves higher (now "95%"). o Once on-time delivery is improved, we change our focus. Lecture Example Classify the following costs as prevention, appraisal, internal failure or external failure. a) Line inspection b) Normal spoilage identified c) Design engineering d) Returned goods e) Product testing equipment f) Customer problems and complaints g) Rework of faulty products prior to sale h) Preventive maintenance i) Product liability claims j) Incoming materials inspection k) Breakdown maintenance l) Product testing labour m) Training n) Warranty repair o) Supplier evaluations Reduction Inventory Just in Time Inventory Systems With the new focus on cost leadership and value-adding, firms are realising that holding inventory is frequently a "non-value-added" activity and cost. Therefore cost can be reduced by reducing inventory, or in the extreme case, as under JIT, eliminating it altogether. A JIT system implies that physical material moves along the production line only in response to customer orders, rather than being pushed into production only to be stored in warehouses. It is sometimes called a "demand pull" system. Firms sit somewhere on a continuum from just in case to 100% just in time, with various number of inventory accounts. o Just in case firms will have Materials, WIP and FG. Others will combine their Materials and WIP into a RIP account (raw materials in process). Others will have a FG account, and still others at the extreme may have none of the above, i.e. only produce to order, so the job can be immediately expensed. Life Cycle Costing Better decision-making will occur, resulting in potential cost reduction, by considering the life-cycle costs of the product rather than just manufacturing costs. o It is particularly important to focus on the upstream costs, because a large percentage of the product's cost is incurred and/or locked in at this early stage. o The high cost items tend to be product design, prototyping, process design, equipment acquisition. More spending here can save cost later. Life-cycle costing is a system that: tracks and accumulates the costs (and revenues) attributable to each product from "inception to abandonment". focuses on the profitability of a particular product to the end of its economic life. differs from traditional costing in that profitability is not measured over the artificial accounting period only. differs from traditional costing in that it considers all estimated costs (the cost of all functions in the value chain - upstream costs in design and development, and downstream costs in marketing, distribution, customer service) not manufacturing costs only.

4 Target Costing Whether firms are price-setters or price-takers, product prices have typically been determined using some variation of the formula: Selling price = cost price + mark-up. Thus it can be said that prices "react" to costs. Target costing is a "proactive" and revolutionary costing technique which effectively goes the other way - cost is determined by first considering the product's price. Target costing differs from traditional costing in two other ways: o It is employed before a product is ever designed, engineered or produced, ie. prior to the production phase. o It considers all costs in the product life cycle, not only manufacturing costs. Target costing is a systems approach which begins with a desired competitive market position and moves back to an operating level (of both costs and efficiency) which will support that outcome. Firms which employ target costing place priority on the desired result, and then design and manufacture products to meet the cost and therefore the price needed for success. Improvements in terms of cost savings are "forced" on manufacturing practices to meet these market-aligned expectations. o The following steps are involved: Establish the target market price. Market research techniques are employed to estimate what the market is prepared to pay for the proposed product. Market share will be considered in arriving at the target market price. An acceptable profit margin is determined. The target cost is calculated: Target market price less profit margin Given a particular design specification, planners develop estimates for each of the elements that make up a product's costs (design, engineering, manufacturing, sales, marketing) and a total estimated cost of the product. The target cost is compared with the estimated cost to determine whether the firm is able to manufacture the product for the target cost. If estimated cost is greater than target cost, the firm considers ways of reducing production costs: o Re-designing the product o Process changes o Change of inputs o Change of suppliers o Other cost reduction techniques discussed above Lecture Example A firm currently sells its product for $125. The firm requires a 30% profit margin (on sales). A competitor has introduced a new product which will sell for $70, so management believes it must lower its price to be competitive. If costs per unit are currently $52, suggest some strategies for the firm. Steps: (1) Determine the target price. (2) Calculate the target cost. (3) Calculate the current cost. (4) Perform value engineering. Customer Profitability Analysis (CPA) Traditionally firms have reported revenues and costs by department or product line, but not by customer group. In more recent times,, firms began to see that different customers or customer groups incurred costs such as ordering, delivery costs, invoicing costs etc in different ways. Customer profitability analysis, therefore, is a cost reduction technique aimed at reporting costs that reflect the way customers differentially use the resources of the firm. o The purpose of the analysis is to identify profitable and non-profitable customers, and target strategies specifically to the different categories of customers. This may include strategies aimed at removing non-profitable customers from the firm s customer base, but it may instead propose strategies for changing non-profitable customers into profitable ones.

5 Performance Evaluation Financial Measures The focus on financial measures is natural because the interest of the major stakeholder in the firm (the owner) is on bottom-line profit and firm value. These measures will continue to be used, but they have a large number of limitations (they are short-term measures; they can frequently encourage actions that are not in the interests of the firm; they can be manipulated, etc etc). One of the limitations is that financial measures are "lag" indicators, meaning that the firm knows about them "after the event". In today's highly competitive environment, it is desirable that firms employ some measures that are "leading indicators". Therefore, firms tend to supplement their financial performance measures with non-financial performance measures. o Not all non-financial measures are leading indicators - many non-financial measures are also lag indicators. o Despite this, non-financial indicators have other advantages, primarily that they focus on the areas that are crucial to the firm's success. Critical Success Factors Performance measures should be tied to the critical success factors, i.e. those factors which are identified as being critical to the firm s success. They include (but are not limited to) items such as the following: Reduction in cycle time Low cost Quick response Order processing Product design Customer satisfaction Customer service Quality Inventory management Productivity The problem with an exclusive focus on financial measures is that most of them do not address these items, which the firm has determined are critical for their success. The challenge is to arrive at a mix of measures (both financial and non-financial) that provide useful information in terms of evaluating performance, but also are useful in terms of improving current period's performance Non-Financial Indicators (NFI) For this unit you are not required to learn off a list of NFIs. However, you should be able to suggest some ways of measuring whether the firm has been successful in that area, e.g. o Customer satisfaction, could be measured by: Survey % of repeat purchases (the higher the better) o Quality could be measured by: Number of product returns (the lower the better) % of returns (the lower the better) % of reworked items (the lower the better) Number of customer referrals (the higher the better)

6 Balanced Scorecard The balanced scorecard is an approach to performance evaluation which explicitly recognises that the organisation is comprised of a number of stakeholders, each with a different view of the organisation and what is an important measure of success, o shareholders will be interested in profit o top management is interested in satisfying corporate objectives o supervisors on the shop floor are interested in operating measures o customers are interested in prompt delivery The balanced scorecard is a single report that allows managers to look at the business from a number of different perspectives. The first scorecard proposed included the following four perspectives, but a firm could design a scorecard to suit their particular circumstances: o A financial perspective (how do we look to shareholders?) o A customer perspective o An innovation and learning perspective (can we continue to improve and create value?) o An internal business perspective (excelling at all stages in the value chain) Having chosen the perspectives the firms wish to measure they will then select the appropriate mix of financial and non-financial performance measures to report on those perspectives.

7 TUTORIAL QUESTIONS QUESTION 1 Classify the following costs as prevention, appraisal, internal failure or external failure. (To save time in tutes, tick the appropriate column on the worksheet.) Line inspection Normal spoilage identified Design engineering Returned goods Product testing equipment Customer problems and complaints Rework Preventive maintenance Product liability claims Incoming materials inspection Breakdown maintenance Product testing labour Training Warranty repair Supplier evaluations QUESTION 2 What are firms trying to achieve by identifying costs as above? QUESTION 3 Beauty Bath Products Pty Ltd manufactures a variety of bath and beauty products for specialty stores. The company has recently introduced the concept of identifying cost of quality and has identified the following costs for the month: Training of quality control supervisors $10,800 Customer complaints $5,500 Inspection of purchased ingredients $3,600 Rework time $7,000 Cost of defective products that cannot be reused $6,000 Laboratory testing for safety (prior to commencing manufacture) $9,000 Product liability $500 Required: a) Prepare a Cost of Quality Report in good form. Show the report in dollars, as a percentage of total costs, and as a percentage of sales (sales are $750,000) for the four cost categories. b) Discuss the report, including suggestions for reduction of costs for Beauty Bath Products P/L.

8 QUESTION 4 Reuter Avionics currently sells radios for $1,800. It has costs of $1,400. A competitor is bringing a new radio to market that will sell for $1,600. Management believes it must lower the price to $1,600 to compete in the market for radios. Marketing believes that the new price will cause sales to increase by 10%, even with a new competitor in the market. Reuter's sales are currently 1,000 radios per year. Required: (a) (b) (c) (d) (e) Describe target costing. How does it differ from traditional costing? In what ways is value engineering related to target costing? What is the target cost per unit if target operating income is 25% of sales? Given the answer to part (c), and given the facts in the question, what possible actions in relation to the product are available for the firm? What is the primary reason a firm would adopt target costing?

9 PRACTICE QUESTIONS

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