1 Chapter 13 Strategic Cost Management IDIS 424 Spring 2004

2 Cost-related Concepts A cost driver is any factor that affects costs. A change in the cost driver will cause a change in the total cost Cost management are actions that managers take to satisfy customers while continuously reducing and controlling costs

3 Cost Behavior Cost behavior refers to the way costs change with respect to a change in an activity level or cost driver Typical cost behavior patterns include: Fixed costs Variable costs Mixed costs Semifixed costs Semivariable costs

4 Cost Behavior Patterns Fixed costs are costs that do not change with changes of a cost driver Variable costs are costs that increase directly and proportionately with changes of a cost driver Mixed costs are costs that have both a fixed and a variable component

5 Cost Behavior Patterns Semifixed costs are costs that increase with the level of activity, but by intermittent jumps, rather than continuously Semivariable costs are costs that increase with increasing levels of activity, but not at a constant rate. Can be separated into costs that: increase at an increasing rate increase at a decreasing rate

6 Cost Behavior Patterns Fixed Costs Variable Costs Semifixed Costs Semivariable Costs

7 Total Cost Total cost is the sum of all costs Total costs increase as the volume of production or service increases, while the cost to produce each unit or provide each service decreases

8 Total Cost Total cost specifics: Total fixed costs do not change with volume increases or decreases Unit fixed costs decrease as volume increases Total variable costs increase with volume Unit variable costs may or may not change with volume changes

9 Cost-related Concepts Direct costs are costs that are related to the cost object and can be traced to it in an economically feasible manner Direct materials (e.g., raw materials, purchased components, expendable packaging associated with a given product) Direct labor (e.g., all labor traceable to a given product)

10 Cost-related Concepts Indirect costs are costs related to the cost object but cannot be traced to it in an economically feasible way. Indirect costs are allocated to the cost object using a cost allocation method (e.g., overhead costs) Indirect costs may have both a fixed and a variable component

11 Overhead Cost Assignment Three common overhead assignment approaches include: Overhead cost per direct labor hour Overhead as a percent of direct labor cost Overhead per machine hour

12 SG&A Expenses SG&A expenses that are associated with supporting the interface between buyer and the supplier as well as those expenses that are not directly related to the organization’s primary operations but are required to support these operations

13 SG&A Expenses SG&A will typically include: Sales salaries and commissions Advertising Administrative salaries Research and development SG&A is usually presented as a percentage of annual net sales

14 Prices, Profit, and Revenue Price is the amount that a buyer is willing to pay for a given product or service Profit is the difference between the total cost to produce a product or service and the selling price Revenue (sales revenue) is the product of price multiplied by the quantity sold

15 Cost-related Concepts Sunk costs are those costs already committed to a project or decision An economic cost is the value of a good when employed in an alternative use. For example, specialized tooling used for a discontinued project that has no other alternative use or scrap value has an economic cost of zero

16 Cost-related Concepts Differential costs refer to cost differences between two or more decision alternatives Controllable costs are those costs under the direct control of a manager. A manager should be accountable for only those cost items that he or she has the ability to control

17 Cost-related Concepts Discretionary costs include any cost that can be avoided in the short term Continued cost avoidance, however, can result in the deterioration of a firm’s competitiveness or contribute to higher long- run costs

18 Cost-related Concepts Relevant costs include only those costs having a direct impact on a decision Relevant costs have three necessary characteristics: They must be differential (costs associated with two or more decision alternatives are different or unique) Future oriented (costs will not occur until after the decision is made concerning how to proceed) Quantifiable

19 Price/Cost Management Price analysis examines price proposals without examining elements of cost and profit Cost analysis addresses actual or future costs

20 Goals of Price/Cost Management Develop accurate price/cost information to enhance negotiating effectiveness Drive continuous price/cost improvement Effectively beat out the competition Determine type of supplier relationship

21 Approaches Price/Cost Management Approaches Market Based PricingCost Based Pricing Non-collaborativeCollaborative

22 Approaches Market-Based Pricing The price the buyer pays is not linked to the supplier's cost structure Cost-Based Pricing The price the buyer pays is directly linked to the supplier's cost structure Hybrid Some elements of cost may be known by the buyer

23 Market-based Pricing Based on supply and demand Suppliers and buyers determine the price according to what either suppliers are asking or buyers will offer

24 Market-based Pricing Approaches Market testing Initial price determined by competitive bid, and on-going negotiations thereafter Quantity discounts Volume consideration linked to price Longer term agreements linked to price Price change control Ceilings established on future price changes Reverse price analysis

25 Reverse Price Analysis Hypothetical Price $20 Profit / SG&A Allowance (15%)-$ 3 Subtotal$ 17 Direct Material- 4 Subtotal$ 13 Direct Labor- 3 Manufacturing Burden$ 10 X TOTAL VOLUME = TOTAL FIXED COST (Will vary as volume changes)

26 Cost-based Pricing - Non-collaborative Market-testing - initial contact through bid and on-going negotiations Target pricing - established ceiling cost to achieve a competitive position in the market for the finished product Supplier uses target price as a basis for accepting the order

27 Cost-based Pricing - Collaborative Cost identified - margin or ROI negotiations Identification of cost drivers Targeted goals Establishment of value added / non-value added costs Continuous cost improvement (collaborative)

28 Supplier Pricing Issues Pricing objectives Long-term versus short-term Price leader versus follower Establish entry barriers Pricing Strategy Cost based pricing (cost + fixed markup) Market based pricing (penetration, skimming, floor pricing)

29 Pricing Strategies Demand (skimming) pricing Introduction and growth of life cycle “What the market will bear” Works under conditions of no competition Cost-plus (penetration) pricing Maturation stage of life cycle Minimum acceptable price Appeals to a mass market with objective of sales increase

30 Pricing Strategies Survival pricing Price remaining capacity at marginal cost Market share pricing Used to take market share from competitors Social responsibility pricing Forgoes sales and profits - puts society first Rule-of-Thumb (myopic) pricing DM + DL + 40% Buy-in (foot in the door, low ball) pricing Cover VC only

31 Pricing Variables External Nature of the product (life cycle) Seller’s market characteristics Buyer’s control variables Internal Seller’s internal characteristics Management orientation Accounting and costing methods

32 Measures of Price Management Effectiveness Types of measures include: Percent improvement of price paid over inflation Percent improvement of price paid vs. prior year Target prices achieved Ratio of actual price change improvement to comparable market index change

33 Problems with Traditional Cost Accounting “Standard” product costs No recognition of tradeoffs Product cost structures Allocation of overhead fixed Budgeting and control Labor efficiencies / machine utilization

34 Assigning Indirect Costs Supervision $1000 Cooling Fluids $2000 Rags $200 Electricity $1500 Direct labor-related cost pool = $2500 ($2500/500 hrs)=$5/hr Material weight-related cost pool = $2200 ($2200/220 kg) = $10/kg Products P1 and P2 Total Cost = $425 Direct material Direct labor $15/kg $10/hr

35 Cost Behaviors Fixed Costs Variable Costs Semifixed Costs Semivariable Costs

36 Which supplier would you rather do business with? High Fixed CostsLow Fixed Costs Breakeven Revenues FC VC Breakeven Revenues VC FC

37 Relationship Between Sales and Costs As a supplier’s sales increase... Fixed costs __________ Average fixed costs _______ Average variable costs ________ Total variable costs __________ Total costs __________ Average total costs _________

38 Production Cost Schedules

39 Average Cost Curve

40 Total Cost Curve

41 Price Reductions

42 What Happens to Profit?

43 Price/Cost Management Price analysis examines price proposals without examining elements of cost and profit Cost analysis reviews actual or future costs COST + PROFIT = PRICE

44 Goals of Price/Cost Management Develop accurate price/cost information to enhance negotiating effectiveness Drive continuous price/cost improvement Effectively beat out the competition Determine type of supplier relationship

45 Approaches Market-Based Pricing The price the buyer pays is not linked to the supplier's cost structure Cost-Based Pricing The price the buyer pays is directly linked to the supplier's cost structure Hybrid Some elements of cost may be known by the buyer

46 Market-based Pricing Based on supply and demand Suppliers and buyers determine the price according to what either suppliers are asking or buyers will offer

47 Framework for Cost Management “Unique Products”“Critical Products” “Generics”“Commodities” LowHigh Value (Cost, Service, Administration) High Risk Low

48 Generics Low Value, Low Risk Strategies Standardize / consolidate Critical Factors Reduce cost of acquisition Metrics: Total Delivered Cost Reduction Percent of CGS Improvement Transportation cost reduction

49 Commodities High Value, Low Risk Strategies Leverage preferred suppliers Critical Factors Reduce cost of materials Metrics Price change improvement to market index

50 Unique Products High Risk, Low Value Strategies Preferred suppliers Critical Factors: High costs when cost/quality problems occur Metrics Unit price cost reduction - Actual to actual prices for same items Target prices achieved, “Should cost” $ Total Delivered Cost Reduction

51 Critical Products High Risk, High Value Strategies Strategic supplier partnerships Critical Factors High costs when cost/quality problems occur Metrics Target prices achieved Unit price cost reduction - Actual to actual prices for same items Joint cost savings sharing