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Why Strategic Cost Management is important for every business?

Varun Hariharan

| Updated: Dec 02, 2020 | Category: CFO Service, Finance & Accounting

Strategic Cost Management

Traditional cost management program involves the allocation of costs and overheads to production, which primarily focuses on cost control and cost reductions. The underlying premise was that a company could achieve greater income with lower costs (direct) and overheads. It involves comparing the real outcomes with the conventional standards (typically budget or standard costs) and evaluating the discrepancy.

But a traditional cost management system suffers from a number of limitations:

  • Cost control and reduction is the main emphasis. In today’s market environment, however, a broad cost reduction plan does not work effectively. If a corporation decides to minimize marketing spending by, say, 20 per cent across all product categories, the sales of profitable goods are also likely to be affected.
  • Traditional cost control program has an internal emphasis and does not look at external factors such as competition, market growth, consumer demand, etc.
  • A broad-based cost reduction could lead to poor product & service quality that could drive consumers away, leading to lower revenue and profitability.
  • Current consumer expectations are very different. Excessive emphasis on cost reduction may impact product and service quality, and alienate customers.
  • Traditional cost accounting systems rely on accounting data that can at times be misleading. Financial statements may be a fantastic tool for reporting, but they may not be able to help with strategic decision making. It does not recognize marketing and economic complexities.
  • Minimum emphasis is placed on updating and improvising current procedures and activities.
  • Traditional cost management is a reactive approach to cost management and it has a short-term outlook, for example, saving costs on an annual basis.

Why does strategic cost management come into the picture?

In the current market environment, cost control is not enough and a company needs toconcentrate on strategically managing costs. Today, companies operate in a world of strong competition, rising customer demands for premium goods and innovation in technology. Afirm’s primary aim is to gain better profits and build value for shareholders. Compared to the competitors, this can be accomplished by superior performance which results in distinctive competitive advantages.

Strategic cost management is the implementation of cost management strategies to boost a company’s strategic position as well as control its costs. It also deals with combining cost information with the system for decision-making to support the organizational strategy as a whole. It is not only restricted to controlling costs but extends its scope to the use of cost information for decision-making purposes by the management.

The methods of cost management should be such that they strengthen an enterprise’s strategic position apart from concentrating on cost control. The basic goal of strategic cost management is to help the company achieve a competitive advantage in a sustainable manner through product differentiation and cost leadership.

Strategic cost management focuses more on continuous enhancement to provide consumers with superior quality products. Strategic cost management needs to be part and parcel of the value chain. This must cover all aspects of production, procurement, design, manufacturing, distribution and operation. Indeed, it is important to include strategic cost management at the early stages of a product development process so as to reduce high failure costs.

Let us take an example to understand the significance of strategic cost management over the traditional system of cost management. The financial statements of a company producing products A & B reveal the following information:

ParticularsProduct AProduct B
RevenueRs. 120lacsRs. 70lacs
Less: Cost of Sales70lacs50lacs
Gross Profit50 lacs20 lacs
Less: Overheads costs10lacs24lacs
Net Profit40 lacs– 4lacs (loss)

If the company ceases to manufacture product B, the sale of product A would fall down by 25%.

Now, if the information detailed above is merely approached using a traditional cost management method,the company might decide to cease the production of Product B because it has a very high overhead cost and also results in a net loss of Rs.4 lacs. Therefore, on the face of it, it appears to be prudent to close down the production of Product B.

However, by combining the data with additionally provided information that the sale of product A would fall down by 25% if Product B is not sold, the decision might change. The company would lose Rs.10 lacs (25% of 40 lacs) because of declined sales of Product A. The net loss for the company if it decides to ceasethe production of Product B is Rs.6 lacs (4 lacs of savings from Product B and 10 lacs of loss of profits from Product A). Hence, the decision to stop the production of Product B isnot prudent.

Thus, strategic cost management can be described as “managing the use of cost information that is specifically directed to one or more of the four strategic management stages”:

  • Formulating strategies
  • Developing and implementing controls to monitor the success of objectives
  • Developing and carrying out tactics to implement the strategies
  • Communicating those strategies throughout the organization

This is cost analysis in a wider sense where the strategic factors are more explicit and structured, aimed at improving the competitive position of the company. Cost data is analysed and used strategically to establish alternative measures to achieve sustainable competitive advantages. Strategic cost management helps to recognize the overall cost relationships between the value chain activities and the process of managing these relationships to the competitive advantage of the company.

Traditional vs. Strategic cost management

BasisTraditional CostManagementStrategic Cost Management
Time SpanShort term conceptLong term concept
FocusInternalBoth internal and external
Cost DriverConceptDependent on volume of the productEach value activity has a distinct and separatecost driver. Hence, not dependent onvolume but on activities associatedwith themanufacturing of theproduct.
ObjectiveScore-keeping, directingattentionand problem-solving.Cost leadership or product differentiation
Cost ReductionThe primary objective is cost reduction.The primary objective is cost containment – cost reduction and value improvement at the same time.
ApproachRisk-averseRisk-taking and the capability to adaptitself with changingenvironment

Components of Strategic cost management

The concept of strategic cost management revolves around three business themes, namely Value Chain analysis, Cost driver analysis and Strategic positioning analysis.

  • Strategic positioning analysis
  • Cost driver analysis
  • Value Chain analysis[1]

Strategic Positioning Analysis:

Strategic positioning analysis is a company’s relative position within its industry with regard to matters related to performance. It depicts the choices that a company makes about the type of value it shall create and how that value would be created differently than competitors. Strategic positioning analysis is concerned with the potential impact of external and internal environment on the company’s overall strategy.

It is necessary to take account of the future and to gauge whether the current strategy is a suitable fit with the strategic position or not. The strategic positioning of an organization involves the devising of the optimal future position of the company on the basis of current and expected developments; and the making of plans to achieve that positioning. The following factors influence the strategic position of a company:

  • External Environment
  • Internal Environment (Resources and Competencies)
  • Organisation Values, Culture and Systems

The external environment can be analysed by using popular models such as PESTEL (Political, Economic, Social,Technological, Environmental and Legal factors) and Porter’s 5 forces.

Cost driver analysis:

Cost is influenced or driven by several factors which are interrelated. Cost is not a simple function of volume or output as is suggested by traditional costing systems. Cost driver concept is described in two broad ways in the parlance of strategic cost management, i.e., Structural cost drivers andExecutional cost drivers.

Structural cost drivers are referred to as the organisational factors that affect the costs of a product. Such factors drive the costs of an organisation in varied ways. The scale and scope of operations of a firm will impact the costs. Apparently, a larger scale of operations is likely to provide an advantage in terms of economies of scale. The use of technology and complexity of operations also determine the costs of different activities within a business firm.

Executional cost drivers are dependent upon the company’s operational decisions on how the various resources are employed to achieve the goals and objectives. Such cost drivers are determined by management style and policy. Some of the examples of Executional cost drivers arethe participation of the workforce towards continuous improvement, the importance oftotal quality management, efficiency of plant layout, etc.

In the case of strategic analysis, the volume is not always the most appropriate way to explain costs. Sometimes, it is more relevant to explain costs based on strategic choices and defined execution skills.

Value Chain Analysis:

Value chain analysis is a strategic tool that is used to identify internal firm activities and is a process by which the firm analyses several activities which add value to the final product. It seeks to locate those activities which do not add value to the final product or service and eliminate such non-value adding activities.

The goal of value chain analysisis torecognize, which activities are the most valuable (i.e. are the source of cost or differentiation advantage) to the business firm and which ones could be improved so to provide a competitive advantage. Resources should be deployed in those business activities that are capable of creating products valued by consumers. Cost leadership can be achieved through techniques such as target costing. Product differentiation is directly proportional to the market movements and changing business requirements.

A company’s activities can be generally divided into primary and secondary activities. Primary activities are those which are involved specifically in the transformation of inputs (raw material) into outputs (finished products) or in the provision of services. The primary activities are supported by secondary activities (also called support activities) such as technological development, human resource management, firm infrastructure, etc. Althoughsecondaryactivities are not directly involved in the manufacture of products, it does not imply that they are of less significance as compared to primary activities.

Takeaway


Strategic cost management should be inherent in each stage of the life-cycle of a product, i.e. during the product’s growth, production, delivery and service life.A well-designed cost management strategy allows the managers to reap maximum value in the form of direct savings. It isan effective way of reducing cost, improving revenue and facilitating survival in the competitive world.

Read our article:A Strategic Approach to Optimise Creditors’ Cost: Management of Payables

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Varun Hariharan

Varun Hariharan has completed the Legal Practice Course from BPP Law School, Manchester. He has a Masters in Commercial and Corporate Law from the Queen Mary University of London and LLB Honours from Bangor University, UK. He specialises in law related to corporate, artificial intelligence and technology law.

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