While I was thinking on writing on this subject, I could see the possible reactions from the various stakeholders (is this a really big word with respect to costing?). Costing is generally looked upon as ‘we know it all’ in manufacturing to ‘we have never done it’ in service industry. Sometimes people say, in today’s world the price is decided by the market, so there is no need of costing. In India, there is a statutory need for some of the industries to provide cost data on a regular basis to the bodies. I have the experience that if I use the words Activity Based Management instead of Activity Based Costing, people are more ready to listen to. But there are few organizations in India which have undertaken the study of their maturity of cost management. This is what, it prompted to me to think on this topic.
When we talk about costing, there are various techniques that are available in this area. Some them could be Product or customer profitability (activity based costing), strategic cost management, target costing, lifecycle costing etc. Each of this technique has its own way maturing in its use. The levels could be just measuring, managing and optimizing etc. At each of this level the use of the technique could be ‘one off’ or a process used by a few people or it is spread across the organization. So when we are trying to gauge the maturity of the cost management within an organization we can do it, at least across three different dimensions; a) # of techniques used b) level of maturity of the use c) how far it is in operation. Some organizations may be using one or two of them but doing to the most, at the same time it is still in the hands of few people in the organization. Like this the level of maturity would be different in different organizations and across different dimensions. A formal study on this would be very useful to create a ‘best practices’ workbook for the use.
Techniques used – There are various techniques that are available for cost management. Starting from the standard costing, absorption costing to calculate the product costs and variances to activity based costing, target costing, lifecycle costing, strategic cost management etc.
In manufacturing industry the bare minimum use of costing is there for inventory valuation. For this generally the absorption costing method is used, where the expenses booked in the period are charged to the products as manufacturing or admin or sales overheads. The method to charge the overheads to the products is bead on volume drivers. In service industry this is not required statutorily so you wouldn’t find there. Most of the times, the same information is used to understand the product profitability and take the business decisions. And we have seen time and again that this leads to incorrect decisions making.
Some organizations use activity based costing to calculate the product, customer profitability. Here the cost of the cost objects is calculated by calculating the cost of the activities first. The cause and effect relationship is used. The cost objects consume the activities and activities consume resources. Based on this relationship the cost flows to cost objects. This is a better way to arrive at product and customer profitability.
In target costing, the organization looks for introducing a product. Before doing this a market survey is conducted to understand the features that are desired by the target customer segment and the price that they are ready to pay for the same. A study of competitor’s product features and the corresponding price is also done. Based on this information the features of the new products are defined. A target price is decided with an expected profit. So the cost is the resultant factor. Target Price – Target Profit = Target Cost. Once this is done, a cross-functional team is formed to work on the design of the product, material, processing, marketing etc. Vendors are involved in this process. With the help of this team the organization tries to achieve the target cost.
In Lifecycle costing, the organization looks at the costs of the product throughout the life of the product. From the design, R&D, introduction, enhancements to the phasing out of the product. This helps the organization to plan the costs as well the price at various stages of the lifecycle of the product. You can plan the overall profitability of the product and manage the costs accordingly. The similar concept is now being introduced for customers also and called as Customer Lifecycle Value (CLV).
Strategic cost management relates the management of the costs based upon the strategic direction of the organization. I repeat, it is the management of the costs according to the strategy of the organization. Quite often I have seen people confusing strategic cost management as the cost of the strategy. In other words, that will be cost to the organization if they have to take certain strategic decision. This is like a cost benefit ratio. Typically if use the Porter’s concept of competitive strategy, there are two ways, a) Cost leadership b) Differentiation.
In case of ‘cost leadership’, the organization has to manage the costs in such a way that costs are at a minimum level without compromising the value to the customer. For this one can use cost driver analysis, waste elimination etc. Activity based costing can help the organization to understand the non-value adding consumption of resources.
In case of differentiation, the organization looks at capturing the market, beating competition and making money by making differentiation in product features, customer services etc. For this the Lifecycles costing concept can be useful, as it will help the organization to make money on overall life of the product and pricing can be defined at various levels of the life-stage of the product. Activity Based Costing can help here to understand the future resource requirement and costs of the same.
Another way of defining strategy is by ‘target customer segment’ management. In this the organization defines its target customer segment and tries to capture, retain and benefit from the customer segment. In this case the target costing can help the organization to manage the product costs.
Maturity level of the technique – The maturity level can be defined at least as a) measurement b) management c) optimization. One can define more in between each of these levels. The level measurement is where the organization is collecting the data. For example in product costing, the organization is just calculating the cost of the product for inventory valuation purpose. No other use of the information is made. Here the typical argument made is ‘the price is defined by the market and we cannot do anything about it’. Here goes into the trap they neither manage the price nor the costs (which at least is in their hands). Some organizations do calculate the costs and start managing those costs. For example they have budgets at expense level; they have standard costs for products. They compare the actual expense and product costs with the standard periodically find the variance, the reasons for the variance and take action plan to improve upon the ‘unfavorable’ variance. It helps to think of cost-optimization in terms of a weight-loss program -- you may temporarily lose weight on a crash diet, but in order to maintain an ideal weight, you must adopt a healthy lifestyle and diet over the long term. Similarly, only executives who take the time to examine the cost structure throughout their business and embed cost discipline within their organization's culture will see gains that can be sustained over the long term. To do this, organizations need to look at costs across whole processes, not just within functions. Ultimately, this means rethinking the entire business model around lower costs, possibly taking out whole layers of the organization or supply chain, examining customer interfaces, and considering outsourcing, shared services, and off shoring. The focus should be on creating a leaner, more efficient organization, with cost reduction as the consequence, not necessarily the target. The other way of looking at maturity level is the ‘SMILE’ pattern. S – see M – measure I – improve L – Learn E – Evolve.
Operationalization – The third dimension that we mentioned earlier was the opertionalization of the use of the technique. In here we first have to look at how frequently the techniques are used. Sometimes the techniques are used once in lifetime, may be due to the influenced by someone at the top and then it ends there. The word ‘used’ here means used in taking business decisions including defining and managing strategy. Quite a few times we see that there are various variance reports are generated but nobody looks at them seriously. In some cases the information generated is very useful, but it given the status of ‘confidential’ and kept in the hands of few people. What I mean by real operationalization is the technique is used regularly for creating information, used for taking business decisions and provided to the people who are going to take those decisions.
In the current scenario, the operationalization can also be looked from the angle of ‘use of technology’ for the cost management techniques. Spreadsheets are the minimum that people use and they know it is not the best of the ways always. There are various stand alone software solutions are available in the market and use of those does help the organization to make most of the techniques. Going further, the results of cost management techniques can be integrated with other cost techniques or overall performance management methodologies.
The maturity of the organizations can then be plotted as shown below.
The horizontal axis talks about the # of techniques that the organization is using. The Vertical axis talks about the overall maturity of various techniques. The diameter of the circle shows the level of overall operationalization in the organization. When I am saying ‘overall’, it is the combined effect for all the techniques that are used. With this we will try to understand the position of various organizations from the graph.
The organization ‘A’ is using may be only one technique and at a very low level i.e. measurement and it is still not operationalized. Organization ‘B’ is using many techniques but their overall maturity of use is low but they have achieved some progress in operationalization. Organization ‘C’ is using couple of techniques only but achieved best of the overall maturity and operationalization. Organization ‘D’ is using few techniques with middle level of maturity and operationalization. Organization ‘E’ is using most of the techniques at a very high maturity level but not operationalized it.
Once such a study is conducted it will definite help to understand the cost maturity of the organization, industry, geography and help the organizations to see which type of technique at what level of maturity and oeprationalization would help them.
Finally, wish you a happy fools’ day.
