AC206 READINGS Flashcards
Why Measure Costs Less Accurately? Kenneth A. Merchant and Michael D. Shields
Authors’ Argument:
Kenneth A. Merchant and Michael D. Shields suggest that deliberately inaccurate cost systems can sometimes benefit organizations by improving decision-making and influencing behaviors.
Key Points:
Accuracy Defined: Accuracy involves precision (no randomness) and lack of bias (neither over- nor underestimating).
Strategic Inaccuracy: Deliberate inaccuracy, including biases or imprecision, may positively affect organizational outcomes when used ethically.
Example: Cost “padding” in an apparel company helped prevent excessive price discounts by salespeople.
Upwardly Biased Costs: Why use them?Kenneth A. Merchant and Michael D. Shields
To prevent excessive price cuts and protect margins in competitive pricing situations.
Key Example:
Apparel Company: Added hidden cost “pads” to prevent salespeople from giving excessive discounts.
NuTone Housing Group: Overstated labor standards to avoid over-discounting and maintained a 40% cost overstatement for years.
Insight: Managers knowingly used biased costs to influence decision-makers and achieve positive results.
Downwardly Biased Costs: Why use them? Merchant and Shields
To motivate innovation and encourage resource usage.
Key Applications:
Target Costing:
Example: Japanese firms set cost standards lower than historical performance to drive cost reductions and innovation.
Encourages employees to improve efficiency for long-term market competitiveness.
Stimulating Service Usage:
Example: Boise Cascade allocated low costs for PC support to increase adoption of personal computers.
Imprecision in Cost Systems: Purpose Merchant and Shields
Focus employee attention on critical performance areas without overwhelming them with complex data.
Examples of Simplified Systems:
Tektronix: Focused engineers on reducing part numbers using a single cost driver, enhancing product design and reducing development time.
Zytec: Used only two cost drivers to motivate improvements in cycle time and supplier lead time, later reducing to one driver for simplicity.
Hewlett-Packard: Iteratively refined its cost system, balancing simplicity with precision to teach engineers manufacturing economics.
When Accuracy Matters: Merchant and Shields
Situations Requiring High Accuracy:
Developing competitive strategies.
Complex product lines needing precise cost allocations.
Decisions requiring detailed cost data, such as General Motors’ make-or-buy strategies.
Examples:
General Motors used 5,000 activity cost pools and 100 cost drivers for a single plant.
Schrader Bellows developed a detailed system with 28 activity cost pools to align product costs with market pricing.
Ethical and Strategic Use of Cost Systems Merchant and Shields
Key Insights from Merchant and Shields:
Less accurate systems are best suited for implementing strategies rather than developing them.
Behavioral focus: Simplified systems improve learning and motivation by making key goals clearer.
Organizational psychology plays a vital role in designing cost systems aimed at behavior modification.
Example: Simplified cost systems, like those in firms with short product life cycles, help prioritize strategic cost reductions.
Value Chain Concept: Shank and Govindarajan (1992)
Key Definition:
A value chain includes all value-creating activities from raw material sourcing to final product delivery.
Key Points:
Broad Focus: Goes beyond the firm’s internal operations to include suppliers, customers, and intermediaries.
Strategic Importance: Understanding the entire chain allows firms to enhance customer value or reduce costs.
Example: Chevron spans many parts of the petroleum value chain but not the entire process (e.g., it doesn’t produce cars).
Competitive Advantage and the Value Chain: Shank and Govindarajan (1992)
Authors’ Claim:
A firm’s ability to sustain differentiation or cost advantage depends on how its value chain is configured relative to competitors.
Key Insights:
Differentiation: Enhancing customer value at equivalent cost.
Cost Leadership: Providing similar value at a lower cost.
Interconnected Costs: Customer or supplier actions significantly influence firm costs (e.g., steel mini-mills reducing downstream costs).
Example: Japanese VCR manufacturers reduced costs by designing products with fewer parts.
Value Chain vs. Value-Added Analysis:Shank and Govindarajan (1992)
Key Difference:
Value-Added: Focuses internally on maximizing the difference between purchase costs and sales revenue.
Value Chain: Considers the entire system of interlinked activities, including suppliers and customers.
Why Value Chain Is Better:
Starts Early: Captures supplier relationships.
Ends Late: Accounts for customer relationships.
Example: Collaborative efforts like P&G’s integration with Walmart’s systems reduce costs for both.
Insights from Value Chain Analysis: Shank and Govindarajan (1992)
Key Benefits:
Identifies areas for strategic cost reduction.
Highlights the interdependence of activities.
Allows firms to explore vertical integration opportunities.
Examples:
Westvaco: Exited paper production but retained envelope converting operations.
NorthAm Packaging: Differentiated strategy for low-cost commodity products and high-margin specialty products.
Challenges in Value Chain Construction: Shank and Govindarajan (1992)
Difficulties Include:
Calculating value for intermediate products.
Identifying cost drivers across linked activities.
Segmenting the chain into meaningful components.
Authors’ Recommendation:
Despite challenges, every firm should attempt a value chain analysis. The exercise itself fosters valuable strategic insights.
Emphasizing Linkages in the Value Chain: Shank and Govindarajan (1992)
Key Insight:
Linked activities within the value chain (e.g., design influencing production) require coordination for optimal outcomes.
Examples:
McDonald’s: Promotional timing impacts production efficiency.
Procter & Gamble: Investments in Walmart’s systems reduced costs for both firms.
Practical Application - NorthAm Packaging Case: Shank and Govindarajan (1992)
Key Lessons:
Two Market Segments: Commodity (price-sensitive) and Specialty (high-margin).
Strategic Focus: Value chain insights helped align resources with customer needs in both segments.
Outcome: The value chain framework allowed NorthAm to enhance cost efficiency and differentiation.
What is Cost Allocation?: Bhimani et al. (2018)
Key Concept:
Cost allocation assigns indirect costs to cost objects (e.g., products, departments, services).
Key Points:
Purpose: Supports decisions, motivates employees, justifies costs, and helps with external reporting.
Challenge: Allocation methods are not always clearly right or wrong but can impact managerial decisions.
Examples:
Allocating university costs across undergraduate, graduate, and research programs.
Four Purposes of Cost Allocation: Bhimani et al. (2018)
Provide Decision-Making Info: E.g., pricing decisions or make-or-buy analysis.
Motivate Employees: Encourages cost-saving behavior, e.g., designing efficient products.
Justify Costs for Reimbursement: Common in contracts, especially government work.
External Reporting: Aligns with regulations for financial reports.
Key Insight:
Allocations may vary depending on purpose, such as R&D costs being included for managerial decisions but excluded in financial reports.
Single-Rate vs. Dual-Rate Allocation Methods: Bhimani et al. (2018)
Single-Rate:
Pools all costs and allocates them using one rate.
Simpler but can distort decisions by treating fixed costs as variable.
Dual-Rate:
Separates costs into fixed and variable pools with different allocation bases.
Provides clearer cost behavior insights.
Example:
Fontaine Informatique allocated IT costs differently for its Microcomputer and Peripheral Equipment divisions.
Direct, Step-Down, and Reciprocal Allocation Methods: Bhimani et al. (2018)
Direct Method: Allocates support costs only to operating departments.
Step-Down Method: Partially allocates costs between support departments before allocating to operating departments.
Reciprocal Method: Fully accounts for mutual services among support departments using linear equations.
Key Insight:
The reciprocal method is more accurate but less common due to complexity.
Choosing the Right Allocation Base: Bhimani et al. (2018)
Key Concept:
The allocation base should reflect a cause-and-effect relationship to improve accuracy.
Challenges:
Using labor hours in automated environments can distort costs.
Some cost drivers (e.g., machine setups) may be hard to measure reliably.
Complex systems with multiple cost pools are expensive to implement.
Example:
Japanese companies use labor hours as a signal to prioritize headcount reduction.
Stand-Alone vs. Incremental Cost Allocation: Bhimani et al. (2018)
Stand-Alone Method: Allocates shared costs proportionally based on independent usage.
Emphasizes fairness (e.g., airfare split between employers).
Incremental Method: Assigns costs to a primary user first, with remaining costs allocated incrementally.
Can benefit newer or less resource-intensive entities.
Example:
A combined flight cost for job interviews allocated between employers.
Common Issues in Cost Systems: Bhimani et al. (2018)
Warning Signs of a Broken System:
Unexplained profit margin changes.
Misunderstood bid successes or failures.
Few cost pools with heterogeneous items.
Competitors’ prices much lower than internal cost estimates.
Actionable Insight:
When these issues arise, a review of the costing system is essential.
Limitations of Traditional Cost Accounting; Cooper & Kaplan
Key Issue:
Traditional cost accounting methods, such as absorption costing, often fail to capture the strategic implications of costs.
Key Points:
Focus on Short-Term Costs: Prioritizes direct and indirect costs over long-term value.
Misses Strategic Factors: Ignores quality, flexibility, and customer satisfaction in decision-making.
Example: Firms using traditional methods may overproduce to absorb fixed costs, leading to inventory buildup.
Strategic Cost Management (SCM): Cooper & Kaplan
Key Concept:
SCM incorporates strategic elements into cost analysis, aligning decisions with long-term goals.
Key Elements:
Value Chain Analysis: Examines costs across the entire value chain, not just internal processes.
Focus on Drivers: Prioritizes cost drivers like setup times, lead times, and production design.
Competitive Advantage: Supports decisions that create long-term market advantages.
The Problem with NPV in Decision-Making: Cooper & Kaplan
Key Criticism:
Net Present Value (NPV) focuses solely on financial metrics, ignoring broader strategic considerations.
Key Points:
Narrow Perspective: NPV doesn’t account for intangible benefits like customer loyalty or improved product quality.
Bias Against Innovation: High initial costs of new technologies often lead to rejection under NPV analysis.
Example: Firms reject automation upgrades despite long-term efficiency gains.
Activity-Based Costing (ABC) and Its Benefits: Cooper & Kaplan
Key Concept:
ABC provides more accurate cost allocation by linking costs to specific activities.
Advantages:
Transparency: Shows true resource consumption.
Improved Decision-Making: Helps identify cost-saving opportunities in non-value-adding activities.
Example: Identifying high costs in product setups can drive process improvements.
