To be a successful and competitive company, manager should not concentrate on traditional management accounting techniques any longer. Because as far more advanced business environment, traditional management accounting techniques cannot supply proper enough management methods for managers to improve company. Based on this phenomenon, many contemporary management accounting techniques are created to solve these problems. In this assignment, two contemporary management accounting techniques will be discussed, which are value chain and life cycle costing. We will define the concept of these two techniques in Part One. In part two, comparing with traditional management techniques, we will analyse cost advantage and differentiation as illustrations of value chain. Additionally, these illustrations are suggested to the managers who do not satisfy with performance of the company
Life Cycle Costing
For life cycle costing (LCC), it is one of accounting and strategic approaches for this manufacturing company to assist a better performance. Life cycle costing would start with a total cost schedule of a particular product or service, and then, attribute to each product's expected life span correspondingly. Goods or services would contain a sum of all recurring and non-recurring costs over its own specific life-span, suggested by Business Dictionary. (Business Dictionary, 2009) Chief executive officer (CEO) could finalise a better decision through various options provided by this analytical report. It could also help this company to track out the most profitable way in this comparable method.
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In applying LCC, it is beneficial for the company to get the whole set of accounting data in hand, such as revenues earned and expenses paid in different streams would precisely anticipated. It is important to get these accounting figures in high visibility because CEO would evaluate the products' proposals through these estimations. DEEP project has mentioned that LCC could show a detail cost schedule to guarantee a wisely use of money. (ICLEI, 2006) Strictly speaking, significant decisions are hinged on the basis of the distribution of manufacturing costs and products' life-span.
The second advantage of utilising LCC technique as it allows the whole manufacturing process of producing a product to be improved step-by-step. The full cost from start to end would be written down, CEO could ameliorate the product by amending the costs or decision making in each level. Take the outlay of investment decisions as an example, when analysing the general ledger of raising a product, CEO could rearrange this cost into a more effective way. Therefore, more profit would be resulted with a more appropriate use of money. In addition, LCC would provide a more precise forecast model of forthcoming costs for this company to be exercised in the long-term assignments.
There would cause a vital impact in future expenditure deal to the judgement made in early stages. A higher percentage of the total cost incurred by a product appeared in early stages of the life cycle would be emphasised by CEO as it take a higher priority than other products. This product would develop as soon as possible as it would take a higher profit earned by the company.
Decisions related to the expenses used by the proposal would be executed by some investment decision makers, just like CEO and chief operation officer (COO). Extra professional experts of evaluating and analysing the whole production process of this proposal is needed, they are obligated to ensure that the project would run smooth without any error raise.
The costs of owning this proposal is aroused and it would be varied by the passage of time. For instances, acquiring costs, operating costs, and disposal costs are the three must-have costs while conducting the proposal. At the very first of the planning stage, the company would have to pay for the patent of the product or the cost of producing a product. The second stage is operating the whole manufacturing process of the product, administrational cost and some general expenses must be incurred during production process. For a proposal, the final stage should be reselling the product, replacing the product during the end of life would create costs.
When procuring the product, some costs would be recognised and distinguished in between either one-off cost or recurrent cost. One-off cost would become a sunk cost after acquiring the product, implementation cost, initial training cost and disposal cost are the example of one-off cost. Recurrent cost is relied on time which would vary over time. Take maintenance cost as an example, as time pass by, the cost of maintaining machineries would increase. Operational cost, services charge and repairing cost are the examples of recurrent costs.
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The methodology of LCC contains several elementary concepts which are inflation, discounting and the structure of breaking down cost.
Inflation is the growth rate of money value which would affect the value of an investment project. The effect of inflation would mostly be ignored when attempting the LCC approach. However, in some point of view, inflation would be counted into LCC analysis when different inflation rates of different products were considered. Repetitive counting of inflation rate should be evaded when calculating the LCC analysis as it would seriously influence the accuracy of the analysis.
Discounting is a concept of time preference, which reflects the customer's behaviour, customer would be more favourable to get the goods or service now rather than later. It is also an attempt in comparing the benefit and loss in different periods of time. Net present value need to be modified over time, in order to assure an accurate and fair assumption would result. In reducing the value of the product over time by discount rate, it actually decreases the dependability of the product. When performing the LCC analysis, same discount rate among different products should be exercised, and should be varied and amended over time.
Cost break down structure (CBS) is the main principal of LCC approach. It would change its content once the decision varies. The objective of LCC is to label down all the relevant costs, so that all the internal costs are listed down clearly with a clear understanding shown. When the cost elements are verifiable with well-structured, the analysers could compare the data much easier in each specific areas. Another objective of LCC is to clarify the border of the project for the sake of evading pretermission and repetition.
According to Kafelnikov (2001) "success in digital economy is the implementation of an integrated value chain that extends across - and beyond - the enterprise." value is created as goods move along the vertical chain. The value chain depicts the firm as a collection of value- creating activities. The products pass through the chain in order. Each activity in the value chain can potentially add to the benefits that the consumers get from the firm's product, and each can add to the cost that the firm incurs to produce and sell the product. In other words, it means the chain of activities gives the products more added values.
Value chain of economic activity is ubiquitous, value chain exist not only in a firm, but also between the firms. It shows that the value chain of a company may be useful in identifying and understanding crucial aspects to achieve competitive strengths and core competencies in the marketplace. The competitive of the entire value chain decide the competitive of the firms.
Value chain has been used as a powerful analysis tool for organizational strategic planning. What activities the firm undertook has the directly links with the competitive advantage. In order to better understand the activities through which a firm creates value and competitive advantage by value chain, we need to know each step in the value chain analysis.
Firstly, it is imperative knowing what value chain can do. Companies implement value chain as an important method in their corporate strategy. Break down the whole firm's into the key activities under each of the major headings. These activities can be categorizes into "primary activities" and "support activities". Porter who was make the value chain famous distinguished five primary activities- "Inbound logistics", 'operations", "outbound logistics", "Marketing &Sales" and "Service". These activities are directly related to the processing of the physical goods. Moreover, the support activities include "The infrastructure of the firm", "Human Resource Management", "Technology development" and "Procurement". (Tutor2u, 2009) For value-added, when different stages produce finished that can be valued using market prices, the firm can estimate the increased value that parts of the value chain create. The goal of these activities is to offer the customer a level of value that exceeds the cost of the activities, therefore resulting in a profit margin. The activities of the value chain are interrelated and influenced by each other. For example, if spend more cost on purchasing the material, it will reduce the working procedure, defective goods and working hours. Moreover, the importance for each activity is decided by what the position it is in the value chain.
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Secondly, assess the potential for adding value via cost advantage or differentiation. It is a useful tool to help the firm define the core competencies and the activities in which it can pursue a competitive advantage. Once the value chain is defined, we need to consider how to allocate the cost to each activity. Moreover, the key point is Active- based costing (ABC). 'ABC was developed to overcome the shortcomings of the traditional method. Manufacturing can use ABC systems to focus cost reducing efforts.'(Alnoor, Charles, Srikant, George, 2008) The firms set cost reduction target in different acidity area. And the objective of ABC is to create the cost per unit of measured cost driver. It assigns costs to activities and identifies the specific drivers of those costs. In addition, cost drivers explain why costs vary across firms. The cost of each activity in the firm's vertical chain may be influenced by a different set of cost drivers.(Besanko, 2007) In the value chain, there are ten cost drives related to the activities, including "Economic scale", "Learning", "Capacity Utilization", "Linkage among activities", "Interrelationships among business units", "Degree of vertical integration", "Timing of market entry", "Firm's policy of cost or differentiation", "Geographic location and Institutional factors". (NetMBA, 2007) For a firm, the cost advantages can be pursued by controlling these drivers better than competitors.
The second strategy for gaining competitive advantage is differentiation. According to the basic points of value chain, not all of the activities can create value for the firm. Actually, each firm needs to build their own strategic part in the value chain. These special activities are the main power to create the competitive advantages. Therefore, a differentiation advantage may be achieved either by changing individual value chain activity to increase uniqueness in the final product. 'Porter identified several drivers for the identification, including polices and decisions, linkages among activities, timing, location, interrelationships, learning, integration, scale, institutional factors'.(NetMBA, 2007) Hence, there are several way for a firm to recognized their value chain to crate uniqueness and though the use of technology or some new distribution channel. Nevertheless, differentiation often leads to high greater costs, these elements also regard as cost drivers.
As Mr. Ryan's company, he should start with define the company's value chain in order to assign the cost and assets to cost activities, where the cost can be defined as purchasing input and operation cost, and assets can be defined as fixed and working capital. Therefore Mr. Ryan could see whether the asset that invested in individual activity is used efficiently and effectively. According to three steps, individual activity illustrates the size and growth of cost, the cost behavior and competitors' differentiation, the value chain can be divided. In this case, Mr. Ryan should cut the defined value chain into individual activity to get a graphically or numerically data first in order to make the value chain visible, and then allocate cost and assets which link to each activity directly or indirectly. A plenty of factors influence cost behavior, which are cost drivers. By reducing the cost of individual value activities or by reallocating the value chain, cost advantage can be achieved. There are ten cost drives, economies of scale, learning, capacity utilization, linkages among activities, interrelationships among business units, degree if vertical integration, timing of market entry, firm's policy of cost or differentiation, geographic location and institutional factors. To control these cost drivers well is way to get cost advantage better than competitors. (Porter, 1985)
For Mr. Ryan's company, as a larger manufacturing, controlling cost drivers can take following methods. Increasing economic scale by manufacturing line extension, market expansion or marketing activities can lower the cost. So to gain a reasonable type of scale is important. Due to learning, mechanization can lower activity cost through layout improvement, labour efficiency improvement and quality improvement and so on, however, the initial cost may be high, but cost must be lower over time. Learning and analyzing competitors is another good way to get cost advantage, such as buy similar product line, using published materials or product design and building relationships with competitors' suppliers. To keep the fluctuation of capacity volume stable and smooth may increase capacity utilization. Additionally, Mr. Ryan could reduce the cost of underutilization product. He may sell the product to subcontractors or agency when the production exceeds demand to cover shortfalls which takes place when the production is lower than demand. For example, Canadian Steel Producers, they sell steel to subcontractors and foreign companies, which the capacity exceeds the demand. They ignore the not stable sales by adding capacity for trend lines demand growth. There are always some linkages among cost activities. To control the linkages well may improve cost position. Mr. Ryan could use information system to work with suppliers to exploit coordinative linkages, so that value chain would be optimized. For example, Mr. Ryan could send the manufacturing plan to materials suppliers by computer in order to let suppliers send materials when needed in a proper volume. This may make good use of time and avoid underutilized materials. Timing is also a big issue for a company to entry the market. As a first mover to a market, the company may choose the best location, lower brand set up cost, majority of customers and lower cost of materials. As a late mover to a market, the company may cost less for labour because the company do not need to employ senior workforce. Location is an important determine factor, since it may be influenced by labour rate, transportation efficiency, suppliers and buyers. Therefore, the location of activity is a relationship with suppliers and buyers. Mr. Ryan had better find an appropriate location for the company in order to gain cost advantage.
However, to identify cost drivers is not an easy work. (Porter 1985) A company may control cost advantage in order to be competitive in the specific market. The cost advantage might be favorable long-term purchase price contracts on raw materials, low overhead or lower shipping costs due to geographic close to markets. Better way to strategically position a company on the advantage of cost is to increase market share by transforming from lowest cost producer to lowest cost supplier of products.
Here is an example of controlling cost drivers about Southwest Airlines. Southwest Airlines Company which was founded in 1971 has been the largest air carrier in the United States. Southwest has a structural cost advantage than other companies, which enables the company charge lower fares. Southwest leads all airlines in the most low air fare for every seat and every day. This is a very different factor from other competitors, and also it is what customers want most. Since customers also have alternative ground transportation, so low fares is suitable and important to attract these customers. They can choose any transportation as they like, but taking plane is more efficiency and not expensive. Another cost the company controls well is fuel cost. Fuel costs are the second largest expense for airlines. As a high competitive industry, it is not a good choice to pass higher fuel cost on to customers by rising tickets price, if the company wants to survive and success. Southwest Company is a winner in this reducing fuel cost competition with its successful fuel hedging strategy. The company has one stale fuel supplier which can offer them good quality fuel with lower price because the amount of fuel they need is huge. Moreover the company buys future fuel but pays now in order to get lower price. By extending the airplane's range, saving fuel, lowering engine maintenance costs, Southwest Company may gain more cost advantage.( Gittell J.H., McGraw Hill. 2005) Furthermore, Labour cost and distribution cost are another two major costs for airlines. Southwest Company use flexible work rules which allow 'cross-utilization' take place to all employees. To use both 'cross-utilization' strategy and company traditional culture of cooperation, labour cost can be lower. That is the cost advantage gained by Southwest Company, and it makes a lead in the industry. Another special idea came out by Southwest Company is to use E-ticketing system which allow customers to book and pay for tickets on line with their credit cards. It can lower distribution cost and labour cost since company does not need to set up retailers. (Terry R. Bacon and David G. Pugh, 2003)
Except controlling cost drivers, reconfiguring value chain is another way to get cost advantage. To achieve cost advantage, there are two methods. First, reconfiguring value chain may create opportunities to reallocate company's cost in order to make new value chain more efficient. A successful example is no-frills airlines reconfigures its value chain and establishes a new cost standard which is as much as fifty percent lower than those of truck transportations. Not only perform the value activities cheaper, but also seek some linkages. Second, by favoring the company's strength, a substitution value chain may lead to cost advantage. To reconfigure the value chain change the important cost drivers, and lead to favour a company. For instance, in the beef processing example, Iowa Beef Company regards location cost as its major cost driver. So the company increases its increased scale sensitivity. A company like Iowa Beef Company often uses shifting to a more sensitive scale value chain to gain more benefit. To create new value chain and make operation strategy differently, companies must know everything they do exactly and competitors as well. They must think to perform activities differently, to reorder value chain in a right and reasonable way and to set contract with suppliers or retailers in order to lower the cost. Mr. Ryan may reconfigure value chain through some activities as following: create different manufacturing process, find a new material and also a new supplier, find a new distribution channel, and change the company location to somewhere relative to suppliers and buyers and make new sale promotion like advertisement. (Porter 1985)
Differentiation is one of the two types of competitive advantages a firm may possess. If a firm differentiate itself from its competitors that can be unique at something that is valuable to buyers. The extent to which competitors in an industry should special and different from each other which is an important element of industry structure. Firms are also different but not differentiated, because they pursue uniqueness forms that buyers do not value (Porter, 1985). Then the article wills analysis differentiation and differentiation strategy.
First, it will describe the sources of differentiation, which can arise anywhere in a firm's value chain. Differentiation allows the firm to order a premium price, to sell more products at a given price and gain equivalent benefits such as greater buyer loyal to product during seasonal downturns. If the price premium get exceed added costs of unique, differentiation would lead to superior performance. A firm's differentiation may implore a broad group of buyers in an industry. For example, Adidas appeals to buyers wanting sporting clothing, but buyers view clothing as too simple. Differentiation grows out of the firm's value chain and any value activity is a potential source of uniqueness. Value chain developed for goal of strategic cost analysis, therefore, may not separate all activities that are important for differentiation. A firm may also differentiate itself through the breadth of its competitive scope.
Differentiation can also stem from downstream. Firms' channel a powerful source of uniqueness and may increase is reputation, service, customer training and any other factors. For example, the Coca Cola independent bottlers are crucial to differentiation. Differentiation strategies throughout the value chain to try to create value for the buyer.
A series of basic drivers determined a firm's uniqueness in value activity. The principal uniqueness drivers are following first is policy choices which influence firms make policy choices about what activities to perform and how perform them. Second one is linkages. Uniqueness often stems from linkages within the value chain or with supplier and channels that a firm utilizes. Third one is timing, it means uniqueness may result from when a firm began performing an activity and being the first to adopt a product image. Then is location, such as bank, it also chose the most convenient branch and automatic machine locations. Fourth one is interrelationships, and then are learning and spillovers, integration, scale and institutional factors. The drivers of uniqueness vary for each activity and may vary across industries for the same activity.
Secondly is cost of differentiation. Differentiation is usually costly. Uniqueness requires that it perform value activities better than competitors, so the firm must incur costs to be unique. Some forms of differentiation are clearly more costly than others. Differentiation that results from superior coordination of linked value activities may not add much cost. The cost of differentiation reflects the cost drivers of the value activities on which based uniqueness. The relationship between uniqueness and cost drivers takes two related forms which are what makes an activity unique can impact cost drivers and the cost drivers can affect the cost of being unique. In purchasing differentiation, a firm often affects the cost drivers of an activity adversely and deliberately adds costs. At the same time as uniqueness often raise cost by affecting the cost drivers and the cost drivers determine how costly differentiation will be (Porter, 1985). Scale, interrelationships, learning, and timing are particularly important cost drivers in affecting the cost of differentiation. The cost drivers thus play an important role in determining the success of differentiation strategies and have important competitive implications. Sometimes making an activity unique also simultaneously lower cost. For example, if integration is a cost driver, integration may make an activity unique but also lower cost. Where achieving differentiation and reducing cost can take place simultaneously, however, this suggests that a firm has not been fully exploiting all the opportunities to lower cost; being unique in an activity was formerly judged undesirable; or an important innovation has occurred which competitors have not adopted, such as a new automated process that both lowers cost and improve quality. In assessing the differentiation cost, a firm must compare the cost of being unique with the cost of being equal to competitors in an activity.
Thirdly is differentiation strategy. Differentiation stem from uniquely creating buyer and value and it can result through meeting use or signaling criteria, through in its most sustainable form it comes from both. There are two routes to differentiation which are performing it's exist value activities and enhance its uniqueness. At the same time, there are a number of approached characterize successful differentiators. First is enhancing the sources of uniqueness which include increase the sources of differentiation rapidly in the value chain, Making real product use consistent with intended use, employing signals of value to strengthen differentiation on use criteria and employing information bundled with the product to facilitate both use and signaling. Second one is making the cost of differentiation and advantage which include exploiting all source of differentiation that are not closely, differentiation minimizing cost by controlling cost drivers, particularly the cost of signaling, emphasizing forms of differentiation where the firm has a sustainable cost advantage in differentiating and reducing cost in activities that do not affect buyer value. Third one is changing the rules to create uniqueness which includes shifting the decision maker to make a firm's uniqueness more valuable, discovering unidentifiable purchase criteria and preemptively respond to changing buyer or channel circumstances. Fourth one is reconfiguring the value chain to be unique in entirely new ways.
However, there are some pitfalls in differentiation. First one is uniqueness that is not valuable. The fact that a firm is unique at something does not necessarily mean it is differentiated. Second one is too much differentiation, because a firm does not understand its activities affect buyer value or the perception of value by the mechanisms. Third one is too big price premium. The price of premium from differentiation is differentiation function of value and its sustainability. If the premium gets too high, buyers abandoned a differentiated competitor. Fourth one is ignoring the signal value need which can open a firm to attack from a competitor providing inferior value but having a better buyer's purchasing process understanding. Fifth one does not know differentiation cost. Differentiation will not lead to superior performance, unless people think it's worth more than its purchase cost. Sixth one is focus on the product instead of the whole value chain. Some companies only see the physical condition of the product differences, failed to take the opportunity to distinguish between other parts of the value chain. Last one is failure to recognize buyer segments which means buyers purchase criteria and their ranking usually vary among buyers, creating buyer segments.
At last, There are some differences to determine who is the real buyer is the step to distinguish between the buyer's value chain and companies for their impact on the buyer purchasing criteria to determine rankings to evaluate a company's unique value chain of existing and potential resources, determine the cost of differentiation existing and potential resources, Select configuration value creation activities of the buyer's most valuable difference in the relative cost differences, testing the sustainability of differences in strategy choice, reduce the cost of activities do not affect the chosen form of differentiation.
Due to the contemporary business environment is characterized by high competition, increasing overhead costs, increasing demand for useful information by customer and market segment and demands for information in order to manage the costs of support departments, traditional costing methods got challenges (Bahaman, 2008). Traditional cost method assign the accumulate overhead costs from all the production departments to single products, allocate and accumulate overhead costs to production department and it use a volume-based cost driver for example total labor hours. Although traditional costing method is good when overhead are low, ignore non-volume related support activities, set-ups, inspection activities and material procurement. Traditional system are suitable only if a large proportion of overheads are volume-related, but it inappropriate for today because organizations produce a wild range of products. Moreover, the traditional costing system is adequate when the product variety is limited, however, the real business market have a wild range of product varieties. Therefore, we can use activity-based cost system (ABC) to refines traditional costing systems by calculating the costs of individual activities. In traditional system, it just calculation the average cost, for example four people go to eat everyone ordered different priced food Queeny $33 Mike $25 Nick $40 Paul $20, but if we use traditional cost system to assume split the bill in four and everyone need to pay 29.5 that means two will pay more and others pay less. So, it's better to use ABC to calculate for each individual activities like to use cost drivers. ABC is system based on activities linking organizational spending on resources to the products and services produced and delivered to customers (Lewis, 1995). ABC's objective is to measure and then price out all the resources used for activities that support the production and delivery of products. The ABC costing method also support overheads do not grow with business volume and costs respond to complexity. When the products make diverse demands on resources due to differences in volume, process steps, batch size or complexity or products that a company is suited to make and sell show small profit while products for which a company is les suited show large profits implementing ABC system is most beneficial (Bhimani, 2008). Therefore, ABC method has more benefits than traditional method, such as it has better profitability measures, better information for controlling capacity cost, detail and clearly of overheads, more accurate and powerful insights and better decision and control.
The traditional system and ABC system have three main differences. First, they use different way to accumulate and redistribute cost. Traditional system use cost centre and ABC use activities. Second, traditional system usually use volume allocates and ABC system asks what activities are being performed the resources of the support department. Last but not the least, traditional system support department expenses are allocated to a production department and ABC system's resource expenses are assigned to activities based on how much of the resource is required to perform the activities. In one word, traditional costing methods allocates on the basis of one drive such as direct labour or machine hours, but it leads to inaccurate and misleading costs and under-costing or over-costing products. ABC costing method refines traditional method to makes more bases and use more cost drivers usage in any industry in order to make better decision making and control.
In conclusion, as we analyses in this report, life cycle costing and value chain can give the firm great help to improve their performance by decreasing the cost of inventory, making powerful method for assessing the true cost of different options over the lifetime to ensure that public money is spent most wisely and making easy judgments. Although these performance need to develop, they already very grateful for helping the companies to have good management accounting performance such as making good and quick decision, better controllable and decrease cost for production and so on. As we found traditional accounting method are already cannot face today's competitions. Therefore, we use this report to suggest the company develop accounting management performance in order to suitable for today's business world.