Cost management

Chapter 1 Cost management

If a company doesn’t understand where its costs are coming from then it is futile to try to manage them. Competition in all manufacturing sectors is constantly increasing and there is continuous pressure to drive costs down and to increase cost management – generally by employing another accountant. Indeed cost management is still seen as vital to the success of any manufacturing company in any sector. But are we really managing costs or are we just playing at it? • Why do we think that if we want to reduce costs then we must start with the labour cost? • Why do we have Human Resources Departments and Purchasing Departments but ignore any attempt at Overhead Management or Energy Management? • Why do we get upset if we see a worker standing still and yet we unthinkingly accept unrealistic overhead allocations and walk past machines operating and not producing any product?

the business. They are central, unmanageable and unavoidable’ and then ignore them or assume they are somebody else's problem? Realistic cost management for the future is not about ignoring huge chunks of cost (such as overheads) but is about trying to understand what we are really doing. Unrealistic costing systems distort the reality of the business, good profitable products are terminated whilst unprofitable products are produced. Cost management is critical to survival and if a company wants to stay in business then it had better know where the costs really come from. This really is a case of ‘What you don’t know can hurt you’. Trying to manage what you don’t understand is a recipe for failure and is one of the reasons that we often see costreduction programmes fail and bring the company down with them. This chapter tries to look at the general management framework and at costs in a broad sense so that cost-reduction efforts can be effectively targeted.

• Why do we always justify machinery purchases on the labour we save and yet rarely analyse how much labour we really have saved? • Why can managers tell you exactly how many staff they have and how much material they have used yet it is often impossible for them to say how much capital equipment they control, how much energy they use or how much of the overheads they control? • Why do we think, ‘Overheads are part of Chapter 1 – Cost management

“Cutting costs without improvement in quality is futile.” Dr. W. E. Deming 3

1.1

Where we are going

The destination Starting out in cost management is a daunting task. There is so much to do and so many places to start. Most sites know that they want to reduce costs but they really have no idea of the steps that they have to take to get there. Is it any wonder that they look at the labour costs first? The start of the cost management journey is normally the arrival of a management edict that says: ‘We have to reduce costs by 10% because our profit is too low’. This assumes that the site is not already working on cost management and comes with no guidance about where to start apart from the inevitable note that the saving has to be delivered by the end of the month. The management then set off on the cost reduction journey with no real plan of where they want to go, how they are going to go about it and how they will measure the progress they are making (if any). The result is a series of partial and disjointed measures that will inevitably fail to deliver the benefits of real cost management but may also cripple the company for the future. Some efforts will fail more miserably than others, but all are eventually doomed, particularly those that focus simply on headcount reduction. Even if a site has an operating and ongoing cost management programme, this is generally run by the financial area and not by the operations people. Operations people know where the real costs are but they have been so reduced in numbers by previous cost management efforts that there is nobody left to do any real work apart from the daily firefighting. Sound familiar? Every site needs a plan (a road-map) to define where they are in cost management and where they want to be. The figure on the opposite page shows some of the major areas, the processes and tools used, the benefits from using the processes and tools and the overall results of a properly functioning and ongoing cost management system. This is not about a one-off cost management panic, it is about how we run our companies on a daily basis so that all the costs are minimised and the profits are maximised. This is real life. 4

This is about the whole company Cost management is sometimes seen as the responsibility of the manufacturing area, obviously they have the greatest number of people and can therefore spare the most. How wrong can you be? The reality is that cost management must permeate every operation of the company. It is not a ‘manufacturing’ issue, it is a management issue for the whole company. Cost management is sometimes seen as something that is to be used only in the bad times and can be safely forgotten about in the good times. This was never true and is certainly not true today. Focusing on cost cutting by the numbers alone may make a company profitable in the short term but, as too many companies have found out, does not guarantee that the company will survive in the long term. It is only by focusing on effective cost management that companies can deliver sustainable long-term profits.

The road-map The road-map identifies the wide range of areas, skills and activities that are necessary to achieve effective cost management and even this is limited by space. The road-map shows the type of things that you will have to do to really achieve cost management. It is not simply about the head count or any other single thing. Specifically, it is not only about manufacturing. It is about the whole company and it is about a mind-set that seeks to reduce costs and improve effectiveness in all areas of the company to deliver both sustainable profits and continued employment. • Tip – None of the actions in the road-

map are ever completed. Get used to continual improvement.

‘Alice: Would you tell me, please, which way I ought to go from here? The Cheshire Cat: That depends a good deal on where you want to get to. Alice: I don't much care where. The Cheshire Cat: Then it doesn't much matter which way you go.’ ‘Alice in Wonderland’ by Lewis Carroll Note: Carroll’s real name was Charles Dodgson and another of his books was ‘An Elementary Treatise on Determinants, With Their Application to Simultaneous Linear Equations and Algebraic Equations’.

“A talent for following the ways of yesterday is not sufficient to improve the world of today.” King Wu-Ling 307 BC

“Everybody has a plan: until they get hit.” Mike Tyson

Chapter 1 – Cost management

Major areas

Management focus

Accounting conventions

Processes/Tools

Benefits

Business model

Strategy planning

Consistent direction

Structured management

Alignment of objectives

Consistent behaviour

Cost structure

Effective product costing

Activity-based Management

Effective process costing

Investment appraisal

Effective investment

Product planning

Road-map for new products

Consistent flow of new products

Design process

Pentamode APQP

Control of design process

Project teams

DFX VA/VE

Relevant accounting

Design

Sustainable design concepts Improve purchasing Supplier partnerships

Appropriate materials

Reduced materials use

Inventory

Inventory reduction

Selection and development

Qualified and trained staff

Systems

Management systems

Data and information

Reduced materials cost

Reduced inventory costs Improved staff response Improved staff retention

Manufacturing strategy

Machine choices

MRP/JIT/OPT

Work cells, work flow

Quality management

Quality costs

Monitoring and targeting

Tools

Reduced energy costs

Benchmarking

Improvement projects

Reduced waste costs

Data management

Systems integration

Management action

Security

Improved and profitable new products

Reduced staff costs

Reduced management risk

Risk assessment

Overheads (energy & waste)

Improved business performance

Reduced purchase costs Reduced materials content

Materials team

Production

Focus on success and cost reduction

Environmental costs decreased

Materials

People and systems

Results

Faster, better cheaper

Service and production

Reduced manufacturing costs

Reduced overhead costs

Reduced total costs

The cost management road-map Cost management involves every aspect of the company. It is not simply about labour costs and it needs a roadmap of the available processes and tools to get the best results. Chapter 1 – Cost management

5

How valuable is this?

The value of cost management Cost management is one of the most important things that a company can do to survive and prosper and that is the reason it is so important. However, most companies are focused on top-line sales growth (the vanity) rather than the bottom-line profit growth (the sanity). Bottom-line profit is the only thing that will allow a company to survive and proper into the future. Sales are nowhere near as important as making a profit. Cost management savings have far more impact on profit than similar sales value increases but most companies are still overwhelmingly focused on sales growth.

Better than increased sales Good cost management is actually better for a company than increased sales and this is easily shown. If a company has a net margin of 5% this means that for every £1 increase in sales they will increase profits by an additional £0.05. For the same company, a cost management saving of £1 will increase profits by an additional £1. In this case, every £1 saved by cost management is 20 times as valuable as an additional £1 in sales, i.e., a savings pound is worth 20 sales pounds. In fact, this ratio gets even better if the company is making low margins (see diagram on the right) and if the net margin is only 3% then a savings pound is worth 33 sales pounds. This high gearing for cost management means that even relatively small cost decreases can have the same impact as apparently large sales increases. • Tip – Why not tell people this value and

communicate what it really means? This does mean revealing your net margin but most of the staff will already have a fair idea of this. You have to start changing behaviour somewhere. • Tip – Look at your own behaviour here. I

once had lunch with a customer (£60) and worked out that we had to sell him £1,200 worth of product to pay for the lunch alone. I also calculated that my car cost the company around £10,000/year and we had to sell £200,000 of product every year to pay for it – frightening! 6

If the margin is 5% (typical for many plastics processors) then a decrease in costs by only 5% through a cost management programme would effectively double profits. To achieve the same result through increased sales would require doubling the sales – not an easy task. What would your site do to gain new business that increased turnover and profit by 100% if you knew that:

Sales are vanity, profits are sanity.

• Your competitors couldn’t stop you

There is nothing wrong with increasing the topline sales value by either increasing sales or by increasing prices.

getting the business. • The business was effectively guaranteed. • The business required only internal

effort. • The business did not require investment

These are both valid strategies to increase profits but they are not cost management.

in new equipment, labour or other resources. • The business was low-risk and had a

payback of less than 12 months. • The business would continue into the

future and probably increase in value. Most companies are enthusiastic about gaining new business through increased sales. Yet, when shown the opportunities to reduce costs and achieve the same results at the profit line, the same sites react with huge indifference.

Nothing changes unless something changes.

The time has come to change something and you need to start now!

Sales value of £1 saved by cost management 100

80 Sales value (£)

1.2

60

40

20

0 0

2

4

6

8

10

12

14

16

18

20

Net margin (%)

The sales value of cost management Cost management is about the sanity of profits rather than the vanity of sales. Companies that are constantly focused on sales are often missing the really big opportunities for cost savings and profit improvements. Chapter 1 – Cost management

The magnitude of the savings

Consider the following questions:

The possible savings from a wellstructured and comprehensive cost management programme are in the region of 10% of the current costs for most plastics processors who have no active and ongoing cost management programme. This includes fully quantifiable savings from quality management and energy management. At a typical margin of 5% then this is the equivalent of trebling both sales and margin.

• What do you invest in new sales and

These savings can be delivered virtually irrespective of the industry sector or process used. The process used makes little difference in the potential savings – as always, it is management that makes the difference.

what payback to you expect? Think about all the costs of finding new business and getting it into production and not simply the sales value. • What do you invest in cost management

and what payback do you expect? • Do you pay commission to sales people or

bonuses to sales people achieving or exceeding their sales targets? • Do you pay commission or bonuses to

people who deliver cost management savings? This may not only be financial but can also include simple recognition of what they have achieved. • Do you think that the sales people who

deliver sales are ‘just doing what we pay them for’?

These savings are possible by changing how we look at our business processes and how we spend our time and allocate the available resources.

• Do you think that people who deliver

The payback

• Do you reward people for cost

The majority of the savings can be delivered through a balanced combination of no-cost, low-cost and investment (maintenance or capital) actions. The average payback for most investments in cost management is less than 12 months and sometimes it is nearly instantaneous. This is true even when the payback is calculated using the costs for internal management efforts.

cost management savings are ‘just doing what we pay them for’? management efforts or do you just expect it to happen?

• Is there somebody in your company who

is responsible for cost management activities across the company?

Who is going to do this? The clue to the answer is in the staff titles:

Why aren’t we focused on this?

• Managers should manage to change

Chapter 1 – Cost management

What message did that send to the other staff?

management throughout the company?

• Directors should direct the mission and

The continued fascination and focus on increasing sales still sees many companies paying bonuses and commission to sales people but ignoring the much more highly geared profit opportunities from cost management and having no consistent focus on cost reduction.

This caused immense difficulties for the other directors who thought he should have done it as part of his job. One of these was the Sales Director who saw no dichotomy in paying bonuses to his sales staff who achieved their targets.

• Do you have a consistent focus on cost

This type of payback makes investment in cost management very attractive from a financial point of view. Not many capital investment projects achieve a payback of less than 1 year and continue to deliver the benefits virtually indefinitely.

Despite this, many companies fail to identify or implement attractive cost improvement projects even though they say that they are ‘doing all that they can’. This is because real cost management projects can be seen as disruptive to the business and difficult to implement. Nothing could be further from the truth and good cost management is simply good management.

One of my staff came up with a brilliant idea for cost reduction. It was really part of his role but I rewarded him (with money) to show that the company was dedicated to cost management.

strategy of the company (see Section 1.4). This includes consistent cost management and improvement in the company across the business and not simply in their specialty area. things and reduce costs. If they are simply administrating existing systems then they are not managers but are administrators and should be paid as such.

“Life is not meant to be easy, my child but take courage: it can be delightful.” George Bernard Shaw

The people who are going to do this are the existing management team. Get ready for change.

If you’ve ‘always done it this way’ then it is probably the wrong way.

7

1.3

What do you want to be?

The first decision

The six business models are:

Many companies involved in plastics processing do not have a clear vision of what they are actually doing in the plastics processing sector and what they want to achieve with their business. Perhaps this is because simple survival has been so difficult in the last few years and strategic thinking has been sacrificed for any work that comes in the door.

Product specialist – the product specialist works hard to differentiate themselves from the competition and has a well developed and well branded product range. The product specialist has also successfully developed the brand recognition to expand sales and addedvalue.

Plastics processors can focus in one of three directions:

Total solution provider – the total solution provider is, in many cases, a plastics processor by default rather than by choice. These companies provide a full service to the customer (including management of the supply chain and subcontractors). The total solution provider often has a limited

Differentiation: Where the product or service is strongly and positively differentiated from the competition and the company focus is on maintaining and strengthening the differentiation to achieve premium prices.

As a result of these three directions, 6 successful business models can be defined (see diagram on the right) and companies that worked within a single model are generally more successful than companies who attempted to operate in more than one model. Having one model and doing it very well is the acknowledged recipe for success. 8

Custom specialist

Differentiation

e

Price: Where price is the main focus and the reason for the company’s success. This focus is becoming harder to maintain in Western countries due to the rise of lowercost economies but many plastics processors remain obsessed with this focus.

Bulk producer

ic Pr

Customer: Where the customer is the complete focus of the activities and the company sees itself primarily as a ‘solution provider’ and not as a ‘plastics processor’. Focus on providing solutions for the customer often means that the processor needs to undertake assembly, metal work or other operations not normally carried out by plastics processors.

Product specialist

The business models

r

Work by the Dutch Federation for the Rubber and Plastics Industry1 identified six successful business models for the plastics industry. They also found that successful companies identified their distinctive strengths and then played to those strengths in all of their operations.

Custom specialist – the custom specialist works with a limited number of customers and sells under the customer’s brand. They retain customers by developing products and processes to meet limited customer demands.

Cu sto me

Despite this, it is acknowledged that successful companies ‘stick to the knitting’ and learn to do one thing very, very well.

Trying to improve your weaknesses rather than playing to your strengths simply weakens you overall.

Total solution provider

Jobber

Custom jobber

The successful business models If you are trying to operate more than one model you are probably not being successful in any of them. (After NRK)

Chapter 1 – Cost management

knowledge of the details of plastics processing. Custom jobber – the custom jobber provides solutions based on their knowledge and skills in plastics processing and uses these skills to develop and deliver specific plastics processing solutions for customers.

which is closest to their skills, their current customer base and their aspirations. Only then can they identify the costs that are inappropriate to their business model and start to reduce these.

A client of ours was a ‘jobber’ and wanted to increase margins by entering the medical products field. It was the work of minutes to determine that they did not have any of the management skills, processing skills, machines or infrastructure to successfully make this transition.

Jobber – the jobber is the no-frills lowestcost producer and effectively provides machines and labour for hire. These are the ‘shoot and ship’ moulders that are under great threat of competition from low-cost countries. Bulk producer – the bulk producer makes simple high-volume products at the lowest cost for a standard range. This standard range is then sold to a variety of customers for use in their own products.

They were a jobber because that is where they felt comfortable and trying to make the transition would have been painful, fruitless and ultimately unsuccessful.

Most readers will be able to identify with these models and name many successful companies that fit each of the business models but the real questions are: • What type of company are you now? • Why are you that type of company? • What type of company do you want to be

in the future? • How do you get from where you are now

to where you want to be in the future? • What are the costs of changing the model

and are you likely to be successful?

Why is this important? It may appear strange to be asking these questions at the start of a book on cost management but these are vital questions.

“A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.”

Trying to be ‘all things to all men’ may appear to be an attractive option but it does not lead to success because there is no compelling reason for any market to choose you as the supplier. It also leads to additional costs that you may not need to succeed if you identify which market you are actually in and which one you want to be in. The custom jobber will be interested in a range of innovative technologies that may be applied to develop new solutions for customers, whereas the jobber will have little interest in these unless they can reduce the cost of the product. A product specialist may well have a large research and development effort for new and improved products, whereas a bulk producer will generally concentrate simply on range extension and expansion. Processors need to understand the differences between the models and decide Chapter 1 – Cost management

Wayne Gretzky

• 1. Dutch Federation for the Rubber and Plastics Industry. 2006. ‘Eindrapport – Management Samenvatting’. This was available at www.nrk.nl (in Dutch) but now appears to be unavailable. A great shame.

If you are not meaningfully unique then you had better be cheap.

9

1.4

Structured management

Getting the ducks in a row Structured management isn’t difficult and shouldn’t be complex. All it means is that everybody in the company needs to know where the company is going and how they are expected to contribute. Unfortunately, in far too many companies the strategic direction is either unclear (the management haven’t thought it through) or it is not stated at all because the management have no real idea of where the company is going.

Mission and goals The mission and goals provide the essential direction for the company. They are ‘what and where we want to be in the future’. The mission and goals need to be simultaneously realistic and challenging. It is obvious that the discussion in Section 1.3 provides the essential direction for the mission and goals. It is unrealistic to set a mission and goals that are totally different to the current skill set of the company.

Mission The mission should be capable of being stated in a single sentence. Any longer and you are probably complicating the issue far too much. The mission should be capable of being translated into defined action. It is not simply enough to state ‘I want to be rich’. This may be a worthy goal but it doesn’t provide the necessary direction.

The company

Mission

Goals

Operational strategies

Improvement plans

The people

Individual objectives

Review and control

The links for structured management A clear statement of what the company wants to do and linking this to the individual objectives of the staff is essential. The key step of regular review and control is the one most often left out, i.e., things change and so must the company.

Goals The goals should be stated over various time-scales to provide reference points for progress towards the ultimate goal. These should include real numbers that can be used to assess progress. • Tip – Set goals over various timescales

so that progress can be assessed at regular intervals, i.e., 6 months, 1 year, 2 years and 5 years.

Strategies Strategy is very different to operations and planning. In a military sense, strategy is bringing your forces into play advantageously and occurs before the armies meet, whereas operations are what happens once the battle begins and how the individual units perform. 10

The relationship between strategy and operations The strategy sets the overall limits and directions for the goal but does not specify the operational moves. Operational moves may change with time but only those operations that move towards the goal should be considered.

Chapter 1 – Cost management

Strategy sets the limits and guidelines for the operations and provides the boundaries for actions but does not specify the details of the operations. Strategies are needed for all areas of the company. Most companies see the need for a ‘marketing strategy’ but it is rare to see a similar strategy for manufacturing, data and information or the technical areas. However, without these strategies, any investment in manufacturing, data and information or technical development is probably a series of unrelated responses to current operational problems. This can lead to machinery, equipment or other purchases on the basis of projected sales and ‘big orders’ that never appear. What appear to be routine decisions can bind a company into equipment, personnel or systems that make it difficult and costly to adapt the business to change with the market requirements. Worse still, having invested in an inappropriate system a company may not be able to re-invest or may not have the time available to do so. After the strategies have been defined they must be integrated to provide the overall business strategy for the company. A marketing strategy that is not accompanied by other consistent strategies is unlikely to be able to produce a product to take to market.

provides a rational method for assessing whether the individual objectives have been achieved or not. If the operational plan calls for reduced inventories then the individual objectives can easily be linked to this and assessment can be impartial and simply based on the numbers. Linking the individual objectives to the company goals is something that is rarely carried out correctly and, as a result, people get paid for doing things that can actually harm the company.

Review and control The final step in structured management is the review and control of the process. Any plan is bound to change with time and it is essential that the whole process is regularly reviewed to check that the goals are being achieved, that they are still relevant and that the strategies are delivering the required improvements. • Tip – A ‘data and information strategy’

is now as important as the need for strategies in the other more traditional areas (see Chapter 7).

Don’t ask me to keep in step; I have enough trouble keeping in line.

A great strategy can always be ruined by poor operations. This is equivalent to expertly setting your boxing opponent up for a knock-out punch and then missing the punch. Wonderful strategy but bad operations.

How many companies have a marketing strategy but have not developed any other strategies for the business?

• Tip – The concept of product- and

process-based division of the company (see Section 1.7) can be used to develop process- or product-based strategies.

Operations Strategies are simply good words unless: • These are also translated into specific

operational improvement plans that are linked to the strategies. • They lie within the strategy limits. • They support the overall goals of the

company. Operational improvement plans give the detail of what is to be improved and how it is to be improved. They are the actual working documents for the functional or product areas and specify what the area is going to do in the next 1 or 2 years. They must very specific about what things are going to change over this period.

Individual objectives

A model for strategy integration

In many companies the individual objectives of the staff are vague and very subjective. Linking the individual objectives to the operational plans

The business strategies for the business need to be integrated into a coherent whole. Concentrating on any one of the strategies without looking at the rest will lead to failure in an area of the business.

Chapter 1 – Cost management

11

1.5

Structured management – where are you now?

Self-assessment Throughout this Workbook there are selfassessment charts designed to help assess the current position in a variety of areas. The charts are easy to complete but we suggest copying the relevant pages before completing the forms. Understanding the current situation provides the basis for an improvement strategy and many of the basic actions necessary for successful implementation.

Completing the chart Each chart has several columns covering various aspects of the main topic.

Read the descriptions in the column cells and select the cell that is closest to the current situation in your company. It is unlikely that the description in the cell will fully describe a specific situation but choose the cell that has the most appropriate description. If in doubt score lower rather than higher. This will give a score ranging from 0 to 4, mark this at the base of the column. After all the columns have been scored, transfer the scores to the radar chart for the relevant columns/axes. This gives a rapid visual assessment of the current situation for the specific topic.

Structured management

Assessing the results

Mission & goals 4 3 2 Review & control

Strategies 1 0

Individual objectives

If you don’t know where you are starting out from then it is unlikely that you will end up where you want to get to!

Ideally, a site would have a balanced score with all columns/axes in the same broad area. This is rare and, in most cases, sites will show strengths in certain areas and weaknesses in others. The axes with low scores are the areas that the site needs to work on to improve the overall score.

Operations

Download the software

Use the chart to assess where you are in structured management The numbers from the self-assessment should be transferred to the radar chart for a quick visual guide to where you are in the basics of structured management. 12

This and similar charts are available as a downloadable spreadsheet at www.tangram.co. uk/cost.

Chapter 1 – Cost management

Structured management Level

4

3

Mission & goals

Individual objectives

Review & control

Strategies clearly Operational Clear & published statement of company stated, widely known & improvement plans in mission & goals. support company place, clearly stated & Mission, goals & mission & goals. clearly related to values aligned with operational strategy & strategic advantages, company mission & skills & capabilities. goals.

Individual objectives clearly stated, widely known & aligned with company mission & goals.

Regular management review & control of all areas. Reviews carried out in accordance with defined process that is consistent across the company.

Company mission & Strategies vague but goals available to broadly related to higher management. company mission & Strategic advantages, goals. skills & capabilities not considered in mission & goals.

Individual objectives Frequent management review & control of key vague but broadly aligned with company areas. mission & goals. Reviews carried out in accordance with defined process that is consistent across the company.

Strategies

Operational improvement plans vague but broadly related to operational strategy & company mission & goals.

Company mission & goals considered at board level.

Strategies vague & unrelated to company mission & goals.

Unstated & unwritten company mission & goals.

Strategies not stated Operational Individual objectives Infrequent or produced. improvement plans not not stated or produced. management review & stated or produced. control of some areas. Reviews have no defined process & are not consistent across the company.

No consideration of company mission & goals.

Strategies differ substantially from company mission & goals.

Operational improvement plans differ substantially from operational strategy & company mission & goals.

x

x

x

2

1

0

Score

Operations

Chapter 1 – Cost management

Operational Individual objectives Infrequent improvement plans vague & not aligned management review & vague & unrelated to with company mission control of most areas. operational strategy & & goals. Reviews carried out in accordance with company mission & defined process but goals. not consistent across the company.

Individual objectives No management differ substantially review & control of any from company mission area. & goals.

x

x 13

1.6

Financial and management accounting

Financial and management accounting Every business, no matter how small, has a need for at least two types of financial and accounting systems. Financial accounting is concerned with the financial control of the business and produces information mainly for use by people outside the company. This is essentially external and historical information and it generally has little to do with the actual operation of the business on a daily basis. Financial accounting is focused on recording the past events and performance of the company. It is concerned with financial record keeping, creditors and debtors, taxation and the raising of finance to continue the business operations. Financial accounting is highly regulated and the reporting of financial results must follow specified formats regulated by external bodies. Management accounting is concerned with providing and interpreting vital and up-todate information to managers. This information is used for:

management accounting in any way that the company managers decide is relevant and that provides the necessary information. This may be in terms of financial reporting (based in money terms) or in terms of other reporting formats that the managers decide upon.

The link between financial and management accounting In general, financial accounting has little to do with cost management. Financial accounting requires the matching of costs with revenues to allow the calculation of profit. Traditionally management accounting has been linked to the financial accounts via the treatment of stock valuation and other similar conventions. This has created time delays which reduce the relevance of the numbers for control and planning, i.e., one of the main reasons for the creation of management accounts. Breaking the linkage between management and financial accounts, with the help of the accountants, allows us to stop thinking about out-of-date and irrelevant financial numbers and start thinking about the real

Variances When confronted with variance reports there is often no clear explanation of how the variance occurred (there is definitely no hint as to how to improve the situation) yet the manager is often expected to explain the reason for the variance. Use the secret words: ‘calendarisation’ and ‘product mix’ to explain any variance to the accounts department and they’ll go away confused until next month.

• Defining costs for products and services. • Providing information for decision

making. • Providing information for performance

assessment. • Providing information and forecasts for

future planning and control. This is essentially internal information and is not generally released to the outside world. Management accounting systems should be designed to give managers the information they need, in a timely manner and in a useable format, to run the company successfully. The information provided by management accounting should be relevant for the intended purpose, be future oriented and reflect the economic realities of the business. Management accounting is not regulated in any way (except by the accountants and their ideas) and the management of the company is free to decide on both the format of the information and the regularity of production. This means that we are free to approach 14

The fundamental differences between management and financial accounting The two types of accounting were designed for different audiences and purposes. One examines the past and the other should look to the future. Try not to confuse the two. Chapter 1 – Cost management

numbers that are important to control and manage our factories.

• Inflexibility.

Luca Pacioli

• Incompatibility with world-class

A classic case of this is the ‘budget report’ that is provided to managers on a monthly basis. This report lists the manager’s expenditure in the various categories (as set out in the budget that was done up to 18 months ago) and the final column is the variance report (generally listed as ‘favourable’ or ‘unfavourable’). The manager is often required to report on these financial variances at great length and the cost accountants read these with great relish. The whole process is generally a waste of time and effort!

approaches.

Luca Pacioli first described ‘double entry’ bookkeeping in Italy in the late 15th century in his book on mathematics (even then the system only merited a chapter).

Johnson1

In fact, Kaplan and in ‘Relevance Lost: The rise and fall of management accounting’ have stated that ‘cost accounting is the number one enemy of productivity’. Kaplan and Johnson argue that traditional cost accounting methods are irrelevant and harmful to the business, they are expensive to maintain and they divert the efforts of the accountants from more important tasks. Harsh words about cost accounting that we have always assumed to be a necessary part of the accounting process. The differences between financial and management accounting make it logical to establish two separate accounting procedures. This is already done in many companies but the management accounts still remain firmly financially based. We need to make a big jump and establish two fundamentally different types of report: one to run the company, which is instantaneous and gives relevant numbers for manufacturing and other areas and another one to provide legally correct accounts. This should not present a problem and why should accounts produced for legal correctness be the best basis on which to run a factory anyway?

• Inappropriate links to financial accounts.

These are major defects and yet in most plastics processing companies the traditional management accounting procedures continue to distort costs, waste time, misdirect efforts and consume great amounts of time. If you are in doubt of this then ask the following questions: • What did it cost us to produce the

management accounts? • Were they useful? • What value did we get from them? • What could we have done with the time

that we spent on them? The answers to these questions may make you want to start to question the value of your current management accounts – after all, these accounts are supposed to add value not subtract it. They are supposed to help the company control and improve the business for the wealth creators not to provide employment for a layer of wealth dissipaters. Management accounting should reflect our activities and the way we make our products. It should be used to manage the result rather than to simply inform upper management of what happened months ago.

Pacioli’s work was one of the first to be printed on the Gutenberg press and revolutionised economy and business – ‘a catalyst that launched the past into the future’. This was probably the last really significant development in the accounting profession. Do you want your 21st century company run by a profession where the last significant intellectual development was over 500 years ago?

The time is ripe to change management accounting and the following sections of this chapter should convince you of the vital need for this.

The aim of forecasting is not to predict the future but to inform the present.

The result of this will be factories that run primarily on non-financial numbers such as work-in-progress levels, delivery conformance and other physical measures of performance – get these right and the financials will automatically fall into place.

Management accounting Maskell2 in ‘Making the numbers count – the accountant as change agent on the world class team’ lists the five main problems with management accounting as:

• 1. Kaplan, R. and Johnson, T. 1991. ‘Relevance Lost: The rise and fall of management accounting’. Harvard Business School Press.

• Lack of relevance.

• 2. Maskell, B. 2009. ‘Making the numbers count – the accountant as change agent on the world class team’. Productivity Press.

• Cost distortion.

Chapter 1 – Cost management

How can you ‘run the company by the numbers’ when the numbers are irrelevant to what you are really trying to do to?

15

1.7

Cost structures

The cost components A major area where management accounting is failing is in the costing of products and this is potentially fatal to processors. When the system is producing distortions it is impossible to manage the costs rationally. Most manufacturing industry recovers the overheads – the indirect costs – by increasing the direct cost of the products by some factor. In the simplest form the total overhead cost for the company is divided by the total number of available direct labour hours (or machine hours) to give an ‘overhead rate’. This overhead rate is multiplied by the number of direct labour hours (or machine hours) required for the individual product to give an overhead allocation. This overhead allocation, the cost of direct labour and the cost of direct materials involved are all added up to give the ‘cost’ of the product. This type of costing procedure is traditionally used in the plastics processing industry and is more fully described later in this chapter.

Overhead costs are rising in relation to other costs Costing in this way grew up in the first half of the 20th century when direct labour was a high proportion of the costs and overheads were lower. Increased investment in machinery and services has reduced direct labour costs and simultaneously increased overhead costs but we still use the same old costing systems. The need for ‘Customer Service’, Quality Management, Health and Safety and compliance with other regulatory requirements has increased overhead costs. Despite these changes, the costing systems have not changed to reflect the new reality. The model we have all grown used to is no longer valid. The problem is that so-called direct costs (such as direct labour) refuse to be variable and are now only a small proportion of the total manufacturing costs. It is totally inaccurate to use them to allocate the indirect costs. Other traditional allocation methods (machine hours, floor space, etc.) are equally inaccurate and attempts to combine these

16

to produce greater accuracy rapidly becomes cumbersome and expensive.

The rise of overheads

Overhead costs are ripe for both change and management.

In fact, the problem is getting worse as time goes by. The direct labour base continues to shrink and overhead costs continue to rise (see below). This makes the older-style cost accounting conventions and formulas even more inaccurate and decision-making based on the results of these can be fatally flawed. They are ripe for both change and management. The cost basis of most manufacturing operations has changed over the past 40 years yet we continue to use direct labour hours as the most common benchmark for cost allocations. Note: The figures below may not be exactly right for every company but they won't be far out. In the past, even when we did look at ‘overheads’ we concentrated on the staff (or labour) element of overheads and ‘delayered’ (another word for ‘made redundant’) the middle management because they were an easy target. This meant that there was nobody left to do any of the work that could really save the company money. Meanwhile the production people were frantically trying to meet the ever-increasing production targets, to complete the new initiatives started by the upper management (the latest set of management fad initials) and the real cost contributors were left unchallenged and out of control.

Every manager worries if he sees a worker with nothing to do, but how many worry when they see a machine doing nothing, and how many worry about stocks and inventory that are in the stores ‘just in case’?

Overheads are rising, labour content is reducing. Tell me about it!

The changing face of manufacturing costs The cost basis of manufacturing has changed and the process is continuing. The cost of direct labour is now much less significant than the cost of materials and overheads, yet direct labour continues to be used as the main benchmark for cost allocations. Chapter 1 – Cost management

The management efforts

What are the new rules?

If we accept that the cost basis has changed then where do we currently allocate our efforts at cost reduction? The traditional Work Study Department measures and controls direct labour, the Purchasing Department attempts to control direct materials purchases after the product has been designed but nobody is responsible for controlling overhead costs and very little effort is spent in this area. The efforts of most manufacturing companies are shown in the diagram on the right.

The rules have changed in manufacturing industry and any company that fails to recognise this is not only going to be ineffective in cost management but also inefficient and at great risk in the future:

• Tip – Even when we do try to control

costs then this is seen as the responsibility of the finance function when really it is everybody’s responsibility. The diagram (and our own knowledge) shows that we spend most of our time and effort on the smallest component of the overall cost and that we largely ignore the other huge chunks of the costs that we ought to be managing. Reducing the overheads by only 10% translates into a product cost reduction of about 3.8% – the same as a labour cost reduction of nearly 50%. Logic tells us that if we want to make reductions then we should start with the big numbers because that is where we can make the big savings. Yet this is not where we start and we wonder why our cost reduction efforts are not as effective as we would like them to be.

The biggest costs generally have the least efforts to reduce them – are we trying to get it wrong?

• Cutting labour costs is not the same

thing as becoming a low-cost producer. • Cutting investment to reduce costs is a

short-term measure. • Managing costs can make you a low-cost

producer, simply cutting them will not!

This misdirection of our efforts continues to cost money and waste resources.

Sack the kWh and kg not the people to make yourself a low-cost producer.

In plastics processing, the labour costs represent only about 8% of the cost of the product but the overwhelming amount of effort still goes into reducing labour in the process – 75% of the effort is in reducing labour costs and only 15% in reducing overhead costs. This misdirected effort continues to cost money and waste resources throughout our industry. Our efforts are badly or incorrectly focused because we still operate instinctively on a model that is wrong and that sends us in the wrong direction when we try to manage costs.

Are we trying to get it wrong? Realistic cost management is trying to understand what we are really doing and where the costs are so that we can take meaningful and effective action. Unrealistic cost management distorts reality and misdirects us so that good profitable products are killed whilst unprofitable products are produced.

Chapter 1 – Cost management

The cost sources and where our efforts go Labour represents only about 10% of the cost of the product but our efforts still go into reducing the cost of direct labour in the process. 75% of our efforts are in reducing labour costs and only 15% in reducing overhead costs. 17

1.8

Activity-based costing

The ABCs of accurate costing Changes in the structure of manufacturing, such as increased investment in advanced manufacturing equipment, have meant that the overheads are no longer directly related to production volumes or direct labour hours. Calculated costs are distorted in relation to the resource use of the product and the real costs. Taken to the limit, in a totally automated factory, where direct labour does not exist, the traditional direct labour allocation method falls down entirely. Activity-based costing (ABC) was developed to assign indirect overhead costs (or transactions) in more accurate proportions to the products that require them. ABC says that activities drive the overhead costs and are a sounder basis for allocating costs than any of the current methods. Take supplying the automotive industry: a processor sees such work as a valuable large-volume contract and neglects to take account of the time and structure necessary to get the work. The work involves getting specifications and quotation documents, completing them and additional complex servicing procedures. This needs extra staff to cope with the work but the extra costs appear as overheads where they are nearly forgotten. Also, they are rarely applied only to the automotive work but are spread out over the total product range. If costs are allocated according to direct labour hours then the increased overheads drive up the price of the traditional work whilst simultaneously underpricing the automotive work (which has directly required the extra overhead costs). ABC concentrates on the ‘cost drivers’ for the product and says that you cannot use a global overhead figure from direct labour or machine hours to work out a product cost. • Tip – You must find the ‘cost drivers’ of

your business and products. The product cost is not just related to the volume of the work but also to the overheads necessary to get and produce the particular job. This requires more analysis but gives clearer understanding of what a product really costs. 18

The costs that can be allocated to a particular product are allocated to that product and only what cannot be allocated remains to be split as overheads. This gives a better clarity of cost causes and can be particularly useful in the ‘make or buy’ decision making.

Transaction costs offer the key to an understanding of the real costs.

If you are not using ABC then the ‘costs’ used for pricing decisions probably bear little relation to those that actually incurred. Despite the increasing relevance of the approach, too few plastics processors use ABC to give accurate product costing and most rely on the ‘global’ approach. The use of ABC gives a clearer allocation of the overhead costs based on the activities. We can then start to concentrate on managing and reducing the transactions that drive the overheads and concentrate on results achieved – i.e., concentrate on effectiveness rather than efficiency. It is useless being efficient at something that you shouldn't be doing in the first place.

Controllable overheads A better understanding of cost behaviour through ABC allows the general overhead costs to be divided into controllable and

Wasted labour is visible when it is not working but how can you tell if an overhead is not working? The drive to measure and improve the productivity of overheads must be seen as one of the keys to success in the future.

Distorting the costs A Sales Office costs £50,000 per year to run and deals with only two products. Both products have sales of £1,000,000 per year and take exactly the same amount of materials and working hours. The only difference between the products is in the sales order pattern. Product A sells in 10 equal orders of £100,000 per year to one customer and Product B sells in 1,000 equal orders per year of £1,000 to 100 different customers. Conventional methods say that the Sales Office costs are distributed equally between the products and both products accept an overhead of £25,000 per year. This is despite the fact that Product B uses at least 100 times as much ‘transaction effort’ of the Sales Office as Product A. Conventional wisdom overprices Product A and underprices Product B – both costs are wrong. Conventional wisdom such as this has led companies to terminate profitable products whilst retaining unprofitable products. The ‘costs’ may be known with great accuracy but still be totally wrong. Under ABC the transaction cost would be £50,000/1010 = £49.50 per transaction. Product A would have an overhead cost of £495 whilst Product B would have an overhead cost of £49,505. This could radically change the ‘profitability’ of the products. Chapter 1 – Cost management

non-controllable overheads. The approximate division for manufacturing industry is that controllable overheads are 27% of the total and this is where effort can be applied. These controllable overheads can generally be easily allocated to specific products, processes or projects. Overheads can then be managed as for any other cost.

and price calculations. This reduces both the amount and complexity of the work involved whilst still providing a more realistic approach to product costs. This approach also provides ‘ownership’ of the management accounts with managers recognising the increased relevance of the numbers and the improved clarity in decision making.

Obviously an understanding of controllable and non-controllable overheads allows a better understanding of the cost behaviour of a company and allows links to be made between other performance measurements and costs.

Despite the validity of these concerns, the fundamental analysis necessary for ABC reveals the basic processes taking place in a company and the true cost of each process. This previously unavailable information provides an essential focus for cost reduction and leads on to even more important techniques such as activitybased management (ABM).

ABC is not a universal panacea to costing and overhead reduction – it is a tool to focus on how costs are generated and the value we get for money. Instead of a ‘shotgun’ approach to overhead reduction, ABC focuses us on activities that add value and allows us to reduce or eliminate those that do not. The Pareto principle (see Section 8.9) tells us that 80% of the added value in our business will be created by 20% of the activities. To improve overhead productivity, shouldn't we focus on and improve the vital 20% and cut or remove the trivial 80%?

Note: ABC can also be applied to customer analysis to assess the ‘value’ of customers to the organisation. Not all customers produce equal amounts of profit even if the sales and margins are the same. Customers who use extensive amounts of the company’s resources need to either pay more or be terminated. A ‘customer culling programme’ can often decrease revenues slightly but dramatically increase profitability.

In the future, managers must manage and control the controllable overheads at their disposal. To do this, managers first have to accept that these costs are actually under their control and that they are not simply there to be allocated away and disappear.

Controllable or non-controllable overheads? As a general rule the division of overheads is as follows: Manufacturing industry: • 27% controllable; • 73% noncontrollable. Distribution and retail: • 63% controllable; • 37% noncontrollable. Financial services: • 67% controllable; • 33% noncontrollable.

As an exercise, look at the use of services, such as compressed air and see how these costs are allocated to products irrespective of their actual use.

The downside of ABC ABC is not the solution to all of the concerns with overheads and costing but it does start to point the way towards improvement rather than ignorance. ABC has suffered from poor implementation in many companies and success has not been universal. Problems have been found with: • The amount of work involved in

accurately collecting the information on activities and drivers. This is especially true if the collection process is treated as ongoing. • The complexity of the overall method.

The terminology of ABC

• The continued focus on financial

Activities – The different types of work done in the company. Activities use resources such as time, people, space.

measurements and the retention of the process in the accounts department where it was still not ‘owned’ by the relevant managers. Cost collection for ABC can be carried out relatively easily on an annual basis to assess the cost drivers for cost assessment Chapter 1 – Cost management

Cost pool – The total costs associated with an activity. These costs may come from various areas of the company but are all related to a single activity. Cost driver – The event (or transaction) that starts an activity. A single cost driver is associated with each cost pool. 19

1.9

Activity-based management

A tool for improvement The knowledge of the fundamental processes (and the associated costs) that can be provided by ABC was previously hidden in the accounts under a variety of headings and conveniently ignored. The routes to true cost reductions were hidden by the way that the numbers were presented. This leads to the concept of activity-based management (ABM) where the information from the ABC process is used to influence the improvement activities and performance of the company. Isn’t this what management accounting was supposed to do in the first place (to tell us where we should be going)? Instead the accounting process became a burden on all concerned with it. ABM is the really useful outcome of ABC and allows us to focus on cost reductions throughout the process. The two example cost reports on this page show the traditional classification-based cost report (including the inevitable variance report line) and the ABM type of report. The traditional report contains a restatement of the budget as assembled by the manager (up to 18 months previously and now largely useless because of changes in the business) and the performance against that budget stated in terms of variances. This report gives no indication of value adding processes or areas to target for cost reduction. The ABM report shows us that the valueadding activities (‘produce mouldings’ and ‘assemble product’) cost £245,000 or 60% of the total. All the other activities add cost (£167,000), but no value, and amount to 40% of the total costs. The areas for improvement are clearly seen and can be targeted for continual or incremental improvement. ABM clearly gives more valuable information than traditional classification-based management accounting and actually allows the accounts to provide direction for future work. This is the actual aim of management accounting but somehow we got lost along the way.

Implementation Implementing ABM starts by looking at 20

and assessing the activities taking place in each department or process group. Each activity is assessed for time taken, total cost and the amount of value added by the activity. This information allows the preparation of an activity-based cost report similar to that shown in the example on the right. The value added by each activity can be clearly defined to provide targets for improvement. This process also produces much of the information necessary for the conventional activity-based costing approach. Although ABM can be carried out on a trial basis in a single department, the true and full benefits only become apparent when the whole company is using ABM.

When we start to measure then we start to manage. ABM provides the methodology for measurement. The managers must then do what they are paid for and manage rather than simply administrate.

Moulding Department – Cost Report Classification based Allocation area

Cost (£)

Variance (%)

Salaries – Managers

20,000

-5

Wages – Labour

80,000

+5

Expenses

10,000

+12

Factory space

100,000

+1

Quality control

15,000

-12

Packaging

25,000

+4

Tool room

30,000

+6

Security

10,000

-4

Telephone

1,000

+6

Training

1,000

-6

Utilities

60,000

+10

Insurance

5,000

+4

Miscellaneous

30,000

-7

Depreciation

25,000

-2

TOTAL

412,000

-2

The traditional cost report showing the classifications and the variances What do you do to get better and to improve performance? What value do the variances add? Do they help you to get better? Why do I have to write a report each month explaining this stuff? Chapter 1 – Cost management

The benefits ABM highlights the cost of non-valueadding activities and points the way to effective cost reductions. In the examples shown, the ABM-based report shows the wasted costs associated with tool changes. Although it only shows the direct cost of tool changeovers (the indirect costs of these are far greater) it does act as an incentive to reduce the time and cost involved in tools changes. Equally the cost of counting product is shown clearly and managers have an incentive to reduce this ‘waste’. ABM also acts as an incentive to think about how the company is organised. The method of looking at departments and companies in terms of processes reveals that most companies are organised around common activities rather than around the processes that they support. This is the same as having a ‘moulding shop’ where all the moulding is carried out and then an ‘assembly shop’ where all the assembly is carried out. In manufacturing, worldclass companies are changing from this functional grouping to focus on grouping for complete products and complete processes rather than on the intermediate steps. ABM helps us to see the logic of this on a company-wide basis. The move to ABM supports the introduction of non-financial measures of performance and provides a method for integrating these non-financial measures back into the accounts when necessary. To use the tool change example – if the moulding department carried out 250 tool changes in the year and the cost of a tool change is £600 then the total cost for tool changes is £150,000. This adds a financial incentive to reduce the time taken to carry out tool changes or to reduce the number of tool changes. Equally, product produced for inventory appears as an asset in the conventional accounts – ABM reveals some of the costs associated with storing the material and can act as a driver to reduce inventories. ABM is the only current financial instrument that truly supports the move towards world-class manufacturing. Most other financial methods do not recognise the wide-ranging benefits of low inventory, low work-in-progress, rapid throughput and the reduction of non-value-adding processes. On this basis alone, ABM is the only way forward for accounting. Note: The concept of assessing the value Chapter 1 – Cost management

of an individual customer to the company can easily be carried out using ABM. The activities to support specific customers can be used as the basis for dividing the costs and these can then be used to assess the profitability of the customer. ABM also allows a company to focus on those processes that support the customer and reduce those that do not. • Tip – ABM looks at processes in much

the same way as the new ISO 9001: 2015 looks at processes (see Section 4.10). Even simple processes will have multiple inputs and multiple cost components. • Tip – Get your finance area to produce a

model of the company looking at the production resources, how they affect costs and the effect of changing these on margins. This can act as a real incentive to make real changes to the management accounting methods.

Starting to focus on processes rather than on departments can be unsettling. It requires changes in attitude as the traditional barriers and power structures are broken down. Functional departments (and their managers) as we know them can easily disappear. Did anybody ever say that survival was easy or mandatory?

Moulding Department – Cost Report Allocation area

Cost (£)

Value added

Produce mouldings

185,000

55,000

Transport product

20,000

0

Tool changes & set-up

35,000

0

Store product

22,000

0

Count product

8,000

0

Inspect product

22,000

0

Segregate scrap

9,000

0

Recycle & rework

8,000

0

Assemble product

60,000

30,000

Machine repair/maint.

37,000

0

Sales of scrap

-2,000

0

Rescheduling

8,000

0

412,000

85,000

TOTAL

The activity-based management cost report showing the costs of the activities The areas for improvement are obvious and can be targeted for improvement by the local management.

21

1.10

Financial structure – where are you now? drivers for real business improvement and cost reduction by focusing attention and therefore the efforts on the real cost and activity drivers.

Financial structure The financial structure and the allocation and reporting of costs drive the cost management process. Only when the real costs in each area are understood is it possible to start to reduce these.

This means critically looking at the area of overheads which have tended to be ignored in favour of crude efforts to reduce direct labour whilst ignoring other larger cost contributions.

This is not helped by many of the current financial structures where the needs of financial accounting and conventional management accounting are regarded as being more important than actually running the business.

Getting the financial structure right is essential for effective cost management.

Completing the chart

We need to see our management accounts as a tool to drive the business and configure them accordingly. The techniques of ABC and ABM can act as

This chart is completed and assessed as for the previous charts.

Financial structure Key costs 4 3 2 Investment

Activitybased costing

1 0

Overhead control

Activitybased management

Use the chart to assess where you are in financial structure The numbers from the self-assessment should be transferred to the radar chart for a quick visual guide to where you are in the basics of financial structure. 22

The wrong financial structure focuses our attention in the wrong places.

Chapter 1 – Cost management

Financial structure Level

4

3

Overhead control

Investment

Overheads controlled Long-term investment & control efforts are in plan available & based proportion with on company mission & expenditure. goals. Justification based on overall cost reduction & not just head count. Good post-project assessment.

Understanding of the Product costing Business costs & Overhead growth is Long-term investment real costs in key areas. approximately reflects control efforts aligned controlled but control plan available but Accounting systems resource usage in in most areas but efforts not fully related adherence is variable. modified to reflect most areas but reporting is based on to proportion of Nominally based on company mission & significant costs are variance model. expenditure. mission & goals but goals. allocated by actually reaction to mechanical formulae events. that are regularly revised.

2

0

Activitybased management

Business costs & Understanding of the Product costing real costs in all areas. reflects the real efforts efforts aligned. & resource usage in Efforts at cost Accounting systems the business. reduction are modified to reflect company mission & Overhead allocation is appropriate to the based on activityrelative magnitude of goals. based assessment of costs. usage. Reporting identifies non-value-adding activities in all areas.

Understanding of the real costs in most areas. Standard accounting systems used.

1

Activitybased costing

Key costs

Overhead growth is Medium-term Product costing Some correlation controlled but control investment plan approximately reflects between costs & resource usage in control efforts in some efforts are sporadic & available but unrelated most areas but areas but little effective unrelated to proportion to company mission & management of real of expenditure. goals. significant costs are allocated by costs. Investment plan is reaction to events. mechanical formulae that are rarely revised.

Understanding of the real costs in some areas. Standard accounting systems used (not modified to reflect company realities).

Product costing accurate for labour & material but large areas of cost are allocated arbitrarily.

Little correlation between costs & efforts.

Key costs not analysed or recorded. Standard accounting systems used (not modified to reflect company realities).

Product costing variable for most elements. Some elements treated with high precision but others ignored in calculations.

Business costs & control efforts are seriously misaligned. Focus is on direct labour but real costs are elsewhere.

Overhead growth is uncontrolled despite large expenditure rises.

No long-term investment plan & cursory post-project assessment. Investment is reactive & justified for a variety of reasons.

Overheads are never No long-term investment plan & little studied & reduced except when post-project demanded by cost assessment. reduction exercises. Investment is reactive & primarily justified by head count reduction.

Score Chapter 1 – Cost management

23

1.11

Product costing – 1

The new world

Costing

ABC and ABM provide new methods of looking at the costs in plastics processing but the very necessary and basic task of pricing a product for a customer remains. ABC provides excellent guidelines in how to allocate transaction costs to products but data are not always available for new products. In such cases, existing ABC allocations for similar products can be used to allocate overheads. This process will allow a ‘cost’ to be generated for a specified product.

Costing and estimating plastics products is often presented as a difficult and complex procedure. Whilst this is true if an exact ‘cost’ is required, the reality is that it is impossible to assign an exact cost to any product and seeking exactness at any stage is almost certainly a waste of time. In many cases, there are seemingly very exact numbers quoted for prices (with many numbers after the decimal point). Probing the input information reveals that these numbers often confuse precision with accuracy – they are very different! The allocation of overheads will distort the calculated costs dramatically.

This fascination with costing is the result of the old world way of operation. In this world the equation was: Cost + Profit Margin = Product Price This equation is now fundamentally flawed (if it was ever true) because: • The product price (what the customer

will pay) is fixed by the market and competing products or processors. If the price is too high then the product will not sell. This is now being recognised by major customers who are introducing ‘target cost’ methods in product design. • The profit margin is fixed by the needs of

the company. If the profit margin is too low then the company cannot afford to produce the product. The new equation is: Product Price - Profit Margin = Cost where the cost is the only variable that the processor can realistically affect. This makes cost management even more important in the current market because it is the only thing that will enable a company to survive.

The hidden costs Costing methods rarely take into account the hidden costs of dealing with some products and customers. The features of hidden cost products and hidden cost customers are listed in the table on the right. Most people will have experienced the trauma of a hidden cost product or customer that simply will not go away and cannot be disposed of. The warning signs are always there but we rarely take account of them and before long they are an expensive drain on the company and personal resources. Avoid them if you can. 24

Managing and reducing costs and even accurately calculating them does not automatically mean that you will achieve good prices for your products. The cost of a product has little to do with the price that you can get for it, despite what some costing systems would have us believe.

There are several methods of costing but only two are considered here, these are: • The ‘exact cost’ method which is highly

dependent on cost allocations. • The ‘budget cost’ method which gives a

quick snapshot of the expected price. The two methods are not incompatible and can be used to complement one another. When used with care, the rapid budget cost method is rarely more than ±5% different from the exact cost method. This doesn't matter because the true cost is almost always unknown and unknowable.

Predicting or calculating the true cost of a product is totally impossible and futile. Products don’t make money – companies do.

High-Cost Products

High-Cost Customers

Are only produced in short runs.

Only order small quantities of slow moving parts.

Have long machine set-up times.

Order irrationally and want urgent delivery.

Need extra planning to fit into the production plan.

Never pay on time and always query invoices.

Are difficult to run and need extra controls (quality, waste etc.).

Do not know their own business and expect you to support them (immediately!).

Use special materials or packaging.

Need additional technical support.

Are awkward to handle.

Are awkward to handle.

High-cost products and customers are hidden from view and distort product costs Locate these products and customers and then indulge yourself in a ‘cull’. It will not only be enjoyable at first but it will also make your life much easier and enjoyable. Chapter 1 – Cost management

The traditional ‘exact’ method Fundamentally there is no real difference between costing for polymer processing and any other ‘conversion process’ in a capital-intensive continuous process industry. Good costing needs: • Forward planning. • An understanding of costs and their

allocation. • Good control procedures.

• Calculate machine hours required from:

Output rate for product. Set up time. • Use the machine hour rate (see above) to

calculate the overhead cost. Total overhead cost to run machine = E. • Calculate total tooling cost and allocate

this as a percentage of the tool life expectancy. Include maintenance and storage costs.

As a rule, the ‘fixed’ costs (including labour) account for over 45% of the product cost and the raw materials account for the bulk of the remaining costs. The first requirement to use or establish a costing system is to establish the fixed cost data. The traditional methods establish the fixed costs (the overheads) and then allocate these in some manner to each product. This method can be based on machine hours, labour hours or any other method chosen at random by the cost accountant.

Total cost of tooling = F.

The background data for costing

This gives the total product cost (T) as:

An annual sales forecast for each product group is produced to include prices, sales value, material costs and net value-added.

Additional factors may be added to cover:

A materials cost estimate is made from the sales forecast to give an estimate of the value-added for each product group. Note: A high value-added product may be allocated a larger fixed cost for sales, technical and quality control areas. A machine requirements estimate is prepared on the basis of machine use (in machine hours). The machine time is often used as a basis for allocation of fixed costs. A table of fixed costs and their allocation is drawn up at this stage to ensure correct allocation. The allocated ‘machine hour rate’ is then used in all estimating situations.

The actual estimation The actual estimate is generally carried out using a checklist as below: • Identify the material to be used. • Identify amount of material required

from: Quantity produced for sale (A). Standard scrap rate for product (B). Storage and other losses (C). Total cost of material = A + B + C = D. • Allocate machine to be used.

Chapter 1 – Cost management

Good costing does not necessarily generate good pricing or good prices.

• Use the utilities factor for the machine to

calculate the utilities cost. Total cost of utilities = G. • Using the packaging and transport costs

calculate the distribution cost. Total distribution cost = H. • Overheads relevant to the product

(apportioned on the basis of direct labour costs, machine time or floor space) are then allocated to the product. Total overhead cost = I. T = D + E + F + G + H + I. • Additional quality controls. • Finishing operations. • Additional packaging.

A standard profit factor is then added to the cost to give the selling price.

The result This approach appears to be rigorous and provide a highly precise estimate of costs but it is wrong to equate precision with accuracy. They are not the same thing. If you doubt this, then find out what percentage of the product cost is accounted for by ‘overheads’ and go back into the system to try to find out how these were allocated. The end result of the detailed method is a precise but probably inaccurate product cost based on many assumptions. ABC provides the solution to this problem of overhead allocation by using the real cost drivers to assign the overheads in relation to the costs incurred by the product. The actual costs should be reviewed regularly to assess the real profitability and validity of the calculation.

Whilst running an ‘exact’ cost system (which calculated the product cost to about five decimal places) I was told that a product was too costly to produce and that I had to reduce the costs. I recalculated the floor space required for the product assembly and this decreased the cost sufficiently to get approval to go to production. We didn’t change a thing except to manipulate the overheads allocated to the product and I felt no shame.

25

1.12

Product costing – 2

The ‘budget’ method

higher investment.

This is a ‘quick and dirty’ method for estimating costs but can give remarkably accurate results if used with care. It not only gives a cost but allows an assessment of the operational efficiency of the factory.

The critical number here is what is called the ‘conversion ratio’, as plastics processing is simply a conversion process.

The model factory For extrusions or injection mouldings a rough allocation of the manufacturing costs can be made as follows: Manufacturing Costs Mass produced product

Technical product

Materials

77%

43%

Machine

13%

27%

Tool

5%

20%

Labour

2%

5%

General

3%

5%

100%

100%

Total

The machine element can be further subdivided into: Machine Costs

The ‘conversion ratio’ says: Total Product Cost = Material Cost × Conversion Ratio or T = MC × CR For a mass-produced part the CR can be as low as 1.25 and for a technical part the CR can be as high as 2.6. The CR can be regarded as a measure of ‘the added value for the product’ and thus has a definite business meaning.

Mass produced/technical To decide whether a part is ‘mass produced’ or ‘technical’ it is necessary to look at the critical tolerances. For any plastic part, the majority of the dimensions will be non-critical and will be open or general tolerances. There will also be critical tolerances which directly relate to the fit and function of the part. As a general rule a ‘mass-produced’ part would have three or less critical tolerances and a ‘technical’ part would have four or more critical tolerances. Normally any product with more than 6–8 critical tolerances is difficult to produce, i.e., you get one tolerance OK and the others drift out.

Mass produced product

Technical product

Electrical

5.8%

5.3%

Water

2.2%

1.1%

Auxiliary and factory

0.3%

Number of critical tolerances

Conversion Ratio

0.1%

Fixed plant

4.9%

20.3%

0

1.25

Total

13%

27%

1

1.40

2

1.60

3

1.75

4

1.95

5

2.10

6

2.25

7

2.45

8

2.60

These results show that for a massproduced part nearly 80% of the cost is locked up in material at the design stage. Machine costs are less because of higher speeds, lower specification machinery and tooling and lower investment. For technical parts, i.e., tighter tolerances, you have higher machinery costs because of slower speeds, higher specification machinery and tooling and generally 26

The number of critical tolerances (which should be between 0 and 8) is assessed and a table similar to the following is used to assign a CR to the part:

Polymer processing is a conversion operation and the use of a ‘conversion ratio’ accurately reflects this. To get an idea of the overall company efficiency it is easy to calculate the ‘company conversion ratio’ (total sales divided by total materials costs). This is really the value added to the polymer and links back into the accounts system very neatly as well as giving a quick view of company performance.

Get your finance area to produce a spreadsheet analysis of the sensitivity of the market to increased prices and the effect on margins and profits. Even if you lose business as a result of price increases then it may be possible to increase margins and profits. The output can be illuminating especially as most customers change suppliers not on the basis of price but on the basis of quality and service.

Chapter 1 – Cost management

Material cost For injection mouldings the part weight is estimated from drawings or from weighing a similar product. The material cost is estimated using the cost/kg for the proposed material to give a material cost per component (cost/component). For extrusions the cross-sectional area of the product is calculated and the weight/ metre (kg/m) of profile is calculated from the density of the proposed material. The material cost is estimated using the cost/ kg for the proposed material to give a material cost per metre length (cost/m).

Product cost The product cost may then be calculated using: Total Product Cost = Material Cost × Conversion Ratio i.e. T = MC × CR There are several conditions to be met in using this method, these are: • There needs to be a minimum yearly

demand or a call-off schedule. • The CR depends on the weight of the

product as well as the number of tolerances, i.e., a small part has a higher CR than a large part with the same number of tolerances. For example, an extrusion with a cross-sectional area of 10 mm2 will generally have a higher CR than a product with a cross-sectional area of 100 mm2 and an injection moulded product with a component weight of 10 g will generally have a higher CR than a product with a component weight of 100 g.

This requires the development of a matrix for the CR which can be presented for each process, an example of the type of matrix that can be developed is shown below. The matrix needs to be used with care and updated at regular intervals using factory costs as reported. In practice this simply means running cross checks or using industry norms.

Summary The detailed and quick costing methods both produce a cost for the product but the detailed method will produce spurious precision by including overhead allocations that cannot really be quantified as accurately as the method assumes. The quick method steps around this issue by looking at the company conversion ratio for the typical product (which has an inherent view of the overhead costs) but has the huge advantage of producing a cost within minutes rather than taking days. I used the ‘quick’ method for over seven years to produce budget quotations and in that time we were never more than 4% away from the detailed calculation yet took only moments to calculate the costs. Product costing for accurate results is probably a fruitless search. The best result will be obtained from a quick and approximate assessment at the quotation stage in order to obtain the work at an adequate profit margin followed by the application of cost management techniques to reduce the cost and increase the profits.

Good enough? Despite the fact that this appears a quick and dirty method of estimation there is considerable academic research that validates the method of using the number of critical tolerances as a method of estimating both tool and product cost, see Fagade and Kazmer, ‘Early Cost Estimation for Injection Molded Parts’, Journal of Injection Molding Technology, September, 2000, 4 (3), p. 97–106.

This method also highlights the importance of material costs (see Chapter 3).

Do not be ashamed of charging a fair price for your product.

Note: Example for extrusion only Number of critical tolerances

Product cross-sectional area (mm2) 1

2

3

4

5

6

7

8

Conversion Ratio 10

1.95

2.10

2.25

2.45

2.60

2.60

2.60

2.60

20

1.75

1.95

2.10

2.25

2.45

2.60

2.60

2.60

30

1.60

1.75

1.95

2.10

2.25

2.45

2.45

2.45

50

1.40

1.60

1.75

1.95

2.10

2.25

2.25

2.25

100

1.40

1.40

1.60

1.75

1.95

2.10

2.10

2.10

250

1.25

1.25

1.40

1.60

1.75

1.95

1.95

1.95

350

1.25

1.25

1.25

1.40

1.60

1.75

1.75

1.75

500

1.25

1.25

1.25

1.25

1.40

1.60

1.60

1.60

Chapter 1 – Cost management

27

1.13

Old ideas and new ideas

The traditions of accounting In order to successfully manage costs we need to make changes in the way we consider the accounting function. The changes in the structure of manufacturing threaten some of the basic ideas that make up management accounting and it is worthwhile looking at some of these in detail.

There are direct costs and indirect costs – direct costs are variable and indirect costs are fixed This simplistic approach no longer works in manufacturing (if it ever did). Direct costs are not always variable. How often do you lay off labour the moment work stops coming in? The simple answer is that you don’t and that they continue to cost you money, but they are now an indirect cost. The labour cost is not directly related to the manufacturing volume so does it make sense to pretend in the accounts that it is? Similarly, indirect costs will sometimes vary with the manufacturing volume and sometimes they won’t. For example, the purchasing function workload will vary with both the work inflow (more incoming orders generally mean more outgoing orders to suppliers) and with the specific products being manufactured at any given time. This direct/indirect cost distribution is no longer valid. Both types are used to convert input to output so why distinguish between them? Instead of setting up artificial boundaries such as ‘direct and indirect’ or ‘variable and fixed’, we ought to understand that they are all simply costs and they will all vary in their own way with varying circumstances in the business. The accountants know this but they just haven’t told the manufacturing people yet.

Products make profits It is common to think that the equation previously used: Cost + Profit Margin = Product Price can be used in the form: Product Price - Cost = Profit Margin 28

to determine the product profit margin and some companies calculate this to determine if they will produce a particular product.

A business can make a profit but a product is simply part of the mix.

In practice taking any product to the ‘profit’ line is very risky unless the company only has one product. It should already be apparent that the allocation of overheads has an undue effect on the calculated product cost and this can easily distort the results. A business can make a profit but a product is simply part of the mix. Products do not make real profits. This equation only works if the numbers are totalled across the whole of the product mix for the company. The real question is – what is the effect of the product on the bottleneck process in contribution terms? The new methods show that company profitability is determined by the rate at which the company earns money not the contribution per product. Some companies think this is all irrelevant because it will all even out in the end. The overhead allocations may be wrong and they will lose money on some products and then they will gain money on others. In truth, there are two scenarios that make this a very dangerous assumption, one is internal and the other is external. Internal: A company decides to rationalise the product or customer base and uses the product or customer margins as a method of doing this. Inappropriate cost allocations are used to determine product or customer profitability and as a result profitable products (those contributing excessively to the overhead burden) are withdrawn or profitable customers are terminated. This means that the overhead burden is redistributed again. The analysis continues and more products or customers are withdrawn or terminated until the company becomes unsustainable and is re-structured. The process begins again and continues until the company finally closes. External: The market for plastics products is generally transparent and usually contains more than one processor competing for a given customer. The

The concepts of bottleneck processes and their effect on contribution are dealt with in more detail in Section 5.5.

“The greatest difficulty in the world is not for people to accept new ideas, but to make them forget about old ideas.” John Maynard Keynes

Chapter 1 – Cost management

processors will always have different overhead allocation methods and structures. Even if similar costing methods are used, the processors will calculate different prices for a given product. The customer will generally choose the cheapest price. Where the overhead allocations are low the price of the product will be low and the processor will get the work (and lose money on the job from failing to recover the overheads). Where the overhead allocations are high the price of the product will be high and the processor will not get the work – it will go to another processor whose cost structure has underpriced that particular job. Incorrect pricing decisions do not even out in the end. They always end up negative and cost the company money.

Inventory is an asset and work in progress (WIP) has an ‘added value’ Inventory can be defined as ‘something you are paying for that no-one else wants’. In this sense, it is a liability to the company and not an asset. There are three categories of inventory: Raw material – This is something you have bought and do not need yet. Work in progress – This is something that you have spent money on but that cannot be sold in its present condition. Finished goods – This is something that you have completed but have not yet sold to the customer. Inventory is not a true asset at any stage in the process. It may be defined as such by the accountants but it is a product of unsynchronised manufacturing. In truth it is a liability eating up cash in the system. This differs from the conventional view of inventory, where inventory creates an ‘added value’. This added value concept says that if you take a kilo of plastic and process it, then you add value. The reality is that until you have the customer’s money in your bank account you have added cost but not value. Answer these questions: • Is a kilo of unsold mouldings really

worth more than a kilo of unprocessed plastic? • What is a finished product really worth if

the customer cannot or will not pay?

The real desire to put a value on inventory comes from the need to link the financial and management accounting systems. True inventory value at any stage can be assessed simply by using the value of the raw materials input to the product at that stage. Using this method, WIP can be valued simply and quickly without trying to assess intermediate amounts of spurious value added. Finished goods inventory can be valued on the basis of the cost of the raw materials. This is a departure from some accounting conventions but inventory has not yet been sold so how logical is it to count the mythical ‘added value’ as an asset?

There are three types of people in the world: those who can count and those who can’t. Most accountants are in the last group.

This method sidesteps the games that can be played with ‘added value’ numbers such as the creation of ‘inventory profits’ (which can act as an incentive to ‘make forward’ or increase inventory even if the products cannot be sold). The method has the advantage of being quick, simple and easily understood but does challenge our current ideas. Current methods of inventory valuation encourage high raw materials stocks, high WIP and large finished goods inventories. If we really want to encourage low inventories, low cycle times and rapid throughput then our measurement systems must encourage these features. The current measurement systems do not. Inventory is not an asset and work in progress has no added value.

Changing the viewpoint Accounting practices are not static and as we change the way we operate we need to change the way we account for and measure the costs. If our strategy is stressing quality, short lead times, low inventory and reliability and none of these are being addressed by our management accounts then there is obviously something wrong! It is clear that many of the current methods of accounting and performance measurement do not provide the right numbers for managing our factories and that changes must take place. The traditional management accounts need to be supplemented by more relevant numbers so that operators and managers can concentrate on creative cost reduction rather than on creative accounting.

“Vision is not enough. It must be combined with venture.” Vaclev Havel

Chapter 1 – Cost management

29

1.14

Investment for cost management

What is investment? When we think about investment we invariably think about purchasing a capital asset: as in ‘The company plans an investment of £400,000 in new machinery next year’. This is the traditional view of investment where the concentration is on the acquisition of fixed assets. The reality is that an investment is ‘something on which a business spends money in order to earn more money’. This definition includes all the time and money we have tied up in the business. These investments are what we have put into the business or have at risk should the business fail. This is a broader definition of investment but it does reflect reality. Investment is necessary to continue to compete in the marketplace and the company that does not invest will surely find itself becoming uncompetitive and will eventually cease to exist. If your aim is a short-term one of cash generation and removal then this is acceptable. If you want to be in business in 5 years time then you need to consider your investment programme very carefully on a continuous basis and this means not only the capital assets as defined by the accountants.

The major resources Before making any investment it is essential that the proper resources are available. The correct resourcing of any project needs to be part of the initial assessment and approval. Inadequately resourced projects will either never be completed or will fail outright. In business you don't get points for starting things, you only get points for finishing things! The major resources needed are: Financial resources – Without the right degree of internal and external financial resources investments will not be successful. The effect on the cash flow of the company is particularly important. Human resources – Investment programmes need the right human resources. This might mean training staff, hiring staff or even redundancies. Some will only be required during the implementation phase but others will be permanent. High-technology machines may require fewer operators but often 30

require more highly skilled maintenance staff to keep them going. It makes no sense installing robotics to reduce direct labour only to have to hire a ‘robot programmer’ at three times the cost to keep them operating. This is rarely recognised and included in the investment costings.

“If you need a new machine and don't buy it then you will eventually find out that you paid for it, but don’t have it.” Henry Ford

Management resources – Investment programmes require management and it is important to invest only in what you can manage. It makes no sense starting on an investment programme unless the management capacity and capability is available to successfully run the project. Technology resources – Most investments will need to fit within the existing operations and equipment. If a project does not fit within the technology currently used, the space available or the equipment available then the costs for these need to be included in the overall cost of the project.

The investment decision – the cost of not doing The conventional accounting treatment of investment is largely based on criteria such as Net Present Value (NPV), Return on Investment (ROI) and Discounted Cash Flow (DCF). These assessment methods look at the pay back and financial implications of an investment and provide a method for judging the financial impact of the investment. The numbers tend to focus on the short-term financial aspects of investment rather than the longer-term strategic needs of the business. They are excellent for making a choice when presented with several alternatives for action but when presented as a reason to do nothing they should always be challenged. They cannot look at the strategic cost of ‘not investing’, which can be far greater in the longer term. As a group of techniques the traditional methods tend to concentrate on increases in efficiency and reductions in manning. The real problem is that these measures are no longer really relevant to the effectiveness of the manufacturing operation. The numbers rarely take into account the effect of reductions in working capital (via WIP and inventory reduction) and any improvement in the ability to

You don't get points for starting things, you only get points for finishing things!

To paraphrase Oscar Wilde: ‘The numbers give you the cost of everything but the value of nothing’.

Chapter 1 – Cost management

compete more effectively in a market that is sensitive to time and variety competition. It is almost impossible to measure factors such as: • What are the tangible benefits of

improving on-time deliveries, being more flexible to customer demands, reducing production lead times? • What is the difference between the

company prospering or going broke? It is apparent that there is a need for two classes of investment criteria to be applied: • Traditional investment criteria – based

on the traditional numbers and firmly supported by these. • Strategic investment criteria – based on

the need for the company to remain in business in the coming years. A management team still needs to be convinced that any proposals are soundly based and likely to achieve their stated objectives but there is a case to show that investment in cost management may need to be made as much on the strategic necessity to stay alive as on the conventional techniques. The conventional techniques should not be ignored and all investments should be justified but some of the intangibles also need to be given numbers. These will later serve as measurements for operational effectiveness improvement.

Investing for flexibility Investment in machinery should always allow for flexible production. Production demands will change with time and with the product mix. Investment in machinery should consider this at the planning stage. It is almost impossible to ‘future proof’ any investment but flexible production capability is essential in any factory, dedicated machines should only be considered if they are low cost and disposable.

The traditional assessment of an investment with the ‘hard’ accounting numbers is based on efficiency improvement and labour reduction. These measurements were designed for a manufacturing environment where direct labour and machine utilisation were important. They don't actually consider if you should be doing the task or not. If the market needs high quality, high reliability, short lead times and low inventory and none of these is being measured in our investment appraisal then there is something wrong. Perhaps there should be more use of measures of real effectiveness that directly affect success in the market place? • Decide what is to be improved and

establish a base line for measurement. • Record and analyse the current

measurements. • Act on the investment plan and

implement the investment. • Measure the results of the investment to

ensure that it has really been effective.

You could have been the most efficient slide rule manufacturer in the world (remember them?) but that wouldn’t have helped you when the market moved on to pocket calculators. Equally, the efficient manufacturers of pocket calculators never made the transition to mobile phones which almost completely wiped out the market for pocket calculators by including a calculator as part of the free package. Two complete market transitions for a fundamental need in less than 30 years.

• Tip – Assessing the implementation

effectiveness is necessary to see how it could have gone better. Understanding problems or failures in implementation will help you to do it better next time. • Tip – Assessment needs to be carried out

without searching for a guilty party to punish – in any case only the innocent will fail to have an alibi prepared!

“Hell, there are no rules here – we are trying to accomplish something.” Thomas Edison

Investment for flexibilty Flexible machinery Flexible production Flexible systems Flexible products

Investment effectiveness Investments are made to earn more money and investments that do not do this are wasted. Despite this, few companies analyse investment effectiveness after implementation. A problem with investment appraisal is that sometimes the measurements used are inappropriate for the investment. The standard appraisal methods provide a financial basis for assessment but do not deal with the more intangible measures. Chapter 1 – Cost management

The flexible and future company

Invest in flexibility for the future to survive the changes to come Assess every investment for flexibility. Change is inevitable and if investments are not flexible then they can make a company resistant to change. 31

1.15

Successful cost management projects

Project management The topic of project management arises in several areas of this book. This is not an accident because project management is at the heart of any change programme in a business. The cost management process is a change programme and needs good project management to be effective.

Project selection A precursor to a successful project is good selection of the project to be undertaken. If this book succeeds in its aims then the reader will have a wide range of projects to choose from and will have to choose from the competing projects. It is best to choose a limited number of projects and succeed at these rather than to start many projects and never to complete any. Project selection is best based on a simple 2 × 2 ‘effort–reward’ matrix as shown in the diagram. Projects can be ranked quickly on the basis of: • The reward – the estimated size of the

cost reduction. • The effort – the ease of implementation.

Projects with a high reward and low effort are preferred and these will be in the A-segment of the matrix. These should be the first projects attempted. Projects in the D-segment of the matrix are realistically never going to start. When faced with a competing group of projects with comparable ‘effort – reward’ indices then the project with the shortest time to completion should be chosen.

• Never start projects that you cannot

finish no matter how attractive they may appear in terms of time or return. An unfinished project is a total waste of time. • If the resource bottleneck is finance

related then insist that the cost management programme is totally selffunding. In this case, an inventory reduction programme (see Section 3.8) is a first priority to release funds for further projects.

Project planning There are three approaches to project planning: • No planning – We’ll do it! • Simple planning methods. • Complex computer-based planning

methods. Project planning is essential for successful cost management but simple planning methods are far preferred. Cost management projects tend to be small in scale both in investment and time and the planning process should match this.

B

A

D

C

Resource bottlenecks Every company has resource bottlenecks, these can be with regard to staff – there are always more things to do than there are time and people or with regard to finance – there are always more demands on capital than there is money in the bank. Whatever the particular resource bottleneck, follow these simple rules to get the best results:

Low

High Size of cost reduction

• Set a limit on the number of cost

management projects that are allowed to be active at any time – do not open any new projects unless one of the current projects is closed or suspended. Make no exceptions to this otherwise staff will not know where to focus efforts or spending. 32

Project selection for cost reduction Deciding which projects to carry out is the start of the cost reduction process. Rank potential projects according to the size of the reduction and the ease of implementation. Go for the greatest reductions and easiest implementations first. Chapter 1 – Cost management

One excellent method is to use top-down planning using Post-it notes. This method is described in the box on the right and, despite the apparent simplicity, is a very powerful and flexible method for small project planning. The method encourages an open approach to planning where the whole process is visible, this is in contrast to the computer-based approaches where the project plan is controlled by the operator of the software. Whatever method of project planning is chosen, every project plan must have the following elements:

Aims and objectives These are the clearly stated aims and objectives of the project. These must be measurable and achievable to allow later performance assessment.

results.

Meetings • Project teams meet regularly.

Schedules • Check progress (and slippage) against

agreed time and financial targets.

Communication • Project teams report on progress via an

agreed and pro-active reporting and communication plan. • One of the best methods is to

communicate on one page and the OnePage Project Manager1 method is an excellent tool for both planning and reporting.

Milestones These are dates (from the start of the project, see Section 2.1) that show when particular tasks are to be completed. Milestones enable assessment of project plan/time results.

Home truths of project management • What you don’t know hurts you. • Any project can be estimated for cost accurately – after it is finished. • Nothing is impossible to the person who doesn’t have to do it. • What is not on paper has not been said. • If you can keep your head while all around you are losing theirs then you haven’t understood the plan.

• 1. Campbell, C.A. and Campbell, M. 2013. ‘The One-Page Project Manager’. Wiley.

Budget All projects should have an initial allocated budget.

Assessment Projects must be assessed after the aims and objectives have been completed or when the project manager decides that no more progress can be made. Assessment allows a review of the achievements against the previously agreed aims. Note: For cost management projects the assessment should not only consider the financial aspects such as return on investment but also other non-financial benefits of the project.

Closure All projects should be formally closed after the assessment phase.

Project management

Project planning using Post-it notes

Project teams

Top-down project planning for cost management can be carried out using Post-it notes and a flip-chart.

• Project teams need a leader or ‘project

champion’. • Delegate control and accountability to

the project manager. • Project teams can make decisions

without fear of being over-ruled later. • Project teams are free to innovate. • Project teams are assessed on their

Chapter 1 – Cost management

Write each task and the time to be allocated to it on a note. Move the notes around and group them according to the major tasks. Combine or divide tasks as the process continues. Leave the chart in view and add, subtract or move the notes around as the plan develops. Finally, move the notes to overlap activities that can be done at the same time and reduce the total time taken for the project (simultaneous engineering). The critical path is easily seen from the sum of the individual tasks. 33

1.16

Cost management projects – where are you now? Cross-functional cost management teams are an invaluable tool for cost management due to the organisation of most companies.

The cost management process Choosing between cost management projects has always been a concern and difficulty. There are always too many projects competing for too few resources.

Completing the chart

Companies need to rapidly assess the potential gains and difficulty of implementing any potential project before rushing into a complex project that has a relatively low cost management potential.

This chart is completed and assessed as for the previous charts. A Technical Manager reporting to me always had too many projects running at any one time and was judged to be ‘failing’. This was because the Managing Director constantly introduced new projects and changed the priorities.

Project selection is a key to cost management. After projects have been selected then an effective project management system is an essential to actually delivering the project and achieving the potential gains.

Cost management projects Project selection 4

We set a limit of eight projects that could be considered to be active at any one time.

3 2 Problem solving

1

Project planning

Any potential new project had both to pass a monthly review and to displace an existing project before it could be considered for action. Any displaced existing project was labelled as being ‘on hold’ and not considered for assessment.

0

Project resources

Select your projects wisely – go for the big bucks and easy projects.

The Managing Director was therefore forced to prioritise the active projects and could not randomly introduce new projects.

Project organisation

The results: • A more stable project list.

Use the chart to assess where you are in cost management projects The numbers from the self-assessment should be transferred to the radar chart for a quick visual guide to where you are in the basics of cost management projects. 34

• More completed projects. • A successful Technical Manager.

Chapter 1 – Cost management

Cost management projects Level

4

3

Project selection

1

0

Project organisation

Formal project Excellent cost All relevant cost reduction project reduction opportunities definition & project identified & prioritised plan necessary for any management system for action. used in all cases. project. Progress is regularly Projects have clearly reported & post-project defined management assessment is carried & cost/benefits. out.

Most available cost Formal project Good cost reduction reduction opportunities planning carried out for project management identified but not all projects but control, system but use is prioritised for action. reporting & variable. Good assessment is integration across variable. departments but many Failed projects are projects have poor sometimes hidden & cost/benefit definition. no lessons learnt.

Some cost reduction opportunities identified but no real planning process.

2

Project planning

Cost reduction project Project planning carried out for most management system projects but control, available but not used. reporting & Some integration of assessment is poor or projects across rarely carried out. departments & poor Failed projects are cost/benefit definition. often hidden & no lessons learnt.

Project resources

Problem solving

Project resources Firmly embedded defined & allocated culture of improvement before project start. & problem solving Projects are rarely through planning, delayed due to action & review. resource constraints. Root causes identified & resolved.

Project resources defined but not allocated at project start.

Problem solving is largely reactive with focus on solving root causes. Solutions developed but not always fully implemented.

Project resources poorly defined at project start.

Problem solving is largely reactive; solutions are developed but rarely fully implemented. Focus on dealing with urgent effects & not on solving root causes.

Project resources rarely considered at project start.

Problem solving is purely reactive & focused on dealing with urgent effects & not on solving the root cause.

Few cost reduction Cursory & opportunities identified undocumented project via unplanned process. planning but no formal project planning or monitoring. Projects can become dormant & remain unfinished.

No cost reduction project management system. Some integration of departments for projects that clearly cross departmental boundaries.

Significant cost No effective project reduction opportunities planning. Actions are ignored due to ‘urgent’ ad hoc & driven by daily pressures. events. Action is seen as more important than planning.

No cost reduction Projects often started Problems are ignored project management without adequate until they go away. system. Every project resources (due to poor is ‘different’. Projects planning) or starved of resources during are run by departments with little project. input from other Urgency is rated more departments. highly than strategic importance.

Score Chapter 1 – Cost management

35

1.17

The cost management process

The real difficulties are rarely in a single department – departments are generally controlled by a single person and cost management projects are relatively easy to run inside a department. The real difficulties (and opportunities) are in the interfaces between departments and ‘managing the interfaces’ is a key barrier to effective cost management. In many sections of this book the concept of using teams is recommended as a part of the method of cost management. Teams use the skills of the members to reduce costs but more importantly they use the skills of the members to enable the management of the interfaces and to look at the complete process.

The business organisation

Cost management is not an accounting function, it is not a design function and it is not a production function. It is a company-wide process that transcends the pure departmental barriers. In fact, if cost management projects do not cross departmental barriers then it is unlikely that they will be truly effective in reducing costs.

The business organisation

Interfaces

How companies are organised Companies are organised vertically along functional lines where people carrying out the same function are grouped together.

How projects and processes are organised Projects and processes are organised horizontally and flow across the functional boundaries. At every interface there are translation problems and misunderstandings as the project or process is passed between functions.

Organisation Cost management is not always assisted by the company organisation and in many cases the organisation structure actually hinders the process. The typical company organisation chart is a pyramid with the Managing Director at the top, department or function heads reporting to the Managing Director, at the bottom is a large flat base of all the other employees. This type of organisation makes control easy but is based on largely obsolete management practices. These use a model of activities and processes that comes from the distant past. The question that needs to be asked is: Why is the control of companies organised vertically when all projects and processes operate horizontally across the organisation? Team-based working cuts across the traditional activity-based company divisions to follow processes from start to finish. This method is applied in Production in the formation of work cells but works equally well in administration 36

Team- or cell-based working Team-based working cuts across the conventional company organisation but follows a process from start to finish. The approach can be used in Production (see Section 5.10) but is equally effective in administration and office-based tasks. The important thing is the completion of the process by a team rather than by a series of people in various departments. The use of multi-skilled teams is fundamental to cost management. Chapter 1 – Cost management

where processes need to be followed and improvements need to be made. Insurance companies have used ‘cell-based’ techniques to decrease response times for insurance claims from 16 weeks down to 6 days. The team-based approach gives much more ownership of the process to the operators – instead of ‘laying bricks’ in a small activity, they are ‘building a cathedral’ as part of the larger process. For cost management to be truly rewarding, companies must to start to use a team-based approach to reduce the fundamental costs of doing business.

Changing attitudes The customer attitude is changing but, despite this, many processors have not changed their model. Across a wide range of sectors the important factor for success is no longer technology but is the management attitude of the plastics processor towards doing business. Typical statements from customers are: • ‘Partnership is about delivering more

than just components.’ • ‘Partnership is the key to success and

proactive suppliers get the business.’ • ‘Partnership is eroding the lines between

“suppliers” and “customers” and the “product team” is taking control.’ • ‘Suppliers must learn to form teams to

produce “turnkey products” and produce complete products ready for delivery to the market.’ • ‘Moulders make money shipping plastic

and added value. Their customers make money selling products. They are partners not competitors.’ • ‘Project management is a key skill in

delivering completed products.’ • ‘Design to add value and reduce cost is

an important driver in the marketplace.’ • ‘Suppliers are expected to carry out

design and engineering to meet target costs rather than simply working to drawings and specifications.’

practices.’ • ‘It is not about mouldings – that is what

moulders do, that is the easy part. The hard part is the logistics.’ • ‘Suppliers need to adjust their business

models to match changes in the customer’s business model.’ The last comment is perhaps the most important – there is a need for new business models that match the customer’s needs and include cost management as an integral part of the model. It is not all about money; it is all about delivering value for money and delivering what the customer needs to succeed.

“If you have a stable system, there is no use specifying a goal. You will get whatever the system will deliver. If you do not have a stable system then there is no point in setting a goal, because you have absolutely no way of telling what the system will produce.” Dr. W. E. Deming

The main requirement for success is not technology. The main requirement is a willingness to accept that the world has changed and the willingness to change with it to meet the customer’s changing needs. Cost management can help to reduce prices but this is not enough to win the race – it is only a ticket to the game. Winning the race demands significant changes in attitudes towards serving the customer.

Why cost management projects have problems delivering savings • Over-enthusiastic estimates or wrong forecast volumes. • Financial systems are not aligned to the phasing of the item purchase/ receipt dates to give actual savings. • Variance reports don't measure standard cost against actual cost. • Variance reports are not aligned to site volume use.

• ‘The supplier is responsible for being a

“solutions provider” producing an innovative solution rather than a product.’ • ‘Price is important but having the right

product to sell is even more important.’ • ‘Cost savings come with innovation

(necessity breeds invention).’ • ‘Suppliers must be cost competitive and

have innovative internal manufacturing Chapter 1 – Cost management

The ‘shoot and ship’ moulder is dead – but when will the industry realise this and adjust their attitudes?

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1.18

The cost management process – where are you now?

Across the company Cost management is rarely a single department activity and most often cuts across the traditional boundaries. The process needs to be organised with this in mind to achieve the gains that are necessary. Cross-functional processes rarely have formal process owners who have responsibility for achievement of the process measures. These processes often fail or under perform because of lack of ownership and the lack of a driver for success.

business processes (preferably in terms of how the customer views the activity, see Section 1.3), assign owners for each business process and task the owners with setting up the appropriate measures and improvement plans. Particular effort needs to be spent on identifying non-value activities (see Section 5.9) and eliminating these. Projects that eliminate non-value activities have a great return on effort.

Completing the chart This chart is completed and assessed as for the previous charts.

Companies need to define their key

Focus on the customer is a key point. • Find out which activities benefit the customer and try to do more of these. • Find out which of your activities do not benefit the customer and do less of these. • Find out which of your activities actively hinder the customer and eliminate these activities. • Find the ‘sales prevention officers’ (they are in every company) and then find them another job, preferably with a competitor.

Cost management process Key business processes 4 3 2 Non-value activities

1

Process owners

0

Process measures

Process improvement

Use the chart to assess where you are in the cost management process The numbers from the self-assessment should be transferred to the radar chart for a quick visual guide to where you are in the basics of the cost management process. 38

Chapter 1 – Cost management

Cost management process Level

4

3

2

1

0

Key business processes All key processes well defined, documented, resourced & optimised. Electronic documentation links to other processes, status, version & approval well controlled.

Process owners

Process improvement

Process measures

Non-value activities

Process owners for all Formal process Process measures in Non-value-adding key business improvement plans in place for all key activities minimised. processes clearly & place for all key business processes. Continuous review of unambiguously defined business processes. Measures regularly processes to prevent with responsibilities & Plans are regularly monitored, reported & accumulation of nonauthority also clearly reviewed for relevance. show continuous value-adding activities. defined. improvement. Prompt action taken on adverse results.

Good understanding of More than half of key most key processes business processes but inadequately have defined process documented & owner but owner resourced. primarily has Automated processes responsibility without filed on company power. Intranet.

Formal process improvement plans in place for some key business processes but no regular review for progress or relevance.

Process measures in place for most key business processes. Measures regularly monitored & reported but do not show improvement & little action is taken.

Non-value activities identified by process flow charts but not totally eliminated. Some gains still to be made in activity reduction

Good understanding of Less than half of key some key processes business processes but generally have defined process inadequately owner. documented & resourced. Processes in common file format on company Intranet.

Informal process improvement plans in place for most key business processes but no regular review for progress or relevance.

Process measures in Non-value activities place for some key identified across the business processes. company but many Those in place are areas remain to be rarely monitored & investigated. reported. Considerable gains still No action taken on to be made in adverse measures. elimination of activities.

Poor understanding of key processes & of how they work. When created processes are in common file format on personal computers only.

Few key business processes have defined process owner.

Informal process Few process improvement plans in measures in place for place for some key key business business processes processes. but no regular review Those in place are not for progress or monitored & reported. relevance.

Little or no understanding of what the key processes are or how they work. When created processes are paper based.

No key business processes have defined process owner.

Sporadic attempt to minimise non-value activities (primarily in production areas). No consistent approach to process analysis & activity reduction.

No process No process measures No attempt to identify improvement plans in in place for any key non-value-adding place. business process. activities in company. Substantial non-value activities seen.

Score Chapter 1 – Cost management

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1.19

World-class principles

World class in every way

• WIP.

Effective cost management is not about simply cutting costs. Simple cost cutting will often degrade a company’s performance substantially both internally and externally and threaten survival. The results of this are seen far too often, cuts are made thoughtlessly and the company suffers as a result.

• Cost of sales.

Cost management is about achieving meaningful savings and simultaneously achieving world-class performance. It is about focusing the efforts, not simply in cutting the costs. World class is not simply about manufacturing or delivery performance, it is also about cost performance.

Key measures One of the major concerns with the measures used in traditional management is that they do not drive cost reduction efforts (see Section 1.9). In many cases they actually hinder cost reduction by focusing our attention on areas that are not important and concealing areas that are vital for success. Measures that are important from the customer’s viewpoint are rarely seen as important by the accounting function because they think of themselves as ‘scorekeepers’ rather than as players in the game. Maskell (see Section 1.6) argues that the accountant can be a ‘change agent’ and has vital role to play in the world-class team. This is because people react to measures and what you measure is what you get.

• Energy use. • Changeover times.

These numbers need to be measured, compared with benchmarks (see below) and regularly reported.

Total quality management World-class performance requires total quality management that actually delivers real improvements in quality levels. Too many attempts at quality management are still related to quality control based on detection of defects after they are produced rather than the easier and cheaper method of preventing defects before they are produced (see Section 5.23 and Kent1).

Resource efficiency Resource efficiency is a key to world-class performance and achieving the maximum output of saleable product from the

Key measures

Health and safety

• Product consistency.

Total quality management

World-class principles

The key measures are therefore vitally important in what the company will deliver and how cost effectively they will deliver it. Some key external measures, from the customer viewpoint, are:

It is no use having the right principles unless you measure yourself against something to check your achievement and drive your improvement.

Environmental ethics

Resource efficiency

• Correct invoicing. • Delivery conformance to order. • Delivery speed.

Some key internal measures, from the company viewpoint, are: • Waste rejects. • Stock levels.

40

World-class principles World-class principles cover how we operate and measure ourselves in a variety of areas. Establishing best practice in the key areas can not only reduce costs but also improve the company’s external image. Chapter 1 – Cost management

minimum input of costly raw materials should always be a key aim of any company.

Environmental ethics No company can be world class unless their environmental ethics and performance are also world class. This does not mean simply saying the right things, it means delivering environmental performance to reduce costs and improve profitability. Being ‘green’ can also be extremely profitable, e.g., reducing energy use delivers reduced costs but also reduced carbon emissions. Do it for the money or do it for the environment, either way costs are reduced and profits are increased (see Kent2).

Health and Safety The beneficial effects of excellent Health and Safety performance are proven. This is not simply about protecting the staff; it is also about improving working conditions to get the best out of them. In most parts of the world, Health and Safety is covered by stringent regulations but world class means exceeding the statutory requirements and achieving the absolute minimum time lost due to accidents.

Benchmarking for world class The key measures and right principles will help drive the cost management process but if the only reference is an internal one then targets can be unrealistic and not provide a challenge. External benchmarking provides the essential reference to best practice and the targets may be more realistic and challenging than internally derived targets. The external benchmarks can then form the basis of the internal targets for the key measures.

• Other parts or divisions of the same

company. • Direct competitors (if information is

available). • Parallel industries with the same

functions, i.e., if delivery speed is important then it may be more relevant to benchmark against a specialist grocery delivery company.

World class is a combination of many things. Achieving only one of them may make you good but it doesn’t make you world class.

Set the target values for the benchmarks based on the best practice you can find.

Discover Investigate how other companies are achieving their performance, particularly those with the best results.

Apply Use the experience and ideas of the bestperforming companies to exceed the standard.

“Everybody is a genius but if you judge a fish by its ability to climb a tree, it will live its whole life believing that it is stupid.” Albert Einstein

• 1. Kent, R.J. 2016. ‘Quality management in plastics processing’. Elsevier. • 2. Kent, R.J. 2017. ‘Energy management in plastics processing’. Elsevier. In preparation

Define

Set

Benchmarking is to give you something to aspire to and work towards. It is not to be used as a club to beat people with.

What makes the difference in the customer’s eyes.

Set standards according to the best practice you can find.

Benchmarking is a four-step process:

Define The first step is to define the appropriate benchmarks. As a general rule the benchmarks should correspond to the key measures, i.e., know what you want to be good at. As with key measures, the appropriate benchmarks should be a combination of internal and external measures.

Set Decide who to benchmark against. When deciding who to benchmark against some of the possibilities are:

Chapter 1 – Cost management

Discover

How the best companies meeting those standards.

Apply

Experience and ideas to exceed the standard.

The steps in benchmarking External benchmarking is an essential for world class. If you want to benchmark your logistics area then try comparing yourself to Amazon. If you want to benchmark your design area then try comparing yourself to Apple. Don’t be shy. 41

1.20

World-class principles – where are you now?

World class in all areas World class is one of the buzz-words but there is really a cost management logic in achieving high standards in all of the areas listed. World-class companies are not doing this because it makes them feel good – they are doing it because it increases profits.

measures against external data will enable companies to set realistic and demanding targets for improvement.

Completing the chart This chart is completed and assessed as for the previous charts.

These are not simple tasks but achieving high ratings in all the areas will reduce costs substantially and improve operational performance. Knowing, measuring and reporting the key measures for the business will focus attention on achieving the things that really matter. Benchmarking these

This is a team effort! Completing the chart on your own is not recommended. It is much better to either complete the chart as a group – you will be amazed at the divergence of opinions – or to get several people in the company to complete the chart separately and then to compare the results.

World-class principles Key measures 4 3 2 Health & Safety

Total quality management

1 0

Environmental ethics

Resource efficiency

Use the chart to assess where you are in world-class principles The numbers from the self-assessment should be transferred to the radar chart for a quick visual guide to where you are in the basics of world-class principles. 42

Chapter 1 – Cost management

World class principles Level

4

3

2

0

Resource efficiency

Environmental ethics

Health & Safety

Key measures TQM is an integral part Resource efficiency is Well developed Excellent Health & established & reported of all company an integral part of all environmental ethics Safety performance. in all critical business operations. operations & at all as an integral part of All areas safeguarded areas. Focus is on delighting product life cycle operations. & minimum time lost All key measures the customer by phases (materials, Improving due to accidents or improving. exceeding their manufacture, use & environmental Health & Safety expectations end-of-life). performance is seen issues. throughout the Operations minimise as profitable & ethical. complete process. waste & maximise resource utilisation. Key measures TQM is used in all established & reported areas of the company. in financial & in most Focus is on delivering other areas. to customer Key measure specification. performance variable.

Resource efficiency considered for all internal impacts but not for complete product life cycle phases. Considerable effort made to reduce internal impacts.

Environmental ethics Good Health & Safety performance. compete with other Most areas exceed issues for management attention regulatory & action but often requirements. sacrificed for shortterm financial gains.

Environmental ethics Acceptable Health & Key measures TQM is important for Resource efficiency established & reported all production products considered for some are treated as Safety performance. in financial & in some & processes but not internal impacts but subsidiary to other Most areas adequately other areas. for all business not all areas, e.g., business requirements protected & few areas processes throughout design. & often overlooked. for improvement the company. Waste is 'production' identified. concern. Some effort made to improve resource efficiency, e.g., energy. Key measures established & reported only in financial areas.

1

Total quality management

Key measures

Minimum regulatory TQM developing & Resource efficiency is Environmental ethics seen as important in seen as relevant in are being developed conformance achieved production areas but some limited areas. but still seen as a cost but areas for to the company not for all products or Very limited efforts significant processes. made to improve instead of an essential improvement easily No extension of TQM resource efficiency. part of the business. identified. Primary driver is public into other areas of the company. relations benefits.

No key measures No concept of TQM. Resource efficiency is No concept of Below minimum defined or measured. Quality is a ‘production an unknown concept. environmental regulatory problem’ & inspection Waste is tolerated & performance or ethics. conformance. Areas of is the primary control not considered a significant risk seen without appropriate method. problem. safeguards.

Score Chapter 1 – Cost management

43

Key tips • Define what type of company you are

and what this means for your cost structure. • Define what type of company you want

to be and what you need to do to get from where you are to where you want to be.

somebody else’s problem. They are a business problem. • Recast budgets into an ABM format and

look for the areas that are costing money without adding value to the customer. • Start to focus on the processes that add

• Define your mission and goals from your

value as part of the budgeting procedure.

company type and make sure that the whole company understands the mission and is aligned with this.

• Shift the focus away from the traditional

• Link personal objectives directly to the

company objectives. • Attempt to understand the role of

management accounting in the decisionmaking process. • Transform the management accounts

into the tool for forward thinking and planning that they should be. • Look at the management accounts to

determine if they really do tell you where you should go – if they are only telling you where you have been then they are not serving their purpose. • Review the current management

accounts on a ‘value for money’ basis. Everything has to justify its existence and management accounts are not exempt. • Review the overall cost structure of the

business to see where the major costs come from. • Allocate the efforts in proportion to the

costs to attack the major costs. • Try to establish where overheads are

coming from in the business. • Make sure that all staff have a clear idea

of the overheads under their control. • Do not think that cost management is

the same as cost cutting. • Start to look at how ABC could be

established in the company – concentrate on the easiest ways of gathering information and implementing the system. Do not make it complicated. • Look for cost allocations that are unfair

to products or processes. • Look for the underlying transaction costs

that run the cost allocations. • Look for controllable overheads in the

departmental structure. • Investigate Business Process Re-

engineering (BPR) to change the focus to process rather than departments. • Look for hidden cost products. • Look for hidden cost customers. • Calculate the company’s overall

‘conversion ratio’. Report this regularly and seek to improve this as a measure of value added. • Review the complete product costing

system, especially the assumptions that allocate the overheads in the costing. • Investigate rapid product costing and

how it can change the company by reducing the workload, giving quicker quotes and smoothing the allocations. Generate rapid costing matrices for standard types of products and create additional add-ons for problem products and customers. • Remove the distinction between direct

and indirect costs and between variable and fixed costs. They are all costs to be managed and minimised. • Stop considering products as profit

makers and look at the contribution that products make to the business. • Review how inventory is treated in the

accounts. Investigate if WIP and finished goods increases can be used to create inventory profits. Stop this happening. • Change the measurement systems to

encourage what the business wants and not what the accountant orders. • Approach cost management as a process

and establish the correct systems and processes to deliver the results. • Accept that customers have changed and

that successful companies change with their customers.

business. • Never accept that overheads are

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Chapter 1 – Cost management