CHAPTER 1

OVERVIEW OF COST MANAGEMENT AND STRATEGY

EXPECTED LEARNING OUTCOMES

After studying the chapter, you should be able to ...
1. Explain what strategy is.
2. Relate strategic cost management to strategic
management
3. Describe the nature of cost management information and
how they are developed -
4. Explain the objective, scope and benefits derived from
proper cost management
5. Enumerate and describe the various users of cost
management information
6. Explain how cost management information is used for the
following management functions
Strategic Management
Planning and Decision-Making
Management and Operational Control
Reportorial and compliance to legal and various
regulatory requirements
7. Understand the cost management accountant's role in strategic cost management
8. Describe the role of the cost management accountant in
the development and implementation of strategic decision for the business firm
9. Enumerate and explain the basic cost management perspectives.

CHAPTER 1
OVERVIEW OF COST MANAGEMENT AND STRATEGY
INTRODUCTION
The growing pressures of global competition, trade wars among countries, technological
innovation and changes in business processes have made cost management much
more important, critical and dynamic than ever before. Business managers must think
and act competitively and doing so requires a strategy.

Strategy is a set of policies, procedures and approaches to business that produce long-
term success while strategic management involves the development of a sustainable
competitive position. Strategic cost management involves the development of cost
management information to facilitate the principal management function which is
strategic management.
In today's business environment, the development and use of information especially
cost management information is a critical factor in the effective management of a firm or
organization.

Cost management information is the information that the manager needs to effectively
manage the firm, profit-oriented as well as not-for-profit organization. This includes both
financial information about cost and revenues as well as relevant nonfinancial
information about productivity, quality and other key success factors for the firm.

Cost management is the practice of accounting in which the accountant develops and
uses cost management information. For competitive success, it is not enough to
emphasize only on financial information. This could lead manager to stress cost
reduction (a financial measure) while ignoring or even lowering quality standards (a
nonfinancial measure). This decision could be a critical mistake which could lead to the
loss of customers and market share in the long run. If a firm is to compete successfully,
importance should be given to nonfinancial and long-term measures of operating
performance such as product and manufacturing advances, product quality and
customer loyalty. Cost management information, is thus a value-added concept. It adds
value by helping a firm be more competitive.

Effective strategic management is very important to the success of every firm or

organization and is thus the pervasive theme of this book.

Strategic thinking involves anticipating changes. Products and production processes are
designed to accommodate expected changes in customer demands. Flexibility is
important. The ability to make fast changes is critical as a result of the demand of the
new management concepts of e-commerce, speed to market, and flexible
manufacturing. Product life cycle - the time from the introduction of a new product to its
removal from the market - is expected to become shorter and shorter. Success in the
recent past days or months is no longer a measure of ultimate success; the manager
must be "driving the firm by using the windshield, not the rear-view mirror.

The strategic emphasis also requires creative and integrative thinking, that is, the ability
to identify and solve problems from a cross-functional view. The business functions are
often identified as marketing, production, finance, and accounting! controllership.
Instead of viewing a problem as a production problem, a marketing problem, or a
finance and accounting problem, cross-functional teams view it from an integrative
approach that combines skills from all functions simultaneously. The integrative
approach is necessary in a dynamic and competitive environment. The firm's attentions
is focused on satisfying the customers' needs; all of the firm's resources, from all
functions, are directed to that goal.
USERS OF COST MANAGEMENT INFORMATION

Cost management information is useful in all organizations: business firms,

governmental units, and not-for-profit organizations. Business firms are usually
categorized by industry, the main categories being merchandising, manufacturing, and
service. Merchandising firms purchase goods for resale. Merchandisers that sell to
other merchandisers are called wholesalers, those selling directly to consumers are
retailers.

Governmental and not-for-profit organization provide services, much like the firms in
service industries. However, these organizations provide the services for which no
direct relationship exists between the amount paid and the services provided. Instead,
both the nature of these services and the customers to receive them are determined by
government or philanthropic organizations. The resources are provided by
governmental units and/or charities. The services provided by these organizations are
often called public goods to indicate that no typical market exists for them. Public goods
have a number of unique characteristics, such as the impractically of limiting
consumption to a single customer (clean water and police and fire protection are
provided for all residents).

USES OF COST MANAGEMENT INFORMATION

Cost management information is needed for each of the following management
functions, namely:
1. Strategic Management
Strategic management involves the development of a sustainable competitive position
in which the firm's competitive advantage spells continued success. A strategy is a set
of goals and specific action plans that if achieved, provide the desired competitive
advantage. Strategic management involves identifying and implementing these goals
and action plans. Management must make sound strategic decisions regarding the
choice of products, manufacturing methods, marketing techniques and channels and
other long-term issues.

The strategic emphasis requires an integrative approach which combines skills from all
business function, namely, marketing, production, finance and accounting
/controllership, is necessary in a dynamic and competitive environment.

Due to increasing strategic issues, cost management has moved from a traditional role
of product costing and operational control to a broader strategic focus: strategic cost
management.
Strategic cost management is the development of cost management information to
facilitate the principal management function, strategic management.

2. Planning and Decision-making

Cost management information is needed to support recurring decision such as replacing
and maintaining equipment, managing cash flows, budgeting raw materials purchases,
scheduling production, pricing and managing distribution of products to customers, and
so forth.

Planning and decision-making involves budgeting and profit planning, cash flow
management and other decision related to the firm's operation such as deciding whether
to lease or buy a facility, whether to replace or just repair as equipment, when to change a
marketing plan or when to begin new product development.

3. Management and Operational Control

Cost management information is needed to provide a fair and effective basis for
identifying inefficient operations and to reward and motivate the most effective
manages.

Operational Control takes place when mid-level manages (e.g., product managers,
regional managers) monitors the activities of operating-level managers and employers
(e.g., production supervisions, department heads). Management control on the other
hand, is the evaluation of mid-level manager by upper-level manager (e.g., Controller or
the Chief Financial Officer (CFO)).

4. Reportorial and Compliance to Legal Requirements

Reportorial and compliance responsibilities require management to comply with the
financial reporting requirements to regulatory agencies such as the Securities and
Exchange Commission (SEC) Bureau of Internal revenue (BIR), and other relevant
government authorities and agencies.

The financial statement preparation role has recently received a renewed new focus
and interest as accounting scandals have shown how crucial and important accurate
financial information is for investors.

The financial statement information also serves the other three management functions
as this information is often an important part of planning and decision making, control
and strategic management.
MANAGEMENT ACCOUNTANT'S ROLE IN STRATEGIC COST MANAGEMENT

Cost Management is the practice of accounting in which the accountant develops and
uses cost management information. This area of accountancy practice is performed by
management accountants. Management accountants are the accounting professionals
who develop and analyze cost management information and other accounting
information.

Management Accounting involves the application of appropriate techniques and

concepts to economic data so as to assist management in establishing plans for
reasonable economic objectives and in the making of rational decisions with a view
toward achieving these objectives. It is the process of identification, measurement,
accumulation, analysis, preparation, interpretation, and communication of financial
information, which is used by management to plan, evaluate and control activities within
an organization. It also comprises the preparation of financial reports for non-
management groups such as shareholders, creditors, regulatory agencies and tax
authorities.

Management accountants (including cost accountants) are concerned with providing

information to managers, that is, people inside an organization who direct and control
the operations. They provide a variety of reports. Some reports focus on how well
managers and business units have performed while other reports provide timely and
frequent updates on key indicators, analysis of business situation or opportunity and
analytical reports that are needed to investigate specific problems.

Management accountants at appropriate levels are involved actively in the process of

managing the entity. The process includes making strategic, tactical and operating
decisions and helping to coordinate the efforts of the entire organization. The
management accountant participates, as part of management, in assuring that the
organization operates as a unified whole in its long-run intermediate and short-run best
interests.

Management accounting is concerned primarily with providing information to internal

managers who are charged with planning and controlling the operations of the firm and
making a variety of management decisions. Generally, management accountants do the
following tasks:
(a) Scorekeeping or data accumulation which enables both internal and external parties
to evaluate organizational performance and position.

(b) Interpreting and reporting of information that helps manager to focus on operating
problems, opportunities as well as inefficiencies. This is commonly associated with
current planning and control and the analysis and investigations of recurring routine
internal accounting reports to signal situations in which management action may be
required.

(c) Problem-solving or quantification of the relative merits of possible courses of action

as well as recommendations as to the best procedure. This is commonly associated
with non-recurring decisions.

Three important guidelines help management accountants provide the most value when
scorekeeping provide the most value when scorekeeping, problem-solving and attention
directing interpreting and reporting). These are
1. Employ a cost-benefit approach
2. Recognize behavioral as well as technical considerations and
3. Use appropriate cost concepts for different purpose

Management accountants continually face resource allocation decisions, such as

whether to purchase a new software package or hire a new employee. The cost-benefit
approach should be used in making these decisions: Resources should be spent if they
are expected to better attain company goals in relation to the expected costs of those
resources. The expected benefits from spending should exceed the expected costs.
The expected benefits and costs may not be easy to quantify. Nevertheless, the cost-
benefit approach is useful for making resource-allocation decisions.

Specifically, the management accountant provides a system which allows

management to receive the necessary information used in performing its
administrative functions of:

(a) planning which involves setting of goals for the firm, evaluating the various ways to
meet the goals and picking out what appears to be the best way to meet the goals;
(b) controlling which involves the evaluation of whether actual performance conforms
with planned goals; and
(c) decision making which involves determination of predictive information (e.g. relevant
costs) for making important business decisions.

Planning
A key activity for all companies is planning. Planning involves identifying alternatives
and selecting a course of action and specifying how the action will be implemented to
further the organization's objectives

The plan communicates a company's goals to employees and specifies the resources
needed to achieve them. The plans of management are often expressed formally in
budgets. Cash budgets, capital budgets, and projected statements of financial position
are examples of contributions which accounting can make in resource planning while
break-even analysis, projected income statements are examples of useful tools in profit
planning.

Control
Control of organizations is achieved by evaluating the performance of managers and
the operations for which they are responsible. The distinction between evaluating
managers and evaluating the operations they control is important. Managers are
evaluated to determine how their performance should be rewarded or punished, which
in turn motivates them to perform at a high level. Based on an evaluation indicating
good performance, a manager might receive substantial bonus compensation. An
evaluation indicating a manager performed poorly might lead to the manager being
fired. In part because evaluations of managers are typically tied to compensation and
promotion opportunities, managers work hard to ensure that they will receive favorable
evaluations.

Cost variance analysis, financial statements analysis, gross profit variance analysis are
some of the accounting control reports used to inform managers when activities which
are part of their responsibility are deviating from the plan. The reports used evaluate the
performance of managers and the operations they control are referred to as
performance reports.

Although there is no generally accepted method of preparing a performance report,

such reports frequently involve a comparison of current period performance with
performance in a prior period or with planned (budgeted) performance.

Performance reports may not provide definitive answers, but they are still extremely
useful. Managers can use them to "flag" areas that need closer attention and to avoid
areas that are under control. It would not seem necessary, for example, to investigate
labor, rent, depreciation, or other costs, because these costs are either equal to or
relatively close to the planned level of cost. Typically, managers follow the principle of
management by exception when using performance reports. This means that managers
investigate departures from the plan that appear to be exceptional; they do not
investigate minor departures from the plan.

Operations are evaluated to provide information as to whether or not they should be

changed (i.e., expanded, contracted, or modified in some way). An evaluation of an
operation can be negative even when the evaluation of the manager responsible for the
operation is basically positive.
Company plans often play an important role in the control process. Managers can
compare actual results with planned results and decide if corrective action is necessary.
If actual results differ from the plan, the plan may not have been followed properly, the
plan may have not been well thought out, or changing circumstances may have made
the plan out of date.

Figure 1-1 presents the major steps in the planning and control process. Once a plan
has been made, actions are taken to implement it. These actions lead to results, which
are compared with the original plan. Based on this evaluation, managers are rewarded
(e.g., given substantial bonuses or promoted if performance is judged to be good) or
punished (e.g., given only a small bonus, given no bonus, or even fired if performance is
judged to be poor). Also, based on the evaluation process, operations may be changed.
Changes may consist of expanding (e.g., adding a second shift), contracting (e.g.,
closing a production plant), or improving operations (e.g., training employees to do a
better job answering customer product inquiries). Changes may also consist of revising
an unrealistic plan.

Figure 1-1: Planning and Control Process

Plan - Decisions to change operations or revise
- Action taken to implement plan – Results - Comparison of planned - Evaluation
- Decisions to reward or punish managers and actual results

Thus, accounting serves management at all stages of the management process, from
the formulation of objectives and so on up to the feedback of performance information
which in turn helps in the reformulation of objectives.

Decision Making
As indicated in Figure 1-1, decision making is an integral part of the planning and
control process - decisions are made to reward or punish managers, and decisions are
made to change operations or revise plans. Should a firm add a new product? Should it
drop an existing product? Should it manufacture a component used in assembling its
major product or contract with another company to produce the component? What price
should a firm charge for a new product? These questions indicate just a few of the key
decisions that confront companies. And how well they make these decisions will
determine future profitability and, possibly, the survival of the company. Recognizing the
importance of making good decisions, we will devote all of Chapter 11 to the topic.

In summary, the management accountant develops cost management information for

the Chief Financial Officer, other managers and employee teams to use to management
the firm and make the firm more competitive and successful.
RELATIONSHIP BETWEEN COST ACCOUNTING AND COST MANAGEMENT

Cost accounting is a systematic set of procedures for recording and reporting

measurements of the cost of manufacturing goods and performing services in the
aggregate and in detail. It includes methods for recognizing, classifying, allocating,
aggregating and reporting such costs and comparing them with standard costs.

Cost management needs the output of cost accounting. Its purpose is to provide
managers with information which aids decision. There are no generally accepted
principles which specify how management accounting information is to be reported.
While systems such as direct costing and standard costing exist in management
accounting, each accounting report should be tailored to the needs of the decision and
the decision maker. The most effective systems result when the manager-decision
maker and the accountant work together until the accountant understands the decision
to be made and the manager understands the source of information that the accountant
will report.

Managers use cost management information to choose strategy, to communicate it and

to determine how best to implement it. They use this information to coordinate their
decisions about designing, producing and marketing a product or service.

STRATEGIC DECISION MAKING AND THE COST MANAGEMENT ACCOUNTANT

Basic Cost Management Perspectives

For cost management process to succeed, it is necessary that managers must

complement their measurement skills with basic management perspectives that "go
beyond the numbers". This will enable them to make intelligent planning. control, and
decision making for the enterprise. These are:
a. A Strategic Management Perspective
b. An Enterprise Risk Management Perspective
c. A Corporate Social Responsibility Perspective
d. A Process Management Perspective
e. A Leadership Perspective
f. An Ethical Perspective

A. A Strategic Management Perspective

An enterprise generates profit by attracting customers willing to pay for the goods
and services it offers. Customers usually compare the goods and services offered by a
company to the same goods and services offered by other companies. The key to a
company's success is creating value for customers while differentiating itself from its
competitors. Identifying how a company will do this is what strategy is all about.
However, a chosen strategy is only as good as how effectively it is implemented. The
management accountant provides input that aids in developing strategy, building
resources and capabilities, and implementing strategy.

A strategy is a "game plan" that enables the company to attract customers by

distinguishing itself from competitors. The focal point of a company's strategy should be
its target customers. A company can only succeed if it creates a reason for its target
customers to choose it over a competitor. These reasons or what are more formally
called customer value propositions are the essence of strategy.

Customer value premises tend to fall into three broad categories, namely, customer
intimacy, operational excellence, and product leadership.

Customer Intimacy Strategy

Companies that adopt a customer intimacy strategy are in essence saying...

"You should choose us because we can customize our products and
services to meet your individual needs better than our competitors."

Operational Excellence
Companies that pursue the second customer value premise called operational
excellence are saying to their target customers...
"You should choose use because we deliver products and service faster, more
conveniently, and at a lower price than our competitors"

Product Leadership
Companies pursuing the third customer value premise are saying to their target
customers...
"You should choose us because we offer higher quality products than our competitors".

B. An Enterprise Risk Management Perspective

A simplified framework for an Enterprise-wide Risk Management
Process follows:
Risk Management System Top Management's Involvement
Oversight Activities:
Establish goals and objectives, Set management policy,
roles and responsibilities, establish context, set limits and
common language, and tolerance, etc.
oversight structure

Risk Management Process:

Step 1: Assess Risks Ensure that process captures all
Identify source, measure business risks

Step 2: Develop / Design Ensure that all available tools

Action Plans: and methodologies are used
Reduce, avoid, retain, transfer, exploit

Step 3: Implement Action Plans Review effectiveness of plans,

Check capabilities

Step 4 Monitor and report risk Review and evaluate regular

Management performance reports on performance

Step 5: Continuously improve Evaluate recommendations for

risk management capabilities improvement

Every business manager should recognize the fact that every strategy, plan and
decision involves risks.

Enterprise risk management is a process used by an entity to identify those risks and
develop responses to them that enable it to be assured of meeting its goals.

The following schedule shows examples of business risks that companies face and the
corresponding example of a control that could be implemented to help reduce each the
risks mentioned:
Examples of Business Risks Examples of Controls to Reduce
Business Risks
1. Losing market share due to the Develop an approach for legally gathering
unforeseen actions of competitors information about competitors' plans and
practices

2. Products harming customers Develop a formal and rigorous new

product testing program

3. Intellectual assets being stolen from Create firewalls that prohibit computer
computer files hackers from corrupting or stealing
intellectual property
 4. A website malfunctioning Thoroughly test the website before going
"live" on the Internet

5. A supplier strike halting the flow of raw Establish a relationship with two
materials companies capable of providing needed
raw materials

6. Poor weather conditions shutting down Develop contingency plans for

operations overcoming
weather-related disruptions

7. A poorly designed incentive Create a balanced set of performance

compensation system causing employees measures that motivates the desired
to make bad decisions behaviour

8. Inaccurate budget estimates causing Implement a rigorous budget review

excessive or insufficient production process

9 Poor environmental stewardship Create a reporting system that tracks key

causing reputational and financial environmental performance indicators
damage

10. Failing to comply with equal Create a report that tracks key metrics
employment opportunity laws related to compliance with the laws

.
Although these types of controls cannot completely eliminate risks, they enable
companies to proactively manage their risks rather than passively reacting to
unfortunate events that have already occurred.

C. A Corporate Social Responsibility Perspective

Corporate social responsibility (CSR) is a concept where business organizations

consider the needs of all stakeholders when making decisions. They are responsible not
only for creating strategies that produce financial results that satisfy shareholders but
also to serve other stakeholders such customers, suppliers, communities and
environmental and human rights advocate whose interests are tied to the company's
performance.

Examples of corporate social responsibilities that are of interest to the stockholders

groups follow. Companies should
I. Provide its customers with:
a. Safe, high-quality products that are fairly priced.
b. Easy-to-use information systems for shopping and tracking orders.
c. Competent, courteous, and rapid delivery of products and services.
d. Easy-to-use information systems for shopping and tracking orders

II. Provide suppliers with:

a. Hassle-free acceptance of timely and complete deliveries.
b. Fair contract terms and prompt payments.
c. Reasonable time to prepare orders.
d. Cooperative rather than unilateral actions.

III. Provide stockholders with:

a. Competent management.
b. Full disclosure of enterprise risks.
c. Easy access to complete and accurate financial information.
d. Honest answers to knowledgeable questions.

IV. Provide its employees with:

a. Fair compensation.
b. Safe and humane working conditions.
c. Non-discriminatory treatment and the right to organize and file grievances.
d. Opportunities for training, promotion, and personal development.

V. Provide the communities with:

a. Payment of fair taxes.
b. Resources that support charities, schools, and civic activities.
c. Honest information about plans such as plant closings.
d. Reasonable access to media sources.

VI. Provide environmental and human rights advocate with:

a. Recycling and resource conversation data.
b. Full disclosure of suppliers located in developing countries.
c. Greenhouse gas emission data.
d. Child labor transparency.

D. A Process Management Perspective

Most companies organize themselves by functional departments, such as Marketing
Department, the Research and Development Department, and the Accounting
Department. These departments tend to have a clearly defined "chain of command” that
specifies superior and subordinate relationships. However, effective managers
understand that business processes, more so than functional departments, serve the
needs of company's most important stakeholders - it customers. A business process is
a series of steps that are followed in order to carry out some tasks in a business. These
steps often span departmental boundaries, thereby requiring managers to cooperate
across functional departments. The term value chain is often used to describe how an
organization's functional departments interact with one another to form business
processes. A value chain, as shown below consists of the major business functions that
add value to a company's products and services.

Business Functions Making Up the Value Chain

Research and Development ; Product Design ; Manufacturing ; Distribution ; Customer
Service

Managers need to understand the value chain to be effective in terms of planning,

control, and decision making. For example, if a company's engineers plan to design a
new product, they must communicate with the Manufacturing Department to ensure that
the product can actually be produced, the Marketing Department to ensure that
customers will buy the product, the Distribution Department to ensure that large
volumes of the product can be cost-effectively transported to customers, and the
Accounting Department to ensure that the product will increase profits.

From a control and decision-making standpoint, managers also need to focus on

process excellence instead of functional performance. For example, if the Purchasing
Department focuses solely on minimizing the cost of purchased materials, this narrowly
focused attempt at cost reduction may lead to greater scrap and rework in the
Manufacturing Department, more complaints in the Customer Service Department, and
greater challenges in the Marketing Department because dissatisfied customers are
turning their attention to competitors.

Managers frequently use a process management method known as lean thinking, or

what is called Lean Production in the manufacturing sector. Lean Production is a
management approach that organizes resources such as people and machines around
the flow of business processes and that only produces units in response to customer
orders.

E. Leadership Perspective

To achieve success, organizational leaders must be able to unite the behaviours of the
fellow employee who have diverse needs, beliefs and goals to the workplace. Leaders
need to understand how (a) internal motivation (b) external incentives and (c) cognitive
bias influence human behaviour

(a) Internal motivation refers to motivation that comes from within one's self. A leader
who is perceived by employees as credible and respectful of their value to the company
can increase the extent to which those employees are intrinsically motivated to pursue
strategic goals.

To be perceived as a credible and respectful leader, he (she) must possess the

following attributes
1. Technical competence (spanning the value chain)
2. Personal integrity (in terms of work ethic and honesty)
3. Strong communication skills (including oral presentation skills and writing skills)
4. Strong mentoring skills (to help others realize their potential)
5. Strong listening skills (to learn from his (her) co-workers and be responsive to their
needs, and
6. Personal humanity (in terms of giving recognition to all
employees who contribute to the organization's success.

(b) External Incentives such as bonus compensation, are given by many organizations
to highlight important goals and to motivate employees to achieve them

(c) Cognitive Bias. Leaders should be aware that are all people (including themselves)
should possess cognitive biases or distorted thought processes such as promoting false
assertion that can adversely affect planning, controlling and decision making. While
cognitive biases cannot be eliminated effective leaders should take steps and reduce
their negative impacts. These steps include
1. They should acknowledge their own susceptibility to cognitive bias (e.g., being overly
optimistic in assessing future outcome or overestimating ones strengths and
underestimating ones weaknesses relative to others)
2. They should acknowledge the presence of cognitive bias in others and introduce
techniques to minimize their adverse consequences

To reduce if not totally eliminate cognitive biases, a leader may routinely appoint
independent team of employees to assess the credibility of recommendations set forth
by other individuals and groups.
F. An Ethics Perspective
Without ethics, the economy would operate much less efficiently less product would be
available to consumers, quality would be lower and most likely, process would be
higher. Ethical behaviour is the lubricant that keep the economy running smoothly.
In other words, without fundamental trust in the integrity of the business, the economy
would operate much less efficiently. Therefore for the benefit of everyone including
profit-making companies - it is vitally important that that business be conducted within
an ethical framework that builds and sustains trust.

Professional management accountants have developed and implemented a set of

Ethical Standards for practitioners. Refer to pages 28 to 34 for Ethics Standards for
Management Accountants.