CHAPTER 11
STRATEGIC COST MANAGEMENT
Activity-based costing (ABC) was introduced in Chapter 4. ABC can significantly improve the accuracy
of product costing. Yet, the value of traditional product cost definition is limited and may not be very
useful in certain decision contexts. Strategic planning and decision making require a much broader set of
cost information than that provided by product costs. Chapter 11 focuses on a value-chain framework
with cost data to support a value-chain analysis. In addition, life-cycle cost management and JIT are
introduced.
LEARNING OBJECTIVES
After studying Chapter 11, students should be able to:
1. Explain what strategic cost management is and how it can be used to help a firm create a competitive
advantage.
2. Discuss value-chain analysis and the strategic role of activity-based customer and supplier costing.
3. Tell what life-cycle cost management is and how it can be used to maximize profits over a product’s
life cycle.
4. Identify the basic features of JIT purchasing and manufacturing.
5. Describe the effect JIT has on cost traceability and product costing.
KEY TOPICS
The following major topics are covered in this chapter (related learning objectives are listed for each
topic):
1. Strategic Cost Management: Basic Concepts (LO 1)
2. Value-Chain Analysis (LO 2)
3. Life-Cycle Cost Management (LO 3)
4. Just-in-Time (JIT) Manufacturing and Purchasing (LO 4)
5. JIT and Its Effect on the Cost Management System (LO 5)
I. STRATEGIC COST MANAGEMENT: BASIC CONCEPTS
The most important strategic elements for a firm are its long-term growth and survival. Strategic decision
making involves choosing among alternative strategies with the goal of selecting a strategy, or strategies,
that provides a company with a reasonable assurance of long-term growth and survival. The key to
achieving long-term growth and survival is to gain a competitive advantage. Strategic cost management is
the use of cost data to develop and identify superior strategies that will produce a sustainable competitive
advantage.
Competitive advantage is the process of creating better customer value for the same or lower cost than
that of competitors or creating equivalent value for lower cost than that of competitors. Customer value is
the difference between what a customer receives (customer realization) and what the customer gives up
(customer sacrifice). The total product is the complete range of tangible and intangible benefits that a
customer receives from a purchased product.
A strategy can be defined as choosing the market and customer segments the business unit intends to
serve, identifying the critical internal business processes that the unit must excel at to deliver the value
propositions to customers in the targeted market segments, and selecting the individual and organizational
capabilities required for the internal, customer, and financial objectives.
Increasing customer value to achieve a competitive advantage is tied closely to judicious strategy
selection. Three general strategies have been identified:
1. Cost leadership
2. Product differentiation
3. Focusing
A company is pursuing a cost leadership strategy when it seeks to provide the same or better value to
customers at a lower cost than its competitors.
A differentiation strategy focuses on increasing customer value by increasing what the customer receives
(customer realization). For example, a retailer of computers might offer on-site repair service, a feature
not offered by other rivals in the local market.
A focusing strategy involves selecting or emphasizing a market or customer segment in which to
compete. This strategy takes into consideration that some segments are more attractive or more
serviceable than others.
Strategic positioning is the process of selecting the optimal mix of these three general strategic
approaches.
Successful pursuit of a sound strategic position mandates an understanding of the industrial value chain.
The industrial value chain is the linked set of value-creating activities from basic raw materials to the
disposal of the finished product by end-use customers.
Fundamental to a value-chain framework is the recognition that there exist complex linkages and
interrelationships among activities both within and beyond the firm. There are two types of linkages that
must be analyzed and understood: internal linkages and external linkages. Internal linkages are
relationships among activities that are performed within a firm’s portion of the value chain. External
linkages describe the relationship of a firm’s value-chain activities that are performed with its suppliers
and customers. External linkages can be categorized as either supplier linkages or customer linkages.
To exploit a firm’s internal and external linkages, it is important to understand the organizational
activities and operational activities. Organizational activities are of two types: structural and executional.
Structural activities are activities that determine the underlying economic structure of the organization.
Executional activities are activities that define the processes and capabilities of an organization and thus
are directly related to the ability of an organization to execute successfully. Exhibit 11.2 on page 572
illustrates both structural and executional activities along with their cost drivers.
Operational activities are day-to–day activities performed as a result of the structure and processes
selected by the organization. Examples include receiving and inspecting incoming parts, moving
materials, shipping products, testing new products, servicing products, and setting up equipment.
Operational cost drivers are those factors that drive the cost of operational activities. Exhibit 11.3 on page
573 describes operational activities and their drivers.
II. VALUE-CHAIN ANALYSIS
Value-chain analysis is identifying and exploiting internal and external linkages with the objective of
strengthening a firm’s strategic position. The exploitation of linkages relies on analyzing how costs and
other nonfinancial factors vary as different bundles of activities are considered. Exhibit 11.5 (p. 575)
provides a diagram that illustrates the internal value chain, which cycles from the design phase through
development, production, marketing, distribution and service. Cornerstone 11.1, on page 575, illustrates
how internal linkages can be exploited to reduce costs in the internal value chain.
Teaching hint: Several exercises related to Learning Objective 2 should be worked in class to illustrate
value chain analysis.
III. LIFE-CYCLE COST MANAGEMENT
Product life cycle is simply the time a product exists—from conception to abandonment. There are
several product life-cycle viewpoints discussed in the text:
1. Marketing viewpoint
2. Production viewpoint
3. Consumable life-cycle viewpoint
The marketing viewpoint of the product life cycle describes the general sales pattern of a product as it
passes through four distinct life-cycle stages: introduction, growth, maturity, and decline.
The production viewpoint of the product life cycle defines stages of the life cycle by changes in the
activities performed: research and development activities, production activities, and logistical activities.
The consumable life-cycle viewpoint focuses on product performance for a given price. Price refers to the
costs of ownership, which include the following elements: purchase cost, operating costs, maintenance
costs, and disposal costs.
Life-cycle cost management consists of actions taken that cause a product to be designed, developed,
produced, marketed, distributed, operated, maintained, serviced, and disposed of so that life-cycle profits
are maximized. Life-cycle cost management emphasizes cost reduction, not cost control. Target costing
is, therefore, a useful tool for establishing cost reduction goals during the design stage. A target cost is the
difference between the sales price needed to capture a predetermined market share and the desired per–
unit profit. If the target cost is less than what is currently achievable, then management must find cost
reductions that move the actual cost toward the target cost.
IV. JUST–IN-TIME (JIT) MANUFACTURING AND PURCHASING
JIT manufacturing and purchasing systems offer a prominent example of how managers can use the
strategic concepts discussed earlier in this chapter to bring about significant changes within an
organization. JIT manufacturing is a demand-pull system. The objective of JIT manufacturing is to
eliminate waste by producing a product only when it is needed and only in the quantities demanded by
customers. JIT assumes that all costs other than direct materials are driven by time and space drivers. JIT
focuses on eliminating waste by compressing time and space.
In a JIT system, supplier linkages are exploited by negotiating long-term contracts with a few chosen
suppliers located as close to the production facility as possible and by establishing more extensive
supplier involvement. Establishing relationships with suppliers so that they deliver quality products in a
timely manner is vital to the success of a JIT system. Suppliers must understand that their well-being is
intimately tied to the well-being of the buyer.
The plant layout is important in a JIT system. A cell structure is often chosen over a departmental
structure in a JIT system because they help save space and time. Each cell is essentially a mini-factory
and workers are able to perform all of the production tasks associated with the cell. The cell structure
enables a company to scale down centralized support departments.
Typically in a JIT setting, employees have a great amount of input. Workers make suggestions to improve
the production process and are often involved in interviewing and hiring. In addition, total quality control
(TQC) is emphasized rather than acceptable quality level (AQL). TQC is essentially a never-ending quest
for perfect quality.
Exhibit 11.12 (p. 596) presents a comparison of JIT approaches with traditional manufacturing and
purchasing. Exhibit 11.13 (p. 597) provides a comparison of product cost assignment in a traditional
environment versus a JIT environment.
V. JIT AND ITS EFFECT ON THE COST MANAGEMENT SYSTEM
A JIT system can simplify the cost management accounting system and simultaneously increase the
accuracy of the cost information being produced. Cellular manufacturing, multiskilled labor, and
decentralized service activities improve the traceability of costs. The enhancement of the traceability of
costs improves the accuracy of product costing.
The JIT system offers the opportunity to simplify the accounting for manufacturing cost flows. Under JIT,
there are cells rather than departments, and there is no need for multiple departmental work-in-process
accounts. Backflush costing is a simplified approach for cost flow accounting that uses trigger points to
determine when manufacturing costs are assigned to key inventory and temporary accounts.
There are four variations of backflush costing, depending on the definition of the trigger points (which, in
turn, depends on how fully a firm has implemented JIT):
1. The purchase of raw materials (trigger point 1) and the completion of goods (trigger point 2).
2. The purchase of raw materials (trigger point 1) and the sale of goods (trigger point 2).
3. The completion of goods (only trigger point).
4. The sale of goods (only trigger point).
Teaching hint: Cornerstone 11.5 (p. 599) illustrates backflush costing. Exercises 11.15, 11.16, and 11.17
provide good examples of the four variations of backflush costing.
VI. INFORMATION ABOUT EXERCISES, PROBLEMS, AND CASES
Exercises and problems are described below and on the following page according to coverage of content,
learning objective(s), and level of difficulty. The time required to solve the problems is roughly
proportional to the level of difficulty.
In general, basic exercises/problems are fairly simple and straightforward. The text material is relatively
brief; only one or two concepts are covered. Basic exercises and problems should take about 15 to 20
minutes each.
Moderate exercises/problems may take longer and involve more concepts. These problems may have a
“twist” and require more thought. Moderate exercises and problems may take 20 to 40 minutes each.
Challenging problems are more comprehensive and may cover more concepts. The text material is
relatively longer and may include some ambiguity. Challenging problems may take 60 to 90 minutes
each.
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Topic
Learning
Objective
Degree of
Difficulty
CS 11.1
Exploiting Internal Linkages
LO 2
Basic
CS 11.2
Activity-Based Supplier Costing
LO 2
Basic
CS 11.3
Activity-Based Customer Costing
LO 2
Basic
CS 11.4
Activity-Based Life-Cycle Costing
LO 3
Basic
CS 11.5
Backflush Costing
LO 5
Basic
11.6
Competitive Advantage: Basic Concepts
LO 1
Basic
11.7
Strategic Positioning
LO 1
Basic
11.8
Driver Classification
LO 1
Basic
11.9
Operational and Organizational Activities
LO 1
Moderate
11.10
External Linkages, Activity-Based Supplier Costing
LO 2
Basic
11.11
External Linkages, Customer Costing, Customer
Profitability
LO 2
Moderate
11.12
Product Life Cycle
LO 3
Basic
11.13
JIT and Traceability of Costs
LO 5
Moderate
11.14
JIT Features and Product Costing Accuracy
LO 4, 5
Moderate
11.15
Backflush versus Traditional Costing: Variation 1
LO 5
Basic
11.16
Backflush Costing: Variation 2
LO 5
Basic
11.17
Backflush versus Traditional Costing: Variations 3 and
4
LO 5
Basic
11.18
Cost Assignment and JIT
LO 4, 5
Moderate
11.19
CPA-Type Exercise
LO 2
Basic
11.20
CPA-Type Exercise
LO 2
Basic
11.21
CPA-Type Exercise
LO 2
Basic
11.22
CPA-Type Exercise
LO 2
Basic
11.23
CPA-Type Exercise
LO 2
Basic
11.24
Internal Linkages, Cost Management, and Strategic
Decision Making
LO 2
Moderate
11.25
External Linkages, Activity-Based Supplier Costing
LO 2
Moderate
11.26
External Linkages, Activity-Based Customer Costing,
and Strategic Decision Making
LO 2
Moderate
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Topic
Learning
Objective
Degree of
Difficulty
11.27
Internal and External Linkages, Strategic Cost
Management
LO 2
Moderate
11.28
External Linkages and Strategic Cost Management
LO 1, 2
Moderate
11.29
Life-Cycle Cost Management and Target Costing
LO 3
Moderate
11.30
Life-Cycle Cost Management
LO 3
Moderate
11.31
JIT, Traceability of Costs, Product Costing Accuracy,
JIT Effects on Cost Accounting Systems
LO 4, 5
Moderate
11.32
JIT and Product Costing
LO 4, 5
Challenging
11.33
Backflush Costing, Conversion Rate
LO 4, 5
Moderate
11.34
JIT, Creation of Manufacturing Cells, Behavioral
Considerations, Impact on Costing Practices
LO 4, 5
Challenging
11.35
Cyber Research Case
LO 2
Moderate
LIST OF ILLUSTRATIONS
Illustration
Topic
Exhibit 11.1
Value Chain for the Petroleum Industry
Exhibit 11.2
Organizational Activities and Drivers
Exhibit 11.3
Operational Activities and Drivers
Exhibit 11.4
Organizational and Operational Activity Relationships
Exhibit 11.5
Internal Value Chain
Exhibit 11.6
Step-Cost Behavior: Purchasing Activity
Exhibit 11.7
General Pattern of Product Life Cycle: Marketing Viewpoint
Exhibit 11.8
Product Life Cycle: Production Viewpoint
Exhibit 11.9
Typical Relationships of Product Life-Cycle Viewpoints
Exhibit 11.10
Target-Costing Model
Exhibit 11.11
Plant Layout Pattern: Traditional versus JIT
Exhibit 11.12
Comparison of JIT Approaches with Traditional Manufacturing and Purchasing
Exhibit 11.13
Product Cost Assignment: Traditional versus JIT Manufacturing