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The new revolution in cost management.

Total cost management is a new cost control concept that is earning increasing respect from corporate executives. They find it responds to their needs at three levels:

* it increases the understanding of cost and profitability.

* it helps identify and prioritize cost reduction opportunities.

* It supports improved pricing and investment management.

How does this new solution to cost management work? Four consultants from the Ernst & Young cost management practice provide some answers in a panel discussion produced by the Financial Management Network. They are: George Alexander, a senior manager in the Los Angeles office; Gary Gienger, a senior manager in Boston; Marcus Harwood, a partner in Atlanta; and Peter Santori, a partner in Chicago.

FINANCIAL MANAGEMENT NETWORK: Ten or 15 years ago, the cost of goods sold comprised about equal parts materials, direct labor, and overhead. Today, U.S. manufacturers have squeezed the direct labor component down to as low as 5 to 9 percent. As a result, traditional cost accounting methods are no longer viable. Overhead is too big a percentage, and direct labor too small. And non-manufacturing costs, never handled well by traditional methods, have grown. This has combined to bring on the total cost management revolution.

Five years ago, a number of manufacturing companies formed a consortium, Computer Aided Manufacturing-International CAM-1), to develop a new approach to product costing. Since then, this consortium has produced a significant body of knowledge on how new cost management systems should function. For the past three years, these companies and others have been implementing parts of that system. In the process, they have also streamlined operations, reducing costs and increasing efficiency. In fact, most companies today find these "by-products" are at least as important as improved product costing.

Before discussing total cost management further, however, we should establish some basic concepts behind the method:

* To manage a company by monitoring the functional aspects of the organization is probably the wrong way to manage today. Instead, you need to optimize the business processes that make up your company, which typically cut across functional boundaries.

* Everything that happens in a company should be geared to producing a product or delivering a service. So an internal product could be closing the books at month end or processing a health claim. An external product could be what the company sells.

* Each product or service is supported by a process, and every process can be divided into activities. Total cost management focuses attention at the level of these activities.

FMN: what bas changed in the environment to create this total cost management revolution?

ALEXANDER: One of the greatest changes in the past half century has been the increase in competition, primarily from abroad.

A second change has been in the use of automation. Insurance employees used to work through actuarial tables with a pen and a piece of paper. Today, computers do that. Therefore, direct labor as a percentage of product cost, whether that product is an insurance policy or an automobile, has shrunk significantly.

The third change has been in the consumer's point of view. Today, businesses need to offer not only low price but also high-quality products and to maintain the ability to react quickly to changes in the marketplace.

Finally, if we compare marketplace changes with changes in the way companies keep track of their costs, we see significant changes in the former and very little change in the latter. Many believe this lack of reliable information has led to companies' not being competitive.

FMN: What are the basic concepts of total cost management?

SANTORI: There are three areas to focus on. The first we call process value analysis, or PVA. We look at a business, identify its major processes, and analyze them. By analyzing the activities in each process, we identify opportunities for improving the organization and reducing cost.

The second area is activity-based costing, or ABC. This improves the product or service costing an organization does. It can also be used to determine the profitability of customers or distribution channels.

The third area is performance measurement. Most companies believe that their systems in this area are inadequate and that there are ways to improve them. When you take a process view of the world rather than a functional or departmental view, the performance measures must change.

FMN: Could you elaborate on the benefits of each pall of total cost management?

GIENGER: Better product costing helps to improve information on product-line, service, and customer profitability, which enables you to make better strategic and tactical decisions. With PVA, major benefits include cost reduction and better quality. Really understanding the process can also result in lead time reductions or throughput time reductions. With performance measurement, there is no doubt that improving both what you measure and how you measure it will result in a lower cost and a more efficient organization. In fact, existing performance measures-such as the amount of overhead absorbed based on labor dollars or machine hours-can actually encourage companies to make products they don't need.

FMN: How does PVA work as part of total cost management?

HARWOOD: PVA analyzes the major business processes from the top down. As we subdivide the processes into activities, we ask if the activities are value-added or non-value-added. That is, do they add value from the customer's perspective or not? The next step is to understand the roots of those activities. Why, for example, do I spend so much time in set-up or in moving material, both of which are non-value-added? Finally, we determine the cost of these activities. Once I understand the roots and the cost they are inflicting on the organization, I will know where and how to improve those activities.

GIENGER: The savings from PVA can be significant. Take a company with $150 million of total costs. If $50 million were in materials or labor costs, you might identify 50 percent of the remaining costs, or $50 million, as non-value-added. Frequently, you can reduce a significant amount of these costs. The near-term payback on projects of this type is typically very high.

FMN: Let's clarify value-added and non-value-added.

ALEXANDER: Value-added activity adds something to your product or service that the customer wants. Non-value-added activity adds cost and time to the product or service, but adds no value in the customer's eye. Examples of the latter are material sitting on the shop floor waiting for the next machine or information sitting in an "in" box waiting to be processed.

FMN: So is it easy for employees to see if an activity is value-added?

ALEXANDER-. Yes, just approach it from the perspective of the customer, whether the customer is external or internal, such as top management. if the customer is not willing to pay for it, then the activity does not add value.

FMN: What about those who say that talking to employees about their work being non-value-added can be threatening?

ALEXANDER. The term is threatening if you apply it to what an individual does, because the next step is to eliminate those activities, which may mean the person's job. But some activities an individual performs will be non-value-added and some value-added. The objective should be to free up the person's time for more value-added activities.

HARWOOD: Some companies take the position that no one will lose employment as a result of PVA. But we have found that when companies do have to reduce their staffs, employees will often be enthusiastic about PVA. They've never seen it as fair when a guy comes in and arbitrarily cuts 20 percent of the staff. But finding out where waste really is seems fair to them, even if it eliminates their own jobs.

ALEXANDER- Not only do employees feel better, the company is better off. It's much safer and saner to cut out unnecessary costs than to cut 10 percent from everything.

HARWOOD: In terms of real results, I know a large paper manufacturer that reduced its closing process from 900 hours to about 450 hours, with a 50-percent saving. Another manufacturer reduced its inventory by 25 percent as a result of streamlining its processes.

FMN: Let's go on to discuss product costing and performance measurement and their application. How does activity-based costing differ from traditional costing techniques?

GIENGER: Under the traditional system, overhead is applied based on volume, which could be the amount of labor dollars consumed or the amount of machine hours. However, we know that product volume is not directly proportional to product cost. Engineering-intensive or low-volume products, for example, can absorb relatively high amounts of overhead that wouldn't be included in their cost under the traditional methods. Activity-based costing looks at activities identified through PVA and determines the resources required to do each of those activities. Then it develops the cost of doing those activities and assigns those costs to the products. ABC can also assign costs that have not traditionally been assigned, such as administrative costs or the economic cost of inventory investment.

FMN: And bow much can products be undercosted by traditional systems?

GIENGER: For low-volume products and engineering-intensive products, undercosting by 200 percent is common.

FMN: Is it fair to say that most companies approach ABC from a product cost perspective?

SANTORI: They think they want to recast their product cost. But after we introduce them to the whole body of science, they see that the real benefit is in the results of the PVA and in getting better performance measurement. Of course, understanding product cost is still helpful, but we usually start with PVA.

FMN: How do you implement activity-based costing?

ALEXANDER: With the assumption that activities consume costs, just as products consume activities, you need to estimate the resources required by each activity. That gives you an activity pool, or a pool of costs associated with an activity; then, you need to assign costs from that pool to the product.

How that is done depends on the type of pool. In the traditional system, there is a direct labor pool whose costs go into the product on the basis of hours, and a portion of the overhead pool is carried along -at 100 to 300 percent of the direct labor cost. Whereas, in an activity-based system, in addition to a direct labor pool, you might have many other pools. For example, you might have a pool called engineering change activity." You then take the dollars associated with engineering change orders, and charge them to the product on a reasonable basis.

FMN: With a large body of science to choose from, do different firms develop different approaches?

HARWOOD: Yes, when they recast their product cost, many firms are now including "below-the-line" costs, instead of only the costs that can be inventoried. This extends the value chain to all product costs. But a more important difference is categorizing costs into value-added and non-value-added. This is important, because when my product cost goes from $10 to $12, 1 want to know how much of that increase is non-value-added and, in turn, what I can do to reduce that cost. Another difference is that some companies charge to a product the cost of holding it in inventory.

ALEXANDER: It's important to have visibility into that carrying cost, because it generally does not show up on a P&L or a balance sheet. We also should understand that even though the opportunities for savings generally lie with non-value-added activities, a dollar saved in value-added activities is just as good.

FMN: Let's move now to performance measurement. What's wrong with today's measures?

ALEXANDER: In companies that use traditional cost accounting systems, the accountants have always been the scorekeeper. But they have always kept score after the fact, producing numbers for the previous month that aren't available until halfway through the next month. This means little to the people performing day-to-day activities. They can't relate what's long past to what they're doing today.

In looking at overhead costs, moreover, we focus on direct labor, because that used to be the largest cost next to materials. This is no longer true, yet traditional cost systems still focus on it. For example, we don't let engineers know how much an engineering change costs. They could spend an incredible amount of money generating a change in order to reduce a product's direct labor cost, when they're actually increasing the cost of the product because of the engineering change process itself ! FMN: How, then, can we develop new performance measures?

SANTORI: We should use the information we learned from our PVA. But we must also recognize such critical success factors as cost, quality, and service, and realize that performance measures need to relate to those factors as well as to processes and activities. We should also remember that most performance measurement systems of the past have had a lot of financial-related measurements, whereas many measurements made in the new systems are non-financial.

FMN: All this is great in theor but how do we implement each aspect of total cost management? One issue I see is the sequence of implementation. We've talked about PVA, about ABC, about performance measures. Can you start with any one?

GIENGER: Typically, companies begin with either activity-based costing or process value analysis. But they always end up with PVA, because as soon as they find out a product's costs, they want to reduce some of those costs.

ALEXANDER: As Peter pointed out, PVA really provides the underlying data you need to obtain the benefits of improved cost and performance measurement systems. Also, by seeing what activities cost and understanding their relationship to each other, you reap some benefits right up front. It almost always surprises management when they find out how much certain activities cost.

SANTORI: Two years ago, most of our clients were approaching us because they'd heard about activity-based costing and were thinking in terms of product costing. But most believe they got the greatest benefits from PVA. They saw a rapid reduction of costs, and at the same time they improved their processes and their responsiveness to customer needs.

HARWOOD: Another question many companies raise is if total cost management, particularly PVA, gets in the way of their total quality (TQ) initiative, or if it complements it. We show them that our concept is so simple that the average employee can relate to it, whereas TQ is so large and pervasive that the average employee often finds it difficult to understand its full scope or where to start.

ALEXANDER: At more than one company, the TQ team was struggling to come up with an analytical method to improve quality and ultimately decided to use PVA.

FMN: What about the systems issue? How many do you need? Do you stan with systems? Do you need a system to get all the benefits?

GIENGER. We see everything from stand-alone PC modeling up to totally integrated systems. An important underlying concept is that it's not the system or the software that's important. There are reasonably priced packages that will do much of what we're talking about. it's the approach and the methodology that matter.

FMN: But some large companies have looked at this body of science and said, "Oh, we need activity-based costing, " and have gone right out to purchase the software.

SANTORI: Companies using software to help them in ABC often tend to do it off-line from their primary systems. We discussed one reason, that an option in costing your products is to pick up below-the-line activities. And, of course, you can't do that for external reporting purposes. Another point is that this is an evolving body of knowledge. It's important to understand that we don't have cost accounting standards to refer to.

FMN: What are the keys to success for total cost management?

HARWOOD: If I had to choose one, I would say employee involvement. If a PVA action plan is done by consultants, or perceived to be clone by anyone other than the employees who work in the process, that action plan is going to sit on the shelf. On the other hand, if it is done by the people who work in the process, not only will they take action, they will become enthusiastic. They will tell management where there is 55 percent non-value-added activity, because they have all the fixes and they're proud of that.

SANTORI: Another key to success is that you've got to have a commitment to total cost management from people who have the ability to achieve change. When you change old performance measurements, change old systems, or look at the business from a different light, there's often resistance. You need people who can overcome that resistance, who can manage the change process and be accepted in doing so.

FMN: To sum up, total cost management is new, is driven by a new body of science, and, although originating within the manufacturing industry, has found applications within all types of businesses. On the PVA side, it achieves rapid and exciting cost reduction and improved efficiency, and it gets employees involved in the process. Moreover, process value analysis, activity-based costing, and performance measurement and their application are themselves changing as we learn more about them. This important new field is of critical importance to management today.

This article was adapted from a panel discussion produced by the Financial Management Network. FMN is a s bscription-based video service sponsored by Financial Executives Institute, the Institute Of Management Accountants, and the Center, for Video Education.
COPYRIGHT 1991 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Management's Strategy
Publication:Financial Executive
Article Type:Interview
Date:Nov 1, 1991
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