Set B · Strategic Cost & Performance Management
Strategic Cost Management and Value Chain Analysis
This is the theory-heavy end of Set B. The marks come from naming things correctly — the nine value chain activities, the three strands of strategic cost management, the four cost management techniques and what each is for.
Traditional cost accounting asks what a product costs. Strategic cost management asks whether the cost structure itself supports the strategy the business has chosen. Everything in this chapter follows from that shift, and examiners test whether you can articulate it in the module’s own vocabulary.
Part 1Chapter-wise quick notes
What strategic cost management adds
- Strategic Cost Management is the application of cost management techniques so that they simultaneously improve the strategic position of the firm and reduce costs.
- It rests on three analyses that the study material treats as a set:
- Value chain analysis — where in the chain of activities value is created and cost incurred.
- Cost driver analysis — what actually causes cost, distinguishing structural from executional drivers.
- Strategic positioning analysis — whether the firm competes on cost leadership or differentiation, which determines what cost information it needs.
- Contrast with traditional cost management: traditional analysis is internally focused, product-centred and periodic. Strategic cost management is externally focused, activity-centred and continuous.
Porter’s value chain
Nine activities in total — five primary and four support. Examiners routinely ask which category an activity falls into.
| Category | Activity | What it covers |
|---|---|---|
| Primary | Inbound logistics | Receiving, storing and distributing inputs |
| Primary | Operations | Transforming inputs into the final product |
| Primary | Outbound logistics | Collecting, storing and distributing the product to buyers |
| Primary | Marketing and sales | Providing the means and inducement for buyers to purchase |
| Primary | Service | Installation, repair, training, parts supply and adjustment |
| Support | Procurement | The function of purchasing inputs, not the inputs themselves |
| Support | Technology development | Know-how, procedures and process equipment |
| Support | Human resource management | Recruiting, hiring, training, development and compensation |
| Support | Firm infrastructure | General management, planning, finance, accounting, legal and quality management |
- Margin is the difference between total value created and the collective cost of performing the activities.
- Steps in value chain analysis: identify the activities, assign cost and assets to each, identify the cost drivers of each activity, identify the linkages, and then act — either by reducing cost or by reconfiguring the chain.
- Linkages exist within the firm’s own chain and between the firm and its suppliers and buyers. Exploiting linkages is often a larger source of advantage than optimising any single activity.
Cost drivers
- Structural cost drivers derive from the firm’s fundamental economic choices and change slowly: scale, scope, experience, technology and complexity.
- Executional cost drivers derive from how well the firm executes and can be improved continuously: workforce involvement, total quality management, capacity utilisation, plant layout efficiency, product configuration and linkages with suppliers and customers.
- The distinction matters because a structural driver is usually addressed by a one-time strategic decision, whereas an executional driver is addressed by continuous improvement.
Strategic positioning
- Cost leadership — competing by achieving the lowest cost position in the industry. Requires tight cost control, standard costing, and detailed variance analysis. Emphasis on engineered costs.
- Differentiation — competing on uniqueness for which the buyer will pay a premium. Cost control is looser; emphasis shifts to marketing, research and development, and the cost of maintaining differentiation.
- Focus — either of the above applied to a narrow segment.
- A firm attempting both without a clear choice risks being stuck in the middle, with neither a cost advantage nor a differentiation premium.
Activity based costing
- Traditional absorption costing spreads overhead using volume-based rates such as labour hours or machine hours. Where overhead is large and products consume support activities unevenly, this systematically over-costs high-volume products and under-costs low-volume products.
- ABC assigns overhead to cost pools defined by activity, then to products using a cost driver that reflects actual consumption.
- Cost hierarchy: unit-level (varies with each unit), batch-level (varies with each batch, such as machine set-up), product-level (sustains a product line, such as design), and facility-level (sustains the plant as a whole, such as factory rent, and is not attributable to products).
- Activity Based Management uses ABC information to make decisions. Operational ABM does things right; strategic ABM does the right things.
- Activities are classified as value added or non-value added. The latter are targets for elimination.
Target costing, life cycle costing and Kaizen
- Target costing works backwards from the market. Target cost = Target selling price − Target profit margin. The cost gap is the excess of the estimated current cost over the target cost, closed through value engineering before the product goes into production.
- Value engineering examines the product’s design and function to remove cost without reducing the value the customer perceives.
- Life cycle costing accumulates cost across the whole life of the product — research and development, design, manufacturing, marketing, distribution and customer service, through to abandonment. The key insight is that a large proportion of total life cycle cost is committed at the design stage, long before it is incurred.
- Life cycle stages: introduction, growth, maturity and decline. Cost and pricing behaviour differ at each.
- Kaizen costing applies during the manufacturing stage, seeking small continuous reductions. Target costing applies at the design stage, seeking large reductions before production begins.
Quality and other techniques
- Cost of quality has four components: prevention cost, appraisal cost, internal failure cost and external failure cost. Spending on prevention and appraisal reduces failure costs, usually more than proportionately.
- Total Quality Management — continuous improvement, customer focus, and the principle that quality is everyone’s responsibility rather than an inspection function.
- Just in Time — production pulled by demand, minimal inventory, short set-up times, and close supplier relationships. Reduces holding cost but increases exposure to supply disruption.
- Theory of Constraints — identify the bottleneck, exploit it, subordinate everything else to it, elevate it, and repeat. Output of the system is limited by its constraint.
- Business Process Re-engineering — fundamental rethinking and radical redesign of processes to achieve dramatic improvement, as distinct from the incremental improvement of Kaizen.
Part 2Repeated questions
Which of the following is a support activity in Porter’s value chain? (A) Operations (B) Procurement (C) Outbound logistics (D) Service
(B) Procurement. Note that procurement refers to the purchasing function, not to the purchased inputs.
Name the three analyses that together constitute strategic cost management.
Value chain analysis, cost driver analysis and strategic positioning analysis.
Machine set-up cost is an example of which level in the ABC cost hierarchy? (A) Unit level (B) Batch level (C) Product level (D) Facility level
(B) Batch level. Set-up is incurred once per batch regardless of the number of units in it.
Scale, scope, experience, technology and complexity are examples of ______ cost drivers.
Structural cost drivers.
The four components of cost of quality are ______.
Prevention cost, appraisal cost, internal failure cost and external failure cost.
Target costing is applied at which stage of the product life cycle?
The design and development stage, before production begins. Kaizen costing applies during manufacture.
Under traditional absorption costing with volume-based overhead rates, high-volume products tend to be: (A) Under-costed (B) Over-costed (C) Correctly costed (D) Not costed at all
(B) Over-costed, with low-volume products correspondingly under-costed. This cross-subsidy is the principal argument for ABC.
Factory rent and plant security fall into which ABC cost level?
Facility level. These sustain the facility as a whole and are not meaningfully attributable to individual products.
A firm that pursues neither a clear cost advantage nor a clear differentiation advantage is described as ______.
Stuck in the middle.
What distinguishes Business Process Re-engineering from Kaizen?
BPR is a radical, fundamental redesign aimed at dramatic improvement. Kaizen is incremental and continuous.
Margin in the value chain represents ______.
The difference between the total value created and the collective cost of performing the value activities.
Which of these is an executional cost driver? (A) Scale (B) Scope (C) Capacity utilisation (D) Technology
(C) Capacity utilisation. The others are structural drivers arising from fundamental economic choices.
The five steps of the Theory of Constraints are ______.
Identify the constraint, exploit it, subordinate everything else to it, elevate it, and then return to step one so that inertia does not become the new constraint.
Life cycle costing highlights that a large proportion of total cost is ______ at the design stage.
Committed, even though it is incurred much later. Design decisions lock in most of the eventual cost.
Distinguish operational ABM from strategic ABM.
Operational ABM improves the efficiency of existing activities — doing things right. Strategic ABM changes the mix of activities and products undertaken — doing the right things.
