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Supply chain management across industries is being revolutionized at a rapid pace by technology. By implementing technology systems, supply chain organizations aspire to eliminate waste, meet customers’ needs at reasonable costs, and ensure profitability. Enterprise Resource Planning systems facilitate in processing unstructured data at an aggregated level. However, at workflow or micro level the data produced through ERPs needs to be further refined to understand costs.
Supply chain experts need to look at their unstructured data and understand the cost of offering a product; know which product mix they should promote; and gauge the impact of service levels on transportation costs, profits, and pricing strategy.
Supply Chain Executives can use the Cost-to-Serve (CTS) Analysis approach to control distribution costs, identify negative-margin products, and prevent profit leakages. CTS Analysis affords the organizations the means to identify the total cost of serving customers—including all the costs in a product’s value chain (from raw material to delivery)—at the product as well as customer levels. The approach helps leaders split and evaluate individual customers, geographies, products, product families, or combinations of products / customers.
The Cost-to-Serve Analysis can be undertaken to identify costs related to Supply Chains, Logistics, Distribution, Warehousing, or Transportation. CTSA allocates indirect cost to products—overhead or fixed costs that are not easily and directly attributable to a single order, shipment, or activity.
The CTS model for costing entails detailed modeling of all the value and non-value added activities in the process. The approach is more precise than other methods in determining “what-if” budgets, as it accounts for all the activities and link them with their relevant cost pools. CTS employs an activity-based modelling algorithm—which segregates the entire supply chain into multiple tasks while calculating the costs at every task—to help the supply chain practitioners calculate costs at various levels.
The CTS Framework entails 5 fundamental steps:
- Obtain Buy-in from Key Stakeholders
- Conduct Cost Categorization
- Determine per Unit Cost Breakdown
- Develop Classification Matrices
- Make Joint Decisions
Let’s delve deeper into the first 2 steps of the CTS Framework.
1. Obtain Buy-in from Key Stakeholders
The first step to implement Cost-to-Serve Framework involves getting across-the-board agreement and stakeholder buy-in. The decision to calculate the impact of cost to serve on revenue entails engagement and collaboration from multiple departments in a company. Multiple cost centers work in partnership across a value chain and thus profit and loss responsibility cannot be attached to a specific unit.
For instance, a decision to trim down the costs to serve a customer (or various customers) has to be agreed upon by stakeholders from the:
- Sales and marketing department to calculate the impact of service level agreements.
- Logistics function to calculate the cost impact.
- Go-to-market Strategy to ensure alignment with Corporate Strategy
- Warehousing unit to ensure resource planning and allocation.
2. Conduct Cost Categorization
The 2nd step of the Cost-to-Serve Framework involves categorization of costs associated with the entire supply chain. Supply chains typically have various cost centers (or functions): e.g., Procurement, Manufacturing, Warehousing, and Logistics. These cost centers further have multiple processes with costs associated with all of them. CTS requires top-down estimation of costs at the process and activity level and then aggregate those back to the cost center level.
This categorization of costs across the various functions of the supply chain and their associated processes facilitates in accurate calculation and obtaining estimates at the micro level.
Interested in learning more about the other steps of the Cost-to-Serve Framework? You can download an editable PowerPoint presentation on Cost-to-Serve Analysis here on the Flevy documents marketplace.
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Cost-based Pricing is fast becoming a relic of the past and being substituted by the concept of Target Costing. Target Costing is referred to as an organized process to determine the cost at which a proposed product must be developed so as to generate profits at the product’s anticipated selling price in future.
In highly competitive markets such as FMCG, construction, healthcare, and energy, prices are determined by market forces. Producers cannot effectively control selling prices. The only control, to some extent, is over costs, so management’s focus has to be on influencing every component of product, service, or operational costs.
Target Costing is a proactive Cost Planning, Cost Management, and Cost Reduction practice. Costs are planned and managed out of a product and business early in product life-cycle, rather than during the later stages. The fundamental objective of Target Costing is to make the business profitable in any competitive marketplace. Target Costing is widely used in several industries e.g. manufacturing, energy, healthcare, construction, and a host of others.
Some key features of Target Costing are:
- Seller is a price taker rather than a price maker.
- The target selling price incorporates desired profit margin.
- Product design, specifications, and customer expectations are built-in while formulating the total selling price.
- Cost reduction and effective cost management is the corner stone of management strategy.
- Target Cost has to be achieved through team collaboration during activities such as designing, purchasing, manufacturing, marketing, and other activities.
Target Costing presents the following advantages over other product pricing techniques:
- More value delivered to customer since the product is created keeping in mind the expectation of the customer.
- Approach to designing and manufacturing products is market driven.
- Competitive Advantage gained through process improvement and product innovation.
- Drastic Process Improvement, which creates economies of scale.
- New market opportunities converted into real savings to achieve the best value for money rather than to simply realize the lowest cost.
The Target Costing process comprises 3 main phases.
- Market-Driven Target Costing
- Product-Level Target Costing
- Component-Level Target Costing
Let’s discuss the 3 phases briefly.
1. Market-Driven Target Costing
In this phase, Selling Price is determined by analyzing the entire industry value chain and all functions of the firm. The focus of this costing phase is on analyzing market conditions and determining the company’s Profit Margin in order to identify the “Allowable Cost” of a product.
In this phase, the desired profit level is set on the basis of firm’s strategy and financial goals, and is deducted from Selling Price to obtain Allowable costs. Intensity of competition, nature of customers, similar product introduction by competitors, and level of customer sophistication are the key factors influencing Market-driven Target Costing.
2. Product-Level Target Costing
In this phase, Allowable Cost only gives a ball-park figure of cost saving to be achieved. It has to be translated into Achievable Target Cost. This type of costing concentrates on designing products that satisfy the company’s customers at the Allowable Cost. The cardinal rule of Product-level Target Costing is to never exceed the Target Cost.
The objective of this Target Costing phase is to create intense but realistic pressure on the product designers to reduce costs. Product Strategy (number of products in the line, frequency of redesign, degree of innovation) and product characteristics (complexity, magnitude of up-front investments, and duration of product development) are the key factors affecting Product-level Target Costing.
3. Component- Level Target Costing
The Component-level Target Costing settles the price at which a firm is willing to purchase the externally-acquired components being used in its product. This phase involves a cross-functional team that is tasked to reduce costs across all functions such as designing, purchasing, manufacturing, marketing, and other activities.
The components cost history serves as the starting point for estimating the new component-level target costs alongside optimal selection of suppliers. A supplier-focused strategy is the key factor that influences Component-level Target Costing.
Interested in learning more about how the Target Costing process works and its key steps? You can download an editable PowerPoint on Target Costing here on the Flevy documents marketplace.
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A commonly quoted statistic is that 80% to 95% of the cost of a product is determined by its design and is therefore set before the item enters manufacturing. This 
assumption suggests that the dominant focus of Cost Management should be during Product Development and not during Manufacturing.
However, contrary to a widely held assumption, companies can integrate a variety of Cost Management techniques not only in the design phase but throughout the product life cycle. This is to ensure that there is a substantial reduction in costs. In fact, companies achieving Operational Excellence and competing aggressively on cost might consider the adoption of some form of an Integrated Cost Management Program that spans the entire product life cycle.
An organization must have a good understanding of Integrated Cost Management and the 5 Cost Management Strategies that they can use to reduce costs but still attain the desired level of functionality and quality at the target costs.
The 5 Cost Management Strategies
The 5 Cost Management Strategies play a crucial role in the company’s integrated approach to Cost Management.
The 5 Cost Management Strategies can be applied throughout the product life cycle with one technique used during the product design and the rest during manufacturing.
- Target Costing. This is a technique applied during the design stage. Target Costing is best used when the manufacturing phase of the life cycle of a product is short.
- Product-specific Kaizen Costing. This is a technique applied during the early stages of the manufacturing phase. It enables the rapid redesign of a new product to correct for any cost overruns. The primary rule in Product-specific Kaizen Costing is that the product’s functionality and quality have to remain constant.
- General Kaizen Costing. The third Cost Management Strategy, this technique is applied during the manufacturing phase. It focuses on the way a product is manufactured with the assumption that the product’s design is already set. This technique is effective when addressing manufacturing processes that are used across several product generations.
- Functional Group Management. This is the technique that is applied in the production process. Functional Group Management consists of breaking the production process into autonomous groups and treating each group as a profit instead of a cost center. The switch to profit as opposed to cost allows groups to increase the throughput of production processes even if changes result in higher costs. It enables the change in mindset that functional group management induces.
- Product Costing. The 5th Cost Management Strategy, this is the technique that coordinates the efforts of the other four techniques. It does coordination work by providing the other four techniques with important, up-to-date information.
Target Costing vis-a-vis Kaizen Costing
Kaizen Costing as known as continuous improvement costing. It is a method of reducing managing costs. Kaizen Costing has a similarity with Target Costing but it also has its differences. (Note: Kaizen is the Japanese term for Continuous Improvement and often tied to the philosophy of Lean Management.)
Both Kaizen Costing and Target Costing can achieve results with lower resources. This is basically their similarity. On the other hand, the differences lie in their usage and involvement.
Target Costing is used on the design stage and requires the involvement only of designers. On the other hand, Kaizen Costing is used during the manufacturing stage and requires high involvement of employees. The general idea of Kaizen Costing is to determine target costs, design products, and process to not exceed those costs.
Interested in gaining more understanding of these Cost Management Strategies? You can learn more and download an editable PowerPoint about 5 Cost Management Strategies here on the Flevy documents marketplace.
Are you a management consultant?
You can download this and hundreds of other consulting frameworks and consulting training guides from the FlevyPro library.
Through this Sunday, learnPPT is having a promo for the Cost Reduction Toolkit. This detailed document identifies over 45+ cost cutting initiatives across the Value Chain. For each initiative, examples are provided, along with projected potential savings.
The Cost Management opportunities are broken down into the areas of:
- Enterprise-wide - These opportunities are cross-functional, meaning they can affect multiple functions within an organization. The impact is largely to SG&A costs.
- Asset Management - These opportunities target the improvement of fixed assets efficiency and decreasing net working capital. The impact is largely capital efficiency.
- Function-specific - Opportunities in this category are specific to primary and support functional activities. These are operational and transactional in nature.
This toolkit also explains the levers and challenges to profitability, as well as the formula identifying cost reduction opportunities.
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