CAMI Article on ABC

Copyright 1998 Tom Freeman and The Consortium for Advanced Manufacturing – International.All rights of reproduction in any form reserved.

Transforming Cost Management into a Strategic Weapon

Tom FreemanProgram Director, The Consortium for Advanced Manufacturing – International(CAM-I)

“The lowest-cost producers of the highest-quality products will cope best with the presentslump. They will soon start growing and profiting again. Some never stopped… Costs,especially, are a decisive factor. Most automakers now are competitive in terms ofproduct quality. But the big differentials remain in cost structures… Cost managementis going to be for the automobile industry in the 1990s what quality control was in the1970s and ‘80s.” (S. Toyoda & T. Toyoda, Toyota Annual Report, October 1993, p.1.)

Introduction

This is a tremendously exciting time in the evolution of strategic cost and resource management. Since theemergence of activity-based costing as a mainstream performance improvement tool in 1986, several costmanagement methods have been developed or documented by CAM-I and others. Among these advances areTarget Costing, Capacity Management, Process-Based Management, and improved performance measurementand reward systems including the balanced scorecard. As a result of these developments, the components of anintegrated cost planning and management approach are becoming visible. Rather than an internally focusedand tactical control system, effectively understanding and managing costs is increasingly being used bycompanies as a strategic weapon. The purpose of this paper is to develop a conceptual model of theorganization and to demonstrate how effective understanding of activities and their resulting costs plays a keystrategic role along the various performance dimensions of the organization.

The Cost Management Systems (CMS) program of CAM-I has worked for the past ten years to developleading-edge research and industry best practices in cost management methods. It has become increasinglyclear as our thinking has evolved that individual management techniques are more effective when they aredeveloped and framed within the context of a larger system of hierarchical relationships and processes. Thepurpose of this conceptual model is to provide a framework that helps the reader to understand the elements ofthis larger system. It will also focus on the relationships among various elements of the model, and to provide acommunication platform that can be used to highlight areas where more effective subordination and integrationis needed.

This paper will focus on a few of the more significant developments that have been made by U.S.manufacturers who are using an integrated cost management approach to achieve strategic advantage. Aconceptual model for understanding the fundamental dimensions of the enterprise where cost managementsystems can focus will be introduced and briefly discussed. Two of the underlying requirements for integrationand strategic leverage, activity based decision support systems and a process-based view of the organizationwill be discussed. The remainder of the discussion will focus on approaches that have been developed andimplemented by leading edge U.S. companies to better understand customer and product profitability, enhancerevenues, plan and manage profitability, and measure and manage capacity. Each of these techniques, bothindividually and in combination, has significant strategic implications for the firm. No firm that we are awareof has fully integrated a system of management that incorporates all of these approaches. However manyorganizations are implementing these techniques concurrently as they move toward a more robust andresponsive approach to strategic cost and resource management.


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The Business Hierarchy

The first critical relationship that affects strategic cost management initiatives is the business hierarchy.

Figure 1 - The Business Hierarchy

(why)

(what)

The CAM-I CMS Framework

market/customer strategy

product / service

process

inputs

(how)

(resources)

business hierarchy of needs

PlanningActivities

ControlActivities

AccountingData Flow

MarketData Flow

Source: Alan Vercio, Texas Instruments, 1995.

This layered model demonstrates the relationships that should guide the deployment of management strategyand initiatives. The top layer represents the presence of the customer in effective business strategy. Byconsidering customer demands, businesses will be able to address the critical "why" questions involved instrategy development. For example, "Why should we be developing new products and/or services?" "Whyshould we pursue new markets?" "Why should we launch a new quality campaign?" This layer represents theintroduction of the voice of the customer into the management process. The ability to transition from this layerto the next is based on the ability to translate the voice of the customer into product capability requirements.The customer can be a real customer in today’s environment, or a perceived customer in tomorrow’senvironment.

The second layer of the hierarchy is the product/service dimension. This represents the important "what"decisions that must be addressed by business strategy. "What products and services will we develop?" "Whatcapabilities will we provide to the customer?" "What levels of functionality will we deliver?" This component,in combination with the voice of the customer, represents the traditional business and market planning andmanagement activities of the organization. The ability to transition from this layer is based on the ability totranslate product capability requirements into manufacturing and/or service delivery process requirements.

The process layer of the model addresses "how" work gets done in the organization, specifically how the factorsof production (materials, labor, facilities, and innovation) are converted into viable products and services thatsatisfy customer demands. This level of the business hierarchy is synonymous with the traditional role ofoperations management in the organization. The final transition point is the translation of manufacturingrequirements into specific resource requirements.

The inputs or resource layer of the hierarchy is representative of the specific factor inputs that are required toexecute the business strategy. This layer represents the development or acquisition of resource inputs that canbe applied in the process layer with the greatest possible degree of productivity.

Only through the effective subordination and integration of each of these levels of the business hierarchy caneffective business strategy and management be accomplished. Planning activities drill down from top tobottom, while managers exercise control over resources, processes and products/services within the specific


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layer(s) for which they are accountable. The CMS program has developed leading-edge research and casestudies on a number of these management tools that will be described in the following pages.

The Underlying Requirements for Strategic Leverage

A Process-based View of the Organization

In 1994, it seemed that every company was involved in a large-scale process-reengineering project. Almostfour years later, the teams have mostly disbanded and moved back into functional responsibilities, theprocess maps have been folded, rolled or neatly bound and put away, and the months of meetings andinterviews are starting to seem like a distant memory. But by virtue of returning to “business as usual”,there is a nagging feeling that something was missed, that there was something that was left undone. And itfeels very much like the performance improvements that were identified through reengineering are slippingaway. Why is this happening?

It is happening because most organizations that embraced process reengineering only made the easychanges – the technical, structural and system changes that were leading directly to dysfunctional workflowand results. They failed to make the deeper changes – the cultural, political and behavioral changes thatbegin to solidify the organization’s commitment to continuous improvement, and insure long-term benefits.Organizations can influence change on three levels as described below.

Figure 2 - Three Layers of Change

Process Structure Technology Structure Organization Structure

Reward Structure Measurement Systems Management Methods

Organizational Culture Political Power Individual Belief Systems

More ConcreteEasiest to Change

Less concreteMore difficult to change

OperationalChanges

ManagerialChanges

Cultural/ValueChanges

Three Layers

Source: Ardenus and Stalich, Business Reengineering Survival Guide (adapted).

Reengineering largely focused on operational changes – work flow, system enablers, departmentalstructure, information flow, etc. The more robust applications improved the performance measurements ofthe organization. But very few efforts dramatically changed the way the organization perceives itself withrespect to its customers and processes. One-time improvement efforts such as reengineering can simply nothave this type of impact due to their duration and focus. This is precisely the role that process managementand continuous process improvement can play. They form a complementary system when used inconjunction with process reengineering, and become the foundation for other far-reaching improvementinitiatives such as ABC/M, target costing, and capacity measurement and management. Consider Figure 3:


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Source: GTE Process Management Steering Team, 1996.

By making a commitment to continuous improvement, organizations can begin to impact the third layer ofchange that affects the organizational culture, political power and belief systems that underlie behavior andsubsequently, performance.

What Does Being a Process-Centered Organization Mean?

Functionally focused organizations are often ineffective and inefficient when work must be coordinatedacross traditional functional boundaries. This is due to the fact that the needs of the customer are oftensecondary to the goals of each functional area, thereby creating functional silos and limiting the creation ofvalue within the company. Worse still, the customer may be ignored and decide to go elsewhere.

In contrast to a functional focus, a process-focused organization requires that every executive, manager andprocess performer constantly consider the needs of the customer in everything that is done. Boundariesbetween functions are torn down as the organization creates core processes that involve personnel,technology and information across numerous functions for the purpose of adding value to the goods andservices that a company creates, thereby maximizing customer satisfaction. A process-focused approachenables organizations to attain a competitive advantage through the integration of otherwise disconnectedinitiatives.

What are the Steps toward Becoming a Process-Centered Organization?

There is a natural migration path that companies who primarily manage by department or function mayfollow if they wish to pursue a process-focused management approach. There are distinct levels ofmaturity that the organizations will attain as they pursue this objective. Texas Instruments (see Figure 4)has developed an excellent depiction of the levels of process maturity.

Process Management

Process Re-engineering Process Improvement

Intensive OngoingRevolutionary EvolutionaryTops down Bottoms upSystems solutions People solutionsDramatic improvements Incremental changes

We Need Both To Be SuccessfulWe Need Both To Be SuccessfulWe Need Both To Be Successful

Figure 3 - The Complementary Roles of Reengineering and Process Management


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Source: Emery Powell, Texas Instruments, 1996.

The levels in TI’s maturity model describe the attributes of organizations at different levels of maturity.But what is the high-level development process that leads to the result? CAM-I has developed a seven-partmigration model to assist companies who are trying to migrate toward process management. These are thebasic components of the approach.

1. Create the Vision – management at all levels must understand and communicate the attributes of aprocess-based organization. Jack Welch described the vision as “boundarylessness.” Everyorganization has to create a language and set of metaphors that describe the way that they wish tointeract with one another, and particularly with their customers. This process is tied directly to theorganization’s strategic intent. GTE expressed its strategic intent as follows – “To be the easiestcompany for our customers to do business with.” This provides a directive for all processimprovement initiatives to center upon – specifically, remove the impediments to world-class customerservice from the processes. Without such a vision, improvement initiatives cannot be defined.

2. Create Process Clarity – Does the organization have an explicit set of named business processes thatare customer-focused and cross functional? It is too easy to simply redefine a departmental role (suchas sales) as a process. This is rarely correct. Processes should be viewed from the customer’sperspective – from the time they request a product or service until it is delivered. Many organizationswho have undergone extensive reengineering still do not have a set of globally-recognized namedbusiness processes.

3. Create Process Awareness – does every employee from the executive to job performer level knowwhat business process(es) they are a part of and what are the performance objectives and standards forthat process? Roles must be communicated in terms of the output of the process rather than in terms ofdepartmental accountability. Figure 5 represents Chrysler’s process structure.

TI ‘Metric & Process Maturity Model’Level Summary

4

1

2

3

5

TotalAlignment

Initial

VerticalAlignment

HorizontalAlignment

Optimizing

Summary

Process management has enabledthe enterprise to be a learning, agile,

and forward looking organization.

Enabling process managementsubordinated to business processes

is implemented, in control, and inmanagement’s unconscious thinking.

Business processes establish acommon language or translator witheach other business process. This

enables inter-business processexcellence (eg. DFM).

Business process management whichbegins and ends with the customer, is

established, in control, and inmanagement’s conscious thinking.

Few processes are defined. Processmanagement is not a strategic thrust.

Process Description

Metric driven actions are simulatedduring the strategy setting process toensure organization alignment before

the metric is put into production.

Metrics in the enabling processes andcenters of excellence are aligned with

the integrated business processes.

Metrics enhance communicationacross the core processes and focuson the investment decision process

where 80%+ of the life cycle costs arecommitted.

Process metrics have been addedand integrated with result metrics.

Metric alignment between the strategyand daily activities in the core

processes is established.

Metrics are adhoc and primarilyresults oriented.

Metric Description

Initial

CustomerFocus

CoreProcessesIntegrated

Holistic

EnablingProcessesIntegrated

© Copyright 1996 Texas Instruments Inc.

Figure 4 - The Texas Instruments Metric and Process Maturity Model


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Source: George Millush, Chrysler Corporation, 1996.

Establish Cross-Functional Process Ownership and Control – is there a system in place withaccountabilities and infrastructure that formally supports coordination of results and performance levels forthe end-to-end process. This is an area of major concern in that many critics of the process-centeredapproach suggest that functional organizations or departments must be removed from the organization chartand replaced with process-based structures. This is simply not true, nor is it desirable. Process owners andprocess team members ideally “wear two hats.” They maintain their functional expertise, whileconcurrently acting as members of a “process team” with accountability for the results of the end-to-endprocess. Figure 6 is a process ownership responsibility system that was developed by GTE TelephoneOperations.

Figure 5 - Chrysler's Value Chain

Chrysler’s Value Chain

CUSTOMER ACCEPTANCE

VOLUME PRODUCTION

PRODUCT CREATION

SUPPORT

DEVELOPMAJOR

PRODUCTELEMENTS

PERFORMRESEARCH

DEVELOPPRODUCTSTRATEGY

DEVELOPPRODUCTCONCEPT

VALIDATEMAJOR

PRODUCTELEMENTS

DEVELOPPRODUCTMETHODS

IMPLEMENTPRODUCTMETHODS

OBTAIN PRODUCT

ORDER

MANU-FACTURE

COMPONENTS

OBTAINCOMPONENTS

ASSEMBLEPRODUCT

DISTRIBUTEFINISHEDPRODUCT

FACILITATEPURCHASE

EXPERIENCE

OBTAINSERVICE

MATERIAL

SERVICEPRODUCT/CUSTOMER

STIMULATEOWNER

LOYALTY

ASSESSCONSUMER

PREFERENCE


7

4. Migration – an initial migration to a process-centered approach includes creating process teams,assessing the current process, identifying improvement opportunities, developing the improvementplan, implementing the process improvements, and evaluating and certifying the results. This is anencapsulated version of the continuous improvement cycle.

5. Establishing Process-Based Performance Measurements – Does the organization have a set ofperformance measurements that reflects its strategic intent and supports the objectives of its coreprocesses? In most cases, bad performance measures are the root cause of poorly alignedorganizational behavior. For example, time or efficiency based measures in an order entry departmentcan cause chaos in a fulfillment process if there is no emphasis on error-free input. While costs aredriven down in the department, rework results later in the process. Performance measures mustsupport the process objective.

6. Continuous Process Management – Are the tools and management systems of the organization welldeveloped and aligned in order to optimize process and organizational performance? Approaches likeABM, capacity management, and target costing are based on the assumption that effective structuresexist to support continuous improvement. The process infrastructure can be the platform upon whichthese and other initiatives are launched and supported.

There is No “Silver Bullet”

Organizations who are looking for a quick cure will not find it in process-based management. Rather it is asystematic approach to improving performance that must be undertaken as a way of doing business, not asone-time improvement opportunity. An example of the commitment to process improvement undertakenby Texas Instruments is outlined in Figure 7.

P r o c e s s E x e c u t i v e• C h a m p i o n P r o c e s s M a n a g e m e n t• F o r m u l a t e P r o c e s s V i s i o n• C h a m p i o n P r o c e s s A c r o s s E n t e r p r i s e• I d e n t i f y C r i t i c a l P r o c e s s B u s i n e s s I s s u e s• B a l a n c e P r o c e s s F o c u s / F u n c t i o n a l F o c u s• P r o c e s s P e r f o r m a n c e M e a s u r e s / T a r g e t s• R e s o u r c e / C a p i t a l A l l o c a t i o n / R e a l l o c a t i o n• A p p o i n t / S u p p o r t P r o c e s s C h a m p i o n s• A p p r o v e G a p C l o s u r e P l a n s

P r o c e s s M a n a g e m e n t R o l e s A n d R e s p o n s i b i l i t i e s

P r o c e s s C h a m p i o n• I d e n t i f i e s C r i t i c a l S u b p r o c e s s B u s i n e s s I s s u e s• D e f i n e s S c o p e o f P r o j e c t• C r e a t e s P e r m a n e n t P r o c e s s T e a m• S e r v e s o n P r o c e s s P a n e l• C h a m p i o n s S u b p r o c e s s / T e a m• M a n a g e W h i t e S p a c e o f P r o c e s s / S u b p r o c e s s• P r o v i d e T e a m R e w a r d s / R e c o g n i t i o n

P r o c e s s T e a m L e a d e r• C o o r d i n a t e L o n g - T e r m V i s i o n a n d M i g r a t i o n

P l a n f o r E a c h P r o c e s s• C r e a t e Q u a n t u m L e a p s f o r P r o c e s s e s• A d v o c a t e / M a i n t a i n E n t e r p r i s e P r o c e s s F o c u s• L i n k W i t h C o n t i n u o u s P r o c e s s I m p r o v e m e n t

T e a m s

P r o c e s s P a n e l• P r o v i d e A l i g n m e n t A c r o s s S u b p r o c e s s e s• I n t e g r a t e s P r o c e s s I m p r o v e m e n t s C r o s s -

F u n c t i o n a l l y• R e a l l o c a t e s R e s o u r c e s t o F u n d A c t i o n P l a n s• P r o v i d e s C l e a r L i n e o f S i g h t t o C u s t o m e r N e e d s• L i n k S u b p r o c e s s P e r f o r m a n c e t o P r o c e s s

P e r f o r m a n c e

P e r m a n e n t P r o c e s s T e a m• B r i n g S u b j e c t M a t t e r E x p e r t i s e t o T e a m• C o n d u c t R o o t C a u s e A n a l y s i s• D e s i g n I m p r o v e m e n t s a n d M e a s u r e s• D e v e l o p / R e c o m m e n d P r o c e s s I m p r o v e m e n t s / G a p

C l o s u r e I d e a s• M a i n t a i n / U p d a t e P r o c e s s D o c u m e n t a t i o n• A d v o c a t e / M a i n t a i n P r o c e s s F o c u s T h r o u g h o u t t h e

E n t e r p r i s e

6

Figure 6 - GTE Telephoe Operations' Process Accountability Structure


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Source: Emery Powell, Texas Instruments, 1996.

When viewed in this context, becoming a process-centered organization defines the vision for businessexcellence that enables strategic intent. The commitment is substantial, in both time and effort. But theresult is a competency that can sustain the organization against most competitive challenges.

Business ExcellenceRoad Map

1991 1994 1996 2000 2004--- Long Range Timing ---

Support Process(s) ImprovementVertical Metric Alignment

1 | 2 | 3 | 4 | 5

Concurrent Effort

Concurrent Effort

• Customer Focus• Order Fulfillmant• Product Development• Business Mgnt Strategy Dev.• Manufacturing Capability

• HR• Legal• Finance• Supply• Quality

Core Process #1 ImprovementVertical Metric Alignment

1 | 2 | 3 | 4 | 5

Core Process #n ImprovementVertical Metric Alignment

1 | 2 | 3 | 4 | 5

Core Process IntegrationHorizontal Metric Alignment

1 | 2 | 3 | 4 | 5

Support Org. Process(s) IntegrationEnterprise Metric Alignment

1 | 2 | 3 | 4 | 5

--- Enterprise Process --- " To Be"(Optimising)

"As Is"(Ad Hoc)

Figure 7 - Texas Instruments’ Business Excellence Roadmap


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Activity-Based Decision Support Systems

The use of cost management techniques as a strategic weapon is also based upon the availability of activity-based decision support systems. These tools range from activity analysis at the most basic level to fullyintegrated activity based costing and management systems that are supported by the organization’soperational and accounting software. The foundation of effective cost management strategy is anunderstanding of the organization’s activities and the associated costs and results. Further, the organizationmust understand the activities that are performed by its suppliers and customers and the impacts on productand service effectiveness and profitability. An understanding of the activities that impact the organizationand their resulting costs and benefits enables a wide range of analyses and evaluations. Performanceimprovement is usually accomplished through a critical evaluation of the trade-off between the benefits ofperforming an activity and the resultant cost.

Cost management activities are based upon one or more views of cost which have distinct levels of detailand different purposes. Strategic leverage can be achieved by developing analyses at both the strategic andoperational levels of the organization. Traditional cost management activities have been based largely onthe financial view.

Figure 8 - Three Views of Cost

View of Cost Strategic Operational FinancialUsers of Information • Business/strategic

planners• Sourcing groups• Capital budgeting• Cost engineers

• Front-line managers• Process

improvement teams• Quality teams

• Financialcontrollers

• Tax managers• Treasury• Tax authorities

Uses • Activity-basedproduct costing

• Target costing• Make vs buy

analysis• Investment

justifications• Life cycle costing

• Key performanceinformation

• Value/non-valueadded identifiers

• Manage dailyactivity

• Shareholderreporting

• Inventory valuation• Preparation of tax

reports• Lenders monitoring

condition

Level of Aggregation • Product lineaggregation

• Information detailbased on type ofdecision

• Very detailed• Work unit level

• High• Often company-

wide data• May be on legal

entity basisReporting Frequency • Ad hoc, as needed

• Usually a specialstudy

• Immediate• Possibly hourly or

daily

• Periodic, usuallymonthly

• Probably quarterlyor annually if otherneeds were met

Type of Measures • Combination ofphysical andfinancial

• Mostly physical • Mostly financial

Time Focus • Future • Current • HistoricalSource: R. Steven Player, Arthur Andersen, L.L.P.

By evaluating their performance on each of these levels, organizations are better understand the impacts ofstrategy, customer and supplier behavior, and internal process performance on their effectiveness and


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profitability. Without a clear understanding of activities and the associated costs, the analyses described inthe remainder of the paper are not feasible.

Customer Focused Techniques

Customer ProfitabilityOne of the most powerful applications of cost management as a strategic weapon is in the development of aproduct and marketing plan based upon superior knowledge of the profit potential of individual customers,products, and distribution channels. Further, understanding the implications of possible combinations ofproducts, customers and distribution channels and their relative costs and performance trade-off providesan organization with a significant advantage over its competitors who do not have access to thisinformation. Consider the situation of Hewlett Packard’s North American Distribution Organization (HP-NADO) in the summer of 1995.

Figure 9 - The Hewlett Packard Story

Hewlett-Packard's Business Environment

Hewlett Packard, with revenues of $25 billion per year, is a world leader inmanufacturing PCs, computer systems, printers, scanners, and workstations. It has fourproduct distribution centers worldwide, with HP-NADO alone distributing 21 productlines through six customer resale channels. In 1994, HP-NADO distributed nearly $7billion in product through five depots to more than 300 principal resellers nationwide.HP-NADO needed more accurate business information to influence and assist itsmanagement and business partners making operational and strategic business decisions.

In Hewlett-Packard's manufacturing process, outside suppliers ship raw materials andparts to primary manufacturing plants. These plants produce standardized versions ofvarious elements of Hewlett-Packard's product lines. The products are then shipped toHP-NADO and other depots for customization to specific geographic markets, packaging,and shipping to Hewlett-Packard's main reseller channels.

Because potential customization steps number in the hundreds or thousands and thevolume of products is huge, keeping records of the "backend" costs to make products andservice customer market channels can become a monumental operation. Hewlett-Packardwas using a traditional costing process that spread these overhead charges across theentire organization, but the company needed a means to generate more accurate businessinformation about HP-NADO's costs. Management needed to know how the costsinfluence the company's profitability (the strategic view of costs) and how the costingprocess could be used to identify opportunities for cost reduction selected areas (theoperational view of costs).1

Using an activity based analysis which comprised both a product profitability model and a customerprofitability model, Hewlett Packard was able to develop the relative cost of each of its major customersand customer segments, products and product segments, and distribution channels. The availability of thisdata provided remarkable insights into the company’s customer and product profitability. They discoveredthat customer behavior generated wide degrees of variability in profitability, even when the customerspurchased the same products or product lines. Their least profitable customers generated multiple inquiriesrelated to order status or product availability. They also submitted numerous unnecessary billing inquiries.Conversely, the most profitable customers generated very few additional order fulfillment or billingdemands, possibly due to higher levels of integration and information sharing via electronic data interfaces. 1 Marino, Chris et al. 1995. “Hewlett Packard Knows What It Takes and What It Costs,” As Easy as ABC,(Issue 21).


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Figure 10 - Strategic Implications for Hewlett Packard

Data could now be looked at in terms of the three views of costs: financial, operational,and strategic. The model linked data from the storyboard sessions with various companybusiness groups, activities, business processes, product lines, and customer segments. Itrevealed opportunities to drill into and analyze the data to see how activities and costsflowed through all levels of the organization.

To demonstrate how the SAM (Strategic Activity Management) information could beused to target and achieve operational improvements, the team identified three areas toreengineer. Overall, the three pilots identified more than $2 million in potential savingsfor Hewlett-Packard. Thus, while the SAM model's primary purpose was to producestrategic cost information, the annual cost savings generated by the pilots provided asignificant short-term return on the costs invested.

The model's strategic value was even more far reaching. From the data, managementlearned that 51 customers accounted for 85 percent of Hewlett-Packard's orders. Themodel proved to be a powerful tool for analyzing customer and channel profitability;developing contract discount structure; analyzing costs of key services; determining theimpact of outsourcing distribution functions and certain products; performingbenchmarking of key areas; and justifying investment decisions.2

One Hewlett Packard executive remarked, “I feel like we have just invented themicroscope – this information was here all along, but now we have the tools to see it.”

As a result of its ABM analysis, Hewlett Packard took dramatic steps to rationalize its product andcustomer profitability. The mix of products offered through specific distribution channels was altered tooptimize the profitability of the product/channel combinations. Additionally, Hewlett Packard “fired”customers. Specifically, those customers whose behaviors caused unusual levels of order fulfillment orbilling support were migrated to distribution systems such as retail which were better positioned to servicetheir needs, or in some cases were diverted to purchase competing products.

2 Ibid.


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Revenue EnhancementActivity based methods, including understanding the cost of activities throughout the value chain can alsobe strategically focused in order to enhance revenue generation. Only by truly understanding the cost ofperforming activities and the value that those activities generate for the customer can an organizationoptimize its product and service offerings. Consider the case of TTI, a Fort Worth, Texas based distributorof passive computer components.

Figure 11 - The TTI Case

TTI’s cavernous 270,000-square foot warehouse on the northern outskirts of Fort Worthis stocked with 90,000 different kinds of capacitors and resistors – over 330 millionindividual pieces worth about $55 million. Another 25,000 products worth about $15million are housed in a smaller facility. Nobody comes close to that depth of inventory,(CEO Paul Andrews) says, adding that he prefers TTI to be “tall and thin” rather than “fatand wide.”

His strategy has paid off with annual sales growth running at 31 percent for the past fiveyears. Pretax profits of about 15 percent are about twice the industry norm. To sustainthat growth, TTI must attract customers who buy by the billions. They historically – oras Mr. Andrews disdainfully say, “notoriously” – have bought directly from thecomponent manufacturer. Five years ago, TTI set its sights on these giants with minimalresults. Mega-customers didn’t bother to study their paper-swirling process and just-in-case stocking practices, because, after all these aren’t the latest and greatest $1,000Pentiums they’re buying. Why worry about items that represent less than 5 percent of thetotal cost? Mr. Andrews is only too happy to enlighten them.

Model BuildingThree year’s ago, guided by Arthur Andersen’s Steve Player, TTI designed a simplecomputer model that lets customers fiddle with the figures and see how much money isactually being spent on shuffling purchase orders, handling parts, eating obsoleteinventory and temporarily halting production when parts are missing. Closing a line foran hour because it’s out of parts typically costs a PC manufacturer about $100,000 in lostproduction, Mr. Andrews says. And it doesn’t matter whether the missing-in-action partis worth 10 cents or $100. Rather than run that risk, many companies build “black holes”of extra inventory in the cheap stuff, he says. That too is dangerous. In a world whereproduct life cycles are counted in months, not years, there’s plenty of opportunity to getburned by stocking too much of what you needed last week but don’t today.

“In most cases, after they go through the checklist,” says Mr. Andrews, “they’ll find it’scosting them 15 to 25 percent in manpower, capital, obsolescence and shutting lines.”TTI promises to eliminate those costs by moving purchasing and inventory control intoits mighty mainframe. No paper to push, no salesman to call. No inventory to handleuntil it’s needed on the line. “It’s not shifting work,” Mr. Andrews says, “it’s getting ridof it.”

For example, Richardson-based Alcatel feeds its parts forecast for the next few monthsinto TTI’s computer, which automatically ships and delivers the necessary capacitors andresistors just in time for their assembly into telecommunications modules being built.Capital and factory floor space have been freed up by 50 percent says Frank O’Reilly,senior director of operations at Alcatel. This year, TTI expects to generate $100 millionin sales with 70 customers via its automated replenishment program.3

3 Hall, Cheryl. “Invisible Ink.” The Dallas Morning News, September 15, 1996.


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By developing a superior understanding of its customers’ activities and the associated cost and performanceimplications, TTI was able to transform a typical cost of service analysis into a strategic revenueenhancement tool. The critical issue is whether or not companies can view their business as a value chainthat links the organization to both its customers and suppliers. If this view is taken, the entire activitysystem can be optimized based on the best capabilities of the participants to reduce costs and generatesuperior performance and value.

Product/Service Focused Techniques

Target Costing as an Integration Strategy

Most of our organizations are engaged in a variety of cost and productivity improvement initiatives. Thesemight include efforts like activity-based costing and management, TQM, continuous process improvement(or Kaizen) and demand flow planning. Others may be engaged in good old-fashioned cost reduction bybrute force - which is systematically reducing headcount until a break point is reached.

Unfortunately, these improvement initiatives only influence about 20% of the total costs of delivering aproduct or service. Consider the following diagram:

Figure 12 - Cost Relationships: Committed vs. Incurred

PRODUCTPRODUCT

CONCEPTCONCEPTDESIGN ANDDESIGN AND

DEVELOPMENTDEVELOPMENTPRODUCTIONPRODUCTION

P R O D U C T D E V E L O P M E N T C Y C L EP R O D U C T D E V E L O P M E N T C Y C L E

Cos

tsC

osts

DISTRIBUTIONDISTRIBUTION

SERVICESERVICE

DISPOSITIONDISPOSITION

00

2020

4040

6060

8080

100 100

Committed CostsCommitted Costs

Incurred CostsIncurred Costs

Source: CAM-I Target Cost Core Group, S. Ansari and J. Bell

The majority of our cost reduction efforts focus on production, distribution, service and disposition. Afterall, this is where the cost is incurred. Unfortunately, by the time a product or service leaves the design anddevelopment phase of the product development cycle, over eighty percent of the life cycle costs of theproduct or service are committed. Once the product is designed and the production process is developedand set in motion, less than twenty percent of the life cycle cost of the product can be influenced without aproduct or process redesign effort. Therefore, the kaizen or continuous improvement initiatives of anorganization are only influencing a relatively small subset of its total costs. World-class competitors are redesigning the way future products and processes are deployed - theyare implementing cost and profit planning. They are developing and advocating Target Costing, aprocess for designing costs out of a product or service.


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Target costing is a management method that allows firms to provide customers with products that theywant, when they want them, at a price they can afford, and still earn adequate financial returns. Targetcosting is strategic in nature and, if done properly, it creates a culture of excellence in an organization thatprovides continuing strategic advantage. It is more than a narrow focus on improving operatingefficiencies or meeting cost budgets.

“Six key principles within (target costing) represent a way of thinking about cost management that is quitedifferent from traditional approaches to cost management and profit planning. They are:

• Price-led costing• Customer focus• Focus on design of products and processes• Cross-functional teams• Life cycle cost reduction• Value chain involvement”4

The following illustration is a summarized version of the target costing process model.

Figure 13 - The Target Costing Process Model

VOICE OF THE CUSTOMER VOICE OF THE CUSTOMER

MarketResearch

CompetitiveStrategy

Product Concept &Feasibility

CompetitiveIntelligence

ProductStrategy &

ProfitPlan

Product Design &

Development

Production and

Logistics

ESTABLISH TARGET COSTS

EXTENDED ENTERPRISE PARTICIPATIONEXTENDED ENTERPRISE PARTICIPATION

ATTAIN TARGET COSTS

Source: CAM-I Target Cost Core Group, S. Ansari and J. Bell In a sense, “target costing” is an unfortunate name for this process. It actually encompasses far more thanestablishing a cost target. The process is based on understanding what features customers want in a productand what they are willing to pay for these features, what product features competitors are likely to offer,and finally what life cycle cost must be attained to insure an adequate return. To mistake target costing fora finance-driven cost reduction exercise would be a tremendous mistake.

However, we find that finance is a major participant in the redesign of the product development processesthrough the use of target costing. Notice that many steps in the target costing summary model requiresubstantial support from the finance organization.

4 CAM-I Target Cost Core Group, S. Ansari and J. Bell: Target Costing: The Next Frontier in StrategicCost Management; Irwin Professional Publishing; 1996


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Figure 14 - Inputs to the Target Costing Process

$

REQUIREDPROFIT

PRODUCT & PROCESS DESIGN CONTINUOUS IMPROVEMENT AND COST REDUCTION

TARGETPRICE

LESS

MARKETRESEARCH

PRODUCT CHARACTERISTICSNEW PRODUCT DEVELOPMENT

SHAREHOLDERSCOMPETITORS’ACTIONS

TARGETCOST

Source: CAM-I Target Cost Core Group, S. Ansari and J. Bell

Finance must help establish the target profit, evaluate the target price, establish and defend the target cost,and assist in evaluating feature/function tradeoffs throughout the design process. It is important to note thatthis is a fundamental shift in the way that prices and profit targets are established. Consider the followingexample:

Figure 15 - Impacts of Target Costing on Cost Management

In The Past Today

Cost

+ Profit

Price

PricePrice

- Margin- Margin

TargetTargetCostCost

Cost of Future ProductsCost of Future Products

Variable Operating CostsVariable Operating Costs

Fixed CostsFixed Costs

Enterprise & Support CostsEnterprise & Support Costs

Life-cycle CostsLife-cycle Costs

Scope of Application

Source: John Dutton, Arthur Andersen, LLP; 1996.

Establishing and achieving target costs has a direct impact on the cost structure and performance of theentire value chain. The success of the target costing process will depend to a large degree on the ability ofthe Finance organization to translate operating performance into financial terms and assess the implicationsfor future products and services. This fundamental shift in the product pricing and profit planning strategyof the organization requires the full support of the finance organization, as an educator, facilitator, andfinally translator of product and process attributes into financial results.

The strategic implications of target costing are far-reaching. As quality becomes more constant, the abilityof firms to deliver products that customers desire, at a price they are willing to pay more quickly than theircompetitors will be the distinguishing characteristic of successful enterprises. Target costing insures thatfirms who do this also attain a life cycle cost target that supports long-term profitability. This ability willbe one of the fundamental strategic weapons of world class competitors.


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Process Focused Techniques

Capacity Measurement and Management

The measurement and management of productive capacity is not a new issue for manufacturing, merely onethat has received very little meaningful consideration during the past seventy years. Measuring andmanaging the sources and uses of capacity and the associated costs last received significant attention in the1910-1920 time frame through the work of H. L. Gantt and Alexander Church.

During subsequent decades, capacity issues at the plant level lost a significant amount of visibility.Beginning with DuPont and General Motors, organizations developed increasingly complex hierarchicalorganization structures. The development of increasingly complex and diverse product lines combinedwith functional specialization decreased the visibility of enterprise-wide capacity issues. Following thestock market crash of the early-1930’s the focus of the accounting community shifted predominantly to therecording and reporting of financial results to the external financial community. Education, reportingpractices, and statutory requirements diminished the emphasis on measurement and management of internalresources and the associated costs. Following World War II, economic issues also diminished the focus oncapacity issues. Increasing affluence, increasing demand, a lack of global competition and the resultingheavy capitalization further diminished the need to aggressively measure and manage capacity and theresulting costs of non-productive capacity utilization.

Why the Renewed Focus on Capacity Management?

Beginning in the 60’s and 70’s, economic issues once again mandated a focus on effective capacitymanagement. Increased global competition, the associated pressures on costs and resource utilization, andthe resulting improvement initiatives have caused capacity measurement and management to regainvisibility and re-emerge as a strategic cost and resource management initiative. Total Quality Management(TQM) began the development of the tools commonly used to measure process variability and theassociated idleness and non-productive uses of organizational capacity. Just-in Time Inventory (JIT)heightened the need for removing the causes of process variability and imbalance. JIT also forcesaggregate measurement of productivity and resource demand at the process level. Business Process Re-engineering (BPR) heightened organizations’ awareness of the need to design organizations and manageresults at the process level. Measurement of end-to-end process results began to re-emerge along withprocess-level accountability structures and improvement teams. Theory of Constraints (TOC) re-emphasized the need to focus on optimizing throughput by measuring and managing the time-basedeconomics of line and machine productivity.

The Development of the CAM-I Capacity Model

The development of the model was guided by a fundamental management axiom:

• You Can't Manage What You Don'tCommunicate

• You Can't Communicate What you Don'tMeasure

• You Can't Measure What You Don't Define

• You Can't Define What You Don'tUnderstand

The research was spearheaded by Alan Vercio of Texas Instruments and an interest group comprised ofmembers of industry, academia, and consultancy. The group set out to address a set of fundamentalquestions:


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n What are the sources of idle capacity?

n How much unused capacity is assigned to product cost?

n How large of a threat is the hidden unused capacity?

n Who is responsible for capacity management?

n How are manufacturing activities communicated in acommon language?

n How can we obtain more capacity without buying it?

At the beginning of the project, the member companies all lacked an effective tool set for understandingand communicating capacity issues, particularly the financial implications which are critical to strategydevelopment. The CAM-I Capacity Model provides such a tool set.

The model is a closed-loop system based on time. That is, all metrics are based on a 24 hour day.

Figure 16 - The Closed Loop Model

Source: The CAM-I Capacity Model Interest Group

By defining capacity in this way, idle capacity resulting from policy decisions such as operating schedules,legal or contractual issues, or unmarketable production capability are always visible. The model, actuallydefines three summary categories of capacity utilization: Productive, Non-productive and Idle.

n Idle– Marketable (Idle) and not marketable (excess)– Off Limits: Legal, Contractual, Management policy

n Nonproductive– Standby, Waste, Maintenance, and Setup– Process Balance & Variability; Scrap, Rework and Yield– Scheduled & Unscheduled Maintenance: Time, Volume,

Changeovern Productive

– Good Production– New Product– Process Development

These broad categories can then be broken down further into sets of activities using a number of drill downand reporting templates. An industry-standard time template is presented in the following diagram:


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Figure 17 - The CAM-I Capacity Model Summary Template

R a t e d C a p a c i t y

S u m m a r y M o d e l I n d u s t r y S p e c i f i c M o d e l S t r a t e g y S p e c i f i c M o d e l

T r a d i t i o n a l M o d e l

N o t M a r k e t a b l e E x c e s s N o t U s a b l e

M a n a g e m e n t P o l i c y T h e o r e t i c a l

I d le Of f L im i t s C o n t r a c t u a l

L e g a l

M a r k e t a b l e I d l e B u t U s a b l e Prac t i ca l

P r o c e s s B a l a n c e

R a t e d S t a n d b y Var iab i l i t y S c h e d u l e d

C a p a c i t y S c r a p

N o n - W a s t e R e w o r k

p r o d u c t i v e Y i e l d L o s s

M a i n t e n a n c e S c h e d u l e d

U n s c h e d u l e d

T i m e

S e t - U p s V o l u m e

C h a n g e - O v e r

P r o c e s s D e v e l o p m e n t

P r o d u c t i v e P r o d u c t D e v e l o p m e n t

G o o d P r o d u c t s

Source: The CAM-I Capacity Model Interest Group

Different templates are defined for different applications and audiences. The reporting tools developed bythe research group include:

• Economic and Time Template• Summary Template• Drill-Down Template• Strategic Template• Responsibility Template• Product Cost Template• Equivalent Unit Template

Models and Templates can be built-up from existing ABC models. In fact, the data necessary to populatethe reporting templates requires that an organization develop an activity-based view of its processes. Thefocus on capacity issues is a logical next step for companies who have developed advanced activity-basedinformation systems. Models are equally relevant to manufacturing, assembly, and service and supportprocesses.

The CAM-I Capacity Model has a variety of implications. It creates a common language forcommunicating capacity issues. It establishes the framework for an effective accountability andperformance measurement system to address capacity. It creates a linkage to investment plans andfinancial results. It provides the opportunity for a linkage to other productivity improvement approachessuch as Theory of Constraints and Total Quality Management. It provides a behavioral model thatdemonstrates the effects of customer, supplier, and employee behavior on capacity utilization and theresulting process and product costs.


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Finally, the model clarifies the accountability system needed for effective capacity planning and utilization.Where previously capacity management issues were largely the responsibility of the Operations Team, theCAM-I model proposes shared accountability between the Operations Team and the Business Team.

Figure 18 - The Capacity Management Responsibility Model

Source: The CAM-I Capacity Management Interest Group

As stated by Robert Kaplan, “Management decisions that continually add new products, services, andcustomers often require additional capacity to be supplied throughout the organization. Many improvementinitiatives such as TQM, re-engineering, and activity-based management usually lead not to immediate costsavings or revenue enhancements but idle capacity.” Using activity-based results, in conjunction with aneffective set of capacity measurement and communication templates, management can quantify sources ofnon-productive and idle capacity, as well as the associated costs to the organization, its shareholders and itscustomers.

From a strategic perspective, capacity utilization has a fundamental impact on the cost structure of anorganization. Consider the case of two similar sized manufacturing facilities. Factory A runs one 8-hourshift, 5 days per week. Factory B runs three 8-hour shifts 7 days per week. Each has identical per-hourunit outputs. Due to the idle capacity when Factory A is not running, the fixed overhead must be borne bya unit base that is only 24% of the output base of Factory B (40 hours vs. 168 hours per week). Therefore,the per-unit fixed cost of Factory A will be 4.2 times higher than that of Factory B. This is a simpleexample based on policy, but similar relationships exist for capacity differentials due to non-productivity,waste, and idleness due to demand variability.

Integration Systems

The challenge that is currently being faced by leading-edge organizations is the development of anintegration system which effectively combines the approaches described in this paper with the other keymanagement initiative to create a holistic approach to performance improvement. Too often, organizationsare adopting improvement methods without understanding the linkage of the approach to their overallbusiness strategy or to the other initiatives that they may be pursuing or considering. The results aresuboptimal uses of scarce resources and limited results. Confusion resulting from conflicting improvementtechniques is one of the most pervasive problems we encounter in our member companies. Toward thatend, CAM-I has embarked on a number of new research projects to explore the issues surroundingintegration. These projects include knowledge management, the conceptual design project, and ourInternational Study of Best Practices in Target Costing.

The Manufacturing Team is responsible forreducing nonproductive activities

and increasing idle capacity

The Business Team is responsible forreducing idle capacity

and increasing productive capacity.

ProductiveIdle

Nonproductive

Manufacturing Team

Business Team


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Notes

1. Alan Vercio of Texas Instruments first presented the Business Hierarchy at a meeting of the CAM-Iinterest group chairs on February 5, 1995.

2. The discussion of Process-based Management was first published in As Easy as ABC, Issue 31.3. The discussion of Target Costing was first published in As Easy as ABC, Issue 28.4. The discussion of Capacity Management was first published in As Easy as ABC, Issue 29


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References

CAM-I Capacity Management Interest Group and Thomas Klammer: Capacity Measurement andImprovement; Irwin Professional Publishing; 1996.

CAM-I Process Management Interest Group, Dennis Daly and Tom Freeman: The Road to Excellence:Becoming a Process-Based Company; The Consortium for Advanced Manufacturing - International; 1997.

CAM-I Target Cost Core Group, S. Ansari and J. Bell: Target Costing: The Next Frontier in Strategic CostManagement; Irwin Professional Publishing; 1996.

Hall, Cheryl. “Invisible Ink.” The Dallas Morning News, September 15, 1996.

Marino, Chris et al. 1995. “Hewlett Packard Knows What It Takes and What It Costs,” As Easy as ABC,(Issue 21).

Metrics Management Guide, Texas Instruments; 1997.

CAMI Article on ABC

Documents

Transcript of CAMI Article on ABC