Improving Bottom-line through improving Cost Competency Prof. Shailesh Gandhi Indian Institute of...
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Transcript of Improving Bottom-line through improving Cost Competency Prof. Shailesh Gandhi Indian Institute of...
Improving Bottom-line through improving Cost Competency
Prof. Shailesh GandhiIndian Institute of Management,
Ahmedabad
India
Perspective on Bottom-line
What is the meaning of bottom-line? Is it a performance metric or set of metrics? How is it to be calculated?
How does a performance metric like bottom-line fit into overall organisational performance measurement and management system?
Tracking organizational performance requires design and implementation of a Performance Management System (PMS).
PMS is an integral mechanism for implementation of organizational strategy.
PMS Framework
Strategy formulation/review process in a company is triggered by changes in external and/or internal environment (industry context). The changes in external environment come from economic, political, social and global dimensions. The changes in internal environment arise due to change of a leader, mergers, acquisitions, etc.
Strategy Formulation/Revi
ew
Strategy Implementation
Goal/ObjectiveStrategies
FRAMEWORK FOR PERFORMANCE MANAGEMENT SYSTEM
PMS Framework (Contd.)
Strategy execution involves a series of coordinated decisions and investments over time leading an organization towards an established goal.
It involves appropriate organization structure and culture, skilled human resources, and alignment of control/business processes.
Strategy Formulation/Revi
ew
Strategy Implementation
Organization Structure
Human/Resources
Control/Processes
OrganizationCulture
Goal/ObjectiveStrategies
FRAMEWORK FOR PERFORMANCE MANAGEMENT SYSTEM
PMS Framework (Contd.)
How does the organization ensure that its strategies are successful/have been working as expected?
It needs to periodically measure its actual performance across selected performance measures/metrics and compare with the target values.
It does so by designing and implementing appropriate PMS.
PMS Framework (Contd.)
The design of PMS requires identification of performance measures and setting target values for them.
Performance measures are current and future Key Performance Indicators/Key Result Areas. If they are improved over a period then the organization is said to have successfully implemented its strategy.
Strategy Formulation/Revi
ew
Strategy Implementation
Organization Structure
Human/Resources
Control/Processes
OrganizationCulture
Performance Management
System
Goal/ObjectiveStrategies
FRAMEWORK FOR PERFORMANCE MANAGEMENT SYSTEM
Performance measures/Metrics
Key Performance Indicators
PMS Framework (Contd.)
Target values of selected performance measures are set during the budgeting process.
A budget is a 1-year slice of the strategic/long range plan.
Budgeting is a critical part of “control/process”.
Strategy Formulation/Revi
ew
Strategy Implementation
Organization Structure
Human/Resources
Control/Processes
OrganizationCulture
Performance Management
System
Goal/ObjectiveStrategies
Data on ActualPerformance
FRAMEWORK FOR PERFORMANCE MANAGEMENT SYSTEM
Performance measures/Metrics
Target Values
Key Performance Indicators
Budgeting
Wal-MartIndustry Industry ContextContext
Competitive Competitive StrategyStrategy
KPIKPI
Strategy Strategy ExecutionExecution
PerformancePerformance
Extremely ToughExtremely Tough
EDLPEDLP
Everyday Low CostEveryday Low Cost
Structure, Controls, Structure, Controls, People, CulturePeople, Culture
????????
PMS Framework (Contd.)
Comparison of actual performance with the target values leads to variance analysis.
Variance analysis involves the following steps: (1) Computation of variance (2) Identification of organizational unit(s)
which caused it (3) Reasons for that variance – controllable
and uncontrollable (4) Corrective action – feedback to budgeting
system and strategy formulation/review
Strategy Formulation/Revi
ew
Strategy Implementation
Organization Structure
Human/Resources
Control/Processes
OrganizationCulture
Performance Management
System
Goal/ObjectiveStrategies
Data on ActualPerformance
FRAMEWORK FOR PERFORMANCE MANAGEMENT SYSTEM
Performance measures/Metrics
Target Values
Key Performance Indicators
Budgeting
Variance Analysis
Feedback toBudgeting orStrategyReview
PMS – Choice of Measures
The choice of measures for PMS is a difficult exercise especially the choice between financial and non-financial measures.
Choice of Measures – Financial Measures
Historically, companies have used several variants of profit (surplus) as financial performance measure such as: A) Contribution B) Gross Profit C) Operating Profit (EBITA) C) Controllable Profit (Profit of Strategic
Business Unit before allocation of corporate overheads)
D) ROI/ROCE E) EVA (Economic Value Added)
Defining Bottom-line
From the previous list, the following are examples of bottom-line indicators:
Operating profit - EBIT/EBITA (Earnings before interest and tax)
RONOA (Return on Net Operating Assets)
ROI/ROCE (Return on Investment/capital employed)
EVA (Economic Value Added)
Cost competency and improving bottom-line measures
Bottom-line measures are influenced by operating efficiency, asset utilisation efficiency and cost of capital associated with capital structure decisions.
The operating efficiency is influenced by control over revenue determinants and cost determinants.
The asset utilisation efficiency is influenced by control over both current and non-current assets.
The cost of capital is influenced by the capital structure.
Review the following diagrams:
How Value Creation is measured
Creation ofValue
TSR TSR
(Total Return (Total Return to to
Shareholders)Shareholders)
TSR TSR
(Total Return (Total Return to to
Shareholders)Shareholders)
EVA EVA
(Economic (Economic Value Added)Value Added)
EVA EVA
(Economic (Economic Value Added)Value Added)
Op. EBITDA / Op. EBITDA / Op. EBITDA- Op. EBITDA-
MarginMargin
Op. EBITDA / Op. EBITDA / Op. EBITDA- Op. EBITDA-
MarginMargin
EconomicEconomicPerformance Performance
(Stakeholder (Stakeholder benefits)benefits)
EconomicEconomicPerformance Performance
(Stakeholder (Stakeholder benefits)benefits)
Outside-in view Internal view
No “easy” calculation, soft assessment consisting
of multiple factors
Dividend paymentsto shareholders+ share price
appreciation
Company result afterconsideration of all
costs of capital,incl. cost of equity
Key operationalindicator focused on
cash-generation/efficiency
Net SalesVolume
x
DistributionCost
ProductionCost ofGoods Sold
Gross profit
-
-Op. EBITAMargin
/
Marketing &Sales Exp.
Admin. Exp.
Op. EBITA
-
-
List price
DiscountsRebates
Net Price
-
Operating EBITA Margin tree
Return on Net Operating Assets (RONOA) Tree
RONOA
NOA
OperatingProfit
NWC
OperatingPPE
Costs
SalesPrices
Volumes
CurrentAssets
Current OperatingLiabilities
Production
Distribution
Marketing and Sales
Administration
Areas for developing cost competency
The following areas emerge from the previous diagrams that provide opportunities for cost competency: Production Distribution Sales & Marketing Administration Asset utilisation and Capital structure –
borrowing cost Understanding cost hierarchy also helps
in developing cost competency as shown:
Level Effect on Example
1. Cost at unit level
Every unit of production
Raw material cost
2. Cost at batch level
Every batch Cost of granulation, cost of in-process quality control
3. Cost at product level
Every product line Development costs, free samples
4. Cost at customer level
Specific customers Cost of special packing, development costs
5. Cost at facility level (general operations level)
All products using the common facility
Insurance, plant administration
Cost competency (Contd.)
In the process of developing cost competency, an organisation attempts to answer the questions like:
How can we find and correct the root causes of excess working capital?
What techniques can improve how we manage inventory, payables, and receivables?
How can we improve forecast accuracy and product design to minimize inventory levels?
Which processes can we rethink or simplify to eliminate costs?
What facilities could we consolidate to minimize funds tied up in fixed assets?
Cost competency (Contd.)
Tools in practice: Value-based cost reduction: eliminating
unnecessary or redundant activities and streamlining those that are necessary
Process redesign: measure factors such as time, cost, errors, and volume to identify inefficient processes and redesign them for major cost savings and performance improvement.
Fixed asset optimisation Working capital management
Cost competency (Contd.)
Activity-based costing and Activity-based pricing
Life-cycle costing: sum of all recurring and one-time (non-recurring) costs over the full life span or a specified period of a good or service
Target costing: a system under which a company plans in advance for the price points, product costs, and margins that it wants to achieve for a new product. A powerful tool for continually monitoring products from the moment they enter the design phase and onward throughout their product life cycles.
Thank You