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Article Excerpt
EXECUTIVE SUMMARY The product with the highest unit profit may not be the product with the highest profit per unit of resource consumed. The Theory of Constraints (TOC), with its emphasis on throughput costing, offers one possible approach to profitability analysis, but it is focused on the short term. The authors discuss why throughput costing, in combination with ABC, is a better option to guide long-term, strategic decision making.
In the fall of 2005, Ford Motor Company announced a nearly 50% reduction in the number of suppliers it would use in the future. Soon after, Delphi Corp., the largest U.S. automotive parts manufacturer, announced its move into Chapter 11 bankruptcy. In the first quarter of 2006, Dana Corp., another large auto parts manufacturer, also resorted to bankruptcy.
Why were such major players in the automotive industry toppling like bowling pins? These events resulted from the mounting costing pressures on companies in the automotive supply chain. In the auto industry, as in any other highly competitive environment, cost management can be crucial. An organization's cost information can turn out to be a strength or a weakness, so the value of cost information depends on how it is used. In this article, we discuss ways that companies can use their cost information strategically.
EFFECTIVE USE OF RESOURCES
An organization creates a competitive advantage through the use of resources to provide features demanded by customers. The resources consumed to create these attributes are not free, and the effective use of the resources is critical in any competitive environment. The value of a cost management system comes from the way management uses it to support decision making, including decisions about long-term strategy.
Having reliable cost information on the various aspects of their business allows management to make decisions such as whether to charge different prices for different attributes, how much demand various processes place on resources, and which products or services to promote. In effect, the cost system becomes a strategic support system. The primary benefit of a strategic cost system is that it takes a long-term view of the organization. The system can provide valuable insights into the firm's operations, which can be used to formulate or assess overall business strategies and plans.
The strategic plan should include a clear picture of the organization's current and future position and offer a map for moving from the current to the future position. Any move an organization makes toward a desired future state requires the effective and efficient use of strategically important resources. A properly designed cost system can help identify and monitor the use of strategic resources.
With this focus in mind, we present a general strategic cost analysis (SCA) approach to managing capacity and apply it to the specific situation faced by Custom Paint Shop (CPS), a fictitious privately held custom painter of automotive components for original equipment manufacturers (OEM) and Tier 1 and Tier 2 suppliers. We introduced our readers to CPS in our article "Cost Management by Customer Choice," which appeared in the Spring 2005 issue of Management Accounting Quarterly. (1) That article contained a detailed scenario explaining the job complexity caused by the wide variety of coatings the company offered and the company's lack of a customer strategy. This lack of a strategy led the company to bid on any job that came their way, without regard for the demand that such jobs would put on important resources.
In the 2005 article, CPS needed to develop a customer strategy. A critical element in any customer-related competitive strategy is knowing which services provide a competitive advantage and which provide the most profit. Determining profitability may not be straightforward because profit can be defined in a number of ways. The product with the highest unit profit may not be the product with the highest profit per unit of resource consumed.
Eliyahu M. Goldratt's Theory of Constraints (TOC) offers one possible approach to profitability analysis. TOC directs management's attention to the resources that represent production constraints. These scarce resources are known as "bottlenecks." TOC promotes focusing on the throughput per unit of scarce resource, defined as revenue less material costs. This costing method, known as throughput costing, is focused on the short term.
Activity-based costing (ABC) analysis is a better option to guide long-term decision making. We will show how management can use the activity and cost information obtained from the ABC process to make decisions related to capacity. ABC is not without its own limitations, however. We propose that management combine TOC and ABC information to help make capacity-utilization decisions regarding strategic resources.
With the goal of helping management make informed decisions regarding orders or types of bids they should pursue, CPS assessed the financial profitability of its various product families (applications of a series of paint coatings and finishes). CPS used ABC analysis to identify the impact each product would have on company profits. The conclusion of the analysis was that an activity-based approach to costing provided a better understanding of costs and, therefore, a possibility for improving company profitability.
While our 2005 article showed that product mix drives costs, it did not define any customer strategy. Essentially, CPS was taking a reactive, short-term approach...
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