When you are working to hold down costs, it is no good knowing the price of everything but the value of nothing. AICPA & CIMA’s Associate Technical Director Peter Spence explains that a successful cost management strategy must be focused on value to customers.
We have all seen what happens when cost management goes wrong. No company can survive in the long run if it costs more to produce their products than their customers are willing to pay for them. Firms that continually cut costs that denude quality or features will eventually find that customers are no longer willing to pay for an inferior product or put up with substandard service. A strategic approach is needed.
Cost management should be approached from a win-win perspective of profitability for the business and value for the customer, meaning that a cost management strategy should explain how a business will optimize the profitability of its product portfolio. Because profits are a function of costs and sales, and these have different drivers, a successful and sustainable cost management strategy will hold down costs relative to sales.
Accepting that cost transformation must take customer wants and needs into account is vital for success, that success begins with product development. 80% of the direct costs of a product are locked in at the design stage, so getting it right is key for successfully managing costs in a way that supports profitability.
One way to achieve this is target costing, which involves estimating the product cost by subtracting a desired profit margin from a competitive market price. The key to understanding target costing is that it is all-encompassing, examining the whole value chain, from what customers expect from a product to how a company will work with its suppliers to generate that customer value.
Because it is so wide ranging, if target costing is to be successful it cannot be the sole responsibility of the finance team. Finance leaders will need to partner with people from disciplines right across the business and understand the impact their decisions have on both costs and the overall product. It is vital that the people developing new products are incentivised to take ownership of product costs as well as quality and speed to market. In this way, cost management is related back to customer needs and forms the foundations of a successful long term cost management strategy.
Just laying solid foundations is not enough. The commercial environment in which an organisation is operating is always changing, so finance leaders should be using a range of risk management tools and techniques to identify threats to the cost management strategy. These threats can range from technological developments which render existing products or processes obsolete earlier than expected, to supply chain issues increasing the cost of materials.
The Enterprise Risk Management concept can be used to identify and address potential risks to the cost management strategy. This involves systematically working out the main drivers of the strategy, for example the cost of inputs or processes, and identifying the right risk responses to potential threats to these drivers.
As with target costing, this is not a process the finance team can complete in isolation. It requires buy-in from across the organisation to develop a deep understanding of what could go wrong, and how the company would respond. In complex organisations, a risk or indeed a risk response in one area will have effects on other areas, so it is important to build a holistic view to make the process robust.
Target costing and enterprise risk management are two concepts which illustrate a deeper point. Cost management is a process that is led by the finance team but it needs to be embedded right across the organisation, and it must relate to the wider goals of the business in order to succeed.
That means finance leaders require proficiency in accounting and finance, and also business partnering and management skills to implement these strategies successfully. They are an example of the increasingly important strategic leadership role that accounting and finance professionals are playing in helping modern businesses gain comparative advantage.
