Measure Strategic Cost Based on Activity-Based Costing Method
Ming-ming Wang1, Dong-ping Han2
School of Management, Harbin Institute of Technology, P.R. China, 150001
Abstract - In present, within this highly competitive
environment, cost management has become a critical
survival skill for many firms. These firms integrate the cost
factor into the establishment of a long-term and external
competitive advantage, and this phenomenon suggests the
need to reposition the management of cost as a strategic
method instead of simply cutting costs. Strategic cost
measurement is an important factor of strategic cost
management, which, to a large extent, has been ignored in
previous academic discussion. The purpose of this paper is
to describe the measurement of strategic cost management.
And this paper consists of two main parts: analyzes the
continents of strategic costs based on ABC, and then
identifies a way to measure the strategic cost accurately. The
additional third part is a supplementary discussion: how to
make the measurement work and how to use the
information to assist strategic decision-makers, followed by
a short further discussion.
Keywords - Strategic cost management; cost driver;
strategic cost measurement; strategic management
evaluation
I.
INTRODUCTION
The idea of “strategic cost management” was born at
Cranfield School of Management, through research in
value management and consequent work at BP. In 1990,
the head of strategic planning at BP Chemicals, Simon
Woolley, was faced with the problem of helping the
management team review costs in the light of external
and competitive pressure[1]. Simon was concerned that the
cost, which needed to be managed for the longer term,
should reflect the BP's approach of Value Based
Management. BP saw cost as a strategic issue, and had
managed it in this way, which led the researchers focus on
the sustainability of cost improvements.
Simultaneously Shank and Govindarajan presented
an analysis-driven framework on this subject. They
analyzed the relative importance of several management
accounting methods depending on whether the firm was
pursuing cost leadership, cost differentiation, or
cost-focus strategies[2]. They suggested that companies
choosing cost leadership would put the most emphasis on
the traditional cost accounting applications. They would
use standard costs to assess performance and product cost
as an input to pricing decisions, and use the flexible
budgeting for manufacturing cost control. They would
perceive meeting budgets and the analysis of competitors’
costs to be of great importance. On the other hand, those
companies which differentiate their products as a way of
achieving competitive advantage would consider
marketing cost analysis to be critical to their success.
They would consider the flexible budgeting and the
meeting of budget to be of only moderate importance, and
rank standard cost for performance assessment, rank
product cost for pricing decisions, and use competitor
cost analysis of little importance. Shank and
Govindarajan published a book named “strategic cost
management” in which they added other important
strategic cost management factors, and established the
management control systems.
Although Michael E. Porter detailed specific ways in
which managers could position their firms to have a
strategic advantage over their competitors ten years
before strategic cost management was defined, his
internal and external value chain theory is widely used by
the researchers in strategic cost management [3]. The value
chain for any firm is the linked set of value-creating
activities from basic raw material sources for component
suppliers through to the ultimate end–use product
delivered into the final consumers’ hands. Value chain
analysis (together with cost driver analysis and strategic
positioning analysis) becomes a basic tool of strategic
cost management.
Kaplan argues that traditional management
accounting systems produce misleading management
information[4]. Historically, costs were allocated in
relation to the physical use of production assets, including
both capital and labor. But as the service element grew as
a proportion of the value chain of most businesses, the
traditional bases of cost allocation became increasingly
irrelevant. There are often more important activities
which underpin the value added within the production
process than those associated with physical operations.
Kaplan proposed that managers should adopt “Activity
Based Costing” or “ABC” as a new cost management
method. “Activity-based costing is a powerful tool”
Robin Cooper and Robert S. Kaplan pointed out, “…ABC
analysis permits managers to understand the sources of
cost variability and reveals actions they can take to reduce
demands on their organizational resources…” by
measuring costs right, manager can make right decisions.
On the other hand, bad information on product costs leads
to bad competitive strategy [5]. “ABC is designed to
provide more accurate information about product
costs…”
Business management is a continuously cycling four
stages: formulate Strategies, communicate strategies,
develop and carry out tactics to implement the Strategies,
and then monitor success at achieving strategic objectives
by developing and implementing controls [6]. Cost
information plays a role at each of these stages. From this
perspective, strategic cost management can be defined as
the managerial use of cost information explicitly directed
at one or more of the four stages of the strategic
management cycle. Then it is quite obvious that cost is
essential in both internal strategic analysis and external
competitive analysis. But if we want to know how to get
detailed cost information, what is the score of a certain
strategy, or how to lower a certain kind of cost, the
published papers do not seem like could provide us much
information.
II. Preparation before Measuring
Firms utilize different strategies to gain competitive
advantage over their competitor, and they use cost
leadership, differentiation, and competitor analysis as
powerful weapons to accomplish this task. No matter
what strategy they are using, they still want to reduce
costs to maximize their profits. This purpose makes
strategic cost measuring and evaluating important in
strategic management. Only if the decision makers know
what their current accurate costs are, and which kind of
costs is unusual, can they make right management
movements to minimize the costs or try another strategy.
Strategic management is famous mostly because it
emphasizes on making decisions between management,
employees, and especially attaches importance to external
environment. We can always find phrases like “supplier
relationships” or “pay attention to our competitors” and
so on, all of which are sending us a strong signal that
external environment is very important in strategic cost
management. Correspondingly, the cost based on
exploring the external environment is a characteristic
factor compared to traditional cost management [6].
However how to measure this important cost has been
long forgotten. The main concern of activity-based
costing is the concept of cost driver. And with an enlarged
concept of cost driver (non-activity based), a whole
picture of SMC measurement could be drew thoroughly.
Activity-based costing (ABC) is designed to provide
more accurate information about production and support
activities and product costs so that management can focus
on the products and processes with the most leverage for
increasing profits. It helps managers make better
decisions about product design, pricing, marketing, and
mix, and it encourages continual operating improvements.
Although it is a system that is used to determine the full
costs of services and products more accurately, it can do a
lot more than that, and providing he cost analysis of other
cost objects is one example. Traditional costing
approaches have been largely based on the use of single
cost drivers to measure or analysis cost behavior. But real
life is not that simple, firms always have economic
activities with multiple cost drivers. The careful selection
of activity and cost drivers in ABC is the key to achieving
the benefits of this cost system. Generally, ABC begins
with the identification of activities that use overhead
resources and pooling the respective activity costs into
cost pools. Second, cost drivers are determined to
measure the amount of activities that are required by
different cost objects. Finally, costs are allocated to the
cost objects in proportion to their respective cost driver
demand. ABC is well known for its cost-allocating
accuracy, but the expensed capital is always beyond
consideration. Although the expensed cost does not count
in the cost of products, it does occupy the company
resources. It is necessary to take expensed cost seriously.
Besides, strategic cost management is outstanding
because it introduces a new cost-managing way:
managing cost to make firms more competitive by
jumping out from the factory (that means the ABC
method should be widened).
Before measuring strategic cost, we have to do an
elaborate preparation.
1. Identify the target firm which we are about to
analysis.
If it is a simple small firm that only has one type
product, a dozen staff, and several machines, then the
strategic cost management is not quite necessary to be
used, because the information cost of strategic cost
management is quite large. We have to make sure the
target firm produces different kinds of goods or services,
and has complicated production lines, and the overhead
costs must be very high. Only in this situation, using ABC
can provide strategic cost management more accuracy
information on the cost side.
2. Make a list that contains detailed costs. Manager
can get this information from accountants’, technician or
other professional staff by interviewing, consulting or
reading subsidiary ledger.
3. Find out cost drivers. In strategic cost
management it is acknowledged that cost is caused, or
driven, by many factors that are interrelated in complex
ways. Understanding cost behavior means understanding
the complex interplay of the set of cost drivers in any
given situation. Before actually choose the cost drivers,
we have to do some groundwork: distinguish cost drivers
[7]
. Cost drivers can be broken into two categories,
structural kind and executional kind. Structural cost
drivers are the causes of expenditure which are already
set before the company begins to run, such as expenditure
of scale, scope, experience, technology, complexity.
executional cost drivers are those determinants of a firm’s
cost position which hinge on its ability to execute
successfully, including work force involvement, capacity
utilization, product configuration, exploiting linkages
with the involvers in the value chain. After discriminating
what are cost drivers and what kind are they, we can
select cost drivers to make preparation for the
measurement of strategic cost. This process should follow
3 steps：
a. Determine the activity centers.
Activity centers were discussed in the process view.
The activity center is defined as series of value-added
activities that happen for the same reason. This concept of
activity center is much broader than the “activity center”
definition that we are already familiar with. It could be
beyond the manufacturing shop, and also take
non-value-added and not-for-profit activities into account.
Strategic
cost
contains
extensive
range
of
resource-consuming subjects, including internal and
external aspects. Determining which activity center we
want to analysis is crucial, especially in cost measurement.
Because of the limited budget and available time, usually
we can not have an overall cost measurement. Costing is
something we want to do to get further information about
the expenditure in a certain activity and this kind of
information derivates from the initial cost information
which can not tell us any thing but a number. After
costing, we can get detailed cost information, and this
information is assigned to a certain activity center in
which we can use the information to evaluate and to help
decision-maker to make the right strategy.
b. Pick cost drivers in the activity center or centers
we choose [8]. Cost is used to improve the firm
performance but not all the activity drivers aim to
improve the firm performance. Picking cost drivers means
the selection should contain all kinds of cost drivers.
We can explain this by the examples below:：
The first class of initiative can be illustrated by an
insurance company. The company redesigns claims
settlement process for clients so that it is simpler, faster,
and less stressful on the clients to remedy their losses.
When the clients want to buy insurance products, this
company seems pretty much attractive. Then this
initiative strengthens the strategic position of this
company. Simultaneously, the insurance company
redesigns its accounts payable system to fit the new
claims settlement process. This movement has no
strategic significance other than to make the firm more
profitable. If the insurance company finds that they have
too much staff stuck at sales department, so human
resources manager decides to downsize this department. A
few months later, this manger would have an earful
criticism because the sales performance is so lame. This
cost-reduction initiative leads to extreme low sales
performance, so that we can not just take cost as the only
factors to make further decision.
The cost drivers are chosen for further study, and
paying attention to the character of each kind of the cost
drivers could be helpful in accurate cost measurement and
cost analysis. If the cost drivers aimed to strengthen the
firm’s strategic position, the decision-maker should know
how many resources did these cost drivers and how well
are strategic position strengthened. When the
improvement was not so obvious and the expenses are
overly obvious, the strategic plan should definitely renew.
c. Assign costs to the cost drivers. In this step, we
want to get detailed cost information attached to each cost
driver. This woke would not be completed if the
accountants recorded cost information in terms of
categories rather than cost drivers in the first place.
Luckily, as the activity-based management is widely used
in many firms, it is possible to calculate costs by the
drivers.
III. Measuring Strategic Cost
We can not allocate costs by direct labor and
machine hours like the traditional costing method did.
The new method ask us to allocate costs based on the
drivers, so distinguishing the expenses in different
hierarchies makes clear what happened in each
hierarchies and why it happened[9]. It provides a
structured way of thinking about the relationship between
activities (or non- activity-based movements) and the
resources they consume. After the preparation expenses
could be allocated to the cost objects in different firm
hierarchies (we can also call them the activity centers but
they do contain non- activity-based centers).
The firm hierarchies (see Fig.1) can be divided into two
categories:
activity-based
expenses,
and
non-activity-based expenses.
Activity-based expenses are the expenses which are
related to activity processes [5]. When managers segregate
activities in this way, a hierarchy emerges. Some
activities like drilling a hole of machining a surface are
performed on individual units. Others-setups, material
movements and first part inspections-allow batches of
units to be processed. Still others-engineering product
specifications,
process
engineering,
product
enhancements, and engineering change notices-provide
overall capability that enables the m=company to produce
the product. And plant management, building and grounds
maintenance and heating and lighting sustain the
manufacturing facility[10].
Non-activity-based expenses are hard to identify and
allocated to a certain product. In this part, manager exerts
capitals in external cost to gain competitive advantages.
The external cost is used to build cooperative
relationships with suppliers and dealers and the other
co-partners in value chain. Others-improving consumer
satisfaction aims to gain comparative advantage over
competitors. Further more, the cost on knowing what our
competitors are doing is crucial to analyze competitors.
Environment protection is another external cost spender.
Sometimes this kind of cost happed because of statutory
and regulatory requirements. Internal cost for long-term
strategy happens in form of quality control, research &
design cost, knowledge creation, and others
The feature of strategic cost management is that it
takes non-activity-based expenses into account, especially
the cost according to competitor analysis. Through the
firm hierarchies, we can notice that the initial investment
can be divided into two parts ultimately: capitalized cost
and expensed cost. Capitalized cost is the defray that
happens to fulfill the main business, so it ought to enter
the costs of products, services or other property.
Expensing the cost is to write off the entire amount in the
first year, and ought to deduct the profit.
Since we have gotten the hierarchies, a list of
available cost drivers in each firm hierarchies can be
made (the non- activity-based cost drivers can be
classified to different department where they took place).
Then assign costs to the cost drivers, and measure the
costs.
J activities are measured by J cost drivers, and j is
jJ
the jth cost driver (
).
I is a set of products or cost objects, and i is the ith
cost object ( i  I ).
Cj is the total cost of the jth cost driver.
Ei is the total cost of the ith cost objects. Ei contains
both capitalized cost and expensed cost.
Qij is the use of jth cost driver j by cost object i.
Rij is the jth cost driver rate by the ith cost objects,
we can call it “cost driver rate” for short.
Rij 
k  m is chosen as the respective allocation basis, its
overhead costs increase from Ck to Ck + Cm，and the
accuracy loss for cost object i is
E i - E im  C m ( Rim  Rik )
Qij
n
 Qij
i 1
,(1)
n
0  Rij  1
are invented, strategic cost measurement can be practical.
The effects of replacing one cost driver by another
one to optimized the model [11].
To eliminate cost driver m by using only simple cost
driver replacements, overhead costs Cm is allocated by
one of the remaining J-1 cost drivers. If cost driver
R
, and
ij
i 1
1
The total cost of the ith cost object is
Carsten Homburg proposed an optimal cost driver
selection theory which brings this theory to completion.
That is to eliminate one cost driver by a set of the
remaining drivers instead of using only simple cost driver
replacements[12].
In this combination each cost driver is assigned a
certain weight determining the portion of Cm to be
allocated on the basis of this cost driver. If in allocating
overhead costs Cm, a weight of
 C1 
C 
 2
Ri 2 , , , Rim  , 
 
 , 
C 3 
m
Ei   Ri j C ij  Ri1
j 1
i  1,, I
 E1   R11
E  R
 2   21
 ,  ,
  
 ,   ,
 E n   Rn1
R12
,
,
R22
,
,
Rn 2
,
,
R1m   C1 
R2 m   C 2 
,  , 
 
,  , 
Rnm  C m 
mk  0
is assigned to
cost driver k  m , its new overhead cost is Ck +
mk  Cm ， and the accuracy loss for cost object i is
J
E i - E im  C m ( Rim   mk  Rik )
k 1
(2)
(4)
To have weights that are consistent with the

0
replacement of cost driver m, one must set m.m
.
Furthermore,
requiring
convex
combinations
J

k 1
(3)
E=RC
E is a matrix of the costs on cost objects individually,
through which we can easily tell the cost structure.
R is a matrix of cost driver rates, and it reflects the
percentage of the use of single cost driver by individual
cost object from the use of same one driver by the whole
objects.
C is a matrix of the total cost of one cost driver, and
it is easy to make a comparison among different cost
drivers.
Several writers point out that, strategic cost
management increases information cost. Besides there are
lots of cost drivers, which makes it even harder to
calculate the cost by cost drivers. Furthermore, it is often
desirable to focus management attention on only a few
main cost drivers. Since the selected cost drivers are used
to allocate overall overhead costs, they must also bear the
overhead costs corresponding to non-selected cost drivers.
But luckily, as some optimal cost driver selection theories
m.k
1
ensures that precisely the overhead costs
Dm are allocated.
This restricted version of the model is familiar to an
approach proposed by Babad and Balachandran where
only simple replacements of cost drivers are feasible[13].
In addition, it reduces the danger of overweighting
selected cost drivers.
IV.
CONCLUSION
In this paper a cost measurement system was proposed.
Firm expenses hierarchies are introduced to exposes the
relationships between economic movements and resource
consumption. Only when these relationships are clarified,
can we identify the cost drivers that hide behind those
movements. A calculation model and two cost
–driver-selection models were used to fulfill the strategic
cost measurement task. Then an evaluation system was
built, and part of which applies the out put of strategic
cost measurement. And there are still a lot researches
need to be done. Here are some further discussions:
1. Accounting information should be more accuracy.
Sometimes, decision-maker should not use accounting
numbers to drive decisions, for the managers may
decorate the accounting data, the accuracy of the numbers
is not totally reliable. Accounting numbers should be used
to guide decisions with care.
2. Strategic cost measuring plays of an influencing role
more than an informing role. Proponents of strategic
management accounting, by comparison, consider that
detailed financial quantification is essential. Based in
many cases on informal guesses, one could question any
comparability between one firm and its competitors.
Some writers assert that the concepts of strategic planning
and positioning only cover part of business strategy.
Strategies may be deliberate, that is, achieved as planned.
However, in many cases strategies emerge from
interaction between management, employees and the
environment. Accordingly, in some cases the emergent
strategy may differ from the strategy originally planned
by management. Because the situation changes
dramatically, so that means strategy can not be planned.
Well this view surely is not believable. Psteur Louis said:
chances favor the minds that are prepared, similarly, a
strategic plan is always necessary for strategic cost
management. All we need is a flexible plan which is
insensitive to the environment, or it is just too risky.
3. Over the past few years, in most industries has put the
spotlight very much on costs. Sometimes this spotlight
has been focused purely internally and without regard for
the interdependencies within the business system. More
rarely has cost management been sensitized to avoid the
negative impact on competitive position. We must all
amplify the message that this generates weaker financial
performance--poor cost management destroys shareholder
value. Strategic cost management is therefore not merely
a philosophy uniting different management disciplines. It
is a practical way of overcoming the narrow and political
budget games which traditionally beset cost management.
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