Cost Management Strategies

Why This Matters

Cost management isn't just about cutting expenses—it's about understanding where costs come from, how they behave, and what drives profitability. On your exam, you'll be tested on your ability to distinguish between strategies that focus on cost allocation accuracy, continuous improvement, waste elimination, and strategic planning. The key is recognizing which tool fits which business problem.

Don't just memorize definitions. Know when a company would choose target costing over kaizen costing, why ABC provides better information than traditional costing, and how these strategies interact with broader concepts like the value chain and break-even analysis. If you can explain the underlying logic, you'll handle any FRQ they throw at you.

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Improving Cost Allocation Accuracy

Traditional overhead allocation often distorts product costs by spreading expenses too broadly. These strategies focus on tracing costs more precisely to the activities and decisions that actually cause them.

Activity-Based Costing (ABC)

• Allocates overhead based on cost drivers—specific activities like machine setups, inspections, or purchase orders that actually consume resources
• Eliminates cross-subsidization where high-volume products unfairly absorb costs that low-volume, complex products actually cause
• Reveals non-value-added activities that can be reduced or eliminated, making it both a costing system and a cost management tool

Cost-Volume-Profit (CVP) Analysis

• Models the relationship between costs, volume, and profit—essential for calculating break-even points using $\text{Break-even units} = \frac{\text{Fixed Costs}}{\text{CM per unit}}$
• Contribution margin is the key metric: $\text{CM} = \text{Sales Price} - \text{Variable Cost per Unit}$
• Supports what-if analysis for pricing decisions, product mix optimization, and understanding operating leverage

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Market-Driven Cost Control

These strategies start with external market conditions and work backward to determine allowable costs. The market sets the price; the company must engineer costs to meet profit targets.

Target Costing

• Starts with market price minus desired profit—the formula $\text{Target Cost} = \text{Market Price} - \text{Target Profit}$ drives all design decisions
• Front-loads cost management into the design phase, where 80-90% of product costs are determined
• Requires cross-functional teams from engineering, manufacturing, and accounting to collaborate before production begins

Life Cycle Costing

• Captures total ownership costs from R&D through disposal—not just manufacturing costs visible in traditional accounting
• Prevents short-term thinking that minimizes production costs but creates expensive warranty, maintenance, or disposal problems later
• Supports sustainability analysis by quantifying environmental costs across the entire product life cycle

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Continuous Improvement Approaches

Rather than one-time cost cuts, these strategies embed ongoing cost reduction into organizational culture. The philosophy: small, sustained improvements compound into significant competitive advantages.

Kaizen Costing

• Targets incremental cost reductions during production—typically 1-3% annual cost reduction goals built into budgets
• Engages frontline employees who understand daily operations and can identify practical improvements
• Complements target costing by continuing cost pressure after the design phase ends

Total Quality Management (TQM)

• Treats quality as a cost driver—reducing defects eliminates rework, scrap, warranty claims, and customer defection costs
• Uses the cost of quality framework: prevention costs and appraisal costs are investments that reduce internal failure and external failure costs
• Data-driven approach relies on statistical process control and root cause analysis to sustain improvements

Benchmarking

• Compares performance metrics against best-in-class competitors or internal high performers
• Identifies performance gaps that reveal specific improvement opportunities with quantifiable targets
• Types include internal, competitive, and functional benchmarking—each provides different strategic insights

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Waste Elimination Strategies

These strategies attack inefficiency directly by identifying and removing activities that consume resources without adding customer value. Waste is anything the customer wouldn't pay for if they knew about it.

Lean Manufacturing

• Targets eight types of waste: defects, overproduction, waiting, non-utilized talent, transportation, inventory, motion, and extra processing (remember: DOWNTIME)
• Uses value stream mapping to visualize material and information flow, exposing bottlenecks and redundancies
• Creates pull systems where production responds to actual demand rather than forecasts

Just-in-Time (JIT) Inventory Management

• Minimizes inventory holding costs by receiving materials only when needed for production—ideally zero raw materials and WIP inventory
• Exposes production problems that inventory previously masked; you can't hide behind buffer stock
• Requires reliable suppliers and accurate demand forecasting—JIT fails spectacularly without strong supply chain partnerships

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Strategic Cost Analysis

These strategies zoom out to examine how costs flow through the entire organization and industry. Understanding your cost structure relative to competitors reveals strategic opportunities.

Value Chain Analysis

• Decomposes operations into primary activities (inbound logistics, operations, outbound logistics, marketing, service) and support activities (infrastructure, HR, technology, procurement)
• Identifies cost drivers at each stage—where does the company create value, and where does it just incur costs?
• Enables make-or-buy decisions by revealing which activities the company performs efficiently versus those better outsourced

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Quick Reference Table

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Self-Check Questions

1. A company discovers that its high-volume products are profitable while low-volume specialty products appear unprofitable. Which cost management strategy would help determine whether this is accurate costing or cross-subsidization?

2. Compare and contrast target costing and kaizen costing. At what stages of the product life cycle is each most effective, and how might a company use both together?

3. Which two strategies both emphasize employee involvement in identifying improvements, and what distinguishes their primary focus areas?

4. A manufacturer wants to reduce inventory costs but is concerned about stockouts disrupting production. Which strategy addresses this, and what prerequisites must be in place for it to succeed?

5. An FRQ describes a company analyzing whether to outsource its distribution function. Which cost management strategy provides the framework for this decision, and what specific analysis would it require?