Case Game: The Case Of Accurate Costing

CASE GAME
The Case Of Accurate Costing

Total Industries, BT's fictional company, must abandon its ''peanut-butter'' costing in favour of a more accurate system. But what should the system be, and how should it be implemented? Morarjee Goculdas' P.K. Gothi, Jamnalal Bajaj Institute of Management Studies' G.P. Jakhotiya, and PricewaterhouseCoopers' R. Sankar deliberate. A BT Case Study.

By R. Chandrasekhar

Abhinav Kumar was amazed at the number of CTV models on display. Barely three months ago, he had visited the same dealer. Now, not only were there more CTV brands in the shop, but also more models from each of the manufacturers.

''Kumar saheb, we need at least 5 to 8 per cent reduction in the prices of Total CTVS,'' said Pradip Jain, Delhi's biggest consumer electronics dealer, referring to the sets made by Kumar's family-managed company, Total Industries, which also manufactured switchgears, batteries, soaps, and oils.

''How can I, Pradip, when CTV component prices are going up by 10 per cent each year?''

''It's simple, Kumar saheb. To be able to sell, you need either a technological edge over others, or a cost-leadership position. It is becoming impossible to push Total CTVs at current prices.''

''I am not promising anything right now except that I'll ask Srikant to talk to you,'' Kumar said. Srikant Suresh was the President of Total's consumer durables division.

There was a time when Kumar actually looked forward to his dealer- and customer-visits. However, it was beginning to be a chore. Wherever he went, he was greeted with the same demand: lower prices. Be it switchgears, refrigerators, or batteries, the pressure to cut prices only seemed to be mounting. What complicated the pricing issue for Total was its product range: 15 CTV models, eight models of refrigerators, 24 types of batteries, and 60 varieties of switchgears. Kumar was also aware that merely cutting prices would prove disastrous in the long run. With its margins shrinking, Total Industries would not be in a position to re-invest in product development, or even in marketing.

Back in the local office, Kumar met Suresh, who was also in town on a dealer visit. Kumar told him about his meeting with Jain.

''I'm not surprised. That's why I avoided him this time,'' Suresh said.

''But that's not the solution. Why do we need so many models of CTVs when just five of them fetch 80 per cent of the CTV sales?'' asked Kumar.

''Because the moment we stop filling up those shop-shelves, some other brand will move in. Even if some of our models don't sell, they help demonstrate the sheer width of our range thus reinforcing our brand-image.''

''I agree, but there are unnecessary upstream and downstream complexities involved in maintaining such a wide portfolio.''

Kumar had a point. Methods of managing the sourcing and logistics for multiple product-lines at Total were proving to be obsolete. During one recent review, Kumar had aired his apprehension over the lack of clarity in costing. He had argued that unless the company could pinpoint cost-drivers, it would not be able to make sound pricing-decisions.

''Clearly, Srikant,'' he continued, ''there is a need to slice our organisation's costs the way a particular business demands it: by customer, by dealer, by division, by function, by process, or by activity.''

''You are right.''

''And this is an issue which concerns not just the consumer durables division but the others as well,'' Kumar pointed out. ''We had better call a meeting of the divisional heads the minute we return.''

week later, all four divisional heads-Ratika Sahai of Batteries, Manoj Kohli of Switchgears, Guneen Roy of Soaps & Oils, and Suresh-CFO Vikas Singh, Kumar, and his father and Total Industries Chairman, Deepak Kumar, were gathered in the conference room.

''Manoj, why don't we start with you,'' Kumar suggested.

''Sure. Before I get into costing, I want to recap my division's standing. We have a 23 per cent marketshare, and make two kinds of switchgears: a standard no-frills, low-margin variety that accounts for 70 per cent of sales, and a value-added, customised, high-margin variety, directly marketed to the institutional customers. Although our nearest competitor, PLT, has only a 16 per cent marketshare, it is growing fast because of its ability to lower prices. Further, PLT and another switchgear maker, Control, are talking about a merger.''

''Another thing to lose sleep over,'' quipped Kumar.

''There is something interesting we discovered. But I would like Vikas to talk about it.''

''Thank you, Manoj. When the question of cutting costs came up, we had to first look at cost allocations,'' said Singh in his baritone voice. ''Traditionally, 70 per cent of all division overheads and marketing costs have been allocated to the plain-vanilla switchgears, and the rest to the premium models. The allocation is a little arbitrary for two reasons: one, it is in direct proportion to the output, and two, it is an accepted practice in the industry.''

''What's surprising about this?'' Kumar Sr asked.

''I am coming to that. When we did some serious number-crunching, we discovered that the high-end switchgears had a significantly higher share of costs.''

''Explain,'' interjected Kumar. ''The costs related to support activities are higher in the case of premium switchgears. As a result, these are not making profits, as we believed. Instead, it is the low-value variety that is making all the profits.''

''I am not surprised... I am shocked,'' said the Chairman.

''Does it mean that if we had found this out last year and fixed it, the division would have turned in more profits?'' Kumar asked.

''I am afraid so. Besides, such anomalies could exist in our other divisions too,'' warned Singh.

Singh proved prophetic. In the course of their presentation, the other division heads also confessed to being surprised by the figures. It was decided that an external consultant should examine the organisation's costing systems.

It was almost two months before the consultant, Arun Sarkar, finalised his report. It corroborated Total's internal findings, and zeroed in on specific problems. For one, the practice of absorption costing in which overheads are allocated on the basis of the quantum of direct labour hours 'consumed' by the product-line, had given a distorted measure of the product-cost. Products known to be money-spinners were actually losing money, and vice-versa.

Secondly, it shattered the myth of fixed costs. No costs, it said, need to be viewed as fixed; all of them were variable in degrees. Viewing costs in this manner would change Total's pricing-decisions across the board. The report also pointed out that the company's emphasis should be on cost-drivers. Purchase costs, it noted, were driven by purchase orders raised, and not by direct labour hours consumed. Therefore, such costs should be allocated to business units on the basis of the number of purchase orders raised by them.

The report urged Total to use Activity-Based Costing (ABC). Apart from providing a much more accurate measure of the costs, ABC, the report said, could easily cascade into an enterprise-wide change management initiative, with direct linkages to business process re-engineering, total quality management, and just-in-time manufacturing.

In the final stage, ABC
could evolve into the concept of the Balanced Scorecard which measures strategic objectives and operational performance across four perspectives-financial, customer, process, and learning-balancing short-term financial performance with the drivers of growth opportunities. ''I have enough ammunition to set off a debate,'' Kumar thought to himself after reading the report.

The executive meeting was explosive. While everyone felt that Total's traditional accounting system based on absorption costing was not reliable, there was little consensus on how to bring about cost reductions, and whether ABC was the costing system best-suited for the company.

''The proportion of overheads to the total cost of operations is low in all of our business,'' noted Suresh of Consumer Durables. ''And since ABC is focused only on the treatment of overheads, it does not make much sense to take this route to control costs.''

''I beg to differ,'' Sarkar chimed in. ''A big advantage of ABC is its ability to highlight the unutilised potential of activity centres. In the traditional costing systems, production absorbs all such costs. However, in ABC, it will be displayed separately, and stick out like a sore thumb.''

Total's executives, however, were not convinced. Roy came up with an alternative: ''We should use the marginal-costing technique. That seems to be the best way to ascertain which products the company should retain in its portfolio. As long as a product recovers all variable costs associated with it, there is merit in retaining it.''

Kohli threw up yet another idea. ''Let's look at cost reduction on a broader scale. What if we were to focus on big ticket expense items like interest costs, receivables, energy, manpower, and raw materials? If these are under control, it shouldn't matter if minor costs over-run a bit.''

Batteries division President Sahai brought in another dimension to the debate. She said that the company should not sacrifice long-term payoffs in pursuit of cost reductions. ''If making a capital investment today means higher productivity tomorrow, Total should not hesitate to make it,'' she argued.

''I couldn't agree more,'' said Kumar. ''But my concern is how to spearhead the cost drive across the business units, where to cut costs, and what kind of a formal accounting system to put in place.''

THE DISCUSSION