Segment Cost Behavior of the firm

Thus  far I   have described   how   to   analyze  the cost behavior  of a business unit as a whole. In practice, however, a business unit usually produces a number of different product varieties and sells them to a number of different buyers. It may also employ a number of different distribution channels. For example, a shipbuilder constructs both liquid natural gas tankers and containerships while a bank  lends to sophisti­ cated high net-worth individuals as well as to middle income customers. Any of these differences may give rise to segments in which the behavior of costs in the value chain may be different. Unless the firm recognizes differences in cost behavior  among  segments, there is a significant danger that  incorrect  or   average-cost   pricing   will   provide   openings for competitors. Thus cost analysis at the segment level must often supplement analysis at the business unit level.

Chapter  7   discusses   the   identification   and   analysis   of segments in more detail. Differences in cost behavior among products, buyers, channels, or geographic  areas is one of the key bases for the existence of segments, and hence cost analysis is an essential input  to segmenta­ tion. The value chain for segments generally parallels that of the whole business unit. However, segment value chains may differ in some re­ spects that  affect cost. For example, the large sizes of a product  line may be produced on different machines than small sizes and require different handling, inspection, and shipping procedures. Similarly, they may require different purchased  inputs. Identifying important  differ­ ences in the   value activities   for different segments   is a starting  point in segment cost analysis.

A firm should  analyze the costs of those product  lines, buyer types, or other portions of its activities that

  • have significantly  different value chains
  • appear to have different cost drivers
  • employ questionable procedures  for allocating costs

In practice, a firm may want to select representative  product varieties or buyers to illuminate differences among segments, rather than analyze every product variety or buyer in complete detail.

The  process used to analyze cost behavior  for segments is the same as that  used for business units.   The  value chain for the segment is identified and costs and assets are assigned to   it. Then  the cost drivers of each activity are determined and  quantified if possible. While the process remains  the same, however, some complications often arise in practice. The prevalence of shared  value activities among  segments (see Chapter 7) requires the allocation of costs among segments. Stan­ dard cost systems often employ arbitrary measures as the basis for allocating cost to segments, such as sales volume  or other  readily measurable variables. While these measures  have the benefit of simplic­ ity, they often have little to do with the true contribution of the segment to overall costs.   For  example,   allocating   the   costs   of a value activity to domestic and international buyers by volume of sales will usually seriously understate the true cost of international sales, because interna­ tional sales often make  disproportionate  demands  in terms  of time and attention. The costs of support activities and the costs of indirect primary activities appear to be most susceptible to misallocation. Such misallocations result in incorrect costs and inappropriate  prices for product or buyer segments.

The costs of value activities shared among  segments should be allocated based on each segment’s actual impact on the effort or capac­ ity of the value activity. Such measures  will capture  the opportunity cost of using a shared  value activity in one segment instead of another. In   technology   development,  for example,   allocation   should  probably be based on the estimated time spent by engineers and scientists on particular product lines rather than on the products’ respective sales volumes.

It is not always feasible or necessary to allocate the costs of shared activities to segments on an ongoing basis. The required  analysis for strategic purposes does not require a high degree of precision, and periodic studies can suffice. To allocate R& D costs, for example, engi­ neers can be interviewed to determine  the percentage  of their time spent on various products and buyers over a period of time long enough to eliminate distortions. Some firms may also be in a position to com­ pute time allocation by sampling engineering change orders or requests for product  modifications flowing to the engineering group  from the sales force. Similar methods  of approximation  can provide  the basis for allocating effort to segments in almost any shared activity.

Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.

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