The behavior of a firm’s costs and its relative cost position stem from the value activities the firm performs in competing in an industry. A meaningful cost analysis, therefore, examines costs within these activities and not the costs of the firm as a whole. Each value activity has its own cost structure and the behavior of its cost may be affected by linkages and interrelationships with other activities both within and outside the firm. Cost advantage results if the firm achieves a lower cumulative cost of performing value activities than its competitors.
1. Defining the Value Chain for Cost Analysis
The starting point for cost analysis is to define a firm’s value chain and to assign operating costs and assets to value activities. Each activity in the value chain involves both operating costs and assets in the form of fixed and working capital. Purchased inputs make up part of the cost of every value activity, and can contribute to both operating costs (purchased operating inputs) and assets (purchased assets). The need to assign assets to value activities reflects the fact that the amount of assets in an activity and the efficiency of asset utilization are frequently important to the activity’s cost.
For purposes of cost analysis, the disaggregation of the generic value chain into individual value activities should reflect three principles that are not mutually exclusive:
- the size and growth of the cost represented by the activity
- the cost behavior of the activity
- competitor differences in performing the activity
Activities should be separated for cost analysis if they represent a significant or rapidly growing percentage of operating costs or assets. While most firms can easily identify the large components of their cost, they frequently overlook smaller but growing value activities that can eventually change their cost structure. Activities that represent a small and stagnant percentage of costs or assets can be grouped together into broader categories.
Activities must also be separated if they have different cost drivers, to be defined in more detail below. Activities with similar cost drivers can be safely grouped together. For example, advertising and promotion usually belong in separate value activities because advertising cost is sensitive to scale while promotional costs are largely variable. Any activity a business unit shares with others should also be treated as a separate value activity since conditions in other business units will affect its cost behavior. The same logic applies to any activity that has important linkages with other activities. In practice, one does not always know the drivers of cost behavior at the beginning of an analysis; hence the identification of value activities tends to require several iterations. The initial breakdown of the value chain into activities will inevitably represent a best guess of important differences in cost behavior. Value activities can then be aggregated or disaggregated as further analysis exposes differences or similarities in cost behavior. Usually an aggregated value chain is analyzed first, and then particular value activities that prove to be important are investigated in greater detail.
A final test for separating value activities is the behavior of competitors. Significant activities should be treated separately when a competitor performs them in a different way.1 For example, People Express and other no-frills airlines offer very different on-board service than the established trunk carriers such as American, Eastern, TWA, and United. Differences among competitors raise the possibility that an activity is the source of a relative cost advantage or disadvantage.
2. Assigning Costs and Assets
After identifying its value chain, a firm must assign operating costs and assets to value activities. Operating costs should be assigned to the activities in which they are incurred. Assets should be assigned to the activities that employ, control, or most influence their use. The assignment of operating costs is straightforward in principle, although it can be time-consuming. Accounting records must often be recast to match costs with value activities rather than with accounting classifications, particularly in areas such as overhead and purchased inputs.
Since assets are expensive and their selection and use often involve tradeoffs with operating costs, assets must be assigned to value activities in some way that will permit an analysis of cost behavior. Assignment of assets to activities is more complex than assignment of operating costs. Asset accounts must usually be regrouped to correspond to activities, and assets must be valued in some consistent way. There are two broad approaches to assigning assets. They may be assigned at their book or replacement value and compared to operating costs in this form, or book or replacement value may be translated into operating costs via capital charges. Either valuation approach poses difficulties. Book value may be meaningless because it is sensitive to the timing of initial purchase and to accounting policies. Calculating replacement value is also frequently a difficult task. Similarly, depreciation schedules are often arbitrary, as are capital charges for both fixed and current assets. The particular method chosen to value assets should reflect industry characteristics, which in turn will determine the most significant biases inherent in the data and the practical considerations in collecting it. The analyst must recognize the biases inherent in whatever method is chosen.2 It may prove illuminating for cost analysis to assign assets in several ways.
The costs and assets of shared value activities should be allocated initially to the value chain of the business unit using whatever methodology the firm currently employs, typically based on some allocation formula. The cost behavior of a shared value activity reflects the activity as a whole and not just the part that is attributable to one business unit. The cost of a scale-sensitive shared activity will depend on the volume of all involved business units, for example. In addition, the allocation formulas covering shared activities may not reflect their economics but may have been set based on convenience or political considerations. As the analysis proceeds, the costs of shared activities can be refined using more meaningful allocation methods based on the cost behavior of the activities.
The time period chosen for assigning costs and assets to value activities should be representative of a firm’s performance. It should recognize seasonal or cyclical fluctuations and periods of discontinuity that would affect cost. The comparison of costs at different points in time can illuminate the effect of strategy changes, as well as help diagnose cost behavior itself. Looking at the cost of an activity during successive periods can highlight learning effects, for example, while comparing costs during periods of widely differing levels of activity may give some indications about scale sensitivity and the role of capacity utilization.
It is important to remember that assigning costs and assets does not require the precision needed for financial reporting purposes. Estimates are often more than sufficient to highlight strategic cost issues, and can be employed in assigning costs and assets to value activities where generating accurate cost figures would require great expense. As the analysis proceeds and particular value activities prove to be important to cost advantage, greater efforts at precision can be made. Finally, a firm may find that competitors assign their operating costs and assets differently. The way in which competitors measure their costs is important because it will influence their behavior. Part of the task of competitor cost analysis is to attempt to diagnose competitor costing practices.
3. First Cut Analysis of Costs
The allocation of costs and assets will produce a value chain that illustrates graphically the distribution of a firm’s costs. It can prove revealing to separate the cost of each value activity into three categories: purchased operating inputs, human resource costs, and assets by major category. The proportions of the value chain can be drawn to reflect the distribution of costs and assets among activities as shown in Figure 3-1.
Even the initial allocation of operating costs and assets to the value chain may suggest areas for cost improvement. Purchased operating inputs will often represent a larger proportion of costs than commonly perceived, for example, because all the purchased inputs in the value chain are rarely cumulated. Other insights can result from grouping value activities into direct, indirect and quality assurance activities as defined in Chapter 2, and cumulating costs in each cate- gory. Managers often fail to recognize burgeoning indirect costs and have a tendency to focus almost exclusively on direct costs. In many firms, indirect costs not only represent a large proportion of total cost but also have grown more rapidly than other cost elements. The introduction of sophisticated information systems and automated processes is reducing direct costs but boosting indirect costs by requiring such things as sophisticated maintenance and computer programmers to prepare machine tapes. In valve manufacturing, for example, indirect cost represents more than 10 percent of total cost. Firms can also find that the sum of all quality assurance activities in the value chain is strikingly large. In many industries, this has led to the growing conclusion that other approaches to quality assurance besides inspection, adjusting, and testing can yield large cost savings.
Figure 3-1. Distribution of Operating Costs and Assets in Flow Control Valves
Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.