Cost Analysis Techniques

Various costing techniques used in procurement, are described.

Traditional Costing

Traditional costing primarily focuses on what is spent in a given fiscal period instead of where and why costs incur. Because it is accounting oriented, it allocates costs to different categories. Traditional costing often allocates costs based on single-volume measures such as direct-labor hours, direct- labor costs, and machine hours.

However, because traditional costing uses the volume-based allocation for cost-assignment purposes, it tends to assign overhead (indirect) costs to products using an arbitrarily predetermined rate. This method can distort the true cost of making products, because it is hard to associate the specific volume of direct labor or direct material with the final output; therefore, a single pool of indirect costs assigned for the entire production unit (e.g., entire plant or department) can be either under- or overestimated.

Total Cost of Ownership

The total cost of ownership (TCO) is a management accounting philosophy that includes all supply chain–related costs expected to be incurred throughout the entire life of product. These costs are composed of three components

• Acquisition costs—Costs associated with the purchase of a product or service
• Ownership costs—Costs associated with the ongoing use of a purchased product or service
• Post-ownership costs—Costs associated with the disposal and quality assurance of a product or service

The detail breakdown of these cost components is summarized in Table 8.3. TCO is useful for a firm that wants to control its supply chain costs, as detailed next:

• TCO allows the buyer to compare one supplier’s total cost performance to others, regardless of the current price tag.
• TCO helps the buyer identify the cost of non-performance (e.g., defects, repair, maintenance, late delivery) and hidden cost (e.g., taxes, customs duties).
• TCO develops an awareness of non-price factors and enhances the suppliers’ accountability for performance failures.
• TCO can capture the likely future revenue and expense streams from the purchases.

Activity-Based Costing

As the focus of cost analysis shifts from the estimate of income to the extent of profit contribution, a growing number of firms are beginning to explore the opportunity to identify and eliminate incremental but avoidable cost elements. Such a shift in cost accounting has given birth to activity-based costing (ABC), which generally refers to a cost accounting system that aims to identify money losers or winners by linking cost drivers directly to products or services that require activities consuming resources. ABC begins with the dissection of supply chain activities in terms of their causal relationship with cost objects and then specifies where non-value-adding activities exist. In other words, ABC helps the firm uncover the root causes of cost increases that do not contribute to profit increases. Therefore, the ultimate purpose of ABC is to increase profit margin by eliminating non-value-adding activities that cost money.