Wk 11: Strategic cost management

  1. Strategic cost management
    • Cost management: is the improvement of an organisation’s cost effectiveness through understanding and managing the real causes of costs.
    • The key is to understand the real causes of cost
    • Main focus is on cost reduction, but also on improving other aspects of performance such as quality and delivery, that may drive customer value.
  2. Conventional versus contemporary approaches
    Drivers of cost
    • Conventional approach: managers control costs by bringing them into line with some predetermined goal (eg. budget or standard costs) The focus is on cost outcomes.
    • Contemporary approach: reduce costs by identifying waste and eliminating it through identifying the real cost drivers (why are we doing these activities in the first place? do we even need to incur these costs?)
  3. Conventional versus contemporary approaches
    Strategic perspective
    • Conventional approach: The primary focus of traditional approaches is on controlling costs within the organisation—an internal perspective.
    • Contemporary approach: within and beyond; cost management also concerned with achieving value for the customer - a strategic perspective (by considering activities over the whole value chain. Eg. what do our suppliers do and how do we do business with our suppliers? how do we manage the relationship with our customers?)
  4. Conventional versus contemporary approaches
    Process perspective
    • Conventional approach: control costs by reporting results for responsibility centres based on functional areas of the business, such as production, marketing and administration.
    • Contemporary approach: recognise that customers’ needs are met by processes which flow across the business and may cross functional
    • areas.
  5. Contemporary approaches include
    • Activity-based management
    • Business process re-engineering
    • Life cycle costing & budgeting
    • Target costing
    • TOC and Throughput accounting
    • Each of these techniques can be used independently to reduce costs, although in some instances they may also be complementary.
  6. Activity-based management (ABM)- recap
    • Process of using information from activity-based costing (ABC) to analyse activities, cost drivers and performance so that customer value and profitability can be improved
    • Customer value: the value that a customer places on a particular feature of a product.

    • ABM in action:
    • 1. Analyse all activities
    • 2. Group activities together into processes to have a better picture of the flow of production
    • 3. Target non-value added activities within each process
    • Ask ‘why’. What are cost drivers of these non-value added activities?
    • Ask ‘why’ again. Are they the real causes? Keep on asking
    • 4. Find out the real causes (root cause cost drivers) and ELIMINATE them
    • 5. Introduce new performance measures to monitor the effectiveness of cost reduction efforts
  7. Redefining activities for ABM
    • Compared to ABC
    • Activities need to be identified at a greater level of detail: to reflect individual tasks or steps in a process. The six activities identified for ABC— machine-related, inspection, setup, material handling, engineering and facility sustaining—need to be disaggregated into smaller activities.
    • –The total cost of each activity will include manufacturing overhead costs plus direct labour cost
    • –The cost of non-manufacturing activities may also be included: The analysis of activities in Chapter 8 stopped at the factory door. Under ABM, activities are built into processes that often extend into non-manufacturing areas
  8. Exhibit 16.2
    Activity costs and value status, Mason & Cox
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    • Exhibit 16.2 provides a list of manufacturing and non-manufacturing activities for Mason & Cox and their costs.
    • The non-manufacturing activities have been classified into corporate management, administration, and sales and dispatch.
    • The six activities used for ABC in Chapter 8 have been replaced by 16 manufacturing activities.
    • The total cost of each activity now also includes the cost of direct labour. It is this list of activities that we will use to demonstrate ABM.
  9. Using ABM to reduce costs 4 steps
    1.Identify the major opportunities for cost reduction

    2.Determine the real causes of these costs

    3.Develop a program to eliminate the causes (and therefore the costs)

    4.Introduce some new performance measures to monitor the effectiveness of cost reduction efforts
  10. ABM Step 1. Identify the major opportunities for cost reduction
    • The pivotal point of the ABC model is the identification and costing of activities.
    • Activities: are the units of work performed within the organisation. 
    • To identify opportunities to reduce costs, you can undertake a value analysis (or activity analysis ), where activities are classified as value-added or non-value added.
    • Value-added activities provide essential value to the customer, or are essential to the functioning of the business.
    • Value added activities include:
    • basic production activities that contribute to the final product, such as making moulds and pouring metal
    • essential administrative activities, such as managing the business and preparing financial statements.

    • Non-value-added activities: do not add value to a product from the customers’ perspective or for the business and, therefore, can be eliminated without detriment to either.
    • In many businesses, major sources of non-value-added activity include waiting, inspection, rework and the unnecessary movement and storage of inventories.
    • Activity analysis is part of the lean-thinking approach to cost management. Its origins are in Toyota’s production system, and the focus is on reducing waste.
    • The analysis and elimination of non-value-added activities can require considerable resources. Many businesses decide to target its major NVA activities
  11. ABM Step 2: Determine the real causes of non-value-added costs
    • To eliminate non-value-added costs, Shannon began by building activities into processes. Then she analysed those processes to find the causes of the non-value added activities.
    • Building activities into processes: 
    • Eliminating non-value-added activities requires a clear understanding of the way work is done in an organisation. One way of developing this understanding is to identify, for each activity, the preceding activities that supply its inputs (that is, its suppliers) and the subsequent activities that consume its outputs (its customers). This information can be used to link activities together into processes.
    • A process (or business process ) is a series of activities that are linked together to achieve a specific objective. Processes cut across responsibility centres such as functional departments.
    • 16.3: Process of filling a customer order for a custom-made casting
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    • Notice: horizontal flow of activities across the business, which crosses functional areas such as product design, manufacturing, sales and administration
    •  and Interdependence between activities, where a preceding activity is the supplier of a subsequent activity (or the subsequent activity is the customer for the preceding activity).

    • Cost driver analysis
    • Once the processes had been identified, Shannon attempted to identify the root cause cost drivers of the three major non-value-added activities.
    • Root cause cost drivers are the underlying factors that cause activities to be performed and their costs to be incurred.
    • Shannon used cost driver analysis to identify root cause cost drivers for the major non-value-added activities.
    • The search for root cause cost drivers inevitably involves continually asking why.
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  12. ABM Step 3: Develop a program for reducing costs
    • Eliminating root cause cost drivers may involve tackling individual activities.
    • Alternatively, it may require a fundamental restructure of processes, called business process re-engineering, which is described later in this chapter.
  13. ABM Step 4: Measure Performance
    • Activity-based performance measures can be used to monitor the effectiveness of cost reduction efforts, as well as other key sources of customer value.
    • management identified three aspects of performance that it believed were critical to the achievement of strategies and, therefore, to the success of the business: quality, delivery time and cost. (These are critical success factors for many businesses.)
    • Shannon identified performance measures that reflected both costs and cost drivers.
    • She also introduced activity-based performance measures to monitor quality and delivery. In some cases these measures were interrelated. For example, a number of the quality and delivery measures, such as defects and cycle time, were also cost drivers.
    • By monitoring the measures over time, managers could obtain feedback on their performance. Targets could be set and corrective actions could be instigated where required.
  14. Impact of activity-based management
    • Activity-based costing system is expensive to implement
    • It is more complex than the traditional management accounting system and more expensive to maintain.
    • ABC and ABM seemed to improve profitability. Part of the improvement was due to the more accurate product costs, which provided a reliable basis for strategic decision making.
    • Part was due to the company’s improved cost management. Cost savings had been achieved by targeting the most significant non-value-added activities. Their real cost drivers had been identified, and managers from across the business worked to eliminate them.
    • Moreover, part of the improvement was due to increased customer satisfaction. In addition to tracking cost drivers, activity-based performance measures enabled the company to monitor and improve quality and delivery, key sources of customer value.
    • Instead of aggregated, outdated, financial measures of their performance, the new approach provided timely information about factors that were important to customers and factors that employees could control.
  15. Managing spare capacity to achieve cost reduction
    • A likely outcome of undertaking ABM is the creation of spare capacity, and cost reductions will not be achieved unless this capacity is reduced.
    • This reorganisation will lead to spare capacity, that is, it will lead to idle time for the shop floor employees who move the materials, and free up space on the factory floor.
    • Employees are paid wages and those costs will only be reduced if the employees are able to use their time on other value-adding activities or if some of the employees leave the company. The costs associated with the freed-up factory floor, such as factory lease, insurance, and cleaning, will be ongoing, whether or not the factory floor can be used for other profitable activities.
    • In summary, cost management programs such as ABM will only lead to cost reduction if the spare capacity that is created through reduction in root cause cost drivers is either eliminated or used for other value-adding activities. This principle applies to other cost management techniques outlined in this chapter, such as business process re-engineering and target costing.
  16. BPR (Business Process Re-engineering) or process re-engineering
    • The fundamental rethinking and radical redesign of business processes to achieve dramatic improvements in critical areas of performance such as cost, quality and delivery
    • Focus is on strategic processes- processes that are essential to achieving the company’s business objectives and strategies
    • The aim of BPR is to totally reorganise the way in which work is done by identifying and enhancing value-added activities and eliminating non-value-added activities for a process.

    • What would be the best way for us to organise these processes and activities? Essentially starting from scratch.
    • If we could completely reorganise the flow of activities and processes to make our product and services- how would we do that?

    • ABM: making small improvements on the way we do things
    • BPR: starting for scratch, more disruptive
  17. BPR- steps
    • Once a process has been identified for re-engineering, BPR involves four major steps:
    • 1.Prepare a business process map: A flowchart of the activities that make up the business process
    • 2.Establish goals: Clear goals for the re-engineered process are established, based on the sources of customer value. These may include quality and delivery performance, as well as cost. Depending on the strategies of the business, they may also include innovation, flexibility and so on. (what are we trying to achieve by re-engineering these business processes?)
    • 3.Reorganise work flow: The flow of work is reorganised to enable the goals to be achieved. (Reconfiguring the business around processes rather than functional departments is a common outcome of business process re-engineering.)
    • (Can we reorganise the order or thew way that we do those processes or eliminate some steps that are not adding value in ways that might help us achieve those goals?
    • 4.Implement the program: The final step is implementation of the changed workflows. Business process re-engineering involves substantial change and, like any change, may meet resistance from employees. Such resistance may be managed through forming re-engineering project teams that involve employees from all functional areas affected by the proposed change. In such situations, employees may feel a stronger sense of ownership of the changes 
    • –Involves substantial change so careful implementation is required to minimise resistance to change and business disruption (to staff and customers)
    • (How are we going to implement these changes to manage those levels of disruption?)
  18. Is BPR the same as ABM?
    • ABM focuses on incremental, continuous improvement of processes and the use of cost driver analysis to manage costs.
    • BPR involves fundamental changes to the way processes are structured. The goal of BPR that directs the re-engineering effort can be cost efficiency, but can also be to maximise quality, innovation, delivery or whatever is of strategic importance to the organisation.
    • Both use activity analysis to identify processes and activities
    • Both are about organising our activities.
  19. 2. Life cycle costing
    • Life cycle costing is an alternative approach to cost management that accumulates and manages costs over a product’s life cycle.
    • There are two important aspects to life cycle costing: the focus on the product cost and the inclusion of all upstream and downstream costs.
    • A product life cycle is the time from the conception of a product through to its abandonment—that is, ‘from cradle to grave’.
    • About broadening our perspective on what are the costs on making the products or delivering the services that we offer?
    • Costs over the entire life cycle rather than just the production phase.
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    • Introduction: still designing the product, testing market, market research
    • Growth/maturity: selling product
    • Decline: even after we sell the product there may still be costs that we incur
  20. Life cycle costing stages
    • From a production perspective, product life cycles usually cover four stages:
    • 1.Product planning and initial concept design: engineers designing product, is there a market
    • 2.Product design and development: building prototypes, trialling for feedback before we settle on final design.
    • 3.Production: direct material, labour, overhead costs
    • 4.Distribution and customer support: may still incur costs after we stop selling product through continued service.
    • The length of a product’s life cycle varies from one product to the next. For example, clothing and fashion goods tend to have a life cycle of one year or less.

    • We may incur a lot of costs before we even begin selling the product.
    • What is the true cost of that product?
    • We don't want to pricing our products to only cover our production costs and ignoring the costs that are often hidden by the traditional system as period costs
  21. Life cycle budgeting- what is
    • Life-cycle budgeting is undertaken to estimate likely profitability of a product and to guide pricing and decide product mix. Can be developed to compare planned costs with predicted revenue over each year of the product’s life.
    • (What do expect potentially to be the sales of this product over its entire life)
    • Can help managers decide which products to produce.
    • Traditional costing systems enable product cost and profitability to be assessed each year, but this approach ignores upstream and downstream costs and the effects of life cycle stages.
    • In cost-plus pricing, cost should be based on the product’s cost over its entire life cycle. This is especially important where products have short life cycles and high upstream and downstream costs. In this situation, prices must be set to recover all costs plus make a profit in a relatively short time.
    • The budget highlights the importance of covering costs in all the value-chain activities, not just production costs.

    • Eg. Apple new iphone: what are the costs incurred in designing new model? If its going to be on the market for let's say 4 years, what do we expect our sales to be over this 4yr period? What is the estimated total revenues compared to total costs over its entire life. 
    • We want to do this to help to set a price point where we can generate enough revenue to cover the cost across the entire life.
    • Might help decide whether its even worthwhile introducing this new model.
  22. Life cycle budgeting- managing costs
    • Estimates are made for each product of revenues and costs from the initial R&D activities to the final withdrawal (recycling/ dumping etc.) of the product and final customer servicing.
    • The life cycle budget provides useful information for managing and reducing costs.
    • The design of the product, and of the processes that will be
    • used to produce it, is a major determinant of subsequent production costs (and customer support costs). Spending more on the design phase can lead to significant savings during the production phase.
    • Traditional cost control systems, such as standard costing, focus on
    • controlling production costs when they are incurred.
    • However, far greater cost reductions can be achieved by designing efficient and effective production processes than by trying to control the costs of the processes after the processes are in place.
    • Cost controls applied once production has begun can be expected to have only a relatively minor impact. Moreover, most conventional costing systems tend to treat pre-production (upstream) and post-production (downstream) costs as period costs, rather than recognising and managing them as product-related costs.
  23. Impediments to Life cycle costing
    • Life cycle costing is not always used in practice for the costing of products.
    • This may reflect the lack of awareness, or uncertainty about how to calculate life cycle costs (particularly by small-medium sized businesses)
    • Not easy for products with longer lives (or undetermined life)
    • It is very difficult to predict the effects of changes in consumer tastes and impact of competitors’ actions
    • –Effects of inflation must also be considered.
    • -globalisation 
    • There is limited information in traditional budgeting systems for constructing life cycle budgets, because traditional systems have a short-term (usually annual) cycle and focus on responsibility centres rather than on products, although the capital budgeting process may support the development of life cycle budgets.
    • Life cycle costing is a tool that is going to be more accurate when we're dealing with products which have a limited life. eg. apple new phone
    • Can be used as part of other techniques, like target costing
  24. 3. Target costing- what
    • Almost a compliment to life cycle costing. They almost go together in some ways.
    • A system of profit planning and cost management. 
    • The required features and performance of the proposed product are established. Then target costing determines the life cycle cost at which a proposed product must be produced to generate the desired level of profit, given the product's anticipated selling price.
    • The cost target for a product is driven by the need to sell the product at a certain market price and to achieve a target profit margin
    • It is cost management technique, not a costing technique

    • Rather than using cost as the basis for determining the price- instead thinks about what is the profit we want to make out of this product. Therefore based upon that, what do our costs need to be? What is the target or our costs?
    • Rather than cost driving price- profit drives cost level
    • What is the goal going to be for our costs?
  25. Target Price and Target Cost
    • Target selling price: the anticipated market price for the product, based on market considerations, such as customer needs and expectations and competitors’ behaviour, as well as the business’ strategic objectives for the product.
    • Target profit margin: This would be influenced by the profit performance of similar products and the long-term profit objectives of the business.
    • Target cost: the cost at which the product must be produced if it is to be sold at the target selling price and generate the rate of return required by the business.
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    • Cost reduction objective is final decision to make (difference between target cost and what costs currently are). How much we need to reduce current costs to achieve the target cost.
  26. Influences on Pricing
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    • Customers: perceived value and loyalty
    • Competitive offerings: relative functionality, competitor's price
    • Strategic Objectives: corporate image, market share, long term profits
    • Target profit margin
  27. Achieving the target cost
    • Target cost is driven primarily by market considerations.
    • Focuses on customer expectations for product features and quality
    • Cost reduction objective: The degree of cost reduction required to achieve the target cost. The difference between target cost and current cost.
    • Current cost: estimate of the cost, including upstream and downstream costs, for which the product could be manufactured, given the current design and resources but prior to any cost reduction activities.
    • Having established the cost reduction objective, the challenge is to find ways to remove cost from the product. This task is often undertaken by a cross-functional team that is set up to manage the target costing process.
    • Individual targets would be set for various functional departments, product components and materials, and value engineering would provide a way of reducing costs while enhancing the functionality of the new product.
    • Under target costing, all areas of the business must make a firm commitment to designing, producing and distributing the product with total life cycle costs equal to the target cost.
  28. Achieving target cost: Value Engineering
    • Techniques such as value engineering can be used to find creative ways of achieving some of these targets.
    • Value engineering (VE): involves analysing the design of the product and the production process to eliminate any non-value-added elements, in order to achieve the target cost while maintaining or increasing customer value.
    • a systematic evaluation of all aspects of the value-chain business functions with the objective to maximise customer value by
    • –Increasing functionality, or
    • –Increasing quality, or
    • –Reducing cost, or
    • –Some combination of the above
    • Value engineering may involve design engineers modifying the design of some components to make them easier to manufacture and maintain, substituting more cost-effective material that does not reduce customer value, and improving the efficiency of the production processes. Thus, in undertaking VE, it is critical that engineers and
    • product designers have a clear understanding of customer value. Value engineering will also involve working with suppliers to provide components or raw materials that meet target costs.
    • Most businesses rely on outsourced components, to some degree, and the product designers may work with suppliers to reduce the costs of those components, which may then create a cycle of target costing within supplier organisations.
    • Notice that the setting of target costs may have behavioural implications. Target costs need to be demanding but achievable, otherwise the target costing process would lose credibility and targets would not be taken seriously
  29. Key features of target costing for cost management
    • It is price led (it begins with the expected market price and works backwards to set the target cost)
    • Focuses on the customer (the product features and quality required to meet customer expectations are established and taken as given when setting the target cost and then working to achieve the target cost)
    • Based on principles of life cycle managementplacing primary emphasis on managing production and downstream costs by focusing on the design and development phase
    • Cross-functional– involving managers from across the value chain
  30. Pursuing continuous improvement once production begins
    • A lot of the costs are locked in after the planning stage such as direct material. However this shouldn't end here
    • Kaizen costing
    • Kaizen is the Japanese term for improvement.
    • Kaizen costing can be thought of as a complement to target costing
    • because, while target costing focuses on making cost reductions in the product planning and design phase of the product life cycle, kaizen costing focuses on reducing costs during the production phase of the product life cycle.
    • As a result, kaizen costing focuses on making small, incremental improvements to processes, given that most cost reduction opportunities exist in the pre-production phase.
    • Kaizen costing operates outside the traditional standard costing systems. Whereas in a standard costing system the aim is to ensure actual costs do not exceed standard costs, in a kaizen costing system the aim is to reduce costs to a level below standard cost, while still ensuring acceptable levels of quality and product functionality are maintained.
    • Additionally, whereas under a standard costing approach standards tend to be revised six-monthly or yearly, under a kaizen costing approach cost reduction targets are revised monthly, as the organisation seeks to identify ways to continually reduce costs.
    • The approach has been criticised for having the potential to create significant pressure and stress on employees
  31. What is throughput?
    • –The amount of work that is done or passes through a specific process in a particular period of time
    • –Many believe that managing throughput is the key to profitability. The approach is based on the TOC (theory of constraint)

    • How many units can pass through a given process or how many units we can make in a given period of time OR a given amount of resources (constraint).
    • If my factory has a throughput of 60 units/hour, that means every hour we are able to make 60 units
  32. What is the theory of constraints?
    • An approach to managing costs and improving quality
    • and delivery performance, focuses on identifying and removing bottlenecks to improve the rate of throughput
    • Bottleneck: a point in a process that blocks or slows progress
    • According to the theory of constraints, the rate of production is limited to the capacity of the constraint (or bottleneck)
    • The rate at which a liquid can be released is constrained to the neck of the bottle. The slowest/smallest part is what is limiting what is pouring out.
    • Any attempt to improve efficiency in non-bottleneck areas will not improve production flow; it will only cause inventory to build up at the bottleneck. It implies increased holding and handling costs.
    • Inadequate labour or machinery can cause bottlenecks. Labour resources can be improved with overtime, hiring and training, but constraints involving plant and equipment are more difficult to rectify.
    • Applying the theory of constraints enables a business to increase revenue, reduce costs and improve customer response time. Removing bottlenecks may also improve quality, as defective units, hidden in the inventory stockpile at the bottleneck, will now be detected more quickly during further processing
  33. Theory of constraint exhibit 16.9
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    • The throughput is limited to the slowest/least efficient part of the process.
    • We're only as fast as the slowest part of the chain.
    • In this example part 1: throughput is 500 units/hr even though testing & packing can handle 800 units and moulding can handle 600 units
    • Extra 100 units from Moulding stockpiles at 100 units/hr
  34. Steps in TOC: there are five
    • 1.Identify the constraint
    • What is it that limits our throughput? The bottleneck- could be based upon time or on material.

    • 2.Determine the most profitable product mix given the constraint
    • –Shift others to non-bottleneck machine/ outsource
    • How can we maximise the profitability of our throughput given we have that constraint? What will provide the biggest return?
    • Eg. we have 2 products and constraint is assembly: one has profit of $50 and uses up 1hr assembly. 2nd product profits $60 but uses 2hr assembly (and therefore only profits $30/hr)

    • 3.Maximise the flow through the constraint
    • How can we improve efficiency at that constraint? Why is the assembly having such low throughput? Is it because the machine keeps breaking down?
    • –Ensure quality: preventative actions
    • –Reduce set up and processing time; eliminate idle time
    • –Double shift if needed on the bottleneck machine.
    • –Subordinate all non-bottle neck ops to the bottleneck ops

    • 4.Add capacity to the constraint
    • Should we hire an extra worker in the assembly line? Invest in newer technology?

    • 5.Redesign the manufacturing process for flexibility and fast cycle time (so that maybe we don't have to rely on that constraining activity)
    • Can you make some connections with other techniques?
  35. Throughput accounting
    • Throughput accounting: is a method of measuring the effect of bottlenecks and operational decisions using financial measures of throughput, investment and operating expense.
    • It recognises that the ultimate business goal is to make money, so the ultimate performance measure must be profit- or cash-based.
    •  Throughput accounting aims to measure the effect on profitability of bottlenecks and operational decisions, using three financial measures:
    • 1. Throughput: the rate at which a business generates profit through sales, calculated as sales revenue minus true variable costs, such as direct material.
    • 2. Investment: which is the resources that the business has tied up in inventory, buildings, machinery and other assets and liabilities
    • 3. Operating expense: which measures the cost of converting inventory into output, such as the cost of labour, machine maintenance and utilities.
    • A decision or action is evaluated by understanding its impact on any one of these three measures. Looking at ROI, cash flow, Net Profit
    • Throughput accounting has been criticised as it concentrates only on the short term. Constraints are often short-term problems and, once identified, they can be overcome. To survive a business must identify strategic objectives, which should form the basis for identifying critical success factors and related performance measures.
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  36. Linkage to traditional measures
    • Let’s now link these three (throughput, inventory, operating expense) with our goals of improving the other three (NP, ROI, CF):
    • –When throughput is increased with no change in the other two, then NP, ROI, and CF should increase
    • –When operating expense is decreased with no changes in the other two, then NP, ROI, and CF should increase
    • –Likewise, when inventory decreases with no changes in the other two, then NP, ROI, and CF should increase
  37. Summary
    • Modern cost management techniques focus on identifying and managing the root causes of costs and eliminating waste, while managing customer value
    • Techniques include ABM, BPR, life cycle costing, target costing and throughput accounting.
Card Set
Wk 11: Strategic cost management
Wk 11: Strategic cost management Cost management traditional vs. contemporary systems Activity-based management (ABM) Business process re-engineering (BPR) Life Cycle costing and budgeting Target costing The Theory of Constraints & throughput accounting