Monitoring Performance, Cost Reductions, and Value Enhancement

Performance Measures in Manufacturing Organisations

• Profitability, activity, liquidity and gearing

These will be the main financial key performance indicators that the organisation will be
interested in, and they look at the overall performance of an organisation.

• Resource utilisation

This can be measured by calculating non-financial indicators such as activity, efficiency and
capacity ratios.

• Variance analysis

Variances are an essential measure of performance.

• Quality

Quality is how well a product or service meets the customer’s needs. It involves applying
various standards and measurement and monitoring of quality costs.

• Customer satisfaction

• Customer satisfaction is essential for the long-term growth and profitability of

companies.

There are several ways that it can be measured. For example, customer survey results and
the number of new customers recommended by current customers are measurement
methods.

Measuring Performance in Service Industries

Service industry organisations provide services and do not produce physical products as
manufacturing industries do. Examples of places where services are provided are
hairdressers, restaurants, hospitals, hotels and accountancy firms.

Services have several characteristics that make them different from products. For example,
services are intangible, perishable, inconsistent and simultaneous.

These characteristics make measuring performance in service industry organisations more

complicated than in other industries.

There would be a focus on non-financial performance measures specifically related to

delivering the service.
Example

Some examples of performance measures for service industries include:

Example company Service performance measure

Arrival on time %

Seat capacity utilisation %

Cost per passenger-kilometre

Revenue per passenger kilometre

Aircraft availability rates

Route market share %

Emissions per passenger-kilometre

Airline Baggage loss rate %

Cost per megawatt-hour supplied

Uninterrupted supply %

Revenue per megawatt hour supplied

Sustainable generation %

Generation efficiency %

Electricity utility Emissions per megawatt-hour generated %

Complaint resolution period

Complaint resolution date

Cost per square foot

Service availability period %

Building management Number of security incidents

Measuring Performance in Non-Profit And Public Sector Organisations

Non-profit seeking organisations include charities, government bodies, educational
establishments and public sector organisations. Let’s look at these in a bit more detail:

• Charities and other voluntary organisations do not look to make a profit. Instead,
donations from donors fund these organisations.

• Public sector organisations, for example, hospitals and schools. These organisations
are controlled and funded by the government (which receives the money in taxes
paid by the taxpayers).

Taxpayers who fund public sector organisations are interested in value for money: they want
low taxes but high public service levels from what they have paid.

Donors who make charitable donations will want to ensure the maximum amount of their
contributions will be spent on its intended purpose (the charity’s beneficiaries) rather than
on administration charges. The donors will therefore want to see that their donations are
being put to good use.

Most public sector organisations aim to provide value for money or the best possible service
for a limited budget. Therefore, in most cases, financial performance measures will not suit
public sector organisations.

Example: Stakeholders' Conflicting Objectives

Stakeholders in a state-funded university:

• The university's management board is accountable to multiple principals.

• However, the requirements of the principals may conflict:

• Students may desire small class sizes, an extensive library, etc.

• Government wants to minimise the costs per student.

• Designing a performance measurement system with multiple and conflicting objectives is tricky.
 Example: Stakeholders' Conflicting Objectives

• Management must try to rank its principals/stakeholders and prioritise objectives.

One of the difficulties in measuring performance in such organisations is how to value their
outputs because the outputs are not usually in financial terms. This problem has led to the
development of the VFM or Value for Money concept.

Value for Money (VFM) concept

The Value for Money concept revolves around the 3E approach – the three Es are:

1.4.1 Economy – Inputs

This is a measure of inputs-related costs (the aim is to minimise costs for a set quality or a
set amount of inputs). Inputs are the resources input, for example, time, money, materials
and labour.

1.4.2 Efficiency – Process

This is a measure of how the inputs and outputs are related, with the aim being to achieve
the maximum output from the actual input (resources) used in a process.

1.4.3 Effectiveness – Outputs.

This relates the outputs of a process to the objectives of an organisation.

Example

A government wants to measure the performance of the state schools in its country and is looking at
both financial and non-financial performance indicators.

The government wishes to assess the average class sizes of state schools. Which of the three Es would
be the best description of the measure of class sizes?

A school will generally consist of many students taught by several teachers.

The teachers can be thought of as the ‘input’; they are the resources that cost money to employ (in the
form of wages), and the students can be considered as the ‘output’ – an educated pupil is the result of a
state-run school education.
Example

Efficiency is a measure of how the inputs and outputs are related, with the aim being to achieve the
maximum output from the actual input (resources) used in a process. The efficiency = outputs/inputs =
pupils/teachers, the result of which is the average class size in a school.

The government wishes to assess the pass rates of the state schools. Which of the three Es would be
the best description of the measure of pass rates?

A school will generally consist of many students taught by several teachers.

Schools will aim to prepare students to the required standard so that they will be able to pass their
exams.

The students can be thought of as the ‘output’ – an educated pupil is the result of a state-run school
education, and ‘pass rates’ are one of the school’s objectives. The VFM measure that links output to
objectives is effectiveness – how well does the school’s output relate to its purpose (pass rate) – the
answer is ‘effectiveness’.

The government wishes to assess the average cost of employing one full-time teacher in each state
school. Which of the three Es would be the best description of the measure of hiring one full-time
teacher?

The teachers can be considered the ‘input’; they are the resources that cost money to employ (in the
form of wages). Therefore, the teachers’ wages are the cost (the amount spent on the inputs).

The measure of employing one full-time teacher can therefore be described as ‘economy’ because this
is the measure that relates cost to input.
 Example University Objectives – Conflicting 3Es

High effectiveness is likely to conflict with economy and efficiency.

Multiple and conflicting objectives also may exist due to the various stakeholders involved.

Assessment Of Managerial Performance and Problems Involved

It is not easy to monitor the individual performance of a division or department manager

within an organisation. This is because sometimes there are factors that may affect a division
but are not under the direct control of the manager of that division. Therefore, it would be
unfair to assess the division manager based only on a single performance measure of his
division.

As well as ensuring the measures represent a fair reflection of the manager’s responsibilities
and area of influence, it is also essential to ensure the criteria used are aligned with the
organisation’s strategy and long-term goals. This is not easy to achieve.

For example, if client or customer satisfaction and long-term customer retention are vital to
the organisation’s long-term success, it would not be appropriate to judge management
performance based only on short-term profitability. A focus on profitability may lead to
managers taking a commercially aggressive stance when dealing with customers and
reducing resources dedicated to customer service, which in the long term may lead to
customers switching to competitors.
Specific targets can be set for managers. For example, a manager could be assigned an
increase in sales target for a period. It would also be fair to assess a divisional manager
based on costs and revenues within their control.

Therefore,

• It would be fair to assess cost centre managers on controllable costs

• It would be fair to assess revenue centre managers on controllable revenues

• It would be fair to assess profit centre managers on controllable costs and revenues

• It would be fair to assess investment centre managers on controllable costs, revenues

and investments.

Controllable costs and revenues result in a controllable profit, and this is commonly used in
the calculation of two performance measures that can be used to assess managerial
performance in divisions that are investment centres:

• Return on investment ratio (ROI)

• Residual income ratio (RI).

• Imputed Interest
•
• The imputed interest (which is sometimes known as the notional interest rate)
is calculated as follows:

Imputed interest = Capital employed (or net assets) × imputed interest rate or cost of capital

• An exam question might give information relating to imputed/notional interest

rates.
• Return on investment (ROI)
•

Return on Investment = Controllable profit/controllable capital employed

or
Return on Investment = Operating profit/Net assets

• The return on investment is a similar ratio to the ROCE. It is commonly used

when assessing the managerial performance of an individual department or
responsibility centre when profit and capital employed (net assets) can be
controlled by the manager in charge.
• ROI is a relative measure (expressed in %)
• Residual income (RI)
•
 Residual Income = Controllable profit − Imputed interest on capital employed
or
Residual income = operating profit − (net assets × imputed interest rate)

• A manager has exceeded the profit level required to satisfy the investors if
residual income is positive. Residual income is an absolute measure
(expressed in $).
Application of RI and ROI

Example

A division currently earns an ROI of 25%.

It is considering investing in a project with a RI of $2,000 at an imputed interest charge of 25%.

What is the project’s effect on the division’s ROI if undertaken?

Substitution - ROI

Start by substituting some simple numbers into the information given. For example, if the division
currently earns an ROI (operating profit over net assets) of 25%, this could be represented by an
operating profit of $25,000 and net assets of $100,000.

ROI = 25,000/100,000 × 100% = 25%

Substitution - RI

A residual income of $2,000 could be represented by an operating profit of $14,000 less an imputed
interest charge of $48,000 × 25%.

Residual income is calculated as follows:

RI = operating profit − (net assets × imputed interest charge)

RI = $14,000 − ($48,000 × 25%) = $(14,000 − 12,000) = $2,000

New ROI

Calculate the new ROI using the following:

• existing net asset and operating profit information; and

• the new net asset and operating profit information.

Existing operating profit = $25,000

 Example

Existing net assets = $100,000

New operating profit = (existing operating profit + project operating profit = $25,000 + $14,000 = $39,000

New net assets = existing net assets + project net assets = $100,000 + $48,000 = $148,000

New ROI = 39,000/148,000 × 100% = 26.4% = an increase in ROI (up from 25%).

Activity RI Versus ROI

The following information is available on a company’s two departments:

Department 1 Department 2

$000 $000

Capital employed 1,000 100

Profits Year 1 200 20

Year 2 220 40

Target ROI = 20%

Determine which department is performing better using the following:

(a) Residual income; and

(b) Return on investment.

*Please use the notes feature in the toolbar to help formulate your answer.

(a) Residual income

Department 1 Department 2

$000 $000

Year 1

Profit 200 20
 Less capital charge 200 (20% × 1,000) 20 (20% × 100)

Residual income 0 0

Year 2

Profit 220 40

Less capital charge 200 (20% × 1,000) 20 (20% × 100)

Residual income 20 20

(b) Return on Investment

Department 1 Department 2

$000 $000

Year 1 20% 200/1,000 20% 20/100

Year 2 22% 220/1,000 40% 40/100

It is easier for the larger division to generate an additional $20,000 residual income, so using
RI to compare departments/managers controlling different asset base sizes is misleading.

Therefore, ROI is the better performance indicator in this situation.

Activity 2: ROI and Decision-Making

The following information is available on a division and its possible investment in a project:

Division Project

$000 $000

Capital employed 1,000 100

Controllable profit 300 25

Target ROI 20%

Required

(a) Calculate ROI and RI for the division:

(i) Pre-project; and

(ii) Post-project.

(b) Explain whether or not the divisional manager would accept the project if they were
paid a bonus based on the following:

(i) ROI; and

(ii) RI.

*Please use the notes feature in the toolbar to help formulate your answer.

a)

ROI % RI ($000)

30% 100

(i) Pre-project 300/1,000 300 − (20% × 1,000)

29.5% 105

(ii) Post-project 325/1,100 325 − (20% × 1,100)

(b)

(i) ROI

Although the project ROI is acceptable to the company (as it is greater than 20%), the
manager would not be motivated to accept the project as it lowers divisional ROI.

(ii) RI

The manager would be motivated to accept the project. This decision would be congruent
with the goals of the company.

Advantages and Disadvantages of ROI

2.6.1 Advantages

• It is similar to the ROCE ratio, so it is widely known.

 • It uses operating profit/controllable profit and capital employed/net assets to
calculate the ratio – this information can be easily obtained from accounting
information.

• The ROI is a relative measure (percentage) and will provide meaningful comparisons
between different-sized divisions.

• ROI is a commonly used ratio, and so it can be used to make comparisons between
different organisations as well as different divisions within an organisation.

2.6.2 Disadvantages

• Identifying the controllable costs and revenues (which impact profit) in ROI
calculations can be challenging.

• The single results of ROI calculations are unlikely to be the 'full story' of how well
divisional managers have performed.

• ROI may lead to managers making decisions that will be best for their performance
measure rather than for the organisation as a whole. For example, managers may
reject projects that have a positive RI if they lower the manager's ROI.

• ROI values may give a false impression of being high when old non-current assets are
valued at their net book value.

Advantages And Disadvantages Of RI

2.7.1 Advantages

It uses operating profit/controllable profit and capital employed/net assets to calculate the
ratio – this information can be easily obtained from accounting information.

The RI is stated as an absolute value and can be useful when information about an actual
value rather than a relative value (such as ROI) is needed.

2.7.2 Disadvantages

• Identifying the controllable costs and revenues (which impact profit) in RI

calculations can be challenging.

• The single results of RI calculations are unlikely to be the 'full story' of how well
divisional managers have performed.

• The RI calculation requires an imputed interest charge which must be estimated.

Benchmarking
Benchmarking compares an organisation’s performance measures to the best in the
organisation’s industry (or to internal departments or divisions) or the best practices from
other companies in a different sector.

Comparisons can help improve performance, and this is important for benchmarking as the
information indicates an organisation’s strengths and weaknesses against its competition.

The process of external benchmarking involves an organisation identifying the best

companies in their industry or in another industry where similar processes exist. The
organisation then compares its results with those of other organisations. The benefit of this
process is that the organisation carrying out the benchmarking process learns how well the
other organisations are performing and what they are doing that makes them successful.

There are four main types of benchmarking.

With internal benchmarking, an organisation compares the performance of its

different divisions or departments.

This is more commonly used in larger organisations which have similar divisions or
departments operating within them.

For example, a large multi-national organisation with offices in many countries

Internal might compare how its accounts receivable departments operate worldwide to help
benchmarking share best practices and promote efficiency.

With competitive benchmarking, organisations look to their industry's most

successful organisations to see how they compare with their competitors'
performances and make changes where improvement can be achieved.

For example, an organisation may wish to improve the performance of its accounts
Competitive receivable department by comparing its processes to those of the organisation in its
benchmarking industry with the best-run accounts receivable department.

With functional benchmarking, an organisation will compare its processes’

performance with a top-performing organisation in another industry which
performs a similar function.

For example, a credit card company would be a good industry for an organisation to
Functional
look to when it is aiming to improve the performance of its accounts receivables
benchmarking
department. This is because credit card companies collect monies that are owed to
 them on a large scale, the same function performed by an organisation’s accounts
receivable department.

Strategic benchmarking compares performance measures like an organisation's

Strategic market share in its industry and its profitability ratios with other organisations to
benchmarking improve its strategic or long-term plans.

Benchmarking enables organisations to learn more about how best-performing divisions

within themselves or the organisations within their industry operate. An organisation can
improve its performance with this information (where it is available).

Benchmarking exercises are carried out by following the benchmarking process.

1. Select the activity to be benchmarked

Where the organisation appears to be underperforming in a particular activity, it may select

this activity as an area to be benchmarked. An organisation identifies areas of poor
performance by comparing its performance measures with those of the following:

• Other departments or divisions within its organisation

• Other organisations within its industry

• Other organisations in different industries.

2. Carry out the benchmarking process.

Obtain detailed information by looking at the following:

• Publically available information

• Observation

• By arranging with other organisations to interview their employees.

3. Identify improvements

The organisation may look to see how improvements can be made, which may include:

• Identifying whether new processes could be developed to improve performance

• Reviewing methods used by other organisations to see whether methods employed

by them could lead to improvements.

4. Act on improving performance

Once organisations have decided which activities they would like to improve upon and how
to bring about this improvement, they must make plans to bring about these improvements
and then act on them.

5. Monitor performance progress

Once a programme to improve performance has been set up, it should be monitored and
reviewed to identify how it is doing. If necessary, this process should be repeated if the
results planned have not been achieved.

Total Quality Management (TQM)

4.1.1 What is Total Quality Management?

Quality can be defined as the standard of something as measured against other things of a
similar kind.

Total quality management (TQM) is a management process that focuses on two main things:

• Getting it right the first time

• Continual improvement of products or services.

TQM’s elements are:

• Total – every part of the organisation is involved in the TQM process: employees,
customers and suppliers.

• Quality – products and services must be provided at the standard expected by the
customer to meet their needs. Quality does not mean perfection. It means meeting
the customer’s expectations and delivering a product or service that is fit for
purpose.

• Management – prevent faulty products from being produced or bad service from
being provided. This is achieved by managing the quality of an organisation’s
products and services.

TQM: Costs of Quality

Specific costs will be involved in producing products and services that meet quality
standards. These costs are known as the costs of quality.

There are four main groups of costs of quality:

 • Internal failure costs - these are the costs that are incurred when faulty products or
poor services are discovered while they are still in the organisation. They are usually
found by the quality assurance team.

o Cost of correcting faulty products or improving poor quality services

o Cost of scrapping poor-quality materials

o Production delays.

For example, at Winston’s Football Factory, footballs made that don’t meet production
standards must be scrapped or reworked, costing the company money.

• External failure costs - these are the costs that are incurred when faulty products or
poor services are discovered after they have left the organisation. They are usually
found by the customer.

o Cost of repairing defective products

o Cost of replacing defective products and poor services

o Loss of customer goodwill.

For example, at Winston’s Football Factory, dissatisfied customers may return poor-quality
footballs or claim a warranty repair. As a result, there might also be a sales decline due to a
reputation for poor quality.

• Prevention costs - these are the costs that arise because an organisation is trying to
prevent producing faulty products and providing poor services.

Examples of prevention costs

o Product design improvements

o Maintenance of quality control equipment

o Wages of quality control staff

o Training of quality control staff

For example, at Winston’s Football Factory, a quality assurance process in monitoring

materials and the manufacturing process is implemented. This costs money and time, as
machines need to be calibrated, employees need to be trained, materials need to be
sourced and inspected, etc.

• Appraisal costs - these are the costs that arise because an organisation is appraising
or assessing the quality of its goods or services.

o Inspection costs of materials received from suppliers

 o Inspection costs of finished goods

o Costs of appraising the services provided to customers.

For example, at Winston’s Football Factory, footballs are subjected to a series of quality tests
and may only be sold to the customer after passing.

4.2.1 Expenses of using TQM

In organisations using TQM, the prevention and appraisal costs will be higher than in
organisations not using TQM. This is because these types of cost increase as more money is
spent on preventing faults and assessing the quality of goods and services.

In organisations using TQM, the internal and external failure costs will be lower than those
not using TQM. This is because organisations using TQM will provide fewer faulty goods and
better quality services.

If using a TQM cost management system is to be beneficial, the costs of quality (prevention
and appraisal costs) should be less than the costs of failure (internal failure and external
failure costs).

Application of TQM

• Change of work culture from the pursuit of the minimum cost to that of satisfying
customers.

• Understanding that poor quality costs money.

• Total involvement of all employees in the pursuit of quality.

• Pursuing continuous improvement and accepting that it is a never-ending process.

• Use benchmarking and other quality tools to understand the true costs of activities
and the value they generate.

• Cost Reduction
•
• Cost control identifies areas where costs are higher than expected (for
example, higher than budget) and aims to bring them back in line with
expectations.
• Cost reduction aims to reduce the unit cost of a product to one that is below
the standard cost by looking at ways in which individual cost elements of a
product can be reduced.
• Cost reduction should be carried out through a planned cost reduction
programme. Cost reduction programmes should be ongoing processes that
continually look for areas where there may be opportunities to reduce costs.
 • Ideally, costs would be minimised and ‘designed out’ of a product or process
at the product or process design stage, and unnecessary costs would be
avoided.
• In reality, inefficiencies and higher-than-necessary costs can become
established within organisations. Eventually, a cost reduction programme may
be introduced. But, unfortunately, some cost reduction programmes are
rushed and relatively unplanned, mainly when there is pressure to cut costs
straightaway.
• Such arbitrary programmes can result in an immediate reduction in costs,
although the steps taken may not be in the organisation’s long-term interests.
For example, the programme may lead to employee redundancies, resulting
in the inability to meet orders due to insufficient staff.
• The main differences between cost reduction and cost control are
summarised in the table below.

Cost reduction Cost control

Broad focus: aims to reduce the unit cost of Narrower focus: focuses on costs that are
producing and delivering a product or service higher than expected

Rather than accepting standards and budgets, Uses standards and budgets as a way of
cost reduction programmes challenge them planning and controlling costs

Attempts to achieve genuine savings in the Involves a comparison of actual costs with the
cost of production, distributing, selling and standard or budget, and an investigation of
administration variances
• Cost reduction may involve work study techniques, which consist of
observing and analysing current working methods and looking for efficiency
improvements. How the people and departments are organised may also be
reviewed to establish whether a more efficient way of working is possible.
Areas for Cost Reduction

5.2.1 Materials

The cost of materials could be reduced by:

• Reducing wastage levels (one way of achieving this is to buy higher quality materials
which are easier to work with)

• Seeking to purchase materials from different suppliers whose prices are lower

• Purchasing materials in bulk to take advantage of quantity discounts which may be

available

• Investigating the use of substitute materials that are cheaper to buy that will do the
same job (and are of the same quality).
5.2.2 Labour

If the employees work more productively, they will produce more output for the same
wages, reducing the labour cost per product unit.

Labour productivity can be increased by:

• Introducing incentive schemes to encourage workers to work more efficiently and to

produce more output

• Regular maintenance of machinery to reduce idle (non-productive) hours that

employees are paid for whether they can work or not.

5.2.3 Machinery

If machinery works more efficiently, it will enable the organisation to produce more output
during the same operating hours, reducing the overheads per unit associated with running
the machinery.

Regular maintenance can improve machinery efficiency to ensure it runs at its most efficient
level.

5.2.4 Production Overheads

Variable and fixed production overheads are often based on labour hours or machine hours.
Therefore, improving labour and machine efficiency will affect the overheads charged to a
product unit.

5.2.5 Non-Production Overheads

Non-production overheads include administration and finance costs, for example. One way
an organisation can look to reduce finance costs is to make sure that it is paying the lowest
interest rate for any finance (bank loan or overdraft) that it might have.

Activity 3

The following table shows the resources involved in making one football at Winston’s
Football Factory:

Standard cost per football Units Cost per kg ($) Cost per unit ($)

Direct materials – Plastic F 1 kg $3 3.00

Direct labour 2 Hours $6 12.00

 Variable overheads 2 Hours $1 2.00

Fixed overheads 2 Hours $2 4.00

Total cost per football 21.00

Winston’s Football Factory is planning a cost reduction programme to look into possible
areas where costs might be reduced without any reduction in the quality of each football.

The following options have been identified:

• A replacement material to Plastic F called Plastic L, which has identical properties but
only costs $2.50 per kg

The material composition of Plastic L is slightly different to that of Plastic F. Even though it is
of the same quality, the difference in its composition means there is less wastage, so the
standard usage of Plastic L would be 0.9 kg per football.

Plastic L is slightly easier to work with, saving five minutes in labour time for each football
manufactured.

• Plans are being made to introduce a bonus scheme, and results have shown that
productivity will increase, resulting in a saving of ten minutes per football produced.

The quality of the footballs will be unchanged, and the standard selling price will remain at
$35 per football.

Calculate the revised cost card and standard profit per football if the suggested options are
implemented (using the absorption costing template below)

Standard cost per football $ per unit

Direct materials – Plastic L

Direct labour

Variable overheads

Fixed overheads

Total cost per football

 Selling price

Revised standard profit

*Please use the notes feature in the toolbar to help formulate your answer.

Standard cost per football $ per unit Note

Direct materials – Plastic L 2.25 1

Direct labour 10.50 2

Variable overheads 1.75 3

Fixed overheads 3.50 4

Total cost per football 18.00

Selling price 35.00

Revised standard profit 17.00 5

Notes:

[1] Plastic L = 0.9 kg × $2.50 = $2.25

[2] Direct labour = 1.75 Hours × $6 = $10.50

[3] Variable overheads = 1.75 Hours × $1 = $1.75

[4] Fixed overheads = 1.75 Hours × $2 = $3.50

[5] The revised standard profit per football (using absorption costing) is now $17

The cost reductions identified in the above activity have resulted in an increase in
profitability for Winston’s Football Factory. For example, if sales were 5,100 footballs during
a period, this could save $15,300 (5,100 × $3) in production costs and a corresponding
increase in profitability.

In the case of this example for Winston’s Football Factory, it is assumed that following the
cost reduction programme, the selling price remained constant at $35.
Another option would be to reduce the selling price to sell more footballs - for example, by
encouraging customers who previously favoured cheaper, lower quality footballs to purchase
a Winston’s Football Factory football.

For example, if the selling price were lowered to $33, the profit per football would still
increase (from the previous $14 per ball to $15). Therefore, It may be possible to sell more
footballs and increase the profit margin. This demonstrates the power of what may seem
relatively small cost reductions.

Value Analysis

Value analysis is a cost reduction method that looks at a product’s or service’s components
and considers how each one affects its unit cost. Value analysis also looks at how the design
of a product or service can be changed without affecting its value.

The main aims of value analysis are:

• To produce a product or cost at a given standard for the most economical cost

• To look closely at each product or service feature and ask how necessary each
feature is.

5.3.1 Types of Value

Four types of value are used when considering how necessary the features of a product or
service are.

Value type Description

The value of the product or service from the point of view of its use. The utility value is
Utility value also known as the use value.

The value of a product or service from the point of view of what it means to the
Esteem value customer (its prestige).

The value of a product or service from the point of view of how much it costs to
Cost value produce and sell.

Exchange
value The value of a product or service from the point of view of its market value.

Value Analysis Method Of Cost Reduction

Two assumptions are associated with the value analysis method of cost reduction:

• Consumers will have a standard of quality that they require for each product or
service, and organisations will work towards this required standard

• The organisation tries to achieve the desired objective for a product or service for the
lowest possible cost.

There are six main steps involved in carrying out a value analysis.

1. Select an item for value analysis

It is common for the product or service that incurs the highest costs (which therefore
represents the greatest possibility of saving costs) to be selected for value analysis.

2. Record information relating to the selected item

When recording the information that relates to the item chosen for value analysis, consider
the following questions:

• Does the product or service carry out its intended function?

• What are the costs associated with producing this product or service?

• Are there any alternative methods of making the product or service, and what are
the associated costs?

3. Analyse product/service information

Analysis of the product/service includes:

• How essential are all of the elements of the product/service?

• Can each individual cost element be purchased or manufactured at a lower cost?

• Are all of the features of the product/service necessary?

• Is it possible to substitute one of the items of cost for a cheaper alternative (of the
same quality and functionality)?

4. Consider alternatives

This stage considers the alternative ways of producing a product/delivering services that are
available to an organisation. It is a good idea to gather information about each alternative’s
cost at this stage.

5. Select the option that costs the least

Evaluate each of the alternatives available and consider their associated costs. Then select
the best option from those available.

6. Recommend the best option

Recommend the best option and begin planning the cost reduction programme.

Value Analysis and Activity-Based Costing

Value analysis reflects aspects of activity-based costing (ABC).

ABC measures activities’ cost and performance level, including how activities contribute to
the organisation’s success. ABC and value analysis aims to ensure that the things the
organisation does are necessary, are done well, and ‘add value’.