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5 steps of internal cost analysis

Internal Cost Analysis : Organisations use the value chain approach to identify sources of profitability and to understand the cost of their internal processes or activities. The principal steps of internal cost analysis are :

1. Identify the firm’s value-creating processes : To identify a firms value-creating processes, the firm must de-emphasise its functional structure. Most large businesses still organise themselves as cost, revenue, profit and investment centres. These and other organisational sub-units, such as departments, functions, divisions or separate companies, that are frequently used for control purposes are not very useful for identifying value-creating processes. Adopting a process perspective requires a horizontal view of the organisation, beginning with product inputs and ending with outputs and customers. Processes are structured and measured sets of activities designed to produce a specified output for a particular customer or market. Emphasising process means focusing not on what work is done but on how work is done within the organisation.

2. Determine the portion of the total cost of the product or service attributable to each value creating process : The next step is to trace or assign costs and assets to each value creating process identified. Although firms maintain internal reports and cost accounting information, this information may not align with their processes. Companies might have to reclassify their data or conduct cost studies to assign costs and assets to each process. However, instead of a detailed cost study, rough estimates to assign costs to their value creating
processes may be useful. A full-cost approach provides the best estimate of life-cycle costs for evaluating the strategic cost advantage of a firm’s value-creating process. 

3. Identify the cost drivers for each process : The next step of internal cost analysis is to identify the factor or cost determinants for each value-creating process. By understanding what factors drive costs, a firm can assign priorities among its cost improvement initiatives. In order to determine its relative cost advantage, a firm should also know the cost factors of its competitors.

4. Identify the links between processes : While individual value activities are considered separate and discrete, they are not necessarily independent. Most activities within a value chain are interdependent. Firms must not overlook value chain linkages among interdependent activities that may impact their total cost.

5. Evaluate the opportunities for achieving relative cost advantage : In many organisations, cost reductions are made across the board (e.g., “eliminate 10 per cent from every department”). Because these firms do not reduce their costs strategically, this effort usually fails. More often than not, across-the-board cost reduction misconstrues the underlying problem. The point is not to become more efficient at insignificant activities, but to better meet customer demands.

Using the value chain approach, a company goes beyond simple across-the-board cuts and attempts to lower cost and improve efficiency within each value-creating process. For instance, a company might negotiate lower costs of process inputs such as wages or purchases, or evaluate make-or-buy options.
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