Cost And Management Accounting

- Term Paper : Cost Leadership -

Under the guidance of Prof. Ramkesh Gupta

Submitted By Group 9

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 Group 9

Asha Nachi
(08PGP222)

Kritika Prabhakar
(08 PG 234)

Nitesh Kumar
(08 PG 246)

Raunaq Chawla
(08 PG 258)

Seshu Pinnamaneni
(08 PG 270)

Vijay Pal Singh

(08 PG 282)

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TA B L E OF CONTENTS

Introduction 5
Cost Leadership Strategy 6
TATA Steel 7
Key Data on the Steel industry 8
Cost Leadership At Reliance Industries 14

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 COST LEADERSHIP
Term Paper

Introduction
Economic recessions usually spark a renewed interest in rigorous, detailed and effective
cost management practices. Given the lack of orientation, preparation or temperament for a
recessionary period, the first response and reaction of most managers typically involves a "siege
mentality" that includes: protecting one's turf; battening down the hatches; slashing all general
ledger expense categories; and viewing the finance's department's role as a head-count "execu-
tioner."

In past recessions, companies such as Chrysler Corp., Johnson& Johnson and several
units of General Electric Co. have improved their profitability, productivity and performance
with the rigorous, systematic and efficient use of business process analysis, activity based cost-
ing and cycle time compression metrics, among other things. Accounting and finance execu-
tives in winning companies have built career lasting reputations for excellence by leading cost
leadership initiatives with the cooperation and support of their business partners.

Successful cost-leadership initiatives often involve more than a singular tool. Imagine
trying to complete a major home repair project with a limit of just one tool; it would be virtu-
ally impossible to do. The same is true for cost-leadership initiatives.

Surveys at a variety of companies in various industries have found that the overall repu-
tation of the finance and accounting function and leadership has improved materially in the
last two decades. Managers and leaders in product development, marketing, manufacturing,
logistics, distribution and other functions may be more open to what an accounting or finance
professionals can offer with a view toward supporting profitable business growth.

The time may be ripe to pursue aggressive, well-planned and sophisticated cost-
leadership initiatives. It is of paramount importance to lay a strong foundation for success by
considering many of the behavioral, measurement, cultural and communication issues in the
planning phase.

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 In his 1980 classic Competitive Strategy: Techniques for Analyzing Industries and
Competitors, Porter simplifies the scheme by reducing it down to the three best strategies.
They are cost leadership, differentiation, and market segmentation(or focus). Market segmen-
tation is narrow in scope while both cost leadership relatively broad in market scope.

Cost Leadership Strategy

This strategy emphasizes efficiency. By producing high volumes of standardized prod-
ucts, the firm hopes to take advantage of economies of scale and experience curve effects. The
product is often a basic no frills product that is produced at a relatively low cost and made
available to a very large customer base. Maintaining this strategy requires a continuous search
for cost reductions in all aspects of the business. The associated distribution strategy is to ob-
tain the most extensive distribution possible. Promotional strategy often involves trying to
make a virtue out of low cost product features.

To be successful, this strategy usually requires a considerable market share advantage or

preferential access to raw materials, components, labour, or some other important input.
Without one or more of these advantages, the strategy can easily be mimicked by competitors.
Successful implementation also benefits from:

1. process engineering skills

2. products designed for ease of manufacture

3. sustained access to inexpensive capital

4. close supervision of labour

5. tight cost control

6. incentives based on quantitative targets.

A firm attempts to maintain a low cost base by controlling production costs, increasing
their capacity utilization, controlling material supply or product distribution and minimizing
other costs including R&D and advertising. Mass production, mass distribution, economies of
scale, technology, product design, learning curve benefit, work force dedicated for low cost
production, reduced sales force, less spending on marketing will further help a firm to maintain
low cost base. Decision makers in a cost leadership firm will be compelled to closely scrutinize
the cost efficiency of the processes of thefirm. Maintaining the low cost base will become the
primary determinant of the cost leadership strategy. For low cost leadership to be effective a
firm should have a large market share. New entrants or firms with a smaller market share may
not benefit from such strategy since mass production, mass distribution and economies of
scale will not make an impact on such firms. Low cost leadership becomes a viable strategy
only for larger firms. Market leaders may strengthen their positioning by advantages attained

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through scale and experience in a low cost leadership strategy. To illustrate this we are looking
at the steel sector and specifically at TATA Steel as the cost leader.

TATA Steel
Tata Steel, India’s largest steel company and the world’s sixth-largest by capacity is the
cost leader in the steel manufacturing sector. Tata Steel owns raw material assets such as coal
and limestone mines through joint ventures or completely, with the assets spread across coun-
tries such as Australia, Oman and Mozambique. Tata Steel and state-owned SAIL have largely
been able to withstand raw material price fluctuations due to captive iron ore mines. Tata Steel
is also one of the least cost markers of steel in the world. Other private steel companies, hit by
steep iron ore and coal prices, have passed on the hikes to the customers, prompting the gov-
ernment to clamp down on price increases to control inflation.

Tata Steel, which bought out global major Corus last year doubled its profits based on
the acquisition. TATA Steel and Corus together sell more than two-thirds of their production
in Europe. The consolidated full year net profit for Tata Steel stood at Rs 12,321.76 crore, com-
pared to Rs 4,165.61 crore, due to contribution from Corus businesses. The consolidated reve-
nue for the full year totaled Rs 1,32,110.09 crore, compared to Rs 25,650.45 crore last year.
Anglo-Dutch steel maker Corus was acquired in January last year for $13 billion.

In 2006 TATA Steel used to produce 6.4 million metric tonnes of steel and was ranked
45th in the world by capacity. In 2007 post acquisition of Corus its capacity became 26.5 mil-
lion metric tonnes and was ranked 6th in the world. Sail is ranked 19th in the list. The other
companies preceding TATA Steel are Arcelor Mittal, Nippon Steel, JFE, POSCO and Bao
Steel. However, while most other companied are facing the challenge of low margins, TATA
Steel has remained positive because of the cost leadership it maintains. In the iron and steel
industry, the prices are determined by the market and hence all that a producer can do is cut
down on its costs ti sustain its margins.

Surprisingly, China happens to be the highest producer and consumer of Iron and steel
in Asia. It has been illustrated in the pie chart below. This presents TATA Steel with a sea of
opportunities as the highest consumer of Steel in the world is its neighbor.

The key factors that work for TATA Steel are as follows

1. Management is confident of passing on to customers the impending raw material cost in-
creases.

2. Continuous improvement programs at Corus to result in savings/benefits of GBP 300 mn

in FY08. In comparison the FY09 savings/benefits is USD 350 mn.

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3. Regards the total acquisition synergy benefits of USD 450 mn, a run rate of 30% (USD 135
mn) has already been achieved.

Key Data on the Steel industry

India is among the least cost producers of Steel and it is reflected in the graph below:

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Cost of raw material in India is much cheaper when compared to other countries; specially
China. As we can see in the figure below, India is among the cheapest countries to source steel.

India also has the cheapest labour costs for a company. Although, brazil and south africa
have cheaper raw material cost, they have a higher labour cost to compensate. TATA Steel has
access to one of the cheap-
est labour markets and
hence is in a very strong
position in minimizing its
cost of production. How-
ever, it must be noted that
Indian labourers are not
the most efficient of la-
bourers. They are much
below the world average
when it comes to efficiency.

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As the Industry data suggests, Indian workers are not the most efficient among workers. TATA
Steel in comparison pays a heavy
sum when compared to its com-
petitors. However, with the ac-
quisition of Corus, it is bound
to improve as corus has one of
the most efficient workforces.
Japanese Nippon Steel and Ko-
rean POSCO rule the roost
when it comes to productivity.

If only TATA Steel can

improve upon employee pro-
ductivity, it can further cut its
costs to a certain extent. It must
however be noted that labour
cost accounts to only to 7-8 %
of TATA Steel’s revenues and
hence may not hold too much
of relevance as yet. But as the
times goes, it is bound to be an

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issue and must be checked immediately. The data on cost as a percentage of revenues is given
below.

Furthermore, TATA Steel also has a high return on investment and capital employed which is
furnished below:

Although it has been declining, it is expected since the world steel prices have taken a beating
since the economic crisis came into the picture.

As we can see in the graph below, India has the competitive advantage in labour beating all
countries including China.

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 According to TATA Steel estimates, it’s operating margins will still remain close to 20%
despite the global slowdown. The EBITDA of 17% for both 2009-10 indicates why it pays to
be the cost leader. The balance sheets of both Nippon Steel and POSCO would indicate that

they have cut production to brace for the coming recession. However, the standalone data of
TATA Steel during the period has shown an increase of 20%. (source: TATA, Nippon, POSCO
annual reports)

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Another important factor adding to the operating expenses of the company includes transpor-
tation and freight charges. Since TATA Steel has to source its raw materials from many points
such as Australia and Africa, freight becomes a major component of of its cost. Also, It has
production facilities in multiple locations and sourcing becomes a important concern. It has
been observed that these have been on the rise yet have been volatile. To neutralize this effect
superior cost control in the areas where it possible is highly important. While on one hand,
there are uncontrollable costs, it is the controllable costs that the company must aim to cut
back on. In this area, TATA Steel has been highly successful.

Organizing to implement a cost leadership strategy requires particular consideration to

the organizational structure, management controls, compensation policies, and implementing
cost leadership strategies. The organizational arrangements and implementation tools should
not only fit but reinforce the strategy. Porter (1980) has divided requirements of overall cost
leadership strategy into “commonly required skills and resources” and “Common organiza-
tional requirements”. Commonly required skills and resources when implementing overall cost
leadership are sustained capital investment and access to capital, process engineering skills, in-
tense supervision of labor, products designed for ease in manufacture, and low-cost distribu-
tion systems. Common organizational requirements constitute of tight cost control, frequent,
detailed control reports, structured organization and responsibilities, and incentives based on
meeting strict quantitative targets. According to Barney & Hesterley (2006), few layers in the
reporting structure, simple reporting relationships, small corporate staff, and focus on narrow
range of business functions are elements of organizational structure that allow firms to “realize
the full potential of cost leadership strategies”. Management control systems that support the
implementation of cost leadership include tight cost control systems, quantitative cost goals,
close supervision of labor, raw materials, inventory, and other costs, and a cost leadership phi-
losophy. Examples of good compensation policies are rewards for cost reduction and incentives
for all employees to be involved in cost reductions.

With the example of TATA Steel, we can see how a cost leadership strategy can serve a
company in good stead. As we see companies like Nippon steel are crumbling under the weight
of their size and are taking cover trying to improve their margins by cutting down staff and so
on. On the other hand a strict cost control program has resulted in good returns to TATA even
in recessionary periods.

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Cost Leadership At Reliance Industries
In the 2005 Annual General Meeting it has been stated that Reliance has become a
global leader in various business activities based on innovation and cost leadership (Reliance
Industries Limited, 2007). Reliance today enjoys a 7 % global market share in the textile poly-
ester business. India, China and South East Asia have nearly 80% of global textile polyester
capacity, along with presence in downstream textiles. Reliance commissioned a 730,000 tonnes
per year PTA plant at Hazira. This makes Reliance the fourth largest producer of PTA in the
world.

Low costs are achieved in two ways: (blacksacademy, n.d)

1. More efficient production arising from experience: Reliance has been in this industry since
1977 and thus the experience lead them to find more efficient methods of production. The
Polyester manufacturing is a complicated/technical process thus Reliance have a competi-
tive advantage as the experience advantage will be greater and difficult to capture in short
term.

2. Economies of scale: Reliance is the Global leader and thus due to high demand and produc-
tion lead the company to have efficient size of plant, management structure and so forth.
Reliance being a Global player have enough sales to justify investing in additional capacity
to capture economies of scale.Reliance will also have a cost advantage because competitors
may not be able to match the scale because of capital requirements (barrier to entry) as the
firm works in many countries and across the international borders.

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3. Through innovation in production methods, leading to new techniques of production or
better organization of production: Reliance always believed in innovation and introduced
many new methods into the Indian Industry of Polyester.

4. Plentiful source of low cost labor: Reliance has its manufacturing units and head Office in
India which helped the company to have a plenty of raw material and skilled labour at low-
est cost.

5. Differential Low-Cost Access to Productive Inputs: Reliance has been founded by Dhiru
Bhai Ambani which gave the firm cost advantage over the others because he introduced/
pioneered the new Polyester manufacturing in India

The benefits of low cost strategy are:

1. The Cost leadership helps the Reliance to survive in the price war against its competitors.

2. Supernormal profits generated from increase in market share and demand helps Reliance
Group to reinvest some funds into their internal business activities to improve quality and
continue cutting costs.

ATCind

ATCff

P D

Above Normal
Economic
Returns or Super
Normal Profits
Q

Risks associated with low cost strategy are:

1. Over-emphasis on costs makes Reliance Group inward looking, production orientated and
poorly focused on customer needs.

2. There can only be one lowest cost producer in the industry.

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3. Gains to be made through learning- i.e. through more efficient production are usually
minimal and the most efficient scale of the plant can be copied. That is "many routes to a
low cost position can be easily copied."

4. If Reliance’s competitors have other profitable products, then being a lowest cost producer
is not enough to survive the price war: competitors can cover their fixed cost with profit
from the other lines and price close to what the variable cots are.

Due to above risks as mentioned we would recommend the company to not fully de-
pend on cost leadership. Reliance should invest ion R&D to keep innovating its product and
offer variety to customers.

Polyester Margin environment

(http://www.ril.com/rportal1/DownloadLibUploads/1210924385906_AR0708R.pdf)

Cotton, the second largest fibre in demand, is witnessing a firm trend in prices. Falling
stocks accompanied by declining acreage has increased prices of cotton by more than 26% in
the previous year. Global quest for bio-fuels is impacting the agriculture economies world-
wide. In February 2008, cotton futures for May 2009 went up to as high as 97 cents per pound
($ 2,138/ tonne) showing signs of firm undertone. This is one of the highest levels in the last
decade.

The United States, the world’s third largest cotton producer, has seen a 28% fall in acre-
age under cotton production for current season (2007-08) and is likely to see a further drop in
the years to come. Most of the farmers have shifted to planting of corn and soybean, due to
robust demand from the bio-fuel industry. Due to rapid additions in polyester capacity in
China, there has been over-supply since 2000. Low margins in the last few years have reduced
incremental growth in polyester capacities in countries like China. From an incremental capac-
ity of 2 million tonnes over incremental demand in 2004, currently incremental demand is
more than the annual new capacity creation.

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 Polyester consumption is growing faster than that of any other fibre. There are large
pockets of population that have low consumption like the Indian sub-continent and Africa.
While the global per capita demand for all fibre stands at 11 Kgs, with China at 16 Kgs and the
US at 38 Kgs, India is still at less than 5 Kgs and Africa is at less than 4 Kgs. These regions con-
tribute to nearly half of the world’s population and are witnessing increase in disposable in-
come with overall economic prosperity. Historically it is seen that rising per capita income and
industrialization increase textile consumption for both apparel and non-apparel applications.
Due to inherent constraints in growth of cotton, polyester is likely to capture the maximum
share of future growth.

The Domestic Scenario

Currency appreciation has been of major concern for textile exporters in India. Last
year, the Indian Rupee has appreciated against US dollar by 7.7%. Textile exports being a highly
competitive business, is adversely affected by an appreciating rupee. The Indian Government
reduced the import duty on polyester from 10% to 7.5% and again to 5% mid year in Novem-
ber 2007. The Government, in an effort to give a fillip to investments in downstream textile
industry has extended Textile Up-gradation Fund in the 11th Five Year Plan. Benefits of this
fund have been extended to technical textiles, which is an under-penetrated segment for indus-
trial and household polyester applications. With a growing presence in domestic textile growth
segments like non-woven, industrial and automotive yarns, Reliance is well positioned to in-
crease its polyester market share over other Indian manufacturers.

Domestic Demand
Polyester witnessed exciting demand growth in the domestic market at 17% over the
previous year. POY demand grew by 18% whereas PSF demand grew by 12%. The increased
demand for polyester was driven by robust investments in textile sector and PET consuming
industries during the previous year.

Touching 28 touching lives. Transforming India. Indian PET bottle resin market grew by
26% and is expected to sustain the growth rate due to a wider scope of increased penetration
in carbonated soft drink, mineral water, fruit juice, and healthcare and agro-chemicals seg-
ments. Reliance, with a share of 55% in PET market, is the largest player in the country. Pro-
duction volumes of the Polyester (PFY, PSF and PET) including Trevira and Recron Malaysia,
increased by 16.6% to 1,910 KT. Production from the new domestic polyester facility has been
placed successfully in the market. The Company has maintained its focus on specialty products
which account for 54% and 38% of PSF and PFY production respectively. Reliance’s domestic
market share is now in excess of 49%.

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New Product Initiatives
1. Copol & Copol blended fabrics.

2. Polyester / Wool / Bamboo blended fabrics with inherent antimicrobial, anti-odor and UV
protection properties.

3. Wool / Soya blended fabrics with having similar moisture absorption capabilities as cotton.

4. Durable moisture management in 100% polyester sports wear fabrics.

5. Fire-retardant and water proof tent fabric, providing additional safety from fire hazards.

6. Water and oil repellant fabrics made from eco-friendly recycled polyester.

With continuous improvements and extensive backward integration, Reliance stands out as the
cost leader in its industry. However, it is important for both TATA Steel and Reliance Indus-
tries LTD. to look at sustaining its cost leadership over the years to come. With effective in-
volvement of cost control, there is further scope for cutting down on costs and remaining the
undisputed cost leader in its segment. Considering the present recessionary phase all over the
world, Cost leadership will stand out as the single biggest recipe for success.

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B I BLI O G RA P H Y
Author Last Name, First Name. “Book Title or Ref-
erence Title.” City: Publisher, Date.

Webster, Williams. CPA. Accounting for Managers, Mc

Graw Hill, 2005

Porter,. E. Michael. Competitive Strategy, Free Press, 1980

Grant,.M. Robert. Contemporary Strategy Analysis, Black-

well publishing, (wiley), Fifth Edition, 2007

Homgren, Charles. Datar, Srikanth. Foster, George. Cost

Accounting. Pearson Prentice Hall, 2005

Website URLs:

www.allbusiness.com

www.tatasteel.com

www.posco.com

www.nsc.co.jp

www.worldsteel.org

www.ril.com

www.sriconsulting.com

Annual reports:

Annual Reports- TATA Corus

Annual report- Nippon Steel

Annual report- Arcelor Mittal

Annual report- POSCO

Annual report- Reliance Industries

Reports:

India Equity research, Metals and Mining, By Edelweiss

November 2008

Cost Leaders in the New World, Steel Consult International

Report on the Polyester Industry: Blacks Academy

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