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Strategic Cost Management
By
Augustin AmaladasProf. Augustin Amaladas
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Strategic Management
Traditional Management accounting is based oncomparing actual results against pre setstandard (Typically budget), identifying and
analysing variances and taking remedial actionto ensure that future outcomes confirm withbudgeted outcomes.
Existing activities are not reviewed.
They are based on cost containment rather thancost reduction. But strategic management is focuses on cost
reduction and continuous improvement.
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Value analysis/value engineering
Aims at the assigned target cost byA)identifying improved product design
Eliminating unnecessary functions thatincreases product cost and for whichcustomers are not willing to pay for it.
Requires functional analysis
The value for each element is determined whichcustomer is willing to pay.
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Value analysis/value engineering
Cost of each function of a product iscompared with the benefits perceived by
the customers. If the cost of the function exceeds the
benefit to the customer, the function is
either eliminated, modified to reduce thecost or enhanced in terms of its perceivedvalue so that its value exceeds the cost.
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2.Business process reengineering
Examining business process and makingsubstantial changes
Redesign of how work done throughactivities.
Collection of activities that are linked
together in a coordinated manner toachieve a specific objective
Example: See next slide
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Material handling
Scheduling production
Storing material
Processing business orders
Inspectingmaterials
Paying suppliers
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Aims of reengineering
Improve the key business processes Simplification, cost reduction, improved
quality and enhanced customersatisfaction.
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Process
Sending production schedule direct to thenominated suppliers and ask the suppliers
to deliver according to the productionschedule.
Inspection done for quality in the
suppliers centre. Benefit: permanent reduction of storage
cost, handling cost, inspection cost
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Reengineering
Features: 1. radical and dramatic changesin the processes
2. Abandoning current practices andreinventing completely new methods ofperforming business processes.
3. Focus on major changes rather thanmarginal change.
4.It also involves adopting JIT system
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3.TQM
All business functions are involved in a process ofcontinuous quality improvement
Moved from statistical monitoring of manufacturingprocesses to customer oriented process of continuousimprovement
High quality but on time Earlier belief is that quality increases cost but it has
saved many companies because of quality.
Better to produce product at cheaper rate first ratherthan wasting resources by making substandard productand spending on rework, rejection, scraped or return tocustomers
How is it done?
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TQM
Management accounting can providereports and measures that motivate and
evaluate managerial efforts to improvequality
The reports are divided into 1.prevention cost 2.appraisal cost 3.Internal failure cost 4.external failure cost
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Cost of quality report
1.Prevention costs
Percentage of sales
Quality trainingSupplier reviews
Quality engineering
Preventivemaintenance
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Cost of quality report
2. Appraisal costs Inspection of materialreceived
Inspection of WIP andcompleted units
Testing equipment
Quality audits
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Cost of quality report
3. Internal failure cost Scrap
Rework
Down due to qualityproblems
retesting
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Cost of quality report
4. External failure costs Returns
Recalls
Warranty repairsHandling customercomplaints
Foregone contributionfrom lost sales
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How Zero defects policydetermined?
Do not use percentages as a unit ofmeasurement
Use parts per million (PPM) It creates pressure for action and trend in defectrates.
Quality reports are useful to top managementwhere as non financial quality measures providemore timely and appropriate target measure forquality improvement.
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Statistical tools
Quality control chart used to distinguishbetween random and non-randomvariations in operating processes. We useX+1SD: X+2SD
days
u
sage
Operation-A
_
X+1SD
_
X+2sd
Statistical quality control chart
_
X_X-1sd_
X-2d
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Control chart-explanations
The control limits are based on a series of pastobservations of a process when it is under control andworking efficiently.
The Past observations are used to estimate thepopulation mean and the population standard deviation. If control limits are say X+2sd , so that all observations
are outside the range are investigated.
X+/- 2sd covers 95.45% of the population therefore4.55% of future operations would result from purechance when process is under control.
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Problems
Page-958 views 22.2 in Drury
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4.Value chain analysis
Performance of one activity affects theperformance and cost of other activities.
It gives link performance of one and itseffects on the other.
There are interdependent exist between
activities and greater amount ofcoordination required
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5.Product life cycle costing
Traditional management accountingcontrol procedures have focused primarily
on the manufacturing stage of a productslife cycle.
Pre-manufacturing costs such as R&D,design, post manufacturing abandonment
and disposal costs are treated as periodcost .They are not incorporated in theproduct cost calculation.
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Product life cycle costing-continuation
Life cycle costing estimates andaccumulates costs over the entire product
life cycle so that the profit earned willcover the entire life cycle cost.
It helps management to understand the
cost consequence of developing andmaking a product and identify areas forcost reduction.
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Tradition vs life cycle reporting
Most of the reporting on a perodby-period basis
Profits are not monitored over the life ofthe product
LCR traces costs and revenues over
various calendar periods. Hurdles: tracing all costs inadequate feed back
information
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Product life cycle phases-relationshipbetween costs committed and costs incurred
Percenta
geofcostsand
committed
Product life cycle
Postsalesandservice
Andaban
donmentphas
e
20%
40%
60%
80%
100%
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Explanations
1.80% of the costs are committedduring the planning and designstage
2.Majority of costs are incurred atthe manufacturing stage but theyhave aready become locked in atthe planning and design stage anddifficult to alter.
3.The pattern of cost commitmentand incurrence will differ based onthe industry and specific productintroduced.
1.Cost management can be mosteffectively exercised duringplanning and design stage and notat the manufacturing stage.
2.Later stage more focus on costcontainment than costmanagement.
3. Aeroplanes manufacturing-highcosts at planning and developmentbut huge abandonment costs atnuclear waste and other toxicchemicals.
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problems
Advanced cost and managementAccounting-by Saxana and Vasist
Prob.16.48-P.16.59 Prob.16.49-P.16.61 Cost and management accounting by
Drury-prob.22.18-P979-981
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Activity Based Costing Historical development
Traditionally cost accountants had arbitrarily added abroad percentage of expenses onto the direct costs toallow for the indirect costs.
However as the percentages of indirect or overheadcosts had risen, this technique became increasingly
inaccurate because the indirect costs were not causedequally by all the products. For example, one productmight take more time in one expensive machine thananother product, but since the amount of direct laborand materials might be the same, the additional cost forthe use of the machine would not be recognised whenthe same broad 'on-cost' percentage is added to allproducts. Consequently, when multiple products sharecommon costs, there is a danger of one productsubsidizing another.
http://en.wikipedia.org/wiki/Accountanthttp://en.wikipedia.org/wiki/Direct_costhttp://en.wikipedia.org/wiki/Indirect_costhttp://en.wikipedia.org/wiki/Direct_costhttp://en.wikipedia.org/wiki/Indirect_costhttp://en.wikipedia.org/wiki/Overhead_costhttp://en.wikipedia.org/wiki/Overhead_costhttp://en.wikipedia.org/wiki/Overhead_costhttp://en.wikipedia.org/wiki/Overhead_costhttp://en.wikipedia.org/wiki/Overhead_costhttp://en.wikipedia.org/wiki/Indirect_costhttp://en.wikipedia.org/wiki/Direct_costhttp://en.wikipedia.org/wiki/Accountant -
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The 1970s and 1980s
The concepts of ABC were developed in themanufacturing sector of the United States duringthe 1970s and 1980s. During this time, theConsortium for Advanced Manufacturing-International, now known simply as CAM-I,provided a formative role for studying and
formalizing the principles that have becomemore formally known as Activity-BasedCosting.[1]
http://en.wikipedia.org/wiki/Manufacturing_sectorhttp://en.wikipedia.org/w/index.php?title=Consortium_for_Advanced_Manufacturing-International&action=edithttp://en.wikipedia.org/w/index.php?title=Consortium_for_Advanced_Manufacturing-International&action=edithttp://en.wikipedia.org/wiki/Activity-based_costinghttp://en.wikipedia.org/wiki/Activity-based_costinghttp://en.wikipedia.org/w/index.php?title=Consortium_for_Advanced_Manufacturing-International&action=edithttp://en.wikipedia.org/w/index.php?title=Consortium_for_Advanced_Manufacturing-International&action=edithttp://en.wikipedia.org/w/index.php?title=Consortium_for_Advanced_Manufacturing-International&action=edithttp://en.wikipedia.org/wiki/Manufacturing_sector -
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cost management systems
Robin Cooper and Robert Kaplan, proponent of theBalanced Scorecard, brought notice to these concepts ina number of articles published in Harvard BusinessReview
beginning in 1988. Cooper and Kaplan describedABC as an approach to solve the problems of traditionalcost management systems. These traditional costingsystems are often unable to determine accurately theactual costs ofproduction and of the costs of related
services. Consequently managers were making decisionsbased on inaccurate data especially where there aremultiple products.
http://en.wikipedia.org/wiki/Cost_managementhttp://en.wikipedia.org/wiki/Robin_Cooperhttp://en.wikipedia.org/wiki/Robert_Kaplanhttp://en.wikipedia.org/wiki/Balanced_Scorecardhttp://en.wikipedia.org/wiki/Cost_managementhttp://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/Cost_managementhttp://en.wikipedia.org/wiki/Balanced_Scorecardhttp://en.wikipedia.org/wiki/Robert_Kaplanhttp://en.wikipedia.org/wiki/Robin_Cooperhttp://en.wikipedia.org/wiki/Cost_management -
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Instead of using broad arbitrary percentages toallocate costs, ABC seeks to identify cause andeffect relationships to objectively assign costs.
Once costs of the activities have been identified,the cost of each activity is attributed to eachproduct to the extent that the product uses theactivity. In this way ABC often identifies areas of
high overhead costs per unit and so directsattention to finding ways to reduce the costs orto charge more for costly products.
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They initially focused on manufacturing industrywhere increasing technology and productivityimprovements have reduced the relativeproportion of the direct costs of labor andmaterials, but have increased relative proportionof indirect costs. For example, increased
automation has reduced labor, which is a directcost, but has increased depreciation, which is anindirect cost.
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Like manufacturing industries, financialinstitutions also have diverse products andcustomers which can cause cross-product cross-
customer subsidies. Since personnel expensesrepresent the largest single component of non-interest expense in financial institutions, thesecosts must also be attributed more accurately toproducts and customers. Activity based costing,
even though originally developed formanufacturing, may even be a more useful toolfor doing this
http://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Financial_institution -
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cost driver
Direct labor and materials are relatively easy to tracedirectly to products, but it is more difficult to directlyallocate indirect costs to products. Where products usecommon resources differently, some sort of weighting isneeded in the cost allocation process. The measure ofthe use of a shared activity by each of the products isknown as the cost driver. For example, the cost of theactivity of bank tellers can be ascribed to each product
by measuring how long each product's transactionstakes at the counter and then by measuring the numberof each type of transaction.
http://en.wikipedia.org/wiki/Cost_driverhttp://en.wikipedia.org/wiki/Cost_driverhttp://en.wikipedia.org/wiki/Cost_driverhttp://en.wikipedia.org/wiki/Cost_driver -
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Limitations
Even in activity-based costing, some overheadcosts are difficult to assign to products andcustomers, for example the chief executive's
salary. These costs are termed 'businesssustaining' and are not assigned to products andcustomers because there is no meaningfulmethod. This lump of unallocated overhead
costs must nevertheless be met by contributionsfrom each of the products, but it is not as largeas the overhead costs before ABC is employed.
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Although some may argue that costsuntraceable to activities should be
"arbitrarily allocated" to products, it isimportant to realize that the only purposeof ABC is to provide information tomanagement. Therefore, there is noreason to assign any cost in an arbitrarymanner.
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The Four Steps to ABCImplementation
1. Identify activitiesperform an in-depth analysis of the operating
processes of each responsibilitysegment. Each process may consist ofone or more activities required byoutputs.
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Assign resource costs toactivities
this is sometimes called "tracing." Traceability refers to tracingcosts to cost objects to determine why costs were incurred. DoDcategorizes costs in three ways:
Directcosts that can be traced directly to one output. Example: thematerial costs (varnish, wood, paint) to build a chair.
Indirectcosts that cannot be allocated to an individual output; inother words, they benefit two or more outputs, but not all outputs.Examples: maintenance costs for the saws that cut the wood, storagecosts, other construction materials, and quality assurance.)
General & Administrativecosts that cannot reasonably beassociated with any particular product or service produced
(overhead). These costs would remain the same no matter whatoutput the activity produced. Examples: salaries of personnel inpurchasing department, depreciation on equipment, and plantsecurity
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Identify outputsy
Identify all of the outputs for which anactivity segment performs activities and
consumes resources. Outputs can beproducts, services, or customers (personsor entities to whom a federal agency isrequired to provide goods or services
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Assign activity costs to outputs
1. activity costs to outputs using activitydrivers. Activity drivers assign activitycosts to outputs based on individualoutputs consumption or demand foractivities. For example, a driver may bethe number of times an activity is
performed (transaction driver) or thelength of time an activity is performed(duration driver).
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Activity-Based Costing encouragesmanagers to identify which activities are
value-addedthose that will bestaccomplish a mission, deliver a service, ormeet a customer demand. It improvesoperational efficiency and enhancesdecision-making through better, moremeaningful cost information
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6.Activity based costing/Targetcosting
Mechanism for determining selling prices. It is a cost management tool.
TATA tries to manufacture a car at Rs. 1,00,000. is a typical example for targetcosting.
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Stages of target costing
1. Determine the target price whichcustomers will be prepared to pay for theproduct
2.Deduct a target profit margin fro thetarget price to determine the target cost
3. Estimate the actual cost of the product 4.If estimated actual cost exceeds the
target cost , investigate ways of drivingdown the actual cost to the target cost
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Target costing-Continues
Customer oriented approach Used by Japanese copanies and recently
adopted by Europe and the USA.
Recently call canters are trying to adopt
this as Indian currency strengthened.
P d
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Procedures:
1.Market research to find the customersperceived value-tear down analysis-examining
the competitors products-dismantling of thecompetitor's product.use value engineering
2.How customers differentiate the product fromthe competitors
3.Target profit margin depends on planned returnon investment and fix % of profits on sales
4.Decomposed into a target profit for eachproduct.
5.Deduct the target profit from target price
6.Compare with the predicted actual cost.
7. If predicted cost>target cost then efforts are
made to close the gap.
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What is required?
Team approach Team members include: 1.designers 2.
engineers 3. Purchasing 4. manufacturing 5.
marketing 6. management accounting personnel The discipline of a team approach ensures that
no particular group is able to impose functionalpreferences.
Aim During product design process is thatelimination of product functions that add costswhich do not increase market price.
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Role of suppliers
Suppliers are included in the design team They can suggest standard
parts/alternative parts instead of custom-design parts which will reduce the productcost.
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If target costs not achieved ?
Product should not be launched Design teams should not be allowed to
achieve target cost by eliminatingdesirable product functions.
Design teams use tear-down analysis
Value engineering is to achieve the targetcost.
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Problems
1. Illustration of target costing-Management and cost accounting by Colin
Drury-page 948
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7. Kaizen costing
It is a mechanism for reducing and managing costs. Improvement to the process rather than applied during
design stage.
Cost reduction through the increased efficiency of theproduction process. To reduce the cost of components and the products by a
pre-specified amount
It is heavily on empowerment of employees Workers are given more responsibilities to improve the
processes and reduce costs.
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8.The balanced score card
The most recent contribution to strategicmanagement accounting
Integrated framework of performancemeasurement
Balanced score card analysis by Southwest
Airlines-Next page
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Balanced score card analysis bySouthwest by Kaplan and Norton
Balanced
score card
analysis
2.Customer
How do customer
See us?
3.Internal
What must we excel
At?
4.LearningCan we continue to
Improve and
Create value?
1.Financial
How do we look
To shareholders?
1 Fi i l
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1.Financialpotential score cardmeasures(Looking back)
Market shareRevenue growthOperating profitReturn on equity
Stock MarketPerformance
Growth in margin
Patient censesUnit profitability
Fund raisedFor capital
ImprovementCost per care% of revenue
-new program
Revenue/cost
Per available
Passenger mile
Mix of freightMix of full fare
To discounted
Average age
of fleet
Available seat
Miles and
related
yields
Outstanding
Loan balances
Deposit balances
Non interest income
Generic Health care Airlines Banking
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2.Customer serviceand satisfaction(Lookingfrom
the outside in)
Customersatisfaction
Customer retentionQuality customer
ServiceSales from new
Products/services
Patientsatisfactory
SurveyPatient retentionPatient referral
RateAdmission or disCharge timeliness
Medical planawareness
Lost bag report
Per 10000Passangers
Denied boarding
Rate
Flight cancellation
Rate
Customer complaIns.
Customer retention
No. of new
Customers
No.of products
Per customer
Face time spent
Between loan
Officers and
customersGeneric
Health careAirlines Banking
l
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3. Internal operatingefficiency(Inside out)
Delivery time costProcess qualityError rates on
ShipmentsSupplier
satisfaction
Weekly patientComplaints
Patient loadsBreakthroughs
In treatments andMedicines
Infection ratesRe-admission
Rate
Length of stay
Load factors
(% of seat occupied)
Utilisation factor
On time performance
Sales calls to
Potential
Customers
thank you calls
Cards to new
Customers
Cross selling
statistics
Generic Health care Airlines Banking
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4. Learning andGrowth(looking ahed)
Employee skill
LevelTraining availa
BilityEmployee
satisfactionJob retention
Over time worked
VacationTime taken
TraininghoursPer care giver
No. of peerviewed
Papers publishedNo.of grants
awardedReferring MDs
Employee turnover
rate
EmployeeAbsenteeism
Work safety statistics
Performance
Appraisals completed
Training programs
Hours per employee
Test results from
Training knowledge
Of product offering,
Sales, and service
Employee satis
Faction survey
Generic Health care Airlines Banking
S t Ai li B l d S d f k
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Soutern Airlines Balanced Scorecard frame workStrategic theme
Operating efficiency
Objectives
(achieve&critical to
success)
Measurement
How success aremeasured)
Target(rate
Ofimprovement
needed)
Initiative
(Key action)
Financial Profitability
Morecustomers
Fewer planes
Market value
Seat revenue
Plane least cost
30% CAGR
20% CAGR
5% CAGR
Customer Flight is ontime
Lowest prices
FAA on timearrival rating
Customerranking(Market)
1
1
Qualitymanagement
Customerloyaltyprogram
Internal
learning
Fast internal
Turnaround
Ground crewalignment
On ground time
On timedeparture
%ground crewtrained
% Ground crewstockholders
30 minutes
90%
Yr.1 70%
Yr.3 90%
Yr.5 100%
Cycle timeoptimisation
ESOP
Ground crew
training
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Benefits and limitations
1. single report but four differentperspective
2.Specific performance measure Operational measurements together Improves communications within
organisation
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Problems
Drury-27.17 page-1024 Drury-23.18 page 1025
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Activity Based costing
Learning objectives: Explain why a cost accumulation system is required for generating
relevant cost information for decision making;
Describe the differences between activity-based and traditional