Cost Control and Cost Reduction
UNIT 1: Cost Control and Cost Reduction: Meaning of cost control and cost reduction, areas covered by cost control and cost reduction – product design, target costing, value analysis, value engineering, value chain analysis, Business Process Re- Engineering (theory only) Pareto Chart.
UNIT 1:
COST CONTROL AND COST REDUCTION
Definition
Cost management
cost management is used “to describe the approaches and activities of managers in the short term and long term planning and control decisions that increase value for customers and lower costs of products and services.
" According to Hansen and Moven, “Cost management identifies, collects, measures, classifies and reports information that is useful to managers in costing (determining what something costs), planning, controlling and decision making.”
It may thus be said that cost management is the practical application and use of cost accounting methods and techniques by the management to improve business performance.
Advantages
The following are the advantages of cost management:
1. Cost management helps in cost based strategic planning. It provides critical information that manager needs to develop and implement successful strategies.
2. Cost management helps in improving factoral productivity and profit margin.
3. Cost management ensures that planning and control of costs are directly linked with revenues and profit planning.
4. Cost management methods and practices are used to help the firm in gaining success.
5. It improves understanding of processes and activities. The same cost may be analysed in different ways to study its relationship with the activity. This helps in more effective planning.
COST CONTROL AND COST REDUCTION
COST CONTROL
Cost control is the utilisation of the available resources economically and prevention of the wastage within the existing environment. It is the function of keeping costs within the prescribed limits.
CIMA, London has defined cost control as, “the regulation by executive action of the cost of operating an undertaking particularly where action is guided by cost accounting”.
COST REDUCTION
Cost reduction is often confused with cost control. Cost reduction is much wider in scope and consists of effecting savings in cost by continuous research for improvement in products, methods, procedures and organisational practices.
Cost reduction is defined by C.I.M.A. London as “the achievement of real and permanent reduction in the unit cost of goods manufactured or services rendered without impairing their suitability for use intended.”
This definition reveals the following characteristics of cost reduction:
(i) Cost reduction must be real – say, through increase in productivity, change in product design, improvement in technology, etc.
(ii) Cost reduction must be permanent — temporary reductions in cost due to windfalls, change in tax rates, changes in market prices, etc., do not come in the purview of cost reduction.
(iii) Cost reduction must not impair the suitability of products or services for the intended use.
The cost reduction is, therefore, the term used for planned and positive approach to the improvement of efficiency. It can be viewed in many ways, such as increasing productivity, elimination of waste, improvement in product design, better technology and techniques, incentive schemes, new layouts and better methods, etc.
Cost Control and Cost Reduction — Comparison
Cost control and cost reduction are two effective tools of cost management to improve efficiency. Cost control and cost reduction are two separate phases of cost improvement. Cost reduction begins where cost control ends.
The main points of difference between the two are as follows:
1. Cost control is the achievement of pre-determined targets of costs whereas Cost reduction is the achievement of the real and permanent reduction in costs.
2. Cost control tends to assume a static state of affairs and that standards once set are not challenged. whereas Cost reduction assumes the existence of concealed potential savings in the standards or predetermined costs set for cost control and that these standards are always subject to challenge.
3. Cost control is concerned with predetermining costs, comparing it with actual costs, analyzing the variances and taking corrective action whereas Cost reduction is not concerned with maintenance of performance according to predetermined targets. It is rather concerned with finding out new product designs, methods, etc.
4. Cost control is a preventive function as it aims to prevent the costs from exceeding the predetermined targets whereas Cost reduction is a corrective function because it challenges the predetermined targets and seeks to improve performance by correcting the targets.
5. Cost control is a part of cost accounting function whereas Cost reduction may be achieved even when no cost accounting system is in operation.
6. Cost control lacks dynamic approach to cost improvement whereas Cost reduction is a more dynamic approach to cost improvement and elimination of waste.
Areas of Cost Reduction
The scope of cost reduction is so wide . Wherever costs are incurred, there is scope for their reduction
in the following areas, scope of cost reduction is the largest :
1. Product design. The design of the product provides the greatest scope for cost reduction. Improvement in product design may result in cost reduction as illustrated below :
- (i) Material cost—Change in design of the product may result in saving in material cost. Economical substitution for existing material may also be considered. For example, in manufacturing kitchen utensils, brass may be substituted by cheaper alloys. In curtain rings, metal may be substituted by plastic.
- (ii) Labour cost— Improvement in design may result in reduced operating time.
- (iii) Factory overhead—Reduced operating time not only helps in saving in labour cost but also in factory overhead.
- (iv) Packing and transportation—Compact design of a product results in reduced cost of packing and transportation.
- (v) Cost of tools, jigs and fixtures can be reduced through design improvement
2. Organisation. Cost reduction may also be achieved by improving factory organisation in the form of clear-cut lines of authority and responsibility, well-defined channels of communications, coordination and co-operation between various executives, etc.
3. Production. A cost reduction programme should make a study of sequence of operations to find out the best one, to use the most suitable machines for the work, to use jigs and fixtures to reduce operating time, to reduce idle time, to reduce scrap by the use of better quality tools, to provide better working conditions conductive to efficiency, etc.
4. Administration- Items under this head include savings effected by modifying the range of cash discounts to customers, introducing mechanical and electronic aids to office routine, modifying internal and external communication system, etc.
5. Marketing-In this function, costs can be reduced by revising the methods of remuneration of salesmen, re-arrange territorial responsibilities of sales representatives, modifying current methods of advertising, improving product design and production quality so as to reduce after sales service, economising channels of distribution, improving packing, etc.
6. Finance-A cost reduction programme should aim at securing capital at economical cost, employing capital to give maximum return and eliminating over and under capitalisation and wasteful use of capital, etc.
Value Analysis
Value analysis is a scientific approach to cost reduction. It aims at cost reduction by increasing the value in a product. cost reduction may be effected in two ways :
(a) Cost reduction by economising expenditure and increasing productivity, and
(b) Cost reduction by improving the use value and esteem value of products.
Use value refers to those qualities and characteristics which make a product useful and esteem value refers to those properties which make it attractive and create in it an aesthetic value.
Value analysis attempts to reduce cost by operating on the latter method.
Value analysis may thus be described as a systematic analysis and evaluation of the techniques and functions in the various spheres of an organisation with a view to exploring channels of performance improvement, so that the value in the product or service may be bettered.
TARGET COSTING
Target costing is a method of determining the cost of a product or service on the basis of competitive price prevailing in the market.
In this technique, it is the market price that determines the cost of a product and not the cost that determines the selling price. In simple words, in cost-plus pricing, it is the cost that determines the selling price. But in target costing, it the selling price that determines the cost.
Definition of Target Cost and Target Costing
A target cost is the maximum amount of cost that can be incurred on a product and with it the firm can still earn the required profit margin from that product at a particular selling price.
According to CIMA Terminology ‘a target cost is a product cost estimate derived by subtracting a desired profit margin from a competitive market price.’
Thus: Target cost = Competitive market price – Required profit
Target costing is defined as ‘a cost management tool for determining and realizing a total cost at which a proposed product with specified functionality must be produced to generate the desired profitability at its anticipated selling price in the future.’
For example, if a manufacturer has target a profit of ` 25,000 on a new product by producing and selling 50,000 units at a price of ` 4 per unit,
Sales 50,000 units @ Rs.4 2,00,000
Desired profit 25,000
Target cost 1,75,000
The target cost is determined by working form the market price of product to the cost that will allow a company to earn a target profit. Thus target costing is a system where a company determines in advance the cost of the product and the profit margin it wants to achieve.
Process of Target Costing
There are a number of steps in the process of target costing. They are:
1. Define the product, i.e., analyse the product and its functions, identify the customers, study competitive position, etc.
2. Establish a selling price for the product and estimated sales volume from an analysis of the market, and a target profit.
3. Set the target price and cost, i.e. set the price that a customer will pay and what should be the target cost by subtracting the profit from the target selling price.
4. Determine the estimated cost for the product.
5. Compare estimate with target.
6. If estimated cost exceeds target cost, repeat cost analysis/value engineering to reduce estimated cost.
7. Make the final decision whether or not to introduce the product once cost estimate is on target.
8. Maintain competitive cost i.e., not only to achieve the target cost but to stay ahead of competitors by using cost reduction methodology on a continuous basis.
VALUE ENGINEERING AND VALUE ANALYSIS
Value Engineering is a systematic method of improving the ‘value’ in new products and services to be launched. Value engineering is carried out at new product design stage or engineering of the product. It is applied during product development.
It is defined as ‘a systematic and organized approach to provide the necessary functions in a product at the lowest cost’. It promotes the substitution of materials and methods with less expensive alternatives, without sacrificing functionality so that more functions are performed at a lower cost.
Value Analysis is concerned with existing products. In other words, value analysis pertains to products which are already in sale as against value engineering which applies to new products. Value analysis process is used to offer a higher performing product or service to the customer at a minimal cost by substituting an existing product which offers inferior solution.
Value Analysis is defined as ‘a process of systematic review that is applied to existing product designs in order to compare the function of the product required by a customer to meet their requirements at the lowest cost consistent with the specified performance and reliability needed.’
Value Analysis Vs. Value Engineering
Value analysis refers to the analysis of an existing product or service while value engineering refers to the same analysis applied to the products or services that are under design and have not been finalised. In other words, value engineering is an early stage process and value analysis is done after the birth of the product i.e. an existing product.
The following points add to the understanding of value analysis and value engineering:
(i) The value analysis and value engineering attempt to increase value in products to customers by reducing cost of materials, components, labour, etc and improving product functions.
(ii) By reducing costs, the revenue and profit from products increase.
(iii) Value analysis enables a business to take commercial advantage of falling prices, if any, of certain materials, components, technologies, etc. This further helps to reduce costs.
(iv) Value analysis helps to make improvements in the product in a variety of ways, such as product design, material selection, manufacturing process, assembly, transportation, aftersales customer service, etc.
(v) With product improvement, the brand value of the product increases. This results in increase in esteem value, thereby making ownership of the product more desirable.
(vi) The customer are prepared to pay higher price for prestigious and branded products. This further adds to the company profitability.
(vii) By making a better product as a result of value analysis and other manufacturing techniques, the company gets a competitive advantage.
VALUE CHAIN ANALYSIS
Meaning and Definition of Value Chain
The value chain is a full range of activities which a business has to go through to bring a product or service from the stage of conception to the stage of delivery. In other words, a value chain is the whole series of activities that create and build value at every step. The total value delivered by the company is the sum total of the value built up all throughout the company.
CIMA London defines value chain as ‘a sequence of activities by which, in the perspective of end-user, value is added to (or costs incurred by) the products or services produced by an entity.’ These activities include designing the product, producing the product, marketing the product and then distribution of the same.
If you add features in the product in other steps of the value chain which are better than competitors, you may create a product which is highly superior to the competitors. The profit margin of the final product is linked directly to the value chain. The more value that is added to the product, the more profit for the company is earned.
Steps in Value Chain Analysis
There are three steps in value chain analysis :
1. Split business activities into two categories: primary activities and support activities
2. Allocate costs to each activity
3. Identify the activities critical to customer satisfaction and market success. :
Primary Activities and Support Activities
Michael Porter defines the value chain as made of primary activities and support activities.
Primary activities are those activities which directly affect the end product and support activities are those which help the primary functions.
Primary activities include the following:
1. Inbound logistics: This includes all those activities that are involved in receiving, storing and distributing the raw materials used in the production process.
2. Operations: This involves all such activities which are concerned with converting the raw material to the final product..
3. Outbound logistics: The distribution of goods produced to customers is carried out in the form of outbound logistics. This means once final product is ready, it is distributed to consumers.
4. Marketing and sales: This involves activities like advertising, promotions, organization sales-force, pricing of products, selecting suitable channels of distribution, customer relationships, etc.
5. Service: This refers to the activities that are needed to maintain the product’s performance after it has been produced and sold. After-sales services is important for maintaining goodwill.
Support activities comprise the following:
1. Procurement: It may appear similar to inbound logistics but the difference is that whereas inbound logistics relates to transportation, procurement deals with the whole process of buying raw materials, such as negotiating with suppliers for price and terms of delivery and managing the complete process of inbound logistics, etc.
2. Technology development: Technology can be used across the board in the development of a product.
3. Human resource management: It is concerned with getting the right people for the right jobs. It includes activities involved in hiring and retaining the proper employees to help design, build and market the product.
4. Firm infrastructure: This refers to an organization’s structure and its management, planning, accounting, finance, legal, IT, government and public relations and quality-control mechanisms.
BUSINESS PROCESS RE-ENGINEERING (BPR)
Business process re-engineering (BPR) is a new concept which is concerned with discovering how business processes currently operate, how to redesign these processes so as to eliminate the wasted or redundant effort and improve efficiency to gain competitiveness.
In other words, business process re-engineering is the analysis and redesign of workflows within and between enterprises in order to optimize end-to-end processes and do away with non-value-added tasks. BPR seeks to help companies radically restructure their organizations by focusing on the groundup design of their business processes.
In simple words, BPR is the practice of rethinking and redesigning the way work is done to better support an organization’s mission and reduce costs. A process is a structured, measured set of activities designed to produce a specified output.
According to Davenport ‘a business process is a set of logically related tasks performed to achieve a defined business outcome.’ Hammer and Champy have dened a process as ‘a collection of activities that takes one or more kinds of input and creates an output that is of value to the customer.’
Re-engineering is the fundamental rethinking and redesigning of business processes to achieve major improvements. Definition of BPR
Hammer and Champy have defined BPR as ‘the fundamental rethinking and radical redesign of business processes to achieve dramatic improvements in critical, contemporary measures of performance, such as cost, quality, service and speed.’
Illustration on BPR
A customer calls a company office to complaint why his order has not been executed so far. For this purpose the customer gives all details of placing the order, such as order number, date of ordering, product name and quantity ordered, etc. There comes the reply ‘your call is being transferred to accounts department to know the status of your order’. Then customer again explains his problem and details of his order to the accounting department.
The accounting department explains that the order has already been invoiced and your call is being transferred to logistic department so that you can know the status of execution of your order. Then the customer has to explain the entire situation again for the third time to the logistic department. The logistic office replies ‘ please hold the line for a while and will find out the position’.
After waiting for some time on the line, there comes the reply, ‘sir, your order execution is in the pipeline. It will be executed shortly. I am sorry for the delay in execution as the lineman was on leave for the last two days’. In this type of situation, the customer will definitely reconsider to place a repeat order with the same company.
In the above case, the emphasis is on department functions and each employee feels satisfied with his own work in the sense that he has discharged his responsibility. But the situation is awkward because there is a lack of sense of total responsibility leading to customer dissatisfaction.
Under BPR, the company will have to reorganize the processes under order processing team in such a way that the order processing is electronically recorded step by step and customer has to speak to only one person and know the status of his order. BPR suggests completely new processes to be implemented on the assumption that current business processes are inappropriate. Such a perspective enables complete redesigning of business processes.
The outcome of the BPR may include the following:
1. Employees are given more powers and decision making is made a part employees’ job.
2. Several jobs may be combined into one.
3. A single point of contact is provided to customers.
4. All tasks which do not add value are minimized.
5. Steps in the processes are performed in the natural order. 6. Work is performed where it makes most sense.
Pareto chart
A Pareto chart is a type of chart that contains both bars and a line graph, where individual values are represented in descending order by bars, and the cumulative total is represented by the line.
Auditing and Reporting Unit 1 click here
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