Cost Control and Cost Reduction
- Pages: 14
- Word count: 3449
- Category: Economics
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A business enterprise must survive, grow, and prosper. Cost Control and Cost Reduction are activities necessary for ensuring that these objectives are fulfilled. With the liberalization of the Indian Economy and Globalization, there is now a cut throat competition from various concerns of the world. As a result there is now a race to secure a place for survival. This has increased the importance of cost control and Cost Reduction.
“Cost control is the regulation by executive action of the costs of operating an undertaking particularly where such action is guided by cost accounting.”
Cost Control is function, which makes sure that actual work is done to fulfill the original intention. It is a widely accepted notion that the actual costs for each cost element should be within the budget.
Cost control is thought of as a managerial effort to attain cost goals within a particular environment. Cost control is not a specific program. Rather, it is a routine activity to be frequently carried out. Cost must be controlled; otherwise, there will be wastage, misappropriation and embezzlement. Checking such wastage and misappropriation of resources is a continuous activity.
A firm exercising a better control last year does not mean that it has now been relaxed from the cost control function. Cost control relies heavily on accounting techniques. Some of the key cost control techniques are responsibility accounting control system, standard costing, budgetary control and cost management ratios. Therefore, cost control includes the routine management of the organizational activities, such as controlling of wastage, misappropriation, loss of work time, set up time etc.
The cost control definition suggests that a company should investigate good procedures for finding out the reason why the costs of the company are not as per the pre-decided or budgeted costs. Thus, cost control can help a company determine, if it is really spending more than it should actually spend. Though it is not essential to be a finance expert to understand the definition of cost control, planning and actually implementing the cost control techniques can be quite a big challenge. It is essential for the senior level managers to have a good understanding of the cost control software which is a part of effective cost control techniques.
Importance of Cost Control
i) It enables the firm to achieve its defined objectives.
ii) It leads to proper utilization of the firm’s resources
iii) It ensures the survival and growth of a firm by preserving its competitive capability iv) It makes sure that organization remains efficient.
“Cost Reduction is to be understood as the achievement of real and permanent reduction in the unit cost of goods manufacture or services rendered without impairing their suitability for the use intended”. Cost Reduction is a systematic effort to improve profit margins by eliminating all forms of waste and unnecessary expense without impairing the generation of revenues. Some commonly used synonyms for this activity are profit improvement, cost improvement, and methods improvement. But, regardless of the terminology used, the aim of cost reduction is to offset the impact of a squeeze on profits by getting the maximum return for every rupee of funds spent by the company.
Cost reduction, should therefore, not be confused with cost saving and cost control. Cost saving could be a temporary affair and may be at the cost of quality. Cost reduction implies the retention of essential characteristics and quality of the product and thus it must be confined to permanent and genuine savings in the costs of manufacture, administration, distribution and selling, brought about by elimination of wasteful and inessential elements form the design of the product and from the techniques and practices carried out in connection therewith.
In other words, the essential characteristics and techniques and quality of the products are retained through improved methods and techniques used and thereby a permanent reduction in the unit cost is achieved. The definition of cost reduction does not however include reduction in expenditure arising from reduction or similar govt. action or the effect of price agreements.
The three fold assumption involved in the definition of cost reduction may be summarized as under:-
1. There is saving in a cost unit
2. Such saving is of a permanent nature
3. The utility and quality of goods remain unaffected, if not improved
Importance of Cost Reduction
i) It leads to an improvement in the competitive capabilities of the company and thereby ensures its survival, growth, and prosperity ii) It ensures reasonable prices to customers by not passing on the inefficiency of the business itself.
Purpose for Cost Control and Cost Reduction
i) To create cash for reinvest in R&D
ii) To reduce manufacturing cost to stay competitive
iii) To lower cost of service in order to provide additional services iv) To become more efficient
Reasons for Cost Reduction
i) To increase company value
ii) To get competitive advantage
iii) To eliminate unnecessary expenses
iv) To reduce price of product or service
Difference between Cost Control and Cost Reduction
Tools and Techniques Used For Cost Control and Cost Reduction
Cost Control Techniques
1) Budgetary Control
2) Bench Marking
3) Target Costing
COST CONTROL TECHNIQUES
Budgetary Control is an establishment of budgets relating the responsibilities of a policy and the continuous comparison of actual with budgeted results either to secure by individual action the objective of that policy, or to provide a basis for its revision.
It is measuring the company’s performance against that of Best-In-Class companies determining how the Best-In-Class achieve those performance levels and using the information as a basis for the company’s targets, strategies and implementation.
Benchmarking is the process of comparing one’s business processes and performance metrics to industry bests and/or best practices from other industries. Dimensions typically measured are quality, time and cost. In the process of benchmarking, management identifies the best firms in their industry, or in another industry where similar processes exist, and compare the results and processes of those studied (the “targets”) to one’s own results and processes. In this way, they learn how well the targets perform and, more importantly, the business processes that explain why these firms are successful.
Target costing refers to the design of product, and the processes used to produce it, so that ultimately the product can be manufactured at a cost that will enable the firm to make profit when the product is sold at an estimated market-driven price. This estimated price is called target price.
Cost Reduction Techniques
1) Value Analysis and Value Engineering
2) Quality Control
3) Business Process Reengineering
4) Inventory Management
5) Kaizen Costing
6) Work Study Method
1. Value Analysis and Value Engineering
Value Analysis is an activity that typically occurs jointly between purchasing and method engineering. This activity is aimed at modifying the specifications of materials, parts, and products to reduce their costs while reducing their original function. Focus is placed on the value of the product. Value Analysis is also called as Value Engineering.
2. Quality Control
Quality Control refers to all those functions or activities that must be performed to fill the company’s Quality objectives. Quality Control aims at investigating the root cause for defects indentified by inspection and take corrective action to overcome the defects for future production. Quality Control helps to minimize the cost of Inspection and Rejection. Quality Control is an approach to prevent the defects rather than detecting the defects. The ultimate aim is to provide products which are dependable, Satisfactory, Economical.
3. Business Process Reengineering (BPR)
A fundamental re-thinking and radical re-design of business processes, to achieve dramatic improvement, in critical contemporary measures of performance such as cost, quality, service and speed to market.
Requirement of BPR Process
Fundamental Understanding of the process
Creative thinking to break away from old traditions and assumptions Effective use of Information Technology
Steps in BPR
1) State need for change
2) Identify process of reengineering
3) Evaluate enablers for reengineering (IT & HR)
4) Understanding the current process
5) Create a new process design
6) Implement the reengineered process
4. Inventory Management
Inventory Management involves administration, policies, and procedures to reduce in inventory cost. Inventory Management involves the development and administration of policies, systems and procedures which will minimize total costs relative to inventory decisions and related functions such as customer service requirements, production scheduling, purchasing and traffic.
5. Kaizen Costing
Kaizen costing is the process of cost reduction during the manufacturing phase of an existing product. The Japanese word ‘Kaizen’ refers to continual and gradual improvement through small activities, rather than large or radical improvement through innovation or large investment technology.
6. Work Study Method
Work Study is a systematic, objective and critical examination of the factors affecting productivity for the purpose of improvement. It uses techniques of method study and work measurement to ensure the best possible use of human and material resources in carrying out a specific activity.
The application of cost reduction & cost control method in the Aroma Soaps Pvt Ltd
The Aroma Company has an average production of 45,000 soaps per month. The company still purchases the raw materials with a rupee of .1 per ml for acid and special chemicals and .2 rupees per ml for perfumes. And the total cost for raw materials producing the units for a month will be 500000 rupees. The price for soap is 15 rupees in the market. But the company only gets less profit even if they have bulk production. So the Aroma Company needs to increase the profit rate without affecting any major problems.
And recently there is a new company arrived who produces the similar kind of products in the market. So there will be a tough competition in the market. If the Aroma Company wants to exist in the market, it’s necessary to maintain the quality of the product and to minimize the cost of production. So the Aroma Company can bring their products in the market with lower cost than the other companies.
So it’s necessary to apply the cost reduction and cost control techniques in the Aroma soaps pvt ltd to increase its profit.
So I can suggest two different ways to control and to reduce the costs in the Aroma Company to get a better results in the production and finally in the profit. And they are:
1. Inventory management
2. Target Costing
Let’s take a look how the inventory management can control and reduce the cost in the Aroma Company. Some of the most important techniques of inventory control systems that can be adopted in the company are:
1. Setting up of various stock levels.
To avoid over-stocking and under stocking of raw materials, the management of Aroma Pvt ltd has to decide about the maximum level, minimum level, re-order level, danger level and average level of raw materials that are to be kept in the store. This will help reduce the risk in production of soaps when they get a bulk order other than their actual production. (a) Re-ordering level:
It is also known as ‘ordering level’ or ‘ordering point’ or ‘ordering limit’. So in this point, the Aroma co has to re-order or purchase for the raw materials for the production. This level is fixed somewhere between the maximum level and the minimum level in such a way that the quantity of materials represented by the difference between the re-ordering level and the minimum level will be sufficient to meet the demands of production. So this will help the company to maintain a fixed amount of raw materials and help avoid the shortage of the raw materials for the production even if a bulk order gets for the company. (e) Danger Level:
Danger level is that level below which the stock should under no circumstances be allowed to fall. Danger level is slightly below the minimum level and therefore the purchases manager should make special efforts to acquire required materials and stores. In the Aroma Co they are keeping the raw materials in this type. They only purchase the raw materials after using all the exiting raw materials with them. So this will be a great problem for them to produce more and to minimize the cost. The rates of the acids and other chemicals are increasing day by day. So this will be a problem if they didn’t stock these items in an average level in the company. The Aroma Co needs to avoid this kind of zero stocking system and try to maintain an average stocking system. This will help to decrease the cost of the production. (f) Economic Order Quantity (E.O.Q.):
One of the most important problems faced by the purchasing department in the Aroma Co is how much to order at a time. Purchasing in large quantities involve lesser purchasing cost. But cost of carrying them tends to be higher. Likewise if purchases are made in smaller quantities, holding costs are lower while purchasing costs tend to be higher. Hence, the most economic buying quantity or the optimum quantity should be determined by the purchase department by considering the factors such as cost of ordering, holding or carrying. Through this process the company can analyze the cost reduction way to minimize the cost while purchase and handle of the raw materials which will help to reduce the cost of production.
2. Preparations of inventory budgets.
Organizations having huge material requirement normally prepare purchase budgets. The Aroma Co is such kind of organization, so they have to prepare the inventory budgets. The purchase budget should be prepared well in advance. The budget for production and consumable material and for capital and maintenance material should be separately prepared. Sales budget generally provide the basis for preparation of production plans. Therefore, the first step in the preparation of a purchase budget is the establishment of sales budget. As per the production plan, material schedule is prepared depending upon the amount and return contained in the plan.
To determine the net quantities to be procured, necessary adjustments for the stock already held is to be made. They are valued as standard rate or current market. In this way, material procurement budget can be prepared in the Aroma Co. The budget so prepared should be communicated to all departments concerned so that the actual purchase commitments can be regulated as per budgets. At periodical intervals actual are compared with the budgeted figures and reported to management which provides a suitable basis for controlling the purchase of materials.
3. Maintaining perpetual inventory system.
This is another technique to exercise control over inventory. It is also known as automatic inventory system. The basic objective of this system is to make available details about the quantity and value of stock of each item at all times. Thus, this system provides a rigid control over stock of materials as physical stock can be regularly verified with the stock records kept in the stores and the cost office of the Aroma Company.
4. Establishing proper purchase procedures.
A proper purchase procedure has to be established and adopted to ensure necessary inventory control in the Aroma Co. So the following steps are involved to establish this in the company (a) Purchase Requisition:
It is the requisition made by the storekeeper for their various raw material requirements. The initiation of purchase begins with the receipts of a purchase requisition by the purchase department. (b) Inviting Quotations:
The purchase department will invite quotations for supply of goods or raw materials on the receipt of purchase requisition. (c) Schedule of Quotations:
The schedule of quotations will be prepared by the purchase department on the basis of quotations received. (d) Approving the supplier:
The schedule of quotations is put before the purchase committee who selects the supplier by considering factors like price, quality of materials, terms of payment, delivery schedule etc. (e) Purchase Order:
It is the last step and the purchase order is prepared by the purchase department. It is a written authorization to the supplier to supply a specified quality and quantity of material at the specified time and place mentioned at the stipulated terms.
5. ABC analysis.
In order to exercise effective control over materials, A.B.C. (Always Better Control) method is of immense use. Under this method materials are classified into three categories in accordance with their respective values. Group ‘A’ constitutes costly items which may be only 10 to 20% of the total items but account for about 50% of the total value of the stores. A greater degree of control is exercised to preserve these items. Group ‘B’ consists of items which constitutes 20 to 30% of the store items and represent about 30% of the total value of stores. A reasonable degree of care may be taken in order to control these items. In the last category i.e. group ‘Q’ about 70 to 80% of the items is covered costing about 20% of the total value. This can be referred to as residuary category. A routine type of care may be taken in the case of third category. This method is also known as ‘stock control according to value method’, ‘selective value approach’ and ‘proportional parts value approach’. If this method is applied with care, it ensures considerable reduction in the storage expenses and it is also greatly helpful in preserving costly items in the Aroma Company.
The Aroma Company can also go through the Target costing method to reduce and control the costs in the company. The target costing includes different steps. So the company has to go through these steps to get the best results. The primary steps in the target costing process are:
1. Conduct research.
The first step is to review the marketplace in which the Aroma Company wants to sell products. The design team in the Aroma Co needs to determine the set of product features that customers are most likely to buy, and the amount they will pay for those features. The team must learn about the perceived value of individual features, in case they later need to determine what impact there will be on the product price if they drop one or more features. It may be necessary to later drop a product feature if the team decides that it cannot provide the feature while still meeting its target cost. At the end of this process, the team has a good idea of the target price at which it can sell the proposed product with a certain set of features, and how it must alter the price if it drops some features from the product. This is the way to fix a price to the soaps they are producing without losing the customers. 2. Calculate maximum cost.
The Aroma Company has to provide the design team with a mandated gross margin that the proposed product must earn. By subtracting the mandated gross margin from the projected product price, the team can easily determine the maximum target cost that the product must achieve before it can be allowed into production. 3. Engineer the product.
The engineers and procurement personnel on the team now take the leading role in creating the product. The procurement staff is particularly important if the product has a high proportion of purchased parts; they must determine component pricing based on the necessary quality, delivery, and quantity levels expected for the product. They may also be involved in outsourcing parts, if this results in lower costs. The engineers must design the product to meet the cost target, which will likely include a number of design iterations to see which combination of revised features and design considerations results in the lowest cost. 4. Ongoing activities.
Once a product design is finalized and approved by the engineers in the Aroma Co, the team is reconstituted to include fewer designers and more industrial engineers. The team now enters into a new phase of reducing production costs, which continues for the life of the product. For example, cost reductions may come from waste reductions in production (known as kaizen costing), or from planned supplier cost reductions. These ongoing cost reductions yield enough additional gross margins for the Aroma Company to further reduce the price of the product over time, in response to increases in the level of competition. These are the two different methods of the cost reduction and cost control techniques I can suggest to the Aroma Co that can be used to reduce and control the cost of the products which the company is producing.