BBA I Semester Managerial Economics Cost Control & Cost Reduction Study Material Notes
Table of Contents
BBA I Semester Managerial Economics Cost Control & Cost Reduction Study Material Notes: Introduction Cost Control Aspects of Cost Control Advantages of Cost Control Main Areas of Cost Control Labour Material Advantages of Budgetary Control Limitation of Budgetary Control Statnard Costing Tools or Techniques of cost Control Advantages of Standard Costing Limitation of Standard Costing Cost Reduction Method Study Factors Hampering cost Control in India Exercise
MCom I Semester Accounts Holding Companies Study Material Notes
COST CONTROL AND COST REDUCTION INTRODUCTION
This chapter studies two important and related problems of cost control and cost reduction and cost estimation which are very important for the financial management of a firm.
COST CONTROL
Meaning
Business firms aim at producing the product at the minimum cost. It is necessary in order to achieve the goal of profit maximisation. Profit is the diference between selling price and cost of production. Generaly, selling price is not within the control of a firm but it can minimise the cost. In fact, the success of a business firm is judged in controlling its costs. Cost control by management means a search for better and more economical ways of completing each operation. Cost control is simply the prevention of waste within the existing environment.
It aims at reducing costs and increasing the profitability of the firm. This is done by reduction in specific expenses of the firm and making a better use of the money spent. If a firm is producing a certain quantity of product, it should ensure that it is produced at the minimum cost and gives more profit.
Management should follow three rules in cost control activities (i) It is easier to keep costs down than to bring costs down. (ii) The amount of effort put into cost control tends to increase when business is bad and decrease when business is good. (iii) Cost control is more profitable when business is good than when it is bad.
Aspects of Cost Control
Cost control involves the following steps and covers various aspects of management. It has to be brought in the following manner:
(i) Planning. Initially a plan or set of targets is established in the form of budgets, standards or estimates.
(ii) Communication. The next step is to communicate the plan to those whose responsibility is to implement the plan.
(iii) Motivation. After the plan is put into action, evaluation of the performance starts. Costs are ascertained and information about achievements is collected and reputed. The Cost Control and Cost Reduction – / 107 fact that the costs are being reported for evaluating performance acts as a prompting to
(IV) Appraisal. Comparison has to be made with the predetermined targets and actual performance. Deficiencies are noted and discussion is started to overcome deficiencies.
(v) Decision-making. Finally, the reported variances are received. Corrective actions and remedial measures are taken or the set of targets is revised, depending upon the administration’s understanding of the problem.
Advantages of Cost Control
Cost control has the following advantages:
(i) It helps the firm to improve its profitability and competitiveness.
(ii) In the absence of cost control, profits may be drastically reduced despite a large and increasing sales volume.
(iii) It is indispensable for achieving greater productivity.
(iv) Cost control may also help a firm in reducing its costs and thus reduce its prices. If the price of the product is stable and reasonable, it can maintain higher sales and thus employment of workforce.
MAIN AREAS OF COST CONTROL
Costs have been rising faster than ever before. The business executives have neglected the more important task of providing effective information to management for the control and reduction of costs. Waste is growing at an enormous rate. It has increased costs in each of the prime resources, namely material, labour, sales, etc. Cost control is essential in the following main areas:
(i) Labour
Labour costs have risen in three ways: (a) higher basic pay, (b) shorter working hours, and (c) reduced output.
Reducing labour costs is a little tricky question. It is not possible to reduce wage rates due to the existence of trade unions and minimum wage legislations. So to motivate the workers, wage rates would need to be revised upwards. The reduction in labour costs would be possible only if over time, the rate of output per worker increases faster than the wage rate increase. This is possible by raising labour productivity. This can be possible either by (i) producing more for the same cost, or (ii) producing the same for a lower cost. Productivity means labour cost reduction. This can be achieved by proper recruitment and training. rewards and punishment, reducing absenteeism and late coming of workers, improved method of production and working conditions, etc.
(ii) Material
The inefficient use of materials is one of the prime causes of increased costs. Wastage through poor control and design has risen much. Waste must be reduced if costs are to be controlled. There are different ways of reducing material cost. If purchasing of materials is done properly, the firm can get various types of discounts. A number of decisions are involved in the case of materials used by a firm. They are availability of cheap and better materials and even substitutes, buying in bulk, reduction in freight cost, etc. Since material costs form a major part of the total cost of production, control and reduction of material cost in these cases is of vital importance. R&D efforts, inventory management, improved production planning, elimination of slow moving stocks, and improved flow of parts and materials, etc. can be effective in controlling and reducing these costs.
(iii) Sales
Sales are another area of cost control. Sales control requires making sure that the company is not overspending to achieve its sales goals. In order to sell, a firm maintains a sales force and spends on an advertisement, etc. The key ratio to watch is advertisement expense to sales.
If the advertisement expenditure is more than the returns from sales, this expenditure will be a waste. Therefore, sales cost can be controlled by rearranging market segments on the basis of demand and plan its advertisement policy accordingly. Consumer choices should be ascertained and communicated to the management so that products are altered according to consumer needs.
(iv) Overheads
Overhead costs are fixed costs that remain the same at a given capacity. A proper selection of capacity, a right choice of equipment and its proper maintenance, reduction in power, fuel and lighting costs, reduction in transport costs by using trucks and wagons, reduction in advertisement costs, reduction in wastages, reduction in bad debts, etc. will control overheads and keep them down.
TOOLS (OR TECHNIQUES) OF COST CONTROL
Business firms use two tools of cost control.
Budgetary control and Standard costing
1 Budgetary Control
Every business firm prepares a budget for planning, coordination and control. It is an anticipated financial statement of revenue and used for a specified period. Thus budgetary control is a system which is used for planning and controlling the entire working of a Business.
According to Floyd H. Rowland and William. H. Barr, “Budgetary control is a tool of management used to plan, carry out and control the operation of business. It establishes objectives and provides the basis for measuring performance against these objectives.”
Budgetary control provides a yardstick against which actual results can be compared. It provides a planned approach for expenditure and financing of the activities of the firm. This results in economy in the utilisation of funds for the maximum benefit of the firm. Budgetary control improves the overall performance of the firm by directing, guiding and supervising its financial management.
The process of budgetary control begins by preparation of cost and revenue budgets hy each department such as sales, distribution, advertising, production, warehousing. sport, administrative, financial and accounts departments. Besides, a capital budget is prepared which contains estimated expenditure on plant, machinery, tools, etc.
After the departmental budgets, a master budget is prepared which covers all departmental budgets, profit and appropriation of profit and major financial ratios. The master budget shows anticipated profit and loss account and balance sheet of the firm for the year.
Fixed and flexible Budgets. For effective cost control a business firm may prepare a fixed or flexible budget.
A fixed budget is a short period budget. It is prepared for a specific output level when the possibilities of changes in the level of activity of the firm are the minimum.
A flexible budget is a variable budget. It provides a basis for determining costs at various levels of activity. It provides a flexible standard to a financial manager for comparing the costs of an actual volume of activity and not with the anticipated costs as given in the fixed budget. To prepare a flexible budget, items of anticipated expenditure are first classified into fixed and variable. The costs remain the same for all levels of activity in the fixed cost budget. But the costs for each item in the variable category are varied for different levels of activity.
Advantages of Budgetary Control
The following are the main advantages of budgetary control :
(i) Budgetary control integrates and brings together all activities of the firm right from planning to controlling.
(ii) Budgetary control provides a yardstick against which actual results can be compared
(iii) Budgetary control provides a clear definition of the objectives and policies of the concern.
(iv) Budgetary control is a useful tool in profit-planning.
(v) Budgetary control helps to eliminate or reduce unproductive activities and minimise waste.
(vi) Budgetary control acts as a basis for internal audit by providing a method for appraisal of performance.
Limitations of Budgetary Control
Budgetary control has several limitations:
(i) As budgets are based on future estimations, there are uncertainties of future.
(ii) The budgetary programme takes a long time to develop a reasonably good system of budgetary control.
(iii) Any deviation from budgeted figures is looked upon with contempt by the management. This contributes negatively to the firm’s objectives.
(iv) The effectiveness of the budget depends largely on the dedication and coordination of the top management which is often lacking.
(v) Budgetary control system requires a lot of paperwork which the technical personnel always resent.
(2) Standard Costing
Standard costing is one of the prominently used systems of cost control. It aims at establishing standards of performance and target costs which are to be achieved under a given set up working conditions. It is a pre-determined cost which determines what each product or service should cost under certain situation.
Standard costing is defined as the preparation and use of standard costs, their comparison with actual costs and the measurement and analysis of variances between actual and standard costs. Standard costs are calculated from efficient operations of the firm on the basis of technical and engineering factors. Cost standards may be set for direct materials, direct labour, overheads, marketing etc. It starts with an estimate of what a product should cost during a future period given reasonable efficiency. Standard costs are established by bringing together information collected from various sources within the firm. The degree of success is measured by a comparison of actual performance (cost) and standard performance (cost). For example, if the standard material input for a unit of production is Rs. 500 and the actual cost is Rs 475 then the variance of Rs. 25 is the measure of performance, which shows that the actual performance is an improvement over the standard. An adverse variance from standard cost may be due to excessive use of materials, higher prices of materials, higher wage rate, less output, more overhead expenditure, etc.
Standard costs are not rigid. They provide a yardstick against which actual costs are measured. Without standard costs, a company’s management has no way of knowing its overall performance. The standard costs are to be established by collecting all information pertaining to different cost functions. The main basis of setting standard costs are technical and engineering aspects.
This comparison of actual costs with standard cost will help in fixing responsibility for non-standard performance and will focus attention on areas in which cost improvement should be sought by showing the source of loss and inefficiency.
Advantages of Standard Costing
Standard costing has the following merits:
(i) It helps in establishing a yardstick with which the efficiency of performance is measured that helps in cost control.
(ii) It provides how the clear goal is to be achieved by providing incentive and motivation to work.
(iii) It provides the management the basic information to fix selling price, transfer pricing, etc.
(iv) It facilitates delegation of authority and fixation of responsibility.
(v) It helps in achieving optimum utilisation of plant capacity.
(vi) It provides means for cost reduction.
(vii) Variance analysis and reporting is helpful for taking corrective measures. Limitations of Standard Costing
This method has the following limitations:
(i) Application of standard costs is quite difficult in practice.
(ii) Standards become rigid over time and do not keep pace with changes in conditions.
(iii) If the standards are outdated, loose, inaccurate and unreliable, they are very harmful.
(iv) If standards set are higher than reasonable, they act as discouraging factor.
(V) Standard costing may be found to be unsuitable and costly in the case of dealing in non-standard products.
(vi) Setting the standard costing are highly technical and mechanical.
RATIO ANALYSIS
Ratio analysis is mainly used as an external standard, that is, for comparing performance with the other organisations in the industry. It can also be effectively used for comparing the performance of the firm over time. It is used for cost control. Ratio is a yardstick which provides a measure of relationship between the two figures compared. The ratio may be expressed in percentage terms as a proportion or as a rate.
In the ratio analysis, an acceptable ratio is determined first and then it is compared with actual performance and the corrective measures can be taken. The significant aspect in this analysis is that the management can take a greater interest in relative as opposed to absolute figures for cost control.
A particular ratio can be chosen depending on the need. It is possible to calculate different ratios relating to aspects like liquidity, profitability, capital structure, etc. But for a programme of cost control and cost reduction, one need to concentrate only on the operating cost ratios.
Ratio analysis is used as an instrument of cost control in two ways:
(1) Ratios can be used to compare the performance of a business firm between two periods. It helps to identify areas which need immediate attention.
(ii) Besides, standard ratios are used to compare actual areas. Standard ratios are averages of the results achieved by several firms in the same line of business.
If these comparisons reveal any significant differences, the firm can take suitable action to eliminate the causes responsible for increase in costs. Some of the most commonly used ratios for cost comparison are listed below:
(i) Net Profits/Sales
(ii) Gross Profits/ Sales
(iii) Net Profits/Total Assets
(iv) Sales/ Total Assets
(v) Production Costs/Cost of Sales
(vi) Selling Costs/Costs of Sales
(vii) Administration Cost / Cost of Sales
(viii) Sales/Inventory
(ir) Material Cost/ Production Costs
(x) Labour Cost/ Production Costs
(xi) Overheads/ Production Costs
It is possible to indicate trends in a firm’s performance overtime by plotting successive ratios on a graph for showing trends. The cause of this trend may be found by going down from top of the ratio pyramid towards bottom
OTHER TECHNIQUES OF COST CONTROL
There are two other techniques which are sometimes used by firms for cost control and reduction. These are : (i) Value Analysis (ii) Method Study
(i) Value Analysis
Value analysis is an important technique of cost reduction. It is defined as “the identification and elimination of unnecessary cost without reducing the quality, reliability, and aesthetic appeal of the product or service concerned”. The objectives of value analysis are:
(a) To analyze the value of the product and its components parts.
(b) To establish the cost of materials and production involved in creating the value.
(c) To determine whether the same or greater value can be created with a reduction in cost.
Value analysis is an approach to cost saving that deals with product design. Here, before buying any equipment or materials, a study is made as to what purpose these things serve? Would other lower-cost designs work as well? Is there a cheap material which can serve the same purpose? So value analysis is a procedure which specifies the function of products or components, establishes appropriate costs, determines the alternatives and evaluates them. It is a process which aims at having a most favourable product design, process design, material use and mix, etc. Thus the objective of value analysis is the identification of such costs in a product that do not in any manner contribute to its specification or functional value. Thus, it is the process of reducing the cost without sacrificing the predetermined standards of performance. It is a supplementry device in addition to the conventional cost reduction methods.
Value analysis is closely related to Value Engineering. It is very helpful in industries where production is done on a large scale and in such cases even a fraction of savings in cost per unit results in substantial savings. Some examples of savings through value analysis are:
(i) Discarding tailored products where standard components can do.
(ii) Dispensing of facilities not required by the customer.
(iii) Use of newly developed materials in place of traditional materials.
(iv) To examine the use of alternatives which are available at a lower price.
(ii) Method Study
Method Study is a systematic study of work data and critical evaluation of the existing and proposed ways of undertaking the work. This technique is known as work study and organisation and method. Work study helps to investigate all factors which enable the management to get the work done efficiently and economically. Its objectives are :
(i) The prime objective is to analyse all factors which affect the performance of a task,
(ii) to develop and install work methods which make optimum use of human and material resources available,
(iii) to establish suitable standards by which the performance of the work can be measured.
Method study aims at analysing and evaluating all those conditions which influence the performance of a task. It is the creative aspect of work study.
FACTORS HAMPERING COST CONTROL IN INDIA
The factors which cause difficulty in cost control in India are the following:
Cost of raw materials and other intermediate products is generally high.
(ii) High foreign commodity prices, particularly oil.
(iii) The effects of inflation and waste.
(iv) Management has little control on wage rates.
(V) Uneconomic size of the business firm.
(VI) Power shortages and underutilisation of capacity.
(vii) Tied credit and high cost of holding money.
(viii) Delays in the issue of licences and red tapism.
(ix) High rates of taxes and levies.
(x) Increase in administered prices.
(xi) Existence of unseen overheads.
COST REDUCTION
Cost reduction refers to bringing down the cost of production. This involves the examination of the purposes for which costs are incurred and by a variety of means. It eliminates or reduces the reasons for spending. The existing standards are closely examined at the broad and detailed levels with a view to improvement. Cost reduction is a continuing process of improving productivity within the organisation. Any cost reduction service must be based on a full knowledge of the organisation’s use of its resources. To achieve success in cost reduction, the management must be convinced of the need for cost reduction. It is a corrective function. It is concerned with the stoppage of unnecessary activity and curtailing of expenditure on non-essentials
Cost reduction is possible only when the firm makes the optimum utilisation of resources. It is possible by incorporating internal and external economies. This means that by economising the cost of manufacture, administration, selling and distribution, the average cost reduction may be achieved. Cost reduction is thus stated as the real and permanent reduction in unit cost of goods manufactured or services without affecting their quality..
Reduction in per unit cost of production can be achieved broadly in two ways:
(i) Reducing expenses, given the volume of output.
(ii) Increasing the volume of output through increased productivity, given the same level of expenditure.
Cost reduction is achieved only through a process of analytical appraisal of all aspects of using resources, carried out on a continuous basis from the moment the product is conceived to the moment the consumer uses it. This calls for specialist knowledge of a technical nature.
Cost Reduction Techniques
Techniques for reducing the cost are:
(1) Product Design. Product design influence all other functions and cost of materials, labour and overheads, etc. The manager can start cost reduction from the design stage. Research can also help in developing various designs and their cost analysis.
(2) Materials Handling and Control. Availability of cheaper substitutes, physical properties of materials, storage, loading and unloading problems, and inventory control problems.
(3) Labour. Increased productivity per man hour, reducting time of operations, etc.
(4) Tools and Equipment. Reduction in the cost of tools, jigs, fixtures and other equipment necessary to make the product on the basis of design.
(5) Sales and Distribution. Selling and distribution costs can be analysed in a variety of ways, depending upon the needs and desires of management. Cost reduction is possible in the areas of product, product lines, channels of distribution, terms of sales, and order sizes.
(6) Administration. Administration is a strategic area, which has cost-saving potetial. Therefore, a manager should make efforts for cutting down expenditures incidential to recruitment of staff, economising stationery cost, reducing travelling expenses, overtime, etc.
(7) Organisation and Methods. Organisation and Methods are defined as, “The systematic examination of activities in order to improve the effective use of human and other material resources”. It is concerned with improving the administrative work, the way it is organised and the way methods and procedures are used. Cost reduction benefits cannot be secured without a good plant layout and factory organisation. Cordial relations between the management and workers are also essential for the successful implementation of a cost reduction programme.
(8) Quality Control. The main role of quality control is to ensure that no defective products leave the company. This can be achieved by checking every one, by sampling, and by automated control.
Important Aspects of Cost Reduction Programme
Following are the important aspects of cost reduction programme:
(i) Cost reduction should cover the various centres, where costs are incurred.
(ii) It should seek the assistance of specialists from outside to plan the programme.
(iii) It should set targets and priorities.
(iv)It should improve the design and methods of production.
(v) It should review the progress made towards cost reduction from time to time.
(vi) It should motivate employees to achieve the target.
Essentials for the success of Cost Reduction Programme:
(a) Every individual within the factory should recognise his responsibility.
(b) Employee resistance to change should be minimised
(c) Cost reduction efforts should be continuously maintained.
(d) Efforts should be concentrated in the areas where the savings are likely to be the maximum.
(e) There should be routine business meetings with the employees to review the cost reduction programmes. Differences Between
Cost Control and Cost Reduction
Cost control and cost reduction are by-products of effective management. Every firm should devise and develop systematic methods of cost control and reduction. Cost control differs from cost reduction in the following ways:
1 Cost control is practiced by the management by assuming standard costs and attempting to keep the actual costs within these standard costs. This promotes the competitiveness of business firm domestically as well as internationally. Cost reduction begins, where cost control ends. It helps the firms to reduce prices, which is very important for a developing economy like India, where there are high costs, high rates of taxes, inefficiency and wastes in production.
2. Cost control is more dynamic in the sense that the standard costs set by the firm are constantly required for improvement. The management has to formulate a detailed and coordinated plan of cost reduction identify the areas of potential savings, fix responsibilities, etc. There is a need for close cooperation between the management and labour in this process. Cost reduction process should be reviewed periodically.
3. Cost control is accomplished by setting targets of performance and striving hard to achieve them by avoiding wastes and inefficiencies. Cost reduction does not concern itself with the maintenance of performance according to the targets set.
4. Cost control helps in achieving the management goals, whereas cost reduction has no such visible and ultimate goal. Cost control techniques aim at preventing costs from rising. When this goal is reached, costs become optimised under controlled conditions.
5. The emphasis in cost control is on past and present while in cost reduction, it is on present and future.
6. Cost control aims at the lowest possible costs under the prevailing conditions. Cost reduction aims at the lowest possible costs in every department of the business firm.
7. Cost control is a preventive measure where costs are optimised before they are incurred. Cost reduction is a corrective measure that operates even in cases where efficient cost control is taking place in a firm.
EXERCISES
1 What is meant by cost control ?
2. What are the advantages of cost control.
3. Differentiate between cost control and cost reduction.
4. Explain the main areas of cost control.
5. Explain the budgetary control system.
6.Explain standard costing as a technique of cost control.
7. Explain the ratio-analysis.
8. Explain the use of value analysis in cost control
9. Explain the use of method study in cost control.
10. Explain the factors hampering cost control in India.
11. What is meant by cost reduction?
12. Explain the various techniques of cost reduction.
13. What are the essentials of a cost reduction programme?
14. Give the main aspects of the cost reduction programme.
15. How cost control differs from cost reduction?
