Cost management is key to business profitability

An understanding of cost behavior not only helps cost management as such but also supports strategic and tactical decision-making across the entire spectrum of business operations. Projects, processes and regular operations can all benefit from cost management, leading to overall business performance improvement.

Cost Analysis for Decision Support Information

When cost accounting started during the industrialization era, the emphasis was on finding the direct costs of making a product or providing a service to help in setting prices. Establishment costs such as rent and administrative expenses tended to be ignored and had to be recovered through the high margins in the selling prices.

Emphasis then turned to ascertaining the “full” cost of producing something. Complex and labor-intensive methods were developed to allocate costs that could not be identified to specific products in a multi-product environment. An idea of full costs can help in better price-setting in a seller’s market.

The increasingly competitive business environment required that cost behavior be analyzed in a way that can help business decisions in such areas as market-oriented pricing and alternative use of production resources. New approaches were developed to provide better decision support information. Cost accounting itself came to be known as management accounting to reflect the new emphasis.

Standard costing involved establishing standards for all cost elements and analyzing the specific reasons for actual costs deviating from these standards. The analysis helped pinpoint such specific performance factors such as:

Inefficient use of materials or equipment,
Higher than budgeted material prices or labor compensation, and
Lower productivity of operations causing an under-recovery of fixed overhead costs.

Activity based costing involved analyzing costs of all activities involved in operations, including such overhead activities as waiting for clear instructions or talking to customers on different issues. With a clear idea about the costs being incurred by different activities, it becomes easier to select areas for focused cost-reduction attempts.

Modern approaches such as lean, throughput and resource consumption accounting seek to identify all factors that affect cost and profit behavior and provide more sophisticated decision support information. In fact, lean accounting seeks to support the operational strategy of lean manufacturing, an approach where all tasks that do not contribute to customer value are sought to be eliminated.

The latest in these developments is the Resource Consumption Accounting, details of which are available at the RCA Website.

Cost Management Implications

Cost management involves using the cost analysis information in different areas such as project, inventory cost, operations, process and overall business performance management. Total cost management (TCM) is an approach to managing cost over the entire life cycle of an enterprise, project, program, facility, product or service. Cost management focus starts from project selection, planning and initiation stage. Costs are then managed through all stages till retirement through:

Cost estimating
Economic analysis
Cost engineering
Program/project management
Planning and scheduling
Monitoring cost and schedule performance and
Change control

Using costs for decision support becomes more meaningful when costs are viewed from different perspectives as outlined below:

Cost Elements: Material, Labor, Expenses
Functional Costs: Production, Selling, Distribution, Administrative, Financial, R&D, Product Development
Cost Identification: Direct costs identifiable with specific products etc, Indirect costs
Cost Variability: Costs that vary with level of operations, Fixed costs, Semi-fixed
Controllability: Controllable costs, Costs uncontrollable within specific time-frames
Cost Alerts: Normal costs, Abnormal costs

Cost management is a key business management function. An understanding of cost behavior can also support decision-making across the full range of business operations, from project selection through pricing, alternative use of resources to retirement of products at the end of their life cycles. New and highly sophisticated approaches are being developed to enhance the decision-support value of cost analysis.

How Budgets Steer Effective Management

The benefits of developing sound budgeting procedures for an entity are varied. The primary among these is that budgets are important tools that guide the firm against over expenditure. By having a budget an organization presents the method through which it can use the available resources prudently to achieve the projected performance.

How Budgets can be Used to Evaluate Responsibility

Budgets can also be used to assess the management’s ability to control a firm’s resources in achieving set goals. The success of a firm’s strategy is for instance determined by how well the actions to achieve the strategy are planned for. As noted in “A Guide for Managers to Assist in Informed Discussion” (Palmer, 2000) comparing outcomes of such actions to budgeted outcomes provides an important feedback to inform on the appropriate corrective action.

The importance of such comparison is heightened for organizations that are organized into responsibility centers. Organizing a firm into responsibility centers as noted in a journal article (Schoute, 2008), is essential for effective management of modern-day huge sized firms where a centralized management approach may not be beneficial. The responsibility centers may either comprise one or more of; cost, revenue, investment and profit responsibilities.

Comparing the results of each center to the budgeted amounts provides information on which an opinion to the leaders’ capacity to use the firm’s resources effectively is built. Such comparison is mainly through variance analysis. A variance in this respect denoting that amount with which the actual performance deviates from the budgeted values. By focusing on the differences between actual and budgeted values the management is able to pay close attention to deviations that show wide differences.

Variances can either be favorable or unfavorable. A negative figure, for instance, denotes adverse performance while a favorable performance is denoted by positive integers. Wide differences could however indicate unforeseen economic events or poor budgeting skills rather than management’s responsibility know-how. Thus, as the manager’s guide advises, punishing deviation may not be the best corrective action; but concentrating on the necessary actions rather than the reasons for the deviations would provide better outcomes.

How to Construct Effective Budgets

Only well constructed budgets provide credible information to base managerial decisions. In constructing a master budget for instance, the knowledge of association of its different components is essential. Calculation of different components of the operating budget such as sales, cost of goods sold and operating income also require astute knowledge of prevailing market rates and the unused capacity that the entity may employ.

The relationship between the operating budget, financial budget and capital expenditures budget in the master budget should also be determinable. Items such as projected cash sales and inventory purchases in the operating budget, should for instance, be reflected in the sources and applications of funds presented in the financial budget. With good forecasting skills the constructed budget can thus present a reasonable guide to effective use of the entity’s resources.