Cost Redcution

Cost reduction may be defined as an achievement of real and permanent reduction in the unit cost of goods produced or services rendered without impairing their quality or functional suitability.

The above definition brings out the following as the essential features of cost reduction:

(i)                                     Cost reduction involves genuine savings in cost of production or providing services. This can be achieved either through research or eliminating wasteful expenditure. Cost reduction obtained as a result of lower material prices, price agreements, reduction in Government duties or taxes or windfall is not be taken as real and hence it cannot be termed as cost reduction.

(ii)                                  Cost reduction involves permanent reduction in the costs. Temporary reduction in cost is not taken as cost reduction.

(iii)                               Cost reduction should not affect the quality or utility of the goods or services. In other words, goods or services should continue to be suitable for the intended use even after cost reduction.

 

Features

1.                                      Unit cost is required to be reduced by reducing expenditure with respect to a given volume of output.

2.                                      Unit cost is attempted to be reduced by increasing production, i.e.. production per unit of input (e.g., material, labours hour, per employee). It implies enhancement in the rate of yield or output, expenditure remaining the same.

Cost Control Versus Cost Reduction

The term ‘Cost Control’ has been explained in chapter. Controlling the costs, already pre-determined on the basis of assumption of reasonable level of efficiency taking the past, present and future into account is the main focus of cost control. The actuals are tried to be brought within the ambit of targets. Cost accounting is primarily concerned with controlling the costs so that losses and wastages are eliminated or at least minimised to the extent possible. While cost reduction is entirely a matter which goes much beyond cost control and hence it is not synonymous with cost control at all, now cost accounting aims at cost reduction also, besides cost control. Cost reduction is a process which actually starts from where cost control ends. Management has to ponder over in terms of bringing down costs to levels lower than the targeted ones so as to face fierce competition and exist in this highly competitive business environment. How, without sacrificing quality or compromising with the utility of the products and services the cost can be permanently cut down, is the real objective of cost reduction. Thus, new ways

 

and means are required to be desired, researches are to be carried out and management has to be innovative.

The main distinctions between cost control and cost reduction can be discussed under various sub-headings as under, though both underline what costs ought to be :

 

Basis	Cost Control	Cost Reduction
1. Objectives	Cost control aims at maintaining the cost in accordance with the established targets or standards.	Cost Reduction is directed to explore the possibilities of improving the targets or standards themselves. It challenges all standards and makes continuous efforts to better them.
2. Approach	Cost control lacks dynamism since it aims to attain lowest possible costs under existing circumstances.	Cost reduction is a continuous process and recognises no conditions as permanent. It involves a continuous process of analysis and tries to find out new means to achieve reduction in costs.
3. Nature	Cost control is a preventive function. Under it, costs are optimised before they are incurred.	Cost reduction is a corrective function. It operates even when efficient cost control system exists. It pre-supposes  that there is always a room for reduction in the achieved costs.
4. Emphasis	In case of cost control, the emphasis is on the past. It aims at keeping the  costs within the limits already set. In case the costs reach the target level, the objective of cost control is achieved.	In case of cost reduction, the emphasis is on the present and the future. The emphasis is not on what have been the cost but what could be the possible improvement in the costs. Thus, there is no end to cost reduction.
5. Assumptions	Cost control assumes the existence of certain standards or norms which are not challenged.	Cost reduction assumes the existence of concealed potential savings in the standards or norms which are therefore subject to constant challenge or improvement.

 

Thus cost control is only a means to achieve the end of cost reduction.

Organisation for Cost Reduction

Cost reduction as stated above involves real and permanent reduction in costs. It is a continuous process. Hence, it requires co-operation of people at all levels. The environment in the organisation should be made so congenial that healthy discussion can take place at all levels of management. The criticisms should be accepted in right spirit with honesty and grace by all, so that corrective action may be taken in time. This requires the formation of a separate Cost Reduction Cell within the organisation. The Cell functions under the supervision and direction of a high-powered authority known as Cost Reduction Committee. The committee consists of responsible executives from various functions such as purchase, planning and design, production, sales, distribution, finance, research, etc. The committee should chalk out a proper cost reduction programme and fix up responsibility of the executives to review the actual performance from time to time.

(i)                          It collects cost data from different departments.

(ii)                       It invites suggestions from different executives for improvement and reduction of costs relating to their areas.

 

(iii)                               It creates cost reduction environment in the organisation by emphasising and explaining to the workers the importance of cost reduction and the benefits which will accrue to them.

(iv)                              It identifies areas where cost reduction is (a) necessary; (b) desirable; and

(a)                                                                                            possible and fixes the priorities.

(v)                                 It frames policies, guidelines and issues directives for bringing changes in product designs, introducing new products and new designs in consultation with technocrats for reducing the cost of production without impairing the quality.

(vi ) It frames policies regarding reduction of costs in administrative and distribution divisions without adversely affecting their efficiency.

Cost Reduction Programme

Cost reduction programme aims at improvement of human efforts at all levels of the organisation which help in reducing costs. It may be a short-term or a long-term programme. A short-term programme is undertaken for sorting out immediate problems; e.g., a problem involving controlling wastages and inefficiencies in a certain department which are likely to push up the cost and reduce the profit margin. Long-term cost reduction programme involves major reduction in costs and may also require capital expenditure. It involves setting up of the target return on capital employed and developing a scheme for its achievement through various cost reduction measures.

Essential requisites for successful implementation

(i)                                     There should be a separate cost reduction cell responsible for proper planning and implementation of the cost reduction programme.

(ii)                                  There should be an efficient system of management reporting at all levels of management.

(iii)                               The programme should have support from the top management. It is a continuous process and, therefore, should not be allowed to degenerate into a routine affair.

(iv)                              There should be close co-operation amongst different executives concerned with the programme. Each departmental head should be given a list of the areas where he is expected to effect economies in cost. Moreover, he should also be encouraged to put forward his own suggestions for improvement.

(v)                                 There should be regular follow-up to the plan and continuous appraisal of the programme performed with the actual cost reduction performance.

(vi)                              The plan should not be confined only to reducing costs but should also examine whether an expenditure is really required or not. In other words, there should be efforts to eliminate uneconomic and unnecessary activities.

Fields Covered by Cost Reduction Programme

The following are the specific areas which are covered by a cost reduction programme:

(a)                 Product Design. Designing the product is a pre-requisite to its production. It is, therefore, necessary that proper care is given to designing the product to effect economies in the cost of materials, labour, tools and equipment. The technique of value analysis, as discussed later, is greatly helpful in designing the product. Product

 

should be designed in a manner that it gives the maximum value at the minimum   cost.

Product designing may be required either for introducing a new design or improvement of the existing design. The introduction of a new design is advantageous but risky since the new venture may or may not be successful. Hence, a careful analysis of its cost elements (i.e. materials, labour and expenses) and its marketability is necessary.

The venture concerning improvement of the existing design is advantageous since the reputation gained by the old product is likely to be enhanced and improved further through improved design of the product. The improvement should be in the direction of making the product less costly; more utility-oriented, attractive and durable.

(b)           Production Planning. Production planning can also greatly help in cost reduction. The location and lay-out of the factory have significant influence on cost. Of course, the factory location cannot be changed so easily but its lay-out can be organised on more scientific lines so as to reduce the cost of production.

The Chartered Institute of Management Accountants, London, in its publication on cost reduction, has laid down the following principles for developing a sound production planning system :

(i)                        Production planning should be based on realistic and detailed sales forecast.

(ii)                     Efficient production system requires fullest possible employment of suitable production facilities, elimination of unnecessary movement and handling of materials provision of adequate working instructions, drawings tools, etc. and the most economical storage of stocks.

The design of a production system is dependent on its location because the resulting physical factors influence lay-out and also because of the fact that the location determines operating and capital costs. In so far as physical factors of plant design are concerned, location may determine the following costs:

(a)         Whether or not power is purchased.

(b)         The extent of air conditioning or humidification required.

(c)         Whether local sub-contracting facilities for components are available or whether provision for the manufacture of components has to be made in the factory.

(d)         Storage space requirements depending on the availability of raw materials in the vicinity.

From the standpoint of costs, transportation costs, labour costs, costs of land, construction cost, etc. will be influenced by the location of the factory.

Even if an existing company intends to start an additional factory, the addition of a new plant is not a matter of determining location independent of the location of the existing plants. Establishment of a new plant may involve re-allocation of capacities so that the combined production and distribution costs are minimised.

 

Plant layout aims at developing a production system that meets the requirements of capacity and quality in the most economical way. Under ideal conditions of manufacture, plant and manufacturing facilities will be laid down after due consideration of all the factors, tending to reduce waste of time, effort, material and resources to the minimum possible level. Easily available and most suitable equipment should be obtained and utilised to the maximum possible extent.

(iii)                                                                                                                                                                                                     The assessment and coordination of equipment, labour and material requirements demand the formulation of a complete operation sequence for all predicts the setting up of material standards and the establishment of reliable process time by the use of work measurement techniques.

(iv)                                                                                                                                                                                                    Efficient production control and economic manufacture require careful determination of the lot size according to nature of methods of production employed.

(v)                                                                                                                                                                                                       Machine loading and labour requirements should be related to full capacity available. Where the idle capacity is found to exist, efforts should be made to ensure its economics utilisation, say, by the introduction of a new product.

(vi)                                                                                                                                                                                                    The production plan once formulated should be used as a measure of the effectiveness of actual performance with a view to correcting the unfavourable divergencies as they occur. It should nevertheless be flexible enough to cope with essential changes arising from changed conditions.

(c)                                                                                 Direct Materials Cost Reduction. Direct materials many constitute even more then half of the cost of a product. The following steps may be helpful in reducing material costs:

(i)                                                                                                                                                                                                           Control should be exercised on purchasing of raw materials. They should be purchased in economic lost at economic prices from reliable dealers at appropriate times. The adoption of the Japanese just in Time (JIT) technique may greatly reduce the material costs.

(ii)                                                                                                                                                                                                        The various inventory control techniques, viz., fixation and observance of inventory levels (maximum, minimum and re-order levels) of inventory, ABC Analysis, Ageing Schedule; Perpetual Inventory System followed by continuous stock taking, etc. should be adopted.

(iii)                                                                                                                                                                                                     All efforts should be made to avoid/minimise losses and wastages of raw material. Economy should also be affected in handling cost of raw materials.

Direct Labour Cost Reducion. Direct labour constitutes second important element of the cost of a product. Cost reduction in labour is possible through proper organisation and, functioning of the personnel, works study and engineering departments. The personnel department is concerned with finding out the right man for the right job and the right job for the right man. While the engineering and works study department is concerned with job studies, time studies and motion studies. All these functions go a long way in reducing costs and therefore all efforts should be made to discharge them with the intention to increase the productivity and reduce costs.

(d)          Overheads Cost Reduction. The term overheads includes factory overheads, office overheads and selling and distribution overheads. Considerable saving can be achieved in the overhead costs through cooperation of the concerned executives at different levels and creating a sense of cost consciousness amongst them as examined below. The reduction in administrative costs whether in factory, office or selling and distribution divisions can be achieved through the following measures:

(i)                        Staff can be reduced by having evaluation of jobs.

(ii)                     Utilisation of machinery and equipment can be improved through systematic supervision.

(iii)                  Productivity of workers and executives can be increased through smooth flow of work.

(iv)                 Expenditure on printing, postage and telephone can be reduced by exercising appropriate control measures.

Similarly, selling and distribution costs can be reduced by examining the following aspects:

(i)                        Whether the channels of distribution are efficient and economical.

(ii)                     Whether distribution and selling methods ensure promptness.

(iii)                  Whether there is an effective system of sales promotion.

(iv)                 Whether the market research is adequate.

(v)                    Whether there is many possibility of reducing the selling and distribution costs without impairing the efficiency of the sales division.

(e)          Finance Cost Reduction. Finance is also an important area where cost reduction is possible through the following measures:

(i)                        Control over utilisation of finance meant for both working capital and fixed capital needs.

(ii)                     Proper evaluation of capital expenditure and consequently control.

(iii)                  Profitable employment of capital with the objective of getting maximum return.

 

Cost Reduction Techniques

The following are some important cost reduction techniques:

(i)                          Budgetary Control;

(ii)                       Standard Costing;

(iii)                    Inventory Control;

(iv)                   Job Study, Works Study and Motion Study;

(v)                      Job Evaluation and Merit Rating;

(vi)                   Value Analysis.

(vii)                Reduction in variety of products

 

The first five techniques have been explained earlier the last two are being discussed here.

 

Reduction in Variety of Products

It is a common knowledge that larger is the variety of products more is the cost involved. A large variety of products means more investment in terms of equipment in both fixed and working capital and larger sales efforts which all push up the cost of production and sales. The reduction in variety of products will lead to cost reduction because of the following reasons :

Reduction in variety of production will lead to standardisation of products. The term standardisation means that the product should be a standard one i.e. made of standard materials and components having a standard design and a standard cost. The standard in each of the above cases has to be determined by management. The standardisation of products will have the following advantages:

(a)          It will reduce investment in inventories since only few standard products will have to be kept in stock.

(b)         The products can be manufactured in larger quantities in each process as a result of increase in the size of each batch.

(c)          The products will be of improved quality, greater reliability and of less cost.

Reduction in variety of products will lead to simplification of the production process. A simplification of production process involves less of machine setting time, longer runs, increased productivity and lower cost of inspection. As a matter of fact, Standardisation will automatically lead to simplification of the production process.

It has already been stated above that standardisation involves giving a standard product to the consumer. This means that quality of the product will not be allowed to get deteriorated but rather it will continuously be retained and, if possible, improved. This will require inspection of the product at different stages of production so that defects may be remedied at the earliest stage. It will bring economy in reducing the cost in terms of reduction in the number of defective units.

Value Analysis

It may not be out of place here to understand the meaning of the term ‘value’. As a matter of fact, the term ‘value’ has different meanings for different persons. For example, for a designer the “value” means the quality of the product, for a salesman the term ‘value’ means the price which he can fetch for the product in the market, and for the top-management the term ‘value’ means return on capital employed. However, an industrial product may have the following concepts of value :

Use Value. This refers to the characteristics which the products should possess to provide a useful service for which it is intended. For instance, a watch is meant for indicating time. In case it gives fairly correct time, it is giving its full use value. The use value is measured in terms of quality of performance. In order to decide whether a product is giving good value, for the money spent on it, it will be appropriate to divide its worth for the concerned person by the price paid for it.

A product may perform several functions. Accordingly, its use value can be divided into three categories:

(a)         Primary use value;

(b)         Secondary use value; and

(c)         Auxiliary use value.

For instance, paint has different use values. It has primary use value when it is applied to protect some surface. It has a secondary use value when it is used for marking lines on the road for crossing by pedestrians. It has an auxilliary use value when it pleases aesthetic sense. Such a functional classification would help one in identifying which paint one should use keeping in mind the objective. If this is not done, perhaps one may use costly enamel paint where use of ordinary paint would have been prudent.

1.             Cost Value. The value is measured in terms of cost in case product is manufactured in the organisation. It refers to the cost of production. In case a product is procured from outside, it refers to cost of its purchase.

2.             Exchange Value. It refers to sales value which a product would fetch. It is important for the sales department since the profit is excess of the selling price (i.e. exchange value) over the cost of the product. Hence, the sales department must ascertain what value the product has for the customers as compared to competitive products available in the market. It will help in advising the management in fixing the selling price of the product.

3.             Esteem Value. This may also be referred to as the prestige value. Certain products or articles have value simply because of their attractiveness or esteemed features. A watch made of gold has an esteem value for its owner, though its utility is not more than that of an ordinary watch. For some people purchase of a gold watch may be a waste. However, it commends a value for the person who wishes to impress upon others and thus have a personal satisfaction.

Important of Value Analysis in Cost Reduction

Also termed as value engineering, the approach focuses upon improvement in value by resulting to a careful and in-depth study of products at the stage of their designing. The different components can be redesigned or standardised. Less costly manufacturing processes or methods may also be used. Such a study reveals the fields which involve avoidable costs and after locating these areas, steps can be taken to eliminate or if not possible reduce such unwanted costs, of course, without in any way compromising on quality.

wing points deserve consideration before embarking upon value analysis in order to critically examine each and every product and its part:

(i)                         Cost-benefit analysis or the item must be carried out.

(ii)                      The aspect of standardisation should be seriously looked into.

(iii)                   The requirement of redesigning should be assessed in order to have durability.

(iv)                  Combination of activities, items or segregation should also be considered to reduce costs of incentives etc.

(v)                     Function of the item must be identified and evaluated.