What is Cost Reduction?
Cost reduction is an extension of cost control. Cost reduction is a much wider concept than cost control. Cost control is essentially a short-term programme in as much as it relates to objective and standards. But cost reduction could have both short-term and long-term programmes.
Cost reduction should not be confused with cost control. Cost Control is the regulation of the costs of operating a business and is concerned with the keeping expenditure within acceptable limits. The major assumption in cost control is that unless costs exceed budget or standard by an excessive amount, the control of costs is satisfactory.
Cost control is a very routine exercise which is almost concurrently carried out for attainment of operational efficiency. On the other hand, Cost Reduction brings about real and permanent savings by continuous and planned research. A cost reduction programme does not stand of its own volition. It is always planned and followed up.
Definition of Cost Reduction
The process of identifying and eliminating unnecessary costs to improve the profitability of a business is known as cost reduction.
According to the Terminology of Cost Accountancy of the Institute of Cost and Management Accountants London, Cost reduction is to be understood as the success of real and unchanging reduction in the unit costs of goods manufactured without impairing their suitable for the use intended.
Features of Cost Reduction
These are Features of Cost Reduction given below:
- Cost reduction is not concerned with setting targets and standards. Cost reduction is the final result in the cost control process.
- Cost reduction aims at improving the standards.
- It is continuous, dynamic, and innovative in nature, looking always for measures and alternatives to reduce costs.
- It is a corrective function.
- This is applicable to every activity of the business.
- It adds thinking and analysis to action at all levels of management.
Areas of Cost Reduction
Cost Reduction may be implemented in the following areas:
- Factory organization and production methods
- Factory labour and equipment
- Utility services
Product design has the greatest scope for cost reduction, for a manufactured article must be functionally useful and at the same time satisfy the customer. While introducing a new design there must be a close co-operation between the designers and cost estimators to consider the influence of design upon:
- Material cost including material specification in relation to substitutes, the yield factor, storage and purchasing problems.
- Labour cost affected by the manufacturing process, tolerances and performance standards.
- Direct expenses such as tools, jigs and fixtures.
- Cost savings due to mechanisation, standardisation, and work simplification.
- Increase in use and esteem values and reduction in after-sales service costs.
Improvement of existing design must be a constant quest and the aim must be to save material cost by establishing standards of materials, reducing labour cost and overhead by reducing time taken for manufacture through improved design and methods.
Too much variety of the same product will probably add to cost. A reduction in variety means longer production runs, more mechanisation, higher productivity and lower cost per unit. There should be a proper value analysis, budgetary control and standard costing to increase use value, esteem value, and exchange value and finally to keep costs within reasonable limits.
Cost reduction in the field of marketing includes representation, advertising, market research, sales office and administration, after sales service, packing, transport and warehousing, Collection and suitable analysis of these services may lead to the introduction of the most economic services in conformity with the present activities of the business.
Cost reduction in the field of finance is an important aspect because on account of a slight negligence on the part of management, capital may be tied up in fixed on current assets associated with risks of obsolescence, bad debts, bank charges, loss of discount, etc. The return on capital employed must be continually watched as a suitable cost reduction programme will ensure the maximum return possible.
Factory Organization and Production Methods
Cost reduction in this field includes correct assignment of authority and responsibility, an exhaustive planning for production and production services such as purchasing and material control, a balanced wage structure, institution of suitable working conditions and suitable works services such as maintenance, inspection and clerical services, adequate work measurement and system analysis, operation research and linear programming applied in the field of the above production services.
In practice, the layout of factory, production scheduling, labour and machine utilisation, service planning, maintenance, inspection and quality control should be given due consideration before establishing a co-ordinated organisation and production methods.
Factory Labour and Equipment
The influence of factory layout and equipment on cost may be substantial. The cost reduction programme may include replacement of obsolete, outmoded, inefficient plant and equipment. A proper work study may enable labour efficiency to be improved.
A productivity deal with the employees may reduce unit labour cost and consequently unit overhead cost. The substitution of labour by automatic plant and machinery may substantially reduce total cost.
Utility services include labour, steam, air-conditioning, water, and other services. Due to the under-utilization of utility services costs may increase to a great extent. So, utmost care is necessary to see that the utility services are efficiently utilised.
Cost Reduction Techniques
There are number of cost reduction techniques, such as:
- Budgetary Control
- Inventory Control
- Standard Costing
- Job Evaluation and Marit Rating
- Reduction in variety of products
- Value Analysis
- Uniform Costing
- Intra-inter firm Comparison
- Operational Research
Budgetary Control is a tool for management used to plan, carry out and control the operations of business. Actual results are compared with budgeted objectives and variations between the two is noted and action is taken to eliminate or minimise the variations.
Inventory control or stock control can be broadly defined as “the activity of checking a shop’s stock. It is the process of ensuring that the right amount of supply is available within a business.
Standard Costing is a technique which uses standards for costs and revenues for the purpose of control through variance analysis.
According to CIMA, London, Standard Costing is “the preparation and use of standard costs, their comparison with actual cost and the analysis of variance to their causes and points of incidence”.
Job Evaluation and Marit Rating
job evaluation define as “a practice which seeks to provide a degree of objectivity in measuring the comparative value of jobs within an organization and among similar organizations”.
While Job Evaluation constitutes a solid ground for establishing categories of wages and salaries, Merit Rating will insure control and adjustment of pay differentials within categories, according to the relative merit of employees, or will guarantee a fair distribution of bonuses.
- Record the progress of employees in their jobs.
- Enhance the morale of supervisors, foremen and employees.
- Provide a basis for agreement.
- Help employee development and adjustment by personal advice, training, and improvement of foremen or supervisors.
- Better selection and placement, by adjusting “the right man to the right job”.
- Measure the employees’ aptitudes to understand and use (or manage) ideas, things (or machines) and men.
Value analysis is one of the important tools of modern management in the area of cost reduction. Value analysis is the process of systematic analysis and evaluation of various techniques and functions with a view to improve organisational performance.
Uniform Costing is the use by several undertakings of the same costing principles and/or practices.
It is a written document prepared to provide instructions and guidance to the managements of member units about determination of costs, their analysis and control and reporting to be done to the Central Organisation created for introducing and applying Uniform Costing. A copy of the Uniform Cost Manual is given to each member-unit.
Intra-inter firm Comparison
The notion of intra-firm efficiency implies a firm that has a firm-specific production frontier and maximum output may not be always obtained due to inefficiencies in the production process. Intra-firm technical efficiency involves computing a particular firm’s technical efficiency degree over time taking the firm-specific production frontier as the reference frontier.
Inter-firm technical efficiency involves choosing the “best practice frontier” at each time period among the set of comparable firms and then evaluating each firm’s technical efficiency degree relative to that frontier. Consequently, inter-firm efficiency reveals a particular firm’s performance relative to the best available technology in the industry.
Defining Operations Research itself is very difficult. Like many other subjects that developed pragmatically and shade imperceptibly into adjoining subjects, it is more easily recognized than defined.
Generally speaking, operations research is an approach to the analysis of operations that to a greater or lesser extent adopts:
- Scientific method (observation, hypothesis, deduction and experimentation as far as possible).
- The explicit formulation of complex relationships.
- An inter-disciplinary nature. (iv) A non-partisan attitude.
Operational Research can also be regarded as a scientific approach to the analysis and solution of management problem.
Productivity may be defined as the ratio between the production of a given commodity measured by volume and one and more of the corresponding input factors also measured by volume.
Productivity is a physical concept. It could be defined as the relationship between output and input resources.
Go On, Share & Help your Friend
Did we miss something in FinanceTutorial or You want something More? Come on! Tell us what you think about our post on Cost Reduction in the comments section and Share this post with your friends.