Strategic Cost Management

Due to increased competition and ever changing customer’s preference and expectation, cost management has become a critical survival skill for many organisations. While every business organisation faces domestic as well as global competition, customers expect timely delivery of quality products at competitive price. Business enterprises can offer competitive price only if they manage cost effectively. They also need to increase revenues and maximize profits. Cost management focuses not just on controlling and reducing cost but also on increasing revenues and maximizing profits.

Business enterprises in the competitive world have threefold objectives.

1. to produce quality goods,

2. to increase value to the customers,

3. to maximize profits

In order to achieve the above, cost have to be managed strategically. Therefore Strategic Cost Management describes cost management that specifically focuses on strategic issues.

This article aims at explaining strategic cost management from the basic term called “cost”, through “ cost control” , “cost reduction” and “cost management”

1. COST :

First of all let us know what is cost.

Cost is the economic value or price of resources that are sacrificed for attaining a particular objective. Objective of any business enterprise is to make profit.

Therefore cost , in any business enterprise, is the economic value of resources that have been sacrificed for making profit. To put otherwise, cost is the economic value of resources that have been consumed or used up during the process of

Manufacturing and sale of a product in case of manufacturers ; or
rendering a service in case of service providers ; or
bringing a product into a saleable condition in case of traders, in order to make profit.

The resources used are Men (wages and salaries) Material (raw material, consumables, etc.,) Machine (depreciation) Overheads (other related expenses) – the terms used for expressing their respective economic values are mentioned within the bracket.

While pursuing the objective of earning profit, it is the endeavor of every enterprise to have a control over the cost so that they can earn the desired or expected profit. For this , it is imperative on the part of management to understand the cost behavior of their operations or they risk losing control over costs.

2. COST CONTROL :

Business enterprises prepare annual budgets for production, sales and profit. Budgeted production and sales may be achieved, but if the costs are not contained within the budgeted level, the desired profits cannot be realised. Hence controlling costs is very important for achieving the budgeted profit.

Cost control aims at

setting standards for each cost element ,
comparing the actual against the standard,
analyzing the variance and
taking necessary corrective steps, to keep the costs within the budgeted level.

Initially operational budgets are prepared from which standards are set. Every effort is made to keep the costs within the established standards. Deviation of the actual performance from the standards are analysed and reported. Based on the variance report, corrective actions are taken.

Reasons for deviations may be

procurement of materials at unfavourable prices,
wastage of materials due to inefficient storage,
improper handling, poor workmanship,
machinery breakdown,
labour idle time, etc.

When exact reasons are found out, necessary corrective actions are taken. Budgetary Control and Standard Costing are the two techniques used for Cost Control.

3. COST REDUCTION :

While cost control aims at keeping the costs within the preset standards so that the budgeted profit is achieved, cost reduction is a planned reduction in cost to maximize the profit. Cost control is a routine process, but cost reduction is a programme to reduce the cost permanently. Therefore cost reduction programme precedes the cost control process. In the cost reduction programme, existing standards are challenged and attempts are made to reduce them further through the following techniques.

Value engineering
Improvement in design
Work study
Variety reduction
Standardisation and simplification
Job evaluation and merit rating
Mechanisation and automation.

The main theme of cost reduction programme is reducing cost per unit without lowering quality. It is achieved through any of the following two ways or combination of both.

1. Reducing expenditure and thereby reducing the cost per unit for a given volume of output.

2. Increasing productivity and thereby increasing production rate for a given amount of expenditure.

For example let us assume that cost of making 1000 units of pen is Rs.25000/-. Cost per unit is Rs.25/-. This can be reduced further by any of the above two methods. If we reduce the expenses from Rs.25000/- to Rs.20000/- for making the same number of pens i.e. 1000 units, cost per unit will be reduced to Rs.20/-. On the other hand , same level of reduction can be achieved by increasing the production from 1000 pens to 1250 and keeping the same expenses of Rs.25000/-. However there must be no compromise on quality.

4. COST MANAGEMENT :

Cost control and cost reduction aim at controlling or reducing the costs. Cost management looks beyond controlling and reducing costs. Cost management has broad focus and should not be interpreted to mean only continuous reduction in cost. It is also linked with revenue and profit planning. It is a system that establishes link between costs and revenues and relates them with the product or service to maximize firm’s profit. It does not focus on cost, independent of revenue and profit. It is a wholistic control process.

Cost management decisions include decisions such as the amounts and kinds of material to be used, stock management and inventory levels, plant location, make or buy components, outsourcing certain processes, changes in plant processes, operate or shut down, changes in product designs, product pricing, acceptance of incremental orders in different situations like spare capacity, full capacity, intra companies transfer pricing, etc.

As part of cost management, managers may deliberately incur additional costs to augment revenue and enhance profits e.g. advertising , product modifications, etc.

Following are the techniques widely used in Cost Management

EOQ model, Re-order level, Maximum level, Minimum Level, Average level and Danger level for making inventory decisions
Marginal Costing
Relevant Cost Analysis
Differential Cost Analysis.

Therefore concept of cost management includes not just controlling and reduction of cost but also enhancing revenue and profit planning.

5. STRATEGIC COST MANAGEMENT :

So far we have seen what are cost, cost control, cost reduction and cost management. Now we are moving on to understand what is strategic cost management. Before going into detail of the same, let us first consider the terms “strategy” and “strategic management” and then we shall see how the concept of “cost management” evolved into the concept of “strategic cost management”

Strategy

In order to be successful, businesses have to set clear objectives. Following are some of common objectives.

To stay in the business – survival,
long term growth,
Maximization of profit,
Increasing market share,
Building brand equity,
Building image and reputation,
Social responsibility,etc .

Strategy is the means to achieve objectives of any business enterprise.

Strategic Management :

Strategic management , according to William F. Glueck , is

Q “a stream of decisions and actions
Q which leads to the development of effective strategy or strategies
Q to help achieve objectives”.

Every business has two things in common – capabilities and opportunities in the market. Strategy specifies how an enterprise matches its own capabilities with the opportunities in the market place to accomplish its objectives.

Business organisations follow any one of the two strategies.

1. Cost leadership strategy – providing quality products or services at low prices. Under this strategy companies strive to provide products of same quality as provided by the competitors but at comparatively lower price.

2. Product differentiation strategy – providing unique products at higher price. Companies incorporate special features into the product/service which is expected by the customers who are willing to pay for it.

When a company is able to deliver the products with same benefits as competitors but at a lower cost or deliver benefits that exceed those of competing products, the company is said to have competitive advantage.

Evolution of Strategic Cost Management :

Earlier organizations tried to cut costs in the short term without any regard for sustainable growth in the long run. Cost reduction programmes had no integration with overall business strategy. In the absence of such integration, cost savings achieved in the short run leaked away and the cost base returned to previous high levels leaving the business in doldrums. These enterprises did not consider “cost” as a strategic issue.

Many of the cost systems followed in the organisations were desperately obsolete, so they had to get rid of these systems and to redesign them or to attune them to the changed requirements.

Fuelled by these requirements, the cost management scenario witnessed the emergence of a new perspective of strategy namely Strategic Cost Management as an important player for solving cost related problems.

As we saw earlier, the most important objectives for any organisation are its long term growth and survival. Profit maximisation is the key to attainment of these objectives. Profit maximisation in turn depends on three factors.

Q Effective allocation of resources and efficient use of the same
Q Increasing revenues
Q Minimizing cost

Strategic cost management helps the business organisations to achieve the above. Therefore we can say that “cost management” that specifically focuses on strategic issues is called Strategic Cost Management.

Strategic cost management is the development of cost management information for strategic management purpose.

Strategic cost management and competitive edge :

Strategic cost management helps the management to obtain competitive advantage by providing information about the sources of competitive advantage i.e.

the cost / productivity/ efficiency advantage of their company relative to competitors; or
the premium prices the company can charge relative to the cost of adding features that make its products or service distinctive.

Depending upon the strategy chosen , cost leadership or product differentiation, firms’ attention on costs and analysis of costs differ.

Cost leadership strategy aims at taking on the competitor directly by cutting costs, while product differentiation aims at attracting more and elite customers by offering unique products.
Importance of competitor analysis is high in case of cost leadership strategy and low in the case of product differentiation strategy.
Importance of marketing cost analysis is critical to success of the product differentiation strategy, while it may not be done in the case of cost leadership strategy.

Cooper and Slagmulder say that strategic cost management is “the application of cost management techniques so that they simultaneously improve the strategic position of a firm and reduce costs”.

Strategic cost management techniques :

In order to achieve competitive advantage, companies have to improve the levels of performance regarding cost and efficiency, quality, time and innovation. These are called key success factors. Strategic cost management provides various techniques help the management improve performance level regarding the key success factors.

Following are such techniques.

1. Activity Based Costing (ABC)

2. Target Costing (TC)

3. Total Quality Management (TQM)

4. Bench marking

5. Business Process Reengineering (BPR)

6. JIT Inventory Control System

7. Balanced Score Card 8. Kaizan Costing

8. Six Sigma

9. Life Cycle Costing (LCC)

10. Theory of Constraints (TOC) and Others.

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