Cost Analysis

Cost Data for Business Decision Company may wish to determine, for instance :

The most profitable rate of operation of a given plant or department

They may desire to know what price to quote to a prospective customer

Often they may need to know whether to accept the particular order

They may want to know whether it would be profitable to buy a new machine

They may have to decide what sales channels to use; and so on

So far as these calculations are related to costs, the businessmen are interested in The cost that will be incurred, those which

lie ahead Not those which have already been

incurred, and to which the business is already committed

Cost Concepts and Classification The kind of cost concept to be used in a

particular situation depends upon the business decisions to be made

Cost consideration enter into almost every decision, and it is important, though sometimes difficult, to use the right kind of costs

Hence an understanding of the meaning of various cost concepts is necessary to emphasize: That cost estimates produced by

conventional financial accounting are not appropriate for all managerial uses

That different business problems call for different kinds of costs

Actual Cost and Opportunity Cost Actual costs mean the actual expenditure

incurred for acquiring or producing goods and services

These costs are also commonly known as Absolute Costs or Outlay Costs

Example: Actual Wages Paid Transportation and Traveling Advertising Purchasing Building, Plant, Machinery,

Equipments, Raw materials Interest Paid, and so on

Opportunity Costs of a good or services is measured in terms of revenue – which could have earned by employing that good or service in some other alternative uses

Opportunity cost can be defined as the revenue foregone by not making the best alternative use

The opportunity cost is also called Alternative Cost

Business and Full Cost Business cost includes all expenses which

are incurred to carry out a business The concept of business cost is similar to

actual cost Business costs includes: payments and

contractual obligations made by firm These cost concepts are used for calculating

Business profit and losses For filing returns for income tax For other legal purposes

The concept of full costs includes business costs, opportunity cost and normal profit

Normal profits are a necessary minimum earning in addition to the opportunity cost, which a firm must get to remain in its present occupation

Incremental (Differential) and Sunk Costs Incremental cost is the additional cost due to

change in the level or nature of business activity Examples

Addition of new product line, or new machinery Changing the channel of distribution or Expansion of

additional markets Replacing a machine by the better machine

Thus, the question of incremental or differential cost would not arise when a business is to be set up afresh

It arises only when a change in contemplated in the existing business

The sunk costs are those which cannot be altered, increased or decreased, by varying the rate of output

Example Once it is decided to make incremental

investment expenditure and the funds are allocated and spent, all the preceding costs are considered as the sunk costs since they accord to the prior commitment and cannot be revised or reversed or recovered when there is change in market conditions or change in business decision.

Past and Future Costs Past costs are actual costs incurred in the

past and are generally contained in the financial accounts

If they are regarded as excessive, management can indulge in post-mortem, just to find out the factors responsible for the excessive costs, if any, without being able to do anything for reducing them

Future costs are costs that are reasonably expected to be incurred in some future period or periods

Future costs are the only costs that matters for managerial decision because they are the only costs subjected to management control

Unlike past costs, they can be planned for and planned to be avoided

The major managerial uses where future costs are relevant are: Cost Control Projection of Future Profit Appraisal of

Capital Expenditure Introduction of New Products Expansion Programs and Pricing

Short-Run and Long-Run Costs Short run and long run cost concepts are

related to variable and fixed costs respectively, and often figure in economic analysis interchangeability.

Short-Run costs are the costs which vary with the variation in output, the size of the firm remaining the same

In other words, short run costs are the same as variable costs

Long-Run costs, on other hand, are the costs which are incurred on the fixed assets like plant, building, machinery, etc

Such costs have long-run implication in the sense that these are not used up in a single batch of production

Long-run costs are, by implication, the same as fixed costs

In the long-run, however, even the fixed costs become variable costs as the size of the firm or scale of production increases

Common Production Cost In some manufacturing companies two or more

different products emerge from a single, common production process and a single raw material

Example: A familiar example is the variety of petroleum

products derived from the refining of crude oil So also in a shoe factory, the same piece of leather

may be used for men's, women's and children's shoes

In a cigarette factory, different parts of tobacco leaves are used for different qualities and products

Joint Costs For product costing, it is desirable to

distinguish between two broad categories of common products: Joint Products: When an increase in the

production of one product causes an increase in the output of another product, then the product and their costs are traditionally defined as joint

Alternative Products: In contrast, when an increase in the output of a product is accompanied by the reduction in other products, the products are called alternative

Allocation of Joint Costs When the processing of material results in

more than one end product a problem that arises is how to apportion the joint costs so as to ascertain unit product costs

There are two methods available for the purpose: Market Value Method Quantitative Unit Method

Market Value Method In case of market value method, it is believed

that joint costs should be allocated to the products according to their ability to pay.

Example: A common process costing Rs. 10800 results in

two products X and Y which can be sold for Rs. 10000 and Rs. 7200 respectively after incurring expense of Rs. 2000 and Rs. 800 respectively

Apportion joint costs according to Market Value Method

Solution

The joint expense, Rs. 10800 will be apportioned in the ratio of 8000:6400 and we shall get Rs. 6000 for X and Rs. 4800 for Y

X (Rs.) Y (Rs.)Gross Realized Value 10,000.00 7,200.00

Post-Separation Expenses

2,00.00 800.00

Net Realized Value 8,000.00 6,400.00

Shutdown and Abandonment Costs Shutdown costs may be defined as those costs

which the firm incurs if it temporarily stops it operations

These costs could be saved if the operations are allowed to continue

Shutdown costs include: Besides the fixed costs The costs of sheltering plant and equipment Lay-off expenses Employment and training of workers when the plant

is restarted Cost of loss of the market

Abandonment costs are the costs of retiring altogether a fixed assets form use.

Example: The plant installed during wartime may be

so improvised that it may not be required during peacetime

Abandonment costs, thus, involve the problem of the disposal of assets

Urgent and Postponable Costs Urgent costs are those that must be incurred

so that the operations of the firm continue Example:

The costs on material, labor, fuel, etc. Those costs whose postponement does not

affect (at least for some time) the operational efficiency of the firm are known as postponable costs.

Examples: The maintenance of building, machinery, etc

Controllable and Non-Controllable Costs Controllable costs are those which are

capable of being controlled or regulated by executive vigilance and therefore, can be used for assessing executive efficiency.

Non-controllable are those which cannot be subjected to administrative control and supervision

Most of the costs are controllable, except for those due to obsolesce and depreciation.

Total Cost Total costs could be divided into two components:

Fixed costs Variable costs

The costs that do not vary for a certain level of output are known as Fixed Cost

Fixed Costs does not vary with variation in the output between zero and certain level of output.

Example: Cost of Managerial and Administrative Staff Depreciation of Machinery, Building, and other fixed

assets Maintenance of Land, etc

Variable costs are those which vary with the variation in the total output

They are a function of output. Example:

Cost of Raw Material Running Costs on Fixed Capital, such as

fuel, repairs, routine maintenance Direct Labor Charges associated with level

of output Cost of all the inputs that varies with output

Many costs fall between the two extremes of being fixed and variable

They are called as semi-variable costs. They are neither perfectly variable nor

absolutely fixed in relation to changes in volume

They change in the same direction as volume but not in a direct proportion thereto

Example: Electricity Bills often include fixed charge and a

charge based on consumption

Separating Fixed and Variable Costs Two methods may be noticed for

separating costs into fixed and variable elements

These are as under: Least Square Method High and Low Points Method

Method of Least Square Under this method, the total cost, Y, is represented

by a straight line consisting of: A fixed element in the total cost, i.e., 'a' The number of units, X, multiplied by the variable

component, 'b', in each unit cost, i.e., bX Thus, the equation is Y = a + bX Equation ‘a’ and ‘b’ can be solved as follows:

b = xy – [ ( x * y) ÷ n ] x2 – ( x2 ÷ n )a = ( Y ÷ n ) – ( X ÷ n)

Where:x = X – ( X / n) y = Y – ( Y / n)

Therefore, Total Cost Y = 195 + 15X

High and Low Points Method Under this method, the total costs (without

distinguishing fixed and variable components) of two volumes of output, one high and the other low, are taken

The difference in the two cost figures (i.e., incremental cost) is divided by incremental output (i.e., the difference in the volume of output between the two levels)

This will give the variable cost per unit Now the total cost of the volume of output less

the total variable cost at that level of output gives the fixed cost which will remain fixed for all levels of output

Calculate the fixed and variable costs from the following figures:

Output (In Units)

Total Costs

3420 13,880.00 1368 8,750.00

Solution: Incremental Cost: 13880 – 8750 = 5130 Incremental Output: 3450 – 1368 = 2052 Variable cost per unit: 5130 + 2052 = Rs. 2.50 Variable Cost for 3420 Units: 3420 * 2.50 = Rs.

8550 Total Cost for 3420 Units: Rs. 13880 Fixed Cost: Rs. 13880 - Rs. 8550 = Rs. 5330

Cost Relationships The relationship between Total Costs, Average Cost

and Marginal Cost as shown below: Average Cost (AC)

= TC ÷ Units of Output Average Fixed Cost (AFC)

= Fixed Cost ÷ Units of Output Average Variable Cost (AVC)

= Variable Cost ÷ Units of Output Average Cost (AC)

= AFC + AVC Total Variable Cost (TVC)

= AVC * Units of Output

Cost Determinants

The cost of production of goods and services depends on a number of factors

These factors may differ from firm to firm within an industry and from one industry to another

The important cost determinants are as under:

Level of Output The larger the output, the greater will be

the production cost For there will be larger use of various

factors of production who shall get larger payments

Thus, total cost varies directly with output

Prices of Input Factors Obviously, changes in input prices

influence costs, depending on the selective usage of the inputs and relative changes in their prices

When a factor, which is a major component in production function becomes relatively costly it raises the cost significantly

Productivities of Factors of Production Productivity of a factor refers to the output

per unit of that factor The higher the productivity of a factor of

production, the lower the costs per unit of the input factor

Thus, an increase in factor productivity would reduce the total production costs for producing a given output

If one considers the short period, the cost curve will rise steeply

However, in case of long period, cost would not increase that steeply

Period of Consideration

Level of Capacity Utilization This especially affects the per unit fixed

cost Thus, with higher capacity utilization, fixed

cost per unit of output is bound to be low

Technology Technology progress or improvement leads

to an increase in efficiency or productivity of factors pf production.

This in turn leads to reduction in cost of production

In other words, cost varies inversely with technological progress

Also, most technological innovations aim at reducing costs

Cost Output Relations

Cost-Output Functions Cost function expresses the relationship

between cost and its determinants In a mathematical form it can be expressed as:

C = f(S, Q, P, T ...)Where:

C = Cost (Unit Cost or Total Cost)P = Price of Inputs Used in ProductionS= Size of PlantT = Nature of TechnologyQ = Level of Output

Relationship between Production and Cost Cost function is simply the production

function expressed in money units The short run cost function operates under

the same limitation as of the short-run production function (except the assumption regarding the input prices)

The table shows the relationship between the production and cost in the short run

Units ofVariable

InputLabor (L)

Total Product

(Q)

TVC(L * Wage Rate

of Rs. 100)

Marginal Cost(TVC / Q)

MarginalProduct

( Q / L)

0 0 0 – –1 10 100 10.00 10 2 22 200 8.33 12 3 40 300 5.55 18

4 55 400 6.67 15 5 62 500 14.33 7 6 65 600 33.33 3 7 60 700 –20.00 –5

Total product (Q) first increases at an increasing rate and later on at a decreasing rateCorrespondingly, the total variable cost (TVC) first increases at a decreasing rate and then at an increasing rate

In mathematical form: Assuming that labor (L) is the variable

input and the wage rate (W) is given, we can state that:

TVC = L * WSince MC = TVC / QTherefore

MC = (L * W) ÷ Q = (1 / MPL) * W

Cost-Output Relationship in the Short-Run In economic theory, the cost-output

relationship in the short run may be studied in terms of: Average Fixed Cost Average Variable Cost Average Total Cost

Units ofOutput

(1)

FixedCost(Rs.)(2)

VariableCost(Rs.)(3)

TotalCost(Rs.)(4)

MarginalCost(Rs.)(5)

AverageCost(Rs.)(6)

AverageFixedCost(Rs.)(7)

AverageVariable

Cost(Rs.)(8)

0 176 0 176

1 176 75 251 75 251 176 75

2 176 130 306 55 153 88 65

3 176 175 351 45 117 59 58

4 176 209 385 34 96 44 52

5 176 238 414 29 83 35 48

6 176 265 441 27 74 29 44

7 176 289 465 24 66 25 41

8 176 312 488 23 61 22 39

9 176 328 504 16 56 20 36

10 176 344 520 16 52 18 34

11 176 367 543 23 49 16 33

12 176 400 576 33 48 15 33

13 176 448 624 48 48 14 34

14 176 510 686 62 49 13 36

15 176 600 776 90 52 12 40

Average Fixed Cost and Output The greater the output, the lower the fixed

cost per unit, i.e., the average fixed cost The reason is that the total fixed cost

remains same and do not change with a change in output

The relation between output and fixed cost is a universal for all types of business

Variable Cost and Output The average variable costs will first fall and then rises

as more and more units are produced in a given plant This is so because as we add more units of variable

factor in a fixed plant; the efficiency of the inputs first increases and then decreases

In fact, the variable factor tends to produce somewhat more efficiently near a firm's optimum output than at very low levels of output

But once the optimum capacity is reached, any further increase in output will undoubtedly increase average variable cost quite sharply

Average Total Cost and Output Average Total Costs, more commonly known as

average costs, would decline and then rise upwards

The significant point to note here is that the turning point in the case of average cost would come a little later than in the case of average variable cost

For example, from the above table, the average cost starts rising after an output level of 13 units while the average variable cost starts rising after an earlier level of output, i.e., 12Units

Average cost consists of average fixed cost plus average variable cost

As we have seen, average fixed cost continues to fall with an increase in output while average variable cost first declines and then rises

So long as average variable cost declines the average total cost will also decline

But after a point, the average variable cost will rise

Here, if the rise in variable cost is less than the drop in fixed cost, the average cost will continue to decline

It is only when the rise in average variable cost is more than the drop in average fixed cost that the average total cost will show rise

Interrelationship between AVC, ATC, and AFC If both AFC and AVC falls, ATC will fall If AFC falls but AVC rises

ATC will fall where the drop in AFC is more than the rise in AVC

ATC will not fall where the drop in AFC is equal to the rise in AVC

ATC will rise where the drop in AFC is less than the rise in AVC

Relations between all the Costs The short run TC is composed of two major

elements: TFC and TVC. That is, in the short run:TC = TFC + TVC

For a given quantity of output (Q), the AC and AFC and AVC can be defined as follows:AC = TC ÷ Q = (TFC + TVC) ÷ QAFC = TFC ÷ QAVC = TVC ÷ Q

Therefore,AC = AFC + AVC

Marginal Cost is defined as the change in the total cost divided by the change in the total output, i.e.

MC = TC * Q Since, TC = TFC ÷ TVC and, in short

run, TFC = 0, therefore,TC = TVC

Furthermore, under marginality concept, Q = 1, MC = TVC

Cost-Output Relationship in the Long-Run

In long run, entrepreneur has before him number of alternatives which include the construction of various kinds and sizes of plants

Thus there are no fixed costs since the firm has sufficient time to fully adapt its plant. And all the costs become variable

Long run costs would refer to the costs of producing different levels of output by changes in the size of plant or scale of production

To understand the long run cost-output relations and to derive long run cost curves it will be helpful to imagine that a long run is composed of a series of short run production decisions

As a corollary of this, long run cost curves is composed of series of short run cost curves.

We may now derive the long run cost curves and study their relationship with output

Long-Run Total Cost Curve (LTC)

STC1 STC2 STC3

LTC

OutputO

Tota

l Cos

t

O3O2O1

Suppose that a firm

having only one plant has its short run total

cost curve as given by STC1

As a result, two more short run total cost curves are added to STC1 in the manner shown by STC2, and STC3

The LTC can now be drawn

through the minimum points of

STC1, STC2, and STC3 as shown by the LTC curve

corresponding to STC

Long-Run Average Cost Curve (LAC)

SAC1 SAC2

SAC3

LAC

OutputO3O2O1O

Tota

l Cos

t

C1

C2C3

Given the STC1, STC2, and STC3 curves in the above

graph, there are three

corresponding SAC

curves as given by

SAC1, SAC2 and SAC3 curves

Thus, the firm has a series of

SAC curves, each having

a bottom point

showing the minimum

SAC

The LAC can be drawn

through the bottom of SAC1, SAC2 and SAC3The LAC curve is

known as 'Envelope

Curve‘Or

'Planning Curve‘

as it serves as a guide to

the entrepreneur

in his planning to

expand production

Cost Functions

Linear Cost Function Suppose a firm producing a certain goods

under the following conditions: It has fixed costs which must be met

irrespective of the quantity of output produced. These fixed costs are represented by 'a'

In order to produce X good, it must buy a proportional amount of raw materials, labor, and other necessary inputs, the cost of which is the variable 'bX'

If total cost of the fixed cost and variable quantities is denoted by TC, the equation representing the total cost of production for the firm is the linear function:

TC = a + bQ

Certain important economic and mathematical properties of this function are as follows:

At zero output, total fixed cost, such as rent, property taxes, insurance, and depreciation due to time and obsolesce, equals total cost.

Increase in total cost due to increase in the output is represented by total variable cost

The average or unit cost function can be obtained by dividing the total cost function by output, X

ATC = TC ÷ Q = (a ÷ Q) + b Since AFC in the above formula is (a / Q),

subtracting from this equation leaves AVC 'b' The marginal cost can be obtained by

differential calculus Thus, MC = b

Quadratic Cost Function This type of function which has been

widely used in empirical studies is represented by the equation:

TC = a + bQ + cQ2

This kind of situation might occur with a firm whose costs were Rs. 5000 a month and whose variable cost for labor, materials, etc., to produce are 250Q + 3Q2

The last variable might rise if the firm's initial cost of labor and material for producing Q units is Rs. 250Q and its growing demand for the limited supply of input bids up their price by the amount 3Q2 as output increases

Its total cost equation would be: TC = 5000 + 250Q + 3Q2

The implication of this equation maybe noted as follows: When Q = 0, TC = a, total cost equals fixed cost It has only one bend as against linear total cost

function TC = a + bQ which has no bends The number of bends is always one less than

the highest component of X Dividing the total cost function by output X can

derive the AC equation:AC = Y / Q = (a / Q) + b + cQ

Since AFC in the above equation equals (a / Q), subtracting this out gives AVC, (b + cQ)

The equation for MC can be obtained by differentiating the TC function

Thus,MC = b + 2cQ2

MC = AVC = b when Q = 0

Cubic Cost Function The typical total cost function is not usually

of linear or quadratic form but rather of the cubic type:

TC = a + bQ – cQ2 + dQ3

The curve shall have two bends – one less than the highest exponent of Q

This function combines the phases of both increasing and diminishing returns to scale

Cost Control

Cost Control is defined as the regulation by executive action of the cost of operating an undertaking

Cost Control is exercised through numerous techniques some of which are Standard Costing Budgetary Costing Inventory Control Quality Control Performance Evaluation

Cost control involves the following steps and covers various aspects of management (Indicated in parentheses)

Initially, a plan or set of targets is established in the form of budget, standards or estimates, which serve as reference point to compare the actual performance with planned objective (Planning)

To communicate the plan to those whose responsibility is to implement the plan (Communication)

Once the plan is put into action, evaluation of the performance starts. The fact that cost are being reported for evaluating performance acts as motivating force (Motivation)

Comparison is made to the actual performance with the predetermined plan / target. Deviations / variances, if any, are analyzed and reported to the appropriate level of management (Appraisal and Reporting)

Lastly, the reported variances are reviewed. Either the corrective actions and remedial measures are taken or the set of targets is revised, depending upon the management's undertaking of the problem (Decision Making)

Tools of Cost Control

Budgetary Control A budget is defined as a financial statement

(prepared and approved) of a policy to be pursued during that period of time for the purpose of attaining a given objective

Budgetary control is a system which uses budgets as a means of planning and controlling

It involves constant checking and evaluation of actual results compared with the budget goals, thus helping in corrective action

The details of budgetary vary form company to company depending upon factors such as: Size and complexity of the company's

operations The degree to which the company is

concerned with costs The degree to which the firm is well

managed

A successful budgetary control depends upon: Commitment of top management to cost control Individuals should be help responsible only for the

costs they can control While favorable deviation in cost should always be

commended, the unfavorable performance must be used as a learning device

The goals of the organization should be clearly defined and must be reasonably attainable

Standard Costing Standard costs are those costs that should

be obtained under efficient operation They are predetermined costs and

represents targets that are considered important for cost control

The degree of success is measured through comparing actual performance with standard performance

If the standard material input for a unit of production is Rs. 100 and the actual cost is Rs. 95, then the variance of Rs. -5 is the measure of performance, which shows that the actual performance is an improvement of the standard

It is better to compare actual cost with standard cost than with any comparative figure form the company's previous financial results, because a comparison between current results and previous results necessarily presupposes that the previous results were at a level of efficiency that was sufficiently suitable to be a yardstick

Generally, this is rarely a case as future conditions generally differ from the past

Basis of Setting Standard Costs Establishing 'standards' as a basis for

evolving standard costs is an important part of the work of an industrial engineer

Technical and engineering consideration underlies many standards, depending on which performance is to be judged

Tolerance Allowance It is not possible for any management to

insist that the performance must always match the 'rigid' standards

Some deviation from the standard are always allowed

It is the limit of these variations or deviations form the set standards that are called Tolerance Limit

These deviations are of two kinds: Random Deviation: Random deviations are

those which arise purely due to chance and are, therefore, uncontrollable

Significant Deviation: Significant deviations have assignable cause and are, thus, subject to managerial control

Variance Analysis Once variances are found, their cause needs to

be determined for taking corrective action These variations may be caused due to several

reasons. Many changes may favorably or unfavorably

influence the performance such as: Product design or product mix Labor productivity Composition of firm's machinery and equipment Organizational structure etc.

An important thing about variance is that the cause of variances may be personalized

So, variance analysis operates in accordance with the principles of responsibility accounting: Production Supervision would responsible for

direct labor time variance Marketing Manager responsible for sales price

variance and sales mix variances Purchasing Department for material price

variance, and so on

Once the standard costs are determined, the next step in operation of a standard costing system is to ascertain the actual cost under each element and compare them with set standards

A detailed analysis of variance, particularly the controllable variances, helps the management to ascertain: The extent of variation Reason for the occurrence of the variance The factor responsible for it The executive / department on which the responsibility

for the variance can be laid

Labor Cost Variance Also known as direct wage variance, is the

difference between the standard direct wages specified and the actual wages paid for an activity

It includes the wage rate variance and labor efficiency

Sales Variance Is the difference between the standard

cost of sales specified and the actual cost of sales?

Four kinds of sales variance are generally found, viz., The mix variance The quantity variance The volume variance The price variance

Overhead Variance Is the difference between the standard

cost of overhead absorbed in the output achieved and the actual overhead cost.

Overhead variances may be computed and analyzed separately for fixed and variable overhead for each cost center

The variable overhead variances are: Overhead Expenditure (or, Budget) variance and Overhead

Value Analysis It is an analysis which helps in reducing cost

without sacrificing the pre determined standards of performance

Firms use value analysis not as a substitute of the conventional cost control methods but only as supplement to them

This technique is more popular in those cases where very large quantities of a good are produced, as in such cases even a fractional amount saved on manufacturing cost per unit ultimately result in substantial savings

Areas of Cost Control

Material If buying is done properly, a firm avails itself

of quantity discount While buying form a particular source, in

addition to the cost of material, consideration should be given to freight charges

While buying one may attempt to buy form the cheapest source by inviting bids.

At times, it may be possible to have more economical substitutes for raw material that a firm is using

Factory overheads may be reduced by Proper selection of equipment Effective utilization of space and equipment Proper maintenance of equipment Reduction in power costs Lightning costs, etc

Example: Florescent lightning can reduce lightning costs

Faulty design may lead to Excessive use of materials or multiplicity of

components Waste of steam Electricity, gas, lubricants, etc

Overheads

Taking advantages of trucks or wagonloads may reduce transport costs

Careful planning of movements also saves transportation costs

Another point to be examined is whether it would be economical to use one's own transport or have hired transport

For reasons of economy many transport companies hire trucks rather than owing them

Reduction of wastes in general can also reduce manufacturing costs considerably

Of course certain amount of waste and spoilage is unavoidable due to Human mistakes Machine failure Faulty raw materials

The normal figure for waste and spoilage depends upon the Complexity of the product The age of the manufacturing plant Skill and experience of the workers

SalesAreas of Control Improved supervision and training of salesmen Rearrangement of sales territories Replanning salesmen's routes and calls Redirecting of sales efforts to achieve a more

economic product mix It may be possible to save selling costs by the

use of warehouse making bulk shipments to the warehouses and giving faster deliveries to the customer thereform

Cost Reduction

Cost reduction implies profit optimizing through economies in costs of Manufactures Administration selling and distribution

We know that profit can be maximized either by increasing scales or by reducing costs

In a monopoly market it may be possible to increase price to earn more profits

On the other hand, in a competitive situation it is not possible to increase the price significantly; growth of profit would, therefore, depends mainly on the extent of cost reduction

Even when monopoly conditions prevail at present, these may not exist permanently

So avenues have to be explored and methods devised for cost reduction

Essentials for Success of Cost Reduction Program Every individual within the factory

recognize his responsibility The cooperation of every individual should

be sought by A careful dissemination of the objectives in

view By encouraging employees to identify their

self-interest with the company's interest

Employee resistance to change should be minimized by Dissemination complete information about

the proposed changes Convincing the employees that the changes

are concerned with the problems faced by the firm and that they would ultimately benefit

Efforts should be concentrated in the areas where the savings are likely to be the maximum

Cost reduction efforts should be continuously maintained.

There should be periodic meetings with the employees to review the progress made towards cost reduction

Approaches to Cost Reduction

Budgetary Approach This approach may be followed when the operating

departments are far over the budget and a situation of financial crisis exists

These approach to cost cutting usually entails the identification of items in the budget that are most amenable to quick changes

Example: Travel is restricted or frozen Coffee and refreshments are no longer provided at

meetings

Input Cost Approach Under this approach, managers try to reduce

the cost of their inputs in various ways Example: Reduction of wage costs through wage

concessions from workers on exchange: Shares and stocks in the company Seat on the board of directors

Moving into offices with lower rents and maintenance costs

Input Substitution Approach Managers can reduce costs by way of cost effective

substitutes for their inputs Example A company may consider a plant in a foreign

country to take advantage of its low wage (of course, he will have to consider the lower input costs relative to its productivity)

If the labor productivity is too low, it could offset any of the cost savings that result form the low wages

'Not Made Here' Approach If it can be determined that an outside

supplier or service vendor can perform an activity for less than it would cost a company, the company should utilize these outside resources.

Outsourcing is an old practice in manufacturing sector but it also growing in service sectors

Suggestion Box Approach Sometimes the best ways to cost reduction

come form suggestion form employees especially those connected directly with the production process