Cost management in tough times

9

© 2011 by Rob ReiderPublished online in Wiley Online Library (wileyonlinelibrary.com).DOI 10.1002/jcaf.20670

featur

e artic

le

Rob Reider

Is business slow? Is your company trying to work itself out of a bad financial situation? Many companies face those problems in these tough times. But mostly the cause of those prob-lems is excessive costs—or an inadequate margin between costs and selling prices. So how can you manage the costs that are most difficult to control—especially now? The author, a well-known management consul-tant, gives you some key checklists and other valu-able insights to get your firm back on track. © 2011 by Rob Reider

Cost Management in Tough Times

Although typically business man-agement places

major emphasis on increasing sales as the solution to increasing the business or work-ing out of a bad finan-cial or operational situ-ation, most times the cause of the problem is excessive costs or an inadequate margin between costs and sell-ing prices. In addition, the business may be making sales that do not generate a profit or contribute to positive cash flow—or the firm may be making sales to less-than-quality customers, who pay late or not at all. In most instances, the control of costs for the business can put more to the bottom line than a continual thrust to increase sales. Remember that a dollar of cost savings goes directly to the bot-tom line, while a dollar increase in sales may in fact produce a loss to the bottom line.

MANAGEMENT SHY OF COST ACCOUNTING

Cost accounting is a major area of operations that busi-

ness management typically shies away from. Unfortunately, everything affecting the busi-ness’s operations relates to cost accounting. While business management may pay minimal attention to the cost side of the profit equation (i.e., sales less costs equals profit or loss), it is management’s responsibility to develop effective systems for identifying, reporting, and con-trolling costs so as to manage the business most economically without sacrificing results and growth.

Let’s look at how your com-pany can do that. Our first step is a quick review of some cost accounting basics.

COST CLASSIFICATIONS

Costs can be divided into a num-ber of categories for business management purposes, depending on the business’s goals and objectives. Each cost categorization is a separate and distinct area with specific uses different from other classifications.

1. Manufacturing Versus Nonmanufacturing Costs

In the case of a manufac-turing business, costs may be divided into two major categories based on the management and functional activities they relate to:

1. Manufacturing costs are prod-uct costs related to the busi-ness’s manufacturing activi-ties, split into direct materials, direct labor, and manufactur-ing overhead:

a. Direct materials are the materials and parts that actually go into the finished product. Supplemental materials and supplies such

JCAF20670.indd 9JCAF20670.indd 9 2/17/11 7:41:59 PM2/17/11 7:41:59 PM

10 The Journal of Corporate Accounting & Finance / March/April 2011

DOI 10.1002/jcaf © 2011 by Rob Reider

of activity. These costs con-tain both a fixed component and a variable component. Examples include electricity costs, maintenance, and mate-rial handling, each of which will increase as production volume increases, but not on a direct proportional basis.

The concept of fixed, vari-able, and semivariable costs refers to how the costs behave or react to changes in levels of activity. This is necessary infor-mation for activities such as flex-ible budgeting, profit planning, cost control, variance analysis, and related management-based decisions.

3. Direct Versus Indirect Costs

Another way to view busi-ness costs is as either direct or

indirect in terms of their traceability to a product/service, department, or other segment of the busi-ness that represents the activity being costed. This type of cost analysis may

be used effectively for product costing, pricing, and profitability analysis purposes or for evalua-tion of business segments.1. Direct costs are those that can

be directly traced to the activ-ity being costed. For example, direct labor, direct materials, specific product advertising, and sales commissions can be directly attributed to a spe-cific product/service.

2. Indirect costs are those that cannot be directly attributed to the activity being costed. Examples include manufactur-ing or administrative overhead, and other shared functional costs (sometimes referred to as common or joint costs) such as purchasing, IT, personnel, accounting, and legal.

of those support functions necessary to keep the busi-ness going, such as own-ers’ salaries or draws, staff costs (such as accounting, IT, purchasing), mailroom, insurance, and secretarial/receptionist.

2. Fixed Versus Variable (and Semivariable) Costs

This category measures the variability of costs relative to changes in production/service volume or some other measures of activity.

1. Fixed costs are ones that remain constant in total regardless of routine changes in the business’s volume of activity. For example, rent, insurance, taxes, depreciation, and the like are costs that

do not fluctuate based on changes in level of activity. They are incurred even if vol-ume drops and remain rela-tively constant even if volume increases. Variations in these costs come about only as a result of major volume shifts or factors independent of vol-ume changes.

2. Variable costs are costs that vary in direct proportion to changes in levels of functional activities. For example, direct labor and direct material costs will vary approximately proportionately with volume-level changes and are there-fore classified as variable.

3. Semivariable costs are costs that vary, but not proportion-ately, with changes in volume

as screws, nails, glue, and so on are usually consid-ered indirect materials and included in manufacturing overhead.

b. Direct labor is the labor cost directly associated with the manufacturer of the product such as costs of production workers. Labor costs for manufacturing supervision, material han-dling, maintenance, quality control, and other support services are usually classi-fied as indirect labor and included in manufacturing overhead.

c. Manufacturing overhead can be considered as including all other costs of manufacturing except direct materials and direct labor. Other costs that are usually part of manufacturing over-head include depre-ciation, rent and/or other facilities costs, fringe benefits, pro-duction support costs, indirect materials, and indirect labor.

2. Nonmanufacturing costs are functional costs related to activities other than manu-facturing functions of the organization. These non-manufacturing costs can also be considered as operating expenses such as selling and marketing expenses, and general and administrative expenses.

a. Selling/marketing expenses relate to the costs of selling the product or service and keeping it sold. They include sales salaries and commis-sions, advertising and pro-motion, travel and entertain-ment, distribution costs, and sales service costs.

b. General and administra-tive expenses include costs

As the activity changes, so does the cost.


The Journal of Corporate Accounting & Finance / March/April 2011 11

© 2011 by Rob Reider DOI 10.1002/jcaf

lot sizing (how much to pro-• duce or services to provide); andwhat businesses to be in • (expand, status quo, curtail, or disband).

COST-REDUCTION TARGETS

Management continually looks for areas in which to reduce costs for the business. The focus must not be on strictly reducing costs, but on maxi-mizing results with the use of the least amount of resources. To effectively accomplish cost reduction without sacrificing results, management must be aware of the elements of the business’s operations. In setting up operating controls directed toward reducing costs and increasing profitability, man-

agement must be aware of those elements or activities that produce costs to the business. Based on the type of business and its inherent operating activities, related cost elements must be iden-

tified, such as the following:

1. Labor—direct and indirect; 2. Materials—direct and sup-

plies; 3. Processing time kept to a

minimum; 4. Lead time condensed to the

smallest amount; 5. Paperwork reduced and

eliminated; 6. Set-up time—manufacturing

and administration—mini-mized;

7. Parts and supplies at the best price, quality, and on time;

8. Vendors: best prices, 100 percent quality, delivered on time;

9. Cycle time—manufacturing and administration—kept to a minimum;

OBJECTIVES FOR COST CONTROLS

Depending on the type of business—such as manufactur-ing, retail, or service—the fol-lowing items could be consid-ered for cost control objectives.

Lower inventories (raw mate-• rial, work in process, fin-ished goods)—conserve cash and use it where needed in the business.Lower product costs (mate-• rial, labor, and overhead)—increase cash and create pricing flexibility.Decrease manufactur-• ing lots (just-in-time manufacturing)—conserve cash by not spending until needed.Improve quality—decrease • quality control costs by making employees responsible for quality control, not other indi-viduals.Decrease lead times • (on-time deliveries)—compress cash conver-sion period—hold onto cash until necessary to spend and collect quickly.Increase productivity—• produce more at the same or less cost (productivity increases while costs do not).Improve customer satisfac-• tion—increase customer ser-vice business and additional quality sales.Identify value-added cost • elements (to product item: direct and indirect)—reduction and elimination of unnecessary costs.Report on other than produc-• tion functions as related to product items (i.e., sales, purchasing, engineering, accounting)—control func-tional costs and cash outlays.

Maximize customer service • while reducing customer-related costs—include cus-tomer costs in your cost for-mula and continually strive to reduce them.

OPERATING DECISIONS AFFECTING COST CONSIDERATIONS

There are many operating decisions that need to be made by business management relative to cost considerations and that affect the business’s operations as well as what cost consider-ations need to be implemented to effectively control such opera-tions. Examples of such deci-sions include:

manufacture versus purchase • (make versus buy);

vendor selection (price, • quality, timeliness);single versus multiple • sourcing;manufacturing or service • providing in-house versus outsourcing;manufacture versus • assembly;cost elements and product/• service item costing;pricing strategies, based on • real costs;capital expenditures (effec-• tive use of facilities);production and service pro-• viding processes and use of personnel;product-line analysis (what • products to sell);inventory levels (in-house • versus vendors/distributors);

True product/service costs create the right decisions.




Balance workloads within • a function or activity—for example, processing of sales orders by customer or by alphabetic categories. When one individual is overworked while others are under-worked or idle, move the employees to the work and determine whether work-loads are shrinking and the function can get by with less personnel support.Reduce or eliminate bottle-• necks that are clogging operations from running smoothly—for example, the requirement that one indi-vidual must sign and approve all incoming customer orders regardless of the amount, which holds up these cus-

tomer orders from being entered into the system should the individual be unavailable. This procedure should be eliminated or used by exception for large or special orders.

Improve process flow so as • to maintain customer service and cash-conversion goals—for example, a customer order put on backlog because the materials are not in due to the inability of the vendor to deliver on time. This is a vendor reliability problem, and either the vendor needs to improve their operations or the business needs to seek other vendors.Improve work layout and • flow of operations—for example, operating the busi-ness out of inventory with insufficient storage space resulting in excessive time being lost in locating goods for shipment. The busi-ness needs to get out of the inventory business through improved reliance on ven-dors, producing or stocking

cost control to monitor and take action on in a developed set of cost controls and reporting sys-tem. The area of improvement should be clearly defined so that management can effectively monitor these areas to ensure that the business is moving in the right direction and that man-agement takes proper corrective action in fixing the cause and not the blame.

Examples of such operating cost controls are:

Eliminate function/work step • on an overall business basis or within an individual func-tion or activity. Management should provide proper guid-ance as to the direction of the business and each func-

tion or activity. For example, eliminate activities where the cost exceeds the value of the transaction (i.e., prepare a purchase requisition and purchase order for less than the cost of preparation, say $50).Eliminate duplication of • efforts within the same func-tion or across functions—for example, the receiving func-tion checking in materials received as well as the user.Combine functions and/or • work steps—for example, having employees submit time and expense reimburse-ment forms through the computer and having the computer software perform the checking and calcula-tions—eliminating the need for further off-line manual checking.

10. Overuse and underuse conditions;

11. Scrap and obsolescence minimized;

12. Stockouts—manufacturing and administration—eliminated;

13. Customer complaints: quality, quantity, timeli-ness—responded to and pre-vented from reoccurring;

14. Uneven production (i.e., 60 percent of orders shipped last week of month);

15. Unplanned downtime reduced;

16. Excesses (i.e., raw material and finished goods inventory, work in process, supplies, equipment);

17. Not shipping or providing services on time or not meet-ing customer expecta-tions;

18. Employee surveys (i.e., anger and frustration) indicating operational weaknesses;

19. Personnel levels (and related costs) out of sync with what’s necessary;

20. Processes/activities (value- and non-value-added) evalu-ated for necessity;

21. Duplications/non-integration of functions—product, func-tional, and customer related; and

22. Unnecessary activities in any part of the operation—prod-uct/service or other.

AREAS FOR IMPROVING ACTIVITIES

In dealing with the afore-mentioned cost-reduction targets, management should consider the following areas for improv-ing activities to make them more economical, efficient, and effective. Each one of these cost-related areas may become a

A dollar of cost savings is a dollar to the bottom line.




based on real customer orders, direct shipping by vendors, and so forth.Improve scheduling: work • and personnel. Work does not always fit the business’s hours of operations or the scheduling of personnel. Adjust the hours of opera-tion and personnel to the work flow and do not have employees waiting for work to come in. Normally work does not come in on a straight-line basis but more erratically—adjust work and personnel to the reality.Eliminate causes of rejects • and rework. Set up the con-trol system to identify all incidences of rejects and rework. Ensure the honesty and reliability of personnel reporting so that such rejects and rework are not hidden from the reporting system. Identify and fix the cause, not the blame. For example, the need to rework a produc-tion function may be due to faulty tools, equipment malfunction or failure, inad-equate training of personnel, poor or sloppy work habits, bad material quality, and so on. By correcting the cause, such rework or rejects should not happen again in the future.Simplify work steps and • processes so that minimal room is left for errors or mistakes—for example, an engineering drawing that presupposes that the operator has an adequate understand-ing of engineering drawings and tolerances. Break the job down into workable steps so any level of employee easily understands it.Improve automation efforts • and results. Eliminate manual operations where

automation can do the job better and more accurately. For example, rather than relying on manually prepared inventory tags on sellable merchandise, make effec-tive use of bar-code reading and tie it into your point-of-sale system so that the right merchandise is charged to the customer and inventory is automatically relieved identifying the remaining inventory and the need for reordering.Increase standardization and • decrease customization. For example, rather than offer many different options for your product, keep customer choices to a minimum. Know what sells and keep to those items (e.g., vanilla, chocolate, and strawberry rather than mango passion and avocado explosion).

Some other guidelines that can be used in developing cost controls and maintaining operational efficiencies for the business include those listed

in Exhibit 1. Some nonfinan-cial cost measures are given in Exhibit 2.

COST OF COMPLIANCE MEASURES

The cost of compliance measures the dollars associated with not doing what is expected. These are considered lost costs or savings and need to be included in an all-inclusive oper-ating control system:

1. Established Standards

time (set-ups, processing, • turnaround)cost (i.e., per purchase order, • data entry, raw materials)quality (i.e., loss in produc-• tion, service delivery)

2. On Time

vendor deliveries• customer deliveries• work-in-process moves (to • production schedule)

Additional Guidelines for Cost Control and Operational

Effectiveness

• Maintain schedules.• Practice good housekeeping.• Strengthen education and training.• Increase use of coaching and facilitation.• Continuously improve.• Meet realistic targets.• Implement effective planning and budgeting systems.• Achieve flexibility: doing the right thing.• Exercise performance measurement and continual review and analysis.• Take an operational perspective.• Implement the concept of economy, efficiency, and effectiveness.

Exhibit 1




3. Production/Service Delivery

time commitments• quality• quantity•

4. Administrative Performance

goals, objectives, and detail • planssales forecasts/real customer • ordersbudget versus actual versus • what it should be

5. Schedules

selling requirements (when • to sell)development (i.e., product or • service engineering)production schedule• production control• shipping/delivery schedules• billing schedules•

COST ELEMENTS

The elements that should be considered in defining the busi-ness’s cost structure are shown in Exhibit 3.

Elements to Consider in Defining Your Business’s Cost Structure

Products

• Individual item• Product group• Product line• Specialty/custom product

Functions (distinct areas within an organization structure)• Departments• Cost centers• Responsibility centers• Profit centers

Activities (within functions)• Manufacturing (i.e., product assembly)• Service delivery• Forms preparation and handling• Data entry• Maintenance

Elements (types of costs generated by activities)• Direct labor• Direct material• Repairs and maintenance • Support work

Customers

• Before sale• During sale• After sale• Customer service

Exhibit 3

Nonfinancial Cost Measures Checklist

Indicators of poor customer service and other operating deficiencies that impact upon the business’s unnecessary costs and effectiveness of operations include the following:

• Customer complaints (returns, rejects, complaints)• Idle inventory (raw material, work in process, finished goods)• Late deliveries (vendors, customers)• Change orders (purchasing, manufacturing, shipping)• Processing (manufacturing, purchase, and sales orders)• Recording (purchase requisitions, time cards, move tickets, etc.)• Quality control (receiving, in process, final)• Equipment (idle time, set-ups, maintenance, downtime)• Production schedule changes (moves, wait time, lost time)• Customer service (late, inadequate, nonresponsive)

Exhibit 2




Rob Reider, CPA, MBA, PhD, is the president of Reider Associates, a management and organizational con-sulting firm located in Santa Fe, New Mexico, which he founded in 1976. Prior to starting Reider Associates, Dr. Reider was a manager in the Management Consulting Department of Peat, Marwick & Mitchell (now KPMG) in Philadelphia. Reider has been a consultant to numerous large, medium, and small businesses of all types in both the private and public sectors. Dr. Reider is the course author and discussion leader and presenter for over 20 different seminars that are conducted nationally for various organizations and associations. He has conducted over 1,000 such seminars throughout the country. He has received the American Institute of Certified Public Accountants (AICPA) Outstanding Discussion Leader of the Year award. He has presented at numerous professional meetings and conferences around the country and has written numerous articles in professional journals.Reider is the author of the following books published by John Wiley & Sons:

• Operational Review: Maximum Results at Efficient Costs; • Benchmarking Strategies: A Tool for Profit Improvements; Managing Cash Flow:• An Operational Focus (coauthor with Peter B. Heyler); • Improving the Economy, Efficiency, and Effectiveness of Not-For-Profits; and • Effective Operations and Controls for the Small Privately Held Business.

He can be contacted at [email protected].


Documents

Cost management in tough times