Sharp ideas for controlling costs

Although businessmanagement typ-ically places a

major emphasis onincreasing sales as thesolution to increasingthe business or work-ing out of a bad cashor operational situa-tion, most times thecause of the problemis excessive costs or aninadequate marginbetween costs and selling prices.In addition, the business may bemaking sales that do not gener-ate a profit or contribution topositive cash flow or makingsales to less-than-quality cus-tomers who pay late or not at all.In most instances, the control ofcosts for the business can putmore onto the bottom line than acontinual thrust to increasesales. Remember that a dollar ofcost savings goes directly to thebottom line while a dollarincrease in sales may in fact pro-duce a loss to the bottom line.

Cost accounting is a majorarea of operations that businessmanagement typically shiesaway from. Unfortunately, every-thing affecting the business’soperations relates to costaccounting. While business man-

agement may pay minimal atten-tion to the cost side of the profitequation (i.e., sales less costsequal profit or loss), it is man-agement’s responsibility todevelop effective systems foridentifying, reporting, and con-trolling costs so as to managethe business most economicallywithout sacrificing results andgrowth.

COST CLASSIFICATIONS

Costs can be divided into anumber of categories for businessmanagement purposes dependingon the business’s goals and objec-tives. Each cost categorization isa separate and distinct methodwith specific uses different fromother classifications.

ManufacturingVersusNonmanufacturingCosts

In the case of amanufacturing busi-ness, costs may bedivided into twomajor categoriesbased on the manage-ment and functionalactivities they relateto:

1. Manufacturing costs areproduct costs related to thebusiness’s manufacturingactivities—they relate to:a. Direct materials are the

materials and parts thatactually go into the finishedproduct. Supplementalmaterials and supplies suchas screws, nails, and glueare usually considered indi-rect materials and includedin manufacturing overhead.

b. Direct labor is the laborcost directly associatedwith the manufacturer ofthe product, such as costsof production workers.Labor costs for manufac-turing supervision, mate-rial handling, maintenance,

Typically, business management shies away fromcost accounting. But it is a major area of opera-tions. And unfortunately, everything affecting thebusiness’s operations relates to cost accounting.So how can you develop effective systems foridentifying, reporting, and controlling costs?

This article is adapted from Effective Opera-tions and Controls for the Small Privately HeldBusiness by Rob Reider, published by John Wiley& Sons, Inc., in January 2008. © 2008 Rob Reider

Rob Reider

Sharp Ideas for Controlling Costs

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© 2008 Rob Reider. Printed with permission.Published online in Wiley InterScience (www.interscience.wiley.com).DOI 10.1002/jcaf.20380

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quality control, and othersupport services are usu-ally classified as indirectlabor and included in man-ufacturing overhead.

c. Manufacturing overhead canbe considered as includingall other costs of manufac-turing except direct materi-als and direct labor. Othercosts that are usually part ofmanufacturing overheadinclude depreciation, rentand/or other facilities costs,fringe benefits, productionsupport costs, indirect mate-rials, and indirect labor.

2. Nonmanufacturing costs arefunctional costs related toactivities other than manufac-turing functions of theorganization. These non-manufacturing costs canalso be considered asoperating expenses suchas selling and marketingexpenses, and general andadministrative expenses.a. Selling/marketing expenses

relate to the costs of sellingthe product or service andkeeping it sold. It includessales salaries and commis-sions, advertising andpromotion, travel and enter-tainment, distribution costs,and sales service costs.

b. General and administrativeexpenses include costs ofthose support functionsnecessary to keep the busi-ness going, such as owners’salaries or draws, staffcosts (i.e., accounting, IT,purchasing), mailroom,insurance, and secretarial/receptionist.

Fixed Versus Variable (and Semivariable) Costs

This category measures vari-ability of costs relative tochanges in production/service

volume or some other measuresof activity.

a. Fixed costs are ones thatremain constant in totalregardless of routine changesin the business’s volume ofactivity. For example, rent,insurance, taxes, and deprecia-tion are costs that do not fluc-tuate based on changes in thelevel of activity. They areincurred even if volume dropsand remain relatively constanteven if volume increases.Variations in these costs comeabout only as a result of majorvolume shifts or factors inde-pendent of volume changes.

b. Variable costs are costs thatvary in direct proportion tochanges in the levels of func-tional activities. For example,direct labor and direct materialcosts will vary approximatelyproportionately with volume-level changes and are thereforeclassified as variable.

c. Semivariable costs are coststhat vary, but not proportion-ately, with changes in volumeof activity. These costs con-tain both a fixed componentand a variable component.Examples include electricitycosts, maintenance, and mate-rial handling, each of whichwill increase as productionvolume increases, but not ona direct proportional basis.

The concept of fixed, vari-able, and semivariable costs refersto how the costs behave or reactto changes in levels of activity.

This is necessary information foractivities such as flexible budget-ing, profit planning, cost control,variance analysis, and relatedmanagement-based decisions.

Direct Versus Indirect Costs

Another way to view businesscosts is as either direct or indirectin terms of their traceability to aproduct/service, department, orother segment of the business thatrepresents the activity beingcosted. This type of cost analysismay be used effectively for prod-uct costing, pricing, and prof-itability analysis purposes or forevaluation of business segments.

a. Direct costs are thosethat can be directlytraced to the activitybeing costed. Forexample, direct labor,direct materials, spe-cific product advertis-ing, and sales commis-sions can be directlyattributed to a specificproduct/service.

b. Indirect costs are those thatcannot be directly attributed tothe activity being costed.Examples include manufactur-ing or administrative overhead,and other shared functionalcosts (sometimes referred toas common or joint costs)such as purchasing, IT, person-nel, accounting, and legal.

OBJECTIVES FOR COSTCONTROLS

Depending on the type ofbusiness, such as manufacturing,retail, or service, the followingitems could be considered forcost control objectives:

• lower inventories (raw mate-rial, work in process, fin-ished goods)—conserve cash

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There is more to be earned throughthe reduction of costs than theincrease of sales.

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and use it where needed inthe business;

• lower product costs (mate-rial, labor, and overhead)—increase cash and createpricing flexibility;

• smaller manufacturing lots(just-in-time manufactur-ing)—conserve cash by notspending until needed;

• improved quality—decreasequality control costs by mak-ing employees responsiblefor quality control, not otherindividuals;

• decrease lead times (on-timedeliveries)—compress cashconversion period—holdonto cash until necessary tospend and collect quickly;

• increased productivity—produce more at the same orless cost (productivityincreases while costs do not);

• improved customersatisfaction—increasecustomer service busi-ness and additionalquality sales;

• identification of value-addedcost elements (to productitem: direct and indirect)—reduction and elimination ofunnecessary costs;

• report on other than produc-tion functions as related toproduct items (i.e., sales, pur-chasing, engineering, account-ing)—control functional costsand cash outlays; and

• maximizing customer ser-vice while reducing cus-tomer-related costs—includecustomer costs in your costformula and continuallystrive to reduce them.

OPERATING DECISIONSAFFECTING COSTCONSIDERATIONS

There are many operatingdecisions that need to be made bybusiness management relative to

cost considerations and that affectthe business’s operations, as wellas what cost considerations needto be implemented to effectivelycontrol such operations. Exam-ples of such decisions include:

• manufacture versus purchase(make versus buy);

• vendor selection (price,quality, timeliness);

• single versus multiplesourcing;

• manufacturing or serviceproviding in-house versusoutsourcing;

• 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 ofpersonnel;

• product-line analysis (whatproducts to sell);

• inventory levels (in-houseversus vendors/distributors);

• lot sizing (how much to pro-duce or services to provide);and

• what businesses to be in(expand, status quo, curtail,or disband).

COST-REDUCTION TARGETS

Management continuallylooks for areas upon which toreduce costs for the business. Thefocus must not be on strictlyreducing costs but on maximizingresults with the use of the leastamount of resources. To effec-tively accomplish cost reductionwithout sacrificing results, man-

agement must be aware of theelements of the business’s opera-tions. In setting up operating con-trols directed toward reducingcosts and increasing profitability,management must be aware ofthose elements or activities thatproduce costs to the businesssuch as those in Exhibit 1.

AREAS FOR IMPROVINGACTIVITIES

In dealing with the abovecost-reduction targets, manage-ment should consider the follow-ing areas for improving activitiesto make them more economical,efficient, and effective. Each oneof these cost-related areas maybecome a cost control to monitorand take action on in a devel-oped set of cost controls andreporting system. The area of

improvement should beclearly defined so thatmanagement can effec-tively monitor these areasto ensure that the business

is moving in the right directionand that management takesproper corrective action in fixingthe cause and not the blame.

Examples of such operatingcost controls are shown in thenext section.

Operating Cost Controls

• Eliminate function/work stepon an overall business basisor within an individual func-tion or activity. Managementshould provide proper guid-ance as to the direction ofthe business and each func-tion or activity (e.g., elimi-nate activities where the costexceeds the value of thetransaction—i.e., prepare apurchase requisition andpurchase order for less thanthe cost of preparation—say,$50).

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Cost accounting affects every activity.

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• Eliminate duplication ofefforts within the same func-tion or across functions (e.g.,the receiving function check-ing in materials received aswell as the user).

• Combine functions and/orwork steps (e.g., having

employees submit time andexpense reimbursement formsthrough the computer andhaving the computer softwareperform the checking and cal-culations—eliminating theneed for further off-line man-ual checking).

• Balance workloads within afunction or activity (e.g.,processing of sales orders bycustomer or by alphabeticcategories). When it happensthat one individual is over-worked while others areunderworked or idle, movethe employees to the workand determine whetherworkloads are shrinking andthe function can get by withless personnel support.

• Reduce or eliminate bottle-necks that are clogging oper-ations from runningsmoothly (e.g., the require-ment that one individualmust sign and approve allincoming customer ordersregardless of the amount,which holds up these cus-tomer orders from beingentered into the systemshould the individual beunavailable. This procedureshould be eliminated or usedby exception for large orspecial orders).

• Improve process flow so asto maintain customer serviceand cash conversion goals(e.g., a customer order puton backlog because thematerials are not in due tothe inability of the vendor todeliver on time. This is avendor reliability problemand either the vendor needsto improve their operationsor the business needs to seekother vendors).

• Improve work layout andflow of operations (e.g.,operating the business out ofinventory with insufficientstorage space, resulting inexcessive time being lost inlocating goods for shipment.The business needs to get outof the inventory businessthrough improved reliance onvendors, producing or stock-ing based on real customer



Cost-Reduction Targets

Based on the type of business and its inherent operating activities,related cost elements must be identified, such as the following:

• Labor—direct and indirect• Materials—direct and supplies• Processing time kept to a minimum• Lead time condensed to the smallest amount• Paperwork reduced and eliminated• Setup time—manufacturing and administration—minimized• Parts and supplies at the best price, quality, and on-time • Vendors: best prices, 100 percent quality, delivered on-time• Cycle time—manufacturing and administration—kept to a minimum• Overuse and underuse conditions• Scrap and obsolescence minimized• Stockouts—manufacturing and administration—eliminated• Customer complaints—quality, quantity, timeliness—responded to

and prevented from reoccurring• Uneven production (i.e., 60 percent of orders shipped last week of

month)• Unplanned downtime reduced • Excesses (i.e., raw material and finished goods inventory, work in

process, supplies, equipment)• Not shipping or providing services on time or not meeting customer

expectations• Employee surveys (i.e., anger and frustration) indicating operational

weaknesses• Personnel levels (and related costs) out of sync with what’s necessary• Processes/activities (value- and non-value-added) evaluated for

necessity• Duplications/nonintegration of functions—product-, functional-, and

customer-related• Unnecessary activities in any part of the operation-product/service

or other

Exhibit 1

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orders, direct shipping byvendors, and so forth).

• Improve scheduling: workand personnel. Work doesnot always fit the business’shours of operations or thescheduling of personnel.Adjust the hours of opera-tion and personnel to theworkflow and do not haveemployees waiting for workto come in. Normally workdoes not come in on astraight-line basis but moreerratically—adjust work andpersonnel to the reality.

• Eliminate causes of rejectsand rework. Set up the con-trol system to identify allincidences of rejects andrework. Ensure the honestyand reliability of personnelreporting so that such rejectsand rework are not hiddenfrom the reporting sys-tem. Identify and fixthe cause, not theblame. For example,the need to rework aproduction function may bedue to faulty tools, equip-ment malfunction or failure,inadequate training of per-sonnel, poor or sloppy workhabits, bad material quality,and so on. By correcting thecause, such rework or rejectsshould not happen again inthe future.

• Simplify work steps andprocesses so that minimalroom is left for errors ormistakes (e.g., an engineer-ing drawing that presupposesthat the operator has an ade-quate understanding of engi-neering drawings and toler-ances). Break the job downinto workable steps so anylevel of employee easilyunderstands it.

• Improve automation effortsand results. Eliminate man-ual operations where

automation can do the jobbetter and more accurately.For example, rather thanrelying on manually pre-pared inventory tags on sell-able merchandise, makeeffective use of bar codereading and tie it into yourpoint-of-sale system so thatthe right merchandise ischarged to the customer andinventory is automaticallyrelieved, identifying remain-ing inventory and the needfor reordering.

• Increase standardizationand decrease customization.For example, rather thanoffering many differentoptions for your product,keep customer choices to aminimum. Know what sellsand keep to those items(e.g., vanilla, chocolate,

and strawberry rather thanmango passion and avocadoexplosion).

Some other guidelines thatcan be used in developing costcontrols and maintaining opera-tional efficiencies for the busi-ness include:

• maintain schedules;• practice good housekeeping;• strengthen education and

training;• increase use of coaching and

facilitation;• continuously improve;• meet realistic targets;• implement effective plan-

ning and budgeting systems;• achieve flexibility: doing the

right thing;• exercise performance mea-

surement and continualreview and analysis;

• take an operational perspec-tive; and

• implement the concept ofeconomy, efficiency, andeffectiveness.

Nonfinancial Cost Measures

Indicators of poor customerservice and other operating defi-ciencies that impact upon thebusiness’s unnecessary costs andeffectiveness of operationsinclude the following:

• customer complaints(returns, rejects, complaints);

• idle inventory (raw material,work in process, finishedgoods);

• late deliveries (vendors, cus-tomers);

• change orders (purchasing,manufacturing, shipping);

• processing (manufactur-ing, purchase, and salesorders);

• recording (purchase req-uisitions, time cards,move tickets, etc.);

• quality control (receiving, inprocess, final);

• equipment (idle time, setups,maintenance, downtime);

• production schedule changes(moves, wait time, losttime); and

• customer service (late, inad-equate, nonresponsive).

Cost-of-Compliance Measures

The cost of compliancemeasures the dollars associatedwith not doing what is expected.These are considered lost costsor savings and need to beincluded in an all-inclusive oper-ating control system. You shouldexamine:

1. Established Standards• Time (setups, processing,

turnaround)



Business life is cost accounting.

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• Cost (i.e., per purchaseorder, data entry, rawmaterials)

• Quality (i.e., loss in pro-duction, service delivery)

2. On-Time• Vendor deliveries• Customer deliveries• Work in process moves (to

production schedule)3. Production/Service Delivery

• Time commitments• Quality• Quantity

4. Administrative Performance• Goals, objectives, and

detail plans• Sales forecasts/real cus-

tomer orders• Budget versus actual ver-

sus what it should be5. Schedules

• Selling requirements(when to sell)

• Development (i.e., productor service engineering)

• Production schedule• Production control• Shipping/delivery

schedules• Billing schedules

COST ELEMENTS

The elements that should beconsidered in defining the busi-ness’s cost structure are shown inExhibit 2.



Cost Elements

These should be considered in defining the business’s cost structure.

Products

• Individual item• Product group• Product line• Specialty/custom productFunctions (distinct areas within an organization structure)• Departments• Cost centers• Responsibility centers• Profit centersActivities (within functions)• Manufacturing (i.e., product assembly)• Service delivery• Forms preparation and handling• Data entry• MaintenanceElements (types of costs generated by activities)• Direct labor• Direct material• Repairs and maintenance • Support workCustomers

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

Exhibit 2

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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 Associ-ates, Dr. Reider was a manager in the Management Consulting Department of Peat, Marwick, & Mitchell(now KPMG) in Philadelphia. He has been a consultant to numerous large, medium, and small businessesof 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 thatare conducted nationally to various organizations and associations. He has conducted over 1,000 such sem-inars throughout the country. He has received the American Institute of Certified Public Accountants Out-standing Discussion Leader of the Year award. Dr. Reider has presented at numerous professional meetingsand conferences around the country and has published numerous articles in professional journals.

He 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); and• Improving the Economy, Efficiency, and Effectiveness of Not-for-Profits.He can be contacted via e-mail at [email protected] article is excerpted and adapted from Effective Operations and Controls for the Small Privately Held

Business, authored by Rob Reider and published by John Wiley & Sons.

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Sharp ideas for controlling costs