Cost Management and Organizational Performance

Cost Management and Organizational Performance

Cost management lies at the heart of the organizational performance since the organization is considered to be performing if it has a healthy bottom line. Two things determine the bottom line namely (i) cost, and (ii) revenue. The organization moves from cost to performance or from failure to success, when it is profitable. Hence, the main objective of any organization is that it is to be profitable. Being profitable also helps the organization to have sufficient funds for its growth as well as for its sustenance during the difficult periods.

The organizational objective to be profitable can be achieved by the management through several of its actions which also include (i) proper planning, (ii) effective resourcing of quality materials needed for the organizational processes, (iii) efficient operation of the technological and other processes with high level of productivity for producing the organizational products, (iv) management of consumptions and wastes (v) keeping the plant and equipment healthy and ensuring that it meets the required technological levels, (vi) production of the quality products required by the market, (vii) efficient, trained and motivated human resource having the required knowledge of the processes, (viii) effective marketing of the organizational products, (ix) efficient handling of the funds and close monitoring of the expenditures, and (x) sound and effective decision making.

Cost management produces information for internal users. Specifically, cost management identifies, collects, measures, classifies, and reports information which is useful to the organizational management for determining the cost of the products, customers, and suppliers, and other relevant objects and for planning, controlling, making continuous improvements, and decision making. Cost management has a much broader focus than that found in traditional costing systems. It is not only concerned with how much something costs but also with the factors which drive the costs, such as cycle time, quality, and process productivity etc. Thus, cost management requires a deep understanding of the cost structure of the organization. Management is to be able to determine the long- run and short-run costs of activities and processes. Causes of these costs are to be also carefully studied.

Earlier it was considered that the cost management encompasses both the cost accounting and the management accounting information systems. Cost accounting attempts to satisfy costing objectives for both financial and management accounting. Management accounting is concerned specifically with how cost information and other financial and non-financial information are to be used for planning, controlling, continuous improvement, and decision making. Management accounting has an overall objective of making sure that the organization makes effective use of the resources so that value is maximized for shareholders and customers and other interested stake-holders.

Cost management is normally built on the both cost accounting and management accounting and assumes knowledge of both. Nonetheless, cost management is not cost accounting. It is much more than just the cost accounting. Cost accounting is the field of accounting which records, measures, and reports information about how much things cost, while the cost management is more comprehensive than cost accounting. Similarly, cost management is not the same as management (or managerial) accounting, which is normally considered as breakeven analysis, economic order quantities, and  above all, calculation of variances between actual and standard costs. Cost management is far more concerned with management’s use of cost information for decision-making. Although, cost management is not cost accounting and management accounting, these at least help to set cost management in context.

Cost management simultaneously improves the strategic position of the organization while reducing the costs.  It requires including of all aspects of production and delivering the product, the supply of purchased parts, the design of products and the manufacturing of these products. So, it is inherent to each stage of the life cycle the product, i.e. during the development, manufacturing, distribution, and during the service lifetime of a product.

Cost management attempts to improve the strategic position of the organization and reduces the costs at the same time. It is important since competition means that the organization is to be constantly aware of its strategic position. The organization is required to compete in the areas of cost, quality, customer service, and flexibility with any cost reduction efforts contributing to an improved strategic position. A sophisticated understanding of the organizational cost structure can go a long way in the search for sustainable competitive advantage. Hence, the cost management can be considered as the managerial use of cost information explicitly directed at one or more of the four strategic phases consisting of (i) formulating strategies, (ii) communicating those strategies throughout the organization, (iii) developing and carrying out tactics to implement the strategies, and (iv) developing and implementing controls to monitor the success of objectives.

There are four stages towards the development of cost management systems in the organization. In the first stage, the cost management systems are basic transaction reporting systems. As they develop into the second stage, cost management systems focus shifts to external financial reporting. The objective is reliable financial reports and hence, the usefulness for cost management is limited. In the stage three, the cost management systems track key operating data and develop more accurate and relevant cost information for decision making and hence, there is the development of the cost management information system. Finally in stage four, strategically relevant cost management information is an integral part of the system.

The first two stages of cost management system development focus on the management accounting measurement and reporting role. In the third stage there is a shift to operational control. In the fourth stage, the ultimate goal, the cost management is an integral part of management, not a reporter but a system which is fully integrated with other management systems and a part of the overall organizational strategy. This requires the identification of the critical success factors of the organization and the use of analytical, forward-looking decision support. Critical success factors are the measures of those aspects of the organizational performance which are essential to its competitive advantage and, hence, to its success. Many of these critical success factors are financial, but many are non-financial.

Limited resource and apparent continuous competition influence the organization towards the cost management which is normally carried out by better managing of the cost of production by implementing standard costing, budget system, monitoring cost information, and focusing on value added activities by eliminating non-value added activities through supplier coordination, and emphasizing on cost structure by analyzing cost and finding the way to reduce costs in the stage of pre-production. The organization with cost management strategy implementation is able to know when the amount of cost is going to incur and the management can take better decision which positively improves the performance of the organization.

The cost behaviour in the organization denotes the way in which a cost changes over time in relation to the changes in the level of an activity or in relation to the specific application of a resource.  Cost is an important measure of organizational performance, the particulars of how a cost changes directly influences performance dynamics. A better way to see costs comes from the recognition that the process of transforming resources into saleable goods and services is the essence of the operations. The relationship between processes and profits is the cost management where financial results begin to be compared with all resources which produced them.

Cost management consists of deliberate decision making aimed at aligning the cost structure of the organization with the organizational strategy and optimizing the performance through close implementation of the strategy. It has considerable positive relation with overall financial operations and is also considered as a long-term strategy to improve the supply chain systems and manufacturing of different cost structure.

The organization is required to have three qualities for an effective cost management. These three qualities are (i) availability of cost management skills, (ii) availability of effective internal controls, and (iii) effective and reliable decision making.

Traditional cost management is based on controlling costs and quality and balancing them temporary, and also focus on internal efficiency. On the contrary, cost management is a process of quality planning and cost decreasing which manages the costs before their occurrence. A well planned cost management strategy provides improvements in quality, cost/price and functionality of a product.

Cost management has three dimensions. These are (i) cost containment, (ii) cost avoidance, and (ii) cost reduction. Cost containment is a process of controlling the expenses required to operate the organization within pre-planned budgetary constraints. It is an important management function which helps to keep costs down to only necessary and intended expenses in order to satisfy financial targets and it focuses on constraining future fixed cost or unit variable cost increases. Cost avoidance refers to the eliminated activities which generate costs of non-added values. Cost reduction is the achievement of real and permanent reduction in the unit cost of the products without damaging the ability of the product to serve the purpose for which it was intended and it refers to an attempt to attain lower current fixed costs and variable costs associated with an essential activity. The three dimensional cost management strategies are applied in all the activities of the organization.

The performance of an organization is ultimately judged by its financial performance which is considered to be as the single most important factor in assessing growth potential, earnings capacity and overall financial strength. The financial performance is generally defined as measuring results of the organizational policies and operations in monetary terms and these results are reflected in the organizational return on investments, return on assets, return on equity, liquidity and solvency.

The financial performance measures of the organization basically serve three purposes namely (i) they serve as a tool of financial management, (ii) they serve as major objectives of the organization, and (iii) they serve as a mechanism for motivation and control in an organization. There can be different performance measures. In many organizations the profitability is the most commonly used measure of performance.

The expected relationship between cost management strategies and financial performance can be either a positive or a negative relationship. One school of thought is that there is a positive relationship in that cost management strategies are considered as critical factors to increase the revenue for the success of the organization. Another positive relationship is that cost containment techniques such as standard costing, sourcing and budget system limit the highest cost which can be incurred and as a result for the same level of revenues, the expenses are lower which results to increase in profitability. Cost reduction refers to an attempt to attain lower current fixed costs and variable costs associated with an essential activity. As a result of this total output of assets is low compared to the resulting income generated. These results to increase of ROA (return on assets) ratio hence increase in profitability. In case of cost avoidance which refers to the eliminated activities that generate costs of non-added values has a positive impact on profitability in that costs which increase expenditure with no future revenue generation are done away with hence reducing the negative impact on the income. Positive increase of revenues leads to increase in ROA and in profitability.

Another approach which indicates a negative relationship of cost management to the financial performance measurement advocates for the supplementing of the traditional cost measures with a diverse mix of non-costing measures which are expected to capture the key strategic performance dimensions which are normally not accurately reflected in short-term cost measures. Many organizations believe that cost measures are too historical and ‘backward-looking’, and  hence lack predictive ability to explain future performance, reward short-term or incorrect behaviour, provide little information on root causes or solution for the problems, and give inadequate consideration to difficult to quantify ‘intangible’ assets such as intellectual capital. As a result, many organizations supplement cost measures with a diverse set of non-cost performance measures which are believed to provide better information on financial progress and success.

Some organizational managements often refer to cost cutting as the cost management. This is a very defective approach since cost cutting can have adverse implications on the organizational performance when viewed from a long term basis. Hence, for the coat management, the most important managerial tools are the cost management strategies. In fact, the cost management strategies are considered as critical factors for the successful performance for the organization.

Cost management strategy supports decision making and improves competitive advantage which results in a better resource allocation. In addition, cost management strategy can be integrated with other organizational strategy for the effective management of the organization in order to facilitate to determine accurately estimated cost involved in an activity before the starting of the activity and this helps to forecast cost occurrence in the future. Cost management strategy effectiveness helps to finish a task within allocated resources, to lower the cost per unit, and better quality of the process and product.

With the proper implementation of the cost management strategy, the organization management is able to know when the amount of cost is going to be incurred in the future and the management and take an informed and proper decision for the actions required to be taken, and this impacts the organizational performance.

If the management takes the right actions then it has a positive impact on the organizational performance. There is a cost element which is involved in every action. Hence, the management of the cost is a very important criterion which is linked to the organizational performance. Cost management is needed for having a healthy organizational performance. The cost management consists of deliberate alignment of the organizational resources and associated cost structure with long-term strategy and short-term tactics. It has two components namely (i) structural cost management, and (ii) executional cost management. Both are central to the effective performance of the organization.

Structural cost management refers to the cost management activities aimed at changing the cost structure of the organization. It includes organizational tools, products and processes designed to build a cost structure which is coherent with strategy. It basically refers to the strategic decisions which typically define the gross parameters of the organizational cost structure. Executional cost management refers to the cost management activities aimed at improving performance for a given strategy. It is based on common management accounting and monitoring tools used to measure cost performance in relation with competitive benchmarking used to identify improvement opportunities. It basically refers to the analysis of performance following strategic decisions. In other words, the purpose of the cost management is to align the organizational resources and associated cost structure with (i) short-term tactics through cost reductions (executional cost management), and (ii) long-term strategy through the re-engineering of the value chain and production of a different cost structure (structural cost management).

Many of the organizational managements concentrate on the executional cost management only since, they are not aware that the structural cost management knowledge is equally important for efficient organizational performance. In fact, there is a need to examine structural cost management more intensively. However, this examination is not to neglect the executional cost management in order to prevent the results from being incomplete or having spurious effects.

Executional cost management activity motivates the management and the employees of the organization to manage, control, and reduce the costs in line with the current organizational strategy, and it prevents sub-optimal decisions being taken.

Monitoring of the production costs in the organization represents an executional cost management activity which provides information concerning the appropriateness of the level and volatility of the production costs as compared to organizational goals and competitive benchmarks. This information raises awareness about the production costs throughout the organization and supports the organizational employees in their understanding of the production processes and organizational activities. More specifically, the tracking of the production costs facilitates the understanding of the links between costs and output, and provides insights into possible cost reductions through specific actions on cost drivers. This understanding acts as the trigger for the development of initiatives to act on those cost drivers, such as product and process redesign, substitution, recycling, etc. Therefore, the tracking of the production costs can help to implement the several initiatives needed to build the cost structure which has been revealed by the improved understanding of cost behaviour.

The monitoring of the production costs also provides information concerning the level of improvement of the production costs, which can reveal potential organizational gaps. In the absence of the specific identification of production costs reflecting areas of improvements, organizational slack can accumulate, i.e. the difference between the potential performance of the organization and the actual performance achieved. The detection of a performance gap slows down the development of slack by stimulating innovation and creativity.

It is normally considered that by improving cost knowledge and detecting a performance gap, the monitoring of the production costs can facilitate the development of various initiatives such as the reduction in the material and energy intensity of the production processes, the reduction in the generation of the waste materials, improvement in the recyclability of the materials, maximum use of cost effective materials, and higher level of the product quality. These initiatives help to address the performance gap revealed by monitoring of the production costs.

Further, the monitoring of the production costs is used not only to communicate the importance of the production costs, but it also integrates the different production issues into the organizational routines through the management information system (MIS) reports. Specifically, the monitoring of the production costs represents one crucial step in the integration of production issues into other MIS reports, such as budgeting, incentives, risk management, and strategic planning. These MIS reports are part of the organizational routines and are used in order to maintain or alter organizational procedures and systems. The costs related MIS reports are used notably to translate intentions into actions. Hence, the monitoring of the production costs and their integration with other MIS reports can contribute to the development of routines which support the implementation of environmental initiatives.

In short, the monitoring of the production costs represents an executional cost management activity which is used to measure the cost performance. By improving cost knowledge and the detection of a performance gap, this tracking contributes to the implementation of the initiatives. This impact also occurs because of the integration of production costs within the other controls of the management. These initiatives, which represent structural cost management activities, help define the gross parameters of the organizational cost structure.

Strategic cost management

Cost management has moved from a traditional role to a strategic role. The term strategic cost management has a broad focus. It is not confined to the continuous reduction of the costs and controlling of the costs. It is far more concerned with management use of the cost information for decision-making.

Strategic cost management is also not confined to use cost management techniques which reduce costs and improve the strategic position of the organization at the same time. It is a philosophy, an attitude, and a set of techniques to contribute in shaping the future of the organization (Fig 1). In addition, the strategic cost management does not confines its concerns and objectives only to the cost, but it also considers revenue, productivity, customer value, and at the same time the strategic position of the organization.

Fig 1 Concepts of cost managements

Strategic cost management is important to the organization since it is more than focusing on the costs. In the present environment, costs is not the only most important factor in a successful organization, but also value and revenue are considered critical factors in the success of the organization.

The cost management is a necessary course of action which acquires strategic significance the more it increases the number of options for discovering new opportunities or inventing new markets. Strategic cost management tends to be an integrated, proactive part of the strategic management aimed at satisfying all key stake-holders. It is a part of the strategy of the organization in order to achieve a radical and long-term increase in the value of the organization. It has both the opportunity and difficult task of defining and shaping its own future as well as the future of the organization.

Strategic cost management needs the support of employees, management as well as information technology because effective and timely communication is a prerequisite for implementing it. Also, it has to consider the value systems, beliefs, and projections of employees, changes in organizational processes and the ways the activities are carried out which, in turn, have to be supported by incentive and other non monetary systems. It has to create win/win situations and to communicate effectively the benefits for all involved.

Strategic cost management is sometimes thought that it is all about cost reduction. However, it is often difficult to demean the importance of cost factor for the success of the organization, but the challenge is to increase revenue, which can be facilitated by strategic cost management. Cost-management knowledge and information is critical to the organizational success.

Strategic cost management is not only cost management but also revenue management and hence, it is seeking to improve productivity, maximize profit, and improve customer satisfaction. This philosophy plays a vital role in determining the future of the organization since it promotes the idea of continually finding ways to help the organization to make the right decisions to create more customer value at lower cost.

Strategic cost management represents a proactive attitude that all the costs of the products and services result from management decisions within the organization and with customers and suppliers.

Strategic cost management is a set of reliable techniques. These techniques or instruments can be used individually to support a specific goal or together to serve the overall needs of the organization. Strategic cost management system is a set of strategic cost management techniques which function together to support the organizational goals and activities.

Traditional cost management and strategic cost management

Change is environment connected with the organization cannot be avoided. The strategic cost management helps in facing such a challenge. Strategic cost management has both the opportunity as well as the difficult task of defining and shaping its own future as well as the future of the organization. Trends and changes in the environment such as (i) increase of global competition, (ii) increasingly demanding customers and shareholders, and (iii) rapid advances in information and manufacturing technology has shown that the traditional cost management is not adaptable to these changes. In fact, many cost management solutions have been devised but their primary concern remained the cost reduction (Fig 1), as result these solutions does not insight towards organizational future. 

Cost and revenue management is the present role of strategic cost management. In the present environment, strategic cost management primary concern is not only the cost management but also increase revenues, improve productivity and customer satisfaction, and at the same time improve the strategic position of the organization (Fig 2).

Fig 2 New concepts of cost management

The key is that costs are to be viewed by looking simultaneously at the value they provide. Strategic cost management is required to recognize that cost/value and revenue are complementary, not competing terms and both are to be understood if the organization is to intelligently choose its customers and markets. Strategic cost management is required to bridge the gap between costs and values as well as between the language of the market and the language of the organization. Traditional cost management is not able to do it. However, strategic cost management faces a future which is unique and rewarding compared to its current realities.

Strategic cost management is not limited to the cost alone, but it is inclusive to all resources used and deployed across the value chain. Hence, it does not confine its concerns and objectives only to the costs, but it also consider revenue, productivity, customer value, and at the same time the strategic position of the organization. The need to understand costs is a clear one. Organization is required to know what the costs are in order to decide and manage the profitability. To help in determining the profitability, the organization is required to understand what the total costs were, are, or are going to be over a given period of time. The difference between the revenue for that period and the costs incurred during the same period determines the profitability for the period. Ultimately, decisions are to be made in the organization to drive profitability.

Other salient factors help to determine the long-term viability of the organization since without profitable performance, long-term viability is not an option. In order to survive for the long run, the organization ultimately is to be able to show that it can make more money from a product or service than it cost to make that product or service. Successful strategic cost management has focus not only on cost improvement, but also on revenue enhancement. The organization is required to sell the right product to the right customer at the right time for the right price (cost), thereby maximizing revenue from its products. The Fig 3 shows the objects and means by which strategic cost management can contribute to the process of cost improvement and revenue enhancement.

Fig 3 Strategic cost management-cost improvement and revenue enhancement

Strategic cost management understands costs and the causes of the costs as well as how to drive the greatest possible productivity through the organization. In strategic cost management, reducing costs alone is not productivity improvement. Many times, reducing cost in one activity can shift costs to another activity. But lead time decrease, product quality improve, revenue increase, overhead and operation expenses decrease, customer satisfaction, continuous improvement are examples for productivity improvement. Hence, strategic cost management plays an important role.

Moreover, successful strategic cost management is required to help the organization to develop and identify superior strategies which produce a sustainable competitive advantage. Competitive advantage is creating better customer value for the same or lower cost than offered by competitors or creating equivalent value for lower cost than offered by competitors. Customer value is the difference between what a customer receives and what the customer gives up. What customer receives includes such things as product functionality (features), product quality, reliability of the delivery, delivery response time, image, and reputation. What customer gives up or sacrifice includes product price, time required to learn to use the product, operation cost, maintenance cost, and disposal cost. Strategic cost management is required to influence the attributes associated with the dimensions of customer value (decrease the customer sacrifice and improve the customer receives) in order to help the organization increase customer value and therefore improve the strategic positioning.

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