Over the last decades, several industrial sectors have been experiencing huge changes involving both the working environment and the internal organization. This process has been so deep and radical as to suggest that a new operation management paradigm has emerged. In this new competitive and turbulent environment, effective cost management has become extremely important to drive improvement efforts in the organization.
Cost management can normally be considered as a set of techniques and methods for controlling and improving the organizational activities, processes, products, and services, as well as to achieve cost effectiveness (cost reduction, value improvement, and substitution) by collecting, analyzing, evaluating, and reporting cost information for budgeting, estimating, forecasting, and monitoring costs, in order to assist decision making process of the management.
The lack of a cost management system in the organization can affect profits and business processes. The management and costs are always factors which stand out in the organization because of the important role which they transmit and result. Increasingly, the highlight of these areas is growing and becoming important for the proper performance of the organization. Practices which consider the alignment of these two terms is needed to be applied in the organization.
The main purpose of the cost management system is to maximize profits. In order to maximize profits, the organization is to continually develop itself and has to face and succeed competition which can come from either domestic or international organizations. In a nutshell, the two primary objectives to provide a cost management system are global competition and continuous improvement.
For an effective cost management normally three types of cost sheets are prepared in the organization. These are standard cost sheets, budget cost sheets, and actual cost sheets. Standard costs are made on the basis of process capabilities i.e., consumption norms as well as fixed charges at the level of 100 % capacity utilization. Budget costs are prepared based on budgeted level of the performance. Actual cost sheets are based on actual performance. Budget costs and standard costs uses pre-determined per unit costs such as landed cost of raw materials, consumables, stores and spares etc. Actual cost sheets use actual data.
An important aspect of cost management is the variance analysis. Variance analysis can be done between actual cost and standard cost or budget cost. Variation analysis breaks down the variation in the costs into various components such as volume variation, material cost variation, and manpower cost variation etc. This helps the management to understand which factor is affecting most for the cost variation with the planned cost and in turn helps in taking appropriate corrective action to correct the situation.
There are different types of costs which are involved in carrying out an activity. Also, there are the relevant and the non-relevant costs. This parameter varies depending on the situation where the process is and what has been budgeted. The relevant costs are important for this approval. Classification of cost is the grouping of costs according to their common characteristics. The different ways in which the costs can be classified is described below.
Elements of cost – The three basic elements of costing are materials, manpower, and expenses.
Nature or traceability – As per nature or traceability of costs there are direct costs and indirect costs. The direct costs are the ones which can be directly assigned to each type of material or activity at the time of its occurrence, i.e., it is connected directly to each type of good or cost function. The direct costs of a process can be easily identified and quantified from necessary resources to carry out the process activities. These costs are directly attributed to the work of the process and hence do not need apportionment to be allocated to the process. Direct costs are directly attributable or traceable to cost object.
The indirect cost is unable to segregate the portion pertaining to each product or different service at the time of application of the cost. Such separation is performed later by a special criterium called apportionment. This cost can be apportioned in different ways and the adequacy of the same depends on the branch to which the organization operates and its needs, so it is an analysis of the best cost allocation. Indirect costs are not directly attributable or traceable to cost object. Indirect costs are allocated or apportioned to the cost objects.
Ability to control the costs – As per the ability to control the costs, the costs can be either controllable or uncontrollable costs. Controllable costs are those costs which can be controlled or influenced by a conscious action of the management while uncontrollable costs cannot be controlled or influenced by a conscious management action.
Normality – As per this classification, costs can be either normal costs or abnormal costs. Normal costs arise during routine day-to-day operations in the organization. Abnormal costs arise because of those abnormal activities which are not part of normal or routine operations. Example of such costs the costs arising out of accidents or serious equipment breakdown etc.
Cost behaviour – Costs are classified according to their behaviour in relation to change in relation to production volume within given period of time. As per cost behaviour, cost elements normally fall into two categories. These are variable costs and fixed costs. Fixed costs and variable costs comprise total cost. Fixed costs are those costs which are always present in the production and which do not have variations. These costs do not vary with production, do not change regardless of the type of service or the same schedule. Fixed Costs remain fixed irrespective of changes in the production volume in given period of time. These costs remain the same throughout the period of the work.
Variable costs are characterized as those costs which vary with the volume of the production or the performed activity. The variable costs increase as the production increases and decrease when the production decreases. These costs are directly proportional to process activities in a given period. An example of variable cost in a process is the raw material cost. These costs differ from fixed costs which tend to remain the same regardless of production output. Variable costs change according to volume of production. Fig 1 shows fixed cost and variable cost.
Fig 1 Fixed cost and variable cost
Time related cost – These costs are historical costs and pre-determined costs. Historical costs are those costs which have been incurred in the past. Pre-determined costs are computed in advance on the basis of factors which affect the cost elements. Examples of pre-determined costs are standard costs, and budget costs.
Decision making costs – These costs are those costs which are used by the management for the purpose of decision making. Example of such costs are cost of a project, and costs to develop a product.
Costs as per the cost functions – There are different functions for which normally the cost is determined. For example, these are production cost, administration cost, marketing cost, and research and development (R & D) cost etc.
Marginal costs – Marginal costs are defined as the change in the total costs because of change in the volume of output by one unit. These costs are the variable costs associated with increasing output in the short run.
Differential costs – Differential costs are the difference in total cost which arise from the selection of one alternative to the other.
Opportunity costs – These are those costs which have been incurred because of the selection of an alternative course of action. These costs represent the value of benefit sacrificed or gained in favour of this alternative course of action.
Relevant costs – These costs are those costs which are relevant because of the different decisions of the management.
Replacement costs – These costs are those costs at which existing items of material or fixed assets can be replaced. These are the costs of replacing existing assets at present or at a future date.
Shut-down costs – These costs are those costs which are incurred because of the shut-down of the operations. These costs are not there if the operations are continued.
Capacity costs – These costs are normally fixed costs. These costs are those costs which are incurred by the organization for providing production, administration, and selling and distribution capabilities in order to perform various functions.
Other costs – These are those costs which do not come under a normal classification of costs.
The analysis for the approval of costs is easier when cost centres are well defined. The cost centre is the categorization of costs. This categorization is to be consistent with the budget. The categorization is intended to show where costs are being accumulated. For standardization of a process, there needs to be a standardization of information so that it can circulate properly within the organization with higher clarity and with the reliability expected. Cost centres, for each process, form the respective chart of accounts, depending on which the process is to be planned, and then the costs and the time needed for carrying out each process element are controlled.
Cost management produces information for internal users. Specifically, cost management identifies, collects, measures, classifies, and reports information which is useful to the managers for determining the cost of products, marketing of products, and purchasing of materials, 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 influence the costs, such as cycle time, quality, and process productivity. Hence, cost management needs a deep understanding of the cost structure of the organization.
Cost management evolves from simple systems which are controlled by the management, and from more advanced management techniques in which the control is very important. The cost is very important for the employee, the management, and the organization. Cost needs adequate management for its control. Further, to know how the organization is performing, the management needs a cost management system since it faithfully demonstrates the process costs, and how to control those costs. Hence, there is a clear need for the organization to have cost management system especially for having adequate controls since financial resources are increasingly expensive and scarce within the organizational context.
Cost management in the organization involves three processes namely (i) estimating the costs, (ii) determining the budget, and (iii) cost control. These three steps are closely linked, aiming to provide knowledge to analyze and manage all the costs involved in the organization. The basis of a good cost management is the tools which are used to control the cost. These tools are aimed at the monitoring of the processes, based on the budget and at what the processes are consuming. These tools are used in accordance with a methodology which is intended to be dynamic and presents the real situation of the processes once they are operated correctly.
Managers in the organization are to be able to determine the long-term and short-term costs of the activities and processes as well as the costs of goods, services, customers, suppliers, and other objects of interest. Causes of these costs are also to be carefully studied. The costs of activities and processes do not appear on the financial statements. Yet, knowing these costs and their underlying causes is critical for the organization engaging in such tasks as continuous improvement, total quality management, environmental cost management, productivity enhancement, and strategic cost management.
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. When cost accounting is used to comply with a financial accounting objective, it measures and assigns costs in accordance with GAAP (generally accepted accounting principles). When used for internal purposes, cost accounting provides cost information about products, customers, services, projects, activities, processes, and other details which can be of interest to management. The cost information plays an important support role for planning, controlling, and decision making. This information need not follow GAAP. 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.
Over the last few decades, world-wide competitive pressures, deregulation, growth in the service industry, and advances in information and manufacturing technology have changed the nature of the economy and caused several manufacturing and service industries to dramatically change the way in which they operate. These changes, in turn, have prompted the development of innovative and relevant cost management practices. For example, activity-based accounting systems have been developed and implemented in several organizations. Additionally, the focus of cost management accounting systems has been broadened to enable managers to better serve the needs of the customers and manage the organizational processes which are used to create customer value. Presently, an organization can establish a competitive advantage by providing more customer value for less cost than its competitors. For securing and maintaining a competitive advantage, managers seek to improve time-based performance, quality, and efficiency. Cost information is to be produced to support these three fundamental organizational goals.
The concept of costs needs to be made explicit to everyone who is part of the organization. Everyone needs to know that any expense applied in production or in any other function within the organization is characterized as cost. The wrong quantification of costs can hurt and damage the organization and its management. Setting costs is a serious and critical task within the organization, as it can result in injury or aid to the profit for the organization.
The organizational management is to be in constant pursuit of management control and cost control. This is a fundamental factor in competitiveness and in strategic positioning of the organization in the market. The strategic cost management in the organization is required to observe, identify, and analyze the cost determinants, to observe the factors which actually cause the costs, called cost drivers, and providing the form which reflects the most precise reality of the situation. This concept is undoubtedly very important for the strategic management of the organization, clearly showing that it is necessary to know the factors which cause losses.
Strategic cost management consists of these three pillars namely (i) value chain, (ii) strategic positioning, and (iii) cost drivers. These factors contribute to the success of cost management in the organization. The cost management is required to involve and give emphasis to the processes which can consistently provide added and superior values to the customer, and achieving the results by means of coordination and management of the cost flow. The organizational managers need to monitor the performance of their area of operation and, hence, rely on relevant management information regarding the costs and also take the needed actions to optimize cost management. Also, in order to facilitate the use and analysis of management information reports, the managers need to have available a proper sequence of information which is relevant to make decisions.
The cost management evolves from simple systems which have been controlled by the management to more advanced management techniques for which the control is very important. There is a clear need for the organization to have adequate controls since financial resources are increasingly expensive and scarce within the organizational context. The cost management in an organization involves three processes namely (i) estimating the costs, (ii) determining the budget, and (iii) cost control. These three steps are closely linked, aiming to provide knowledge to analyze and to manage all the costs involved in the organizational processes. The relevance of costs can be separated for approval in a given situation.
The basis of a good cost management is the tools used to control the cost. The tools are aimed at the process of monitoring the progress of the processes, based on the budget and on what the processes are consuming. The tools are used in accordance with a methodology which is intended to be dynamic and presents the real situation of the processes when they are operated in stable condition. The most relevant information within the organization is the measurement of waste and activities which do not add value to the processes. Managers can check and view the quantity of waste during the processes and undertake efforts to improve the factors of costs where there is a higher return (profit). Based on this concept, the importance of tools for managing costs is that they are to be examined, since they let the managers view where the waste is taking place since waste can make the process contributing to the losses. Presently, there are a number of cost-control tools which are available.
Softwares serve as aids for monitoring the cost and its presentation. A good software brings a number of features to control, and can add other management applications, so that it can show the whole situation of the process. There is a wide variety of softwares, but the organization is to use the one which best fits with the process and budget. Softwares are electronic platform to create multiple applications. Managers can make calculations, enter the database and even provide reports. They are powerful tools when they are operated and structured as per the process requirements. The use of this tool is not limited only to observe and count the costs, but also to display and to record the optimization of the resources allocated, so being able to manage if there is a better performance in the process, which areas need improvement in order to bring satisfaction and continuous improvement for the organization.
Cost management is a broad concept than cost accounting, cost control, and cost reduction. Cost management information is the information which the management needs to effectively manage the organization and includes both financial information about cost and revenues as well as relevant non-financial information about productivity, quality, and other key success factors for the organization to lead the organization to competitive success. In cost management, the objective is to increase productivity of resources and factors of production and to relate them to improve profitability. It continuously looks for and identifies opportunities to have higher return on investment by studying customer needs, bringing improvement in the existing products or services, smoothening process and layout of manufacturing goods or services with a view to supply the improved products to the customers and to ensure customer satisfaction so as to maximize margins and earn higher profits. In this way, cost management achieves its goals by creating and sustaining linkages among revenue, cost, products manufactured or services rendered and the use of resources and infrastructure of an organization.
Cost management identifies, collects, measures, classifies and reports information which is useful to managers and other internal users in cost ascertaining, planning, controlling and decision-making. According to certain views, the term cost management has no uniform definition. Hence, as per these views, the term cost management describes the approaches and activities of managers in short-run and long-run planning and control decisions which increase value for customers and lower the costs of products and services. For example, managers make decisions regarding the quantities and kinds of materials being used, changes in plant processes, and changes in product designs. Information from accounting systems helps managers to manage costs but the information and the accounting systems themselves are not cost management.
Cost management in its broadest sense includes all those activities and related infrastructures which the organization employs to set and measure the achievement of its goals and objectives. Cost management provides the vital link between the organizational strategy and its evaluation process, and seeks to determine whether its operational activities are aligned with and contributing to the successful execution of the strategy. This includes measuring not only the organization wide cost but also each organizational unit contribution to the overall cost.
Developing information within cost management needs that the managers are to be aware about the cost structure of the organization. Managers are to know how to ascertain costs of different activities, processes, customers, goods, services and any other costing objects. Financial accounting does not deal with these costs and these costs are not found on the financial statements. However, knowledge about these costs is necessary to help the managers in productivity enhancement, strategic planning and management, total quality management, and management control.
Cost control refers to management actions to keep the costs within standards and / or budget. Cost control can be defined as the comparative analysis of actual costs with appropriate standards or budgets to facility performance evaluation and formulation of corrective measures. It aims at accomplishing conformity between actual results and standards or budgets, keeping expenditures within prescribed limits. Cost control has several features which include (i) creation of responsibility centres with defined authority and responsibility for cost incurrence, (ii) formulation of standards and budgets which incorporate objectives and goals to be achieved, (iii) timely cost control reports (responsibility reporting) describing the variances between budgets and standards and actual performance, (iv) formulation of corrective measures to eliminate and reduce unfavourable variances, (v) a systematic and fair plan of motivation to encourage the employees to accomplish budgetary goals, and (vi) follow-up to ensure that corrective measures are being effectively applied.
Cost control does not necessarily mean reducing the cost but its aim is to have the maximum utility of cost incurred. In other words, the objective of cost control is the performance of the same job at a lower cost or a better performance for the same cost. Cost reduction can be defined as a planned, positive approach to bring costs down. It implies real and permanent reduction in the unit cost of products manufactured or services rendered without impairing the (products or goods) quality or suitability for the use intended, that is, without reducing their value in terms of utility or satisfaction to the customers.
The goal of cost reduction is achieved in two ways namely (i) by reducing the cost per unit, and (ii) by increasing productivity. The steps for cost reduction include elimination of waste, improving operations, increasing productivity, search for cheaper materials, improved standards of quality, finding other means to reduce unit costs. Cost reduction has to be achieved using internal factors within the organization. Reduction of costs because of the external factors such as reduction in taxes, government subsidies, grant, etc., do not come under the concept of cost reduction. It is not to be the result of wind falls.
Because of the globalization, it is necessary for an organization to reduce costs so that prices of its products are really competitive in the world markets. This needs a huge effort for cost reduction in the organization. Hence, the cost reduction techniques occupy a prominent position in any organization which aims to maximize profits. Management is always to attempt to remove difficulties normally found in cost reduction programmes. Some such difficulties are (i) employees do not welcome cost reduction programmes and can resist their implementation, (ii) cost reduction programmes are normally carried out on an ad hoc basis, (iii) the schemes are applied only in some areas but it is required to cover all the activities, and (iv) cost reduction programmes are normally implemented in a hurry, whereas, they are to be carried out after careful thought and in a planned manner.
Cost reduction is a much wider concept than cost control. Cost control aims at controlling costs within prescribed limits with the help of budgets and standards. There are differences between cost reduction and cost control. These differences are given in Tab 1.
|Tab 1 Comparison of cost control and cost reduction|
|Cost control||Cost reduction|
|Cost control process involves (i) setting targets and standards, (ii) ascertaining actual performance, (iii) comparing actual performance with targets, (iv) investigating the variances, and (v) taking corrective action. In cost control, standards form benchmarks for evaluating actual performance.||Cost reduction is not concerned with setting targets and standards and maintaining performance according to the standards. It involves critical examination of the various products, processes, and methods, etc., with a view to reduce costs and improve efficiency and effectiveness.|
|Cost control aims at adherence to and achieving standards, that is, cost targets. It assumes existence of standards and these standards are not challenged over the period.||Cost reduction aims at real and permanent reduction in costs. Hence, it aims at improving the standards. It challanges standards and assumes existence of concealed potential savings in the standards.|
|Cost control lacks a dynamic approach as the only objective is not to exceed the standards.||Cost reduction is continuous, dynamic and innovative in nature, looking always for measures and alternatives to reduce costs.|
|Cost control is a preventive function.||Cost reduction is a never-ending corrective function.|
|In cost control, costs are optimized before they are incurred. Being a routine exercise, it is operation oriented.||In cost reduction, there is always assumed a scope for reducing the incurred costs under controlled conditions. It is study oriented, always trying to reduce costs through planned study.|
|Cost control is normally applicable to items which have standards.||Cost reduction is applicable to every activity of the organization.|
|Cost control contains guidelines and directive of management as to how to do a thing.||Cost reduction adds thinking and analysis to action at all levels of management.|
|Cost control needs close monitoring and timely corrective actions.||Cost reduction demands creativity.|
|Budgetary control and standard costing are important tools of cost control.||Cost reduction uses techniques like value engineering, value analysis, work study, operation research, ABC analysis, and simplification and standardization, etc|
Both cost control and cost reduction are continuous processes in an organization. In the organization, there is needed a planned, dynamic programme for cost reduction so that cost standards needed for cost control can be improved continuously. However, cost reduction programme is neither a substitute nor it can replace a cost control system which emphasizes prompt investigation into variances and taking immediate corrective actions.
In the present-day environment, cost management involves several functions of the organizational value chain, from manufacturing to marketing to distribution to customer service. This need is particularly important when the organization is also serving in the export market. Definitions of product cost can vary. Hence, the cost management has moved beyond the traditional manufacturing cost approach to a more inclusive approach. This newer approach to product costing can take into account the costs of the value-chain activities defined by initial design and engineering, manufacturing, distribution, sales, and service. A manager who is well schooled in the various definitions of cost and who understands the shifting definitions of cost from the short run to the long run can be invaluable in determining what information is relevant in decision making. Managers with the ability to think cross-functionally can shift perspectives, expanding the understanding of problems and their solution.
Cost management system
The objectives of cost management system are (i) accurate product / service costs, (ii) assessing product and service profitability, (iii) understanding internal processes and activities, (iv) controlling costs, and (v) assisting in achieving strategies such as strategic plan, and value chain.
There is not one cost management system which exists. Costs important to one organization can be irrelevant to another organization. Similarly, costs which are important in one context to the organization are unimportant in other contexts. An understanding of the structure of the market environment in which the organization operates is an important input in designing a cost management system. Fig 2 shows integrated cost management system.
Fig 2 Integrated cost management system
The cost management information system is primarily concerned with producing outputs for internal users using inputs and processes needed to satisfy management objectives. The cost management information system is not bound by externally imposed criteria which define inputs and processes. Instead, the criteria which govern the inputs and processes are set by managers of the organization. The cost management information system has three broad objectives which provide information for (i) costing out services, products, and other objects of interest to management, (ii) planning and control, and (iii) decision making. The information requirements for satisfying the first objective depend on the nature of the object being costed and the reason for the management to know the cost.
Cost information is also used for planning and control. It helps managers to decide what is to be done, why it is to be done, how it is to be done, and how well it is being done. Further, cost information is a critical input for several managerial decisions. The cost information produced by the cost management information system is to benefit the organization as a whole. Hence, a high-quality cost management system is needed to have an organization-wide perspective. Managers working in different areas of the organization need cost information. It is since managers are to make strategic decisions. Costs of production, marketing, and servicing can vary widely. Having reliable and accurate cost information is critical for sound decision making. To provide this cost information, the cost management system is needed to interact with the production, marketing, and customer service systems. Cost information for tactical decision making is also important. In the past, little effort has been made to integrate the cost management system with other operational systems. However, the present competitive environment dictates that the organizations are required to pay much greater attention to cost management in all functional areas.
The cost management system consists of two sub-systems namely (i) the cost accounting system, and (ii) the operational control system (Fig 3). The cost accounting system is designed to assign costs to individual products and services and other objects as specified by management. For decision making, accurate product costs are needed. If possible, the cost accounting system is needed to produce product costs which simultaneously are accurate and satisfy financial reporting conventions. If not, then the cost system is to produce two sets of product costs namely (i) one which satisfies financial reporting criteria, and (ii) one which satisfies management decision-making needs.
Fig 3 Sub-systems of cost management system
The operational control system is a cost management system designed to provide accurate and timely feedback concerning the performance of the processes and others relative activities to the managers for their planning and control of activities. Operational control system is concerned with what activities are to be performed and assessing how well they are performed. It focuses on identifying opportunities for improvement and helping to find ways to improve. A good operational control system provides information which helps managers engage in a programme of continuous improvement of all aspects of the operations. Product cost information plays a role in this process, but by itself, is not sufficient. The information needed for planning and control is broader and encompasses the entire value chain. Cost information concerning quality, different product designs, and post-purchase customer needs is important for managerial planning and control.
For knowing the cost accounting system and operational control system, it is necessary to understand the meaning of cost and to become familiar with the cost terminology associated with the two systems. Managers are also to understand the process used to assign costs. Cost assignment is one of the key processes of the cost accounting system. Improving the cost assignment process has been one of the major developments in the cost management field in recent years. For this, it is necessary to define what is meant by cost. Cost is the cash or cash equivalent value sacrificed for goods and services which are expected to bring a current or future benefit to the organization. It is said cash equivalent since non-cash assets can be exchanged for the desired goods or services.
Costs are incurred to produce future benefits. In a profit-making organization, future benefits normally mean revenues. As costs are used up in the production of revenues, they are said to expire. Expired costs are called expenses. In each period, expenses are deducted from revenues on the income statement to determine the period’s profit. A loss is a cost which expires without producing any revenue benefit. Several costs do not expire in a given period. These unexpired costs are classified as assets. Equipments and factory buildings are examples of assets lasting more than one period. The main difference between a cost being classified as an expense or as an asset is the timing. This distinction is important.
In cost management, the cost accounting can be either functional based or activity based. The functional-based cost accounting system assumes that all costs can be classified as fixed or variable with respect to changes in the units or volume of product produced. Hence, units of product or other drivers highly correlated with units produced, such as direct employee hours and machine hours, are the only drivers assumed to be of importance. These unit-based or volume-based drivers are used to assign production costs to products.
A cost accounting system which uses only unit-based activity drivers to assign costs to cost objects is called a functional-based cost system. Since unit-based activity drivers normally are not the only drivers which explain causal relationships, much of the product cost assignment activity is to be classified as allocation (allocation is cost assignment based on assumed linkages or convenience). Hence, the functional-based cost accounting systems tend to be allocation-intensive. The product costing objective of a functional-based cost accounting system is typically satisfied by assigning production costs to inventories and cost of products sold for purposes of financial reporting. More comprehensive product cost definitions, such as the value-chain and operating cost definitions are not available for management use. However, functional-based cost accounting systems frequently furnish useful variants of the traditional product cost definitions. For example, prime costs and variable manufacturing costs per unit can be reported. (Variable manufacturing costs are direct materials, direct employee, and variable overhead, where variable overhead is based on the number of units produced.)
A functional-based operation control system assigns costs to the organizational units and then holds the organizational unit manager responsible for controlling the assigned costs. Performance is measured by comparing actual outcomes with standard or budgeted outcomes. The emphasis is on financial measures of performance (non-financial measures are normally ignored). Managers are rewarded based on their ability to control costs. This approach traces costs to individuals who are responsible for incurrence of costs. The reward system is used to motivate these individuals to manage costs. The approach assumes that maximizing the performance of the overall organization is achieved by maximizing the performance of individual organizational sub-units (referred to as responsibility centres).
Activity-based cost management system has evolved in response to considerable changes in the competitive environment faced by the organization. The overall objective of an activity-based cost management system is to improve the quality, content, relevance, and timing of cost information. Normally, more managerial objectives can be met with an activity-based system than with a functional-based system.
The activity-based cost accounting system emphasizes tracing over allocation. The role of driver tracing is considerably expanded by identifying drivers unrelated to the volume of product produced (called non-unit-based activity drivers). The use of both unit-based and non-unit-based activity drivers increases the accuracy of cost assignments and the overall quality and relevance of cost information. A cost accounting system which uses both unit-based and non-unit-based activity drivers to assign costs to cost objects is called an activity-based cost (ABC) system. Hence, an activity-based cost accounting system tends to be tracing-intensive. Product costing in an activity-based system tends to be flexible. The activity-based cost management system is capable of producing cost information for a variety of managerial objectives, including the financial reporting objective. More comprehensive product costing definitions are emphasized for better planning, control, and decision making. Hence, the maxim of ‘different costs for different purpose’ takes on real meaning. Tab 2 shows comparison of functional-based and activity-based cost management system.
|Tab 2 Comparison of functional-based and activity-based cost management systems|
|Functional based||Activity based|
|Unit-based drivers||Unit-based and non-unit-based drivers|
|Narrow and rigid product costing||Broad, flexible product costing|
|Focus on managing costs||Focus on managing activities|
|Sparse activity information||Detailed activity information|
|Maximization of individual unit performance||Systemwide performance maximization|
|Uses financial measures of performance||Uses both financial and nonfinancial measures of performance|
The activity-based operational control sub-system also differs considerably from that of a functional-based system. The emphasis of the traditional cost management accounting system is on managing costs. The emerging consensus, however, is that management of activities – not costs – is the key to successful control in the advanced manufacturing environment. Hence, activity-based management is the heart and soul of a contemporary operational control system. Activity-based management (ABM) focuses on the management of activities with the objective of improving the value received by the customer and the profit received by the organization in providing this value. It includes driver analysis, activity analysis, and performance evaluation and draws on ABC as a major source of information. Fig 4 shows an activity-based management model.
Fig 4 Activity-based management model
In Fig 4, the vertical dimension traces the cost of resources to activities and then to the cost objects. This is the activity-based costing dimension (referred to as the cost view). It serves as an important input to the control dimension, which is called the process view. The process view identifies factors which cause an activity’s cost (explains why costs are incurred), assesses what work is done (identifies activities), and evaluates the work performed and the results achieved (how well the activity is performed). Hence, an activity-based control system needs detailed information on activities. This new approach focuses on accountability for activities rather than costs and emphasizes the maximization of system-wide performance instead of individual performance. Activities cut across functional and departmental lines, are system-wide in focus, and need a global approach to control. Essentially, this form of control admits that maximizing the efficiency of individual sub-units does not necessarily lead to maximum efficiency for the system as a whole. Another significant difference is that in the ABM operational control system, both financial and non-financial measures of performance are important.
An activity-based cost management system offers considerable benefits, including higher product costing accuracy, improved decision making, improved strategic planning, and an increased ability to manage activities. These benefits, however, are not cost-free. An activity-based cost management system is more complex and needs a considerable increase in measurement activity, and measurement can be costly. In deciding whether to implement an activity-based cost management system, a manager is required to assess the trade-off between the cost of measurement and the cost of errors.
Measurement costs are the costs associated with the measurements needed by the cost management system. Error costs are the costs associated with making poor decisions based on inaccurate product costs or, more generally, bad cost information. Optimally, a cost management system minimizes the sum of measurement and error costs. However, the two costs conflict. More complex cost management systems produce lower error costs but have higher measurement costs. (Consider, for example, the number of activities which are to be identified and analyzed, along with the number of drivers which are to be used to assign costs to products.) The trade-off between error cost and measurement cost is shown in Fig 5. The message is clear. For some organizations, the optimal cost system cannot be an ABM system even though it is a more accurate system. Depending on the trade-offs, the optimal cost management system is to be a simpler, functional-based system. This can explain, in part, why majority of the organizations still maintain this type of system.
Fig 5 Trade-off between error cost and measurement cost
Recent changes in the manufacturing environment, however, are increasing the attractiveness of more accurate, yet complex, cost management systems. New information technology decreases measurement costs. Computerized production planning systems and more powerful, less expensive computers make it easier to collect data and perform calculations. As measurement costs decrease, the measurement cost curve shown in Fig 5 shifts downward and to the right, causing the total cost curve to shift to the right. The optimal cost management system is now one which allows more accuracy. As the cost of measurement has decreased, the cost of errors has increased. Basically, errors consist of over-costing or under-costing products. If competition heats up for an over-cost product, the organization can drop what now appears to be an unprofitable product.
Although the majority of the organizations still use a functional-based cost management system, the use of activity-based costing and activity-based management is spreading, and interest in contemporary cost management systems is high. Several organizations across the globe have adopted activity-based costing and management systems.
Activity-based management defines strategic cost management since it is cost analysis in a broader context, where the strategic elements become more conscious, explicit, and formal. Here, cost data is used to develop superior strategies enroute to gaining sustainable competitive advantage. A sophisticated understanding of the organization’s cost structure can go a long way in the search for sustainable competitive advantage. Competitive and structural changes in the organization have focused the attention of management on the improvement of the cost management processes and systems.
Consequences of lack of strategic information are (i) decision-making is based on guesses and intuition only, (ii) there is lack of clarity about direction and goals, (iii) there is lack of a clear and favourable perception of the organization by customers and supplier, (iv) there are incorrect investment decisions i.e., choosing products, markets, or manufacturing processes inconsistent with strategic goals, (v) there is inability to effectively benchmark competitors, resulting in lack of knowledge about more effective competitive strategies, and (vi) there is failure to identify most profitable products, customers, and markets.
Traditional cost management depends on conventional cost accounting and data generated in this system. Basically, variance analysis is done in respect of each element of costs such as material, employee, and overhead for evaluating the performance, controlling the costs, and taking corrective actions. Overhead variances encourage management to maximize production as a way to absorb overhead costs and to avoid unfavourable variances. Managers are rewarded or penalized for unfavourable variances in their respective performances. Traditional cost-management aims at meeting the standard costs. It institutionalizes and provides in the system normal allowance for waste, scrap, rework, etc. Traditional cost management considers only financial measures developed under cost accounting system to judge the performance and reward / punish the managers accordingly. Tab 3 shows the comparison between traditional cost management and strategic cost management.
|Tab 3 Comparison between traditional cost management and strategic cost management|
|Traditional cost management||Strategic cost management|
|Standard cost system with normal allowance for scrap, waste, rework, zero defect standard is not practical.||No allowance for scrap, waste, rework; zero defect is the concept.|
|Overhead variance analysis, maximize production volume (not quality) to absorb overhead.||Overhead absorption is not the key; standard costs and variance analysis are de-emphasized, in general.|
|Variance analysis on raw material price, procurement from multiple suppliers to avoid unfavourable price variance, low price / low-quality raw materials.||No control on raw material price, certify suppliers who can deliver right quantity, right quality, and on time.|
|No emphasis on nonfinancial performance measures.||Heavy use of nonfinancial measures (parts-per-million defects, percentage yields, scrap, unscheduled machine down times, first-pass yields, number of employee suggestions).|
|No tracking of customer acceptance.||Systematic tracking of customer acceptance (customer complaints, order lead time, on-time delivery, incidence of failures in customers’ locations).|
|No cost of quality analysis.||Quality costing as a diagnostic and management control tool.|
|The goal is to be in the top tier of the reference group.||The goal is kaizen.|
|The annual target is to meet the standards.||Industry norms set the floor.|
|Standards are to be met, not exceeded.||The annual target is to beat last year’s performance.|
|Standards are tough but attainable.||Try to beat this year’s target (continual improvements).|
|A regularly exceeded standard is not tough enough.||Each achievement level sets a new floor for future achievement.|
Strategic cost management is tied with strategies which provides the organization with reasonable assurance of long-term growth and survival which, in turn, yields sustainable competitive advantage. The organization succeeds by implementing a strategy, i.e., a set of policies, procedures, and approaches to its operations which produce long-term success. Finding a strategy begins with determining the purpose and long-range direction, and hence, the mission of the organization. The mission is developed into specific performance objectives, which are then implemented by specific corporate strategies, i.e., specific actions to achieve the objectives which fulfils the mission.
The organization is required to link goals to overall strategies. This can happen only if the managers and their teams understand the value creation process and embrace the framework as a part of their culture. The framework for cost management is to be continuously challenged for ensuring that the information needs are kept current as strategies change to meet competitive pressures and opportunities.
For the development of a strategy, managers are to answer two basic questions namely (i) where they want to go, and (ii) how they want to get there. One of the cost management roles is to provide ‘financial reality’ to the answers to these questions and to the development of a successful strategy by focusing the organization on providing more value at lower cost. Strategic decision-making determines ‘where’ and ‘how’ by choosing and implementing actions which affects the organization’s future abilities to achieve its goals. For example, strategic decisions can include launching an innovative product line to meet an emerging market or organizing to be the lowest-cost producer of an existing product.
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 (customer realization) and what the customer gives up (customer sacrifice). What is received by a customer is called the total product cost leadership, product differentiation, and focusing. A drawback of the cost leadership-strategy is that the organization has the tendency to cut costs in a way which undermines demand for the product or service, for example, by deleting key features of the product. The cost leader remains competitive only so long as the customer sees that the product or service is (at least nearly) equivalent to competing products which cost somewhat more.
The differentiation strategy is implemented by creating a perception among the customers that the product or service is unique in some important way, normally by being of higher quality. This perception allows the organization to charge higher prices and out-perform the competition in profits without reducing costs considerably. Most of the competitive advantage is created by providing something to the customers which is not provided by the competitors. Hence, such product characteristics are to be created which set the product apart from its competitors. Differences in products can be functional, aesthetic, or stylistic.
Customers value differentiation in those product lines for which the perception of quality and image is important. Furthermore, the value added to the customer by differentiation is to exceed the organizational costs of providing the differentiation. If customers see the variations as important and if the value added to the customer exceeds the cost of providing the differentiation, then a competitive advantage has been established.
A focusing strategy is selecting or emphasizing a market or customer segment in which to compete. One possibility is to select the markets and customers which appear attractive and then develop the capabilities to serve these targeted segments. Another possibility is to select specific segments where the organization’s core competencies in the segments are superior to those of competitors. A focusing strategy recognizes that not all segments need focusing. As used in the definition, ‘choosing market and customer segments’ is actually focusing, and ‘delivering value propositions’ is choosing to increase customer realization and / or decrease sacrifice and, hence, entails cost leadership and / or differentiation strategies, or a combination of the two. Developing the necessary capabilities to serve the segments is related to all three general strategies.
Porter has illustrated the importance of competitive advantage linking it to the activities. An organization can outperform rivals only if it can establish a difference which it can preserve. It is to deliver higher value to the customers or create comparable value at a lower cost, or do both. The arithmetic of superior profitability then follows i.e., delivering higher value allows the organization to charge higher average unit prices with higher efficiency resulting in lower unit costs. Ultimately, all differences between organizations in cost or price derive from the hundreds of activities needed to create, produce, sell, and deliver their products and services, such as calling on customers, assembling final products, and training employees.
Cost is generated by performing activities, and cost advantage arises from performing particular activities more efficiently than competitors. Similarly, the differentiation arises from both also observe that the organization succeeds by adopting and effectively implementing one of the strategies explained earlier. By recognizing that although one strategy is normally dominant, the organization is most likely to employ all the strategies at the same time. However, the organization following the strategies is likely to succeed only if it achieves one of them considerably. The organization which does not achieve at least one strategy is not likely to be successful. This situation is what Michael Porter calls ‘getting stuck in the middle’. The organization which is stuck in the middle is not able to sustain a competitive advantage. Tab 4 shows the distinctive aspects of two competitive strategies.
|Tab 4 Distinctive aspects of cost leadership and differentiation|
|Strategic target||Broad cross section of the market||Focused section of the market|
|Basis of competitive advantage||Lowest cost in the industry||Unique product or service|
|Product line||Limited selection||Wide variety, differentiating features|
|Production emphasis||Lowest possible cost with high quality and essential product features||Innovation in differentiating products|
|Marketing emphasis||Low price||Premium price and innovative, differentiating features|
Factors which influence cost management are (i) changes in the working environment and competition, and (ii) manufacturing technologies. Speed-to-market is the ability to deliver the product or service faster than the competitors. Several organizations are scrambling to survive. The increased competition has made managers more conscious of the need to have accurate cost information for planning, controlling, continuous improvement, and decision-making. Hence, the changes in the industry add to the demand for innovative and relevant cost management systems. A key change in the working environment is increased customer expectation for product functionality and quality. Organizations are concentrating on the delivery of value to the customer with the objective of establishing customer loyalty. This has resulted into shorter product life cycle, as organizations seek to add new features and make new products as quickly as possible, thereby increasing the overall intensity of competition. As a result, there is a need to evaluate process or activity to justify whether it is important to the customer.
The cost management system is required to track information relating to a wide variety of activities important to customers (e.g., product quality, environmental performance, new product development, and delivery performance). Organizations are to compete not only in technological and manufacturing terms but also in terms of the speed of delivery and response. In earlier years, an organization typically succeeded by focusing on only a relatively small number of products with limited features and by organizing production into long, low-cost, and high-volume production runs aided by assembly-line automation. Present day processes focus instead on customer satisfaction. Producing value for the customer changes the orientation of managers from low-cost production of large quantities to quality, service, timeliness of delivery, and the ability to respond to the customer’s desire for specific features. 5
Perhaps the most fundamental of the organizational operational changes in recent years has been the increasing use of information technology, the Internet, and e-commerce. Several significant developments have taken place in the areas of information technology. With automated manufacturing, computers are used to monitor and control operations. Since a computer is being used, a considerable quantity of useful information can be collected, and managers can be informed about what is happening within the organization almost as it happens. The ‘enterprise resource planning’ (ERP) system is a centralized database system which integrates all functional areas of the organization and provides access to real-time data from any functional area of the organization. Using this real-time data enables managers to continuously improve the efficiency of organizational units and processes.
The second major advance makes available the required tools such as the availability of personal computers (PCs), online analytic programs (OLAP), and decision support systems (DSS). The PC serves as a communication link to the organizational information system, and OLAP and DSS helps the managers with the capability to use that information. Frequently, a PC acts as a networking terminal and is connected to the organizational database, allowing managers to access information more quickly, do their own analyses, and prepare their own reports.
The third major advance is the emergence of electronic commerce. E-commerce is any form of commercial activity which is executed using information and communication technology. Internet commerce activity, electronic data interchange, and bar coding are examples of e-commerce. Internet commerce activity allows buyers and sellers to come together and execute transactions from diverse locations and circumstances. Internet commerce activity allows the organization to act as a virtual organization, hence reducing overhead. These technologies have fostered the growing strategic focus in cost management by reducing the time needed for processing transactions and by expanding the individual manager’s access to information within the organization, the industry, and the market environment around the globe.
Management of the organization has changed in response to the changes in marketing and in the process of manufacturing. Because of the focus on customer satisfaction and value, the emphasis has shifted from financial and profit-based measures of performance to customer-related, non-financial performance measured such as quality, time to delivery, and service. Similarly, the hierarchical command and control type of organization is being replaced by a more flexible organization form which encourages teamwork and coordination among the organizational functions. In response to these changes, cost management practices are also changing to include reports which are useful to cross-functional teams of managers. These reports reflect the multi-functional roles of the teams and include a variety of operating and financial information such as product quality, unit cost, customer satisfaction, and production bottle-necks etc.
The new operational environment requires the organization to be flexible and adaptable and to place higher responsibility in the hands of a more highly skilled employees. Additionally, the changes tend to focus the organization on the factors outside the production of its product or provision of its service to the ultimate consumer and the global society in which the consumer lives. Tab 5 shows comparison of earlier and present organizational working environment.
|Tab 5 Comparison of earlier and present organizational working environments|
|Area of operation||Earlier environment||Present environment|
|Basis of competition||Economies of scale, standardization||Quality, functionality, customer satisfaction|
|Manufacturing process||High volume, long production runs, considerable levels of in-process and finished inventory||Individually and team-paced, high-level skills|
|Manufacturing technology||Assembly line automation, isolated technology applications||Low volume, short production runs, focus on reducing inventory levels and other nonvalue-added activities and costs|
|Needed employee skills||Machine-paced, low-level skills||Robotics, flexible manufacturing systems, integrated technology applications connected by network|
|Emphasis on quality||Acceptance of a normal or usual quantity of waste||Goal of zero defects|
|Products||Relatively few variations, long product life cycles||Large number of variations, short product life cycles|
|Markets||Largely domestic||World wide|
|Type of information recorded and reported||Almost exclusively financial data||Financial and operating data, the organizational stategic success factors|
|Management organizational structure||Hierarchical, command and control||Network-based organization forms, teamwork focus–employee has more responsibility and control, coaching rather than command and control|
|Management focus||Emphasis on the short-term, short-term performance measures and compensation, concern for sustaining the present price, short tenure and high mobility of top managers||Emphasis on the long-term, focus on critical success factors, commitment to the long-term success of the organization, including shareholder value|
The growing pressures of global competition, technological innovation, and changes in the operating processes have made cost management much more critical and dynamic than ever before. Managers are to think competitively and for doing so a strategy is needed. Strategic thinking involves anticipating changes and products and production processes are to be designed to accommodate expected changes in customer demands. Flexibility is important. The ability to make fast changes is critical as a result of the demand of the new management concepts of e-commerce, speed to market, and agile manufacturing. Product life cycle which is the time from the introduction of a new product to its removal from the market, is expected to become shorter and shorter. Success being achieved presently is no longer a measure of ultimate success. Management is needed to drive the organization by using the windshield, not the rear-view mirror.
Cost management is the analysis of activities to determine the best mix of activities and the optimal level of resources assigned to activities. There are certain the key components of a cost management system. These are described below.
Activity investment management – Activity investment analysis evaluates the impact of changing an activity process, such as introducing a new technology, on the cost, performance, and inter-dependences of activities. The analysis process systematically decomposes the organizational objectives and strategies into activity level goals which provide a foundation for judging the value of an investment. This facilitates measurement of the cost and non-financial performance impacts of the investment by defining the base line set of activities against which to measure change. Activity investment management embraces the concept of continual improvement by routinely challenging how activities are performed. It decreases the probability of selecting and implementing an inappropriate investment by evaluating capital investments relative to ‘efficient operations’ rather than to existing cost structures.
Cost driver analysis – Cost driver analysis identifies activities which influence the cost and performance of subsequent activities. By reducing or eliminating the event which triggers the first activity in the chain, it can eliminate the need for all subsequent the activities. For example, the detection of a defective part needs the part to be reworked or scrapped, the cause of the defect to be corrected, the problem documented, and other related activities. By eliminating the cause i.e., the defective part, the need to perform all subsequent activities is eliminated since they are executed only when a defective part occurs. Costs are hence reduced. By identifying the cost drivers of an organizational process or an activity, the organization can control costs most effectively.
Activity budgeting – Assessing the factors which control activity volume is an important technique for budgeting the resources necessary to perform an activity. For example, one division of the organization needs 20 expeditors, whereas another division with a similar revenue needs only eight. At first glance, it appears that the performance of the second division is better considerably. However, when one looks at factors such as the number of parts, number of suppliers, and complexity of the manufacturing process, the reason for the difference in support department size becomes evident. The first division has several differentiated products which needs considerably more expediting support than the second division, which has only a few high-volume products. Understanding the number of activity occurrences is an effective tool in predicting the effect on support costs of different strategic decisions. A low-volume product line needs considerably more support cost than a high-volume line.
Non-value-added analysis – Activities which are non-value-added result in profitless expense of time, money, and resources and add unnecessary cost to the products. The non-value-added analysis identifies activities which can be eliminated with no deterioration of the organizational performance (cost, function, quality, and perceived value). Non-value-added analysis highlights wasteful activities.
Best-practice analysis – A best-practice analysis compares activity cost and performance between different departments, divisions, suppliers, and / or competitors to identify the most efficient way to perform an activity. Once, the activities with lowest cost and highest performance are identified, they can be analyzed to identify the source of excellence. The results of the analysis can then be shared with other groups within the organization which perform the activity to determine the applicability to their operations.
Activity target cost analysis – Activity target cost analysis determines activity cost and performance goals based on market demand for a product. Target costs are derived by estimating the market price necessary to capture a certain market share and then subtracting the desired profit margin. Typically, a target cost is lower than the initial estimated cost to build a product. The challenge is to reduce the production cost to the target level. Activities provide a very good basis for identifying opportunities to achieve targets. Identification of non-value-added activities and best practices provides a basis to apply value engineering techniques to eliminate or improve the cost and performance of these activities.
Activity strategic cost analysis – Activity strategic cost analysis uses activity cost and performance data to develop organizational strategies. Strategic cost analysis evaluates the activities of the organization, from design to distribution, and determines where value to the customer can be improved or costs lowered.
Organizations are in constant pursuit of cost management and cost control. This is an elemental factor in competitiveness and in strategic positioning in the market. The strategic cost management observes, identifies, and analyzes the cost determinants, observes the factors which actually cause the costs, called cost drivers, providing the form which reflects the most precise reality of the situation. This concept is undoubtedly very important for the strategic management of the organization, clearly showing that it is necessary to know the factors which cause losses.
Strategic cost management consists of three pillars namely (i) value chain, (ii) strategic positioning, and (iii) cost drivers. These factors contribute to the success of cost management in the organization. The cost management involves and gives emphasis to processes which can consistently provide added and superior values to their customer, achieving these results by means of coordination and management of the cost flow. The management needs to monitor the performance of the organization and, hence, is required to rely on relevant management information regarding to the costs and also reliable reports for optimizing the cost management. Further, in order to facilitate the use and analysis of management information reports, the management is required to have available a proper sequence of information which is relevant to make decisions.