Written by Rutger van den Berg

How to use the power of cost management to stay competitive in today's environment

Over the years CPMview consultants have been involved in numerous projects to improve the effectiveness and efficiency of cost management. Around the change of the century we have seen many projects for implementation of Activity Based Costing. More often than not these failed due to the bureaucracy involved in keeping the ABC system up and running. The last few years has seen an increased interest in strategic cost accounting, aimed at improving the overall profitability of the company.

Many companies today are looking for ways to engage in cost analysis and profitability analysis, in order to make decisions that help the company survive the economic downturn. We have listed some of the do's and don'ts to keep in mind when working on this type of decision-making.

Keep it simple

A bit of an open door, but we have seen far too many cases of really complex cost management systems that either nobody was able to understand or were too difficult and expensive to build and maintain. For instance with Activity Based Costing, which is a great approach in theory, most organizations are tempted to make a very elaborate collection of activities and cost objects. Although this will lead to a very detailed insight, it is usually not necessary to have all this detail to make sound decisions about costs. Rather, we would recommend to keep the number of actvities limited to around 20-30 for the company as a whole. The key is to identify activities of sufficient size to justify separate treatment and for which a single cost driver can be identified. There may be a trade-off between accuracy and the cost of a very detailed analysis.

Focus on costs that can be influenced

When engaging in cost analysis for the purpose of saving costs, it is not useful to focus attention to costs that can't be influenced in the short run. A distinction commonly made is between direct and indirect costs, and fixed and variable costs. Although direct costs will often be variable and indirect costs may be fixed, this is not always the case. Costs such as depreciation of equipment, rent and rates of the building and indirect and supervisor wages are all fixed (at least in the short term), however, costs of labour and power is likely to change to some extent in relation to output. Identifying costs that can be influenced is key in making decisions for the purpose of cost reduction.

Look at total profitability, not just costs

In the end it's not only about costs, but about profitability. Taking revenue into account opens up a whole new range of possibilities for improvement. One analysis that's often very useful is plotting the cumulative margin for every customer, product or channel. This enables the type of 80/20 insight where 80% of your company's margin comes from 20% of your customers. When it's necessary to save on costs, it might be a good idea to say goodbye to products or customers that are not profitable. Or to focus scarce resources more on really profitable products, customers or channels.

Identify costs at the right level for decision-making

When using an integrated approach to cost accounting that uses causal relations to allocate indirect cost (e.g. Activity Based Costing), then changes in the level of activity will not lead to a proportionate change in total costs. For decision-making purposes it is recommended to analyse costs according to a cost hierarchy. This hierarchy can be identified at four levels: unit, batch, product, company:

• Unit: Unit level costs increase in proportion to the number of units actually produced (e.g. labour hours)
• Batch: Costs at the batch level increase as a result of batch of units being produced (e.g. set-up or purchasing costs)
• Product: Costs at this level are incurred irrespective of the volume of products or batches produced and might include costs like technical support
• Company: Costs at the company level are incurred to sustain the company as a whole, and cannot be assigned to products directly (e.g. general administration and management)

When costs are analysed in this manner, it should be easier to better understand the impact of different decisions.

Select appropriate cost drivers

The extent to which individual cost drivers provide a good explanation of actual cost behaviour should be questioned thoroughly. A number of factors may cause costs to change, however, practical limitations may lead to those that are easily measured being chosen. Although this is tempting, and in check with the 'keep it simple' principle, it carries the risk of ultimately making the wrong decision. In the short term, significant change in the level of activity is often required before action is taken to change both staffing levels and the labour cost of the company.

Kaplan differentiates between the cost of resources supplied and the cost of resources used. He suggests that the cost of resources supplied = the cost of resources used + the cost of unused capacity. In other words, if employees are not fully occupied, there is likely to be a cost of unused capacity.