By CA. Dr. Indrani Hazarika
Business Faculty, Higher Colleges of Technology- Dubai Women’s Campus
Impact of Cost Control and Cost Reduction techniques on quality of earnings
Every business aims at enhancing profits and shareholders’ wealth by improving the net operating income
and earnings available to common shareholders. This can be made possible either by maximizing sales
revenue or minimizing costs. In a competitive market with multiple products and substitutes backed by
brand consciousness and quality, increasing the selling price may adversely impact the sales volume and
market share. Ideally it is the cost area which is the focal point of consideration in terms of analysis and
action. The common problem faced by every business is to prioritize cost control which is a short term
goal or cost reduction which is a long term planning and aims at reducing cost per unit. The present study
is focused on cost control and cost reduction techniques and its impact on the quality of earnings available
to common shareholders. The paper tends to emphasize the available earnings and categorize between
high quality and low quality earnings as per the strategy adopted by a company in terms of costs savings.
Introduction:Cost control and cost reduction are management efforts for saving costs and reducing expenditure.
Controlling costs is basically keeping the amount spent on a particular product, process, activity or
element of cost whether fixed or variable as per the budgeted amount or standard costs. Cost reduction is
a reduction in the overall cost of production per unit through improved methods of production, process,
technology, superior quality materials, innovation and technology. It can improve profit by saving
product, manufacturing and life cycle cost by implementing cost reduction strategies. Cost reduction may
call for capital investment and the benefits may be spread over a period of time as it maximizes efficiency
without compromising growth and enhances operating and structural advantage. Efficiency of business
operations is a goal of every business through cost saving techniques and effective management of
material, equipment performance, utility conservation and labor. On the other hand quality of earnings is
a condition how earnings are recognized and its reasonableness. Strong Cash Flows or Earnings that are
calculated conservatively are considered to have higher quality and are sustainable than those calculated
by aggressive accounting policies or computed during inflation. The subsisting relation between cost
control and cost reduction techniques and quality of earnings depends on how profit has been earned
based on the underlying economic activity, permanence and sustainability of reported earnings. The
present study aims at establishing a relation between earnings quality through cost control and cost
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reduction techniques. High profitability and earnings by controlling costs can be categorized as high or
low quality earnings if it negatively impacts non-financial performance indicators.
Objective of the study:
The present study has been undertaken to open up new research areas on analytical study on the cost
control and cost reduction and its impact on quality of earnings. Cash flows or high profits earned
through cost control should be categorized as high or low quality earnings in contrast with gradual
reduction in the cost per unit by continuous improvement in business process, product, customer
satisfaction and learning and innovation.
Review of literature:
The result of the project “An architecture for cost control in manufacturing: the use of cost
information in order-related decisions” by Arthur Liebers has been a starting point for this
research. In addition, the results of the project “Manufacturing integration based on information
management” by Eric Lutters have been employed in this research. The research has been
performed in the framework of a research program focused on sheet metal manufacturing as part
of the IOP-research program supported by the Dutch Ministry of Economic Affairs. From
American Trade Magazines- Research Paper: “Cheap Ways to Corral Laundry Costs—Cost
Control for Textile Services” by Bruce Beggs has been referred for cost saving techniques and
other valuable guidance from some of the industry’s top experts where efficiency is a common
theme in the pages of American Laundry News. Money being scarce all over even in the laundry,
managers rarely have spending freedom and commercial operators work hard to keep costs low
and managers look for savings anywhere they can find to earn profit.
“Earnings Quality” by Patricia M. Dechow and Catherine M. Schrand (Source: Research
Foundation Publication, July 2004, Vol. 2004, No.3, Research Foundation of the CFA Institute)
has focused on earnings quality from the perspective of analyst by stating that a high quality
earnings number is one that accurately reflects the company’s current operating performance,
good indicator of future operating performance and is a useful summary measure for assessing
firm value and annuitizes the intrinsic value of the firm. Such earnings are referred to as
permanent earnings in the accounting literature (e.g. Black 1980, Beaver 1998 and Ohlson and
Zhang 1998). Earnings are of high quality when return on equity is a good measure of the
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Internal Rate of Return on the company’s current portfolio of projects with expected future cash
flows likely to be both persistent and predictable. Earnings quality can vary in any company as a
function of accruals. Research Foundation of CFA Institute also examines how investors respond
to earnings and highlight trading strategies based on earnings quality.
“Getting Return on Quality: Revenue Expansion, Cost Reduction, or Both?” Roland T. Rust,
Christine Moorman and Peter R. Dickson Journal of Marketing Vol. 66, No. 4 (Oct., 2002),
states that financial benefits in terms of profit and cash flows may be derived from revenue
expansion , cost reduction or both simultaneously. The literature on both market orientation and
customer satisfaction provides support for revenue expansion whereas the literature on both
quality and operations provide impressive support for the cost reduction perspective. There is
little evidence for the effectiveness of attempting both revenue expansion and cost reduction
simultaneously and some of what little empirical and theoretical literature available suggests that
emphasizing both at a time may not work. In firms seeking to obtain a financial return from
quality improvements, the authors address the issue of which quality profitability emphasis
(revenue expansion, cost reduction or both) is most effective. Although no company can neglect
either revenue expansion or cost reduction, the empirical results suggest that firms that adopt
primarily a revenue expansion perform better than firms that try to emphasize cost reduction and
better than firms that try to emphasize both revenue expansion and cost reduction
simultaneously. Earnings of high quality may be the outcome of conservative accounting
standards or strong cash flows, decrease in production costs or increase in sales. Low quality
earnings may be from artificial sources like inflation or aggressive accounting and cost control is
considered as a strategy to achieve targeted profit but not a determinant of earnings quality
Scope of study:
On analyzing the previous research work, it is observed that either cost reduction or revenue
expansion are the two strategies on which quality of earnings has to be decided. Cost control and
its consequences and impact on earnings are probable areas of research on manufacturing
companies to decide the earnings quality. Cost controls are the control measures adopted to
reduce the adverse variances of actual costs from budgeted or standard cost every year and it is
not predictable or persistent. It is a process, influencing the factors that affect cost and managing
the changes so that actual cost does not exceed the budgeted or standard costs. A favorable cost
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variance increasing currents year’s profit and cash flows without indicating future operating
performance, can it be regarded as high quality earnings as it does not provide firm’s value. The
present paper highlights the strategies in managing or controlling costs and its impact on
profitability and quality of earnings. With the economic crisis sweeping across the globe every
company is facing with cost control challenge and dealing with budget constraints. But cost
reduction is a systematic approach that provides a comprehensive framework or may be at times
additional investments for reducing the costs over time and may not reflect on the company’s
current operating performance. In the current economic climate companies require an approach
that reduces costs in a strategic, disciplined and sustainable mannered delivered at a pace as it is
a challenging and high risk activity. Cost reduction activities are encouraged and supported
through cost driver approach and results are quantified. Cost control focuses on the minimization
of wastage rather than cost savings or reduction of costs as it is applied on continuous basis when
there is an adverse variance between budgeted and actual cost components and relies heavily on
accounting techniques. Cost reduction is applied when an opportunity is identified with
competitive advantage for a longer time through new production process, improved plant layout
and scientific material handling and may not involve accounting techniques.
Earnings quality is closely connected to accounting policies through the budget process
and accounting controls but cost reduction may not involve accounting techniques. Below I
propose a frame work to analyze the current and future years’ operating performance and cash
flow and value of the firm on the basis of the adverse variance between actual and budgeted
expenses and cost control initiatives to reduce the adverse cost variance and its impact on current
operating performance and cash flows.
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