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Cost reduction refers to the real and permanent
reduction in the unit cost of the goods manufactured or
services rendered.
COST REDUCTION CAN BE EFFECTED BY EITHER OF
THE FOLLOWING WAYS:
(i) By reduction in unit cost of production:
This is usually brought by elimination of wasteful
and non-essential elements in the design of products and
from techniques and practices carried out.
(Any reduction in costs due to changes in Government
policy like reduction in taxes or duties or due to price
agreements do not come into the area of cost reduction as
these are not real and permanent reductions in costs).
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(ii) By increasing productivity:
This refers to increase in the volume of output with the
expenditure remaining the same. But this should not be achieved at the
cost of the characteristics and quality of the product.
AREAS OF COST REDUCTION:
1. Design
2. Factory organisation and method
3. Product planning
4. Factory layout and equipment
5. Utility services
6. Marketing
7. Finance
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Cost control is concerned with keeping the expenditure
within acceptable limits. Its major assumption is that costs are in
control unless costs exceed budget or standard by an excessive
amount.
DIFFERENCES BETWEENCOST CONTROL
COST REDUCTION
1. Controls costs towards
Represents real and permanent
achievement of predetermined
decrease in costs.
target or goals.
2. It is a routine exercise.
It is a planned process.
3. It is a preventive function.
It is a corrective function.
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COST CONTROL IS EFFECTED THROUGH
BUDGETING &
STANDARD COSTING
Budgeting:
A budget may be defined as a comprehensive and
coordinated plan of action, expressed in monetary terms. It is
prepared and approved prior to the budget period and may show
income, expenditure and capital to be employed to attain the
objective.
Standard costing:
In this, standards are set and actuals are compared with
the standard. Corrective measures are undertaken for any
discrepancy found between the standard and actuals.
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TECHNIQUES OF COST REDUCTION
1. VALUE ANALYSIS:
Value analysis is the identification of unnecessary cost
i.e. cost that neither provides quality, nor use, nor life, nor
appearance, nor customer satisfaction. Thus value analysis attacks
costs at production stage.
2. ECONOMIC BATCH QUANTITY: (EBQ)
EBQ is that point where carrying costs equals set up
cost approximately. At this point the total cost will also be
minimum.
3. ECONOMIC ORDER QUANTITY: (EOQ)
EOQ is the quantity fixed at a point where total cost
of ordering and the cost of carrying the inventory will be minimum.
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ILLUSTRATION:
A publishing house purchases 2000 units of a particular item per
year at a unit cost of Rs.20/-.
The ordering cost per order is Rs.50/- and the inventory carrying
cost is 25%.
Find the optimal order quantity and the minimal total cost
including purchase cost.
If 3% discount is offered by the supplier for purchase in lots of
1000 or more, should the publishing house accept the offer?
SOLUTION:
Optimal order quantity or EOQ =
2 x annual consumption x ordering cost per order
inventory carrying cost per unit
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2 x 2000units x Rs.50
Rs.20 x 0.25
= 200units.
CALCULATION OF MINIMUM TOTAL COST WITHOUT
DISCOUNT:
No. of orders to be placed for getting 2000units
= 10orders
Average inventory (200units / 2)
= 100 units
Purchase price of 2000units @ Rs.20/unit
= Rs.40000
Ordering cost (10orders @ Rs.50/order)
= Rs. 500
Carrying cost for 100uts (avg. inventory) (Rs.20*0.25) = Rs.
TOTAL COST
500
= Rs.41000
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CALCULATION OF TOTAL COST WITH 3% DISCOUNT
WHEN PURCHASE ORDER QUANTITY IS 1000 UNITS:
Unit cost after 3% discount (Rs.20 – 3% of Rs.20)
= Rs.19.40
Lot size
= 1000 uts
No. of orders for 2000units @ 1000units / order
= 2 orders
Avg. inventory (1000 uts per order / 2)
= 500 uts
Purchase cost for 2000 uts @ Rs.19.40/ut.
= Rs.38800
Ordering cost for 2 orders at Rs.50/order
= Rs.
100
Carrying cost for avg. inventory (500 * 19.40 * 0.25) = Rs. 2425
TOTAL COST
= Rs.41325
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The above computation shows that supplier’s offer of
3% discount should NOT BE ACCEPTED because it
will INCREASE COST by Rs.325/- as compared to the
EOQ of 200 units.
Counter offer of higher discount should be made if
the cost is to be less than Rs.41000/-.
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4. ACTIVITY BASED COST MANAGEMENT:
ABC assumes that resource-consuming
activities cause costs. Its aim is to directly control the
activities that cause costs, rather than cost. By
managing activities that cause costs, costs will be
managed in the long run.
Cost causing activities – designing, engineering,
manufacturing, marketing, etc.
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A CASE STUDY IN ABC:
Under ABC in a direct mail printing firm, cost reduction
occurred by developing plans to eliminate idle time and reduce the
total set-up time rather than layoff employees.
The firm was reporting decreasing profit although operating
at capacity. Its short-run solution was to reduce the labour force,
which is a cost the company can control in short run. A study of
activities in the printing process, however, indicated a set-up time
of 35 hours on complex orders with employees being idle 25% of
the time during set-up.
ABC demonstrated that this idle time was costing the firm
approximately US$.41000 in wages per complex order.
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5. JUST-IN-TIME APPROACH: (JIT)
The aims of JIT are to produce the required items, at
the required quality and in the required quantities, at the precise
time they are required.
JIT helps in cost reduction by –
a. elimination of non-value-added activities,
b. zero inventory,
c. zero defects,
d. zero breakdowns,
e. single batch ordering.
Though the above goals are unlikely to be achieved, it
represent targets and create a climate for continuous improvement
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and excellence.
6. TOTAL QUALITY MANAGEMENT: (TQM)
TQM works on the philosophy that all business
functions are involved in a process of continuous quality
improvement.
TQM reduces cost by producing the products correctly
the first time rather than wasting resources making substandard
items and incurring additional expenditure on inspection, rework
and scrapping.
It helps organisations to achieve their quality goals by
providing reports and measures that will improve quality.
TQM aims at a customer-oriented process of
continuous improvement that focuses on delivering products or
services of consistent high quality in a timely fashion.
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7. SUPPLY CHAIN MANAGEMENT: (SCM)
SCM attempts to build a cost effective chain beginning
with the ultimate customer and links all the previous suppliers
under one platform.
An effective SCM eliminates most of the activities in
between customers and raw material suppliers along with
associated costs. Most of the non-core activities are outsourced and
hence fixed costs are kept minimal.
Close interaction between the corporate R&D and the
suppliers facilitates continuous improvements in product design,
process methodologies, etc. resulting in customer value
enhancement and cost reduction.
A rupee spent on the supply chain can give more value
than a rupee spent on marketing. The supply chain is part of the
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service offering.
A CASE STUDY:
ESCORTS TRACTORS FARMS – BPR resulted to target cost
reduction per tractor by 20 %. Introduced in process involving the
manufacturers of rear axles, one that required maximum movement
of materials across the halls. Pre-reengineering, the manufacture
involved 9 changes in ownership, had 21 workers in any given
shift, and lead-time of 19 days. Today the process requires only 12
workers per shift, and lead-time has fallen to 8 hours.
“The physical resources are easy to change. The key to success lies
in motivating employees up to the grass root level to initiate
change, not just accept it.”
Farm Tract has extended its efforts to SCM and reduced the
number of vendors and brought down the total acquisition cost by
5%.
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8. PERT ANALYSIS:
Programme Evaluation Review Technique (PERT)
reduces cost by giving an optimum schedule for the activities
necessary to complete a project.
SOME OTHER COST REDUCTION TECHNIQUES ARE
9. Simplification and Standardisation
10. Design analysis
11. Substitute material utilisation
12. Production planning and control
13. Technological forecasting
14. Market research etc.
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Non-Conventional Approach
• Material Cost
• Manpower Cost
• Cost Management Initiatives
– Selling and Distribution
• Funding Cost
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Non-Conventional Approach (Contd)
•
Material cost – Cost reductions thru’
–
E-sourcing
• Discovery of new sources
• Competitive pressures
• Rationalisation of suppliers
–
Thrust on Value Engineering
• Re-Visiting Designs
• Application oriented engineering
–
Product Life Cycle Management
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Non-Conventional Approach (Contd.)
• Manpower Cost
– Right-sizing of Employees – VRS Schemes
– Optimum utilisation of Manpower
• Transition from Machine engagement time to ManEngagement time.
– Productivity-linked wage settlements
– Adopting new concepts
• MOST
• CELL Layout
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IMPORTANCE OF COST CONTROL AND COST
REDUCTION FOR CORPORATE TURNAROUND
The importance of cost control and reduction
in a manufacturing organisation can never be
overemphasized. These phrases that were mere clichés
not too long ago, have now come to acquire a new
meaning in the last few years.
In fact, it may not be an overstatement to say
that the revival and subsequent boom in the corporate
sector in the last couple of years was primarily driven
by the conscious efforts towards controlling costs.
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Whether it be manpower reduction, controlling
overheads, reducing input costs or bringing down
finance charges, Corporate India has done it all in the
effort to stay profitable in the new milieu.
There have been basically two drivers behind
this emergence of cost consciousness in the corporate
sector.
First is the compulsion to stay profitable, which is the
basic instinct of any company.
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As the demand cycle goes through a dip and sales begins to
shrink, companies typically look inward to keep afloat.
And the time-tested way of doing this is by slashing at the
cost structure and save money.
However, it is the second reason that is the more
significant one. In a highly competitive market place
increasingly populated by multinationals, the best way for
Indian companies to survive and grow is by offering better
quality products at cheaper price.
The only way to do this is by constantly
chipping away at the cost structure to eliminate
unproductive expenditure so that the company will
have the pricing freedom in the marketplace.
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The old equation of
COST + MARGIN = SELLING PRICE
has now been turned on its head to mean that
MARGIN = SELLING PRICE – COST.
Of this, only one variable, cost, is under the
control of the company while the market dictates selling
price. Margin therefore is a function of how efficient the
company is in controlling costs.
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CHANGING PERSPECTIVE OF PROFIT
 COST + PROFIT = SALES
In a sellers market cost and profits are reimbursed by the
customer.
 SALES - COST = PROFIT
With more players in the market place, Selling price is
determined by the market forces ; having locked to a level of cost
, focus is on cost control and reduction . Cost information is for
tactical decision making.
 SALES
-PROFIT = COST
Selling price is determined by market forces: Profit is
determined by the risk/return profile of business with a focus on
cost management to achieve the targeted results.
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ROLE OF COST REDUCTION IN TATA MOTORS’
TURNAROUND – FROM A Rs.500 CRORE LOSS TO Rs.500
CRORE PROFIT IN 2 YEARS!
Tata Motors presents a classic case study of how studious
efforts at cost control can pay rich dividends.
The company reported a historic loss of Rs.500 crore in 2000-01
when doomsayers said that the company would be history soon.
But the company bounced back and proved them wrong by
registering a Rs.510 crore profit in 2002-03 literally rising like
Phoenix from the ashes.
How did the company manage this?
Of course, the business environment improved and sales of
commercial vehicles, its primary product, began to grow.
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But there was also some silent work done in the
background that helped the turnaround in Tata Motors’
fortunes.That was cost control. The company managed to
eliminate as much as Rs.900 crore in costs in just two years’
time.
Instead of concentrating on any one aspect of cost,
the company slashed them across the board. Thus, there was a
reduction in material costs, staff costs through VRS, interest
costs and in other expenditure.
Of course, it did help that interest rates during the
period were low but there can be no doubt that the company
showed exceptional financial management skills to overcome the
dark phase.
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EMERGING BUSINESS MODELS
In the Present Scenario, the very nature of competition
will change. Increasingly customers will demand
Ever-greater choice, so that products and services
are customised for market segments of one customer.
Procurement will find new ways of working with
suppliers and new ways of working internally. New
business models will emerge that organisations must learn
to recognise and understand.
The key issues - the driving forces, the charactistics of
new business models , the keys to success and the
challenges companies face.
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FIVE FORCES OF NEW
ECONOMY
•
•
•
•
•
Globalisation of both markets and sources.
Open for business 24 x 7.
The rapid expansion of internet.
Continued evolution of transport services.
Service economy.
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CHARACTERISTICS OF NEW
MODELS
• Focus on core activities.
• Automation/integration.
• Complexity of relationship.
• Ubiquitous and real-time information.
• Organisational structure.
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KEYS TO SUCCESS
• The Supply Chain
• The Balance of Power
• The Competitive Landscape
• Service not Product
• Future Cast
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