Skip toVoices Cost Management Systems

Introduction

Actual cost reporting is an effective method of cost reporting for small

companies with low sales volume. However, it is not realistic for larger

companies to use this form of cost reporting. As smaller companies grow they must

recognize that a formal cost management system is necessary. In order to

examine formal integrated cost management systems it is necessary to

define cost management systems, understand the scope of these systems,

recognize the goals of these systems, and consider the items that affect

the design of these systems.

Integrated Cost Management Systems

A cost management system is a method that is used to plan and control

the decisions an organization makes regarding cost generating activities,

in order to lower product cost and increase product value for customers.

Cost management systems provide information that helps management

make short-term and long-term decisions regarding "amounts and kinds

of materials being used, changes in plant processes, and changes in

product design" (Horngren et al, 2006, p. 2-3). Ultimately, cost

management systems are used to help make decisions that will increase

short-term profit and improve the long-term position of the company.

Three of the most common costing systems are job order costing, process

costing, and activity-based costing (ABC). Job order costing is used by

companies that produce products for specific orders. This type of system

estimates the costs associated with producing goods for different jobs.

Process costing is often used by companies that operate using continuous

processing. This type of system applies the costs of production, labor,

and support activities as the goods pass through the different process

stages, ABC is a two-stage method of allocating costs. In the first stage,

costs are allocated to pools and in the second stage the cost pools are

allocated to products or services.

Cost management systems cover a broad scope of activities and "should

not be interpreted to mean only continuous reduction in costs".These

systems separate product costs into three categories: direct material,

direct labor, and overhead. However, cost management systems do more

than that. They help management measure various cost activities, such

as production volume, sales volumes, machine hours, manpower hours,

volume of material used, etc. Using the information provided by the cost

management system, management may make decisions that appear to

increase costs. For example, management may choose to increase

advertising costs. This increases costs initially, but the goal is to

ultimately improve profit later.

Items that Affect the Design of an Integrated Cost Management

System

Motivation - A company must first set organizational goals, and then

create measurements to determine whether those goals are being

reached, as well as train and motivate management to reach those goals.

For example, management may look at prior year income statements and

note that net income increased by 42% from 2003 to 2004 and 45.54%

from 2004 to 2005. Based on that information, management might set a

goal to increase net income by 50% from 2005 to 2006. Once this goal

has been set, the company must create measurements that can be used

to determine throughout the year whether the company is likely to meet

that goal at year end. In addition, the company must provide training and

motivation to managers in order to increase the likelihood of reaching

the goal.

Information - the system should be designed so that it provides

information which helps management plan, control, make decisions, and

evaluate performance. For example, a fruit juice company may decide

that it wants to evaluate information regarding total juice costs, as well

as apple juice costs and grape juice costs separately. In order to design a

system for this company, requirements would include the ability to

provide information on unit production, production costs, unit sales, unit

sales price, total sales price, and cost of goods sold.

Reporting - the system should be designed so that it provides reports

with the necessary information in a manner that management can use in

order to make decisions. The reporting feature of any system is of great

importance. The company must decide how the information should be

presented and then design the system so that the information is

organized and displayed in the manner most beneficial to management.

Conclusion

Actual cost reporting may work for smaller companies, but as a company

grows it will become more and more difficult to use that form of cost

reporting. An integrated cost reporting system will be invaluable to the

company, as it will assist management with planning, controlling, and

decision-making.

Advantages/Importance of Cost Management SystemAfter the recent recessions many companies are looking for ways to boost sales and increase profits; the most efficient way of funding the growth profitability is to free up costs and capital and then re-invest these funds in the most promising growth opportunities. One of the best examples of a Company which has achieved this is Wrigley, the chewing gum manufacturer. Since the mid 1990’s they have significantly improved gross margins and overall operating efficiency, and then redirected much of the savings towards increased marketing, trade spend and innovation to drive growth. As a result they have been able to outperform competitors and provide good returns for shareholders.

Cost management should be closely aligned with and made part of corporate growth strategies, the challenge is not just to lower costs but also to ‘out invest’ competitors on growth. There are four principles for achieving this involving the use of ambitious sales and earnings growth targets, tailored cost-reduction targets, selective cost cutting and improved organisational capabilities.

There are, however, some problems with cost-cutting programmes; since the 1980’s cost cutting programmes have become an integral part of corporate life in the search for increased profits, it does lead to temporary gains in efficiency however, whilst helping to meet earnings targets they rarely lead to sustained improvement in competitive position. There are three main reasons for this:

1)They are an excellent way to enhance profits in the short-term but can undermine efforts at more durable competitive improvements. They tend to be implemented at a time of ‘belt-tightening’ in hard times or as part of a turnaround, and their main aim is to protect or increase the bottom line. Therefore: cost-cutting programmes rarely fortify or improve the company’s product and service offerings because benefits go straight to the bottom line or to customers in the form of lower prices.

2) Most cost-cutting programmes take a single target and apply measures across all of the different businesses in a company without regard for the peculiarities of each business. The challenge is to differentiate between ‘good costs’ which add to profitability and ‘bad costs’ which may be eliminated without affecting profits.

3) Cost-reduction programmes are often treated as finite projects, instead of continuous processes. Even after a successful cost-cutting exercise companies will find that their competitors follow suit, or costs creep up perhaps in a different area, so any gained advantage is temporary. To prevent this, improved and continuous cost management must become part of the ethos of the organisation, not just the use of aggressive cost-cutting. Continuous cost management will provide more permanent gains and it limits the need for large scale efficiency initiatives.

There are four principles for aligning cost management and top line growth:

Principle One – Use ambitious sales and earnings growth targets to motivate the need for, and commitment to, growth oriented cost management.

– Use ambitious sales and earnings growth targets to motivate the need for, and commitment to, growth oriented cost management.

Most companies do not see cost management as linked to corporate strategy, or as a platform for growth. E.g. a company with solid historical earnings growth but with only modest sales growth requires a change in performance; this may be achieved by setting challenging top- and bottom-line targets so that the businesses need to cost cut and increase sales to achieve the desired earning growth. If their competitor has a more efficient cost base they will achieve similar levels of profitability, but will also be able to invest more in marketing and innovation. Ultimately consistent under investment in growth compared to competitors and maintaining rather than lowering operating costs will lead to a limit of top-line growth and erosion of the business position over time.

Principle Two – Tailor cost-reduction targets to the existing cost position and strategy of each business.

– Tailor cost-reduction targets to the existing cost position and strategy of each business. This requires the growth targets for managers across businesses to reflect the characteristics of that business; this will affect what percentage of the increased

earnings will come from cost-cutting and what from top-line growth across different businesses.

In addition to the earning growth targets set by senior mangers three other factors should be taken into account when setting cost-reduction targets for any business, they should be balanced, and none should take precedence:

- How do the cost levels compare to those of other businesses in the company?

- How do the cost levels compare with those for competitors?

- What level of costs will be necessary to support projected growth rates and ensure that the business is not ‘out-invested’ on growth by competitors?

Principle Three – Differentiate between ‘good’ and ‘bad’ costs.

– Differentiate between ‘good’ and ‘bad’ costs. The most important part of this approach of growth orientated cost management begins once the earning and cost-reductions targets have been set. The challenge is to reduce costs but not lose the critical capabilities that maintain competitiveness. E.g. by assessing costs across selling, general and administration areas of a business cost-cutting initiatives may bring business costs in line with those of competitors, and create funds for re-investment in growth.

Principle Four – Create the right conditions for ongoing cost management.

– Create the right conditions for ongoing cost management. Making changes to management processes, organisation and capabilities is often a pre-requisite for continuous cost management. This may be achieved by improving the way in which financial reporting is made on specific cost areas of each business, and making sure that cost-cutting in one area is not going to drive up costs in another. Also by sharing and coordinating the best practice from each business within a company the whole group will benefit from each others experience.

Balancing Top and Bottom

Managing costs for increased growth means having to find the right balance between top-down directions, and bottom-up initiatives. Senior management provide the rallying cry, but it is line management who perform the task of checking the details of the business, finding good and bad costs, and the trade-offs between different cost-reduction options.

The most essential element in getting cost management to be effective is the link with growth, cost-reduction must be given a clear and agreed role on the growth agenda so that it drives both top- and bottom-line performance.

– Use ambitious sales and earnings growth targets to motivate the need for, and commitment to, growth oriented cost management. – Tailor cost-reduction targets to the existing cost position and strategy of each business. – Differentiate between ‘good’ and ‘bad’ costs. – Create the right conditions for ongoing cost management