Cost Control Definition And Management Accounting Essay

A good knowledge about costs is vital in order to better understand what cost control is about. Authors have defined costs in different ways. The definition of cost was the money that was to be spent on production in the 1970`s (Van der Schroeff et al., 1970). This definition was later re-analysed and confirmed by Bilkerbeek(1992), van`t Klooster(1992) and Horgren(2005). Costs are the factors of production like raw materials, labour and machines that are used in production activities. The monetary value associated with these factors is called costs ( Bilkerbeek at al., 1992).

Another definition was the monetary value of the resources that a company sacrifices and from which goods are produced to satisfy customer need when sold is called costs. However, it is not necessary that cost in monetary values equals to payments (van`t Klooster et al., 1992). Lastly the sacrifice of resources that an organisation must do to produce goods and services, usually measured in terms of monetary units is cost (Horgren et al., 2005).

2.2 Cost control definition

The most common problem that many industries are facing nowadays in the cutting of costs is how to control costs. There is no exact rule or definition of cost control. The definitions and meanings of cost control have evolved with time due to changes in the business environment and ideologies of entrepreneurs. Below are some of the definitions of cost control:-

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Cost control is defined as the way through which the measurement of sales and manufacturing performances are carried through the establishment of guidance and set of rules of internal operations of an organisation by means of modern costing methods (Stanford, 1948). While on the other hand, Jackson (1974) defined cost control as a mean to discover and correct defects and weaknesses of operations, in order to reduce wastage and decrease costs.

In simpler terms, cost controls refer to keeping the expenses in limits.

2.3 Cost management

Cost management is among the most important activity in an organisation which has an impact over the business functions in a company. There are arguments that imply that cost management is another factor that is likely to level up competitive advantage. Usually, cost management is described as the approaches and activities of executives and top level managers in the short run and long run planning and control decisions to increase customer satisfaction as well as reduce costs of production (Potter, Libby, Libby and Short, 2009). However to attain the desired results, managers need statistical figures and costs of the actual performance of the business to compare them with the planned budget performance in order to supervise and control costs (Crossman, 1953).

Moreover, the argument that Davila and Wouters (2004) put forward was that opportunities of cost reduction resulting from cost management would also indulge organisation generating huge profits. Organizations would benefit from efficient management of product cost in the sense that the latter will increase productivity and margin of resources (Rayburn, 1989).

Thus, only after an identification and classification of activities and processes that generate costs the efforts of cost management will be successful. Hence controlling of costs can be done by only altering the nature and extent of processes. Cost management should not simply restrict itself to cost cutting as there are cost management techniques as well which focuses on other paths towards improvement of organizations outcomes (Trussel & Bitner, 1998).

As a result, cost management is not static process rather it is an evolutionary one. It keeps on changing with time, due to the fact that costs is always influenced by external factors including inflation, demand and supply effects, technological innovations and climatic changes as well. With innovation in technology, there exists new ways that support increased cost management efforts.

2.4 Purpose of Cost control.

The purposes of cost control may be as follows:-

Guidance for actual budget equate to the estimate budget.

Provide a value-for-money project, with total cost consideration approach.

Reduce waste to avoid excessive waste without compromising with quality or quantity

2.5 Types of Costs.

There are different types of costs, to better understand them they are group into categories based on their cost behavior. They are:-

Fixed and Variable costs

According to Horgren, cost can be classified in variable and fixed costs (Horgren, 2005):

Table 2.5.1: Fixed Cost and Variable Costs

Types Of costs

Definitions

Variable costs

Variable costs are costs which vary directly with the level of production. Examples are sales costs and raw materials costs.

Fixed costs

In contrast to variable costs, fixed costs are costs which do not vary with the level of production. Either production increases, decreases or there is no production at all, fixed costs are still incurred. However there are certain types of fixed costs that increase when a range limit is exceeded. Examples of fixed costs are rent of the building, salaries of full time employees.

Fixed costs can be divided into:

Avoidable costs

As it name itself suggest, these costs are costs that can be avoided, that is, if an operation in production is stopped or change, then this cost will not be incurred. An Example of avoidable costs includes department salaries that could be eliminated by closing that specific department.

Unavoidable costs

Unavoidable costs cannot be prevented from incurring unlike avoidable costs, even if the specified operation is discontinued.

Direct, Indirect and common costs

An important characteristic of a cost is the relationship between the cost and the particular cost objective. Therefore costs can be categorized into three ways, namely direct cost, indirect cost and unallocated cost. This can be illustrated as follows:-

Table 2.5.2: Direct, indirect and Common Costs

Types of costs

Definitions

Direct costs

Accountants can identify direct costs specifically and exclusively with a given cost objective in an economically feasible way. Costs are directly assignable to a particular service or activity. The resources with which the costs are associated are usually totally assigned to the product.

Indirect costs

Indirect costs are costs that are not accountable to a cost object. These costs can be fixed costs or variable costs and they are not related to production. An example is administration costs.

Common or Unallocated costs

These costs are where no relationship can be created to a cost objective. Common costs are overhead costs that cannot be classified as direct or indirect. They are not traceable to a given product and the resources with which the costs are associated are usually shared by several products. For example; Research and Executives salaries.

Historical, Current and Forward Looking Costs

Table 2.5.3: Historical, Current and Forward Looking Costs

Types of Costs

Definition

Historical costs

These are costs that have incurred and they are based on past figures from accounting statements of previous years.

Current costs

These are costs that that values assets at their current replacement costs compared to the price that the assets were originally purchased. Moreover this type of cost takes into account environmental factors like depletion of land fertility.

Forward Looking Costs

These are expected costs for producing output based on new and more efficient technologies, possibly at lower cost.

Categorized and Functional Costs

Table 2.5.4: Categorized and Functional costs.

Types of Costs

Definitions

Categorized costs

Costs can be classified according to the types of resources they associated with. Examples are labor costs, raw material and depreciation on fixed assets.

Functional costs

Functional costs distribute costs according to their function. Examples are Research and Development, Procurement and Marketing costs.

Management instruments to control costs.

2.6.1 Management Control

The critical determinant of an organisation success is the control function. After all the plans and strategies are set, it is the mangers priority and responsibility to make the employees follow them. The main task of managers is delegating the activities to others and ensures that the task is being performed well.

Management control involves a variety of activities, including (Russ Headley, 2009):

Planning what the organization should do.

Coordinating the activities of several parts of the organization.

Communicating information.

Evaluating information.

Deciding what, if any, action should be taken.

Influencing people to change their behavior.

The three objects of control are (Merchant, 1982):-

Specific action control-The actions to make employees give their best performance at work.

Results control- Regular tracking of results and reporting of the level of performance of employees, along with motivating them to meet their aims.

Personnel control: Expectations from employees to make them do what is the best for the organisation, and training facilities will be given to support them.

Table 2.6.1: A control tool classification framework

(Source: Merchant, 1982)

2.6.2 Effective cost control systems.

Cost control system is defined as a logical structural of activities that is designed to analyze and evaluate the control over expenditure during a period of time (http://www.finance-lib.com/financial-term-cost-control-system.html ). Hence, when information is produced, it should be put in an effective way to be used. Actually, there are five parts to an effective cost control system. They are (http://www.fao.org/docrep/W4343E/w4343e05.htm ):-

Budget preparation.

Communication and agreements on budget by all concerned stakeholders.

An accounting system that will records all details of actual costs.

Preparation of statements that will compare actual expenditure to budgeted ones.

Actions are taken based on the analysis of variances.

2.6.3 Cost control Tools and Techniques.

For the systematic and effective control of costs, management instruments are used. Below is the instrument that helps in order to control costs:-

Budgeting

Activity Based costing

2.6.3.1 Budgeting

It is a process of preparing a budget which is a financial plan where all the future costs and revenues are calculated. A budget is used to create the goals of the company, to have a control over resources, to communicate plans and motivate managers to achieve the set of objectives (http://en.wikipedia.org/wiki/Budget).

Another definition of budget by Merchant (1982) is “a budget is a result oriented control system. This form of control involves holding employees responsible for certain results. This type of control is future-oriented and means that targets have to be set by management and that employees have to be motivated to reach these targets” (Merchant, 1982). Compared to Vosselman who defined budget as a leather suit case, a ‘pouch’, “more than a plan and more than a co-ordination device” and a performance contract and constraint as well as a device for empowerment (Vosselman et al., 2008).

Furthermore, Horgren, Sundem and Stratton stated that there are three major advantages of budgeting (Horngen, 2005).

Budgeting forces managers to think one step ahead by formalization of their responsibilities for planning.

Expectations which are the best framework for judging subsequent performance is provided by budgeting.

Budget helps managers to coordinate their efforts so that their objectives meet that of the organization as a whole.

Budget is a tool that helps managers in their planning and controlling of activities. However, managers have also been using them to evaluate about what has been happening in the past (Horngen, 2005). Although budget is still viewed as an organizational imperative to control costs and financial performances to be met ( Frow et al., 2010, p.445), it is seen by practitioners of being incapable of meeting the competitive environment demand (Ekhol and Wallin, 2000, p. 1; Østergren and

Stensaker, 2011, p. 150). Hence, it is hugely being criticized for the impeding of efficient resources allocation, encouragement for myopic decision making and budget games (Otley, 2003; Hansen et al., 2003; Hope and Fraser, 2003). Morover at the same time, there is little empirical proof that businesses are adopting new and updated budgeting practices (Ekhol and Wallin, 2000, p. 1; Østergren and Stensaker, 2011, p. 150).

To better understand this paradox, a deep study and knowledge is needed of the process which would lead to the adapted budgeting practices acceptance in the organization (Ahmad et al., 2003; Hansen et al., 2003). This acceptance of the new management control practices is explained by the use of frameworks based on deliberate decision making and economic arguments (Van de Ven and Vosselman, 2005).

2.6.3.2 Activity Based costing

Activity based costing is a technique whereby cost estimates of a project is subdivided into distinct, measurable activities or a work unit. It compensated the lack of relevance of traditional costing methods in the 1980s. ABC does not form part of financial accounting system, but it is an approach that measures cost and performance of business activities and their outputs in order to acquire a more efficient way to view and interpret information (http://www.thomasandalex.com/articles/finance-accounting/activity-based-costing-2/).

Table 2.6.3.2: Basic Flow of Activity-Based Costing.

http://www.thomasandalex.com/wp-content/uploads/2009/10/activity-base-costing3.gif

According to McKenzie (1999), ABC identifies activity centers or cost pools in an organization and based on a number of events, it assigns costs to the cost drivers involved in the production of goods and services (McKenzie, 1999). The ability to understand ABC leads the managers to have a greater knowledge of the business processes of the firm and underlying expenses.

ABC helps to evaluate overhead and operating expenditures by the establishment of a relationship between costs and consumers, goods and services. Moreover, through ABC managers are able to detect profitable and non-profitable goods and services. ABC studies reveal that it provides substantial assistance in decision making process relating to costs. It enables management to include costs with relevant drivers only. The reason that has triggered firms to adopt ABC is that they have a clear picture of how resources are spent, secondly accurate. Other benefit is the accuracy in the costs information gathered in a process, along with sufficient information can be gathered to take decisions about profitability of the different production lines in an industry. Due to the constant changes in the market, firms had to adopt this technique as it meets the requirement of adapting to modern cost accounting methods along with computer technologies which make its use easier.

However it is important to note that many problems was associated with the implementation of ABC in some organizations. The issue arising was that the ABC is not appropriate for all types of organizations. For example, firms having low overhead costs will not benefit when adopting the system. Organizations also faced difficulties to make employees and managers to properly use this system. In general, ABC is very time consuming due to lengthy procedures it does. In short, ABC implementation is a resource consuming activity.

Hence the instrument that will rouse the implementation of ABC costing will be taken into consideration in the study to know about the compatibility of this technique at Le Marina Hotel and Club.

2.7 Factors affecting the cost control practices

According to Hansen-Mowen (2003), there exists various influencing cost management. The following factors are discussed below:-

2.7.1 Globalization

Perfect competition strategies and advancement in communication and transportation lead to compete on the global market in the service and manufacturing industry. This new era of globalization has significantly increased the need for more efficient information on cost complemented with accuracy and reliability.

2.7.2 Emerging service industry

The importance of service sector is increasing in capacity and ability. The influence of globalization has led to standardization of many services including telecommunication, airlines and among others. Fierce competition forced managing teams to opt for accurate information about cost for managerial decisions.

2.7.3 Technological advancement

Innovative technology has evolved in every business aspect. The Enterprise Resource Planning is an effective tool providing relational software system which encompasses various business operations by minimizing redundancy and inconsistency. The different systems at the three managerial levels are inter-related helping an effective flow of real time information empowering various stakeholders to gain access to precise and reliable information; enhancing responsiveness of managers with greater flexibility to cater for complex product costing.

2.7.4 Total Quality Management.

Continuous improvement and the aim for zero defects are the core criteria of the hospitality sector. Quality of a product is tool to sustain competiveness in the business eco-system. Managing cost is the basis of Total Quality Management through provision of critical information analysis related to quality in the business activities and cost quality control procedures.

2.7.5 Efficiency and Time

Value chain comprises of two empirical factors namely time and efficiency. These critical success factors help in sustaining the competitive environmental forces in the modern economy through shorter product cycle to offer a product on the market while re-engineering processes orienting towards elimination of non-value added activities and waste. Efficiency is also a major concern to aim at gaining competitive advantage. Cost is a measurement of efficiency. For the measuring tools to be effective a proper definition of cost must be provided, measured and precisely allocated.

The grooming of the various factors discussed renders a complex competitive business environment triggering the need to constantly innovate and acquaint cost control method on the strategic time plan.