Concepts of Cost Management in Business

In times of economic difficulty and greater financial pressures on organisations of all sizes, issues such as cost management, budget and the decisions they make in these areas become increasingly important. Regardless of the type of company, understanding the way in which cost concepts work and how they should be applied in the specific organisation is central to adding value to any business. Consideration will also be given to the area of budgeting and how the setting of specific budgets can be used to alter the behaviours of those making management decisions (Kirzner, 1979)^[1].

One of the sectors that has given particular attention to this area of cost control and budgeting is that of the construction industry. Award winning house builder, Redrow, has found that its ability to manage costs in such a way that it can pass this on in the form of cheap housing has assisted in recovering from the current downturn in the construction industry, as a whole (Vosselman, 2006)^[2].

Cost management is clearly important for companies at all times, but becomes particularly crucial during times of economic turmoil. Understanding where exactly the costs are being spent and how this expenditure can be better used, for the benefit of the company, is vital. In this report, the issue of cost concepts will first be considered, looking at the key ways in which an organisation can account for its costs; it will then move on to consider budgetary concerns related to these cost concepts and will finally look at the way costs and budgets can be managed to ensure maximum efficiency. All of these issues will be analysed with reference to housing giant, Redrow, and the way that its position is being managed (Ryan, 1995)^[3].

Cost Concepts – Absorption Costing

Every organisation will have costs that it incurs in producing its final product or service. There are multiple cost concepts that can be used to determine how much can be attributed towards each item produced. Direct costs such as the material needed to produce each item can be clearly attributed to the item, but it is the management of additional costs that causes the greatest controversy.

One of the popular choices is that of absorption costing where all costs incurred by the company are distributed amongst all units produced by the company. For example, additional costs such as administration, rent of business premises should be absorbed into the individual unit costs (de Korvin, 1995)^[4]. When it comes to setting budgets, absorption costing is often preferred as it does not ignore the fixed costs that have to be incurred by the organisation. This is the method that is used during the preparation of financial accounts; therefore, by managing ongoing budgets in the same way, an organisation will have a much greater idea of how it is performing and how this will be reflected in the year end accounts which are available for public scrutiny. However, as all fixed and variable costs are merged together, it can make it difficult for management to make relevant budgetary and management decisions in relation to controlling costs as they cannot readily identify which costs are fixed and which are variable.

Redrow has recently cut its workforce by 40 per cent in a bid to control spiralling costs. Many of these costs have occurred directly with the construction workers, but also with workers such as those involved in the administration of the company who would be considered as fixed costs. By using absorption costing, Redrow would be able to focus on ALL costs involved and look at ways of trimming these costs in this difficult climate, not simply the costs immediately attributed to the final product (Omar, 2002)^[5].

Cost Concepts – Marginal Costing

Marginal costing takes a slightly different approach by notably splitting the variable and fixed costs. In this model, the marginal cost of each unit is calculated with the fixed costs being calculated on a per period basis and not split across all units produced. A marginal cost model calculates the exact and direct costs for each item and is, therefore, often referred to as the direct cost model. Fixed costs are not split across every unit but remain as a period cost. Once the marginal cost has been ascertained, this is taken off the income from the item, with the profit being considered as the contribution that each unit can make to the fixed costs of the company.

This model can be particularly useful and it is clear that Redrow will have referred to this approach when launching its new ‘affordable’ housing product. As this model allows the company to ascertain the exact marginal cost, a company can, therefore, make a specific production decision (Kern, 2006)^[6]. For example, if a product covers its marginal costs, even if very little contribution is made to the fixed costs, in times of economic difficulty, this is better than making no contribution at all (Noy, 1999)^[7].

Although marginal costing concepts are clearly beneficial for management teams when making decisions in relation to pricing and production decisions, ignoring fixed costs can result in missed opportunities. This underlying assumption that fixed costs are immovable means that wastage spent in these fixed area may not be adequately controlled as they are simply accepted (Witzel, 2003)^[8].

Marginal costing is also not particularly useful for long term decisions, as ignoring fixed costs is simply not realistic. These are real costs that a company will have to pay; therefore, removing these from the decision making process can result in false long term decisions being made and companies need to ensure that suitable importance is given to managing and reducing these fixed costs.

Budget Setting – Processes and Impact

Companies are required to manage their finances through a series of budgets and cost considerations. Budgets are generally prepared on an annual basis but will often be re-assessed and altered throughout the year to take account of the changing economic position (Lau, 2001)^[9].

Budgeting is merely the approach of matching expected revenues from a product to the costs incurred by the company during the same process. The way in which a budget is drawn up is clearly a product of the cost concepts followed by the company, as discussed above.

The chosen budgetary process has a profound impact on the company, not simply from the point of view of how well it is seemingly performing, over a period of time, but also in impacting the behavioural decisions made by the managers in an attempt to match the budgetary targets. In many companies, the budgetary process is merged directly into the performance management of top management. By fundamentally linking the budgets to the performance management of the managers, there is a growing encouragement for budgets to be manipulated in a way that is not necessarily for the overall benefit of the company (Craig, 2002)^[10].

Critically, budgets are either bottom up or top down. A top down budget will come from the top management team and will generally dictate the desired revenue that the company wants to achieve, letting those closer to the ground to work out how these revenues can be achieved through cost management and increased sales. A bottom up budget will set costs and sales targets with the expectation that these will lead to a certain revenue level.

It is evident that having clearly defined goals at the top level of management can result in undesirable behaviour from middle managers. For example, if a top manager sets a net profit target, middle managers may be encouraged to make short term decisions that are not necessarily good for the long term health of the company, but allow the manager to reach the set goal. Sufficient flexibility needs to be built into the budgeting process to ensure that managers are encouraged to make cost and production choices that are for the overall benefit of the company. This is particularly important in a difficult and rapidly changing economic climate. For example, Redrow has had to make substantial rapid changes to its cost profile in order to survive during difficult times. Where previously the house building company would have been encouraged to aim for a certain percentage profit on every sale, it must now relax this target in order to make any sale that allows some contribution towards fixed costs, e.g. through the sale of affordable housing which is naturally less profitable, but nevertheless assists the company by generating cash flows (Carroll, 1999)^[11].

Pricing Decisions: Overhead Absorption v Activity Based Costing

Deciding on the pricing make-up for products or services provided by a company is more than simply deciding how much the market will tolerate and charging top price. Pricing decisions are amongst the most important decisions that a company makes. Not only does it have a direct impact on the revenues of the company, but it also has a direct impact on the company’s market position, e.g. as a budget brand or as a value-added brand (Hormozi, 1999)^[12].

The two main ways in which pricing decisions are considered are overhead absorption and activity based costing, both of which have their own merits and inherent difficulties associated with them.

Absorption costing involves taking all fixed and variable costs and ensuring that they are incorporated into the prices that are charged for the goods. This has the benefit of being in line with generally accepted accounting principles that are required for external reporting^[13]. All overhead costs are apportioned across every unit of output and this absorption cost is used to formulate the basis of pricing decisions. This method ensures that all costs are accounted for, but can potentially result in bad pricing decisions. Take Redrow and its budget range of housing, for example. These budget houses produce sufficient revenue to cover the variable costs associated with producing the product, but do not cover what would be seen to be their fair share of fixed costs. These fixed costs have already been agreed to and are, therefore, considered as sunk; any contribution is valuable, particularly in times of economic difficulty, even if it is not a contribution at the full level.

Due to the potential difficulties with absorption costing, many companies operate an activity based costing approach alongside the externally reported absorption costs, in order to assist with decision making within the company. Direct, or activity based costing, involves allocating each unit of output just the direct costs associated with creating the unit. No fixed costs are considered. If the direct costs are met by the sale of the product, then anything over and above this will contribute to the already sunk fixed costs. This direct costing method will clearly show a company the smallest possible price at which it it can sell products and is a valuable tool for making the relevant pricing decision, particularly in an ever changing economic climate (Allan, 2005)^[14].

For most companies, both methods will be used. Absorption costing is required for external financial reporting, whereas direct or marginal costing is an invaluable pricing tool. By using both of these methods, the management team can gain a much more rounded view of the financial position of the company and thus make the relevant pricing decisions.

Standard Costing

Careful control is needed in order to ensure that actual costs are managed in line with the budgets laid out. Whilst flexibility is required in the budget to allow for changes that could not have been predicted, it is also important that the organisation has some level of predicted costs (or standard costs) that can be used as a benchmark to monitor performance, over time (Cheatham, 1993)^[15].

Standard costs per unit are derived from a mixture of past knowledge, general research as well as engineering knowledge and capability. As actual figures become known, they are then compared to the standard cost allocated to that specific process or activity to see if the individual costs are being exceeded or indeed saved upon.

This method allows for flexible budgeting that can shift during the life of the product being developed and is particularly useful for long term construction type industries such as Redrow, where any costs that are incurred in excess of those budgeted for can be identified and separated so as to not reflect on other distinct aspects of the project. This is clearly beneficial for cost management, as each element of the process is broken down and identified independently.

There are, however, weaknesses in this analysis. Traditionally, workers completed a large portion of their work on a paid per item approach that has lent itself to this type of cost management. Now that most workers are paid on an hourly rate, allocating direct costs can be much harder and less meaningful as salaries are paid regardless of efficiency, in most cases. Similarly, equipment is now much more complex and splitting costs down can prove more problematic than it is worth. Therefore, whilst standard costing offers relevant information for cost management functions, its use may become more limited the more complicated the processes within the organisation become (Vance, 2002)^[16].

Value Engineering and Total Quality Management

Value engineering and total quality management are reasonably innovative yet important possibilities for all companies. It is recognised that value is made up and determined by the ratio of cost to function. Therefore, in order to increase value, either the costs have to be reduced or the functionality has to be increased. Considerable discussion has been given above to the issue of cost management; however, organisations often underestimate the possibilities of increasing quality of goods in order to improve value (Boronico, 1996)^[17].

Considering Redrow, for example, the market is simply not buoyant in the upmarket homes or top of the range new build sector. Naturally, the company has made considerable efforts to ensure that costs are minimised, for instance, by reducing staff numbers, but consideration has also been given to the functionality of the company in order to produce greater value (Brickley, 2002)^[18]. It should be noted that quality does not simply refer to the quality of the product, but also refers to the quality of the return to the shareholders. By expanding into offering budget housing, Redrow has enhanced the quality of its offering to shareholders essentially by diversifying away from a dwindling market of luxury new build properties. By ensuring that the offering in relation to these budget properties is in line with the requirements of the ultimate consumer, quality is maintained and the overall value of the company is increased.

This ability to use quality management as a way of increasing value should not be overlooked. Decisions are not based solely on costs; additional functionality should also be considered as a way of increasing the overall profitability of the company (Thierauf, 1999)^[19].

Conclusions

Managing costs and ensuring that accurate budgets are drawn up is a critical aspect of any management team’s role, particularly in the current climate when with increased economic pressures, costs are coming under an increasing degree of scrutiny. There are multiple different costing concepts that can be used within a company, all of which have their own benefits and disadvantages. Whilst external reporting requires use of absorption costing, managers often find direct costing principles more meaningful in terms of decision making and increasing value within the organisation (Boulianne, 2005)^[20].

Construction firm, Redrow, has clearly indicated the importance of cost control for decision making. By using direct costing, the company could see whether the proposed project offered any form of contribution to the already accrued fixed costs within the company. Adding value to the process can be achieved not only through cost management but also through enhanced functionality, both of which have been used by Redrow to attempt to mitigate the effects of the substantial downturn in the construction industry.

Cost management and adding value is a continuous process which requires management attention at all stages of the process. By doing this, a company such as Redrow can make the best possible decision with all the available information at the time, which is a critical capability during these difficult economic times.

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Footnotes

^[1] Kirzner, I., 1979. Perception, Opportunity and Profit. Chicago: University of Chicago Press.

^[2] Vosselman, E. & van der Meer-Kooistra, J., 2006. Efficiency seeking behaviour in changing management control in interfirm transactional relationships: An extended transaction cost economics perspective. Journal of Accounting & Organizational Change, 2 (2).

^[3] Ryan B. & Ryan, R.J., 1995. Strategic Accounting for Management. Cengage Learning EMEA.

^[4] de Korvin, A., Strawser, J. & Siegel, P.H., 1995. An Application of Control System To Cost Variance Analysis. Managerial Finance, 21 (3).

^[5] Omar, E.A.A. & Mangin, J-C., 2002. A new cost control model and indicators to measure productivity on building sites. Construction Innovation: Information, Process, Management, 2 (2).

^[6] Kern, A.P.& Formoso, C.T., 2006. A model for integrating cost management and production planning and control in construction. Journal of Financial Management of Property and Construction, 11 (2).

^[7] Noy, E., 1999. There are profits in your management control systems. Managerial Auditing Journal, 14 (7).

^[8] Witzel, M., 2003. Fifty Key Figures in Management. Routledge.

^[9] Lau, C.M., 2001. The Interactive Effects of Emphasis on Tight Budget Targets and Cost Control on Budgetary Performance. Pacific Accounting Review, 13 (1).

^[10] Craig, J., 2002. Performance-Based Budgeting in a Performance-Based Budget-Cutting Environment.

The Public Manager, 31.

^[11] Carroll, G.R. & Teece, D.J., 1999. Firms, Markets, and Hierarchies: The Transaction Cost Economics Perspective. Oxford University Press.

^[12] Hormozi, A.M. & Dube, L.F., 1999. Establishing Project Control: Schedule, Cost, and Quality. SAM Advanced Management Journal, 64.

^[13] Fabozzi, F. J., Peterson, P.P. & Peterson Drake, P., 2003. Financial Management and Analysis. John Wiley and Sons.

^[14] Barnett, I., Dawkins, S. & Allan, W., 2005. Performance Evaluation: Performance Evaluation. Butterworth-Heinemann.

^[15] Cheatham, C.B. & Cheatham, L.R., 1993. Updating Standard Cost Systems. Quorum Books.

^[16] Vance, D.E., 2002. Financial Analysis and Decision Making: Tools and Techniques to Solve Financial Problems and Make Effective Business Decisions. McGraw-Hill Professional.

^[17] Boronico, J.S., 1996. Budget-constrained high-quality procurement strategies subject to risk. British Food Journal, 98 (8).

^[18] Brickley, J.A., Smith, C.W., Zimmerman, J.L. & Willett, J., 2002. Designing Organizations to Create Value: From Strategy to Structure. McGraw-Hill Professional.

^[19] Thierauf, R.J., 1999. Knowledge Management Systems for Business. Quorum Books.

^[20] Boulianne, E., 2005. The impact of procurement card usage on cost reduction, management control, and the managerial audit function. Managerial Auditing Journal, 20 (6).