Quantum Leap In Cost Management

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A quantum leap in cost management A. V. Ramana Rao

‘Unless you sow the seed of a plant, You cannot hope to reap the fruits you want’

Cost Management takes a quantum leap when it is viewed as a holistic analysis of organizational strategy in entirety.

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ost determination is now taken over by computers, leaving enough time to the cost accountant to devote to improving organizational effectiveness through cost management. Cost determination was taking 90% of a cost accountant's time. Cost management could be given little or no time, even though a number of cost strategies were being continuously evolved for profit improvement. The chief function of a cost accountant is' cost management' and not mere 'cost determination'. There is an imminent need for a mind shift on the part of managements towards this paradigm change to reap the full advantage of cost management. Marginal costing and breakeven analysis, with their multifarious application possibilities, were evolved to help managements to improve business profitability. Instead they were wrongly used mostly in pricing products, often below breakeven levels, with the hope that at

Past President of ICWAI

some point of time price could suitably be raised to make profits. But that point never comes, because any subsequent price rise goes only to compensate a rise in costs rather than to improve profits. The incorrect use was due more to misapplication of the breakeven concept itself, than by intent. Classification of costs into material, labor and different types of overheads will continue to dominate the costing scene. They are meaningful. But the division of costs into the presently used categories of 'variable' and 'fixed' costs, or 'direct' and 'indirect' costs, has been misleading and arbitrary. In fact there are only two types of costs in business: 'material costs' and 'time costs'. Material costs are those, which physically go into making of the product; the rest of the costs, labor and overheads, are time costs, time spent on processes and the costs incurred thereon, costs which are necessary to convert the materials into saleable products to reach the consumer and get paid for the same: production, sales or other processes. Time spent on these is also in proportion to the respective processes involved and can be computed for each

cycle of stage and component. of the processes. Once standardized, the processes, including their components, have to run to the fixed time, till they get altered for specific reasons. This represents the' cycle time costs' of each process, operation or activity, what we refer as 'activity costs'. This classification helps control of costs. Both material costs and the cycle time costs are equally variable at every given level of activity. To apply the same to breakeven analysis, recovery of variable costs would mean recovery of all the' costs '. The first postulate of cost management is, therefore, that costs in business are only of two types: 'material costs' and 'cycle time costs', and both are variable. This may be termed a landmark progress in ' cost management' techniques. The next step in cost management is to examine these two costs in some more detail. In financial accounting we presume the formula for consumption of materials in quantity as: opening balance + purchases -closing balance = consumption. This of course is an unquestionable fact. Materials that are not there have been consumed. In ' cost management, consumption of

Cover Feature mate-rials means the exact quantity of material that is required to make the product. This is also a fact, because only that quantity of material that are required for the product have gone into the product; any thing in excess of that has not been consumed by the product, but has been wasted somewhere. The exact quantity required is determined at the time of designing and launching the product, and should form the real requirement for the product, the 'benchmark' for consumption for that product. Any material that is consumed in excess of this benchmark is excess consumption, and is required to be justified. In normal production practices excess consumptions are said to be estimated in advance and added as allowances; only excesses over such allowances are required to be examined. Thus, inefficiencies get built into the system by way of liberal allowances. In a highly competitive and technically fast changing global scenario, and more importantly to maintain a high level of efficiency of operations, these allowances should not be taken for granted. It would be more prudent to take the exact benchmark requirement only as consumption and any deviation from such benchmarks be identified and validated. More often than not, one would find that such practice would lead not only to considerable improvement in the material consumption pattern, but also in improving the benchmark itself Further, such a system introduces inherent accountability for the people concerned and contributes to more effective and motivated controls and improved performance. Alternately, 'standards' for consumptions are fixed in advance and actual consumptions compared with the standards to study variances periodically. This system suffers from the same disability as advance estimating system, for standards also include liberal allowances and taken

from sources, which are either outdated or not reliable for too numerous reasons. A similar system of benchmarking like material consumption can also be developed for time consumption of the input time that is necessarily required for each of the business process at each stage. The above system of benchmarking, discussed so far, would apply both to material and cycle time in terms of quantity. We shall examine the value part separately. The second postulate of cost management is that the quantity of 'material' and 'cycle time' should represent benchmark quantities, and not whatever quantity as was taken. A clear distinction is required to be made between actually consumed and necessarily required. Costs on excess consumption incurred are mere 'expenses', redundant, avoidable, controllable or consciously met out of profits. Every expense that is planned to be incurred is expected to bring in a more than proportionate benefit (profit), in other words a value addition to the product. Some excess costs may not add value to the product or service, but could not be avoided for valid reasons and hence can be taken as justifiably incurred. Periodical excess consumptions have to be considered in pricing, not as allowances, but as margins of safety, lest profitability be affected. Such adverse variance could sometimes be substantial. They have to be reviewed and remedied at the earliest opportunity, and preferably be done online to afford immediate correction. Standard costing practices have become outmoded also due to frequent cost changes that take place in various other aspects of business processes, like favorable changes in Input material and time as a result of improved

methods like replacements by faster machines, value engineering, learning, material and process improvements or substitutions and many more. No standard cost can be valid for long, particularly in the current dynamic market and technological scenario. Frequent changes made in standards would also frustrate the operation of the system. In fact, standard costing system itself is not in effective use in most organizations, and, where in use, it is used more often to explain away variances than to stick to standards. As an after event analysis it also becomes ineffective. The third postulate in cost management, therefore, is that standard costing needs to be replaced by the more effective system of benchmarking with close online monitoring and quick improvements. Benchmarks are better suited to quantities in use than perhaps values; for vales in terms of costs keep changing in the short run, and frequently too for benchmarking. Therefore, cost changes have necessarily to be built into the pricing system rather than in benchmarking. Taken together, benchmarks for quantities with margins of safety and proportionate cost changes of input costs, the system helps exercise proper controls to maintain the profitability of an organization. Value addition should be the ultimate hallmark for validation of costs. Benchmarks are attainable costs and should be the target to achieve to maintain high organizational efficiencies. The fourth postulate of cost management is, therefore, to monitor all costs in terms of the benchmarks and to make price changes to the products, proportionate to other cost changes. Any expenses, incurred by an organization, other than those necessarily required for purposes of business processes, are purely

Cover Feature decisional 'expenses' to be spent out of profit and should not form part of costs. Expenses, adding or sacking, should be viewed from the angle of values they add, or lose. Business Process Reengineering, (BPR), is a system evolved to organize the logistics of the various processes of a business to optimize performance and results. Process time is determined for each component of each process, so that optimization of each component aggregates to optimization of the organizational result as a whole. The BPR system also considers alternate means and processes within the available or viably affordable additional facilities in the organization. Cost/benefit analysis is made of any alternate necessary additions to be made. Thus benchmarks also get continuously updated. The fifth postulate of cost management is to use the system of BPR to optimize process costs and controls on a continuous basis. I remember having read an awardwinning article of Dr. Reid in the journal of the Chartered Institute of Management Accountants of UK in the early sixties about the ineffectiveness of the system of budgeting and budgetary controls, because they were found to contribute little to cost controls. There is, even today, little or no participation of line managers in the process of budgeting, even though they should take responsibility for the budgets as well as their implementation. Budgets have become more of routine accountant's statements, made at the instance of and for the Boards of companies to showcase a rosy picture of the future, quite often unrelated to current trends. They represent more of hopes than facts. In the circumstances, budgets need alternate systems. Targets, short or long term, can achieve what budgets cannot, (Management By Objectives, MBO). I am not thoroughly discounting the use of budgeting and

budgetary controls as part of financial planning, but only if they are effectively made and used. Targets, like benchmarks for each component or process could be more effective. I may emphasize here that budgeting system can be useful only, and if only, its intentions are positive; otherwise, not. Even psychologically, budgets are taken as limits up to which one can go, a laissez-faire system, while targets are objectives to be reached compulsively. While budgets are made by major expense divisions, targets are individualized to components of the organizational system. This mental shift makes a vital difference. Targets are necessarily to be fixed by the line managers and planners, an hence they become a commitment for the people concerned, and controlled by self assessment (CSA). It fixes accountability. The scope for use of budgets is limited, mostly to values, though generally based on quantitative infomlation. Targets have no restrictions. They can be fixed for any aspect of activity of an organizations: quantity, quality, value, period, (yearly, half yearly, quarterly, monthly, weekly, daily, hourly), sales, production, revenues, expenses, batches, orders and what have you. It is open to the management to fix a target for anything or for any purpose to evaluate impacts or results, to judge performance, capacity, to test a process or any of the kind. Performance against targets are self assessable. The use of targets is limitless Hence their preference over budgets. The sixth postulate of cost management is, therefore, to use effective targets, for short or long term, as suitable, which can ably support benchmarking. Targets are in fact benchmarks by themselves. I have not dealt with selling costs separately but as part of various other casts. They are treated like any other

process cost, sales being one of the processes. Any cost incurred at the instance of a customer, like it can happen even at the production stage, can be given the same treatment. While cost systems are normally taken to refer to 'costs', the impact of such costs on performance is a vital part of cost management systems, which include both costs and the income. Strategies evolved in the costing systems are always for optimizing organizational results. Thus cost strategies aim at optimization of the bottom line, profits of an organization by evaluation of costs, prices, pricing policies, margins, customer services, relations and complaints, quick organizational response to market environment, delivery schedules, brand equity, quality assurance and attainment, organizational image and all connected issues, including products and their range, their mixes. material, expenses and their mixes, outsourcing products and services, resource planning etc., that could contribute to improved results. 'Cost Management' is a technical breakthrough in cost accounting. It is managerial economics, that takes a holistic view of an organization in all its aspects, production, marketing, finance, human relations, inter-firm costs and strategies etc. compre-hensively. Reverse- engineering helps stripping others' strategies to revitalize subject companies, strategies. 'If others can do it, why not I?' Strategic cost management thus embraces the entire gamut of organizational matters, all of which are intertwined. It aims, in brief, at a better bottoin line. The seventh postulate, therefore, is that 'cost management' is a holistic analysis of the organizational strategies in its entirety. Techniques are being continuously evolved to improve organizational effectiveness in all their aspects more as strategies, than as techniques. The

frontiers are not in sight, for the search will go on. Online cost methods are developed for day-to-day management and not for a year-end or periodical review. The time-old Miroku system of accounting of Japan or the Padtha system of Birla companies in India, both of them products of manual accounting days, are examples of day to day controls. producing a daily Profit and Loss Account, as effective means of daily business review, relevant and in use even today. They aim at a continuous evaluation of a profit earning system, and, where faltering, to put back on rails at once. For example, I had used a' round trip' evaluation system for a private airline company, which gave. the economic results of a voyage within an hour of the last trip made by the aircraft for the day, less than a day's evaluation. Slimming, as a cost- cutting system, is done for strategic value and not for mere cost reduction. The entire organization works as a profit building team. A cost management system works for value optimization, for clearer views of business realities and performance improvement in each area of the organization. And that constitutes the 'Quantum Leap in Cost Management', remodeling an organization into an effective 'profitmaking business entity'. Recently the government of India, while revising the Cost Audit Report Rules, 2001, has introduced the concept of 'internal audit of cost records'. Internal audit of cost records should constitute: implementation of a cost management system, and monitoring the system continuously and online. It is a well-conceived move and organizations should voluntarily opt for it. I have sown only a few seeds of thought. The field is vast. Progressive organizations use them today with immense benefits. I have outlined the systems only in brief; details should be developed by organizations to suit requirements

according to individual needs. It is also the duty of every cost accountant and cost consultant to present the perceived value of their wares. These have been evolved out of historical systems into more effective online strategic systems. Bring these systems from 'darkness to light', and make them available to produce desired, or even better results. 'Tamaso ma Jyotirgamaya.' Lead us from Darkness to Light', the very motto of our great Institute.