Cost control and reduction refers to the efforts business managers make to monitor, evaluate, and trim expenditures. These efforts might be part of a formal, company-wide program or might be informal in nature and limited to a single individual or department. In either case, however, cost control is a particularly important area of focus for small businesses, which often have limited amounts of time and money. "In a small business, you are so busy serving your customers, you tend to get lackadaisical about what you're buying," business owner John Clark noted in Jane Applegate's Strategies for Small Business Success. Even seemingly insignificant expenditures—for such items as office supplies, telephone bills, or overnight delivery services—can add up for small businesses. On the plus side, these minor expenditures can often provide sources of cost savings.
Cost control refers to management's effort to influence the actions of individuals who are responsible for performing tasks, incurring costs, and generating revenues. First managers plan the way they want people to perform, then they implement procedures to determine whether actual performance complies with these plans. Cost control is a continuous process that begins with the annual budget. As the fiscal year progresses, management compares actual results to those projected in the budget and incorporates into the new plan the lessons learned from its evaluation of current operations. Through the budget process and accounting controls, management establishes overall company objectives, defines the centers of responsibility, determines specific objectives for each responsibility center, and designs procedures and standards for reporting and evaluation.
A budget segments the business into its components, or centers, where the responsible party initiates and controls action. Responsibility centers represent applicable organizational units, functions, departments, and divisions. Generally a single individual heads the responsibility center exercising substantial, if not complete, control over the activities of people or processes within the center, as well as the results of their activity. Cost centers are accountable only for expenses. Revenue centers primarily generate revenues. Profit centers accept responsibility for both revenues and expenses. The use of responsibility centers allows management to design control reports and pinpoint accountability. A budget also sets standards to indicate the level of activity expected from each responsible person or decision unit, and the amount of resources that a responsible party should use in achieving that level of activity.
The planning process, then, provides for two types of control mechanisms: feedforward, which provides a basis for control at the point of action (the decision point); and feedback, which provides a basis for measuring the effectiveness of control after implementation. Management's role is to feedforward a futuristic vision of where the company is going and how it is to get there, and to make clear decisions coordinating and directing employee activities. Management also oversees the development of procedures to collect, record, and evaluate feedback.
Control reports are informational reports that tell management about a company's activities. Control reports are only for internal use, and therefore management directs the accounting department to develop tailor-made reporting formats. Accounting provides management with a format designed to detect variations that need investigating. In addition, management also refers to conventional reports such as the income statement and balance sheet, and to external reports on the general economy and the specific industry.
Control reports need to provide an adequate amount of information so that management may determine the reasons for any cost variances from the original budget. A good control report highlights significant information by focusing management's attention on those items in which actual performance significantly differs from the standard.
Managers perform effectively when they attain the goals and objectives set by the budget. With respect to profits, managers succeed by the degree to which revenues continually exceed expenses. In applying the following simple formula, Net Profit Revenue-Expenses, managers realize that they exercise more control over expenses than they do over revenues. While they cannot predict the timing and volume of actual sales, they can determine the utilization rate of most of their resources; that is, they can influence the cost side. Hence, the evaluation of management's performance and the company's operations is cost control.
For cost control purposes, a budget provides standard costs. As management constructs budgets, it lays out a road map to guide its efforts. It states a number of assumptions about the relationships and interaction among the economy, market dynamics, the abilities of its sales force, and its capacity to provide the proper quantity and quality of products demanded. An examination of the details of the budget calculations and assumptions reveals that management expects operations to produce the required amount of units within a certain cost range. Management bases its expectations and projections on the best historical and current information, as well as its best business judgment.
For example, when calculating budget expenses, management's review of the historic and current data might strongly suggest that the production of 1,000 units of a certain luxury item will cost $100,000, or $100 per unit. In addition, management might determine that the sales force will expend about $80,000 to sell the 1,000 units. This is a sales expenditure of $80 per unit. With total expenditures of $180, management sets the selling price of $500 for this luxury item. At the close of a month, management compares the actual results of that month to the standard costs to determine the degree and direction of any variance. The purpose for analyzing variances is to identify areas where costs need containment.
In the above illustration, accounting indicates to management that the sales force sold 100 units for a gross revenue of $50,000. Accounting's data also shows that the sales force spent $7,000 that month, and that production incurred $12,000 in expenses. While revenue was on target, actual sales expense came in less than the projected, with a per unit cost of $70. This is a favorable variance. But production expenses registered an unfavorable variance since actual expenditures exceeded the projected. The company produced units at $120 per item, $20 more than projected. This variance of 20 percent significantly differs from the standard costs of $100 and would likely cause management to take corrective action. As part of the control function, management compares actual performance to predetermined standards and makes changes when necessary to correct variances from the standards. The preparation of budgets and control reports, and the resulting analysis of variances from performance standards, give managers an idea of where to focus their attention to achieve cost reductions.
A variety of techniques can be employed to help a small business cut its costs. One method of cost reduction available to small businesses is hiring an outside analyst or consultant. These individuals may be independent consultants or accountants who analyze costs as a special service to their clients. They generally undertake an in-depth, objective review of a company's expenditures and make recommendations about where costs can be better controlled or reduced. Some expense-reduction analysts charge a basic, up-front fee, while others collect a percentage of the savings that accrue to the company as a result of their work. Still others contract with specific vendors and then pool the orders of their client companies to obtain a discount. Some of the potential benefits of using a consultant include saving time for the small business owner, raising awareness of costs in the company, and negotiating more favorable contracts with vendors and suppliers.
In his book One Hundred Ways to Prosper in Today's Economy, Barry Schimel suggested a variety of simple ways for small business owners to reduce costs, including printing or photocopying on both sides of the paper whenever possible, locking the office supply cabinet to prevent employee theft, and canceling insurance on unused equipment and vehicles. Schimel went on to outline an internal cost-cutting program that small business owners can apply. He recommended that small business owners set aside time to review several months' worth of checks and invoices and make a detailed list of all their monthly expenses. Then they should decide upon a few areas that might benefit from comparison-shopping for better prices. If the small business owner is not inclined to undertake the comparison-shopping personally, a responsible employee can be assigned to the task.
It may be helpful to compare the prices in office-supply catalogs to those offered by local stores, and to purchase supplies in bulk at a discount if possible. Some small businesses are able to form purchasing cooperatives with other small businesses in order to buy in larger quantities and negotiate better prices. After comparing the various options available and finding the lowest prices, Schimel suggested that small business owners take those numbers back to their original vendors and ask them to meet the lowest price. Many vendors are willing to do so in order to avoid losing business.
Despite the importance of cost control to small businesses, and the potential for cost savings, Schimel still warned small business owners that cost reduction alone cannot guarantee success. "You can't cost-cut your way to prosperity," he stated. "To improve profits, you also need more sales and adequate margins." In fact, overzealous cost cutting can sometimes reduce a company's potential for growth. "Only the most exceptional leaders of the most exceptional companies avoid getting sucked into a period of heady growth followed by desperate cutbacks," Alan Mitchell wrote in Management Today. "These companies have learned the hard way that cost cutting alone doesn't guarantee customer preference."
Mitchell went on to explain that every business reaches a point in its growth when management recognizes a need to cut costs, usually in the face of a crisis. "Over time, you get a cost cutting culture," consultant Paul Taffinder told Mitchell. "Once you have, the types of people who are good at building things—creating new values, new products, new services—are driven out of the business because it is unpleasant for them to work there. Then, once boom time arrives again, the organization piles on capacity but doesn't solve the problem of creating innovative potential. It has to hire talented new people again." Many companies repeat this process of inefficient growth several times.
Instead of blindly trying to cut costs in the face of crisis, Mitchell recommended that managers embrace cost cutting as a strategic issue and approach the task from a marketing perspective. "If you are going to talk about waste, you need to define what value is, because the opposite of waste is value," business school professor Dan Jones told Mitchell. "And you can only define value from the end customer's perspective. If you can really do this—if you really know what it is that doesn't add value to the customer—then you can start asking 'How can we get rid of that?' Otherwise, we are just saying 'Let's cut costs.' "
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Mitchell, Alan. "Corporate Dieting Can Make Your Company Fat." Management Today. May 1998.
Schimel, Barry. One Hundred Ways to Prosper in Today's Economy. Acropolis Books, 1994.