Cost Analysis

Cost Data for Business

Decision
 Company may wish to determine, for instance :
 The most profitable rate of operation of a given
plant or department
 They may desire to know what price to quote to
a prospective customer
 Often they may need to know whether to accept
the particular order
 They may want to know whether it would be
profitable to buy a new machine
 They may have to decide what sales channels to
use; and so on
 So far as these calculations are related to
costs, the businessmen are interested in
 The cost that will be incurred, those which
lie ahead
 Not those which have already been
incurred, and to which the business is
already committed
Cost Concepts and
Classification
 The kind of cost concept to be used in a
particular situation depends upon the
business decisions to be made
 Cost consideration enter into almost every
decision, and it is important, though
sometimes difficult, to use the right kind of
costs
 Hence an understanding of the meaning of
various cost concepts is necessary to
emphasize:
 That cost estimates produced by
conventional financial accounting are not
appropriate for all managerial uses
 That different business problems call for
different kinds of costs
Actual Cost and
Opportunity Cost
 Actual costs mean the actual expenditure
incurred for acquiring or producing goods and
services
 These costs are also commonly known as
Absolute Costs or Outlay Costs
 Example:
 Actual Wages Paid
 Transportation and Traveling
 Advertising
 Purchasing Building, Plant, Machinery,
Equipments, Raw materials
 Interest Paid, and so on
 Opportunity Costs of a good or services is
measured in terms of revenue – which
could have earned by employing that good
or service in some other alternative uses
 Opportunity cost can be defined as the
revenue foregone by not making the best
alternative use
 The opportunity cost is also called
Alternative Cost
Business and Full Cost
 Business cost includes all expenses which are
incurred to carry out a business
 The concept of business cost is similar to
actual cost
 Business costs includes: payments and
contractual obligations made by firm
 These cost concepts are used for calculating
 Business profit and losses
 For filing returns for income tax
 For other legal purposes
 The concept of full costs includes
business costs, opportunity cost
and normal profit
 Normal profits are a necessary
minimum earning in addition to the
opportunity cost, which a firm
must get to remain in its present
occupation
Incremental (Differential)
and Sunk Costs
 Incremental cost is the additional cost due to change
in the level or nature of business activity
 Examples
 Addition of new product line, or new machinery
 Changing the channel of distribution or Expansion of
additional markets
 Replacing a machine by the better machine
 Thus, the question of incremental or differential cost
would not arise when a business is to be set up afresh
 It arises only when a change in contemplated in the
existing business
 The sunk costs are those which cannot be
altered, increased or decreased, by varying
the rate of output
 Example
 Once it is decided to make incremental
investment expenditure and the funds are
allocated and spent, all the preceding costs
are considered as the sunk costs since they
accord to the prior commitment and cannot be
revised or reversed or recovered when there is
change in market conditions or change in
business decision.
Past and Future Costs
 Past costs are actual costs incurred in the
past and are generally contained in the
financial accounts
 If they are regarded as excessive,
management can indulge in post-mortem,
just to find out the factors responsible for
the excessive costs, if any, without being
able to do anything for reducing them
 Future costs are costs that are reasonably
expected to be incurred in some future
period or periods
 Future costs are the only costs that
matters for managerial decision because
they are the only costs subjected to
management control
 Unlike past costs, they can be planned for
and planned to be avoided
 The major managerial uses where future
costs are relevant are:
 Cost Control
 Projection of Future Profit Appraisal of
Capital Expenditure
 Introduction of New Products
 Expansion Programs and Pricing
Short-Run and Long-Run
Costs
 Short run and long run cost concepts are
related to variable and fixed costs
respectively, and often figure in economic
analysis interchangeability.
 Short-Run costs are the costs which vary
with the variation in output, the size of the
firm remaining the same
 In other words, short run costs are the
same as variable costs
 Long-Run costs, on other hand, are the
costs which are incurred on the fixed
assets like plant, building, machinery, etc
 Such costs have long-run implication in the
sense that these are not used up in a
single batch of production
 Long-run costs are, by implication, the
same as fixed costs
 In the long-run, however, even the fixed
costs become variable costs as the size of
the firm or scale of production increases
Common Production Cost
 In some manufacturing companies two or more
different products emerge from a single, common
production process and a single raw material
 Example:
 A familiar example is the variety of petroleum products
derived from the refining of crude oil
 So also in a shoe factory, the same piece of leather may
be used for men's, women's and children's shoes
 In a cigarette factory, different parts of tobacco leaves
are used for different qualities and products
Joint Costs
 For product costing, it is desirable to
distinguish between two broad categories of
common products:
 Joint Products: When an increase in the
production of one product causes an increase
in the output of another product, then the
product and their costs are traditionally
defined as joint
 Alternative Products: In contrast, when an
increase in the output of a product is
accompanied by the reduction in other
products, the products are called alternative
Allocation of Joint Costs
 When the processing of material results in
more than one end product a problem that
arises is how to apportion the joint costs so
as to ascertain unit product costs
 There are two methods available for the
purpose:
 Market Value Method
 Quantitative Unit Method
Market Value Method
 In case of market value method, it is believed that
joint costs should be allocated to the products
according to their ability to pay.
 Example:
 A common process costing Rs. 10800 results in two
products X and Y which can be sold for Rs. 10000 and
Rs. 7200 respectively after incurring expense of Rs.
2000 and Rs. 800 respectively
 Apportion joint costs according to Market Value
Method
 Solution

X (Rs.) Y (Rs.)
Gross Realized Value 10,000.00 7,200.00

Post-Separation 2,00.00 800.00

Expenses
Net Realized Value 8,000.00 6,400.00
 The joint expense, Rs. 10800 will be
apportioned in the ratio of 8000:6400 and we
shall get Rs. 6000 for X and Rs. 4800 for Y
Shutdown and
Abandonment Costs
 Shutdown costs may be defined as those costs
which the firm incurs if it temporarily stops it
operations
 These costs could be saved if the operations are
allowed to continue
 Shutdown costs include:
 Besides the fixed costs
 The costs of sheltering plant and equipment
 Lay-off expenses
 Employment and training of workers when the plant
is restarted
 Cost of loss of the market
 Abandonment costs are the costs of
retiring altogether a fixed assets form use.
 Example:
 The plant installed during wartime may be
so improvised that it may not be required
during peacetime
 Abandonment costs, thus, involve the
problem of the disposal of assets
Urgent and Postponable
Costs
 Urgent costs are those that must be incurred so
that the operations of the firm continue
 Example:
 The costs on material, labor, fuel, etc.
 Those costs whose postponement does not affect
(at least for some time) the operational efficiency
of the firm are known as postponable costs.
 Examples:
 The maintenance of building, machinery, etc
Controllable and Non-
Controllable Costs
 Controllable costs are those which are
capable of being controlled or regulated by
executive vigilance and therefore, can be
used for assessing executive efficiency.
 Non-controllable are those which cannot be
subjected to administrative control and
supervision
 Most of the costs are controllable, except for
those due to obsolesce and depreciation.
Total Cost
 Total costs could be divided into two components:
 Fixed costs
 Variable costs
 The costs that do not vary for a certain level of output
are known as Fixed Cost
 Fixed Costs does not vary with variation in the output
between zero and certain level of output.
 Example:
 Cost of Managerial and Administrative Staff
 Depreciation of Machinery, Building, and other fixed
assets
 Maintenance of Land, etc
 Variable costs are those which vary with
the variation in the total output
 They are a function of output.
 Example:
 Cost of Raw Material
 Running Costs on Fixed Capital, such as
fuel, repairs, routine maintenance
 Direct Labor Charges associated with level
of output
 Cost of all the inputs that varies with output
 Many costs fall between the two extremes of being
fixed and variable
 They are called as semi-variable costs.
 They are neither perfectly variable nor absolutely
fixed in relation to changes in volume
 They change in the same direction as volume but
not in a direct proportion thereto
 Example:
 Electricity Bills often include fixed charge and a
charge based on consumption
Separating Fixed and
Variable Costs
 Two methods may be noticed for
separating costs into fixed and variable
elements
 These are as under:
 Least Square Method
 High and Low Points Method
Method of Least Square
 Under this method, the total cost, Y, is represented
by a straight line consisting of:
 A fixed element in the total cost, i.e., 'a'
 The number of units, X, multiplied by the variable
component, 'b', in each unit cost, i.e., bX
 Thus, the equation is Y = a + bX
 Equation ‘a’ and ‘b’ can be solved as follows:
b = Σ xy – [ ( Σ x * Σ y) ÷ n ]
Σ x2 – ( Σ x2 ÷ n )
a = ( Σ Y ÷ n ) – ( Σ X ÷ n)
 Where:
x = X – ( Σ X / n) y = Y – ( Σ Y / n)
Therefore, Total Cost Y = 195 + 15X
High and Low Points
Method
 Under this method, the total costs (without
distinguishing fixed and variable components)
of two volumes of output, one high and the
other low, are taken
 The difference in the two cost figures (i.e.,
incremental cost) is divided by incremental
output (i.e., the difference in the volume of
output between the two levels)
 This will give the variable cost per unit
 Now the total cost of the volume of output less
the total variable cost at that level of output
gives the fixed cost which will remain fixed for
all levels of output
 Calculate the fixed and Output (In Total Costs
variable costs from the Units)
following figures: 3420 13,880.00

1368 8,750.00
Solution:
 Incremental Cost: 13880 – 8750 = 5130
 Incremental Output: 3450 – 1368 = 2052
 Variable cost per unit: 5130 + 2052 = Rs. 2.50
 Variable Cost for 3420 Units: 3420 * 2.50 = Rs.
8550
 Total Cost for 3420 Units: Rs. 13880
 Fixed Cost: Rs. 13880 - Rs. 8550 = Rs. 5330
Cost Relationships
 The relationship between Total Costs, Average Cost
and Marginal Cost as shown below:
 Average Cost (AC)
= TC ÷ Units of Output
 Average Fixed Cost (AFC)
= Fixed Cost ÷ Units of Output
 Average Variable Cost (AVC)
= Variable Cost ÷ Units of Output
 Average Cost (AC)
= AFC + AVC
 Total Variable Cost (TVC)
= AVC * Units of Output
Cost Determinants
 The cost of production of goods and
services depends on a number of factors
 These factors may differ from firm to firm
within an industry and from one industry to
another
 The important cost determinants are as
under:
Level of Output
 The larger the output, the greater will be
the production cost
 For there will be larger use of various
factors of production who shall get larger
payments
 Thus, total cost varies directly with output
Prices of Input Factors
 Obviously, changes in input prices
influence costs, depending on the selective
usage of the inputs and relative changes in
their prices
 When a factor, which is a major component
in production function becomes relatively
costly it raises the cost significantly
Productivities of Factors of
Production
 Productivity of a factor refers to the output
per unit of that factor
 The higher the productivity of a factor of
production, the lower the costs per unit of
the input factor
 Thus, an increase in factor productivity
would reduce the total production costs for
producing a given output
Period of Consideration
 If one considers the short period, the cost
curve will rise steeply
 However, in case of long period, cost would
not increase that steeply
Level of Capacity
Utilization
 This especially affects the per unit fixed
cost
 Thus, with higher capacity utilization, fixed
cost per unit of output is bound to be low
Technology
 Technology progress or improvement leads
to an increase in efficiency or productivity
of factors pf production.
 This in turn leads to reduction in cost of
production
 In other words, cost varies inversely with
technological progress
 Also, most technological innovations aim at
reducing costs
Cost Output Relations
Cost-Output Functions
 Cost function expresses the relationship between
cost and its determinants
 In a mathematical form it can be expressed as:

C = f(S, Q, P, T ...)
Where:
C = Cost (Unit Cost or Total Cost)
P = Price of Inputs Used in Production
S= Size of Plant
T = Nature of Technology
Q = Level of Output
Relationship between
Production and Cost
 Cost function is simply the production
function expressed in money units
 The short run cost function operates under
the same limitation as of the short-run
production function (except the
assumption regarding the input prices)
 The table shows the relationship between
the production and cost in the short run
 Correspondingly,
Total product (Q) first
the increases
total variable
at an cost
increasing
(TVC)
rate and
first increases
later on
at at
aadecreasing
decreasingrate
rateand then at
an increasing rate

Units of Total Product TVC Marginal Cost Marginal

Variable Input (Q) (L * Wage Rate ( δ TVC / δ Q) Product
Labor (L) of Rs. 100) ( δ Q / δ L)

0 0 0 – –
1 10 100 10.00 10
2 22 200 8.33 12
3 40 300 5.55 18
4 55 400 6.67 15
5 62 500 14.33 7
6 65 600 33.33 3
7 60 700 –20.00 –5
 In mathematical form:
 Assuming that labor (L) is the variable

input and the wage rate (W) is given, we

can state that:
δ TVC = δ L * W
Since MC = δ TVC / δ Q
Therefore
MC = (δ L * W) ÷ δ Q
= (1 / MPL) * W
Cost-Output Relationship
in the Short-Run
 In economic theory, the cost-output
relationship in the short run may be
studied in terms of:
 Average Fixed Cost
 Average Variable Cost
 Average Total Cost
Units of Fixed Variable Total Marginal Average Average Average
Output Cost Cost Cost Cost Cost Fixed Variable
(1) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) Cost Cost
(2) (3) (4) (5) (6) (Rs.) (Rs.)
(7) (8)

0 176 0 176
1 176 75 251 75 251 176 75
2 176 130 306 55 153 88 65
3 176 175 351 45 117 59 58
4 176 209 385 34 96 44 52
5 176 238 414 29 83 35 48
6 176 265 441 27 74 29 44
7 176 289 465 24 66 25 41
8 176 312 488 23 61 22 39
9 176 328 504 16 56 20 36
10 176 344 520 16 52 18 34
11 176 367 543 23 49 16 33
12 176 400 576 33 48 15 33
13 176 448 624 48 48 14 34
14 176 510 686 62 49 13 36
15 176 600 776 90 52 12 40
Average Fixed Cost and
Output
 The greater the output, the lower the fixed
cost per unit, i.e., the average fixed cost
 The reason is that the total fixed cost
remains same and do not change with a
change in output
 The relation between output and fixed cost
is a universal for all types of business
Variable Cost and Output
 The average variable costs will first fall and then rises as more and
more units are produced in a given plant
 This is so because as we add more units of variable factor in a fixed
plant; the efficiency of the inputs first increases and then decreases
 In fact, the variable factor tends to produce somewhat more
efficiently near a firm's optimum output than at very low levels of
output
 But once the optimum capacity is reached, any further increase in
output will undoubtedly increase average variable cost quite sharply
Average Total Cost and
Output
 Average Total Costs, more commonly known as
average costs, would decline and then rise upwards
 The significant point to note here is that the turning
point in the case of average cost would come a little
later than in the case of average variable cost
 For example, from the above table, the average cost
starts rising after an output level of 13 units while the
average variable cost starts rising after an earlier
level of output, i.e., 12Units
 Average cost consists of average fixed cost
plus average variable cost
 As we have seen, average fixed cost
continues to fall with an increase in output
while average variable cost first declines
and then rises
 So long as average variable cost declines
the average total cost will also decline
 But after a point, the average variable cost
will rise
 Here, if the rise in variable cost is less than
the drop in fixed cost, the average cost will
continue to decline
 It is only when the rise in average variable
cost is more than the drop in average fixed
cost that the average total cost will show
rise
Interrelationship between
AVC, ATC, and AFC
 If both AFC and AVC falls, ATC will fall
 If AFC falls but AVC rises
 ATC will fall where the drop in AFC is more
than the rise in AVC
 ATC will not fall where the drop in AFC is
equal to the rise in AVC
 ATC will rise where the drop in AFC is less
than the rise in AVC
Relations between all the
Costs
 The short run TC is composed of two major
elements: TFC and TVC. That is, in the short run:
TC = TFC + TVC
 For a given quantity of output (Q), the AC and

AFC and AVC can be defined as follows:

AC = TC ÷ Q = (TFC + TVC) ÷ Q
AFC = TFC ÷ Q
AVC = TVC ÷ Q
Therefore,
AC = AFC + AVC
 Marginal Cost is defined as the change in
the total cost divided by the change in the
total output, i.e.
MC = δ TC * δ Q
 Since, δ TC = δ TFC ÷ δ TVC and, in short
run, δ TFC = 0, therefore,
δ TC = δ TVC
 Furthermore, under marginality concept,
δ Q = 1, MC = δ TVC
Cost-Output Relationship
in the Long-Run
 In long run, entrepreneur has before him number
of alternatives which include the construction of
various kinds and sizes of plants
 Thus there are no fixed costs since the firm has
sufficient time to fully adapt its plant. And all the
costs become variable
 Long run costs would refer to the costs of
producing different levels of output by changes in
the size of plant or scale of production
 To understand the long run cost-output relations
and to derive long run cost curves it will be
helpful to imagine that a long run is composed of
a series of short run production decisions
 As a corollary of this, long run cost curves is
composed of series of short run cost curves.
 We may now derive the long run cost curves and
study their relationship with output
 Long-Run Total Cost Curve
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Cost Functions
Linear Cost Function
 Suppose a firm producing a certain goods
under the following conditions:
 It has fixed costs which must be met
irrespective of the quantity of output
produced. These fixed costs are
represented by 'a'
 In order to produce X good, it must buy a
proportional amount of raw materials,
labor, and other necessary inputs, the
cost of which is the variable 'bX'
 If total cost of the fixed cost and variable
quantities is denoted by TC, the equation
representing the total cost of production
for the firm is the linear function:
TC = a + bQ
 Certain important economic and
mathematical properties of this function
are as follows:
 At zero output, total fixed cost, such as
rent, property taxes, insurance, and
depreciation due to time and obsolesce,
equals total cost.
 Increase in total cost due to increase in the
output is represented by total variable cost
 The average or unit cost function can be
obtained by dividing the total cost function by
output, X
ATC = TC ÷ Q = (a ÷ Q) + b
 Since AFC in the above formula is (a / Q),
subtracting from this equation leaves AVC 'b'
 The marginal cost can be obtained by
differential calculus
 Thus, MC = b
Quadratic Cost Function
 This type of function which has been
widely used in empirical studies is
represented by the equation:
TC = a + bQ + cQ2
 This kind of situation might occur with a firm
whose costs were Rs. 5000 a month and whose
variable cost for labor, materials, etc., to produce
are 250Q + 3Q2
 The last variable might rise if the firm's initial cost
of labor and material for producing Q units is Rs.
250Q and its growing demand for the limited
supply of input bids up their price by the amount
3Q2 as output increases
 Its total cost equation would be:
TC = 5000 + 250Q + 3Q2
 The implication of this equation maybe noted as
follows:
 When Q = 0, TC = a, total cost equals fixed cost
 It has only one bend as against linear total cost
function TC = a + bQ which has no bends
 The number of bends is always one less than the
highest component of X
 Dividing the total cost function by output X can
derive the AC equation:
AC = Y / Q = (a / Q) + b + cQ
 Since AFC in the above equation equals (a / Q),
subtracting this out gives AVC, (b + cQ)
 The equation for MC can be obtained by
differentiating the TC function
 Thus,
MC = b + 2cQ2
MC = AVC = b when Q = 0
Cubic Cost Function
 The typical total cost function is not usually
of linear or quadratic form but rather of the
cubic type:
TC = a + bQ – cQ2 + dQ3
 The curve shall have two bends – one less
than the highest exponent of Q
 This function combines the phases of both
increasing and diminishing returns to scale
Cost Control
 Cost Control is defined as the regulation by
executive action of the cost of operating an
undertaking
 Cost Control is exercised through
numerous techniques some of which are
 Standard Costing
 Budgetary Costing
 Inventory Control
 Quality Control
 Performance Evaluation
 Cost control involves the following steps and
covers various aspects of management (Indicated
in parentheses)
 Initially, a plan or set of targets is established in
the form of budget, standards or estimates, which
serve as reference point to compare the actual
performance with planned objective (Planning)
 To communicate the plan to those whose
responsibility is to implement the plan
(Communication)
 Once the plan is put into action, evaluation of
the performance starts. The fact that cost are
being reported for evaluating performance acts
as motivating force (Motivation)
 Comparison is made to the actual performance
with the predetermined plan / target. Deviations
/ variances, if any, are analyzed and reported to
the appropriate level of management (Appraisal
and Reporting)
 Lastly, the reported variances are
reviewed. Either the corrective actions and
remedial measures are taken or the set of
targets is revised, depending upon the
management's undertaking of the problem
(Decision Making)
Tools of Cost Control
Budgetary Control
 A budget is defined as a financial statement
(prepared and approved) of a policy to be pursued
during that period of time for the purpose of attaining
a given objective
 Budgetary control is a system which uses budgets as
a means of planning and controlling
 It involves constant checking and evaluation of actual
results compared with the budget goals, thus helping
in corrective action
 The details of budgetary vary form
company to company depending upon
factors such as:
 Size and complexity of the company's
operations
 The degree to which the company is
concerned with costs
 The degree to which the firm is well
managed
 A successful budgetary control depends upon:
 Commitment of top management to cost control
 Individuals should be help responsible only for the costs
they can control
 While favorable deviation in cost should always be
commended, the unfavorable performance must be used
as a learning device
 The goals of the organization should be clearly defined
and must be reasonably attainable
Standard Costing
 Standard costs are those costs that should
be obtained under efficient operation
 They are predetermined costs and
represents targets that are considered
important for cost control
 The degree of success is measured
through comparing actual performance
with standard performance
 If the standard material input for a unit of production is
Rs. 100 and the actual cost is Rs. 95, then the variance
of Rs. -5 is the measure of performance, which shows
that the actual performance is an improvement of the
standard
 It is better to compare actual cost with standard cost
than with any comparative figure form the company's
previous financial results, because a comparison
between current results and previous results necessarily
presupposes that the previous results were at a level of
efficiency that was sufficiently suitable to be a yardstick
 Generally, this is rarely a case as future conditions
generally differ from the past
Basis of Setting Standard
Costs
 Establishing 'standards' as a basis for
evolving standard costs is an important
part of the work of an industrial engineer
 Technical and engineering consideration
underlies many standards, depending on
which performance is to be judged
Tolerance Allowance
 It is not possible for any management to
insist that the performance must always
match the 'rigid' standards
 Some deviation from the standard are
always allowed
 It is the limit of these variations or
deviations form the set standards that are
called Tolerance Limit
 These deviations are of two kinds:
 Random Deviation: Random deviations are
those which arise purely due to chance and
are, therefore, uncontrollable
 Significant Deviation: Significant deviations
have assignable cause and are, thus,
subject to managerial control
Variance Analysis
 Once variances are found, their cause needs to be
determined for taking corrective action
 These variations may be caused due to several reasons.
 Many changes may favorably or unfavorably influence the
performance such as:
 Product design or product mix
 Labor productivity
 Composition of firm's machinery and equipment
 Organizational structure etc.
 An important thing about variance is that the
cause of variances may be personalized
 So, variance analysis operates in accordance
with the principles of responsibility accounting:
 Production Supervision would responsible for
direct labor time variance
 Marketing Manager responsible for sales price
variance and sales mix variances
 Purchasing Department for material price
variance, and so on
 Once the standard costs are determined, the next step
in operation of a standard costing system is to
ascertain the actual cost under each element and
compare them with set standards
 A detailed analysis of variance, particularly the
controllable variances, helps the management to
ascertain:
 The extent of variation
 Reason for the occurrence of the variance
 The factor responsible for it
 The executive / department on which the responsibility
for the variance can be laid
Labor Cost Variance
 Also known as direct wage variance, is the
difference between the standard direct
wages specified and the actual wages paid
for an activity
 It includes the wage rate variance and
labor efficiency
Sales Variance
 Is the difference between the standard
cost of sales specified and the actual cost
of sales?
 Four kinds of sales variance are generally
found, viz.,
 The mix variance
 The quantity variance
 The volume variance
 The price variance
Overhead Variance
 Is the difference between the standard
cost of overhead absorbed in the output
achieved and the actual overhead cost.
 Overhead variances may be computed and
analyzed separately for fixed and variable
overhead for each cost center
 The variable overhead variances are:
Overhead Expenditure (or, Budget)
variance and Overhead
Value Analysis
 It is an analysis which helps in reducing cost
without sacrificing the pre­determined standards
of performance
 Firms use value analysis not as a substitute of the
conventional cost control methods but only as
supplement to them
 This technique is more popular in those cases
where very large quantities of a good are
produced, as in such cases even a fractional
amount saved on manufacturing cost per unit
ultimately result in substantial savings
Areas of Cost Control
Material
 If buying is done properly, a firm avails itself
of quantity discount
 While buying form a particular source, in
addition to the cost of material, consideration
should be given to freight charges
 While buying one may attempt to buy form
the cheapest source by inviting bids.
 At times, it may be possible to have more
economical substitutes for raw material that
a firm is using
Overheads
 Factory overheads may be reduced by
 Proper selection of equipment
 Effective utilization of space and equipment
 Proper maintenance of equipment
 Reduction in power costs
 Lightning costs, etc
 Example:
 Florescent lightning can reduce lightning costs
 Faulty design may lead to
 Excessive use of materials or multiplicity of
components
 Waste of steam
 Electricity, gas, lubricants, etc
 Taking advantages of trucks or wagonloads
may reduce transport costs
 Careful planning of movements also saves
transportation costs
 Another point to be examined is whether it
would be economical to use one's own
transport or have hired transport
 For reasons of economy many transport
companies hire trucks rather than owing
them
 Reduction of wastes in general can also
reduce manufacturing costs considerably
 Of course certain amount of waste and
spoilage is unavoidable due to
 Human mistakes
 Machine failure
 Faulty raw materials
 The normal figure for waste and spoilage
depends upon the
 Complexity of the product
 The age of the manufacturing plant
 Skill and experience of the workers
Sales
Areas of Control
 Improved supervision and training of salesmen
 Rearrangement of sales territories
 Replanning salesmen's routes and calls
 Redirecting of sales efforts to achieve a more
economic product mix
 It may be possible to save selling costs by the
use of warehouse making bulk shipments to the
warehouses and giving faster deliveries to the
customer thereform
Cost Reduction
 Cost reduction implies profit optimizing
through economies in costs of
 Manufactures

 Administration

 selling and distribution

 We know that profit can be maximized

either by increasing scales or by reducing
costs
 In a monopoly market it may be possible to
increase price to earn more profits
 On the other hand, in a competitive situation it
is not possible to increase the price
significantly; growth of profit would, therefore,
depends mainly on the extent of cost reduction
 Even when monopoly conditions prevail at
present, these may not exist permanently
 So avenues have to be explored and methods
devised for cost reduction
Essentials for Success of
Cost Reduction Program
 Every individual within the factory
recognize his responsibility
 The cooperation of every individual should
be sought by
 A careful dissemination of the objectives in
view
 By encouraging employees to identify their
self-interest with the company's interest
 Employee resistance to change should be
minimized by
 Dissemination complete information about
the proposed changes
 Convincing the employees that the changes
are concerned with the problems faced by
the firm and that they would ultimately
benefit
 Efforts should be concentrated in the areas
where the savings are likely to be the
maximum
 Cost reduction efforts should be
continuously maintained.
 There should be periodic meetings with the
employees to review the progress made
towards cost reduction
Approaches to Cost
Reduction
Budgetary Approach
 This approach may be followed when the operating
departments are far over the budget and a
situation of financial crisis exists
 These approach to cost cutting usually entails the
identification of items in the budget that are most
amenable to quick changes
 Example:
 Travel is restricted or frozen
 Coffee and refreshments are no longer provided at
meetings
Input Cost Approach
 Under this approach, managers try to reduce
the cost of their inputs in various ways
 Example:
 Reduction of wage costs through wage
concessions from workers on exchange:
 Shares and stocks in the company
 Seat on the board of directors
 Moving into offices with lower rents and
maintenance costs
Input Substitution Approach
 Managers can reduce costs by way of cost effective
substitutes for their inputs
 Example
 A company may consider a plant in a foreign
country to take advantage of its low wage (of
course, he will have to consider the lower input
costs relative to its productivity)
 If the labor productivity is too low, it could offset
any of the cost savings that result form the low
wages
'Not Made Here' Approach
 If it can be determined that an outside
supplier or service vendor can perform an
activity for less than it would cost a
company, the company should utilize these
outside resources.
 Outsourcing is an old practice in
manufacturing sector but it also growing in
service sectors
Suggestion Box Approach
 Sometimes the best ways to cost reduction
come form suggestion form employees
especially those connected directly with
the production process