Cost Management Requires a Total Approach
Cost Analysis and Accounting are not Enough for Managing Costs
Aug 9, 2009
Cost management is not an accounting issue. Rather it is more of a strategic issue concerned with what can be described as portfolio selection. The portfolio of products, customers, assets, methods and systems all must be selected by considering alternative opportunities. For example, unprofitable products are eliminated, alternative production processes and materials are evaluated and profitable customers get focused attention.
Significance of Cost Management
In a competitive market, businesses do not have much say in setting the selling price (unless they are willing to set a price lower than the market price). In such a situation, it is costs that determine how profitably a business operates.
The typical approach to cost management was to cut costs wherever possible, without looking at the consequences. However, such indiscriminate cost-cutting campaigns can undermine the very objective of controlling costs. For example, by cutting down on customer care, a business might soon find many customers going elsewhere. Costs might rise by the consequent lower sales (and production) volumes.
Total Cost Management
Total cost management is a formal approach pioneered by the Association for the Advancement of Cost Engineering (AACEI). The approach asks engineers not to focus just on the physical product but also on other dimensions such as money, time and other resources involved. A document titled Total Cost Management Framework is available for download at the AACEI website.
Traditionally, products were costed by considering the costs of materials, direct labor and a somewhat arbitrary allocation of overhead costs (costs that cannot be directly associated with the product).
From a business' viewpoint, there are several activities involved in generating revenue from a product, much more than just producing it. For example, even at the early stage of product development, a costly design might be accepted without considering alternatives. Selected production processes might not be the most cost effective ones. Finally, there are costs associated with handling, storing and shipping the products.
Apart from the above costs, there are the costs involved in marketing the product, including marketing channel costs and publicity costs.
All the costs must be considered before the true cost of a product can be identified. Only when this true cost is known can the business identify the profitable and unprofitable products.
Total cost management goes even further by seeking to identify the profitable product designs, production processes and customers. Disciplines like value engineering and lean manufacturing are part of the cost control exercise.
Activity Based Costing
As mentioned above, traditional cost accounting focused on the costs of making a product. On the other hand, if costs of different activities are identified, and the products are costed by looking at the activities related to each, from development through production to marketing and distribution, a more accurate picture of product cost can be obtained. It is this cost that will help identify the really profitable products.
Cost management is not a simple issue of cutting costs that appear easy to cut. Instead, it involves a strategic approach to identify all the costs of operations and consideration of alternatives. Such an approach can help reduce costs without affecting the business' goals. Modern approaches like total cost management focuses on this big picture.
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