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COST CONTROL

Roger J. Binder

Reference for Business，Encyclopedia of Business, 2nd ed.

Cost control, also known as cost management or cost containment, is a broad

set of cost accounting methods and management techniques with the

common goal of improving business cost-efficiency by reducing costs, or at

least restricting their rate of growth. Businesses use cost control methods to

monitor, evaluate, and ultimately enhance the efficiency of specific areas, such

as departments, divisions, or product lines, within their operations.

During the 1990s cost control initiatives received paramount attention from

corporate America. Often taking the form of corporate restructuring,

divestment of peripheral activities, mass layoffs, or outsourcing, cost

control strategies were seen as necessary to preserve—or boost—corporate

profits and to maintain—or gain—a competitive advantage. The objective was

often to be the low-cost producer in a given industry, which would typically

allow the company to take a greater profit per unit of sales than its

competitors at a given price level.

Some cost control proponents believe that such strategic cost-cutting must be

planned carefully, as not all cost reduction techniques yield the same benefits.

In a notable late 1990s example, chief executive Albert J. Dunlap, nicknamed

"Chainsaw Al" because of his penchant for deep cost cutting at the companies

he headed, failed to restore the ailing small appliance maker Sunbeam

Corporation to profitability despite his drastic cost reduction tactics. Dunlap

laid off thousands of workers and sold off business units, but made little

contribution to Sunbeam's competitive position or share price in his two years

as CEO. Consequently, in 1998 Sunbeam's board fired Dunlap, having lost

confidence in his "one-trick" approach to management.

COST CONTROL APPLICATIONS

A complex business requires frequent information about operations in order

to plan for the future, to control present activities, and to evaluate the past

performance of managers, employees, and related business segments. To be

successful, management guides the activities of its people in the operations of

the business according to pre-established goals and objectives. Management's

guidance takes two forms of control: (1) the management and supervision of

behavior, and (2) the evaluation of performance.

Behavioral management deals with the attitudes and actions of employees.

While employee behavior ultimately impacts on success, behavioral

management involves certain issues and assumptions not applicable to

accounting's control function. On the other hand, performance evaluation

measures outcomes of employee's actions by comparing the actual results of

business outcomes to predetermined standards of success. In this way

management identifies the strengths it needs to maximize, and the

weaknesses it seeks to rectify. This process of evaluation and remedy is called

cost control.

Cost control is a continuous process that begins with the proposed annual

budget. The budget helps: (1) to organize and coordinate production, and the

selling, distribution, service, and administrative functions; and (2) to take

maximum advantage of available opportunities. As the fiscal year progresses,

management compares actual results with those projected in the budget and

incorporates into the new plan the lessons learned from its evaluation of

current operations.

Control refers to management's effort to influence the actions of individuals

who are responsible for performing tasks, incurring costs, and generating

revenues. Management is a two-phased process: planning refers to the way

that management plans and wants people to perform, while control refers to

the procedures employed to determine whether actual performance complies

with these plans. Through the budget process and accounting control,

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 and controlling the results of their activity. Cost

centers are accountable only for expenses, that is, they do not generate

revenue. Examples include accounting departments, human resources

departments, and similar areas of the business that provide internal services.

Profit centers accept responsibility for both revenue and expenses. For

example, a product line or an autonomous business unit might be considered

profit centers. If the profit center has its own assets, it may also be considered

an investment center, for which returns on investment can be determined.

The use of responsibility centers allows management to design control reports

to pinpoint accountability, thus aiding in profit planning.

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. A budget

establishes the responsibility center, delegates the concomitant

responsibilities, and determines the decision points within an organization.

The planning process provides for two types of control mechanisms:

1. Feedforward: providing a basis for control at the point of action (the

decision point); and

2. Feedback: providing 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. Therefore, effective

management controls results from leading people by force of personality and

through persuasion; providing and maintaining proper training, planning,

and resources; and improving quality and results through evaluation and

feedback.

CONTROL REPORTS

Control reports are informational reports that tell management about an

entity's activities. Management requests control reports only for internal use,

and, therefore, 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 funds

statement, and external reports on the general economy and the specific

industry.

Control reports, then, 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.

Because key success factors shift in type and number, accounting revises

control reports when necessary. Accounting also varies the control period

covered by the control report to encompass a period in which management

can take useful remedial action. In addition, accounting disseminates control

reports in a timely fashion to give management adequate time to act before

the issuance of the next report.

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, managers, especially those in operations, realize that they exercise

more control over expenses than they do over revenue.

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 its operations is cost control.

STANDARDS

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

indicates that management expects the sales force to spend only so much in

pursuit of the sales forecast. The details also reveal 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.

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 also determines that the sales force will expend about $80,000

to sell the 1,000 units. This is a sales expenditure of $80. 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 data also

shows that the sales force spent $7,000 that month, and that production

incurred $12,000 in expenses. Table 1 summarizes the data that management

reviews to identify variances. While revenue was on target, actual sales

expense came in less than projected, with a per unit cost of $70. This is a

favorable variance. 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 call

management to action if the variance exceeded acceptable levels (levels that

were established before manufacturing began).

THE ROLE OF ACCOUNTING

Accounting plays a key role in all planning and control. It does this in four key

areas: (1) data collection, (2) data analysis, (3) budget control and

administration, and (4) consolidation and review.

DATA COLLECTION.

Accurate and timely information is the foundation of any accounting system,

and thus detailed cost data are essential to any cost control endeavor.

Management must understand—in great detail—how funds have been spent in

the past and how they are being spent currently. As a result, companies invest

large sums into sophisticated and error-resistant accounting systems in order

to gain a nuanced understanding of their finances.

Table 1

Comparison of Actual and Standard Costs

Table 1

Comparison of Actual and Standard Costs

Units

Gross

Revenues

Expenses

Sales

Expense

Production

Expense

Projected

Total

1,000

Per Units

Unit Sold

Actual

Month Projected—Actual

1.00 100.00 100.00 0.00

$500,000 $500 $50,000 $50,000 $0

$180,000 $180 $18,000 $19,000 - $1,000

$80,000 $80 $8,000 $7,000 $1,000

$100,000 $100 $10,000 $12,000 - $2000.00

Total Variance = -2000

DATA ANALYSIS.

Accounting's specialty is in the control function, yet its analysis is

indispensable to the planning process. Accounting adjusts and interprets the

data to allow for changes in company specific, industry specific, and

economy-wide conditions.

BUDGET AND CONTROL ADMINISTRATION.

The accountants play a key role in designing and securing support for the

procedural aspects of the planning process. In addition, they design and

distribute forms for the collection and booking of detailed data on all aspects

of the business.

CONSOLIDATION AND REVIEW.

Although operating managers have the main responsibility of planning,

accounting compiles and coordinates the elements. Accountants subject

proposed budgets to feasibility and profitability analyses to determine

conformity to accepted standards and practices.

STRATEGIC COST CONTROL

Management relies on such accounting data and analysis to choose from

several cost control alternatives, or management may direct accounting to

prepare reports specifically for evaluating such options. As the Chainsaw Al

episode indicated, all costs may not be viable targets for cost-cutting measures.

For instance, in mass layoffs, the company may lose a significant share of its

human capital by releasing veteran employees who are experts in their

fields, not to mention by creating a decline in morale among those who remain.

Thus management must identify which costs have strategic significance and

which do not.

To determine the strategic impact of cost-cutting, management has to weigh

the net effects of the proposed change on all areas of the business. For

example, reducing variable costs related directly to manufacturing a product,

such as materials and transportation costs, could be the key to greater

incremental profits. However, management must also consider whether

saving money on production is jeopardizing other strategic interests like

quality or time to market. If a cheaper material or transportation system

negatively impacts other strategic variables, the nominal cost savings may not

benefit the company in the bigger picture, e.g., it may lose sales. In such

scenarios, managers require the discipline not to place short-term savings

over long-term interests.

One trend in cost control has been toward narrowing the focus of corporate

responsibility centers, and thereby shifting some of the cost control function

to day-to-day managers who have the most knowledge of and influence over

how their areas spend money. This practice is intended to promote bottom-up

cost control measures and encourage a widespread consensus over cost

management strategies.

SUMMARY

Control of the business entity, then, is essentially a managerial and

supervisory function. Control consists of those actions necessary to assure that

the entity's resources and operations are focused on attaining established

objectives, goals and plans. Control, exercised continuously, flags potential

problems so that crises may be prevented. It also standardizes the quality and

quantity of output, and provides managers with objective information about

employee performance. Management compares actual performance to

predetermined standards and takes action when necessary to correct

variances from the standards.

SEE ALSO : Cost Accounting ; Costs ; Managerial Accounting

[ Roger J. AbiNader ]

FURTHER READING:

Anthony, Robert N., and Vijay Govindarajan. Management Control Systems.

Chicago: Irwin, 1997.

Cooper, Robin, and Robert S. Kaplan. The Design of Cost Management

Systems. Upper Saddle River, NJ: Prentice Hall, 1998.

Cooper, Robin, and Regine Slagmulder. "Micro-Profit Centers." Management

Accounting, June 1998.

Hamilton, Martha M. "Who's Chainsawed Now? Dunlap Out as Sunbeam's

Losses Mount." Washington Post, 16 June 1998. Rotch, William, et al. Cases

in Management Accounting and Control Systems. 3rd ed. Englewood Cliffs,

NJ: Prentice Hall, 1995.

Shank, John K., and Vijay Govindarajan. Strategic Cost Management. New

York: Free Press, 1993.

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