Techniques of Cost Reduction
The main techniques used for cost reduction are as follows
1. Cost Analyses
2. Ratio Analysis
3. Break-even Analysis
4. Methods Study
5. Management Audit
6. Value Analysis.
1. Cost Analyses -First technique is Cost analysis. Cost analyses are one of the most valuable tools available for identifying possibilities and potentials of reducing costs. Cost accounting reports are required for the evaluation of the success of a cost reduction programme. Cost analyses provide useful information for finding where, why and by how much costs are high. Such analyses focus attention on functions or areas with maximum potential for cost reduction.
Cost accounting reports can reflect causes of high costs so that quick and appropriate remedial action may be taken. The various alternatives and their costs can be compared to choose the most cost effective procedure/process. The cost standards can also be appraised and modified.
2. Ratio Analysis – Second technique is Ratio analysis. Ratio is a statistical yardstick which provides a measure of relationship between two figures. This relationship may be expressed as a rate (costs per dollar of sales), as a percentage (cost of sales as a percentage of sales) or as a quotient/proportion (sales as number of times the inventory). Ratios are widely used in the analysis of operaions as the use of absolute figures might be misleading. Relative figures are better for control purposes.
Under ratio analysis, a desirable ratio is determined beforehand. The actual ratio is compared with this predetermined ratio and wherever necessary corrective action is taken. It is possible to compute several types of ratios relating to liquidity, profitability, solvency, etc. But for cost reduction, only operating cost ratios are used. Some of the commonly used ratios for cost comparison are given below :
(a) Net profits/Sales
(b) Sales/Direct labour
(e) Sales/Direct materials
(f) Production cost/Cost of sales
(g) Selling costs/Cost of sales
(h) Administration cost/Cost of sales
(i) Material costs/Cost of production
(j) Labour costs/Cost of production
(k) Overhead/Cost of production.
Ratios serve as standards of comparison for evaluation of performance. They can be used for cost reduction in two ways :
(i) A business may compare its ratios with the ratios of other firms in the industry. Sometimes, comparison is made with standard ratios in the industry which are averages of the results of all firms in the industry.
(ii) A firm’s ratios for the period under scrutiny may be compared with similar ratios of previous periods. Such comparison over time would reveal the areas that need attention.
3. Break-Even Analysis – It is also one important technique of Cost reduction. Break-even analysis or cost-volume profit analysis is the study of interrelationships among a firm’s sales, cost and operating profit at various levels of output. It reveals the effect of fixed costs, variable costs, prices, sales mix, etc., on the profitability of a firm. In break -even analysis, break-even point and break-even chart are of particular significance.
4. Methods Study – Methods study or methods engineering is a valuable tool of cost reduction. It involves systematic and critical evaluation of the methods and techniques of doing work. It helps in improving the conditions that influence work performance. Methods study results in the establishment of work standards and better methods which make the best use of materials and human resources. Significant cost reduction can be achieved through work simplification, standardization, motion and time studies, etc.
Statistical quality control is also helpful in reducing costs associated with inferior quality. Improvements in quality help to reduce scrap, costs of reworking, excess inspection, etc. Control charts, OC curves and inspection are useful techniques of controlling quality. For cost reduction proper balance should be maintained between inspection and defective work.
5. Management Audit – Management audit is a systematic and comprehensive appraisal of every aspect of the organization. It is the process of analyzing, evaluating and examining the overall performance of management. It consists of
(a) compilation of data relating to performance, and
(b) analysis of the collected data.
The overall performance of every individual and of the management as a whole is made. As a thorough analysis of the different facets of an organization, management audit can yield significant savings or reduction in costs. It can reveal overlapping duties, wasteful efforts duplication of control etc. Organization Charts and manuals are also very useful in this respect.
6. Value Analysis-Value analysis is a technique of cost reduction. It involves study of cost in relation to product design. Before making or buying a product/material/equipment, a study of its value (function) is made. The purpose is to reduce the cost of the prescribed function without sacrificing the required standard of performance. First, the required function is determined and then the best way to perform it at a lower cost is found. Value analysis is a supplementary device in addition to the conventional cost reduction methods.