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Cost Control

Effective Budgeting

August 15, 2013 by Dr. Jon Warner in Cost Control

Effective Budgeting

Managing overall expenses in any organization, no matter what the size or type, is often a complex business because there are often unseen implications in cost control which only become apparent after the process has commenced. People therefore now commonly therefore talk more about “strategic cost management” as being their goal. Whilst this is an impressive sounding name, it has the same risks to the enterprise if it is not well understood and the implications carefully considered.

Some expenses, particularly those of an administrative nature, have a tendency to grow year after year without adding to the productivity or profit of the organization. So, our starting point to controlling expense must be to review the growth patterns of all expenses.

The best way to do this is to classify all expenses into useful categories. These categories will be governed by the profit or cost centers of the organization in question.

Whilst many enterprises will be able to gather revenue and cost data for a current year (and may have this at call on a computer system) it is also necessary to gather data over several years to look at overall patterns or trends. The best way to do this is as follows:

  1. Calculate all groups of expenses as a percentage of sales or funding/income for the past five periods so that trends in the pattern of expenses can be highlighted.
  2. If it is found that a category of expenses is increasing in a consistent pattern, check to find out why this is happening by looking at each individual item in that expense category.

Once you have this kind of analysis, you can ask questions such as:

  • Which expenses have increased as a percentage of sales or funding and which have decreased?
  • Why has this occurred?
  • What are the alternatives to allowing a pattern of increase to continue?
  • What will happen if I cut this expense by 5%, 10%? or even 20%?

This simple sounding strategy may take a huge coordinated effort on the part of several people in order to make the exercise real and meaningful. Unfortunately this can often mean gathering a great deal of data, but not much information. As such, it may be necessary to summarize the key pieces of information or construct summary tables and charts. PCs with spreadsheet packages offer highly flexible ways to do this and can also provide diagrams and graphs which can sometimes make even the “driest” data easy to read and understand.

Analyzing the expense data

Naturally, different costs have different patterns of increasing and decreasing. The pattern will depend upon the cost driver for that particular cost. A cost driver is the reason why a cost goes up or down. For example:

  • the cost of sales in a trading business increases because: more sales are made;
  • the material cost in a factory increases because: more units are produced;
  • salaries paid on an annual basis increase because: time is passing;
  • the wages bill for casual employees increases because: their working hours increase.

Expenses whose cost driver is volume produced or sold (so that they increase with the level of production or sales) are called variable expenses. Expenses that stay the same, regardless of production or sales are called fixed expenses. Some expenses are partly fixed and partly variable. These are called mixed expenses. Usually, the fixed and variable elements of a mixed cost can be separated. For example, telephone costs are a mixed cost. You pay a fixed fee per month plus a variable amount depending upon your call units. Where the amount spent is a budgetary decision, such as advertising and promotion, or research and development, this is called a discretionary cost because you can exercise your discretion in how much is spent. Discretionary costs are fixed costs once the decision to spend a certain amount is made.

Variable costs can only be reduced by lowering the cost per unit, such as using cheaper material or being more efficient in labor use. Fixed costs can be reduced by being more efficient. Discretionary costs are the easiest to reduce because it only requires a decision when preparing the budget. However, choosing not to spend money on promoting your goods or services can be a very costly decision in the long run.

Determining what is value added or not (using ABM)

Once you have gathered and analyzed the expenses and understood which are fixed and variable you can start to determine which expenses look as if they are adding value (and which ones may not be) and what to do about this. One excellent approach to use in determining this and taking subsequent action is activity-based management (or ABM). ABM is the process of understanding, reengineering, benchmarking and making decisions about the activities of the business or organization to bring about continuous improvement and excellence. So, simply put there are four stages to ABM:

1. FIND AND ELIMINATE NON-VALUE ADDED ACTIVITIES AND COSTS

Value-added activities are those that contribute something that is worthwhile:

  • To the organization, such as paying the employees which satisfies an organizational need; or
  • To its customers, such as painting a new car or delivering shipments on time.

Non value-added activities on the other hand represent waste. Inspection of incoming raw materials is a non value-added activity. Customers do not value inspection, they value quality products. If a supplier of materials commits to supplying high quality materials, inspection is no longer required. Buying testing equipment and hiring more people to inspect the material wastes time and money.  They could be eliminated without decreasing the organization’s ability to compete or satisfy its customers. Armed with a list of non value-added activities the organization can then create teams to find ways to reduce or eliminate the activity.

2. RE-ENGINEER THE ORGANISATION

Armed with much richer cost data and what is non-vale added, reengineering is the redesign of how work is done through examination of the activities carried out. This may take several months or even years in a large organization because existing systems and methods must be replaced thereby eliminating the non value-added costs.

3. BENCHMARK THE VALUE-ADDED ACTIVITIES

Once the non value-added activities have been eliminated the value-added activities must be made as efficient as possible. This ideally requires benchmarking, which is comparing the activity with sector or world best practice. Comparisons can be made with other divisions of the organization or with organizations in different industries to set targets that are equal to or better than the world’s best.

4. DEVELOP AN ONGOING PERFORMANCE MEASUREMENT SYSTEM

Under the ABM approach, a performance measurement system should be designed to bring about not only greater efficiency and effectiveness but continuous improvement. Such a performance measurement system must therefore be:

  • Consistent with the organization’s goals
  • Quantifiable by ratios or figures
  • Simple for everyone to understand
  • Based on measurements under an individual’s or the team’s control
  • Focused on the positive aspects not just the problems.

Activity based management, or activity based costing as it is also often called, has developed quite a following in recent years. This approach has also regularly been combined with zero-based budgeting approaches which seek to avoid the pitfalls of just adding in the prevailing g rate of inflation to last year’s costs. However, even these newer approaches are only as good as the time and attention that people can give to a detailed analysis of costs.

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About Dr. Jon Warner

Dr. Jon Warner is a prolific author, management consultant and executive coach with over 25 years experience. He has an MBA and a PhD in Organizational Psychology. Jon can be reached at OptimalJon@gmail.com

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Jon Warner

Jon Warner is an executive coach and management consultant and in the past has been a CEO in three very different companies. Read more

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