Steps for Effective Reduction in Product Cost
Steps for Effective Reduction in Product Cost
In the present day competitive environment, every organization is to produce its products in a cost effective manner in order to remain competitive in the market. It is necessary for the organization to manage the cost of manufacturing the product. Cost management is one of the functions of the organizational management. It crosses department lines and the alignment between front-line employees, managers and executives in each department is critical for the success of cost management process. Cost management has two components namely (i) cost control, and (ii) cost reduction. Cost control requires organizational management to monitor regularly the cost of producing the product.
Monitoring the cost of production helps in controlling the cost against a standard cost but does not help in reduction in the production cost. For the reduction in the cost which is incurred during the product manufacture, effective steps are needed. Cost reduction steps are effective only when they are taken after evaluating all the aspects. Cost reduction is a vigorous and purposeful activity which tries to minimize cost.
There is significance of cost control and cost reduction activities in the organization since these activities are important as well as they are two major fundamental financial management tools with the organization to regulate and reduce unwanted expenditures. The cost control consists of the process of establishing a standard and then maintaining the performance according the standard. The cost reduction is a planned positive approach to reduce expenditure and it is defined as the reduction in unit cost of the product without impairing its suitability for the intended use. Any organization which is successful in the cost reduction can sell its product at a lower rate than its competitors without reducing the product quality. The importance of cost reduction activities within the organization cannot be overstated especially when the organization is struggling to maintain profitability.
Cost control aims at reducing the actual to the targets, cost reduction aims at reducing the targets themselves. In other words, the aim of cost reduction is to see whether there is any possibility in bringing about a saving in cost incurring activities in the organization. Thus, the term cost reduction denotes real or genuine saving in the costs resulting to the elimination of wasteful and non-essential elements. The necessity for cost reduction arises when the profit margin has to be increased without an increase in the sales turnover i.e. for the same volume of sales; the cost is needed to be reduced.
The product cost has two constituents namely ‘necessary costs’ and ‘avoidable costs’. Necessary costs are required to achieve and sustain a defined objective or standard of product quality. These are those costs which are needed to carry out an activity efficiently and to achieve and sustain a defined standard of product quality. Avoidable costs occur whenever wrong things are done or things are done in a wrong way. Necessary costs include prevention and inspection costs. Avoidable costs are those which do not contribute to the improvements but can cause certain failures.
Necessary costs include prevention and inspection while avoidable costs include costs of failure. Prevention costs of any actions are the costs intended to make sure that things will not go wrong. Inspection costs are the costs of finding out if things are going on correctly so that in case of a deviation corrective and preventive actions can be taken. Avoidable costs also include those costs which are incurring after the failure. These costs are incurred whenever wrong things are being done or things are being done wrongly. Failure costs are the costs incurred when a customer is or will be dissatisfied. In such case one pays the price in damaged reputation, rework, waste, legal penalties, special charges or loss of pride. The cost of failure is always huge and bringing back the things to normal conditions need a herculean task involving cost at each step.
The cost of producing a product has four major components (Fig 1). These are (i) process related costs, (ii) human related costs, (iii) product marketing related costs, and (iv) administrative costs. Process related costs constitute the highest cost component which is incurred during the production of the product while the contribution of the administrative costs in the total cost for producing a product is very low. The component of human related cost and the product marketing related costs are substantial. All the four cost components have several sub components and they are influenced by several factors.
Fig 1 Major components of product costs
The reduction in any of the cost components results into reduction in the cost of production of the product. But the organizational management is to see the effectiveness of the cost reduction steps. It has to judge the efforts needed for the steps with respect to the savings achieved in the cost of producing the product. For example, a major initiative taken for cost reduction in the administrative cost can have very low effect towards reduction of the product cost but the efforts needed for this initiative may be quite high and may be disproportionate with the quantum of the results achieved. On the other hand, in case of process related costs, even a small effort can provide substantial reduction in the product cost.
Further, before taking the cost reduction step, the organizational management is to ensure that it is not counter-productive. It can happen that there may be reduction in costs which is visible but it can result into an increase of cost which is invisible. The decrease of cost which is visible can be offset by the increased cost which is invisible. Sometimes the invisible cost increase may be even more than the visible cost reduction.
Process related costs
Process related costs constitute the highest percentage of the total cost incurred for the production of the product. They are those costs which relate to the items connected with the process of producing the product. The process related costs are highly dependent on (i) the technology employed, (ii) the process of production used, (iii) stability of the process parameters during the production process, (iv) automation and controls available for the process, (v) the layout for the process, and (vi) type of equipment used for producing the product. It includes the cost of raw and other materials, fuel, energy, utilities, consumables, and spares etc. which are needed to produce the product.
The factors which affects the process related costs include (i) quality of the product, (ii) quality of raw and other materials, fuel, energy, utilities, consumables, and spares, (iii) yield of the prime product, (iv) generation of by-products and secondary products, rejects, arising and waste materials, (v) specific consumptions of raw and other materials, fuel, energy, utilities, and consumables, (vi) stability of the process and maintenance of the process parameters, (viii) process efficiency and process productivity, (viii) health of the equipments and their availability for production, (ix) equipments maintenance and breakdowns, and (x) quality and inventories of the in-process materials. Some of these factors are inter-dependent which means that improvement or deterioration in these factors have their effect on other factors. These factors are described subsequently.
For a person to take effective cost reduction steps, he is to be thorough with all the items mentioned above connected with the process. In the absence of the complete knowledge related to the process, the cost reduction steps taken may not be effective, and sometimes they may be counter-productive.
Quality of the product – The least requirement with respect to the product quality is that it should be saleable. Normally the quality of the product is to be the same if not better than the quality of the similar product available in the market. The product quality is to be dependable and should not fluctuate. Also, there should not be any mix up of products of different qualities since any mix up reduces the price of the product. Higher product quality delights the customer and he is prepared to pay even premium while purchasing the product. Poor product quality leads to the customer complaints and results into payment of compensation to the customer and sometimes leads to the rejection of the product at the premises of the customers.
Quality of raw and other materials, fuel, energy, utilities, consumables, and spares – The cost of raw and other materials, fuel, energy, utilities, consumables, and spares constitutes the major costs and affects the product cost substantially. The cost is usually dependent on the quality of these materials. Lower per unit cost of these materials may not result into reducing the cost of producing the product effectively if the quality of these materials undergoes changes. On the other hand, the changed quality of the materials can have an adverse effect on the process parameters and can have damaging effect on the some other factors affecting the cost. Hence, the quality of raw and other materials, fuel, energy, utilities, consumables, and spares is important and required to be controlled to a level (i) which ensures process stability, (ii) does not adversely affect the process parameters, (ii) does not have effect on their effective consumptions, and (iii) does not deteriorate the product quality. It is to be at such level that it reduces the overall cost of producing the product.
Yield of the prime product – Yield of the prime product is very important for the reduction in the product cost. Even small increase in the yield of the prime product results into substantial reduction into the product cost. This is because increased yield results into reduction in the quantity of rejects, secondary product and waste materials and hence eliminates the problems associated with the generation of these materials.
Generation of by-products and secondary products rejects, arising, and waste materials – Higher generation of by-products and secondary products rejects, arising, and waste materials reduces the yield of the prime product. Also, the value of the secondary products, rejects, and arising is much lower than the value of the prime product. Further, waste materials are required to be disposed-off in an environmentally friendly way and this has substantial costs which increases the product cost substantially. Thus, steps taken for the reduction of the generation of secondary products, rejects, arising and waste materials has substantial effect on the product cost.
Specific consumptions of raw and other materials, fuel, energy, utilities, and consumables – Raw and other materials, fuel, energy, utilities, and consumables have high per unit cost. In this regards, any reduction in their specific consumption reduces the overall cost of producing the product. Further, recycling of generated waste materials which does not have any effect on the process stability, and which does not deteriorate the product quality reduces the specific consumptions of raw materials and other materials needed for the process and hence has substantial effect on the reduction the overall cost of producing the product. Materials used for recycling may be generated by the same process or by some other process in the plant.
Stability of the process and maintenance of the process parameters – A stable process where the process parameters are maintained results into higher process productivity since it ensures higher availability of the process equipment for the production. A disturbed process can also result into an increase in the (i) specific consumption of raw and other materials, fuel, energy, utilities, and consumables, and (ii) in the generation of secondary products, rejects, arising and waste materials. Hence the stability of the process and maintenance of the process parameters are important for the reduction of the overall product cost.
Process efficiency and process productivity – All those steps which are taken to improve the process efficiency and process productivity, results into the reduction in the product cost. These steps may be of varying nature and can encompass a large spectrum of the steps which are related to (i) technology, (ii) process, (iii) equipment, (iv) layout, (v) automation and controls, (vi) safety of the process, equipment and the workmen, (vii) house-keeping and cleanliness, and (vii) work environment. Since the process is operated by the workmen hence all the steps taken for improving the human productivity and human efficiency have a positive effect on the process efficiency and the process productivity.
Health of the equipments and their availability for production – Health of the equipments and their availability for production has a substantial influence on the product cost. Unhealthy equipment results into frequent break-downs which affects the availability of the equipment for the process to continue. This results into lower production which increases the component of specific fixed cost in the product cost. Further break-down of the equipment has also adverse effect on the yield of the prime product since it increases the generation of secondary products, rejects, arising and waste materials.
Equipments maintenance and breakdowns – Regular and effective maintenance of the equipment keeps the equipment healthy and reduces the breakdowns. This in turn improves their availability for the production process to continue and results into increased production and hence results into overall reduction in the product cost. Also, unhealthy equipment can cause drop in process productivity and even can result into deterioration in the quality of the product.
Quality and inventories of in-process materials – Higher quality of the in-process material results into improvement in the productivity of the subsequent process as well as improves the quality and the yield of the finished product. Further, any mix up taking place in the in-process materials lower production of the prime product and higher generation of the secondary product and can generate even product rejection. The chances of mix-up in the in-process materials are usually increased when the inventories of these materials are high. Also, higher levels of inventories of in-process materials are big drag on the steps taken for the reduction of the product cost.
Human related costs
Human related cost consists of the second highest component of the product cost. The human related costs are the costs incurred on the employees who execute the processes needed for the production of the product. These costs are those costs which keep employees happy, healthy, safe, and motivated. These costs are important costs since they affect the productivity and the efficiency of the processes and can even affect the quality of the product.
The major components which constitute the human related costs include (i) salary and wages, (ii) incentives and rewards, (iii) costs incurred for the employees’ training and development, (iv) costs incurred on the employees’ safety, health and welfare, and (v) costs incurred on perks and other facilities given to the employees.
Human related costs are necessary costs since they motivate the employees to give their best. Motivated employees not only improve their own performance but also have a big impact in the improvement of the process productivity and efficiency. Human related costs are important costs since any reduction in these costs can be not only counter-productive but also can have big impact on the other costs.
Product marketing related costs
Product marketing related costs constitute substantial component of the product cost. These costs include various activities required for the marketing of the product.
Major product marketing related costs are (i) maintenance of marketing offices at different locations preferably nearer to the major customers, (ii) maintenance of stockyards at different locations preferably nearer to the major consumers and users of the product, (iii) customers’ relations management, (iv) customers’ education and knowledge enhancements, (v) incentives and rewards for customers depending upon the targeted purchase volume, (vi) product promotional activities, (vii) collection of marketing intelligence and its analysis, (viii) attending to the quality related issues and their amicable settlements, (ix) port handling expenditures in case of exports, and (x) logistics of product movement.
Administrative costs
Administrative costs are the costs of administrative activities needed for the organization to carry out its various functions. The contribution of the administrative costs in the overall cost of producing the product is quite low. Hence any saving in the administrative costs has very low impact on the overall cost of producing the product. Administrative costs include all those costs which are required for managing the organization. The activities needed for administration can differ from organization to organization.
Some of the major administrative activities needed for the management of the organization are (i) management of accounts and finance, (ii) activities of purchase, stores, and logistics, (iii) security of the organizational assets, (iv) co-ordination with government, regulatory, and other agencies, (v) maintenance of liaison offices, (vii) public relations, corporate communications, and social responsibility, (vii) vigilance in the organization, (ix) complimentary gifts, hospitality, and maintenance of guest houses etc.
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