FINANCIAL  MANAGEMENT

 

 

Issue

 

What do we mean by cost? In the context of an organisation, cost may be explained as the valuation in money terms of the effort, material, use of long-lived resources, consumption of utilities, wasted time, risks incurred, and opportunities foregone in making a product or service available to our customers. Let's be very clear though about one thing. Knowing the cost of doing business, in itself, will not enable us to differentiate ourselves from our competitors. How we go about our business – our knowledge of all things relative to our organisation – is what will make our organisation, our products, and our service solutions unique. The way we manage and lead our people, and how we organize our operations will determine whether we succeed. This requires us to make a choice among alternatives, which may be a daunting task. It involves a decision-making process that requires an understanding of the costs attaching to each of the alternatives. To be better prepared for making decisions like this we need to know more about the different measures of cost, about cost behaviour patterns, and about the different ways we are able to establish the total cost of a product or service. Armed with this better understanding, we shall find out more about how we may use our knowledge of costs to assist in choosing between the alternatives we are faced with on a day-to-day basis.

 

Solution

 

For all organisations one of the key essentials in achieving our business strategy is to reduce or contain costs. To attempt this, we first need to know what makes up the total cost of each of our products or services. Then we need to split the total cost into two distinct components so that we are able to understand those costs that are driven by a particular cost object and those costs that maintain our support functions.

 

Are you familiar with the term cost object? Many of you will immediately associate this term with the products or services your organisation sells. That would be a reasonable starting point. On the other hand, they may not be the prime drivers of the money that you spend. I'm sure that in a number of organisations, especially service organisations, it is your customers, and their requirements, that really drive your cash outflows. If this is the case, then the customer is your cost object.

 

Nevertheless, whatever our cost object, we need to break down our total cost into those costs that are readily traceable to our cost object – the direct costs – and those costs that are necessary to support our activities but that we are not able to readily trace to our cost object – the indirect costs, which are often referred to as overheads. Any item of cost may be either direct or indirect depending on its traceability to a particular cost object. As a result of their traceability, direct costs are usually considered to be variable costs because they increase or decrease in line with changes in the level of activity of the cost object.

 

Indirect costs, on the other hand are more likely to remain unchanged in the face of changing levels of activity and so are considered fixed costs. Since it is imperative, in the longer term, that we recover all of our costs to remain profitable it is important that we have some mechanism to allocate these indirect, or fixed, costs to our cost objects in order to calculate the full cost. This process of allocation is a significant problem for many organisations because it is not easy to understand how much of their indirect costs are consumed by their cost objects. If it was understandable then we would probably consider them direct costs and our problem would go away. Unfortunately, this arbitrary allocation of indirect costs often results in misleading information about cost object profitability.

 

We should always strive to identify as many costs as possible in the direct category but, if we need to understand the total cost of our cost object, we may still be left with the need to allocate some costs. How should we go about that? Traditionally, the most common methods of allocating indirect cost have been on the basis of a relevant direct input such as labour hours, or machine hours, or units of material. Old traditions die hard but the nature of our competitive environment is changing rapidly and the ways of old are proving insufficiently flexible to deal with the complexity encountered in our modern organisations.

 

Cost information will always be the basis for most management decision making, both tactical and strategic, but it will always be the activities an organisation undertakes that drives its costs. If we focus on how activities consume resources and how products, services or customers trigger activities then we shall have a basis to manage the causes (activities) and not the effects (costs) and so be in a better position to assess the value creation to the customer of each and every one of our activities. Many organisations worldwide are now adopting a more comprehensive strategic approach to cost management. A seismic shift occurs when organisations extend their thinking beyond mere price and cost reduction into direct delivery of profitability, which is the result of focusing on activities rather than costs.

 

Costs are the fundamental element in the creation of value for our owners. Everything we do requires that we reliably understand our cost of doing business. In particular, cost is one of the determinants of the price at which we shall sell our products or services. Just as the price we pay our suppliers – our costs – impacts on value creation in their organisations, our selling price impacts on value creation in our customers' organisation.