Cost control definition

What is Cost Control?

Cost control involves targeted expenditure reductions in order to increase profits. This is a necessary activity for any business in a competitive market that wants to generate a reasonable rate of return for an extended period of time. Implementing this level of control can have a profoundly positive impact on profits over the long term. The following four steps are associated with cost control:

Step 1. Create a Baseline

Establish a standard or baseline against which actual costs are to be compared. These standards may be based on historical results, a reasonable improvement on historical results, or the theoretically best attainable cost performance. The middle alternative is generally considered to yield the best results, since it sets an achievable standard.

Step 2. Calculate a Variance

Calculate the variance between actual results and the standard or baseline noted in the first step. Particular emphasis is placed on the detection of unfavorable variances, which are those actual costs that are higher than expected. If a variance is immaterial, it may not be worthwhile to report the item to management.

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Step 3. Investigate Variances

Conduct a detailed drill-down into the actual cost information to ascertain the reason for an unfavorable variance. The main point is to find any actionable reasons for these variances, such as changing to higher-quality raw materials. These actionable items are then remediated in the following step.

Step 4. Take Action

Based on the information found in the preceding step, recommend to management whatever corrective actions are needed to reduce the risk of continued unfavorable cost variances. Management will likely prioritize its actions to focus on those corrective actions that involve the least risk and the greatest reward.

Why is Cost Control Important?

Maintaining tight control over costs is most important in a competitive marketplace, where other companies are driving their prices down in order to gain market share. In this environment, a business needs to reduce its costs wherever possible, so that it can maintain reasonable margins while still meeting the price points set by competitors. Cost control is especially important for those businesses that want to be the low-cost provider. They do this in order to drive prices down so low that other organizations exit the marketplace, allowing them to pick up more market share, produce more units, and drive down their costs even more.

When to Use Cost Control

The preceding steps are only recommended if a company routinely attempts to force its actual costs incurred to closely match its budgeted cost structure. If there is no budget, then an alternative way to practice cost control is to plot individual cost line items from the income statement on a trend line. If there is an unusual spike in the trend line, then the spike is investigated in relation to the average cost level, and corrective action is taken. Thus, operating without a budget eliminates the first two steps in the preceding list of activities, but cost control still requires investigatory work and recommendations to management for corrective action.

The shareholders of a publicly held company are particularly interested in a system of cost control, for they realize that tight control gives a company considerable influence over its cash flows and reported profits.

Cost Control Techniques

There are many types of cost control techniques that you can use. Here are several options:

  • Use temporary workers for overflow work. When activity levels are increasing within a business, do not automatically hire new full-time employees to assist with the work load. If you do, a result may be that the current activity level is not sufficient to keep the new staff busy. Instead, bring in temporary staff to handle the incremental work load. If the activity level drops, remove the temporary workers with a call to the temp agency that supplied them. If activity levels prove to be more permanent, then it is time to replace the temporary workers with permanent positions.

  • Shift employees to part time. The work situation of some employees may allow them to accept part-time status for a certain period of time, perhaps due to a family situation, such as supporting elderly parents. The amount of benefits paid to them can be negotiated. This approach should be treated as a call for volunteers, rather than a mandatory cut-back to part-time status. In the latter case, many employees simply cannot survive on part-time pay, and so would have to look for work elsewhere.

  • Swap titles for pay. It may be possible to award a larger number of higher-ranking titles in exchange for keeping pay levels relatively low (witness the number of vice presidents in the banking industry). This cannot be done to too great an extent, since doing so would water down the effect of using the titles. Still, it may allow for a limited reduction in compensation.

  • Allow employee turnover. There are job positions where only a certain level of expertise and/or experience is required, and yet employees will continually expect pay raises over time. In these situations, it may make sense to restrict the pay level, and accept a larger amount of employee turnover. This is a common concept in the tax, auditing, and consulting professions, where only a small proportion of employees are promoted into more senior positions, and the remaining staff is counseled out in order to make room for new hires.

  • Swap time off for benefits. If employees do not have a need for certain benefits, encourage them to take other benefits in exchange that are less costly to the company. For example, a younger person may feel that life insurance is not necessary, and so may be willing to swap it for an extra day off, perhaps even at a reduced rate of pay.

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