Cost Reduction – Meaning and Techniques

Meaning of Cost Reduction

A cost reduction program is a type of method which is to improve profitability of the organization or by expected to get a good result that flow to the bottom line of the financial statement and exempted from any serious damage to the organization itself. As this program is much more about reducing cost or reducing expenses of the organization, so a good cost reduction program is all about how to control the damage of an organization. Furthermore, a cost reduction program is said to be improve the profitability of an organization because by reducing expenses, profits are increased without making others changes.

On the other hand, if the cost reduction program can matched with a sales improvement program and perhaps, finally it will get the double profit. A cost reduction program must be a complete plan that is results-oriented. A structured cost reduction program will put the company on track to achieve maximum profitability and achieve the highest performance. Moreover, this program also implies a series of program that retain all of the essential characteristics and quality of the product and thus it must be confined to permanent and genuine savings in the costs of manufacture, administration, distribution and selling, brought about by elimination of wasteful and inessential elements form the design of the product and from the techniques and practices carried out in connection therewith.

What is the difference between cost control and cost reduction? The difference between both of it can be summarized as cost control ensuring the costs is in accordance with established standards whereas cost reduction is concerned with try to improve the cost by continuous and without accordance with any of the standard.

The main benefits of cost reduction programs are it can enhance profitability and enhance cash flow of the organization. It presents the key elements and factors to consider in program design and implementation. Cost reduction program is also can ensure the results will match with the goals or objective and the values of the organization. It is a widely-acknowledged fact that cost reduction program is one of the most challenging responsibilities or tasks that a company needs to undertake, especially when there are so many ways open to cost-conscious managers. Finally, an integrated tax reduction program can reduce the onerous financial burdens that can stable a company’s development and can free up precious capital that can be result to the firm’s long-term benefit.

Cost Reduction Techniques

There are five main cost reduction methods are employed by businesses. The methods including Target Costing (TC), Activity-Based Costing (ABC), Just in Time (JIT), Enterprise Resource Planning (ERP), and Value Engineering (VE).

1. Target Costing

Target costing also called product costing method in which an attempt at the planning and development phase of a product life cycle to attain a specified cost that is decided by management. This approach is to seek the lower costs by designing a quality product that reduces costs in the production phase. It can be described as a systematic process of cost management and profit planning.

Case study:

In 1993, Toyota uses target costing approach to generally reduce costs at the design stage. By using this approach, Toyota sets goals for cost reduction and then tries to achieve these new targets through design changes that will accomplish the cost reduction goal. Toyota was comparing the costs of the new design with the old design in order to guarantee a cost reduction after implementation of the new technique. This is the main idea that Toyota uses to achieve their company-wide goals. There are several steps in the sequence of price, production, and cost decisions.

First, Toyota decides what the new retail price of the automobile by taking the old price and adding the value of any new functions. The sales division comes up with the suggestion for the production volume by taking past numbers and indexing them to market trends and the state of competitors.

Second, Toyota is focus on cost planning. This cost planning is based on the product plan and targets for retail price and also production volume. The purpose of using cost planning by Toyota is for determine the amount by which costs can be reduced through better design of the new model. Toyota establishes a profit target that is subtracted to determine their target cost. These cost planning decisions are made for three years before they release the model.

Toyota estimates the approximate costs of a new model by sums of the cost variations of the new model and the old model. This technique is very beneficial to Toyota, because it tends to be less work and provides more accurate results. In addition, it also helps the specific divisions understand the cost fluctuations. Besides that, Toyota removes variable costs both models incur such as wages and indirect costs by using this approach. Meanwhile, they use their decisions on costs that change between the two models in design and production volume.

The main point in this case study is to show how cost planning at Toyota is focused on the design phase. Toyota does this by setting goals for cost reductions through design changes. Toyota takes these goals and then assesses them to different divisions to make the necessary changes. Toyota believes that by changing product design to produce lower price to achieve a higher level of profitability.

2. Activity-based Costing

Activity-Based Costing is a costing model that identifies the cost pools, or activity centers, in an organization and assigns costs to products and services (cost drivers) based on the number of events or transactions involved in the process of providing a product or service. The concept of Activity-Based Costing has been considered a sophisticated method of cost calculation since the early 1980s.

In addition, Activity-Based Costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity-Based Costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities.

Case study:

Boeing Commercial Airplane Group (BCAG) is the world’s largest manufacturer of commercial airplanes. It comprises approximately 60% of Boeing’s total revenues. BCAG Wichita is a cost center manufacturing plant producing fuselages, noses, struts, nacelles, and thrust reversers for 737, 747, 757, 767, and 777 airplane models. In May 1999, the plant employed approximately 16,835 employees directly, and was responsible for indirect employment of 53,100 workers within the state of Kansas. As part of its overall drive to gain and retain world-class aerospace manufacturing status, BCAG Wichita is focused on developing a lean, efficient design and production system supported by an effective cost management strategy.

The cost management strategy supports initiatives designed to link the manufacturing process and support activities so as to simplify the whole production process, while maximizing benefits from the use of lean business practices. Cost management strategy initiatives include simplifying production, shortening flow and cycle times, increasing quality and inventory turnover, identifying core products and processes, and linking the design and manufacturing process to decrease product time-to-market. Activity-Based Costing links and supports the manufacturing process. It provides information to tailor business streams and material management, costs of activity and processes, value added versus non-value added analysis and profitability analysis used to improve the make versus buy decision-making process. ABC also provides analysis of set-up and run costs, costs of scheduled and unscheduled maintenance, costs of asset failure, and costs of manufacturing capacity, thereby allowing manufacturing managers to manage the assets under their control more effectively. Finally, ABC provides analysis on the costs of design changes in configuration as impacted on the manufacturing floor, costs of incorporating complexity into a configuration design, and the costs of quality.

The highest hurdle in achieving this type of cost management architecture lies in moving the corporate financial department from its classic accounting role as scorekeeper or policeman to the role of business partner. In a business partner role, the corporate financial department can support strategic decisions relevant to the company’s continued competitive advantage by providing financial data that highlights the impact of these decisions. BCAG Wichita views a successful implementation of ABC as one that fulfills three major roles:

  • Addresses the size, complexity, and diversity of the manufacturing process,
  • Facilitates the integration of financial decision makers into a more supportive business partnership role, and
  • Implements effective cost management strategy initiatives.

3. Just in Time

Just-in-time (JIT) production also known as lean production, it is a ‘pull’ system of production, means the actual orders provide a signal for when a product should be manufactured. When there is Demand-pull, it enables a company to produce only what is required, with the correct quantity and correct time. These features of Just-in-time production system accomplish close organization among work- stations. Therefore, its objective can be defined as producing the right part in the right place at the right time (in other words, “just in time”).

Case study:

From July 1990, top managers of Daioku have begun completing the Kanban production system-moving from the traditional push-type production management to pull-type production management. This type of system produces only quantities necessary to fulfill the demands of the next operation. The quantity is pulled when it is needed, where it is needed, and in the exact quantity which is needed.

For instead, since beginning the implementation of Just-In-Time, many difficulties have occurred. The difficulties include:

  1. Combining the data and material flows instead of classifying them.
  2. Post the products, its store and manufacturing process instead of a flow without any post.
  3. Changing from L-shape assembly line into V-shape assembly line. This requires a set of new equipment’s and techniques.

Problems exist between Daioku and supplier (subcontractors), for instance, traditional ways of shipping material based on the pre-determined plan is now being eliminated and every supplier are now required to collect the “Kanban” back from the order-post and ship their material based on the information in the Kanban.

Everyone in the firm required to participate in Just-In-Time. They need to determine how to make the shop floor operations become easier and efficient.

Daioku carried out discussions and meetings to find solutions to the problems in the year of 1992. Therefore, Daioku sent their experts to help suppliers to solve their problems gradually. In Daioku, The inventory part was reduced the dramatically in this year.

By using Just-In-Time method, the stock levels of raw materials, work in progress, components and finished goods can keep in a minimum. However, this requires a carefully planned scheduling and flow of resources through the production process. Just-in-time method promotes continuous enhances on the products. At the same time, this method can eliminate waste. Waste results from any activity that adds cost without adding value. For example, the unnecessary moving of materials, the accumulation of excess inventory, or the use of faulty production methods that create products requiring subsequent rework. Just-In-Time should enhance the profits and return on investment by reducing inventory levels (rising the inventory turnover rate), reducing variability, improving product quality, reducing production and delivery lead times, and reducing other costs (like those associated with machine setup and equipment breakdown). In conclusion, Just-In-Time production system aims to (1) meet customer demand in a timely manner (2) at the lowest possible total cost and (3) with high-quality products.

4. Enterprise Resource Planning

Enterprise Resource Planning (ERP) is a computerized inventory control and production system that was born from Material Requirements Planning systems (MRP). It is a system that organizes functions of an institution. It assists in account, finance, human resources and e-commerce applications through creation of databases and graphical user interfaces. It unifies the tasks of institutions like corporations, government agencies, non-profit organizations, powerful institutions and industries and businesses establishments. There are some businesses start to compete on a global scale, it is critical to streamline operations and processes in business to reach a higher level of productivity and efficiency in information exchange and supports e-commerce applications, for example supply chain management (SCM) and customer relationship management (CRM). On the other hand, software that comes up with functionality to various systems that will coincide with one another as a whole is required to combine all of the information or operations of a company into a single unit. Central database is one of the most outstanding parts of the ERP system.

Case Study:

By October 1997, a group of 50 top business executives and 10 senior IT professionals had been congregated to device the SAP project to come up with a set of best practices that would become common work procedures for every Nestle division which are manufacturing, purchasing, accounting and sales by adopted new pan-Nestle’ way.

Firstly, in order to implement the technical side, a common structure across the company, the vanilla would be code 1234 in every division. The SAP system customize around the uniform affair procedure. The group decided that they are not to use SAP in supply chain because the ERP supply chain module adopted was brand-new and therefore risky. Furthermore, Manugistics’ supply chain module followed all the SAP standards and could easily be integrated.

Nestle implement five SAP modules which are purchasing, financials, sales and distribution, accounts payable and accounts receivable and the Manugistics’ supply chain module which deployed across every Nestle division, by March 1998. Besides that, the purchasing company for confections pursues the identical best practices and information as the purchasing company for beverages.

To beat the Y2K deadline, the best project group had overlooked the integration points between the modules. All purchasing departments now used general names and systems, and followed a general process, but their system was not integrated with the financial, planning or sales groups. A salesperson may have given a valuable customer a discount rate and entered it into the new system, however the accounts receivable department wouldn’t know about it. Hence, it would appear to the accounts receivable operative as though the invoice were only partially paid as customer paid the discounted rate. The project team had essentially replaced divisional silos with process silos to unify the company’s separate brands.

The time constraints necessitated by Y2K had put too much pressure on the people in charge of executing the changes. The project team had lost the big picture of how the various components would work together. Hence, the existing modules had to be integrated and the team still needed to roll out another two more SAP modules which are sales and distribution on the domestic side, and accounts receivable as well as a new module for the supply chain. Since Dunn had rejected the SAP supply chain module two years before, therefore, it leads to decision to replace all but a couple of parts of the Manugistics system with APO.

The last state of design was completed on April 2001 and giving the project teams a highly detailed road map to follow. One month later, Tom James came on board as director of process change for the Best project with the responsibility as a connection between the divisions and the project team. He was so surprised by the poor relationship between divisions and project team. They conducted surveys that were involved of how the workers affected by the new systems were dealing with the changes and the feedback was the users were not prepared to make process alter.

ERP projects are famous and need a long period and a lot of money to done it. Dunn maintains the slow and steady wins the race. Nestle United State accomplishes the significant ROI with the greatest bulk of savings from better demand forecasting.

The old process included a sales man giving a number to the those men and demand planner do not know what the hell they are talking about then the factory changes the number again.

With SAP in place, general databases and business processes lead to more trustworthy demand forecasts for the various Nestle products. Furthermore, because all of Nestle United State also using the same data then Nestle can forecast down to the distribution center level to diminish the inventory and the redistribution expenses that occur when too much of a product is sent to one place and not enough to another. The supply chain improvements accounted for a major chunk of the $325 million has saved from SAP.

5. Value Engineering (VE)

Value engineering (VE) is a systematic method to improve the “value” of goods or products and services by using an examination of function. Value, as defined, is the ratio of function to cost. Value can therefore be increased by either improving the function or reducing the cost. It is a primary tenet of value engineering that basic functions be preserved and not be reduced as a consequence of pursuing value improvements.

Value engineering is sometimes taught within the project management or industrial engineering body of knowledge as a technique in which the value of a system’s outputs is optimized by crafting a mix of performance (function) and costs. In most cases this practice identifies and removes unnecessary expenditures, thereby increasing the value for the manufacturer and/or their customers.

Case Study:

This project was for an underground car park beneath a new shopping center in Three Waters, Madrid. A fully ducted ventilation system was the approved design contained with the Spanish Building Regulations. However, this would be costly to install and would impact on the development programmed. Therefore, the purpose of the simulation was to demonstrate that a non-ducted, mechanical system would also meet the Spanish Building Regulations. The planning requirements often mean extensive car parks to proposed offices, residential and retail developments. The ventilation of these car parks can present a significant cost to the developer in terms of capital expenditure for plant, energy consumption and maintenance, as well as the implications for the programmed if extensive ductwork and plant has to be installed. The use of Computational Fluid Dynamics (CFD) is most effectively used at early design stage, also can be used as a tool for solving existing problems. The specific objectives of a project can vary considerably. The key objectives of the simulations are normally to ensure that the distribution and concentration of carbon monoxide (CO), is in accordance with Building Regulations. The Building Regulations comprise a number of Approved Documents. These Approved Documents contain design options which if adopted, the scheme is ‘deemed’ to comply.

Applying Value Engineering can identify potential savings in capital, maintenance and energy costs without any adverse effect on performance. Computer simulation is therefore, becoming an essential value engineering design tool. For example, a designer may question why 6 air changes per hour (ACH) should be provided when 4 ACH will accomplish the desired result. The benefits of simulation are that the proposed designs can be tested against the acceptance criteria contained within the Building Regulations before any financial commitment is made.

In conclusion, Three Waters using of Computational Fluid Dynamics (CFD) as a tool for value engineering can significantly benefit new and existing developments by avoiding unnecessary capital expenditure, reducing construction time, and providing reductions in energy consumption, CO2 emissions and maintenance.

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