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.