Cost Reduction: How to Go About It Effectively

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Cost reduction is an efficient method to get a better cash flow.

Companies can maximise their profits by either raising their product’s sale price or by reducing its cost per unit. Since raising prices may not be an ideal option for some SMEs, given the competitive landscape they function in and the cash flow they need to be aware of, cost reduction is a more appropriate choice of action.

Cost reduction: Meaning

Cost reduction refers to the process of permanently reducing the expenses involved in manufacturing products or rendering services. It comes about without unduly impairing the end use or quality of the product or service.

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All reductions that are a result of a temporary fall in raw material costs or are in response to a change in government policy do not fall under the ambit of cost reduction. Thus, cost reduction involves the following:

  • A fall in expenditure with the same production volume.
  • An increase in production with the same level of production.
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Cost reduction: Examples

Some common cost reduction examples are:

  • Reducing labour costs by automating routine tasks or by outsourcing non-core business functions.
  • Bringing down office expenses, such as electricity bills, by opting for energy-saving technologies or scaling down on office space by offering remote working options.
  • Negotiating better terms with suppliers to source material at lower costs or be offered higher trade discounts.

Cost reduction: Process

A cost reduction process varies significantly based on the achievable targets and corresponding strategies. However, it commonly entails the steps outlined below.

  1. Determine the scope for cost reduction: A cost reduction process starts by analysing the existing cost structure of your firm. These costs are then compared against pre-established benchmarks or industry standards to identify areas for cost reduction. In the case of multiple opportunities, it is best to undertake a spending analysis and prioritise those yielding the greatest benefit.
  2. Create a cost reduction programme: After ascertaining problem areas, firms must carry out a detailed analysis by employing various quantitative and qualitative techniques. The aim is to decide on the most suitable cost reduction techniques and their possible impact. Some preliminary testing of these techniques may also be carried out at this stage.
  3. Plan for implementation: After designing a cost reduction programme, it’s time to bring all business executives, key management personnel, contractors, and employees on board to create the plan of action. This is to ensure there is a clear demarcation and delineation of roles, and that everyone remains on top of the details to minimise any lapses.
  4. Put the programme into action: Finally, deploy the cost reduction programme by establishing a governance structure and control deadlines. Continuously monitor the progress and optimise the strategies further based on the results.

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Cost reduction framework

A typical cost reduction framework involves the identification of wasteful expenses and the implementation of cost reduction strategies and techniques.

Types of cost reduction

Some of the types of cost reduction are as follows:

  • Product design cost: When designing a new product or reworking an old design, companies can rework the following costs. 1) Material cost: Whether a change in design can reduce costs by allowing for the substitution of a cheaper raw material or utilising a lower material quantity. Economic Order Quantity (EOQ) is a useful cost reduction technique at this stage. 2) Labour cost: A design change may reduce operational time or time devoted to after-sale services, minimising labour costs.
  • Organisation or factory layout costs: Companies may see the potential for cost reduction in using under-utilised machines, spaces, and manpower.
  • Administrative costs: A cost reduction analysis can be carried out to determine if the company is incurring any unnecessary routine expenses. Some expenses worth reviewing are telephone expenses, travel costs, office stationery, and postage charges.
  • Management costs: Some SMEs may be needlessly incurring expenses due to poor communication. Framing a proper delegation and accountability framework with well-defined responsibilities can go a long way in reducing firm costs.
  • Marketing costs: Firms must evaluate the impact of marketing on enhancing their sales. If the marketing system is ineffective, costs allocated to advertisement, warehousing, and distribution can be streamlined. ABC analysis is a handy cost reduction strategy for determining the appropriate allocation of marketing budgets to different customers.
  • Financing costs: Financial management is another cost reduction area. Here, you must consider whether there are any over-investments or if the cost of capital is too high. You can also track issues with working capital, like any inventory hold-ups.

Cost reduction techniques

Firms can bring about cost reduction in myriad ways. Some of the popular cost reduction techniques include

  • Budgetary control: Companies can compare their actual costs incurred against the budgeted numbers and take remedial actions in case of discrepancies and unnecessary costs, achieving better cost efficiency.
  • Simplification: The role of efficiency and cost reduction comes into play when firms reduce the diversity of their product offerings and scale the remaining products. It helps streamline business operations, raise cost efficiency, and reduce costs.
  • Standard costing: In this cost reduction technique, enterprises carry out a variance analysis to bring out the differences between standard estimated costs and actual costs. Consequently, they can track the areas exhibiting high-cost variances and the possible reasons for them.
  • Value analysis: Also called value engineering, a value analysis entails a systematic review of product design and production processes with an emphasis on reducing total production costs without compromising product quality or functionality.
  • Design improvement: By improving product designs, companies can improve production processes, enhance product performance, and generate cost savings.

This list is by no means exhaustive. Techniques like contribution analysis, job evaluation, material control, market research, finance control, cost-benefit analysis, and labour and overhead control can also be utilised for cost reduction.

Key Takeaways on Cost Reduction

Cost reduction is the process of identifying and eliminating excessive expenditures that reduce a company’s production efficiency and profitability. Firms can implement several cost reduction strategies and techniques, including value analysis, budgetary control, and design improvement, to streamline their operations and cash flows.

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