31 July 2022 16:30:00 IST

Getting a grip on how to manage costs effectively

The art of budgeting | Photo Credit: Getty Images

In a business environment driven by extreme volatility and uncertainty, it is important to monitor the costs of products and services. The business, driven by customer demands and competition, has moved away from the old paradigm where selling price was fixed based on the cost to which was added a desirable profit. 

The equation has since changed, with profit now the balance of selling price as reduced by costs with selling price, inevitably determined by external forces. In such a situation, one needs a reference point, a north star, to guide managing costs.  

Standard costing does exactly that. It would be illogical to incur expenses and then determine the actual cost involved for future production, therefore these standards. Simply put, these are variables that determine the drivers of actual costs.

These variables are developed using direct estimation and industry norms. It goes without saying that there will be a slight difference with the actuals and the standards. The reconciliation of this difference is called variance analysis.  

Meeting targets

This analysis aims at finding out where the differences lie, between the standards and the actuals. Then, the variance is examined to find out the reasons for a possible below-the-standard performance. This study helps the management to find out the deviations from the standard process and take decisions that align with their objectives. There is always space for improvement, changes are possible for developing strategies for correction.   

To understand variances and their types a bit better, here’s an example. Let’s assume that there is a repair budget of ₹25,000 for 100 bags of cement worth ₹250 each. Say the actual expenditure is ₹24,480, which on the face of it, appears to be better. On a closer look, it was observed that the cement was actually purchased at ₹240 per bag but the actual consumption of bags went up from a planned 100 bags to 102 bags. 

This analysis of variance into price and volume will enable us to target the problems in a better way. The difference between the standard price and actual price — ₹10 per bag is called a price variance of ₹1,020, computed as the difference between actual cost and standard cost multiplied by the actual quantity.

It is favourable but there was an additional requirement of two bags of cement, this is termed as volume variance of ₹500, computed as the difference between the actual and standard quantity of materials used multiplied by the standard cost which is negative thus giving a net positive variance of ₹520. Essentially breaking down the variance as price and volume will help organisations make informed decisions and deal with appropriately. 

It is imperative that we make a note of both the unfavourable variances as well as favourable variances, which are usually ignored. Too much attention to the unfavourable variances might bring down employee morale. The standards must be attainable and reasonable only then the employees will have hope of achieving.  

While standard costing is where we produce our product while keeping the cost of the materials as a standard and comparing the actuals, target costing is a process where we first fix a price for the product and then we build our product and our cost around it. We put up a ceiling on the allowable cost of the product.

For example, we ascertain the price of a toy at ₹100 and we want to earn a profit of ₹20 on each piece sold. So, we build our toy with this, the target cost has been set at ₹80 for each piece. And we make sure that the cost of production is not more than ₹80 per piece. Here is where standard costing comes into play.

It helps us build our toy by providing budgets in order to produce as well as it helps us control costs and make sure that our costs align with the budgets and standards set. This helps us reduce the cost in the existing level.  

Improving cost control

Target costing is referred to as a complete process to determine the cost at which a product must be produced so as to generate profits at the product’s selling price in future. Here, the life cycle of the product is studied completely in order to ascertain the price along with market variables like the price of the competitors, margin and return on sales, etc. Whereas, Standard Costing uses historical data, industry norms in order to estimate the prices.  

Standard costing is also used while budgeting, given the difference between standard costs and the actual cost incurred. Standard costs and budget are two different things with a lot of similarities. The scope of budgeting is large compared to standard costing.

Standard costing is used in order to put together a budget and helps us compare future revenue and the standard cost. While budgeting is a function of the management which examines the budget and involves cost control.  

Standard costing helps the management make decisions and it provides more information. It takes cost control to a whole new level. More importantly, it helps in benchmarking, but it should be kept in mind that these standard costs should be revised frequently in order to make sure the estimations are valued properly.

While standard costing helps in budgeting and benchmarking, the formulation of price uses standard costing to its maximum. The price of a product can be set with the help of standard costing which helps in arriving at the total cost of production of a product. A well rolled out system of standard costs can be an effective control and pricing tool.

(The writer is CMA Intern, RVKS And Associates, Chennai.)