What is Cost Reduction?

What is Cost Reduction?
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Cost reduction can be understood as the achievement of a real and permanent reduction in the number of goods manufactured or services offered without damaging their purpose or decreasing the quality of the product.

You can maximize the profit of any organization in two ways, either to increase the sale price of a unit or to reduce that unit’s cost. Both methods may result in gaining profit. As you may find that most companies or organizations face challenging market situations wherein an increase in the sale price may lead to a loss of sales. Increasing the sale price is only possible if the business that produces the products is dealing in monopoly. Consumers are aware that such a situation cannot prolong for any company and its products. In this case, cost reduction is the right scientific way to take to deal with this situation. Cost reduction management should not result from a decrease in the cost of raw materials, a change in government policies, or the unit’s price of quality.

Reduction of cost can be obtained in:

  • The volume of production should be the same while reducing the expenses.
  • Without changing the process or level of production, there should be an increase in production.

The following are important factors of Cost Reduction Program:

  • Cost reduction program should be based on the requirements of the business.
  • Cost reduction program is a continuous activity that can’t be treated as one time or short term process. Continued improvement of efforts can deliver the success of a cost reduction program.
  • Cost reduction programs should be real and permanent.
  • The cost reduction management’s setter should be a top company employee, but the success of the program still lies in the cooperation of all employees and the department of the company.
  • Employees who participated in the cost reduction management and shared their innovative ideas should be rewarded.

What Does Reduce Cost Mean?

Cost cutting refers to the strategies implemented by the company to minimize its expenses and maximize revenue. Cost cutting programs are usually implemented during difficult times or financial distress for a company or during economic crises. They may also be implemented if a company expects issues in the future wherein cost cutting should be part of the business strategy.

Understanding Cost Cutting

Shareholders seek maximum monetary returns on their investments in a business, and they expect that they will maintain growth in profits. When the business is doing well, companies can generate profit growth. But in a downturn of the industry, profits may decrease, and if it stays low for a long period, the company will feel the pressure from shareholders to cut costs to avoid totally hitting bottom.

Cost cutting programs may include company employee layoffs, reducing employee pay, closing facilities, trimming the supply chain, downgrading to a smaller office, transferring to a less expensive area or building, minimizing or eliminating professional services from outside, like advertising agencies and contractors.

Employing new technology can also be considered as a cost cutting method. You can settle for a new machine to replace a certain number of employees to cut labor costs. In time, you can make up the cost of the machine after a certain period of not spending on labor costs.

Cost Cutting Strategy

If you consider cost cutting, it is vital to plan a strategy and not just cut costs spontaneously. Some costs are necessary, so you must classify the good costs, bad costs, and the best costs.

Good costs focus on the growth of the company, which is aligned with the customers and how to meet their needs. Bad costs do not contribute to the company’s strategic growth and only a waste of resources. When these costs are cut, more resources can be freed up to be more productive. Best costs are the expenses associated with what makes the company unique, how it can differentiate itself from the competition, and how it can provide real value to its customers.

Once a business can allocate its cost into one of those classifications, it would be easier to focus on cutting bad costs and increasing the best costs.

 You must note that cost-cutting does not really mean cutting a cost completely. It also refers to the optimization and efficiency of allocating resources and workforce. Maximizing productivity may help reduce costs, so it is also vital to monitor productivity. Today, some apps allow companies to check and measure employees’ productivity, along with the time they spent on different work and projects.

What are the Benefits of Cost Reduction?

Cost reduction strategies help reduce the cost of operations of the business. It can help to set a competitive price for a product or service to maximize market share and increase returns.

Cost reduction measures can improve margins wherein the business can pass on the savings to customers in lower prices or more quantity at the same price. This can create more demand for the products, more employment, and all-around improvement in living standards.

Increased strength to compete in the industry stimulates more exports. So, profit is increased by reducing the costs, wherein it can be utilized to expand the business, which may create more employment and overall industrial progress. Increasing profits can also provide a basis for more dividends to the shareholders and investors, with high management expectations.

How Do You Calculate Cost Reduction?

Based on research by the Center for Applied Purchasing Studies (CAPS), the main goal of the purchasing department is to reduce total costs. The supply managers are under an increasing amount of pressure to ensure the accuracy and validity of their cost reduction activities. Often, their goal is directly linked to promotions and bonuses as an incentive in helping the purchasing department achieve its goals. In this way, the cost reduction strategies must be able to withstand thorough questioning from top management. Measuring cost reduction in an organization is a blend of knowing actual cost savings and distinguishing how improvements dodge future cost increases. The study showed seven different techniques to measure cost savings.

1. Price over Price

The new contract price is compared to the previous one, and any downward difference is considered as savings. But in recording accurate savings, market adjustments should be considered.

2. Average Bid vs Successful Bid

All the bids taken for distinct goods or services are balanced to avail the average price. The successful bid is compared to the average bid to calculate the savings. When using this technique, it is important to make sure that each bid is for the same item. Be cautious in determining which bids to include in the average.

3. Market Comparisons

This technique is considered a “catalog approach” by comparing the purchase price with other posted prices. On the other hand, the market comparison is the number of goods the consumers buy every day. The difference between the average catalog price and the purchase price is the savings.

4. Total Cost

Instead of just considering purchase price, the total cost perspective also covers all the related costs. Total costs involve items such as transportation, inventory, payment terms, warranty, and disposal. It is a more precise cost measure than purchase price. Some cost data is difficult to get, as they come from different departments.

5. Target Price or Cost

This technique is usually used in the initial stages of new product development to meet a price or cost goal. The challenge is to create a product with the needed functionality and quality within the pricing limits. The marketing or product design team establishes the target. A cost or price savings is acknowledged if the materials that make up the product can be bought for less than the target.

6. Cost Avoidance

Cost prevention or cost avoidance can be considered the same as cost savings. In some cases, it is easy to measure cost avoidance. Say a higher grade upholstery on the office chairs for large banking institutions lessens the amount of furniture replacement every year over a three-year period. But, the problem with this documentation is it takes 3 years to document the actual savings.

7. Innovations or Product Improvements

If an enhanced element of one item is bought at the same price as the one without improvement, the improved one offers a competitive advantage to the manufacturer. On the other hand, the competitor had the glare problem and can sell the better device at the same price as the older models. In this manner, the purchasing department could ask for a second supplier to estimate the cost of developing and producing the improved item. And the price of the second supplier can be the cost-saving figure of the purchasing department.

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