We are all too familiar with the basic profit equation which states that Profit = Revenues - Costs. It is clear that profit can be increased by manipulating revenues and costs. Three combinations are possible: 1) keep costs constant and increase revenues through increased sales, 2) keep revenues constant and decrease costs through improved cost control, and 3) increase revenues and reduce costs simultaneously. Most managers tend to take costs as fixed, and generally focus on maximizing profit by increasing revenues. This approach requires an increase in the sales volume and/or an increase in the prices of the goods sold.Increasing sales often requires expensive marketing effort, particularly if the product is new or it is at the mature stage in its life cycle. Raising the price of a good, is probably not an effective revenue generating strategy for a price-conscious consumer population like ours in St. Lucia. One of the key weaknesses in focusing on the revenue side of the equation is that success for the strategy depends heavily on consumer behavior in response to either the marketing campaign or the increase in prices. As such, the locus of control is outside of the organization making it difficult to predict success.
I prefer a strategy that focuses on costs for several reasons: 1) the strategy is more transparent to the consumer, 2) the strategy forces the organization take responsibility for the cost of delivering the good or service; 3) a cost focus would encourage the organization to improve the operating efficiency of its cost centers; and 4) the strategy would facilitate improved price stability - a competitive asset. A key limiting factor in improving cost performance, has to do with the way in which traditional accounting practice has allocated costs for goods and services. The archaic system uses primarily three categories of costs: direct material costs, direct labor costs, and overhead costs which is supposed to reflect the indirect costs associated with the product or service. The gross error lies in the practice of calculating overhead cost as a fraction of the total direct cost of producing the good or service. It could range anywhere from 15% - 40%. Consider a manufacturing firm producing hundreds of appliances using a standard 25% overhead rate for all of its products. How could a wide variety of products all have the same overheard structure. It is impossible! Overhead, therefore, is under-charged in as many cases as it is over-charged. One doesn’t have to be a genius to appreciate that the making of a wiper blade and the making of an engine block do not have the same structure or level of indirect activities. Hence to charge a flat 20% overhead rate in both cases would be wrong.
This highly aggregate nature of allocating costs makes it near impossible to undertake cost improvement projects. If material and labor costs are fixed, then by extension, overhead costs cannot be changed. Management will therefore conclude that costs improvements are impossible. To break this cycle of thought, management has to accept the notion that the production of a good or service requires a series of processes each with its own set of activities. Each activity in a process consumes resources, and the acquisition of these resources incurs costs. Hence the cost of a product or service is the sum total of the costs of all of the resources consumed by the activities that are required to produce the good or the service. This approach to costing is known in the accounting literature as activity-based costing (ABC).
The value of ABC is that it forces management to identify key cost drivers for all of its products and services, and to focus on ways to improve the management of costs. Further, ABC provides management with a framework to analyze and re-engineer the critical activities that drive costs. In addition, ABC will allow costs to be allocated to appropriate cost-centers within the organization, and give focus to the responsibility for controlling different elements of the cost of the product or service. For example, if a significant activity for a product is inspection and documentation, say 30% of the total throughput time of the product, then the production department which is implicated in contributing significantly to overhead, will be encouraged to re-design their inspection process. Under the traditional accounting system for allocating overhead, no one would have focused on the need for inspection to redesign that part of the production process.
Before any organization, private or public, seek to raise its revenues, it should conduct a serious examination of its implicit or explicit cost management system. If the organization still uses the ancient method of allocating overhead as a fraction of direct costs (and that is 90% of existing organizations), then it is time change the accounting system. This paradigm shift is particularly crucial for public sector institutions that are made up primarily of cost centers. Cost control is a must - particularly in these recessionary times! In St. Lucia, the government has sought to increase revenues through the telephone levy, through threats to non-licensed drivers, and through increased collection of taxes. The government, however, must embark on a similar aggressive campaign to improve its cost management systems within each Ministry. I am not aware of any well-orchestrated cost control strategy by our government to take us into the 21st century. Unless this is done, very shortly, we can anticipate knee-jerk IMF inspired actions such as heavy job retrenchment, currency devaluation, increased taxes, reduced social spending, and the like.
It is incumbent upon all public and private sector organizations to focus on cost control strategies as a means to making both of the sectors more productive, efficient, and competitive.
