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Modernising cost management systems in emerging economies

By Anil Kshatriya, ACMA, CGMA

To reach their full potential, small and midsize companies in emerging countries must pay special attention to modernising their cost management.

Companies in emerging economies that are labour-intensive and technologically under-invested must give special attention to cost management. A strong culture of cost-consciousness translates into bottom-line growth, but limited resources and the presence of operational bottlenecks tend to become barriers to the progress of these enterprises.

Most operate with traditional accounting systems and techniques not commonly used in developed markets. As a result, up to 70% of micro, small, and midsize companies in emerging markets lack access to credit, according to the World Bank.

Adopting best practices of cost management and cost control helps a small and medium-size enterprise (SME) in exploiting its full potential:

Cost control. In small and midsize enterprises cost is often considered a given phenomenon. Junior-level employees and managers don’t think beyond their routine practices of producing the output according to the pre-defined standard. The entire focus is on the “output” side. There is little or no discussion around cost control. Cost cutting is not the same as cost control. Owners of SMEs tend to be more concerned with cost cutting, which often leads to resource cutting.

Such cost-saving exercises are ad hoc and made on a case-by-case basis. Cost control is a planned and systematic process. Holding back resources has implications on behavioural aspects within a company. Using low-quality raw materials also has implications. Motivation of people is affected and the quality of output suffers in those cost-saving exercises.

Controlling costs may not always result in resource cutting. Changing the source of the raw material by exploring better logistical feasibilities is an example of planning for controlling costs. But replacing the superior source of raw material with an inferior, cheaper variant is what SME managers end up doing as an alternative cost-saving mechanism.

Cost measurement. Another important factor that affects cost efficiency of SMEs is the system of costing itself. SMEs in India, for example, generally don’t have well-defined cost systems that can measure costs of operations accurately for various cost centres of the enterprise. The process of costing is unscientific and vague. Direct costs are fairly traced to the final output, but the method of tracing indirect costs and overheads is not appropriate. Indirect costs are usually bundled into a single aggregate expense and then spread across various products, using a trial-and-error method of allocation such as volume of production or labour hours per category of product.

Such simplification in measuring and reporting of costs does not give a clear picture of how costs behave for each of the categories of products sold by an SME. Unavailability of unit-level and product-level data then becomes a major constraint in keeping track of costs.

Adaptability is key

The biggest advantage enjoyed by any learning enterprise is its ability to adapt to change. SMEs are agile organisations. Because they are small and nimble, it is easier to change their cultural structuring. SMEs have tremendous opportunity to shape the cost-conscious behaviour of their people. It pays off by giving them insights into business problems that are not apparent and obvious to owners.

Midsize companies in developing countries can benefit greatly from reconfiguring processes and practices because they cater to the demands of consumers who are sensitive to prices.

Digitisation and artificial intelligence are likely to change the job market in emerging economies much faster than the pace at which these economies adapted to the challenges of globalisation. They have to shape strategies that will integrate every aspect of technology-driven value creation within a very short span of time. Better control on cost will become an imperative to function in the coming decade. The sooner they get ready to innovate for these changes, the better their chances to survive the wave of technological transformation.

Action plan to improving cost-consciousness

A good action plan for enterprises ready to make improvements but not ready for a full-scale cost transformation initiative might include these three steps:

1. Owners of small and medium-size enterprises (SMEs) should look at establishing a modern costing system as an investment that yields returns over a long period of time. Having a good system of cost accounting is not a statutory prerequisite for a small company. Therefore, the normal tendency of SME founders is to avoid spending time and effort in laying foundations of costing for a newly started company. But visionary founders and good enterprises always look at it as one of the key elements towards future success of their business.

Indian companies that have ramped up their operations from small scale to large scale are the ones that concentrated their effort on monitoring their financial performance from time to time. Modern manufacturing systems demand modern costing systems. SMEs should adopt techniques such as activity-based costing for overhead cost allocation and customer profitability management.

An activity-based approach of costing traces costs to an individual product category using cost drivers that drive the resource consumption. In an activity-based environment a company can control the costs by controlling its activity-driven resource consumption.

2. Creating awareness about cost control among employees is another step towards cost-consciousness. Training managers to deal with cost data helps them in creating the right outlook. Review meetings must be held with discussions about how and what goes into product costs. Every section or department of the company must be made aware of the impact of their respective actions on overall cost of production. Suggestions and ideas must be welcomed across the organisation to make the system of costing fully robust.

Sometimes company owners fail to perceive an operational issue, but workers on the shop floor might have a better understanding of the problem at hand. A culture of cost-consciousness can resolve such matters in a timely manner and avoid undue complexities that lead to a drain in financial resources.

Bottom-up communication should be encouraged rather than top-down, unidirectional communication. It may be a good idea to involve an external expert in reviewing the costing system because over time the system tends to become less dynamic.

3. Finally, SMEs should link the performance of people to the cost management process.Management control systems such as budgeting and variance analysis should be defined to measure and manage the contribution of managers towards cost-consciousness. Without linking rewards to performance, the possibility of continuing with a systematic approach for cost management remains low. Hence, there should be standard operating procedures for achieving targets set for cost management and control.

Innovative initiatives of managers for managing cost must be included as part of their appraisal for future progression within the enterprise. All the functions from manufacturing to sales should be given equal importance and weights. Cost-effectiveness is not the responsibility of the shop floor alone. Only when it becomes part of the entire organisational culture does it find meaningful acceptance across the enterprise.

Anil Kshatriya is an associate professor of accounting at the Institute of Management Technology in Nagpur, India.

This article was originally published in the December 2017 issue of Financial Management magazine.