L.N. WELINGKAR INSTITUTE OF MANAGEMNET

DEVELOPMENT AND RESEARCH
MATUNG (E), MUMBAI – 400 019

Name: MALLIKA M. KATDARE

Roll No: 30

Subject: MAFM Internal Assignment

Semester 2 (MMM)
Cost Reduction

Cost reduction techniques is a process, aims at lowering the unit cost of a product
manufactured or service rendered without affecting its quality by using new and
improved methods and techniques. It ensures savings in per unit cost and
maximization of profits of the organization.

Cost Reductions aims at cutting off the unnecessary expenses which occur during the
production, storing, selling and distribution of the product. To identify cost reduction,
the following majors are the major elements:
Ø Savings in per unit cost
Ø No compromise with the quality of product
Ø Savings are non-volatile in nature.

Cost Reduction Techniques In Manufacturing Industry

INTRODUCTION:

A business enterprise must survive, grow, and prosper. Cost Control and Cost
Reduction both are the activities necessary for ensuring that these objectives are
fulfilled. With the liberalization of the Indian Economy and Globalization, there is
now a cut throat competition from various concerns of the world. As a result there is
now a race to secure a place for survival. This has increased the importance of Cost
Control and Cost Reduction.
Hence it is required to study the different tools and techniques used for the Cost
Control and Cost Reduction. For the same we need to start with understanding deeply
the concept of cost. Once we understand the meaning of cost, its controllability, main
areas where cost arises, then we can think of how to control or reduce the cost. We
can classify the cost according to their nature, behavior then we can easily know the
cost which can be controlled or reduced.
Here more emphasis is on the Controllable and Non-Controllable cost, because this
classification of the costs helps us understanding what and how we can control. If the
cost can be controlled then what steps should be taken for controlling purpose; if
cannot be controlled, what should be done. It is totally depends upon the managerial
decisions, and it is the activity of Management Accounting.
With the given type of industry the cost element varies for the industry. Piaggio
Vehicles Pvt. Ltd. is a manufacturing industry engaged in producing world-class
diesel 3-wheelers and 4-wheelers. Manufacturing industries are engaged in
transforming raw material into finished product with the help of machines and
manpower. The contribution of material cost in the total cost is more than 70%.
Hence the main focus is on raw material for this industry. Therefore, more emphasis
should be given to the material cost and need to find out the possible outcomes to
control & reduce the material cost.
 Importance of Cost Reduction

1. It leads to an improvement in the competitive capabilities of the company and

thereby ensures its survival, growth, and prosperity2.
2. It ensures reasonable prices to customers by not passing on the inefficiency of the
business itself Purpose for Cost Control and Cost Reduction
i. To create cash for reinvest in R&D
ii. To reduce manufacturing cost to stay competitive
iii. To lower cost of service in order to provide additional services
iv. To become more efficient

Reasons for Cost Reduction

1. To increase company value

2. To get competitive advantage
3. To eliminate unnecessary expenses
4. To reduce price of product or service

Cost Reduction techniques in Manufacturing Industries:

• Reduce Labor Costs.

In many cases, the most significant expense incurred by a manufacturing firm is in

the salaries paid to factory workers. This means that reducing labor costs is an
essential cost-cutting measure. There are two potential ways to do this: pay your
workers less or make them more efficient at what they do.

• Improve Worker Efficiency

Start by increasing the skilled labor force. Hire only skilled laborers to do the work
as they are more efficient. Also, implement a training program for existing staff, so
they can master new skills and become more efficient at what they do. The goal is to
reduce the number of steps a product has to go through before it is finished. Small
businesses can often increase efficiency by introducing incentive programs to
 encourage workers to work harder and smarter. You can also reward for workers
who suggest techniques that increase the efficiency of the production process.

• Reduce the Cost of Materials.

Materials are another significant part of the production costs involved in

manufacturing. When much of the manufacturing expense is due to raw material
costs, there need to be ways to reduce these costings.
Buying Raw material at lower price or Buy the materials in large amounts to take
advantage of discounts on bulk purchases from your suppliers, for example.
Negotiate with multiple suppliers and compare them with one another, such as in a
procurement process, to ensure you get the most competitive price on your
materials.

• Use Fewer Materials.

Reducing material costs is to use fewer materials in your products. If you can reduce
the amount of material going into a unit without significantly impacting the quality
of the product, then you reduce your material costs. You can also eliminate or
reduce the materials that do not contribute directly to your product, such as
packaging and documentation. Look into improving the efficiency of the production
process so that less material is wasted. Reducing a high level of waste ties back to
training your laborers and having skilled labor in the production process. Document
the materials and train your workers in efficient methods of preventing raw
materials from being wasted or written off as scrap during the production process.

• Consider Lean Manufacturing.

Use lean manufacturing as a way to keep your material costs down. Lean
manufacturing is thought to have originated from the manufacturing techniques of
Toyota, the car manufacturer, in the mid-20th century. However, the main idea
behind lean manufacturing, which is to reduce waste to an absolute minimum, is as
old as manufacturing and the basis of many cost reduction techniques in
manufacturing. According to lean manufacturing 7 type of waste should be
addressed and corrected:
 - Overproduction
- Inventory
- Conveyance
- Correction
- Motion
- Processsing
- Waiting

• Reduce Overhead Costs.

Overhead costs are the expenses that are associated with the running of the factory itself
and include utilities, office supplies, insurance coverage, and other building costs.
Establish a clear budget for overhead and explore various options to save money. Limit
administrative costs to the ones that increase revenue in the long run.

• Smart Capital Investment.

Smart capital investments increase efficiency. By investing in efficient manufacturing

machines and tools, you can reduce your overall manufacturing costs. this method of
lowering costs involves spending a significant amount of money upfront, you need to be
aware of just how much money you are spending and what you are spending it on.
Prepare a return on investment for every capital purchase under consideration, and
make purchasing decisions based on the projected savings.

• Optimize the production output level.

Production Optimization refers to the various activities of measuring, analyzing,

modeling, prioritizing and implementing actions to enhance productivity of a field:
reservoir/well/surface. Production Optimization is a fundamental practice to ensure
recovery of developed reserves while maximizing returns.

• Leverage Automation

Leveraging automation helps organization in becoming true proactive coaches,

advocates, and partners for their customers, by taking care of all the things that do not
 require human sensitivity. Here are three ways to leverage automation to empower
your Customer Success team.
1) Data 2) Process 3) Communication

 
 
• Value Analysis and Value Engineering

Value Analysis is an activity that typically occurs jointly between purchasing and
method engineering. This activity is aimed at modifying the specifications of
materials, parts, and products to reduce their costs while reducing their original
function. Focus is placed on the value of the product. Value Analysis is also called as
Value Engineering.

• Quality Control

Quality Control refers to all those functions or activities that must be performed to fill
the company's Quality objectives. Quality Control aims at investigating the root cause
for defects identified by inspection and take corrective action to overcome the defects
for future production. Quality Control helps to minimize the cost of Inspection and
Rejection. Quality Control is an approach to prevent the defects rather than detecting
the defects. The ultimate aim is to provide products which are dependable,
Satisfactory, Economical

• Requirement of BPR Process

i. Fundamental Understanding of the process

ii. Creative thinking to break away from old traditions and assumptions
iii. Effective use of Information Technology

• Steps in BPR

1. State need for change

2. Identify process of reengineering
3. Evaluate enablers for reengineering (IT & HR)
4. Understanding the current process
5. Create a new process design
6. Implement the reengineered process
• Inventory Management

Inventory Management involves administration, policies, and procedures to reduce in

inventory cost. Inventory Management involves the development and administration
of policies, systems and procedures which will minimize total costs relative to
inventory decisions and related functions such as customer service requirements,
production scheduling, purchasing and traffic

• Kaizen Costing

Kaizen costing is the process of cost reduction during the manufacturing phase of an
existing product. The Japanese word 'Kaizen' refers to continual and gradual
improvement through small activities, rather than large or radical improvement
through innovation or large investment technology.

• Work Study

Work Study is a systematic, objective and critical examination of the factors affecting
productivity for the purpose of improvement. It uses techniques of method study and
work measurement to ensure the best possible use of human and material resources in
carrying out a specific activity

CONCLUSION

In Manufacturing unit, where its main cost element is the Material Cost.
Manufacturing companies prefer techniques like Value Engineering, Quality Control,
and Budgetary Control, for the purpose of Cost Reduction. This technique fulfills the
objective of Company i.e. 'Low Cost Manufacturer'.

The paper specifies that the Cost reduction Techniques are now- a- days required to
be implemented in each and every organization. Objective of the paper is to find the
Cost Reduction and Cost Control Techniques, which are being used in the various
stages and their effect on the cost of material. The secondary aim of paper is to find
all other cost reduction techniques, which are useful.

In times of difficult business climate when sales are reducing and uncertain every
business must adopt to cost reduction strategies as soon as possible to avoid the
business running into losses. By using this company has achieved its basic goal of
being 'Low Cost Manufacturer'.
Capital Budgeting & Its Techniques

Ø What is Capital Budgeting?

Capital budgeting is the process a business undertakes to evaluate potential major

projects or investments. Construction of a new plant or a big investment in an outside
venture is examples of projects that would require capital budgeting before they are
approved or rejected.

As part of capital budgeting, a company might assess a prospective project's lifetime

cash inflows and outflows to determine whether the potential returns that would be
generated meet a sufficient target benchmark. The process is also known as
investment appraisal.

In Layman terms, Capital budgeting is basically a process of evaluating investments

and huge expenses in order to obtain the best returns on investment.

Capital Budgeting Process involves

} Identifying investment opportunities

} Assembling of proposed investments
} Decision making
} Preparing capital budget and rationing
} Implementing the capital expenditure plan
} Performance review –feedback.

Ø Various techniques of Capital Budgeting

1. Profitability index:

It is the ratio of the present value of future cash benefits, at the required rate of return
to the initial cash outflow of the investment. It may be gross or net, net being simply
gross minus one. The formula to calculate profitability index (PI) ratio is as follows.

PI = PV cash inflows/Initial cash outlay A

2. Payback period method:

The payback (or payout) period is one of the most popular and widely recognized
traditional methods of evaluating investment proposals, it is defined as the number of
years required to recover the original cash outlay invested in a project, if the project
generates constant annual cash inflows, the payback period can be computed dividing
cash outlay by the annual cash inflow.

Payback period = Cash outlay (investment) / Annual cash inflow = C / A

3. Net present value method:

The net present value (NPV) method is a process of calculating the present value of
cash flows (inflows and outflows) of an investment proposal, using the cost of capital
as the appropriate discounting rate, and finding out the net profit value, by subtracting
the present value of cash outflows from the present value of cash inflows.

The equation for the net present value, assuming that all cash outflows are made
in the initial year will be:

Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost
of the investment proposal and n is the expected life of the proposal. It should be
noted that the cost of capital, K, is assumed to be known, otherwise the net present,
value cannot be known.
4. Internal Rate of Return method:

The internal rate of return (IRR) equates the present value cash inflows with the
present value of cash outflows of an investment. It is called internal rate because it
depends solely on the outlay and proceeds associated with the project and not any rate
determined outside the investment.
It can be determined by solving the following equation:

5. Modified Rate of Return method:

The Accounting rate of return (ARR) method uses accounting information, as

revealed by financial statements, to measure the profit abilities of the investment
proposals. The accounting rate of return is found out by dividing the average income
after taxes by the average investment.

ARR= Average income/Average Investment

Cost of Capital & It’s Components

Ø What is Cost of Capital?

The term “Cost of Capital” refers to the maximum rate of return a firm must earn on
its investment so that the market value of company’s equity shares does not fall. This
is a consonance with the overall firm’s objective of wealth maximization. This is
possible only when the firm earns a return on the projects financed by equity
shareholders’ funds at a rate which is at least equal to the rate of return expected by
them.

If a firm fails to earn return at the expected rate, the market value of the shares would
fall and thus result in reduction of overall wealth of the shareholders. Thus, a firm’s
cost of capital may be defined as “the rate of return the firm requires from investment
in order to increase the value of the firm in the market place”.

Cost of Capital is also called as Hurdle Rate.

Ø Main components of Cost of Capital -

1. Cost of Equity Share Capital:

The cost of equity share capital is the rate of return required by a company's common
shareholders. A company may increase common equity through the reinvestment of
earnings-that is, retained earnings-or through the issuance of new shares of stock.

The estimation of the cost of equity is challenging because of the uncertain nature of
the future cash flows in terms of the amount and timing.

Commonly used approaches for estimating the cost of equity include:-

} Capital Asset Pricing Model

} Dividend Discount Model
} Bond Yield plus Risk premium Model.

2. Cost of Preference Share Capital:

The cost of Preference Share capital is the cost that a company has committed to pay
preferred stockholders as a preferred dividend when it issues preference shares. In the
case of nonconvertible, non-callable preference shares that has a fixed dividend rate
and no maturity date (fixed rate perpetual preference shares), we can use the
following formula to determine the value of preference shares:

Value = DP / RP

Where, the cost of preference share is the dividend per share divided by the
preference share’s current price per share. Unlike interest on debt, the dividend on
preference share is not tax-deductible by the company; therefore, there is no
adjustment to the cost for taxes.
 3. Cost of Debts:

Cost of debt refers to the total cost or the rate of interest paid by an organization in
raising debt capital. However, in a real situation, total interest paid for raising debt
capital is not considered as cost of debt because the total interest is treated as an
expense and deducted from tax. This reduces the tax liability of an organization.
Therefore, to calculate the cost of debt, the organization needs to make some
adjustments. Let us understand the calculation of cost of debt with the help of an
example.
Suppose an organization raised debt capital of Rs.10000 and paid 10% interest on it.
The organization is paying corporation tax at the rate of 50%. In this case, the total
10% of interest rate would not be deducted from tax and the deduction would be 50%
of 10% (i.e. 5%)
While calculating cost of debt capital, discount allowed, underwriting commission,
and cost of advertisement are also considered. These expenses are added to the
amount of interest paid, which is considered as total cost of debt capital.

4. Cost of Retained Earnings:

Retained earnings are organizations own profit reserves, which are not distributed as
dividend. These are kept to finance long-term as well as short-term projects of the
organization. It is argued that the retained earnings do not cost anything to the
organization. It is debated that there is no obligation either formal or implied, to earn
any profit by investing retained earnings.

However, it is not correct because the investors expect that if the organization is not
distributing dividend and keeping a part of profit as reserves then it should invest the
retained earnings in profitable projects. Further, the investors expect that the
organization should distribute the profit earned by investing retained earnings in the
form of dividend.