How much the customer retains depends on the bargaining power of the customer, which in turn depends on competition from other firms manufacturing the same or similar products or from substitutes. Firms aim to improve the margin, which has two components: the price and the cost. Firms manage the margin and not the cost or revenue in isolation. The term 'cost management' refers to management of margin.
Often, the adjective total is pre-fixed to the term cost management to remind the manager two important principles. The first principle is that cost management should be all pervasive. It should cover all functions and all employees within the firm. Cost management should not be limited to only design and production activities. Marketing, distribution and administrative activities should also be covered under cost management. Moreover, cost management should become a culture of the firm. Employees should be encouraged to continuously explore the possibility of managing cost and revenue.
This helps to generate many new ideas, some of which deserve further consideration. For example, many companies get good results by inviting suggestions from employees at all levels. The second principle is that managers should look for cost management opportunities both within and outside the firm. In absence of both internal and external focus, a firm might miss many opportunities. Cost management opportunities exist at linkages with other firms and individuals.
The focus has now shifted from management of 'value added' to 'value chain'. Value added is the difference between the selling price and cost of bought out inputs including services. Management of value added is inward looking. Value chain of an industry refers to the chain of interlinked value-creating activities beginning with the production of the basic raw material and ending with delivery of the product or service to the final customer. Frequently these activities span multiple organisations.
It is to the benefit of all the players in the value chain if they together can increase the total value created in the system. Understanding the value chain of the industry and the relationship between each activity is important to achieve the objective of increasing the value created by the system.
Each individual player in the value chain aims to increase its share in the total value created in the system. How the value is shared depends on the relative bargaining power of the players. Relative bargaining powers of different players are shaped by forces that are beyond the control of any individual player. For example, state regulation on contract farming determines the bargaining power of farmers. Relative bargaining powers of players in the value chain changes over time. For example, if one of the players gains market power, its bargaining power increases while those of others reduce. For example Microsoft has a much stronger bargaining power than other players in the value chain. In fact, firms always leverage on its market power to increase its share in value created in the value chain. However, the relationship between all the players is sustainable only if all the players earn return on investment at least equal to its cost of capital.
Each linkage in the value chain has a unique set of cost drivers and unique competitive advantage. For example, in the case of 30GB version of Apple's fifth generation iPod, Apple has captured the major part ($80) of the value created in the value chain. It has outsourced the entire manufacturing of the device, while four large suppliers (Toshiba, Toshiba Mitsushita, Broadcom, and Portal player) of components together supply components which constitute almost 75 per cent of the total cost and they together capture value of $32 approximately.
One theme that cuts across all the cost management techniques is that 'cost can be managed only at the point of commitment and not at the point of incidence'. In other words, a firm can manage only future costs (and revenues). The potential to manage current costs is very low. For example, a firm commits costs when it finalises the design of a product and the method of its production. The potential to manage cost is significant at the product development stage. It reduces at each subsequent stage. For example, the potential for cost management reduces as the product moves from the development stage to the design stage. It reduces further as the product moves from the design stage to the production stage. Similarly, in a service industry, the opportunity to manage cost reduces very significantly after the process for delivering service is finalised.
It is a well-known maxim that 'aggregate cannot be managed'. This saying is very much applicable to cost management. Cost management requires that aggregate cost and price of a product is broken down and assigned to each element of functionality and quality of a product.
However, if no reasonable basis exists for assignment of cost and revenue to each element of functionality and quality, it is advisable not to assign cost and revenue to attributes and quality arbitrarily.
Assignment of costs and revenues arbitrarily to different elements obscures vision and misleads managers. Therefore, cost management should be supported by intensive market research. The firm must clearly understand 'who is paying for the product or service and why'. To be more precise, the firm must understand 'who will pay and why' at the product development stage.
Any firm, irrespective of the industry in which it is operating, can adopt cost management practices that are most appropriate to its business. Cost management cannot be taken up as a project, when the going is bad. Cost management culture should be built when the going is good and employee morale and enthusiasm is high. Cost management is a continuous process. There is no limit for improving margin and therefore, successful firms lift the bar for performance excellence continuously.
