Cost hierarchy and opportunities for cost savings

Cost savings are important for all organizations regardless of their industry, business model, or strategy. While cost savings are especially important for companies that rely on the cost leadership strategy and those in the mature life cycle stage, organizations that pursue differentiation strategy can still benefit from cost saving opportunities. In this article, we will discuss how cost hierarchy can be used to identify opportunities to save costs.

1. Classification of costs as unit, batch, product, and companywide level

Cost hierarchy is a management classification scheme that is used to classify costs into various levels. Organizations that use activity-based costing (ABC) to allocate overhead costs will likely identify different levels of activities and therefore different levels of costs. In contrast, organizations that do not use the ABC will likely recognize only one level of activities and hence one level of costs (i.e., production volume or service related). Nevertheless, even if an organization does not use the ABC, it can still benefit from using the cost hierarchy as a framework in analyzing various decisions that impact costs.

To manage cost effectively, managers can classify them as follows:

  • Unit level: these costs are related to the volume of activity (e.g., production). In other words, each unit of a product consumes a particular resource. Examples of unit-level costs include: raw materials per unit, direct labor cost per unit, inspection cost per unit, electricity costs incurred in a manufacturing facility, etc.
  • Batch level: these costs are related to the number of batches or orders. Examples of batch-level costs: setup costs per batch of products, delivery cost per order, procurement cost per raw materials purchase order, etc.
  • Product level: these costs are related to the product or service type. Examples of product level costs: design costs incurred for a specific product, inspection costs incurred to comply with regulatory requirements for a specific product, research and development (R&D) costs incurred by product line, advertising cost incurred for a specific service offering, marketing costs for a specific product line, etc.
  • Facility or companywide level: these costs are incurred to support an entire organization or facility. Facility or companywide level costs include general and administrative costs such as executive salaries, legal counsel costs, accounting department costs, IT costs, headquarter building’s costs (e.g., rent, cleaning, utilities), factory building costs (e.g., rent, property taxes, maintenance), etc.
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