Cost hierarchy and opportunities for cost savings

2. Cost hierarchy and cost savings

Batch-level and product-level costs provide the greatest opportunities for organizations to manage their costs. In contrast, unit level and facility (companywide) level costs provide some opportunities for cost savings but are usually more difficult to manage.

Unit level costs are driven by the production volume and thus are variable. Some unit level costs can be easily managed (e.g., raw materials costs) while others might be difficult to control due to various regulations. For example, direct labor cost is a variable cost: with a decline in the production volume, the direct labor cost should decline. However, the rate of decline in the direct labor cost might be not as fast as the decline in the production volume because of labor regulations. Most countries have laws that protect employee rights: terminating employment contracts or adjusting certain provisions might be a challenge for organizations facing declined production and temporary closures (e.g., mandated closures in certain regions during the COVID-19 pandemic; labor strikes). In addition to labor regulations, some organizations might keep extra labor force if a turnaround (increased production) is likely to be achieved in the near future: this approach can reduce labor turnover costs.

Some unit level costs can be effectively managed in the design stage. Once organizations commit to product design and related production processes, it is difficult to manage product costs. Approximately 80% of product costs are determined in the design stage, and thus, organizations should strive to manage costs before, not after, production starts.

As indicated earlier, raw material costs can be usually managed well by organizations. However, this might not always be the case. For example, a shock in the supply chain can significantly impact raw materials costs and related costs. The COVID-19 pandemic disrupted the supply chain for many organizations which affected raw materials costs and shipping costs.

In contrast to unit level costs, facility level costs are often fixed. These costs are usually fixed because of the contractual agreements.  These costs are committed and cannot be adjusted in the short run (e.g., property taxes on a manufacturing facility, insurance). In the long run, however, all costs are variable. While many facility costs are fixed in the short run, some are subject to managers’ discretion or could be possibly renegotiated.

Both unit level and facility level costs can be adjusted in the long run.  In the short run, batch level and product level costs provide the most opportunities for cost savings. Both batch level and product level costs are affected by activities or processes and thus can be actively managed by changing activities or processes in the short run. For example, order costs can be reduced by increasing the number of items per order and hence decreasing the number of orders, holding total purchases constant (i.e., it is less costly to process one invoice for 100 items than 10 invoices for 10 items each). Another example: to reduce shipping and delivery costs to customers and related costs (e.g., taking orders, packaging), organizations can require a minimum purchase from customers to qualify for free or reduced shipping (e.g., order merchandise worth $100 to receive free shipping).

In terms of product level or customer level costs, they also can be adjusted in the short run. For example, advertising and marketing costs often vary by product type. If advertising and marketing costs are not committed, organizations can adjust those costs in the short run (e.g., spend more or less on advertising a specific product or service).

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