Efficient Management of Cost Centers in an Organization - Research Paper Example

Introduction The issue that is to be discussed in this assignment is whether or not a firm’s value added solely depends on how efficiently it manages its cost centers. However, in order to properly investigate this issue one needs to have clarity about what is meant by cost centers and value added. Value Added Value added broadly means the increase in value of a product as it passes through each successive production processes and is measured as the difference between the total value of inputs and the value of output. For intermediate production processes, cost accountants impute a notional value to the output while the total costs incurred till that stage are considered as value of inputs. For an organization as a whole, the total costs incurred in production, administration and distribution are compared with the sale value of the output and the difference is the value added by the organization (Copeland, Koller and Murrin 1990). There is also another concept called Economic value Added (EVA) which is arrived at by comparing the profit after taxes with the opportunity cost of capital employed (Stern Stewart & Co. 2010). EVA accepts that capital is not available for free and imputes a notional value on the capital used by a business unit after considering the inherent risk involved in a business and the weighted average cost of total capital employed in the business. The earnings for the year are then examined in detail and any unusual or abnormal earnings and expenditures are removed to derive the normal earning for that year. If such adjusted earning is more than the cost of capital, the organization has created value; else, it has destroyed it (Grant 2003). Thus, EVA encourages managers to increase operating profits without injecting fresh capital, finding avenues for investment that would generate higher returns and reallocating funds from less profitable ventures to ones that are more profitable. This approach does not depend merely on proper management of balance sheet but also on the level of efficiency of an organization. If the balance sheet is not properly managed, a company might carry a lot more capital than it actually requires thus unnecessarily increasing the desired levels of operating profit that would just match the weighted average cost of capital. Again, if the company is not run efficiently it would not be able to earn sufficient operating profits so as to qualify as a value creator (Neale and Haslam 1994). Cost Center Definitions of cost centers vary from country to country and it would be worthwhile to investigate how cost centers are perceived in Germany and United States (Portz and Lere 2010). In Germany, Grenzplankostenrechnung (GPK), a common approach to cost accounting in that country, defines a subunit of an organization as a cost center if the output of that subunit can be measured by a single unit (Kilger, Pampel and Vikas 2004). In United States, on the other hand, if the decisions taken by a subunit in charge have an impact on the total cost incurred by the organization then such a subunit is considered as a cost center (Horngren, Datar and Foster 2006). Thus, the definition of a cost center in Germany is more restrictive as compared to that in United States. It would be of interest to note that while in United States a cost center that is concerned with drilling as a part of the entire production process would be considered as a single cost center, in Germany it would be considered as two cost centers – one that is concerned with setting up drilling machines while the other that actually performs the drilling operation (Harrison and McKinnon 1999). Responsibilities of cost center managers Thus, responsibilities of cost center managers also vary depending on whether the organization adopts GPK approach or American perspective. While the primary responsibility of a cost center manager under GPK system would be to ensure that proportional costs vary directly with increase/decrease of output of the cost center, an American cost center manager has a far wider responsibility. As a typical US manager is responsible for all costs that are incurred at the cost center for which he is responsible, he would also look at opportunities for reducing cost by decreasing output or by undertaking a profitable tradeoff between small increase in one element of cost with a substantial reduction in another element of cost. The latter would lead to an overall reduction in total cost (Calabrese 1999). How efficient management of Cost Centers add value Cost centers play a very vital role in organization structure and cost ascertainment of German companies. Each cost center is considered as an independent responsibility of the cost center manager. Comparisons between budgeted and actual costs at cost center level are done in order to ascertain the performance of cost center managers. Thus, value addition is basically brought down to cost center level and rewards and incentives for superior performances are determined at the level of cost centers. This in a sense allows cost controllers to control cost at product level (Johnson and Scholes 2008). Profit & Loss Account drawn under GPK is based on contribution margin analysis where the relevant data is collected from cost centers. Contribution is another measure of value addition by each production process and this can be simple or layered depending upon the requirement. By adopting a sophisticated contribution margin analysis an organization can apportion fixed costs with a fair degree of accuracy to products, sales regions and even customers. Such a sophisticated analysis allows the organization to accurately identify value added at each cost center which in turn helps management to administer each cost center in a much more efficient manner by setting targets and budgets at a more realistic level. All those German companies that adopt this highly sophisticated system of cost accounting are also able to segment their overall profitability in extremely detailed and shop level breakups which allow the management to accurately identify where they might be able to improve more in their quest for overall value addition (Friedl, et al. 2009). So, those US managers who feel that they are not being able to collect sufficient details at cost center level and are therefore hamstrung in their efforts at increasing the levels of value addition might do well to convert into German cost accounting system (Krumwiede 2005). Is this the only way to increase value? There is a persistent complaint against traditional budgeting is it does not identify waste or levels of service and concentrates solely on inputs costs rather than output quality and, what is most important, does not promote value creation. The main emphasis of traditional budgeting is on cost centers while cross functional business processes are often ignored. An example would perhaps clarify the issue in a better way. Most organizations in spite of having department-wise or cost center-wise cost data would be hard pressed to calculate the total cost of setting up an overall budget for the company as this involves enormous amounts of cross-functional activities. Similarly, they would be able to provide accurate cost data of human resource department, training department or security department but would hardly be able to provide a correct cost figure of training, obtaining security approval and hiring a new employee. Such lack of cross-functional approach prevents organizations from continually improving these business processes. Instead what is done is implementation of periodic reengineering techniques to improve a specific process. Thus, activity based budgeting could be a better way to enhance value creation where each activity is analyzed and its interrelation with other activities is unearthed. Resources are allocated to each activity depending on how much it would cost to complete that activity efficiently and successfully (Brimson and Antos 1999). Conclusion From what has been discussed above it is reasonably clear cost center-wise collection of cost data is possibly one of the most important ways in which an organization can add value to its processes but there are certain inherent drawbacks in traditional budgeting system that might drastically reduce efficacy of the entire effort. One way out could be activity based budgeting which would enable an organization to add value while setting up realistic budgets for interlinked processes in an organization. Thus, one cannot fully agree with the contention that efficient management of cost centers is the only way to increase value added by an organization. References Brimson, James A., and John Antos. Driving Value Using Activity-Based Budgeting. New York: John Wiley & Sons, 1999. Calabrese, Vincent J. "Economic Value Added: Finance 101 on Steroids." The Journal of Bank Cost & Management Accounting. Volume: 12. Issue: 1, 1999: 3-11. Copeland, T., T. Koller, and J. Murrin. Valuation: measuring and managing value. New York: John Wiley, 1990. Friedl, Gunther, Carola Hammer, Burkhard Pedell, and Hans-Ulrich Küpper. "How Do German Companies Run Their Cost Accounting Systems?" Management Accounting Quarterly. Volume: 10. Issue: 2, 2009: 38-46. Grant, James L. Foundations of Economic Value Added. London: John Wiley & Sons, 2003. Harrison, G., and J. McKinnon. "Cross-cultural design in management control systems design: a review of the current state." Accounting, Organizations and Society 24, 1999: 483-506. Horngren, C., S. Datar, and G. Foster. Cost Accounting: A Managerial Emphasis. Upper Saddle River, NJ: Prentice-Hall , 2006. Johnson, G., and K. Scholes. Exploring Corporate Strategy. Prentice Hall, 2008. Kilger, W., J. Pampel, and K. Vikas. "Introduction: Marginal Costing as a Management Accounting Tool." Management Accounting Quarterly 5 (2), 2004: 7-28. Krumwiede, K.R. "Rewards and realities of German cost accounting." Strategic Finance 86 (10), 2005: 26-34. Neale, A., and C. Haslam. Economics in a Business Context. London: Thomson Business Press, 1994. Portz, Kris, and John C. Lere. "Cost center practices in Germany and the United States: impact of country differences on managerial accounting practices." American Journal of Business , 2010. Stern Stewart & Co. Stern Stewart & Co.: Operations Strategy Finance Governance. 2010. http://www.sternstewart.com/?content=proprietary&p=eva (accessed February 19, 2011). Read More