BREAKING DOWN 'Cost Control'?

Controlling costs is one way to plan for a target net income, which is computed using the formula: (Sales - fixed costs - variable costs = target net income). Assume, for example, a retail shop wants to earn $10,000 in net income on $100,000 in sales for the month. To reach the goal, management reviews both fixed and variable costs, and attempts to reduce the expenses. Inventory is a variable cost that can be reduced by finding other suppliers to offer more competitive prices. It may take longer to reduce fixed costs, such as a lease payment, because these costs are usually fixed in a contract. Reaching a target net income is particularly important for a public company since investors purchase the issuer’s common stock based on the expectation of earnings growth.

A variance is defined as the difference between budgeted and actual results, and managers use variance analysis to identify critical areas that need change. Every month, a company should perform variance analysis on each revenue and expense account. Management can address the largest dollar amount variances first, since those accounts have the biggest impact on company results. If, for example, a clothing manufacturer has a $50,000 unfavorable variance in the material expense account, the firm should consider obtaining bids from other material suppliers to lower costs and eliminate the variance moving forward. Some businesses analyze variances and take action on the actual costs that have the largest percentage difference from budgeted costs.