What Is Cost Control?

Cost control is the practice of identifying and reducing business expenses to

increase profits, and it starts with the budgeting process. A business owner
compares the company's actual financial results with the budgeted expectations,
and if actual costs are higher than planned, management has the information it
needs to take action.

As an example, a company can obtain bids from different vendors that provide
the same product or service, which can lower costs. Cost control is an important
factor in maintaining and growing profitability.

Understanding Cost Control

Factoring in Target Net Income
Controlling costs is one way to plan for a target net income, which is computed
using the following formula:

 Sales - fixed costs - variable costs = target net income

Assume, for example, that a retail clothing shop wants to earn $10,000 in net
income from $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 that
may 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 over time.

Cost Control and Variance Analysis at Work

A variance is defined as the difference between budgeted and actual results.
Managers use variance analysis as a tool to identify critical areas that may 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 are most likely to have the biggest
impact on company results.

If, for example, a toy 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.

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THE OPERATING CYCLE

The management cost and control system (MCCS) takes on paramount importance during the operating
cycle of the project. The operating cycle is composed of four phases:

● Work authorization and release (phase II)

● Cost data collection and reporting (phase III)

● Cost analysis (phase IV)

● Reporting: customer and management (phase V)

These four phases, when combined with the planning cycle (phase I), constitute a closed system
network that forms the basis for the management cost and control system.

Phase II is considered as work release. After planning is completed and a contract is received,
work is authorized via a work description document. The work description, or project work authorization
form, is a contract that contains the narrative description, organization, and time frame for eachWBS
level. This multipurpose form is used to release the contract, authorize planning, record detail
description of the work outlined in the work breakdown structure, and release work to the functional
departments.

Contract services may require a work description form to release the contract. The contractual
work description form sets forth general contractual requirements and authorizes program
management to proceed.

Program management may then issue a subdivided work description form to the functional
units so that work can begin. The subdivided work description may also be issued through the combined
efforts of the project team, and may be revised or amended when either the scope or the time frame
changes. The subdivided work description generally is not used for efforts longer than ninety days and
must be “tracked” as if a project in itself. This subdivided work description form sets forth contractual
requirements and planning guidelines for the applicable performing organizations. The subdivided work
description package established during the proposal and updated after negotiations by the program
team is incrementally released by program management to the work control centers in manufacturing,
engineering, publications, and program management as the authority for release of work orders to the
performing organizations. The subdivided work description specifies how contractual requirements are
to be accomplished, the functional organizations involved, and their specific responsibilities, and
authorizes the expenditure of resources within a particular time frame.

The work control center assigns a work order number to the subdivided work description form,
if no additional instructions are required, and releases the document to the performing organizations. If
additional instructions are required, the work control center can prepare a more detailed work-release
document (shop traveler, tool order, work order release), assign the applicable work order number, and
release it to the performing organization.
 A work order number is required for all in-house direct and indirect charging. The work order
number also serves as a cross-reference number for automatic assignment of the indentured work
breakdown structure number to labor and material data records in the computer.

Small companies can avoid this additional paperwork cost by going directly from an awarded
contract to a single work order, which may be the only work order needed for the entire contract.

COST ACCOUNT CODES

Since project managers control resources through the line managers rather than directly, project
managers end up controlling direct labor costs by opening and closing work orders. Work orders define
the charge numbers for each cost account. By definition,a cost account is an identified level at a natural
intersection point of the work breakdown structure and the organizational breakdown structure (OBS)
at which functional responsibility for the work is assigned,and actual direct labor,material,and other
direct costs are compared with actual work performed for management control purposes.

Cost accounts are the focal point of the MCCS and may comprise several work packages,as
shown in Figure 15–4. Work packages are detailed short-span job or material items identified for the
accomplishment of required work. To illustrate this, consider the cost account code breakdown shown
in Figure 15–5 and the work authorization form shown in Figure 15–6. The work authorization form
specifically identifies the cost centers that are “open” for this charge number, the man-hours available
for each cost center, and the operational time period for the charge number. Because the exact dates of
operation are completely defined, the charge number can be assigned perhaps as much as a year in
advance of the work-begin date. This can be shown pictorially, as in Figure 15–7.

BUDGETS

The project budget, which is the final result of the planning cycle of the MCCS, must be reasonable,
attainable, and based on contractually negotiated costs and the statement of work. The basis for the
budget is either historical cost, best estimates, or industrial engineering standards. The budget must
identify planned manpower requirements, contract allocated funds, and management reserve.

All budgets must be traceable through the budget “log,” which includes:

● Distributed budget

● Management reserve

● Undistributed budget

● Contract changes

Management reserve is the dollar amount established by the project office to budget for all
categories of unforeseen problems and contingencies resulting in out-of-scope work to the performers.
Management reserve should be used for tasks or dollars, such as rate changes, and not to cover up bad
planning estimates or budget overruns. When a significant change occurs in the rate structure, the total
performance budget should be adjusted.

In addition to the “normal” performance budget and the management reserve budget, there are
two other budgets:

● Undistributed budget, which is that budget associated with contract changes where time
constraints prevent the necessary planning to incorporate the change into the performance budget.
(This effort may be time-constrained.)

● Unallocated budget, which represents a logical grouping of contract tasks that have not yet
been identified and/or authorized.

VARIANCE AND EARNED VALUE

A variance is defined as any schedule, technical performance, or cost deviation from a specific
plan. Variances must be tracked and reported. They should be mitigated through corrective actions and
not eliminated through a baseline change unless there is a good reason. Variances are used by all levels
of management to verify the budgeting system and the scheduling system. The budgeting and
scheduling system variance must be compared because:

● The cost variance compares deviations only from the budget and does not provide a measure of
comparison between work scheduled and work accomplished.

● The scheduling variance provides a comparison between planned and actual performance but does
not include costs.

There are two primary methods of measurement:

● Measurable efforts: Discrete increments of work with a definable schedule for accomplishment,
whose completion produces tangible results.

● Level of effort: Work that does not lend itself to subdivision into discrete scheduled increments of
work, such as project support and project control.

Variances are used on both types of measurement.

In order to calculate variances, we must define the three basic variances for budgeting and
actual costs for work scheduled and performed. Archibald defines these variables3:

● Budgeted cost for work scheduled (BCWS) is the budgeted amount of cost for work scheduled to be
accomplished plus the amount or level of effort or apportioned effort scheduled to be accomplished in a
given time period.
● Budget cost for work performed (BCWP) is the budgeted amount of cost for completed work, plus
budgeted for level of effort or apportioned effort activity completed within a given time period. This is
sometimes referred to as “earned value.”

● Actual cost for work performed (ACWP) is the amount reported as actually expended in completing
the work accomplished within a given time period.

RECORDING MATERIAL COSTS USING EARNED VALUE MEASUREMENT

Using “earned value” measurement, the actual cost for work performed represents those direct
and indirect costs identified specifically for the project (contract) at hand. Both the recorded and
reported costs must relate specifically to this effort. Recording direct labor costs usually presents no
problem since labor costs are normally recorded as the labor is accomplished. Therefore, recorded and
reported labor will be the same.

Material costs,on the other hand,may be recorded at various times. Material costs can be
recorded as commitments, expenditures, accruals, and applied costs. All provide useful information and
are important for control purposes.

Because of the choices available for material cost analysis, material costs should be reported
separately from the standard labor hour/labor dollar earned value report. For example, cost variances
associated with the procurement of material may be determined at the time that the purchase orders
are negotiated and placed with the vendors since this information provides the earliest visibility of
potential cost variance problems. Significant variances in the anticipated and actual costs of materials
can have a serious effect on the total contract cost and should be reflected promptly in the estimated
cost at completion (EAC) and explained in the narrative part of the project status report.

Separating labor from material costs is essential. Consider the following example:

Example 15–1. You are budgeted to spend $1,000,000 in burdened labor and $600,000 in
material. At the end of the first month of your project, the following information is made available to
you:

Labor: ACWP = $90,000

BCWP = $100,000

BAC = $1,000,000

Material: ACWP = $450,000

BCWP = $400,000

BAC = $600,00
 For simplicity’s sake, let us use the following formula for EAC:

EAC (ACWP/BCWP) X BAC

Therefore,

EAC(labor) = $900,000

EAC(material) = $675,000

If we add together both EACs, the estimated cost at completion will be $1,575,000,
which is $25,000 below the planned budget. If the costs are combined before we calculate EAC,
then

EAC = [($450,000 + $90,000)/$500,000] X ($1,600,000) - $1,728,000

which is a $128,000 overrun. Therefore, it is usually best to separate material from labor
in status reporting.

COST CONTROL PROBLEMS

No matter how good the cost and control system is, problems can occur. Common causes of cost
problem include:

● Poor estimating techniques and/or standards, resulting in unrealistic budgets

● Out-of-sequence starting and completion of activities and events

● Inadequate work breakdown structure

● No management policy on reporting and control practices

● Poor work definition at the lower levels of the organization

● Management reducing budgets or bids to be competitive or to eliminate “fat”

● Inadequent formal planning that results in unnoticed, or often uncontrolled, increases in

scope of effort

● Poor comparison of actual and planned costs

● Comparison of actual and planned costs at the wrong level of management

● Unforeseen technical problems

● Schedule delays that require overtime or idle time costing

 ● Material escalation factors that are unrealistic

Cost overruns can occur in any phase of project development. The most common causes for cost
overruns are:

● Proposal phase

● Failure to understand customer requirements

● Unrealistic appraisal of in-house capabilities

● Underestimating time requirements

● Planning phase

● Omissions

● Inaccuracy of the work breakdown structure

● Misinterpretation of information

● Use of wrong estimating techniques

● Failure to identify and concentrate on major cost elements

● Failure to assess and provide for risks

● Negotiation phase

● Forcing a speedy compromise

● Procurement ceiling costs

● Negotiation team that must “win this one”

● Contractual phase

● Contractual discrepancies

● SOW different from RFP requirements

● Proposal team different from project team

● Design phase

● Accepting customer requests without management approval

● Problems in customer communications channels and data items

● Problems in design review meetings

 ● Production phase

● Excessive material costs

● Specifications that are not acceptable

● Manufacturing and engineering disagreement

PROBLEMS

15–1 Do cost overruns just happen, or are they caused?

15–2 Cemeteries are filled with projects that went out of control. Below are several causes that can
easily develop into out-of-control conditions. In which phase of a project should each of these
conditions be detected and, if possible, remedied?

a. Customer’s requirements not understood

b. Project team formed after bid was prepared

c. Accepting unusual terms and conditions

d. Permitting a grace period for changing specifications

e. Lack of time to research specifications f. Overestimation of company’s capabilities

15–3 Below are several factors that can result in project delays and cost overruns.
Explain how these problems can be overcome.

a. Poorly defined milestones

b. Poor estimating techniques

c. A missing PERT/CPM chart

d. Functional managers not having a clear understanding of what has to be done

e. Poor programming procedures and techniques

f. Changes constantly being made deep in the project’s life cycle