SAID BUSINESS SCHOOL MBA Hillary Term 2007 FINANCIAL MANAGEMENTeanh_class_notes.s3.amazonaws.com/FMcomp.pdf · 2012-09-08 · 3. What is Hilton's most profitable product? 4. What

SAID BUSINESS SCHOOL

MBA Hillary Term 2007

FINANCIAL MANAGEMENT

Chris Chapman & Niels Dechow

N.B. Please remember to check the Intranet for the most current version of this list. Library staff regularly update hyperlinks, shelfmarks and copy information.

Course Aims and Objectives Rubric: Analysis of cost behaviour; The design and implementation of systems for organizational planning, control, and performance evaluation. The aim of the course is to introduce the basic techniques and approaches of financial management. Specific aims of the course are to provide a grounding in:

• Cost analysis frameworks: o fixed and variable costs, breakeven, cost volume profit (CVP) analysis,

opportunity cost o direct and indirect costs, full(absorption) costing, activity based costing

• Customer profitability analysis, Cost standards and variance analysis, Transfer pricing

• The construction of robust budgets and planning systems and the different roles such systems can play in the control of organizations

• Financial control and performance evaluation, Residual Income (EVA™), Balanced scorecard

Course Organisers and Lecturers: Dr Chris Chapman Dr Niels Dechow Office: 20.135 Office hour: Wednesdays 12:30-13:30, Weeks 1-5

Office: 30.027 Office hour: Wednesdays 12:30-13:30 Weeks 6-8

Reading and Preparation: All necessary technical skills will be developed through the readings together with exercises in class. It is essential that you come to class well prepared, having read thoroughly the assigned cases, and attempted to answer the assigned questions. We anticipate that proper class preparation will involve several hours per session, and given the cumulative nature of the material we encourage everyone to spend this time evenly throughout the course. The readings discussed below should help you in achieving this. We strongly recommend that you purchase a copy of the following text book: (Atrill & McLaney, '05, Management Accounting for Decision Makers).

Updated – Oct 2006 1

Session 1 – Chris Chapman Essential reading before class: (Barwise et al., '89, Must finance and strategy clash?) Article available on Business Source Premier. For pdf click here Session 1.1 – Financial forecasting and management We will start with the ('02, Caribbean Internet Cafe) case. This case is designed to set out the basic principles of cash flow forecasting, and will also cover the principles of good spreadsheet design. HANDOUT You should address the following questions:

1. Based on the information in the case prepare a monthly cash budget for the first year of operation of the café (See text book pages 158-159).

2. Based on this budget prepare a budget profit and loss, balance sheet and cashflow statement for the café’s first year of operation.

3. Do you think John’s proposed financing arrangements are appropriate for the description of the business outlined in the case? What (if any) alternative arrangements would you suggest?

4. What further analysis should John carry out before committing to this project? Session 1.2 – Introduction to Cost-Volume-Profit (CVP) analysis In the case this session we have built a quite complex model of a business. CVP represents a set of simplifying assumptions that can be used in modelling short-run cash flows. We will be applying these in the case assigned for the next session.


http://sbs-xnet.sbs.ox.ac.uk/int_pdfs/HT04/MBA/FM/Barwise.pdf

Session 2 – Chris Chapman Essential reading before class: Text book chapters 2 and 3 on Opportunity costs and CVP analysis Session 2.1 – Marginal costing and CVP We will start with the ('04, Hilton Manufacturing Co.) case. IN STUDY PACK You should address the following questions:

1. If the company had dropped product 103 as of January 1, 2004, what effect would that action have had on the $158,000 profit for the first six months of 2004?

2. In January 2005, should the company reduce the price of product 101 from $9.41 to $8.64?

3. What is Hilton's most profitable product? 4. What appears to have caused the return to profitable operations in the first six

months of 2004? Session 2.2 – Introduction to full and activity based costing (ABC) In the Hilton case we see exhibits based on the principles of full costing. We will briefly look at the pros and cons of this approach, contrasting it with ABC, an approach to the treatment of overheads that offers advantages in terms of accuracy and opportunities for cost management.


Session 3 – Chris Chapman Essential reading before class: (Cooper & Kaplan, '88, Measure costs right: Make the right decisions) Article available on Business Source Premier. For pdf click here Session 3.1 – Activity Based Costing (ABC): Calculation and Implementation First we will look at Activity Based Costing in the ('03, Wilkerson Company) case. IN STUDY PACK You should address the following questions:

1. Use the Monthly production and operating statistics in Exhibit 4 and other data on manufacturing costs to estimate product costs for valves, pumps, and flow controllers applying the principles of ABC.

2. Calculate the ABC product costs based on the theoretical capacity of activities. 3. Compare the estimated costs you calculated in 1&2 above to existing standard

unit costs (Exhibit 2). What causes the different product costing methods to produce such different results?

4. What actions would you recommend to managers at Wilkerson Company in order to make their company more profitable in the light of these various calculations?

Session 3.2 – Introduction to Variance Analysis and Operational Control We will look at the basic principles of variance analysis in preparation for the case assigned in the next session. Follow up reading after class: (Cooper & Kaplan, '91, Profit priorities from activity based costing)

Article available on Business Source Premier. For full text (html) click here. (Kaplan & Anderson, '04, Time-driven Activity-based costing) Text book chapters 4 & 5 Wider readings: (Kovac & Troy, '89, Getting transfer prices right: What Bellcore did)


http://sbs-xnet.sbs.ox.ac.uk/int_pdfs/HT04/MBA/FM/CooperMeasure.pdf

http://search.epnet.com/direct.asp?an=9107010659&db=buh

Session 4 – Chris Chapman Essential reading before class: Text book chapter 7 Session 4.1 – Operational control systems and variance analysis We will look at ('03, Hereford steak houses) case IN STUDY PACK You should address the following questions: 1. Calculate the following variances for restaurant #219

a. The static budget profit variance b. The flexible budget profit variance c. The sales volume profit variance d. Usage/efficiency variances for each individual ingredient used in

restaurant #219 2. If you were the manager of restaurant #219 what steps would you take in response

to these various calculations? Follow up reading after class: (Kaplan, '88, One cost system isn't enough) Article available on Business Source Premier For pdf click here (Churchill, '84, Budget choice: planning vs. control)


http://sbs-xnet.sbs.ox.ac.uk/int_pdfs/HT04/MBA/FM/Kaplan.pdf

Session 5 – Chris Chapman Session 5.1 – Mock examination review You should have attempted to complete the provided mock examination in your own time before class. The mock should be submitted as coursework before your scheduled class. In class we will review the specifics of the mock examination, taking the opportunity to review the more general calculative principles that have been covered in the course so far.


Session 6 – Niels Dechow Essential reading before class: (Hope & Fraser, '00, Beyond Budgeting) (Steele & Albright, '04, Games Managers Play at Budget Time) Session 6.1 – Profit Planning We will explore the issues at stake in the design of organisational planning and control systems in the ('00, Codman & Shurtleff, Inc.: Planning and Control System) case. The purpose of the discussion is to clarify strengths and weaknesses. In preparing for this class you must therefore focus on the characters – who gets involved, when and in what ways? IN STUDY PACK Odd numbered study groups should address these questions:

1. What are the particular strengths of the system Even numbered study groups should address these questions

2. Based on an analysis of weaknesses in the current system of management control, prepare specific proposals as to how you would run things if you were Jim Burke.

Session 6.2 - Responsibility Accounting Systems In the second part of the lecture we focus on decentralisation in organizations. Once an organization grows beyond a few functions, corporate management needs to delegate responsibility to middle management. However, whilst delegation is relatively easy, it is not always simple to ensure coordination. The starting point for our discussion is set by the question: When are profit centres a good idea? Follow up reading after class: (Campbell, '99, Tailored not benchmarked: A fresh look at corporate planning) (Kirby, '02, The Cost Center That Paid Its Way) Wider readings on budgeting: (Viscione, '84, Small Company Budgets: Targets are Key) Textbook, Ch.6: “Budgeting” – Pp.142-170


Session 7 – Niels Dechow Essential reading before class: (Eccles, '83, Control with fairness in transfer pricing) (Allen, '87, Make Information Services Pay its Way) Session 7.1 – Transfer pricing and organisational design We will discuss how issues of cost relate to organizational design through transfer pricing and responsibility accounting in the ('95, San Francisco Bay Consulting) case. IN STUDY PACK You should address the following questions:

1. What are the reasons for the disputes and frustrations at SF Bay? Who is being unreasonable?

2. How should the monthly rental rate for desktop computers be set? In answering this question you should consider

3. What do you think of the “incidentals” charging system? What are the costs and benefits of this charge?

4. What changes – in people, approaches or policies – would you recommend at SF Bay to solve the problems with computer services?

Session 7.2 – Service Department Costing & Balanced Scorecards The second part of the lecture discusses management control of service departments. As illustrated by the San Francisco Bay case, it matters how costs incurred by service departments get allocated to operating departments. First, we discuss different cost allocation methods and how they can affect the performance evaluation of operating departments. Then, we take a brief look at the performance measurements of the Balanced Scorecard concept and the question: how does a Balanced Scorecard work? Follow up reading after class (Vancil, '73, What kind of Management Control do you Need?) (Jacobs et al., '93, An Alternative Method for Allocating Service Department Costs) Wider readings: (Kaplan & Norton, '96, Using the balanced scorecard as a strategic management system) (Simons, '95, Control in an age of empowerment) Textbook, Ch.10: “Measuring and controlling divisional performance” – Pp.300-328


Session 8 – Niels Dechow Essential reading before class: (Kaplan, Using Strategic Themes to Achieve Organizational Alignment) (Sharpe & Keelin, '98, How Smithkline Beecham makes better resource-allocation decisions) Session 8.1 – Review and Design of Management Control Systems To encourage strategic business units (SBUs) to act both effectively and efficiently in carrying out a corporations strategy requires managers: 1/ to communicate to the SBUs what is expected of them; 2/ to motivate SBUs to achieve corporate goals and; 3/ to measure and evaluate the performance of SBUs. Even numbered Study Groups:

1/ Prepare an overall Strategy Map for San Francisco Bay taking into account SF Bays needs for both delegation and coordination

Uneven numbered Study Groups 2/ Prepare and match scorecards for IT & for SBUs that emphasize both the

need for departmental differentiation and the need for corporate integration. Both strategy maps and scorecards should take point of departure in our lecture 7 review of current organizational blocks and control levers at San Francisco Bay. Session 8.2 – Between EVA & ROI The second part of the class begins with a brief review of the Smithkline Beecham approach to resource allocation in order to understand the way corporations in practice link calculations with decision making. The class then continues with an introduction to the financial performance measurement known as the economic value added concept (EVA). First, we focus on the premises of calculation itself. Then, we discuss the strategic properties of this concept vis-à-vis the return on investment concept (ROI). Two questions frame this discussion. The first one is: what are the comparative effects of using EVA rather than ROI? The second one is: When is it purposeful, in particular, to use EVA? Follow up reading after class (Neely & Najar, '06, Management Learning not Management Control: The True Role of Performance Measurement) (Young, '97, Economic Value Added - A Primer for European Managers) Wider readings: (Ridgway, '56, Dysfunctional consequences of performance measurement) (Stern et al., '96, EVA an integrated financial management system) Textbook, Ch.11: “Strategic Management Accounting” – From Pp.343-370


References

(1995). San Francisco Bay Consulting: 9-195-096.

(2000). Codman & Shurtleff, Inc.: Planning and Control System: 9-187-081.

(2002). Caribbean Internet Cafe: 9A98B002.

(2003). Hereford steak houses: Working paper.

(2003). Wilkerson Company: 9-101-092.

(2004). Hilton Manufacturing Co.: 9-192-063.

Allen, B. (1987). Make Information Services Pay its Way. Harvard Business Review(January-February), 57-63.

Atrill, P., & McLaney, E. (2005). Management Accounting for Decision Makers. (4th ed.). Edinburgh: Pearson Education Ltd.

Barwise, P., Marsh, P., & Wensley, R. (1989). Must finance and strategy clash? Harvard Business Review, 67(5), 85-91.

Campbell, A. (1999). Tailored not benchmarked: A fresh look at corporate planning. Harvard Business Review(March/April), 41-50.

Churchill, N. (1984). Budget choice: planning vs. control. Harvard Business Review, 62(4), 150-164.

Cooper, R., & Kaplan, R. S. (1988). Measure costs right: Make the right decisions. Harvard Business Review(September/October), 96-103.

Cooper, R., & Kaplan, R. S. (1991). Profit priorities from activity based costing. Harvard Business Review(May-June), 130-135.

Eccles, R. (1983). Control with fairness in transfer pricing. Harvard Business Review(November/December), 149-161.

Hope, J., & Fraser, R. (2000). Beyond Budgeting. Strategic Finance, 30-35.

Jacobs, F., Marshall, R., & Smith, S. R. (1993). An Alternative Method for Allocating Service Department Costs. The Ohio CPA Journal(April), 20-24.

Kaplan, R. Using Strategic Themes to Achieve Organizational Alignment. Harvard Business Review(Balanced Scorecard Report - On Balance, Part 1), 3-7.

Kaplan, R. S. (1988). One cost system isn't enough. Harvard Business Review, 66(1), 61-66.


Kaplan, R. S., & Anderson, S. R. (2004). Time-driven Activity-based costing. Harvard Business Review, 82(11), 131-138.

Kaplan, R. S., & Norton, D. P. (1996). Using the balanced scorecard as a strategic management system. Harvard Business Review(January/February), 75-85.

Kirby, J. (2002). The Cost Center That Paid Its Way. Harvard Business Review, 80(4), 31-39.

Kovac, E., & Troy, H. (1989). Getting transfer prices right: What Bellcore did. Harvard Business Review(148-154).

Neely, A., & Najar, M. A. (2006). Management Learning not Management Control: The True Role of Performance Measurement. California Management Review, 48(3), 101-114.

Ridgway, V. (1956). Dysfunctional consequences of performance measurement. Administrative Science Quarterly, 1(2), 240-247.

Sharpe, P., & Keelin, T. (1998). How Smithkline Beecham makes better resource-allocation decisions. Harvard Business Review(March-April), 45-57.

Simons, R. (1995). Control in an age of empowerment. Harvard Business Review(March/April), 80-88.

Steele, R., & Albright, C. (2004). Games Managers Play at Budget Time. Sloan Management Review, 45(3), 81-84.

Stern, J., Stewart III, G., & Chew Jr., D. (1996). EVA an integrated financial management system. European Financial Management, 2(2), 223-246.

Vancil, R. F. (1973). What kind of Management Control do you Need? Harvard Business Review(March-April), 75-85.

Viscione, J. A. (1984). Small Company Budgets: Targets are Key. Harvard Business Review(May-June), 42-52.

Young, D. (1997). Economic Value Added - A Primer for European Managers. European Management Journal, 15, 335-343.


Month 1 Month 2 Month 3 Month 4 Month 5

Opening cash balance 2,250,000 1,070,383 1,463,767 1,857,150 2,250,533 Cash receiptsSales revenue (1) 1,033,333 1,033,333 1,033,333 1,033,333 1,033,333

Cash paymentsDirect food/drink/computer (2) 433,333 433,333 433,333 433,333 433,333

Manager salary 40,000 40,000 40,000 40,000 40,000 Student wages (3) 31,200 31,200 31,200 31,200 31,200 Advertising 10,000 10,000 10,000 10,000 10,000 Gen operating exp 115,000 115,000 115,000 115,000 115,000

Interest on loan (4) 10,417 10,417 10,417 10,417 10,417

Equipment (5) 1,426,000 Initial costs 147,000

Balance for month (1,179,617) 393,383 393,383 393,383 393,383 Closing cash balance 1,070,383 1,463,767 1,857,150 2,250,533 2,643,917

Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12

2,643,917 3,037,300 3,430,683 3,824,067 4,217,450 4,610,833 5,004,217

1,033,333 1,033,333 1,033,333 1,033,333 1,033,333 1,033,333 1,033,333

433,333 433,333 433,333 433,333 433,333 433,333 433,333

40,000 40,000 40,000 40,000 40,000 40,000 40,000 31,200 31,200 31,200 31,200 31,200 31,200 31,200 10,000 10,000 10,000 10,000 10,000 10,000 10,000

115,000 115,000 115,000 115,000 115,000 115,000 115,000

10,417 10,417 10,417 10,417 10,417 10,417 10,417

393,383 393,383 393,383 393,383 393,383 393,383 393,383 3,037,300 3,430,683 3,824,067 4,217,450 4,610,833 5,004,217 5,397,600

Total for year

12,400,000

5,200,000

480,000 374,400 120,000

1,380,000

125,000

1,426,000 147,000

3,147,600

MBA FM 1 1

MBAFinancial Management

Session 1

Caribbean Internet Cafe

Dr. Chris Chapman

MBA FM 1 2

Caribbean assigned questions

1. Prepare cash budget2. Prepare financial statements3. Are financing arrangements appropriate?4. What else to consider?

MBA FM 1 3

How do we make decisions?• Experience, gut-feel, intuition• Analysis

– Extrapolation• Comparators, last year plus, etc.

– Causal modelling• Break the problem domain into a set of components and their

relationships

• Experience and Analysis should not clash• Evaluate the costs and benefits of analysis

– Will a more detailed model change my actions?

MBA FM 1 4

Preparing a cash budget

• A cash budget forecast tabulates cash receipts and payments (see P.1584th,1865th )– Monthly sales will be £1,000

• 50% of monthly sales will be for in cash, 50% will be credit sales paid the following month

– Monthly cost of sales will be £240• Paid evenly over 3 months

– Annual rent of £2,000• Payable quarterly in advance

MBA FM 1 5

Month 1 Month 2 Month 3 Month 4 ÉOpening balance - 80- 760 1,520 ÉReceiptsThis month @ 50% 500 500 500 500 ÉPrevious month @ 50% 500 500 500 ÉPaymentsRent 500- 500- ÉThis month COS @ 33% 80- 80- 80- 80- ÉPrevious month COS @ 33% 80- 80- 80- ÉPrior month COS @ 33% 80- 80- ÉBalance for month 80- 840 760 260 Closing balance 80- 760 1,520 1,780 É

Spreadsheet

• Spreadsheets became popular since they allowed comparative freedom

• This freedom can be better and worse exploited

MBA FM 1 6

Spreadsheet model development• Organise models into three sections

– Input• Key variables, things you might want to change• F4 to toggle relative and absolute addressing

– Calculation (depends on model size)• With complex models you will not be able to test the

realism of your assumptions just by looking at the end result

• Beware compound growth rates!– Output

• For presentation of the results of calculations

MBA FM 1 7

Model documenting and testing• You will not remember how you built your model,

and so…• Document model with comments• Use name labels for variables (Excel Insert menu)

– Named single cells will be absolute addresses– Named ranges will be relative– Can use names on tables

• Test the model– Extreme values (e.g. 1 or 0) help clarify logic

• NB You can find mistakes, but rarely canyou be certain you have found them all

MBA FM 1 8

How “Robust” is a decision?Year CF PV 1998 544 1261986 -457 -457 1999 636 1301987 -476 -421 2000 594 1071988 -497 -389 2001 689 1101989 -522 -362 2002 729 1031990 -551 -338 2003 796 1001991 -584 -317 2004 859 951992 -619 -297 2005 923 911993 211 90 2006 983 851994 489 184 2007 1050 811995 455 151 2008 1113 761996 502 148 2009 1117 671997 530 138 2010 17781 946

NPV @ 13.0% £246

• How confident am I that because NPV>0in this table that I should invest?– IRR=13.6%

MBA FM 1 9

• Spider plots help understand significance of individual variables– XY Graph showing % change in variables (X) against

change in outcome (Y)• Data tables (Excel Data menu)

– You give variable values and get answer

• Goal seeking (Excel Tools menu)– You give answer and get variable value required

Result 1 Result 2 É Result Var 2 Var 2 ÉVar 1 Var 1Var 1 Var 1É É

Sensitivity analysis

Column input variables

Row input variable

MBA FM 1 10

Intervention - Risk managementFrequency distribution of profit

05

1015202530

-10 -5 0 5 10 15 20

Profit

Original Risk managed

• Analysis of the model can help to show how to favourably affect the outcomedistribution

MBA FM 1 11

Scenario manager

• Allows for the testing of results in relation to sets of variables (Excel Tools menu)– Base case, optimistic, pessimistic

• Have a “testing” scenario• What about the competition?• What about abandonment?

MBA FM 1 12

We tend to apply inappropriately simple analytical strategies

• Which is more likely to indicate a biased coin?– 4 heads out of 5 flips of a coin– 30 heads out of 50

• Anchoring and adjustment of probabilities– Estimated chance of income tax audit over a 2yr period

28%– Extended to 35% over an 8yr period– Should be 73% based on 2yr estimate

MBA FM 1 13

Small samples lead to high subjective confidence

• We tend to remember things that comeeasily to mind– often exceptions rather than averages

• Entrepreneurial optimism– 80% of sample believed their chances of business

success > 70%, with 33% believing success is certain– Estimated chances for a business like theirs 59%– Actual success rate turned out at 25-35%

MBA FM 1 14

1981 1991 1998British Museum 2.6 5.1 5.6National Gallery 2.7 4.3 4.8Tate Gallery 0.9 1.8 2.2Natural History Museum 3.7 1.6 1.9Science Museum 3.8 1.3 1.6Blackpool Pleasure Beach 7.5 6.5 7.1Alton Towers 1.6 2 2.8Chessington World of Adventures 0.5 1.4 1.7Tower of London 2.1 1.9 2.6Windsor Castle 0.7 0.6 1.5Edinburgh Castle 0.8 1 1.2Roman Baths 0.6 0.8 0.9Stonehenge 0.5 0.6 0.8London Zoo 1.1 1.1 1.1London Aquarium . . 0.7Source: www.statistics.gov.uk Dataset ST301314

Beware group dynamics

• Get some data, don’t just accept “inside” views– The Millennium Dome was financially engineered to

break-even at 12m visitors

MBA FM 1 15

Spreadsheets make graphs very easy to produce

• Be clear what are you trying to say before doing so however– Simply graphing a mass of quantitative information

does not make it more intelligible– Select issues of interest, don’t always go for the whole

story in one graph• Watch the data to ink ratio for your graphs

– Remember a table of numbers is oftenfar more effective

MBA FM 1 16

Pie chartsvar 1var 2var 3var 4var 5var 6

• Lose effectiveness > 3 components• At least sort variables by size for pies• Show percentages, or have separate table

20% 21%

27%7%8%

17%

var 2var 6var 4var 1var 3var 5

AwfulBetter

MBA FM 1 17

Column versus Line charts

0

20

40

60EastWestNorthSouth

• Stacking columns– Can hide relationships in long time series (>4?)– Vertical stacks better than multiple pies

• Indexing can help– All stacks lose effectiveness > 3 components– Line charts better for 4-6 variables

0

20

40

60EastWestNorthSouth

MBA FM 1 18

Possibly the worst graph ever?• From: Tufte, E. (1983) The

visual display of quantitative information, Connecticut, graphics press

• Scale is broken 3 times• 6 colours used• 3D effects• All for 5 data points

– Shows % of total collegeenrolment over and under 25

MBA FM 1 19

Cost Volume Profit analysis(Ch 3. P.434th,525th)

• CVP is an application of variable costing• Variable costing makes the following simplifying

assumptions to facilitate analysis– Variable costs: Vary with volume– Fixed costs: Do not vary with volume

• From these two basic assumptions follow– Contribution: Revenue* less Variable Costs– Breakeven: Total cost=Total revenue– Calculated as: Fixed costs/Contribution

• Good for modelling short run cash flows*Variable revenue

MBA FM 1 20

Breakeven helps us evaluate risk

Actual production

£

Quantity

Total cost=Q*VC+FCTotal revenue=Q*P

Breakeven

Marginof

safety

At breakeven profit=0TR-TC=0

Q*P-Q*VC-FC=0Q*(P-VC)=FCQ=FC/(P-VC)

Requires P>VC

MBA FM 1 21

Simple example• A management development consultancy runs one-week

training programmes for executives. • A forthcoming programme has capacity for 40 participants.• Only 34 participants are currently booked on the

programme.• An advertisement in a specialist journal to fill the

remaining spaces will cost £12,000.• The price of the programme is £5,000 per participant.• Accommodation, meals and other variable costs

are £3,000 per participant. • Should you run the advertisement?

MBA FM 1 22

CVP problems and complications

• What about other cost forms?– Step, semi-variable– Non-linear (Economies of scale, etc.)

• Critical assumptions relate to the– Relevant range– Relevant time horizon

• Curvilinear multi-breakeven point analysisis quite feasible but…– Remember cost benefit of analysis

MBA FM 1 23

Dealing with multiple products

• Calculating a Weighted Average Contribution Margin allows the expression of breakevenin terms of units of an assumed sales mix– Can work out from that breakeven point what

sales levels of individual products would be– The more products the less likely constant

sales mix

Product A Product B Product CWeighted Avg. Total

Revenue per unit 14.00 12.00 7.00 11.40 VC per unit 4.00 4.00 1.50 3.25 Contribution per unit 10.00 8.00 5.50 8.15

*Sales Mix 45% 25% 30%

=WA Contribution margin 4.50 2.00 1.65 8.15

MBA FM 1 24

Financial Reporting data is most commonly available

August September

Sales £90,000 £75,000Cost of Sales 36,000 30,000Gross Profit 54,000 45,000Operating Expenses: Rent 1,800 1,800 Rates & Insurance 900 900 Light & Heat 1,400 1,400 Advertising 900 900 Salaries & Commissions 31,500 28,500 Supplies 1,800 1,500 Miscellaneous 4,500 4,500Total 42,800 39,500Operating Profit £11,200 £5,500

• Models allow exploration of managerially relevant questions– e.g. What level of sales

is necessary to earn a 10% margin on sales?

• Financial reports do not offer much help with these kinds of questions

MBA FM 1 25

CVP model from FR data

• Need to decide on a proxy for volume– Sales is best available (assuming constant prices)

• Anderson, S., Banker, R., & Janakiraman. (2003). Are selling, general and administrative costs sticky? Journal of Accounting Research, 41(1), 47-63

• Check correlation between cost lines and proxy• Semi-variable (Salaries&commission)

– Either• A 15k drop in sales leads to a 3k drop in commission• Ratio is £0.2 commission per £1 sales• 28.5k - .2*75k=13.5k fixed element

– Or solve as simultaneous equations

MBA FM 1 26

Resulting modelSales 75,000.00£ Less variable costs

1 Cost of sales @ .40 per £1 rev 30,000.00 2 Supplies @ .02 1,500.00 3 Commission @ .20 15,000.00

Variable costs per £ sales 46,500.00 Less fixed costs

1 Rent 1,800.00 2 Rates 900.00 3 Light 1,400.00 4 Advertising 900.00 5 Salaries 13,500.00 6 Miscellaneous 4,500.00

Total fixed costs 23,000.00 Operating profit 5,500.00 Profit Margin 7%

MBA FM 1 27

Gross margin and selling price

• Mark up=Profit/Cost• Margin=Profit/Price

• Cost of goods sold on the income statement is not only made up of variable costs

• Margin=Mark up/[1+Mark up]• Mark up=Margin/[1-Margin]

Revenue 100£ 150£ Cost 75£ 100£ Gross profit 25£ 50£

Margin 25% 33%Markup 33% 50%

MBA FM 1 28

Full costing (Ch. 4)

• Full costing aims to show all costs at the unit level• Direct costs

– Costs that can be identified with specific cost objects• Not about volume necessarily, for example “Direct” labour

may be a “fixed cost”

• Indirect costs (overheads)– All other costs– Aggregated into cost pools– Charged to units through an overhead recovery

(absorption / burden) rate• Full cost might be considered as break-even price

(P.994th,1135th)

MBA FM 1 29

Direct Labour

Direct Expenses

ManufacturedCost

Prod’n Overh’d

Sales & Dist’n

Administrative

R & D

Financing Cost

Direct Materials

CommercialOverhead

Full Cost

Direct Cost

Elements of Full Cost

MBA FM 1 30

Variable costing

• For financial reporting Matching requires partial allocation of fixed costs between periods when there is inventory

AssumptionsRevenue per unit 5.50 Variable cost per unit 4.50 Fixed costs 9,000 Units produced 12,000 Units sold 9,000

Revenue 49,500.00 9000 units @ £5.50 eachless Cost of Sales 40,500.00 9000 units @ £4.50 eachGross profit 9,000.00 Less Fixed costs 9,000.00 Profit -

Inventory 13,500.00 3000 units @ £ 4.50 each

Variable Cost Income Statement

Variable Cost Balance Sheet

MBA FM 1 31

Full costing of previous exampleAssumptions regarding split of fixed costs

Production overheads 3,000.00 Other overheads 6,000.00

Total 9,000.00 Then

Allocate 3,000.00 OverheadsAcross 12,000.00 Units of production

Overhead recovery rate = 0.25 per unit

Revenue 49,500.00 9000 units @ £5.50 eachless Cost of Sales VC 42,750.00 9000 units @ £4.75 eachGross Profit 6,750.00 Less other overheads 6,000.00 Profit 750.00

Inventory 14,250.00 3000 units @ £4.75 each

Full Cost Income Statement

Full Cost Balance Sheet

• £750 of overheads have been transferred to balance sheet in inventory to be matched against revenues when inventory is actually sold

MBA FM 1 32

Readings

• Essential:– Barwise, P, P Marsh, and R Wensley (1989)

Must strategy and finance clash? Harvard Business Review 67(5),85-91.

• Preparing for next session:– Text book chapter 2 & 3

• For Hilton see in particular Marginal analysis, p614th,725th

MBA FM 2 1


Session 2

Hilton Manufacturing Company

Dr. Chris Chapman

MBA FM 2 2

• Based on the this per unit information what is the breakeven level of sales revenue?– Assume fixed costs are allocated based

on units of production

Prod. A Prod. B Prod. CRevenue (£) 4.60 4.25 7.00 Variable costs (£) 2.50 1.50 5.00 Allocated fixed costs (£) 1.65 1.25 1.20 Profit (£) 0.45 1.50 0.80

Sales volume (units) 10,000 12,000 18,000

CVP reminder exercise

MBA FM 2 3

SolutionProd. A Prod. B Prod. C

Contribution = Revenue - Variable Cost = 2.10 2.75 2.00

Sales Mix (calculated from unit sales) 25% 30% 45%

Weighted Average contribution marin 2.25

Fixed costs allocated to individual products 16,500 15,000 21,600 Total of all allocated fixed costs 53,100

Breakeven quantity = Fixed costs/WA Contribution 23,600 units of production

Sales of products at breakeven 5,900 7,080 10,620 Revenue per product 27,140 30,090 74,340 Total revenue 131,570£

orWeighted average revenue per unit 5.575 Breakeven quantity * WA Revenue 131,570£

MBA FM 2 4

Questions

• Q1 What if we had dropped 103 as of 1st Jan 2004, what would profit have been in Exhibit 4?

• Q2 In Jan 2005 should we drop the price of product 101?

• Q3 What is Hilton’s most profitable product• Q4 What has caused return to

profitability in 2004?

MBA FM 2 5

Evaluating full costing systems

• Hilton Exhibits 2&4 shows full cost calculations– Their aim is to consider all costs at the product unit

level

• How many cost pools and allocation bases should there be?– Cost pool homogeneity– Cost of analysis– Purpose of calculations

• “Peanut butter costing” fine for inventory, notfor control

MBA FM 2 6

Choice of allocation base?• External reporting

– Ease of calculation appropriate• Direct labour consistently chosen

• Ability to bear• Lumpiness• Create awareness of overhead costs

– Might be specific motivation such as encouraging automation by loading direct labour

• Cause and effect– Not possible with volume-related allocation

base like direct labour

MBA FM 2 7

Two-stage allocation process• Distinguish between product cost (e.g. 101, 102,

103) and service cost (e.g. rent, property insurance, etc.) centres– Using departments as the basis of cost pools is a

common feature of full costing• Stage 1: Overheads from service centres must first

be allocated to production centres– Due to volume-related allocation bases used in stage 2

• Stage 2: Overheads now in productioncentres allocated to products

• Complicated ≠Accurate ≠Useful

MBA FM 2 8

Simple two-stage example

• 2 Service cost and 3 Production cost centres– Marketing centre has overheads of £5,000– Finance centre has overheads of £4,000

• Relationships– 20% of finance time is spent on work for marketing– 10% of marketing time is spent on work for finance– Of the remaining

time

• How to get service centre overheads into production centres?

Marketing Finance

Production A 20%

50%

30%

25%

Production B 25%

Production C 50%

MBA FM 2 9

1. Direct method

Marketing Finance

Production A Prod. B Prod. C

£5,000 £4,000

1000+1000 2500+1000 1500+2000

20% A50% B30% C

25% A25% B50% C

Products

Burden rate Burden rate Burden rate

1

2

Percentage of Marketing department time spent on work for individual production departments

Allocation of Marketing overheads Would also includeproduction overheads

Allocation of Finance overheads

MBA FM 2 10

2. Sequential/Step down method

Marketing Finance

Prod A Prod B Prod C

£5,000+800 £4,000-800

1160+800 2900+800 1740+1600

20% A50% B30% C

20% Marketing25% A25% B50% C

Products


1

2

Finance costs allocated to marketing first

MBA FM 2 11

3. Reciprocal method

Marketing Finance


5067 3933

1013.4+983.25 2533.5+983.25 1520.1+1966.5

10% Finance20% A50% B30% C

Products



1

2

MBA FM 2 12

Workings• [fin]=4000+.1[mar] • [mar]=5000+.2[fin]• [fin]=4000+.1(5000+.2[fin])• [fin]=4000+500+.02[fin]• .98[fin]=4500• [fin]=4592• [mar]=5000+.2(4592)• [mar]=5918

• Formulate as simultaneous equations to find “complete reciprocated costs”

• Results in “artificial costs”– Always higher than actual

costs• Pro rata back down to

original level– [4592]/[4592+5918]=43.7%

• Finance=43.7% of 9000– £3,933

• Marketing=56.3% of 9000– £5,067

MBA FM 2 13

• Methods are progressively more complicated• Look backwards towards “true” cost

– Banker, R., G. Potter, et al. (1994). “An empirical analysis of manufacturing overhead cost drivers.”Journal of Accounting and Economics 19: 115-137.

• Look forwards to cost management– Activity Based Costing required

Direct Step-down ReciprocalProd. Dept. A 2000 1960 1,997 Prod. Dept. B 3500 3700 3,517 Prod. Dept. C 3500 3340 3,487

9000 9000 9,000

Cost/benefit of approaches

MBA FM 2 14

101 102 103 VC (Std) FC (Act)Rent Fixed 1,021 Property tax Fixed 307 Property insurance Fixed 278 Compensation ins. @ 5% Semi Variable (+3) 116 81 - 197 86 Direct labour Variable (-27) 2,321 1,619 - 3,940 Indirect labour Fixed 1,721 Power Variable (-5) 40 66 - 107 Light and heat Fixed 83 Building service Fixed 50 Materials Variable (+25) 1,372 1,251 - 2,623 Supplies Variable 94 127 - 221 Repairs Variable (+3) 32 39 - 71 Selling expense Fixed 3,706 General administration Fixed 1,378 Depreciation Fixed 2,686 Interest Fixed 290

3,975 3,183 - 7,158 11,606

Exh 4 reconfigured as a variable cost statement

Q1 Drop 103 in Jan 2004?5% indirectlabour only

5% direct labour only

MBA FM 2 15

• Marginal analysis if Drop 103

• Assumes– Product sales are independent– That fixed costs are not avoidable in the

short run• What would happen to the full-costs of 101

& 102 if we dropped 103?

Sales revenue from 101 & 102 only 16,179 Less variable costs for 101 & 102 only 7,158 Contribution to fixed costs 9,021 Less fixed costs 11,606 Add other income 42 Profit (loss) 2,543-

Revised Income Statement

MBA FM 2 16

Opportunity Cost

• Extending marginal analysis with Opportunity cost– Text book distinguishes relevant and outlay costs

• Figure 2.1– Coase, R. (1968). The nature of costs. In D. Solomons

(Ed.), Studies in cost analysis (pp. 118-133): Richard Irwin.• Total avoidable cost of a taking course of action together with the

total revenues forgone by taking that course of action

• The opportunity cost of a course of action is determined by the highest avoidable cost /revenue forgone where there are alternatives

MBA FM 2 17

Minimum acceptable price?Initial Note

Original cost of manufacture (direct cost plus 100% overhead charge) 32,000 1 Deposit retained when order cancelled - 5,000

27,000 Add conversion costs: Direct materials (at cost) 2,600 2 Overheads @ 100% direct cost 2,600 3 Total conversion costs 5,200 Original costs plus conversion costs 32,200

Add 25% mark up for profit 8,595 5 Suggested minimum price for conversion 40,795

Possible analysis for pricing of conversion work

• A ship has already been built for a customer, but they have now cancelled the order. What is the minimum economically rational price that can be charged to a new customer who offers to buy the ship subject to minor conversion work?

MBA FM 2 18

Supplementary note 1

• Some of the materials originally used might be salvaged for resale as scrap valued at £10,000.

• The salvage work would take 20 hours of labour, paid £6.00 per hour, to put the material in a suitable form for the sale.

• The firm’s maintenance department would undertake the work. The department has little work on at this time.

MBA FM 2 19

Supplementary note 2

• The direct materials that would be used for the conversion were ordered a year ago at a price of £4,200.

• Delivery was delayed, and its net realisable value has fallen to £1,000.

• In recognition of this, the suppliers have given the firm a discount of £1,600.

• The material could be used only for this one job, since the job it was going to be used for has been cancelled and there are no plans to continue that line of activity.

MBA FM 2 20

Supplementary notes 3,4,5

3. The firm’s fixed overhead rate includes a charge for depreciation of £700. But only hand tools will be used in this conversion.

4. If the vessel were not sold to the new buyer then the plans, patents and specifications of the vessel could be sold on the open market for £1,750.

5. The mark-up for profit has been reduced from the firm’s normal 50% because this rate is unlikely to be obtained for this transaction

MBA FM 2 21

Opportunity Cost of Conversion Salvaged materials 10,000 1 Materials used for conversion 1,000 2 Revenue lost from sale of plans 1,750 4

12,750

• In principle better off with price of £12,751• Remember robustness

– There are many assumptions and estimations underlying this analysis

– The cost of researching them should be offset against the potential benefits in terms of the decision

• Always remember to price to the market

MBA FM 2 22

Summary of assumptions

• Assumes labour costs unavoidable– Labour often a “fixed” cost– Labour not otherwise occupied in this case

• Net Realisable Value is relevant• Accounting not Economic depreciation• Revenue forgone• Hoped for profit is not an opportunity cost

– Price to Market not Cost– But lowering price here might damage future

market price which would be an opportunity cost• Recursive!

MBA FM 2 23

Opportunity cost in practice

• Sunk costs may act as a barrier to entry• Escalation of commitment

– Software projects– Capital budgeting– Performance appraisals

• Vera-Munoz, S. (1998). The effects of accounting knowledge and context on the omission of opportunity costs in resource allocation decisions. The Accounting Review, 73(1), 47-72.

MBA FM 2 24

Q2 Drop price 101 in Jan 2005?101 102 103

Listed sales price 9.41 9.91 10.56 Exhibit 2Less discount 1.08% 2.22% 1.72%Actual price 9.31 9.69 10.38

Variable costsCompensation ins. @ 5% DL 0.1164 0.1137 0.1337 Direct labour 2.3281 2.2736 2.6748 Exhibit 4Power 0.0403 0.0932 0.1175 Materials 1.3765 1.7569 1.8866 Supplies 0.0943 0.1777 0.1368 Repairs 0.0319 0.0554 0.0395

Total variable cost per unit 3.9875 4.4705 4.9890 Contribution per unit 5.32 5.22 5.39

Increase mats. 5% & supplies 7% 0.0754 0.1003 0.1039 Revised contribution 5.25 5.12 5.29

Unit contributions of the three products

MBA FM 2 25

Maximise contribution from 101

• If can retain volume higher than 854,842 units at the current price then maintaining price is superior option

Option 1Do nothing

Option 2Drop price

Robustness Check

Change in price none 0.76- noneExpected volume 750,000 1,000,000 854,842

Contribution per unit 5.25 4.49 5.25 Total contribution from 101 3,935,468 4,485,607 4,485,607

MBA FM 2 26

• If I have a constrained resource then maximising contribution per unit of production maynot be the right thing to do

• Limiting factor analysis as above is a simple form of linear programming (only 1 constraint)

X YRevenue per unit 8.40 6.00 Variable labour costs 6.00 4.00 Contribution per unit 2.40 2.00

If labour hours cost £4 each then:Labour hrs required per unit (cost/rate) 1.50 1.00 Contribution per labour hour 1.60 2.00

Dealing with scare resources

MBA FM 2 27

Q3 Most profitable?

• It depends at what level and in what way you measure profit– Table above shows contributions after

cost increases and price drop• “Relevant” profit/cost figure is determined

by why you want to know

101 102 103Contribution per unit 4.49 5.12 5.29 Total contribution 8,970,582 7,295,890 5,301,709 Contribution margin % 48% 53% 51%

MBA FM 2 28

• Increased volume has taken company pastits breakeven point

101 102 103 Unit contribution margin 5.32 5.22 5.39 Sales volume in 2003 2,132,191 1,029,654 986,974 4,148,819 Sales mix 51.4% 24.8% 23.8%Weighted Average Contribution 2.73 1.30 1.28 5.31 Sales volume in 6mths 2004 996,859 712,102 501,276 2,210,237 Sales mix 45.1% 32.2% 22.7%Weighted Average Contribution 2.40 1.68 1.22 5.30

6mths 2004 2,003 Fixed Costs less other income ($'000s) 11,564 22,241 Weighted Average Contribution ($/unit) 5.30 5.31 Breakeven Quantity (units) 2,180,350 4,186,846 Actual sales volume - Breakeven (units) 29,887 38,027- Profit ($) 158,513 201,998-

Q4 Return to profit why?

*

*This is not $192k sincecompensation insurance

was actually $9k less than 5%used in model for 2003

Initial contributionfrom Slide 24

Exhibit 2

Exhibit 4

MBA FM 2 29

How good is this news?

• The breakeven point has increased– Fixed costs are relatively higher than 2003– Weighted Average Contribution Margin is

lower than 2003• Sales for the second half of 2004 are

dropping• Paul Hilton still doesn’t understand

how to read the accounting reports

MBA FM 2 30

Revised analysis of fixed costsFixed cost analysis

2003Exh. 2

Half of 2003

2004Exh. 4

VarAct-Std

Rent 2,042 1,021 1,021 - Property tax 585 293 307 15 Property insurance 556 278 278 - Comp. ins. @ 5% indirect labour 170 85 86 1 Direct labourIndirect labour 3,390 1,695 1,721 26 PowerLight and heat 145 73 83 11 Building service 96 48 50 2 MaterialsSuppliesRepairsSelling expense 7,059 3,530 3,706 177 General administration 2,504 1,252 1,378 126 Depreciation 5,216 2,608 2,686 78 Interest 556 278 290 12

MBA FM 2 31

Variances in Exhibit 4

• Based on full cost principles– Overheads/Allocation base = Overhead

recovery rate• The overhead recovery rate is based on last

year’s volume• Since volume this year is higher, overheads

are being over-recovered• The large variances in Exhibit 4 are

savings against an artificially inflated target

MBA FM 2 32

Variable costing / Full costingSummary

• Variable costs charged to products, fixed costs charged to period

• Cost per unit does not change with output

• May result in lack of control over fixed costs

• Cannot be used for external reporting

• Direct and Indirect costs charged to products

• Maybe problems of over/under recovery

• Managers range of interest extended by indirect costs in their performance reports

• Must be used forstock valuation for external reporting

MBA FM 2 33

ABC guiding intuition

• “Overheads do not just occur, they are caused by activities that drive the costs”– Traditionally direct labour (Drury survey

suggests 70% in 2000)• See Figure 5.1 on P1144th1325th

• Products/Customers/Markets consume activities

MBA FM 2 34

Readings

• Reviewing work so far:– Ch 4 on full costing

• Preparation for next session:– Cooper, R., & Kaplan, R. (1988). Measure

cost right: Make the right decisions. Harvard Business Review (Sep/Oct), 96-103

• See P.99 in particular

Gross Sales 40,690,234 Cash discount 622,482

Net sales 40,067,752 Cost of Sales 25,002,386

Gross margin 15,065,366 Less:

Selling expense 7,058,834 General administration 2,504,597 Depreciation 5,216,410

14,779,841

Operating income 285,525 Other income 78,113

Income before interest 363,638 Less: Interest expense 555,719

Income (Loss) 192,081-

MBA FM 3 1

Financial ManagementSession 3

Wilkerson Company

Dr. Chris Chapman

MBA FM 3 2

Full costing reminder exercise

• If the 2006 burden rate is used in 2007 what will be the amount of overheads over/under absorbed?

• What should the burden rate have been in 2007?

2006 2007Overheads ($) 120,000 150,000 Direct Labour (hrs) 15,000 20,000

MBA FM 3 3

• Direct labour (or any other volume-based allocation base) move overhead costs to volume which is by definition a problem in terms of cost behaviour

Burden rate in 20062006 Overheads/2006 direct labour 8.00

Overheads applied in 20072006 burden rate * 2007 direct labour 160,000

Compared to 2007 actual overheadsOverabsorbed 10,000

Burden Rate for 20072007 Overheads/2007 direct labour 7.50

Solution

MBA FM 3 4

Questions

• Q1. Estimate product costs for valves, pumps, and flow controllers applying the principles of ABC.

• Q2. Calculate the ABC product costs based on the theoretical capacity of activities.

• Q3. Compare the estimated costs you calculated in 1&2 above to existing standard unit costs (Exhibit 2).

• Q4. What actions would you recommend to managers at Wilkerson Company in order to make their company more profitable in the light of these various calculations?

MBA FM 3 5

• Activity analysis– Business process

reengineering– Activity management

• Activity cost analysis– What drives cost?

• Activity based costing– Calculate rate

Activity-based costing

• Break organisation up into activities, not functional departments

• Trace (not allocate) costs of activities direct to products, customers, …

• Using many(non-volume related)cost drivers

• Cost objects consume activities which consume resources

MBA FM 3 6

ABC versus Theory of constraints

• Goldratt, E., & Cox, J. (1992). The Goal: A Process of Ongoing Improvement. (2nd ed.). Croton-on-Hudson: NY: North River Press.– [Throughput] = [Cash received from sales] - [materials

costs] - [operating expenses] - [all organizational expenses other than materials costs] - [inventory]

– TOC is good for short term product mix and scheduling of bottleneck resources

– But fixed cost levels are given not managed in TOC• ABC is complementary not competing

MBA FM 3 7

Wilkerson• Overall Wilkerson faces declining profits• Market behaviour does not fit with product

profitabilities suggested by current cost system– No price competition despite high margins on

commodity valves product– Downward price pressure on commodity pumps

product despite already low margins– Demand unchanged by 10% price rise for customised

flow controllers despite high margins• Exhibit 1 shows total overheads are 111%

of total direct costs.– Burden rate is 300% of direct labour

MBA FM 3 8

Q1 Calculate ABC product costs

• First identify cost pools and activity drivers• Exhibit 1 shows 5 overhead cost pools

• Total overhead / activity driver = traced cost

Cost pool from Exhibit 1 Activity Activity Driver Source1. Machine-related expenses Machine operation Machine hours (note 1)2. Setup labor Set ups Production runs (note 2)3. Receiving and production control Inventory movements Production runs (note 3)4. Engineering Specific work Engineering hours Exhibit 45. Packaging and shipping Packing Shipments (note 4)

Cost poolsExhibit 1

Cost poolExhib. 1

Act. driverExhib. 4 Traced cost

1. Machine-related expenses 336,000 11,200 30 2. Setup labor 40,000 160 250 3. Receiving and production control 180,000 160 1,125 4. Engineering 100,000 1,250 80 5. Packaging and shipping 150,000 300 500

MBA FM 3 9

Total cost traced to products Valves Pumps FC Total1. Machine-related expenses 112,500 187,500 36,000 336,000 2. Setup labor 2,500 12,500 25,000 40,000 3. Receiving and production control 11,250 56,250 112,500 180,000 4. Engineering 20,000 30,000 50,000 100,000 5. Packaging and shipping 5,000 35,000 110,000 150,000

151,250 321,250 333,500 806,000

Valves Pumps FC TotalRevenue 645,000 1,087,500 420,000 2,152,500 Direct costs 195,000 406,250 128,000 729,250 Traced overheads 151,250 321,250 333,500 806,000 Gross profit 298,750 360,000 41,500- 617,250

Per unit costs based on traced totalsUnits (from Exhibit 4) 7,500 12,500 4,000 Overheads per unit 20.17 25.70 83.38 Plus direct costs (from Exhibit 2) 26.00 32.50 32.00 Total cost 46.17 58.20 115.38 Sales price (Exh. 2) 86.00 87.00 105.00 Profit per unit 39.83 28.80 10.38-

Profit Margin % 46.3% 33.1% -9.9%

Revised product profitability

MBA FM 3 10

Customer Profitability Analysis

High Cost-to-Serve• custom products• small quantities• often change delivery requirements• manual interventions• large pre-sales support• large post-sales support• require company to hold inventory• pay late

Low Cost-to-Serve• standard products• large order quantities• no changes to delivery requirement• electronic processing• little pre-sales support• no post-sales support• require little inventory• pay on time

• ABC analyses activities rather than products making possible far more sophisticated forms of customer profitability analysis– Not just the profitability of the products they buy but

the way that they buy them

MBA FM 3 11

Managing unprofitable customers

• Are they unprofitable by design?– New customers?– Lifetime profitability?– Positive reputational & learning effects?

• Or by default?– Reduce cost-to-serve

• Improve unncessary internal processes• Improve ordering and delivery relationships

– Menu-based pricing• Based on cost-to-serve

MBA FM 3 12

Cost poolsExhibit 1

Cost poolExhib. 1

Act. drivercapacity Traced cost

Unused capacity

1. Machine-related expenses 336,000 12,000 28 800 2. Setup labor 40,000 180 222 20 3. Receiving and production control 180,000 180 1,000 20 5. Packaging and shipping 150,000 400 375 100

Cost tracing to products Valves Pumps FC Capacity Total1. Machine-related expenses 105,000 175,000 33,600 22,400 336,000 2. Setup labor 2,222 11,111 22,222 4,444 40,000 3. Receiving and production control 10,000 50,000 100,000 20,000 180,000 4. Engineering (as previous calcs) 20,000 30,000 50,000 - 100,000 5. Packaging and shipping 3,750 26,250 82,500 37,500 150,000 Total 140,972 292,361 288,322 84,344 806,000

Overheads per unit 18.80 23.39 72.08 Profit margin 47.9% 35.8% 0.9%

Q2 What about capacity?

MBA FM 3 13

• Activity available = Activity usage + unused capacity– Activity usage drivers mean traced costs will vary with

operations or there will be under and over absorption– Hides issue of capacity as a question for management

• Capacity cash flow timing will vary in practice

1,000 units 2,000

$5,000

$10,000

What about capacity?

MBA FM 3 14

Q3 Comparison

• What will happen to net income next month if we introduce ABC?– ABC does not model short run cash flows

• We must take actions that ultimately affectcash flows

Compare three different treatments Valves Pumps FCOriginal (from Exhibit 2) 34.9% 19.5% 41.0%ABC using actual activity levels 46.3% 33.1% -9.9%ABC using capacity information 47.9% 35.8% 0.9%

MBA FM 3 15

Q4 What would you do?

• Revisit market behaviour in relation to our pricing strategies– Are competitors overlooking opportunities in flow

controllers? Should we worry about price pressure on pumps? Should we decease price on valves to gain market share and utilise capacity?

– Remember price is set in the market• If I need X% market share, that gives me required

price/product attribute bundles, which gives me a target cost todeliver my required profits

• Current arrangements are almost certainly notthe most profitable ones. What changes mightyou make?

MBA FM 3 16

ABC supports cost management

• ABC makes resource consumption decisions more visible– Requires tracing not allocation

Flow controller cost

-

20.00

40.00

60.00

80.00

100.00

120.00

Traditional ABC

Rec. & Prod.Pack & shipEngineeringMachineSetupOverheadDirect LabourDirect Materials

MBA FM 3 17

Hierarchy of costs

• ABC does not necessarily aim for full costs• Sustaining costs occur at different levels

– Firm, production facility, product line, product unit, …customer

• Don’t push costs below the level at which they feasibly behave, this is allocation not tracing– Allocations distort profitability analysis and offer no

cost management opportunities– Allocation may help to reframe figures, but remember

it does not show how costs behave• Highlighting sustaining costs opens them up for

consideration

MBA FM 3 18

0

10

20

30

40

50

60

Customers / Products / Orders / Markets …

Cumulative Profit

$

Opportunity*

Profitability cliffs• Which are are our best products / customers /

orders / markets?

*Assumes products are independent and that resource spending not just consumption can change

MBA FM 3 19

Implementing ABC Principles

• Stage 1: Need to move from general ledger cost pools to activity cost pools

• Stage 2: From activity cost pools activity drivers trace costs to customers, products, markets

Resource Cost PoolsTotal Resource

CostsProvide ATM

services Clear Debit Items

Branch Operations Debit Items

Issue Personal Cheque Book

Clear Credit Items

Branch Operations Credit Items

Lending Control & Security

Customer Enquiries

Account Management Center £1,557,280 £0 2,388 66,293 0 509 0 5,647 903,565Account Opening Teams 368,355 0 0 0 0 0 0 0 0ATM Network 111,031 111,031 0 0 0 0 0 0 0Branch Operations 3,475,959 95,229 40,756 487,269 0 11,641 545,606 5,709 306,263Clearing Operations 833,575 20,099 650,287 1,291 0 135,744 1,394 4,791 0Collections 968,256 0 0 36 0 0 1,168 912,190 41,378Collections Fees 329,205 0 0 0 0 0 0 329,205 0Outsourced Fees 2,120,071 104,151 0 0 0 0 0 41,611 37,796Financial Advisors 1,214,383 0 0 0 0 0 0 0 9,799Information Technology 1,669,453 0 0 65,293 0 0 0 67,261 0Marketing Fees and Staff 884,380 16,236 0 0 0 0 0 0 0Postage 713,474 92,397 0 0 107,706 0 0 0 0Regional Processing Centers 485,102 25,023 0 61,263 0 70,107 0 0 0Stationery 277,746 0 328,709 0 156,243 0 0 0 0Telesales 129,235 0 0 0 0 0 0 0 0VISA Stamps and Statements 433,491 0 0 0 0 0 0 0 0Other 55,671 26,136 0 2,655 0 0 0 14,349 0Total Activity Costs £15,626,667 £490,302 £1,022,140 £684,100 £263,949 £218,001 £548,168 £1,380,763 £1,298,801

MBA FM 3 20

Types of cost drivers• Transaction

– offer financial advice

• Duration– offer 3 hours of financial

advice

• Intensity / direct charging– offer 2 hours of management

time and 1 hour of administrative time

• Direct measurement– How many times did I

offer financial advice

• Complexity indexing– Rather than actually

measuring duration (transaction) I might complexity index the transaction (intensity)measure

As always, trade-off accuracy for cost

MBA FM 3 21

Time-Driven ABC

• Thus far we have adopted a top-down approach to ABC calculations

• Dealing with people’s time is difficulty– They will never report unused capacity– They can switch flexibly between activities

• Time-driven ABC is a bottom-up approach– Work out individual cost/minute charge– Cost activities according to a menu of standard times

allowed• Kaplan, R. S., & Anderson, S. R. (2004). Time-driven

Activity-based costing. Harvard Business Review, 82(11), 131-138.

MBA FM 3 22

Operational control systems

• Operational control– Objectives– Measurable outputs– Predictive model– Capability of taking

action

• Simple feedback– Thermostat

• Complex feedback– Fuzzy Logic

• Feedforward

Provide accurate, timely feedback to managers on their performance

MBA FM 3 23

Calculating variances

• Variance analysis models financial results based on assumptions about cost (per unit), revenue (per unit), sales mix and quantity (units)

• Individual variances are comparisons of models based on particular combinations of standard (originally planned) and actual parameters

• The intention is to identify a hierarchy offinancial impacts driven by specific factors

MBA FM 3 24

Key Variance Definitions

• The static budget variance– Actual results - original budget

• Calculating a flexible budget allows this overall result to be decomposed into separate effects– The flexible budget is calculated using actual sales

quantity and mix, but standard per unit cost and revenue assumptions

– Sales volume variance• Flexible budget - Original budget

– Flexible budget variance• Actual results - Flexible budget

MBA FM 3 25

Hierarchy of variancesStatic budget

variance

Flexiblebudget

variance

Salesvolumevariance

Sales mixvariance

Sales quantityvariance

Indirectcosts

Purchase price

variance

Efficiency/Usage

variance

Direct costsSales pricevariance

Market sizevariance

Market sharevariance

Individual item

Individual item Planned Unplanned

MBA FM 3 26

Simple Soup - Original BudgetVegetarian Chicken

Revenue per dish 2.00 2.75 Cost per dish 1.50 2.00 Sales mix 40% 60%

Weekly customers 1,000

Total weekly revenue 2,450.00 Total weekly cost 1,800.00 Total weekly profit 650.00

MBA FM 3 27

Simple Soup - Actual ResultsVegetarian Chicken




• Green indicates actual values

MBA FM 3 28

Simple Soup - Flexible BudgetVegetarian Chicken




• Flexing the original per unit assumptionsof cost and revenue, but adjusting foractual sales volume and mix

MBA FM 3 29

Simple Soup - VariancesOriginal budget

Flexible budget Actual results

Profit 650.00 687.50 789.80

Static budget variance 139.8 Favourable

Sales volume variance

Flexible budget variance

37.50 Favourable

102.30 Favourable

MBA FM 3 30

Input Price (spending) andEfficiency (usage) variances

• The graph shows the total cost of materials

• In formulae– AQ=actual units *

actual usage per unit– SQ=flexed units *

standard usage per unit

Price Variance (1) = AQ ( AP - SP)Efficiency Variance (2) = SP ( AQ - SQ)

£

Usage/efficiencyFavourable

Q

Price/spendingUnfavourable

SP

AP

AQ SQ

1

2

MBA FM 3 31

Joint variance Joint Variance (2) =(AP-SP)*(AQ-SQ) =

included in pricevariance with formulae

below

AQ

SP

Price Variance (1 & 2) = AQ ( AP - SP)Efficiency Variance (3) = SP ( AQ - SQ)

£

Q

AP

SQ

1 2

3

MBA FM 3 32

Simple Soup - breaking down the flexible budget variance

Actual StandardSoup portion per customer (ml) 280 300 Soup cost per litre 5.05 5.00

Vegetable Customers 550 Total Quantity (litres) 154 165

Efficiency variance SP 5.00 (AQ-SQ) (11.00)

SP*(AQ-SQ) (55.00) Favourable

Input Price variance AQ 154 (AP-SP) 0.05

AQ*(AP-SP) 7.70 Unfavourable

Direct cost variance (in this case less cost) (47.30) FavourableSales price variance (in this case more revenue) 55.00 FavourableFlexible budget variance (in this case more profit) 102.30 Favourable

MBA FM 3 33

Readings

• Follow up:– Cooper, R., & Kaplan, R. S. (1991). Profit priorities

from activity based costing. Harvard Business Review(May-June), 130-135.

– Kaplan, R. S., & Anderson, S. R. (2004). Time-driven Activity-based costing. Harvard Business Review, 82(11), 131-138.

• Wider reading:– Kovac, E., & Troy, H. (1989). Getting transfer prices

right: What Bellcore did. Harvard Business Review(148-154).

Exhibit 1

Sales 2,152,500 Direct Labor Expense 271,250 Direct Materials Expense 458,000 Manufacturing overhead

Machine-related expenses 336,000 Setup labor 40,000 Receiving and production control 180,000 Engineering 100,000 Packaging and shipping 150,000 Total Manufacturing overhead 806,000 Gross margin 617,250 29%General, Selling and Admin. Expense 559,650 Operating income (pre-tax) 57,600 3%

Exhibit 2

Valves Pumps Flow ControllersDirect labor cost 10.00 12.50 10.00 Direc material cost 16.00 20.00 22.00 Manufacturing overhead (@300%) 30.00 37.50 30.00 Standard unit costs 56.00 70.00 62.00

Target selling price 86.15 107.69 95.38 Planned gross margin 35% 35% 35%

Actual selling price 86.00 87.00 105.00 Actual gross margin 34.9% 19.5% 41.0%

Exhibit 3

Valves Pumps Flow ControllersMaterials per unitcomponents 4 5 10

Materials cost per unit 16 20 22

Direct labor per unit (hrs) 0.4 0.5 0.4Direct labor $/unit @ $25 per hr 10 12.5 10

Machine hours per unit 0.5 0.5 0.3

Exhibit 4

Valves Pumps Flow ControllersProduction (units) 7500 12500 4000Machine hours 3750 6250 1200

Production runs 10 50 100Number of shipments 10 70 220Hours of engineering work 250 375 625

Total2400011200

160300

1250

Restaurant # 219 budget report - week 48

Budget ActualCovers 1,500 1,600 Revenue 13,563.75 13,116.00 Cost 7,120.50 6,805.50 Gross profit margin £ 6,443.25 6,310.50 Gross profit margin % 47.5% 48.1%

Actual dishes soldSoup 240Steak & Chips 480Fish & Chips 480Fish fingers 400

Hereford Steak Houses: A case illustrating flexible budgeting and variance analysis in a chain restaurant

Thomas Ahrens (Warwick Business School)

Christopher S. Chapman (Saïd Business School) This case requires you to calculate a series of variances based on the information concerning standard costs, and the details of the sales of one restaurant for one week. The system presented here is based on a field study in an actual restaurant chain. As well as presenting an opportunity to practice the calculative aspects of this form of accounting control, the assigned questions will encourage you to think about the managerial implications of such systems. The significance of controlling food costs is underlined by the face that they represented about 33% of turnover, and just over 40% of total costs for Hereford Steak Houses. Introduction

“I’d love to know where I am as an area manager. I don’t know what to do with food margin. Shall I say to my restaurant managers, well done? Thank you? You’re fired?”

Hereford Steak Houses operated a chain of more than 200 wholly owned, full-service restaurants across the UK. Over the past 10 years the division had achieved substantial growth in revenues and earnings through the addition of new restaurants. More recently, however, with increasing numbers of new entrants to the UK eating-out market and the growing saturation of Hereford Steak Houses’ own outlets, senior management were increasingly turning their attention to internal financial controls as a means to sustain earnings growth. National branding and marketing for the chain was managed centrally by Hereford Steak Houses’ head office. Most significant to this was the nation-wide menu that defined the food specifications, cost and price of all dishes for sale in all outlets. Menus were designed to deliver a target food gross profit margin that was agreed between the boards of Hereford Steak Houses and the corporate leisure group of which it was part, and applied to all of Hereford Steak Houses’ outlets. Whilst food cost was a primary element of restaurant controllable costs, as the above quotation from an area manager indicates, there was a lack of agreement on how the food margin reports should be used to evaluate restaurant manager. Restaurant managers emphasised that they wanted leeway to meet the demand of their local clientele. The gross profit margin was defined as sales minus cost of food used, and was generally referred to as the “food margin”. For each new menu a selection of dishes was iteratively developed in order to achieve the target food margin (in terms of % and cash). This was a complicated process since the menu needed to contain dishes at a range of price points to appeal to different customers. Depending on the selling price, different levels of

1

margin were realistic. For example, a very high margin on high cost dishes resulted in unrealistic sales prices, but could be sustainable on low cost dishes. High volume dishes offered scope for the centralised purchasing department to negotiate substantial price discounts. Hereford Steak Houses’ position as a buyer of large quantities of food also allowed them to enforce strict quality standards for raw materials. The process of developing individual restaurant budgets started with an estimation of the achievable level of sales growth based on expected number of dishes and prices from the central menu. Budgets were painstakingly built up. They drew on the database of standard ingredient costs, which included a standard allowance for wastage (see exhibit 1). Then dish specifications, prices and expected sales mix were decided (see exhibit 2). For weekly management reporting this data was used to generate a target food margin based on each restaurant’s actual dish-mix that could be compared with the actual cost of food used (see exhibit 4). The actual cost of food was calculated by adding the opening inventory to deliveries received minus closing inventory (see exhibit 3). In order to take advantage of centralised purchasing and also to ensure tight control over quality standards, restaurants sourced all their food purchases through the centralised supply chain. Especially for seasonal produce it was normal for Hereford Steak Houses to agree price bands with their food suppliers. Fluctuations in the price of food purchased were accounted for by the central purchasing department. The weekly budget reports for the restaurants were based on the standard costs that had been defined during the design of the menu.

2

Exhibit 1: Menu design ingredients database report

Standard wastage percentage: 1% Ingredient # Description Input cost Wastage Standard cost

100 1 pat butter 0.05 0.001 0.05 101 1 standard garnish 0.20 0.002 0.20 102 1 sachet ketchup 0.05 0.001 0.05 151 1 bread roll 0.15 0.002 0.15 297 1 portion of fries 0.60 0.006 0.61 314 1 carton vegetable soup 2.40 0.024 2.42 601 9 oz rump steak 6.00 0.060 6.06 907 6 oz frozen cod fillet 3.60 0.036 3.64 915 1 fish finger portion 0.25 0.003 0.25

Exhibit 2: Dish specification and costing report @ standard cost

Cost Sales Price Gross profit

margin Dish # Description % sales Ingredients £ £ % £

1 Soup 10.0% 1 pat butter 0.05 1 bread roll 0.15 1 carton vegetable soup 2.42 Total 2.63 5.50 52.3% 2.87

11 Steak & Chips 45.0% 1 standard garnish 0.20 1 portion of fries 0.61 9 oz rump steak 6.06 Total 6.87 11.95 42.5% 5.08

12 Fish & Chips 25.0% 1 standard garnish 0.20 1 portion of fries 0.61 6 oz frozen cod fillet 3.64 Total 4.44 8.50 47.7% 4.06

21 Fish fingers 20.0% 1 sachet ketchup 0.05 1 portion of fries 0.61 1 fish finger portion 0.25 1 fish finger portion 0.25 1 fish finger portion 0.25 Total 1.41 4.95 71.4% 3.54

3

Exhibit 3: Restaurant #219 – Stock keeping report - week 48

IOp

stock111111961

ngredient # Description ening

count

Purchases during

week

Closing stock count

100 pat butter 200 120 30 101 standard garnish 200 1300 300 102 sachet ketchup 300 400 300 151 bread roll 300 100 60 297 portion of fries 2000 900 1840 314 carton vegetable soup 100 180 40 601 oz rump steak 300 400 160 907 oz frozen cod fillet 250 300 70 915 fish finger portion 200 1200 200

Exhibit 4: Restaurant # 219 budget report - week 48 Budget Actual Dishes 1,500 1,600 Revenue 13,563.75 13,116.00Cost 7,120.50 6,805.50Gross profit margin £ 6,443.25 6,310.50Gross profit margin % 47.5% 48.1% Actual dishes sold Soup 240 Steak & Chips 480 Fish & Chips 480 Fish fingers 400

4

MBA FM 4 1

Financial ManagementSession 4

Hereford steak houses

Dr. Chris Chapman

MBA FM 4 2

CVP Practice Question

• A train running between Oxford and London has space for 300 passengers.

• The ticket price for each passenger is £17 and the variable cost per passenger is £2, and the breakeven number of passengers is 250

• What are fixed costs and what is the profit at capacity?

MBA FM 4 3

CVP SolutionCapacity 300 Rev 17 VC 2 BE 250

Contribution 15

FC=BE*Contribution 3,750

Contribution*capacity 4,500 Total contrib-Fixed costs 750£

MBA FM 4 4

ABC Practice QuestionAccounting department costs £

Invoice processing

Sustaining costs

Salaries 36,000 70% 30%Premises 50,000 18% 82%Telephone 7,500 90% 10%Photocopying 4,500 90% 10%

98,000

Total invoices processed 1,000 Of which

Simple 60% Base level x 1Moderately complex 30% Base level x 2Very complex 10% Base level x 6

Applying ABC principles what is the amount of cost to be traced to the three kinds of invoices?

MBA FM 4 5

ABC SolutionCost of invoice processing

Salaries 25,200 Premises 9,000 Telephone 6,750 Photocopying 4,050

Total 45,000 What is the traced cost to simple and complex invoices?

Activity driver calculationsSimple 600 Moderate 600 Complex 600 Total 1,800

Traced cost per driver unit 25

Total traced cost Total Per invoiceSimple 15,000 25Moderate 15,000 50Complex 15,000 150

45,000

MBA FM 4 6

• Both managers got the job done, achieved similar levels of customer satisfaction and employee stress levels

Budgeted amount

Actual results

Manager 1 1,000£ 950£ Manager 2 750£ 850£

Expenses

Who is doing a better job?

MBA FM 4 7

Beyond budgeting?

• The word budgeting has come to be seen as– Time consuming ritualistic behaviour uncoupled from

(or worse conflicting with) both operational or strategic decision making

• Budgeting is likely to work better if it has clearly defined and well communicated roles that fit the context of the organisation– Beware benchmarking of “technical” practices

• Zero-based budgeting, rolling budgets, etc.

• Churchill (1984) Planning versus Control

MBA FM 4 8

Operatingbudget

Budget preparationSales budget

Purchases budget

Cost of goods sold budget

Operating expenses budget

Budgeted P&L

Ending-inventory budget

Capital budgets

Budgeted balance sheet

Cash budget

Financialbudget

MBA FM 4 9

Hereford Steak Houses

• Operational control system– Input prices held constant in restaurant accounts– Requires weekly inventory count to calculate

actual direct cost of food• Opening inventory + purchases – closing inventory

– Sales mix collected through EPOS

MBA FM 4 10

Original budgetStandard sales volume - standard sales mix (static budget)Covers 1500

% mix dishes price cost revenue cost profitSoup 10% 150 5.50 2.63 825.00 393.90 431.10 Steak & Chips 45% 675 11.95 6.87 8,066.25 4,635.90 3,430.35 Fish & Chips 25% 375 8.50 4.44 3,187.50 1,666.50 1,521.00 Fish fingers 20% 300 4.95 1.41 1,485.00 424.20 1,060.80

100% 13,563.75 7,120.50 6,443.25 47.5%

Exhibit 2Covers * mix

Exhibit 2Exhibit 2

Dishes * price

Dishes * cost

Revenue – costsee Exh. 4

MBA FM 4 11

Control

Chapman, C.S. (1998) Accountants in organizational networks, Accounting, Organizations and Society, (23)8, pp. 737-766

Operational managers

Company seniorManagement

Group levelaccountants

Sales director

MBA FM 4 12

Chittenden, F., Poutziouris, P., & Michaelis, N. (1998). Financial Management and Working Capital Practices in UK SMEs: Manchester Business School.

010

203040

506070

8090 Production

budgetPurchasesbudgetBudgetedbalance sheetCash budget

OverheadsbudgetBudgeted profitand lossSales budget

MBA FM 4 13

Flexible budgetActual sales volume - actual sales mix (flexible budget)Covers 1600

% mix dishes price cost revenue cost profitSoup 15% 240 5.50 2.63 1,320.00 630.24 689.76 Steak & Chips 30% 480 11.95 6.87 5,736.00 3,296.64 2,439.36 Fish & Chips 30% 480 8.50 4.44 4,080.00 2,133.12 1,946.88 Fish fingers 25% 400 4.95 1.41 1,980.00 565.60 1,414.40

100% 13,116.00 6,625.60 6,490.40 49.5%

Exh. 4

MBA FM 4 14

• What are the implications of these figures?

Original Budget Flexible Budget ActualGross Profit 6,443.25 6,490.40 6,310.50

Static budget variance


Flexible budget variance

(132.75) Unfavourable

47.15 Favourable


Q1a-c) Variances

MBA FM 4 15

• New solutions must be worked out that bring together emerging operational and market circumstances in a financially satisfactory way.

• The financial target is important, but perhaps less so than the process of producing it

Planning

MBA FM 4 16

Separating volume and mix?Actual sales volume - standard sales mixCovers 1600

% mix dishes price cost revenue cost profitSoup 10% 160 5.50 2.63 880.00 420.16 459.84 Steak & Chips 45% 720 11.95 6.87 8,604.00 4,944.96 3,659.04 Fish & Chips 25% 400 8.50 4.44 3,400.00 1,777.60 1,622.40 Fish fingers 20% 320 4.95 1.41 1,584.00 452.48 1,131.52

100% 14,468.00 7,595.20 6,872.80

Original Budget Std Mix budget Flexible BudgetGross Profit 6,443.25 6,872.80 6,490.40


Sales quantity variance

Flexible mix variance

47.15 Unfavourable

429.55 Favourable


MBA FM 4 17Budget difficulty

$

Budgeted performance

Actualperformance

Motivation• Expectancy theory

– Target must be reasonable and quantified

– Reward for success– Requires participation from

those being managed• Difficulty and

achievability?– Merchant, K. A., & Manzoni, J.

F. (1989). The achievability of budget targets in profit centres: A field study. The Accounting Review, LXIV(3), 539-558.

• Motivation versus Insulting Integrity?

MBA FM 4 18

Convention

• Note these are conventions, and open to debate– Bastable, C. W., & Bao, D. H. (1988). The fiction of sales quantity

and sales mix variances. Accounting Horizons, 2(2), 10-17.• Alternative approaches are possible

– Comparing 1-4 against Actual

• Might argue this approach more economicallysensible, but resulting variances do not “add up”– Conflicts with separated accountabilities

Static Budget Flexible Budget ResultsCosts (per unit) Planned Planned Planned Planned ActualSales price Planned Planned Planned Actual ActualSales mix Planned Planned Actual Actual ActualSales quantity (units) Planned Actual Actual Actual Actual

1 2 3 4 ActualCosts (per unit) Actual Actual Actual Planned ActualSales price Actual Actual Planned Actual ActualSales mix Actual Planned Actual Actual ActualSales quantity (units) Planned Actual Actual Actual Actual

MBA FM 4 19

Q1d) Ingredient usage variances

used target paid Actual

Budgeted cost @

standard

Variance (Actual-budget)

% on standard

cost1 pat butter 290 240 0.05 14.50 12.12 2.38 20%1 standard garnish 1200 960 0.20 240.00 193.92 46.08 24%1 sachet ketchup 400 400 0.05 20.00 20.20 (0.20) -1%1 bread roll 340 240 0.15 51.00 36.36 14.64 40%1 portion of fries 1060 1,360 0.60 636.00 824.16 (188.16) -23%1 carton vegetable 240 240 2.40 576.00 581.76 (5.76) -1%9 oz rump steak 540 480 6.00 3,240.00 2,908.80 331.20 11%6 oz frozen cod fille 480 480 3.60 1,728.00 1,745.28 (17.28) -1%1 fish finger portion 1200 1,200 0.25 300.00 303.00 (3.00) -1%

6,805.50 6,625.60 179.90 3%

Exhibit 3:Opening inventory+Purchases-Closing inventory

From flexiblebudget (maybe multiple meals, e.g. garnish or fries)

input cost (Exh. 1)

used*paid

target*standard cost from Exh. 1

MBA FM 4 20

Relevance for operational control?

• Variances measure effectiveness at meeting predetermined targets– Good for high volume standard production– Management by exception– Can be used to separate out individuals’

responsibilities• Not good for operational control if

the process is supposed to be variable– Clinical treatment episodes

MBA FM 4 21

Interpreting variances

• What about efficiency?– Standards may include wastage allowances– Standards maybe a motivational target

• Possible interdependence of causal factors analytically separated by variance calculations

• Must consider strategic context– Is it always “favourable” to cut costs?

• Marketing• R&D

MBA FM 4 22

Wastage allowances removed

• No longer masking size of unfavourableeffect on steaks with false favourable onfish, etc.

Actual

Budgeted @ input

cost

Variance (Actual-budget)

Wastage allowance

1 pat butter 14.50 12.00 2.50 0.12 1 standard garnish 240.00 192.00 48.00 1.92 1 sachet ketchup 20.00 20.00 - 0.20 1 bread roll 51.00 36.00 15.00 0.36 1 portion of fries 636.00 816.00 (180.00) 8.16 1 carton vegetable soup 576.00 576.00 - 5.76 9 oz rump steak 3,240.00 2,880.00 360.00 28.80 6 oz frozen cod fillet 1,728.00 1,728.00 - 17.28 1 fish finger portion 300.00 300.00 - 3.00

6,805.50 6,560.00 245.50 65.60

MBA FM 4 23

Q2 Sources of a food margin deficit?

• Failure of portion control• Inappropriate food

preparation• Inappropriate food storage

– Appropriate treatment FIFO not LIFO. Requires “inventory rotation”

• Poor quality deliveries• Theft

– In restaurant or at stage of delivery

• Customer served wrong food

• Customer changes mind• Stock count wrong

– “Managers’ stock”• No price variances as such

but manager might “comp” someone

MBA FM 4 24

Concluding comments on system

• Holds people accountable only for things they control– Usage in restaurants Price in central purchasing– No allocations

• Weekly reporting system (not daily)– Trade-off cost versus control

• Use of financial measure rather than many operational ones privileges local management efforts to manage the business– Allows the construction of an argument rather

than the tight delineation of best practice

MBA FM 4 25

Kaplan (1988)

Tracing

MBA FM 4 26

System Implementation Issues

• Design choices– Integrated or stand alone– Ownership and choice of team– Historical or future– Initial design complex or

simple– Consultants

• Costing systems are often:– Expensive– Complicated– Constructed over time by

different people– Monolithic

• Should cost analysis be a system?

• Gosselin, M. 1997. The effect of strategy and organizational structure on the adoption and implementation of activity-based costing. Accounting, Organizations and Society, 22(2): 105-122.

• Dearman, D., & Shields, M. 2001. Cost Knowledge and Cost-Based Judgement Performance. Journal of Management Accounting Research, 13: 1-18

• Briers, M., & Chua, W. 2001. The role of actor networks and boundary objects in management accounting change. A field study of an implementation of activity-based costing. Accounting, Organizations and Society, 26(3): 237-269.

MBA FM 4 27

Goal congruenceHigh Low

Validitity High Computation Bargainingof predictive Answer Ammunitionmodel Low Judgement Inspiration

Learning Rationalisation

Based on: Hopwood A. (1980) “Organizational and behavioural aspects of budgeting and control” pp. 221-240 in Arnold J., Carsberg B. & Scapens R. (eds.), Topics in Management Accounting

• Accounting helps structure questionsmore often than it provide answers

Accounting and decision making

MBA FM 4 28

Variance Practice Question

Static budget profit varianceSales volume profit varianceFlexible budget profit variance

Price variance for direct materialsEfficiency variance for direct materials

Actual PlannedConsulting engagements 10.00 Revenue per engagement ($) 450.00 450.00 Cost per engagement ($) 300.00 Total revenue ($) 4,950.00 4,500.00 Total cost ($) 3,234.00 Total profit ($)Hrs of consulting time per engagement 2.10 Average charge out rate per hour 150.00

Based on the following information calculate the following variances:

MBA FM 4 29

Variance SolutionEngagements 10 11

Original Flexible ActualRevenue 4,500.00 4,950.00 4,950.00 Cost 3,000.00 3,300.00 3,234.00 Profit 1,500.00 1,650.00 1,716.00

Static budget variance 216 FavourableSales volume variance 150 FavourableFlexible budget variance 66 Favourable

Efficiency variance = SP * (AQ - SQ)150.00 23.10 22.00 165.00 Unfavourable

Price variance = AQ * (AP - SP)23.10 140.00 150.00

231.00- Favourable

MBA FM 4 30

Mock examination

• To be completed before assigned class in week 5• Treat it as much like a real exam as possible

– Do it without reference to notes or books, take 1.5hrs, do it in one sitting, write it out

• You are required to submit something through the practical work system– Before the beginning of your assigned class in week 5– A word file with the numerical answers only

• No workings - Do not do this in the real exam

• We will go through the mock in class in week 5

MBA FM 4 31

Readings

• Kaplan, R. S. (1988). One cost system isn't enough. Harvard Business Review, 66(1), 61-66

• Churchill, N. (1984). Budget choice: planning vs. control. Harvard Business Review, 62(4), 150-164.

Financial Management – Part 2

Dr. Niels DechowRoom 30.027

Course OverviewFinancial

Forecasting

Marginal Costing

Activity BasedCosting

OperationalControl

Planningvs Control

Coordination vs Delegation

Performancevs Risk

MockMockMock

ProductPerspective

Organisational Perspective<<<Object

<<<

Behaviour

Course OverviewFinancial

Forecasting

Marginal Costing

Activity BasedCosting

OperationalControl

Planningvs Control


Performancevs Risk

MockMockMock

ProductPerspective

Organisational Perspective

<<<

Behaviour

TodayProfit Planning – Codman & ShurtleffResponsibility Accounting Systems

Week 7Transfer Pricing & Org.DesignSDC & Balanced Scorecards

Week 8Review & Design of MCSBetween EVA & ROI

Course Overview

Planningvs Control


Performancevs Risk

MockMockMock

Organisational Perspective

<<<

Behaviour

TodayProfit Planning – Codman & ShurtleffResponsibility Accounting Systems

Week 7Transfer Pricing & Org.DesignSDC & Balanced Scorecards

Week 8Review & Design of MCSBetween EVA & ROI

EXAM CASE

“SERONO”

Div Firm

BSC

Attitudes

“SERONO” CASE• What advise can you offer Ian?

• Case Available after Lecture

• Can NOT respond to specific questions

• Do reserve time in Week 10

• Think ‘trade-offs’


Session 6

Profit Planning / Codman & Shurtleff

INFORMATIONAND ANALYSIS

POSITIONING&

COMPETENCIES

INTERNAL:STRENGTHS &WEAKNESSES

EXTERNAL:

OPPORTUNITIES& THREATS

STRATEGIC PLANNING• Strategic intent• Strategic programmes to realise intent• Outline financial plan

OPERATIONAL PLANNING AND BUDGETING• Action plans with milestones and dates• Budgets and financial forecasts - profit,

investment, cash flows

PERFORMANCE MEASUREMENT• Operating performance against action plans• Financial performance against budgets and

forecasts

Strategic and Operational Planning

Budgets

1. Initiation and Planning2. Implementation3. Timing4. Rolling Budgets & Revision5. Fixed or Flexible6. Bonuses based on budgets7. Evaluation Criteria8. What degree of Stretch

NB: See also Churchill (1984)

Budgets and control

• Budgets will reflect internal political power structures

• Centralised (Top-Down)– Strategic direction comes from centre– Budget integrates sub-unit activity

• Decentralised (Bottom-Up)– Strategic decision making in sub-units– Budget helps manage uncertainty

Planning & Control in Perspective

• '50s/'60s Budgeting Systems– one to two year horizons– dominantly financial incremental “continuity & improvement”

• 60s/'70s Long Range Planning– five to ten year horizons– dominantly financial incremental “predict & prepare”

• '80s/'90s Strategic Planning– five to ten year horizons (Shrinking)– non-financial & financial proactive “redesigning the future”

• ’00s/’10s New Directions– Separation of Planning & Control– Refocusing of Planning & Control Purposes

11Source: Perrow (1967)

low highTASKVARIETY

policyanalysis

researchdepartments

performingartists

money marketdealers

assemblylines

auditchecks

legalservices

engineeringtasks

A Model Of Task Structure

ROUTINECRAFT NON- ROUTINE

TECHNICAL-PROFESSIONAL

Task Structure & Cost Control

Structured tasks• measurable outputs• predetermined inputs• control through

standards

Unstructured tasks• output may not be

measurable• uncertain inputs• control through

– resource allocation– benchmarking– professional

standards

Control and information processing• Appropriate control style depends on level of

uncertainty (not complexity)

• Galbraith (1973) defines the level of uncertainty as amount of information required for task completion that is not currently available– Affected by: Number inputs, number of outputs, level

of interdependence, level of performance required

– With low uncertainty then preplanning and cybernetic control are best

– With high uncertainty preplanning will not work and ongoing learning is required

hrm…

Implications

• As uncertainty increases either– Accept a lower level of performance explicitly

or through slack resources• or

– Invest in vertical information processing

• until you must– Invest in horizontal information processing

• ie. separate planning from control

Control & Performance Link

• Budgeting can support information sharing

• There is often information asymmetry between managers and their subordinates

• If rigid adherence to the budget becomes a major part of performance evaluation under uncertainty then dysfunctional behaviours will occur– Padding / Slack– Periodicity may distort behaviour

• investment, sales (channel stuffing), spending

Painful Budgeting Attitudes

… and how to neutralize them !

– ‘Sandbagger’ : Enforce Top-Down Corp Goals

– ‘Magician’ : Focus on Trends in Core Business

– ‘Lone Agent’ : Reinforce Group Cost / Benefits

– ‘Visionary’ : Require demonstration of feasibility

– ‘Hostage Taker’ : Establish Trade-Offs

Case: Codman & Shurtleff• Johnson & Johnson

– operates in 3 health-care markets world-wide• consumer products• pharmaceutical products• professional products

– 75,000 people; 155 autonomous businesses

• Codman & Shurtleff– competing through technological innovation– competitive environment– 2,700 products; 12 product groups; 800 people– neuro-spinal surgery

R.W BlackPresident

C.W DunnVice President

New Business Development

W.D. BaileyVice President

Research & Development

A.FleitesVice President

Information & Control

R.J. MarlattVice President

Human Resources

R.H. DickVice President

Marketing

J.A CherryVice PresidentManufacturing

D.M. HamletDirector

International(not board member)

M.J. McCahillTreasurer

H.G. StolzerExecutive Committee

R.E. CampbellVice Chairman, Executive CommitteeProfessional / Latin America Sector

Johnson & Johnson, Inc.Jim Burke

CEO – Johnson & Johnson

J & J Credo:“An intangible system that keeps J&J

organized”

D.R. ClarePresident – Johnson & JohnsonChairman Executive Committee

Codman & Shurtleff, Inc.- Board of Directors

C.W DunnVice President

New Business Development

W.D. BaileyVice President

Research & Development

A.FleitesVice President

Information & Control

R.J. MarlattVice President

Human Resources

R.H. DickVice President

Marketing

J.A CherryVice PresidentManufacturing

M.J. McCahillTreasurer

R.E. CampbellVice Chairman, Executive CommitteeProfessional / Latin America Sector

D.R. ClarePresident – Johnson & JohnsonChairman Executive Committee

Johnson & Johnson, Inc.

Resp for 17 SBUs.35 Years with Johnson & JohnsonEngineering & Management

25 Years with Johnson & Johnson18 Years with Codman & ShurtleffPrimarily Marketing Experience

Data Producer

Price & Mix Focus

24 Y J&J / Mainly MarketingMission Focus Designer

Jim BurkeCEO – Johnson & Johnson

Burke Letters(C&S = 1 of 155

5-10 Plans: Stretch Imagination2nd Year Forecasts: Run BusinessAnnual Budget: Evaluate Managers

H.G. StolzerExecutive Committee

R.W BlackPresident

D.M. HamletDirector

International(not board member)

Codman & Shurtleff, Inc.- Board of Directors

FebJan Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Jim BurkeCEO

Exec Comm155 Cos

Herb Stolzer17 Cos

CodmanFunctional

CodmanBoard

Areas

FebJan Mar Apr May OctJun Jul Aug Sep Nov Dec

5/10 Year Plan-by area- bus segment- strategy- marketing plan- departm. plan

Preliminary 5/10 Year Plan





Initial Draft ofProfit Plan &2nd year forecast

Debate & Adjust

Debate & Adjust

Review Profit Plan

Approve2nd yearforecast

Mission Statement

BottomlineReview

BottomlineReview

BottomlineReview

BottomlineReview

BL

Debate & Adjust

BottomlineReview

BottomlineReview

BottomlineReview

StrategyReview

Debate & Adjust

Debate & Adjust

Approve5/10 Year

Plan

2 PageBurke Letter

2 PageBurke Letter

Debate & Adjust

JuneRevision

NovRevision

Expense LevelAnalysis

Full Rebudgetof Profit Plan

The C&S Planning Process

• 5 and 10 year ‘strategic’ plans– emphasis on targets

• annual profit plans– 1 and 2 years ahead

• weekly and monthly reporting to J&J• centralized reviews• tough, challenging system

Johnson & Johnson, Inc.

Business Plan Structure

1/ Executive Summary2/ Market Overview3/ SWOT Analysis4/ Key Issues5/ Strategy (1 Page)6/ Action Plan (1 Page)

Nov Update10 Months Results

2 Months Action Plan

June RevisionRe-budget in May for

remainder of year

January > May: LRP5&10 Year Plans

Mission Statement Review

Segment By SegmentBusiness PlansCompetitor AnalysisPro Forma IncomeStrategyMarketing Plans

Departmental BasisAction Plan

May – JuneReviews, Challenges &

Adjustments

Planning & Control

1. 5 & 10 Year Plan 3 days pr Year2. 2nd Year Forecast3. Annual Budget4. Rev & Exp Control Monthly5. Rev & Exp Reports Weekly > H.G.S

Codman & Shurtleff, Inc.

Factors Affecting Profit PlanDeterioration of the USD

Unfavorable Mix VarianceInventory Variances

Competitive Profile12 Major Product Groups

2700 Product ItemsPrice Sensitive Market

Since DRG, Industry Volume off with 20%

C&S Strategic Actions Condensed 14 locations to 4

Reduced staff levels by + 20%Some cuts in R&D

Codman & Shurtleff, Inc.

Strengths & Weaknesses

• Please evaluate the Planning & Control Systems at Johnson & Johnson

Codman & Shurtleff

Strategy

• Formulation & Implementation

Codman & Shurtleff

Organisational Learning

• How do formal processes produce OL?

Codman & Shurtleff

Organisational Innovation

• Link btw formal control & org innovation

Codman & Shurtleff

Alt.1: Reengineer Processes• Larger, long established bureaucratic organisations often

have unnecessarily long and complex budget cycles.

• Re-engineer existing processes to reduce the time and effort involved in preparing the budget and/or set targets for reductions in budget cycle.

• Process map the current processes including time lines

• Document opportunities for– reducing times within each iteration– reducing the number of iterations– eliminating redundant processes– running sequential processes simultaneously

• The challenge: prevent any reduction in quality of the outputs

Alt.2: Optimize Structure • Larger, long established bureaucratic organisations often

organize themselves with profit and investment centres, yet manage these as if they were cost and revenue centres.

• In practice true decentralisation is rare– Empowerment with control (Simons)

• Decentralised (Bottom-Up) control– Strategic decision making in sub-units– Development and refinement of strategy

• The Challenge: To decide what framework of discussion budgets are supposed to establish

Alt 3:________________

Better without budgets?The opposite list builds on dissatisfaction with poorly implemented budgets, but is largely an exercise in benchmarking, not tailoring financial planning

• Targets – aim to beat the competition, not the budget

• Strategy – Develop strategy inclusively and continuously, not as a top-down annual event

• Improvement – Think radically, not incrementally• Resources – Manage for long-term value, don’t

allocate resources• Co-ordination – Manage cause and effect not

budgets• Costs - Manage value, not whether costs go up

or down• Forecasts – create the future, don’t just keep on

track• Control – Use a few key measures,

not a mass of detail• Rewards – Encourage team work not

individualism• Delegation – Give managers responsibility

and freedom to act, don’t micromanage themSource: Campbell (1999) vs Hope & Frazer (2000): Beyond Budgeting

Tailored not benchmarked• Financial planning requires clearly defined and well

communicated roles that fit each other and the context of the organisation:

– Granada• quantum ‘stretch’ profit targets• fosters fresh thinking

– Dow Chemical• constant pressure on costs• cyclical industry

– Emerson Electric• incremental improvement in sales & margins

Source: Campbell, A. (1999). Tailored not benchmarked: A fresh look at corporate planning. HBR (March/April), 41-50.

Budgets – a popular view• “The budget is the bane of corporate

America. It should never have existed…everyone is negotiating...you get the lowest out of people”– Jack Welch, GE

• “The budget gives you the wrong target…to beat the budget..[not] to beat the competition”– Jan Wallander, Svenska Handelsbanken

• “The most political of all processes…”– Greg Vesey, Director, Texaco

Beyond Budgeting

Source: Hope & Frazer (2000): Beyond Budgeting

Vision

Strategic Plan

Annual Budget

Keeping on Track

Control (vs Budget)

Incentives (vs Budget)

Strategic Goals& Boundaries

Challenge & Stretch

Relative TargetsRolling ForecastsFlexible StrategiesInternal MarketDistributed ControlsRelative Rewards

CultureResponsibility

EnterpriseLearning

ContractCompliance

Control

Beyond Budgeting Process

• Top-Down / Bottom-Up Communication– Clarity in Roles– Clarity in Contribution

• Outcome: Learning rather than Control– Clarity in definition of purpose– How process affects decision making

NB: See also Campbell (1999) & Churchill (1984)

Beyond budgeting?• The word budgeting has come to be seen as

– Time consuming ritualistic behaviour uncoupled from (or worse conflicting with) both operational or strategic decision making

• Budgeting is likely to work better if it has clearly defined and well communicated roles that fit the context of the organisation– Beware benchmarking of “technical” practices

• Zero-based budgeting, rolling budgets, etc.

• THINK: Planning versus Control


Session 6

Responsibility AccountingSystems

Decentralisation and responsibility accounting

• Hold managers responsible for factors that they can control

or• Responsibility as a

motivator even without control

• Cost centre• Revenue centre• Profit centre• Investment centre

Relevant Definitions• Responsibility centre ...

• Organization unit that is headed by a responsible manager;

• It denotes the apportioning of responsibility for a particular set of inputs and/or outputs to an organization unit.

Relevant Definitions• Responsibilities can be expressed in terms of:

• Physical units of outputs;• Particular characteristics of the services provided;

– e.g., schedule attainment, customer satisfaction, etc.

• Quantities of inputs consumed;• Financial indicators of sets of performance in these

areas.

• Financial responsibility centres ...• Responsibility centres in which the manager's

responsibilitiesare defined at least partially in financial terms.

Responsibility centre Designs

• Cost centre– focus on inputs (appropriation of funds)

• Standard cost centre– focus on productivity and efficiency measures (unit

costs and standard costs)• Revenue centre

– focus on outputs (revenues per product or per sales person)

• Profit centre– focus on effectiveness of operations (profits)

• Investment centre– focus on effectiveness of investments (profitability)

Cost centres ...• Managers of cost centres are held accountable for

costs (expenses):

– Standard cost centres or engineered expense centres– Inputs can be measured in monetary terms;– Outputs can be measured in physical terms; and,– Causal relationship between inputs-outputs is direct / stable;

» e.g., manufacturing departments, but also, warehousing,distribution, personnel administration, catering.

– Managed cost centres or discretionary expense centres– Outputs produced are difficult to measure; and,– Relationship between inputs-outputs is not well known;

» e.g., R&D, PR, HR, marketing activities.

Control in cost centres ...• Engineered cost centres

• Standard cost vs. actual cost– i.e., the cost of inputs that should have been consumed in

producing the output vs. the cost that was actually incurred.

• Additional controls– Volume produced; quality; training; etc.

• Discretionary cost centres• Ensuring that managers adhere to the budgeted level of expenditures

while successfully accomplishing the tasks of their centre.

• Subjective, non-financial controls– e.g., quality of service as perceived / evaluated by users.

• Personnel controls• Tools: benchmarking

Revenue centres ...• Managers of revenue centres are held

accountable for generating revenues:• e.g., Sales departments in commercial organizations;• e.g., Fundraising managers in not-for-profit organizations.

• No formal attempt is made to relate inputs (measured as expenses) to outputs.

• However, most revenue centre managers are also held accountablefor some expenses (e.g., salespeople's salaries and commissions);

• But, still they are not profit centres because:– These costs are only a tiny fraction of the revenues generated;– Revenue centres are not charged for the costs of the goods they sell.

Profit centres ...• Managers of profit centres are held accountable for

generating profits:– As a measure of performance, profit is ...

– Comprehensive– i.e., it incorporates many aspects of performance;– Unobtrusive– i.e., the profit centre manager makes the revenue/cost tradeoffs.

• Main question / problem in practice: Has the manager significant influence over both revenues and costs?

• Charge standard cost of goods sold to sales-focused entities;• Assign revenues to cost-focused entities;• Pseudo profit centres.

Investment centres ...• Managers of investment centres are held

accountable for the accounting returns (profits) on the investment made to generate those returns.

• Measures: ROI, ROE, ROCE, RONA, EVA etc.

• Managers have two performance objectives:• Generate maximum profits from the resources at

their disposal;

• Invest in additional resources only when such aninvestment will produce an adequate return.

Problems of decentralisation

• System of performance measurement should:– System should allow for unit autonomy

• The performance appraisal of a unit is not affected by the decisions of other units

– System should promote goal congruence• Avoid sub-optimisation

• You get what you measure…– But is that what you wanted?

Problems of decentralisation

?

? ? ? ? ? ?

What is your Business Model ?

Transfer pricingDefinition: Rules to allocate jointly earned revenue

among responsibility centres1. Market price (efficient if there is a market)2. Cost based prices (what is incentive to

supply?)– Marginal cost (including opportunity costs)– Full cost (determined how?)

3. Negotiated – Between divisions (gives responsibility, is “fair”)– By head office (avoids potentially wasted time)

4. Dual book accounting (not widely used)

Transfer pricing decision

• Is the supplier division a profit or investment centre with both revenue and cost responsibility?– If not the treat as a cost centre with standard or actual cost

transfer price• Else, Is the supplier division permitted to sell to

external customers?– If not, set transfer price at negotiated level between variable

cost and market price• Else, Is the supplier division operating at capacity?

– If not, set transfer price at negotiated level between variable cost and market price

• Else, Use market price as transfer price

Source: Warren, Reeve, & Fess “Financial and Managerial Accounting” (4th ed.)

Evidence from practice

• Variable cost• Standard full cost• Actual full cost• Cost plus a markup• Negotiated• Market price

3.6%15.2%

9.0%16.6%16.6%36.7%

Source: Tang (1992) “Transfer pricing in the 1990’sManagement Accounting (February), pp. 22-26

Evidence from practice

• Variable cost• Standard full cost• Actual full cost• Cost plus a markup• Negotiated• Market price

3.6%15.2%

9.0%16.6%16.6%36.7%

Source: Tang (1992) “Transfer pricing in the 1990’sManagement Accounting (February), pp. 22-26

Here quoted from Atrill & McLaney (2005): Management Accounting for Decision Makers – P.324

Source: Eccles (1983): Control with fairness in transfer pricing

No Transfer Pricing

Mandated Full Cost

Market Prices

Mandated / Market

Cooperative Collaborative

CompetitiveCollective

Vertical Integration

Emphasis onInterdependence

Diversification

Emphasis on Independence

LL

H

H

Source: Eccles (1983): Control with fairness in transfer pricing

Characteristics of competitive, cooperative and collaborative Organisations

Characteristic Competitive Cooperative Collaborative

Strategy

Structure

Systems

Processes

Method of Managers evaluationTop managementcontrol

Through systemson outcomes

Impartialspectator

Bottom-up:Disruptivebargaining

Profits, ROICompared withbudget, int & ext

Multidivisional

Aggregate of divisions strategies

Through systemson actions

Through processesbalancing structureand systems

Shared fate Rational trust

Top-DownIntegrativebargaining

IterativeMixed modebargaining

Costs comparedwith budgets &history

Combination ofcosts, profit, andROI compared withbudget

Functional Matrix

Total companystrategy

Mutually definedTotal companybusiness perspectives

International Transfer Pricing

• Multinationals operate in many different tax regimes that give different TP incentives– General corporate tax– Import duties– Regulations on repatriation of profits– Also currency fluctuation

• Tax authorities enter a negotiation but will prefer:– Comparable uncontrolled price (arm’s length)

• US Whistle blower law provides a % so different internal and tax figures might be dangerous

Readings• Follow-Up

– Campbell (‘99): Tailored not Benchmarked– Kirby (‘02): The Cost Centre that Paid its Way

• Wider Readings– Viscione (’84): Small Company Budgets: Targets are

Key

• Essential for Week 7– Eccles (’83): Control with Fairness in Transfer Pricing– SF Bay Case– Allen (’87): Make Information Services Pay its Way

LMBB 7D67

M.B.A. Mock Examination

__________________________________________________________

FINANCIAL MANAGEMENT _________________________________________________________

HILARY TERM 2007

There are 10 questions in this paper. All questions are compulsory.

All questions carry equal marks.

Materials: Calculators

Time allowed 1.5 hrs to be carried out in your own time. Solutions must be submitted through the MBA coursework system before your scheduled

class in week 5

1

Answer ALL questions.

Question 1 Given the following data-set, determine the per unit selling price that will result in a profit of £975,000? What operating profit margin does this achieve? Budgeted Sales 850 units Direct Materials per unit £ 2,250 Direct Labour per unit £ 20 per hour Hours of Production per unit H 195 hours Fixed Costs £ 925,000

Question 2 Suppose that: Your revenue per unit is £ 9495 Direct Materials per unit £ 1,800 Direct Labour per hour £ 30 Hours of Production per unit H 150 hours Fixed costs are £ 875,000 And: You advertise a rebate on the sales price of £ 495 Cost of the advertising campaign £ 40,000

What is the target sales level in units required to make a profit of £1,325,000? What profit margin does this achieve?

Question 3 A company makes only two products which have the following characteristics

Product A Product B Revenue per unit £6.00 £7.50 Direct labour hours per unit (charged at £10 per hour) 0.20 hrs 0.30 hrs If the budget of £100 for direct labour cannot be exceeded then what is the maximum possible profit the firm can earn if general running costs are £150? What profit margin does this imply?

TURN OVER

LMBB 7D67 2

Question 4 Company Y produces widgets. Each widget is budgeted to require 4 kgs of raw material, priced at $5 per kg. Budgeted production per day is 100 units. Total cost yesterday was $2,600. Input costs/kg were as planned, but each unit consumed only 96.25% of planned raw materials. Calculate the following variances for cost: (a) static budget variance (b) sales volume variance (c) flexible budget variance (d) If total revenue for the month was £3,000 and sales prices were unchanged what should the profit margin have been according to the flexible budget.

Question 5 Company G operates a policy of setting weekly production such that it covers that weeks sales and leaves a closing inventory of 50% of the following weeks expected sales. Assume all transactions are paid for at the end of the week. Week 1 Week 2 Week 3 Week 4Sales in units 1,000 1,200 1,400 1,500 Sales price (£) £10.00 Firm has a gross margin of (%) 60% Opening stock (units) 500

Based on this information prepare a cashflow forecast for the first 3 weeks of the month.

Question 6 The costs of the accounting department are $5,000 per month. The chief accountant estimates that $1,040 of these are department sustaining costs, and the rest are spent on the main activity, which is processing invoices. She estimates that, working flat out, the department might process 400 standard invoices per month. Complex invoices were felt to take about twice as long as standard invoices to process. Last month the department actually processed 300 invoices of which 10% were complex ones. Applying the principles of Activity Based Costing, what would be the total accounting department cost traced to a customer who was invoiced 10 times during the month, 2 of them being complex invoices. Also how much of monthly accounting department cost represents unused capacity?

TURN OVER

LMBB 7D67

3

Question 7 Company X is in the business of removing potentially toxic building materials from old houses. Work supervisors and estimators don't agree on the costing. Supervisors believe that estimators are not distinguishing sufficiently between routine and non-routine work. To shed light on this controversy, the company has initiated an activity-based costing study of all its costs. Data from the ABC system follow. Activity Cost Pool Activity Measure Activity for the YearJob size Thousands of sq meters 800Estimation and job setup Number of Jobs (see note 1 below) 500Dealing with non-routine jobs Number of non-routine jobs 100

Note 1: 100 non-routine jobs included in the total of 500 jobs. Costs for the Year Wages and salaries 300,000Disposal fees 700,000Licensing and insurance 400,000Total Cost £ 1,400,000

Resource Consumption Across Activities

Job size Estimation &

Setup Non-Routine Sustaining TotalWages & Salaries 50% 10% 30% 10% 100%Disposal fees 60% 0% 40% 0% 100%Licensing and insurance 30% 0% 50% 20% 100%

Determine the average cost per thousand sq meter of for the following two jobs, according the ABC system:

(i) A routine 1000 sq meter asbestos removal job (ii) A non-routine 2000 sq meter asbestos removal job

Question 8 Company H makes type-two widgets. The standard price of raw materials per kg is $3.90, and the budgeted materials cost for the originally expected level of production of 100 units was £1,560. In fact both production volume and input price per kilogram rose by 10%. If the flexible budget variance was £77 unfavourable, then how much of this was attributable to price increases, and how much to the inefficiency?

TURN OVER

LMBB 7D67 4

Question 9 Linn, an audio products manufacturer, has been approached by a small components supplier offering to supply a component for its loudspeakers at £33.50 each. Linn currently produces the component, along with others, in an automated plant. Production costs for 10,000 units of the component are as follows:

Direct materials £300,000 Factory overhead

Indirect labour £80,000 Supplies 30,000 Other 40,000 150,000

Total cost £450,000

If Linn discontinued its production of the component, it would save two-thirds of the supplies cost and £30,000 of indirect labour costs. All other overhead costs would continue. Considering only issues of opportunity cost, should Linn outsource the component?

Question 10 The total factory overhead costs of a manufacturing company fluctuate considerably from year to year in relation to the level of direct-labour hours worked in the factory. Total factory overhead cost at high and low levels of activity for recent years are as given below: Level of Activity Low high Direct labour hours 50,000 75,000 Total factory overhead costs 14,250,000 17,625,000 The factory overhead costs above consist of indirect materials, rent and maintenance. According to company analysis these costs at the low level of activity are as follows: Indirect materials (V) 5,000,000 (V) = Variable Rent (F) 6,000,000 (F) = Fixed Maintenance (M) 3,250,000 (M) = Mixed Total factory overhead costs 14,250,000

To have data available for planning, the company wants to break down the maintenance cost into its variable and fixed cost elements (a) Estimate how much of the factory overhead cost at the high level of activity consists of maintenance costs. (b) What is the amount of the fixed element of maintenance cost, and what is the

variable cost per direct labour hour.

LAST PAGE

LMBB 7D67

5

Variable Costs per unit

Direct materials 1,800 Contribution per unit 2,700

2,240,000

Profit margin 17.75%

Two products have the following characteristics Product A Propduct B

Revenue per unit 6.00£ 7.50£

Contribution per direct labour hour 20 15

Total revenue = units * per unit revenue 300

SQ per unit (kgs) 4.00 3.85 96.25%

Static budget variance 600.00 Unfavourable

Question 1

Income target 975,000 Fixed costs 925,000

Sub-Total 1,900,000 Add direct costs Labour 3,315,000 Add direct costs Materials 1,912,500

Sub-Total 5,227,500 =Total revenue required 7,127,500 Divide out by units 8,385 Total profit / Total revenue 13.68%

Question 2Revenue (price less rebate) 9,000

Direct labour 4,500 6,300

Fixed Costs (including adversiting campaign) 915,000 Target profit 1,325,000

Units req'd 830 Total revenue at this level 7,466,667

Question 3

Revenue per unit 6.00£ 7.50£ Direct labour hours per unit (charged at £10 per hour) 0.20 0.30

Solution 3

Direct labour cost per unit 2.00 3.00 Contribution per unit 4.00£ 4.50£

If budget£100 then 10hrs available, so maximum contri 200 Less fixed costs 150 Profit earned 50

Total production of A at this level (hrs/per unit) 50 units of production of A


Question 4 Planned Actual

SP $ per kg 5.00 5.00 SQ (units) 100 135.06

Static budget cost Flexible cost Actual costTotal cost 2,000.00 2,701.30 2,600.00

Target closing stock (next period sales * .5) 600 700 750

Sales cash collections 10,000 12,000 14,000

Balance for week 5,600 6,800 8,200

Standard invoicing capacity 400

Actual number of invoices processed 300

Traced cost per standard invoice 9.90

2 complex 4.00 Standard invoice units for the customer 12.00 Charged at the traced cost rate 118.80

Cost unused capacity charged at traced cost rate 693

(see note 1 below)

jobs

Disposal Fees 700,000


Inventory calculationsOpening stock 500 600 700 less sales 1,000 1,200 1,400 Production (Target closing stock + Sales - Opening sto 1,100 1,300 1,450

Cashflow forecastB/fwd - 5,600 12,400

Less production cost payments 4,400- 5,200- 5,800-

C/fwd 5,600 12,400 20,600

Question 6Accounting dept cost 5,000

Sustaining costs 1,040

Complex 10%Complex multiple 2

Customer required invoices 10 2 complex

Cost involved (activity costs only) 3,960 Activity driver (use capacity) 400

Traced to customer8 standard 8.00

Capacity 400 less Simple activity 270 less Complex activity 60 Gives Unused capacity in standard invoices 70

Question 7Activity Cost Pool Activity Measure Activity for the YearJob size Thousands of sq mt 800 Estimation and job setup Number of Jobs 500 Dealing with non-routine jobs Number of non-routine jobs 100 Note 1: 100 non-routine jobs included in the total of 500

Costs for the YearWages and salaries 300,000

Licensing and insurance 400,000Total Cost £ 1,400,000

AQ /unit1,560.00

Flexible budget cost

Efficiency Variance SP*(AQ-Flexed Q) 3.90 418 440 22-

Total cost 450,000

Avoidable costs of internal manufactureCost of outsourcing 33.50 335,000.00 450,000 435,000

Do outsource Do outsource Do outsource

Less cost of Rent (F) 6,000,000

Driven by difference in activity (labour hrs) 25,000 Variable maintenance costs per labour hr 35 Fixed component of maintenance therefore 1,500,000

the component are as follows:

Total Per 000 sq ftJob 1 922.50 922.50£ Job 2 7,485.00 3,742.50£

Question 8 Standard ActualSP £/kg 3.90 4.29 110%SQ/unit 4.00 3.80 Units 100.00 110.00 110%

Actual cost FBV1,716 1,793 77 Unfavourable

(Act-Std)Price Variance AQ*(AP-SP) 418 4.29 3.90 0.39 163 Unfavourable

86- Favourable77 Unfavourable

Question 9 Linn, an audio products manufacturer, has been approached by a small components supplier offering to supply a component for its loudspeakers at £33.50 each. Linn currently produces the component, along with others, in an automated plant. Production costs for 10,000 units of

Direct materials 300,000 Factory overhead

Indirect labour 80,000 Supplies 30,000 Other 40,000 150,000

If Linn discontinued its production of the component, it would save two-thirds of the supplies cost and £30,000 of indirect labour costs. All other overhead costs would continue. Other things being equal, should Linn outsource the component?

3 possible methods1 2 3

Per unit Not outsourc OutsourceDirect costs 30.00 300,000.00 300,000 335,000 Indirect labour 3.00 30,000.00 80,000 50,000 Supplies costs 2.00 20,000.00 30,000 10,000

35.00 350,000.00 40,000 40,000

Question 10Total cost at high activity 17,625,000 Less cost of indirect materials (V) 7,500,000 100

Total Maintenance costs at high activity 4,125,000

Total Maintenance costs at low activity 3,250,000 Difference in maintenance costs 875,000

4 £ per kg 3.8

Static20,000

Flex-Static 4,000

Budget Actual

1000 units 1200

5 kg/unit 5.2

Based on this information calculate all variances for cost

Flex Actual24,000 23,712

Act-Static 3,712 Static budget variance UAct-Flex 288- Flexible budget variance F

Sales volume variance U

Week 7 Session / San Francisco Bay


Operational Control Conclusions

• Conceptual– Budgeting often used to collapse to planning & control and make

operational control, strategic planning and individual performance management indistinguishable

• Organisational– Budgeting processes are not unique but need to be tailored to

specific planning and/or control purposes. If budgeting focus ison planning, develop guidelines to help managers develop/ maintain appropriate behaviour when strategy & controls clash.

• Individual– In operational control it is important A/ to distinguish controllable

from uncontrollable factors and therefore B/ to stand-over rather than under the systems in use. Whilst from an organisational perspective you might have profit responsibility, from a strategic perspective what matters most is profit conscious behaviour

(Week 6)

Decentralisation and responsibility accounting

• Hold managers responsible for factors that they can control

or• Responsibility as a

motivator even without control

• Cost centre– Service centre

• Revenue centre• Profit centre• Investment centre

Transfer pricingDefinition: Rules to allocate jointly earned revenue

among responsibility centres1. Market price (efficient if there is a market)2. Cost based prices (what is incentive to

supply?)– Marginal cost (including opportunity costs)– Full cost (determined how?)

3. Negotiated – Between divisions (gives responsibility, is “fair”)– By head office (avoids potentially wasted time)

4. Dual book accounting (not widely used)

Transfer price decision tree

• Is the supplier division a profit or investment centre with both revenue and cost responsibility?– If not the treat as a cost centre with standard or actual cost

transfer price• Else, Is the supplier division permitted to sell to

external customers?– If not, set transfer price at negotiated level between variable

cost and market price• Else, Is the supplier division operating at capacity?

– If not, set transfer price at negotiated level between variable cost and market price

• Else, Use market price as transfer priceSource: Warren, Reeve, & Fess “Financial and Managerial Accounting” (4th ed.)

What Responsibility Acc System?

CEO

Manufa

cturin

g Marketing

Admin Staff

Manufacturing Marketing

1. Standard Cost Ctr Revenue Ctr2. Standard Cost Ctr Profit Ctr3. Profit Ctr Revenue Ctr4. Profit Ctr Profit Ctr

Consequence ?

Alternatives

NB: See also Vancil (1973) What Kind of Management Control do You need?

Transfer Pricing & Organisational Design

Session 7.1

CEO

CFO Litigation Consulting

Econ Lit Energy /Regulation

Transport Pharma

Min &Metal

Chem &Plast

Gnr Service LibraryCSG PersonnelPublications Accounting Secretarial Support

SF Bay

CSG Consult. Client

Int. Billing Ext. Billing

CSGCSG

Monthly rental:$461.1 K

Usage Charge:$ 423.9 K

Log-on Charge$283 K($333 K = Act Cst)

Usage Charge:$ 349 K

- General Perception of Overcharging - Project Managers reluctant to bill for CSG in any instance

- 33 Mhz Computers instead of 66 Mhz- Initial Purchase of SUN problematic

B/E ctr Profit Ctr

- CSG actually supports all projects, onlyhesitant on corp.-wide hw/sw introductions

- Consultants constantly compare CSG tocurrent market prices

- Confusion of role of CSG

Billable Hours

Billed HoursW

riteDown Collected

HoursRealization

Rate

Usage 74.9K

Log-On 50 K

- SF BAY 1965 > 1992- Data Crunching a Core Competence- Among first to bill for services (CSG)- Competitors charge computer usage(but are able to split charges on usage type)

Q1 Disputes?• Computer services viewpoint:

– Responsibility for service stability and cost of service provision not understood by individual consultants

• Consultants viewpoint:– CS is unresponsive to their needs and they generate

‘unreasonable’ charges to clients and to consultants• Exhibit 2 (p8) shows external billing much lower than internal

– $333k written down to $283k for desk tops– Bonus based on realisation rate (p9)

• People are responding to the incentives the internal accounting systems give them

Q2 Monthly rental of desktops?

• Monthly rental charge– Charges vary according to

specification– Rates changed annually– Computer prices dropping fast and

differentials between machines have dropped considerably

– Software charged through rental but CS can only recoup 1/3 unbudgeted costs current year (p5)

– Software seems “free” to consultants

Machines monthly annual486-33 600 7,200 386-33 450 5,400 386-25 350 4,200 386-20 250 3,000

From Exhibit 1

Pricing shared services

• Allocated based on expected usage (see Table 1)

• Why is Sun usage predicted so low? (P10?)

Budgeted Actual VarianceHardware Rentals Personal computers 434,000 406,100 27,900-

Printers 55,000 55,000 - total 489,000 461,100

Usage Charges Storage on network 206,500 172,500 34,000- SUN 35,000 196,200 161,200 Laptops 21,700 41,500 19,800 Other Usage charges 23,000 13,700 9,300-

286,200 423,900 Total Revenue 775,200 885,000

Budgeted and Actual Internal Billings

Breakeven centre makes a profit

• Consultants are not passing on costs• Problems of over and under-recovery

– Ends up a small profit, but based on large variances

PC Ops Sun Storage Other TotalRevenue 406,100 196,200 172,500 110,200 885,000 Cost 762,600 45,900 52,600 861,100 Profit 356,500- 150,300 172,500 57,600 23,900

Q3 Incidentals

• Charge a flat rate of $3.50 per hour? (P7)– Costs only (?) 2.5% of revenue– Usage reasonably consistent

• Reduces visibility of cost– Systems already in place to track– Unambiguous cost attribution

• People circumventing system?

Q4 Changes?

• 1. Keep current system– Adjust rates more frequently

• 2. Make CS a profit centre– Free to sell and free to buy

• 3. Make CS a cost centre– Flat rate billing to groups as per incidentals– Groups keep surplus

Q5 Results?• Option 1

– Basic system a problem• Option 2

– Better understanding of cost for consultants• Freedom to get “best of breed” solutions if prepared to pay

– Cream off profitable areas for CS?• Not if free to price• How to price network provision?

• Option 3– Still don’t understand costs

Service Department Costing

Session 7.2.1

3 Allocation Methods

• The Direct Method does not take interdepartmental services into account.

• The Step Method does Imperfectly – Demands departmental alignment

• The Reciprocal Method (perfectly)– Method not popular because of calculation

by means of matrix algebra. – Results not substantially different from Step

Method.

A: Direct, B: Step, C: Reciprocal

Remember Week 2?

MBA FM 2 7

Two-stage allocation process• Distinguish between product cost (e.g. 101, 102,

103) and service cost (e.g. rent, property insurance, etc.) centres– Using departments as the basis of cost pools is a

common feature of full costing• Stage 1: Overheads from service centres must first

be allocated to production centres– Due to volume-related allocation bases used in stage 2

• Stage 2: Overheads now in productioncentres allocated to products

• Complicated ≠Accurate ≠Useful

MBA FM 2 8

Simple two-stage example

• 2 Service cost and 3 Production cost centres– Marketing centre has overheads of £5,000– Finance centre has overheads of £4,000

• Relationships– 20% of finance time is spent on work for marketing– 10% of marketing time is spent on work for finance– Of the remaining

time

• How to get service centre overheads into production centres?

30%

50%

20%

Marketing

50%Production C

25%Production B

25%Production A

Finance

MBA FM 2 9

1. Direct method

Marketing Finance

Production A Prod. B Prod. C

£5,000 £4,000

1000+1000 2500+1000 1500+2000

20% A50% B30% C

25% A25% B50% C

Products


1

2

Percentage of Marketing department time spent on work for individual production departments

Allocation of Marketing overheads Would also includeproduction overheads

Allocation of Finance overheads

MBA FM 2 10

2. Sequential/Step down method

Marketing Finance


£5,000+800 £4,000-800

1160+800 2900+800 1740+1600

20% A50% B30% C


Products


1

2

Finance costs allocated to marketing first

MBA FM 2 11

3. Reciprocal method

Marketing Finance


5067 3933

1013.4+983.25 2533.5+983.25 1520.1+1966.5

10% Finance20% A50% B30% C

Products



1

2

MBA FM 2 12

Workings• [fin]=4000+.1[mar] • [mar]=5000+.2[fin]• [fin]=4000+.1(5000+.2[fin])• [fin]=4000+500+.02[fin]• .98[fin]=4500• [fin]=4592• [mar]=5000+.2(4592)• [mar]=5918

• Formulate as simultaneous equations to find “complete reciprocated costs”

• Results in “artificial costs”– Always higher than actual

costs• Pro rata back down to

original level– [4592]/[4592+5918]=43.7%

• Finance=43.7% of 9000– £3,933

• Marketing=56.3% of 9000– £5,067

MBA FM 2 13

• Methods are progressively more complicated• Look backwards towards “true” cost

– Banker, R., G. Potter, et al. (1994). “An empirical analysis of manufacturing overhead cost drivers.”Journal of Accounting and Economics 19: 115-137.

• Look forwards to cost management– Activity Based Costing required

Cost/benefit of approachesDirect Step-down Reciprocal

Prod. Dept. A 2000 1960 1,997 Prod. Dept. B 3500 3700 3,517 Prod. Dept. C 3500 3340 3,487

9000 9000 9,000

Is there ever a case for full costing ?

The Simple Approach

Direct Method

Service Department(Cafeteria)

Service Department(Custodial)

ProductionDepartment(Machining)

ProductionDepartment(Assembly)

Cost of servicesbetween servicedepartments areignored and all

costs areallocated directly

to userdepartments.

Costsignored

The Most Common Approach

Step Method





Service departmentcosts are allocated

to productiondepartments

- and hierarchicallyto other servicedepartments

The Complex Approach

Reciprocal Method





Interdepartmentalservices are given

full recognitionrather than partialrecognition as withthe step method.

Service Department Costing

1. Trace Direct Costs and Allocate Overhead Costs to Departments

2. Allocate Service Department Costs to Production Departments

3. Allocate Production Department Costs to Products

(Full Costing) in three steps

Costs, fixed within period

Volume dependent costs

plant managementbuilding and groundheating and lighting

facilitysustaining

process engineeringproduct specificationsengineering change noticesproduct enhancement

productsustaining

setupsmaterial movementspurchase ordersinspections

direct labourmaterialsmachine costsenergy

batchlevel

unitlevel

Transactiondependent

costs

Service Department Costing Focus

Tracing Factors

Machinerelatedcosts

Laborrelatedcosts

Occupancyrelatedcosts

Servicerelatedcosts

A cost driver is thefactor that causes or “drives”

an activity’s costs.

Selection Criteria

ReasonablenessCausal Relation Benefits received

Dual Cost Allocation

• Fixed Costs – Definition– Those costs that do not change with the

number of services provided

• Variable Costs – Definition– Fixed rate per unit of service provided

Fixed & Variable

Dual Cost Allocation

• Fixed Costs– Long run average– Peak consumption

• Variable Costs– B.rate x budgeted activity (begin)

– B.rate x actual activity (end)

Capacity & Charge

Activity Approach

• Consumption of shared services is made visible in terms of activities.

• Efficiency of shared services is made visible (internal market).

Relevance

San Francisco Bay revisited

40 Years of Struggle

CostingApproaches

KPISystems

Matrix StructuralApproaches

San FranciscoBay Case

Responsibility CentreAccounting

Managing the Business Model

Matrix Organisation Argument

• Functional specialization is good for driving efficiency– Focus

• Product organizations is good for driving effectiveness– Entrepreneurial Culture

• Why not combine the two ?

Source: Vancil (1973) What Kind of Management Control do you need?

Costing Approaches Structural Approaches Systems Approaches

40 Years of Struggle1950s 1970s 1990s

Matrix Organisation:

- Efficiency

- Effectiveness

- Users of functional skillscharged w attractive results

Balanced Scorecard:

- Strategy

- Financial Measures

- Non-financial Measures

Text Reference

Cost Allocation:

- Direct Method

- Step by Step Method

- Reciprocal Method

:

Jacobs, Marshall & Smith: An alternative method for allocatingservice department costs

Text Reference:

Vancil: What kind of Management Control do you need ?

Text Reference:

Kaplan & Norton: Using the Balanced Scorecard as a Strategic Management System

Strategy & Management Control

Source: Simons, R. (2000): Performance Measurement & Control Systems for Implementing Strategy.

BusinessStrategy:

risks to beavoided core values

critical performance variables

strategicuncertainties

…as “Position” …as “Perspective”

…as “Plan” …as “Patterns in action”

Staking

out th

e

Territory

ObtainingCommitment

Getting thejob done Expe

riment

ing

& Learn

ing

Control Systems TaxonomyBoundarySystems

BeliefSystems

DiagnosticSystems

InteractiveSystems

BusinessStrategy

mission, purpose, core values

budgets,‘rules of the game’, unacceptable risks

background monitoring systems

focus on key strategic uncertainties

Source: Simons, R. (2000): Performance Measurement & Control Systems for Implementing Strategy.

Characteristics of control leversPotential Organisational

BlocksManagerial Solution

To contribute Uncertainty about purpose

To do right

To achieve

To create

Pressure or temptation

Lack of focus or resources

Lack of opportunity or fear of risk

Open organisational dialogue to encourage learning

Build and support clear targets

Specify and enforce rules of the game

Communicate core values and mission

Control Lever

Belief systems

Boundary systems

Diagnostic control systems

Interactive control systems

The Balanced Scorecard

Session 7.2.2

Systems Argument• The insight from our work with hundreds of

organisations is that organisations should not search for the perfect structure for their strategy. Instead, they should choose a structure that is reasonable and seems to work without major conflicts, and then design a customized, cascade system of linked Strategy Maps and Balanced Scorecards to tune the structure – the corporation and its collection of centralized functions and decentralized product groups and geographical units – to the strategy

Quote Source: Kaplan & Norton (2006) Alignment – P.38

design a customized, cascade system of linked Strategy Maps and Balanced Scorecards

Structure

Strategy

Budget

Strategyand

Vision

BusinessPlanning

PersonalIncentives

Feedbackand

Learning

Source: Based on Kaplan & Norton, 1996 – P.192 & Kaplan & Norton, 2001 – P.24

From a Management Control System– Designed around a Short-Term, Control-Oriented Financial Framework

1. Vision and Strategy Not Actionable

2. Strategy Notlinked to Departm. Team &Individual Goals

3. Strategy Not Linked to Resource Allocation

3. Feedback that is Tactical, Not Strategic

Source: Based on Kaplan & Norton (1996) – P. 201, 225, 253, 274 & Kaplan & Norton, 2001 – P.24

To a Strategic Management System- Designed around a Longer-Term Strategic View

BalancedScorecard

Clarifying and translating the

vision and strategy

BusinessPlanning

Communicating and

Linking

StrategicFeedback and

Learning

• Stretch targets are established and accepted• Strategic Initiatives are clearly defined• Investments are determined by the strategy• Annual budgets are linked to long-range plans

• Feedback system used to test thehypotheses on which strategy isbased

• Team problem solving• Strategy development is a continuous process

• The strategy is the reference point forthe entire management process

• The shared vision is the foundation forstrategic learning

• Goal alignment exists from topto bottom

• Education and open communicationabout strategy are basis for employee empowerment

• Compensation is linked to strategy

Source: Kaplan, R. & Norton, D. (1992): The Balanced Scorecard – Measures that Drive Performance. Harvard Business Review

GOALS MEASURES

GOALS MEASURES GOALS MEASURES

GOALS MEASURES

Financial Perspective

Customer Perspective Int. Business Perspective

& Learning PerspectiveInnovation

How do customerssee us ?

How do we lookto shareholders ?

What must we excel at ?

Can we continue toimprove and create value ?


Translating Strategy into Action

Quality of service

Process Reliability

Customer Loyalty

Market Share

Infrastructure

Competences / Will to act

Learning Perspective

Customer Perspective- Satisfaction- Retention- Acquisition

Process Perspective- Quality & Scrap- Supplier Lead Times- Cost Reduction

- People- Procedures- Technology

Financial Perspective- Profitability- Liquidity- Solvency

No of Innovations

Solvency

Lagging Measures Leading Measures

BSC for Service Departments• When constructing a support unit Strategy Map and BSC, it

is useful to think of the support unit as a ‘business within business’

– Customer Perspective• Corporate Management• Business Units

– The Financial Perspective• Support Unit Efficiency & Effectiveness

– Internal Process Perspective• Operational Excellence• Relationship with internal customers• Providing customers with new capabilities

– Learning & Growth• Specific staff needs for training, technology and supportive climate

Source: Kaplan & Norton (2006) Alignment – P.138

Ways to use the Balanced Scorecard

Key question

Notion of Balance Use Design

Information system ’What

happens?’

Varied information

picture

Background to

management discussions

Correct and reliable

information

Performance management system

‘What should be achieved?’

Balanced between targets

Performance in specified

areas

Relevant and timely

information

Strategic management system

‘How does the business

look?’

Balance between activities

Relations between

elements of the firm

Connections; value

propositions

Responsibility Centre Accounting• Conceptual

– The link between organisational responsibility structure and internal pricing approaches is decisive for the extent to which and the ways in which facility sustaining costs are controlled.

• Organisational– Whilst there is no case for full costing in a product related

context, there is a case for full costing (service department costing) when the goal is to support cost conscious behaviour.

• Individual– The major challenge in responsibility centre accounting is to

create interdepartmental fairness and goal congruence in relation to the business model as seen by the customer.

(Week 7)

Week 8 Session 8.1

Review & Design of Management Control Systems


The Balanced Scorecard Picture

“To succeed financially, how should we appear to our share-holders?”

FINANCIALObjectives Measures Targets Initiatives

“to achieve our vision, how will we sustain our ability to change and improve?”

LEARNING AND GROWTH

Objectives Measures Targets Initiatives

“To satisfy our shareholders and custo-mers, what business processes must we excel at?”

INTERNAL BUSINESS PROCESS


“To achieve our vision, how should we appear to our customers?”

CUSTOMER


Vision and Strategy

ABB’s early Balanced Scorecard

• T50 strategy: reduce all times by 50%• 5 perspectives:

– Financial perspective– Customer perspective– Supplier perspective– Process perspective– Innovation and learning perspective

Innovation and developmentMeasure Method Goal Actual %

Process innovation # suggestions 133 98 87%New products # products 12 10 83%Empow erment 100% 50% 50%Flexibility Hours in other unit 30% 22% 73%Competency development Hours /person 40 30 75%

74%

Customer relationsMeasure Method Goal Actual %

Satisfaction Questionnaire 100 p 90 p 90%On time delivery # on time delive. 100% 75% 75%Quality Questionnaire 100 p 87 p 87%Hit rate - offers Orders/offers 70% 70% 100%Market share 60% 45% 75%

85%

Financial resultsMeasure Method Goal Actual %

Volume Orders 500 MSEK550MSEK 110%Margin Accouting 20% 18% 90%Net result Accounting 45 MSEK 40 MSEK 89%Operating result Accounting 40 MSEK 35 MSEK 88%ROCE Accounting 35% 33% 94%

94%

ProcessesMeasure Method Goal Actual %

Throughput time Order-delivery 7 days 5 days 71%WIP Reduction of WIP 10 MSEK 6 MSEK 60%Quality First time right 100% 75% 75%Productivity Units/day 500 400 80%On time delivery # on time delive. 100% 78% 78%

73%

Supplier relationsMeasure Method Goal Actual %

Throughput time Order-delivery 7days 5 days 71%On-time delivery Deliveries on time 100% 80% 80%Product quality % without errors 100% 80% 80%Supplier cooperation Points 100 p 60 p 60%

73%

ABB’s Measures


1996 20011992

The Balanced Scorecard –Measures That Drive Performance

The Balanced Scorecard –Measures That Drive Performance

HBR

“The process of building a Balanced Scorecard clarifies the strategic objectives and identifies the critical few drivers of the strategic objectives”

P.12

2004 2006

Packaged Deliverables ?1992 1996

2001 2006

Strategy Map

• Visualisation of the connections in the firm’s strategy– sets of strategic focus areas which identify the

paths to the strategy– a set of linkages within each strategic focus

areas that connect between the four perspectives

– hypothetical causal links between leading and lagging elements

Internal Process PerspectiveInternal Process Perspective

Learning & Growth PerspectiveLearning & Growth Perspective

Customer PerspectiveCustomer Perspective

Price Quality Time Function Image Relation-ship

Value Proposition

+ +

“Build the Brand”

“Make the Sale”

“Deliver the Product”

“Service Exceptionally

”

Financial PerspectiveReturn on Investment

Sources of Growth Sources of Productivity

Revenue Strategy

Productivity Strategy

1. The economic model of key levers driving financial performance

2. The value proposition of target customers

3. The value chain of core business processes

4. The critical enablers of performance improvement, change and learningStaff

CompetenciesTechnology

InfrastructureClimate for

Action

Strategy Mapping

A Telecom CorporationVision Strategic Objectives Value Drivers Parameters (KPI)

The XXXX vision

We want to earn our customers’ lifetime loyalty by offering the best customer experience and value for money.

4. Have dedicated, enthusiastic and proud employees

Best in Class Customer Service – The best possible service at the most competitive prices

Cost-Conscious Organization

Marketing & Sales excellence – The best possible service at the most competitive prices

2. Achieve best in class customer satisfaction and loyalty

3. Achieve solid financial results

1. Deliver excellence in sales

Employee satisfaction & commitment

Net Revenue

EBITDA

Service Level in Customer Care

Market shares

Customer churn rates

Number of FTE

Share of women in higher management

Cross Selling / Product bundling (TBD)

Free Cash Flow (ONWC)

Customer Satisfaction

CapEx // CapEX in % of Net Revenue

Acquisition / Retention costs

Customer Care Complaint Rate

Average revenue per user

Activation of Sites (GSM/UMTS/EDGE)

Lea r

nin g

Fina

n cia

lC

usto

mer

Inte

rnal

Pro

cess

Be more proactive

Establish a stable and broadly based growth of revenue by proactive offer financial solutions that creates superior value

Attract and develop core competencies

Build a customer focused organisation

Attract, develop and retain highly motivated, competent and empowered employees

Limited and controlled risk

exposure

Allocate capital reflecting risks as well

as economic and strategic goals

Develop an empowering leadership

Improve operational efficiency

“Provide me with seamless services and easy

accessibility”

“Provide me with a broad set of innovative

financial solutions”

“Provide me with competitive advisory

services”

Improve market position and reputation

Excel in development and delivery of

financial solutions

Provide highly ranked e-based financial

solutions

Increase share of wallet

Understand customers and anticipate their

needs

Attract and expand high value

customer base

Work actively with our capital by optimising financial structure and risk taking thereby lowering cost of

capital

Deliver promised merger

synergies

Ensure operational excellence in all processes by using benchmarking and best

practice

Deliver economic profit in line with the best among our peer group

Understand opportunities of

technology

Create shareholder Value

Unify processes by implement best

practice

A Bank strategy map

Quality Assurance of Strategy

• BSC connects strategy, critical success factors, targets and measurements

• BSC shows the story about the firm’s strategy

• BSC is a communication device• Strategy is to be formulated so that it can be

translated to measurements• Strategy has to cover SMART perspectives

Important Design Questions

• Where do we want ?– Tight control / Loose control

– Single-Loop/Double-Loop Learning• What is the amount of discretion ?• What is the degree of influence ?• What uncertainties could influence ?

• Should action/improvement be driven:– Top/Down / Bottom Up ?

The Strategy-focused Organisation

1. Translate the strategy to operational terms

2. Align the organization to strategy

3. Make the strategy everyone’s everyday job

4. Make strategy a continual process

5. Mobilize change through executive leadership

5 Key Principles

Source: Kaplan & Norton (2001/2004)

Mobilising a Balanced Scorecard

“… a properly constructed Balanced Scorecard should tell the story of thebusiness unit’s strategy. It should identify and make explicit the sequence

of hypotheses about cause & effect relationships” (Kaplan & Norton, 1997)

Financial view

Customerview

Operationalview

Developmentview

BSCTechnique

1

2

3

4Customer Perspective

Process Perspective


- Satisfaction- Retention- Acquisition

- Quality & Scrap- Supplier Lead Times- Cost Reduction



Performance Management

• Plot

• Hope

• Risks

• Reason

- As construction of “BECAUSES”

Classical Story-TellingProperties

Novo Nordisk BSC in 2004

Establish strong position in XXX marketRealise full potential of XXX indicationsAchieve superior customer satisfaction & company reputationEnsure sound environmental, social and bioethical performanceImprove our collaboration with key stakeholders in diabetes care worldwide

Customers & Society Finance

Realise growth in Operating ProfitEnsure competitive ROICImprove Operating MarginEnsure competitive Cash to Earnings Ratio

Business Processes People & Organisation

Ensure execution and completion of XXX and XX trials on timeLaunch XXX successfullyImprove quality management focus in all business processesImprove high level risk management focusEnsure successful implementation of IT projects

Improve customer relationsEnhance winning cultureAttract and retain the bestEnsure development of peopleEmbed social responsibility

Why is BSC Challenging?

1. Simplicity is deceptive. The BSC has no object, and challenges corporations to think about premises for coordination and delegation !

2. The BSC narrative is about rolling out a project, not about how to make it work in practice.

3. Increasingly dependent on Information Technology, but who is in charge of the information model ?

4. Combination of Graphical visualizations & narratives portray management in strategic roles.

A recent US survey(Management Accounting Quarterly, summer 2003)

"In this survey, balanced scorecard users consistently report higher agreement about having the information necessary for selecting the best decisions than do nonusers. In addition, respondents perceive this information is strategically focused and helps them make decisions regarding performance objectives. But the respondents also indicate that their performance measurement system includes more measures on average than nonusers report. In light of the information overload problem, how can individuals indicate higher volumes of information and not experience overload? The answer to this question lies in the consistency of the information they receive".

A Scandinavian Consulting Firm: - Profitability per employee

Week 8 / Session 8.2 EVA & ROA


Smith-Kline Beecham

Management Teams

Project Teams

Phase 1 Phase 2 Phase 3

Guidance Calibration Decision Making

Options Evaluations Refinements

Allocate Resources

GenerateAlternatives

Value Alternatives

Source: Sharpe & Keelin (1998): How Smith-Kline Beecham makes better resource allocation decisions

- Linking Calculations & Decision Making

Formulas for Profitability Calculations• Return on Assets

– Profits / Asset• Return of Capital Employed

– Profits / Interest bearing liabilities• Return on Equity

– Profit / Equity• Economic Value Added

– Profit – r*Asset

Origins of EVA

• RI did not appear in the accounting literature before the 1960s:– GE did not ‘invent’ RI. However, they were among the

first to use it to compensate for dysfunctional behavior.– GE also were among the first to abandon RI again because

ROI was more consistent with the financial reporting to shareholders.

Source: Kaplan & Johnsonn - Relevance Lost, 1987

Residual Income by General Electric

EVA

72

Sales

2,406

Costs

2,047

Fixed Assets

467

Working Assets

253

Net Contribution

359

Tax

96

Net Opr. Assets

562

Goodwill

1,502

NOPAT

263

Investors’ Funds

1964

Cap. Charge

191

W.A.C.C.

9.72%

-

+

-

+

-

x

Other Items

158

Tax/Oth. Liabilities

100

--

Economic Value Added

EVA: The WACC

W.A.C.C.

(x) %After tax cstof dbt capital x Market value

of debt + Cst of eq.capital x Market value

of equity=

Market value of debt + Market value

of equity

W.A.C.C.

9.72 % = (.063) x

($40.000.000)

+ (12%) x

($60.000.000)+

($40.000.000) ($60.000.000)

EVA: Cost of Equity Capital

• No explicit agreement to pay common shareholders any particular rate.

• Implicit rate of return required in order to attract and maintain investors.

= “Risk-Free Rate” + Equity Risk Premium

• Risk Free Rate = Interest Rate + Exp. Inflation• Risk Premium = Beta – Risk Free Rate

(Beta = Expected Return on Market)

CAPM Assumption

EVA™

• Over 120 Adjustments in principle• About 10-15 in practice

1. Is the required information relatively easy to track and derive?

2. Can the operating people really grasp it?3. Can the managers influence to outcome?4. Is it likely to have a material impact?

Does EVA give better information?

• A study of 325 firms from Standard & Poor’s 500 and the Business Week 1000 found that their stock returns have a higher association to RI & ROI than to EVA.

• An econometric study of stock returns for 773 firms from the Business Week 1000 (1988 data) found that EVA added only marginally to the information content of accounting earnings.

Source: Does EVA beat earnings ? Evidence on associations with Stock Return & Firm Values. Journal of Accounting & Economics, 1997 – Pp.301-336

Some calculations of economic value

Revenues 1000

EBITDA 100

Profits (after interest) 80

Assets 500

Interest bearing liabilities 400

Equity 250

RoA 100 / 500 = 20%

ROCE 100 / 400 = 25%

RoE 80 / 250 = 32%

EVA 100 – 5%*500 = 75

Economic Value Added vs Return on Assets

Profits = 100; Assets = 500; r% = 5%

ROA = Profits / Assets = 100 / 500 = 20% EVA = Profits – r% * Assets = 100 – 25 = £75

∆P = 10; ∆A = 100

New ROA = 110 / 600 = 18%New EVA = 110 – 30 = £80

Return on Investment, by Dupont Powder Company

• Dupont Powder Company 1919– Measure internal efficiency of capital

across three departments– Created the DuPont ROI Formula

• Not a ‘run by the numbers’ company– ROI Formula only for top management, as

they alone assumed responsibility for investment and allocation decisions

Source: Kaplan & Johnsonn - Relevance Lost, 1987

Sales

Return on Assets

Selling exp

Adm exp

Cash

A.Receive.

Inventory

W.Assets

O.Assets

COGS

Opr.exp

Current Assets

N-Current Assets

+

-Net OprIncome

Sales

Avg TtlAssets

/

/

Sales

Profit

Turnover

ROI/A x

Dupont’s 5 Reasons for ROI1. Create a complete absence of narratives

2. Focus on the ease at which the entire management group can be held to one item

3. Define rules that more or less rigidly govern the assembly of data

4. Maintain strict adherence to format until such times where it becomes clear that a change would substantially improve the presentation

5. Make sure to leave the decision to the executive committee

Source: T.C. Davis. 1950

Alignment1. Enterprise Value Proposition

• The corporate office defines strategic guidelines to shape strategies at lower levels of the organisation

2. Board & Shareholder Alignment• The corporation’s board of directors reviews, approves and monitors the corporate

strategy3. Corporate Office to Corporate Support Unit

• The corporate strategy is translated into those corporate policies that will be administered by corporate support units

4. Corporate office to business units• The strategic priorities of the business units are incorporated in the strategies of the

functional support units5. Business units to support units

• The strategic priorities of the business units are incorporated in the strategies of the functional support units

6. Business units to customers• The priorities of the customer value proposition are communicated to targeted

customers and reflected in specific customer feedback and measures7. Business support units to suppliers and other external partners

• The shared priorities for suppliers, outsourcers, and alliance partners are reflected in business unit strategies.

8. Corporate support• The strategies of the local business support units reflect the priorities of the corporate

support unit.

Measure

ShareholderValue Added

Total Shareholder

Return

LeadingIndicatorsof Value

Management Control Systems Design

People Level

ExceedPeer or

Market Index

ExceedInvestor

Expectations

SupportSVA

Achievement

Frontline employeesand managers

Operating UnitExecutives

Corporate Executives

Top/Floor Performance Management

[email protected] 32


“… a properly constructed Balanced Scorecard should tell the story of thebusiness unit’s strategy. It should identify and make explicit the sequence

of hypotheses about cause & effect relationships” (Kaplan & Norton, 1997)

How should we appear to our shareholders ?

How should we look to our customers ?

What processes must we excel at ?

How do we sustain our ability to improve

or change ?

Vision &Strategy

1

2

3

4Customer Perspective

Process Perspective


- Satisfaction- Retention- Acquisition

- Quality & Scrap- Supplier Lead Times- Cost Reduction



Total Shareholder Return

Dividend + (closing share price – opening share price)

Opening Share Price

Below Cost of Capital Exceeds Cost of Capital

PositiveGrowth

NegativeGrowth

Limit Value

CreateValue

ReleaseValue

Destroy Value

RealAssetGrowth

Net Return

Asset Management

SBU

SBU

SBU

SBU

HQ

Sources of Enterprise-Derived Value

Source: Kaplan, R.S & Norton, D.P (2005): Creating Value from Organizational Alignment. HBR. Nov-Dec – Pp.3 - 10

• internal capital management – create synergythrough effective management of int capital

• corporate brand management – integrate a diverse set of businesses around a single brand, promotingcommon values or themes

• cross selling – create value by cross-selling a broad range ofproducts/services from the different business units

• common customer value proposition – create a consistent buyingexperience, conforming to corporate standards at multiple outlets

• shared services – create economies of scale by sharing the systems, facilities, and personnel of critical support processes

• value chain integration – create value by integrating contiguous processes in the industry value chain

Financial Synergies

How can we increase the shareholder value of the SBUs in our portfolio ?

Customer Synergies

How can we share the customer interface to increase total customervalue ?

Internal Process Synergy

How can we coordinate the processes in our SBUs to achieve economies of scale or value chain integration ?

Learn. & Growth Synergy

How do we develop and share our intangible assets ?

• leveraging intangible assets – share competencies involving thedevelopment of human, information, and organizational capital;manage internal labor market

Enterprise Scorecard

ROA/E

How would the choice of ROA/E affect WFO’s design of a strategy map?

Strategy Map – Wells Fargo Online Bank

Misalignment is when….

chief knowledge officer oversees knowledge sharing

corporate communications unit disseminates information

top executives conduct monthly management reviews

Q1 Q2 Q3 Q4

Strategy update: CEO & Executive Team clarify vision

CFO oversees budgeting

Line-of-business and support-unitleaders conduct strategy planning

HR coordinates personal goal setting,Incentives, and personal development

Senior executiveshave no consistent way

to describe strategy

2/3 of HR & ITorganizations are

not aligned with strategy60% of

companies do not linkbudgets to strategy

95% of theworkforce does notunderstand strategy

The vast majority ofexecutive teams spendless than one hour pr

month discussing strategy

70% ofmiddle managers do not

have strategy-linkedincentive-pay

Source: Kaplan, R.S & Norton, D.P (2005): The Office of Strategy Management. HBR. October – Pp.2-11

SF Bay BSC Exercise

Week 8

In order to improve coordination and eliminate internal inefficiencies, the aim is to align control systems with the business model that customers perceive

Financial SynergiesMajor revenues are to be pursued predominantly from [certain types of] services / [certain type of] projects / [certain types of] clients that match current capabilities

Customer SynergiesCustomers buy - and pay through the fee structure of service professionals for - an overall solution involving consulting/litigation services as well as technological data crunching powered by CSG.

Int Process SynergiesA service level close to 100% is vital to the operation of all working parties at SF Bay. It is important to continue investing in new technologies (HW/SW) in pursuit of client assignments. In order to implement new technologies on a companywide basis, they must prove their stability and profitability first.

Learn & Grow SynergiesIn relation to rolling profit targets, CSG, Consulting & Litigation will together review overall overhead costs in conjunction with a review of the number and type of shared services to be offered.

Week 8: Exercise Q1 / Solution

1/ Measures (eg level of expenditure), 2/ Measurements (eg hours spend on project); 3/ what would be a realistic frequency (week, month, quarter) 4/ who should have/(share) the responsibility for updating and/or replacing the performance measure


CSG Consulting / Litigation

MEASURES


Productivity/Efficiency

NetworkService level

Training:- Technical- Business

Quality of Service:- Admin- Projects



MEASURES

Test New HW/SWcrucial to future revenues

Ext: SatisfactionInt: Referrals

Links:Revenue/StrategyProduct/Customer

Profitability

Production within technological capacity

Fine-tuning of corporate OH




MEASUREMENTS

Month 1 Month 2 Month 3 Month 4 Month 5

Opening cash balance 2,250,000 1,070,383 1,463,767 1,857,150 2,250,533 Cash receiptsSales revenue (1) 1,033,333 1,033,333 1,033,333 1,033,333 1,033,333

Cash paymentsDirect food/drink/computer (2) 433,333 433,333 433,333 433,333 433,333

Manager salary 40,000 40,000 40,000 40,000 40,000 Student wages (3) 31,200 31,200 31,200 31,200 31,200 Advertising 10,000 10,000 10,000 10,000 10,000 Gen operating exp 115,000 115,000 115,000 115,000 115,000

Interest on loan (4) 10,417 10,417 10,417 10,417 10,417

Equipment (5) 1,426,000 Initial costs 147,000

Balance for month (1,179,617) 393,383 393,383 393,383 393,383 Closing cash balance 1,070,383 1,463,767 1,857,150 2,250,533 2,643,917

Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12

2,643,917 3,037,300 3,430,683 3,824,067 4,217,450 4,610,833 5,004,217

1,033,333 1,033,333 1,033,333 1,033,333 1,033,333 1,033,333 1,033,333

433,333 433,333 433,333 433,333 433,333 433,333 433,333

40,000 40,000 40,000 40,000 40,000 40,000 40,000 31,200 31,200 31,200 31,200 31,200 31,200 31,200 10,000 10,000 10,000 10,000 10,000 10,000 10,000

115,000 115,000 115,000 115,000 115,000 115,000 115,000

10,417 10,417 10,417 10,417 10,417 10,417 10,417

393,383 393,383 393,383 393,383 393,383 393,383 393,383 3,037,300 3,430,683 3,824,067 4,217,450 4,610,833 5,004,217 5,397,600

Total for year

12,400,000

5,200,000

480,000 374,400 120,000

1,380,000

125,000

1,426,000 147,000

3,147,600

Gross Sales 40,690,234 Cash discount 622,482

Net sales 40,067,752 Cost of Sales 25,002,386

Gross margin 15,065,366 Less:

Selling expense 7,058,834 General administration 2,504,597 Depreciation 5,216,410

14,779,841

Operating income 285,525 Other income 78,113

Income before interest 363,638 Less: Interest expense 555,719

Income (Loss) 192,081-

Restaurant # 219 budget report - week 48

Budget ActualCovers 1,500 1,600 Revenue 13,563.75 13,116.00 Cost 7,120.50 6,805.50 Gross profit margin £ 6,443.25 6,310.50 Gross profit margin % 47.5% 48.1%

Actual dishes soldSoup 240Steak & Chips 480Fish & Chips 480Fish fingers 400

Variable Costs per unit

Direct materials 1,800 Contribution per unit 2,700

2,240,000


Two products have the following characteristics Product A Propduct B

Revenue per unit 6.00£ 7.50£

Contribution per direct labour hour 20 15

Total revenue = units * per unit revenue 300

SQ per unit (kgs) 4.00 3.85 96.25%

Static budget variance 600.00 Unfavourable

Question 1

Income target 975,000 Fixed costs 925,000

Sub-Total 1,900,000 Add direct costs Labour 3,315,000 Add direct costs Materials 1,912,500

Sub-Total 5,227,500 =Total revenue required 7,127,500 Divide out by units 8,385 Total profit / Total revenue 13.68%

Question 2Revenue (price less rebate) 9,000

Direct labour 4,500 6,300

Fixed Costs (including adversiting campaign) 915,000 Target profit 1,325,000

Units req'd 830 Total revenue at this level 7,466,667

Question 3

Revenue per unit 6.00£ 7.50£ Direct labour hours per unit (charged at £10 per hour) 0.20 0.30

Solution 3

Direct labour cost per unit 2.00 3.00 Contribution per unit 4.00£ 4.50£

If budget£100 then 10hrs available, so maximum contri 200 Less fixed costs 150 Profit earned 50

Total production of A at this level (hrs/per unit) 50 units of production of A


Question 4 Planned Actual

SP $ per kg 5.00 5.00 SQ (units) 100 135.06

Static budget cost Flexible cost Actual costTotal cost 2,000.00 2,701.30 2,600.00

Target closing stock (next period sales * .5) 600 700 750

Sales cash collections 10,000 12,000 14,000

Balance for week 5,600 6,800 8,200

Standard invoicing capacity 400

Actual number of invoices processed 300

Traced cost per standard invoice 9.90

2 complex 4.00 Standard invoice units for the customer 12.00 Charged at the traced cost rate 118.80

Cost unused capacity charged at traced cost rate 693

(see note 1 below)

jobs

Disposal Fees 700,000


Inventory calculationsOpening stock 500 600 700 less sales 1,000 1,200 1,400 Production (Target closing stock + Sales - Opening sto 1,100 1,300 1,450

Cashflow forecastB/fwd - 5,600 12,400

Less production cost payments 4,400- 5,200- 5,800-

C/fwd 5,600 12,400 20,600

Question 6Accounting dept cost 5,000

Sustaining costs 1,040

Complex 10%Complex multiple 2

Customer required invoices 10 2 complex

Cost involved (activity costs only) 3,960 Activity driver (use capacity) 400

Traced to customer8 standard 8.00

Capacity 400 less Simple activity 270 less Complex activity 60 Gives Unused capacity in standard invoices 70

Question 7Activity Cost Pool Activity Measure Activity for the YearJob size Thousands of sq mt 800 Estimation and job setup Number of Jobs 500 Dealing with non-routine jobs Number of non-routine jobs 100 Note 1: 100 non-routine jobs included in the total of 500

Costs for the YearWages and salaries 300,000

Licensing and insurance 400,000Total Cost £ 1,400,000

AQ /unit1,560.00

Flexible budget cost

Efficiency Variance SP*(AQ-Flexed Q) 3.90 418 440 22-

Total cost 450,000

Avoidable costs of internal manufactureCost of outsourcing 33.50 335,000.00 450,000 435,000

Do outsource Do outsource Do outsource

Less cost of Rent (F) 6,000,000

Driven by difference in activity (labour hrs) 25,000 Variable maintenance costs per labour hr 35 Fixed component of maintenance therefore 1,500,000

the component are as follows:

Total Per 000 sq ftJob 1 922.50 922.50£ Job 2 7,485.00 3,742.50£

Question 8 Standard ActualSP £/kg 3.90 4.29 110%SQ/unit 4.00 3.80 Units 100.00 110.00 110%

Actual cost FBV1,716 1,793 77 Unfavourable

(Act-Std)Price Variance AQ*(AP-SP) 418 4.29 3.90 0.39 163 Unfavourable

86- Favourable77 Unfavourable

Question 9 Linn, an audio products manufacturer, has been approached by a small components supplier offering to supply a component for its loudspeakers at £33.50 each. Linn currently produces the component, along with others, in an automated plant. Production costs for 10,000 units of

Direct materials 300,000 Factory overhead

Indirect labour 80,000 Supplies 30,000 Other 40,000 150,000

If Linn discontinued its production of the component, it would save two-thirds of the supplies cost and £30,000 of indirect labour costs. All other overhead costs would continue. Other things being equal, should Linn outsource the component?

3 possible methods1 2 3

Per unit Not outsourc OutsourceDirect costs 30.00 300,000.00 300,000 335,000 Indirect labour 3.00 30,000.00 80,000 50,000 Supplies costs 2.00 20,000.00 30,000 10,000

35.00 350,000.00 40,000 40,000

Question 10Total cost at high activity 17,625,000 Less cost of indirect materials (V) 7,500,000 100

Total Maintenance costs at high activity 4,125,000

Total Maintenance costs at low activity 3,250,000 Difference in maintenance costs 875,000

4 £ per kg 3.8

Static20,000

Flex-Static 4,000

Budget Actual

1000 units 1200

5 kg/unit 5.2

Based on this information calculate all variances for cost

Flex Actual24,000 23,712

Act-Static 3,712 Static budget variance UAct-Flex 288- Flexible budget variance F

Sales volume variance U

Compensation Can Never Work !1. Pay doesn’t motivate

2. Rewards Punish

3. Rewards rupture Relationships

4. Rewards ignore the causes behind problems

5. Rewards kill creativity

6. Rewards undermine interest

Tailor Compensation to StrategyProblem Areas

• Alignment Structure, Strategy & Systems

– HQ-Subsidiary Relationships

– Short versus Long run

– Interdivisional Relationships

– Risk Aversion vs Risk Taking

Problems vs Key Incentive Aspects

• Financial Instruments• Performance Measures• Degree of Discretion• Size & Frequency• Degree of Uniformity• Funding Method

Design

Incentives

Mobilisation

A Performance Measure Trade-Off

NarrowerMeasures

BroaderMeasures

Stock PriceFirm Wide Accounting Profits

Divisional Accounting ProfitsDepartment Profit Centre

Department Cost CentreGroup Performance

Individual Performance

Controllability

Alignment

Interdependency

• Poorer line of sight btwindividual’s actions and the performance measure

• Noisier measure of individual performance

• Less likely to create distortionary behaviour

• Incentives for cooperationare stronger, but this comes at the expense of weaker individual incentives

• Better ‘line of sight’ btwindividuals action and the individual performance measure

• Less Noisy measure of individual performance

• More likely to create distortionary behaviour

• Incentives for cooperation are weaker, but individual incentivesare stronger (less free-riding)

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