1: Traditional/Advanced costing methods

Why need to know cost/unit? 1. Value Inventory in balance sheet 2. Record costs in income statement 3. Price products 4. Make decisions on what product should be made & in what quantities

How to calculate cost/unit: Reminder: Absorption Costing Aims to determine full prod cost/unit Total Cost= Production Costs + Non-production costs Production Costs= Direct (prime) costs (e.g. materials/labour) + Indirect costs (production overheads) (e.g. rent, electricity) Uses a Cost Card Direct Materials/unit X Direct Labour/unit X Production o/head/unit X _ Full Production cost/unit X Easy to guess cost/unit of Direct Materials & Labour, harder for prod o/head as is an indirect cost. All prod o/heads must be absorbed into units of production using a suitable basis (e.g. units produced, labour hours) Need to calculate an overhead absorption rate (OAR) OAR=Production overhead/Activity Level (must be chosen) Activity level must be appropriate for business, e.g. units of production (if make only one product), machine hours (if production more machine intensive) or labour hours (if production more labour intensive) A predetermined OAR is used to smooth out seasonal fluctuations in overhead costs, and to enable costs to be calculated quickly throughout year: Pre-determined OAR=Budgeted Oheads/Budgeted Volume

Reminder: Marginal Costing Is where variable costs are charged to cost units, and fixed costs of period are written off in full against the aggregate contribution. Helps recognise cost behaviour Marginal Cost is extra cost as a result of making and selling one more unit. Contribution is difference between sales value and variable cost of sales.

ABC Costing (activity based costing):

Reasons for development of ABC: 1. Oheads used to be small in relation to other costs in traditional manufacturing & production oheads (e.g. machine depreciation) were a small proportion of overall costs. Oheads now larger proportion of total costs as manufacturing has become more machine intensive Diversity & Complexity of products has changed as the market is highly competitive

2. 3.

Calculating full production cost/unit using ABC: 1. 2. 3. 4. 5. Group the prod oheads into activities (Cost Pools) according to how they are driven. A Cost Pool is an activity which consumes resources. Identify Cost Drivers for each Cost Pool, a Cost Driver is a factor that drives the level of cost Calculate an OAR for each Cost Pool Absorb the activity costs into the product Calculate full production cost &/or profit/loss

Advantages of ABC More accurate cost/unit. And therefore pricing, sales strategy, performance management should improve Provides better insight into what drives ohead costs Recognises that not all oheads relate to production & sales volume Can be applied to all ohead costs, not just production Can be used in Service Costing, not just Product Costing

Disadvantages of ABC Limited benefit if ohead costs are primarily volume related or small proportion of final costs Must allocate all ohead costs to specific activities Can be more complex to explain to Stakeholders Costs more due to its complexity, benefits might not justify

Target Costing:
What is Target Costing? Involves setting a target cost by subtracting a desired profit from a competitive market price. Opposite of cost plus pricing Steps: 1. Estimate selling price, considering selling price of competitors and how much customers willing to pay 2. Reduce figure by firms required level of profit 3. Produce a target cost figure for designer to meet 4. Reduce costs to provide a product that meets target cost Closing the target cost gap Target Cost Gap is established in above step 4 TCG=Estimated product cost - target cost Ways to close can include: can any materials be eliminated? Cheaper Materials? Labour Savings? Key aspect is to understand which features of product are essential to customer satisfaction. Can use Value Analysis Value Analysis Otherwise known as cost/value engineering Technique in which a cos products are subjected to a systematic critical analysis by small group of specialists. Asks of a product questions like: is its cost proportionate to its value? Does it need all of its features? Etc Strategic implications can be measured in terms of components relative cost vs relative performance. 4 diff situation: 1. Component more expensive and inferior to competitor. Change might be necessary 2. Component is competitively superior. Possible price increase or promotion campaign 3. Component cheaper but inferior. Possible deemphasising that part or upgrading 4. Component cheaper and superior. Increased emphasis on part.

Implications of using Target Costing On Pricing: Considers demand, so superior to Cost-plus pricing (as long as demand estimates are accurate & costs are controlled). Also considers competitors prices & what customers willing to pay. On Cost Control: Changes overall mindset from recording costs to reducing costs, so has major positive impact. Can generate new ideas & new ways of working On Performance Management: also potentially enhanced due to above reasons Difficulties of using TC in the Service Industry Much harder to make service comparisons than product comparisons, meaning much harder to determine a market driven price New Products & Services occur much less frequently in service industry, so the equivalent of a manufacturing design team are much less common Bought materials are usually of modest significance so cant really put pressure on suppliers Major cost in service industry is Salary, so limited scope for cost reduction

Life-cycle costing:
What is LC Costing? Tracks and accumulates actual costs and revenues attributable to each product over its entire product lifecycle. So can determine the total profitability of any given product. According to Berliner & Brimson (1988) advanced manufacturing companies finding that 90% of a products LC costs are determined by decisions made early in the cycle. (e.g. product design, prototyping etc) So tightest controls must be made at design stage

5 Stages of Product life-cycle 1. 2. 3. Product Development: high level of setup costs Launch/Market Development: Extensive marketing & promotion costs Growth Stage: continuing marketing/promotion. Sales volume increases so unit costs fall (as fixed costs are absorbed over larger volumes) Maturity Stage: Profits continue to increase, as setup costs are recovered. Price competition & product differentiation will erode Decline Stage: marketing costs cut. Volumes fall so production economies will be lost. Replacement product should be under development.

4. 5.

Ways to maximise products return over life-cycle Design teams should not work in isolation from each other to ensure minimal number of components used and therefore reduce costs. Minimise Time to market. This gets you ahead of the competition, and ensures you get a head start in profits Maximise length of lifecycle. Get to market quicker, or find other uses for product or stagger launch of product in different countries. Skimming the market

Implications of using LC Costing On Pricing: Pricing decisions based on total life-cycle costs rather than just for a single period On Cost Control: helps show what costs need to be allocated to a product so that org can recover its costs. Also allows an analysis of links between business functions On Performance Management: Improved Control & Improved Reporting

Back-flush accounting:

Reminder: Traditional accounting system: Inventory is a key item. Traditional manufacturing firms hold high levels of inventory. Traditional approach is to track cost of products through sequential stages of production. Building up costing record for direct materials consumed.

Back-Flush Accounting System Offers simplified approach by getting rid of unnecessary costing records Suitable for use in just in time (JIT) environments, as hold minimal amount of stock, production is fast and efficient, and minimal finished goods held. Instead of building up costs sequentially, BFA calculates prod costs retrospectively, at end of acc period. Cost of raw-materials is allocated to a raw materials and in progress (RIP) account & labour and prod oheads are allocated straight to cost of goods sold account. At end of acc period an inventory stock take is carried out to determine closing balances of raw materials, WIP & finished goods. Closing inv values for raw materials & WIP are then back flushed into finished goods account. Closing inv for finished goods back flushed into finished goods account So there will be a significant reduction in accounting costs

Advantages of BFA Simpler, and therefore cheaper When inv levels are low or constant it yields same results as traditional costing methods

Disadvantages of BFA Only appropriate in JIT environment where there is a short production cycle and low inventory. Provides less detailed management information than traditional costing systems. Controlling production more difficult as detail and variance info is lost. Inv values included in cost of goods sold account are based on budgeted/standard figures so these have to be accurate

Throughput accounting:

Aims to make best use of a scarce resource (bottleneck) in a JIT environment Is a measure of profitability & defined as: Throughput=Sales Revenue - Direct Mat Cost Aim is to maximise measure of profitability whilst reducing operating expenses and inventory Achieved by determining what factors prevent the throughput from being higher. (e.g. limited machine hours) In short term, the best use should be made of bottleneck. (may result in idle time in non-bottleneck resources) In long term, the bottleneck should be eliminated (e.g. buying a more efficient machine) Assumptions Only totally variable cost in short term is purchase cost of raw materials bough from external suppliers Direct Labour Costs are not variable in short term. Throughput Accounting Ratio (TPAR) Where there is a bottleneck resource, performance can be measured in terms of throughput for each unit of bottleneck resource consumed 3 Ratios: 1. Throughput per factory hour=Throughput / Products time on bottleneck 2. 3. Cost per factory hour=Total fac cost / total bottlen resource time available TPAR=Throughput per factory hour / per factory hour

NB the total factory cost is the fixed production cost including labour. This may be referred to as operating expenses

Interpreting TPAR If >1 suggest throughput exceeds operating costs so product should be profitable. Priority should be given to those products with best ratio If <1 suggests throughput is insufficient to cover operating costs, resulting in a loss Difficult to apply throughput accounting concepts in the long-term, where all costs are variable, and vary with volume of production and sales.

Improving TPAR Increase sales price for each unit sold to increase throughput per unit Reduce material costs per unit Reduce total operating expenses to reduce costs per factory hour Improve productivity of bottleneck

Multi-part product decision making 1. 2. 3. 4. 5. Identify bottleneck constraint Calculate throughput per unit per product Calculate throughput per unit of bottleneck resource for each product Rank products in order of throughput per unit of bottleneck resource Allocate resources using this ranking and answer question

2: Planning with Limiting Factors

Limiting Factors Firms may face constraints on their activity such as: 1. 2. 3. Limited demand Limited skilled labour and other production resources Limited finance

Planning with 1 limiting Factor The usual objective in a question is to maximise profit. Given that fixed costs are not affected by the production decision in the short run, the approach should be to maximise contribution earned. To solve with 1 LF, use key factor analysis: 1. 2. 3. 4. 5. Identify bottleneck constraint Calculate contribution/unit for each product Calculate cont/unit of bottleneck resource for each product Rank products in order of cont/unit of bottleneck resource Allocate resources using this ranking

Planning with several limiting Factor Use linear programming to find solution (maximise contribution and/or minimise costs) 1. 2. 3. 4. 5. 6. Define the variables Define & formulate the objective (e.g. maximise cont) Formulate constraints Draw a graph identifying the feasible region Solve for the optimal production plan using iso-contribution line Answer question

Step 4 in more detail Step 4 is to represent the constraints on a graph Normally best to compute the intercepts on x & y axis (x=0 & y=0) After inserting straight lines onto graph, can work out feasible region It shows the combinations of variables which are possible given constraints In question, note the use of less than and equal to, more than... Less than and equal to is all points on line & all points below. (vice-versa for more)

Assumptions That there is a single quantifiable objective (e.g. maximise contribution) in reality there may be multiple simultaneous objectives Each product always uses same quantity of scarce resource (no learning effects) Cont/unit is constant, in reality may not be the case e.g. the selling price may have lowered Products are independent, but in reality customer may expect to buy both products together, or they may be manufactured together Scenario is in short term, so ignores fixed costs

Shadow Prices & Slack Slack is the amount by which a resource is under-utilised. It will occur when optimal point does not fall on a given resource line. It is important because unused resources can be put to another use The Shadow (dual) Price of a resource can be found by calculating the increase in value which would be created by having one additional unit of limiting resource at its additional cost. So represents the maximum premium the firm should pay for one extra unit of each constraint. Non-critical constraints will have zero shadowprice, as they already have slack.

Calculating Shadow Price 1. 2. 3. Take equations of lines that intersect at the optimal point. Add one unit to the constraint concerned, leaving the other unchanged Use simultaneous equations to derive a new optimal solution Calculate the revised optimal contribution. The increase=the shadow price

Implications of Shadow Price Can use it as a measure of maximum premium should pay for one more unit of scarce resource Should be considered carefully. Could be possible to negotiate for a lower price After a certain point there will be little point in buying more scarce resource as any non-critical constraints will become critical.

3: Pricing

Pricing important because: Makes a pivotal contribution to maximising profit Business make profit by selling goods at price higher than cost The amount they are able to sell is often determined by the price charged

Types of market structure The price that a business can charge will be determined by the market in which it operates. Perfectly Competitive market Every buyer or seller is a price taker & no participant influences the price of the product it buys or sells Zero Entry/Exit barriers It is relatively easy to enter or exit as a business Perfect Information Prices & quality of products known to all consumers and producers Companies aim to maximise profit- Firm aims to sell where marginal cost=marginal revenue Homogenous Products- Characteristics of products dont vary across suppliers

Imperfect Competition Monopoly- only one seller of a good. Can use its market power to set a profitmaximising price. Oligopoly-A few companies dominate market and are inter-dependant (i.e. must take into consideration the reaction of a competitor before changing price-e.g. major supermarkets) Monopolistic Competition Products are similar but not identical. Many producers, and many consumers but no business has total control.

3 approaches to pricing 1. 2. 3. Demand based approaches Cost based approaches Marketing Based approaches

Demand based Looks at relationship between selling cost and demand. As demand increases, price decreases. In theory it is possible to establish an optimum price (to maximise profit) There are 2 methods: Tabular & Algebraic.

Tabular approach involves breaking down price/unit into variable cost/unit and contribution/unit. Multiplying the number of units sold by the contribution/unit, then minus the fixed costs. This gives a net profit for that quantity of units. Repeat for other quantities (see pg92) Algebraic Step 1: Establish linear relationship between Price (P) and quantity demand (Q). P=a+bQ a=intercept b=gradient of line Step 2: double the gradient to find marginal revenue: MR=a-2bQ Step 3: Establish marginal cost (MC); this equals variable cost/unit Step 4: To maximise profit MC=MR, solve to find Q Step 5: Use value of Q in price equation to find optimum price

Elasticity of Demand If a business plans to change price of product, ask to what degree will demand be affected? The Price elasticity of demand measures change in demand as a result of change in price: =Change in quantity demanded as a %age of demand / Change in Price as a %age of price >1 demand=elastic, i.e. very responsive to change in price Total revenue increases when price reduced Vice-versa Price increases not recommended, price cuts recommended

<1=inelastic. Opposite of above

Cost based Cost equations derived from historical cost data. Once a cost equation is established it can be used to estimate further costs. Y=a+bx a=fixed cost per period (the intercept) b=variable cost/unit (the gradient) x=activity level (independent variable) y=total cost (fixed cost + variable cost (dependent variable))

Cost-Plus pricing This establishes selling price by first calculating the unit cost, then adding a mark-up (profit as %age of cost) or margin (profit as %age of selling price) to provide profit. More suited to businesses that either sells products in large volumes or operates in markets dominated by price. Unit cost may reflect: Full cost Production costs only Variable costs only

Profit may reflect Risk involved in product Competitors mark-up Desired profit or ROCE(return on capital employed) Type of cost used Type or product

Marketing (Customer) Based Reflects customers perceptions of benefits of purchasing the product e.g. convenience or status. Product priced to reflect these benefits. Reflects belief that greater you understand your customer, the better placed you are to price your product. (E.g. selling drink on hot beach)

NB: when asked if should increase sales and production levels, key question is: Will increased contribution (sales-variable costs) exceed any additional fixed costs? If yes-the opportunity should be pursued

Different Pricing Strategies: Cost-Plus Market Skimming Penetration pricing Complementary Product Pricing Product-Line Pricing Volume Discounting Price Discrimination Relevant Cost Pricing

Cost Plus-continued Advantages: Widely used/accepted Simple to calculate if costs known Justification for Price increases

Disadvantages: Ignores economic relationship between Price & Demand No attempt to establish Optimum price Does not guarantee profit-if sales volumes are low, fixed costs may not be recovered

Market Skimming This involves charging high prices when product first launched to maximise short-term profitability. Once market is saturated price can be reduced. Suitable conditions When Product new and different and has little direct competition When Product has short life-cycle Must create barriers of entry to dissuade competitors from entering market e.g. patent protection

Penetration pricing This is the charging of low prices when a new product is launched. Once market share achieved, prices are increased. Suitable conditions If firm wishes to increase market share If firm wants to discourage new entrants into market If demand is highly elastic & so would respond well to low prices

Complementary Product Pricing This is a product that is normally used with another. (eg razors & razor-blades) Can take 2 forms: 1. 2. The major product is priced relatively low to encourage purchase & lock consumer into subsequent purchases (eg printer cartridges) The major product is priced relatively high to create a barrier to entry & exit & to lock consumer into subsequent purchases (eg golf club/green fees)

Product-Line Pricing A product line is a range of products related to each other. Works by: Capitalising on consumer interest in a number of products in range. Making price entry point relatively low Pricing other items in range relatively high

Volume Discounting Means offering customer lower price/unit if purchase a set volume. Can take 2 forms: 1. 2. Quantity discounts-for ordering large quantities Cumulative quantity discounts-discount increases as cumulative total increases (over time)

Benefits Increased customer loyalty Attracts new customers Lower sales processing costs

Suitable conditions Sales margin is substantial allowing profits to be made even after discounting Products with a limited shelf life

Price Discrimination This is where a company sells same product at different price in different markets. Suitable conditions Seller must have some degree of monopoly power Customers can be segregated into different markets Customers cannot buy at lower price in one market, and sell at higher price in other market

Dangers A black market may develop Competitors join market and undercut Customers in higher bracket look for alternatives and so demand becomes more elastic over time.

Relevant Cost Pricing This can be used to arrive at a minimum tender price for a one-off tender or contract. Minimum price should equal total of all relevant cash flows. Suitable conditions Only suitable for one-off decision since: Fixed costs may become relevant in long term Problems estimating incremental cash flows

NB Relevant Cost Pricing will be looked at in Chapter 4

4: Make or Buy (& other short term decisions)

Short term decisions based on costing principles that are typically made by a business: Make vs. Buy Decisions Shut-Down Decisions One-off Contract Decisions Further Processing Decisions

Recap: Relevant cash flow is a future incremental cash flow. When a business is making on of the short-term decisions mentioned above it should only consider the relevant cash flows that arise as a result of the decision Future: Only future cash flows that occur as a result of decision should be considered. Sunk costs and committed costs are not relevant Incremental: Only extra cash flows that occur as a result of the decision should be considered. Fixed costs should be ignored unless there is an incremental fixed xost. Opportunity costs should be ignored Cash Flows: Only cash items are relevant to the decision. Depreciation is not relevant. Relevant cost of materials: 1. 2. 3. If out of stock, relevant cost=current purchase price If in stock & in regular use RC=current purchase price If in stock & wont be replaced, RC=opportunity cost

Relevant cost of materials: 1. 2. If cant hire more, RC=opportunity cost of diverting labour If can hire more, RC=extra cost of labour

Make Vs Buy A product should be made in-house if relevant cost of making it in-house is less than cost of buying product. If spare capacity: RC to make prod in-house=variable cost of internal manufacture + directly related fixed costs If no spare capacity: RC=variable cost of int.manuf + directly related fixed costs + opp.cost of int.manuf Other issues... Reliability of external supplier

Specialist skills (if not available in-house) Alternative use of resources (outsourcing may free up resources for other uses) Social (outsourcing may result in reduction of workforce) Legal (any contractual obligations?) Customer reaction

Shut-Down Decisions If part of business or product is unprofitable may have to be shut down. Quantifiable cost or benefit of closure RC associated with closure should be considered: Lost contribution from area being closed (RC of closure) Savings in specific fixed costs from closure (RBenefit of closure) Known penalties & other costs resulting from closure (RC of closure) Reorganisation costs (RC of closure) Additional contribution from alt use of resource (RB of closure)

If RBs are greater than RCs then closure should occur. But before a final decision is made the non-quantifiable costs should be considered: Non-quantifiable cost or benefit of closure Certain of the above values may not be known when making the decision: Penalties and other costs (e.g. redundancy costs) may not be known Reorganisation costs may not be known Additional contribution from alt use of resource may not be known The knock on impact of the shut down (customers may no-longer purchase)

One-off Contracts When a business is presented with a one-off contract it should apply relevant costing principles to establish the cash flows associated with the project. Min contract price=total of RCFs associated with the contract If contract price does not cover these cash-flows then it should be rejected

Further Processing Decisions Will be tested in context of joint products in exam Joint product recap: Joint products arise when manufacture of one product makes inevitable the manufacture of another Specific point where individual products become identifiable is known as split-off point Costs incurred before split off point are called joint costs and must be shared between joint products After split of fpoint any further processing costs are allocated directly to separate product. Basis of apportionment of joint costs to products is usually one of: o Sales value of production (market value) o Production units o Net realisable value

When deciding whether to process a product further or to sell after split off point only future incremental cash flows should be considered: Any difference in revenue and any extra costs Joint costs are sunk at this stage and thus not relevant to the decision

5: Risk & Uncertainty

Risk is the variability of possible returns. Risk & Uncertainty Distinctions Risk: a known number of possible outcomes & probability of each outcome is known Uncertainty: a known number of possible outcomes but probability of each is not known. Research techniques to reduce uncertainty Desk Research: Info collected from 2ndry sources Obtains existing data by studying other available sources Can eliminate need for extensive field work May not be up to date Quicker & cheaper than field research 3 main types of desk research: 1. Economic intelligence, info relating to the economic environment within which a company operates. It provides company with a picture of past and future trends with an indication of the companys position as a whole. 2. Market intelligence, info about a companys present or possible future markets 3. Internal Co. Data, often most neglected source

Field Research: Info collected from primary sources More expensive and time consuming than desk research More accurate and relevant 2 main types of field research: 1. Motivational research, objective to understand factors that influence why consumers do or do not buy products. Some techniques include Depth Interviewing (undertaken at length by a trained person), Group Interviewing (a group is asked to consider relevant subject), Triad Testing (which of a given 3 items do you prefer?) 2. Measurement research, objective to build on motivation research by trying to quantify the issues. Sample surveys might be given out, or point of sale enquiries, Random sampling could be used, as could quota sampling (samples designed to be representative), Panelling (sample kept for subsequent investigation)

Focus Groups: Involves small groups selected from broader population Group interviewed in informal environment by a facilitator Results are qualitative Small sample size means results may not be representative Individuals may feel under pressure from rest of group Costly and logistically complex Can now have On-Line focus groups

Other Methods: Simulation This is a modelling technique that shows the effect of more than one variable at a time, often used in capital investment appraisal. The Monte Carlo simulation method uses random numbers and probability statistics; it can include all random events that might affect the success or failure of a proposed project. It identifies key variable in a decision by assigning random numbers to each variable in proportion to their base probability of occurring. A powerful computer is then used to repeat the decision many times over to give range and levels of likely outcomes Drawbacks Not a technique for making a decision, only for obtaining more info Can be very complex Time and costs involved can outweigh outcome

Expected Values Is a weighted value of all possible outcomes, shown as: EV=sum(px) Where p=probability of each outcome X= value of each possible outcome Advantages Takes risk into account by considering probability of each outcome Info results in a single number resulting in easier decisions Calculations are relatively simple

Disadvantages Probabilities usually v subjective EV is merely a weighted average so has little meaning for a one-off project Gives no indication of possible outcomes May not correspond to any of actual outcomes

Sensitivity Analysis Takes each uncertain factor in turn and calculates the change that would be necessary in that factor before the original decision is reversed. Establishes which variables are more critical than others. Advantages No complicated theory Identifies areas which are crucial to success Disadvantages Process Best estimates for variables are made Each variable analysed in turn to see how much the original estimate can change before the original decision is reversed Estimates can then be reconsidered to assess the likelihood of the decision being wrong Max possible change often shown as a %age Assumes changes to variables can be made independently Only sees how far a variable needs to change, not the probability of it changing Does not point to correct decision

Maximax, Maximin & minimax regret Maximax Involves selecting variable that maximises the maximum pay-off achievable. The optimistic approach Maximin Involves selecting variable that maximises the minimum pay-off achievable. The pessimistic approach Minimax Involves minimising the maximum regret (opportunity loss) Risk-neutral approach

6: Budgeting 1
A budget is a quantitative plan prepared for a specific time period. (normally 1 year) Purposes: Planning: forces a business to look to the future Control: Actuals compared to budget Communication: a formal communication channel Co-ordination Evaluation: Responsibility accounting divided the org. Into budget centres each of which has a manager responsible for evaluating performance Motivation: May be used as a target to aim for Authorisation Delegation: Managers may be involved in setting the budget

Performance Hierarchy (recap) 1. 2. 3. Strategic Planning (top tier) is long term, looks at whole org. Tactical Planning (middle) is medium term, looks at department/divisional Operational Planning (lower) is v.short term, v.detailed.

Behavioural aspects of budgeting-Hopwood 1973 Management Style: Budget Constrained Style Performance Eval: Manager Evaluated on ability to achieve budget in short-term Manager will be criticised for poor results

Behavioural Aspects: Job related pressure Can result in poor working relations with colleagues Can result in manipulation of data

Management Style: Profit Conscious Style Performance Eval: Manager Evaluated on ability to reduce costs and increase profit in long-term So can exceed short-term budget if increase profit in long-term

Behavioural Aspects: Less job related pressure Better working relations with colleagues Less manipulation of data

Management Style: Non-Accounting Style Performance Eval: Manager Evaluated mainly on non-accounting performance indicators E.g. Quality & customer satisfaction

Behavioural Aspects: Similar to Profit Conscious Style but less concern for accounting info

Behavioural aspects of budgeting-Otley 1978 Otley studies in UK coal mining contradicted Hopwoods US steelworks findings. One main difference was that the UK study showed a closer link between budget-constrained style and good performance. Difficulty level of budget Targets will assist motivation and appraisal if they are at right level An Expectations budget is a budget set at current achievable levels. Unlikely to motivate managers to improve, but may give more accurate forecasts. An Aspirations budget is set at a level which exceeds the level currently achieved. May motivate managers to improve if its seen as attainable, but may have adverse results if too hard to achieve.

7: Budgeting 2
Different budgeting systems: 1. 2. 3. 4. 5. 6. Top Down vs Bottom Up Incremental Zero-based Rolling Activity Based Feed-Forward

Top Down vs Bottom Up Top Down is a budget that is set without allowing the ultimate budget holder to participate in budgeting process. Bottom Up gives the budget holder the opportunity to participate. Advantages of Bottom Up Increased motivation due to ownership Should contain better info Increases managers understanding and commitment Senior managers can concentrate on strategy

Disadvantages of Bottom Up Senior managers may resent loss of control Dysfunctional behaviour: managers may lack a strategic perspective so may not be in line with corporate objectives Bad decisions due to inexperience Slow and disputes can arise Budgetary slack: managers may set targets too low so are easy to achieve

Incremental Starts with previous periods budget or actual results and adds/subtracts an incremental amount to cover inflation and other changes. This is suitable for stable businesses where costs are not expected to change significantly. Advantages Quickest and easiest method Suitable if business is stable and historic figures are acceptable as only increment needs to be justified

Disadvantages Builds in previous problems and inefficiencies Uneconomic activities may be continued Managers may spend unnecessarily to use up budgeted expenditure

Zero-based Requires each cost element to be specifically justified, as though the activities to which the budget relates were being undertaken for the first time. Without approval the budget allowance is zero. Suitable for allocating resources in areas where spend is non essential, or public sector organisations. 4 stages 1. 2. 3. 4. Mangers should specify, for their responsibility centres, the activities that can be individually evaluated Each activity then described as a decision package. DP should state costs and revenues expected from given activity. Each DP is evaluated and ranked, usually using cost/benefit analysis Resources then allocated to various packages

Advantages Inefficient or obsolete operations can be identified and discontinued Leads to increased staff involvement Responds to changes in business environment Knowledge and understanding of cost behaviour in business increased Resources allocated efficiently and economically

Disadvantages Emphasises short-term benefits over long-term May become too rigid, and so may not be able to react to unforeseen opportunities/threats Management skills may not be present Managers may feel de-motivated due to large amount of time spent on process Ranking can be difficult when benefits are qualitative in nature

Rolling Kept continuously up to date by adding another accounting period when earliest period has expired. Suitable if accurate forecasts cannot be made or for any area of business that needs tight control. Advantages Planning and control based on more accurate budget Reduce the element of uncertainty since they concentrate on short-term Always a budget that extends into the future Forces management to reassess the budget regularly

Disadvantages More costly and time consuming than incremental May de-motivate employees if spend large amount of time budgeting Danger that the budget may become the last budget plus or minus a bit Increase in budgeting work may lead to less control of actual results

Activity Based Use of overhead costs determined using activity-based costing as a basis for preparing budgets. This creates an activity matrix that identifies the activities in each column, and the required resources in each row. Advantages Draws attention to costs of overhead activities which can be large proportion of total operating costs Recognises that its activities that drive costs. If we control the causes (drivers) then the costs should be managed Can provide useful info in a total quality management environments by relating the cost of an activity to the level of service provided

Disadvantages Considerable amount of time and effort may be needed to establish the key activities and their cost drivers May be difficult to identify clear individual responsibilities for activities

Feed-Forward Compares budgeted results against a forecast. Control action is triggered by differences between budgeted and forecasted results. Advantages Encourages managers to be proactive and deal with problems when they occur Re-forecasting on a monthly or continuous basis can save time when it comes to completing a quarterly/annual budget.

Disadvantages May be time consuming as control reports must be produced regularly May require a more sophisticated forecasting system, which could be expensive.

Selecting a suitable budgetary system Factors to determine suitability include: 1. 2. 3. 4. Type and size of organisation Type of industry Type of product and product range Culture of organisation

Information required for budgeting usually includes: 1. 2. 3. 4. 5. 6. Previous years actual results Other internal sources (e.g. training needs of staff, state of repair of fixed assets) Estimates of costs of new products Statistical techniques such as linear regression Models may be used to forecast optimal inventory External sources of information

PESTEL (recap) Political change: change in government policy Social change: changes in social responsibility change every generation Economic change: from boom to recession Technological change: as technology advance, old techniques become inefficient Legal change

Changing a budgetary system This could bring about improved planning, control and decision making. But the fllowing issues should first be considered: Is their suitably trained staff available to implement change? Will it take up management time better used focussing on strategy? All staff involved will need training in new system All costs of change should be evaluated against benefits

Dealing with uncertainty There are several techniques to help with uncertainty in budgeting: 1. 2. 3. Rolling budgets. Updated regularly so uncertainty reduced Sensitivity analysis. Variable can be changed one at a time and a large number of busgets can be produced Simulation. Similar to above, but can change more than one variable at a time

Spreadsheets in budgeting Advantages Can include large volumes of info Can use formulae and look up tables. Results can be printed out or distributed electronically Can represent data as a chart

Disadvantages May take time to develop. The benefit must outweigh the cost of developing it Data can be accidentally changed or deleted without user being aware Errors in design can produce invalid data which can be difficult to locate Security issues

8: Quantitative Analysis
Use of Judgement and experience in forecasting The quantitative models below are mainly based on past information and extrapolate the results into the future figures. Managers may have access to many sources of info (eg a competitor has recently launched a new product) that can help them judge whether the final analysis is accurate. They may forecast more than one scenario to give a most likely, a pessimistic, and an optimistic outcome. Different types: 1. 2. 3. 4. 5. High/Low Analysis Regression Analysis Time Series Analysis Average Growth Model Learning Curve Model

High/Low Analysis A method of analysing a semi-variable cost into its fixed and variable elements based on an analysis of historical information about costs at different activity levels. The fixed and variable costs can then be used to forecast the total cost at any level of activity. Step 1: Select highest and lowest activity levels, and their costs Step 2: Find variable cost/unit: (cost at high level activity-cost at low level) / (high level activity-low level) Step 3: Find fixed cost using either high or low level activity Step 4: Use variable & fixed cost to forecast the total cost for a specified level of activity Advantages Simple Easy to understand and easy to use

Disadvantages Assumes activity level is only factor affecting costs Assumes historical costs reliably predict future costs Results may be distorted as only using two values

Regression Analysis This is another method of forecasting. Uses historical data to find line of best fit between two variables (one dependant on other) and uses straight line to predict future values. Uses a scatter diagram, where the dependent variable goes on y axis, and independent variable on x. Equation of straight line is y=a+bx

a=intercept with y axis b= gradient Can use a formula (given in exam) to work out a & b without drawing scatter diagram

Correlation Coefficient Used to work out the strength of the relationship between two variables (so shows how useful regression analysis will be). The outcome will be between -1 & +1. If r is close to +1: strong positive correlation r is close to -1: strong negative correlation r is close to 0: little correlation Coefficient of determination Is r squared It shows the %age change in the dependent variable.

Time Series Analysis A time series is a series of figures relating to the changing value of a variable over time. Often creates a pattern over time, which can be extrapolated into future forecasts. Components The Trend: long term general movement of data Seasonal Variations: a regular variation around the trend over a fixed time period Cyclical Variations: economic cycle of booms or slumps Residual variations: Unpredictable, irregular, random fluctuations in data

Numerical Analysis Trend and seasonal variation will be given in exam Can be combined, using either additive or multiplicative model and used to forecast future values Additive Model: Actual=Trend = Seasonal Variation (SV expressed in absolute terms0) Multiplicative Model: Actual= Trend x Seasonal variation(SV as a %age or decimal)

Average Growth Model Strategic plans may include an average growth of profit/productivity target. 1 + g = (nth root of) (Most recent figure/Earliest figure) g=average growth rate as a decimal n= number of periods grown

Learning Curve Model As workers become more familiar with the production of a new product, average time (and average cost) per unit will decline. Will only apply for a certain range of production, will eventually reach as steady state (labour hours will no longer reduce) Wright Law states that as cumulative output doubles,, the cumulative average time per unit falls to a fixed %age (the learning rate) of the previous average time. Learning Curve calculations Method 1: set up a table and reduce the average time by the leaning rate each time output doubles Use formula y=ax (to power b) y= cumulative average time (or average cost) per unit/batch a=time (or cost) for first unit/batch b=log r/log 2 (r=rate of learning as a decimal) x=cumulative output in units/batches

Applications Pricing decisions: prices will be set too high if based on costs of first few units Work scheduling: less labour per unit will be required as more units are made Product viability: may change if learning effect exists Standard setting Budgeting Limitations Only applies if: Process is labour intensive: modern manufacturing very machine intensive. Will not apply if machines limit speed of labour. No breaks in production Product is new Product is complex Process is repetitive

9: Standard costing & basic variances

A standard cost for a product or service is a pre-determined unit cost. Standard costing is most suited to mass production organisations or ones with repetitive assembly work. A standard cost is based on expected price and usage of material, labour and overheads. The main purposes of standard costs are: Control: SC can be compared to actual cost and any differences investigated Performance Measurement: diff between SC & AC can be used a basis for assessing cost centre managers performance Value Inventories Simplify accounting

Types of Standard: Attainable Standards Based on efficient operating conditions Standard will include allowances for Idle time, waste etc Most frequently encountered type of standard Helps to motivate employees

Basic Standards Long-term standards Sole use is to show trends over time Cannot be used to highlight current efficiency May de-motivate over time, as easy to achieve

Current Standards Based on current working conditions Useful when current conditions are abnormal No attempt to motivate employees

Ideal Standards Based on perfect operating conditions No wastage or scrap etc May have adverse motivational impact as could be impossible to achieve

Flexible budgeting Fixed budget: prepared at beginning of budget period for a single level of activity Flexible budget: prepared at beginning of budget period for a number of levels of activity & requires analysis of costs between fixed and variable element Flexed budget: prepared at end of budget period. Is based on actual level of output

Revision of basic variance analysis Variance analysis is process by which total difference between standard and actual results is analysed A number of basic variance can be calculated It is important to be able to: Calculate the Variance, Explain meaning of variance calculated, and identify possible causes for each variance Once variances calculated an operating statement can be prepared Basic variances can be calculated for Sales, Material, Labour, Variable oheads & fixed oheads.

Sales Variances Total Sales variance =sales price variance + sales volume variance Price variance= Actual quantity sold x actual price Minus Actual quantity sold x standard price

Volume variance= Actual quantity sold x standard margin Minus Causes: Sales Price: Favourable (unexpected price increase): Higher than anticipated customer demand Lower demand for competitors product An improvement in quality or performance Budget quantity x standard margin

Adverse (unexpected price decrease): Lower than anticipated customer demand Higher demand for competitors product A decrease in quality or performance

Sales Volume: Favourable (unexpected demand increase): Lower price Improved quality or performance Fall in competitors quality or performance Successful marketing campaign

Adverse (unexpected demand decrease): Opposite of favourable

Material Variances Total materials variance= materials price variance + materials usage variance Price variance= Actual quantity bought x actual price Minus Actual quantity bought x standard price

Usage variance= Actual quantity used x standard price Minus Causes: Material Price: Favourable Poorer quality materials Discounts given for buying in bulk Change to a cheaper supplier Incorrect budgeting Adverse Higher quality materials Change to more expensive supplier Incorrect budgeting Standard quantity used x standard price

Material Usage: Favourable Higher quality materials More efficient use of material Incorrect budgeting Adverse Poorer quality materials Less experienced staff using more materials Incorrect budgeting

Labour Variances Total Labour variance= Labour rate variance + Labour efficiency variance Rate Variance= Actual hours x Actual rate Minus Actual hours x Standard rate

Efficiency Variance= Actual hours x Standard rate Minus Causes: Labour rate: Favourable Lower skilled staff Cut in overtime/ bonus Incorrect budgeting Adverse Higher skilled staff Increase in overtime/ bonus Incorrect budgeting Unforeseen wage increase Standard hours x Standard rate

Labour Efficiency Favourable Higher skilled staff Improved staff motivation Incorrect budgeting Adverse Lower skilled staff Fall in staff motivation Incorrect budgeting

Variable oheads variances Total variable ohead variance= VO expenditure variance + VO efficiency variance Expenditure variance= Actual hours worked x actual rate Minus Actual hours worked x standard rate

Efficiency variance= Actual hours worked x standard rate Minus Causes: VO expenditure & VO efficiency Favourable Unexpected saving in cost of service More economic use of services Incorrect budgeting Adverse Unexpected increase in cost of service Less economic use of services Incorrect budgeting Standard hours worked x standard rate

Fixed oheads variances Total fixed ohead variance= FO expenditure variance + FO efficiency variance FO efficiency variance= FO capacity variance + FO efficiency variance Expenditure variance= Actual cost Minus budgeted hours x standard rate

Efficiency variance= Actual hours x standard rate Minus Standard hours x standard rate

Capacity variance= Budgeted hours x standard rate Minus Actual hours x standard rate

Volume variance= Efficiency variance + Capacity variance

Causes: FO expenditure Favourable Decrease in price Seasonal effects Adverse Increase in price Seasonal effects

FO volume Favourable Increase in production volume Increase in demand Change is productivity of labour Adverse Decrease in production volume Decrease in demand Production lost through strikes

FO Capacity & FO efficiency Favourable Hours worked higher than budget Adverse Hours worked lower than budget

In Marginal costing the only FO variance is FO expenditure. In Absorption costing we use all of the above variances Also: Marginal costing has a slightly different operating statement, with the following changes: 1. 2. 3. A sales volume contribution variance is used instead of sales volume profit Only FO variance is expenditure Reconciliation is from budgeted to actual contribution, then FOs are deducted to arrive at a profit

Labour Idle time Idle Time Idel time occurs when employees are paid for time when they are not working. If Idle time exists an idle time labour variance should be calculated. Total Labour variance= labour rate variance + Labour efficiency variance Labour efficiency variance= productive efficiency variance + Excess idle time variance Rate Variance= Actual Hours paid x actual rate Minus Actual Hours paid x standard rate Excess Idle Time variance= Actual Idle time x standard grossed up rate Minus Standard idle time x standard grossed up rate

Productive Efficiency variable= Actual hours worked x standard grossed up rate Minus Standard hours worked x standard grossed up rate

When should a variance be investigated? Factors to consider: Size. A business may decide to only investigate variances over a certain amount. Techniques they could use include Fixed size of variance, Fixed percentage, or statistical decision rule Favourable or Adverse. Adverse variances could be considered more important Cost. The cost of the investigation must be less than the benefits Past pattern. Variance should be monitored over a number of periods to monitor any trends

10: Advanced variances

Material Mix & Yield variance These are calculated if a product uses more than one type of material, and the materials are interchangeable. Total material variance= material price variance + material usage variance Material usage variance= material mix variance + material yield variance A favourable total mix variance would suggest a higher proportion of a cheaper material is being used. An adverse total yield variance would suggest that less output has been achieved for a given input. These variances may be interrelated Changing the mix (and therefore the yield) can impact on: Cost (reducing cost of a material, may reduce the quality) Quality (can affect the price) Performance measurement

Planning and operation variance Traditional variance= planning variance + operational variance Planning and operation variance may be calculated for Sales Materials Labour

Each volume variance can be sub-divided into a planning and operational variance E.g. for Sales 1. 2. 3. Original budgeted sales x standard margin Revised budgeted sales x standard margin Actual sales quantity x standard margin

1 2 = market size variance 2 3 =market share variance In exam, when applying planning and operating principles to cost variances, flex both original and revised budgets to actual production levels.

When should a budget be revised? A change in one of main materials Unexpected increase in price of materials Change in working methods that alters expected direct labour time Unexpected change in rate of pay

Advantages/Disadvantages of revising budget Advantages Variances are more relevant Managers are more likely to be motivated Analysis helps in standard setting learning process

Disadvantages Considerable administrative work Frequent demand for budget revisions can result in bias Poor performance can be excused as being the fault of a badly set budget

Using Variance analysis Modern manufacturing environments 2 aspects of modern manufacturing management to deal with Total Quality Management (TQM) & Just in Time (JIT) TDQ Is continuous improvement in quality, productivity and effectiveness through a management approach focussing on both the process and the product Features include: Prevention of errors before they occur Importance of total quality in the design Real participation of all employees Commitment of senior management Recognition of vital role of customers and suppliers Recognition of need for continual improvement

JIT This is a system of planning and control pulling work through the system in response to customer demand. So, goods are only produced when they are needed. Key factors for successfully operating JIT: High quality Speed (rapid throughput to meet demand) Reliability (computer-aided manufacturing technology will assist) Flexibility (small batch sizes and automated techniques) Low costs

Variance analysis in modern manufacturing environment Key features of companies using JIT & TQM are: 1. 2. 3. 4. 5. High level of automation High levels of oheads and low levels of direct labour costs Customised products in small batches Low stocks Emphasis on high quality and continuous improvement

Variance analysis may not be appropriate because: Non Standard products (standard product costs only apply when products are identical) Standard costs become outdated quickly. (shorter product lifecycles in modern world means standard cost will need to be reviewed more frequently) Production is highly automated Emphasis on continuous improvement (standard costing is inconsistent with concept of continuous improvement) Detailed info is required

Standard costs and behavioural issues Standard costs are set with a view to measuring actual performance against the standard. The aims of setting standards are: Setting a target for performance Motivating mangers to achieve targets Holding managers accountable for actual performance

Factors to include when standard setting Type of standard set Individuals might respond to standards in different ways depending on difficulty of achieving the standard: Ideal Standard. When a standard level of performance is high Current Standard. When standard of performance is not high Attainable Standard. Challenges employees to improve their performance. Works for some, but not for others Basic Standard. Gives a long term target, may motivate, but may de-motivate

The level of participation in standard setting In favour of participation Could motivate employees to set higher standards for achievement Staff more likely to accept standards they have been involved in setting Morale and actual performance levels might improve Staff will understand more clearly what is expected of them

Against participation Senior management might be reluctant to share responsibility of budgeting Standard-setting process could be time consuming Staff may be inclined to set standards that are easy to achieve Could result in conflicts rather than co-operation Staff might feel their suggestions have been ignored

Use of pay as a motivator If employees are offered a bonus for achieving standard costs, this could increase their incentive to set low standards of performance.

11: Performance Management & Control

Ratio Analysis Many ratios use figures at a particular point in time, so may not be representative of the position throughout a period. Ratios are of little use in isolations. Though comparisons can be made to last years figures or competitors figures Ratios can be manipulated by management- window dressing Ratios dont give a definitive answer, just an indication of areas that need investigating Three main classes of ratios are: Profitability, Liquidity, & Risk

Profitability ratios Gross profit margin = Gross Profit / Turnover x 100 A high gross profit margin is desirable. Indicates that either sales prices are high or production costs are under control Net profit margin = Net Profit / Turnover x 100 A high net profit margin is desirable. Indicates that either sales prices are high or all costs are under control Return of cap employed (ROCE)=Net (or operating) Profit / Capital Employed x 100 Capital employed = total assets less current liabilities or total equity plus long term debt. ROCE can also be calculated as follows: ROCE= net profit margin x asset turnover ROCE is a key measure of profitability. Shows net profit generated from each $1 of assets employed. A high ROCE is desirable. Asset turnover = Turnover / Capital employed Shows turnover generated from each $1 of assets employed. A high asset turnover is desirable.

Liquidity Current ratio = current assets / current liabilities This measures a co.s ability to meet its short term liabilities as they fall due. A ratio in excess of 1 is desirable, but this varies depending on type of industry. A year-onyear decrease in this figure could indicate the co. has liquidity problems Quick ratio (acid test) = current assets-inventory / current liabilities Same as current ratio, but inventory is removed due to its poor liquidity in short term. Inventory holding period = inventory / cost of sales x 365 Indicates average number of days inventory items are held for. A decrease is desirable. An increase in this could show that the co is having problems selling it products or an increased level of obsolete stock. Receivables (debtor) collection period = receivables / turnover x 365 This is the average period it takes co.s debtors to pay what they owe. Possible checks to reduce the ratio include credit checks on customers or improved credit control. Payables (creditor) period = payables / purchases x 365 This is the average period it takes a co. to pay for its purchases. An increase could indicate that the co. Is struggling to pay its debts.

Risk Financial gearing = debt / equity x 100 Or debt / debt + equity x 100 This is the long term debt as a percentage of equity. A high level indicates that the co. relies heavily on debt to finance its long term needs. This increases the level of risk for the business. Interest cover = operating profit / finance cost (Operating profit = profit before finance charges and tax). A decrease indicates there is an increased risk of not being able to meet finance payments when due. Dividend cover = net profit / dividend A decrease indicates there is an increased risk of not being able to make dividend payments.

Issues surrounding use of performance indicators All of the above ratios have concentrated on the financial performance of the business. However, many of them can also be used to assess the performance of a division and of the managers in charge of that division. Achievement of these target ratios may be linked to a reward system to help motivate. However, there are a number of problems associated with using financial performance indicators to monitor performance: Short- termism. Managers may be tempted to make decisions that improve shortterm profitability but may have a negative impact on the long-term. Manipulation of results. E.g. Accelerating revenue- revenue included in one year may be wrongly included in previous year. Delaying costs- similar to above. Do not convey the full picture. The use of short-term financial performance indicators has limited benefit as does not convey full picture regarding long-term profitability.

Non- financial performance indicators (NFPIs) A company may choose to use a mixture of financial and non-financial PIs in order to achieve the optimum system for performance management and control. A firms success usually involves focussing on a small number of critical areas that they must excel at. These vary from business to business, but may include: having a wide range of products, having a strong brand name/image, low prices, quick delivery or customer satisfaction. Most of these are best assessed using NFPIs. The balanced scorecard This approach to performance management and control emphasises the need to provide management with a set of info which covers all relevant areas of performance. Focuses on the following four different perspectives and uses financial and non-financial indicators. 1. 2. 3. 4. Customer - What is it about the business that new/existing customers value? Internal What process must the business excel at to achieve objectives? Innovation & Learning How can the business continue to improve and add value? Financial How to create value for shareholders?

For each of the above perspectives a company should identify a series of goals and measures. Benefits Focuses on factors, including non-financial ones, which enable a company to succeed in the long-term. Provides external as well as internal information.

Problems

Election of measures can be difficult, e.g. how can a co. measure innovation? Obtaining information can be difficult Information overload due to a large number of measures being chosen Conflict between measures.

The building block model A framework for design and analysis of performance management systems based on 3 building blocks: 1. 2. 3. Dimensions - These are the goals for the business and suitable measures must be developed to measure each performance dimension. Standards - these are the measures used Rewards - To ensure employees are motivated to meet standards.

Dimensions Competitive Performance (egs of standards = market share, sales growth, customer base) Financial Performance (egs of standards = profitability, liquidity, risk) Quality of Service (egs of standards = reliability, responsiveness, competence) Flexibility (egs of standards = volume flexibility, delivery speed) Resource Utilisation (egs of standards = productivity, efficiency) Innovation (egs of standards = ability to innovate, performance of innovations)

Standards- should have the following qualities: Ownership Achievability Equity

Rewards- targets should have the following: Clarity Motivation Controllability

External Considerations Performance measures should be considered in the context of the external environment to gain a full understanding of how the business has performed. External considerations that are particularly important are: Stakeholders Stakeholders will have different objectives Market conditions These will impact business performance Competitors Actions of competitors must also be considered

12: Divisional Performance Measurement & Transfer Pricing

Types of Divisional Performance management Cost Centre Profit Centre Investment Centre

Cost Centre Division incurs costs but has no revenue stream (e.g. IT support department) Typical measures used to assess performance: Total cost & cost/unit Cost variances NFPIs related to quality, productivity & efficiency

Profit Centre Division has both costs and revenue. Manager does not have the authority to alter the level of investment in the division. Typical measures used to assess performance: All of above PLUS Total sales and market share Profit Sales variance Working capital ratios NFPIs related to productivity, quality & customer satisfaction

Investment Centre Division has both costs and revenue. Manager does have authority to invest in new assets or dispose of existing ones. Typical measures used to assess performance: All of above PLUS ROI RI These are used to assess the investment decisions made by managers. And are discussed below.

ROI (return on investment) This is similar to ROCE, but used to appraise investment decisions. ROI= (Controllable profit / Capital employed) x 100 Controllable profit is usually taken after depreciation but before tax. In exam take whatever is closest to this. Capital employed is total assets less long term liabilities OR total equity plus long term debt. In exam use net assets id cap employed not given.

Advantages Widely used and accepted Can be used to make comparisons with other divisions or companies Can be broken down into secondary ratios for more detail

Disadvantages May lead to dysfunctional decision making ROI increases with the age of the asset if NBVs are used, giving managers an incentive to hold onto outdated assets. May encourage manipulation of profit and capital employed.

RI (return on investment) =Controllable profit Notional interest on capital Controllable profit is calculated same as above NIoC = capital employed by division x notional cost of capital or interest rate Capital employed is calculated same as above Advantages Encourages managers to make new investments if they add to RI Makes managers more aware of the costs under their control Disadvantages Does not facilitate comparisons between divisions Based on accounting measures of profit and capital employed which may be subject to manipulation

Comparing divisional performance ROI & RI are common methods, but others can be used: Variance analysis Ratio analysis Other management ratios (e.g. sales per employee, or transport costs per mile) Other information (e.g. staff turnover or market share)

Transfer Pricing A transfer price is a price at which the goods or services are transferred from one division to another within same organisation. Objectives Goal congruence. Decisions should be consistent with objectives of organisation as a whole. Performance measurement. The transfer price should allow the performance of each division to be assessed fairly. Autonomy. If autonomy is maintained, managers tend to be more highly motivated. Recording movement of goods/services. Extremely important to simply record the movements.

Setting the transfer Price Method 1-Market based approach: If an external market exists the TP could be set at external market price Advantages TP deemed to be fair by managers of buying & selling divisions The companys performance will not be impacted negatively.

Disadvantages May not be an external; market price The external market price may not be stable Savings may be made from transferring the goods internally. These should be deducted from external market price before TP is set

Method 2-Cost based approach: Transferring division would supply the goods at cost + %age profit A standard cost should be used rather than an actual cost since: Actual costs do not encourage the selling division to control costs If standard cost is used then buying division will know cost in advance and can make plans Could use Full cost, Marginal (variable) cost or opportunity cost

13: Performance measurement in not-for-profit organisations

The problem of non-quantifiable objectives In the not-for-profit sector many of the benefits arising from expenditure are nonquantifiable. There is a danger that if a cost cannot be quantified, then it may be ignored. Another problem is that they do not generate revenue, but have a fixed budget for spending. Value for money often becomes an objective, but measuring value is a problem. Performance measurement i not-for-profit organisations Not-for profit organisations may have some non-quantifiable objectives but that does not exempt them from the need to plan and control their activities. E.g. a university performance measures may include: University overall Overall costs compared to budget Number of students Amount of research funding received Proportion of successful students Quality of teaching

Individual department Cost per student Cost per exam pass Staff/student ratios Students per class Number of teaching hours per member of staff

Problem of multiple objectives Multiple stakeholders in a not-for-profit organisation give rise to multiple objectives. So objectives must be prioritised. E.g. in a hospital employees will seek a high level of job satisfaction, whereas a patient wants a high level of care. Value for money A common method of assessing public sector performance is to assess value for money (VFM). This has three elements: 1. 2. 3. Economy- an input measure. About balancing the cost with the quality of resources Efficiency- here we link inputs with outputs. Focuses on the efficient use of any resources acquired Effectiveness- an output measure looking at whether objectives are being met.