Study Guide 67593o

COST MANAGEMENT SYSTEMS ACCT 2013 STUDY GUIDE Study Period 5, 2006

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© University of South Australia 2006

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CONTENTS

Page

WELCOME

5

HOW TO USE THIS STUDY GUIDE

7

TOPIC 1

PROCESS COSTING

9

TOPIC 2

T COSTING

25

TOPIC 3

PRICING & PRODUCT MIX DECISIONS

35

TOPIC 4

ACTIVITY BASED MANAGEMENT& MANAGING CUSTOMERS

39

TOPIC 5

MANAGING SUPPLIERS, INVENTORY & QUALITY

47

TOPIC 6

RESPONSIBILITY ING, DECENTRALIZATION & TRANSFER PRICING

57

TOPIC 7

FINANCIAL PERFORMANCE MEASURES & REWARD SYSTEMS

54

TOPIC 8

CONTEMPORARY APPROACHES TO MEASURING PERFORMANCE

71

TOPIC 9

CAPITAL BUDGETING

77

TOPIC 10

CAPITAL BUDGETING: SOME ADDITIONAL ISSUES

85

TOPIC 11

SOCIAL AND ENVIRONMENTAL ING

93

COURSE OVERVIEW

97

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ACCT 2013

Cost Management Systems

Introduction

WELCOME Welcome to Cost Management Systems, ACCT2013, a course that includes a mix of traditional and contemporary management ing topics. This course expands and extends upon ACCT2006, Management ing. We hope you find your studies interesting, enjoyable and useful. The aim of this course is to expand your knowledge of management ing and its application in both the private and public sectors. After increasing your knowledge of costing systems, we focus even more so on the management of costs rather than on the costing of products. In addition to teaching you about some new management ing topics, we also revise and revisit from a new perspective, the flow of costs and costing of manufacturing overhead as taught in Management ing. Therefore, it is desirable that you are confident of your knowledge in these topics, that is, the contents from your textbook of chapters 1 to 7. Understanding rather than memorising is an essential part of this course, as is being flexible in applying your knowledge. You will need to be able to adapt to varying circumstances and learn that there may be a range of alternative answers to any given situation. This Study Guide is comprised of a series of eleven topic summaries, which are the cornerstone and hub of the learning for this course. Topic summaries are very important because they provide you with an overview of what you need to learn and supplement references in your textbook. They also list the tutorial questions for each topic, and your learning should be organized around these topic summaries.

Basil Tucker

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ACCT 2013


Introduction

This course has five sections: 1. Costing Systems: Topics 1 and 2. In Management ing, namely chapter 4 of the textbook, you studied costing systems such as Job Costing; this course revisits the flow of costs and moreover it will teach you about some new costing techniques. 2. Cost Management Systems (CMS) and Strategy: Topics 3 – 5. The term Cost Management Systems only emerged approximately 15 years ago and it encomes techniques on how to better manage costs compared to the traditional cost control methods and techniques such as standard costing, budgeting, responsibility ing… This course will cover some CMS and Strategic Management ing techniques. 3. Control and Performance Evaluation: Topics 6 – 8. You would have already studied budgeting and standard costing, which are two traditional control and performance evaluation topics. In this course, we will look at two additional traditional topics, namely, Responsibility ing and Financial Performance Measures. Finally, we will introduce you to two contemporary performance evaluation techniques, that is, the Balanced Scorecard and Benchmarking. 4. Capital Budgeting: Topics 9 and 10. In this topic, we study medium and long term decision-making. This topic will contrast and complement your previous studies in short term or tactical decision-making from Management ing. 5. Social and Environmental ing: Topic 11. Finally, to conclude this course, we consider the role management ing can play in the determination of the social and environmental impacts of corporate policies and practices.

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ACCT 2013


Introduction

HOW TO USE THIS STUDY GUIDE You should: 

Study the topics, in the sequence, as outlined on page 4, of this Study Guide.



Organise your learning around the individual topic summaries in this Study Guide.

Specifically, for each topic, you should: 

Note the Objectives for the topic.



Then read the topic summary.



Next and most importantly read your textbook and any articles mentioned in the topic summary.



If you are having difficulty, then, refer to “Other Text Reading”. 

As they arise in the topic summary, attempt all of the tutorial questions for the topic. This course applies concepts and theories to



practical situations and it is essential, to be successful, that you do all



of the tutorial questions. 

Finally, refer again to the topic objectives and check that you have mastered each objective for the topic.

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Topic 1

TOPIC 1 COSTING SYSTEMS: PROCESS COSTING OBJECTIVES By the end of this topic you should be able to:  Understand the concept of process costing.  Explain when to use a process costing system.  Define the term equivalent units.  Calculate equivalent units for both FIFO and Weighted Average.  Using equivalent units, calculate the appropriate unit costs and total costs in order to determine process transfer costs and closing balances.  Enter cost flows into appropriate s, including transfer costs, opening and closing WIP inventories.  Understand how to for and record normal losses.  for and record abnormal losses using weighted average.  Explicate the concept of operations costing.  Describe when to use an operations costing system.  Calculate the cost per unit and total cost for each batch (product).  Record the cost flows for an operations costing system.

Resource: Text Reading Langfield-Smith, K; Thorne, H and Hilton, R (2006), Management ing: Information for managing and creating value. 4th edition. Sydney: McGraw Hill, Chapter 4 & Chapter 5. Resource: Other Text Reading Hansen & Mowen (2003), Management ing, 6th Edition, South-Western. Chapter 6 pages 198-210 & 215-219. Morse, Davis & Hartgraves (2003), Management ing: A Strategic Approach, 3rd

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Edition, South-Western., Chapter 6 pages 249-257. ACCT 2013

1.


Topic 1

PROCESS COSTING: AN INTRODUCTION In your previous studies, you would have learned about job costing and how to record job costing, cost flows into ledger s. Ultimately, the key to a job (project) costing system is to understand the role of the underlying subsidiary ledger or job cards (sheets) as it is from here that we track the costs for each order, client or customer. Contrasted with job costing is process costing and organisations involved in process costing demonstrate the following characteristics:  They make their products in batches.  They only produce one product or a small range of almost identical products.  Their manufacturing generally involves a number of processes and therefore a WIP for each process.  They are involved in some of the mass production industries. Interestingly, the textbook refers to a number of industries as examples of the application of process costing systems. Later, in this topic, once you have studied operations costing, it may be appropriate to then reflect again on the survey figures.

More specifically, the ing for process costing systems involves:  Products with the same or very similar material, labour and manufacturing overhead costs.  More than one WIP .  In general, less “paperwork”, because accumulating batch costs is less onerous than collecting job costs.  Accumulating the cost of each process, and then averaging these costs across all units produced in order to get the cost of one unit. We will now, in the following sections, look at some example of process costing.

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2.


Topic 1

THE FLOW OF COSTS: A BASIC EXAMPLE Similarly to job costing, the flow of costs in process costing consists of direct material, direct labour and manufacturing overhead being transferred to a WIP or s then to Finished Goods and COGS. Using the data provided in the text, for Spritz Soft Drinks, we will now look at the recording of cost flows in a basic example of process costing. This example is described as basic because there is no opening or closing inventory in either of the two Work in Process s, namely, the Mixing Dept. and the Finishing Dept. You should now analyse the recording of double entry into Spritz’s cost flow s as demonstrated below. Also, to complete the cost flows, let us assume that 98% of finished drink production is sold.

Material and Supplies

Mixing

Mixing

505,400

Mat’ls & Supplies

505,400

Finishing

275,124

Wages Payable

30,880

MOH Applied

110,600 646,880

Finishing Mixing

646,880

Mat’ls & Supplies

275,124

Wages Payable

24,400

MOH Applied

98,800

Finished Goods

1,045,204

1,045,204

Finished Goods Cost of Sales Finishing

1,024,300

1,045,204 Closing Balance 1,045,204

20,904

1,045,204

Cost of Goods Sold Finished Goods

1,024,300

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1,045,204

Finishing

646,880

646,880

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3.0


Topic 1

PROCESS COSTING WITH CLOSING INVENTORIES In a job cost system, to value our closing inventory for Work in Progress, we simply add up the total of our incomplete job cost cards (sheets). Likewise to get a value on our completed production (cost of goods manufactured), we simply add up the total of our completed job cards for the period. WIP DM

150,000

Transfer cost

???

DL

50,000

Balance

???

O/H

200,000 400,000

400,000

But how in a Process Costing system do we get these values because we do not have any job cost sheets? There are two answers:  Firstly, if the value of our closing inventory is zero or close to zero, then do not worry about the value but just record zero or some arbitrarily small amount. This situation will be prevalent in organisations and industries using a Just in Time (JIT) approach to inventory management.  Secondly, when the value of closing inventory is considered important then we need to find a means of valuing the inventory on hand along with the inventory which has been completed in each process. The means to this valuation is achieved through the application of a concept called “Equivalent Units”

3.1

EQUIVALENT UNITS: A BASIC EXAMPLE Using the above example in 3.0, if you were told that the Closing WIP was 50% complete and it represented 20,000 units out of a total of 400,000 units of production then you could calculate the credit entries as follows: Equivalent units = (380,000 + [20,000 x 50%]) = 390,000 finished equivalents. Therefore, the cost per unit = $400,000/390,000 = $1.025641. Using this information, the credit entries are demonstrated below. For example, the closing balance = ([20,000 x 50%] x $1.025641) = $10,257.

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Topic 1

Process 1

DM

150,00

DL

50,000

O/H

200,000

Transfer to Process 2

389,743

Balance

10,257

400,000 400,000

4.0

PROCESS COSTING WITH OPENING INVENTORIES In sections 3.0 & 3.1, our example focused on the closing inventory of WIP, but what about when there is also an opening inventory? Initially the answer is straight forward, in that, the closing inventory of one period always becomes the opening inventory of the next period. However, the manufacturing costs of one period’s production may not be the same as the next period because of increases in the costs (prices) of materials, wages and manufacturing overheads. This therefore raises the issue of inventory flow and whether a First in First Out (FIFO) system is being used or alternatively Weighted Average because we need to know this in order to complete our WIP process costings. In a FIFO system, the WIP inventory that is left over from the previous period (month) would be the first completed and transferred out in the next period. Using a FIFO system requires that we “track” the costs of earlier incomplete batches separately from new batches started in the current period. Conversely, a Weighted Average system does not attempt to distinguish the fact that batches of different periods may have slightly different costs; this type of system just pools the costs of all batches and calculates the average cost. Also, there was an over simplification in the 3.1 equivalent units, basic example. This example assumed the three elements of cost, namely, material, labour and manufacturing overhead were all proportionately consumed or applied to production. In reality, material usually is added at specific points of production, for example, at the beginning, whereas conversion costs (labour and manufacturing overhead) are usually consumed or applied evenly, that is, in proportion throughout the production process. For example, if we are going to build a batch of computers then firstly we would probably go and get (buy) all of the components we would need to assemble to make the batch. This would include the boxes, processor boards, CD drives, floppy drives, operating & application software etc. We would then assemble and install everything. In summary, we would have had all of our material available at the beginning of assembly (processing) and we would then have applied the labour and overhead proportionately in order to build the computers. The following pages incorporate this production reality by separating material from conversion in calculations using Weighted Average and FIFO. Weighted Average is covered in Section 4.1 and FIFO is covered in Section 4.2.

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4.1


Topic 1

WEIGHTED AVERAGE: AN EXAMPLE At this point, if we recorded the cost data into our Mixing , it would appear as follows: Mixing Balance

$59,270

DM

505,400

DL

30,880

O/H

110,600

Transfer out of Mixing

???

Balance

???

706,150 706,150

Now, in order to complete our credit entries, we need to perform the following five steps: 

Analyse our physical flow of units.



Calculate our material and conversion finished equivalents.



Calculate our unit costs for material and conversion.



Calculate our total costs for the closing balance of Mixing and the cost of completed production (transfer cost).



Record our credit entries. Using the data from the Spritz example, these five steps are now demonstrated on the next page using Weighted Average and then using FIFO.

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Topic 1

WEIGHTED AVERAGE For Step 1 and the physical flow of units, we are told, that 20,000 litres is on hand at the beginning of April and that 380,000 litres were started “from scratch” during April. Of the 380,000 litres, 10,000 litres are still incomplete at the end of April. Therefore, 370,000 litres must have been started and finished in April. For Step 2, importantly, we are told that the closing inventory of 10,000 litres is 100% complete (finished) for materials but only 50% complete for conversion cost. Using the above data is crucial to determining our equivalent units as shown in steps 1 and 2 in the table below. Note how the material finished equivalents are determined separately to the conversion finished equivalents. Opening WIP (20,000 litres) Units started & completed (370,000) Closing WIP (10,000 litres)

Equivalent units (litres)

Opening WIP Costs incurred during April Total cost to for Costs per equivalent unit (litre)

Total cost of goods completed Cost of WIP closing balance

Direct Material 20,000 370,00 10,000 400,000

$54,600 $505,40 0 $560,00 0 $1.40

$4,670 $141,48 0 $146,15 0 $0.37

(390,000 x $1.77) (10,000 x $1.40) (5,000 x $0.37)

Conversion 20,000 370,000 5,000 395,000

Total

Steps 1&2

$59,270 $646,880 $706,150 Step 3

$1.77

= = =

$690,300 14,000 1,850 $15,850

Step 4

Using the above data, we can now complete the credit entries for the Mixing process. Mixing

Balance DM

$59,270 505,400


DL

30,880

Balance

13

690,300 15,850

Step 5

O/H

110,600 706,150 706,150

On the next page, we now use the same data to construct a table for FIFO and then record our Mixing credits

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4.2


Topic 1

FIRST IN FIRST OUT (FIFO): AN EXAMPLE Note how compared to weighted average, FIFO has less “work” in step 3 but more calculations for step 4.

Opening WIP (20,000 litres) Units started & completed (370,000 litres) Closing WIP (10,000 litres) Equivalent units (litres)

Direct Material 0 370,000

Conversion 18,000 370,000

10,000

5,000

380,000

393,000

Total

393,000

Costs incurred during April

$505,400

$141,480

$646,880

Costs per equivalent unit (litre)

$1.33

$0.36

$1.69

Opening Balance Previous cost of opening work in process Additional Direct Materials Additional Conversion Units started and completed in the same month Total cost of goods completed Direct material Conversion Cost of the WIP closing balance

(18,000 × $0.36) (370,000 x $1.69) (10,000 × $1.33) (5,000 × $0.36)

Steps 1& 2

Step 3

$59,270 0 $6,480 $625,300 $691,050 $13,300 $1,800 15,100

Step 4

Using the above data, we can now complete the credit entries for the Mixing process. Mixing Balance DM

$59,270 505,400

DL O/H

30,880 110,600 706,150

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Transfer out of Mixing 691,050 Balance

15,100 706,150

Step 5

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5.


Topic 1

SPOILAGE AND LOSSES Although organisations aim to avoid having any defective production, the reality is that spoilage does occur including production that cannot be reworked. This raises the question of how do we for spoiled or lost production. Referring to your textbook, it continues with the Spritz soft drink example and states that 39,500 of the 390,000 litres of the mixture were contaminated (spoiled) and that this spoilage was detected at the 25% completion point. We will now reconsider the Spritz costings using weighted average but with spoilage. You need to follow the same five steps as in the previous examples, however, note the insertion of a row for spoiled production.

Direct Material Opening WIP (20,000 litres) Units started & completed (330,500 litres) Spoiled (39,500 litres) Closing WIP (10,000 litres) Equivalent units (litres)

20,000 330,500 (100%) 39,500 10,000 400,000

Conversion

Total

20,000 330,500 (25%) 9,875 5,000 365,375

Opening WIP Costs incurred during April

$54,600 $505,400

$4,670 $141,480

$59,270 $646,880

Total cost to for

$560,000

$146,150

$706,150

$1.40

$0.40

Costs per equivalent unit (litre) Total cost of goods completed

(350,500 × $1.80) =

Cost of the WIP closing balance (10,000 × $1.40) = (5,000 × $0.40) = Cost of the Spoilage

(39,500 × $1.40) = (9,875 × $0.40) =

$1.80

$630,900 $14,000 $2,000 $55,300 $3,950 $59,250

Using the above table, we can now complete the credit entries for the Mixing process assuming that the loss is an Abnormal Loss.

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6.


Topic 1

PROCESS COSTING IN SEQUENTIAL DEPARTMENTS In the previous examples on Spritz Soft Drinks, our focus was always on the Mixing Department as it was the first WIP . We will now look at what happens when we wish to record credit entries in the next WIP , namely, the Finishing Department. We will continue with our original example of Spritz Soft Drinks and you should refer again to the data provided in the text. Also, we will use “Weighted Average” to determine our costings. The process is the same five-step process as first outlined on earlier but we need to insert an additional equivalent units column (see the next page) to allocate the transfer cost from Mixing to Finishing. Otherwise the material and conversion costs are calculated as previously demonstrated. Mixing Balance DM DL O/H

$59,270 505,400 30,880 110,600


630,900

Balance

15,850

706,150

706,150

Finishing Balance Transfer into Finishing DM DL O/H

$35,688

Transfer out of finishing

???

690,300 275,124 24,400 98,800

Balance

???

1,124,312

1,124,312

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Topic 1

Now refer to the weighted average example for the Finishing Department. Note the different stages of completion for the Closing WIP of 40,000 bottles, namely 100% for units transferred in, 60% for material added and 90% conversion.

WEIGHTED AVERAGE FINISHING DEPT. Transfer Cost Opening WIP (20,000 bottles) Units started & completed (1,180,000 bottles) Closing WIP (40,000 bottles) Equivalent units Opening WIP Costs incurred during April Total cost to for Costs per equivalent unit (litre)

Direct Material

Conversion

20,000

20,000

20,000

1,180,000 (100%) 40,000 1,240,000

1,180,000 (60%) 24,000 1,224,000

(90% ) 36,000

$26,420 $690,300 $716,720 $0.578

$6,396 $275,124 $281,520 $0.23

Total

1,180,000 1,236,000

$2,872 $123,200 $126,072 $0.102

$35,688 $1,088,624 $1,124,312 $0.91

Total cost of goods completed

(1,200,000 × $0.91) = $1,092,000

Cost of the WIP closing balance

(40,000 × $0.578) = $23,120 (24,000 × $0.23) = $5,520 (36,000 × $0.102) = $3,672 $32,312

Finishing Balance

$35,688

Transfer into Finishing

690,300

DM

275,124

DL

24,400

O/H

98,800 1,124,312

Transfer out of Finishing

1,092,000

Balance

32,312

1,124,312

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7.


Topic 1

OTHER ISSUES AFFECTING PROCESS COSTING  Weighted Average versus FIFO.  Organisations using JIT, TQM and continuous improvement manufacturing practices.

8.

OPERATION COSTING: AN INTRODUCTION Process Costing as already covered is based on the assumption that each batch has the same or very similar costs of material, labour and overhead. In reality, in contemporary industries with flexible processing and diverse ranges of products and services, it is not always easy to find, any longer, traditional examples of process costing. Rather what we are more likely to see is that each individual batch is different to the previous in regards to some processes and/or the consumption of material, labour and manufacturing overhead. Today, the individual batches and products often differ in some significant aspects. The costing system used for these process and batch production industries is an extension of process costing called Operations or Hybrid Costing. In fact, as you will see, this costing system has an element of both process costing and job costing. In your textbook, the example used incorporates different material for each batch but the same conversion costs for each process. In other words, the costing of the material can be associated with job costing, as the material needs to be traced to each batch whereas the conversion is associated with each process and therefore resembles process costing. In fact, in operations costing, all three elements may vary from batch to batch which therefore requires that batch costs be traced for each separate batch. This is not dissimilar to tracing costs to jobs. In the next section, we now consider an example where material costs vary for each product but the conversion costs are the same for shared processes.

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9.0


Topic 1

OPERATION COSTING: AN EXAMPLE

Finishing

Mixing

Packaging

Product A: 20,000 bottles of strawberry drink; uses the first two processes only. Product B: 10,000 bottles of orange drink for children; uses all three processes.

9.1

THE CALCULATION OF BATCH COSTS Referring to the Spritz example in Chapters 4 and 5 of the text, we determine our batch costs. This can be done either, as shown below, on a total cost per batch basis or as shown in the textbook on a unit cost per batch basis. Batch Costs Strawberry

Orange

Direct Material Mixing Finishing Packaging

8,500 4,500

$3,950 2,250 1,000

Conversion Mixing Finishing Packaging

1,800 2,000

900 1,000 500

Total Batch Costs $16,800 $9,600

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9.2


Topic 1

RECORDING THE COST FLOWS Using our costing calculations, we now record our cost flows into the three Work in Process s, namely Mixing, Finishing and Packaging. Be careful as this requires concentration. Mixing Material

8,500 3,950

Conversion

1,800 900

Transfer to Finishing

15,150

15,150

15,150 Finishing

Transfer from Mixing Material Conversion

15,150 4,500 2,250 2,000 1,000

Transfer to Finished Goods

16,800

Transfer to Packaging

8,100

24,900

24,900 Packaging

Transfer from Finishing

8,100

Material

1,000

Conversion

500

Transfer to Finished Goods

9,600

9,600

9,600 Finished Goods

Transfer from Finishing

8,100 COGS

Transfer from Packaging

26,400

9,600 26,400

26,400

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Topic 1

The cost flows on the previous page would become much more complex if we were to introduce opening and closing inventories and thus had to determine equivalent units for each batch to determine the individual batch costings etc., however, you are not required to do this.

SUMMARY In this topic you extended your knowledge of processing costing such that you now know a method of dealing with the costing of opening and closing inventories and how to for spoilage, in using both the weighted average and FIFO approach. You have also covered operation costing in more detail than in your prior studies. Next we consider the difficulties posed by having multiple products output from one material input and one process. We will look at four different options for allocating the t costs between the different outputs.

TUTORIAL QUESTIONS Starting from page 208 in your textbook, please attempt Self-Study problems 1 and 2 followed by Q5.1, Q5.2, P5.44 and P5.55.

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Topic 2

TOPIC 2 COSTING SYSTEMS: T COSTING OBJECTIVES By the end of this topic you should be able to:  Explain the : t products, t cost, t process, split-off point, separable or further processing costs and by-products.  Understand when to use a t costing system.  Allocate t costs using the following methods: Physical Measures, Constant  Gross Profit, Relative Sales Value and Net Realisable Sales Value.  Record the cost flows associated with t costing.  Calculate whether t products should be sold or processed further.  Allocate t costs when there is a by-product.  Evaluate the four allocation methods. Resource: Text Reading Langfield-Smith, K; Thorne, H and Hilton, R (2006), Management ing: Information for managing and creating value. 4th edition. Sydney: McGraw Hill, Appendix to Chapter 19.

Resource: Other Text Reading Hilton, Maher & Selto (2000), Cost Management: Strategies for Business Decisions, International Edition, McGraw-Hill, Chapter 8. Hansen & Mowen (2003), Management ing, 6th Edition, South-Western. Chapter 17 pages 716-718. The “Sell or Process Further Decision”.

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1.


Topic 2

T COSTING: AN INTRODUCTION t Costing is an extension of Process Costing and Operations Costing and applies to those industries which produce what are called t Products. t products are produced when more than one product emerges simultaneously from the same production process and raw material. Examples of t products can be found in the following industries: petroleum, meat processing, fruit processing, seafood processing, palm oil (kelapa sawit) processing… The challenge for cost ants, in these industries, is to value each of the t products that emerge at split off. Split-off occurs at that point in production when the t products become identifiable. For example, refer to page 932 of your textbook and the cocoa beans example in Exhibit 19.15 as shown below. t Product costs need to be determined for reasons of inventory valuation, however, as demonstrated later, one needs to be careful when it comes to decision-making and the sell or process further decision.

Cocoa beans costing $500 per 1 tonne batch

t production process costing $600 per tonne

Total t cost: $1100 per 1 tonne batch

ACCT 2013

Cocoa butter sales value: $750 for 750 kg

Separable process costs: $1,560

Tanning cream: sales value $3,000 for 250kg

Split-off point Cocoa powder sales value: $500 for 250kg

Separable process costs: $800


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Instant cocoa mix sales value: $2000 for 250kg

Topic 2

2.0

T COSTING ALLOCATION METHODS Consider the following example. Using a t process, Gemerling Ltd. manufactures the following two domestic cleaning products, Gemo and Glosso. Both Gemo and Glosso can be sold immediately at split-off point in a basic but somewhat pungent form or processed further to add a pine or lemon fragrance along with improved packaging. Gemerling sells its products in bulk to wholesalers. The following information is available for the month of June.

Selling Price at Split-Off

Production Gemo 2,000,000 litres Glosso 500,000 litres

$0.40 $0.90

Selling Price $0.875 per litre $1.30 per litre

t Cost t Cost

$520,000

Costs after Split-off point Gemo Glosso

$40,000 $80,000

In order to understand the ways in which we can calculate the t cost allocations for Gemo and Glosso, there are four methods to be learned, as demonstrated over the next two pages. We will then discuss the issues to consider when choosing between the methods.

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2.1


Topic 2

THE PHYSICAL MEASURES METHOD This Physical Measures method is based on the physical features of each t product such as weight (kilos) or volume (litres). PHYSICAL MEASURES

t Product Gemo Glosso

Volume in Litres 2,000,000 500,000 2,500,000

Proportions 0.8 0.2 1

Cost Allocation $416,000 $104,000 $520,000

As demonstrated below, the t cost calculations are easily set up in a spreadsheet. B 3 4 5 6 7

C

D

E

PHYSICAL MEASURES

t Products Gemo Glosso

Volume in Litres 2000000 500000 =SUM(C5:C6)

Proportions =C5/$C$7 =C6/$C$7 =SUM(D5:D6)

Cost Allocation =D5*$E$7 =D6*$E$7 520000

Similarly to process and operations costing, the flow of costs for t costing consists of direct material, direct labour and manufacturing overhead being transferred to a WIP or s then to Finished Goods and COGS. See below. Gemo Processing Detergent t Processing $520,000

$416,000 $40,000

$416,000 $104,000

Glosso Processing

$104,000 $80,000 Note that the completed production from both Gemo Processing and Glosso Processing would be transferred to Finished Goods.

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2.2


Topic 2

THE CONSTANT GROSS PROFIT METHOD This method is based on each t product having the same Gross Profit (Margin) rate. Firstly, we need to calculate the Gross Margin percentage. 11 12 13 14 15

I Sales Prod’n Costs Gross Profit Gross Profit %

J $2,400,000 $640,000 $1,760,000 73.3%

Secondly, we allocate our t cost to our t products as shown below. THE CONSTANT GROSS PROFIT METHOD t Products

Gross Margin %

Sales Revenue

Required Gross Margin

Total Cost

Separable Cost

Cost Allocation

73.3% 73.3%

$1,750,000 $650,000 $2,400,000

$1,283,333 $467,667 $1,760,000

$466,667 $173,333 $640,000

$40,000 $80,000 $120,000

$426,667 $93,333 $520,000

Gemo Glosso

2.3

THE RELATIVE SALES VALUE METHOD

This method is based on the sales value of each t product at split-off point. See the shaded area in the spreadsheet below. B 17 18 19 20 21

2.4


C D THE RELATIVE SALES VALUE METHOD Sales Value at Split off Proportions $800,000 0.64000 $450,000 0.36000 $1,250,000 1

E Cost Allocation $332,800 $187,000 $520,000

THE NET REALISABLE VALUE METHOD This method is based on the net realisable (sales) value (NRV) at split-off point for each t product. See the shaded area in the spreadsheet below. B

24 25 26

t Products Gemo

27

Glosso

C D E F THE NET REALISABLE SALES VALUE METHOD Sales Revenue Separable NRV Proportions Cost $1,750,000 $40,000 $1,710,00 0.750 0 $650,000 $80,000 $570,000 0.250

27

G Cost Allocation $390,000 $130,000

$2,400,000

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3.

$120,000

$2,280,00 0

1.000

$520,000


Topic 2

FORMULAE FOR THE FOUR METHODS Using a spreadsheet, shown below are the formulae for each of the four t costing methods.





PHYSICAL MEASURES Volume in Proportions Litres 2000000 =C5/$C$7 500000 =C6/$C$7 =SUM (C5:C6) =SUM(D5:D6)

Gross Margin % =$J$15 =$J$15

Cost Allocation =D5*$E$7 =D6*$E$7 520000

THE CONSTANT GROSS PROFIT METHOD Sales Revenue Required Gross Total Cost Margin =2000000*0.875 =D12*C12 =D12-E12 =500000*1.3 =D13*C13 =D13-E13 =SUM(D12:D13) =SUM(F12:F13) =SUM(G12:G12)

Separable Cost

Cost Allocation

40000 80000 =SUM(G12:G13)

=D12-E12-G12 =D13-E13-G13 520000

THE RELATIVE SALES VALUE METHOD Sales Value at Proportions Cost Allocation Split off =2000000*0.4 =C19/$C$21 =D19*$E$21 =500000*0.9 =C20/$C$21 =D20*$E$21 =SUM(C19:C20) =SUM(D19:D20) 520000

THE NET REALISABLE SALES VALUE METHOD Sales Revenue Separable Cost NRV Proportions

Cost Allocation

2000000*0.4 500000*0.9 =SUM(C26:C27)

=F26*$G$28 =F27*$G$28 520000

40000 80000 =SUM(D26:D27)

=C26-D26 =C27-D27 =SUM(E26:E27 )

=E26/$E$28 =E27/$E$28 =SUM(F26:F27)

SELL OR PROCESS FURTHER Gemo Glosso Incremental =C26-C19 =C27-C20 Revenue Less Separable 40000 80000 Costs Incremental =D32-D33 =E32-E33 Profit

4.

VALUATING THE FOUR ALLOCATION METHODS Your textbook provides you with issues to consider in selecting between the different methods presented above. You may decide that the bulk of the cost should be borne by a product that you are specifically in business to produce, the other products merely being lucrative ‘asides’ to your real business focus. When these should be considered by-products is covered in the next section of this topic. Note in particular the argument in the text ing t cost allocations to set cost on which prices will be determined. Obviously three of the four methods use sales price to set cost allocation,

28

so we have a circular calculation. On the other hand you may want to allocate these costs on the principal of ‘ability to bear’. This means that the product with the highest sales value can bear a greater proportion of the cost and should do so.

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Whichever method you use it is important to recognise that they are all arbitrary allocations. Decisions with regard to product mix also need to recognise that these products cannot exist without one another, and the proportion of production (for example, the volume of pineapple juice that is produced is closely tied to the weight, or number of tins, of pineapple chunks) is usually set as well

5.

DECISION-MAKING AND T COSTING: THE SELL OR PROCESS FURTHER DECISION A common question regarding t products concerns whether we should sell the product immediately at split off point or perform further processing in order to add more value to the product. For example, should a butcher sell a cut of steak as raw meat or should the butcher marinate the steak. This decision assumes that there is demand for both products and that the butcher only has limited supplies of meat and space in which to display and store products each day. The answer to the process further question is that, the choice, from a financial perspective, will centre around which option makes the greater profit: that is, sell as raw steak or marinate. Continuing with the Gemerling example, we calculate the incremental revenue and incremental costs. A decision-making analysis of the relevant data is provided below: SELL OR PROCESS FURTHER Incremental Revenue Less Separate Costs Incremental Profit

GEMO

GLOSSO

$950,000 $40,000 $910,000

$200,000 $80,000 $120,000

From the above, it is shown that processing further, in both cases, adds to Gemerling’s profits. In making the process further decision, the t cost is irrelevant for decision-making purposes because the cost does not change.

TUTORIAL QUESTIONS You should now attempt E19.38, E19.39, P19.53, & P19.55.

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6.


Topic 2

ALLOCATING BY-PRODUCTS A t product is called a by-product, if it is of incidental (small) value. Examples, of byproducts, may also include scrap and waste that emerge at split-off point. There are two ing treatments for the profit made from a by-product.  Record the by-product income (profit) as “Other Income”.

 Deduct the by-product profit (net realizable income) from the t cost. We will now consider an example of this method. By-product example. Gemerling Ltd. from a t process manufactures the following three domestic cleaning products: Gemo, Glosso and Cleano. Cleano is considered to be a by-product. The following information is available for the month of June.

Gemo Glosso Cleano

Production

Selling Price

2,000,000 litres 500,000 litres 50,000 litres

$0.875 per litre $1.30 per litre $0.60 per litre

t Cost t Cost

$520,000

Costs after Split-off point Gemo Glosso Cleano

$40,000 $80,000 $10,000

In this example, in the inventory valuation process, the net realizable income of Cleano is deducted from the t cost. Also, Gemerling Ltd. allocates its t costs using the Net Realisable Value Method

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Topic 2

ALLOCATING BY-PRODUCTS Firstly, we need to calculate the adjusted t cost as follows: t Cost

$520,000

Less Income from Cleano

$30,000

- Cleano Separable Costs

$10,000

$20,000

Adjusted t Cost

$500,000

Now we can determine the t cost allocations for Gemo and Glosso. t Products Gemo

Sales Value of the Final Product $1,750,000

Separable Cost $40,000

Glosso

$650,000 $2,400,000

$80,000 $120,000

NRV $1,710,00 0 $570,000 $2,280,00 0

Proportions t Cost Allocation 0.75 $375,000 0.25 1.00

$125,000 $500,000

TUTORIAL QUESTION During July 2006, Millers Ltd. processes wheat into three products: white flour, bran and wheat germ. During processing, 15% of the wheat is lost. Other data related to July is provided below. The t cost is $250 per tonne. White Flour Produced (Kg) 153,000 Sold (Kg) 140,000 Selling Price per Kg. $1.00 Separable Costs per Kg. $0.10

Bran 85,000 80,000 0.40 $0.05

Wheat Germ 4,250 4,250 $1.50 $0.20

Treating Wheat Germ as a by-product, allocate the t cost using the Net Realisable Value Method. The net realizable income from Wheat Germ is deducted from the t cost.

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Topic 2

TUTORIAL ANSWER: MILLERS LTD. a)

Kilograms Produced White Flour Bran Wheat Germ Total

153,000 85,000 4,250 242,250

b)

242,250 divided by 85% = 285,000 Kg. (the original quantity before the 15% processing loss)

c)

285,000 Kg. = 285 tonne.

d)

t Cost = (285 x $250 per tonne) = $71,250

d)

The Net Realisable By-Product Income from Wheat Germ Sales Separable Costs By-Product Income $5,525

E

Total t Cost Less By-Product Income t Cost to be Allocated

$6,375 (4,250 X $1.50) $850 (4,250 X $0.20)

$71,250 $5,525 $65,725

f) t Products

THE NET REALISABLE SALES VALUE METHOD Sales Revenue Separable Cost NRV Proportions

White Flour

$153,000

$15,300

Bran

$34,000 $187,000

$4,250 $19,550

$137,70 0 $29,750 $167,45 0

Cost Allocation

0.822

$54,048

0.178 1.000

$11,677 $65,725

SUMMARY You should now be confident in discussing the four methods of t cost allocation, based on physical units; constant gross profit; relative sales value and net realisable value. In your discussion you should be able to include a description of the methods as well the issues with regard to the adoption of each. In addition, you should be comfortable calculating the allocation of costs using each method. Now that you have extended your knowledge of product costing we will proceed to use product costs in certain decision making scenarios. In this topic we have already looked at certain product

33

mix decisions, when we considered whether t products should be processed further or sold at ‘split off point’. Now we will look at other product mix decisions, as well as pricing issues.

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Topic 3

TOPIC 3 PRICING & PRODUCT MIX DECISIONS OBJECTIVES By the end of this topic you should be able to:  Understand the importance of pricing.  Explain some major influences on pricing.  Determine (calculate) prices in the context of specific pricing strategies.  Rationalise product-mix decisions. Resource: Text Reading Langfield-Smith, K; Thorne, H and Hilton, R (2006), Management ing: Information for managing and creating value. 4th edition. Sydney: McGraw Hill, Chapter 20. Resource: Other Text Reading Hansen & Mowen, Management ing, 6th Edition, 2003, South-Western. Chapter 17 pages 718-724. Morse, Davis & Hartgraves (2003), Management ing: A Strategic Approach, 3rd Edition, South-Western. Chapter 6 pages 366-372 & 138-142.

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1.


Topic 3

PRICING: AN INTRODUCTION

One of the most important decisions that some mangers have to make is to decide what price to charge for their organisation’s products or services. This topic looks firstly at some factors that influence pricing and its determination, and then it considers the decision-making question of pricing mix.

2.

PRICING: MAJOR INFLUENCES For any organisation, when determining the pricing of its products and services, there are a number of potential influences, including:  Market Positioning.  Product Cost, that is, how much it costs to make the product or provide the service.  The nature of the product or service and how much the consumer needs or desires the product, that is, Customer Value.  What competitors are currently doing or how they are likely to react.  Government legislation such as the Trade Practices Act (TPA) and how the TPA’s regulatory authority the Australian Competition and Consumer Commission (ACCC) is likely to react or respond.  Political pressure from state or federal governments.

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3.


Topic 3

DETERMINING PRICES There exist a range of strategies that can be used to set prices including: 

Cost-Plus pricing: the traditional notion of pricing was to manufacture a product then calculate its costs and finally add a mark up. For example, determine the selling price for the following: an organisation has a required return (mark-up) on a product of 75%. The manufacturing cost of the product is comprised of direct material $5, direct labour $0.20 and Manufacturing Overhead $2.80. The Cost Plus pricing formula is: price = cost plus (mark-up x cost) Therefore the price = ($5 + $0.20 + $2.80) + [($5 + $0.20 + $2.80) x 50%] = $12. Alternatively, ($5 + $0.20 + $2.80) x 150% = $12. One of the issues regarding cost plus pricing is which cost to use. For example, absorption cost as in the above example, or variable cost or full cost…



Time and Material pricing. This pricing technique and variations of it are used in industries such as: “the trades”, motor vehicle servicing & repairs, landscaping & lawn mowing, public ing, legal services, medical & dental services (not including general practitioners), the repair & maintenance of home appliances, computers… The feature of this pricing technique is that the labour rate (in this case, the charge for labour rather than the wage rate) includes not only the direct labour but also the manufacturing overhead and the required profit margin. For example, determine the selling price for the following: a motor mechanic services a motor vehicle for three hours. The labour rate that is charged by the business is $80 per hour and the materials used in servicing the vehicle cost $40. Using Time and Material pricing the formula is: price = labour cost plus material cost ($80 x 3) + $40 = $280.



Value-Based pricing.



Economic Value pricing.

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Topic 3

TUTORIAL QUESTIONS From page 983 of your textbook, please attempt the Self-study problem and then P20.41 & P20.43.

4.

PRODUCT MIX DECISIONS Product mix decisions involve maximising the use of limited resources such as time. Please refer to the Sydney Sailing Supplies example in your textbook. Initially, we are told that Sydney Sailing Supplies manufactures two products Cleats which contribute $1.00 per unit to profits and Shackles which add $2.00 per unit to profits. From this information, it would seem that Sydney Sailing Supplies should concentrate on making the more profitable Shackles until such time as market demand is satisfied and then switch to the less profitable Cleats. However, we are then informed that Cleats require 1.2 minutes (0.02 of an hour) per unit to manufacture whereas Shackles require 3 minutes (0.05 of an hour) per unit to manufacture. Using this “time required” information for Cleats and Shackles, a revised profitability evaluation for the two products is provided below. Contribution per unit Machine hours required per unit

Cleats $1.00 0.02 hrs

Shackles $2.00 0.05 hrs

Contribution Margin per hour

$50.00

$40.00

This analysis places a different perspective on the profitability of the two products and from it we can see that Cleats are more profitable by $10 per manufacturing hour compared to Shackles.

TUTORIAL QUESTIONS You should now attempt E20.38, P20.47 & P20.48.

SUMMARY From this topic you should have a greater appreciation of decision making issues with regard to pricing methods and product mix options. Pricing, in particular, was discussed in the context of a strategic approach. We will now focus more on strategy related decisions. The place of the next few topics in a cost management course is due to their relationship to cost management, as opposed to costing. For example, activity based costing provides a means to costing a product but activity based management techniques are useful for managing the costs through the use of the activity analysis. This is illustrated in the next topic when we look at customer profitability analysis.

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Topic 4

TOPIC 4 COST MANAGEMENT SYSTEMS & STRATEGY ACTIVITY BASED MANAGEMENT & CUSTOMER PROFITABILITY ANALYSIS OBJECTIVES By the end of this topic you should be able to:



Understand the concept of Activity Based Management.



Explain the value adding activity and non-value-adding activity.



Identify value adding and non-value-adding activities.



Choose root cause cost drivers.



Select appropriate performance measures for root cause cost drivers.



Understand the concept of Supply Chain Management.



Comprehend the concept of Customer Relationship Management (CRM).



Analyse customer profitability.



Evaluate customer performance including non-financial considerations.

Resource: Text Reading Langfield-Smith, K; Thorne, H and Hilton, R (2006), Management ing: Information for managing and creating value. 4th edition. Sydney: McGraw Hill, Chapter 15 pages 693-703 & Chapter 2 pages 48-49. Chapter 16 pages 761-769. Resource: Articles Gupta M & Galloway K (2003), Activity based costing/management and its implications for operations management, Technovation, vol. 2, issue 2,, pages 131-138 Dickinson V & Lere J (2003), Problems evaluating sales representative performance? Try activity-based costing, Industrial marketing management, volume 32, pages 310-307.

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Topic 4

Van Raaij E, Vernooij M & Van Triest S (2003), The implementation of customer profitability analysis: a case study, Industrial marketing Management, vol. 32, pages 573583. Resource: Other Text Reading Hilton, Maher & Selto (2000), Cost Management: Strategies for Business Decisions, International Edition, McGraw-Hill, Chapter 10. Morse, Davis & Hartgraves (2003), Management ing: A Strategic Approach, 3rd Edition, South-Western, Chapter 5 pages 193-196. Hansen & Mowen (2003), Management ing, 6th Edition, South-Western, Chapter 15 pages 626-629.

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Topic 4

ACTIVITY BASED MANAGEMENT (ABM): AN INTRODUCTION The concept of costing activities as promoted by Activity Based Costing has had a significant effect on Management ing, in that; it has spawned several new techniques, which have been collectively referred to as either Cost Management Systems (CMS) or Strategic Management ing. These techniques are focussed on managing costs as distinct from traditional techniques, such as budgeting, flexible budgets, standard costing… and their focus on controlling costs. One such cost management technique is called Activity Based Management (ABM). ABM uses and evaluates information provided by Activity Based Costing in seeking to improve customer value by identifying opportunities to improve the efficiency of organisational processes and activities. In its most simple form, ABM methodology seeks to separate activities into two types: value adding and non-value adding. A value adding activity is defined as an activity that adds value to the customer whereas a non-value adding activity does not. By using ABM an organisation can improve its business performance by identifying non-value adding activities; what causes them (root cause drivers) and then implementing a plan to eliminate these causes or drivers. A basic example of eliminating non valuing adding activities occurs for some people, each New Year’s Day when they promise to eliminate some non-value adding, lifestyle activity (habit). For example, smoking, eating junk food… ABM analysis is about conducting a thorough analysis of an organisation’s value chain, the identification of wasted resources and the elimination of what causes them. The Value Chain The following diagram is taken from page 49 of the textbook. Services • • • • •

Human Resources Finance Legal Informaion Systems Telecommunications

Value of products and services

Research and Development

Design

Supply

Manufacturing or Production

Marketing

Distribution

Customer Service

One needs to be aware that separating activities into merely two groups, namely value adding and non value adding overlooks the reality that some non valuing adding activities are essential, even though they do not add value to the customer. For example, paying employee wages, preparing invoices, packaging for some products… You cannot entirely

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Topic 4

eliminate these non value-adding processes; however you may be able to make them more efficient. Some organisations when conducting an ABM analysis rank activities on a scale from one to five. For example, level one is used for activities that irrefutably do not add value; level three is used for all essential non value adding activities and finally, level 5 is used for all activities that are clearly value adding.

2.

ACTIVITY BASED MANAGEMENT: AN EXAMPLE You should now read the Mason and Cox example in your textbook in order to see how ABM is used to better manage costs by identifying non-value-adding activities such as correcting invoices, moving materials, inspecting moulds, welding defects etc. Most importantly, in the Mason and Cox example, Exhibit 15.4 lists a number of potential primary causes (drivers) of the various non-value-adding activities. The ultimate success of ABM centres on the organisation’s ability to manage, that is, eliminate these causes of wasted resources. Identifying the non value adding activities is not the end of ABM as the organisation must be able identify what causes the activities that waste resources and then effect a strategy to eliminate them.

TUTORIAL QUESTIONS Starting from page 724, in your textbook, attempt Self-Study problem 1 followed by E15.26, E15.27 and P15.41.

3.

SUPPLY CHAIN MANAGEMENT (SCM): AN INTRODUCTION Supply Chain Management is the process of streamlining the supply chain by managing costs, accelerating time-to-market of new products, and creating close relationships with suppliers and customers. Today in seeking supply chain improvements, organisations often adopt electronic commerce solutions in their pursuit for improved:  Business to Business (B2B) relationships with suppliers through improved management of inventory along with electronic transmission of purchase orders, payment of s and technical .  Business to Customer (B2C) relationships by using web sites offering fast access to information, sales services, settlement and technical .

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Topic 4

Leveraging electronic business solutions offers benefits that include speed and much cheaper data processing, storage and retrieval costs compared to the more traditional forms of business communication and commerce.

4.0

CUSTOMER RELATIONSHIP MANAGEMENT (CRM): AN INTRODUCTION

Customer Relationship Management is by no means a new concept but what is new, since the 1990s, is the leveraging of the Internet through organisation web sites to collect and analyse data. This is done in order to better understand individual customer’s needs and purchasing patterns (data mining) and thus establish better customer relationships. Electronic Customer Relationship Management moreover aims to acquire and retain customers by offering a superior and cheaper service than traditional sales and channels. The aim of electronic CRM is not only to acquire new customers cheaply but also to retain existing clientele bearing in mind that the cost of “winning back” lost customers, clients and consumers is deceptively expensive. CRM on the Internet comes basically at three levels:  The static site which can only provide information to the consumer.  The database and forms site which besides providing information can also retrieve information. Using these web sites, you can buy software, books, flowers, tickets etc; listen to online audio and watch multi-media. This level facilitates electronic commerce (trade).  The personalised and customised web site which is tailored to individual customer needs. These web sites include all of the services of levels 1 & 2 but moreover they may anticipate choices and based on a customer profile can automatically recommend solutions and alternatives. Activity Based Costing, when applied to the field of CRM, provides management ants with new costing opportunities in regards to evaluating customers and clients. In particular, it offers the opportunity to evaluate more fully the cost of different customers or groups of customers and their profitability. With this information, organisations can then better identify which customers create the highest profits and therefore the strategic question, how do we retain them? Also, which customers generate the lowest profits and what strategy can be effected to make them more profitable? Customer Profitability Analysis (A) identifies and analyses the costs of five groups of customer activities:  Customisation of products.  Marketing and Selling.  Distribution.

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Topic 4

 Customer .  Cost of Goods Sold (traditionally the sole determinant). We will now consider, in the next section, an example, of customer profitability analysis.

4.1

MANAGING CUSTOMERS: AN EXAMPLE

Please now refer to the example starting on page 766 of your textbook. There are two parts to this customer analysis; firstly the customer cost analysis and then secondly the customer profitability analysis as demonstrated below. Customer Cost Analysis Direct Customers Small Retailers Sales Order Delivery Sales Calls Complaints Research Advertising

514,500 242,000 0.00 11,400 0.00 25,000

Large Retailers

17,640 12,100 80,000 9,600 40,000 20,300

29,400 15,400 56,000 3,000 40,000 49,700

Total Costs 792,900 179,640 193,500 Customer Profitability Analysis Sales COGS Gross Profit Customer Costs

Direct Customers 576,000 126,000 450,000 792,900

Small Retailers 816,000 198,000 618,000 179,640

Large Retailers 1,968,000 456,000 1,512,000 193,500

Net Profit (342,900) 438,360 1,318,500

4.2

OTHER CONSIDERATIONS Textbook page 769, in particular Exhibit 16.15

Although the textbook example demonstrates that large retailers are the most profitable customer group, there may be other customer performance measures, used by organisations which may impact on and affect their customer analysis and evaluation. For example, a change in market share, an increase in new business, the retention rate of existing customers, the proportion of returns, the level of returns under warranty…

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Topic 4

TUTORIAL QUESTIONS Starting from page 777, in your textbook, attempt Self-Study problem 1 and C16.55.

SUMMARY Now that you have an understanding of activity based management and the impact that activity analysis can have on the way to manage customer related costs, we need to look to suppliers and the costs that they can cause. In the next topic, when we have considered supplier related costs, we will look at other inventory related issues such as inventory management and quality control.

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Topic 5

TOPIC 5 COST MANAGEMENT SYSTEMS & STRATEGY MANAGING SUPPLIERS, INVENTORY AND QUALITY OBJECTIVES By the end of this topic you should be able to:  Describe Supply-Chain Management (SCM) and its significance.  Understand the concept of Managing Suppliers.  Analyse supplier costs.  Evaluate supplier performance including non-financial considerations.  Comprehend the concept of inventory management.  Use traditional approaches to inventory management including o

order quantity,

o

timing of orders

o

stock-out risk management.

 Explain Just-In-Time (JIT).  Explicate the key features of JIT and JIT Purchasing.  Understand the concepts of Managing Quality and Total Quality Management (TQM)  Apply the concepts of TQM in analysing and evaluating quality. Resource: Text Reading Langfield-Smith, K; Thorne, H and Hilton, R (2006), Management ing: Information for managing and creating value. 4th edition. Sydney: McGraw Hill. Chapter 16 pages 746-761 & 768-775. Resource: Other Text Reading Hansen & Mowen (2003), Management ing, 6th Edition, South-Western. Chapter 4 pages 131-134, Chapter 19 pages 808-826 & Chapter 11 pages 438-455.

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1.0


Topic 5

MANAGING SUPPLIERS: AN INTRODUCTION

Traditionally, managing suppliers centred, in particular, around finding suppliers who were both reliable and offered a cheap purchase price. This was a consequence of, in part, the fact that the traditional costing system struggled to provide additional information relevant to managing supplier costs. However, with the advent of Activity Based Costing systems, there has emerged the opportunity to cost other activities related to dealing with suppliers, including activities such as:  The Costs of purchasing, ordering, receiving and inspection.  The Costs of holding inventory.  The Costs of poor quality.  The Costs of delivery failure. An organisation which can cost these activities is in a stronger position to analyse, evaluate and then manage its suppliers compared to only being able to compare purchase prices. In the next section, we will now consider an example of supplier analysis.

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1.1


Topic 5

MANAGING SUPPLIERS: AN EXAMPLE

The Hardy Saucepans example in your textbook provides us with a basic example of supplier cost analysis and it demonstrates how merely comparing supplier purchase prices can be misleading in the overall cost analysis of suppliers. Supplier Cost Analysis Plastex Industries Handles Ltd. Purchase Order Delivery Inspection Storage Rework Downtime Late Deliveries

$1,440 $4,800 $2,400 $5,600 $2,250 $1,350 $2,500

$1,200 $3,600 $1,800 $2,800 $250 $180 $250

Total Supplier Costs Unit Supplier Costs

$20,340 $2.034

$10,080 $1.68

Purchase Price plus Unit Supplier Costs

$4.034

$3.88

An additional technique, which can be used to compare suppliers, is called the Supplier Performance Index (SPI). SPI is defined as Total Supplier Costs Total Purchase Price For Hardy Saucepans the SPI calculations are as follows: SPI Analysis Plastex Industries SPI =

Total Supplier Costs Total Purchase Price $20,340 (10,000 x $2)

Handles Ltd. Total Supplier Costs Total Purchase Price $10,080 (6,000 x $2.20)

= 1.017

= 0.7636

From a financial perspective, the supplier with the higher SPI is more expensive, in this case Plastex Industries.

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1.2


Topic 5

OTHER CONSIDERATIONS

Although the textbook example demonstrates that Handles Ltd. is the cheaper supplier, there may be other supplier performance measures, used by organisations which may impact on and affect their final purchase decision. Other considerations may include: the delivery time, the reliability of supply, being environmentally responsible, being a designated country of choice (federal government tenders)…

TUTORIAL QUESTIONS You should now attempt P16.43 & C16.55.

2.0

MANAGING INVENTORY: AN INTRODUCTION

In the previous section, on the analysis of supplier costs, a number of the costs involved inventory and its management. In fact, some of the costs of inventory management are frequently directly related to the quantity of materials ordered as this then in turn influences how much is stored, for how long and how often orders are placed. There are two approaches, we will now consider, regarding the question of how much to order (order quantity). The first technique is a long standing method called Economic Order Quantity (EOQ) and the second method a much newer technique, of recent decades, called Just in Time (JIT). We will now consider an example of EOQ in section 3.1 and JIT in section 3.2.

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Topic 5

MANAGING INVENTORY: AN EXAMPLE OF EOQ

EOQ is based on the belief that inventory management is all about balancing two groups of competing costs, namely, order costs and carrying costs. Moreover, EOQ considers that if we place fewer orders, we must purchase in larger batches and therefore we must carry (store) more materials. In other words, as order costs go down then carrying costs will go up and vice versa. From this viewpoint, we derive the EOQ formula for calculating the optimum order quantity.

EOQ

=

2× Annual Demand× Cost per Order Annual Carrying Costs per Unit

Referring to the example on pages 754 - 757 of your textbook, we get the following calculation for the optimum order size that will minimise overall order costs and carrying costs.

EOQ =

2×4800×$60 $2.50

= 480 bags

Also, related to the economic order size is the timing of when to place an order so as to reduce the risk of a “stock out” that is, running out of stock. This timing is often expressed not just in days of “lead time” but also in how many, in this case, bags we can “run down to” before we must place an order. For example, if we run our bags down to zero then production will stop as we wait for the next order to be filled which will take 2 weeks. Based on an average usage of 96 bags per week (4,800 bags /50 weeks), an order needs to be placed once our material stock is run down to (2 weeks x 96 bags) = 192 bags. In our everyday lives, we all apply the concepts of “lead time” and “stock outs”. For example, with regard to the replenishing of food at home before it runs out, putting more petrol into the car before it comes to a halt etc. The calculation above can then be further refined by the inclusion (addition) of a safety stock in order to further minimize the risk of a “stock out” occurring. Safety stock is an additional margin of safety added to the lead time. It could be expressed in days or in bags.

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Topic 5

MANAGING INVENTORY: JUST IN TIME (JIT)

Over the last four decades, JIT philosophy has had a significant effect globally on how to manage all levels of inventory, that is, raw materials, WIP and finished goods. Although there are a number of aspects to this concept, it is characterised by the view that carry costs such as storage costs and the costs of moving inventory can dominate inventory cost management. Moreover, we know from ABM that both of these costs are considered to be non-value adding. Unlike traditional large scale manufacturing, which operates by estimating market demand and then pushing product onto the marketplace, often ed by extensive marketing, JIT waits until purchase orders are placed and then manufactures on the basis of this actual demand, that is, manufacturing is pulled by the order. A radical departure from traditional manufacturing, in a perfect world, organisations using JIT would carry zero inventory at all points. Raw materials would arrive on demand as needed by manufacturing, WIP would never be stockpiled as it would flow immediately to the next process and ultimately the finished goods would be automatically delivered to the person or organisation that placed the order.

TUTORIAL QUESTIONS You should now attempt E16.32, E16.33, P16.45, & P16.47.

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Topic 5

MANAGING QUALITY: AN INTRODUCTION

In a perfect world, no one would make mistakes and therefore no time or money would be lost finding, fixing and preventing errors. The reality is, of course, usually otherwise and organisations have to decide how they will go about maintaining quality and how much money they are prepared to spend in the pursuit of quality. There are a number of philosophies regarding quality of which Total Quality Management (TQM) and the promotion of a corporate culture of quality and continuous improvement is popularly referred to in contemporary literature on quality. Strictly, TQM means the improvement of quality in every way at every level of the organisation. It is a philosophy that has the objective of eliminating all defects. There is also a competing viewpoint that there exists an optimal level of quality, which minimises the total cost of quality. Under this philosophy, managers determine that point at which any further investment to improve quality would need be greater than the costs that could be saved from that reduced level of defects. TQM proponents would argue that this Acceptable Quality Level (as espoused by one major automotive manufacturer)  Provides competitors with the opportunity to establish a competitive edge, and  Ignores the costs of future lost sales when customers receive defective goods. The pursuit of quality through TQM is achieved by recognising four groups of activities that are related to quality. These groups of costs of quality are:  Prevention costs, namely, those costs incurred to prevent and minimise internal, external and appraisal costs.  Appraisal costs, e.g. the costs of finding defects by inspecting raw material, WIP and finished goods.  Internal failure costs. e.g. the costs of reworking defective production.  External failure. e.g. the costs of sales returns, warranty claims… The theory of the cost of quality is based on the belief that the costs of prevention and appraisal offset the costs of failure. AQL espouses that further attempts to drive down the defect rate, after some optimal point, will cause an increase in prevention and appraisal costs, which will, by now, have become greater than the savings in failure costs. We will now, in the next section, look at an example of these costs and the preparation of a Cost of Quality report.

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Topic 5

MANAGING QUALITY: AN EXAMPLE

Please refer to Exhibit 16.18 in your Textbook. Prevention Costs Quality Training Quality Planning Quality Reporting Quality Systems Appraisal Costs Mat’ls Inspection WIP Inspection Finished Goods Inspection Laboratory testing Internal Failure Costs Scrap in Prod’n Scrapped Finished Goods Rework Downtime External Failure Costs Warranty Out of Warranty Customer Complaints Transport losses Litigation Although a Cost of Quality report can help an organisation identify what is considered to be an optimal level of quality and it can put a dollar figure on the costs of poor quality, how ethical is this in industries such as health, air transport (safety) etc. Also, how do we impute a figure on contingent litigation? In Australia, each year, there are defective products recalled for safety reasons ranging from food to motor vehicles to children’s toys to health products.

3.2

OTHER QUALITY CONSIDERATIONS

ISO accreditation in Australia was “flavour of the month” a decade ago but has seemingly lost momentum. If the certification of quality is a good idea, then why has it lost its impetus? Maybe, because it was incredibly time consuming and more about bureaucracy than proving “real” quality?

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Topic 5

TUTORIAL QUESTIONS Attempt Self-Study problem 2 from page 779 in your textbook followed by P16.54.

SUMMARY One way to manage costs caused by suppliers is to analyse the costs associated with suppliers according to activities performed and see whether these costs can be brought under control through either negotiating with the suppliers, or taking the level of non-value adding costs caused by suppliers into consideration when selecting them. Further cost management related to inventory comes from the traditional approach of EOQ and average usage estimates being used for order point and safety stock decisions. The contemporary approach of JIT and TQM can be seen to relate to the EOG formula. EOQ assumes that all elements except order quantity are constant. However, if we wish to hold minimal inventory, we can see from the EOQ formula that ‘order costs’ (i.e. in manufacturing this is requisition cost) needs to reduce to prevent the total costs from spiralling out of control. Hence, costs such as set up costs needed to be reduced. With shorter set up times production could become more responsive, since it provided shorter lead times, and consequent lower set up costs meant that even the EOQ formula makes smaller batch sizes more economical. One can also see a link between JIT and TQM—JIT relies on the quality of throughput and the quality of processes. The focus on TQM assists in this regard. In turn, the investment in quality can provide better cost management through increasing certain costs to reduce costs overall. The competing philosophies of TQM and AQL were also explained in this topic. If the strategic approach adopted by a firm includes quality as a prime objective, TQM provides one form of performance measurement. We will now move on to other control and performance measurement techniques.

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Topic 6

TOPIC 6 CONTROL AND PERFORMANCE EVALUATION DECENTRALIZATION, RESPONSIBILITY ING, AND TRANSFER PRICING OBJECTIVES By the end of this topic you should be able to:  Explain decentralization, its benefits and costs.  Define the responsibility centre, investment centre, profit centre, revenue centre and cost centre.  Comprehend new developments such as shared services and team-based structures.  Utilise segmented profit statements.  Prepare hierarchical performance reports.  Describe the nature and reasons for transfer pricing.  Apply different transfer pricing methods.  Calculate and determine transfer prices for a range of scenarios. Resource: Text Reading Langfield-Smith, K; Thorne, H and Hilton, R (2006), Management ing: Information for managing and creating value. 4th edition. Sydney: McGraw Hill. Chapter 12. Resource: Other Text Reading Hansen & Mowen (2003), Management ing, 6th Edition, South-Western. Chapter 13 pages 530-533 & 544-552 and Chapter 15 pages 620-625. Morse, Davis & Hartgraves (2003), Management ing: A Strategic Approach, 3rd Edition, South-Western. Chapter 13 pages 576-582.

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Topic 6

CONTROL AND PERFORMANCE EVALUATION: AN INTRODUCTION This topic is the first of three topics that looks at several concepts and techniques related to control and performance evaluation. Previously, you would have studied budgeting and variance analysis, which are control and performance evaluation topics.

2.

DECENTRALIZATION, RESPONSIBILITY CENTRES & RELATED NEW DEVELOPMENTS Some corporations have organisational structures that revolve around a head office, which dominates all aspects of the organisation’s strategy and operations including centralization of systems, power and decision-making. Other organisations, however, prefer to decentralize these functions and devolve responsibility to branches, divisions or investment centres and allow local decision-making. This devolution of power, decision-making and responsibility is often part of what is referred to as having “flatter structures” and team based participative management practices. There is a range of reasons why an organisation would choose to devolve its systems and decision-making not the least of which is to speed up decision making and to let those at “the coal face” be directly responsible for their actions. Although the notion of decentralization is many decades old, more recently, for several reasons, some decentralized organisations have introduced centralized (shared) services such as enterprise wide databases and information technology sometimes known as ERP (enterprise resource planning).

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Topic 6

FINANCIAL PERFORMANCE REPORTS, SEGMENTS, CONTROLLABILTY AND RESPONSIBILITY In measuring and evaluating the performance of the managers of investment centres, profit centres etc., it is believed that they should only be assessed on activities, costs and revenue that they have control over and not those over which they have no control such as allocated costs and traceable non controllable costs. This is the essence of what is known as responsibility ing. We will now look at the use of a segment report which focuses on evaluating management only on what they control. Note how this report uses variable costing as the preferred reporting format. The profit statement (performance report) below is a summary of the key sections of Exhibit 12.5 in your textbook. Importantly the top (shaded) section lists all controllable, that is manager responsible revenue and expenses whereas the bottom section incorporates the items for which the segment manager should not be held responsible, namely, the non controllable items.

Sales Variable Operating Costs Segment Contribution Margin

Byron Bay Hotels $2,500 $1642 858

Company Segments Southern Division $1,600 1027 573

Northern Division $900 615 285

less Fixed expenses Controllable by the Segment Manager Profit Controllable by the Segment Manager

30

21

9

828

552

276

Less Fixed Traceable Expenses but Not Controllable by the Segment Manager Segment Profit Less Common Fixed Costs Net Profit before Tax

750 78 10 68

500 52

250 26

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Topic 6

For another example of a responsibility performance report now refer to Exhibit 12.6. This report demonstrates the connection between budgets and responsibility ing through the presentation of a hierarchical, segmented performance report. Below is a summary of the key features of this report and its hierarchical nature. This report is made up of investment centres, profit centres, revenue centres and cost centres. FEBRUARY

Budget Company Southern Division Northern Division Head Office Total Profit

Actual

$18,400 18,470 12,260 12,246 - 2,900 - 3,000 27,760 27,716

Northern Division Coffs Harbour Brisbane Newcastle Total Profit

6,050 2,100 4,110 12,260

Variance -

6,060 2,050 4,136 12,246

Newcastle Grounds and Maintenance Housekeeping Recreational Hospitality Food and Beverage Total Profit

- 45 - 40 40 2,800 1,355 4,110

Food and Beverage Banquets Restaurant Kitchen Total Profit

600 605 1,785 1,760 1,030 - 1,025 1,355 1,340

$70 14 100 44 -

10 50 26 14

-

-

-

44 41 41 2,840 1,340 4,136

TUTORIAL QUESTIONS You should now attempt E12.3, E12.30, E12.33 and E12.36.

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1 1 - 1 - 40 15 - 26

-

5 25 - 5 15

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Topic 6

TRANSFER PRICING: AN INTRODUCTION

Transfer pricing occurs when products and services, from within the same organization, are transferred (sold) from one investment centre or profit centre to another. If the management of both entities involved, namely the seller (supplier) and purchaser, are evaluated and/or rewarded (get bonuses) based on their profits then this internal price will be of importance to both parties. The supplier will want to get as high an internal price (transfer price) as possible to boost their revenue, and the purchaser will want to pay as close to zero as possible to minimise their cost of purchasing. As a consequence, the issue becomes how to set the transfer price. Approaches used include:  Direct Intervention from Head Office, corporate management.  Market-Based prices.  Cost-Plus prices.  Negotiated prices. Negotiation of transfer prices essentially depends on the bargaining power of the two parties and this is influenced by factors such as: the existence of an external market for the supplier and also whether the supplier does or does not have excess capacity. These two variables create as many as five bargaining scenarios, which as seen from the perspective of the supplier are:

4.1

NEGOTIATION SCENARIOS

Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5

Supplying Division External Market Excess Capacity Yes Yes Yes No Yes Limited No Yes No No

Now please refer to your textbook page 584. Scenario 1 External Market plus Excess Capacity. Page 585 The Industrial Division would like to sell at the market price of $1,000 per tonne but because it has excess capacity anything over its cost of $700 per tonne will add to its profits. The Soap Division will want to purchase at anything below market price of $1,000; the lower the better as it will reduce its costs and thus increase profits. The transfer price will be bargained between the variable cost of $700 per tonne and the market price of $1,000 per tonne.

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Scenario 2 External Market but no Excess Capacity (Full Capacity). In this case, as the Industrial Division has an external market and is at full capacity, it will not want any other transfer price than market price. Its bargaining position is powerful and if the Soap Division rejects the offer of $1,000 per tonne then the Industrial Division will just sell on the open market for $1,000 per tonne. Scenario 3 External Market and Limited (restricted) Excess Capacity. This scenario is an extension of scenario 2 in that the Industrial Division will want to sell all it can at the open market price of $1,000 per tonne and then just negotiate with the Soap Division for whatever it cannot sell at the open market price. The negotiations with the Soap Division for the surplus will then follow scenario 1. Scenario 4 No External Market but Excess Capacity. The Industrial Division will want to sell at as high a transfer price as possible but with excess capacity anything over $690 per tonne, its variable costs, will add to its profits. The Soap Division will want to purchase at anything below its market price of $1,100 minus its $200 per tonne processing cost, namely, $910 per tonne. The transfer price will be bargained between $690 per tonne and $910 per tonne, which is the Soap Division’s top price. Scenario 5 No External Market and no Excess Capacity (Full Capacity) Operating at full capacity, the Industrial Division will demand a minimum of $990 per tonne from the Soap Division in order to compensate for any lost contribution margin from “regular” customers.

TUTORIAL QUESTIONS You should now attempt E12.39, P12.45 and P12.46.

SUMMARY In this topic we revisited a topic considered in ACCT 2006, namely responsibility centres and the evaluation of their managers. While variance analysis can form a major element in the evaluation of cost centre and revenue centre managers, profit centre (including investment centre) managers can have performance measures that have the potential for significant influence from the decisions of others. This needs recognition, and you were shown how to do this. Transfers of components and services between business units present more situations in which managers can influence each others results. Hence, the setting of transfer prices can be a major cause of dispute and bad feeling. You now should understand a variety of transfer pricing options and the implications for how transfer prices are set. While transfer prices affect the measure of profits, a measure of profit in isolation does not take into consideration the level of resources utilised in its generation. Yet managers usually need to

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be held able for the efficient usage of resources. This issue forms the major part of the material in the next topic.

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Topic 7

TOPIC 7 CONTROL AND PERFORMANCE EVALUATION FINANCIAL PERFORMANCE MEASURES AND REWARD SYSTEMS OBJECTIVES By the end of this topic you should be able to:  Understand the term financial performance measurement and reasons for financial performance measurement.  Distinguish between some traditional and contemporary approaches to financial performance measurement.  Calculate and interpret Return on Investment and Residual Income.  Explain problems associated with using Return on Investment and Residual Income.  Briefly, explain Economic Value Added and Shareholder Value Added.  Describe and apply different types of reward systems.  Discuss issues and difficulties related to reward systems. Resource: Text Reading Langfield-Smith, K; Thorne, H and Hilton, R (2006), Management ing: Information for managing and creating value. 4th edition. Sydney: McGraw Hill. Chapter 13. Resource: Other Text Reading Hansen & Mowen (2003), Management ing, 6th Edition, South-Western. Chapter 13 pages 533-544. Morse, Davis & Hartgraves (2003), Management ing: A Strategic Approach, 3rd Edition, South-Western. Chapter 13 pages 583-590.

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Topic 7

FINANCIAL PERFORMANCE MEASURES: AN INTRODUCTION This topic is, in particular, about techniques that can be used to measure and evaluate the financial performance of investment centres or divisions. See the shaded area below.

Investment Centres

Profit Centres Revenue & Cost Centres

Some reasons for wanting to measure and evaluate the performance of investment centres include to:  See if they are meeting their targets.  Identify problems and what causes them.  Assist in the determination of management bonuses. (Later, in this topic, we look at different types of reward systems.)  Evaluate the effectiveness of the communication of divisional goals and strategy.

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Topic 7

TRADITIONAL FINANCIAL PERFORMANCE MEASURES OF INVESTMENT CENTRES

This section looks at two traditional measures of the financial performance of investment centres. These techniques are called Return on Investment (ROI) and Residual Income (RI).

2.1

RETURN ON INVESTMENT (ROI)

Return on Investment (ROI) is defined as Profit/Investment. For example: if an investment centre has earnings of $1,000,000, expenses of $750,000 and an Investment of $10,000,000, then, The ROI would = ($1,000,000 - 750,000)/$10,000,000 = 2.5%. This raises some questions such as:  Is 2.5% good or bad?  What if the Required Rate of Return is 6%?  How is the Required Rate of Return determined? In summary, essentially, ROI measures the efficiency of the usage of resources as distinct from the added wealth. An extension of the ROI formula is called the Du Pont formula. Why would you use this formula? ROI, although traditionally popular, can encourage dysfunctional behaviour if management performance rewards are centred solely on it. Refer to the example on page 617 of your textbook and the disincentive for an investment centre manager to invest in a new project, even though it exceeds the required rate of return. The replacement of aging assets is a particular issue here. Note that it is the way in which ROI is used that creates problems, rather than the calculation itself. If managers are assessed by taking a trend over time, or comparing their ROI against others, the managers will take steps to maximise their ROI. However if, for performance evaluation, their ROI is compared with the budgeted ROI (preferably flexed for circumstances encountered during the year), then it is a comparison against what it ought to be in the circumstances, including projects adopted and equipment replaced. Any ROI far in excess of the budget would then be a cause for investigation, as much as an ROI below budget.

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Topic 7

RESIDUAL INCOME (RI)

A second traditional technique is called Residual Income and it is defined as: Profit minus (Investment x Required Rate of Return) Residual Income measures the added wealth created from the additional resources allocated. Using the data from the previous example, the RI would be: ($1,000,000 - 750,000) – (6% of $10,000,000) = negative $350,000. What does this mean? Is it good or bad? A positive result is considered to be an indicator of good financial performance whereas a negative result is considered to be the opposite. We can compare it with ROI to see what it tells us. Basically, in our example, we can ask: if the investment returned 6%, what would the profit be? The answer is 6% of $10m, or $600,000. Since the profit was $250,000, we can see that it falls $350,000 short of what is required.

TUTORIAL QUESTIONS Attempt the Self-Study problem on page 636 of your textbook followed by: E13.30, E13.33 and P13.38.

2.3

PROBLEMS IN MEASURING PROFIT AND INVESTED CAPITAL

If an investment centre and its management are to be evaluated using either ROI or RI, then, from the outset, it needs to clearly defined how the profit and also the investment value will be calculated. Initially, this may appear straight-forward but, in fact, there are a number of issues that need to be resolved in order to ensure that there is a consistent basis of calculation from period to period. You should make sure that you are clear about the options, covered in your textbook, otherwise you will not be able to apply the ROI or RI calculations since you will not know what figures to use for the elements of the equation.

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Topic 7

CONTEMPORARY FINANCIAL PERFORMANCE MEASURES OF INVESTMENT CENTRES

Contemporary financial performance measurement seeks to determine how much value has been added to an investment centre from the perspective of shareholders. We will now briefly consider two approaches to determining how shareholder added value can be measured.

3.1

ECONOMIC VALUE ADDED (EVA)

Economic Value Added is determined from a specific interpretation of the RI formula. The EVA formula is: Net Operating Profit after tax – (Capital Employed x Weighted Average Cost of Capital). EVA uses the average cost of debt and equity called weighted average cost of capital (WACC) whereas RI has a range of notions as to what actually is the required rate of return and how to calculate it. Also, sometimes in using EVA, people substitute net cash inflow for net operating profit.

3.2

SHAREHOLDER VALUE ADDED (SVA)

Another technique used to determine economic value is shareholder added value, which is determined by calculating the present value of future cash flows less the market value of the organisations debt.

TUTORIAL QUESTIONS You should now attempt E13.35 and P13.40.

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Topic 7

REWARD SYSTEMS One of the reasons for conducting financial performance measurement is to determine executive bonuses. There are, however, several issues regarding reward systems including:  How does a company ensure that its performance measurement system accurately measures management performance?  How does a company ensure that its performance measurement system will actually motivate management to work in the best interests of the company rather than their personal interests?  Which type of reward system should a company choose? •

Individual or Team?

•

Money or Shares?

•

Profit Sharing or Gainsharing?

The challenge for an organization is to design and implement performance measurement systems that are aligned to improved and improving business performance and, concurrently, motivate management personally to achieve these goals in the short, medium and long . The problem is exacerbated by using this performance evaluation with a reward system, which is adopted for the purpose of additionally motivating managers but, consequently, a poor evaluation system could equally motive dysfunctional behaviour as goal congruent behaviour. Each year in the Australian media, we hear of cases of abysmal company performance and senior executives receiving generous bonuses. How does this happen? Certainly, we can conclude that the bonus system and company performance are not properly aligned. Are bonus systems difficult to design and implement? Deg bonus systems that balance short, medium and long term corporate goals is not easy. Also, we could ask the question: who designs a company’s bonus system? Is it the shareholders? Is it the executive management? Of course, it is the latter. Is there a conflict of interest? Finally, senior executives are often on short and medium term contracts which reward them for financial performance over the period of their contract; hardly, therefore, an incentive for planning longer than the term of the contract.

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Topic 7

TUTORIAL QUESTIONS You should now attempt E13.36 and P13.37.

SUMMARY The focus of this topic has been on evaluating the control managers have over the efficient utilization of assets. In this context we need to recognise that control is not absolute control but is related to the degree of influence, since ‘influence’ is a continuum from absolutely no influence to total control. For ‘control’ we should expect significant influence (ie toward the positive end of the continuum). Now that you are familiar with the traditional forms of performance evaluation, which are still very widely used, we need to turn to more contemporary methods. Contemporary methods do not replace traditional measures but usually complement them, often incorporating the traditional measures into more contemporary monitoring and reporting techniques.

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Topic 8

TOPIC 8 CONTROL AND PERFORMANCE EVALUATION: CONTEMPORARY APPROACHES TO MEASURING PERFORMANCE By the end of this topic you should be able to:  Discuss the weaknesses of traditional and contemporary financial performance measures.  Understand the features of contemporary performance measurement.  Develop a balanced scorecard.  Explain the term benchmarking, different types of benchmarking and their problems.  Identify the warning signs of problems in a performance measurement system.  Recognise the characteristics of a good performance measurement system. Resource: Text Reading Langfield-Smith, K; Thorne, H and Hilton, R (2006), Management ing: Information for managing and creating value. 4th edition. Sydney: McGraw Hill. Chapter 14. Resource: Articles Ittner C & Larcker D (2003), Coming up short on non-financial performance measurement, Harvard Business Review, Nov. Ballou B, Heitger D & Tabor R (2003), Non financial performance measures in the health care industry, Management ing Quarterly, Autumn. Resource: Other Text Reading Morse, Davis & Hartgraves (2003), Management ing: A Strategic Approach, 3rd Edition, South-Western. Chapter 13 pages 590-593 and Chapter 9 pages 388-390.

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Topic 8

PROBLEMS WITH FINANCIAL PERFORMANCE MEASURES Contemporary approaches to measuring performance have emerged because of weaknesses in the traditional techniques. These criticisms include that they:  Focus only on dollar values and do not use non-financial data such as Quality, Innovation, Customer Service…  Are short-term measures only. e.g. One year.  Are too aggregated and therefore not relevant (controllable) for most staff. e.g. Profit, Revenue, ROI, RI…

 Are results or outcomes oriented, rather than also being focused on what causes or drives the results.  Are not clearly linked to organisational goals and strategy.  Neglect external benchmarking.

2.

CONTEMPORARY PERFORMANCE MEASUREMENT: AN INTRODUCTION Contemporary approaches to measuring performance seek to overcome the problems listed above by incorporating either all or some of the following:  The use of both financial and non-financial measures. E.g. customer satisfaction, quality, on time delivery…  The linking of goals, strategy and performance evaluation.  Benchmarking.  The incorporation of continuous improvement into performance targets.

In the following sections, we will look at two contemporary approaches to performance measurement and evaluation, namely, the Balanced Scorecard and Benchmarking.

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Topic 8

THE BALANCED SCORECARD A well publicised, contemporary technique used for operational control is the Balanced Scorecard. The Balanced Scorecard seeks to provide a balanced perspective on performance by using a mix of financial and non-financial perspectives, key performance indicators (KPIs) and key performance drivers (KPDs). The original model of the scorecard developed by Kaplan & Norton was based on four perspectives.  A Financial Perspective.  A Customer Perspective.  An Internal Process Perspective.  A Learning & Growth Perspective. EXHIBIT 14.4 Key Performance Indicators (KPIs) Or Lag Indicators

Key Performance Drivers (KPDs) Or Lead Indicators

Financial Perspective Customer Perspective Internal Process Perspective Learning & Growth Perspective

Note that it is quite feasible to have additional perspectives such as the community, the environment etc, and not just be constrained to the Kaplan and Norton four perspective framework. (Note the relationship of this with Topic 11 on Social and Environmental ing.) The key to developing the balanced scorecard is not merely to identify the perspectives and their objectives but most importantly the inter-related KPIs and KPDs (lag and lead indicators). Finally, the scorecard needs to be developed so that it is relevant to staff at all levels of the organisation. This, however, tends not to be demonstrated fully in textbooks. The Balanced Scorecard, not unlike Activity Based Management (ABM), seeks to identify what causes things to happen, that is, drivers. ABM is focused on identifying drivers of no value adding activities whereas the Balanced Scorecard is focused on drivers of the Objectives and KPIs for each perspective.

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Topic 8

In developing a scorecard, using the model above, there are four steps or stages:  Identify the Perspectives.  Identify an Objective or Objectives for each perspective.  Identify an indicator or measure (KPIs or lag indicators) that will show whether an objective has been achieved.  Identify the Drivers (KPDs or lead indicators), for the Objectives and KPIs, that is, what causes the Objective and Lag Indicators to be attained. Note: a lead indicator in one situation, point in time or to one person may become a lag indicator in another situation or point in time or to another person. For example, your midterm exam results towards your objective of ing this course. Is it KPI (lead) or (KPD) a lag indicator? The Balanced Scorecard is not an exact instrument and this is part of the challenge to understanding it. Your textbook demonstrates two Balanced Scorecard models; the first in Exhibit 14.4 is for a manufacturer and the second example, in Exhibit 14.5, is for the service sector and a bus company. Some people find the manufacturing example easier to understand because there is a physical product. You could develop your own scorecard for your studies or even for this course. For example, if we build a basic scorecard for this course with just one perspective it might look as follows. KPIs or Lag Indicators

KPDs or Lag Indicators

Attendance at classes

% of lectures attended % of tutorials attended % completion of tutorial questions Frequency of participation in tutorials

Academic Record Perspective Objective Participation in tutorials To, at least, Cost Mgt. Systems

Mid semester exam result Assignment result

Attempting past exam papers Completing the assignment one week before the due date!

At first, the concept of the Balanced Scorecard is not difficult to understand, but the more you think about it, sometimes the more complex it can become. Also, if you look at the KPDs above you could think that academic success is driven mainly by attendance at classes but where does that leave external students?

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Topic 8

TUTORIAL QUESTIONS Attempt the Self-Study problem from page 680 in your textbook followed by: E14.25, E14.30 and P14.34.

4.

BENCHMARKING Although the term “Benchmarking” is relatively new, the concept itself is not because benchmarking simply means to compare oneself with others in order to find ways to improve. The key to organisational benchmarking is to find someone else, namely, another organisation against which to compare and from who lessons can be learned. There are two main categories of benchmarking, internal and external of which the latter has three levels as described below:  Internal Benchmarking, for example, one BHP division benchmarking with another division.  External Benchmarking. • • •

Competitive, e.g. a direct competitor, such as the National Australia Bank (NAB) benchmarking against the ANZ, WestPac or Commonwealth Banks. Industry, e.g. an organisation from the same industry, such as the NAB benchmarking against MacQuarie Bank or the Police Credit Union or Wells Fargo. Bank.Best-In-Class, e.g. by using any industry which seems suitable for comparison. For example, The NAB benchmarking against QANTAS or Woolworths.

One of the challenges with benchmarking sometimes is not so much identifying a suitable benchmarking partner but rather getting co-operation and access to their information and ways of doing things. In particular, this can be an issue where the benchmarking partner is a competitor. Surprisingly, sometimes even prospective internal benchmarking partners, in some organisations, will not be willing to co-operate because of internal rivalry.

TUTORIAL QUESTIONS You should now attempt E14.26 and P14.38

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5.


Topic 8

WARNING SIGNS OF PERFORMANCE MEASUREMENT PROBLEMS There are several signs or symptoms that a performance measurement system is not working properly including when staff treat official reports as “a joke” and “play games”, in order, to be seen to meet targets. Also, in some organisations, some staff may go further and design their own “local” performance measurement system often using spreadsheets. They then use this information in meetings as representing the “true’ state of affairs. Another not uncommon problem with performance measurement systems is that information is not available when needed and it appears weeks or months too late.

6.

SOME CHARACTERISTICS OF A GOOD PERFORMANCE MEASUREMENT SYSTEM Good performance measurement systems have a number of features and are respected by s when at the ’s level in the organisation the information:  Is simple and “makes sense”.  Is relevant.  Is controllable.  Is not too complex or detailed.  Is up to date.  Is received on time.  Is linked to strategy.  Compares favourably with realistic benchmarks and targets.

TUTORIAL QUESTIONS You should now attempt Q4.12 and Q4.14.

SUMMARY This topic incorporated recent developments (specifically the balanced scorecard and the issues that led to its development) into our consideration of performance evaluation techniques. Part of performance evaluation is the comparison against the budget. One element of the master budget that we have not yet covered is the capital budget. We do this in the next topic.

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TOPIC 9 CAPITAL BUDGETING OBJECTIVES By the end of this topic you should be able to:  Understand the term Capital Budgeting and when to use Capital Budgeting techniques.  Describe the concept of discounted cash flow (DCF) and the importance of the time value of money.  Evaluate Capital Budgeting decisions by calculating Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period and the ing Rate of Return.  Discuss assumptions, advantages and disadvantages of NPV, IRR, Payback Period and the ing Rate of Return.  Explain the management ant’s role in Capital Budgeting.  Comprehend the role of post completion audits.

Resource: Text Reading Langfield-Smith, K; Thorne, H and Hilton, R (2006), Management ing: Information for managing and creating value. 4th edition. Sydney: McGraw Hill. Chapter 21 and the Appendix to Chapter 21. Resource: Other Text Reading Hansen & Mowen (2003), Management ing, 6th Edition, South-Western. Chapter 18 pages 752-764. Morse, Davis & Hartgraves (2003), Management ing: A Strategic Approach, 3rd Edition, South-Western. Chapter 10 pages 408-423.

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Topic 9

CAPITAL BUDGETING: AN INTRODUCTION In your previous studies in management ing you would have learned about short term, (i.e., tactical) decision-making. We will now look at medium and long term decision making, called Capital Budgeting. Capital Budgeting involves making decisions regarding what we know as non-current assets, namely, the purchase and replacement of plant, machinery, equipment, transport, infrastructure etc. In essence, what distinguishes tactical decisions from capital budgeting decisions is the time period involved: the former involves decisions affecting, in theory, the profit of only one year, and the latter for two or more years. The fact that capital budgeting involves costs and revenues of more than one year then raises the issue of the time value of money. The time value of money recognises that a dollar today is more valuable than a dollar in the future because, among other things, it can be invested and earn interest. In the Appendix to Chapter 21, you will find additional information on the concept of the time value of money. If you are unfamiliar with this concept then you should thoroughly study the Appendix to Chapter 21 with an emphasis on Present Value. Please note also the Tables at the back of the Appendix. In the following sections, we will now consider four capital budgeting techniques, the first two of which recognise the time value of money and make adjustments for the costs and revenue of different years through discounted cash flow (DCF).

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Topic 9

NET PRESENT VALUE (NPV) NPV calculates the net present value of capital projects over their lifetime and it is the first of two discounted cash flow (DCF) techniques covered in your textbook. As an example, you should now read the background information for the Monash Medical Centre and its CT scanner problem on page 1013. DCF techniques require that we distinguish cash flows for each year and they, as shown below, are ideally set up in a spreadsheet. Both Exhibits 21.4 and 21.7 in your textbook demonstrate this and although the layouts are slightly different I have reproduced the second format below. B

C

2 3 4

D

0

5

Purchase cost of the new CT scanner Installation Cost Additional Operating Costs

6 7 8

E

F

G

H

CT Scanner Decision Annual Cash Flows 1 2

3

4

5

585,000 - 74,715 107,000 90,000 200,000

Additional Revenue Savings because inpatients do not have to stay as long in hospital

9

107,000 90,000 200,000

107,000 90,000 200,000

107,000 90,000 200,000

- 107,000 90,000 200,000

Once we have recorded our annual cash flows then we next total each of the columns and calculate our yearly net present values and finally the NPV for the project. See below. B 2 3 4 5 6 7 8 9

1 0 1 1 1 2 1 3 1 4 1 5 1

C

Purchase cost of the new CT scanner Installation Cost Additional Operating Costs Additional Revenue Savings because inpatients do not have to stay as long in hospital

Cost of Capital of 10%

NPV=

D CT Scanner Decision Annual Cash Flow 0 1 - 585,000

E

F

G

H

2

3

4

5

- 107,000 90,000 200,000

- 107,000 90,000 200,000

- 107,000 90,000 200,000

- 107,000 90,000 200,000

- 107,000 90,000 200,000

-$ 659,715

$ 183,000

$ 183,000

$ 183,000

$ 183,000

$ 183,000

1

0.909091

0.826446

0.751315

0.683013

0.620921

-$ 659,715

$ 166,364

$ 151,240

$137,491

$124,991

$113,629

- 74,715

$33,999

77

6 1 7

Note, this model has been constructed in Excel and is accurate to the nth decimal place.

ACCT 2013


Topic 9

A positive NPV means that wealth is added to the organization and that, from a financial perspective, the project is viable, whereas a negative NPV means the project should be rejected because it has not reached its cost of capital. That implies that the return from the investment is less than the cost of the funding for the project. (Sometimes we use the return on an alternative investment (e.g the bank rate, debentures, other projects) as the discount rate to assess whether this project will return a higher return than the alternative investment opportunity.) The Cost of Capital or Required Rate of Return or Hurdle Rate is the minimum financial return required by an organization from a project. In your studies, if you study financial management then you will study this topic and, in particular, how to calculate the Weighted Average Cost of Capital, that is, the average cost of an organisation’s equity and debt. Note that capital project evaluation is often complicated by many non-quantifiable influences and that these influences may be given greater priority than the financial decision.

TUTORIAL QUESTIONS You should now attempt E21.27 & E21.29.

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Topic 9

INTERNAL RATE OF RETURN (IRR) The second DCF technique used to evaluate capital projects is called the Internal Rate of Return (IRR). Initially, to calculate IRR you use the same spreadsheet layout as NPV, however, rather than use a predetermined hurdle rate, you have to calculate the rate of return that will give the project an NPV of zero. Spreadsheets again are ideal for this purpose along with their IRR function. C

2 3 4 5 6 7 8 9

1 0 1 1 1 2 1 3 1 4 1 5 1 6

D

Purchase cost of the new CT scanner Installation Cost Additional Operating Costs Additional Revenue Savings because inpatients do not have to stay as long in hospital

E CT Scanner Decision Annual Cash Flow 0 1 - 585,000

F

G

H

I

2

3

4

5

- 107,000 90,000 200,000

- 107,000 90,000 200,000

- 107,000 90,000 200,000

- 107,000 90,000 200,000

- 107,000 90,000 200,000

$ 183,000

$ 183,000

$ 183,000

$ 183,000

$ 183,000

- 74,715

-$ 659,715

For an NPV of

0.00

IRR=

11.9975%

This has been solved using the Excel function called IRR

If you do not use a spreadsheet to determine the IRR then a financial calculator can also automatically solve the IRR. Otherwise it has to be solved using a combination of Trail and Error (guessing) and sometimes a technique called linear interpolation. This latter method can be most tedious.


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4.


Topic 9

COMPARING NPV AND IRR An appropriate question is which of the two DCF methods is better? NPV measures added wealth and IRR the efficiency or rate of return of the investment. NPV is favoured academically, however, it is not uncommon for organizations to use IRR and then to compare it with current borrowing rates. Since IRR assumes that cash inflows during the life of the project are reinvested at the same rate as the IRR this should be taken into consideration when deciding how valid the comparison of the IRR’s for of different projects would be.

5.

THE PAYBACK PERIOD The Payback Period calculates the time it takes for the profits from an investment to cover the cost of the investment. There are two models of the Payback Period, namely “with even cash flows” and “with uneven cash flows”, both of which are demonstrated in your textbook on page 1025. The formula for the Payback Period with even cash flows is: The Initial Investment on the Project Annual Cash Inflow =

$659,715 $183,000

= 3.61 years

Although payback period has a number of weaknesses it is, in fact, used by some organisations in their initial screening of potential capital projects. These organisations, as part of their investment policy, have a maximum payback period of, for example, three years or five years. In other words, no project will even be considered that exceeds the benchmark payback period. Potential projects that are inside the benchmark are then more thoroughly analysed and evaluated using techniques such as IRR and NPV. It should also be noted that to improve the accuracy of the payback period calculation we can use discounted cash flows for each of the years. This type of payback is called Discounted Payback Period.


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6.


Topic 9

THE UNADJUSTED (ANTS) RATE OF RETURN The ants Rate of Return also referred to as the Unadjusted Rate of Return is calculated by the following formula. Average Annual Profit from the Project Investment =

$183,000 – 131,943 (dep’n) $659,715

= 7.74%

There are two models of the ants Rate of Return, namely “Investment” and “Average Investment”, both of which are demonstrated in your textbook on pages 1026-1027. Although ants Rate of Return has a number of weaknesses, sometimes it is used as a fast approximation for IRR. However, it is important to realise that as an approximation its reliability declines significantly as the project lifetime gets longer and the later year profits become larger.

7.

OTHER ASPECTS OF CAPITAL BUDGETING In this course it is important for you to grasp the role of the management ant in capital budgeting. We have looked at the techniques because an understanding of them assists in the provision of data that will be incorporated in the financial analysis. The management ant can be called upon to have a key role in determining the data to be input into the formulae. From a cost management perspective, as with other budgets, it is important to monitor and analyse what actually happens against the plan. This is the role of implementation audits. You should study this section of the textbook to become familiar with:  The ants role in capital budgeting.  Post completion audits.

TUTORIAL QUESTIONS Attempt the Self-Study problem starting from page 1033 in your textbook followed by: P21.45, P20.46 and P21.47.

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Topic 9

SUMMARY This topic has looked at the section of the master budget that was not studied in ACCT 2006. It has provided a basic overview of capital budgeting techniques. Discounted Cash Flow (DCF) techniques in particular require further consideration to make you aware of some complicating issues with regard to the statement of cash flows, such as the tax issues (e.g. depreciation is not a cash flow but the its impact on tax payments does create an incremental cash flow, and tax payments are usually made the year after the revenue and expense cash flow). The next topic completes our study of DCF techniques and, in particular, the calculation of incremental cash flows.

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Topic 10

TOPIC 10 CAPITAL BUDGETING OBJECTIVES By the end of this topic you should be able to:  Explain the direct and indirect effects of tax on discounted cash flow techniques.  Calculate the direct and indirect effects of tax on discounted cash flow techniques.  Answer a comprehensive question on capital budgeting.  Explicate the concept of ranking  Rank capital projects.  Understand the nature and difficulties of capital investments in advanced technologies

Resource: Text Reading Langfield-Smith, K; Thorne, H and Hilton, R (2006), Management ing: Information for managing and creating value. 4th edition. Sydney: McGraw Hill. Chapter 22. Resource: Articles Bruggeman W & Slagmulder R, (1995) The impact of technological change on management ing, Management ing Research, volume 6, issue 3, pages 241-252. Resource: Other Text Reading Hansen & Mowen, Management ing (2003), 6th Edition, South-Western. Chapter 18 pages 765-778. Morse, Davis & Hartgraves (2003), Management ing: A Strategic Approach, 3rd Edition, South-Western. Chapter 10 pages 423-435.

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1.


Topic 10

CAPITAL BUDGETING: ADDITIONAL ISSUES The previous topic introduced capital budgeting but it ignored the effects of taxes on corporate cash flows. Tax has a double-edged effect on cash flow in that tax on revenue (profit) results in a Payment (cash outflow) to the Australian Taxation Office (ATO) whereas most expenses are an allowable deduction and thus reduce the amount of tax payable. We will now consider a series of individual examples that demonstrate the effects of tax on cash flow. Later, in Section 3, we will then look at a consolidated example of these individual concepts.

2.0

TAX ON ADDITONAL SALES

The effect of tax on sales is to reduce the cash inflow into an organisation by the amount of tax paid on the sales. Please refer to your textbook and the example on pages 1058-1059. Additional Sales Less Additional Cost of Goods sold

$110,000 60,000

Additional Gross Profit

50,000

Less Tax at 33% Cash Inflow after Tax

16,500 33,500

Note that, currently, in Australia, the company tax rate is now 30% and no longer 33%. Also, in the example, it is assumed that all sales and costs are either collected or paid and nothing is outstanding, that is, on credit any longer.

2.1

TAX ON ADDITIONAL EXPENSES

The effect of tax on additional expenses is to reduce the amount of tax paid to the ATO and therefore to decrease the cash outflow of the organisation because expenses are generally an allowable deduction. Please refer to your textbook and the example on page 1059. Additional Expenses Tax at 33% Net Cash Outflow after Tax

$30,000 9,900 20,100

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2.2


Topic 10

TAX ON THE PURCHASE OF A NON-CURRENT ASSET

Purchasing a non-current asset such as the textbook example of a truck on page 1059 generally involves a depreciation write off and an allowable deduction for tax purposes. Although depreciation itself is only an ing book entry and is not cash flow, the taxation deduction however does reduce the amount of tax payable to the ATO and therefore does affect cash flow. This is demonstrated in Exhibit 21.1. In answering capital budgeting questions, there is more than one way to present or format an answer. The following examples all use the format first demonstrated in Exhibit 21.7 on page 1023, whereas your textbook generally uses a more concise and condensed format. Ultimately, it is up to you to decide which layout you prefer. In the example below, row 15 is the row, which claims the cash saving on tax from the depreciation on the truck. The calculation is based on annual depreciation of $8,000 @ 33% company tax = $2,640. A

3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

B C D Purchase of Delivery Truck Year 0 1 2 Cash Inflow from Additional Sales 50,000 50,000 Cash Outflow from Additional Wages -30,000 -30,000 Total Taxable Cash Flows from Operations 0 20,000 20,000 Tax @ 33% 0 6,600 6,600 After Tax Cash Flows from Operations $0 $13,400 $13,40 0

Initial Investment After Tax Cash Flows from Operations

-40,000 0

$13,400

Annual Dep’n Savings Total Cash flows

-40,000

2,640 16,040

1 -40,000

0.893 $14,324


20 21

NPV @ 12%=

$17,82 4

TUTORIAL QUESTION You should now attempt E22.25.

85

E

F

G

3 50,000 -30,000 20,000 6,600 $13,40 0

4 50,000 -30,000 20,000 6,600 $13,40 0

5 50,000 -30,000 20,000 6,600 $13,400

$13,40 0 2,640 16,040

$13,40 0 2,640 16,040

$13,40 0 2,640 16,040

$13,400

0.797 $12,78 4

0.712 $11,42 0

0.636 $10,20 1

0.567 $9,095

2,640 16,040

ACCT 2013

2.3


Topic 10

PROFIT OR LOSS ON DISPOSAL OF A NON CURRENT ASSET

If a non-current asset is sold, traded-in or scrapped, there probably will be a book profit or loss on the sale. Although this book profit per se is not cash flow, the amount itself represents either under depreciation or over depreciation on the asset and what has or has not previously been claimed from the ATO. Therefore, a book loss being under depreciation can now, at sale, be claimed from the ATO whereas a book profit, which means too much had been claimed in previous years, must now be given back. Both are demonstrated in your textbook with the book loss example of Exhibit 21.2 demonstrated below in cell B6 below. The amount of $264 is calculated as follows: [($4,000 - $3,200) x 33%]. A 3 4 5 6

7 8 9 10 11 12 13 14 15

Year Initial Investment Tax Savings from the Loss on Disposal of the old Forklift Tax Savings on Annual Operating Costs Annual Dep’n Savings Salvage Value Total Cash Flows Cost of Capital of 12%

NPV @ 12% =

B

C

D

0 -$12,000

E

F

G

H

Purchase the New Forklift 3 4 5

1

2

$1,675

$1,675

$1,675

$1,675

$1,675

$0

$0

$0

$0

3,200 -$8,536

$1,675

$1,675

$1,675

1

0.893

0.797

-$8,536

$1,496

$1,335

I 6

J

K

L

7

8

9

10

$1,675

$1,675

$1,675

$1,675

$1,675

$0

$0

$0

$0

$0

$0

$1,675

$1,675

$1,675

$1,675

$1,675

$1,675

$1,675

0.712

0.636

0.567

0.507

0.452

0.404

0.361

0.322

$1,193

$1,065

$950

$849

$757

$677

$605

$539

$ 264

$929

TUTORIAL QUESTION You should now attempt E22.26.

2.4

INVESTMENT IN WORKING CAPITAL

At the beginning of a capital project, that is year 0, sometimes, additional raw materials have to be purchased to increase current holdings (balances). If this occurs then the increase in stock levels would be an additional cash outflow in year zero. Conversely, in the final year of a project this additional inventory would probably be “run down” and put into production thus increasing cash flow in the final year. This is demonstrated in Exhibit 22.33.

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Topic 10

CAPITAL BUDGETING: A COMPREHENSIVE EXAMPLE Exhibit 22.5 is a complete example of NPV, which incorporates the various ways in which tax can impact either directly or indirectly on cash flows. Understanding this model is important. The presentation below is divided into three sections: Keep the Old Equipment and Purchase the New Equipment, which in turn has two sections: Operating Cash Flows and Total Cash Flows. A

2 3 4 5 6 7 8 9 1 0 1 1 1 2 1 3 1 4 1 5 1 6 1 7 1 8 1 9 2 0 2 1 2 2 2 3 2 4 2 5 2 6 2 7 2 8 2 9 3 0 3 1 3

B

Year Cost of Overhaul Salvage Value Total Cash Flows after Tax Cost of Capital of 12%

D

E

F

G

H

Keep the Old Equipment 0 1 2 2,345

3

4

5

6

0 1 $ NPV@12%=

C

0 0.893 $ -

2,345 0.797 $ -

0 0.712 $ -

0 0.636 $ -

0 0.567 $ 0

0 0 0.507 $ -

$1,869

Purchase the New Equipment Year

0

1

2

3

4

5

6

Annual Incremental Profits from Additional Sales Annual Operating Cost Savings

40,000

40,000

40,000

40,000

40,000

40,000

15,000

15,000

15,000

15,000

15,000

15,000

Annual Cost of Systems Operator

-30,000

-30,000

-30,000

-30,000

-30,000

-30,000

Annual Marketing Analysis Costs

-4,500

-4,500

-4,500

-4,500

-4,500

-4,500

Software Update

-4,500

Retraining

-5,000

Retag Inventory

-3,000

Total Taxable Cash Flows from Operations

-8,000

20,500

20,500

16,500

20,500

20,500

20,500

Tax @ 33%

-2,640

-6,765

-6,765

-6,765

-6,765

-6,765

-6,765

After Tax Cash Flows from Operations

-$5,360

$13,73 5

$13,73 5

$13,73 5

$13,73 5

$13,73 5

$13,735

0

1

2

3

4

5

6

13,735

13,735

13,735

13,735

13,735

13,735

6,600

3,960

2,376

1,426

513

855

Year Initial Investment

50,000

After Tax Cash Flows from Operations

-5,360

Annual Dep’n Savings Investment Allowance

87

2 3 3 3 4 3 5 3 6 3 7 3 8 3 9

Salvage Value

804

Total Cash Flows


1,440

-54,556

21,985

17,695

13,431

15,161

14,248

16,030

1

0.893

0.797

0.712

0.636

0.567

0.507

-$54,556

$19,63 3

$14,10 3

$9,563

$9,642

$8,127

$8,127

NPV @ 12% =

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Topic 10

TUTORIAL QUESTIONS Attempt the Self-Study problem starting from page 1075 in your textbook followed by: P22.33, P221.37 & P22.39.

4.

RANKING OF PROJECTS Ranking means to order alternative capital projects in sequence from best to worst. The reasons for ranking capital projects include:  Having limited funds (money) or other resources.  Mutually exclusive projects, namely one project precluding the adoption of other alternative projects. For example, building or upgrading an airport or other form of infrastructure such as a hospital, freeway, university, bridge, sports or entertainment stadium etc. Your textbook introduces a Profitability Index as a means of ranking besides using NPV, IRR and Payback Period. Technically, NPV is superior to IRR, in that, it measures added wealth compared to the efficiency of the investment. However, in reality the ranking of projects with different lives is most difficult because you are trying to estimate, predict or guess what will happen after the shorter of the two projects concludes. Some organisations in order to resolve ranking problems use a maximum Payback Period of, for example, 3 or 5 years; any projects that recover funds over a longer period are automatically rejected. The downside to this approach is that some exceptional profit opportunities may be forgone if an organisation is totally inflexible in its application of this type of ranking policy. NPV, IRR and the Profitability Index may give us some insight and guidance but they quite likely will not give us a conclusive ranking and ultimately they may well need to be complemented by non quantifiable information or even just a “feeling”. See Section 5 on the next page.

TUTORIAL QUESTION You should now attempt P22.43.

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5.


Topic 10

INVESTMENTS IN ADVANCED TECHNOLOGIES

One of the shortcomings in using capital budgeting techniques is that depending on the project(s) being considered there may be significant benefits and costs that simply are too difficult to quantify or cannot be quantified. Indeed there may be impacts from projects, which at the time of evaluation are either not seen or by any means properly understood in of their effects on profits. For example, how do you quantify improved customer service, which is the result of installing new database software? The recently emerged business channel of Electronic Commerce is an example of just how difficult capital projects can be to evaluate. Today, in many cases, if you do not offer online services then you will loose market share, that is, competitive advantage. The issue with E Commerce in some industry sectors is not about making a positive NPV or satisfactory IRR; it is about business survival. What do you think the future prospects would be for any of the following who do not offer online services: airlines, major hotel chains, financial institutions, stock brokers, real estate agents, universities etc? One of the benefits of Internet technologies is that the transaction, data storage and retrieval costs are extremely small relative to traditional commerce. In the medium and long , in some of the previously mentioned industries, as more clients and customers migrate to the Internet ultimately organisational cost structures will be considerably lowered. However, in the formative years of E Commerce, for each industry, there are usually no cost savings because for the first market entrant it is about “grabbing” a strategic advantage by capturing a greater market share. If the first entrant is successful, then, for its competitors, E Commerce becomes all about retrieving lost market share and survival. The difficulty for capital budgeting techniques is that the potential cost savings at the time of adopting E Commerce technologies are often far too vague to be confidently quantified for individual NPV, IRR and Payback analyses. Sometimes, to get an improved perspective of potential projects, it can help if we model NPV, IRR etc. for a range of scenarios (estimates). For example, best case, worst case etc. You should thoroughly read this section, in your textbook, as it is needed to place our ing techniques in their proper perspective, namely, as useful tools for evaluating capital projects but with a number of limitations.

TUTORIAL QUESTION You should now attempt 22.21.

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Topic 10

SUMMARY This topic has introduced you to some of the more intricate issues that impact on the preparation of cash flow statements for the evaluation of medium and long-term projects, especially when DCF techniques are to be used. Naturally the cash flow statements will sometimes be used to find ways to adjust the project to bring it within the financial constraints of the firm. In this way it is important in cost management. Cost management also becomes an issue when these detailed plans are used in the monitoring of the implementation and in the post implementation evaluation of projects.

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Topic 11

TOPIC 11 SOCIAL AND ENVIRONMENTAL ING OBJECTIVES By the end of this topic you should be able to:  Explain the term social and environmental ing.  Understand the concept of environmental management ing.  Know the benefits of recognising social and environmental impacts.  Describe the difficulties in measuring and recognising social and environmental impacts.  Recognise the role of social and environmental ing in improved decision-making.  Improve supply chain management through the application of social and environmental ing.  Measure social and environmental performance.  Apply capital budgeting in social and environmental ing. Resource: Text Reading Langfield-Smith, K; Thorne, H and Hilton, R (2006), Management ing: Information for managing and creating value. 4th edition. Sydney: McGraw Hill. Chapter 17 Supplementary Reading, not included Norris, G and O'Dwyer, B (2004) "Motivating Socially Responsive Decision Making: The Operation of Management Controls in a Socially Responsive Organisation", The British ing Review June, pp.173-196

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1.


Topic 11

ENVIRONMENTAL MANAGEMENT ING (EMA) Environmental and social management ing looks at the role that management ing can play in enabling managers to assess the impact on society and the environment from their decisions, policies and practices. EMA considers issues such as the costs of: pollution, waste management, energy practices, toxic chemicals, noise etc. Management ing techniques such as activity based costing, cost of quality reporting, capital budgeting, life cycle costing, the balanced scorecard, supply chain analysis…all provide management with techniques that can be adapted and applied to determining and evaluating social and environmental costs and benefits. EMA techniques can be broadly classified as:  Financially oriented techniques, for example, the cost of recycling.  Physically oriented techniques, for example, the weight of solid waste produced. Additionally, management ing also has a role to play in the determination of non quantifiable or intangible effects such as company image, employee morale, potential liability…

2.

THE BENEFITS OF RECOGNISING ENVIRONMENTAL AND SOCIAL IMPACTS First we must clarify some conflict in the use of in the academic literature on social and environmental ing. There are two schools of thought about the we are using, namely social responsibility and environmental responsibility. One school of thought sees them as different but related. The other school of thought regards environmental responsibility as a subset of social responsibility, putting the category ‘environment’ together with categories such as society at large, local communities and employees. Consequently, if you refer to academic literature on this topic you should understand that the mention of social responsibility, social responsiveness and social ing does not necessarily preclude environmental issues but could be written to implicitly include environmental issues. Consistent with the reading provided to you, we will adopt the clumsy reference to ‘Social and Environmental…’. There is a view that organisations that seek to be socially and environmentally responsible improve their corporation’s long term prospects through establishing a “good” corporate image, retention of staff, improved cost management, improved long term competitiveness…

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3.


Topic 11

DIFFICULTIES IN MEASURING AND RECOGNISING ENVIRONMENTAL AND SOCIAL IMPACTS There are several difficulties in the field of social and environmental ing including:  It is not possible to predict all of the future impacts of today’s decisions.  Quantifying the costs and benefits.  How to define social ing.  How to define environmental ing.  How to analyse social and environmental costs. (One suggested technique is to modify cost of quality analysis (topic 5) to society and the environment by using the four categories of prevention costs, appraisal costs, internal failure costs and external failure costs.)

4.

ENVIRONMENTAL ING AND IMPROVED DECISION MAKING Once we have collected data relevant to the costs of social and environmental impacts it can then be used for management decision-making. Please refer to the Cormack example on how the costs of environmental waste provided a new perspective on the company’s plastic moulding processes.

5.

IMPROVING SUPPLY CHAIN MANAGEMENT THROUGH ENVIRONMENTAL AND SOCIAL ING Supply chain management and the managing suppliers and the managing customers from topics 4 and 5 can both be applied to social and environmental ing through establishing relationships that promote environmentally friendly practices. For example, by the promotion of recycling with both suppliers and customers.

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6.


Topic 11

MEASURING ENVIRONMENTAL AND SOCIAL PERFORMANCE Performance evaluation techniques such as the balanced scorecard can be modified to include social and environmental evaluation, whether that is through the addition of a social and environmental perspective or through the incorporation into existing perspectives of social and environmental objectives, KPIs and KPDs.

7.

ENVIRONMENTAL ING AND CAPITAL BUDGETING Comprehensive capital budgeting as covered in topic 10 should endeavour to measure cost savings from activities such as improved energy practices, improved waste management, and reduced material purchases due to recycling…

TUTORIAL QUESTIONS From the textbook, please attempt Self-Study problems 1 and 2; then attempt: Q17.2, Q17.14, E17.30.

SUMMARY In this topic you have been exposed to some ways in which the management ant can assist with decisions that relate to environmental management and also others that are in some other way socially responsible.

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Overview

COURSE OVERVIEW In this course we have taken you on a journey through refinements of the costing techniques you studied in prior studies, to the use of product costs in decisions about pricing and product mix. The mix of products has a direct impact on revenues but also on costs and cost management. We then proceeded to look closely at other cost management approaches such as management through the use of activity analysis (ABM). In this context we not only considered internal management issues (for example, business process reengineering) but also the management of non-value adding costs cause by customers and suppliers. The natural progression from suppliers to inventory and quality management was pursued. We considered the management of costs through the identification of the appropriate times to place orders and the most economic quantity to order or produce at one time. The more recent cost management technique of producing/ordering ‘Just in Time’ was also studied. Further, the management of costs through improved quality decisions and quality cost analysis was considered and was seen to be linked to the move toward JIT principles in organisations. In the second half of this course we moved away from product cost and operation cost issues toward managerial control and some planning issues. Managerial control through performance evaluation techniques (responsibility centres, reward etc) prompted consideration of traditional and contemporary performance monitoring and evaluation, moving us from ROI and RI toward the balanced scorecard and benchmarking. Control issues suggest monitoring and the comparison with plans so we completed our study of financial planning by covering capital budgeting. Finally, you were presented with material that considers the potential role of management ing, and cost management in particular, in environmental and social management decisions. We hope you have enjoyed studying this course and wish you well in any future management position, in which we hope you will benefit from the discussion of cost management and other issues covered here.

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