F5 AGCGA\ PERFORMANCE MANAGEMENT KEY NOTES EoGEUF Activity based casting Target costing Life-cycle costing ‘Throughput accounting Environmental accounting Relevant cost analysis Cost volume profit analysis Limiting factor Pricing decisions Make- or-buy & other short-term decisions Dealing with risk & uncertainty in decision-making Objectives Budgetary systems Boteur Bb 35 3 Types of budget Quantitative analysis in budgeting Behavioural aspects of budgeting Budgeting & standard costing Basic variances & operating statements Material mix & yield variances sales mix & quantity variances Planning & operational variances Behavioural aspects of standard costing ‘The scope of performance measurement Divisional performance & transfer pricing Performance analysis in NFP organisations & public sector External considerations & behavioural aspects B 81 85 97 101 103 107 109 117 123 125Features of GTG's keynotes: Full colour — to make learning more memorable! Diagrams — to aid the learning process + They highlight points, simply and succinctly ‘Short sharp sentences ~ easy to memorise + Clearty laid out cons used to aid understanding Linked directly to Study Text Expansion / to show clarification when es going from one box to another Tip or important point to remember ‘The SG name can be found at the bottom of the page, here. Page No. is here eee ‘Activity-based costing ~ focuses on individual activities as fundamental cost objects and uses costs ofthese activities to assign costs to products or services ‘Commonly-used terms in ABC Example a Allocation base is a factor used for allocation of overhead costs to the products ‘Number of machine hours, number of ‘A product, a service, a department or an activity,Cost pool: collective cost of manufacturing / gb Set-up cost, depreciation, supervisor's service department or activity salary may be pooled in machine shop Cost driver ‘A variable, which has a ‘cause & effect relationship with costs in a glven time span. Instead of ‘allocation bases’ or ‘overtiead allocation rates, the term ‘cost diver is used by the ABC system. [Refers to activities which have a ‘correlation with number of | |Righ correlation with number yi i °F Tnatches of production, number lof purchases Depreciation Machine hour Indirect labour cost Direct labour hours Machine set-up cost No. of set-ups. ‘Order piecing cost No. of purchases ‘Inspection cost No. of inspections Design cost No. of product designs ‘Steps for the calculation of cost per driver eet eakadtiee bead aah ued Total costs are allocated Overhead cost per unit ‘Cost per driver x Number of units of relevant activity | | ‘Total overhead cost allocated to a product per required per unit of a product” ‘number of units produced’ ieee kako eter! Traditional system DepartmentABC system + First assigns costs to the major activities ‘Thea reallocates these casts to products / * Overheads tend to be pooled by actiity- based cost centres * Production process activities and support activities are recognised as cost centres + Both volume-based as well as non. volume-based cost drivers are used + Costs are not merged. Service department costs are not allocated to production cost centres. They are allocated directly to the cost objects, First allocation to the departments. ‘Then departmental costs reallocated to the products / services (Overheads tend to be pooled by departments (n0 activities) Activities are not recognised as cost centres ‘Only volume-based overhead allocation bases are used Costs are merged. Allocates service Cepartment costs to production cast centres ‘and not to the cost objects, eo ed Target cost per unit = Target price per unit ~ Desired (target) profit per unit Examines all possible ideas for cost reduction at the product planning and R&D stages Not just a cast reduction technique; part of 2 comprehensive strategic profit ‘TC per unit is the estimated long-term cost/unit of product or service that enables manufacturer or ‘service provider to achieve its desired mer unit when selling at target price. Cost =p ei aDifficulties of using TC in service industries + Service industries are mostly not design driven. Therefore, application is limited, + Too much focus on cast may take attention away from quality + Cost reduction is iterative process-takes 2 lot of effort to administer ‘Its time consuming hence can delay the sale of the product or service losing of Target Cost gap ae ‘Steps to close the ‘gap’ Cost accountants help engineering planners and designers ‘to decompose the target cost into each cost element Production engineers determine standards for ‘material and part usage, labour cost etc. Purchasing staff negotiate with outside liers regarding prices Design, engineering, marketing and 4 |} other departments also negotiate Fundamental mechanism resorted to close the gap is Value EngineeringIdentifying improved product design without affecting functionality The costs involved at different stages of the li eeu Lal Service and abandonment po fal ufacturing and service industries Costs involved: RED cost, costs of product design, etc. Costs involved: all costs relating to after sales service, ‘costs of abandonment & disposal of product Eliminating unnecessary functions that increase product cost and for which customers are not ready to payTracks & accumulates individual value chain costs Lec attributable to each product from initial R&D to final customer gj servicing. Includes the total costs incurred by a customer to ‘Customer LCC = ‘acquire and use a product or service until itis replaced. Costs that have not been incurred, but will | « be Incurred in the future on the basis of socritced decisions already taken oO oO Costs incurred vihen a resource js used or ‘About 80% of the life- ‘eyde costs of ‘The actual cost of a product are product is butt up committed at the ‘mostly in the planning and design ‘manufecturing stage, ‘age service & Present Future abandonment stage. (decision) (cost) Life cycle cost refers to the system that tracks & accumulates every individual cost incurred during the whole life cycle of a product. Customer ifecyce cost includes the total costs incurred by a customer to acquire and ‘use a product or service until it replaced ° eJfe cycle costing benefits In pricing eestimates & accumulates cast over the entire fe cycle & determines whether the profit earned during the manufacturing ‘process will cover the cost incurred during the pre & post manufacturing stages In decision making It provides a long-term picture ofthe product profitability, feedback on the effectiveness of inal planning & cost data to darify the economic impact of the alternative in design Calculate & interpret TPAR ‘Throughput accounting (TA) + rate at which the system generates money through sales. ‘© Throughput = Sales revenue ~ Direct materlal cost + acknowledges only material cast to be truly variable. no caleultion, estimation, approximation of cost of products. 1 not a costing system Tn throughput accounting, the smallest ‘amount Is held in inventory compared ‘to both absorption costing & marginal costing Constraints Generates money‘Suggest how a TPAR could be improved Steps for TAPR improvement Determine the most efficient utilisation of each bottlenecks ‘Add capacity to the bottleneck resource Example of Steps for TAPR improvement in a Toy making Co &),....-<> & = Cis the bottleneck + Cis mult-purpose machine but shauld only be used for assembling because this activity i the most cra + Cshould be allowed to work continuousty, If mp)” neated. * If measures taken in point 3 are not sufficient, then another machine should be bought oF work should be outsourced. + The entice process should be re-riented to ensure ‘that return / machine C hour increases & cost / factory hour decreases in te long Fun,Apply throughput accounting to a mutti-product decision making problem In this system, decision criterion for identifying the most profitable product is contribution / unit. In this system, decision criterion for identifying the most profitable product is throughput ratio. In monetary terms the product costs more than it generates Return per factory hour = (Sales price ~ material cost)rTime ‘on et resource If the: Ta pe fora product the product line, itis given higher Cost per factory hour = Total factory ee : cost/Total time avaliable on key eas resources Drs beeen ceca’ Environmental Management Cost (EMA): to provide information for decision-making within an organisation; the Information generated could be used for ather purposes such as for ‘external reporting. Environmental costs: include disposal costs, investment costs and external costs incurred because poor environmental quality exists or may exist uw e Prevention “— Detection costs ‘many intemal and external stakeholders are showing Internal fellure External failure | increasing interest in the environmental performance of costs ‘east ‘organisations| cotati >. a 2 Allocation of capital & Concer about revenue expenditure of environmental ‘environmental costs ‘contingent labities Die kcdena ace bis mia Its necessary to cover: ‘+ intemal reporting of environmental costs | appropriate identification & allocation of environmental costs Material flow cost accounting (MFCA): aims to reduce consumption of materials which ‘impact the environment 35 well asthe total costs in the long-run, Life cycle costing: includes eco-costs into the total cost of the products footer Relevant costs: costs pertinent to specific managerial decisions, These are essentially the future costs and should differ according to the possible alternative courses of action. Differential / i Cash outflows |} Future costsSe cee Materials in regular use Replacement cost of materials Higher of curent reaisable value & the value Materials with alternative use they may fetch if put to the alternative use Existing idle workforce used for a certain job Labour cost & overtime wages wherever ont entSI Maximum contbution Opportunity foregone by relcing one alternative over the newt best cost ‘ternative ‘Analysis of effects on future profit of changes in fixed cost, variable cost, sales price, quantity & mixeet Marginal cost equation [BEP: whenever a new product is going to be introduced in the market, itis obvious that the lorganisation needs to know the sales level at which the sales revenue would be sufficient to recover the entire costs. This is a vital indicator because any additional quantity of sales beyond this level would make a profit for the organisation. Break-even point sales in units = —————— Contribution per unit Break-even point in terms of sales value = Fixed costs _C/S ratio or Break-even point in units x Selling price per unit [MOS: the difference between the budgeted sales or actual sales and the break-even point, It measures the soundness of a business. Margin of safety (MOS) = Budgeted / Expected sales — Sales at break-even point Margin of safety % = {(Budgeted / Expected sales — Sales at break-even point)/Sales} x 100 5 BEP is much below the sales level Soren OY Contribution to sales (C/S) ratio in single & multi-product situations [C/S ratio is also termed as profit-volume ratio (P/V ratio). Usually itis expressed as a percentage. The contribution to the sales ratio remains constant if the selling price & variable cost of an organisation remain constant. /S ratio under single i Totalcontributon ‘ Contribution tosakes ratio = Tt@tcontnbuton Product sca Sales value C/S ratio under multi-product WACM = (CS ratio of product 1 x Proportion of product 1 in total scenario (Weighted average seles)+ (C/S ratio of product 2x Proportion of product 2 in total sales) x contribution margin (CIS rato of product x Propartion of product in total sles) x100— Target sale smix = Fixedcost+ targetproft eed (in terms of units) weighted averagecontribution per unit ‘Target sale six - ——Fikedcost targetproft__ (in terms of dollars) weightedaveragecontribution margin Contribution break-even chart Profit/volume chart ‘Traditional break-even chart page no. 23In case of multi-products: Profit path chart coma pote om) ead * time consuming to prepare a break» analysis can only be applied « it assumes that FC are constant ‘even chart to 2 single product at diferent output levels, + Not useful for production planning ee muteeasde ue tsecul Limiting factor Is a factor of production (or of any other activity) that Is in short supply and that prevents an organisation from expanding its production (or activities) and maximising Its profit. “Identity the optimum altemative ina situation when one of the resources Is scarce “+ Identify the optimum alternative ina situation when there are multiple scarce resources * Assumes SP and VC remains constant * Inventory Is not consideredLinear programming Is a mathematical technique used for selecting the optimum decision variable in circumstances where a business problem contains a number of constraints Le. scarce resources ‘The objective s & constraints are expressed as linear functions or equations or Inequalities. ‘amongst the various competing activities “There must be a finite number of activities and constraints ‘A limiting factor is any factor which limits the organisation from expanding its activities because of its scarce supply. Limiting factors are also known as key factors. They can be ‘man hours, machine hours, raw materials, demand for the product etc limiting factor Is any factor which limits the ‘organisation from expanding its activities because of its scarce supply. Limiting factors are also known as key factors Make or buy decision In the case of scarcity of resources, a business can elect to buy the required components from the market rather than manufacturing the components in-houseTo arrive at proper decision the following factors are relevant: ‘availablity of surplus production capacity ‘+ marginal cost of that component / element eto ‘A shadow price is an increase in value which would be created by having available one additional unit of a limiting resource at its original cost. This represents the opportunity ‘cost of not being able to use the one extra unit Implications of shadow pricing on decision-making and performance management ‘Shadow price normally applies to relatively small changes in resource levels. The shadow price can provide decision makers a powerful insight. Into the problems, behets a ree sal od ld hdd mei ‘Slack variables indicate that any constraint may remain unused at the point of optimality. if any resource or limiting factor is totally exhausted while attaining optimal solution, then there is no stack i.e, value of the slack variables zero)Implication of slack in decision making & performance management ‘after identiying the optim solution, the optimal values of the decision variables ‘are substituted to the left hand side of the constraints so as to obtain important information about whether a resource could be fully utilised or some part of resource remained unutilised. © ° oO the valuo on the loft hand. side of the constraint may be < the right hand side the total value on the left hand side of the constraint that on the right hand side. indicating that the resource is fully utlised in the i ; ‘contribution ie., there is no lack Factors that influence the pricing of a product or serviceof demand (PED) ED = %6 change in demand/% change in price ofthe goods ve Reese f dev gods to cage n i 1 Demand ee Demand equation mapQ=a+bP Inverse demand equation P = c+ dQ Q= quantity price, a, b, C & d are the constant parameters called intercept and slope ‘Total cost function equation: \Without volume-tased discount = C (x) = mx + b where, [C (x) = tata cast, m= variable cost, b = ‘xed cost] With volume-based discount = C (x) = [mx —d (x—s]] +b where, [d = discount] Optimum selling price equating with MC & MR & to increase production & sales levels, considering incremental costs & revenues ‘According to micro-economic theory, profit is maximised when MR= MC, where MR=marginal revenue MC = marginal costee ee Demand based pricing ‘The aim of the demand based approach to pricing is to explore the effect that different prices may have on the demand in the market for a product Complementary products = Price of one is influenced by price of others + _Price depends on sale strategy of both the products 1Product line + Depends on additonal cost incurred for adding feature to preceding product Discrimination Sell identical product in different segments of market at different prices ‘+ Applicable mostly in market monopoly condition Calculation of price from a given strategy using cost-plus & | Total budgeted production cost (TRPC) = Total Budgeted variable cost per unit = (material + direct cost + Total production overheads (OH) labour + direct expenses + variable Cost Seling price = Total budgeted cost + Profit marginCaloulate marginal cost of producing & selling the product. Seling price = Relevant cost/unit. + Profit ‘margin/unit eee ed Important terms Features: + Differential costs + Future costs Cash costs ‘Cost Opportunity cost isthe valve of the Outsourcing involves the transfer of bbenefts sacrificed when one course of action | organisational functions to a third party to is chosen, in preference to an alternative. ‘get the work done by them, Avoidable costs are the specific costs of an ‘activity or sector ofa business which would bbe avoided if that activity or sector did not Outsource deal exist.Process of make or buy decision ‘Cost of manufacturing (COM) = Number of units sold (n) x Variable cost per unit (v) + Relevant fixed cost (F) com * Direct material * Direct labour * Variable overheads + Increase in fixed costs cop. "Cost of purchase * Cost of transportatioApply relevant costing principles Cl hedeninelhelne bathed thee Rel lik kei Costs relevant for shut down = Additional fixed cost: = Avoidable fixed cost: cost that would be avoided if the activity is shut down ~~ — Factors affecting one-off contract decision: ‘Success of the pilot project oD + Cost consideration - the relevant costs are the’ same as that of an outsourcing decision. Furthermore, the only other major consideration this decsion is intial capital outlay. Pilot project: developing, deploying and evaluating new processes and technology that benefit and advanoehe ede et una ee ent et taal 'No knowledge of any states of nature & i's probability Outcomes can’t be estimated Following techniques are used to obtain information =z Focus group: a qualitative technique, in which a small group of people are selected for free discussion about their opinions on and attitude towards a particular subject e.g, product, service, idea etc. Market research: a systematic and objective gathering, recording and analysis of information about customers, competitors, market etc.Ea Outsource ‘Shutdown, Pilot project (entirely new product in the market) ~ Decision to be taken ‘under uncertainty Decision to be taken : ic pes Imm) Launching a new product which ae already has market lat <= + Gambling ‘Aquanttative technique 2 Transportation ses computerised mathematical models for gH} | + Arraft and crew scheduling decsion-making under conditions of uncertainty + Hub internet flow balancing, + Evoluates altemative courses of action based upon the | | + Trafic scheduling facts & assumotions + Medical diagnos: + Monte Carlo isa videly used method Where, represents @ paticular strategy [E(S)] = PotastPaMatnnnetPaatins*PoXin | xy denotes payoffs at the juncture of 7 & state of n 'n- number of possible events fora particular = E apy strategy & the probabilities ofthe said events je are denoted By By Pay =~» PrerPnImportant terms ‘i Pay-off 4 * Conditional value of a strategy Cegb, | = Indicates net gain or net iss Senstvty analysts ‘inne eet Beyond control ‘Explores the various risks to the project & te impact of these risks + Bamines a project in the light of possiole changes in the parameters of the project Provides decision-makers with information about the responsiveness of the project to the parameters Influences management to make contingency plans. Profit project is very sensitive to If Then | labour rate but not ae sensitive to material cost Labour rate Material rate ‘Maximax, maximin & minimax regret to decision making & multi stage decision Decision making techniques under uncertainty Maximasc: an optimistic decison, in which the strategy withthe highest possible pay-of is selected assuming that the events occur in the best possible way. Maximin: a strategy with the highest pay-off under the worst possible concitions is selected. Minimax regret: a strategy wit the lowest possible regret is selected. Find out maximum pay-off for || Find outa minimum pay-off for || Find out highest payoff for each of the strategies each of the strategies each state of nature Calculate regret table Set the mavirum outof the || Select the maximum aut the |] Maximum reget for en tacmum payer wertfed’n || minimum papastsnthed || Srayy Berend ‘he precndng Select inmu rom he maximum regret selected ‘denty a state Identity the strat vmnimx coresponding tothe masmax. || coreszondng tothe maxinin |” saect strategy according to the minimax regretPerfect information would be very easy to make a decision as the uncertainty and the risk associated with it would be non-existent. Thus, management would like to know the cost of obtaining the perfect information about future events. This is technically known as “expected value of perfect information (EVPI) EVPI = Expected value under certainty — Maximum Expected Monetary Value (EMV) Expected Opportunity Loss (EOL) ‘Imperfect information refers to the information that reduces uncertainties, but, unlike perfect information does not eliminate the uncertainties. Expected value of perfect information (EVI) is calculated before: calculating imperfect information. Established before Refers to the occurrence of || Conditioned prior ‘additional information | | an event as a result of probabilities is acquired, ‘occurrence of some other eventSteps to calculate expected value of imperfect information(EVIT) Calculation of iG EVIE eae Decision tree is a useful analytical tool for classifying the range of alternative courses of action and their possible outcoms J Represent points at which the || Represent points at which Represent the ends of paths company has to make a cnoice || chance, or probability, plays a | | from left to right through the of one alternative from @ dominant role and reflect decision tree ‘number of possible alternatives alternatives ‘over which the company has (€ffectively) no controlDecision trees are able to generate understandable rules ‘These trees perform classification without requiring much computation Decision trees are able to handle both continuous @ categorical variables ‘These trees provide clear indication of which fields are more important for prediction or classification. ‘These trees are less appropriate for estimation tasks where the goal is to predict the value of a continuous attribute. Decision trees are prone to errors in classification problems ‘The process of developing decision tree is very expensive ‘These are not very effective in the case of non-rectangular region The objectives of a budgetary control system Budgeted Budgetary control system Monitoring revenue 8 costs ‘Compares budgeted figures with actual results to find out discrepancies ‘Takes corrective action| nel es Objectives of budgetary control system am re oe Performance evaluation © Means of communication Increase profitability Identify the areas of inefficiency ‘Optimal use of resources* Participation of all levels of [Organisation Individual, management ‘Agreeent betneen corporate + Co-ordination of budget Conflict bev te ation of = Transparency in the budgeting vcrParment pr000ss Identify and resolve conflicting objectives (CO) and explain implications Planning objective and motivation Planning objective and performance ‘evaluation (PE) Motivation objective and PE“Techniques to resolve the conflicts between sbjectives: ‘To avoid / resolve conflicts = Roll budget objectives, budget Rolling budget targets should be neither too { omingeney plonng a ernts bigh nor too low iso, when Updating sgh recast i ‘substantial change takes place in { Peomance evtuston on the basis ofrevied budgets [| 22 ange Mig te gow anager Seal telanuiat os ‘© An approach combining bottom-up & top-down werever required, badges Sopra Should be revised ccna. ee ei ee Top management & ie ee amt strategic planning mm Top management G28 Operational planning (4M Middle management i ee operational activities dumm Lower management Performance hierarchyAppropriate budgetary systems for an organisation Top-down approach ‘Budgets are prepared inline with the strategic objecives of an organisation. “Top management (Mgmt) makes the guidelines. ‘Top Mgmt specifies their expectations & objectives. Enables communication between top level of Mgmt & other levels. Most suitable to small organisations vihere superiors have overall Jenowiledge of the warking of the organisation ‘Suitable in situations where the organisation can’t allow much time oF cost for planning. Construction ‘organisation works in uncertain environment Zero-base approach (ZBB) Requires each cost element to be specifically justified, as though the ‘activites to which the budget relates are being undertaken for the frst time. Without appreval, the budget allowance is zero. ‘For an activity where there is no dear relationship between the input and ‘output, a zero-base budget can be used. ZB can be successfully applied to discretionary costs and support ‘activities, ‘+ Best sulted to service industries and not-for-profit organisations. Service organisationMARUTI moving forward =» Uses an ABC system Incremental approach ‘+ Atradtional way of preparing budgets. ‘+ Budgets are prepared an the basis of the previous year’s budget with some additions and deletions for forthcoming budget period, = + An incremental budget is suitable for all organisations which have the previous year's budget. However, itis criticised for ‘not Justifying the cost elements included in the budgets. Even 50, itis widely accepted by organisations. Any organisation Feed forward control approach: BUY 100 + contol system where varables i. factors affecting the system, are SHARES preted and corrective actions are taken before they occur and affect the system. Broker = Suitable to those organisations working in a highly volatile ‘environment. This contol predic the future bottlenecks and takes ‘corrective action to minimise the potential negative effects of these ; > bottlenecks thereby allowing organisations to successfully pursue Highly volatite coeds, ‘environment used in budgetary systems & the sources of the information needed ‘Sources of the information needed: Internal forms & records Market research & focus group Newspapers & other news media Information from regulatory authorities ‘Suppliers’ price lists & brochures Government reports & statistics eeDifficulties ‘= Resistance to change + Threat of new system + Reluctance to learn new system * Requirement. of continuously updating with recent changes Time & cost consuming How budgetary systems can deal with uncertainty in the environment Uncertainty can be dealt with using help of: ‘rolling budget feed forward control market research & focus groups ‘contingency planning predictions of changing economic parameters Shorter budget periods other forecasting techniques pplication of probability theory Contingency planning Usefulness of & problems with different budget types Zero-base budget (2BB) Problems + Time & cast consuming + Determination of performance measure is dificult + May cause conflicts between departments + Curtails short-term expenditure which will prove ‘expensive in long run ‘+ For approval, budgets are prepared optimistically Managers may dislike having to justify each minor ‘component of their proposal ‘+ Tfused for years, there is @ possiblity that ‘managers will repeat the same arguments to justify the cost elementsContinuous improvement rhe aca rica esoures optimally Facilitates continuous improvement Reduces costs & eliminates wasteful activities Reduces workloads to a minimum Co-ordinates closely with supplors & meets the needs of customers Incremental budget Usefulness: Simple , cost & time saving, widely accepted Familiar to staff Problems Carries forward inefficiencies & budget slacks from previous year Cost elements are not evaluated for value addition Master budget Problems +" Based on forecasting that may be unc * Based on certain assumptions, that may not hold tne = Functional budget Problems ‘= May not be in line with strategic objectives ‘Influenced by internal & external factors which are forecasted Individual —————————Usefulness, Problems + Controls cost + Determining level of activity itself is ‘+ Useful in uncertain environment difficult + Simple, time and cost saving technique plan |/ « Analysing cost behaviour is time + Activity levels can be changed according to consuming process which people are the availabilty of resources unwilling to do hoot Li elle nese From conventional to ABB + People may not co-operate & may resist Ye . Time 2 ‘consuming activity The wuts! eee ea Shortcomings: IF the high & low levels are found at ‘the extremes, this may not perfectly indicate the fied & variable ‘components of the total cost range. + In short-term analysis of cost, the ‘bue nature of cost may not be revealed. +I any abnormal cost is considered in the analysis it wil distort the result of analysis. Regression method 'm = {nSUM(xy) ~ SUM(x) x SUM(y)} = = sales ty - aa sales aty-| Actual sling price) x] | Actual contribution | | Actual sales qty) x Std]. | Actual sales aly) x Sta AQsad margin) x AQ sold proitjunit contrbution/unit ‘Sales volume variances: Based on standard profit (or contriturtion) Causes of sales variances when actual. (Qty, pice, profit) margin & not on standard price exceeds budgeted (Qty, price, profit) or vice-versa Direct Material Price Variance (MPV) Direct Material Usage Variance (MUV) (SP AP) xAQ (SQ for actual production ~ AQ) x SP ted wage rater Actual wags (Std labour hrs for actual production — [ ° Dirt Labour Rate Variance LAV) Direct Labour Efficiency Variance (LEV) x Actual labour hrs ‘Actual labour hrs) x Std wage rate/hrFluctuations in market prices ‘Changes in basic wage rates, ‘Quality of material, Effective use of material, TQM | Insufficient training, Incomplete supervision Waste / Spoiloge, Purchasing std / non-std lots | Use of defective machinery & equipment Misappropriation / Theft ‘VOH Expenditure Variance (VOXV) VOH Efficiency Variance (VOEV) (Std VOH rate/hr - Actual VOH rateyhr) x Actual (Std hs for actual production - Actual hrs) x hrs worked ‘Std VOH ratefnr FOH Efficiency Variance (FOEV) FOH Capacity Variance (FOCV) (Std hrs for actual production - Actual hrs (Budgeted hrs - Actual hrs) x FOH absorption rate worked) x FOH absorption rate ee ee ae ake ed Use of learning curve 4+ Effective for labour intensive organisation rather than capital intensive Effective in dealing with new product Improves production planning & standard setting Ensures better control Ensures higher level of motivation for employeesLee ee) ee i house cei |All manufacturing costs (variable and fixed) Only variable manufacturing costs are treated as treated as product costs, product costs and fixed costs as period costs ‘Changes nse volume & reduction volune | Change n reduction volume wl not afert will affect operating income Effect & possible causes of idle time (budgeted) and waste on variances & fina kekee dak tel headers it heenaken ed (Hrs paid — Hrs worked ) x ‘Std wage rate/hr Waste ‘Arising in the course of mfg process & no measurable sale value ‘Some material physically disappears ‘on a/c of shrinkages, evaporation et. Waste beyond normal limit is reflected as material usage variance ‘Methods of investigation 1 Setting predetermined criteria ~ absolute size of variance is > pre-determined 9% Determining statistical probability to chart in-control & out of control distribution Statistical decision model — incorporates costs & benefits(AC incurred Frexible budget costs) (Retual cost incurred - Flexible ‘budget costs) (AQ of VOH cost allocation base used for ‘actual production - Budgeted Qly of VOH cost allocation base allowed for actual output) FOH costs - FOH allocated using budgeted input allocated for actual output units produced) ‘actual production (AVC/Unit of cost allocation base - Budgeted VOH cost/Unit of ‘ost allocation) x AQ of VOH cost allocation base used for Et === From thi Material Vield Variance (MYV) ‘A sub-variance of material usage variance Applicable when materials are combined in a ‘standard proportion + Thisis (F) when there is a postive effect on ‘operating income; otherwise (A) Caused by change in raw material costs due to change in input Qty when used at Std mic: we get Yield wu (Standard yield for actual mix ~ Actual yield for actual mix) x Std cost per unit of output jemeure anak le bade ee ey methods of controlling production (Prodn) processes Issues involved in changing the mix + Relative prices Avallabilities & technical characteristics of input material at the time of mix Technical substitutability of alternative material Planned yield should be considered based on actual mix of material Interdependencies between material variances & other process inputs, Work order flowRee ek ‘Then Fr reve ® Viewnersa Then “ = a Influences If Sales mix & quantity variance & thelr relationship with sales volume variance Sales Quantity Variance (SQV) ‘indicates the effect on profit of selling a different total ‘quantity from the budgeted total quantity. It.will be favorable only if actual sales exceed budgeted sales sales at budgeted mix)Example of revised budget We can see in the diagrams that the ori rice is low and quantity is high but when sales Price increases due to market trend (uncontrollable factor), quantity is reduced. leet Dele ‘Selecd ed ‘Sales Price Factors that could and could not be allowed in revising an original budget Uncontrollable factors have substantial impact on budget => budget should be| impact on budget => budget should not be (Revised budgeted (ex-post) quantity ~ ‘Actual performance in quantity) x Std margin (Original budget (ex-ante) quantity - Revised budgeted quantity) x Std margin (Budgeted market share %) x (Actual industry sales volume in units - Budgeted industry sales volume in units) x Budgeted avg, contribution margin/unit (Actual market share % - Budgeted market share %) x ( Actual industry sales volume in units - Budgeted industry sales volume in units)ue ceed ‘At regular intervals ‘Acual performance compared with budgeted performance Report showing variances sent to originators of budget “This process identifies components of the budget which are not working according to plan & reasons behind this, ‘Management reviews each condition & decides courses of action accordingly Material purchase operation Often causes Use of labour according to labour variance to | demand rather than just be adverse to fil abour time Actual is compared ‘with budgeted During the budget year ‘company’s future plans expected, plan should be adjusted ‘operating plans for remaining budget period = Budget committee evaluates actual performance & reappraises the ‘+ If there are changes in actual conditions from those originally ‘+ This revised budget represents a revised statement of formal Material purchased from price variance is under long-term | | Often causes less important contract but prices material negotiated are subjectto | | usage short-term fluctuations Emphasis on total cost of, variance to be favourableBehavioural problems resulting from using standard costs in rapidly changing ete Fee ee eed eee tte ==GP margin = (GP/Sales) x 100 Operating ratio = EBIT/Net sales (Administrative + Selling) expenses/Net sales] x 100 Return on capital employed (ROCE) = (EBIT/Average total capital employed) x 100 Return on shareholder's equity = (PAT - Preference dividend)/Average rnet worth] x 100 PE ratio = (Market price per share/EPS) x 100 EPS = NP available to equity holders/ No. of ordinary shares outstanding Residual income = Profit of the unit ~ charge on investments Retum on sales x Operating asset turnover x Sales Operating assets employed Net working capital ratio = Net working capital Net assets id-test ratio = Quick assets/CL Current ratio = CA/CL ‘Operating cash flow ratio = Cash flow from operation/CL Inventory turnover ratio = Cost of goods sol 1d/Average inventory Receivable turnover ratio = Credit sales/Average receivable Payables turnover ratio = Credit purchases/Average payables D/E ratio = Long-term debt/shareholders’ equity Debt to total capital ratio = Long term debt/Permanent capital Financial leverage =EBIT/(EBIT Interest) ‘Operating leverage = (Sales — Variable costs)/EBIT Debt service coverage ratio = (PAT:+Interest)/(Interest + Repayment of principal)Non-financial performance indicators include: Measure of quality, customer satisfaction & internal performance = Both quantitative & qualitative measures = Focuses on critical success factors of non-financial nature SMART goals & objectives critical to success are important M | Measurable Effectiveness Efficiency Productivity A (Actual output/Expected (Resource actually output/Input R ‘output) x 100 used Planned to be nines used) x 100 Competitiveness | Strategic Relative market share, sales growth, measures of customer base Flexibility Operational Flexibility towards volume of production / sales or service, specification, speed of delivery etc. Quality of service | Operational Responsiveness, competence, easy access reliabity Resource ‘Operational Productivity, efficiency etc. utlisation Innovation Operational Performance of innovation process, performance of individual innovations etc. blems created by short term-ism & financial manipulation Short term-ism ‘= Focuses on immediate gain without considering long-term consequences Induced by the reward system that focuses on short-term performanceBalance scorecard, Building Block model proposed by Fitzgerald & Moon Format of Balance Scorecard ‘The performance measurement Building block model system (PMS) is compared & contrasted using dimensions, standards & rewards framework which poses three questions for PMS: What dimension of performance to measure, how ‘to set standards for these measurements & what rewards are to be associated with the achievement of those ‘standards?Deeks iene hake elk Lak bee a tackaned Tt is always difficult to measure a qualitative factor & accordingly to set a target in qualitative areas. Qualitative targets & factors are not expressed in monetary terms. Rather the existence of Qualitative factors is reported alongside the quantitative factors. Difficult to measure Difficult to set target in ‘a price at which goods / or services are internally transferred from one division to another in same Co. \ Objectives of transfer pricing ‘Achieve goal congruence is Maintain divisional autonomy ronan Faclitate evaluation of divisional performance services in same Co Promoting the optimisation of profits + Allocate divisional resources + Minimise tax » Tax . minimisation’Includes direct Includes cost of Includes total cost production costs & production & cost of 8 mark-up variable indirect other business production costs functions e.g. RAD, + ‘marketing etc. Production + Bargaining takes place between | Listed price of the product or the actual selling unit & buying unit pice at which the product is sold in the ‘external market in an arm’s length transaction Decided price is largely based Difficult to determine the market price for Upon negotiating skils of the intermediate products departmental authoritieset er Fixed cost (PP cone part of cae) ake Fixed cost burden is “The total cost Full cost is passed not passed on to incurred for ‘on to transferee & the transferee production is certain amount of division passed on the profit charged on it transferee division ‘Negotiated price + Divisions which have good bargaining stills ill be at an advantage Doesn't present a rational TP & leads to distorted performance levels forthe departments involved in the transfor (of goods or services & decision made Full cost + profit Fullcost (Extra part of cake) Trcates the profitably ofa ision per 15 of investment eoremed ‘asa % The larger the % better the ROL Income: Charge on investment Charge on investment = Investment x Desired rate of return Retum on sales x Assets turnover‘Compare divisional performance & recognise problems in doing so Problems in comparing divisional performance + Seleding an appropriate measure Different working conditions Different scale of operation “Transfer pricing dificulties Different regulation Tranefor pricing Differant working reguations dificuties conditions appropriate measure cee ka ka eee eed 'NQO may be expressed in general terms as ? + Providing best possible service + Meeting customer needs + Maintaining high standard of quay NQO benefits * + Essential to the business + Very useful attributes + Desirable, but not essential + Possible, if funding is available + Doubtful & afficut to justity Protas of having Difficult to measure & express in quantitative / Difficult to monetary terms measure in dam) * 700 many objectives & cfficult to identity prime monetary terms objectiveDifficult to identity key objective Difficult to judge whether key objective can be achieved or not ‘VFM: Available funds are spent In the provision of services in a way that maximises the benefits to the users of services. suggest ways in which EC could be allowed for in PM & interpret performance in the light of EC Customers Expectations, tastes & needs of customers Competitors Market share, brands, ideas, pricing policies of competitors Legal environment Regulatory & legal framework in which the Co needs to ‘operate Suppliers Financial strength, quality of material of suppliers Economic environment | Interest rate, foreign exchange rate Political environment _| Political disturbanceLeider ar sel snhhebdiececedaeein pin Concentrating on one area of management In order to achieve better results. May lead to ‘overlooking other aspects. ‘Sub-optimisation jlecting decline in sale of existing product Concentrating on new product promotion scheme Tknow it’s ‘temporary, but my manager will be happy \ Misinterpretation 7 Interpreting performance measures in an | pore incorrect or aver-simplified wayBudget Sale of 4,000 units due to poor market. ‘conditions (low target) Ossification: Unwilingness to introduce new performance ‘measures in place of backdated & ineffective measures that are in use Hin fact, Tam 14,000 units (actual result is Performance reward scheme far better than = Individual budgeted result) + Group