Understanding Processes and Value Creation

Users Uses Management Internal (middle to top level management) - Planning (strategy LT v ST) - Controlling (monitor things going to plan) - Facilitating decision making - Evaluation (qualitative & quantitative) No mandatory rules - Only, benefits > costs to provide data Relevance, Timeliness, Flexibility Financial & Non-financial (subjective possible) Broad & multidisciplinary but decision specific Future Financial External - Investment - Tax - Borrowing - Regulation GAAP, IFRS, IAS, AASB Objectivity, Reliability, Precision Financial only More self-contained and aggregated Past

Reporting Standards Emphasis Information Content/detail Orientation

Management Accounting: the processes and techniques that focus on the effective and efficient use of organizational resources, to support managers in their tasks of enhancing both customer value and shareholder value. Resources: financial (debt/equity) and non-financial (factors of production) means of an organisation Customer value: difference between what a customer receives (customer realisation) and what the customer gives up (customer sacrifice) Customer realisation: tangible and intangible benefits received from products services Shareholder value: the value that shareholders place on a business E.g. dividends, share price, profits

Process Analysis
Process analysis seeks to realign task performance and resource use to realise desired strategic goals and enhanced customer value i.e. the link between strategic goals and resourcing to achieve those goals Objective of Process Analysis - Understanding (Business process map) Understand the interrelationships, as well as the linkages with resources and strategy - Monitoring (Statistical process map) Establishing key process attributes; and having these variables measured and compared, and taking correction action if required - Prioritising(Pareto diagram) Identifies critical business processes and to differentiate between value adding and non-value adding; in order to rank improvement of these first. - Problem Solving Recognises where and why a problem occurs and by suggesting approaches to correct these problems Identify the Process Process: group of interdependent activities which, when performed, utilise the resources of a business to produce a definite product i.e. ordered activities to convert inputs into outputs
INPUTS TRANSFORMATIONAL PROCESS (inter-related activities) OUTPUTS

The activities are related because a specific event initiates the first activity in the process, which in turns triggers subsequent activities. An output or information flow occurs where two activities interact. Value Chain: sequence of activities that creates a good or service in which each step of the sequence should provide attributes of the product that the customer values: Primary activities: those that involve the physical creation of the product, its sale and transfer to the customer and after-sale service i.e. inbound logistics, operations, outbound logistics, marketing & sales, after-sale services Support activities: activities that support primary activities and each other i.e. HR, technology, procurement, firms infrastructure

Note: the configuration of activities within the value chain and the co-ordination/optimization of linkages between activities differ between organisations, resulting in competitive advantages or disadvantages Chart the Process Process mapping involves decomposing the process to be analysed into its component activities and arranging them in a logical or sensible sequence Start/End Flow Activity Decision

Can be multiple ends

Requires a verb at the start

Answer is either Y/N

Note: Dont include any unimportant activities as this will lead to an overload! Also, make sure to look at activities performed by the firm only Evaluate the Process Value Adding v Non-Value Adding Activities Value adding activity: is a necessary activity, either because it: Increases customer satisfaction Willingness to pay for that activity If activity is removed, is service potential reduced? Does the activity bring the process closer to completion? Critical to remain in business

Non-value adding activity: dont add value to the customer (i.e. customer would not be willing to pay for it) or can be eliminated without detriment to the business. Note: activity improvements are not restricted to non-value adding activities i.e. value adding activities can be improved via activity sharing, reduction, selection or elimination Effectiveness v Efficiency Efficiency: ability of activities or processes to use the fewest possible resources to meet customer needs Measured by resource usage i.e. amount of resources being consumed relative to the quantity of outputs produced by a process Determined by the process and activity design and how they operate

Effectiveness: ability of a process or activity to meet customer needs

Determined by activity design and measured by the degree of goal attainment

Note: there is a traditional trade-off between the efficiency and effectiveness Effectiveness Measures Customer satisfaction/complaints % of sub-components accepted by subsequent processes % of on-time deliveries % of problems-free deliveries Number of returned goods/sold goods Efficiency Measures Material yield and productivity Manufacturing cycle time Machine set-up time Number of invoices processed per hour Chargeable hours per employees

Note: Measures are not an action, need to be specific generic is not good enough and proportions are better Value Parameters Customer/Process value parameters: Time 2 dimensions: duration (how long does it take?) and timeliness (when do you get it?) Cost: amount of resources consumed in a process Improvement isachieved ifthe same process is carried out with lower levels of resource consumption Eliminate non-value added costs and reduce value-added costs Quality should not be compromised when improving time and cost i.e. defect rate and variability

Process Attributes that support or constrain its ability to meet customer value parameters: Responsiveness: processes need to flexibly and efficiently cope with changing patterns of demand Productivity: increased efficiency and consistency (reduced variability) enhances productivity Linkages: interdependencies between activities i.e. change in one functional area may be adverse for others Empowerment: employee empowerment is the key to innovativeness, which is critical to the long-term success

Useful Tools Useful analytical tools that can be applied to process analysis as well as a range of managerial situations 1. Root Cause/Driver Analysis Root cause: most fundamental reason why something happens Root cause analysis: the identification of the reasons for activity costs (choose one!) The most important question to ask is why? Why is the activity carried out this way or performed at all? Why do we spend so much time and resources moving raw materials around

2. Fishbone Diagrams Fishbone diagrams: are cause-and-effect diagrams, used to assist root cause analysis
MACHINERY METHOD

PRIMARY PROBLEM

MATERIALS

LABOUR

1. The horizontal line (spine) represents the primary problem to be solved. 2. The main potential causes are then added as the major ribs of the fish 3. Smaller bones are attached to each of the ribs to identify the possible causes of the ribs/main causes.

In process analysis, a fishbone diagram allows us to identify the reasons for poor performance of processes, and opportunities to improve the efficiency and effectiveness of processes.

3. Statistical Process Control Statistical Process Control (SPC): a technique that relies on the use of statistical analysis and control charts to understand, monitor and reduce variability in a process. Used to pinpoint uncommon variances (a result of assignable causes) that need to be addressed Those above or below the upper and control limits

4. Pareto Diagrams Pareto Diagram: a graphical bar chart representation used to plot the cause of problems in a process according to the frequency of their occurrences. Allows managers to prioritise improvements by focusing on the problem that occurs most frequently Based on the idea that a small number of causes are responsible for a large percentage of quality problems; and that the majority of problems in process management can be traced to only a few parts of the process

Process Improvement - Continuous Improvement or Business Re-engineering Business Process Re-engineering (BPR) Radical Cross-functional teams One-off Continuous Improvement (CI) Incremental Everyone Ongoing

Scale of Change Personnel Involvement Timing

Note: BPR and CI are not mutually exclusive. Look at the change relative to the process to determine whether it is continuous improvement or business re-engineering Four ways to reduce activity costs, accomplished by changes in product or process design: Activity Elimination: aims to save organisation resources by eliminating activities, which reduces resource usage Activity selection: choosing an activity with the lowest cost that matches the chosen strategy, all other things being equal i.e. if you have choices, choose the cheapest Activity reduction: reduction of the resources consumed by an activity i.e. increase efficiency Activity sharing: choosing or designing an activity that permits sharing between different products (economies of scale)

The horizontal view allows you to determine which activities are value & non-value adding: Cost Dimension Resources Process Dimension Driver Analysis Why? Activities What? Performance Analysis How Well?

Product

Cost Basics
Cost: cash or cash equivalent value sacrificed for goods and services that is expected to bring a current or future benefit to the organisation i.e. dollar measure of the resources used to achieve a given benefit. Costs should be managed strategically and reduced (efficiency) whilst providing the same or greater customer value Expenses/Expired Costs: actual costs incurred for a current benefit i.e. to generate revenue Costs incurred for a future benefit e.g. WIP, unsold inventory Opportunity cost: benefit given up or sacrificed when one alternative is chosen over another

Cost Object: any item for which costs are measured and assigned Activity: basic unit of work performed within an organisation and can also be described as an aggregation of actions within an organisation useful to managers for purposes of planning, controlling and decision making Note: an activity is described by an action verb joined with an object that receives the action

Cost Classification
Product Costs: cost assignment that supports a well-specified managerial objective Different cost classifications occur due to different information requirements Managers should only be responsible and evaluated on the costs they can control or significantly influence

Value Chain Internal value chain: set of all activities required to design, develop produce, market, distribute and service a product. It provides a more complete picture by showing the costs assigned to both upstream (supplier) and downstream (customer) activities, then assigning the cost of these activities to products Traceability Ability to assign a cost to a cost object in an economically feasible way by means of a cause-and-effect relationship Note: If this is done easily and accurately, then it is a direct cost; otherwise it is an indirect cost. The more costs that can be traced to the object, the greater the accuracy of the cost assignments. Function Production Costs: associated with the manufacture of goods or the provision of services Direct Materials: materials directly traceable to the goods and services being produced because physical observation can be used to measure the quantity consumed by each product Direct Labour: labour that is directly traceable to goods and services being produced because physical observation can be used to measure the quantity of labour used to produce a product or service Manufacturing Overhead: costs that cannot be directly traced to the cost object or it is not economically feasible to or it is more appropriate to treat this cost as a cost of all output Overtime premium is treated as OH unless, it is incurred when a special order is taken at 100% capacity, where then it is treated as a direct labour cost

Non-production Costs: associated with the functions of design, development, marketing, distribution, customer service and general administration Selling: costs necessary to market, distribute and service a product or service Administrative: research and development and general administrative costs

Note: prime costs are the sum of direct materials and direct labour costs and conversion costs are the sum of direct labour and overhead costs

Cost Behaviour Methods

Cost Behaviour: relationship between the change in costs incurred and the change in volume of output/activity Variable Costs: varies in direct proportion to output changes Cost per unit is constant Fixed Costs: Within the relevant range, costs in total remain constant despite changes in the activity output (over the short-term) Relevant range: range of output over which the assumed cost/output relationship is valid Unit fixed costs decrease as output increases In the long run, all fixed costs become variable Step Costs: Costs fixed over a certain range i.e. volume of outputs and then jumps to another level, where it remains for a similar range of output. Items that display this kind of behaviour must be purchased in chunks Mixed Costs: cost that has both a fixed and variable component Curvilinear Costs: there is no linear relationship between cost and activity output Can be estimated with a straight line IF a relevant range is specified

Other considerations to be taken into account: Time horizon short or long term? Resources available = resources used + unused capacity Flexible: supplied as used and needed through acquisition from outside sources with no long-term commitment for any given amount of the resource (i.e. QD = QS) e.g. raw materials Variable Activity rate = total cost of flexible resources / capacity used Committed: supplied in advance of usage and are acquired through a contract to obtain a given quantity of resource regardless of whether the amount is fully used or not Committed Fixed Expense: independent of actual resource usage and provide long-term activity capacity Discretionary Fixed Expense: independent of the quantity used in the short run Note: Fixed Note: resource spending changes lag behind changes in permanent activity/output demands Sufficient Capacity: ability to do something Maximum Engineering Capacity: maximum volume of quantities able to be produced under ideal conditions Practical Capacity: maximum capacity that can be produced while also operating efficiently Idle/Un-used Practical Capacity: extent to which production could be increased without incurring additional fixed costs i.e. buffer

Understanding cost behaviour increases the accuracy of costing. This is important as it enhances cost prediction enabling more effective and efficient planning, control and decision-making.

Cost Drivers
Cost Drivers: observable causal factors and activities that drives and measures a cost objects resource consumption (i.e. incurred costs). Generally, there is either a cause-and-effect relationship or very strong correlation

the accuracy of driver tracing depends on the quality of the causal relationship described by the driver Production (Unit-Level) drivers explain changes in cost as units produced change Non-unit level drivers explain changes in cost as factors others than units change i.e. costs are incurred no matter how many units are produced

Activity Hierarchy Based on concept that activities cause resources to be consumed. Each level has activities costs, which respond to different types of cost drivers (so, see if it is a unit level cost first, and work your way up): Able to measure the costs incurred by each activity from each product

Unit Level Costs: costs incurred by performing an activity each time a unit of product is produced Costs vary with the number of units produced Batch Level Costs: costs incurred by performing an activity each time a batch or group of units is produced Costs vary with the number of batches but are fixed with respect to the number of units in each e.g. production scheduling, materials handling, set-ups Product Level Costs: costs incurred by performing an activity needed to supportspecific products or product families produced i.e. consumes inputs that develop products or allow products to be produced and sold Rises as the number of different products increase e.g. engineering changes, development of product-testing procedures, marketing a product, process engineering and expediting Facility Level Costs: costs incurred by performing activities that sustain a firms general manufacturing process i.e. benefit the organisation at some level but do not provide a direct benefit for any specific product Costs are fixed and are not driven by any of the cost drivers in any of the first three levels Technically, not included as it is difficult to trace costs to product Not included in activity based-costing e.g. factory management, landscaping, community support programs, security, property taxes and building depreciation

Note: if production facilities are organised around product lines, then it can be argued that space drivers measure the consumption of facility level costs

Cost Estimation
The process of determining the cost behaviour of a particular cost item; there are 3 approaches: Managerial Judgment: using judgment based on knowledge and experience to classify costs Advantages: simple and cost effective i.e. no additional data or formal analysis required, able to foresee the future and possible absurdity behind statistical results Disadvantages: relies on managers abilities, so you need a good one Engineering Approach: studies the processes that result in the incurrence of a cost; including time and motion studies. Advantages: past data does not exist or is irrelevant, cost effective when you can trace the costs to the object Disadvantages: costly, accuracy is dependent on workers behaviour Quantitative Analysis

Note: Qualitative methods may be chosen over quantitative because there is a lack of knowledge on how to use quantitative methods, there are problems with the data, time shortages prevent the collection and collation of data and a low priority is given to high accuracy i.e. subjective cost estimates are good enough.

Cost Formula Assumes there is a linear relationship between the cost of an activity and its associated driver. Total Cost = fixed cost + variable rate output Note: the independent variable measures output and explains changes in cost i.e. it is the activity driver. The choice of an independent variable is related to its economic plausibility. High-Low Method Use the highest and lowest level of output/activity and their corresponding cost levels to calculate the cost function. Advantages: objective, easy computation, requires little data (two data points only!) Disadvantages: Not necessarily an accurate model as outliers are used in the computation (distortion) and it will differ depending on the specified relevant range

Scatter-Plot Method Plot the data on a graph and draw a line of best fit Advantages: enables a visual assessment as to whether a linear assumption is reasonable, highlights the outliers, incorporates all the data points and is thus more representative Disadvantages: subjective determination of line of best fit, only reflects a relationship between the one driver i.e. cost and activity usage

Regression Analysis Uses the least squares method to come up with an objective best-fitting line. Advantages: objective, accurate/complete, enables the consideration of more than one cost driver, allows for statistical evaluation Disadvantages: may be costly, there is more than one relevant range

Assumptions: Cost behaviour depends on a single activity Cost behaviours are linear within a relevant range

Evaluating a Regression Model 1. Is it economically plausible to impose such a relationship? i.e. does it make sense? 2. Look at adjusted R Square - Coefficient of Determination (R2): percentage of variability in the dependent variable that is explained by an independent variable i.e. % is a goodness-of-fit measure - Adjusted R Square is used to compensate for a small sample size and in multiple regression, since another degree of freedom is taken away, the increase in R2 does not necessarily mean a better fit 3. Look at p-values (<0.05 is significant, independent variables do account for some variance in the dependent variable) a. F-statistic = relationship between costs and all cost drivers Has it occurred by chance? b. T-statistic = relationship between costs and that particular cost driver

Cost Assignment
How do we measure and associate the costs involved with the units produced? (involves a relative concept of reasonableness and logic in choosing a method)

Key to creating a reasonably accurate cost assignment is establishing a cause-and-effect relationship between the cost to be assigned and the cost object Cost of Resources Manufacturing Overhead Driver Allocation Tracing Causal Relationship Cost Object: Product Reduces overall accuracy but is simple and cheap! Assumed Relationship Direct Tracing: identifying and assigning costs that are exclusively and physically associated with the cost object Driver Tracing: using observable causal factors to measure a cost objects resource consumption Allocation: allocate indirect costs based on convenience and assumed linkage

DM and DL Direct Tracing Physical Observation

Managing Costs I: Overhead Costs

Cost Measurement
Cost measurement: the dollar value amounts of direct materials, direct labour and overheads used in production. Total Cost: prime costs (direct materials + direct labour) + overhead costs Unit Cost: Accuracy is essential in order to make decisions about product & service design, whether to keep, introduce or scrap a product/service, submit meaningful competitive bids (i.e. specify the price, knowing the cost to get a preferable margin)

Actual Costing: assigns the actual cost of direct materials, direct labour and overheads to products Rarely used, as it cannot provide accurate unit cost information on a timely basis

Normal Costing: assigns the actual cost of direct materials and direct labour but a predetermined/budged cost for overhead. OH Costs = manufacturing OH + non-production costs + responsibility centres costs (i.e. support departments)

Overhead Assignment
Unit-Level Activity Drivers: factors that cause changes in cost as the units produced change i.e. assumes overhead consumed are highly correlated with the number of units produced E.g. units produced, direct labour hours, direct labour dollars, machine hours, direct material dollars

Activity Capacity Measures for measuring cost drivers: Expected Activity Capacity: output firm expects to attain for the coming year Normal Activity Capacity: average activity output that the firm experiences in the long term Theoretical/Engineered Activity Capacity: absolute maximum output if everything works perfectly Practical Activity Capacity: maximum output if everything operates efficiently

Cost Pool: aggregate of costs to be allocated to cost objects that have only one allocation base

Cost Allocation base: some factor or variable that is used to allocate costs in a cost pool to cost object. Ideally but rarely, it is also a cost driver. Generally, it has a high correlation or causal relationship. Volume based input (how much do you put in?) v. output (how much do you get out?) Is it common to all products? How easy is it to measure the cost driver?

Factorywide Method A single overhead rate is calculated for the entire production plant i.e. there is one cost pool, the production plant 1. Identify the OH cost driver 2. Calculate the OH rate i.e. predetermined MOH = budgeted (manufacturing) OH / expected activity 3. Apply the manufacturing OH cost to the product based on the predetermined OH rate i.e. applied OH = predetermined OH actual activity Note: OH variance = actual applied OH i.e. overapplied if actual < applied Department Method Factorywide overhead cost are divided up and assigned to individual production departments, creating departmental overhead cost pools, because: Steps: 1. 2. 3. 4. 5. Departmentalise the firm Classify each department as a support or a producing department Assign all OH costs in the firm to a support or producing department Allocate support-department costs to the producing department costs to the producing departments Calculate predetermined OH rates for the producing departments Adding the allocated support costs to the overhead costs that are directly traceable to the producing department / total activity 6. Allocate OH costs to the units of individual products through the predetermined overhead rates a. i.e. OH is assigned by Note: budgeted variable costs are calculated using the charging rate and the actual activity, whereas budgeted fixed costs are calculated using the charging rate and the expected activity Activity Based Costing 1. Measure the cost of resources consumed by activities a. Identify resources, resource drivers and then, cost per resource driver b. Identify activities and resource drivers consumed by activity 2. Allocate activities to cost objects a. Identify activity drivers and calculate cost per activity driver b. Identify activities consumed by product and allocate activity costs to product Some producing departments are more overhead-intensive than others and therefore should be assigned more overhead costs Departments are affected by different unit-based cost drivers

Homogenous Cost Pools Grouping activities into homogenous sets reduces the number of overhead rates, but homogenous cost pools must be based on both these similar characteristics: 1. Must be logically related e.g. same activity level 2. Must have the same consumption ratio i.e. the same proportion of each activity consumed by a product Steps to put activities into homogenous cost pools: 1. Classify overhead into cost hierarchies unit, batch, product or facility 2. Create homogenous cost pools and identify activities that belong to each pool 3. Identify the activity driver for each pool (it doesnt matter which one is used) and calculate the pool rate

Allocating Support Department Costs to Producing Department (Department Method!)

Common (mutually beneficial) Costs: same resource is used in the output of two or more services or products Producing Departments: directly responsible for creating the products or services sold to customers Support Departments: provide essential support services for producing departments e.g. maintenance, engineering, personnel and storage Note: OH costs must be assigned to only one department Objectives 1. To obtain a mutually agreeable price ensure that youll make a profit, whilst competitively pricing 2. To compute product-line profitability how much profit is generated by each product line? 3. To predict the economic effects of planning and control appropriate product mix & resource reallocation 4. To value inventory 5. To motivate managers encourage efficiency Principles of allocation: Causal relationship: activities within a producing department that provoke the incurrence of support service costs i.e. how much resources are consumed by each department; uses a single charging rate Benefits received how much benefit does department receive? How do we quantify this? Uses a multiple charging rate Ability to bear: the more profits, the more costs assigned to you i.e. uses a multiple charging rate

Budgeted rather than actual costs should be allocated because: 1. Timeliness needed to cost the units produced before the end of the accounting period to set price, etc. 2. Performance evaluation used as a benchmark a. Using budgeted means no efficiencies or inefficiencies from support departments are transferred Note: Actual usage should be used instead of budgetedto assist with performance evaluation and so that departments, which make more use of the support service, pay more. Direct Method Allocates support-development costs only to the producing departments i.e. ignores the fact that support departments provide services to each other.

Variable service costs are allocated directly to producing departments in proportion to each departments usage of the service Fixed costs are allocated directly to the producing department but in proportion to the producing departments normal or practical capacity

Sequential Method Partially accounts for the provision of services between support departments. Cost allocations are performed in a stepdown fashion, following a predetermined ranking procedure Steps: 1. Calculate the Allocation Ratios 2. Allocate the Support-department costs using the allocation ratios calculated in the first step Reciprocal Method Fully accounts for the provision of services between support departments i.e. budgeted amount + that used by other support services Steps: 1. Specify a set of equations that express the relationship between the departments i.e. Total cost = direct costs + allocated costs , where allocated costs = % received from other support 2. Solve the simultaneous equations (note: pronumerals represent total costs) 3. Allocate the total cost of operating each support department to various departments that use its services Allocation in one direction, from greatest amount of services provided (highest budgeted cost) i.e. A B C

Managing Costs II: Activity Based Costing

Activity-Based Costing: a methodology that can be used to measure both the cost of cost objects and the performance of activities i.e. it addresses the issues relating to non-unit related overhead costs and product diversity Resources: inputs required to produce an output Activity: a unit of work performed i.e. something that you do Activity dictionary: list of activities performed in an organisation and their critical activity attributes Conduct interviews with departments and draw a process map to find the list Activity attributes: financial and non-financial information describing activities Cost Driver: a factor or activity that causes cost to be incurred Resource driver: factors that measure the consumption of resources by activities Activity driver: factors that measure the consumption of activities by cost objects

Methodology 1. Assigning resources to activities (resource drivers) a. Assign cost of resources to activity centres b. Identify and cost the activities performed in each activity centre 2. Assigning activities to cost objects (activity drivers) a. Prepare a dictionary of activities for each cost object b. Calculate the activity cost per unit of activity driver

Symptoms of outdated cost accounting system 1. The outcome of bids is difficult to explain 2. Competitors prices appear unrealistically low 3. Products that are difficult to produce show high profits 4. Operational managers want to drop products that appear profitable 5. Profit margins are difficult to explain 6. The company has a highly profitable niche all to itself 7. Customers do not complain about price increases 8. The accounting department spends a lot of time supplying cost data for special projects 9. Some departments are using their own cost accounting system 10. Product costs change because of changes in financial reporting regulations

Functional-Based Costing v. Activity-Based Costing

Cost drivers Functional-Based Costing (FBC) Assumes OH costs are consumed the same way - based on the number of units produced - Volume unit-level drivers Allocation intensive (assign to departments) Narrow & Rigid Sparse Managing costs Maximization of individual unit performance 1. OH costs are a small proportion of total costs 2. OH costs are driven by unit-level drivers Activity-Based Costing (ABC) Recognises that activities have different consumption ratios - Unit & non-unit level drivers used Tracing intensive (assign costs to activities) Broad & Flexible Detailed Managing activities Maximisation of system-wide performance 1. OH costs are a significant portion of total costs and a large part is not directly related to unit-level activities 2. Products consume support resources at diverse rates; not by volume-based drivers 1. Complexity - Detailed data collection Map out process - Constant updating Must re-map after CI - Very expensive Cost v benefit analysis 2. Facility level costs not included - Not allocated as there is no relationship with the product, but how do we recover cost?

Cost Assignment Product Costing Activity Information Focus Aims Most Beneficial

Limitations

1. Existence of non-unit level drivers related to OH costs - Activities arent performed each time a unit of product is produced - Increases in upstream & downstream activities are not driven by volume - Arbitrary allocation of a lot of facility level costs may distort product costs 2. Product Diversity products consume overhead activities at different rates

Standard Costs and Variance Analysis

Planning and control ensure that plan and objectives are achieved. Control systems provide regular information to assist in control, which is an essential part of effective resource management. Necessary Requirements for Control: 1. 2. 3. 4. A predetermined or standard performance level A measure of actual performance A comparison between standard performance and actual performance Investigate causes of significant variances

Standards
Standard Cost: a budgeted cost of one unit of product i.e. - Product costing: costs are assigned to products using standards for all 3 manufacturing costs DM, DL, OH provides readily available unit cost information that can be used for pricing decisions - Performance evaluation: comparing actual cost with budgeted costs by calculating variances provides specific signals regarding the need for corrective action and where that action should be focused. Helps to distinguish between controllable and non-controllable costs To determine the unit standard cost, 2 decisions must be made: 1. Quantity decision: the amount of input that should be used per unit of output 2. Pricing decision: the amount that should be paid for the quantity of input to be used Source / Responsibility Quantity Historical Evidence Standard Engineering Studies Participative Standard Setting Price Operations Standard Purchasing Personnel Accounting Types of Standards What is it? Ideal Standards Demands maximum efficiency and can be achieved only if everything operates perfectly; reflects minimum attainable costs Encourages further training, capital investment and innovation i.e. process improvement Encourages dysfunctional behaviour Currently Attainable Standards Attainable performance under efficient operating conditions, with allowances made for normal breakdowns, downtime and wastage Motivated because goals are demanding but achievable Imperfection allowance encourages slack What / Why? Provide a good basis for predicting future costs Determines the most efficient way to operate Significant input from operating personnel as they are responsible for achieving the standards Determines the quality of the inputs required Acquiring the input quality requested at the lowest price (market conditions but can be negotiated) Recording the price standards and preparing reports that compare actual performance of the standard Caution May include past operating inefficiencies May be too rigorous Budgetary slack i.e. may under-report

Positive Impacts Negative Impacts

Standard Cost Sheet: provides the details underlying the standard unit cost description, standard price, usage, cost Direct Materials Standards Standard material quantity: total amount of direct material required to produce one unit of product Standard material price: total delivered cost of the material less quantity discounts Quantity discounts are based on ordering a certain quality of material in specific order quantities from a specified supplier Direct Labour Standards Standard direct labour: number of labour hours normally needed to manufacture one unit of products Standard labour rate: total hourly cost of wages, including on-costs On-costs: extra salary-related costs that all Australian companies have to pay

Note: a process map helps in determining what resources are used where and beware of defect rates (imperfections), which potentially affect both the standard cost of direct materials and direct labour.

Variance Analysis
Variance Analysis: comparing actual with standard is about management control

Unfavourable variances: whenever actual prices or usage of inputs are greater than standard prices or usage Favourable variances: actual prices/actual quantity < standard prices/standard quantity Total Variance = price variance + usage variance Total Variance = AQ(AP - SP) + SP(AQ-SQ) Total Variance = AP AQ AQ SP + SP AQ SP SQ Total Variance = (AP AQ) (SP SQ)

Direct Materials Price Variance Measures the effect on cost of purchasing at a price that is different from the standard. MPV = (AP AQ) (SP AQ) MPV = AQ(AP SP) , where AQ = actual quantity of material used , where AP = actual price per unit , where SP = standard price per unit

The responsibility for controlling the materials price variance usually belongs to the purchasing (procurement) departments. Although, prices are generally beyond their control, they can reduce prices by their negotiating skills, quantity discounts, differing the quality purchased. However, pressure to generate favourable variances could result in lower quality materials being purchased or too much inventory to take advantage of quantity discounts. Note: calculating the price variance at the point of purchase is preferable as corrective action can be taken then. Direct Materials Quantity Variance Measures the effect on cost of the direct materials actually used compared with the direct materials that should have been used for the actual output. MUV = (SP AQ) (SP SQ) MUV = SP(AQ SQ) , where AQ = actual quantity of material used , where SQ = standard quantity used, given actual output , where SP = standard price per unit

The production manger is generally responsible for materials usage minimising scrap, waste and rework to ensure that the standard is met. Pressure can be problematic as they might allow a defective unit to be transferred to finished goods, which will create customer relations problems. Direct Labour Rate Variance Measure of the effect on cost of paying a different labour rate than what should have been paid LRV = (AR AH) (SR AH) LRV = AH(AR SR) , where AH = actual DLH used , where SR = standard rate per hour , whereAR = actual rate per hour

Labour rates are largely determined by external forces labour markets and union contracts. Variances are generally assigned to individuals who decide how the labour will be used, asunexpected overtime, using the average wage rate as the standard rate or using more skilled and highly paid labourers for less skilled tasks creates variances. Direct Labour Efficiency Variance Measure of the effect on cost of using a different number of direct labour hours, compared with what should have been used for the actual output LEV = (AH SR) (SH SR) LEV = SR(AH SH) , where AH = actual DLH used , where SH = standard hours allowed given actual output , where SR = standard rate per hour

Production managers are responsible for the productive use of direct labour. Pressure poses a risk of dysfunctional behaviour, where defective units could be deliberately transferred to finished goods to prevent using additional hours

Investigating Significant Variances and Taking Corrective Action

Investigations should be undertaken if anticipated benefits exceed the expected costs Benefits: reduced costs if cause of variance is eliminated, causes of favourable variances may improve work practices Costs: time & resources spent investigating the problem, disruption to the production process as the investigation is conducted, corrective actions (revision of standards)

Possible causes of variance performance, standard or uncontrollable factor Control limits are arbitrarily set, where variances falling outside the acceptable range are reported if significant: Size of variance Recurring variance reveal inefficiencies/efficiencies that should be abandoned/used elsewhere Trends Controllability non-controllable derivations should result in a revising of standards

Note: interactions make it difficult to assign responsibility for particular variances and thus you need to track down the root cause, so that responsibility may be assigned elsewhere

Costing and Tactical Decisions

Life-Cycle Costing
Product life cycle: time a product exists, from conception to abandonment Life Cycle costs: all the costs associated with the product for its entire life cycle, including: Development (planning, design, testing) 90% of costs are committed at this stage!!! Production (conversion activities) Logistics Support (advertising, distribution, warranty)

Note: If a cost reduction objective exists, it is important to redesign processes, products and marketing i.e. simplify it, BEFORE manufacturing takes place so that whole-life costs can be reduced. Whole-life cost: life cycle cost + postpurchase costs incurred e.g. operation, support, maintenance, disposal If post-purchase cost is a significant % of whole-life costs, then it becomes an important decision in the purchasing decision; and if reduced, can create a competitive advantage.

Product Cost is made up of: 1. 2. 3. 4. Non-recurring costs (planning, designing and testing) Manufacturing costs Logistic costs Customers postpurchase cost

Allows managers to be better assess the effectiveness of life cycle planning and build more effective and sophisticated marketing strategies Increases managers ability to make sound pricing decisions and improve assessment of product profitability

Life cycle cost management: focuses on managing value-chain activities to create a long-term competitive advantage Value-chain activities: set of activities required to design, develop, produce, market and service a product Must balance a products whole life cost, method of delivery, innovativeness and various product attributes including performance, features offered, reliability, conformance, durability, aesthetics and perceived quality Activity based costing can be used to encourage good life cycle planning by careful selection of cost drivers

Target Costing Target Costing: a system of profit planning and cost management that determines the life cycle cost at which a proposed product must be produced to generate the desired level of profit i.e. price = profit margin + cost Works backwards from a price acceptable to consumers to find the cost necessary to manufacture the product Focuses on the customer and customer expectations, ensuring that it is value adding Powerful when used with life cycle costs, as it provides the guidelines on where to reduce the costs Externally driven, generated by analysis of markets and competitors Target Cost = Target Selling Price Target Profit Margin Target Selling Price shaped by desired market share and market conditions Target Profit Margin = required rate of return on sales Cost Reduction Objective = Current Cost Target Cost Cost Reduction Methods used: 1. Reverse engineering: tears down competitors products with the objective of discovering more design features that create cost reductions 2. Value Analysis: assess the value placed on various functions by customers, if the price theyre willing to pay is less than the cost, the function should be eliminated i.e. value engineering and cost-gap analysis 3. Process Improvement: redesign processes to improve their efficiency Note: you NEVER reduce costs at the cost of the functionality of the product Activity Analysis: process of identifying, describing and evaluating the activities that an organisation performs to suggest what activities are undertaken, how many people perform the activities, the time and resources required to perform the activities and an

Tactical Decisions
Tactical Decision Making: choosing among alternatives with an immediate or limited end in view short term decisions that generally have a long term strategic impact e.g. cumulative tactical decisions 1. 2. 3. 4. 5. 6. Define the problem Identify alternative feasible courses of action Identify relevant costs and benefits of each alternative Total the relevant costs Compare cost and benefits of each possible course of action (including qualitative figures) Select a course of action

Relevant Information Relevant Costs: future costs that differ across alternatives i.e. variable costs, not allocations of costs already incurred Costs that relate to future actions (sunk costs and allocations e.g. depreciation are irrelevant) Change in demand across activities changes resource supply changing activity costs Demand for resource exceeds current supply Demand drops permanently and excess supply can be cut from activity capacity Costs (rev) that differ across alternative actions (incremental costs/rev, non-avoidable, opportunity costs) Qualitative Factors

Note: Avoidable costs are those not incurred if a particular decision is made. However, long term committed resource costs are often fixed; and treating them as such requires assuming that you can drop them without any penalty. Accept/reject a special order Q. Supply a customer with a single one-off order for goods or services at a special price? A. Accept special order if, incremental revenue > incremental costs Excess Capacity $ Incremental Revenue xxx - Price special order quantity Lost Revenue (xx) - Opportunity cost of forgoing (xx) Incremental Costs - DL/DM/VOH xxx - Commissions/one-off costs Contribution from special order Note: ABC costing improves ability to recognise relevant information as it makes more costs variable Qualitative Considerations 1. Is this really one-off? Could be a strategic change 2. Find alternative capacity if no excess e.g. cheaper to rent some excess capacity or forgo production? 3. Existing customers reaction to this special price especially if we cant deliver their regular order 4. Is this new customer likely to become a repeat customer? Make or buy a product/service Q. Produce or purchase from an external supplier a particular good or service? A. Whichever is cheaper! Total Cost Approach Incremental Cost Approach Make ($) Buy ($) Make ($) Buy ($) Cost of purchasing xxxx Cost of purchasing xxxx Variable Costs Avoidable Costs - DM/DL/VOH xxx - DM/DL/VOH xxx Fixed Costs - Avoidable FOH xxx (xxx) - Unavoidable xxx Opportunity Cost - Avoidable xxx - Use Spare Capacity xxx (xxx) Opportunity Cost Additional costs from buying xxx - Use Spare Capacity xxx xxxx xxxx Note: Consider whether we increase our level of excess capacity if we outsource and can we reduce resources supplied? Incremental Revenue - Price special order quantity Incremental Costs - DL/DM/VOH - Commissions/one-off costs Contribution from special order No or Limited Excess Capacity $ xxx (xx) (xx) (xx) xxx

Qualitative Considerations 1. Outsourcing decisions are difficult to reverse and can have strategic implications 2. Quality of product & degree of customisation required 3. Responsiveness of supplier 4. Ability of the supplier to respect confidential information 5. Capabilities of producing the product/service, require use of core resources? Add or delete a product, service or department Key considerations are still incremental revenue and costs; if differential is positive take the action. Keep xxx Variable expenses Direct avoidable fixed expenses (xx) (xx) xxx Drop xxx (xx) (xx) xxx Drop and Replace xxx (xx) (xx) xxx Differential xxx (xx) (xx) xxx

Sales Less: -

Total Relevant Benefit/(Loss)

Qualitative Considerations 1. Customers may prefer full service suppliers and leave 2. Deleting a department lowers morale 3. Removing a product can lead to excess idle capacities in the short term 4. Costs do not immediately disappear as a product is removed Joint product: sell or process further Joint Products: two or more products produced simultaneously from the one production process. Q. Sell the joint product or process it further? A. If the Profit of processing further > profit of selling and not
Split-off point

Product A
Product B Product C

Resources

Processing

Total Joint Costs

Note: Costs prior to split-off (total joint costs) are not relevant Steps: 1. Profit of Product B (B) Revenue Less: - Packaging Costs - Delivery Costs Profit $ xxx (xx) (xx) xxx 2. Profit of Product C (C) i.e. processing further $ Incremental Revenues xxx Less: Incremental Costs - Processing Costs (xx) - Packaging/Delivery Costs (xx) Incremental Profits from Processing Further xxx 3. Calculate Difference in Profits i.e. B - C

Qualitative Considerations 1. Do we have the capabilities to process further? 2. Is this a long term or one-off decision? 3. Do we have problems with existing customers who want to purchase product B? 4. Potential competition?

Transfer Pricing
Responsibility Accounting
Responsibility Accounting: assigns responsibility and accountability to managers to run sub-units of an organisation Reinforces the advantages of decentralisation

Responsibility Centre: sub-unit manager is held accountable for the sub-units activities and performance Cost Centre responsible for costs only Revenue Centre responsible for sales and direct costs only Profit Centre responsible for both revenues and costs Investment Centre - responsible for revenues, costs and investments

Objective is to influence behaviour so individual and organisational initiatives are aligned to achieve a common goal, by: 1. 2. 3. 4. Assigning Responsibility Establishing Performance Measures or Benchmarks Evaluating Performance Assigning Rewards

i.e. delegation of responsibility for performance, and then accounting for performance Functional-based accounting Stable: - Maintain status quo - Low competitive pressures - Standardised products & processes Individual in charge Financial outcomes i.e. operating efficiency e.g. costs Determined by budgeting and standard costing i.e. unit costing - Objective financial measures - Support the status quo and are currently attainable - relatively stable i.e. static - Compare actual v standard outcomes - Accountable for controllable costs only - Focus on financial efficiency Financial performance i.e. manage costs to achieve or beat budgetary standards Profit Sharing: global incentive to contribute to overall financial wellbeing of the firm Activity-based accounting Dynamic: - Competitive - Increasing organisational complexity - Change and continuous improvement Cross-functional Teams - Emphasises value chain activities Financial outcomes continuously enhancing revenues, reducing costs and improving asset utilisation - Process orientated financial & non-financial measures e.g. quality, time, efficiency - Optimal standards provide ideal targets and identify potential for improvement - Dynamic reflect new goals & conditions - Standard reflects value-added by processes - Focus on quality improvement, cost & time reduction indicative of improved process - Progress to achieving optimal standards multidimensional performance i.e. accountable for individual and team performance Gainsharing: share in gains related to specific improvement projects

Suited Operating Environment

Responsibility Assigned to? Responsibility defined in? Establishing Performance Measures or Benchmarks

Measuring Performance Individuals rewarded based on Nature of Rewards

Decentralisation
Decentralisation: restructuring of the organisation into smaller sub-units, such as divisions and departments, each with specific operations and decision making responsibilities i.e. delegating decision-making authority to lower levels

Obtaining goal congruence (consistency between managers personal goals and organisational goals) helps to ensure the effectiveness of decentralised organisations

Benefits 1. Ease of gathering and using local information more effective management of sub-unit markets and operations - Removes information overload, misinterpretation, transmission times better decision making 2. Focusing on central management allows more time for considering strategic issues 3. Training and motivating segment managers greater motivation, job satisfaction & managerial training 4. Enhanced competition, exposing segments to market forces more responsive to opportunities and problems Costs 1. Managers focus on their own sub-unit performance rather than attaining the organisations overall goals 2. Some tasks and services may be duplicated unnecessarily 3. Goal Congruence may be difficult to achieve (ameliorated by correctly set reward systems)

Transfer Pricing
Transfer Price: internal selling price used when goods and services are transferred between profit centres and investment centres in a decentralised organisation. Becomes the revenue of the selling division and the cost of the buying division i.e. allows the selling division to record revenue and earn profit to reflect their effort in producing the product Matches revenue when finished good is sold to external customers to expenses incurred to obtain intermediate goods Consequently, divisional profits should be reliable and accurate measure of divisional performance Preserves and encourage divisional autonomy If you set an appropriate transfer price, everyone will be motivated to do the right thing i.e. goal congruence Used to transfer profits between business units in different countries for tax considerations ethical?

Transfer Pricing Methods Corporate management may set a general policy for transfer pricing but divisions have the autonomy to set and accept transfer prices. Qualitative considerations should be taken into account and this transfer price only affects the units being sold/purchased. Note: fixed costs are only considered when considering profitability! Market-based Price If a perfectly competitive, external market exists, then: Transfer Price = market price avoidable sales expenses It reflects all the opportunity costs of both the buying and selling division; and thus no division can benefit at the expense of another i.e. division actions simultaneously optimise divisional and organizational profits. Opportunity Cost Approach Provides a bargaining range for the transfer price of a good, where the opportunity cost (minimum price) of the selling division is less than the opportunity cost (maximum price) of the buying division. Consequently, total divisional profits will not decrease by this internal transfer. Minimum Transfer Pricing = additional outlay costs (variable costs) + opportunity costs Maximum transfer price = external market price ALWAYS

Maximum External Market - Excess Capacity no opportunity cost but - Limited Capacity opportunity cost (external price variable costs) needs to be calculated on units affected are added to determine the average transfer price - No Excess opportunity cost of lost profits on external sales need to be accounted for in the transfer price No External Market - Excess Capacity no opportunity cost associated with the transfer; transfer price may be based on cost-plus - No Excess transfer will need to account for opportunity cost of lost sales due to the transfer - Alternative use of committed resources prolong negotiation and possible dysfunctional behaviour Negotiated Price Practical alternative to market price, where opportunity costs of both sides set the boundaries. It involves internal negotiation amongst divisional managers. Advantages 1. Means to achieving goal congruence throughout entire firm 2. Reflects autonomy 3. Training for divisional managers Disadvantages 1. Information asymmetry divisional manager with private information may take advantage 2. Negotiation can consume considerable time and resources 3. Performance measures may be distorted by negotiating skills of managers potential conflict of interest Do the managers possess required negotiation skills? Service Level Agreement: contract between 2 sub-units that establish the nature of the service that will be provided; its price, quality and time of delivery, problem-solving arrangements, ways it can changed or terminated. Cost-plus price Appropriate if there is no external market for the intermediate product i.e. no external market price; particularly if the formula is set during negotiation. Also, its simplicity and objectivity are suitable when transfers have a small impact on the profitability of either. Transfer Price = Standard Variable Cost + Mark-Up Allows supplying division to show a contribution margin on the transferred product Standard costs should always be used instead of actual, to prevent cost inefficiencies being passed on Avoid standard absorption cost i.e. full cost as it leads to overpricing and possible dysfunctional behaviour

Managing Quality
Quality: total features and characteristics of a product or service that enable it to satisfy stated or implied needs i.e. extent to which customer expectations are met or exceeded. Quality of Design = Customer Expectations + Design Specifications Quality of Conformance = Design Specifications + Final Products Best operational definition, as product specification should implicitly incorporate many quality dimensions i.e. reliability, durability, fitness for use, performance

Quality Dimensions 1. Performance consistent functionality of product Dimensions for services are responsiveness (willingness/prompt), assurance (trust/confidence), empathy 2. Aesthetics appearance 3. Serviceability ease of maintaining and/or repairing the product 4. Features (quality of design) differentiating characteristics features + performance 5. Reliability probability that products or service will perform its intended function for a specified time 6. Durability length of time a product functions 7. Quality of Conformance measure of how well finished product matches product design specifications 8. Fitness for Use - suitability of carrying out what it is supposed to do. 9. Perceived Quality Quality Views Defective product: one that does not conform to specifications View Optimal Quality Trade-Off Variability Traditional (AQL) Zero Defects Robust (World Class) Occurs where total cost of quality No defects No defects, no variation from is minimised, some defects are target even in specification allowed and encouraged limits Increasing Control Costs reduce None, increase in control cost will reduce failure costs and Failure Costs (should balance out) ultimately total cost of quality As long as attribute value falls within specification limits, it is QLF any variation from target acceptable and not costly value is unacceptable as it causes hidden quality costs Inspect for quality and rework if Quality should be designed and necessary built in Quantity is as important as Without quality, quantity is quality irrelevant

Quality Quantity

Note: Spending more on conformance costs although non-value adding in the short term will be less costly in the future. QLF further suggests that by building quality into business processes, in the long term, these costs will disappear.

Cost of Quality
Cost of Quality: financial measures suggesting costs exist because poor quality may or does exist. 2 sub-categories: Control Costs: incurred to ensure products/services conform to quality standard prevent & detect Preventative Costs: prevent poor quality products being produced in the first place E.g. recruiting skilled workers, quality engineering, quality training programs, quality audits Appraisal Costs: detects any non-conformance after an activity is performed e.g. inspection and testing Process acceptance: sampling goods while in the process to assess the process Product acceptance: sampling from batches of finished goods Failure Costs: incurred because product/services have not conformed to standard Internal Failure Costs: cost of non-conforming products detected by appraisal and corrective costs E.g. scrap, rework, downtime due to defects, re-inspection, retesting, design changes External Failure Costs: costs associated with poor quality products delivered to, reaching customers E.g. product recalls, returns, warranties, repairs, loss market share, complaint adjustment

Note: In assessing where the cost falls ask, why am I performing this activity and why is the cost incurred?

Measuring Quality Costs

Observable Quality Costs: those available from an organisations accounting records Hidden Quality Costs: opportunity costs resulting from poor quality leading to loss of reputation. Arises from external failure and are significant. Estimated by: 1. Multiplier Method Assumes total failure cost is a multiple of measured failure costs. The multiplier is determined by research and experience. i.e. Total external failure cost = k measured external failure costs 2. Market Research Method Use formal market research (customer surveys and interviews with companys sales force) to assess the effect of poor quality on sales and market shares, where results are used to project future profit losses attributable to poor quality. 3. Taguchi Quality Loss Function The QLF assumes any variation from the target value of a quality characteristic causes hidden quality costs i.e. the customer expects a level of quality, if they dont or cant expect that level as it deviates, then their perception of the company is affected. Hidden costs increase quadratically as the actual value deviates from the target value

L = unit loss y = actual value of the characteristic T= target value of the characteristic k = proportionality constant k = c/d2 , where c = loss associated with a unit produced at the specification limit d = distance from the target value to the specification limit Note: if youre willing to accept a larger distance, it means you dont value quality that much. Therefore, to calculate total hidden costs: 1. Use QLF to calculate the loss for each sample unit 2. Average these losses out 3. Multiply this average with the number of units

L = k(y-T)2

, where

Quality Cost Reporting

Important as the information is used to improve and facilitate managerial planning, control and decision making e.g. quality, program implementation evaluating effectiveness of quality programs (monitoring)s strategic pricing quality cost information and total quality control programs contribute to a significant decision new product analysis COQ Associate quality with $ Rank Problems Highlight trade off between conformity and nonconformity costs Allows aggregation Focuses on consequences Assists in understanding, monitoring, prioritising DMOQ Identify root cause of problems Understandable/acceptable Timely Disaggregated Focus on processes Facilitates direct solutions and feedback Assists in understanding, monitoring and problem solving

Quality Cost Report (COQ) Reveals magnitude of quality costs and their distribution among the four categories, revealing opportunities for improvement. Also, useful as a measure of performance and impact on bottom line. <Company Name> Quality Cost Report for the year ending <Date> Quality Costs ($) % of Sales Prevention Costs: Appraisal Costs: Internal Failure Costs: External Failure Costs Total Quality Costs Note: long and costly to compute this report Non conformance to conformance ratio = Failure Costs Control Costs Ideally, close to 0

Report directs attention and assists in evaluating performance. Steps to take: 1. 2. 3. 4. Look at failure costs Identify where the problem comes from Identify root cause Take corrective action

Trend Analysis Used to assess the change in quality costs through time, by plotting the percentage of sales of each of the 4 categories. Direct Measure of Quality (DMOQ) Direct Measure of Quality: non-financial measure of a correctable physical attribute that customers value helps you to pinpoint where the problem is, often depicted in a SPC or Pareto charts Good measures are specific, youre able to put a number on it (not $ amount) and time comparable External: customer response time, % of on time delivery, etc. Internal: looks at process e.g. defect rates, cycle times, equipment downtime

Total Quality Management

Emphasis on continuous improvement on processes undertaken to provide products and services as good quality costs less than poor quality. anticipating, meeting and exceeding customer needs and experiences is important match spending to customer requirements i.e. spend on design parameters that customers value holistic approach, where all members are committed to TQM employees need full support in efforts to improve quality requires cross-functional approach variability should be analysed as it adversely affects customer perceptions, multiplies and makes processes harder to manage often monitored using statistical process control (SPC) charts

Role of Management Accountants 1. Encourage quality awareness reduce costs by increasing customer demand or decreasing costs i.e. wastage eliminating/reducing non-value adding activities improving efficiency and effectiveness optimal use of human capital 2. Evaluate quality performance 3. Identify and prioritise quality problems 4. Ascertain causes of poor quality 5. Monitor quality improvements

Managing Time: The Theory of Constraints

Time-based management: compresses the time required to undertake processes to enhance customer value and reduce costs i.e. how do we manage constraining resources in order to generate revenue at an increased rate? Dictates the rate at which products are produced and revenue generated Determines how time resources are tied up in processes: delays lead to inventory build up new products/services i.e. first-in advantage Time to market Measures to assess product development process Break-even time

Time taken to fill customer orders Order Placed Order Received Order Receipt Time (NVA) Order Receipt Time (NVA)

Order Setup

Order Produced

Order Delivered

Production Cycle (Lead) Time (VA) Waiting Time (NVA) Production Time (VA)

Delivery Time (NVA) Delivery Time (NVA)

Aggregated, would give you an indication of the customers experience. The time taken is reduced by: Involving suppliers Efficient design process Using cross-functional teams and decentralisation make use of specialisation

Constraints
Constraint: any element that prevents the organisation from making more money. It can be either: external/internal tangible/intangible Preferable to have internal and intangible constraints i.e. more easier to control and change

AVOID treating all constraints as capacity constraints because getting to the root cause will often identify behavioural, managerial and/or logistical factors, which when addressed will make the constraint disappear Binding constraint/bottleneck: weakest link in the organisations value chain i.e. most harmful constraint External Constraints (Capacity > Demand) - Market constraint: when production capacity exceeds customer demand Find ways to retain existing customers whilst seeking additional markets i.e. simultaneously provide greater customer value at lower cost value engineering: effective in differentiating the product in cost-effective ways Overproduction leads to obsolete inventory that clogs warehouses and makes it less responsive to changing customer requirements. Implementing a reliable JIT system also decreases the customers need to hold inventories, thus reducing total costs and increasing the acceptable price for the product. - Supply Constraint:insufficient raw materials i.e. NO access to labour, raw materials poor planning unreliable suppliers managing supplier relationships is important material shortage in the market place

Internal Constraints (Demand > Capacity) - Materials: production processes are starved of materials i.e. got the materials but something is wrong, preventing them from flowing through e.g. poor scheduling, breakdown of preceding process synchronisation & inventory buffers important - Capacity: total demand exceeds total capacity i.e. different machine/people capacities labour and machines capacities directly influence the ability to maintain the required production flow - Logistical: resources alternate between insufficient capacity and excess capacity as waves of production hit them planning and control issues i.e. variability e.g. batch order entry system causes demand to come in waves that adversely affect the synchronous operation of the system - Managerial: strategies and policies which adversely affect synchronous operations i.e. lead to the suboptimisation of the system limit the firms capacity e.g. decisions about batch sizes and order quantities may be based on policies and procedures that have failed to keep up with changes in the manufacturing environment e.g. no overtime working, only one shift per day, no new product development - Behavioural: managerial policies and procedures affects the habits, practices & attitudes of employees as they are entrenched in the evaluation and reward systems: e.g. large amounts of raw materials inventory i.e. buy in bulk cheaper e.g. keep-busy approach work being done that is not required or scheduled

Theory of Constraints (TOC)

Theory of Constraints: focuses on the time element, concentrating on reducing the time taken to generate profits and the rate at which direct materials are turned into sales i.e. rate at which a system generates money. Identifies selling price, sales volume and material cost as the three key values determining profitability and focuses on product flow by treating overhead and labour costs as fixed in the short term Somewhat simplistic, linear view of the production chain Global goal of an enterprise is to make more money now and in the future. i.e. any action that moves the organisation toward making money is productive Organisations have sought to simultaneously reduce cost, improve quality, respond faster and be innovative due to increased competition & more stringent customer requirements Emphasises the generation of revenue rather than the minimisation of costs increasing the rate the system generates money through sales through increasing customer value manage resources according to ability to achieve goal i.e. focus on constraints before cost reduction (only so much you can cut) Throughput rate at which the system generates money through sales Inventory all the money that the system has invested in purchasing things that it intends to sell i.e. money tied up in the system sales unit-level variable costs Direct materials + PPE + R&D i.e. sales direct materials i.e. carrying value of plant, property and equipment + inventories valued at direct materials costs only Very short term focus: if you Excess inventories can get in the way and produce something, but dont make it difficult to find what is needed sell it, its not throughput i.e. no value until you sell it Operating Expenses All costs other than direct materials incurred to turn inventory into throughput Labour costs + overhead salaries, utilities, supplies, marketing expenses, insurance, tax, etc Net Profit = throughput operating expenses

Definition

Measured by

Notes

Increase throughput whilst reducing inventory and operating expenses i.e. T I OE Note: only the sale of finished goods contributes to making money i.e. accumulating inventory incurs additional costs (cost of warehouse, insurance, risk of obsolescence, etc.) where the buildup of WIP inventory will choke the production flow and tie up excessive amounts of capital (raw materials have to be purchased and investment cannot be recouped until finished product is sold)

Return on inventory is maximised by improving throughput, reducing operating expenses or reducing inventory: Increasing yields, reducing downtime and/or reducing product changeover time on the binding constraint increases throughput but may also decrease operating expense Improving the processing time on the binding constraint increases T but may also decrease OE

Measures to promote maximum throughput at bottlenecks Continually measuring workforce productivity and direct material yields at the binding constraint Monitoring pre-biding constraint buffer stocks of WIP Providing constraint capacity measures for different product lines in order to prioritise work at constraints Report on lead times, setup times, wait times Measure schedule adherence Being aware of, and providing a measurement system for all factors that affect performance Monitoring of stock by location, idle time and wait time throughout the production processes can be valuable as indicators of the existence of constraints

Managing Constraining Resources Constraint management: tool that seeks to ensure a flow of products through the plant that matches market demand in a timely manner i.e. least capacity will determine the rate of production managing this capacity constraint is critical to the organisations ability to generate revenue. Remove the constraint by purchasing additional resources BUT this is a longer term decision for potentially a short term and perhaps avoidable reason If demand for that resource declines because the root cause is addressed, it may be difficult to cut back Constraint determines the throughput contribution of the whole organisation Drum: bottleneck sets rhythm or rate of production for organization Rope: crucial to communicate what is happening with the constraint at all times Critical to ensure upstream operations produce the appropriate amount Prevent inventory from continually building up in front of the binding constraint Buffer: shield binding constraint from variability by maintaining inventory in front of it Ensure it is operating at all times as constraint cannot catch-up

Steps: 1. 2. 3. 4.

Identify the systems binding constraint Exploit the binding constraint Subordinate all other activities along the production line to the constraint Elevate/Eliminate the binding constraint

5. Repeat the process Identify the binding constraint The actual flow of materials through the production plant will differ from the planned flow because: 1. Unpredictable disruptions E.g. machine breakdowns know machine will breakdown but no idea of when 2. Inaccurate/indeterminate information E.g. time standards precise set up/ batch processing time varies but on average may match standard 3. Large number of variables Too many variables to be considered in the planning process Therefore, the identification of a binding constraint is particularly difficult when there is process variability, operations are synchronized and inventory levels are minimal i.e. bottleneck appears to be constantly moving between resources. Important to distinguish between day-to-day firefighting where production can catch-up and those constraints that have a long term impact i.e. as the latter is where the binding constraint is The binding constraint can be identified by: Informal measures Observation: resources with a large quantity of inventory waiting to be worked on Extracting knowledge from staff: asking questions or conducting interviews Formal measures Gantt Charts Capacity usage: If production capacity is known and not variable, the binding constraint can be identified by determining the capacity of each resource.

Note: if there are two constraining resources, the greater deficiency would be the binding. However, the effect of the other constraint must be considered to ensure the proposed optimal product mix is feasible. Exploit the binding constraint (How do we make the most of it in the short term?) Do everything possible to ensure the production process (and particularly the binding constraint) is operating as efficiently and effectively as possible. i.e. Ensure that the binding constraint keeps working at maximum capacity. 1. Determine Optimal Product Mix maximises revenue by prioritising greatest throughput per unit of bottleneck i. Calculate the throughput contribution for each product i.e. Price DM ii. Calculate throughput contribution with respect to constraint time i.e. throughput/bottleneck time needed iii. Use this throughput per unit of the binding constraint to priorities the production of each product subject to market demand Note: If a person has to perform 2 processes to complete a product, the time she performs both is in the ratio of the time taken for each process. 2. Provide Quality Inputs - if the binding constraint receives poor quality inputs, it will be slowed down even more (require rework) or result in wastage loss of sales i.e. throughput Prevented by supplier management or inspection of incoming materials 3. Eliminate idle time -binding constraint does not have excess capacity to catch-up; and if idle due to variability, interrupted flow of work in process from proceeding steps, throughput is lost forever

Inventory buffers:held in front of the binding constraint to ensure that the binding constraint can keep working, if production breaks before it. the size of the buffer will be determined by the variability of the preceding processes and the rate at which the constraint consumes the work in process/raw material Reduce set-up times 4. Preventative maintenance unscheduled down time will result in lost throughput preventative maintenance should minimise the amount of down time Subordinate all other activities Non-binding resources should produce at the rate dictated by the effective use of the binding constraint, even if it means working below capacity the alternative is to build up work-in-process inventories which can be disruptive TOC assumes that direct labour is a fixed cost, therefore idle time does not increase costs but reducing inventories will decrease costs (opportunity costs + cost of physically holding inventory): Rationale TOC emphasizes the TQM principle of building quality into process, rather than inspecting the finished product The product can incorporate the latest technology Lower operating costs e.g. overtime and lower inventory-carrying costs Avoid investment in additional unnecessary capacity to deal with bottlenecks caused by poor scheduling Lower inventories and increase the rate of every part of its operation help to increase the rate of throughput

Product

Quality Engineering Higher Margins Lower investment per unit Due-date performance Shorter quoted lead time

Price

Responsiveness

Elevate the binding constraint if necessary Spend money to reduce or change the nature of the constraint i.e. take actions to alleviate or eliminate the constraint Outsourcing Process/product redesign Cross-training Hire more workers, more experienced workers Capital investment Invest in ergonomic equipment, purchase faster machines

Note: look how long it takes to break even when trying to justify i.e. benefits > costs Repeat the process The process of identifying and eliminating constraints is never-ending. As each constraint is identified and brought under control, another constraint will emerge. The binding constraint should be the focus point for continuous improvement endeavours It is imperative to review the applicable rules and policies implemented to address the constraint or else the system may end up wallowing in a sea of policy constraints, causing inertia

Implications An important message of the theory of constraints is that resources need to be managed according to their effect on throughput. There will always be a constraint that limits the throughput of the organization. That constraint must be identified and carefully managed to ensure that it operates at maximum capacity i.e. other non-binding resources will often be operating at less than maximum capacity (idle time).

Resource management Short term do not divert resources to non-binding constraints Long term reducing WIP and finished good inventories will benefit the organisation Inventory/products Mix - optimise throughput relative to the binding constraint Quality poor quality inputs represent an opportunity cost of the lost throughput Performance measures KPIs and reward systems need to be re-evaluated Mentality of employees: produce as much as you can need to be retrained Should be evaluated on the basis of deviations from planned performance Concepts conventional cost accounting Direct costs are variable and indirect costs are fixed Inventory is an asset and working on material increases its value Summing component costs to derive a product cost and subtracting the result from the sales price is a good way to determine relative product profitability Reducing component costs directly increases profits New principles of throughput accounting Distinguishing between indirect and direct costs is not useful Not an asset, it is the outcome of unsynchronised manufacturing and hinders the organisation in achieving the global goal - It is the rate at which the factory earns money that determines ultimate profitability, not the contribution of each product - Profit is a function of material cost, total factory cost and throughput

Role of Direct & Indirect Costs Inventory

Profit

Limitations - Distortions if assumptions dont hold: If direct labour and VOH are not fixed in the short-term - Difficulty in identifying the constraint if processes are subject to variability - Constraints are not easily controlled or addressed if external or intangible - Suggests that orders should be accepted as long as short run marginal pricing exceeds cost of raw materials BUT fixed costs need to be recovered!

Capital Expenditure Decisions

Capital Investment decisions are concerned with expenditure on non-current assets or long term resources that usually involve a significant outlay of funds and require long-term commitment. Undertaken for: Strategy: further organisations long term goals for success (enhancement of quality, expansion) i. cement market position or gain market share Profitability: revenue generation, cost reduction Regulation: environmental/OH&S requirements Infrastructure IT

Note: each reason may have a different return i.e. profit not in terms of dollars but intangible like community benefit Organisations can only carry out value adding activities if they have the necessary resources to support them! Two types of capital investment projects:

1. Independent projects: if accepted or rejected, do not affect cash flows of other projects 2. Mutually exclusive projects: if accepted, preclude the acceptance of all other competing projects

Investment/Approval Process i.e. Capital Budgeting

1. 2. 3. 4. 5. 6. Project generation Estimation & analysis of projected cash flows Progress to approval Analysis and selection of projects Implementation of projects Post-audit of process

Incremental Cash Flows Consider incremental costs and benefits when estimating, we must consider (inflation, working capital (CA CL), opportunity costs, disposal of equipment, relevant inflows/outflows after tax) Note: when given tax rate, always use after-tax cash flows Incremental cash outflows 1. Initial cost 2. Operating cost over project life Tax Implications on Cash Flows Increase in taxable income greater cash outflow 1. Gain on sale 2. Increased revenues 3. If government gives you an investment allowance, and you make a capital investment, the allowance will be taxed Incremental cash inflows 1. Cost savings (savings from a cash outflow) 2. Additional revenues

Decrease in taxable income lesser cash outflow 1. Loss on sale 2. Increased expenses 3. Depreciation may reduce tax paid (indirectly). Unless told otherwise, assume: a. depreciation for tax purposes = depreciation for accounting purposes b. straightline depreciation

Analysis and Selection of Projects - Investment Analysis Techniques Managers make capital investment decisions by using formal models to decide whether to accept or reject proposed projects. Depending on whether they address the time value of money, these decision models are classified as: Non-Discounting Definitions Calculations Payback Payback period: time required for a firm to recover its initial investment (shorter time preferred) For even cash flows, For uneven cash flows, cash flows are summed until investment is recovered - If only a fraction of the year is needed, then it is assumed that cash flows occur evenly payback period < required time for payback Easy to understand simple Provides a measure of the liquidity and risk (obsolescence + uncertain CF) of a project Relatively simple and easy to understand Considers profitability of the project after payback i.e. returns throughout asset life Accounting Rate of Return Measures the return on a project in terms of profit

Acceptance criteria Advantages

Ensures certain accounting ratios are not adversely affected e.g. debt-restrictions

Limitations

Ignores time value of money Ignores cash flows beyond payback period i.e. ignores the profitability of the project

Consistent with performance evaluation Screening with respect to accounting ratios Used for debt covenants, contracts with the bank Ignores cash flows Ignores time value of money Accrual accounting distorts

Discounting 1. Required rate of return/discount rate/hurdle rate/cost of capital 2. Adjusted for risk of particular project i.e. higher risk, higher rate 3. Minimal acceptable rate of return Assumes: 1. Year-end timing of cash flows cash flows comes in at the end of the year 2. Certainty of cash flows Net Present Value difference between the present value of future cash flows and the initial investment outlay i.e. measures the true economic return of the project, the productivity of capital, and the change in wealth of shareholders Calculation present value of all project cash flows initial investment , where I = initial investment, Internal Rate of Return Finding the interest rate that equates the present value of a projects cash inflows with the present value of its cash outflows. Measures the true rate of return of the project and productivity of capital invested assumes discount rate at which NPV of cash flow is zero IRR > required rate of return

i = required rate of return Acceptance NPV > 0 - present value of the inflows is greater than the Criteria present value of the outflows, the project is viable i.e. it generates sufficient returns to justify the investment and risk involved. Notes: Two present value tables to simplify calculations: 1. PV of $1 works out the discount factor 2. PV of annuity used if you have a constant cash flow (think summing of a geometric series, where a is the constant cash flow) Advantages - Considers time value of money - Considers size of the investment - use firm discount rate (can adjust for risk) Limitations - Assumes all cash flows are reinvested at the required rate of return

Provide same decision outcome as NPV for independent project analysis

Considers time value of money Managers are accustomed to working with rates of return Stated as a percentage rather than a dollar amount Assumes cash flows are reinvested at the IRR of the project May not select the project that maximizes firm value

Small firms use DCF less, because of: 1. Liquidity issues 2. Unfamilarity with the techniques

3. Small project sizes dont worry extensive analysis Limitations - Heavy reliance on estimation - Use of unrealistic status quo assumes market conditions stay the same regardless of investment decision - Hurdle rates too high want to be sure that itll be a profitable project i.e. remove the risk by increasing rates - Time horizons too short distortion of what is best people dont stay at the firm forever, are motivated by incentive rewards for their generation of returns, now! - Difficulty in gaining approval for large projects - Strategic and competitive concerns may be overlooked doesnt take into account what the other firms will do - High potential for exclusion of benefits that are difficult to quantify or put into financial terms: Financial outcomes: lower direct labour costs, less scrap and rework, lower stock costs, increase in software Non-financial outcomes (how do you quantify these?) Reduction in manufacturing cycle time, increase in manufacturing flexibility, increase in business risk due to higher fixed cost structure, improved product delivery and service Dealing with Limitations - Try to quantify the benefits - Consider market conditions and economic trends - Include strategic and competitive concerns - Match required rate of return to uncertainty - Conduct sensitivity analysis determine how much estimates can change before an investment looks bad - Conduct multiple scenario analysis the risk and uncertainty can be incorporated by identifying multiple scenarios and calculating expected NPV and assigning a relevant probability Management of Investment Capital investment in the advanced manufacturing environment is affected by the way in which inputs are determined. Much greater attention must be paid to the investment outlays because peripheral items can require substantial resources. In assessing benefits, intangible items such as quality and maintaining competitive position can be deciding factors choice of the required rate of return is also critical. Tendency of firms to use required rates of return that are much greater than the cost of capital should be discontinued. Salvage value of an automated system can be considerable, it should be estimated and included in the analysis.

Post-audit of process Post auditing evaluate the actual performance of a project in relation to the expected performance Post-implementation and/or post-completion audits: compare actual with estimated cash flow May lead to corrective action to improve the performance of the project or to abandon it Control mechanism employees will be a bit more careful - Serves as an incentive for managers to make capital investment decisions prudently which projects should be reviewed? Provides feedback on accuracy of initial estimates i.e. hopefully benefits future decisions

Behavioural Implications Performance evaluation

Performance measures Investment proposal generation if you know that the company would like to, but you dont because its bad for your figures Escalation of commitment you know its wrong, but you dont get rid of it, because youve already committed resources

3 qualitative considerations that should generally be considered in capital budgeting evaluations include: Quicker responses to market changes and flexibility in production capacity Strategic fit and long-term competitive improvement from the project, or the negative impact to the companys competitiveness or image if it does not make the investment Risks inherent in the project, business, or country for the investment

Performance Evaluation and Control

Role of Accounting Information in Organisational Control
The Accounting Information System is an integral part of the organisations control system, as it provides: Decision-facilitating information (Planning) Budgeting, standard setting Decision-influencing information (Controlling) Assessing someones performance influencing your opinion of persons effort Variance analysis, cost of quality report

Create and Sustain Value

Efficient and effective use of organisational resources

Organisational Performance

Function of ability, uncertainty, effort, resources, etc.

Individual Performance
What motivates people?

Motivation to exert effort

intended to provide motivation for organisational members to take actions and make decisions consistent with the organisaitons objectives

Control System Design

Motivation
Motivation: an individuals intensity, direction and persistence of effort toward attaining goals Energises and guides behaviour toward obtaining a particular outcome

2 types; and incentive system must strike a balance between them Intrinsic: generated internally within the individual e.g. satisfaction Make work interesting improves opportunities for intrinsic rewards Extrinsic: granted externally by the organisation e.g. recognition, praise, remuneration, prizes Effective incentive system if extrinsic rewards reinforce intrinsic rewards

Factors affecting motivation: Individual Characteristics e.g. specific to the person Interests, attitudes & needs that people bring to the work place controlled through recruitment Job-related Characteristics Content & context of task environment autonomy, variety, difficulty Work Situation Characteristics Immediate work environment policies, culture

Motivation Theories
1. Goal Setting Theory Setting a specific, difficult but attainable goal improves performance by motivating employees to put more effort (direct attention, increase persistence, stimulate effort) in. Limitations: 1. Employee ability and task complexity (consider feedback) 2. Degree of goal acceptance and commitment (ameliorated by participation in goal setting) 3. Tunnel vision: person focuses on goal but forgets everything else (avoid by setting a number of goals and focusing on effectiveness and efficiency) 2. Expectancy Theory Employees are motivated by an incentive plan that provides expectancy that desirable behaviour leads to rewards i.e. must provide a: 1. Desirable outcome (desirable reward/undesirable penalties); and 2. High probability that behaving consistently with organizational objectives will lead to the outcome Effort --- EXPECTANCY LINK -->Performance --- INSTRUMENTALITY LINK -->Outcomes --- VALENCE LINK -->Satisfaction Expectancy link: Does effort result in performance? Can I achieve the target? Is my effort reflected in performance? Instrumentality link: Does performance result in the reward? i.e. how certain are you that youll get the reward? How do outcomes reflect measured performance? Do outcomes reflect all facets of my performance? Valence link: Is the reward desirable? What outcomes do I value/want? How much do I value them?

Note: If any of these linkages are weak, the reward system is lousy. The stronger the linkages (relationships), the more motivated employees will be.

3. Agency Theory Interdependent relationship exists between principals (employers) and agents (employees) who want to maximize their rewards at minimum costs. Agents are motivated by self-interest and have more information i.e. information asymmetry. Therefore, goal incongruence can lead to dysfunctional behaviour. Monitoring and incentives becomes important i.e. if you reward people properly, theyll do the right thing Total agency costs = opportunity cost of misbehaviour + incentive & monitoring expenses

Incentive Systems
The best incentive plans trades off the cost of administering alternative incentive plans against the cost of misbehaviour i.e. must attract and motivate qualified employees to behave according to the organisation goals, reward them if they do; and requires monitoring to ensure the performance measures are reasonable require reliable, objective and verifiable performance measures and clear guidance for evaluating trade-offs Theoretical Principle Most individuals are motivated by self-interest Organisations get the behaviour they reward Effort follows rewards Difficult but attainable goals motivate best Fairness is a basis for sustained motivation Manipulation undermines fairness and effort Different rewards can motivate effort Incentive systems involve trade-offs Implications Performance based rewards must be greater than alternative rewards from non-performance Performance measures and related rewards must reflect organizational goals Employees must believe that their efforts influence performance and will be rewarded. Impossible and easy goals are demotivators. Make goals difficult but not impossible Rewards must be linked to desired performance in a fair and consistent manner Performance measures must be observable and verifiable Rewards must meet market conditions and be available Minimizing the overall costs of aligning goals and monitoring behaviour is a goal of incentive system design

Theory Agency Agency Expectancy Goal Setting Expectancy Agency/Expectancy Expectancy Agency

Balanced Scorecard: model of cause and effect relations among leading and lagging indicators of performance. Useful for measuring and communicating the effects of activities on organizational performance as it is looks at 4 areas of performance: 1. 2. 3. 4. Learning and Growth Internal Business Process Customer satisfaction & loyalty Financial

Assign overall scorecard incentives to managers at higher levels to reinforce the goal to ensure subordinates are working to improve the measures they directly control. Use of a balanced scorecard in an incentive system is contentious. Principles of Incentive System Design The key to designing incentive systems is to understand as well as possible which behaviours are desired and how incentives and rewards are likely to influence behaviours.

1. Use Multiple Measures Financial levels & growths of revenues, costs, cash flows, operating income, ROI, stock price non-financial e.g. customer and employee satisfaction, social responsibility 2. Employees must believe that the reward is a result of something they can control 3. Measure output v. input Absolute or relative? Avoid rewarding output if: Output cannot be measured consistently Output is affected by uncontrollable factors Output is expensive to measure i.e. cost prohibitive & difficult to measure 4. Link to critical success factors what is crucial to the firm? 5. Clear standards that employees can accept i.e. goal Specific Measurable: quantifiable Achievable: Realistic: Time bound: 6. Measures must accurately assess performance accurate, reliable and verifiable otherwise, conflict and cheating opportunities created 7. Group performance (relationship between actions and company performance) v individual performance Choices of Incentive System - Absolute or Relative measures - Reward formula-based (meeting targets + %) or subjective performance (take into account circumstances and other desirable things about performance)? Effect on effort-performance linkage? Potential for playing the system? - Financial or non-financial measures - Narrow or broad responsibility of performance - Current or deferred rewards Salary, bonus, or stock Consider risks, alignment of interest Current Rewards Cash or stock that can be cashed immediately or soon after the award closely linked to current performance i.e. strong motivation to improve current performance Deferred Rewards Defer payment or payment is restricted until a future date incentives to stay with the company focus attention on long term performance capture the lag effect of non-financial performance too far in the time horizon to be motivational -

What is it? Advantages

Disadvantages

induce employees to manipulate performance measures without concern for future performance or with the expectation of cashing out and leaving the company