B405F Advanced Management Accounting Revision Lecture 11
Five-Step Decision Process • Gathering information • Making predictions • Choosing an alternative • Implementing the decision • Evaluating performance
The Meaning of Relevance • Relevant costs and relevant revenues are expected future costs and revenues that differ among alternative courses of action. • Sunk costs are irrelevant because they are past costs. • Common fixed costs are irrelevant because they are non-differential costs.
Quantitative and Qualitative Relevant Information • Quantitative factors are outcomes that are measured in numerical terms: • Financial • Nonfinancial • Qualitative factors are outcomes that cannot be measured in numerical terms: • Nonfinancial
One-Time-Only Special Order • Decision criteria: Accept the order if the revenue differential is greater than the cost differential.
Make or Buy Decision • Opportunity costs are not recorded in formal accounting records since they do not generate cash outlays. • These costs also are not ordinarily incorporated into formal reports.
Product-Mix Decisions Under Capacity Constraints • Decision criteria: Aim for the highest contribution margin per unit of the constraining factor. • When multiple constraints exist, optimization techniques such as linear programming can be used in making decisions.
Equipment Replacement • The book value of existing equipment is irrelevant since it is neither a future cost nor does it differ among any alternatives (sunk costs never differ).
Decisions and Performance Evaluation • Managers often behave consistent with their short-run interests and favor the alternative that yields best performance measures in the short run. • When conflicting decisions are generated, managers tend to favor the performance evaluation model. • Top management faces a challenge – that is, making sure that the performance-evaluation model of subordinate managers is consistent with the decision model.
Time Horizon of Pricing Decisions • Two key differences when pricing for the long run relative to the short run: • Costs that are often irrelevant for short-run pricing decisions (fixed costs) are often relevant in the long run. • Profit margins in long-run pricing decisions are often set to earn a reasonable return on investment.
Alternative Long-Run Pricing Approaches • Market-based • Cost-based (also called cost-plus)
Target Price is... • the estimated price for a product (or service) that potential customers will be willing to pay. • The target price, calculated using customer and competitors inputs, forms the basis for calculating target costs.
Target Costs • Target sales price per unit • Target operating income per unit • Target cost per unit
Implementing Target Pricing and Target Costing • Steps in developing target prices and target costs: • Develop a product that satisfies the needs of potential customers. • Choose a target price. • Derive a target cost per unit. • Perform value engineering to achieve target costs.
Value-Added Costs • A value-added cost is a cost that customers perceive as adding value, or utility, to a product or service: • Adequate memory • Pre-loaded software • Reliability • Easy-to-use keyboards
Nonvalue-Added Costs • A nonvalue-added cost is a cost that customers do not perceive as adding value, or utility, to a product or service. • Cost of expediting • Rework • Repair
Cost Incurrence and Locked-in Costs Cumulative Costs per unit Locked-in Cost Curve Cost Incurrence Curve Value Chain Functions Manufacturing Mktg., Dist., & Cust. Svc. R&D and Design
Cost-Plus Pricing • The general formula for setting a cost-based price is to add a markup component to the cost base. • Cost base $X Markup component Y Prospective selling price $X + Y
Life-Cycle Budgeting • The product life-cycle spans the time from original research and development, through sales, to when customer support is no longer offered for that product. • A life-cycle budget estimates revenues and costs of a product over its entire life.
Predicted Costs • Many of the production, marketing, distribution and customer service costs are locked in the R&D and design stage. • Life-cycle budgeting facilitates value engineering at the design stage before costs are locked in.
Strategy • Strategy specifies how an organization matches its own capabilities with the opportunities in the marketplace to accomplish its objectives • A thorough understanding of the industry is critical to implementing a successful strategy
The Balanced Scorecard • The balanced scorecard translates an organization’s mission and strategy into a comprehensive set of performance measures. • The balanced scorecard does not focus solely on achieving financial objectives. • It highlights the nonfinancial objectives that an organization must achieve in order to meet its financial objectives.
Aligning the Balanced Scorecard to Strategy • Different strategies call for different scorecards. • What are some of the financial perspective measures? • Operating income • Revenue growth • Cost reduction is some areas • Return on investment
Aligning the Balanced Scorecard to Strategy • What are some of the customer perspective measures? • Market share • Customer satisfaction • Customer retention percentage • Time taken to fulfill customers requests
Aligning the Balanced Scorecard to Strategy • What are some of the internal business process perspective measures? • Innovation Process • Manufacturing capabilities • Number of new products or services • New product development time • Number of new patents
Aligning the Balanced Scorecard to Strategy • Operations Process • Yield • Defect rates • Time taken to deliver product to customers • Percentage of on-time delivery • Setup time • Manufacturing downtime
Aligning the Balanced Scorecard to Strategy • Post-sales service • Time taken to replace or repair defective products • Hours of customer training for using the product
Aligning the Balanced Scorecard to Strategy • What are some of the learning and growth perspective measures? • Employee education and skill level • Employee satisfaction scores • Employee turnover rates • Information system availability • Percentage of processes with advanced controls
Features of a Good Balanced Scorecard • Tells the story of a firm’s strategy, articulating a sequence of cause-and-effect relationships: the links among the various perspectives that describe how strategy will be implemented • Helps communicate the strategy to all members of the organization by translating the strategy into a coherent and linked set of understandable and measurable operational targets
Features of a Good Balanced Scorecard • Must motivate managers to take actions that eventually result in improvements in financial performance • Limits the number of measures, identifying only the most critical ones • Highlights less-than-optimal tradeoffs that managers may make when they fail to consider operational and financial measures together
Balanced Scorecard Implementation Pitfalls • Managers should not assume the cause-and-effect linkages are precise: they are merely hypotheses • Managers should not seek improvements across all of the measures all of the time • Managers should not use only objective measures: subjective measures are important as well
Balanced Scorecard Implementation Pitfalls • Managers must include both costs and benefits of initiatives placed in the balanced scorecard: costs are often overlooked • Managers should not ignore nonfinancial measures when evaluating employees • Managers should not use too many measures
Evaluating Strategy • Strategic Analysis of Operating Income – 3 parts: • Growth Component – measures the change in operating income attributable solely to the change in the quantity of output sold between the current and prior periods • Price-Recovery Component – measures the change in operating income attributable solely to changes in prices of inputs and outputs between the current and prior periods • Productivity Component – measures the change in costs attributable to a change in the quantity of inputs between the current and prior periods
Revenue Effect Analysis P2 Price Recovery Component Q2 Growth Component P1 Q1
Cost Effect Analysis Q2 Productivity Component P2 Price Recovery Component Q Growth Component P1 Q1
The Management of Capacity • Managers can reduce capacity-based fixed costs by measuring and managing unused capacity • Unused Capacity is the amount of productive capacity available over and above the productive capacity employed to meet consumer demand in the current period
Analysis of Unused Capacity • Two Important Features: • Engineered Costs result from a cause-and-effect relationship between output and the resources used to produce that output • Discretionary Costs have two parts: • They arise from periodic (annual) decisions regarding the maximum amount to be incurred • They have no measurable cause-and-effect relationship between output and resources used
Managing Unused Capacity • Downsizing (Rightsizing) is an integrated approach of configuring processes, products, and people to match costs to the activities that need to be performed to operate effectively and efficiently in the present and future • Because identifying unused capacity for discretionary costs is difficult, downsizing, or otherwise managing this unused capacity, is also difficult.
Customer-Profitability Profiles • Customer profitability reports often highlight that a small percentage of customers contribute a large percentage of operating income. • It is important that companies devote sufficient resources to maintaining and expanding relationships with these key contributors to profitability.
Other Factors in Evaluating Customer Profitability • Likelihood of customer retention • Potential for sales growth • Long-run customer profitability • Increases in overall demand from having well-known customers • Ability to learn from customers
Sales Volume Variance aMi Sales Mix aQ bMi Sales Quantity bQ BCMi aX Market Share aZ BCM Market Size bX bZ
Purposes of Cost Allocation • There are four essential purposes of cost allocation: • To provide information for economic decisions • To motivate managers and other employees • To justify costs or compute reimbursement • To measure income and assets for reporting to external parties
Cost Allocation Criteria Cost Allocation by Ability to Bear How many resources are consumed by the cost object? Cost Allocation by Cause and Effect The ability for the cost object to absorb additional cost given reasonable profit margin Cost Object Cost Allocation by Benefit Received User How many benefits are received by the user from using the cost object?
Allocating Costs of a Supporting Department to Operating Departments • Supporting (Service) Department – provides the services that assist other internal departments in the company • Operating (Production) Department – directly adds value to a product or service
Allocation Method Tradeoffs • Single-rate method is simple to implement, but treats fixed costs in a manner similar to variable costs • Dual-rate method treats fixed and variable costs more realistically, but is more complex to implement
Allocation Bases • Under either method, allocation of support costs can be based on one of the three following scenarios: • Budgeted overhead rate and budgeted hours • Budgeted overhead rate and actual hours • Actual overhead rate and actual hours • Choosing between actual and budgeted rates: budgeted is known at the beginning of the period, while actual will not be known with certainty until the end of the period
Budgeted versus Actual Rates • Budgeted rates let the user department know in advance the cost rates they will be charged. • Users are better equipped to determine the amount of the service to request. • Budgeted rates also help motivate the manager of the supplier department to improve efficiency.
Budgeted versus Actual Usage Allocation Bases • When budgeted usage is the allocation base, user divisions will know in advance their allocated costs. • This information helps the user divisions with both short-run and long-run planning. • The main justification given for the use of budgeted usage to allocate fixed costs relates to long-run planning.
Allocating Support Departments Costs • Three methods are widely used to allocate the costs of support departments to operating departments: • Direct allocation method • Step-down method • Reciprocal method