Strateic Cost Management

Strategic Cost Management

Unit 1 – The Cost Function / Basic Cost Concepts

Importance of cost information in decision making

Relevant Cost

Types of CostsDirect and Indirect CostFixed , Variable and Mixed CostSunk Cost / Opportunity Cost

Identifying relevant cost from accounting system

Cost driver / Potential Cost drivers

Unit 2 – Planning and Control : Maximize Contribution

Cost Estimation – Methods of Estimation

Cost Volume Profit Analysis

Relevant cost for non routine operating decisions.

Unit 3 – Cost Information : Internal & External Reporting Contribution

Process Costing

Job Costing

Activity Based Costing

Unit 4 – Cost Information : Planning and Monitoring

Cost Budgets

Standard Costs and variance analysis

Investment Decision

Unit 5 – Cost Information : Management Control and Performance measurement

Investment Decision

Strategic performance measurement and balanced scorecard.

Objective:

Cost Accounting information is increasingly defined to include both financial and non financial information and also include items that do not relate strictly to measurement of cost.

Strategic cost management – focus on reducing cost and improving organization’s strategic position

Learn how to generate cost information and how to use that information for business decisions.

Importance of cost information

Accounting information not sufficient for management decision making.

Poor monitoring and controlling

Poor strategy and growth

Cost Object: A thing or activity for which we measure cost

Relevant Cost

Identification of relevant cost is key to decision making

Helps to understand impact on various stake holders

Consider and analyze strengths and weaknesses of various alternatives

Not all relevant cost information can be obtained from accounting system

Direct and Indirect Cost

Direct Cost: Clear cause and effect relationship between object and cost. Cost of each unit / product line can easily be traced. Information is readily available / can be obtained easily

Indirect Cost: Not easily traceable to individual cost object Relate to more than one / multiple product or services. Potentially traceable but may be overly expensive All indirect cost are generally clubbed as “Overhead

Cost”

Fixed, Variable and Mixed Cost

Variable Cost: Change proportionately with change of activity level Cost per unit remains constant

Fixed Cost: Do not change with small change in activity Increases in a stepwise manner with each significant

change in activity.

Mixed Cost: Partially fixed and partially variable

Sunk Cost: Expenditure made in past Unavoidable and not relevant for decision making Can not be changed by future action.

Opportunity Cost: The benefits of decision taken over the alternative Difficult to measure in all cases

Cost Driver, Cost Pool and Cost Object

Cost Driver: Any factor that has the effect of changing the level of total cost Critical to identify the key cost driver in achieving

competitive advantage

Cost Pool: Meaningful groups into which costs are grouped Cost can be grouped in many different ways Cost pool can be defined in different ways – by type of

cost ( labor, material etc), by responsibility ( Manager, staff , department etc.) etc.

Cost Object: Any product, service, customer, activity or organization unit to which costs are assigned for management purpose.

Cost Drivers

One : One or one : many cost driver for cost object

Same cost object may have different cost drivers in different business settings.

Some costs can not easily be associated with any type of cost driver.

Past discretionary costs might not be relevant for future behaviour

Cost Assignment and Cost Allocation

Cost Assignment: Process of assigning cost to cost pool or from cost pool to cost object – Direct Cost

Cost Allocation: Process of charging indirect cost to cost pool / object

Unit 2 – Planning and Control : Maximize Contribution

Cost Estimation – Methods of Estimation

Cost Volume Profit Analysis

Relevant cost for non routine operating decisions.

Cost Estimation

Cost management information is critical in planning and decision making

Strategic management requires accurate cost estimates for....a) Strategic positioning analysis – cost leadershipb) Value chain analysis – make or buyc) Target Cost

Six Steps of Cost Estimation1) Define the cost object to be estimated2) Define the cost drivers3) Collect consistent and accurate data4) Graph/ Analyze the data5) Select the estimation method6) Assess the accuracy of the cost estimate

Cost Estimation – Methods of estimation

High- Low Method : Uses highest and lowest data points of the cost driver Not always accurate Estimated Cost = Fixed Cost + units of cost driver * unit

variable cost

Work Measurement : Detailed study of some production or service activity to measure the time and input required per unit of output

Regression Analysis : Statistical measurement of the average change in dependent variable ( cost object) for every change in one or more independent variable ( cost driver/s) Simple Regression – Cost : one driver Multiple Regression – Cost : two or more cost drivers

Cost – Volume – Profit ( CVP ) Analysis Method for analyzing how operating / marketing decisions will

effect net income.

Based on explicit model of the relationship between three factors – costs, revenue and profit and how they change in predictable way as the volume of activity changes.

The CVP model is …… Profit = Revenue – Total cost ( Fixed cost + variable cost )

Helps in… Setting price for product and services Set sales targets for avoiding losses / achieve targeted

profits Introducing a new product / service Make or Buy decision Replacement decision – increase fixed cost Strategic decision – what if analysis : evaluate biz. risks

Cost – Volume – Profit ( CVP ) Analysis Understand contribution margin, contribution margin ratio

Strategic role of CVP analysis Cost Leadership – Low operating cost by lowering fixed

cost per unit by optimum volume Target costing – introduction of new product/ services and

their impact on profitability Life-cycle costing – a) most cost effective processes:

replace machine , introduce automation, make or buy b) marketing and distribution cost: salary or commission, discount levels.

Cost – Volume – Profit ( CVP ) AnalysisEquation method for breakeven Sales = Fixed cost + variable cost + Profit OR ………………

Units sold (Q)* price per unit (P) = fixed cost (F) + Variable cost (V) * units sold (Q) + Profit (N)

Contribution margin ratio (CMR): (P – V) / P

Revenue Planning: Breakeven in units : Q = (F + N) / (P – V) Breakeven in revenue : Revenue = (F+N) / CMR

Cost Planning: Trade-offs between Fixed and Variable cost Sales commissions and salaries

Cost – Volume – Profit ( CVP ) Analysis Margin of safety: Amount of sales above the breakeven point

Margin of safety = Planned sale – Breakeven sales Useful for assessing the risks Low margin of safety indicates high risks : need more

management attention.

Operating leverage : Is the ratio of the contribution margin to profits Higher value for operating leverage indicate higher risk –

change in sales will have greater impact on profits

Decision making with relevant cost and a strategic Emphasis

Decision makers consider both short term and long term effects in decision making.

Cost management provide two important resources to improve the decision: relevant cost analysis strategic cost analysis. Relevant cost analysis: Short tem focus Strategic cost analysis: Long term focus

The Decision making Process

First:

Determine the Issue

Second:

Specify the criteria and identify the alternative Actions

Third:

Relevant Cost and Strategic Cost analysis

Predict Future Values of Relevant costs and Revenues

Consider Strategic issues / Qualitative Issues

Fourth:

Select and Implement the best course of action

Fifth:

Evaluate Performance

Identify and collect relevant information


Relevant Cost: Costs that will be incurred at some future time; it differ for each option available to the decision maker.

A relevant cost can be either variable or fixed Variable costs: Mostly relevant, occasionally not relevant Fixed cost: Mostly not relevant, occasionally relevant

Strategic Costs: Management decisions involve strategic issues like product, capacity, diversity, features etc.

Other important factors: Fixed Costs and Depreciation - Depreciation is portion of

committed cost and is sunk and irrelevant Opportunity Costs – Important to include in situation of

constraints


Relevant Cost Analysis

Short – term focus

Not linked to strategy

Product cost focus

Focused on individual

product or decision

situation

Strategic Cost Analysis

Long – term focus

Linked to org. strategy

Customer focus –

consider all customer

related issues.

Summary of Information used in Decision

Special Order: Decision Rule - Accept if price is greater than or equal to the

sum of variable cost, relevant fixed costs, and opportunity cost.

Relevant fixed costs – Only new fixed costs associated with the special order

Opportunity cost – Contribution margin of any regular business replaced.

Strategic/ Qualitative factors – Capacity utilization, impact on Brand, short term v/s long term pricing, Quality.

Uncertainties – Will some fixed cost increase, cost estimate


Make or Buy: Decision Rule - Buy if cost is less than or equal to the sum of

variable cost and relevant fixed cost minus opportunity cost

Relevant fixed costs – Only fixed costs that can be avoided if buy

Opportunity cost – Benefits from using release capacity for other purposes.

Strategic/ Qualitative factors – Quality, delivery on time, core competency, Capacity utilization,

Uncertainties – Measurement and cost of Quality, reliability of vendor, cost estimate


Keep or Drop: Decision Rule - Drop if contribution is less than the sum of

relevant fixed costs and opportunity cost.

Relevant fixed costs – Only fixed costs that can be avoided if drop

Opportunity cost – Benefits from using release capacity for other purposes.

Strategic/ Qualitative factors – Impact on Brand, impact on sale of other products, HR issues

Uncertainties – Customer reaction


Product Emphasis – under constraints Decision Rule - Emphasize product with highest CM per unit, if

resources are constrained then emphasize product with highest CM per unit of constrained resource.

Strategic/ Qualitative factors – Impact on Brand, impact on sale of other products, Strategic plans of the org.

Uncertainties – demand and cost estimates


Product Emphasis – relaxed constraints Decision Rule - Incur cost to relax constraint if cost is less than

or equal to the sum of CM per unit of constrained resource and the current unit cost of the resource.

Relevant fixed cost – Only new fixed costs to relax the constraint.

Strategic/ Qualitative factors – Impact on Brand by delays, future supply cost,

Uncertainties – demand and cost estimates

Unit 3 – Cost Information : Internal & External Reporting Contribution

Job Costing

Process Costing

Activity Based Costing

Product Costing

Process of accumulating, classifying and assigning direct material , direct labor, and factory overhead costs to products or services. Different product costing systems available are……

Cost accumulation method – job or process costing systems.

Cost measurement method – actual, normal or standard costing system

Overhead assignment method – traditional or activity based costing system

The choice depends nature of the industry, products or services of the firm, management information needs and cost and benefits of the particular system

Cost Accumulation

Job Costing Process Costing

The jobs or batches of products or services are the cost objects

All manufacturing costs incurred are assigned to the jobs

Appropriate when costs can be readily identified with products, batches, contracts or customer

Production Process or departments are the cost objects

Used by firms engage in continuous mass production of one or few products

Cost Measurement

Actual Costing: Uses actual costs incurred including overheads Process of accumulating, classifying and assigning direct. Difficult to measure in all the cases and prone to errors

Normal Costing: Uses actual costs for direct material and direct labor and normal cost for Involves estimating the overheads to be assigned Provides timely information

Standard Costing: Uses standard costs and quantities for all three types of costs; direct material/ labor/ overheads Works as a target cost the firm should attain Provides basis for cost control, evaluation and process

improvement

Cost Measurement ...Types of cost used for

Costing System

Direct Material

Direct Labor Overheads

Actual Costing Actual Cost Actual Cost Actual Cost

Normal Costing Actual Cost Actual Cost Applied Overhead – @ predetermined rate(s)

Standard Costing

Standard Cost Standard Cost Standard Cost

Overhead Assignment

Traditional Product Costing system: allocate overheads to product or job using a volume based cost driver. Works on assumption that each products uses same

amount of overhead Not fully accurate

Activity Based Costing (ABC) :allocates overheads costs usin cause and effect criteria with multiple cost drivers. Uses both volume based and non volume based cost drivers Is more accurate

Job Costing

Product Costing system that accumulate costs and assign the to specific job . Directs Costs are assigned on actual costs. Overheads are allocated based on cost object and cost pool. Overheads are allocated on actual costs or estimated costs

Underapplied / Overapplied Overheads: can be disposed in two ways… Adjust the cost of goods sold Proration among inventories and cost of goods sold

Job Costing in service industries

Extensively used in service industries such as consulting, legal, advertising, construction, accounting etc. Different industries uses it with different names …

accounting or law firm: client or project, law firm: case, construction: contract, other : project etc.

Same as manufacturing industries except that direct material cost will be nil or insignificant.

Primary focus on direct labor cost. Overheads are generally allocated based on direct labor hours or labor cost

Underapplied / Overapplied Overheads: can be disposed in two ways… Adjust the cost of goods sold Proration among inventories and cost of goods sold

Process Costing

Process Costing is a product costing system that accumulate costs according to processes or department and assign them to large number of nearly identical products. Firms using this system employs a standardize production

process to manufacture homogenous products Used in many industries like oil refining, drugs, food

processing, chemicals, paper etc. Can also be used by service organization like check

processing in Bank, payroll processing companies Equivalent Units : are the number of the same or similar

complete units that could have been produced given the amount of work actually performed on both complete and partially complete units

Process Costing – steps Step 1: Analyze Flow of Physical units – accounting for both

input and output units

Step 2: Calculate Equivalent Units – partially complete physical units are converted into equivalent number of whole units

Step 3: Determine total costs to account for – include current costs incurred and cost of the units in work in progress

Step 4: Compute Unit Cost: determine proper product costing and income.

Step 5: Assign total cost: assign total cost incurred to the units completed and transferred out during the period and units still in process at the end of the period – total costs assigned in this step should be equal the total cost as in step 3

Process Costing – methods Weighted Average method: includes both current period and

prior period costs in calculating unit cost Prior period costs and current period costs are averaged;

hence the name. Status of the product at the end of the period is the only

element considered. First-in-first-out (FIFO) method: includes in calculating the unit

costs incurred and work effort performed during the current year Considers the beginning inventory as a batch of goods

separate from the goods started and completed in the current period.

FIFO method looks at the input as well as the output of the production process whereas weighted average method looks only at the output of the production process ( completed and ending WIP inventory)

Process Costing – example WIP inventory June 1 10,000 units

Direct material – 100% complete $10,000Direct Labor – 30% complete $ 1,060Overheads – 40% complete $ 1,620

Beginning WIP inventory $12,680

Units started in June 40,000 unitsUnits completed 44,000 unitsWIP June 30

Direct material – 100% completeDirect Labor – 50% completeOverheads – 60% complete

Cost incurred during JuneDirect material $44,000Direct Labor $22,440Overheads $43,600

Beginning WIP inventory $110,040

Activity-Based Costing

Volume Based Data

Head Amount – RsSalaries 500,000.00Material 180,000.00Travel 90,000.00Rents 25,000.00Depreciation 55,000.00Electricity 100,000.00

950,000.00

ABC Data

Head Amount – Rs

Input claims 45,000.00Verification 235,000.00Filing 105,000.00Make copies 120,000.00Respond to queries 375,000.00Training 80,000.00

950,000.00


Volume-Based Costing is sufficient when

Direct Material and Direct Labor costs are significant part of the total cost.

Product range is limited

Homogeneous conversion processes for all products or services.

Relatively low overheads costs


Some Important terms:

Activity: is an action or an aggregation of actions performed

Resource: is an economic element needed or consumed in

performing activities

Cost Driver: is a factor that causes or relates to a change in the cost of an activity.

Activity-Based costing: is a costing approach that assigns resource costs to a cost object based on activities performed for the cost object

Activity-Based Costing… two stage cost assignment procedure

First Stage:

Resources consumption cost driver

Second Stage:

Activity consumption cost driver

Cost Pools: Activities or activity centres

Cost Object

Resource Costs

Activity-Based Costing...steps in designing ABC System

Step 1: Identify the relevant Cost Object Step 2: Identify activities: Select the best set of cost pools

Establish activity and cost pool relationship – one activity: one cost pool or many activities: one cost pool

Step 3: Identify Resource Costs: Classify all activities according to the way in which activities consume resources Unit Level - performed on each individual unit of products

or services like direct material, labor Batch Level – performed for each batch and not related to

no. of units in each batch like set up cost, batch shipping costs

Product sustaining – support production of product or service like product manager wages, product advertisement

Facility sustaining – supports the operations in general and not unaffected by no. of products,sales volume etc. like insurance etc. Mostly not allocated

Activity-Based Costing...steps in designing ABC System

Step 4: Assign Resource Costs to Activities : use resource consumption cost drivers to assign cost to activities The cost of the resource can be assigned to activities by

direct trace or estimation

Step 5: Assign Activity costs to Cost objects: allocated on the actual volume of activities for the cost driver

Activity-Based Costing...benefits and limitations

Benefits: clearly shows the effect of difference in activities and changes in product or service on cost Better Profitability - accurate product cost help in pricing,

marketing strategies Better control – measurement of activities driving cost help

in controlling cost and or improving value

Limitations: Allocations – not all costs have appropriate activity or

resource consumption cost drivers like property taxes Omission of costs: cost identified by ABC is likely to miss

some costs associated with it like R&D, marketing though directly traceable.

Expensive - switchover from volume based to ABC system cab very expensive and time taking activity

Activity-Based Costing…let’s solve a case

Nokia makes two type of cell phones; Type A is with superior features and is expensive, Type B is with lesser features and is meant for mass selling. Following details are available from their records….

Product – A Product – BProduction Volume 5,000 20,000Selling Price $400.00 $200.00Direct Costs $200.00 $ 80.00Direct labor hours 25000 75000Direct Labor hours per unit 5 3.75

Budgeted Overheads:Activity Budgeted Cost Cost driver

Engineering $ 125,000.00 Engineering HoursSetups $ 300,000.00 No. of set upMachine running $1,500,000.00 Machine hoursPacking $ 75,000.00 No. of packing orderTotal $2,000,000.00 No. of labor hours

Activity-Based Costing…let’s solve a case

Other Information:Activity Product – A Product – B Total

Engineering 5,000 7,500 12,500Setups 200 100300Machine running 50,000 100,000 150,000No. of Packing Order 5,000 10,000 15,000

Prepare profitability analysis based on volume costing and ABC method

Activity-Based Management ( ABM )

Manage Activities to improve the value of products or services to the customers and increase organization’s profitability

Operational ABM – enhances operational efficiency and lower the cost : doing things right and performing activities more efficiently. Used in Quality management, business process reengineering.

Strategic ABM – evaluate the need for the activities and increase profitability i.e. eliminate unnecessary activities, reduce unprofitable activities etc. Used in product design, product line, customer mix, marker segmentation etc.

ABM uses cost driver analysis, activity analysis and performance measurement to improve the operations.

Unit 4 – Cost Information : Planning and Monitoring

Cost Budgets

Standard Costs and variance analysis

Investment Decision

Budgets

A Budget is an organization’s operational plan for a specified period. The budget is both a guidance for operations and projection of operating results. Use of budgets helps orgs….

Communication device thru which top management defines its plans and goals.

Run smoother operations and achieve better results.

Identify current and potential bottlenecks in Operations.

Motivate employees as there is clarity about what is expected from them and resources available.

Serve as frame of reference - criteria for monitoring and controlling activities.

Serve as basis for assessing performance

Master Budgets..relationship between Strategic goals, Long term

objectives and Master Budget

A Master Budget is organization’s operating and financial plans for a specified period

Strategic Goals

Long Term Objectives

Capital Budgets

Cost Object

Long Term Plans

Master Budgets

Operations

Budgets

Operating Budgets:

Sales Forecast Sales Budget Production Budget Various Cost Budgets ( Direct / overheads) Cost of Goods sold Budget Income statement Budget

Financial Budgets:

Capital Budget Long Term Financing Budget Cash Budget Cash Flow statement

Budgets

Zero- Based Budgeting: Budgets based on as if no past or historical information about cost or budgets are available. Time consuming Encourage to reduce the cost

Rolling Budgets: Prepared more frequently (monthly, quarterly) and reflects planning changes Helps to incorporate significant changes in business

strategy , operating plans and income statements

Budgets

Activity Based Budgets: A budgeting process based on activities and cost drivers of the operations Extension of a organization activity based costing Helps to

incorporate significant changes in business strategy , operating plans and income statements

Kaizen Budgeting : Is a budgeting approach that explicitly demand continuous improvement and incorporate the expected improvement in the budget Set targeted cost reductions anticipating price reduction

across the life of product Target quality improvement to enhance value Not only limited to internal improvements – expect

improvements of their suppliers and incorporate changes Is not the same as the budget cuts

Budgets …… few more important terms

Static Budget: Is a budget that is developed only for a specific output level Useful for initial planning and coordination of activities of

the period Guidelines or benchmark in monitoring and controlling Prepared before the beginning f the period

Flexible Budget : Is a budget that adjust revenues and costs to the output achieved Differ from master / static budget in the no. of output Unit selling price and unit variable costs is same as in the

master budget Total fixed costs are usually the same unless the actual

level of operation differs substantially from the planned level

Prepared at the end of the period

Evaluating Operating Results

Operations control involves evaluating operating results

Variance is the amount that actual operating results deviate from the expected amount from the operations Variance help managers to not spend time on operations

that are under control and focus on the areas that are not in control

Two Ares of management’s interest in evaluating operating results …….. Effectiveness Efficiency

Effectiveness & Efficiency

Effectiveness:

An effective operation means attaining the goal set for the operations

Organizations measure their effectiveness by analyzing one or few of their critical success factors like operating Income , market share, launch of new product on time etc. against the master budget

Operating income variance : difference between the actual operating income and budgeted operating income in the master budget indicate effectiveness of the operations

Does not identify the causes for the variance or help the organization to identify any remedial action required.

Effectiveness & Efficiency Efficiency:

An efficient operation means no resources are overused / wasted in carrying out the operations

Assessment of effectiveness is independent of assessment of efficiency

Flexible budgets are used for measuring the efficiency of the organization

Efficiency can be assessed by identifying Operating level Sales Volume Variance : measure the effect of

change in units of sales on sales revenue, expenses, contribution margin or operating income for the period Units sold – budgeted units of sale * master budget contribution per unit

Operating level Flexible Budget Variance : measure the difference between the actual operating results and the flexible budget at the output levelActual operating income earned – flexible budget operating income

Standard Cost

Is the cost a firm should incur for the operation. A standard cost is usually expressed on a per unit basis Are bases in planning, controlling and performance

evaluation activities . Includes establishing standards for each operating cost

element including manufacturing, selling and administrative expenses

different level of standard expectations – ideal standard and currently attainable standard

Sources of Standards Activity Analysis Historic Data Benchmarking

Standard Cost for Direct Material & Labor

A Standard Cost for direct material has three factors…. Quality – determine the quality of the product and many

other aspects like quantity , price ,processing time etc. Quantity – depends on product design, quality of material,

manufacturing equipment etc. Price - Long term contracts for supplying required material

on time

Direct Labor costs vary with type of work ,product complexity, employee skills manufacturing process etc. A Standard Cost for direct labor has two factors…. Quantity – depends on product design, quality of material,

manufacturing equipment etc. Price

Standard Cost and Variance

Efficiency can be assessed by identifying Operating level Sales Volume Variance plus Operating level Flexible Budget

Operating Level Flexible Budget consist of…. Selling Price Variance plus Variable Cost Flexible Budget Variance plus Fixed Expenses Flexible Budget Variance

Standard Cost : Selling Price Variance

Is the difference between the total sales revenue received and the total sales revenue in the budget for the actual unit sold during the period

Actual selling price per unit – Flexible budget selling price per unit * unit sold

Standard Cost : Variable Cost flexible budget Variance

Is the difference between the variable expenses incurred and the total variable expenses in the flexible budget for the period

Can be further broken and analyzed into ……. Direct Material flexible budget variance plus

Direct Labor flexible budget variance plus

Variable Overhead flexible budget variance plus

Variable selling and admin. flexible budget variance

Above variances can further be analyzed for variance due to price and usage

Standard Cost : Direct Material Variance

Is the difference between the total direct material cost incurred and the total standard material cost for the output of the operations

Reflects efficiency in buying and using the direct material

Direct material price variance……. Actual price paid for one unit of material – standard price for

one unit of material * total no. of units of material purchased (actual)

Direct material usage variance…….. Total quantity of the material used – total standard quantity of

material for units manufactured * standard cost per unit of the material

Standard Cost : Direct Labor Variance

Is the difference between the total direct labor cost incurred and the total standard labor cost for the output of the operations

Reflects efficiency in rate (price) and usage (efficiency) of the direct labor

Direct labor rate variance……. Actual labor wage rate – standard labor wage rate * total no. of

labor units worked (actual)

Direct labor efficiency variance…….. Total labor units worked – total standard labor units for the

output * standard labor rate

Hierarchy of Variance

Operating Income Variance

Flexible Budget Variance Operating Income Variance

Sales Volume Variance

Selling and Admn. Exp. variance Variance ariance

Manufacturing Cost Variance Selling Price Variance

Overhead variance Direct Labor Variance Direct Material Variance

Direct Material

Price Variance

Direct Material

usage Variance

Direct Labor rate

Variance

Direct Labor

efficiency Variance

Variable Overhead Variance

Fixed Overhead Variance

Variable selling & Admn.

Exp. Variance

Fixed selling & Admn.

Exp. Variance

Standard Cost : Overhead Cost Variance Is the difference between the total actual variable overheads

and total standard variable cost for the output of the operations Same like other materials like material and labor variance

Total Variable O/H variance……. Total (actual) variable O/H – standard quantity of activity for

applying overhead * standard variable O/H rate per unit of activity

i. Variable O/H spending variance …….. Total variable O/H incurred – ( actual quantity of activity

measure * standard variable O/H rate per unit of activity for applying variable O/H )

ii. Variable O/H efficiency variance …….. ( Actual quantity of activity measure – standard quantity of

measure ) * standard variable O/H rate per unit of activity

Variance : Causes and corrective action Random Variance : are beyond the control of management

(technically or financially) and are considered as uncontrollable

Systematic Variance: are likely to recur until corrected Prediction Error: due to inaccurate estimation of variable in

the standard setting process like increase in prices faster than expected – Modify standard setting process

Modeling Error : failure to include all relevant variable cost or including wrong/ irrelevant variables – Revise model / modeling process

Measurement Error : use of incorrect numbers due to accounting system or procedure – correct /adjust accounting process

Implementation Error : are errors due to operator error like setting up machine with incorrect measurements – take corrective actions

Unit 5 – Cost Information : Management Control and Performance measurement

Investment Decision

Strategic performance measurement and balanced scorecard.

Profit and Performance Measurement

Profit SBUs are commonly used for business performance evaluation. Strong effect on the motivation of the employees

However Profit alone can not be used for evaluation and comparing the business performance Desired profits depends on multiple factors like its size and

operating characteristics

The profits per unit of money invested for different businesses / units can be used to compare the profitability. It is usually called return on investment (ROI)

Return on Investment

ROI depends on multiple factors like ….. General Economic conditions Current economic condition of the firm’s industry : vary

very differently in cyclic conditions

Investment : Determined by assets of the business

ROI : Profit / Assets

For better analysis it can seen as return on sales and sales turnover

ROI = ( Profit / Sales ) * ( Sales / Assets )

Measuring Investment

Which assets to include : Net cost of long lived assets plus working capital Depends on degree to which SBU controls it.

Allocating shared assets : Management decision

Current Value of Investment : Should include net book value of long lived assets plus historical costs of current assets

Strategic Issues in using ROI

Excessive short term focus : attention on the current period’s costs and revenue – use balanced score card to address this issue

Disincentive for new Investment by most profitable SBU : encourage to only invest in projects that earns higher than the current ROI. In contrast the SBU with lowest ROI will have an incentive to invest in new businesses – use residual income method for new investment decision

Alternative measures of Investment decision

Residual Income: amount equal to the income of SBU less a charge for the investment in the unit Firm can adjust the required rates of return for difference of

risk like higher rate for low success investment

Different required rates can also be applied for different assets like higher rate in case of special asset having no ready re-sale market

Economic Value added : is income after deducting cost of capital

Strategic Performance Measurement Top management uses measurement system to evaluate

performance of SBU managers – can be used when responsibility can be effectively delegated and measured

Organizational are structured in – centralized or decentralized management format

Broadly the SBUs can be differentiated as.

1) Cost SBU – have the goal of providing best quality product or service at the lowest cost . Mostly firms production or support functions

2) Revenue SBU – focus on maximizing the sale / revenue. Defined by product line or Geographical area

3) Profit SBU – designed when manager is responsible for both generating revenue and incurring major costs.

4) Investment SBU – are corporate divisions responsible for investment decisions.

Balanced Scorecard

Cost, Revenue and Profit are widely used to achieve strategic performance measurement.

Little or nil nonfinancial information Can not be considered as complete performance

measurement

Balanced Scorecard – a formal method to incorporate both financial and no financial performance measures into organization management

Translate organization vision and strategies into performance objectives

Help to prevent future problems and take advantage of opportunities

Continuous strategic analysis from multiple perspective Works as a guide to managers

Balanced Scorecard …… Strategy Map

Financial

Goals:

Earnings, sales, growth

Determine the Issue

Customer

Goals:

Customer satisfaction rate, staff response time, market

share

Operations

Goals:

Process capability, quality, cycle time, utilization rate

Learning and Innovation

Goals:

Staff competency, strategy awareness,

Uses balanced scorecard to describe the firm’s strategy in detail by cause and effect diagrams

Balanced Scorecard …… Strategy Map

Reinforces the idea that financial performance and shareholder value are the ultimate goals for application of balanced scorecard

The other perspective contribute directly to the ultimate financial goals

Lets build a balanced scorecard for newly set up commercial bank

Activity-Based Management …. uses

Managing Customer Profitability – used to evaluate the profitability across different customer types. Price the product according to service cost Standardizing the products or services.

Managing Product – Strategic input for focusing on high value added activities or eliminate non value added activities

Managing Quality - ABM uses cost driver analysis, activity analysis and performance measurement to improve the operations.

Strateic Cost Management

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