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
Decision making with relevant cost and a strategic Emphasis
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
Decision making with relevant cost and a strategic Emphasis
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
Summary of Information used in Decision
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
Summary of Information used in Decision
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
Summary of Information used in Decision
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
Summary of Information used in Decision
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
Activity-Based Costing
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
Activity-Based Costing
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.
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