Review

Agenda Review Cost management systems Product and service costing Management control systems Budgeting Variances Performance measurement Transfer pricing

Cost Management Systems Costs are caused by Resources These Resources are used by Products These Products Generate Revenue Mapping Resource Costs to Products A challenge Requires deep understanding of the organization

Cost Management Systems Direct Costs: Resources dedicated to a particular product Direct materials Direct labor Overhead: Resources shared by multiple products Allocation of these resources to products is imprecise

Cost Diagrams Direct Material Direct Labor Overhead Directly traced Based on Direct labor $ Fuel Tanks Mufflers Manifolds

Overhead Allocation: Mechanics Shared Resource Level Collect the shared or overhead resources into various cost pools Figure out the allocation base (or the activity level) Common allocation bases include direct labor cost, direct labor hours, and machine hours Overhead or Burden rate = Overhead Cost ÷ Allocation Base Product Level Allocated Indirect Cost: Compute the product’s use of shared resources and charge it accordingly Total Product Cost = Direct Cost + Allocated Indirect Cost

Overhead Mechanics: Two-Stage System Multiple overhead cost centers Overhead costs vary with different factors Different allocation bases can be used for each center Product Level Allocate overhead costs to each product based on how much of each overhead cost pool the product uses

Diagram: Two-Stage System (Cost Pools) Overhead 1st Stage Directly traced (Cost Centers) Administrative Test Room Machine hours 2nd Stage DL $ (Cost Objects) Components

Overhead Mechanics: Activity-Based Costing Resource Level Costing Shared Resource hierarchy Volume (unit) Batch (run) Product Facility Cost “centers” are activities Shared resources exist to conduct these activities Product Level Costing Products that “cause” more work get more cost

Costing Mechanics at the Boundaries Cost objects might be customers or suppliers Customers cause costs by ordering behavior Suppliers cause costs by delivery failures Aggregation of costs is different, but the process of developing costs is the same Shared resource level Identify the activities Cost the activities Product Level Determine how much resources a customer (supplier) uses

Costing Systems: Organizational Issues From a Mechanics Perspective More accuracy is better The only costs are implementation costs From an Organizational Perspective Is the organization ready to work with a complex cost system? Will employees worry about transitioning to a new cost system that changes their profit numbers? Will the new system display volatility in the cost numbers? Your judgment and leadership skills are key to managing the transition

Budgeting Mechanics Run the Business Process in Reverse Forecast Sales  Production Volume  Input Purchases The value of Budgeting to an organization Exchange and consolidate information from employees about the future The dual use of Budgeting in an organization Making Investment Plans Setting Performance Targets

Organizational Issues in Budgeting Who should make the forecast? The manager with the knowledge Will the manager make the correct forecast? Depends on how the manager is compensated Organizational costs of improper forecasts Wasted investment dollars Managerial judgment and leadership are key budgeting skills

Variances Difference between actual and budgeted profits Decomposed into Revenue and Cost Variances Further Decomposition of Cost Variances Volume variances Price (rate) variance Efficiency (use) variance All decompositions have the same unit of measurement ($) Different variances can therefore be compared

Variance Mechanics Actual Costs Flex Budget Master Budget Flexible Budget: Budget at expected unit costs but actual volume Price and Efficiency Variances Volume Variance

Organizational Issues in Variance Analysis The Value of Variance Analysis to an organization Provide important information about business future Dual Use of Variances Refocus Investment Plans Reevaluate Employee Performance Variances are highly political Require much management judgment and skill to manage Can quickly lead to dysfunction if not properly managed

Balanced Scorecards Multiple measure systems Four perspectives Financial, Customer, Internal, Learning or innovation Strategy map links perspectives through the business model Value of Balanced Scorecard Provide information on business to management Dual Use of Balanced Scorecards Tool to guide and help managerial decision-making Tool to compensate managers

Financial Performance Measures Return on investment (ROI) ROI = Income ÷ Assets Residual Income Income – (Cost of capital x Assets) Economic value added (EVA) Adjusted Income – (Cost of capital x Adjusted Assets) Income and assets modified to “correct” accounting distortions from economic values Examples include R&D and advertising

Organizational Uses of ROI, RI, EVA Each measure has its strengths and weakness ROI is easily compared (ratio): But subject to the ROI dilution problem RI and EVA do not suffer the ROI dilution problem But can differ across divisions simply due to accounting rules Capitalization vs. expensing of various items These measures’ use Cannot be formulaic Top management must understand the division’s situation Requires managerial judgment and leadership

Transfer Pricing Rationale Basic issue Divisions are interconnected Change the reported profit number of the divisions to reflect this interconnection The “price” at which to transfer products or services from one profit center to another

Transfer Pricing Mechanics Optimal transfer price formula use the “Price = Incremental Cost” formula: If Price is available use it as the transfer price Else use Incremental Cost of producing one extra unit Difficult if producing extra units require investments in “chunky” capacity Two-step transfer pricing Charge a lump sum every period Charge incremental cost

Organizational Issues in Transfer Pricing Value of transfer prices to an organization Provide important information on divisional profitability Dual use of a transfer pricing system in an organization Refocus investment plans Evaluate divisional manager performance Optimal formulas exist But must be applied with organizational judgment in mind Can we change TP often when outside market is highly volatile? Rules on splitting the pie can affect the size of the pie

Takeaway Understand the production process behind the final product In particular, understand the nature of the shared resources These resources generate cost; the product generates sales In particular, understand the divisional managers Their responsibilities Their motivation and compensation Internal accounting systems will be a crucial source of information Most of you will use internal accounting systems heavily in MAP and in the early stages of your career as a junior manager