Management Accounting: Information That Creates Value Chapter 1  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Management Accounting Information (1 of 5) The institute of Management Accountants has defined management accounting as: A value-adding continuous improvement process of planning, designing, measuring and operating both nonfinancial information systems and financial information systems that guides management action, motivates behavior, and supports and creates the cultural values necessary to achieve an organization’s strategic, tactical and operating objectives  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Management Accounting Information (2 of 5) Be aware that this definition identifies: Management accounting as providing both financial information and nonfinancial information The role of management information as supporting strategic (planning), operational (operating) and control (performance evaluation) management decision making In short, management accounting information is pervasive and purposeful It is intended to meet specific decision-making needs at all levels in the organization  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Management Accounting Information (3 of 5) Examples of management accounting information include: The reported expense of an operating department, such as the assembly department of an automobile plant or an electronics company The costs of producing a product The cost of delivering a service The cost of performing an activity or business process – such as creating a customer invoice The costs of serving a customer  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Management Accounting Information (4 of 5) Management accounting also produces measures of the economic performance of decentralized operating units, such as: Business units Divisions Departments These measures help senior managers assess the performance of the company’s decentralized units  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Management Accounting Information (5 of 5) Management accounting information is a key source of information for decision making, improvement, and control in organizations Effective management accounting systems can create considerable value to today’s organizations by providing timely and accurate information about the activities required for their success  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Changing Focus Traditionally, management accounting information has been financial information Denominated in a currency such as $ (dollars), £ (pound sterling), ¥ (yen), or € (euro) Management accounting information has now expanded to encompass information that is operational or physical (nonfinancial) information: Quality and process times More subjective measurements, such as: Customer satisfaction Employee capabilities New product performance  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financial v. Management Accounting Financial Accounting Communicates economic information to individuals and organizations that are external to the direct operations of the company Stresses the form in which it is communicated Is based on historical information Management Accounting Provides information to managers and employees within the organization Allows great discretion to design systems that provide information for helping employees and managers make decisions Forward looking  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

A Brief History (1 of 8) The earliest management accountants were scribes whose job was to record the receipt and disbursements of cash and to provide an accounting of the current stock of wealth including valuable ores and foods Considerable evidence of scribes in early Babylon, Greece, and during the era of the Roman Empire In Egypt, during the time of the Pharaohs, the treasurer, who was the head scribe, occupied the most senior administrative position in the empire, responsible for managing all aspects of the Pharaohs’ wealth This treasury role for management accountants was virtually the same until medieval England  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

A Brief History (2 of 8) In medieval England, producers (the Guilds) kept detailed records of raw materials and labor costs as evidence of product quality Change of focus from measuring wealth to providing a basis for quality assurance Still, the role was primarily recording the assets From 1400-1600, the rudiments of basic modern management accounting practice emerged They included notions of standards for materials use, employee productivity, job costing forms, and budgets Management accounting became more decision oriented and supported decisions relating to building or retiring fixed assets, managing costs, and product pricing  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

A Brief History (3 of 8) Cost of Manufacturers In 19th century America, textile mill owners kept detailed records of costs to direct efficiency improvement activities and to provide a basis for product pricing But there was little or no standardized management accounting practice Then, in 1885, Henry Metcalf published Cost of Manufacturers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

A Brief History (4 of 8) In the late 19th century, railroad managers implemented large and complex costing systems Allowed them to compute the costs of the different types of freight that they carried Supported efficiency improvements and pricing in the railroads The railroads were the first modern industry to develop and use broad financial statistics to assess organization performance About the same time, Andrew Carnegie was developing detailed records of the cost of materials and labor used to make the steel produced in his steel mills  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

A Brief History (5 of 8) Carnegie was highly effective in reducing costs and unsentimental in closing mills that he felt were irretrievably inefficient The emergence of large and integrated companies at the start of the 20th century created a demand for measuring the performance of different organizational units DuPont and General Motors are examples Managers developed ways to measure the return on investment and the performance of their units (more on this later)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

A Brief History (6 of 8) After the late 1920s management accounting development stalled Accounting interest focused on preparing financial statements to meet new regulatory requirements It was only in the 1970s that interest returned to developing more effective management accounting systems American and European companies were under intense pressure from Japanese automobile manufacturers During the latter part of the 20th century there were innovations in costing and performance measurement systems – the focus of this text  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

A Brief History (7 of 8) The history of management accounting comprises two characteristics: Management accounting was driven by the evolution of organizations and their strategic imperatives When cost control was the goal, costing systems became more accurate When the ability of organizations to adapt and change to environmental changes became important, management accounting systems that supported adaptability were developed  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

A Brief History (8 of 8) Management accounting innovations have usually been developed by managers to address their own decision-making needs Management accounting needs to be both pragmatic and add value to the organization  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Role of Financial Information Financial information pervades our economy It is the primary means of communication between profit seeking organizations and their stakeholders For this reason organizations use financial measures internally as a broad indicator of performance This financial information provides a signal that something is wrong, but not what is wrong Financial information summarizes underlying activities But to explain financial results, managers need to dig deeper Detailed information provides additional insight into what is happening to profits  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Business Level Strategy and the Value Proposition (1 of 2) A key element of any organization’s strategy is identifying its target customers and delivering what those target customers want What the organization tries to deliver to customers is called its value proposition Value propositions have four elements: Cost – the price paid by the customer, given the product features and competitors’ prices Quality – the degree of conformance between what the customer is promised and what the customer receives For example a defect free automobile that performs as promised by the salesperson  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Business Level Strategy and the Value Proposition (2 of 2) Value propositions have four elements (cont.): Functionality and features – the performance of the product, for example a meal in a restaurant that provides the diner with the level of satisfaction expected for the price paid Service – all the other elements of the product relevant to the customer For example, for an automobile service might include: how the customer is treated as the automobile is purchased and the degree and form of after sales service Dell Computer’s value proposition is building to customer requirements, quickly, and at a low price  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Delivering the Value Proposition Organizations use processes that they design and manage to deliver the value proposition Dell delivers its value proposition by providing customers easy and accessible access to ordering and insisting that suppliers locate close to its assembly facilities These steps enable Dell to minimize its inventories and avoid the costs of holding inventory and of obsolete inventory in a rapidly changing industry  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financial Control As previously stated, an organization can use financial and nonfinancial information to monitor the organization’s ability to deliver its chosen value proposition At a higher level, however, organizations use broad measures of financial performance to assess the overall success of the organization’s chosen strategies This approach to evaluating aggregate performance is called financial control  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Origins in 20th-Century Enterprises Many innovations in financial control systems occurred in the early decades of the twentieth century to support the growth of multiple-division diversified corporations E.g., DuPont and General Motors As the DuPont Company expanded, it had to: Acquire raw materials from many different suppliers Process these materials through many production stages in several different types of plants Produce a diversified mix of chemical products that were bought by companies in many different industries  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financial Control at DuPont The senior executives of the diversified DuPont Company devised techniques to coordinate operating activities in their different divisions: An operating budget The document that forecasts revenues and expenses during the next operating period, including monthly forecasts of sales, production, and operating expenses A capital budget The document that authorizes spending for resources with multiyear useful lives (capital assets) The vital return on investment (ROI) performance measure developed by Donaldson Brown, the chief financial officer (CFO) of DuPont  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

ROI: The DuPont Formula The ROI calculation gave DuPont executives a single number to evaluate the performance of their operating divisions and decide which of their divisions should receive additional capital to expand capacity The ROI measure combined a profitability measure with a capital intensity measure to produce return on investment or ROI Profitability Measure: = Operating income/Sales Asset or Capital Utilization Measure: = Sales/Investment  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financial Control at GM (1 of 4) Around 1920, Brown left DuPont to become CFO for General Motors under its new chief executive officer, Alfred Sloan Under Sloan’s and Brown’s leadership, General Motors introduced many management accounting initiatives to accomplish the company’s guiding operating philosophy of “centralized control with decentralized responsibility” Decentralized responsibility refers to the authority that local-division managers had in order to make their own decisions without having to seek higher approval on pricing, product mix, customer relationships, product design, acquisition of materials, and appropriate operating processes  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financial Control at GM (2 of 4) Decentralization allowed managers to use their superior access to information about local opportunities and operating conditions to make better and more timely decisions Centralized control of decentralized operations was accomplished by having corporate managers receive periodic financial information about divisional operations and profitability This summary financial information helped assure the senior managers that their division managers were making decisions and taking actions contributing to overall corporate goals  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financial Control at GM (3 of 4) The management accounting system at General Motors, enabled such a complex organization to plan, coordinate, control, and evaluate the operations of multiple, somewhat independent operating divisions E.g., assembly divisions producing Chevrolet, Pontiac, and Buick automobiles And component divisions producing parts E.g., radiators, batteries, fuel pumps, engines, and transmissions  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financial Control at GM (4 of 4) The management accounting system enabled the managers of these divisions to pursue their individual financial, operating, design, and marketing objectives aggressively while contributing in a coherent fashion to the overall wealth of the corporation Sloan’s and Brown’s initiatives played a critical role in creating an enormously successful enterprise from 1920 to 1970  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Organization Control and the Management Accountant Organization control comprises the systems that organizations use to ensure that managers and employees behave in a way that is consistent with the organization’s ethics and best interests Although internal control systems protect the organization’s assets from fraud or theft, little interest or attention was paid to evaluating the appropriateness of management’s governance and strategic choices Massive corporate governance failures in 2002 caused intense interest in organization control  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Changes in Organization Control (1 of 2) After massive corporate governance failures organizations call on management accountants to develop structures to motivate and monitor compliance with behavior that is consistent with the organization’s best interests Failures in organizations like Tyco International, Sunbeam, Waste Management, Cendant, WorldCom and Adelphia  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Changes in Organization Control (2 of 2) Innovations will likely include developing: Information that independent Boards of Directors can use to evaluate the organization’s strategy Monitoring employee attitudes toward the organization’s success, environment, and decisions to ensure behavior consistent with the organization’s objectives Developing information systems to assess whether the organization’s ethical standards are actually being practiced  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Management Accounting and Control in Service Organizations The major changes in the demand for management accounting and control information experienced by manufacturing companies in recent years have also occurred in virtually all types of service organizations Service companies have existed for hundreds of years Their importance in modern economies has increased substantially during the twentieth century  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Service Companies (1 of 2) Service companies differ from manufacturing companies in several ways Obvious difference: service companies do not produce a tangible product Less obvious: many employees in service companies have direct contact with customers Service companies must be especially sensitive to the timeliness and quality of the service that their employees provide to customers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Service Companies (2 of 2) Customers of service companies immediately notice defects and delays in service delivery The consequences from such defects can be severe Dissatisfied customers usually choose alternative suppliers after an unhappy experience They also usually tell others about their bad experience  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Service Companies’ Use of Management Accounting Information Managers in service companies have historically used management accounting information far less intensively than managers in manufacturing companies Such a lack of accurate information about the cost of operations probably occurred because many service organizations operated in noncompetitive markets Either highly regulated or government owned E.g., national railroads, airlines, postal services, and telecommunications companies Others, such as local retailers, were subject only to local, not national or global, competition  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Lack of Competition In a noncompetitive environments, managers of service companies were not under great pressure to: Lower costs Improve the quality and efficiency of operations Introduce new products that made profits Eliminate products and services that were incurring losses Accordingly, there was little demand from them for information to help them make decisions on those issues Management accounting systems in most service organizations were simple, designed to allow managers to: Budget expenses by operating department Measure and monitor actual spending against these functional departmental budgets  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Competitive Environment (1 of 2) The competitive environment has now become far more challenging and demanding for both manufacturing and service companies Accordingly, companies now demand better management accounting information Starting in the mid-1970s, manufacturing companies in North America and Europe encountered severe competition from Asian companies that offered higher-quality products at lower prices Before long it was not sufficient for a company to have cost and quality parity against its domestic competitors A company could survive and prosper only if its costs, quality, and product capabilities were as good as those of the best companies in the world  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Competitive Environment (2 of 2) The ground rules under which many service companies operate have completely changed The deregulation movement in North America and Europe since the 1970s The switch from centrally controlled socialist economies to free market economies in much of the world Managers of service companies now require accurate, timely information: To improve the quality, timeliness, and efficiency of the activities they perform To make decisions about their individual products, services, and customers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Government Agencies Government and nonprofit organizations as well as profit-seeking enterprises are feeling the pressures for improved performance Citizens are demanding more responsive and more efficient performance from their local, regional, and national governments The U.S. Congress passed The Chief Financial Officers (CFO) Act of 1990 The Government Performance and Results Act (GPRA) of 1993  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

CFO Act The U.S. Congress, in 1990, passed the Chief Financial Officers Act Requires each major federal agency to have a chief financial officer who is responsible for: The development and reporting of cost information The systematic measurement of performance  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

GPRA The Government Performance and Results Act of 1993 requires that each U.S. federal agency: Establish top-level agency goals and objectives, as well as annual program goals Define how it intends to achieve those goals Demonstrate how it will measure agency and program performance in achieving those goals In signing GPRA, President Clinton announced that the act would: Chart a course for every endeavor paid for by taxpayers’ money See how well we are progressing Tell the public how we are doing Stop the things that don’t work Never stop improving the things that are worth investing in  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Implementing CFO Act and GPRA In response to the CFO and GPRA acts, the Financial Accounting Standards Board issued a document of “Managerial Cost Accounting and Standards for the Federal Government” This document stated, “In managing federal government programs, cost information is essential in the following five areas: Budgeting and cost control, Performance measurement, Determining reimbursements and setting fees and prices, Program evaluations, and Making economic choice decisions.” The demands for cost information in government will be identical to those in for-profit manufacturing and service companies  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Nonprofit Organizations (1 of 2) Nonprofit organizations are also feeling the pressure for cost and performance measurement There has been explosive growth in nongovernmental organizations dealing with: Economic development The environment Poverty Illiteracy Hunger and malnutrition Public and private health Social services and the arts  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Nonprofit Organizations (2 of 2) These organizations compete for funds from governments, foundations, and private individuals Increasingly the public and private donors are demanding accountability from the organizations they fund, including measures of effectiveness Are the organizations achieving their intended purpose and measures of efficiency? Are they using their resources productively? Managers of all types of nonprofit organizations are looking to adapt management accounting procedures, developed in the private sector, to meet the demands placed on them for accountability and cost and performance measurement  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financial & Nonfinancial Information in Government and Not for Profit Organizations (1 of 2) The objectives of customers should be the objectives of the organization In innovative government and not-for-profit organizations, managers use nonfinancial and financial performance measures to evaluate how well and how efficiently these organizations use their funds to provide services to their customers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financial & Nonfinancial Information in Government and Not for Profit Organizations (2 of 2) Governments and not-for-profits need to look at the processes they use to deliver services to their customers to verify that these processes meet customer requirements at the lowest possible cost For example, what is the best way to approach training for an individual who is chronically unemployed so that the person’s needs are met at the lowest cost to society?  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Behavioral Implications (1 of 4) As measurements are made on operations and especially on individuals and groups, their behavior changes People react when they are being measured, and they react to the measurements They focus on the variables and behavior being measured and spend less attention on those not measured Two old sayings recognize these phenomena: “What gets measured gets managed” “If I can’t measure it, I can’t manage it.”  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Behavioral Implications (2 of 4) People familiar with the current system may resist as managers attempt to introduce or redesign cost and performance measurement systems They have acquired expertise in the use (and, perhaps, misuse) of the old system and wonder whether their experience and expertise will apply to the new system People also may feel committed to the decisions based on the information the old system produced Actions taken may no longer seem valid based on the information produced by a newly installed management accounting system A new management system can be a threat or lead to embarrassment and may lead to a resistance to change  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Behavioral Implications (3 of 4) Management accountants must understand and anticipate the reactions of individuals to information and measurements An analysis of the behavioral and organizational reactions to the measurements must accompany the design and introduction of new measurements and systems More importantly, when the measurements are used not only for information, planning, and decision-making but also for control, evaluation, and reward, employees and managers place great pressure on the measurements themselves  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Behavioral Implications (4 of 4) Managers and employees may take unexpected and undesirable actions to influence their score on the performance measure For example, managers seeking to improve current bonuses based on reported profits may skip discretionary expenditures that may improve performance in future periods Preventive maintenance Research and development Advertising  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Ethics & the Management Accountant (1 of 9) When management accounting information is used for control, management accountants may find themselves in complex situations, fraught with conflict Especially when it is used for performance evaluation Pressure may be exerted to influence the numbers to make a favored product, customer, or line of business appear more profitable than it actually is Department managers may distort information so that unfavorable factors are not revealed in a management accounting report The cost of inefficient processes The existence of substantial amounts of excess capacity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Ethics (2 of 9) Senior executives whose incentive compensation is based on the reported financial numbers may put pressure on accountants To recognize revenue from a customer early To defer until subsequent periods the recognition of an expense In some circumstances, to recognize certain expenses early so that much higher earnings may be reported in future periods All of these behaviors were evident in the frauds dominating the financial news in recent years Organizational leadership plays a critical role in fostering a culture of high ethical standards  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Ethics (3 of 9) The way an individual responds to pressure derives from inner values and beliefs, but individuals are strongly influenced by their view of organizational standards If individuals see unethical or illegal behavior practiced by the organization’s leaders and superiors or coworkers, they may feel that such behavior is accepted and sanctioned An individual without a strong set of personal beliefs and values may find it difficult to withstand the pressure to “go along with the flow” and participate in this behavior when a difficult or conflicting situation arises Such as being asked to misrepresent an organization unit’s performance potential when the unit is being offered for sale  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Ethics (4 of 9) Beyond the example set by senior executives, companies may use two types of control systems to foster high ethical standards among their employees Beliefs systems Boundary systems A beliefs system is the explicit set of statements, communicated to employees, of the basic values, purpose, and direction of the organization: Credos Mission statements Vision statements Statements of purpose or values  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Ethics (5 of 9) The statements in a beliefs system are intended to inspire and promote commitment to the organization’s core values and its purpose for being in business When conflicting situations arise, however, the lofty rhetoric in the statements will only have true meaning and serve as guides to actions if employees observe senior managers acting according to the statements In this way, employees learn that the company’s stated beliefs represent deeply rooted and actionable values Articulate and actionable beliefs systems may inspire people to higher values and aim at higher missions but they may not communicate clearly what behavior and actions are unacceptable  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Ethics (6 of 9) Companies also need boundary systems that communicate what actions must never be taken Boundary systems are stated in negative terms, or in minimal standards of behavior Intended to constrain the range of acceptable behavior For example, the organization might tell employees in the Purchasing Department that accepting any gifts under any circumstances from suppliers will result in immediate termination Boundary systems also include clear communication of the laws under which the company operates Examples include antitrust laws; zero tolerance for sexual, racial, and gender discrimination and harassment; environmental, health, and safety laws; and foreign corrupt practices regulations  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Ethics (7 of 9) Management accountants, like all employees, must be aware of and be deeply committed to act in ways that do not violate their organization’s code of conduct and societal laws governing organizational behavior and actions As designers and custodians of the organization’s reporting and control systems, they have an additional obligation to ensure that such boundary systems exist in their organization, and that the boundary systems are clearly communicated throughout the organization They should also monitor that senior executives act quickly and decisively when behavior in violation of these standards is detected  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Ethics (8 of 9) If violations are detected but not acted upon, management accountants can communicate with the audit committee of the board of directors, who are the shareholders and society’s representatives in the organization Management accountants, as members of a profession, also operate with an additional boundary system: the code of behavior promoted or advocated by their industry and professional association In the United States, the Institute of Management Accountants (IMA) In the United Kingdom and elsewhere, the Chartered Institute of Management Accountants (CIMA)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Ethics (9 of 9) Professional organizations usually establish ethical norms and codes of professional conduct for their members The professional association can monitor and police its norms and codes through peer reviews They have procedures for disciplinary action when violations are detected Many of the guidelines are phrased in terms of what management accountants should not do, consistent with how boundary systems operate  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Meeting the Challenge (1 of 3) Management accounting has become an exciting discipline that is undergoing major changes to reflect the challenging new environment that organizations worldwide now face This chapter has introduced the need for organizations to develop and use appropriate financial and nonfinancial information that will: Focus on aggregate, usually financial, measures of performance in for-profit organizations that provide an overall summary of performance, and the ability of the organization to meet its financial objectives  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Meeting the Challenge (2 of 3) In government and not-for-profit organizations the focus will be on the organization’s performance in meeting the needs of their citizens or clients Focus on the organization’s success in meeting its customers’ requirements in for-profit organizations so that the organization can react promptly to failures in delivering the value proposition In public sector and not-for-profit organizations focus on the cost to deliver services to customers and to monitor and improve process efficiency Enable all organizations to identify process improvements needed to improve the organization’s ability to deliver its value proposition  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Meeting the Challenge (3 of 3) Enable all organizations to identify the potential of the organization’s members to manage and improve process performance Enable the for profit organization to assess the profitability and desirability of continued investment in various entities such as products, product lines, departments, and organization units Enable the organization to motivate, monitor, and detect noncompliance with inappropriate organization behavior  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Management Concepts and Cost Behavior Chapter 2  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

What Does Cost Mean? There is no single definition of cost Costs are developed and used for some specific purpose The way the cost is to be used will define the way it should be computed Management accountants have used different systems, or classifications, to develop cost information  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Computing The Cost Of Something  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Object A cost object is something for which we want to compute a cost: A product A pair of pants A product line Women’s boot cut jeans An organizational unit The on-line sales unit of a clothing retailer  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Direct Cost A cost of a resource or activity that is acquired for or used by a single cost object Cost object = A dining room table Cost of the wood that went into the dining room table Cost object = Line of dining room tables A manager’s salary would be a direct cost if a manager were hired to supervise the production of dining room tables and only dining room tables  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Indirect Cost The cost of a resource that was acquired to be used by more than one cost object The cost of a saw used in a furniture factory to make different products It is used to make different products such as dining room tables, china cabinets, and dining room chairs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Direct or Indirect? A cost classification can vary as the chosen cost object varies Consider a factory supervisor’s salary If the cost object is a product the factory supervisor’s salary is an indirect cost If the factory is the cost object, the factory supervisor’s salary is a direct cost A cost object can be any unit of analysis including product, product line, customer, department, division, geographical area, country, or continent  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Organizing Costs Based On The Way They Are Created  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Flexible Costs The costs of using flexible resources Flexible resources are resources whose costs are proportional to the amount of the resources used Wood used to make furniture in a factory Electrical power to operate machinery Fuel used to deliver the furniture to customers Always direct costs If inconvenient to account for them as direct costs or when the cost is only a small part of total costs, flexible costs are treated as indirect costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Capacity-Related Costs The costs associated with capacity-related resources Capacity-related resources are acquired in advance of the work being done Most personnel costs Depreciation on machinery and buildings Capacity-related costs depend upon how much of the resource is acquired, not used May be direct or indirect costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Labor Costs Cause of both confusion and controversy in costing circles Originally flexible costs, because workers were paid in proportion to how much they produced Scheduling and union considerations have changed most labor costs into capacity-related costs Most organizations now treat labor costs as capacity-related rather than flexible  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Use of Cost Information Defines Its Focus and Form  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Calculating A Cost Is Not An End In Itself A cost number is only valuable if it serves a purpose The use to which a cost is put defines its relevance and appropriate form It is useful to divide those purposes into external and internal purposes  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

External Use of Cost Information The key issues for external users of accounting information: Consistency Reasonably accurate allocation of costs between the income statement and the balance sheet Generally Accepted Accounting Principles prescribe how to determine costs for external reporting Focus on process rather than the decision relevance of the resulting cost allocations  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Classifications (External Use) The structure of traditional cost accounting systems has reflected the need to determine product costs for external financial statements Must satisfy external financial reporting requirements imposed by GAAP Also, where they differ from GAAP, must satisfy requirements of income tax regulations  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Traditional Cost System External requirements specify which costs: To assign to products Cost of goods sold Inventory To exclude from product cost calculations Costs usually classified by Type Product and period costs Function Manufacturing and nonmanufacturing costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Classifying Costs by Type GAAP defines cost as the monetary value of goods and services expended to obtain current or future benefits Expenses are the costs of goods or services that have expired. i.e., used up in the process of creating goods or services Costs incurred to receive future benefits are recorded as assets  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Product Costs Organizations incur product costs to produce the volume and mix of products made during the period Materials costs, labor costs, and the cost of equipment, machinery and buildings GAAP focuses on valuing unsold goods in ending inventory (asset) Any remaining manufacturing costs allocated to cost of goods sold (expense)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Period Costs Nonmanufacturing costs such as: Administrative Research & development Marketing Selling Costs Some nonmanufacturing costs, such as selling, clearly do not apply to inventory items since they relate to products that have been sold Other nonmanufacturing costs (e.g., administrative) have such an ambiguous relationship to inventory that GAAP refuses to include these elements of cost in valuing inventory  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Internal Use of GAAP Cost Types Some GAAP notions of costs are not particularly useful in management accounting: Product and period costs Manufacturing and nonmanufacturing The objective is to determine all the components, both manufacturing and nonmanufacturing, of the costs associated with a cost object  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Classifying Costs by Function GAAP uses two broad functional cost classifications: Manufacturing costs: all costs incurred inside the factory associated with transforming raw materials into a finished product Nonmanufacturing Costs: an organization’s other costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Manufacturing Costs Direct manufacturing costs are traced or assigned to the products that created those costs and include the cost of material and the cost of labor that is paid based on the amount of work done Indirect manufacturing costs include costs of equipment, as well as the wages and benefits paid to production supervisors and workers who provide the general capacity to undertake production activities in the factory  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Indirect Manufacturing Costs More difficult to trace to products because these costs have a cause-and-effect relationship with capacity rather than with individual units of production Assigning to a product involves allocating what is deemed to be a fair share of the indirect cost to that product Generally allocated based on the product’s use of the various capacity resources  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Nonmanufacturing Costs (1 of 2) Distribution costs involve delivering finished products to customers Examples are freight and the salaries of shipping and delivery personnel Selling costs include sales personnel salaries and commissions and other sales office expenses Marketing costs include advertising and promotion expenses  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Nonmanufacturing Costs (2 of 2) After-sales costs involve dealing with customers after the sale and include warranty repairs and the cost of maintaining help and complaint lines Research and development costs include expenditures for designing and bringing new products to the market General and administrative costs include expenses, such as the chief executive officer’s salary and legal and accounting office costs, that do not fall into any of the above categories  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Influence of GAAP GAAP considers all nonmanufacturing costs as period costs used to support the sales of products in the current period only GAAP only includes manufacturing costs in calculating the cost of inventory for external reporting purposes Costing systems designed in the past conserved on information-processing costs by adopting the structure imposed by GAAP Most cost accounting systems we observe in organizations today tend to be driven by the rules that determine product costs for inventory valuation and cost of goods sold under GAAP  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Internal Use Of Cost Information Inside the organization costs serve many different purposes, broadly categorized as: Planning Using cost as a basis for determining the selling price of a prospective product Using cost in a budgeting model to forecast costs under different levels of activity Evaluation Deciding whether the market price for an existing product makes the product profitable Determining whether a process is cost efficient compared to similar internal or external processes  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Management Accounting’s Role Decision makers use costs to make decisions and to control the processes they manage The cost calculation may be tailored to the specific decision that is being made Tailoring the cost calculation is the role of the management accountant and the management accounting system  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost-Volume-Profit Analysis  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

CVP Analysis Decision makers often like to combine information about flexible and capacity-related costs with revenue information to project profits for different levels of volume Conventional cost-volume-profit (CVP) analysis rests on the following assumptions: All organization costs are either purely flexible or capacity related Units made equal units sold Revenue per unit does not change as volume changes  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The CVP Profit Equation Revenue - Flexible costs - Capacity-related costs (Units sold x Revenue per unit) - (Units sold x flexible cost per unit) - Capacity-related costs [Units sold x (Revenue per unit-Flexible cost per unit)] - Capacity-related costs (Units sold x Contribution margin per unit) - Capacity-related costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Break-even Volume Using the CVP profit equation, break-even volume is determined by calculating the volume where profit = 0 0 = (Units sold x Contribution margin per unit) - Capacity-related costs Units sold to break even = Capacity-related costs ÷ Contribution margin per unit  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The CVP Chart Decision makers often summarize cost-volume-profit information in a cost-volume-profit (CVP) chart The CVP chart provides a convenient way of summarizing the relationship between volumes, revenues, costs, and profits and provides a visual way to display the effect of volume changes on profits  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

CVP Chart (from Exhibit 2-3)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

CVP Analysis for Multiple Products There are many combinations of sales levels for multiple products that would allow the organization to break even These can be simulated on a spreadsheet by varying the sales levels of the multiple products and finding combinations that result in total profits being zero Before the use of spreadsheets became widespread, management accountants developed an extension of basic CVP analysis that allowed them to continue to use its basic profit equation and graphing techniques by developing a weighted average product based on the estimated sales mix  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Weighted Average Product Compute each product’s share of total sales Multiply each product’s revenue per unit by its proportion of total sales to get a weight Add the weights for all the products to get the total weighted revenue Apply the same technique to compute the weighted flexible cost Subtract the weighted flexible cost from the weighted revenue to get the weighted contribution margin per unit of “product”  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Multi-Product Example (1 of 4)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Multi-Product Example (2 of 4) The result of these calculations is a fictitious product that reflects the average revenue and flexible cost characteristics of the real products Given that the total capacity-related costs at Joan’s Landscaping is $300,000, use the formula for breakeven to compute the breakeven level of sales for this composite product  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Multi-Product Example (3 of 4) Break-even quantity = 300,000/53.06 = 5,653.50 To translate this average product break-even quantity to individual products, simply reverse the process of computing the average: Lawn Mowing = 5653.50 x 4600/6200 = 4194.529 Layout Design = 5653.50 x 350/6200 = 319.14892 Other Maintenance = 5653.50 x 1250/6200 1139.818  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Multi-Product Example (4 of 4) Note that this breakeven calculation focuses on breakeven for the company as a whole and not for individual departments This breakeven calculation will remain valid so long as the sales mix remains constant  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost-benefit Considerations Unlike external reporting, where the format is prescribed by GAAP, the format for determining costs for internal decision making is at the discretion of the decision maker Because the organization must pay someone to develop cost information, its expected benefits should exceed its development costs The cost-benefit consideration is important even if it is difficult to compute the value of using cost information in a particular decision  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Decision Defines “Cost” An old adage states, “different costs for different purposes” The specific decision at hand will define: The nature of the required cost The way it should be computed The value of any cost number A cost number that is useful for one decision may be useless or perhaps even harmful if it is used for another decision  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Can Conflicting “Costs” Cause Confusion, Conceivably Chaos? One challenge of working with costs is that they are used in many different contexts One might think it curious or even wrong that cost is not a rigid number calculated according to some formal rules Does “cost” mean a historical cost or a future cost; does it take into consideration any potential discounts; does it include implicit costs or only explicit costs? Note that GAAP accounting for external reporting is designed to avoid all these issues  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Opportunity Cost An opportunity cost is the sacrifice you make when you use a resource for one purpose instead of another Opportunity costs are implicit costs that do not appear anywhere in the accounting records Machine time used to make one product cannot be used to make another, so a product that has a higher contribution margin per unit may not be more profitable if it takes longer to make. Management accountants often use the concept of opportunity cost  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Classifications Revisited (1 of 3) The dividing of costs into direct and indirect costs and the dividing of costs into flexible and capacity-related costs are different systems All flexible costs are direct costs Some direct costs, however, are treated as if they were indirect because of cost-benefit considerations When treated as indirect costs, they are applied to production based on some measure of volume  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Classifications Revisited (2 of 3) Capacity-related costs can be direct or indirect Most capacity-related costs are indirect Some of the most egregious costing errors have been committed, however, by treating direct capacity-related costs as if they were indirect Exclusivity of use by the cost object defines whether a cost is direct or indirect  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Classifications Revisited (3 of 3) A cost’s definition can change as the perspective changes A decision maker might define a cost one way for one decision and another way for another Direct means that the resource that created the cost was acquired for, and used by, a single cost object It is important, then, to understand clearly how the cost object is defined  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Effect of Time Frame (1 of 2) Short run is the period over which a decision maker cannot adjust capacity The level of capacity-related resources, hence of capacity-related costs, is fixed The only costs that vary in the short run are those that vary in proportion to production or some activity that is related to production Short run costs are flexible costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Effect of Time Frame (2 of 2) Long-run costs are the sum of flexible and capacity-related costs associated with a cost object – which is usually a product They are important for product planning purposes as they are an estimate of the cost of all resources consumed to make the product The price charged for a product must cover its long-run cost for the organization to replace the capacity used to make the product when the capacity deteriorates  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Creating Costs An organization creates different costs at different stages: Starting up Early growth Reaching the boundaries of existing capacity Expanding product lines Expanding capacity Redefining the business Continued growth These costs are not created evenly over time and should be planned for  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Changing Cost Structures (1 of 4) The composition of manufacturing costs has changed substantially in recent years Many formal cost systems were first implemented in the early 1900’s: Direct labor represented a large proportion, sometimes 50% or more, of the total manufacturing costs Direct material costs were also substantial Capacity-related costs generally represented a small fraction of total manufacturing costs Usually accumulated in a single pool and allocated to products in proportion to some volume measure such as the labor or machine hours used by the product  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Changing Cost Structures (2 of 4) Today, direct labor is only a small portion of manufacturing costs E.g., in the electronics industry direct labor is often less than 5% of the total manufacturing cost The cost of direct materials remains important, representing 40% to 60% of the costs in many plants The big change has been the vastly increased share of total costs from capacity-related costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Changing Cost Structures (3 of 4) The increase in capacity-related costs results from: The shift toward greater automation, which requires more production engineering, scheduling, and machine setup activities The emphasis on better customer service The increase in support activities required by a proliferation of multiple products Further, both flexible and capacity-related costs associated with design, product development, distribution, selling, marketing, and administrative activities have increased  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Changing Cost Structures (4 of 4) Changing cost structures have caused cost systems allocating indirect costs using volume measures to become increasingly inaccurate in computing product costs Many costing systems take costs that did not vary proportionally with volume, accumulate them, and then allocate them using a measure of volume These systems often underallocate costs to cost objects (e.g., product lines) produced in low volumes  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Types Of Production Activities Traditional cost systems classified activities into those that varied with volume and those that did not This simple dichotomy does not capture the variety of the types of activities that take place in organizations A new classification system, developed originally for manufacturing operations, gives a broader framework for classifying an activity and its associated costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

New Classification System The new classification system places activities and their associated costs into one of the following categories: Unit related Batch related Product sustaining Customer sustaining Business sustaining  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Unit-Related Activities Unit-related activities are those whose volume or level is proportional to the number of units produced or to other measures, such as direct labor hours or machine hours that are themselves proportional to the number of units produced Unit-related activities apply to more than just production activities Loading shipments onto a truck is an example of a unit-related activity because it is proportional to the volume of shipments  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Batch-Related Activities In a production environment, batch-related activities are triggered by the number of batches produced rather than by the number of units manufactured E.g., Machine setups are required when beginning the production of a new batch of products Indirect labor for first-item quality inspections involves testing a fixed number of units for each batch produced and is, therefore, associated with the number of batches Many shipping costs may be batch related if the organization pays the shipper a charge per container or truckload  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Product-Sustaining Activities Product-sustaining activities support the production and sale of individual products These activities provide the infrastructure the enables the production, distribution, and sale of the product but are not involved directly in the production of the product Examples include: Administrative efforts required to maintain drawings and labor and machine routings for each part Product engineering efforts to maintain coherent specifications such as the bill of materials for individual products and their component parts and their routing through different work centers in the plant Managing and sustaining the product distribution channel The process engineering required to implement engineering change orders (ECOs)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Customer-Sustaining Activities Customer-sustaining activities enable the company to sell to an individual customer but are independent of the volume and mix of the products and services sold and delivered to the customer Examples of customer-sustaining activities include: Sales calls Technical support provided to individual customers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Business-Sustaining Expenses Business-sustaining expenses are other resource supply capabilities that cannot be traced to individual products and customers: The cost of a plant manager and administrative staff Channel-sustaining expenses, such as the cost of trade shows, advertising, and catalogs The expenses can be assigned directly to the individual product lines, facilities, and channels, but should not be allocated down to individual products, services, or customers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Business-Sustaining Activities Business-sustaining activities are those required for the basic functioning of the business For example, organizations need only one CEO irrespective of their size, and they need to perform certain basic functions, such as registration or reporting, that also are independent of the size of the organization These core activities are independent of the size of the organization, or the volume and mix of products and customers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Using The Cost Hierarchy The cost hierarchy just discussed is a model of cost behavior that can be used in two ways: To predict costs To develop the costs for a cost object such as a product or product line If we understand the underlying behavior of costs, we have a basis to predict costs and to understand how costs will behave as volume expands and contracts  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Nonmanufacturing Costs As Product Costs Although manufacturing costs often are the most significant component of total costs, nonmanufacturing costs are large and growing in many organizations Research and development Selling Logistical activities The management of nonmanufacturing costs is an increasingly important contributor to an organization’s financial success  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Nonmanufacturing Costs (1 of 3) Traditionally management accountants have looked at nonmanufacturing costs as a large pool of costs that should be managed by periodic budget appropriations For example, expenditures on items such as advertising are determined by what the organization can afford rather than by the mission it has to accomplish with advertising  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Nonmanufacturing Costs (2 of 3) Nonmanufacturing costs include both flexible and capacity-related components The nonmanufacturing costs that have attracted the most attention are customer-related costs Cost of selling the product to the customer Putting the product in the customer’s hands Providing after-sales support to the customer Can be significant and they can vary widely across different customers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Nonmanufacturing Costs (3 of 3) Many organizations have begun to undertake what they call customer accounting to determine the profitability of dealing with different customers or different types of customers Customer accounting systems have caused some organizations to abandon certain customers or to provide differential service fees based on the services that customers demand  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Life-Cycle Costs Life-cycle costing is a relatively new perspective that argues that organizations should consider a product’s costs over its entire lifetime when deciding whether to introduce a new product There are five distinct stages in a typical product’s life cycle Not all products will follow this pattern Some products will fail early and have a truncated life cycle  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Product Life Cycle (1 of 6) Product development and planning The organization incurs significant research and development costs and product testing costs Because of the increasing costs of launching products, organizations are devoting more effort to the product development and planning phase The nature and magnitude of these costs should be identified so that when products are initially proposed, planners have some idea of the cost that new product development will inflict on the organization Shorter life cycles provide less time to recover costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Product Life Cycle (2 of 6) Introduction phase The organization incurs significant promotional costs as the new product is introduced to the marketplace At this stage the product’s revenue will often not cover the flexible and capacity-related costs that it has inflicted on the organization  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Product Life Cycle (3 of 6) Growth phase The product’s revenues finally begin to cover the flexible and capacity-related costs incurred to produce, market, and distribute the product There is often little or no price competition The focus of attention is on developing systems to deliver the product to the customer in the most effective way  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Product Life Cycle (4 of 6) Product maturity phase Price competition becomes intense and product margins begin to decline While the product is still profitable, profitability is declining relative to the growth phase The organization undertakes intense efforts to reduce costs to remain competitive and profitable  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Product Life Cycle (5 of 6) Product decline and abandonment phase Phase in which the product begins to become unprofitable Competitors begin to drop out—the least efficient first—and the remaining competitors find themselves competing for a share of a smaller and declining market The organization incurs abandonment costs, which can include selling off equipment no longer required or restoring an asset (e.g., land) prior to abandoning it  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Product Life Cycle (6 of 6) Product-related costs occur unevenly over the product’s lifetime The motivation for considering total life cycle costs before the product is introduced is to ensure that the difference between the product’s revenues and its manufacturing and distribution costs cover the other costs associated with developing, supporting, and abandoning the product Life-cycle costing is a good example of a costing system designed for decision making that has little or no practical relevance in external reporting  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Traditional Cost Management Systems Chapter 3  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Management Systems (1 of 2) Cost management systems have a wide variety of uses The next two chapters will focus on their role in measuring the costs of products, services, and customers Two cost management systems have been used traditionally to cost products and services Job order costing Process costing Many companies continue to use these two systems  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Management Systems (2 of 2) Since the mid-1980s companies have been adopting activity-based costing (ABC) for product and customer costing These three systems are often portrayed as distinct; however, all cost systems work in essentially the same way: Expense categories are developed and then expenses are mapped to service departments, production centers, or activities Expenses are then attached to cost objects The way these links are made and the activities defined is what differentiates these systems  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Job Order v. Process Costing Systems A job order costing system estimates the costs of manufacturing products for different jobs required for specific customer orders Applicable in organizations that treat each individual job as a single unit of output A process costing system is applicable when all units produced during a specified time frame are treated as one unit of output Every unit made during the time period is essentially identical  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Need for Job Order Costing Products may differ Materials content Hours of labor required Machine time required Demand placed on support activity resources (i.e., manufacturing overhead) Special customer needs that require customized production With such variety, managers need to understand the costs of individual products so that they can assess product and customer profitability  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Cost Flow Model The cost flow model essentially uses an inventory concept to track costs Raw materials inventory Work-in-process (WIP) inventory Raw materials are transformed by labor and support resources Costs of the resources for each job not yet completed Finished goods inventory When the goods are sold, they are accounted for in the expense category Cost of Goods Sold  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Bidding Using Job Order Costing Firms are sometimes required to bid on jobs before customers decide to place an order with them Costs need to be estimated for each job in order to prepare a bid Job order costing systems provide the means to estimate these costs A job bid sheet provides a format for recording the estimated costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Job Bid Sheet (1 of 6) Panel 1 identifies the customer, the product, and the number of units required Bid Number: J4369 Date: July 6, 2004 Customer: Michigan Motors Product: Automobile engine valves (Valve #L181) Engineering Design Number: JDR-103 Number of Units: 1,500  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Job Bid Sheet (2 of 6) Panel 2 lists all the materials required to complete the job Materials Quantity Price Amount Bar steel stock 3” 3,600 lbs $11.30 $40,680 Subassembly 1,500 39.00 58,500 Total direct materials $99,180  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Job Bid Sheet (3 of 6) Panel 3 lists the amount of direct labor required for the job Labor Hours Rate Amount Lathe operators 480 $26.00 $12,480 Assembly workers 900 18.00 16,200 Total direct labor 1,380 $26,680  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Job Bid Sheet (4 of 6) Panel 4 contains estimates for cost driver costs Support Costs Amount 600 machine-hours @ $40/hour $24,000 1,380 direct labor hours @$36/hour 49,680 Total support costs $73,680  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Job Bid Sheet (5 of 6) Direct material $ 99,180 Direct labor 28,680 Panel 5 summarizes the total costs estimated for the job Direct material $ 99,180 Direct labor 28,680 Support costs 73,680 Total costs $201,540  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Job Bid Sheet (6 of 6) Total costs $201,540 Add 25% markup 50,385 A markup rate is applied to translate the estimated cost into a bid price A 25% markup rate is assumed in this example Total costs $201,540 Add 25% markup 50,385 Bid price $251,925 Unit cost $134.36 Unit price $167.95  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Job Costs And Markup Most firms mark up the job costs by adding an additional amount, or margin, to make a profit on the job The total job costs plus the margin equals the bid price The markup rate depends on a variety of factors: The amount of support costs excluded from the cost driver rate The target rate of return desired by the corporation Competitive intensity Past bidding strategies adopted by key competitors Demand conditions Overall product-market strategies  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Determination Of Cost Driver Rates Determining realistic cost driver rates has become increasingly important in recent years Support costs now comprise a large portion of the total costs in many industries Many firms now recognize that several different factors may be driving support costs rather than one or even two factors, such as direct labor or machine hours Firms are now taking greater care in identifying which support costs should relate to what cost driver  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Driver Rates All costs associated with a cost driver, such as setup hours, are accumulated separately Each subset of total support costs that can be associated with a distinct cost driver is referred to as a cost pool Each cost pool has a separate cost driver rate The cost driver rate is the ratio of the cost of a support activity accumulated in the cost pool to the level of the cost driver for the activity Activity cost driver rate = Cost of support activity / Level of cost driver  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Stable Cost Driver Rates (1of 2) The cost of the support activity is the cost of the resources committed to the particular activity The level of the activity cost driver is the long-term capacity made available by the amount of resources committed to a support activity The cost of a support activity, therefore, excludes fluctuations in costs caused by short-term adjustments such as overtime payments The level of the support activity cost driver also excludes short-term variations in demand as reflected in overtime or idle time  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Stable Cost Driver Rates (2of 2) The ratio shown in the previous equation is based on costs and cost driver levels, the rate remains stable over time: It does not fluctuate as activity levels change in the short run It does not change simply because of short-run changes in external factors that do not affect the efficiency or price of the activity resources  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Fluctuating Rates For example, if the rate for machine costs is based on quarterly cost driver levels instead of the normal levels: The rate increases as the demand for the machine activity falls The rate decreases as the demand increases In contrast, the cost driver rate based on costs and activity levels remains fixed throughout the year Costs depend on the machine capacity made available and not on the season  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Problems With Fluctuating Rates Determination of cost driver rates based on short-term usage results in higher rates during periods of lower demand Job costs appear to be higher during time periods when demand is lower Bid prices based on estimated job costs are likely to be higher during periods of low demand when they probably should be lower The higher bid price can further decrease demand, which in turn leads to higher cost driver rates and even higher prices Conversely, in periods when demand is high and capacity is short, job costs will appear to be lower, and bid prices will also be low  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Number of Cost Pools The number of cost pools can vary Some German firms use over 1,000 The general principle is to use separate cost pools if the cost or productivity of resources is different and if the pattern of demand varies across resources The increase in measurement costs required by a more detailed cost system must be traded off against the benefit of increased accuracy in estimating product costs If cost and productivity differences between resources are small, having more cost pools will make little difference in the accuracy of product cost estimates  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Recording Actual Job Costs Job order cost accounting systems record costs actually incurred on individual jobs as they are produced This process allows comparison of actual costs with the estimated costs Copies of all materials requisition notes and worker time cards are forwarded to the accounting department, which then posts them on a job cost sheet The system calculates total costs for the portion of the job completed The structure of the job cost sheet is similar to that of the job bid sheet The direct materials and direct labor costs on the job cost sheet represent the job’s actual costs incurred  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Multistage Process Costing For many plants engaged in continuous processing production flows continuously, semi-continuously, or in large batches from one process stage to the next At each successive process stage, there is further progress toward converting the raw materials into the finished product In continuous processing it is necessary first to determine costs for each stage of the process and then to assign their costs to individual products  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Multistage Process Costing Systems The design of product costing systems in such process-oriented plants allows measurement of the costs of converting the raw materials during a time period to be made separately for each process stage The conversion costs are applied to products as they pass through successive process stages This system for determining product costs, known as a multistage process costing system, is common in process-oriented industries  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Process-Oriented Industries Multistage process costing systems are found in plants engaged in continuous processing, such as those in the chemicals, basic metals, pharmaceuticals, grain milling and processing, and electric utilities industries We also find multistage process costing systems in some discrete-parts manufacturing plants such as those producing automobile components, small appliances, and electronic instruments and computers The common feature in these settings is that the products manufactured are relatively homogeneous Few and relatively small differences occur in the production requirements for batches of different products  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Comparison With Job Order Costing Both systems have the same objective: Assign material, labor, and manufacturing support activity costs to product Process costing systems differ in that they: Do not maintain separate cost records for individual jobs Measure costs only for process stages Determine cost variances only at the level of the process stages instead of at the level of individual jobs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Job Order and Multistage Process Costing (1 of 3) In job order costing production is carried out in different jobs In multistage process costing, production is carried out continuously, semi- continuously, or in large batches  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Job Order and Multistage Process Costing (2 of 3) In job order costing, production requirements are different for each individual job In multistage process costing, production requirements are homogeneous across products or jobs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Job Order and Multistage Process Costing (3 of 3) In job order costing, variances between actual and estimated direct material and direct labor costs are determined for each individual jobs In multistage process costing, variances between actual and estimated costs are determined for individual process stages  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Service Department Cost Allocations Appendix 3-1  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Operating Expense Allocations Traditional cost accounting systems assign operating expenses to products with a two-stage procedure: Expenses are assigned to production departments Production department expenses are assigned to the products Departmental structure influences the first-stage allocation process  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Effect Of Departmental Structure Many plants are organized into departments that are responsible for performing designated activities Departments that have direct responsibility for converting raw materials into finished products are called production departments Service departments perform activities that support production, such as: Machine maintenance Production engineering Machine setup Production scheduling All service department costs are indirect support activity costs because they do not arise from direct production activities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Two-Stage Cost Allocation (1 of 2) Conventional product costing systems assign indirect costs to jobs or products in two stages In the first stage: System identifies indirect costs with various production and service departments Service department costs are then allocated to production departments The system assigns the accumulated indirect costs for the production departments to individual jobs or products based on predetermined departmental cost driver rates  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Two-Stage Cost Allocation (2 of 2)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Allocating Service Department Costs To Production Departments There are three ways that companies allocate service department costs to production departments: Direct allocation Sequential allocation Reciprocal allocation The last two are used when service departments consume services provided by other departments (Examples based on PATIENTAID information in text)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Step 1 of Stage 1 cost allocations (given) PATIENTAID EXAMPLE Step 1 of Stage 1 cost allocations (given)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Direct Allocation Method The direct allocation method is a simple method that allocates the service department costs directly to the production departments Allocations to production departments are based on each production department’s relative use of the applicable cost driver It ignores the possibility that some of the activities of a service department may benefit other service departments as well as production departments  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Allocation Bases Values  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Based on relative allocation basis value Allocation Ratios Based on relative allocation basis value 300,000 / 1,200,000 = 0.250  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Allocation of Service Department Costs Multiply service department cost by the allocation ratios $160,000 x 0.250 = $40,000  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Stage 2 Cost Allocations Stage 2 allocations Require the identification of appropriate cost drivers for each production department Assign production department costs to jobs and products while they are worked on in the departments Conventional cost accounting systems use unit-related cost drivers, such as the number of units made, the number of direct labor hours (or cost), and the number of machine hours Dividing the indirect costs accumulated in each production department by the total number of units of the corresponding cost driver results in cost driver rates for each department  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

PATIENTAID Stage 2 (1 of 2) The Casting Department allocates its indirect costs to jobs based on machine hours, with total capacity for Casting equaling 6,000 machine hours Total indirect costs for Casting, after the allocation from service departments in Step 2 of Stage 1 was $216,000 As a result, Casting allocates indirect costs to jobs at a rate of $36.00 per machine hour $216,000/6,000 hours Each department will make a similar calculation  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

PATIENTAID Stage 2 (2 of 2) If Job J189-4 uses 40 machine hours while in the Casting Department, Casting will allocate $1,440 of its indirect costs to Job J189-4 40 hours x $36.00 per hour Each department will allocate indirect costs to Job J189-4 in a similar manner, and Casting will allocate some costs to all jobs in a similar manner To determine the total cost of Job J198-4, add the Direct Material and Direct Labor cost assigned in each department and the indirect cost allocated from each department To determine the cost per unit, divide the total cost by the number of units in Job J189-4  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Distortions in A Two-Stage Allocation (1 of 2) The two-stage allocation can cause some products to be overcosted and others undercosted if allocations are based on unit measures but the units of different products have different relative consumption ratios In the Minnetka example in the textbook, Products A and B use the same number of machine hours, resulting in an equal allocation of indirect, including setup, costs per unit Product A, however, runs in larger batches, so one unit’s relative consumption of setup resources is lower for A than for B  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Distortions in A Two-Stage Allocation (2 of 2) Cost distortions are greater when the difference between the relative proportion of the cost driver for the activity (e.g., setup hours) and the relative proportion of the basis for second-stage assignment of support costs (e.g., machine hours) is greater Such distortions could be eliminated if the costing system used the actual cost driver for each support activity to assign costs directly to the products This logic underlies the development of activity-based costing systems discussed in the following chapter  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Sequential and Reciprocal Allocation Methods Sequential and reciprocal allocation methods are used when service departments consume services provided by other service departments The sequential allocation method allocates service department costs to one service department at a time in sequential order The reciprocal allocation method determines service department cost allocations simultaneously  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Sequential Allocation Method (1 of 5) The sequential method is appropriate when there is not a pair of service departments in which each department in that pair consumes a significant proportion of the services produced by the other department in that pair  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Sequential Allocation Method (2 of 5) The sequential allocation method requires that the service departments first be arranged in order A service department can receive costs allocated from another service department only before its own costs have been allocated to other departments Once a service department’s costs have been allocated, no costs can be allocated back to it from other departments  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Sequential Allocation Method (3 of 5) Service Departments Production Departments Item Power Engineering Machining Assembly Totals Services Used: Kilowatt hours Eng’ring hours 100,000 480,000 2,000 220,000 800,000 4,000 Allocation ratios: 0.125 0.600 0.500 0.275 1.000 Directly identified costs $320,000 $180,000 $120,000 $80,000 $700,000 480,000/800,000 = 0.600 2,000/4,000 = 0.500  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Sequential Allocation Method (4 of 5) Service Departments Production Departments Item Power Engineering Machining Assembly Totals Directly identified costs $320,000 $180,000 $120,000 $80,000 $700,000 Cost Allocations: (320,000) 40,000 (220,000) 192,000 110,000 88,000 $ 0 $ 422,000 $ 278,000 $ 700,000 $320,000 * 0.600 = $ 192,000 ($180,000 + 40,000) * 0.500 = $ 110,000  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Sequential Allocation Method (5 of 5) In this example, the power department does not receive engineering services, but the engineering department uses power Therefore, in the sequential method: The power department costs are allocated first Then the engineering department costs are allocated The total cost of a service department allocated to other departments equals the amount directly identified with the service department plus the amount allocated earlier to the service department from other service departments  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Reciprocal Allocation Method (1 of 6) If both service departments in this example consume each other’s services, the reciprocal allocation method is appropriate The sequential method ignores or suppresses such reciprocal relations The reciprocal allocation method recognizes reciprocal interactions between different service departments The example changes only to recognize Power’s use of Engineering’s services  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Reciprocal Allocation Method (2 of 6) Service Departments Production Departments Item Power Engineering Machining Assembly Totals Services Used: Kilowatt hours Eng’ring hours 1,000 100,000 480,000 2,000 220,000 800,000 5,000 Allocation ratios: 0.200 0.125 0.600 0.400 0.275 1.000 Directly identified costs $320,000 $180,000 $120,000 $80,000 $700,000 480,000/800,000 = 0.600 2,000/5,000 = 0.400  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Reciprocal Allocation Method (3 of 6) Before allocating any costs to the production departments, determine the reciprocal allocation between service departments: Power’s total cost is $320,000 + 20% of the total cost of Engineering (P=320,000+.20E) Engineering’s total cost is $180,000 + 12.5% of the total cost of Power (E=180,000+.125P) Solve the simultaneous equations by substitution  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Reciprocal Allocation Method (4 of 6) P=320,000+.20E, with E=180,000+.125P P=320,000+.20(180,000+.125P) P=320,000 + 36,000 + .025P .975P=320,000 + 36,000 P= $ 365,128 E=180,000+.125P E=180,000+.125(365,128) E=180,000+45,641 E= $ 225,641 These costs will be allocated to the production departments using the allocation ratios shown previously  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Reciprocal Allocation Method (5 of 6) Service Departments Production Departments Item Power Engineering Machining Assembly Totals Directly identified costs $320,000 $180,000 $120,000 $80,000 $700,000 Cost Allocations: (365,128) 45,128 45,641 (225,641) 219,077 90,256 100,410 90,257 $ 0 $ 429,333 $ 270,667 $ 700,000 ($320,000 + 45,128) * 0.600 = $ 192,000 ($180,000 + 45,641) * 0.400 = $ 110,000  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Reciprocal Allocation Method (4 of 6) Notice that the allocations were different from those obtained in the earlier illustration for the sequential method The power department’s total costs were higher because it also consumed some engineering services Because the machining department consumed a relatively larger amount of power, the costs allocated to it were higher in this case Notice also that only the allocations were different; the total amount of costs did not change as a result of using a different allocation method  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Final Word on Two-Stage Allocation The fundamental assumption of the two-stage allocation method is the absence of a strong direct link between the support activities and the products manufactured For this reason, service department costs are first allocated to production departments using one of the conventional two-stage allocation methods previously described Activity-based costing rejects this assumption and instead develops the idea of cost drivers that directly link the activities performed to the products manufactured and measure the average demand placed on each activity by the various products Activity costs are assigned to products in proportion to the average demand that the products place on the activities, usually eliminating the need for the second step in Stage 1 allocations  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Activity-Based Cost Management Systems Chapter 4  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Problems With Simple Cost Accounting Systems: The Cooper Pen Company Example Cooper Pen had been the low-cost producer of blue pens and black pens, with profit margins exceeding 20% of sales Several years ago Cooper Pen expanded their business by extending their product line into products with premium selling prices  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Cooper Pen Company Example Five years ago red pens were introduced The same basic production technology Could be sold at a price that was 3% higher than for blue and black pens Last year purple pens were added Could be sold at a 10% price premium The controller of Cooper Pen was disappointed with the most recent quarter’s financial results Overall profitability for all four together had decreased The red and purple pens, however, were more profitable than the blue and black pens  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Total Profitability by Product Blue Black Red Purple Total Units 50,000 40,000 9,000 1,000 100,000 Price $ 4.50 $ 4.65 $ 4.95 Sales $225,000 $180,000 $41,850 $4,950 $451,800 Material 75,000 60,000 14,040 1,650 150,690 Labor 30,000 24,000 5,400 600 Overhead 90,000 72,000 16,200 1,800 180,000 Total Mfg. Expenses 195,000 156,000 35,640 4,050 390,690 Gross Margin $ 30,000 $ 24,000 $ 6,210 $ 900 $ 61,110 G.M. % 13.3% 14.8% 18.2% 13.5%  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Concern at Cooper Pen The controller of Cooper Pen wondered whether the company should continue to deemphasize the blue and black commodity products and keep introducing new specialty colored pens Cooper’s manufacturing manager commented on how the introduction of colored pens had changed the production environment: Everything ran smoothly when producing just blue and black pens in long production runs Difficulties started when the red pens were introduced and required more changeovers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Changes Caused by New Pens (1 of 2) Making black ink was simple; there was not even a need to clean out the residual blue ink from the previous run if enough black ink was dumped in to cover it up Red required Cooper to stop production, empty the vats, clean out all remnants of the previous color, and then start the production of the red ink Even small traces of the blue or black ink created quality problems The ink for the purple pens also had demanding specifications, though not quite as demanding as the red ink  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Changes Caused by New Pens (2 of 2) Cooper Pens was also spending more time on purchasing and scheduling activities and keeping track of existing, backlogged, and future orders Cooper’s manufacturing manager was concerned about rumors that new colors may be introduced in the near future He did not think they had any more capability to handle additional confusion and complexity in the operations Last year’s new computer system helped to reduce some of the confusion  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Pen Production At Cooper’s Pen production at the factory involved: Preparing and mixing the ink for the different color pens Inserting the ink into the pens in a semiautomated process Packing and shipping the pens in a manual stage Each product had a: Bill of materials that identified the quantity and cost of direct materials required for the product Routing sheet that identified the sequence of operations required for each operating step This information was used to calculate the labor expenses for each of the four products From this information, it was easy to calculate the direct materials costs and direct labor costs for each color pen  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cooper’s Indirect Cost Allocation Because it was a small company and historically had produced only a narrow range of products, Cooper used a simple costing system All the plant’s indirect expenses were aggregated at the plant level and allocated to products based on each product’s direct labor cost Currently the cost system’s overhead burden rate was 300% of direct labor cost Before the new specialty products were introduced, the overhead rate was only 200% of direct labor cost  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cooper Pen’s Cost System Cooper’s management accountants designed the system years ago when: Production operations were mostly manual Total indirect costs were less than direct labor costs Cooper’s two products had similar production volumes and batch sizes Given the high cost of measuring and recording information, the accountants at the time judged correctly that a complex costing system would cost more to operate than the benefits it would provide  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

A Changed Production Environment Direct labor costs have decreased and indirect expenses have increased as a result of automation As custom low-volume products, such as red and purple pens were added, Cooper needed: More scheduling More setups More quality control personnel A computer to track orders and product specifications  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

An Outdated Cost System Cooper operates with only a single cost center, the plant Most complex companies use many cost centers for cost accumulation Even if Cooper Pen used multiple production and service department cost centers, it could still encounter severe distortions in its reported product costs: In an environment of high product variety, using only unit-level drivers (such as direct labor costs) to allocate overhead costs to products could lead to product cost distortion  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Reason for Cost Distortions (1 of 3) A complex factory has a much larger production support staff because it requires more people to: schedule machine and production runs perform setups inspect produced items after setup move materials ship orders expedite orders rework defective items design new products improve existing products negotiate with vendors schedule materials receipts order, receive, and inspect incoming materials and parts update and maintain the much larger computer-based information system A complex factory generally also operates with higher levels of idle time, setup time, overtime, inventory, rework, and scrap  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Reason for Cost Distortions (2 of 3) Because the factory has the same physical output, it has roughly the same cost of materials (ignoring the slightly higher acquisition costs for smaller orders of specialty colors and other materials) Because all pens are about the same complexity, each pen would require the same number of direct labor hours and machine hours to produce The Cooper Pen Company factory has about the same property taxes, security costs, and heating bills as before, but it has much higher indirect and support costs because of its more varied product mix and complex production tasks  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Reason for Cost Distortions (3 of 3) On a per unit basis, high-volume standard blue and black pens require about the same amount of direct labor costs (the allocation basis) as the low volume color pens Therefore, the traditional costing system would report essentially identical product costs for all products, standard and specialty, irrespective of their relative production volumes This would hold true even if the cost system had multiple production and service cost centers Clearly, however, considerably more indirect and support resources are required on a per-unit basis for the low-volume, newly designed products than for the high-volume, standard blue and black pens  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Activity-Based Cost Systems Activity-based cost systems have been developed to eliminate this major source of cost distortion Activity-based cost (ABC) management systems use a simple two-stage approach similar to but more general than traditional cost systems The next slide compares the essential elements of the two systems  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Traditional v. ABC System Uses actual departments or cost centers for accumulating and redistributing costs Asks how much of an allocation basis (usually based on volume) is used by the production department Service department expenses are allocated to a production department based on the ratio of the allocation basis used by the production department ABC: Uses activities, for accumulating costs and redistributing costs Asks what activities are being performed by the resources of the service department Resource expenses are assigned to activities based on how much of the resource is required or used to perform the activities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Tracing Costs to Activities Here’s how an ABC system works, using the Cooper Pen Company as an example: The controller started an analysis of indirect expenses, beginning with indirect labor The controller interviewed department heads in charge of indirect labor and found that the people in these departments performed three main activities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Indirect Labor Activities (1 of 2) 50% of indirect labor was involved in what the controller called “handle production runs” Scheduling production orders Purchasing, preparing, and releasing materials Inspecting the first few units produced each time the process was changed to a new-colored pen 40% of indirect labor actually performed the physical changeover from one color pen to another, an activity that she labeled “perform setups” Change to Black pens takes 2.4 hours Change to Red or Purple pens takes 5.6 hours  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Indirect Labor Activities (2 of 2) 10% of the time was spent on activities the controller called “support products:” maintaining records on the four products, such as: Making up the bill of materials and routing information Monitoring and maintaining a minimum supply of raw materials and finished goods inventory for each product Improving the production processes Performing engineering changes for the products  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

First Steps in Design of An ABC System As she conducted the interviews, the controller was performing the first two steps for designing an activity-based cost system: Develop the activity dictionary: the list of major activities performed by both the factory’s human and physical resources Obtain sufficient information to assign resource expenses to each activity in the activity dictionary (50% of indirect labor to “handle production runs,” 40% to “perform setups,” and 10% to “support products”)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Computer System Expenses (1 of 2) The controller next turned her attention to the $30,000 of expenses needed to operate the company’s computer system and interviewed the manager of the data center and the manager of the management information system department 20% of computer expenses should be assigned to “support products,” an activity already defined in her activity dictionary, because it was used to keep records on the four products, including: Production process Associated engineering change notice information  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Computer System Expenses (2 of 2) About 80% of the computer resource was involved in the production run activity and seemed to relate well to the “handle production runs” activity already defined: Schedule production runs in the factory Order and pay for the materials required in each production run Since each production run was made for a particular customer, also included in this activity was the computer time required to: Prepare shipping documents Invoice a customer Collect from a customer  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Other Overhead Expenses There were three remaining categories of overhead expense: Machine depreciation Machine maintenance Energy to operate the machines These expenses were incurred to supply machine capacity to produce the pens: A practical capability of 10,000 hours of productive time could be supplied to pen production The controller labeled this production activity “run machines”  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Identifying Cost Hierarchies The controller noted that even though she had defined only four activities for Cooper’s indirect costs, they represented the three different levels of the manufacturing cost hierarchy: ACTIVITY COST HIERARCHY RUN MACHINES UNIT LEVEL HANDLE PRODUCTION RUNS BATCH LEVEL SETUP MACHINES BATCH LEVEL SUPPORT PRODUCTS PRODUCT SUSTAINING Finding at least one activity for each hierarchy level gave her confidence that the complexity of the manufacturing process could be represented well enough by the activity-based cost system  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Benefits from Half an ABC System The ABC model was only half completed (costs have not yet been driven down to products), yet it had already provided some important insights: Now the controller could see why Cooper Pens was incurring expenditures for resources instead of seeing categories of expenses In particular she saw how expensive activities such as handling production runs and setting up machines were The ABC model shifted the focus from what the money was being spent on (labor, equipment, supplies) to what the resources acquired by spending were actually doing  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

From ABC to ABM (1 of 2) In the past, industrial engineers at Cooper Pen had studied labor and materials usage closely: These had been the high cost resources They were also the primary cost categories featured by Cooper’s traditional cost system The high overhead rate on direct labor seemed to amplify any benefits from direct labor cost savings that the industrial engineers could achieve  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

From ABC to ABM (2 of 2) It would be worthwhile to have industrial engineers study the way Cooper handled and scheduled production runs and how the employees set up machines to uncover new opportunities for cost reduction and process improvement projects This is an example of operational activity-based management (ABM), where managers use information collected by the ABC system at the activity level to identify opportunities for reducing costs in indirect and support activities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Tracing Costs From Activities To Products The controller next turned her attention to understanding the demands for these activities by the four different products By understanding how products use activities, she would be able to relate the cost of performing activities to individual products  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Activity Cost Drivers Activity cost drivers represent the quantity of activities used to produce individual products The controller identified the following activity cost drivers for the activities in her activity dictionary: ACTIVITY ACTIVITY COST DRIVER HANDLE PRODUCTION RUNS PRODUCTION RUNS SET UP MACHINES SETUP HOURS SUPPORT PRODUCTS NUMBER OF PRODUCTS RUN MACHINES MACHINE HOURS PROVIDE FRINGE BENEFITS LABOR DOLLARS  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Completing the ABC Model (1 of 2) Once the activity cost drivers had been determined, the controller obtained quantitative information on: The total quantity of each activity cost driver The quantity of cost driver used by each product  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Completing the ABC Model (2 of 2) The controller now had sufficient information to estimate a complete activity-based cost model for Cooper Pen’s factory She calculated the activity cost driver rate (ACDR) by dividing the activity expense by the total quantity of the activity cost driver She then multiplied the activity cost driver rate by the quantity of each activity cost driver used by each of the four products  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Activity Cost Drivers Activity Cost Driver Blue Black Red Purple Total** DL hr/unit 0.02 2,000 Mach. hr/unit 0.1 10,000 Prod. runs 70 65 50 15 200 Setup time/run 4 2.4 5.6 -- Total setup hr 280 156 84 800 # of products 1 **Total = per unit X quantity 50,000 40,000 9,000 1,000  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Activity Cost Driver Rates (ACDR) Activity Expense Activity Cost Driver Driver Quantity ACDR Handle Production Runs $66,000 Number of production runs 200 $330 per run Set up machines $33,600 Number of setup hours 800 $42 per setup hr Support Products $14,400 Number of products 4 $3,600 per product Run Machines $42,000 Number of machine hours 10,000 $4.20 per machine hr $156,000  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Activity Expenses Assigned Blue Black Red Purple Total Handle Production Runs $23,100 $21,450 $16,500 $4,950 $66,000 Set up machines 11,760 6,552 3,528 33,600 Support Products 3,600 14,400 Run Machines 21,000 16,800 3,780 420 42,000 Total Costs Assigned $ 59,460 $ 48,402 $ 35,640 $ 12,498 $ 156,000  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

ABC Profitability Report The controller combined the activity expense analysis for each product with their direct materials and labor costs to obtain a new ABC profitability report The results from the activity-based costing system were quite different from the results based on the traditional cost system The controller now understood why the profitability of Cooper Pen has deteriorated in recent years: The two specialty products, which the previous cost system had reported as the most profitable, were in fact the most unprofitable, and losing lots of money The company had added large quantities of overhead resources to enable these products to be designed and produced, but their incremental revenue did not cover those costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Total ABC Profitability by Product Blue Black Red Purple Total Sales $225,000 $180,000 $41,850 $4,950 $451,800 Material 75,000 60,000 14,040 1,650 150,690 Labor 30,000 24,000 5,400 600 40% fringe on DL 12,000 9,600 2,160 240 Support 59,460 48,402 35,640 12,498 156,000 Total Mfg. Expenses 176,460 142,002 57,240 14,988 390,690 Gross Margin $ 48,540 $ 37,998 $(15,390) $(10,038) $ 61,110 G.M. % 21.6% 21.1% -36.8% -202.8% 13.5%  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Using ABC to Improve Profitability (1 of 2) The ABC information provides managers with numerous insights about how to increase the profitability of Cooper Pen: Increase either their sales volume or prices to compensate for the large batch and product-sustaining expenses of the red and purple pens Impose minimum order sizes to eliminate short, unprofitable production runs Try to increase demand for the highly profitable black and blue pens, which could generate new revenues that exceed their incremental costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Using ABC to Improve Profitability (2 of 2) Improve processes, particularly the processes performing batch and product-sustaining activities Manufacturing personnel can redirect their attention: From trying to run their production equipment faster, in order to improve the performance of unit-level activities To learning how to reduce setup times, in order to improve the performance of batch-level activities so that small batches of the specialty products would require fewer resources to produce and be less expensive The goal of these ABM actions is to enable the company to produce the same volume and mix of products with fewer resources This leads to lower costs for producing low-volume, specialty products, and reduces the pressure to raise prices or impose minimum order sizes on customers in order to make such products profitable  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Selecting Activity Cost Drivers (1 of 2) Activity cost drivers are the central innovation of activity-based cost systems They are also the most costly to measure Particularly the quantity of each activity cost driver used by each product Accordingly, it is important to understand the issues involved in selecting activity cost drivers The selection of an activity cost driver reflects a subjective trade-off between accuracy and the cost of measurement An ABC system with 50 activity cost drivers and 2,000 products would require that 100,000 data elements be estimated  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Selecting Activity Cost Drivers (2 of 2) Because of the large number of potential activity-to-product linkages, management accountants attempt to economize on the number of different activity cost drivers Activities triggered by the same event may all use the same activity cost driver For example, preparing production orders, scheduling production runs, performing first part inspections, and moving materials may all use the number of production runs ABC system designers choose from three different types of activity cost drivers: Transaction Duration Intensity (direct charging) The choice of a transaction, duration, or intensity cost driver can occur for almost any activity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Transaction Drivers Least expensive type of cost driver Also the least accurate They assume that the same quantity of resources is required every time an activity is performed For example, a transaction driver such as the number of setups assumes that all set­ups take about the same time to perform For many activities, the variation in the quantity of resources used by each is small enough that a transaction driver will be fine for assigning activity expenses to the cost object E.g., all setup times are between 30 and 35 minutes If the amount of resources required to perform the activity varies considerably from product to product then more accurate and more expensive types of cost drivers should be used E.g., Setup times range from 30 minutes to 6 hours  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Duration Drivers Represent the amount of time required to perform an activity Should be used when significant variations exist in the amount of activity required for different outputs A transaction driver such as number of setups will overcost the resources required to set up simple products and undercost the resources required for complex products More expensive to implement because they require an estimate of time needed each time an activity is performed The choice between a duration driver and a transactional driver is, as always, one of economics: Balancing the benefits of increased accuracy against the costs of increased measurement  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Intensity Drivers Directly charge for the resources used each time an activity is performed A duration driver, such as setup cost per hour, assumes that all hours are equally costly but does not reflect the higher costs that may be required on some setups: E.g., extra personnel, more skilled personnel, more expensive machinery Activity costs may have to be charged directly to the output, based on work orders or other records that accumulate the activity expenses incurred for that output Intensity drivers are the most accurate activity cost drivers but the most expensive to implement Intensity drivers should be used only when the resources associated with performing an activity are both expensive and variable each time an activity is performed unless the measurements are inexpensive  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Designing an ABC System (1 of 2) Sometimes ABC system designers get carried away with the potential capabilities of an activity-based cost system For product costing and customer costing purposes, most companies: Limit their activity dictionary to 30 to 50 different activities Choose activity cost drivers that can be obtained simply and are available within their organization’s existing information system  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Designing an ABC System (2 of 2) The goal of an ABC system should be to have the best cost system -- not the most accurate one The ABC system designer should balance the cost of errors resulting from inaccurate estimates with the cost of measurement Most of the benefits from a more accurate cost system can be obtained with simple ABC systems  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Measuring The Cost Of Resource Capacity (1 of 2) The calculation of activity cost driver rates are sometime based on the capacity actually used Analysts can obtain a better estimate for the cost of resources required to handle each production run by dividing activity expenses by the practical capacity of work the resources could perform Otherwise, the activity cost driver rates overestimate the cost of the activity provided The cost of unused capacity should not be assigned to products produced or customers served during a period  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Measuring The Cost Of Resource Capacity (2 of 2) The activity cost driver rate should reflect the underlying efficiency of the process: the cost of resources to handle each production order This efficiency is measured better by using the capacity of the resources supplied as the denominator when calculating activity cost driver rates Still, the cost of unused capacity should not be ignored  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost of Unused Capacity (1 of 2) The cost of unused capacity remains someone’s or some department’s responsibility Usually you can assign unused capacity after analyzing the decision that authorized the level of capacity supplied For example, if the capacity was acquired to meet anticipated demands from a particular customer or a particular market segment, then the costs of unused capacity due to lower than expected demands can be assigned to the person or organizational unit responsible for that customer or segment Such an assignment is done on a lump-sum basis; it will be treated as a sustaining, not a unit-level, expense.  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost of Unused Capacity (2 of 2) If the unused capacity relates to a particular product line then the cost of unused capacity is assigned to that product line, where the demand failed to materialize Unused capacity should not be treated as a general cost, to be shared across all product lines In making assignment of unused capacity costs, we trace the costs at the level in the organization where decisions are made that affect the supply of capacity resources and the demand for those resources The lump-sum assignment of unused capacity costs provides feedback to managers on their supply and demand decisions  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Fixed and Variable Expenses Most indirect expenses assigned by an ABC system are committed costs Committed costs become variable via a two-step procedure: First, demands for resources change either because of changes in the quantity of activities performed or because of changes in the efficiency of performing activities Second, managers must make decisions to change the supply of committed resources, either up or down, to meet the new level of demand for the activities performed by these resources  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Activity in Excess of Capacity If activity volumes exceed the capacity of existing resources, the result is Bottlenecks Shortages Increased pace of activity Delays Poor-quality work Such shortages occur often on machines, but can also occur in human resources who perform support activities Facing such shortages, companies typically make committed costs variable They relieve the bottleneck by spending more to increase the supply of resources to perform work This is why many indirect costs increase over time  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Decreased Demand for Resources Demands for indirect and support resources also can decline Consciously through activity-based management Inadvertently through competitive or economy-wide forces that lead to declines in sales Should the demands for batch and product-sustaining resources decrease, few immediate spending reductions will be noticed Even for many unit-level resources, such as machines and direct labor, reduced demands for work does not immediately lead to spending decreases The reduced demand for organizational resources lowers the cost of resources used, but this decrease is offset by an equivalent increase in the cost of unused capacity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Making Committed Costs Variable Downward After unused capacity has been created, committed costs will vary downward if, and only if, managers actively reduce the supply of unused resources What makes a resource cost “variable” downward is not inherent in the nature of the resource It is a function of management decisions To reduce the demands for the resource To lower the spending on it  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Managers Make Costs Fixed (1 of 2) Organizations often create unused capacity through activity-based management actions Process improvement Repricing to modify the product mix Imposing minimum order sizes on customers They keep existing resources in place, when demands for the activities performed by the resources have diminished They also fail to find new activities that could be done by the unused resources already in place  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Managers Make Costs Fixed (2 of 2) The organization receives no benefits from its activity-based management decisions that reduced the demands on their resources if capacity is not reduced or redeployed The failure to capture benefits from activity-based management is not because their costs are “fixed” The failure occurs because managers are unwilling or unable to take advantage of the unused capacity they have created by Spending less on capacity resources Increasing the volume of work processed by the capacity resources The cost of these resources is only “fixed” if managers do not exploit the opportunities from the unused capacity they helped to create Making decisions based solely upon resource usage (the ABC system) may not increase profits if managers are not prepared to reduce spending to align resource supply with future lower levels of demand  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Problems Implementing ABC (1 of 3) Several problems arise in practice from the common approach to activity-based costing that assigns many resource expenses to activities based on interviews, surveys, and direct observation of production and support processes The interview and survey processes are time consuming and costly This front-end cost to an ABC analysis is often a barrier to widespread ABC adoption  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Problems Implementing ABC (2 of 3) Inaccuracies and bias may affect the accuracy of cost driver rates derived from individuals’ subjective estimates of their past or future behavior Companies must periodically repeat the interviewing and surveying processes if they want to keep their activity-based cost systems updated High updating cost leads to infrequent updates of many ABC systems and, eventually, to obsolete cost driver estimates Adding new activities to the system is also difficult, requiring re-estimates of the relative amount of resource time and effort required by the new activity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Problems Implementing ABC (3 of 3) A more subtle and serious problem arises from the interview or survey process People estimating how much time they spend on a list of activities handed to them invariably report percentages that add up to 100% Few individuals report that a significant percentage of their time is idle or unused Accordingly, the cost driver rates calculated from this process assume that resources are working at full capacity But operations at capacity are more the exception than the rule  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Time-Driven ABC: An Alternative Approach Several companies have overcome these problems by using a new approach for estimating their ABC models The insight for the new approach is simple: Most ABC systems use a large number of transactional cost drivers that assume each occurrence of the event (a production run, a customer order, a product to support) consumes the same quantity of resources  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Time-Driven ABC: This homogeneity assumption provides the foundation for an alternative approach to estimating cost driver rates. The new approach requires two new estimates: The unit cost of supplying capacity, and The consumption of capacity (unit times) by each activity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Unit Cost Estimate (1 of 3) The new procedure starts with the same information used by a traditional ABC approach: The cost of resources that supply capacity and The practical capacity of the resources supplied Practical capacity is often estimated as a percentage (e.g., 80% or 85%) of theoretical capacity This estimate allows time (e.g., 15 – 20%) for nonproductive time: For personnel, time for breaks, arrival and departure, and communication and reading unrelated to actual work performance  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Unit Cost Estimate (2 of 3) For machines, an allowance for downtime due to maintenance, repair, and scheduling fluctuations With estimates of the cost of supplying capacity and practical capacity, the analyst can calculate the unit cost of supplying capacity: Unit cost = Cost of capacity supplied Practical capacity of resources supplied  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Unit Cost Estimate (3 of 3) For example, assume that indirect labor employees supply about 2,500 hours of labor in total each quarter at a cost of $84,000. The practical capacity (at 80% of theoretical) is about 2,000 hours per quarter, leading to a unit cost (per hour) of supplying indirect labor capacity of: $84,000 Indirect labor cost per hour = 2000 hours = $42 per hour  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Unit Time Estimate The second piece of new information is an estimate of time used each time a committed resource performs a transactional activity Precision is not critical Rough accuracy is sufficient Estimates for the indirect labor from the Cooper Pen example are: Resource Activity Unit Time Indirect Labor Production Run 5 hours Support Products 50 hours  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Driver Rate Assume similar calculations regarding computer resources produced estimates of $60 per hour and 2 hours per production run The cost driver rate for the activity, handle production runs, can now be calculated as the costs of using indirect labor and the computer for each production run: Unit Cost Unit Time Cost Driver Indirect Labor Resource $42 per hour 5 hours/run $210 per run + Computer Resource $60 per hour 2 hours/run 120 per run = Activity Cost Driver Rate $330 per run  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Advantages of Time-Driven ABC Managers may easily update their time-driven ABC model to reflect changes in their operating conditions They can incorporate the new knowledge by providing reasonable estimates about the unit times required for different activities for each type of product Managers may also easily update the activity cost driver rates Changes in the prices of resources supplied affect the hourly cost rate Activity cost driver rates change when there has been a shift in the efficiency of the activity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Tracing Marketing-Related Costs to Customers The costs of marketing, selling, and distribution expenses have been increasing rapidly in recent years Result of increased importance of customer satisfaction and market-oriented strategies Many of these expenses do not relate to individual products or product lines but are associated with: Individual customers Market segments Distribution channels Companies need to understand the cost of selling to and serving their diverse customer base  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Alpha – Beta Example (1 of 7) Assume Alpha and Beta are customers generating about equal revenue and seen as equally valuable customers Using a conventional cost accounting system, marketing, selling, distribution, and administrative (MSDA) expenses were allocated to customers at a rate of 35% of Sales ALPHA BETA Sales $320,000 $315,000 CGS 154,000 156,000 Gross Margin $166,000 $159,000 MSDA expenses (@35% of Sales) 112,000 110,250 Operating profit $ 54,000 $ 48,750 Profit percentage 16.9% 15.5% In many respects, however, the customers were not similar  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Alpha – Beta Example (2 of 7) Beta’s account manager spent a huge amount of time on that account Beta required a great deal of hand-holding and was continually inquiring whether the company could modify products to meet its specific needs Beta’s account required many technical resources, in addition to marketing resources Beta also: Tended to place many small orders for special products Required expedited delivery Tended to pay slowly All of which increased the demands on the order processing, invoicing, and accounts receivable process  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Alpha – Beta Example (3 of 7) Alpha, on the other hand: Ordered only a few products and in large quantities Placed its orders predictably and with long lead times Required little sales and technical support The Accounting Manager in Marketing knew that Alpha was a much more profitable customer than the financial statements were currently reporting He launched an activity-based cost study of the company’s marketing, selling, distribution, and administrative costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Alpha – Beta Example (4 of 7) The multifunctional project team: Studied the resource spending of the various accounts Identified the activities performed by the resources Selected activity cost drivers that could link each activity to individual customers The Accounting Manager used: Transactional activity cost drivers Number of orders, number of mailings Duration drivers Estimated time and effort Intensity drivers when he had readily-available data Actual freight and travel expenses  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Alpha – Beta Example (5 of 7) The manager also used a customer cost hierarchy that was similar to the manufacturing cost hierarchy Some activities were order-related Handle customer orders Ship to customers Others were customer-sustaining Service customers Travel to customers Provide marketing and technical support  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Alpha – Beta Example (6 of 7) The picture of relative profitability of Alpha and Beta shifted dramatically Alpha Beta Gross Margin (as previously) $166,000 $159,000 Marketing & tech. support 7,000 54,000 Travel to customer 1,200 7,200 Distribute sales catalog 100 Service customers 4,000 42,000 Handle customer orders 500 18,000 Warehouse inventory 800 8,800 Ship to customers 12,600 Total activity expenses 26,200 172,100 Operating profit $ 139,800 $ (13,100) Profit percentage 43.7% (4.2%)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Alpha – Beta Example (7 of 7) As the manager suspected, Alpha Company was a highly profitable customer Its ordering and support activities placed few demands on the company’s marketing, selling, distribution, and administrative resources Almost all the gross margin earned by selling to Alpha dropped to the operating margin bottom line Beta Company was now seen to be the most unprofitable customer that the company had While the manager intuitively sensed that Alpha was a more profitable customer than Beta, he had no idea of the magnitude of the difference  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

ABC Customer Analysis The output from an ABC customer analysis is often portrayed as a whale curve A plot of cumulative profitability versus the number of customers Customers are ranked, on the horizontal axis from most profitable to least profitable (or most unprofitable)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Customer Profitability Cumulative sales follow the usual 20-80 rule 20% of the customers provide 80% of the sales A whale curve for cumulative profitability typically reveals: The most profitable 20% of customers generate between 150% and 300% of total profits The middle 70% of customers break even The least profitable 10% of customers lose 50% - 200% of total profits, leaving the company with its 100% of total profits It is not unusual for some of the largest customers to turn out being the most unprofitable The largest customers are either the company’s most profitable or its most unprofitable They are rarely in the middle  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Managing Customer Profitability (1 of 3) High-profit customers, such as Alpha, appear in the left section of the profitability whale curve These customers should be cherished and protected They could be vulnerable to competitive inroads The managers of a company serving them should be prepared to offer discounts, incentives, and special services to retain the loyalty of these valuable customers if a competitor threatens  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Managing Customer Profitability (2 of 3) The challenging customers, like Beta, appear on the right tail of the whale curve, dragging the company’s profitability down with their low margins and high cost-to-serve The high cost of serving such customers can be caused by their: Unpredictable order pattern Small order quantities for customized products Nonstandard logistics and delivery requirements Large demands on technical and sales personnel  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Managing Customer Profitability (3 of 3) The opportunities for a company to transform its unprofitable customers into profitable ones is perhaps the most powerful benefit the company’s managers can receive from an activity-based costing system Managers have a full range of actions for transforming unprofitable customers into profitable ones Process improvements Activity-based pricing Managing customer relationships  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Process Improvements Managers should first examine their internal operations to see where they can improve their own processes to lower the costs of serving customers If customers are migrating to smaller order sizes: Strive to reduce batch-related costs, such as setup and order handling Electronic systems greatly lower the cost of processing large quantities of small orders If customers prefer suppliers offering high variety Try to customize products at the latest possible stage Use information technology to enhance the linkages from design to manufacturing  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Activity-Based Pricing Pricing is the most powerful tool a company can use to transform unprofitable customers into profitable ones Activity-based pricing establishes a base price for producing and delivering a standard quantity for each standard product To this base price, the company provides a menu of options, with associated prices, for any special services requested by the customer Special services may be priced just to cover costs or also to earn a margin Activity-based pricing prices orders, not products  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Managing Relationships Companies can transform unprofitable customers into profitable ones by persuading the customer to use a greater scope of the company’s products and services The margins from such increased business purchases contribute to covering customer-sustaining costs If these efforts fail, the company may then contemplate “firing” the customer Some customers may be unprofitable only because it is the start of the relationship with the company Companies can afford to be more tolerant of newly-acquired unprofitable customers than they can of unprofitable customers they have served for 10 or more years  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University SOME CUSTOMERS MAY BE UNPROFITABLE ONLY BECAUSE IT IS THE START OF THE RELATIONSHIP WITH THE COMPANY. THE COMPANY MAY HAVE INCURRED HIGH COSTS TO ACQUIRE THE CUSTOMER AND THE CUSTOMER’S INITIAL PURCHASES OF PRODUCTS OR SERVICES WERE INSUFFICIENT TO COVER ITS ACQUISITION AND MAINTENANCE COSTS. NO ACTION IS REQUIRED AT THIS POINT. THE COMPANY EXPECTS AND HOPES THAT THE CUSTOMER’S PURCHASES OF PRODUCTS AND SERVICES WILL INCREASE AND SOON BECOME PROFITABLE, INCLUDING RECOVERING ANY LOSSES INCURRED IN THE START-UP YEARS. COMPANIES CAN AFFORD TO BE MORE TOLERANT OF NEWLY-ACQUIRED UNPROFITABLE CUSTOMERS THAN THEY CAN OF UNPROFITABLE CUSTOMERS THEY HAVE SERVED FOR 10 OR MORE YEARS.

ABC at Service Companies (1 of 2) Although ABC had its origins in manufacturing companies, many service organizations today are obtaining great benefits from this approach In practice, the actual construction of an ABC model is nearly identical for both types of companies This should not be surprising since, in manufacturing companies, the ABC system focuses on the “service” component of the company  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

ABC at Service Companies (2 of 2) Service companies in general are ideal candidates for activity-based costing Virtually all costs are indirect and appear fixed They often do not have direct, traceable costs to serve as convenient allocation bases They must supply virtually all their resources in advance to provide the capacity to perform work for customers during each period  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Implementation Issues (1 of 2) Not all ABC systems have been sustained or contributed to higher profitability for the company Some companies have experienced difficulties and frustrations in building and using activity-based cost and profitability models for some of the following reasons Lack of clear business purpose The project may start in Accounting/Finance, and nobody outside the department understands what changes need to be made and why Lack of senior management commitment The group (usually Accounting/Finance) that initiates the project probably does not have the authority to make decisions about processes, product designs, etc., without full senior management support  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Implementation Issues (2 of 2) Delegating the project to consultants Consultants are usually not familiar enough with the business’s organization and problems and may not be able to build management consensus Poor ABC model design The model may be too complicated to build and maintain and too complex for managers to understand and act upon Or the model may use arbitrary allocations that merely create different distortions than the old system The new data requirements may increase the workload of other functions without increasing the benefits to them Individual and organizational resistance to change People may feel threatened by the suggestion that their work might be improved Resistance may be overt, but it may be more subtle and passive  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Management Accounting Information for Activity and Process Decisions Chapter 5  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Evaluation of Financial Implications Managers must evaluate the financial implications of decisions that require trade-offs between the costs and the benefits of different alternatives Financial implications are important when considering decisions such as whether to: Redesign an entire production process or replace existing machines Purchase services such as custodial help or to simply hire in-house custodians Financial information about the different types of costs form the basis of decisions about the organization’s activities and processes  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Relevant Costs and Revenues Whether particular costs and revenues are relevant for decision making depends on the decision context and the alternatives available When choosing among different alternatives, managers should concentrate only on the costs and revenues that differ across the decision alternatives These are the relevant cost/revenues Opportunity costs by definition are relevant costs for any decision The costs that remain the same regardless of the alternative chosen are not relevant for the decision  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Sunk Costs are Not Relevant Sunk costs often cause confusion for decision makers Costs of resources that already have been committed and no current action or decision can change Not relevant to the evaluation of alternatives because they cannot be influenced by any alternative the manager chooses  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Replacement Of A Machine (1 of 2) A Company purchased a new drilling machine for $180,000 on September 1, 2003 They paid $30,000 in cash and financed the remaining $150,000 with a bank loan The loan requires a monthly payment of $5,200 for the next 36 months On September 27, 2003, a sales representative from another supplier of drilling machines approached the company with a newly designed machine that had only recently been introduced to the market and offered special financing arrangements The new supplier agreed to pay $50,000 for the old machine, which would serve as the down payment required for the new machine In addition, the new supplier would require monthly payments of $6,000 for the next 35 months  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Replacement Of A Machine (2 of 2) The new design relied on innovative computer chips, which would reduce the labor required to operate the machine The company estimated that direct labor costs would decrease by $4,400 per month on the average if it purchased the new machine In addition it had fewer moving parts than the current machine The new machine would decrease maintenance costs by $800 per month The new machine has greater reliability This would allow the company to reduce materials scrap cost by $1,000 per month Should the company dispose of the machine it just purchased on September 1 and buy the new machine?  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Analysis Of Relevant Costs (1 of 3) If the company buys the new machine, it will still be responsible for the monthly payments of $5,200 committed to on September 1 Therefore, the $30,000 that it paid in cash for the old machine and the $5,200 it is committed to pay each month for the next 36 months are sunk costs The company already has committed these resources, and regardless if it decides to buy the new machine, it cannot avoid any of these costs None of these sunk costs are relevant to the decision  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Analysis Of Relevant Costs (2 of 3) What costs are relevant? The 35 monthly payments of $6,000 and the down payment of $50,000 are relevant costs, because they depend on the decision Labor, materials, and machine maintenance costs will be affected if the company acquires the new machine The relevant expected monthly savings are: $4,400 in labor costs $1,000 in materials costs $ 800 in machine maintenance costs The revenue of $50,000 expected on the trade-in of the old machine is also relevant, because the old machine will be disposed of only if the company decides to acquire the new machine  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Analysis Of Relevant Costs (3 of 3) In a comparison of the cost increases/cash outflows to cost savings/cash inflows The down payment required for the new machine is matched by the expected trade-in value of the old machine The expected savings in labor, materials, and machine maintenance costs each month ($6,200) are more than the monthly lease payments for the new machine ($6,000) Thus, it is apparent that the company will be better off trading in the old machine and replacing it with the new machine  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Difficulty of Making Correct Decision The technically correct decision for the company on a level is to dispose of the machine and replace it Not all managers would do so: They are concerned about their reputations within their own organization Reversing a major decision made only just a month earlier makes the decision look like an error In many circumstances, by maintaining the original course of action, the manager does not have to reveal that a better decision could have been made  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Responsibility For Decisions (1 of 2) If the manager does not purchase the new machine, then his or her behavior may be viewed as suboptimal It ensures lower productivity or performance from the old machine rather than improved performance with the new one By not making the correct decision now, the manager may incur the effects of a bad decision later If the manager admits to making an error when purchasing the old machine, that person might garner more respect from colleagues for accepting the responsibility  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Responsibility For Decisions (2 of 2) Many decision makers have a difficult time distinguishing sunk cost business decisions from sunk cost personal decisions In contrast to business decisions, the associated costs of previous life decisions can evoke a complex set of personal feelings Unlike the case in the business decision, we do not end a friendship simply because a new friend materializes Thus, identifying what is relevant and disentangling personal responses when dealing with business decisions are critical tasks for any business decision maker  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Make-or-Buy Decisions (1 of 3) As managers attempt to reduce costs and increase the competitiveness of their products, they face decisions about whether their companies should Manufacture some parts and components for their products in-house Subcontract with another company to supply these parts and components Such make-or-buy decisions illustrate how to identify relevant costs and revenues  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Make-or-Buy Decisions (2 of 3) A company manufactures about 15% of the lamps required for its automobiles in its own plant in Ohio The company’s president would like to reduce costs and has asked the production manager to evaluate the possibility of outsourcing all the lamps The production manager obtains firm quotes from several suppliers for the four types of lamps the company manufactures in-house: Standard rear lamps Standard front lamps Multicolored rear lamps Curved side and rear lamps  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Make-or-Buy Decisions (3 of 3) Std. Rear Std. Front Multicolor Curved Product cost per unit: Direct materials $ 36 $ 49 $ 56 $ 58 Direct labor 22 25 24 28 Unit-related support 14 16 18 20 Batch-related support 10 19 Product-sustaining overhead 6 12 Facility-sustaining overhead 8 11 Total manufacturing costs $ 96 $ 128 $ 142 $ 161 Bids from outside suppliers: Lowest bid $ 82 $ 109 $ 140 $ 156 Second lowest $ 88 $ 116 $ 147 $ 164 Annual production (units) 36,000 48,500 6,800 8,700  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Avoidable Costs (1 of 3) Avoidable costs are those eliminated when a part, product, product line, or business segment is discontinued If the production manager decides to outsource a product, the company may avoid certain production costs (using the std. rear lamp as an example): $1,296,000 of direct material costs ($36 x 36,000) $792,000 of direct labor costs ($22 x 36,000) $504,000 of unit-related support costs ($14 x 36,000) Contraction or redeployment of resources may allow the company to save: $360,000 ($10 x 36,000) of batch-related support costs $216,000 ($6 x 36,000) of product-sustaining support costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Avoidable Costs (2 of 3) To decide whether facility-sustaining support costs are avoidable requires further consideration The company cannot dispose of part of the facility used to support the production of the standard rear lamp without disposing of the entire machine or building Most facility-sustaining support costs represent the prorated costs of indivisible common facilities Building space Machines  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Avoidable Costs (3 of 3) It could be possible to find an alternative use for the part of the facility made available by not producing a product The manager considered the possibility of shifting the remaining production lines to another facility The company could save the facility-sustaining costs for the rental facility by terminating its lease there Such indirect savings in facility-sustaining costs for the organization are relevant for the decision to outsource production, because they can arise only if the lamp is outsourced The manager determined that it would be technically infeasible to transfer the manufacture of the other product lines to another plant  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Summary of Financial Analysis To summarize the analysis so far, if the standard rear lamp is outsourced, the company may avoid $3,168,000 of manufacturing costs Assuming batch-related and product sustaining support costs may be avoided The company would spend $2,952,000 to purchase the parts from the low-bid supplier The company could save $216,000 by outsourcing  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Qualitative Factors For most decisions such as this, several additional factors, which are more qualitative in nature, need to be considered: Permanence of the lower price Reliability of the supplier: In meeting the required quality standards In making deliveries on time Many companies have adopted the practice of certifying a small set of suppliers who are dependable and consistent in supplying high-quality items as needed They provide their certified suppliers with incentives, such as quick payments and guaranteed total purchase volumes  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Facility Layout Systems (1 of 2) In addition to understanding the relevant costs for many decisions that change the nature of activities and processes, managers must consider the entire operations process within a facility There are three general types of facility designs: Process layouts Product layouts Cellular manufacturing Regardless of the type of facility design, a central goal of the design process is to streamline operations and thus increase the operating income of the system  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Facility Layout Systems (2 of 2) One method that can guide this process for all three designs is the theory of constraints (TOC) TOC maintains that operating income can be increased by carefully managing the bottlenecks in a process A bottleneck is any condition that impedes or constrains the efficient flow of a process A bottleneck can be identified by determining points at which excessive amounts of work-in-process inventories are accumulating The buildup of inventories also slows the cycle time of production  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Theory of Constraints (1 of 2) The theory of constraints relies on the use of three measures Throughput contribution Investments Operating costs Throughput contribution is the difference between revenues and direct materials for the quantity of product sold Investments equal the materials costs contained in raw materials, work-in-process, and finished goods inventories Operating costs are all other costs, except for direct materials costs, that are needed to obtain throughput contribution  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Theory of Constraints (2 of 2) TOC emphasizes the short-run optimization of throughput contribution Proponents of TOC view operating costs as difficult to alter in the short run Accordingly, ABC-type analyses of activities and cost drivers are not conducted This limits the usefulness of the theory for the longer run In theory, however, there is no reason why TOC and ABC cannot be used together  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Process Layouts In a process layout, all similar equipment or functions are grouped together Process layouts exist in organizations in which production of unique products is done in small batches The product follows a serpentine path, usually in batches, through the factories and offices that create it Process layouts are also characterized by high inventory levels It is necessary to store work-in-process in each area while it awaits the next operation Products might travel for several miles within a factory during the production process  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Process Layout in a Bank (1 of 2) As an example, the process associated with a bank loan application may occur as follows: The customer goes to the bank (a moving activity) The bank takes the loan application from the customer (processing activity) Loan applications are accumulated (storage activity) … and passed to a loan officer (moving activity) … for approval (both processing and inspection activity) Loans that violate standard loan guidelines are accumulated (storage activity) then … passed (moving activity) to a regional supervisor … for approval (processing activity)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Process Layout in a Bank (2 of 2) The customer is contacted when a decision has been made (processing activity) If the loan is approved, then the loan proceeds are deposited in the customer’s account (processing activity) In most banks, work-in-process stockpiles at each of the processing points or stations Loan applications may be piled on desk of: The bank teller The loan officer The regional supervisor  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

WIP Accumulation (1 of 3) Work-in-process inventory accumulates at processing stations in a conventional organization for three reasons Handling work in batches At each processing station all items in the batch must wait while the designated employees process the entire batch before moving that batch to the next station Organizations use batches, on the other hand, to reduce setting up, moving, and handling costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

WIP Accumulation (2 of 3) If the rate at which each processing area handles work is unbalanced, work piles up at the slowest processing station Occurs when one area is slower or has stopped working due to problems with equipment, materials, or people Scheduling delays result Inventory levels increase  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

WIP Accumulation (3 of 3) If processing area managers are evaluated on their ability to meet production quotas Many managers deliberately maintain large stocks of incoming work-in-process so that they can continue to work even if the processing area that feeds them is shut down To avoid idling the next processing station and suffering the resulting recriminations, managers may store finished work they can forward to supply stations further down the line when their stations are shut down due to problems  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Product Layouts In a product layout, equipment is organized to accommodate the production of a specific product Automobile assembly line Packaging line for cereal or milk Product layouts exist primarily in companies with high-volume production The product moves along an assembly line beside which the parts to be added to it have been stored Placement of equipment or processing units is made to reduce the distance that products must travel Arrangements for delivery of raw materials and purchased parts directly to the production line can often be made  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Product Layout in a Cafeteria (1 of 2) Consider the work-in-process in a cafeteria setting: People pass by containers of food and take what they want Employees organize the food preparation activities so that the containers are refilled just as they are being emptied The batch-related setup costs otherwise (one serving at a time) would be prohibitively expensive  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Product Layout in a Cafeteria (2 of 2) Reducing setup costs allows for the reduction of batch sizes along the line This reduces the level of inventory (and costs) in the system It also improves quality while increasing customer satisfaction The ultimate goal is to reduce setup costs to zero and to reduce processing time to as close to zero as possible, so that the system can produce and deliver individual products just as they are needed  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cellular Manufacturing (1 of 2) Cellular manufacturing, refers to the organization of a plant into a number of cells Within each cell all machines required to manufacture a group of similar products are arranged in close proximity to each other The machines in a cellular manufacturing layout are usually flexible and can be adjusted easily or even automatically to make different products  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cellular Manufacturing (2 of 2) The shape of a cell is often a U shape, which allows workers convenient access to required parts Often when cellular manufacturing is introduced, the number of employees needed to produce a product can be reduced due to the new work design The U shape also provides better visual control of the work flow because employees can observe more directly what their coworkers are doing  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Problems with Batch Production (1 of 2) It creates inventory costs It also creates delays associated with storing and moving inventory These delays increase cycle times, thereby reducing service to customers Delays may even happen before manufacturing begins:  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Problems with Batch Production (2 of 2) A manufacturer may require that a product be manufactured in some minimum batch size. If a customer order is less than the minimum batch size and if the order cannot be filled from existing finished goods inventory, then the customer must wait until enough orders have accumulated to meet the minimum batch size requirement A loan application (that may take a loan officer only five minutes to read and approve) may have to wait for hours or days before it reaches the loan officer, because having a clerk deliver each new loan application when it arrives is too expensive  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Inventory-Related Costs (1 of 2) Demands for inventory lead to huge costs in organizations, including the cost of: Moving Handling Storing Obsolescence or damage Many organizations have found that factory layouts and inefficiencies that create the need to hold work-in-process inventory hide other problems leading to excessive costs of rework  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Inventory-Related Costs (2 of 2) In batch operations, workers near the end of a process (downstream) often find batch-size problems resulting from the way workers have done their jobs earlier in the process (upstream) When work is performed continuously on one component at a time, however, workers downstream can identify an upstream problem in that component almost immediately and correct it before it leads to production of more defective components  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost of Nonconformance and Quality Issues Cost reduction has become a significant factor in the management of most organizations Reducing costs involves much more than simply finding ways to cut product design costs For example, by using less expensive materials The premise underlying cost reduction efforts today is to decrease costs while maintaining or improving product quality in order to be competitive If the quality of products and services does not conform to quality standards, then the organization incurs a cost known as the cost of nonconformance (CONC) to quality standards  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Quality Quality usually may be viewed as hinging on two major factors: Satisfying customer expectations regarding the attributes and performance of the product E.g., its functionality and features Ensuring that the technical aspects of the product’s design and performance conform to the manufacturer’s standards Whether it performs to the expected standard  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Quality Standards Global competition has led to the development of international quality standards Company certification under these standards indicates to customers that management has committed their company to follow procedures and processes that will ensure the production of the highest-quality goods and services ISO9000:2000 Series of Standards, developed in Europe, is one widely-recognized quality standard certification  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

ISO9000 (1 of 6) In 1987, the International Organization for Standardization (ISO), headquartered in Geneva, Switzerland, developed the first ISO9000 Series of Standards These standards were revised in 1994 and again in 2000 The goal of the member nations is to develop globally recognized independent (third party) quality system verification Today, over 400,000 organizations have been certified worldwide Many types of organizations are interested in becoming IOS9000 registered in order to: Comply with external regulatory agencies, Meet or exceed customer requirements, or Implement a quality improvement program to remain competitive  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

ISO9000 (2 of 6) ISO 9000 contains more than 20 standards and documents Because of the increase in the number of standards, ISO 9000:2000 was developed ISO 9000:2000 consists of four primary standards and a greatly reduced number of supporting documents (guidance standards, brochures, technical reports, technical specifications) The major points in previous versions of the standards were integrated into the four primary standards  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

ISO9000 (3 of 6) The four primary standards are: ISO 9000: Quality management systems – Fundamentals and vocabulary ISO 9001: Quality management systems – Requirements ISO 9004: Quality management systems –  Guidance for performance improvement ISO 19011: Guidelines on quality and/or environmental management systems auditing (To be published)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

ISO9000 (4 of 6) The most significant changes in the revised ISO 9000 standards are: Increased focus on top management commitment Emphasis on a process approach within the organization Continual improvement Increased focus on enhancing satisfaction for customers and other interested parties  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

ISO9000 (5 of 6) The overall revisions to ISO 9001 and 9004 are based on eight quality management principles from best management practices: Customer focus Leadership Involvement of people Process approach System approach to management Continual improvement Factual approach to decision making Mutually beneficial supplier relationships  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

ISO9000 (6 of 6) The ISO 9000:2000 Standards apply to all kinds of organizations in all kinds of areas: Oil and gas Petrochemicals Publishing Shipping Telecommunications Health care Hospitality Utilities Aviation Food processing Agriculture Government Education Recreation Manufacturing Forestry Electronics Computing Legal services Financial services Accounting Trucking Banking Retailing Drilling Recycling Aerospace Construction Pharmaceuticals Sanitation Software development Consumer products Transportation Design Tourism Communications Biotechnology Engineering Farming Entertainment Consulting Insurance and others More information can be obtained from the International Organization for Standardization (www.iso.org)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Costs Of Quality Control Companies have discovered that they can spend as much as 20% to 30% of total manufacturing costs on quality-related processes The best-known framework for understanding quality costs classifies them into four categories: Prevention costs Appraisal costs Internal failure costs External failure costs Experience shows that it is much less expensive to prevent defects than to detect and repair them after they have occurred  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Prevention Costs Prevention costs are incurred to ensure that companies produce products according to quality standards: Quality engineering Training employees in methods designed to maintain quality Statistical process control Training and certifying suppliers so that they can deliver defect-free parts and materials and better, more robust, product designs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Appraisal Costs Appraisal costs relate to inspecting products to make sure they meet both internal and external customers’ requirements Inspection costs of purchased parts and materials Costs of quality inspection on an assembly line Inspection of incoming materials Maintenance of test equipment Process control monitoring  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Internal Failure Costs An internal failure occurs when the manufacturing process detects a defective component or product before it is shipped to an external customer Reworking defective components or products is a significant cost of internal failures The cost of downtime in production is another example of internal failure Engineers have estimated that the cost of defects rises by an order of magnitude for each stage of the manufacturing process that the defect goes undetected Inserting a defective $1 electronic component into a subassembly leads to $10 of scrap if detected at the first stage, $100 at the next stage, and perhaps $10,000 if not detected for two more stages of assembly  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

External Failure Costs External failures occur when customers discover a defect All costs associated with correcting the problem Repair of the product Warranty costs Service calls Product liability recalls For many companies, this is the most critical quality cost to avoid Not only are costs required to fix the problem in the short run, but also customer satisfaction, future sales, and the reputation of the manufacturing organization may be in jeopardy over the long run  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost-of-Quality Report (1 of 2) This information is compiled in a cost-of-quality (COQ) report, developed for several reasons It illustrates the financial magnitude of quality factors Often managers are unaware of the enormous impact that rework has on their costs Cost-of-quality information helps managers set priorities for the quality issues and problems they should address For example, one trend that managers do not want to see is a very high percentage of quality costs coming from external failure of a product External quality problems are expensive to fix and can greatly harm the reputation of the product or organization producing the product  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost-of-Quality Report (2 of 2) The cost of quality report allows managers to see the big picture of quality issues It allows them to try to find the root causes of their quality problems The problem at its root will have positive ripple effects throughout the organization, as so many quality issues are interrelated  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Just-in-Time Manufacturing Just-in-time (JIT) manufacturing is a comprehensive and effective manufacturing system that integrates many of the ideas discussed in this chapter Just-in-time production requires making a product or service only when the customer, internal or external, requires it It uses a product layout with a continuous flow No delays once production starts There must be a substantial reduction in setup costs in order to eliminate the need to produce in batches Processing systems must be reliable  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Implications Of JIT Manufacturing (1 of 6) Just-in-time manufacturing is simple in theory but hard to achieve in practice Some organizations hesitate to implement JIT With no work-in-process inventory a problem anywhere in the system can stop all production Organizations that use just-in-time manufacturing must eliminate all sources of failure in the system The production process must be redesigned so that it is not prohibitively expensive to process one or a small number of items at a time This usually means reducing the distance over which work in process has to travel and using very adaptable people and equipment that can handle all types of jobs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Implications Of JIT Manufacturing (2 of 6) At the core of the JIT process is a highly trained workforce whose task is to carry out activities using the highest standards of quality When an employee discovers a problem with a component he or she has received, it is the responsibility of that employee to call immediate attention to the problem so that it can be corrected Suppliers must be able to produce and deliver defect-free materials or components just when they are required In many instances, companies hold a competition between suppliers of the same components to see who can deliver the best quality At the end of a performance period, the supplier who performs the best will obtain a long-term contract Preventative maintenance is also employed so that equipment failure is a rare event  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Implications Of JIT Manufacturing (3 of 6) Just-in-time manufacturing has two major implications for management accounting First, management accounting must support the move to JIT manufacturing by monitoring, identifying, and communicating to decision makers the sources of delay, error, and waste in the system Second, the clerical process of management accounting is simplified by JIT manufacturing, due to the smaller inventory to monitor and report  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Implications Of JIT Manufacturing (4 of 6) Important measures of a JIT system’s reliability include the following benchmarks of manufacturing cycle effectiveness Defect rates Cycle times Percent of time that deliveries are on time Order accuracy Actual production as a percent of planned production Actual machine time available compared with planned machine time available Conventional labor and machine productivity ratios are inconsistent with the just-in-time production philosophy  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Implications Of JIT Manufacturing (5 of 6) Just-in-time manufacturing has been a benefit to many organizations Those interested in implementing this system need to remember several things: Any significant management innovation, such as ABC or JIT, requires a major cultural change for an organization JIT also can alter the pace of work and the overall work discipline of the organization It can cause structural changes in such areas as the arrangement of shop floors  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Implications Of JIT Manufacturing (6 of 6) Because the central ideas behind JIT are the streamlining of operations and the reduction of waste, many people inside companies are ill-prepared for the change Because JIT relies on teamwork, often individuals have to subordinate their own interests to those of the team Some employees find this difficult, especially if they have come from a work environment where they worked on a single component in relative isolation, or if their personalities are not team oriented  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Information for Pricing and Product Planning Chapter 6  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Role Of Product Costs In Pricing And Product Mix Decisions Understanding how to analyze product costs is important for making pricing decisions: At most firms whose managers make decisions about establishing or accepting a price for their products, managers need to make decisions about, for example, whether they should offer discounts for large orders or to valued customers Even when prices are set by overall market supply and demand forces and the firm has little or no influence on product prices, management still has to decide the best mix of products to manufacture and sell  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Role of Product Costs Product cost analysis is also significant when a firm is deciding how best to deploy marketing and promotion resources How much commission (or how many other incentives) to provide the sales force for different products How large a discount to offer off list prices This chapter examines some of the more traditional methods of pricing and considers short- and long-run factors  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Short-term and Long-term Pricing Considerations (1 of 3) Managers must consider both the short-term and long-term consequences of their decisions The costs of many resources committed to activities are likely to be committed costs in the short-term because firms cannot easily alter the capacities made available for many production and support activities So for short-term decisions, it is important to pay special attention to whether surplus capacity is available for additional production, or whether shortages of available capacity limit additional production alternatives  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Short-term and Long-term Pricing Considerations (2 of 3) Of special concern when evaluating a particular order is how long a firm must commit its production capacity to fill that order The length of time is relevant because a long-term capacity commitment to a marginally profitable order may: Prevent the firm from deploying its capacity for more profitable products or orders, should demand for them arise in the future Force the firm to add expensive new capacity to handle future sales increases  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Short-term and Long-term Pricing Considerations (3 of 3) If production is constrained by inadequate capacity, managers need to consider whether overtime production or the use of subcontractors can help augment capacity in the short term In the long term, managers have considerably more flexibility to adjust the capacities of activity resources to match the demand for them in producing various products Decisions about whether to introduce new products or eliminate existing products have long-term consequences The emphasis is, therefore, on analyzing how such product decisions will affect the demand placed on the firms capacity resources  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Ability To Influence Prices (1 of 2) We also classify decisions based on whether the firm can influence the price of its products If the firm is one of a large number of firms in an industry, and if there is little to distinguish the products of different firms from each other: Economic theory states that prices will be set by the aggregate market forces of supply and demand No single firm can influence prices significantly by its own decisions The result will be similar if prices are set by one or more large firms leading an industry, while a smaller firm on the fringe must match the prices set by the industry leaders Such a firm is a price taker, and it chooses its product mix given the prices set in the marketplace for its products  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Ability To Influence Prices (2 of 2) In contrast, firms in an industry with relatively little competition, who enjoy large market shares and exercise leadership in an industry, must decide what prices to set for their products Firms in industries in which products are highly customized or otherwise differentiated from each other (because of special features, characteristics, or customer service) also need to set the prices for their differentiated products Such firms are price setters; they announce their prices, customers place orders, and production follows  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Price Takers A small firm, or a firm with a negligible market share in this industry, behaves as a price taker It takes the industry prices for its products as given and then decides how many units of each product it should produce and sell If the small firm demands a higher price for any of its products, it risks losing its customers to other competing firms in the industry, unless it can successfully differentiate its products by offering special features or services Conversely, if the small firm seeks to increase its market share by asking a price lower than the industry prices, then it risks a price war that would make the firm, and the entire industry, worse off than if the firm had complied with industry prices This action is most painful to smaller firms that have fewer resources to rely on should an unprofitable price war occur  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Short-Term Decisions for Price Takers A price taker should produce and sell as much as it can of all products whose costs are less than industry prices Although this may appear to be a simple decision rule, two important considerations complicate matters First, managers must decide which costs are relevant to the short-term product mix decision Should all the product costs identified in Chapter 3 be considered? Should only those costs that vary in the short term be considered? Second, in the short-term, managers may have little flexibility to alter the capacities of some of the firm’s resources The available equipment capacity may limit the ability of a firm to produce and sell more products whose costs are lower than their prices  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Garment Manufacturer (1 of 3) Consider a company that sells five types of ready-made garments to discount stores such as Kmart and Wal-Mart The company is operating at full capacity and is contemplating short-term adjustments to its product mix It is necessary for the company to determine: What costs will vary with production levels in this period What costs will remain fixed when a change occurs in the production mix The costs of utilities, plant administration, maintenance, and depreciation for the machinery and plant facility will not alter with a change in the product mix, because the plant is operating at full capacity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Garment Manufacturer (2 of 3) Varying with the quantity of each garment produced are: The costs of direct materials The direct labor that is paid on a piece-rate basis Inspectors are paid a monthly fixed salary, but they are employed as required to support the production of different garments If production increases, the company may have to hire more inspectors Therefore, inspection labor costs also vary with quantity of production of different garments  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Garment Manufacturer (3 of 3) If its capacity were unlimited, the company could produce garments to fill the maximum demand for them Capacity is constrained, however, and therefore the company must decide how best to deploy this limited resource The capacity is fixed in the short-term, so the company must plan production to maximize the contribution to profit earned for every available machine hour used Therefore, the company should rank-order the products by their contribution per machine hour Not by their contribution per unit Contribution per machine hour is obtained by dividing the contribution per unit by the number of machine hours per unit  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Impact Of Opportunity Costs (1 of 2) If the garment manufacturer receives a special order request, it would have to decide the minimum price it would accept Its out-of-pocket costs will increase in the short-term by the amount of flexible costs required for the order, but a simple comparison of the price with flexible costs is not adequate for this decision Because its production capacity is limited, the company must cut back the production of some other garment to enable it to produce the goods for the special order Giving up the production of some profitable product results in an opportunity cost, which equals the lost profit on the garments that the company can no longer make  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Impact Of Opportunity Costs (2 of 2) The lost profit in this case would be the contribution on the goods it will not make In deciding which products to take off of the production schedule, the company should once again look at the contribution per machine hour The product with the lowest contribution per hour should be sacrificed The profit (contribution) lost on those products would need to be covered by the price of the special order  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Short-Term Pricing Decisions for Price Setters In many businesses, potential customers request that suppliers bid a price for an order before they decide on the supplier with whom they will place the order In this section, we examine the relationship between costs and prices bid by a supplier for special orders that do not involve long-term relationships with the customer For example, we will use a tool and die company that manufactures customized steel tools and dies for a wide variety of manufacturing businesses A new customer has asked for a bid on a set of customized tools  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Determining a Bid Price (1 of 3) Based on the tool design, production engineers determine the routing through different production departments and estimate the quantity of different materials required for the order and the number of labor hours required in each department This information is used to prepare a job bid sheet as described in Chapter 3 Then the company uses this information, and materials prices and labor wage rates, to estimate the direct materials and direct labor costs Support activity costs are assigned to the job based on activity cost drivers and the corresponding activity cost driver rates as described in Chapter 4  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Determining a Bid Price (2 of 3) Assume that the full costs for the job are estimated to be $28,500 consisting of: $ 8,400 of direct materials $ 9,900 of direct labor $10,200 of support activity costs, consisting of: $ 3,400 of Supervision $ 3,700 of batch related expenses $ 3,100 of business sustaining expenses Setting the price of a product also means determining a markup percentage above cost, an approach known as cost-plus pricing The markup percentage is determined by a company’s desired profit margin and overall rate of return The company has decided the markup percentage is normally to be 40% of full costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Determining a Bid Price (3 of 3) If the bid request came from a regular customer, the bid price would have been $39,900 1.40 x $28,500 But for this special order from a new customer, what is the minimum acceptable price? One of the critical factors to consider is the level of available capacity The example looks at two cases: There is surplus machine capacity available in the short term to complete the production of the job Existing demand for the company’s services already uses all available capacity and the only way to manufacture the customized tools for the special order is by working overtime or adding an extra shift  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Available Surplus Capacity The company’s incremental costs of filling the order will be $ 22,000 (material, direct labor, batch related expenses) The costs of supervision and business-sustaining support activities will not increase if excess capacity of these resources is available to meet the production needs of the order The price that the company should bid must cover the incremental costs for the job to be profitable In other words, the minimum acceptable price is $22,000 since surplus production capacity is available This is the price at which the company will break even on the order The company would likely add a profit margin above incremental costs and make the bid price something higher than $22,000, depending on competitive and demand conditions  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

No Available Surplus Capacity (1 of 3) If surplus machine capacity is not available, the company will have to incur additional costs to acquire the needed capacity Companies often meet such short-term capacity requirements by operating its plant overtime Paying its supervisors overtime wages Incurring additional expenditures for heating, lighting, cleaning, and security More machine maintenance and plant engineering activities will be necessary Experience has shown that the incidence of machine breakdowns increases during the overtime shift  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

No Available Surplus Capacity (2 of 3) Under its machinery leasing contract, the company also incurs additional rental costs for the extra use of machines when it adds an overtime shift Assume management estimates the order would cause: $5,100 of incremental supervision costs (including overtime premium) $5,400 of incremental business-sustaining costs Thus, the total cost of overtime required to manufacture customized tools for the order is $10,500 ($5100 + $5400)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

No Available Surplus Capacity (3 of 3) Therefore, the minimum acceptable price in this case is $32,500 ($22,000 + $10,500) The actual price will depend on the amount of markup charged over the incremental costs The principle illustrated here is the same as that described in the previous case: the minimum acceptable price must cover all incremental costs When the firm must acquire additional capacity to satisfy the order, there are more incremental costs involved in the decision to accept or reject the order  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Long-Term Pricing Decisions for Price Setters You may have noticed that the relevant costs for the short-term special order pricing decision differ from the full costs of the job Most firms rely on full-cost information reports when setting prices Typically, the accounting department provides cost reports to the marketing department, which then adds appropriate markups to the costs to determine benchmark or target prices for all products normally sold by the firm  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Use of Full Costs in Pricing (1 of 3) There is economic justification for using full costs for pricing decisions in three types of circumstances: Many contracts for the development and production of customized products and many contracts with governmental agencies specify that prices should equal full costs plus a markup, and prices set in regulated industries are based on full costs When a firm enters into a long-term contractual relationship with a customer to supply a product, it has great flexibility in adjusting the level of commitment for all resources  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Use of Full Costs in Pricing (2 of 3) Most activity costs will depend on the production decisions under the long-term contract, and full costs are relevant for the long-term pricing decision In many industries, firms make short-term adjustments in prices, often by offering discounts from list prices instead of rigidly employing a fixed price based on full costs When demand for their products is low, the firms recognize the greater likelihood of surplus capacity in the short term  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Use of Full Costs in Pricing (3 of 3) They adjust the prices of their products downward to acquire additional business based on the lower incremental costs they incur when surplus capacity is available When demand for their products is high, they recognize the greater likelihood that the existing capacity of activity resources is inadequate to satisfy all of the demand They adjust the prices upward based on the higher incremental costs they incur when capacity is fully utilize, thereby rationing the available capacity to the highest profit opportunity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Fluctuating Prices (1 of 2) Because demand conditions fluctuate over time, prices also fluctuate with demand conditions over time Most hotels offer special weekend rates that are considerably lower than their weekday rates Many amusement parks offer lower prices on weekdays when demand is expected to be low Airfares between New York and London are higher in summer, when the demand is higher, than in winter, when the demand is lower Long-distance telephone rates are lower in the evenings and on the weekends when the demand is lower  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Fluctuating Prices (2 of 2) Although fluctuating short-term prices are based on the appropriate incremental costs, over the long term their average tends to equal the price based on the full costs that will be recovered in a long-term contract In other words, the price determined by adding on a markup to the full costs of a product serves as a benchmark or target price from which the firm can adjust prices up or down depending on demand conditions Most firms use full cost-based prices as target prices, giving sales managers limited authority to modify prices as required by the prevailing competitive conditions  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Markup Rate (1 of 2) Just as prices depend on demand conditions, markups increase with the strength of demand If more customers demand more of a product, then the firm is able to command a higher markup Markups also depend on the elasticity of demand Demand is said to be elastic if customers are very sensitive to the price, that is, if a small increase in the price results in a large decrease in the demand Markups are smaller when demand is more elastic Markups also fluctuate with the intensity of competition If competition is intense, it is more difficult for a firm to sustain a price much higher than its incremental costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Markup Rate (2 of 2) Firms decide on markups for strategic reasons: A firm may choose a low markup for a new product to penetrate the market and win over market share from an established product of a competing firm Many internet businesses have adopted the strategy of setting low prices to build the business, acquire a brand name, build a loyal customer base, and garner market share In contrast to this penetration pricing strategy, firms sometimes employ a skimming price strategy, as in the audio and video equipment industry, where initially a higher price is charged to customers who are willing to pay more for the privilege of possessing the latest technological innovations  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Long-Term Decisions for Price Takers Decisions to add a new product or to drop an existing product from the portfolio of products usually have significant long-term implications for a firm’s cost structure Product-sustaining costs are relevant costs for such decisions Product design and engineering, vendor and purchasing costs, part maintenance, and dedicated sales force costs Batch-related costs are also likely to alter if a change occurs in the product mix either in favor of or against products manufactured in large batches Setups, materials handling, and first-item inspections  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Use of Full Costs (1 of 3) Bear in mind that managers cannot easily change the amount of resources committed for many product-sustaining and several batch-related activities in the short run The cost consequences of either introducing a new product or deleting an existing product evolve over time Both decisions require careful implementation plans stretching over several periods  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Use of Full Costs (2 of 3) As a result, managers use the full costs of products, including the cost of using various resources to produce and sustain the product Such resources include the number of setup staff, the number of product and process engineers, and the number of quality inspectors Managers use the costs of all resources in their product-related decisions, because in the long-term, the firm is able to adjust the capacity of activity resources to match the resource levels demanded by the product quantities and mix  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Use of Full Costs (3 of 3) Comparing product costs with their market prices reveals which products are not profitable in the long-term Over the long-term, firms can adjust activity resource capacities to match production requirements If some products have full costs that exceed the market price, the firm must consider several options Although dropping these products appears is to be an obvious option, customers may expect the company to maintain a full product line But a comparison of the prices with costs still provides a valuable signal to managers because it indicates the net cost of the strategy to offer a full product line  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Options if Full Cost > Price (1 of 2) Managers may consider options other than dropping the product Reengineering or redesigning unprofitable products, to eliminate or reduce costly activities and bring their costs in line with market prices For example, they could improve the production processes to reduce setup times and streamline material and product flows They may want to explore market conditions more carefully and differentiate their products further to raise prices and bring them in line with the costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Options if Full Cost > Price (2 of 2) Firms may offer customers incentives, such as quantity discounts, to increase order sizes and thereby reduce total batch-related costs If these steps fail, and if the marketing strategy of offering such a full product line cannot justify the high net cost of such products, then managers must consider a plan to phase out the products from their line Customers also need to be shifted to substitute products still retained in the company’s product line  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Profit Increase is Not Automatic Dropping products will help improve profitability only if the managers: Eliminate the activity resources no longer required to support the discontinued product, or Redeploy the resources from the eliminated products to produce more of the profitable products that the firm continues to offer Costs result from commitments to supply activity resources They do not disappear automatically with the dropping of unprofitable products Only when companies eliminate or redeploy the resources themselves will actual expenses decrease  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Summary Managers use cost information to assist them in pricing and in product mix decisions The manner in which they use cost information in making these decisions depend on whether the firm is a major or minor entity in its industry A major entity would be able to influence the setting of prices A minor entity would take the industry prices as given and adjust its product mix in response to the prices it could charge The role of cost information also depends on the time frame involved in the decision Business-sustaining costs are frequently relevant for long-term decisions, but less often for short-term decisions Short-term prices are based on incremental costs that depend on the availability of activity resource capacity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Economic Analysis of the Pricing Decision Appendix 6-1  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Quantity Decision (1 of 2) Introductory textbooks in economics usually analyze the profit maximization decision by a firm in terms of the choice of a quantity to produce. In turn, the quantity choice determines the price of the product in the marketplace Economists present the quantity choice in terms of equating marginal revenue and marginal cost Marginal revenue is defined as the increase in revenue corresponding to a unit increase in the quantity produced and sold Marginal cost is the increase in cost for a unit increase in the quantity produced and sold If marginal revenue is greater than marginal cost, then increasing the quantity by one unit will increase profit If marginal revenue is less than the marginal cost, then it is possible to increase profit by decreasing production  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Quantity Decision (2 of 2) In this analysis, the firm chooses the quantity level, and the market demand conditions determine the corresponding price Considered next a firm that must choose a price, not a quantity, to announce to its customers Customers then react to the price announced and determine the quantity that they demand The price decision analysis uses differential calculus to analyze the firm’s pricing decision  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Pricing Decision (1 of 3) Total costs, C, expressed in terms of its fixed and flexible cost components are: C = f + vQ, Where f is the committed cost, v is the flexible cost per unit, and Q is the quantity produced in units Quantity produced is assumed to be the same as quantity demanded The demand, Q, is represented as a decreasing linear function of the price P: Q = a – bP In general, we may have nonlinear demand functions, but the linear form provides a convenient characterization for our analysis A higher value of b represents a demand function that is more sensitive (elastic) to price  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Pricing Decision (2 of 3) An increase of a dollar in the price decreases demand by b units A higher value of a reflects a greater strength of demand for the firm’s product. For any given price, P, the demand is greater when the parameter, a, has a higher value The total revenue, R, is given by the price, P, multiplied by the quantity sold, Q. Algebraically, we write this: R = PQ = P(a – bP) = aP – bP2 The profit, Π, is measured as the difference between the revenue, R, and the cost, C:  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Pricing Decision (3 of 3) = PQ - (f + vQ) = P(a - bP) - F - v(a - bP) Π = R - C = PQ - (f + vQ) = P(a - bP) - F - v(a - bP) = aP - bP2 - F - va + vbP To find the profit-maximizing price, P*, we set the first derivative of profit P with respect to P equal to zero: dΠ /dP = A – 2bP + vb = 0 This equation implies: P* = (a + vb)/2b = a/2b + v/2  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Long-Term Benchmark Prices (1 of 2) This simple economic analysis suggests that the price depends only on v, the flexible cost per unit Committed costs are not relevant for the pricing decision A more complex analysis that considers simultaneously the pricing decision and the long-term decisions of the firm to commit resources to facility-sustaining, product-sustaining, and other activity capacities indicates that the costs of these committed resources do play a role in the pricing decision The costs of these committed activity resources appear to be committed costs in the short-term, but they can be changed in the long-term  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Long-Term Benchmark Prices (2 of 2) The prices that a firm sets and adjusts in the short term, based on changing demand conditions, fluctuate around a long-term benchmark price, pL, that reflects the unit costs of the activity resource capacities: pL = a/2b + (v + m)/2 Here m = f ÷ X is the cost per unit of normal capacity, X, of facility-sustaining activities In this case, the degree of price fluctuations around the benchmark price increases with the proportion of committed costs As a result, prices appear more volatile in capital-intensive industries where a large proportion of costs are for facility-sustaining activities E.g., airlines, hotels, and petroleum refining  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Competitive Analysis (1 of 3) In a situation when other firms compete in the same industry with products that are similar but not identical to each other, some customers may switch their demand to a competing supplier if the competitor reduces its price Therefore, a firm’s pricing decision must consider the prices that may be set by its competitors Consider two firms, A and B, and represent the demand, QA, for firm A’s product as a function of its own price, PA, and the price, PB, set by its competitor: QA = a – b PA + e PB The demand for firm A’s product falls by b units for each dollar increase in its own price, but increases by e units for each dollar increase in the competitor’s price, because firm A gains some of the market demand that firm B loses  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Competitive Analysis (2 of 3) The profit, PA, for firm A is represented by the following: Π A = PA QA - (f + v QA) Π PA(a - b PA + e PB) - f - v(a - b PA + e PB) Profit maximization requires this: d π A ÷ d PA = a - 2b PA + e PB + vb = 0 Therefore, the profit-maximizing price PA0 given the other firm’s price PB is: PA0 = (a + vb + e PB) ÷ 2b The pricing decision thus depends on what the competitor’s price is expected to be  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Competitive Analysis (3 of 3) If the firm expects its competitor to behave as it does and expects it to choose the same price as its own, then we set PA = PB = P* in the equation a - 2b PA 1 + e PB + vb = 0 to obtain: a - 2bP* + eP* + vb = 0 P* = a + vb/2b - e We refer to this price as the equilibrium price, because no firm can increase its profits by choosing a different price provided the other firm maintains the same price P* This analysis is based on a concept called Nash equilibrium, for which its discoverer, John Nash, won the 1994 Nobel Prize in economics.  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Management Accounting and Control Systems: Assessing Performance over the Value Chain Chapter 7  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Management Accounting and Control System Generates and uses information to help decision makers assess whether an organization is achieving its objectives A cost management system is one of the central performance measurement systems at the core of a larger entity known as a management accounting and control system  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

“Control” In Management Accounting And Control A set of: Procedures Tools Performance measures Systems Used by organizations to guide and motivate employees to achieve organizational objectives  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

In Control A system is in control if it is on the path to achieving its strategic objectives It is deemed out of control otherwise For the process of control to have meaning and credibility, the organization must have the knowledge and ability to correct situations that it identifies as out of control  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Five Stages Of Control (1 of 2) Planning Developing an organization’s objectives Choosing activities to accomplish the objectives Selecting measures to determine how well the objectives were met Execution Implementing the plan  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Five Stages Of Control (2 of 2) Monitoring The process of measuring the system’s current level of performance Evaluation When feedback about the system’s current level of performance is compared to the planned level so that any discrepancies can be identified and corrective action prescribed Correcting Taking the appropriate actions to return the system to a state of in control  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

A Well-Designed MACS Designers of management accounting and control systems (MACS) have both behavioral and technical considerations to meet Behavioral aspects covered in a later chapter The technical considerations fall into two categories Relevance of the information generated Scope of the system  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Characteristics of Relevant Information (1 of 2) Accurate Inaccurate information is not useful for decision making because it is misleading Timely Accurate information that is available too late is of no use for decision making The MACS must be designed so that the results of performance measurement are fed back to the appropriate units in the most expedient way possible  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Relevant Information (2 of 2) Consistent The language used and the technical methods of producing management accounting information do not conflict within various parts of an organization Flexible MACS designers must allow employees to use the system’s available information in a flexible manner so they can customize its application for local decisions If flexibility is not possible, an employee’s motivation to make the best decision may be lessened for the decision at hand, especially if different units engage in different types of activities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Scope Of The System Must be comprehensive and include all activities across the entire value chain of the organization If the MACS measures and assesses performance in only the actual production process, it ignores the performance of: Suppliers Design activities Postproduction activities associated with products Without a comprehensive set of information, managers can only make limited decisions  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Value Chain (1 of 2) A sequence of activities that should contribute more to the ultimate value of the product than to its cost All products flow through the value chain: Begins with research, development, and engineering Moves through manufacturing Continues on to customers Customers may require service and will either consume the product dispose of it after it has served its intended purpose  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Value Chain (2 of 2) The value chain may be divided into cycles, which correspond to different cost control approaches Research, Development & Engineering Cycle Manufacturing Cycle Post-Sale Service and Disposal Cycle Target Costing & Value Engineering Total-Life-Cycle Costing Environmental Costing Benchmarking Kaizen Costing  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Total-Life-Cycle Costing (1 of 4) Total-life-cycle costing (TLCC) is the name of the process of managing all costs along the value chain TLCC is also known as managing costs “from the cradle to the grave”  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Total-Life-Cycle Costing (2 of 4) A TLCC system provides information for managers to understand and manage costs through a product’s stages of: Design Development Manufacturing Marketing Distribution Maintenance Service Disposal  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Total-Life-Cycle Costing (3 of 4) Deciding how to allocate resources over the life cycle usually is an iterative process Initially a company may decide to spend more on design to reduce the costs of upstream costs, such as manufacturing, and service-related costs At a later time, the company may determine how to reduce those initial design costs of new products Opportunity costs play a heightened role in a total-life-cycle cost perspective It is possible to develop only a limited number of products over a particular time period  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Total-Life-Cycle Costing (4 of 4) Numerous life-cycle concepts have emerged in various functional areas of business A TLCC perspective integrates the concepts so that they can be understood in their entirety From the manufacturer’s perspective, total-life-cycle product costing integrates these functional life-cycle concepts: Research, development, and engineering Manufacturing Post-sale service and disposal  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Research, Development, And Engineering (RD&E) Cycle The RD&E Cycle has three stages: Market research Emerging customer needs are assessed and ideas are generated for new products Product design Scientists and engineers develop the technical aspects of products Product development The company creates features critical to customer satisfaction and designs prototypes, production processes, and any special tooling required  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Control in the RD&E Cycle By some estimates, 80% to 85% of a product’s total life costs are committed by decisions made in the RD&E cycle Committed costs are those that a company knows it will have to incur at a future date Decisions made in this cycle are critical An additional dollar spent on activities that occur during this cycle can save at least $8 to $10 on manufacturing and post-manufacturing activities: Design changes Service costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Manufacturing Cycle After the RD&E cycle, the company begins the manufacturing cycle Costs are incurred in the production of the product This is where product costing traditionally plays its biggest role Usually at this stage there is not as much room for engineering flexibility to influence product costs and product design because they have been set in the previous cycle  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Control in the Manufacturing Cycle Operations management methods help to reduce manufacturing life-cycle product costs Facilities layout Just-in-time manufacturing Companies have begun to use management accounting methods such as activity-based cost management to identify and reduce non-value-added activities in an effort to reduce costs in the manufacturing cycle  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Post-sale Service & Disposal Cycle This cycle overlaps the manufacturing cycle The service cycle begins once the first unit of a product is in the hands of the customer Disposal occurs at the end of a product’s life and lasts until the customer retires the final unit of a product The costs for service and disposal are committed in the RD&E stage  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Service Cycle The service cycle typically consists of three stages: Rapid growth From the first time the product is shipped to the growth stage of its sales Transition From the peak of sales to the peak in the service cycle Maturity From the peak in the service cycle to the time of the last shipment made to a customer  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Disposal Cycle Disposal occurs at the end of a product’s life and lasts until the customer retires the final unit of a product Disposal costs often include those associated with eliminating any harmful effects associated with the end of a product’s useful life Products whose disposal could involve harmful effects to the environment, such as nuclear waste or toxic chemicals, often incur very high costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Life-Cycle Costs The following table illustrates four types of products and the percentage of life-cycle costs incurred in each cycle Combat Jets Commercial Aircraft Nuclear Missiles Computer Software RD&E Manufacturing Service & Disposal Average Years in Life Cycle 21% 45% 34% 30 20% 40% 25 60% 2 to 25 75%* * 25% 5 * For computer software, RD&E and manufacturing are often tied directly together  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Target Costing A method of profit planning and cost management that focuses on products with discrete manufacturing processes Its goal is to design costs out of products in the RD&E stage of a product’s total life cycle Rather than trying to reduce costs during the manufacturing stage It is a relevant example of: How a well-designed MACS can be used for strategic purposes How critical it is for organizations to have a system in place that considers performance measurement across the entire value chain  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Traditional Method Begins with market research into customer requirements followed by product specification Companies engage in product design and engineering and obtain prices from suppliers Product cost is not a significant factor in product design at this stage After the engineers and designers have determined product design, they estimate cost Product designers do not attempt to achieve a particular cost target If the estimated cost is considered to be too high, then it may be necessary to modify the product design  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Target Costing Method (1 of 5) Both the sequence of steps and the way of thinking about determining product costs differ significantly from traditional costing Although the initial steps appear similar to traditional costing, there are some notable differences: First, marketing research under target costing is not a single event as it often is with the traditional approach While customer input is obtained early in the marketing research process, it is also collected continually throughout the target costing process  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Target Costing Method (2 of 5) Second, much more time is spent at the product specification and design stage To minimize design changes during the manufacturing process when it is far more expensive to implement Third, the total-life-cycle concept is used by making it a key goal to minimize the cost of ownership of a product over its useful life Not only are costs such as the initial purchase price considered, but also the costs of operating, maintaining, and disposing of the product  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Target Costing Method (3 of 5) After these initial steps, the target costing process becomes even more distinctive Determining a target selling price and target product volume depends on the company’s perceived value of the product to the customer The target profit margin results from a long-run profit analysis, often based on return on sales Return on sales is the most widely used measure because it can be linked most closely to profitability for each product The target cost is the difference between the target selling price and the target profit margin  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Target Costing Method (4 of 5) Once the target cost has been set, the company must determine target costs for each component The value engineering process includes examination of each component of a product to determine whether it is possible to reduce costs while maintaining functionality and performance In some cases, product design may change, materials used in production may need replacing, or manufacturing processes may require redesign Several iterations usually are needed before it is possible to determine the final target cost  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Target Costing Method (5 of 5) Two other differences characterize the process First, cross-functional teams made up of individuals representing the entire value chain guide the process throughout From both inside and outside the organization A second difference is that suppliers play a critical role in making target costing work If there is a need to reduce the cost of specific components, firms will ask their suppliers to find ways to reduce costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Supply Chain Management Develops cooperative, mutually beneficial, long-term relationships between buyers and suppliers As trust develops between buyer and supplier, decisions about how to resolve cost reduction problems can be made with shared information about each other’s operations The buyer may expend resources to train the supplier’s employees in some aspect of the business A supplier may assign one of its employees to work with the buyer to understand a new product  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Concerns About Target Costing Some studies of target costing in Japan indicate that there are potential problems in implementing the system Especially if focusing on meeting the target cost diverts attention away from the other elements of overall company goals Companies may find it possible to manage many of these factors Organizations interested in using the target costing process should be aware of them before attempting to adopt it  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Examples of Problems (1 of 2) Conflicts can arise between various parties involved in the target costing process Excessive pressure on subcontractors and suppliers to conform to a schedule and reduce costs can lead to alienation and/or failure of the subcontractor Design engineers may become upset when other parts of the organization are not cost conscious They argue that they exert much effort to squeeze pennies out of the cost of a product while other parts of the organization (administration, marketing, distribution) are wasting dollars  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Examples of Problems (2 of 2) Employees in many Japanese companies working under target costing goals experience burnout due to the pressure to meet the target cost Burnout is particularly evident in design engineers Development time may increase because of repeated value engineering cycles to reduce costs May lead to the product coming late to market For some types of products, being six months late may be far more costly than having small cost overruns  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Kaizen Costing (1 of 2) Similar to target costing in its cost-reduction mission However, it focuses on reducing costs during the manufacturing stage of the total life cycle of a product Kaizen is the Japanese term for making improvements to a process through small, incremental amounts rather than through large innovations  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Kaizen Costing (2 of 2) Kaizen costing’s goal is to ensure that actual production costs are less than the prior year cost Kaizen’s goals are reasonable The product is already in the manufacturing process, thus it is difficult and costly to make large changes to reduce costs It is tied to the profit-planning system If the cost of disruptions to production are greater than the savings due to kaizen costing, then it will not be applied  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Example From Auto Plant (1 of 2) An annual budgeted profit target is allocated to each plant Each automobile has a predetermined cost base, which is equal to the actual cost of that automobile in the previous year All cost reductions use this cost base as their starting point The targeted cost reduction is the amount the cost base must be reduced to reach the profit target  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Example From Auto Plant (2 of 2) The target reduction rate is the ratio of the target reduction amount to the cost base This rate is applied over time to all variable costs Results in specific target reduction amounts for materials, parts, direct and indirect labor, and other variable costs Then management makes comparisons of actual reduction amounts across all variable costs to the pre-established targeted reduction amounts If differences exist, variances for the plant are determined  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Concerns About Kaizen Costing The system places enormous pressure on employees to reduce every conceivable cost Some Japanese automobile companies use a grace period just before a new model is introduced This cost-sustainment period provides employees with the opportunity to learn any new procedures before the company imposes kaizen targets on them Kaizen costing leads to incremental rather than radical process improvements This can cause myopia as management tends to focus on the details rather than the overall system  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Environmental Costing Environmental remediation, compliance, and management have become critical aspects of many businesses All parts of the value chain, and their costs, are affected by environmental issues Environmental costing involves: Selecting suppliers whose philosophy and practice in dealing with the environment matches the buyer’s Disposing of waste products during the production process Addressing post-sale service and disposal issues These issues are being incorporated into cost management systems and overall MACS design  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Controlling Environmental Costs Only when managers and employees become aware of how the activities in which they engage create environmental costs will they be able to control and reduce them The activities that cause environmental costs have to be identified The costs associated with the activities have to be determined These costs must be assigned to the most appropriate products, distribution channels, and customers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Types of Environmental Costs Environmental costs fall into two categories: Explicit costs The direct costs of modifying technology and processes, costs of cleanup and disposal, costs of permits to operate a facility, fines levied by government agencies, and litigation fees Implicit costs More closely tied to the infrastructure required to monitor environmental issues These costs are usually administration and legal counsel, employee education and awareness, and the loss of goodwill if environmental disasters occur  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Benchmarking A way for organizations to gather information regarding the best practices of others Often highly cost effective, by: Avoiding the mistakes that other companies have made Not reinventing a process or method that others have already developed and tested Selecting appropriate benchmarking partners is a critical aspect of the process The process typically consists of five stages  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Stage 1 Internal study and preliminary competitive analyses The organization decides which key areas to benchmark for study Then the company determines how it currently performs on these dimensions by initiating Preliminary internal competitive analysis Preliminary external competitive analyses Both types of analyses will determine the scope and significance of the study for each area These analyses are not limited to companies in a single industry  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Stage 2 (1 of 2) Developing long-term commitment to the benchmarking project and coalescing the benchmarking team Because significant organizational change can take several years, the level of commitment to benchmarking has to be long term rather than short term Long-term commitment requires Obtaining the support of senior management to give the benchmarking team the authority to spearhead the changes Developing a clear set of objectives to guide the benchmarking effort Empowering employees to make change  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Stage 2 (2 of 2) The benchmarking team should include individuals from all functional areas in the organization An experienced coordinator is usually necessary to organize the team and develop training in benchmarking methods Lack of training often will lead to the failure of the implementation  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Stage 3 (1 of 3) Identifying benchmarking partners—willing participants who know the process Some critical factors are as follows: Size of the partners Will depend on the specific activity or method being benchmarked For example, if an organization wants to understand how a huge organization with several divisions coordinates its suppliers, then it would probably seek an organization of similar size Size is not always an important factor  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Stage 3 (2 of 3) Number of partners Useful for an organization to consider a wide array of benchmarking partners Must be aware that as the number of partners increases, so do issues of coordination, timeliness, and concern over proprietary information disclosure Researchers argue that today’s changing business environment is likely to encourage firms to have a larger number of participants Increased competition and technological progress in information processing increases benchmarking benefits relative to costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Stage 3 (3 of 3) Relative position of the partners within and across industries Newcomers and those whose performance has declined are more likely to seek a wider variety of benchmarking partners than those who are established industry leaders Those who are industry leaders may benchmark because of their commitment to continuous improvement Degree of trust among partners Developing trust among partners is critical to obtaining truthful and timely information Most organizations operate on a quid pro quo basis, with the understanding that both organizations will obtain information they can use  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Stage 4 Information gathering and sharing methods Two related dimensions emerge from the literature: Type of information that benchmarking organizations collect There are three broad classes of information on which firms interested in benchmarking can focus: product, functional (process), and strategic benchmarking Methods of information collection There are two major methods of information collection for benchmarking, unilateral and cooperative  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Stage 5 Taking action to meet or exceed the benchmark The organization takes action and begins to change After implementing the change, the organization makes comparisons to the specific performance measures selected The decision may be to perform better than the benchmark to be more competitive The implementation stage is perhaps the most difficult stage of the benchmarking process, as the buy-in of members is critical for success  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Motivating Behavior in Management Accounting and Control Systems Chapter 8  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Management Accounting and Control Systems Chapter 7 discussed the technical characteristics of a well-designed management accounting and control system (MACS) However, a major role for control systems is to motivate behavior congruent with the desires of the organization since human interests and motivation can vary significantly  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Major Behavioral Considerations Embedding the organization’s ethical code of conduct into MACS design Using a mix of short and long-term qualitative and quantitative performance measures The balanced scorecard approach Empowering employees to be involved in decision making and MACS design Developing an appropriate incentive system to reward performance  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Impact of MACS on Behavior Many managers try to implement new systems without considering the behavioral implications and consequences of a MACS If they do not pay careful attention to behavioral factors, then: Goal congruence may not occur Motivation could be low Worst of all, employees may be encouraged to engage in dysfunctional behavior  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Human Resource Model Of Motivation (HRMM) Perhaps the most contemporary management view of motivation Based on initiatives to improve the quality of working life and the strong influence of Japanese management practices Introduces a high level of employee responsibility for and participation in decisions in the work environment Serves as the basis for the presentation of the four behavioral considerations in MACS design  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Central Assumptions of the HRMM (1 of 2) Organizations operate under a system of beliefs about the values, purpose, and direction of their organization People find work enjoyable and desire to participate in: Developing objectives Making decisions Attaining goals in their work environment Individuals are motivated by both financial and nonfinancial means of compensation  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Central Assumptions of the HRMM (2 of 2) Employees have a great deal of knowledge and information about their jobs, the application of which will improve the way they perform tasks and benefit the organization as a whole Individuals are highly creative, ethical, and responsible They desire opportunities to effect change in their organizations  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Ethical Code of Conduct and MACS Design A set of ethical principles is at the center of many boundary systems A set of standards relating to acceptable behavior Thus, a well-designed MACS should incorporate the principles of an organization’s code of ethical conduct To guide and influence behavior and decision making A MACS design that incorporates ethical principles can provide decision makers with guidance as they face ethical dilemmas  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Pressures Affecting a MACS The key MACS users (managers) are often subject to intense pressures from their job circumstances and from other influential organizational members to suspend their ethical judgment in certain situations These pressures include the following: Requests to tailor information to favor particular individuals or groups Pleas to falsify reports or test results Solicitations for confidential information Pressures to ignore questionable or unethical practices  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Ethics and Management Accountants Management accountants are guided by the organization’s code of ethical conduct and the ethical standards of their professional associations For a CMA (Certified Management Accountant), the Institute of Management Accountants (IMA), which issues the certificate, provides a set of professional and ethical standards that require the CMA to be competent and to always maintain confidentiality, integrity, and objectivity Management accountants often play a significant role in MACS design, which should reflect their professional standards  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Incorporating Ethics into a MACS Design (1 of 2) To incorporate ethical principles into the design of a MACS and help managers deal effectively with the ethical pressures, system designers might attempt to ensure the following: That the organization has formulated, implemented, and communicated to all employees a comprehensive code of ethics (often accomplished through the organization’s beliefs system)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Incorporating Ethics into a MACS Design (2 of 2) That all employees understand the organization’s code of ethics and the boundary systems that constrain behavior Boundary systems are designed to specify what actions are appropriate and those that must never be taken That a system exists to detect and report violations of the organization’s code of ethics Employees must have confidence in the system for it to be effective  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Avoiding Ethical Dilemmas Most organizations attempt to address ethical considerations and avoid ethical dilemmas by developing a code of ethics No universal hierarchy of ethical principles exists, but five categories capture the broad array of ethical considerations: Legal rules Societal norms Professional memberships Organizational/group norms Personal norms This hierarchy is listed in descending order of authority  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Ethical Hierarchy An action that is prohibited by law should be unacceptable by society, by one’s profession, by the organization, and then by each individual However, an action that is legally and socially acceptable may be professionally unacceptable and, in turn, unacceptable to the organization and its employees Any hierarchy of this sort has a number of gray areas; nevertheless, it provides general guidelines for understanding and dealing with ethical problems that arise  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Dealing With Ethical Conflicts A decision maker may face an ethical conflict when the individual’s code of ethics sets a higher standard than the organization’s Organizations that formulate and support specific and unambiguous ethical codes create an environment that reduces ethical conflicts One step is to maintain a hierarchy of authority The organization’s stated code of ethics should not allow any behavior that is either legally or socially unacceptable Because most professional codes of ethics reflect broad moral imperatives such as loyalty, discretion, and competence, an organization would create public relations problems for itself if its stated code of ethics conflicted with a professional code  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Role of Senior Management A critical variable that can reduce ethical conflicts is the way that the chief executive and other senior managers behave and conduct business If these individuals demonstrate exemplary behavior, other organizational members will have role models to emulate Organizations whose leaders evince unethical behavior cannot expect their employees to behave according to high ethical standards  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Conflicts within a Code of Ethics In some cases, when organizations develop a formal code of ethics, they can create the potential for explicit ethical conflicts to arise with the code itself The conflicts that appear most in practice are those between the organization’s code of ethics and: The law Common societal expectations The individual’s set of personal and professional ethics Other conflicts relate to personal values and norms of behavior that were acceptable prior to the adoption of the organization’s new code of ethics but that are now in question  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Conflict Between Individual and Organizational Values (1 of 3) If the organization’s code of ethics is more stringent than an individual’s code, conflicts may arise, but if adherence to the organization’s ethical code is required and enforced: It is possible to diminish ethical conflicts if the individual is asked and expected to pursue a more stringent code of ethics Individuals may raise their own ethical standards without conflict  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Conflict Between Individual and Organizational Values (2 of 3) Difficult issues may arise when the individual’s personal code of ethics prohibits certain types of behavior that are legal, socially acceptable, professionally acceptable, and acceptable to the organization Potential for conflict in such situations is heightened when the action that is unacceptable to the individual is desirable to the organization The organization may require that the person do things that he or she finds unacceptable  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Conflict Between Individual and Organizational Values (3 of 3) In this case, the individual is confronted with a personal choice Unfortunately, the employee may have little institutional support in this situation but may be able to lobby within or outside the organization This tactic may be effective, or the affected employee may choose not to work for that organization depending on what he or she values most  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Conflict with Stated Values (1 of 4) Employees may observe management, even senior management, engaged in unethical behavior This type of conflict is the most difficult because the organization is misrepresenting its ethical system Forces the employee to make a choice between going public with the information or keeping it quiet In this setting, the employee is in a position of drawing attention to the problem by being a whistle-blower Many have found this to be a lonely and unenviable position Whistle-blowers have chosen personal integrity over their loyalty to the organization  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Conflict with Stated Values (2 of 4) Experts who have studied this problem advise that the individual should determine: That the facts are correct That a conflict exists between the organization’s stated ethical policy and the actions of its employees in practice Whether this conflict is institutional or reflects the decisions and actions of only a small minority of employees Faced with a true conflict most experts recommend that the employee work with respected leaders in the organization to change the discrepancy between practiced and stated ethics Other potential courses of action include:  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Conflict with Stated Values (3 of 4) Point out the discrepancy to a superior and refuse to act unethically This may lead to dismissal, the need to resign from the organization, or the experience of suffering hidden organization sanctions Point out the discrepancy to a superior and act unethically The rationale for this choice is that the employee believes, incorrectly, this affords protection from legal sanctions Take the discrepancy to a mediator in the organization, if one exists Go outside the organization to publicly resolve the issue  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Conflict with Stated Values (4 of 4) Go outside the organization anonymously to resolve the issue Resign and go public to resolve the issue Resign and remain silent Do nothing, hoping that the problem vanishes If the organization is serious about its stated code of ethics, it should have an effective ethics control system to ensure and provide evidence that the organization’s stated and practiced ethics are the same, including a means for employees to point out inconsistencies and to protect those employees  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Effective Ethical Control (1 of 3) To promote ethical decision making, management should implement an ethical control system that should include the following: A statement of the organization’s values and code of ethics written in practical terms, with examples that the employees can relate to their individual jobs A clear statement of the employee’s ethical responsibilities for every job description and a specific review of the employee’s ethical performance as part of every performance review Adequate training to help employees identify ethical dilemmas in practice and learn how to deal with those they can reasonably expect to face  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Effective Ethical Control (2 of 3) Evidence that senior management expects members to adhere to its code of ethics, meaning that management must: Provide a statement of the consequences of violating the organization’s code of ethics Establish a means of dealing with violations of the organization’s code of ethics promptly, ruthlessly, and consistently according to the statement of consequences Provide visible support of ethical decision making at every opportunity Provide a private line of communication (without retribution) from employees directly to the chief executive officer, chief operating officer, head of human resource management, or someone else on the board of directors  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Effective Ethical Control (3 of 3) Evidence that employees can make ethical decisions or report violations of the organizations stated ethics (be the whistle-blower) without fear of reprisals from superiors, subordinates, or peers This usually takes the form of an organization mediator who has the authority to investigate complaints, wherever they lead, and to preserve the confidentiality of people who report violations An ongoing internal audit of the efficacy of the organization’s ethical control system Formal training is part of the process of promoting ethical decision making  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Motivation In addition to fostering ethical behavior, a central issue in MACS design is how to motivate appropriate behavior at work When designing jobs and specific tasks, system designers should consider the following three dimensions of motivation: Direction: the tasks on which an employee focuses attention Intensity: the level of effort the employee expends Persistence: the duration of time that an employee will stay with a task or job  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Goal Congruence Careful attention to motivation is a key step for the organization and its employees to align their respective goals This is known as achieving goal congruence The alignment of goals occurs as employees: Perform their jobs well and are helping to achieve organizational objectives, and Are attaining their individual goals at the same time E.g., obtaining promotions, earning financial bonuses, or advancing their careers in other ways  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Diagnostic Control Systems Even if goals are aligned, different types of tasks require different levels of skill, precision, responsibility, initiative, and uncertainty In most situations, managers try to establish systems that they do not have to personally monitor on a regular basis The hope is that if these systems are well designed then the manager has much more time to attend to other concerns These are called diagnostic control systems Feedback systems that monitor organizational outcomes and correct any deviations from predetermined performance standards  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Interactive Control Systems If there is a large degree of strategic uncertainty, managers spend much more time monitoring the decisions and actions of their subordinates Strategic uncertainty offers threats and opportunities that could alter the operating assumptions These are called interactive control systems Unlike diagnostic systems, interactive systems force a dialogue among all organizational participants about the data that is coming out of the system and what to do about it At the core of both systems are two common methods of control: task and results control  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Task Control (1 of 2) Task control is the process of finding ways to control behavior so that a job is completed in a pre-specified manner Task control can be broken down into two categories: Preventive control Much if not all of the discretion is taken out of performing a task Monitoring Inspecting the work or behavior of employees while they are performing a task  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Task Control (2 of 2) Task control is most appropriate when: There are legal requirements to follow specific rules or procedures to protect public safety For example, in the manufacture of prescription drugs, and in the operation of nuclear power generation facilities Employees handle liquid or other precious assets To reduce the opportunity for temptation and fraud The organization can control its environment and eliminate uncertainty and the need for judgment The organization can then develop specific rules and procedures that employees must follow  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Results Control (1 of 2) Results control methods focus on measuring employee performance against stated objectives For results control to be effective, the organization must have clearly defined its objectives, communicated them to appropriate organization members, and designed performance measures consistent with the objectives E.g., sales people are often evaluated on the volume of sales they made during a specific time  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Results Control (2 of 2) Results control is most effective when: Organization members understand the organization’s objectives and their contribution to those objectives Organization members have the knowledge and skill to respond to changing situations by taking corrective actions and making sound decisions The performance measurement system is designed to assess individual contributions so that an individual can be motivated to take action and make decisions that reflect their own and the organization’s best interests  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Need For Multiple Performance Measures The ways in which organizations measure performance send signals to all employees and stakeholders about what the organization considers as its priorities If organizations choose performance measures without careful consideration, then non-congruent behavior can occur Using multiple measures of performance helps employees focus on several dimensions of their jobs rather than just keying in on one dimension  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Behavior Not Goal-Congruent Occasionally employees are so motivated to achieve a single goal that they engage in dysfunctional behavior: Gaming the performance indicator Altering actions specifically in an attempt to manipulate a performance indicator through job-related acts Data falsification Knowingly altering records Smoothing (a form of earnings management) Accelerating or delaying the flow of data without altering the organization’s activities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Encouraging The Desired Behavior Boundary systems give employees a clear understanding of what is considered appropriate and inappropriate behavior Organizations may also design performance measurement systems that encourage the desired behavior One possibility is to use multiple performance measures to reflect the complexities of the work environment Cause employees to recognize the various dimensions of their work and to be less intent on trying to maximize their performance on a single target at the expense of other aspects of their jobs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Using A Mix Of Performance Measures In addition to using multiple performance measures, MACS designers need to expand their views of the kinds of performance measures to use Only recently have managers become aware of the need for measures of quality, speed to market, cycle time, flexibility, complexity, innovation, and productivity Performance measures should also reflect new realities, such as the movement from “tall” organizations to “flat” organizations  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

MACS Design: Empowering Employees Empowering employees in MACS design requires two essential elements: Allowing employees to participate in decision making Ensuring that employees understand the information they are using and generating  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Participation In Decision Making Research has suggested that employees who participate in decision making feel greater morale and job satisfaction These heightened feelings often translate into increased productivity as employees begin to feel they have some control over what they do at work In most industries, people still perform the majority of work and have superior information: How work is best accomplished How to improve products and processes MACS designers should, therefore, strongly consider enlisting the participation of employees  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Understanding Information The second critical element of empowering employees is to ensure that they understand the information they use and on which they are evaluated Some executives believe that only managers need to understand the information generated by the MACS It has become evident to many managers that employees at all levels must understand the organization’s performance measures and the way they are computed in order to be able to take actions that lead to superior performance For MACS to function well, employees have to be constantly re-educated as the system and its performance measures change  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Incentive Systems The final behavioral consideration in MACS design is to consider the most appropriate reward systems to further motivate employees Intrinsic rewards Extrinsic rewards Organizations use many systems of financial rewards A number of different theories of motivation exist: Expectancy theory Agency theory Goal setting theory  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Intrinsic Rewards Come from within an individual and reflect: Satisfaction from doing the job Growth opportunities the job provides Intrinsic rewards may reflect the nature of the organization and type of work one is performing Even when people are financially compensated, one of management’s most challenging tasks is to design jobs and develop a culture that lead employees to derive intrinsic rewards Their nature is such that they are not affected by management accounting information  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Extrinsic Rewards Any reward that one person provides another to recognize a job well done Based on assessed performance Common examples include meals, tips, bonuses, and recognition in newsletters and on plaques Reinforce the notion that employees have distinguished themselves within the organization Some believe that extrinsic rewards reinforce the perception that wages compensate the employee for a minimally acceptable effort and that the organization must use additional rewards to motivate the employee to provide additional effort  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Intrinsic v. Extrinsic Rewards (1 of 3) Many compensation experts believe that organizations have not made enough use of intrinsic rewards They claim that, given proper leadership, intrinsic rewards may have even stronger motivational effects than extrinsic rewards The effectiveness of intrinsic and extrinsic rewards is a topic of debate in the management literature Some argue that people who expect to receive a reward for completing a task successfully do not perform as well as those who expect no reward This argument is built around the idea that the preoccupation with extrinsic rewards undermines the effectiveness of reward systems and that the design of organizations and jobs should allow employees to experience intrinsic rewards  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Intrinsic v. Extrinsic Rewards (2 of 3) The issue remains unresolved, but one thing is clear: Most organizations ignore the role of intrinsic rewards in motivation and blindly accept the view that only financial extrinsic rewards motivate employees Many people believe that financial extrinsic rewards are both necessary and sufficient to motivate superior performance Both systematic and anecdotal evidence suggest: Financial extrinsic rewards are not necessary to create effective organizations Performance rewards do not necessarily create them Both nonfinancial extrinsic and intrinsic rewards have a role to play in most organizations  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Intrinsic v. Extrinsic Rewards (3 of 3) Some people argue that any incentive compensation program is unacceptable They suggest that organizations must strive to be excellent to survive in a competitive world Superior and committed performance is necessary for all employees and is part of the contract of employment and does not merit additional pay Still, many organizations rely on extrinsic monetary rewards to motivate performance Monetary rewards are a tangible indicator of how well one is doing relative to others  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Incentive Compensation Incentive compensation reward systems provide monetary (extrinsic) rewards based on measured results Pay-for-performance systems Base rewards on achieving or exceeding some measured performance Require performance measurement systems that gather relevant and reliable performance information Based on absolute performance, performance relative to some plan, or performance relative to that of some comparable group  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Absolute Performance Measures of absolute performance include: The number of acceptable quality units produced A piece-rate system The organization’s results Profit levels or an organization’s balanced scorecard measures of customer or employee satisfaction, quality, and rate of successful new product introductions The organization’s share price performance A stock option plan  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Relative Performance Examples of rewards based on relative performance are those tied to the following: The ability to exceed a performance target level Paying a manager for accomplishing his or her goals under budget, or paying a production group a bonus for beating a benchmark performance level The amount of a bonus pool Sharing in a pool defined as the organization’s reported profits less a stipulated return to shareholders The degree to which performance exceeds the average performance level of a comparable group  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Effective Performance Measurement (1 of 2) Six attributes must be in place for a measurement system to motivate desired performance Employees must understand their jobs and the reward system and believe that it measures what they control and contribute to the organization Designers of the performance measurement system must make a careful choice about whether it measures employees’ inputs or outputs The choices and decisions for these two comprise one of the most difficult tasks in the design of performance measurement and compensation systems  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Effective Performance Measurement (2 of 2) The elements of performance that the performance measurement system monitors and rewards should reflect the organization’s critical success factors The reward system must set clear standards for performance that employees accept The measurement system must be calibrated so that it can accurately assess performance When it is critical that employees coordinate decision making and other activities with other employees, the reward system should reward group, rather than individual, performance  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Conditions Favoring Incentive Compensation Not all organizations are suited to incentive compensation systems Incentive compensation systems work best in organizations in which employees have the skill and authority to react to conditions and make decisions When the organization has empowered its employees to make decisions, it can use incentive compensation systems to motivate appropriate decision-making behavior  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Incentive Compensation And Employee Responsibility The incentive compensation system must focus primarily on outcomes that the employee controls or influences Employees’ incentive compensation should reflect the nature of their responsibilities in the organization A mix of rewarding both short and long-term outcomes is consistent with the goals of the balanced scorecard approach  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Rewarding Outcomes Another consideration in the design of effective incentive compensation systems is the manner in which performance is measured Incentive compensation schemes tie rewards to the outputs of employee performance rather than to inputs such as their level of effort Incentive compensation based on outcomes requires that organization members understand and contribute to the organization’s objectives  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Input-Based Compensation Rewards may be based on inputs when: It is impossible to measure outcomes consistently Outcomes are affected by factors beyond the employee’s control Outcomes are expensive to measure Input-based compensation measures the employee’s time, knowledge, and skill level The expectation is that the unmeasured outcome is correlated with these inputs Many organizations use some form of knowledge-based remuneration  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Managing Incentive Plans (1 of 2) Considerable evidence indicates that organizations have mismanaged incentive compensation plans, particularly those for senior executives Many articles have appeared in influential business periodicals arguing that executives, particularly of U.S. Corporations, have been paid excessively for mediocre performance Experts debate whether compensation systems motivate goal-seeking behavior and whether they are efficient That is, whether they pay what is needed and no more  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Managing Incentive Plans (2 of 2) Some studies show a positive correlation between executive compensation and shareholder wealth Other studies report finding no, or even a negative, correlation between organization performance and executive compensation Many professionals argue that the amounts are excessive and reflect high status rather than performance The issue of fairness has also surfaced Surveys indicate that, on average, CEOs in the United States earn 300 times the amount of the lowest paid employee In Japan, the relationship is only 30 times the lowest paid worker  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Types Of Incentive Plans The most common incentive compensation plans are cash bonuses, profit sharing, gainsharing, stock options, performance shares stock, stock appreciation rights, participation units, and employee stock ownership plans (ESOPs) We can group compensation plans into two broad categories: Those that rely on internal measures, invariably provided by the organization’s management accounting system Those that rely on performance of the organization’s share price in the stock market Management accountants get involved in the first group Most employees who participate in financial incentive plans take the plans very seriously  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cash Bonus A cash bonus plan pays cash based on some measured performance Such a bonus is a one-time award that does not become part of the employee’s base pay in subsequent years Cash bonuses can be: Fixed in amount (triggered when measured performance exceeds the target) or proportional to the level of performance relative to the target Based on individual or group performance Paid to individuals or groups  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Profit Sharing A cash bonus calculated as a percentage of an organization unit’s reported profit A group incentive compensation plan focused on short-term performance All profit-sharing plans define: What portion of the organization’s reported profits is available for sharing The sharing formula The employees who are eligible to participate in the plan The formula for each employee’s share  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Gainsharing Gainsharing is a system for distributing cash bonuses from a pool when the total amount available is a function of performance relative to some target E.g., employees in a designated unit receive bonuses when their performance exceeds a performance target Gainsharing is a group incentive that usually: Provides for the sharing of financial gains in organizational performance Applies to a group of employees within an organization unit, such as a department or a store Gainsharing promotes teamwork and participation in decision making  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Stock Option Plans A stock option is the right to purchase a unit of the organizations stock at a specified price, called the option price Judging by the published remarks of compensation experts, stock options are the most widely known, misused, and maligned approach to incentive compensation A common approach to option pricing is to set the option price at about 105% of the stock’s market price at the time the organization issues the stock option  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Other Stock-Related Plans Organizations use many other forms of stock-related incentive compensation plans: Performance shares stock, stock appreciation rights, participation units, and employee stock ownership plans (ESOPs) These plans provide incentive compensation to the participants when the stock price increases They are designed to motivate employees to act in the long-term interests of the organization by acting so as to increase its market (stock) value All these plans assume that stock markets will recognize exceptional behavior with increased stock prices  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Balanced Scorecard Chapter 9  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Achieving Success in the Information Era To achieve success in the information era, companies need more than prudent investment in physical assets and excellent management of financial assets and liabilities Companies mobilize and create value from their intangible assets as well as their physical and financial ones  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Intangible Assets An organization’s intangible assets include: Loyal and profitable customer relationships High-quality processes Innovative products and services Employee skills and motivation Databases and information systems Some academic scholars and practitioners have tried to expand the financial model to incorporate the valuation of intangible assets on a company’s balance sheet  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Measuring Intangible Assets Difficulties in placing a reliable financial value on intangible assets have prevented them from being recognized on a company’s balance sheet Likely to continue to be the case Yet these assets are critical for success Managers understand that if “you can’t measure it, you can’t manage it” Many managers have searched for a system that would help them measure and manage the performance of their intangible, knowledge-based assets  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Balanced Scorecard The Balanced Scorecard (BSC) provides a system for measuring and managing all aspects of a company’s performance The scorecard balances traditional financial measures of success, such as profits and return on capital, with non-financial measures of the drivers of future financial performance The Balanced Scorecard measures organizational performance across different perspectives Derived from the organization’s vision and strategy  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Perspectives Four different but linked perspectives are derived from the organization’s strategy Financial: How is success measured by shareholders? Customer: How do we create value for customers? Internal: At what internal processes must we excel to satisfy customers and shareholders? Learning & Growth: What employee capabilities, information systems, and organizational climate do we need in order to continually improve internal processes and customer relationships?  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Balanced Measurements Rather than rely on an measurement system that reports only on financial results, the BSC enables companies to: Track financial results Simultaneously monitor how they are building the capabilities for future growth and profitability With customers With their internal processes With their employees and systems  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Connecting the Four Perspectives A strategy map provides a visual representation of the linkages in the four perspectives of the BSC Financial Perspective Return on Investment Customer Perspective Customer Loyalty On-Time Delivery Internal Perspective Process Quality Cycle Time Learning & Growth Perspective Employees’ Process Improvement Skills  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Connections (1 of 3) Return on investment (ROI) is a widely recognized measure of financial success Accordingly, ROI is included on the scorecard But what drives ROI? Repeated and expanded sales from existing customers, the result of a high degree of loyalty among existing customers, could be one driver of this financial measure Customer loyalty is included on the scorecard because it is expected to have a strong influence on ROI But how will the organization achieve customer loyalty?  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Connections (2 of 3) Analysis of customer preferences may reveal that on-time delivery (OTD) of orders is highly valued by customers Improved on-time delivery performance is expected to lead to higher customer loyalty So both customer loyalty and OTD are incorporated into the scorecard’s Customer perspective But how will the organization improve OTD? The company must excel at internal processes to achieve exceptional OTD  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Connections (3 of 3) Short cycle times and high-quality production processes are two drivers of on-time delivery These two parameters are measured in the Internal perspective But how do organizations improve the quality and reduce the cycle times of their production processes? The company must have skilled production workers, well-trained in process improvement techniques A measure of employees’ skill and capabilities in process improvement is, therefore, used in the Learning & Growth perspective  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Strategy and the BSC A properly constructed Balanced Scorecard tells the story of the business unit's strategy It identifies and makes explicit the hypotheses about the cause and effect relationships between: Outcome measures in the Financial and Customer perspectives E.G., ROI and customer loyalty and the performance drivers of those outcomes that are measured in the Internal and Learning & Growth perspectives Such as zero defect processes, short cycle times, and skilled, motivated employees  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Objectives (1 of 2) Are concise statements that articulate what the organization hopes to accomplish Best stated as action phrases May include the means and the desired results Tell the story of the strategy through the cause-and-effect relationships in each of the four balanced scorecard perspectives The company’s balanced scorecard would typically contain an extensive (3-5 sentence) description of each objective The following examples are abbreviated versions  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Objectives (2 of 2) Typical objectives found in each of the four BSC perspectives include: Increase revenues through expanded sales to existing customers (Financial perspective) Become service oriented (Customer perspective) Achieve excellence in order fulfillment through continuous process improvements (Internal perspective) Align employee incentives and rewards with the strategy (Learning & Growth perspective) Even descriptions of a paragraph are insufficient to give complete clarity to the objective Measures describe how success in achieving an objective will be determined  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Measures Provide specificity and reduce the ambiguity that is inherent in word statements Specifying exactly how an objective is measured will give employees a clear focus for their improvement efforts Once the objectives have been translated into measures, managers select targets for each measure  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Targets and Initiatives Targets establish the level of performance or rate of improvement required for a measure Should be set to represent excellent performance Should, if achieved, place the company as one of the best performers in its industry Even more important would be to choose targets that create distinctive value for customers and shareholders Finally, managers identify initiatives The short-term programs and action plans that will help achieve the stretch targets established for its measures  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Vision and Mission Before determining the objectives and measures, an organization should already have a vision and mission statement And a general idea of its strategy These high-level statements can then be translated into detailed objectives and measures The exact definitions of vision and mission can vary, but the following examples should provide helpful guidelines  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Vision A concise statement that defines the mid to long-term (3 - 10 year) goals of the organization The vision should be external and market-oriented and should express, often in colorful or “visionary” terms, how the organization wants to be perceived by the world: “The City of Charlotte will be a model of excellence that puts its citizens first. Skilled, motivated employees will be known for providing quality and value in all areas of service. We will be a platform for vital economic activity that gives Charlotte a competitive edge in the marketplace. We will partner with citizens and businesses to make Charlotte a community of choice for living, working and leisure activities”  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Mission Statement A concise, internally-focused statement of how the organization expects to compete and deliver value to customers It often states the reason for the organization’s existence, the basic purpose towards which its activities are directed, and the values that guide employee’s activities: “The mission of the City of Charlotte is to ensure the delivery of quality public services that promote the safety, health and quality of life of its citizens. We will identify and respond to community needs and focus on the customer through: Creating and maintaining effective partnerships Attracting and retaining skilled motivated employees Using strategic business planning”  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Putting Vision in Action The Vision and Mission set the general direction for the organization They are intended to help shareholders, customers, and employees understand what the company is about and what it intends to achieve But these statements are far too vague to guide day-to-day actions and resource allocation decisions Companies start to make the statements operational when they define a strategy of how the vision and mission will be achieved  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

What is Strategy? The strategy literature is uncommonly diverse Different scholars and practitioners have very different definitions or even understanding about what strategy is and how it should be defined For purpose of this chapter, we adopt the general framework articulated by Michael Porter, one of the founders and still an outstanding leader in the field of the strategy  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Strategy According to Porter Porter argues that strategy is about selecting the set of activities in which an organization will excel to create a sustainable difference in the marketplace The sustainable difference may be to: Deliver greater value to customers than competitors Provide comparable value at a lower price than competitors He states, “Differentiation arises from both the choice of activities and how they are performed”  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Building the Balanced Scorecard With this background on establishing high-level direction for the organization, we now develop the role for the BSC to provide needed specificity that makes vision, mission and strategy statements meaningful and actionable for employees Starting with the Financial perspective of the scorecard and working successively through the Customer, Internal, and Learning & Growth perspectives  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financial Perspective (1 of 2) The ultimate objective for profit-maximizing companies Financial performance measures indicate whether the company's strategy, implementation, and execution are contributing to bottom-line improvement Financial objectives typically relate to profitability For example, operating income and ROI A company’s financial performance can be improved in two ways: Revenue growth and increased productivity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financial Perspective (2 of 2) Companies generate revenue growth by: Selling new products Selling to new customers Selling in new markets Increased productivity occurs by: Lowering direct and indirect expenses Enabling a company to produce the same quantity of outputs while spending less on people, materials, energy, and supplies Utilizing their financial and physical assets more efficiently Reducing the working and fixed capital needed to support a given level of business  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Customer Perspective (1 of 3) In this perspective, managers identify the targeted customer segments in which the business unit competes and the measures of the business unit's performance in these targeted segments The Customer perspective typically includes several common measures of the successful outcomes from a well-formulated and implemented strategy: Customer satisfaction Customer retention Customer acquisition Customer profitability Market share Account share Virtually all organizations try to improve these common customer measures so these measures by themselves do not describe a strategy  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Customer Perspective (2 of 3) A strategy identifies specific segments targeted for growth and profitability E.g., Southwest Airlines, targets price-sensitive customers while Neiman-Marcus targets customers willing to spend their high disposable incomes Companies must also identify the objectives and measures for the value proposition it offers customers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Customer Perspective (3 of 3) The value proposition is the unique mix of product, price, service, relationship, and image offered to the targeted customers Defines the company’s strategy Should communicate what the company expects to do for its customers better or differently from its competitors Value propositions used successfully by different companies include: “Best buy” or lowest total cost Product innovation and leadership Complete customer solutions  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Internal Perspective (1 of 3) Once an organization has a clear picture of its financial objectives and customer objectives, it should determine the means by which it will: Produce and deliver the value proposition for customers Achieve the productivity improvements for the financial objectives The Internal perspective identifies the critical processes at which the organization must excel to achieve its customer, revenue growth, and profitability objectives  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Internal Perspective (2 of 3) Organizations perform many different processes, which may be classified into four groupings: Operating processes The basic, day-to-day processes by which companies produce their existing products and services and deliver them to customers Customer management processes Processes by which companies expand and deepen relationships with targeted customers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Internal Perspective (3 of 3) Innovation processes Processes by which companies develop new products, processes, and services, often enabling the company to penetrate new markets and customer segments Regulatory and social processes Processes by which companies ensure that they meet or exceed regulations on business practices Managers should identify which of the process objectives and measures are the most important for their strategy Need to follow a “balanced” strategy and invest in improving processes in all four groups  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Learning & Growth Perspective (1 of 3) Identifies objectives for the people, systems, and organizational alignment that create long-term growth and improvement Managers define the employee capabilities, skills, technology, and organizational alignment that will contribute to improving performance in the measures selected in the first three perspectives They learn where they must invest to improve the skills of their employees, enhance information technology and systems, and align people to the company’s objectives  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Learning & Growth Perspective (2 of 3) The Learning & Growth perspective of the scorecard identifies how executives mobilize their intangible assets (human, information, and organization) to drive improvement in the internal processes most important for implementing their strategy In general, for companies to develop their Learning & Growth objectives and measures, managers examine each of the processes they selected in the Internal perspective  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Learning & Growth Perspective (3 of 3) They then determine the factors that enable that process to be performed in an outstanding manner so that it can contribute to the success of the company’s strategy: The employee capabilities, knowledge, and skills The information systems and databases Employee culture, alignment, and knowledge-sharing  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

KPI Scorecards Some organizations identify key performance indicators (KPIs) and classify them into the four BSC perspectives KPIs typically are common measures, such as customer satisfaction, quality, cost, employee satisfaction, and morale They are worth striving to achieve but do not reflect a company’s strategy Companies may expand their compensation system to reward executives for a broader set of performance than simply short-term financial results based on KPIs Not as powerful as selecting measures that can be linked back to the strategy and that will drive successful strategy implementation  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

BSC in Nonprofits and Government Organizations The BSC is especially well-suited for nonprofit and government organizations (NPGOs) Their success has to be measured by their effectiveness in providing benefits to constituents NPGOs cannot be measured primarily by their financial performance Since nonfinancial measures can assess performance with constituents, the BSC provides the natural performance management system for NPGOs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

NPGOs and Strategy Many NPGOs encountered difficulties in developing their initial BSC, finding that they didn’t have a clear strategy NPGO’s thinking has to shift from what it plans to do to what it intends to accomplish Many NPGOs place their mission objective at the top of their scorecard and strategy map Cannot use the standard BSC architecture where financial objectives are the ultimate, high-level outcomes to be achieved Also expand the definition of who is the customer  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Using BSC to Implement Strategy BSC was originally developed to improve performance measurement, but organizations learned that measurement has consequences far beyond reporting on the past Measurement creates focus for the future The BSC concept evolved during the 1990’s from a performance measurement system to a new strategic management system BSC focused the entire organization on strategy implementation  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

5 Principles for Becoming Strategy-Focused (1 of 3) Organizations achieved their strategic alignment and focus in different ways, at different paces, and in different sequences, but they generally followed a common set of five principles: Translate the Strategy to Operational Terms Executive teams often report great benefits from the process of building the scorecard Align the Organization to the Strategy For organizational performance to exceed the sum of its parts, the strategies of diverse, decentralized units must be linked and integrated  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

5 Principles for Becoming Strategy-Focused (2 of 3) Make Strategy Everyone’s Job Employees must learn about the strategy and reorient their day-to-day tasks to contribute to the success of that strategy This is top-down communication about what the organization is attempting to accomplish, leaving to employees the challenge and opportunity to perform their work in new and different ways to help the organization achieve its strategic objectives Make Strategy a Continual Process  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

5 Principles for Becoming Strategy-Focused (3 of 3) Mobilize Leadership for Change The single most important condition for success in becoming truly strategy-focused is ownership and active involvement of the executive team If those at the top are not energetic leaders of the process, change will not occur and strategy will not be implemented successfully  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Pitfalls (1 of 3) As with any new technology or management tool, not all BSC implementations have been successful Several design factors can lead to problems and disappointment when applying the BSC Too few measures in the scorecard to provide: A complete picture of the company’s strategy A balance between desired outcomes and the performance drivers of those outcomes Too many measures Attention is diffused, and insufficient attention is given to those few measures that make the greatest impact  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Pitfalls (2 of 3) The drivers in the Internal and Learning & Growth perspectives don't link to the desired outcomes in the Financial and Customer perspective E.g., strategy may call for creating innovative solutions for its customers but the measures in the internal perspective focus exclusively on operational improvements As these design flaws are detected, they can be easily corrected The biggest threat is a poor organizational process for developing and implementing the scorecard, seen when:  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Pitfalls (3 of 3) Senior management is not committed, and the BSC project is delegated to middle management One senior manager builds the scorecard alone Senior executives feel that only they need to know and understand the strategy, and BSC responsibilities don't filter down The BSC is treated as a one-time event that requires the perfect scorecard for implementation BSC is an iterative process All BSC’s start with some new measures for which no data currently exists The BSC is treated as a systems project rather than as a management project  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

BSC Summary (1 of 2) BSC integrates measures based on strategy Retains financial measures of past performance Also introduces the drivers of future financial performance The drivers are derived from an explicit and rigorous translation of the organization's strategy into tangible objectives and measures The new measurement and management system will have its greatest impact when the executive team is leading the transformational processes  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

BSC Summary (2 of 2) The benefits from BSC are realized as the organization integrates its new measurement system into management processes that: Cascade the strategy to all organizational units Communicate the strategy to all employees Align employees’ individual objectives and incentives to successful strategy implementation Integrate the strategy with ongoing management processes: Planning, budgeting, reporting, and management meetings  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Using Budgets to Achieve Organizational Objectives Chapter 10  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Resource Flexibility In many business decisions, especially decisions affecting the short-term, the firm’s capacity-related costs are considered as given and fixed Relevant costs in the short run are flexible costs Ideally, the supply of capacity resources is based on the amount needed to produce the projected volume of product The budgeting process makes clear that some resources, once acquired, cannot be disposed of easily if demand is less than expected  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Budgeting Process (1 of 5) The process that determines the planned level of most flexible costs Budgeting for capacity-related resources is discussed as a separate topic in another chapter Budgeting also includes discretionary spending such as for R&D, advertising, and employee training These do not supply the firm with capacity but they do provide support for the organization’s strategy by enhancing its performance potential Once authorized, discretionary spending budgets are committed or fixed; they do not vary with level of production or service  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Budgeting Process (2 of 5) Budgets serve as a control for managers within the business units of an organization Planning and control are the core of the design and operation of management accounting systems Budgets play a central role in the relationship between planning and control Budgets reflect in quantitative terms how to allocate financial resources to each part of an organization, based on the planned activities and short-run objectives of that part of the organization  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Budgeting Process (3 of 5) A budget is a quantitative expression of the money inflows and outflows that reveal whether a financial plan will meet organizational objectives Budgeting is the process of preparing budgets Budgets provide a way to communicate the organization’s short-term goals to its members  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Budgeting Process (4 of 5) Budgeting the activities of each unit can Reflect how well unit managers understand the organization’s goals Provide an opportunity for the organization’s senior planners to correct misperceptions about the organization’s goals Budgeting also serves to coordinate the many activities of an organization In this sense, budgeting is a tool that forces coordination of the organization’s activities and helps identify coordination problems  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Budgeting Process (5 of 5) Budgets help to anticipate potential problems and can serve to help provide solutions Budgeting reflects the cash cycle and provides information to help the organization plan any borrowing needed to finance the inventory buildup early in the cash cycle If budget planning indicates that the organization’s sales potential exceeds its manufacturing potential, then the organization can develop a plan to put more capacity in place or to reduce planned sales Managers need to be able to anticipate problems since putting new capacity in place can take several months to several years  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Forecasting Demand for Resources (1 of 2) Budgeting involves forecasting the demand for four types of resources over different time periods: Flexible resources that create variable costs (or flexible costs) May be acquired or disposed of in the short term Intermediate-term capacity resources that create capacity-related costs For example, forecasting the need for rental storage space that might be contracted on a quarterly, semi-annual, or annual basis  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Forecasting Demand for Resources (2 of 2) Resources that, in the intermediate and long run enhance the potential of the organization’s strategy Discretionary expenditures, which include research and development, employee training, maintenance of capacity resources, advertising, and promotion Long-term capacity resources that create capacity-related costs For example, a new fabrication facility for a computer chip manufacturer, which might take several years to plan and build and might be used for ten years  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Master Budget Two major types of budgets comprise the master budget: Operating budgets Summarize the level of activities such as sales, purchasing, and production Financial budgets Identify the expected financial consequences of the activities summarized in the operating budgets  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Operating Budgets (1 of 3) The sales plan Identifies the planned level of sales for each product The capital spending plan Specifies the long-term capital investments, such as buildings and equipment, that must be paid in the current budget period to meet activity objectives The production plan Schedules all required production The materials purchasing plan Schedules all required purchasing activities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Operating Budgets (2 of 3) The labor hiring and training plan Specifies the number of people the organization must hire or release to achieve its activity objectives, as well as all hiring and training policies The administrative and discretionary spending plan Includes administration, staffing, research and development, and advertising These plans specify the expected resource requirements of selling, capital spending, manufacturing, purchasing, labor management, and administrative activities during the budget period  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Operating Budgets (3 of 3) Operations personnel use the plans represented in the operating budget to guide and coordinate the level of various activities during the budget period Operations personnel also record data from current operations that can be used to develop future budgets  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financial Budgets Planners prepare the financial budgets to evaluate the financial consequences of investment, production, and sales plans Projected balance sheet Projected income statement Projected statement of cash flows Planners use the projected statement of cash flows in two ways: To plan when excess cash will be generated They can use it to make short-term investments rather than simply holding cash To plan how to meet any cash shortages  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Demand Forecast An organization’s goals provide the starting point and the framework for evaluating the budgeting process To assess the plan’s acceptability, planners compare the tentative operating plan’s projected financial results with the organization’s financial goals The budgeting process is influenced strongly by the demand forecast An estimate of sales demand at a specified selling price  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Developing the Demand Forecast Organizations develop demand forecasts in many ways: Market surveys conducted either by outside experts or by internal sales staff Statistical models to generate demand forecasts from trends and forecasts of economic activity in the economy and the relation of past sales patterns to this economic activity Assume that demand will either grow or decline by some estimated rate over previous demand levels Regardless of the approach used, the organization must prepare a sales plan for each key line of goods and services  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Importance of Sales Plans The sales plans provide the basis for other plans to acquire the necessary factors of production: Labor Materials Production capacity Cash Because production plans are sensitive to the sales plans, most organizations develop budgets on computers Planners can readily explore the effects of changes in the sales plans on production plans  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Level of Detail in Budget (1 of 2) Choosing the amount of detail to present in the budget involves making trade-offs: More detail in the forecast improves the ability of the budgeting process to identify potential bottlenecks and problems by specifying the exact timing of production flows Forecasting and planning in great detail for each item can be extremely expensive and overwhelming to compute  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Level of Detail in Budget (2 of 2) Production planners use their judgment to strike a balance between The need for detail The cost and practicality of detailed scheduling Planners do this by grouping products into pools Each product in a given pool places roughly equivalent demands on the organization’s resources Planning is simplified  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Production Plan Planners determine a production plan by matching the completed sales plan with the organization’s inventory policy and capacity level The plan identifies the intended production during each of the interim periods comprising the annual budget period Interim periods may be defined as days, weeks, or months Depending on how regularly the people managing the acquisition, manufacturing, selling, and distribution activities need information  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Inventory Policy (1 of 3) The inventory policy is critical and has a unique role in shaping the production plan Planners use the inventory policy and the sales plan to develop the production plan One policy is to produce goods for inventory and attempt to keep a target number of units in inventory at all times This level production strategy is characteristic of an organization with highly skilled employees or equipment dedicated to producing a single product Reflects a lack of flexibility  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Inventory Policy (2 of 3) Another inventory policy is to produce for planned sales in the next interim period within the budget period Organizations moving toward a just-in-time inventory policy produce goods to meet the next interim period’s demand as an intermediate step in moving to a full just-in-time inventory system Each interim period becomes shorter and shorter until the organization achieves just-in-time production The scheduled production is the amount required to meet the inventory target of the level of the next interim period’s planned sales  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Inventory Policy (3 of 3) Another inventory policy is a just-in-time (JIT) inventory policy In a JIT inventory strategy, demand directly drives the production plan Production in each interim period equals the next interim period’s planned sales A JIT inventory policy requires: Flexibility among employees, equipment, and suppliers A production process with little potential for failure  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Aggregate Planning Aggregate planning compares: The production plan The amount of available productive capacity This comparison assesses the feasibility of the proposed production plan It does not develop a detailed production schedule to guide daily production in the organization It determines whether the proposed production plan can be achieved by the capacity the organization either has in place or can put in place during the budget period Planners may need to consider ways to modify existing facilities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Spending Plan (1 of 4) Once planners identify a feasible production plan, they may make tentative resource commitments The purchasing group prepares a plan to acquire the required raw materials and supplies Since sales and production plans change, the organization and its suppliers must be able to adjust their plans quickly based on new information At some point the plans have to be locked in place and no additional changes made For example, commitment to a production schedule in a large automotive assembly plant occurs about eight weeks before production takes place Provides managers the time to put raw materials supply in place and schedule the production  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Spending Plan (2 of 4) The personnel and production groups prepare the labor hiring and training plans Works backward from the date when the personnel are needed to develop hiring and training schedules that will ensure the availability of the needed personnel When an organization is contracting, it will: Use retraining plans to redeploy employees to other parts of the organization, or Develop plans to discharge employees Because they involve moral, ethical, and legal issues and may involve high severance costs, layoffs are usually avoided unless no alternative can be found  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Spending Plan (3 of 4) Other decision makers in the organization prepare an administrative and discretionary spending plan Summarizes the proposed expenditures on activities such as for R&D, advertising, and training Discretionary expenditures provide the required infrastructure for the proposed production and sales plan “Discretionary” means the actual sales and production levels do not drive the amount spent The senior managers in the organization determine the amount of discretionary expenditures Once determined, the amount to be spent on discretionary activities becomes fixed for the budget period and is unaffected by product volume and mix  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Spending Plan (4 of 4) The appropriate authority approves the capital spending plan to acquire new productive capacity A long-term planning process rather than the one-year cycle of the operating budget drives the capital spending plan Capital spending projects usually involve time horizons longer than the period of the operating budget  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Choosing Capacity Levels (1 of 4) Three types of resources determine capacity: Flexible resources that the organization can acquire in the short term If suppliers do not deliver the resources or deliver unacceptable products, production may be disrupted Capacity resources that the organization must acquire for the intermediate term Capacity resources that the organization must acquire for the long term The level chosen reflects the organization’s assessment of its long-term growth trend  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Choosing Capacity Levels (2 of 4) Organizations develop sophisticated approaches to balance the use of short, intermediate, and long-term capacity to minimize the waste of resources We may classify resource-consuming activities into three groups Activities that create the need for resources (and resource expenditures) in the short-term Activities undertaken to acquire capacity for the intermediate-term Activities undertaken to acquire capacity needed for the long-term Planners classify activities by type because they plan, budget, and control short, intermediate, and long-term expenditures differently  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Choosing Capacity Levels (3 of 4) Analysts evaluate short-term activities by considering efficiency and asking: Is this expenditure necessary to add to the product value perceived by customers? Can the organization improve how it does this activity? Would changing the way this activity is done provide more satisfaction to the customer? Choosing the production plan (i.e., choosing the level of the short-term activities) fixes the short-term expenditures that the master budget summarizes  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Choosing Capacity Levels (4 of 4) Analysts evaluate intermediate- and long-term activities by using efficiency and effectiveness considerations and asking: Are there alternative forms of capacity available that are less expensive? Is this the best approach to achieve our goals? How can we improve the capacity selection decision to make capacity less expensive or more flexible? Choosing the capacity plan (i.e., making the commitments to acquire intermediate and long-term capacity) commits the firm to its intermediate and long-term expenditures  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Handling Infeasible Production Plans Planners use forecasted demand to plan activity levels and provide required capacity If planners find the tentative production plan infeasible, then they have to make provisions to: Acquire more capacity, or Reduce the planned level of production Occurs when projected demand exceeds available capacity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Interpreting The Production Plan Production is the lesser of: Total demand Production capacity Demand is the quantity customers are willing to buy at the stated price Production capacity is the minimum of: The long-term capacity The intermediate-term capacity The short-term capacity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Financial Plans Once the planners have developed the production, staffing, and capacity plans, they can prepare a financial summary of the tentative operating plans The projected balance sheet serves as an overall evaluation of the net effect of operating and financing decisions during the budget period The income statement serves as an overall test of the profitability of the proposed activities A cash flow forecast helps an organization identify if and when it will require external financing  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Cash Flow Statement The cash flow statement has three sections: Cash inflows from cash sales and collections of receivables Cash outflows For flexible resources that are acquired and consumed in the short term For capacity resources that are acquired and consumed in the intermediate and long term Results of financing operations  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financing Operations Summarizes the effects on cash of transactions that are not a part of the normal operating activities Includes the effects of: Issuing or retiring stock or debt Buying or selling capital assets Short-term financing Often involves obtaining a line of credit, secured or unsecured, with a financial institution The line of credit allows a company to borrow up to a specified amount at any time  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Using The Financial Plans (1 of 2) Organizations can raise money from outsiders by borrowing from banks, issuing debt, or selling shares of equity Based on the information provided by the cash flow forecast, organizations can plan the appropriate mix of external financing to minimize the long-run cost of capital  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Using The Financial Plans (2 of 2) A cash flow forecast helps an organization Identify if and when it will require external financing Determine whether any projected cash shortage will be: Temporary or cyclical Can be met by a line-of-credit arrangement, or Permanent Would require a long-term loan from a bank, further investment by the current owners, or investment by new owners (or a combination)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

What If Analysis Using a computer for the budgeting process, managers can explore the effects of alternative marketing, production, and selling strategies For example, a manager may consider raising prices, opening a retail outlet, or using different employment strategies Alternative proposals like these can be evaluated in a what-if analysis The structure and information required to prepare the master budget can be used easily to provide the basis for what-if analyses  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Sensitivity Analysis (1 of 2) What-if analysis is only as good as the model used to represent what is being evaluated The model must be complete, it must reflect relationships accurately, and it must use accurate estimates Otherwise, it will not provide good estimates of a plan’s results Planners test planning models by varying the model estimates If small changes in an estimate used in the production plan have a dramatic effect on the plan, the model is said to be sensitive to that estimate  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Sensitivity Analysis (2 of 2) Sensitivity analysis is the process of selectively varying a plan’s or a budget’s key estimates for the purpose of identifying over what range a decision option is preferred Sensitivity analysis enables planners to identify the estimates that are critical for the decision under consideration  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Variance Analysis (1 of 2) To help interpret production and financial outcomes, organizations compare planned (or budgeted) results with actual results A process called variance analysis Variance analysis has many forms and can result in complex measures, but its basis is very simple: An actual cost (or revenue) amount is compared with a target cost (or revenue) amount to identify the difference  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Variance Analysis (2 of 2) Accountants call the difference a variance A variance represents a departure from what was budgeted or planned An investigation will try to determine: What caused the variance What should be done to correct that variance  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Sources of Budgeted Costs Budgeted or planned costs can come from three sources: Standards established by industrial engineers Such as cost of steel that should go into the door of an automobile based on the door’s specifications Previous period’s performance For example, the cost of steel per door that was made in the last budget period A benchmark, the best in class results achieved by a competitor The cost of steel per comparable door achieved by the competitor that is viewed as the most efficient  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Variances (1 of 4) The financial numbers are the product of a price and a quantity component: Budgeted amount = expected price * expected quantity Actual amount = actual price * actual quantity Variance analysis explains the difference between planned and actual costs by evaluating: Differences between planned and actual prices Differences between planned and actual quantities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Variances (2 of 4) Accountants focus separately on prices and quantities because in most organizations: One department or division is responsible for the acquisition of a resource Determining the actual price A different department uses the resource Determining the quantity A variance is a signal that is part of a control system for monitoring results A variance provides a signal that operations did not go as planned  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Variances (3 of 4) Supervisory personnel use variances as an overall check on how well the people who are managing day-to-day operations are doing what they should be doing When compared to the performance of other organizations engaged in comparable tasks, variances show the effectiveness of the control systems that operations people are using  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Variances (4 of 4) If managers learn that specific actions they took helped lower the actual costs, then they can obtain further cost savings by repeating those actions on similar jobs in the future If they can identify the factors causing actual costs to be higher than expected, then they may be able to take the necessary actions to prevent those factors from recurring in the future If they learn that cost changes are likely to be permanent, they can update their cost information when bidding for future jobs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

First-Level Variances The first-level variance for a cost item is the difference between the actual costs and the master budget costs for that cost item Variances are favorable (F) if the actual costs are less than estimated master budget costs Unfavorable (U) variances arise when actual costs exceed estimated master budget costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Planning Variances A flexible budget adjusts the forecast in the master budget for the difference between planned volume and actual volume It reflects a cost target based on the level of volume that is actually achieved, rather than the planned volume that underlies the master budget Cost differences between the master and the flexible budget are called planning variances They reflect the difference between planned output and actual output They arise entirely because the planned volume of activity was not realized  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Flexible Budget Variances Flexible budget variances are the differences between the flexible budget and the actual results Reflect variances from the target level of costs adjusted for the actual level of activity A manager’s focus should be on these variances to determine whether cost-cutting activities have been successful Flexible budget variances reflect: Quantity variances -- the difference between the planned and the actual use rates per unit of output Cost variances -- the difference between the planned and the actual price or cost per unit of the various cost items  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Second & Third-Level Variances The second-level variances are the planning variance and the flexible budget variance Together they add up to the first-level variance The direct material flexible budget variances and direct labor flexible budget variances can be decomposed further into third-level variances: Efficiency variances Price variances Together they explain the flexible budget component of the second-level variance  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Direct Material Variances (1 of 2) The material quantity variance is calculated as: Quantity variance = (AQ-SQ) x SP Where: AQ = actual quantity of materials used SQ = standard (estimated) quantity of materials required SP = standard (estimated) price of materials  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Direct Material Variances (2 of 2) The material price variance is calculated as: Price variance = (AP-SP) x AQ Where: AP = actual price of materials SP = standard (estimated) price of materials AQ = actual quantity of materials used The sum of these two second-level variances is the total flexible budget variance for direct materials The price variance may, however, be calculated using the quantity purchased rather than the quantity used  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Direct Labor Variances The labor cost variances are determined in a manner similar to the material quantity and price variances: Efficiency variance = (AH-SH) x SR Rate variance = (AR-SR) x AH Where: AH = actual number of direct labor hours AR = actual wage rate & SR = standard rate SH = standard (estimated) number of direct labor hours The sum of the rate variance and the efficiency variance equals the total flexible budget direct labor variance  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Support Activity Cost Variances (1 of 2) Support costs can reflect either flexible or capacity-related costs The quantity of capacity-related costs may not change from period to period, but the spending on them may fluctuate E.g., engineers can travel, take courses, vacation, quit, and be replaced with someone else Monitoring spending variances on capacity-related resources is possible and desirable Even if one cannot monitor efficiency variances, which will show up as changes in used and unused capacity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Support Activity Cost Variances (2 of 2) Flexible support costs reflect behind-the-scenes operations that are proportional to the volume of activity but are not directly a part of the product or service provided to the customer For example, an indirect support cost in a factory would be the wages paid to employees who move work in process around the factory floor as the product is being made Flexible support costs consist of a quantity (or usage) component and a price component Flexible support cost variances may be analyzed in a manner similar to direct material or direct labor variances  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Budgeting In Nonmanufacturing Organizations (1 of 3) As in manufacturing organizations, budgeting helps nonmanufacturing organizations perform their planning function by coordinating and formalizing responsibilities and relationships and communicating the expected plans Budgeting serves a slightly different but equally relevant role in natural resource companies, service organizations, not-for-profit organizations, and government agencies  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Budgeting In Nonmanufacturing Organizations (2 of 3) In the natural resources sector, the focus is on balancing demand with the availability of natural resources Because the natural resource supply often constrains sales, success requires managing the resource base effectively to match supply with potential demand In the service sector, the focus is on balancing demand and the organization’s ability to provide services, which is determined by the organization’s level and mix of skills People rather than machines usually represent the capacity constraint in the service sector Planning is critical in high-skill organizations because people capacity is expensive and services cannot be inventoried when demand falls below capacity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Budgeting In Nonmanufacturing Organizations (3 of 3) In not-for-profit organizations, the focus of budgeting has been to balance revenues raised by taxes or donations with spending demands In government agencies planned cash outflows, or spending plans, are called appropriations Appropriations limit a government agency’s spending Many governments are looking for ways to eliminate unnecessary expenditures and to make necessary expenditures more efficient These agencies must establish priorities for their expenditures and improve the productivity with which they deliver services to constituents  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Periodic Budgeting The basic budgeting process described in this chapter involves many organizational design decisions, such as the length of the budget process, the basic budget spending assumptions, and the degree of top management control In a periodic budget cycle, the planners prepare budgets periodically for each planning period Periodic budgeting is typically performed once per budget period—usually once a year Planners may, however, update or revise the budgets  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Continuous Budgeting In continuous budgeting, as one budget period passes, planners drop that budget period from the master budget and add a future budget period in its place Usually a month or a quarter The length of the budget period reflects the competitive forces, skill requirements, and technology changes that the organization faces Long enough for the organization to anticipate important environmental changes and adapt to them Short enough to ensure that estimates for the end of the period will be reasonable and realistic  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Periodic v. Continuous Budgeting Advocates of periodic budgeting argue that continuous budgeting takes too much time and effort and that periodic budgeting provides virtually the same benefits at a smaller cost Advocates of continuous budgeting argue that it keeps the organization planning, and assessing, and thinking, strategically year-round rather than just once a year at budget time  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Controlling Discretionary Expenditures Organizations generally use one of three general approaches to budget discretionary expenditures: Incremental budgeting Zero-based budgeting Project funding Each has benefits distinct from the others  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Incremental Budgeting Incremental budgeting bases a period’s expenditure level on the amount spent during the previous period If the total budget for discretionary items increases by 10%, then: Each discretionary item is allowed to increase 10%, or All items may experience an across-the-board increase of, for example, 5% and the remaining 5% increase may be allocated based on merit Some people have criticized incremental budgeting because it does not require justification of the organization’s goals for discretionary expenditures  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Zero-Based Budgeting (1 of 2) Zero-based budgeting (ZBB) requires that proponents of discretionary expenditures continuously justify every expenditure Zero-based budgeting is not appropriate for budgeting that relates to engineered costs that vary in proportion to production The starting point for each line item is zero Zero-based budgeting arose, in part, to combat indiscriminate incremental budgets where projects that take on a life of their own and resist going out of existence  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Zero-Based Budgeting (2 of 2) Under ZBB, planners allocate the organization’s resources to the spending proposals they think will best achieve the organization’s goals This approach to project budgeting has been used primarily to assess government expenditures In profit-seeking organizations, ZBB has been applied only to discretionary expenditures Even for engineered costs, ZBB could be effective when combined with the reengineering approach Critics of ZBB complain it is expensive because it requires so much employee time to prepare  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Project Funding Some critics of ZBB have proposed an intermediate solution to mitigate the disadvantages of ZBB and incremental budgeting The intermediate solution is called project funding A proposal is made for discretionary expenditures with a specific time horizon or sunset provision Projects with indefinite lives (sometimes called programs) should be continuously reviewed to ensure that they are living up to their intended purposes Requests to extend or modify the project must be approved separately  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Activity-Based Budgeting A recent approach to budgeting is activity-based budgeting, which is based on activity-based costing Activity-based budgeting uses knowledge about the relationship between the quantity of production units and the activities required to produce those units to develop detailed estimates of activity requirements underlying the proposed production plan The two main benefits of activity-based budgeting are It identifies situations when production plans require new capacity It provides a more accurate way to project future costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Managing the Budgeting Process (1 of 2) Many organizations use a budget team, headed by the organization’s budget director or the controller, to coordinate the budgeting process The budget team usually reports to a budget committee, which generally includes the chief executive officer, the chief operating officer, and the senior executive vice presidents The composition of the budget committee reflects the role of the budget as the planning document that reflects and relates to the organization’s strategy and objectives  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Managing the Budgeting Process (2 of 2) The danger of using a budget committee is that it may signal to other employees that budgeting is something that is relevant only for senior management Senior management must take steps to ensure that the organization members affected by the budget do not perceive the budget and the budgeting process as something beyond their control or responsibility  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Behavioral Aspects of Budgeting Because of the human factor involved in the process, budgets often do not develop smoothly Social scientists have engaged in extensive study about the human factors involved in budgeting Two related areas are of particular importance with respect to the behavioral issues they raise: Designing the budget process Influencing the budget process  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Designing the Budget (1 of 2) How should budgets be determined and who should be involved in the budgeting process? Three common methods of setting budgets are: Authoritarian A superior simply tells subordinates what their budget will be Participation All parties agree about setting the budget targets, using a joint decision-making process Consultation Managers ask subordinates to discuss their ideas about the budget but determine the final budget alone  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Designing the Budget (2 of 2) Research shows that the most motivating types of budgets are those that are tight With targets that are perceived as ambitious but attainable Recently, companies such as Boeing and General Electric have implemented what are known as stretch targets Stretch targets exceed previous targets by a significant amount and usually require an enormous increase in a goal over the next budgeting period The theory is that only in this manner will companies completely reevaluate the ways in which they develop and produce products and services  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Influencing The Budget Process When incentives and compensation are tied to the budget, some managers have been known to play budgeting games in which they attempt to manipulate information and targets to achieve as high a bonus as possible (or the best evaluation) Participation provides employees the opportunity to affect their budgets in ways that may not always be in the best interests of the organization Subordinates might ask for resources above and beyond what they need to accomplish their budget objectives  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Budget Slack Budget slack is created by requiring excess resources or distorting performance information If subordinates succeed in creating budget slack, they will find it easy to meet or exceed their budgeted objectives Budgeting games can never be eliminated, although some organizations have devised methods to decrease the amount of budget slack Management can use a long, iterative process to formulate the budget to remove much slack An incentive system may provide higher levels of bonuses based on attaining higher targets  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Capital Budgeting Chapter 11  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Long-Term (Capital) Assets Chapters 3 and 4 discussed the cost of capacity resources that organizations purchase and use for years to make goods and provide services Capital assets create these capacity-related costs Cost commitments associated with long-term assets create risk for an organization: Remain even if the asset does not generate the anticipated benefits Reduce an organization’s flexibility Therefore, organizations approach investments in long-term assets with considerable care  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Need to Control Capital Assets Organizations have developed specific tools to control the acquisition and use of long-term assets because: Organizations are usually committed to long-term assets for an extended time, creating the potential for Excess capacity that creates excess costs Scarce capacity that creates lost opportunities The amount of money committed to the acquisition of capital assets is usually quite large The long-term nature of capital assets creates technological risk Capital budgeting is a systematic approach to evaluating an investment in a capital asset  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Investment and Return The fundamental evaluation issue in dealing with a long-term asset is whether its future benefits justify its initial cost Investment is the monetary value of the assets the organization gives up to acquire a long-term asset Return is the increased future cash inflows attributable to the long-term asset Investment and return form the foundation of capital budgeting analysis, which focuses on whether the expected increased cash flows (return) will justify the investment in the long-term asset  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Time Value of Money (1 of 2) Time value of money (TVM) is a central concept in capital budgeting Because money can earn a return: Its value depends on when it is received Using money has a cost The lost opportunity to invest the money in another investment alternative In making investment decisions, the problem is that investment cash is paid out now, but the cash return is received in the future We need an equivalent basis to compare the cash flows that occur at different points in time  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Time Value of Money (2 of 2) Because money has a time-dated value, the critical idea underlying capital budgeting is: Amounts of money spent or received at different periods of time must be converted into their value on a common date in order to be compared  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Some Standard Notation For simplicity, the following notation is used: Abbr. Meaning n FV PV a r Number of periods considered in the investment analysis; common period lengths are a month, a quarter, or a year Future value, or ending value, of the investment n periods from now Present value, or the value at the current moment in time, of an amount to be received n periods from now Annuity, or equal amount, received or paid at the end of each period for n periods Rate of return required, or expected, from an investment opportunity; the rate of interest earned on an investment  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Future Value Because money has time value, it is better to have money now than in the future Having $1.00 today is more valuable than receiving $1.00 in the future because the $1.00 on hand today can be invested to grow to more than $1.00 The future value (FV) is the amount that today’s investment will be after earning a stated periodic rate of return for a stated number of periods For one period: FV=PV x (1+r) Because investment opportunities usually extend over multiple periods, we need to compute future value over several periods  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

FV with Multiple Periods An initial amount of $1.00 accumulates to $1.2763 over five years if the annual rate of return is 5%: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 $1.0000 $1.0500 $1.1025 $1.1576 $1.2155 $1.2763 This calculation assumes the following: Interest earned stays invested until the end of year 5 Therefore, interest is earned each year on both the initial investment and the interest earned in previous periods Financial analysts call that process the compound effect of interest The rate of return is constant  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Computing Future Values For Multiple Periods (1 of 2) The formula for a future value is FV=PV x (1+r)n One may compute this value in different ways: Calculator methods (using 5 years at 5% for examples) Multiply $1.00 by 1.05 five times If your calculator computes exponents directly, you may compute $1.00x(1.05)5 Financial calculators have TVM functions that allow you to compute FV Follow your calculator’s instructions  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Computing Future Values For Multiple Periods (2 of 2) Table Method Tables that provide the factors needed to compute a future value for different numbers of periods and rates of return are available For example, Exhibit 11-2 in the textbook Find where the column (r) intersects with the row (n). Multiply this factor by the amount of the initial investment to find the future value Spreadsheet Method Every computer spreadsheet program can compute future values and all other financial calculations described in this chapter  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Choosing a Common Date An investment’s cash flows must be converted to their equivalent value at some common date in order to make meaningful comparisons between the project’s cash inflows and outflows Although any point in time can be chosen as the common date, the conventional choice is the point when the investment is undertaken Analysts call this time zero, or period zero Therefore, conventional capital budgeting analysis converts all future cash flows to their equivalent value at time zero  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

PV = FV/(1 + r)n or PV = FV x (1 + r)-n Present Value Analysts call a future cash flow’s value at time zero its present value The process of computing present value is called discounting We can rearrange the FV formula to compute the present value: FV = PV x (1 + r)n PV = FV/(1 + r)n or PV = FV x (1 + r)-n Methods similar to those described earlier may be used to compute this value Calculator, tables, or spreadsheet software  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Decay of a Present Value Invested amounts grow at a compound rate through time Similarly, a fixed amount of cash to be received at some future time becomes less valuable as: Interest rates increase The time period before receipt of the cash increases One consequence of this decay is that large benefits expected far in the future will have relatively little current value, especially when interest rates exceed 10% Arbitrarily high interest rates will result in projects (especially long-term ones) being inappropriately turned down  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Annuities Not all investments have cash outlays at time zero and provide a single benefit at some future point Most investments provide a series, or stream, of benefits over a specified future period An investment that promises a constant amount each period over n periods is called an n-period annuity Many lotteries are examples of an n-period annuity because they pay prizes in the form of an annuity that lasts for 20 years or longer  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

PV of an Annuity To illustrate the idea of an annuity and its present value, suppose you have won a $20 million lottery prize that pays $1 million a year for 20 years You are interested in selling this annuity to raise cash to purchase a business What is the value of this annuity today, if the current rate of interest is 7%? Using a table we can compute the present value of the lottery annuity as follows: PV = a x annuity present value factor7%, 20 periods = $1,000,000 x 10.594 = $10,594,000  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Computing the Required Annuity We may need to compute the annuity value that a current investment will generate For example, if you agreed to repay a loan with equal periodic payments, then you are selling the lender an annuity in exchange for the face value of the loan The factor required to compute the amount of the annuity to repay a present value is simply the inverse of the present value factor for an annuity: Annuity factor = 1 / PV factor  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost of Capital The cost of capital is the interest rate used for discounting future cash flows Also known as the risk-adjusted discount rate The cost of capital is the return the organization must earn on its investment to meet its investors’ return requirements The organization’s cost of capital reflects: The amount and cost of debt and equity in its financial structure The financial market’s perception of the financial risk of the organization’s activities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Capital Budgeting Capital budgeting is the collection of tools that planners use to evaluate the desirability of acquiring long-term assets Organizations have developed many approaches to capital budgeting Six approaches are discussed here: Payback Accounting rate of return Net present value Internal rate of return Profitability index EVA criterion  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Shirley’s Doughnut Hole To show how each of these methods works and alternative perspectives, we apply each to Shirley’s Doughnut Hole as it considers the purchase of a new automatic doughnut cooker: Cost: $70,000 Life: five years Benefit: expanded capacity and reduced operating costs would increase Shirley’s profits by $20,000 per year Shirley’s cost of capital is 10% The new cooker would be sold for $10,000 at the end of five years  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Payback Criterion The payback period is the number of periods needed to recover a project’s initial investment Shirley’s initial investment of $70,000 is recovered midway between years 3 and 4 The payback period for this project is 3.5 years Many people consider the payback period to be a measure of the project’s risk The organization has unrecovered investment during the payback period The longer the payback period, the higher the risk Organizations compare a project’s payback period with a target that reflects the organization’s acceptable level of risk  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Problems with Payback The payback criterion has two problems: It ignores the time value of money Some organizations use the discounted payback method, which computes the payback period but uses discounted cash flows It ignores the cash outflows that occur after the initial investment and the cash inflows that occur after the payback period Despite these limitations, some surveys show that the payback calculation is the most used approach by organizations for capital budgeting This popularity may reflect other considerations, such as bonuses that reward managers based on current profits, that create a preoccupation with short-run performance  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Accounting Rate of Return (1 of 2) Analysts compute the accounting rate of return by dividing the average accounting income by the average level of investment Analysts use the accounting rate of return to approximate the return on investment The increased annual income that Shirley’s will report related to the new cooker will be $8000 $20,000 - $12,000 of depreciation The average income will equal the annual income since the annual income is equal each year The average investment is $40,000 [($70,000 + 10,000) / 2]  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Accounting Rate of Return (2 of 2) The accounting rate of return for the cooker investment is computed as: $8,000 / $40,000 = 20% If the accounting rate of return exceeds the target rate of return, then the project is acceptable Like the payback method the accounting rate of return method has a drawback: By averaging, it does not consider the timing of cash flows This method is an improvement over the payback method in that it considers cash flows in all periods  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Net Present Value (1 of 4) The net present value (NPV) is the sum of the present values of a project’s cash flows This is the first method considered that incorporates the time value of money The steps used to compute an investment’s net present value are as follows: Step 1: Choose the appropriate period length to evaluate the investment proposal The period length depends on the periodicity of the investment’s cash flows The most common period used in practice is one year Analysts also use quarterly and semiannual periods  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Net Present Value (2 of 4) Step 2: Identify the organization’s cost of capital, and convert it to an appropriate rate of return for the period length chosen in step 1 Step 3: Identify the incremental cash flow in each period of the project’s life Step 4: Compute the present value of each period’s cash flow using the organization’s cost of capital for the discount rate Step 5: Sum the present values of all the periodic cash inflows and outflows to determine the investment project’s net present value Step 6: If the project’s net present value is positive, the project is acceptable from an economic perspective  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Net Present Value (3 of 4) To determine the NPV of Shirley’s investment: Step 1: The period length is one year All cash flows are stated annually Step 2: Shirley’s cost of capital is 10% per year Because the period chosen in step 1 is annual, no adjustment is necessary to the rate of return Step 3: The incremental cash flows are: $70,000 outflow immediately $20,000 inflow at the end of each year for five years $10,000 inflow from salvage at the end of five years It is useful to organize the cash flows associated with a project on a time line to help identify and consider all the project’s cash flows systematically  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Net Present Value (4 of 4) Step 4: The present value of the cash flows when the organization’s cost of capital is 10% are: For a five-year annuity of $20,000, PV = $75,816 For the $10,000 salvage in five years, PV = $6,209 Step 5: To sum the present values of all the periodic cash flows and determine NPV The PV of the cash inflows (from step 4) is $82,025 Because the investment of $70,000 takes place at time zero, the PV of the total outflows is $(70,000) The NPV of this investment project is $12,025 Step 6: Because the NPV is positive, Shirley’s should purchase the cooker It is economically desirable  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Internal Rate of Return (1 of 2) The internal rate of return (IRR) is the actual rate of return expected from an investment The IRR is the discount rate that makes the investment’s net present value equal to zero If an investment’s NPV is positive, then its IRR exceeds its cost of capital If an investment’s NPV is negative, then it’s IRR is less than its cost of capital By trial and error, or the use of a financial calculator or spreadsheet software, we find that the IRR in Shirley’s is 16.14% Because a 16.14% IRR > 10% cost of capital, the project is desirable  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Internal Rate of Return (2 of 2) IRR has some disadvantages: It assumes that a project’s intermediate cash flows can be reinvested at the project’s IRR Frequently an invalid assumption It can create ambiguous results, particularly: When evaluating competing projects in situations where capital shortages prevent the organization from investing in all positive NPV projects When projects require significant outflows at different times during their lives Moreover, because a project’s NPV summarizes all its financial elements, using the IRR criterion is unnecessary when preparing capital budgets Still, it is a widely used capital budgeting tool  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Survey Results: % Rating the Capital Budgeting Tool as Extremely Important  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Profitability Index (1 of 2) The profitability index is a variation of the net present value method It is used to make comparisons of mutually exclusive projects with different sizes and is computed by dividing the present value of the cash inflows by the present value of the cash outflows A profitability index of 1 or greater is required for the project to be acceptable  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Profitability Index (2 of 2) Recall that with Shirley’s Doughnut Hole, the present value of the cash inflows was $82,025 and the present value of the cash outflows was $70,000 Therefore, the profitability index for that project was 1.17 $82,025/$70,000 It is possible for project A to have a higher profitability index while project B has a higher NPV An organization must determine how to choose when the criteria give conflicting results  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Economic Value Added (1 of 2) Recently, some analysts and consultants have proposed using the economic value added (EVA) criterion as a way to evaluate organization performance Although the criterion is not directly suitable for evaluating new investments, its insights are useful Computing EVA begins by using accounting income calculated according to GAAP Then the analyst adjusts accounting income for what the EVA proponents consider to be GAAP’s conservative bias Common adjustments include capitalizing and amortizing research and development and significant product launch costs, adjusting for the LIFO effect on inventory valuation, and eliminating the effect of deferred income taxes  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Economic Value Added (2 of 2) Next, the analyst computes the amount of investment in the organization and derives economic value added as follows: EVA = Adj. accounting income - (Cost of capital x Investment) The formula for economic value added is directly related to the net present value criterion The major difference between the two is that EVA begins with accounting income, which includes various accruals and allocations rather than net cash flow as does NPV This is why EVA is more suited to evaluating an ongoing investment than a new investment opportunity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Effect of Taxes (1 of 3) In practice, capital budgeting must consider the tax effects of potential investments The exact effect of taxes on the capital budgeting decisions depends on tax legislation, which is specific to a tax jurisdiction In general, the effect of taxes is twofold: Organizations must pay taxes on any net benefits provided by an investment Organizations can use the depreciation associated with a capital investment to reduce income and offset some of their taxes The rate of taxation and the way that legislation allows organizations to depreciate the acquisition cost of their long-term assets as a taxable expense varies over time and by jurisdiction  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Effect of Taxes (2 of 3) Assume Shirley’s income taxed rate is 40% For simplicity, assume that the relevant tax law requires Shirley’s to claim straight-line depreciation as a tax-deductible expense (Historical cost less salvage value) / useful life This analysis requires converting all pretax cash flows to after-tax cash flows: Using straight-line depreciation, Shirley’s Doughnut Hole will claim $12,000 depreciation each year Taxable income of $8,000 will result in Shirley’s paying $3,200 in income taxes each year The annual after-tax cash flow will be $16,800  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Effect of Taxes (3 of 3) The investment provides two after-tax benefits: Five-year annuity of $16,800 Lump-sum payment of $10,000 at the end of five years Because book value after five years is $10,000, there is no gain in selling it for $10,000 and, therefore, no tax The present value of the five-year annuity of $16,800 discounted at 10% is $63,685 The present value of the lump-sum payment of $10,000 is $6,209 The net present value of this investment project is $(106) ($63,685 + 6,209 - 70,000) Because the project’s net present value is negative, it is not economically desirable  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Effect of Inflation Inflation is a general increase in the price level To account for inflation we must adjust future cash flows so that we can compare dollars of similar purchasing power Similarly, we discounted future cash flows to the present using an appropriate discount rate to account for the time value of money We discount each cash flow by the appropriate discount rate and the expected inflation rate If Shirley’s expected inflation of 2.5%, the combined discount rate would be 1.1275% 1.10 x 1.025  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Uncertainty in Cash Flows (1 of 2) Capital budgeting analysis relies on estimates of future cash flows Because estimates are not always realized, many decision makers like to know how their estimates affect the decision they are making Estimating future cash flows is an important and difficult task Important because many decisions will be affected by those estimates Difficult because these estimates will reflect circumstances that the organization may not have previously experienced  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Uncertainty in Cash Flows (2 of 2) Most cash flow estimation is incremental Meaning that it is based on previous experience E.g., based on manufacturer claims, a new machine might be expected to decrease costs by 10% Many organizations assume that learning will systematically reduce the costs of a new system or process Cash flows related to sales of a new product are often estimated based on past experiences with similar products The forecast usually starts with previous experience and makes adjustments  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

High Low Method One approach to estimating cash flows begins by asking the planner to estimate the most likely effect of a decision, such as a cost decrease or a revenue increase, and then to estimate the highest and lowest possible values The planner next constructs a normal distribution with a mean equal to the most likely value estimated and a standard deviation calculated by subtracting the mean from the highest estimated value and dividing the difference by 3 Only the mean or expected value of the estimate is needed for the net present value model, but by developing a distribution of expected outcomes, the planner can develop probabilistic statements about the results E.g., “I believe the probability is about 98% (.9772) that the net cash flow benefit will be at least $80,000”  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Expected Value Method Another approach for the planner is to identify four or five possible outcomes and to assign each a probability of occurring, such that the total probabilities assigned equals one Then the expected value of the estimate is computed by weighting each estimate by its probability This estimate would be used in the capital budgeting model to project the revenue and cost effects of the investment project  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Wait and See In some circumstances, an organization may be able to delay a final decision and undertake a smaller version of the project to gain more information E.g., introducing a prototype of a new product to a consumer panel, or purchasing a few machines instead of many machines Analysts have developed an interest in applying options theory to investment decisions A process called real options analysis In real options analysis, the organization purchases an option that allows the option holder to purchase an asset at a specified future point in time at a specified price A form of option called a European call option The value of the option is determined by the volatility of the future value of the asset  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

What-If & Sensitivity Analysis (1 of 2) Two other approaches to handling uncertainty are what-if and sensitivity analysis In the Shirley’s Doughnut Hole example, Shirley might ask, “What must the cash flows be to make this project unattractive?” Fortunately, computer spreadsheets make questions like this easy to answer Most planners today use personal computers and electronic spreadsheets for capital budgeting The planner can set up a computer spreadsheet to make changes to the estimates of the decision’s key parameters  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

What-If & Sensitivity Analysis (2 of 2) If the analysis explores the effect of a change in a parameter on an outcome, we call this investigation a what-if analysis For example, the planner may ask, “What will my profits be if sales are only 90% of the plan?” A planner’s investigation of the effect of a change in a parameter on a decision, rather than on an outcome, is called a sensitivity analysis For example, the planner may ask, “How low can sales fall before this investment becomes unattractive?”  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Strategic Considerations (1 of 3) The common benefits associated with acquiring long-term assets (e.g., increased profits) ignore the assets’ strategic benefits, which are of increasing importance Including strategic benefits in a capital budgeting example is controversial They are difficult to estimate, so they are risky to include However, strategic benefits are likely to be no more difficult to estimate than the profits from expected sales or expected cost savings  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Strategic Considerations (2 of 3) Long-term assets usually provide the following strategic benefits: They allow an organization to make goods or deliver a service that competitors cannot E.g., by developing a patented process to make a product that competitors cannot replicate They support improving product quality by reducing the potential to make mistakes E.g., by improving machining tolerances or reducing reliance on operator settings They help shorten the production cycle time E.g., by implementing one-hour photo developing  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Strategic Considerations (3 of 3) Shirley’s may consider investing in a cooker that senses when a doughnut is cooked and ejects it automatically It may allow the hiring of less-skilled, and lower-paid employees The cooker may improve the consistency of cooking and the quality of the doughnuts Customers are likely to find Shirley’s doughnuts more desirable In this situation, the benefits from the automatic cooker can include increased sales and lower operating expenses if the competitors do not have this cooker The automatic cooker can prevent an erosion of sales if Shirley’s competitors also purchase it In either situation, acquiring the automatic cooker provides benefits that should be incorporated in the capital budgeting analysis  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Post-Implementation Audits (1 of 3) After-the-fact audits can provide an important discipline to capital budgeting Revisiting the decision to purchase a long-lived asset is called a post-implementation audit of the capital budgeting decision and provides many valuable insights for decision makers When estimates are used to support proposals, recognizing the behavioral implications that lie behind them is important For example, a production supervisor who is anxious to have the latest production equipment may be optimistic to the point of being reckless in forecasting the benefits of acquiring the equipment  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Post-Implementation Audits (2 of 3) This behavior is mitigated if people understand that, once equipment is acquired, the company will compare results with the claims made in support of the equipment’s acquisition And that higher costs, including depreciation, will be assigned to products or customers produced with or served by this asset Many organizations fail to compare the estimates made in the capital budgeting process with the actual results This is a mistake for three reasons:  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Post-Implementation Audits (3 of 3) By comparing estimates with results, the organizations planners can identify where their estimates are wrong and try to avoid making similar mistakes in the future By assessing the skill of planners, organizations can identify and reward those who are good at making capital budgeting decisions By auditing the results of acquiring long-term assets, companies create an environment in which planners are less tempted to inflate estimates of the cash benefits associated with their projects in order to get them approved  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Budgeting Other Spending Proposals (1 of 2) Organizations develop spending proposals for discretionary items other than capital expenditures E.g., R&D, advertising, and training Such items can provide benefits that will be realized for many periods into the future Even if GAAP requires that they be currently expensed Their magnitude suggests that they should be evaluated like capital spending projects when possible  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Budgeting Other Spending Proposals (2 of 2) The approach to analyzing a discretionary expenditure is identical to that used to decide whether to make a capital investment: Estimate the discounted cash inflows (benefits) and discounted cash outflows (costs) associated with any discretionary spending project Accept the project if the NPV is positive  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financial Control Chapter 12  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

What are Financial Controls? Financial control involves the use of financial measures to assess organization and management performance The focus of attention could be a product, a product line, an organization department, a division, or the entire organization Financial control provides a counterpoint to the balanced scorecard view that links financial results to its presumed drivers Focuses only on financial results Chapter 9 discussed the role of the balanced scorecard  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Environment of Financial Control (1 of 2) Organizations have developed and exploited financial measures to assess performance and target areas for improvement because external stakeholders have traditionally relied on financial performance measures to assess organization potential Such as investors, stock analysts, and creditors  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Environment of Financial Control (2 of 2) Financial measures do not identify what is wrong, but they do provide a signal that something is wrong and needs attention Financial control is treated separately in this book because its use and tools are so pervasive in our economy Part of the broader topic of organization control  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Financial Control Chapter 10 discussed using variance analysis to evaluate operations One of the oldest and most widely used forms of financial control This chapter focuses on broader issues in financial control Including the evaluation of organization units and of the entire organization Managers use and consider both: Internal financial controls Information used internally and not distributed to outsiders External financial controls Developed by outside analysts to assess organization performance  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Decentralization (1 of 2) Decentralization is the process of delegating decision making authority down the organization hierarchy It was the phenomenon that prompted the original development and use of internal financial control in organizations in the early 1900’s Highly centralized organizations tend not to respond effectively or quickly to their environments  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Decentralization (2 of 2) Centralization is best suited to organizations that: Are well adapted to stable environments Have no major information differences between the corporate headquarters and the employees Have no changes in the organization’s environment that required adaptation by the organization Decentralization is more appropriate for an organization when any of those conditions does not hold true  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Centralized Organizations (1 of 2) In centralized organizations: Technology and customer requirements are well understood The product line consists mostly of commodity products for which the most important attributes are price and quality When price is critical, so too are cost control and quality  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Centralized Organizations (2 of 2) To accomplish this, organizations develop standard operating procedures to ensure that: They are using the most efficient technologies and practices to promote both low cost and consistent quality There are no deviations from the preferred way of doing things  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Changing Environment In response to increasing competitive pressures and the opening up of former monopolies to competition, many organizations are changing the way they are organized and the way they do business Even in industries that were once thought to have stable environments, such as utilities, couriers, and financial institutions This is necessary because they must be able to change quickly in a world where technology, customer tastes, and competitors’ strategies are constantly changing  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Becoming More Adaptive Being adaptive generally requires that the organization’s senior management delegate or decentralize decision-making responsibility to more people in the organization Decentralization : Allows motivated and well-trained organization members to identify changing customer tastes quickly Gives front-line employees the authority and responsibility to develop plans to react to these changes  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Many Degrees of Decentralization Some organizations restrict most decisions to senior and middle management Others delegate important decisions about how to make products and serve customers to the employees who perform these activities The amount of decentralization reflects the organization’s need to have people on the front lines who can make good decisions quickly and: The organization’s trust in its employees The employees’ level of skill and training The employees’ ability to make the right choices  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

From Task to Results Control In decentralization, control moves from task control to results control From where people are told what to do To where people are told to use their skill, knowledge, and creativity to improve results In financial control those results are measured in financial terms For example, a production supervisor would be told to reduce costs by improving the manufacturing processes  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Responsibility Centers (1 of 2) A responsibility center is an organization unit for which a manager is made responsible A responsibility center is like a small business But it is not completely autonomous Its manager is asked to run that small business to promote the best interests of the larger organization  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Responsibility Centers (2 of 2) The manager and supervisor establish goals for their responsibility center These goals should: Be specific and measurable so as to provide employees with focus Promote the long-term interests of the larger organization Promote the coordination of each responsibility center’s activities with the efforts of all the others  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Coordinating Responsibility Centers For an organization to be successful, the activities of its responsibility units must be coordinated Imagine dividing the operations in a fast-food restaurant into three groups: Order taking, order preparation, and order delivery Picture the chaos and customer ill will that would be created if the communication links between any two of these organization groups were severed Unfortunately, sales, manufacturing, and customer service activities are often very disjointed in large organizations, resulting in diminished performance In general, nonfinancial performance measures detect coordination problems better than financial measures  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Responsibility Centers & Financial Control Organizations use financial control to provide a summary measure of how well their systems of operations control are working When organizations use a single index to provide a broad assessment of operations, they frequently use a financial number because it is a measure that describes the primary objectives of shareowners in profit-seeking organizations E.g., revenue, cost, profit, or return on investment  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Responsibility Center Types The accounting report prepared for a responsibility center reflects the degree to which the responsibility center manager controls revenue, cost, profit, or return on investment When preparing accounting summaries, accountants classify responsibility centers into one of four types: Cost centers Revenue centers Profit centers Investment centers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Center A responsibility center in which employees control costs but do not control revenues or investment level Virtually every processing group in service operations or in manufacturing operations is a candidate to be treated as a cost center Organizations evaluate the performance of cost center employees by comparing the center’s actual costs with target or standard cost levels for the amount and type of work done Therefore, cost standards and variances figure prominently in cost center reports  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Other Issues in Cost Center Control (1 of 2) Many organizations make the mistake of evaluating a cost center solely on its ability to control costs Other critical performance measures may include: Quality Response time Meeting production schedules Employee safety Respect for the organization’s ethical and environmental commitments  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Other Issues in Cost Center Control (2 of 2) If management evaluates cost center performance only on the center’s ability to control costs, its members may ignore unmeasured attributes of performance Performance measures should reflect all contributions the cost center makes to the organization’s success  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Revenue Center A responsibility center whose members control revenues but control neither the manufacturing or acquisition cost of the product or service they sell nor the level of investment made in the responsibility center Examples include a department in a department store, a regional sales office of a national or multinational corporation, and a unit in a large chain of units Some revenue centers control price, the mix of stock carried, and promotional activities In these centers, revenue will measure most of their value added activities and will indicate in a broad way how well they carried out their various activities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Costs Incurred by Revenue Centers Most revenue centers incur sales and marketing costs and have varying degrees of control over those costs It is common in such situations to deduct the responsibility center’s traceable costs from its sales revenue to compute the center’s net revenue Traceable costs may include salaries, advertising costs, and selling costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Drawbacks of Revenue Centers Critics of the revenue center approach argue that basing performance evaluation on revenues can create undesirable consequences For example, sales staff rewarded solely on sales may: Promote a wide product line that in turn may create excessive diversity-related costs (both production and logistical) Offer excessive customized services In general, focusing only on revenues causes organization members to increase the use of activities that create costs in order to promote higher revenue levels  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Profit Center A responsibility center where managers and other employees control both the revenues and the costs of the product or service they deliver A profit center is like an independent business, except that senior management, not the responsibility center manager, controls the level of investment in the responsibility center For example, if the manager of one outlet in a chain of discount stores has responsibility for pricing, product selection, purchasing, and promotion, but not the level of investment in the store, then the outlet meets the conditions to be evaluated as a profit center Most units of chain operations are treated as profit centers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Profit Centers? (1 of 3) It is doubtful that a unit of a corporate-owned hotel or fast-food restaurant meets the conditions to be treated as a profit center The head offices make most purchasing, operating, pricing, and promotional decisions These units are sufficiently large that: Costs may vary due to differences in controlling labor costs, food waste, and scheduled hours Revenues may also shift significantly based on how well staff manages the property  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Profit Centers? (2 of 3) Although these organizations do not seem to be candidates to be treated as profit centers, local discretion often affects revenues and costs enough so that they can be Many organizations evaluate units as profit centers even though the corporate office controls many facets of their operations The profit reported by these units reflects both corporate and local decisions  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Profit Centers? (3 of 3) If unit performance is poor, it may reflect: Poor conditions no one in the organization can control Poor corporate decisions Poor local decisions Organizations should not rely solely on profit center’s financial results for performance evaluations Detailed performance evaluations should include quality, material use, labor use, and service measures that the local units can control  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Investment Center A responsibility center in which the manager and other employees control revenues, costs, and the level of investment in the responsibility center The investment center is like an independent business For example, between 1970 and 2000 General Electric acquired many businesses Including aircraft engines, medical systems, power systems, transportation systems, consumer products, industrial systems, broadcasting, plastics, specialty materials, and financial services Senior executives at General Electric developed a management system that evaluated these businesses as independent operations – in effect as investment centers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Evaluating Responsibility Centers (1 of 2) Underlying the accounting classifications of responsibility centers is the concept of controllability The controllability principle states that the manager of a responsibility center should be held responsible only for the revenues, costs, or investment that responsibility center personnel control  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Evaluating Responsibility Centers (2 of 2) Revenues, costs, or investments that people outside the responsibility center control should be excluded from the accounting assessment of that center’s performance Although the controllability principle sounds appealing and fair, it can be difficult, often misleading, and undesirable to apply in practice  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Problems with the Controllability Principle (1 of 2) A significant problem in applying the controllability principle is that in most organizations many revenues and costs are jointly earned or incurred In most organizations, the activities that create the final product are sequential and interdependent Evaluating the individual performance of one center requires the firm to consider many facets of performance  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Problems with the Controllability Principle (2 of 2) As part of the performance evaluation process, the organization may want to prepare accounting summaries of the performance of individual units to support some system of financial control The management accountant immediately confronts the dilemma of how to account for highly interrelated centers as if they were individual businesses Some people do not agree that the controllability principle is the best way to view performance evaluations  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Using Performance Measures to Influence v. Evaluate Decisions Some people suggest that the choice of the performance measure should influence decision-making behavior They argue that controllability is not a valid criterion to use in selecting a performance measure When more costs or even revenues are included in performance measures, managers are more motivated to find actions that can influence incurred costs or generated revenues  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Example from a Dairy (1 of 2) A dairy faced the problem of developing performance standards in an environment of continuously rising costs The costs of raw materials, which were 60% - 90% of the final costs, were market determined Thought to be beyond the product managers’ control People argued that evaluation of the managers should depend on their ability to control the quantity of raw materials used rather than the cost Senior management announced that it would evaluate managers on their ability to control total costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Example from a Dairy (2 of 2) The managers quickly discovered that one way to control raw materials costs was through long-term fixed price contracts for raw materials Contracts led to declining raw materials costs The company could project product costs several quarters into the future, thereby achieving lower costs and stability in planning and product pricing When more costs or revenues are included in performance measures, managers are more motivated to find actions that can influence incurred costs or generated revenues Even when they cannot control costs entirely, they can take steps to influence final product costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Using Segment Margin Reports Despite the problems of responsibility center accounting, the profit measure is so comprehensive and pervasive that organizations prefer to treat many of their organization units as profit centers Because most organizations are integrated operations, the first problem designers of profit center accounting systems must confront is the interactions between the various profit center units In particular, this means deciding how to assign the responsibility for jointly earned revenues and jointly incurred costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Segment Margin Report (1 of 2) A common form of the segment margin report for an organization that is divided into responsibility centers includes one column for each profit center The revenue attributed to each profit center is the first entry in each column Variable costs are deducted from its revenue to determine the contribution margin The contribution made by operations to cover its costs that are not proportional to volume Next, the costs not proportional to volume are deducted from each center’s contribution margin to determine that unit’s segment margin  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Segment Margin Report (2 of 2) A unit’s segment margin measures its controllable contribution to the organization’s profit and indirect costs Allocated avoidable costs are deducted from the unit’s segment margin to compute its income Allocated avoidable costs are the organization’s administrative costs Such as personnel-related costs and committed costs for facilities Can be avoided if the unit is eliminated and the organization has time to adjust its capacity levels Finally, the organization’s unallocated costs, which represent the administrative and overhead costs incurred regardless of the scale of operations, are deducted from the total of the profit center incomes to arrive at total profit  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Evaluating the Segment Margin Report (1 of 2) What can we learn from the segment margin report? The contribution margin for each responsibility center is the value added by the manufacturing or service-creating process before considering costs that are not proportional to volume A unit’s segment margin is an estimate of its short-term effect on the organization’s profit It also represents the immediate negative effect on corporate income if the unit is shut down  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Evaluating the Segment Margin Report (2 of 2) The unit’s income is an estimate of the long-term effect of the responsibility center’s shutdown on the organization’s profit after fixed capacity is allowed to adjust The difference between the unit’s segment margin and income reflects the effect of adjusting for business-sustaining costs Committed in the short run but can be reduced in the long run as the facilities that they reflect are scaled back  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Good or Bad Numbers? Organizations use different approaches to evaluate whether the segment margin numbers are good or bad The most popular sources of comparative information are: Past performance Is performance this period reasonable, given past experience? Comparable organizations How does performance compare with similar organizations? Evaluations include comparisons of: Absolute amounts, such as cost or revenue levels Relative amounts, such as each item’s % of revenue  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Interpreting Reports with Caution (1 of 2) The segment margin statement may seem to be a straightforward approach to financial control Segment margin statements should be interpreted carefully, however, because they reflect many assumptions that disguise underlying issues Segment margins present an aggregated summary of each organization unit’s past performance Like all approaches to financial control Important to consider other facets relating to critical success factors that will affect future profits  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Interpreting Reports with Caution (2 of 2) Segment margin reports usually contain “soft numbers” Allocations that may be quite arbitrary and over which there can be legitimate disagreement Perhaps most important, the revenue figures reflect important assumptions and allocations that sometimes can be misleading These assumptions relate to the transfer pricing issue, which focuses on how revenues the organization earns can be divided among all the responsibility centers that contribute to earning those revenues  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Transfer Pricing (1 of 3) Transfer pricing is the set of rules an organization uses to allocate jointly earned revenue among responsibility centers Can be arbitrary when a high degree of interaction exists among the individual responsibility centers To understand the issues and problems associated with allocating revenues in a simple organization, consider the activities that occur when a customer purchases a new car at a dealership:  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Transfer Pricing (2 of 3) The new car department sells the new car and takes in a used car as a trade The used car is transferred to the used car department There, it may undergo repairs and service to make it ready for sale, or may be sold externally on the wholesale market The value placed on the used car transferred between the new and used car departments is critical in determining the profits of both departments:  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Transfer Pricing (3 of 3) The new car department would like the value assigned to the used car to be as high as possible to increase revenue The used car department would like the value to be as low as possible because that makes its reported costs lower The same considerations apply for any product or service transfer between any two departments in the same organization  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Approaches to Transfer Pricing Organizations choose among four main approaches to transfer pricing: Market-based transfer prices Cost-based transfer prices Negotiated transfer prices Administered transfer prices Transfer prices serve different purposes; however, the goal of using transfer prices is always to motivate the decision maker to act in the organization’s best interests  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Market-Based Transfer Prices If external markets exist for the intermediate (transferred) product or service, then market prices are the most appropriate basis for pricing the transferred good or service between responsibility centers The market price provides an independent valuation of the transferred product or service, and of how much each profit center has contributed to the total profit earned by the organization on the transaction Unfortunately, such competitive markets with well-defined prices seldom exist  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost-Based Transfer Prices When the transferred good or service does not have a well-defined market price, one alternative to consider is a transfer price based on cost Some common cost-based transfer prices are: Variable cost Variable cost plus a percent markup on variable cost Full cost Full cost plus a percent markup on full cost Economists argue that any cost-based transfer price other than marginal cost leads organization members to choose a lower than optimal level of transactions Assuming that marginal cost can be computed  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Problems with Cost-Based Price (1 of 3) Cost-based approaches to transfer pricing do not support the intention of having the transfer pricing mechanism support the calculation of unit incomes Moreover, organization units prefer to be treated as profit centers, not cost centers, because profit centers are considered more prestigious Transfer prices based on actual costs provide no incentive to the supplying division to control costs, since the supplier can always recover its costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Problems with Cost-Based Price (2 of 3) One solution is to use a standard cost as the transfer price Developing and operating accurate costing systems is quite a challenge People are likely to complain and become frustrated if they believe the organization is using an inaccurate costing system for transfer-pricing purposes  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Problems with Cost-Based Price (3 of 3) It does not provide the proper economic guidance when operations are capacity constrained Production decisions near full capacity should reflect the most profitable use of the capacity, not only cost considerations The transfer price should be the sum of the marginal cost and the opportunity cost of capacity, where opportunity cost reflects the profit of the best alternative use of the capacity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Interesting Variations A dual rate approach: The receiving division is charged only for the variable costs of producing the unit supplied The supplying division is credited with the net realizable value of the unit supplied This has the desirable effect of letting marginal cost influence the decisions of the buying division while giving the selling division credit for an imputed profit on the transferred good or service Charge the buying division with the target variable cost That amount includes the number of standard hours allowed for the work done multiplied by the standard cost per hour, in addition to an assignment of the supplying division’s committed costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Allocations to Support Financial Control (1 of 2) In spite of the difficulties of measuring responsibility center performance, many organizations want to develop responsibility center income statements People seem satisfied as long as the revenue and cost allocation rules chosen and put in place are fair and consistently applied, even if they are arbitrary  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Allocations to Support Financial Control (2 of 2) Organizations need to design and present responsibility center income statements in such a way that they isolate the discretionary components included in the calculation of each center’s reported income It should show the revenue and variable costs separately from the other costs in the profit calculation, that is, separate from the indirect or joint costs that are allocated  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Allocation of Indirect Costs In general, the managerial accountant can choose among many different activity bases for selecting a method to allocate indirect costs For example, a responsibility center’s direct costs, floor space, or number of employees Many people believe that allocating indirect costs in proportion to benefit is fair It is a widely used criterion to evaluate an indirect cost allocation method Determining “fair” may be difficult when one segment benefits another Conventional segment margin statements cannot capture interactive effects  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Interpreting Segment Financials The authors’ message is that responsibility center income statements have to be interpreted with considerable caution and healthy skepticism They may include arbitrary and questionable revenue and cost allocations And they often disguise interrelationships among the responsibility centers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Negotiated Transfer Price Some organizations allow supplying and receiving responsibility centers to negotiate transfer prices between themselves In the absence of market prices Given the drawbacks of cost-based transfer pricing Negotiated transfer prices reflect the controllability perspective inherent in responsibility centers, since each division is ultimately responsible for the transfer price that it negotiates However, negotiated transfer prices and therefore production decisions may reflect the relative negotiating skills of the two parties rather than economic considerations  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Optimal Transfer Price In an economic sense, the optimal transfer price results when the purchasing unit offers to pay the net realizable value of the last unit supplied for all the units supplied The net realizable value of a unit of transferred material is the selling price of the product less all the costs that remain to prepare the final product for sale If the supplying unit is acting optimally, it chooses to supply units until its marginal cost equals the transfer price offered by the purchasing unit This leads to the optimal quantity of the transferred units being supplied  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Problem with Negotiated Prices Problems arise when negotiating transfer prices, because the bilateral bargaining situation causes: The supplying division to want a higher than optimal price The receiving division to want a lower than optimal price When the actual transfer price is different from the optimal transfer price, the organization as a whole suffers It results in the transfer of a smaller than optimal number of units between the two divisions  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Administered Transfer Price (1 of 2) An arbitrator or a manager applies some policy to set administered transfer prices Organizations often used administered transfer prices when a particular transaction occurs frequently Such prices reflect neither pure economic considerations, as do market-based or cost-based transfer prices, nor accountability considerations, as negotiated transfer prices do  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Administered Transfer Price (2 of 2) Administered transfer prices inevitably create subsidies among responsibility centers Subsidies obscure the normal economic interpretation of responsibility center income Subsidies may provide a negative motivational effect if members of a responsibility center believe the rules are unfair  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Transfer Prices Based on Equity Considerations (1 of 2) Administered transfer prices are usually based on cost I.e., the transfer price is cost plus markup or market Sometimes administered transfer prices are based on equity considerations Designed around some definition of a reasonable division of a jointly earned revenue or a jointly incurred cost Possible alternatives include: Relative cost method Each manager bears a share of the cost that is proportional to that manager’s alternative opportunity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Transfer Prices Based on Equity Considerations (2 of 2) This process is fair in the sense of being symmetrical All parties are treated equally and each allocation reflects what each individual would otherwise incur Another approach is to base the allocation of cost on the profits that each manager derives from using the asset Reflects the equity criterion of ability to pay Still another approach is to assign each manager an equal share of the asset’s cost Reflects the equity criterion of equal division Each of the different approaches to cost allocation reflects a particular view of equity  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Assigning and Valuing Assets in Investment Centers When companies use investment centers to evaluate responsibility center performance, there are: All the problems associated with profit centers Plus some new problems unique to investment centers The additional problems concern how to identify and value the assets used by each investment center This task presents troubling questions that have no clear answers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Determining Level of Asset Use In determining the level of assets that a responsibility center uses, the management accountant must assign the responsibility for: Jointly used assets, e.g., cash, buildings, and equipment Jointly created assets, e.g., accounts receivable Once decision makers have assigned assets to investment centers, they must determine the value of those assets What cost should be used—historical cost, net book value, replacement cost, or net realizable value? Supporting arguments can be made for all these costing alternatives (See advanced cost accounting texts for details)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Measuring Return on Investment The culmination of the allocation of revenues, costs, and assets to operating divisions is the calculation of the division’s return on investment (ROI) Dupont, as a multiproduct firm, pioneered the systematic use of ROI to evaluate the profitability of its different lines of business The following slide presents Dupont’s approach to financial control in summary form At Dupont, the actual exhibit contained 350 large charts that were updated monthly and permanently displayed in a large chart room at its headquarters  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Dupont ROI Control System  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Dupont System (1 of 2) The Dupont system of financial control focuses on ROI and breaks that measure into two components: A return measure that assesses efficiency A turnover measure that assesses productivity The Dupont approach to financial control develops increasingly more detailed subcomponents for the efficiency and productivity measures by focusing on more detailed calculations of costs and different groups of assets It is possible to compare these individual and group efficiency measures with those of similar organization units or competitors  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Dupont System (2 of 2) The productivity ratio of sales to investment allows development of separate turnover measures for the key items of investment The elements of working capital Inventories, accounts receivable, cash The elements of permanent investment Equipment and buildings Comparisons of these turnover ratios with those of similar units or those of competitors suggest where improvements are required  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Assessing Productivity Using Financial Control (1 of 2) The most widely accepted definition of productivity is the ratio of output over input Organizations develop productivity measures for all factors of production, including people, raw materials, and equipment  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Assessing Productivity Using Financial Control (2 of 2) For example, in the fishing industry, the ratio of weight of salable final products to the weight of the raw fish is typically around 30% Most organizations in the natural resource industry keep a close watch on raw material productivity, because the cost of acquiring raw materials is a large part of total costs Many organizations in continuous process industries, such as paper manufacturing, monitor their machine productivity ratios  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Questioning The ROI Approach Despite its popularity, ROI has been criticized as a means of financial control Some critics object to the sole use of any financial measure as being too narrow for effective control They argue that the most effective approach to control is to monitor and assess the critical success factors, such as quality, service, and employee skills and knowledge Others who accept the need for financial measures still find weaknesses with the return on investment measure They observe that profit-seeking organizations should make investments in order of declining profitability until the marginal cost of capital of the last dollar invested equals the marginal return generated by that dollar Financial control based on ROI may not yield this result  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Using Economic Value Added (1 of 3) People have responded to this criticism of ROI by creating a different investment criterion Economic value added (EVA—previously called residual income) equals income less the economic cost of the investment used to generate that income For example, if a division’s income is $13.5 million and the division uses $100 million of capital, which has an average cost of 10%, the EVA is computed as follows: Economic value added = Income – Cost of capital =$13,500,000 – ($100,000,000 x 10%) =$3,500,000  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Using Economic Value Added (2 of 3) Like ROI, EVA evaluates income relative to the level of investment required to earn that income Unlike ROI, EVA does not motivate managers to turn down investments that are expected to earn more than their cost of capital It is possible to compute the EVA for every major product or product line to evaluate its contribution to creating shareholder wealth Recently, EVA has been extended to adjust GAAP income for the conservative approach that GAAP uses to determine income and value assets The intent is to develop an income number that better reflects the organization’s long-run earnings potential  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Using Economic Value Added (3 of 3) Organizations are beginning to use economic value added to identify products or product lines that are not contributing their share to organization return, given the level of investment they require These organizations have used activity-based costing analysis to assign assets and costs to individual products, services, or customers This allows them to calculate the EVA by product, product line, or customer Organizations can also use economic value added to evaluate operating strategies A measure of the increasing importance of EVA in organizations is the seniority of people who are appointed to manage their EVA implementation projects  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Efficacy of Financial Control (1 of 5) Although financial control is widely practiced, many people have questioned its true insights and effectiveness Critics have argued that: Financial information is delayed—and highly aggregated—information about how well the organization is doing in meeting its commitments to its shareowners This information measures neither the drivers of the financial results nor how well the organization is doing in meeting its other stakeholders’ requirements A leading indicator of future financial performance  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Efficacy of Financial Control (2 of 5) Financial control may be an ineffective control scorecard for three reasons: It focuses on financial measures that do not measure the organization’s other important attributes Such as product quality, the speed at which the organization develops and makes products, customer service, the ability to provide a work environment that motivates employees, and the degree to which the organization meets its legal and social obligations to society  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Efficacy of Financial Control (3 of 5) Financial control measures the financial effect of the overall level of performance achieved on the critical success factors, and it ignores the performance achieved on the individual critical success factors Financial control is usually oriented to short-term profit performance, seldom focusing on long-term improvement or trend analysis, instead considering how well the organization or one of its responsibility centers has performed this quarter or this year This is the result of the misuse of financial control rather than an inherent fault of financial control itself  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Efficacy of Financial Control (4 of 5) Financial control is an important tool in the process of control If used properly, financial results provide crucial help in assessing the organization’s long-term viability and in identifying processes that need improvement It is a tool to be supported by other tools since it is only a summary of performance Financial control does not try to measure other facets of performance that may be critical to the organization’s stakeholders and vital to the organization’s long-term success  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

The Efficacy of Financial Control (5 of 5) It can, however, provide an overall assessment of whether the organization’s strategies and decisions are providing acceptable financial returns Organizations can also use financial control to compare one unit’s results against another This financial benchmarking signal indicates whether the organization’s operations control systems, which seek to monitor, assess, and improve performance on the critical success factors, are operating well enough to deliver the desired financial results  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University