1. 1 Martin Zralý: COST CONTROL Department of Enterprise Management and Economics Faculty of Mechanical Engineering, Czech Technical University in Prague martin.zraly@fs.cvut.cz Prague 11/2010

2. 2 What is it about ? What is it about ? Subjects of Cost Control Subjects of Cost Control Information areas linked with Cost Control Information areas linked with Cost Control Budgeting - principal notes + relationships Budgeting - principal notes + relationships Costing - principal notes + relationships + recent development Costing - principal notes + relationships + recent development Hour Cost Tariffs (HCT) Method principal notes + applications Hour Cost Tariffs (HCT) Method principal notes + applications Example: Application of Contribution Margin + HCT-Method in Costing structure Example: Application of Contribution Margin + HCT-Method in Costing structure Final Conclusions to Cost Control Final Conclusions to Cost Control

3. 3 Subjects of Cost Control What are the basic subjects (entities), to which the costs are linked? Products (incl. services) (set of products, products group) Products (incl. services) (set of products, products group) Processes: productive + supportive Processes: productive + supportive Activities (= as parts of processes or autonomous ones) Activities (= as parts of processes or autonomous ones) Projects Projects Resources: Resources: Human Human Tangible and Intangible Tangible and Intangible Finance Finance Departments (Centres) Departments (Centres) All of then join technical and financial features in mutual interaction All of then join technical and financial features in mutual interaction

4. 4 Information areas (agenda) directly linked with Cost Budgeting, namely Operating budgeting Budgeting, namely Operating budgeting Costing Costing Accounting, namely Internal Accounting (on entities) Accounting, namely Internal Accounting (on entities) Financial and Investment Calculations Financial and Investment Calculations Operative recording (non-financial measures): time, capacity utilization, quantity, … Operative recording (non-financial measures): time, capacity utilization, quantity, …

5. 5 Basic practical principles of the Oper-budget application Basic practical principles of the Oper-budget application 1/2 Budget is primarily about Activities and Processes !!: Figures of Costs + Revenues are only the consequence (BUT important!) of the decision which Activities to do and in which way Activities (processes) to do (BUT important!) of the decision which Activities to do and in which way Activities (processes) to do Budget = a trivial matter ?? Budget = a trivial matter ?? It is about, what I (= manager) do. Do I know it? YES? It is about, what I (= manager) do. Do I know it? YES? Then: No problem to create the budget ! Then: No problem to create the budget ! The budget creating put the questions, which are useful (needed) for deeper understanding of Activities within the department or process: The budget creating put the questions, which are useful (needed) for deeper understanding of Activities within the department or process: Do I know, what is the utility of it ? Revenues (Incomes) Do I know, what is the utility of it ? Revenues (Incomes) Do I know, how much does it cost ? Costs (Expenditures) Do I know, how much does it cost ? Costs (Expenditures) + Summary the ANSWERS.

6. 6 2/2 Budget = complex matter. It concerns on: Budget = complex matter. It concerns on: Content and providing of Activities and Processes and their measurement (indicators has to be determined) Content and providing of Activities and Processes and their measurement (indicators has to be determined) Needed resources: Workers (staff), machines, equipment, software, … Needed resources: Workers (staff), machines, equipment, software, … Costs and Revenues Costs and Revenues Future (half a year, one year, two or more years), Close future = rest of the period (Expected Actual) and Actual Future (half a year, one year, two or more years), Close future = rest of the period (Expected Actual) and Actual Budget = Important element of Enterprise control Budget = Important element of Enterprise control see previous point Budget is also about to establish positive and stable conditions for activities (rules, standards, agreements, …) Budget is also about to establish positive and stable conditions for activities (rules, standards, agreements, …) Budget is also about to searching of the most suitable way, how to provide activities (workers skill + training + equipment, activities outsourcing or license, …) Budget is also about to searching of the most suitable way, how to provide activities (workers skill + training + equipment, activities outsourcing or license, …)

7. 7 Costs and Revenues are only Consequences of Activities and Processes applied After the targets are given and the set of activities is quite obvious, Costs + Revenues (C + R) can be determined After the targets are given and the set of activities is quite obvious, Costs + Revenues (C + R) can be determined Also on the contrary: According to targeted size of C + R the changes (or alternatives) of the activities are made (searched) Feedback (feedback cycle) Also on the contrary: According to targeted size of C + R the changes (or alternatives) of the activities are made (searched) Feedback (feedback cycle) C + R are the consequence of the decision-making about the way of activities providing: Purchase, by own means, outsourcing, way of financing, …and other agreements conditions C + R are the consequence of the decision-making about the way of activities providing: Purchase, by own means, outsourcing, way of financing, …and other agreements conditions C + R are the significant result of Activities selection – they link technical and economic process point of view !!! (Do we fix C + R ?? WE has to try it again and again) (see also: Managers responsibility) C + R are the significant result of Activities selection – they link technical and economic process point of view !!! (Do we fix C + R ?? WE has to try it again and again) (see also: Managers responsibility)

8. 8 Oper-Budget and Activity Based Management (ABM) Oper-Budget and Activity Based Management (ABM) 1/2 ABM = natural conclusion to managerial philosophy based on Activity as principal building item in Management Control: ABM = natural conclusion to managerial philosophy based on Activity as principal building item in Management Control: To two basic lines of Enterprise control (Products + Departments) is added the third: = Activities To two basic lines of Enterprise control (Products + Departments) is added the third: = Activities Activities are, what produce (or support producing) products (and revenues), what is done in the departments and what consume costs Activities are, what produce (or support producing) products (and revenues), what is done in the departments and what consume costs That's why: ACTIVITIES (PROCESSES) has to be controlled That's why: ACTIVITIES (PROCESSES) has to be controlled Problem: By detailed decomposition into Activities, they are hundreds, but rather thousands Laboriousness (to plan, to record, to evaluate them!!) How effective the result is? Problem: By detailed decomposition into Activities, they are hundreds, but rather thousands Laboriousness (to plan, to record, to evaluate them!!) How effective the result is? Recommendation: To apply Methodology Activities Set for Product Sets (AS/PS) Recommendation: To apply Methodology Activities Set for Product Sets (AS/PS)

9. 9 : The Entities priority in Enterprise Control is changing : 2/2 Products are primary Products are primary Towards Products the Processes, resp. Activities are considered: Towards Products the Processes, resp. Activities are considered: ? Which Activities (A) (Processes (P)) are needed (necessary) ? ? In which scope ? ? How to do them (own or purchased)? etc. Departments (org. structure) has to be tailored to both previous it tends to flexible org. structure, to flexible modification to A + P Departments (org. structure) has to be tailored to both previous it tends to flexible org. structure, to flexible modification to A + P The Role of Activities in Entities: The Role of Activities in Enterprise Control Entities: Activities: mostly a part of other Entity (process, dptm., functional area) Activities: mostly a part of other Entity (process, dptm., functional area) BUT also an autonomous entity Processes = relevant and chronological sequence of activities, mostly targeted to some partial or final product Processes = relevant and chronological sequence of activities, mostly targeted to some partial or final product Products: are developed due to activities (processes) Products: are developed due to activities (processes) Set of Activities = targeted grouping of Activities for specific Set of Products Set of Activities = targeted grouping of Activities for specific Set of Products Departments = organizational systemization (arrangement) of Resources and Activities Departments = organizational systemization (arrangement) of Resources and Activities Functional areas (product development, production, purchase, etc.): are realized by Activities Functional areas (product development, production, purchase, etc.): are realized by Activities

10. 10 Oper-budget creation Oper-budget creation 1/2 Budget is about Activities and Processes then it has to be of a different form in each Enterprise and created in an different way (and evaluated in another way) Budget is about Activities and Processes then it has to be of a different form in each Enterprise and created in an different way (and evaluated in another way) Budget creation: Long-term and multi-circle process. WHY? Budget creation: Long-term and multi-circle process. WHY? Is linked to the Strategy (e.g. by BSC), particularly to the perspective of Internal processes Objectives + Targets + Process conditions Is linked to the Strategy (e.g. by BSC), particularly to the perspective of Internal processes Objectives + Targets + Process conditions In large companies: 1. version of annual budget is get ready at the end of 3/201x In large companies: 1. version of annual budget is get ready at the end of 3/201x Creation is an continuous process: The essential factors are respected Creation is an continuous process: The essential factors are respected Systematic, no one step process Systematic, no one step process To respect essential budgetary factors needs time for balancing and argued To respect essential budgetary factors needs time for balancing and argued It offers time to ensure external partnerships (services, parts, …) It offers time to ensure external partnerships (services, parts, …) Importance of existence the plan in technical units (pcs, hours, m 3, GJ) Importance of existence the plan in technical units (pcs, hours, m 3, GJ) The starting point for budget creationannual business plan The starting point for budget creation is mostly the agreed annual business plan

11. 11 2/2 Consensus on Budget is required Consensus on Budget is required Cooperation of all staff is necessary Cooperation of all staff is necessary Preparation of agreements on services, deliveries, …is a part of budget creation process. It is necessary for credibility and stability of the budget Preparation of agreements on services, deliveries, …is a part of budget creation process. It is necessary for credibility and stability of the budget Budget 1.step: Balancing of internal services + tariffs Budget 1.step: Balancing of internal services + tariffs Budget = Basic part of Enterprise motivation system Budget = Basic part of Enterprise motivation system To set up correctly the consolidation rules To set up correctly the consolidation rules Breakdown into months is necessary (it affect to higher accuracy, it is needed due to monthly evaluation, relationships to Cash-Flow, Costing, …) Breakdown into months is necessary (it affect to higher accuracy, it is needed due to monthly evaluation, relationships to Cash-Flow, Costing, …) Necessity of budget creation procedure description (steps, time schedule, responsibility, …) Necessity of budget creation procedure description (steps, time schedule, responsibility, …)

12. 12 Oper-budget Evaluation Regularly and a consistently (monthly) - Regularly and a consistently (monthly) - in advanced stated date Managers monitors the budget size continuously during the whole month Managers monitors the budget size continuously during the whole month Superior manager has to take a part in evaluation ( Decisions are made immediately) Superior manager has to take a part in evaluation ( Decisions are made immediately) The values of current period and cumulated values are evaluated The values of current period and cumulated values are evaluated Application of Expected Actual Value (EAV) (forecast) Application of Expected Actual Value (EAV) (forecast) Necessity: To have on disposal supportive recordings (time, capacity, …consumption) and other information Necessity: To have on disposal supportive recordings (time, capacity, …consumption) and other information Expected future difficulties are considered, too Expected future difficulties are considered, too Result of evaluation: Result of evaluation: Budget confirmation or decisions making about changes (in activities, figures) EAV Budget confirmation or decisions making about changes (in activities, figures) EAV

13. 13 Expected Actual Values and Overhead Tariffs Expected Actual Values Expected Actual Values = Tool for updating budget (fitting it to contemporary situation) = Tool for updating budget (fitting it to contemporary situation) = Actual value up to this time point + (possibly) update for the rest of period (year) = Actual value up to this time point + (possibly) update for the rest of period (year) Rules has to be accepted for EAV application (Budget updating) Rules has to be accepted for EAV application (Budget updating) Purpose: To control under real (not fictive) conditions and targets Purpose: To control under real (not fictive) conditions and targets Cost Tariffs (of the centres, activities, …) Cost Tariffs (of the centres, activities, …) They appreciates cost level of activities, processes, … They appreciates cost level of activities, processes, … The link the cost to capacity !!! The link the cost to capacity !!! The significance is growing, because the price of resources capacity is growing (of equipment, staff, …) The significance is growing, because the price of resources capacity is growing (of equipment, staff, …) Application for activities evaluation and appreciation (motivation) Application for activities evaluation and appreciation (motivation) Hour Cost Tariffs (HCT) Method Hour Cost Tariffs (HCT) Method The controlling evaluation of decisive factors influence is on disposal The controlling evaluation of decisive factors influence is on disposal

14. 14 Why the Head Manager has to be responsible for the Budget ? Because the Budget is about Activities and Processes : Because the Budget is about Activities and Processes : Who else should be responsible for Activities and Processes and their development ? Who else should be responsible for Activities and Processes and their development ? Budget is linked with the resources utilization, i.e. with: Budget is linked with the resources utilization, i.e. with: Staff (workers) (number of them, their activities, skills, salaries) Staff (workers) (number of them, their activities, skills, salaries) Equipment (machines, tools, …) Equipment (machines, tools, …) Process conditions Process conditions Consumed services Consumed services Cooperation internal + external Cooperation internal + external Because the Budget is about Technical and Financial aspects (Costs + Returns) of processes (activities) Because the Budget is about Technical and Financial aspects (Costs + Returns) of processes (activities)

15. 15 Decalogue of budgeting practice 1/2 Budget is firstly about Activities and Processes and then subsequently about C + R Budget is firstly about Activities and Processes and then subsequently about C + R Budget is something like the Company Low Budget is something like the Company Low Budget is the control tool of primary importance for all levels of enterprise control hierarchy (from top to down) Budget is the control tool of primary importance for all levels of enterprise control hierarchy (from top to down) Enterprise (master) budget = linked set of budgets Enterprise (master) budget = linked set of budgets Budget creation = define contents and conditions of activities for the next period Budget creation = define contents and conditions of activities for the next period Budget creation = Long-term and multi-circle process: Enough time is necessary for carefully budget preparation Budget creation = Long-term and multi-circle process: Enough time is necessary for carefully budget preparation

16. 16 2/2 Budget evaluation: Regularly and a consistently Budget evaluation: Regularly and a consistently Required: To apply the Expected Actual Values technique Required: To apply the Expected Actual Values technique Close relationships to the other information sets in enterprise (Accounting, Costing, Technical recordings (mostly to hour-recordings (!!)), Investment and Financial calculations, and to other control tools (BSC, ABM, Process control, Target costing, …) Close relationships to the other information sets in enterprise (Accounting, Costing, Technical recordings (mostly to hour-recordings (!!)), Investment and Financial calculations, and to other control tools (BSC, ABM, Process control, Target costing, …) Required: Existence and a regular updating of standards linked with budget procedures (budget standards) Required: Existence and a regular updating of standards linked with budget procedures (budget standards)

17. 17 Costing 1/10 Costing = To allocate in an acceptable way the cost to the cost driver in: Costing = To allocate in an acceptable way the cost to the cost driver in: production process production process sales process sales process development process development process …… …… in an acceptable way ?? in an acceptable way ?? accurate is not achievable, BUT mostly it can be done in an acceptable way (accurate: only for direct cost !!) acceptable = trustworthy for managerial use accurate is not achievable, BUT mostly it can be done in an acceptable way (accurate: only for direct cost !!) acceptable = trustworthy for managerial use cost driver ?? cost driver ?? one piece or multiplying of pieces one piece or multiplying of pieces production order production order particular activity particular activity business case (order) business case (order) … … … …

18. 18 Costing 2/10 Costing - what are key factors? Costing - what are key factors? cost (cost identification, type of cost: direct, indirect, fixed, variable, …) cost (cost identification, type of cost: direct, indirect, fixed, variable, …) cost drivers (identification, which one or which structure of them is used) cost drivers (identification, which one or which structure of them is used) allocation / no allocation to cost drivers allocation / no allocation to cost drivers or partial allocation Absorption Costing x Variable costing capacity (of process, resources, …) utilization capacity (of process, resources, …) utilization revenues (expected, planned) as starting point for calculation (variable costing) revenues (expected, planned) as starting point for calculation ( variable costing) What kind of Costing - (time point of view)? What kind of Costing - (time point of view)? planned (pre-costing) planned (pre-costing) operational costing operational costing actual (final) costing actual (final) costing proposal costing (for submit an offer for order) proposal costing (for submit an offer for order) Target Costing Target Costing

19. 19 Costing 3/10 Costing - approaches: Costing - approaches: Absorption Costing Absorption Costing Variable Costing Variable Costing Costing - methods and techniques: Costing - methods and techniques: Hour cost tariff (HCT) method Hour cost tariff (HCT) method Surcharge Costing (= additional cost charges according selected cost driver) Surcharge Costing (= additional cost charges according selected cost driver) Standard Costing Standard Costing Activity Based Costing Activity Based Costing ….. ….. In practice: combination of different methods and techniques

20. 20 Costing 4/10 Planned Costing (pre-costing): WHY? Planned Costing (pre-costing): WHY? For each product or even a its innovation or changes has to be calculated its costs in advance and make comparison with potential price For each product or even a its innovation or changes has to be calculated its costs in advance and make comparison with potential price resp. To design product in such a way, that its total costs will be lower then in advance given COST TARGET (Target Costing), i.e. product will bring required size of CM, resp. size of profit resp. To design product in such a way, that its total costs will be lower then in advance given COST TARGET (Target Costing), i.e. product will bring required size of CM, resp. size of profit If TARGET is not kept, the product has to be redesigned with respect to the COST TARGET (cost limit). Otherwise not start the production! If TARGET is not kept, the product has to be redesigned with respect to the COST TARGET (cost limit). Otherwise not start the production! Final (actual) Costing: WHY? Final (actual) Costing: WHY? It normally do not influence the agreed price, BUT it is necessarily for: It normally do not influence the agreed price, BUT it is necessarily for: Assessment of size and METHODOLOGY of planned (PL) Costing (learning) Assessment of size and METHODOLOGY of planned (PL) Costing (learning) Reward/not reward due to keeping/not keeping PL-Costing. Reward/not reward due to keeping/not keeping PL-Costing.

21. 21 Costing Costing 5/10 Topical (and most frequent) are application of: Topical (and most frequent) are application of: Hour Cost Tariff (HCT) Method Hour Cost Tariff (HCT) Method Variable Costing (Contribution Margin application) Variable Costing (Contribution Margin application) mostly in interrelated applications. mostly in interrelated applications. Application of Variable Costing (Contribution Margin (CM)) Application of Variable Costing (Contribution Margin (CM)) (usually Multi-level Contribution margin alternative (3-10) levels) - see Model-3P By creating of aggregate annual plan (total CM) By creating of aggregate annual plan (total CM) By product (service) costing (total or per unit) By product (service) costing (total or per unit) By business orders (total and per unit) By business orders (total and per unit) In assessment of salesman (instead or together with return) In assessment of salesman (instead or together with return) In assessment of heads of dptm. In assessment of heads of dptm. In assessment of customers In assessment of customers …. ….

22. 22 Costing Costing 6/10 HCT-Method applications are in particular contributive in areas as: HCT-Method applications are in particular contributive in areas as: All kind of services All kind of services Technical activities and dptms. (Development, Project, Pre-production, Programming, etc.) Technical activities and dptms. (Development, Project, Pre-production, Programming, etc.) Production activities and dptms. (if more expensive even for workplaces) Production activities and dptms. (if more expensive even for workplaces) Post-production activities and dptms. (Packaging, dispatching, etc.) Post-production activities and dptms. (Packaging, dispatching, etc.) Assessment of cooperation and make / buy projects assessment. Assessment of cooperation and make / buy projects assessment. Reason: It interrelated time costs with time expression of resource capacity!! Reason: It interrelated time costs with time expression of resource capacity!! + see Integrative ability and integrative consequences of HCT-Method

23. 23 HCT-Method: Cost-Capacity assessment of the entity Product costing (incl. services) Motivation rewards Entity (subject) on which the HCT can be applied: Department or center Workplace Machine or Equipment Activity ( Activity Based Management) Process ( Process Control) Worker (research, technician, office, manual, …) Indirect cost: IC HCT = i=1..n (HCT i t i ) Total product cost: TC = DC + IC HCT Hour Cost Tariffs (HCT, HOT) Method Hour Cost Tariffs (HCT, HOT) Method 1/3

24. 24 (1) Basic: (centre, workplace, activity, process, …) HCT (one value) for entity (subject)(centre, workplace, activity, process, …) Items: (2) Items: HOT is itemized into more partial Cost-items Examples: Depreciations (leasing-payments), Personal-costs, Material-costs, Depreciations (leasing-payments), Personal-costs, Material-costs, Costs of maintenance, Space-costs, Costs of energy, Other costs To gain information about the size and development of the partial cost items Purpose of the itemizing: To gain information about the size and development of the partial cost items Vertical (hierarchical): (3) Vertical (hierarchical): HOT is itemized according to vertical enterprise structure Example: Workplace (machine) - Centre Controlling: (4) Controlling: The factors causes difference HCT AC - HCT PL are determined The factors causes difference HCT AC - HCT PL are determined Purpose: To trace the influence of factors on the HCT difference Purpose: To trace the influence of factors on the HCT difference HCT Method - Methods Alternatives HCT Method - Methods Alternatives 2/3

25. 25 WHY to apply?? It includes TIME (capacity in time expression, time consumed by …) It links budgets of IC + Capacity plan (in mutual interaction) Reasonably stated hour cost of resources (machines, workers) for expected capacity utilization Indirect Cost (IC), which are mostly time costs, allocate to product according to the cost consumption (NOT according to the Direct Cost!!!) Easy and trustworthy cost calculation /product by changes of parameters of product or process (e.g.: purchase of new machine) Easy alternative planned calculations for different capacity utilization For motivation reward executives + staff Direct link with Activities ( Activity Based Management) E.g.: Offer very accurate calculation for insourcing or outsourcing of Activities, for cooperation calculations Direct link with Processes ( Process management) It is simple, it works with commonly used data + ……... HCT Method - purpose and application HCT Method - purpose and application 3/3

26. Example: Application of Contribution Margin + HCT-Method in Costing structure: Price simulation + Target Costing application (TC) + Price (Revenues) (utility features, brand, competitive situation,...) - Profit - Sales margin - CM / (for) common overhead (exec., admin., marketing, IT network, …) = Production + Pre-production + Post-production Costs (Direct + Indirect) - CM / product development (HCT) (contribution margin to dptm-cost) - CM / techn. preparation of production, incl. tools, prototypes, … (HCT) - CM / guarantee reparation (part. HCT) - CM / …. …. according to specific situation in enterprise - CM / launching to market (to cover product mktg. costs) = Production + other costs - Another Direct pre-production, production, post-production (e.g. packing) costs = Indirect production costs (HCT) By application of TC, the minimizing of time/unit consumption + maximizing of capacity utilization. Conclusion: By application of TC, the minimizing of time/unit consumption + maximizing of capacity utilization.

27. 27 Final Conclusions to Cost Control (FCCC-1) If you want to effect Costs, you has to effect on Activities If you want to effect Costs, you has to effect on Activities the Cost Control = requires to control Activities the Cost Control = requires to control Activities (1)Which Activities (lean point of view) are really needed to be applied to produce PRODUCTS + necessary to support key processes needed for producing products (2)Activities: In which way to realize the Activities In which way to realize the Activities which kind of Activities (to substitute ACT with other kind of ACT?) which kind of Activities (to substitute ACT with other kind of ACT?) make or buy make or buy or in cooperation (mix of make + buy) or in cooperation (mix of make + buy) Under which conditions Under which conditions In which scope In which scope ABC = Activity Based Costing (!!! but what does it mean actually?)