MBI-5 2007/08. Financial Management part Management Accounting. Lecture 6. 10-30-2007
Lecture 6.
Topics to be discussed:
Chapter 6 on the relationship of prices with costs, demand and competition.
Chapter 7 on the value chain.
Chapter 8 on motivation and the use of management accounting in controlling behaviour.
CHAPTER 6. Pricing and product-mix decisions.
Two dimensions determining the role of cost accounting:
Competitive position of the firm.
The size of the firm, the characteristics of its products and the competitive structure of the industry make the firm a:
Price taker: it accepts the prices set in the marketplace, but can adapt the product mix.
Price setter: it can – within certain boundaries – set the prices and/or discounts for its products.
- The time period considered in making pricing
decisions:
short-term: the capacity cannot be extended or
reduced.
long-term: the capacity can be adapted.
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MBI-5 2007/08. Financial Management part Management Accounting. Lecture 6. 10-30-2007
The naïve approach concerning the relationship between prices and costs are laid down in the traditional cost-plus methods:
Flexible costing: prices are determined by adding a markup to the flexible product costs. Also often referred to as
Direct Costing.
Full (absorption) costing: prices are set by adding a markup to the full ( flexible plus capacity-related ) product cost.
However, more factors influence pricing than costs alone:
A. Price taker, short-term.
Produce and sell as much as possible given the available capacity as long as the price exceeds the relevant cost.
Relevant costs are: flexible costs plus opportunity costs.
When capacity is fully used, the product mix will be determined by maximizing the total contribution margin.
This is accomplished by producing in order of the level of the contribution margin per required unit of the most constrained production resource.
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MBI-5 2007/08. Financial Management part Management Accounting. Lecture 6. 10-30-2007
Example:
Product
Sales price/unit
Flexible costs
Support costs
Contribution margin/unit
Machine hrs./unit needed
Minimum sales units
Blouses
8,00
4,40
0,20
3,60
0,4
5000
Shirts
5,00
4,00
0,20
1,00
0,4
6000
Maximum sales units
Contribution/mach.hr.
15000
9,00
14000
2,50
Available: 5000 machine hours.
The chosen product mix will be, maximizing contribution: minimize shirts: 6000 units, capacity needed 2400 machine hours. maximize blouses: ( 5000 – 2400 ) / 0,4 = 6500 units.
Total contribution: 2400*2,50 + 2600*9 = 29400.
Additional shirts could be sold, if opportunity costs ( = the machine hour contribution of blouses ) are accounted for:
minimum price of a shirt, sacrificing one blouse:
4,00 + 0,4 * 9,00 = 7,60
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MBI-5 2007/08. Financial Management part Management Accounting. Lecture 6. 10-30-2007
B. Price setter, short-term.
1.
Capacity is available:
The price will be set by adding a mark-up to the incremental ( mostly the flexible manufacturing and selling costs ) costs. Be aware however of a possible loss of contribution margin by the “cannibalisation effect“.
Add – if applicable – incremental product support
and business support costs, if they arise from
additional orders.
2. Capacity is constrained:
All incremental costs of overtime work, additional
shifts, outsourced production to free capacity, or
contribution of orders foregone are added to the
flexible costs in order to determine the minimum
acceptable price.
THIS SITUATION IS THE MODEL FOR THE “COST-
PLUS PRICING”, BUT REGRETTABLY NO
INDICATION HAS BEEN GIVEN FOR THE LEVEL OF
A MARK-UP.
Re-think the cost-of-capital approach in finance to find the clue of determination of the profitability required by the capital suppliers.
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MBI-5 2007/08. Financial Management part Management Accounting. Lecture 6. 10-30-2007
C. Price setter, long-term.
The price setting is based on a full-cost plus mark-up approach. Reasons for this are:

Contracts for customized product development and manufacturing for private and governmental clientele require this type of accounting.

Capacity will be installed in view of long-term commitments to certain market segments and customer groups: the related costs are considered incremental to these markets.

The usual approach to pricing is to vary the mark-up on full costs overtime ( e.g. by offering discounts or raising prices ) depending on:
- the strength of demand in a typical period.
- the perceived price-elasticity of demand.
- the intensity of the competition.
Forms of “strategic pricing “ are:

Penetration strategy: introducing a new product with a low mark-up in order to gain market share quickly.

Skimming strategy: initially charging high mark-ups when introducing a new product, followed by a gradual decline of the price when competition intensifies.
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MBI-5 2007/08. Financial Management part Management Accounting. Lecture 6. 10-30-2007
D. Price taker, long-term.
As prices are dictated by the market, the emphasis is on the management of the product mix. Price trends give rise to periodic scrutiny of the profitability of each part of the product mix.
Eliminating or adding products to the mix have important effects on the capacity-cost structure of a firm as soon as decisions on the limitation or expansion of product-, customer- and business sustaining costs are taken.
Price deterioration in the market may trigger product- and process reengineering and redesigning in order to cut costs and maintain profitability.
You may skip the appendix to this chapter.
Illustrations: problems 6-33, 6-35, 6-44 (6-34,6-36,6-45).
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MBI-5 2007/08. Financial Management part Management Accounting. Lecture 6. 10-30-2007
CHAPTER 7: Assessing performance over the value chain.
Management accounting and control systems. (MACS).
A MACS is a set of procedures, tools, performance measures and systems, mainly but not exclusively in financial terms, to be used in guiding and motivating people to achieve organizational objectives.
The stages of the control cycle are:
- planning
executing
monitoring
evaluating
correcting
The technical assessment of a MACS covers:
relevance of information provided, should be
1. accurate
2. timely
3. consistent
4. flexible, that is tuned to circumstances.
MACS in a TLCC-setting.
Scope of the system: should cover the total
value chain, thus leading to total-life-cycle
costing, recognizing the stages:
1. research, development and engineering
2. manufacturing
3. post-sales service, disposal
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MBI-5 2007/08. Financial Management part Management Accounting. Lecture 6. 10-30-2007
This TLCC-concept assumes, that decisions in the initial stages have a major impact on the outcomes of the following phases. Most of the manufacturing, service and disposal costs are committed to in the product-design and product-development stages. Changes in the cost structure during execution of the manufacturing and sales stages can only be small and are generally very costly.
TLCC requires a multi-functional overall approach to the cost development over the total lifetime, part of which can be target costing and kaizen costing. Some experts add environmental costing to the concept, expecting authorities to charge the firm – in future ?? - for any detrimental effect to society caused by their products and processes.
Traditional cost control procedure.
Market research determines customer requirements.
Product specification.
Design.
Engineering.
Suppliers prices.
Estimated costs + desired profit margin= sales price; if too high, go back to product specification.
Plan profit: sales – costs.
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MBI-5 2007/08. Financial Management part Management Accounting. Lecture 6. 10-30-2007
Control focuses on cost compliance (standard cost budgets) with periodic cost reduction programs.
Target costing procedure.
Market research to determine customer needs and price points.
Product specification and design.
Target selling price and sales volume – Target profit.
Target costs.
Supplier pricing and value engineering.
Plan for costs and continuous cost reduction.
In algorithms:
Traditional costing: Price – costs = profit
or
Costs + profit = Price
Target costing: Price – profit = costs
Target costing can imply:
Value engineering: examining each component of a product to determine whether its costs can be reduced without loss of functionality and performance.
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MBI-5 2007/08. Financial Management part Management Accounting. Lecture 6. 10-30-2007
Supplier pricing: the commitment of suppliers to be part of the target costing process can lead to supply chain management, that is creating a cooperative, mutual beneficial long-term relationship between buyers and sellers.
Concerns with target ( and kaizen ) costing:

Conflicts of various parties within and outside the firm.

Employees may experience burn-out.

Development time may increase considerably.
Kaizen costing procedure.
Kaizen is a cost reduction scheme, applied during the manufacturing stage of the life cycle.
As cost base is chosen the actual costs of ( a part of ) the manufacturing process of the previous period.
For the current period a target cost reduction ratio ( of the cost base ) will be determined. When establishing such ratios, an important role is played by the operational employees on the work floor.
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MBI-5 2007/08. Financial Management part Management Accounting. Lecture 6. 10-30-2007
Environmental costing.
A system that estimates the cost of the effects an organization has on the environment.
Categories of such costs are:

Explicit costs as those of modifying technology and processes, clean-up, disposal, licenses, taxes.

Implicit costs as incurred by creating an infrastructure to monitor environment-related problems.
Benchmarking.

Studying and adapting to the practices of other organizations to improve the firm’s own performance.

Establish a point of reference in order to measure the internal performance.
Stages of the benchmarking process are:
1. Internal study and preliminary competitive analysis.
- internal and external analyses.
- determine key areas of interest.
- define scope and significance of the study.
2. Develop long-term commitment and form the
benchmarking team.
- gain senior management support.
- develop a set of objectives.
- empower employees to make changes.
3. Identify benchmarking partners.
- size and number of partners.
- within and across the industries.
- degree of mutual trust.
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MBI-5 2007/08. Financial Management part Management Accounting. Lecture 6. 10-30-2007
4. Information gathering and sharing methods.
- Type: product, process, strategies.
- Collection methods: unilateral or cooperative.
- Determination of performance measures.
- Determining the “performance gap” in the firm.
5. Taking action to bridge the gap, or exceed the measure.
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MBI-5 2007/08. Financial Management part Management Accounting. Lecture 6. 10-30-2007
Motivation is an individual’s interest or drive to act in a certain manner.
Problem: How to motivate people, especially those with the authority to make decisions, to act in line with the objectives of the organization?
Theoretical answers: a) Scientific management: by strict procedures, monitoring and control, financial rewards and sanctions. b) Human relations: improving morale, job satisfaction, respect and discretion over the job. c) Human resources: under a system of beliefs ( values, purpose and direction ) enhancing employee responsibility, participation in decision making and creativity.
Ideally a situation of employee self-control would align the goals of individuals with the organization’s. In less utopian situations can be used: a) diagnostic controls: formal information systems – e.g. budgets – that signal deviations of outcomes from standards and imply corrective action. b) Interactive controls: formal information systems that trigger direct involvement of managers in the decision making of subordinates, e.g. threshold in spending and investing.
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MBI-5 2007/08. Financial Management part Management Accounting. Lecture 6. 10-30-2007
Both control systems can make use of: a) Task control: sets of standard procedures to fulfil a task. It is enforced by preventive control ( e.g. training ) and monitoring ( inspection on the job ). b) Results control: be convinced of the knowledge of the firm’s objectives with ( qualified ) people, expect they find a way to comply, and assess the resulting performance.
However:
The threat of non-goal congruent ( dysfunctional ) behavior is there!

Gaming the performance indicator ( maximize a
single goal at the cost of other/others.

Data falsification, speaks for itself.

Smoothing ( e.g. earnings management ).
Incentive systems to reward performance.
Types of rewards:

Intrinsic: feelings of well-being of an individual as job-satisfaction, respect and growth opportunities.

Extrinsic: explicit – mostly financial – rewards.
Pay-for-performance systems can be based on:
- absolute performance ( e.g. sales volume ).
- relative performance ( e.g. exceed target volume ).
So performance has to be measured in a MACS!
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MBI-5 2007/08. Financial Management part Management Accounting. Lecture 6. 10-30-2007
Conditions for measurement to cause motivation are:
- Employees understand their jobs and the reward
system, of which they believe that it measures
controllable items.
- Careful choose how employee’s inputs or
outputs are measured.
- The measured performance should reflect the
organization’s critical success factors.
- The performance standards must be clear and
acceptable for employees.
- The measurement should be accurate and
unambiguous.
- When performance depends on actions of others,
the reward system should be directed at groups.
Types of extrinsic reward systems:

Cash bonus ( pay for performance, see above ).

Profit sharing ( cash payment as a % of the unit’s reported profit ).

Gain sharing ( cash payment from funds created from excess performance over targets ).
 Stock option plan ( rights to buy company’s shares for a predetermined price in a certain period of time).
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