COST MANAGEMENT BASICS
COST PLANNING
Agenda
•
•
•
•
•
•
•
•
•
•
Explanation of Cost & Cost Planning
Computing Rates
Measuring Performance
Master Data
Identifying Requirements & Forecasting
Benchmarking
Establishing Operational Requirement Levels
Setting Cost Targets
The Role of Budgeting in Planning and Control
Managerial Performance Reports
2
Explanation of Cost &
Cost Planning
3
Cost Management Involves
• Capture and Valuate Data
– Accurate, timely and relevant data
– Connecting operational output/performance
data to financial data
– Allocate Overhead
• Cost Planning
– Set Cost Targets and
Efficiency Goals
– Compute Standard
Rates
Cost
Planning
• Cost Controlling
– Move to action based on
analysis
– Change targets
– Change resources
– Change quality
Cost
Accounting
Cost
Management
Process
Cost
Controlling
• Cost Analysis
– Variances
– Depreciation
Cost
Analysis
– Trends and forecasting
– Product, service or activity
cost by element (labor,
contract etc)
– Understanding full costs of
organizations, operations,
products and services
4
What is cost?
• Amount of resources given up in exchange
for some goods or services
– The amount of expenditure (actual or notional)
incurred on, or attributable to, a specified thing or
activity
– A foregoing, measured in monetary terms, incurred or
potentially to be incurred to achieve a specific
objective
• Discussion:
– What does cost mean to you?
– At home?
• Water, cable, phone bill
– To your organization?
• Maintenance, services, IT contracts
5
What is cost?
• Basic elements of cost:
– Raw materials
– Labor
– Indirect expenses/overhead
6
Resources/Inputs
Cost = Converting and
Measurement of Work
Cost Center
Organization - Labor, Materials, Supplies
Asset / Equipment
Outputs
Project / Program
Plant, Property & Equipment
Building Project, Weapon System
Internal Order
Services, Events (SSP, Course)
WBS / Work Order
Job (Set of Tasks) – Maint & Repair
7
Cost Planning
Cost Planning is the use of a Cost Model for “should-cost”
forecasting to make informed decisions
Often Performed for:
Cost
Accounting
Cost
Planning
Cost
Management
Process
Cost
Controlling
Cost
Analysis
•
•
•
•
•
•
Budget Requirements Requests
Costs Estimations
Output Quantities
Capacity Management
Risk Analysis
Various Time Frames: Out year /
Current year, Quarterly, Monthly
• Standard Rates
• Defining Targets to Measure
Efficiency and Effectiveness
8
What is Cost Planning?
• A cost plan determines the fiscal feasibility of an
initiative. This is done by setting the lifecycle budgets
and cost controls to manage the delivery and quality of
the initiative's outcomes over a set timeframe.
• Cost Estimating and Cost Planning are not the same
– A cost estimate is an assessment or approximation
of the likely costs of an initiative with an indication as
to the degree of accuracy, usually +/- percent.
• In the construction industry—a good example of
project management—a cost estimate is a
prediction of the costs of construction.
9
Cost Planning Example
– In the construction industry, a cost plan is used as a
way of controlling the estimated costs during the
design and construction phases of a project.
– Cost plans are living artifacts, just like project
management plans. They must be managed
throughout the lifecycle of any initiative in any
industry.
10
How to cost plan
• Art or science?
• Sound commercial principles dictate how
cost estimation migrates into cost planning
– right modeling tools
– experience
11
Guiding Principles
– Time is money
– Risk and reward are opposites. The higher the risk,
the greater potential for reward. If the risk is
unsustainable, there'll be no reward.
– Appropriate controls to develop, implement and
manage cost estimates and cost plans are the key to
repeatable quality outcomes and commercial
success.
– Cost estimating and cost planning outcomes provide
the framework for cost control through the lifecycle
of any initiative.
12
Cost Planning Highlights
– Successful cost planning is made up of diversified
choices in approach and execution.
• There is no one approach that fits all scenarios.
• Making the best and most appropriate choices to fit the
situation.
– Before developing the cost plan for any initiative, you
need to consider the framework.
– There are decisions that need to be made in order to
determine the best approach for your cost plan and
deliver the desired outcome and accuracy.
13
What is cost planning?
• Decisions to be made when determining the best approach:
– What is being planned? The principles are the same but the environment,
approach and tolerances will be different.
– Is the opportunity a deal or a contract? A contract may have penalties for nonperformance or delays. A deal is more of a partnership.
– Do I need to test the market with an RFI or RFP/RFT/RFQ?
– What is the commercial envelope? Is it a fixed lump sum, target sum, open book,
or other?
– Has there been a sound assessment of the risk versus the complexity?
– What is the degree of confidence and/or accuracy?
– Do I need to obtain market coverage to sharpen the accuracy?
– Is there a comprehensive work breakdown structure (WBS) for services and
materials?
– Do I have a strong understanding of the concept of money and the methods to
determine the investment value or the return on investment?
– What about developing present and future value-of-money models?
– How does time affect the proposed cost plan?
– Is risk covered and are there adequate contingencies?
14
Cost Planning Summary
– The success formula for repeatable execution of
quality cost estimates and cost plans is a combination
of experience, commercial intellect, optimal choices of
tools, and approach.
– Cost estimating and cost planning are both an art and
a science. But most importantly, they require a strong
dose of structure and discipline.
– And never underestimate what experience brings to
the table.
15
Planning vs. Actual Data
• Cost Planning aims to be predictive and to inform
operational decisions.
• Cost Planning is necessarily speculative and
approximate to some degree—variances in cost and
other variables will always exist.
16
Starting Point: The Plan (Budget)
• Just as in analyzing volume and performance
variance we must start with an expectation
– This is the plan or budget
• The plan or budget must define two of the following
three variables in the equation: cost = output x cost
per output
– Some measure of output (like units)
– A measure of cost per output
– The total cost
• Furthermore, the plan defines these variables for all
time periods or milestones within the project
17
Computing Rates
18
Computing Rates
• What is a rate?
– Basic Definition: a quantity measured with respect to another
measured quantity
– Miles per hour (mph)
– $ per gallon (gasoline, etc.)
– $ per kWh (kilowatt-hour; i.e. your electricity bill)
– Calories per serving
• Specific definition for our purpose: the cost per unit of a
commodity or service
– $ per hour for electrician (i.e. DPW work at an installation)
– $ per hour for depot maintenance work (i.e. AMC)
19
Computing Rates Examples
• Your water bill (i.e. cost per gallon of water)
– Primary considerations:
•
•
•
•
Number of customers
Forecasted total consumption; consumption per customer
Equipment costs
Labor costs
– Other considerations:
• Planned maintenance (replacing aging pipes)
• Unplanned maintenance (replacing damaged pipes)
• Rent/leasing a house ($/month)
– Primary considerations:
•
•
•
•
•
•
Mortgage costs (includes: principal, interest, insurance, taxes, etc.)
Utilities
Homeowners Association dues
Maintenance costs
Rental market comparables
Profit
– Other considerations
• Unplanned maintenance (refrigerator dies)
• Unrented periods
20
Computing Rates
Army rates discussion:
• For most Army organizations, labor is the predominant
resource used and is the key component for most
services
• Therefore, the ability to accurately estimate and project
labor costs is absolutely essential to help managers
make informed operational and cost decisions
• Standard labor rates provide managers with a tool for
developing estimates of current and future labor costs
21
Labor Rates
• Standard cost is any cost computed with the use of preestablished measures
• Standard costing is a costing method that attaches costto-cost objects based on reasonable estimates or cost
studies and by means of budgeted rates rather than
according to actual costs incurred
• A standard labor rate is the total value of costs planned
for a workforce divided by the planned annual productive
hours available for that workforce (planned labor dollars /
planned productive hours).
• Stabilized labor rate is the standard labor rate
established for a depot or other working capital fund
activity and is a cost per direct labor hour (or other
output measure) customers are charged for the products
and services provided by a depot or activity group.
22
Labor Rate Example
• AMC charges standard rates for depot maintenance
work, and
• ATEC uses standard rates when charging customers for
test and evaluation support.
• It is imperative these rates include all the components of
the full (AMC) or reimbursable (ATEC) cost incurred by
these organizations when performing work for
customers.
• Organizations should not only be able to identify direct
costs, but also indirect costs when formulating rates.
– For example: ATEC includes overhead costs in the rates
charged to non-DoD customers.
23
Establishing Standard Rates
• Standard labor rates are based on documented labor
and service (production) costs from previous fiscal years.
• These historic costs are adjusted for inflation, anticipated
productivity changes and other factors that are expected
to impact costs in the next fiscal year.
• The inclusion of leave within the Std. Rate is required to
accurately associate the cost of work performed to the
receiver cost object. Leave hours should be associated
with the organization owning the resource, not charged
to products/services, customers, or programs.
24
Establishing Standard Rates
(cont.)
• The organization must accomplish the following to establish the
standard labor rates (next slide):
1. Divide the organization into resource (cost) pools.
2. For each resource pool, determine the total pay and benefits
paid over the course of the fiscal year.
3. For each resource pool, determine the total number of
available work hours for the fiscal year.
–
Note that this is not the number of hours for which employees were paid. It
is the number of hours for which they were present for work. Leave is
utilized within the determination of the productive work hrs available.
4. Divide total pay and benefits by the number of available work
hours to establish the actual historic labor rate. Adjust this
historic rate by factoring in inflation, anticipated productivity
changes, and other factors expected to impact labor costs in
the next fiscal year. This is the standard labor rate for a
resource pool.
25
GFEBS Standard Rates Example
26
Measuring Performance
27
Performance Measurement
Performance measures describe how
well an individual has performed a task
A good performance
measure reveals the
actions of the individual
and
being evaluated
Motivates individuals
to act in the
organization’s best
interest
Cultural differences influence performance measurement
28
Performance Measurement
Certain aspects of financial accounting
systems exist today because of the
demand for performance measures
Multiple performance measures
generally will reveal an individual’s
actions more accurately than a single
measure
29
Example Performance Metrics
Quality and Performance
 Customer satisfaction measures
 Error rate
 Rework or scrap rate
 Internal failure costs
Capacity Planning; Supplement C, Waiting Lines; Supplement H, Measuring
Output Rates; Supplement I, Learning Curve Analysis
 Processing time
 Total time from start to finish (throughput time)
 Setup time
 Operating expenses
 Capacity utilization
 Average waiting time
 Average number of customers or jobs waiting in line
30
Example Performance Metrics
Constraint Management
 Cycle time
 Idle time
Lean Systems
 Setup time
 Average waiting time
 Total time from start to finish (throughput time)
 Waste
31
Productivity
Productivity =
Units produced
Input used
• Measure of process improvement
• Represents output relative to input
• Only through productivity increases can
our standard of living improve
32
Productivity Calculations
Labor Productivity
Productivity =
=
Units produced
Labor-hours used
1,000
250
= 4 units/labor-hour
One resource input  single-factor productivity
33
Multi-Factor Productivity
Productivity =
Output
Labor + Material + Energy +
Capital + Miscellaneous
•
Also known as total factor productivity
•
Output and inputs are often expressed in
dollars
Multiple resource inputs  multi-factor productivity
34
Collins Title Productivity
Old System:
Staff of 4 works 8 hrs/day
Payroll cost = $640/day
8 titles/day
Overhead = $400/day
New System:
14 titles/day
Overhead = $800/day
35
Collins Title Productivity
Old System:
Staff of 4 works 8 hrs/day
Payroll cost = $640/day
8 titles/day
Overhead = $400/day
New System:
14 titles/day
Overhead = $800/day
Old multifactor
=
productivity
8 titles/day
$640 + 400
= .0077 titles/dollar
New multifactor =
productivity
14 titles/day
$640 + 800
= .0097 titles/dollar
36
Measurement Problems
1. Quality may change while the
quantity of inputs and outputs remains
constant
2. External elements may cause an
increase or decrease in productivity
3. Precise units of measure may be
lacking
37
Preferred Performance
Measures
• Preferred Performance Measures are those that
are sensitive to or change significantly with the
manager’s performance.
• They do not change much with changes in factors
that are beyond the manager’s control
• They motivate the manager as well as limit the
manger’s exposure to risk, reducing the cost of
providing incentives
• May include Benchmarking
38
Performance Measures at
the Individual Activity Level
•
Two issues when evaluating performance
at the individual activity level:
1. Designing performance measures for
activities that require multiple tasks
2. Designing performance measures for
activities done in teams
39
Master Data
40
Master Data: Activity Types
• An Activity Type represents a group of resources within
a Cost Center. These resource groups have capacity
and a unit of measure such as: labor hours, machine
hours, square footage, etc.
• Activity Type Uses:
– Capture Capacity or Planned Output
• Example: technician works 2088 Hrs or machine runs 3500 Hrs (10 Hrs/Day
for 350 days)
– Holds the rate for the output of the resource pool
• Example: $2 Hr, $5 Hr, $20 Hr
– Assigns capacity consumed by products/ services
• Example: Hrs/min worked per diagnostic test, which then valuates based on
the rate
41
Master Data: Things You Do
• Various other cost objects are used to represent the things
that the Cost Centers/Orgs are providing: Internal Orders,
Projects/Work Breakdown Structures, Maintenance Orders,
etc.
– Internal Orders: are short term in nature, represent an event or
job, do not replace the rigor of the Project/WBS Element
structure
• Example: Courses, CLS-SSPs, Pre-Deployment, Professional Certification
– WBS Elements: sub-tasks within Projects used for planning,
executing, and costing and managing dependencies
• Example: MEDCOM MRMC Labs projects, DPW Minor Constructions,
Environmental clean-ups. Additionally, WBS Elements are used for
reimbursable work either through a MIPR or as a Direct Charge.
– Business Process: Captures costs of cross-functional activities
(the “work” performed by the Cost Center/Activity Types) and
typically related to an action such as a “verb”
• Example: Pick Items, Pack Boxes, Ship Pallet
42
Master Data: Things You Track
• A Statistical Key Figure (SKF) is a piece of information
about the cost object it is assigned to
• Example: # FTE for a cost center, # of telephones, # of Students in
a Class, # of Ads within a Campaign
• SKFs are used to:
• Capture non-financial information
• Calculate the basis (cost driver) for cost assignments
• Example: # of telephones to allocate out from the phone bill
• Measure performance
• Example: # of tests SKF can plan for the year and then actuals
captured to report progress
• Calculate a unit cost rates
43
Identifying Requirements
&
Forecasting
45
Quality Function Deployment
1. Identify what customer wants
2. Identify how the good/service will satisfy the
customer wants
3. Relate customer wants to product how’s
4. Identify relationships between the firm’s how’s
5. Develop customer importance ratings
6. Evaluate competing products
7. Compare performance to desirable technical
attributes
46
QFD House of Quality
47
What is Forecasting?
• Process of predicting a future event
• Underlying basis of all business decisions
–
–
–
–
Production
Inventory
Personnel
facilities
??
48
Forecasting
• Forecasts are critical inputs to business plans,
annual plans, and budgets
• Finance, human resources, marketing,
operations, and supply chain managers need
forecasts to plan output levels, purchase
services and materials, workforce and output
schedules, inventories, and long-term capacities
• Forecasts are made on many different variables
• Forecasts are important to managing both
processes and managing supply chains
49
Components of Demand
Demand for product or service
Trend
component
Seasonal peaks
Actual demand
line
Average demand
over 4 years
Random variation
|
1
|
2
|
3
|
4
Time (years)
50
Trend Component
• Persistent, overall upward or downward pattern
• Changes due to population, technology, age,
culture, etc.
• Typically several years duration
51
Seasonal Component
• Regular pattern of up and down fluctuations
• Due to weather, customs, etc.
• Occurs within a single year
PERIOD LENGTH
“SEASON” LENGTH
NUMBER OF “SEASONS” IN PATTERN
Week
Day
7
Month
Week
4 – 4.5
Month
Day
28 – 31
Year
Quarter
4
Year
Month
12
Year
Week
52
52
Cyclical Component
• Repeating up and down movements
• Affected by business cycle, political, and
economic factors
• Multiple years duration
• Often causal or associative relationships
0
5
10
15
20
53
Random Component
• Erratic, unsystematic, ‘residual’ fluctuations
• Due to random variation or unforeseen events
• Short duration and non-repeating
M
T
W
T
F
54
Naïve Approach
• Assumes demand in next period is the same as
demand in the most recent period
– Example: if January sales were 68, then February
sales will be 68
• Naïve approach is sometimes cost effective and
efficient
• Can be a good starting point
55
Demand Patterns
• A time series is the repeated observations of
demand for a service or product in their order of
occurrence
• There are five basic time series patterns:
–
–
–
–
–
Horizontal
Trend
Seasonal
Cyclical
random
56
Moving Average Method
•
•
•
MA is a series of arithmetic means
Used if little or no trend is present
Used often for smoothing
–
Provides overall impression of data over time
demand in previous n periods
å
Moving average =
n
57
Weighted Moving Average
•
Used when some trend might be present
–
•
Older data is usually less important
Weights based on experience and intuition
((
)(
Weighted å Weight for period n Demand in period n
moving =
å Weights
average
))
58
Exponential Smoothing
•
Form of weighted moving average
–
–
•
Requires smoothing constant ()
–
–
•
Weights decline exponentially
Most recent data = weighted most
Ranges from 0 to 1
Subjectively chosen
Involves little record keeping of past data
59
Trend Projections
•
Fitting a trend line to historical data points to
project into the medium to long-range
•
Linear trends can be found using the least
squares technique
y = a + bx
where y = computed value of the variable to be
predicted (dependent variable)
a = y-axis intercept
b = slope of the regression line
x = the independent variable
60
Values of Dependent Variable (y-values)
Least Squares Method
Actual observation
(y-value)
Deviation7
•
Deviation5
Deviation6
Deviation3
Deviation4
Deviation1
(error)
Deviation2
Least
Squares
Method
minimizes
the sum of
squared
errors
(deviations
Trend line, y^= a + bx
|
|
|
|
|
|
|
1
2
3
4
5
6
7
Time period
61
Associative Forecasting
• Used when changes in one or more
independent variables can be used to predict
the changes in the dependent variable
• Most common technique is linear
regression analysis
• We apply this technique just as we did in
the time-series example
62
Associative Forecasting
Forecasting an outcome based on predictor variables
using the least squares technique
y = a + bx
where y = value of the dependent variable (in our
example, sales)
a = y-axis intercept
b = slope of the regression line
x = the independent variable
63
Correlation
•
•
•
How strong is the linear relationship between
the variables?
Correlation does not necessarily imply
causality!
Coefficient of correlation, r, measures degree
of association
–
Values range from -1 to +1
64
Correlation Coefficient
r=
nå xy - å xå y
é
2
êënå x -
ùé
2
å x úûêënå y -
( )
2
(
ù
å y úû
)
2
65
Multiple Regression Analysis
If more than one independent variable is to be used in the
model, linear regression can be extended to multiple
regression to accommodate several independent
variables
ŷ = a + b1x1 + b2 x2
Computationally, this is quite complex
and generally done on the computer
66
Monitoring and Controlling
Forecasts
Tracking Signal
•
•
Measures how well the forecast is predicting
actual values
Ratio of cumulative forecast errors to mean
absolute deviation (MAD)
–
–
Good tracking signal has low values
If forecasts are continually high or low, the
forecast has a bias error
67
Tracking Signals
Signal exceeding limit
Tracking signal
+
Upper control limit
0 MADs
Acceptable
range
–
Lower control limit
Time
68
Adaptive Smoothing
•
•
It’s possible to use the computer to continually
monitor forecast error and adjust the values of the a
and b coefficients used in exponential smoothing to
continually minimize forecast error
This technique is called adaptive smoothing
69
Focus Forecasting
•
Developed at American Hardware Supply, and is
based on two principles:
1. Sophisticated forecasting models are not always better
than simple ones
2. There is no single technique that should be used for all
products or services
•
Uses historical data to test multiple forecasting models
for individual items
•
Forecasting model with the lowest error used to
forecast the next demand
70
Seasonal Variations in Data
The multiplicative
seasonal model can
adjust trend data for
seasonal variations
in demand
71
Seasonal Variations in Data
Steps in the process for monthly seasons:
1. Find average historical demand for each month
2. Compute the average demand over all months
3. Compute a seasonal index for each month
4. Estimate next year’s total demand
5. Divide this estimate of total demand by the
number of months, then multiply it by the
seasonal index for that month
72
Capacity and Scale
• Economies of scale
–
–
–
–
Spreading fixed costs
Reducing construction costs
Cutting costs of purchased materials
Finding process advantages
• Diseconomies of scale
•
Complexity
•
Loss of focus
•
Inefficiencies
73
Average unit cost
(dollars per patient)
Capacity and Scale
250-bed
hospital
500-bed
hospital
Economies
of scale
750-bed
hospital
Diseconomies
of scale
Output rate (patients per week)
74
Benchmarking
75
Benchmarking
-Definition:
• A measurement of the quality of an organization's policies,
products, programs, strategies, etc., and their comparison
with standard measurements, or similar measurements of its
peers.
– Objectives:
(1) to determine what and where improvements need to be
made
(2) to analyze how other organizations achieve their high
performance levels
(3) to use this information to improve performance
76
Types of Benchmarking
•
•
•
•
•
•
•
•
•
•
•
Process benchmarking
Financial benchmarking
Benchmarking from an investor perspective
Benchmarking in the public sector
Performance benchmarking
Product benchmarking
Strategic benchmarking
Functional benchmarking
Best-In-Class benchmarking
Operational benchmarking
Energy benchmarking
77
Typical Benchmarking
Methodology
• Identify problem areas
• Identify other industries that have similar
processes
• Identify organizations that are leaders in these
areas
• Survey companies for measures and practices
• Visit the "best practice" companies to identify
leading edge practices
• Implement new and improved business practices
78
Marginal Costs
Marginal Costs are the costs to produce one
more additional unit of output
The slope of the Total Cost Curve at any
given level of production is the marginal cost
for one more unit
Marginal costs are highest at very low output
rates and at output rates near capacity
79
Marginal Costs
Total cost
Total
C
(£)
High marginal costs
A
B
Lowest marginal costs
High marginal costs
Output
80
Average Costs
Average Cost is calculated by
dividing the total cost by the total
units produced
Average Cost is very high at low
levels of output
81
Approximations of
Activity Costs
• Activity costs are not always easy to estimate
thus managers often use approximations
• One approximation is to use the market value
of resources for the opportunity cost
• Total activity costs can be approximated using
fixed and variable costs
Fixed Costs
Cost of using facilities, purchasing
machines, hiring and training
employees, and using other
resources that do not change with
the rate of output
Variable Costs
Cost of using additional labor,
materials and other resources to
increase the output of the activity
82
Earned Value Management
• Earned Value Management (EVM) provides a
common set of metrics for measuring both
• Schedule variance
• Cost Variance
• EVM combined with AAR offers a template for
cost management and control of projects
83
What Does Earned Value Mean?
• Since there are risks to both cost and schedule,
some method is needed to link the two
• Earned value measures what has been
accomplished in terms of planned (budgeted)
cost
– In this sense, it is similar to the flexible forecast we
used previously in analyzing volume variance
– Just like in the flexible forecast, we will use the
original planning factors to evaluate (in dollar terms)
how much more or less work has been done
84
The Balanced Scorecard
Financial Perspective
creating organizational value
for owners/shareholders
Customer
perspective
process
Strategy
adding value for customers
Internal business
process
ensuring efficiency and
quality in the value chain
Learning and growth
investing in organizational
infrastructure
85
The Balanced Scoreboard
Each organizational objective has driver performance
measures and outcome performance measures
Driver
Performance Measures:
Outcome
Performance Measures:
measure of input activities to
achieve the objective
measures to determine whether the
objective has been realized
e.g. the number of employee training
sessions is a driver performance
measure for the objective of increasing
employee skills to serve customers
e.g. the number different
services that an employee
can offer a customer
86
Balance Scoreboard Example
Objectives
Initiatives
Performance measure
Target
Financial Perspective
Increase shareholder wealth
Develop new products
Return on assets
25%
Growth
Increase online sales
% growth in sales
30%
Increase market share
Increased advertising
% market share
10%
Customer satisfaction
Increase post-sales service
% satisfied through survey
99%
Reduce throughput time
Reduce non-value-added
activities
Average throughput time
On-time delivery
Streamline delivery process
% pm-time delivery
Reduce defects
Quality teams
% defects
Multi-skilled workforce
Employee training
% of employees with multiple
skills
Improve information systems
Hire new employees in
computing
Number of employees in
computing
Reduce employee turnover
Pay higher salaries
% annual turnover
Customer Perspective
Internal business perspective
4 hours
90%
0.01%
Learning and growth perspective
80%
20
10%
87
Limitations of the
Balanced Scoreboard
It is difficult to optimize performance across the 4
perspectives while making the appropriate trade-offs
necessary to do so
The addition of too many
measures leads to a unwieldy
scorecard where managers
are left to determine the
relative importance of
measures subjectively
Over reliance on the
financial perspective
leads to an unbalanced
scorecard which
focuses on the short
term
88
Rewarding Performance Through
Compensation Contracts
An organization can be viewed as a set of
contracts that identify the assignment of
responsibilities, the performance measures to
evaluate the members, and how the benefits
generated by the organization are shared
Compensation is often
used as a motivational tool
89
The Management Processes
Resource
Managers
Operational
Managers
$
Inputs
Resources:
Labor
Material
Equipment
Supplies
Contracts
Assets
Conversion
“Work”
Work Performed by
Organizations (Cost
Centers) to Produce
Products and Services
for Customers
Outputs
Products Services:
Courses
Services Support Programs
Tests
Research Projects
Training Events
90
90
Setting Cost Targets
91
Estimating Product Costs for
Planning Decisions
Planning decisions are improved with
better estimates of product costs
The costs and benefits of different
decisions must be estimated
The item to be costed is called
the cost objective – the primary
cost objects are the products or
services provided by an
organization
The cost of using resources to
provide a product or service is
called the product or service
cost
92
The Role of Budgeting in Planning
and Control
93
The Role of Budgeting in Planning
and Control
94
The Role of Budgeting in Planning
and Control
• Types of Budgets
– Master budget
• Operating budgets
• Financial budgets
• Time frame
– Annual period
– Multi-year rolling budget
95
The Role of Budgeting in Planning
and Control
• Gathering information
– Forecasting sales
– Forecasting other variables
• The master budget starts with the sales forecast,
which is the basis for the sales budget
• All other operating and most financial budgets
are generated from the sales budget
96
The Role of Budgeting in Planning
and Control
97
Preparing the Operating Budget
• The first budget is the sales budget which is
based on the sales forecast
Schedule 1 (in thousands)
Starting point for ‘Production’ budget
Starting point for ‘Marketing Expense’ budget
Goes to ‘Budgeted Income Statement’
98
Preparing the Operating Budget
Schedule 2 (in thousands)
Starting point for ‘Direct Materials Purchases’ budget
Starting point for ‘Direct Labor’ budget
99
Preparing the Operating Budget
Schedule 3 (in thousands)
* Follows
the inventory policy of having 8 million pounds of materials on hand at the end of the first and second
quarters and 5 million pounds on hand at the end of the third and fourth quarters.
Goes to ‘Cost of Goods Sold’ budget
100
Preparing the Operating Budget
Schedule 4 (in thousands)
Starting point for ‘Overhead’ budget
Goes to ‘Cost of Goods Sold’ budget
101
Preparing the Operating Budget
Schedule 5 (in thousands)
*Includes $200,000 of depreciation in each quarter.
Goes to ‘Cost of Goods Sold’ budget
102
Preparing the Operating Budget
Schedule 6 (in thousands)
aAmounts
taken from Schedule 3.
bAmounts
taken from Schedule 4.
cAmounts
taken from Schedule 5.
dBudgeted
fixed overhead (Schedule 5)/Budgeted direct labor hours (Schedule 4) = $1,280/240 = $5.33.
Goes to ‘Cost of Goods Sold’ budget
103
Preparing the Operating Budget
Schedule 7 (in thousands)
*Production
needs  $0.01 = 416,000  $0.01.
Goes to ‘Budgeted Income Statement’
104
Preparing the Operating Budget
Schedule 8 (in thousands)
Goes to ‘Budgeted Income Statement’
105
Preparing the Operating Budget
Schedule 9 (in thousands)
Goes to ‘Budgeted Income Statement’
106
Preparing the Operating Budget
Schedule 10 (in thousands)
Goes to ‘Budgeted Income Statement’
107
Preparing the Operating Budget
Schedule 11 (in thousands)
108
Operating Budgets for Various
Organizations
• Merchandising:
– Merchandise purchases replaces production
– Direct materials and direct labor are not required
• For-Profit-Service:
– Sales budget is the production budget
– Inventories are non-existent
• Not-For-Profit Service:
– Budget for the level and types of services produced
– Statement of sources and uses replaces income
statement
109
Preparing the Financial Budget
• Cash Budget
– Breakdown into short time periods
– Forecast need for short-term borrowing
– Forecast periods of high cash balances
Beginning cash balance
+ Cash receipts
Cash available
– Cash disbursements
– Minimum cash balance
Excess or deficiency of cash
– Repayments
+ Loans
+ Minimum cash balance
Ending cash balance
110
Preparing the Financial Budget
Schedule 12 (in thousands)
111
Preparing the Financial Budget
Schedule 12 (in thousands)
112
Preparing the Financial Budget
Schedule 12 (in thousands)
113
Preparing the Financial Budget
• Budgeted Balance Sheet
– Current (actual) balance sheet
– Integrate data from all other budgets
114
Preparing the Financial Budget
Schedule 13 (in thousands)
a Ending balance from Schedule 12.
b 30 percent of fourth-quarter credit
sales (0.30 × $800,000); see
Schedules 1 and 12.
c From Schedule 3 (5,000,000 lbs.
× $0.01).
d From Schedule 6.
e From the December 31, 2009,
balance sheet.
f December 31, 2009, balance
($9,000,000) plus new equipment
acquisition of $600,000; see the
2009 ending balance sheet and
Schedule 12.
g From the December 31, 2009,
balance sheet and Schedules 5, 8,
and 10 ($4,500,000 + $800,000 +
$20,000 + $40,000).
h 20% of fourth-quarter purchases;
see Schedules 3 and 12.
i From the December 31, 2009,
balance sheet.
j $6,825,000 + $894,000 (December
31, 2009, balance plus net income
from Schedule 11).
115
Shortcomings of the Traditional
Master Budget Process
• Department orientation:
– Plan from resources to outputs
– Does not recognize interdependencies among
departments
• Static budgets:
– Developed for a single level of activity
– Based on incremental adjustments
• Results orientation:
– Disconnects the process from its output
– Cost-cutting accomplished by across-the-board cuts
116
Static Budgets for Planning and
Control
• Static Budget:
–
–
–
–
–
Vital for planning
Less useful for control
Master budget
developed around a single level of activity
Budgeted activity level rarely equals actual activity
117
Static Budgets for Planning and
Control
118
Flexible Budgets for Planning and
Control
• Flexible Budgets:
– Variable budget
– Provides expected costs for a range of activity
– Provides budgeted costs for the actual activity level
119
Flexible Budgets for Planning and
Control
120
Flexible Budgets for Planning and
Control
• Flexible Budget Performance Report:
– Compare budgeted costs given the actual level of
activity to the actual costs for the same level
– Locate possible problem areas by examining the
flexible budget variances
– Examines efficiency
121
Managerial Performance Reports
122
Managerial Performance Reports
• Have flexible budget variances
– Actual results vs. flexible budget
– Examines efficiency
• Has volume variances
– Static budget vs. flexible budget
– Examines effectiveness
123
Managerial Performance Report
Managerial Performance Report: Quarterly Production
(in thousands)
Actual
results
3,000
Units produced
Production costs:
Direct materials $ 927.3
Direct labor
360.0
Supplies
80.0
Indirect labor
220.0
Power
40.0
Supervision
90.0
Depreciation
200.0
Rent
30.0
Total Costs
$ 1,947.3
Flexible
budget
3,000
$
780.0
360.0
90.0
210.0
60.0
100.0
200.0
20.0
$ 1,820.0
Flexible
budget
variances
$ 147.3
(10.0)
10.0
(20.0)
(10.0)
10.0
$ 127.3
U
U
F
U
F
F
U
U
124
Managerial Performance Reports
Managerial Performance Report: Quarterly Production
(in thousands)
Actual
results
3,000
Units produced
Production costs:
Direct materials $ 927.3
Direct labor
360.0
Supplies
80.0
Indirect labor
220.0
Power
40.0
Supervision
90.0
Depreciation
200.0
Rent
30.0
Total Costs
$ 1,947.3
Flexible
budget
3,000
$
780.0
360.0
90.0
210.0
60.0
100.0
200.0
20.0
$ 1,820.0
Flexible
budget
variances
$ 147.3
(10.0)
10.0
(20.0)
(10.0)
10.0
$ 127.3
U
U
F
U
F
F
U
U
Static
budget
2,400
$
624.0
288.0
72.0
168.0
48.0
100.0
200.0
20.0
$ 1,520.0
Volume
variances
600 F
$ 156.0
72.0
18.0
42.0
12.0
$ 300.0
U
U
U
U
U
U
125
Flexible Budgets for Planning and
Control
• A flexible budget can be built for five overhead activities using three
drivers; each driver is budgeted for two activity levels
126
Activity Based Performance
Report
• Measures budget variances for each of the
overhead activities
127
Activity Based Budgets
• ABB begins with output and then determines the
resources necessary to create that output
• ABB works backwards from activities and their
drivers to the underlying costs
– Traditional budgeting relies on functional-based line
items (salaries, supplies, etc.)
– Flexible budgets use cost behavior to split functionalbased line items into fixed and variable
128
Activity Based Budgets
Traditional budgeting: relies on functional-based line items
129
Activity Based Budgets
Flexible Budgeting: uses cost behavior to split functional-based line
items into fixed and variable costs
130
Activity Based Budgets
• Steps to construct an ABB
– 1. determine the unit’s output
– 2. identify the activities (and related drivers) needed
to deliver the output
– 3. estimate the demand for each activity
– 4. determine the cost of resources required to
produce the relevant activities
131
Activity Based Budgets
132
The Behavioral Dimension of
Budgeting
• Characteristics of a good budgetary system
–
–
–
–
–
–
Frequent feedback on performance
Monetary and non-monetary incentives
Participative budgeting
Realistic standards
Controllability of costs
Multiple measures of performance
133
Planning Considerations
134
Planning Capacity
• Capacity is the maximum rate of output of a
process or system
• Accounting, finance, marketing, operations,
purchasing, and human resources all need
capacity information to make decisions
• Capacity planning is done in the long-term and
short-term
• Questions involve the amount of capacity
cushion and expansion strategies
135
Measures of Capacity Utilization
• Output measures of capacity
• Input measures of capacity
• Utilization
Utilization = average output rate
maximum capacity
=
100%
136
Deming’s Fourteen Points
TABLE 6.2
Deming’s 14 Points for Implementing Quality Improvement
1. Create consistency of purpose
2. Lead to promote change
3. Build quality into the product; stop depending on inspections to catch problems
4. Build long-term relationships based on performance instead of awarding business on
price
5. Continuously improve product, quality, and service
6. Start training
7. Emphasize leadership
8. Drive out fear
9. Break down barriers between departments
10. Stop haranguing workers
11. Support, help, and improve
12. Remove barriers to pride in work
13. Institute a vigorous program of education and self-improvement
14. Put everyone in the company to work on the transformation
137
Measuring Performance
Total Revenue:
Increase sales through
better customer service
Cost of Goods Sold:
Net Income:
Reduce costs of
transportation and
purchased materials
Improve profits with
greater revenue and
lower costs
Operating Expenses:
Reduce fixed expenses
by reducing overhead
associated with supply
chain operations
Net Cash Flows:
Improve positive cash
flows by reducing lead
times and backlogs
Return on Assets
(ROA):
Working Capital:
Reduce working capital
by reducing inventory
investment, lead times,
and backlogs
Fixed Assets:
Inventory:
Increase inventory turnover
Increase ROA with
higher net income
and fewer total
assets
Reduce the number
of warehouses
through improved
supply chain design
Total Assets:
Achieve the same
or better
performance with
fewer assets
138
Process Considerations
• Push/pull method of work flow
• Quality at the source
– Jidoka
– Poka-yoke
– Anadon
• Uniform workstation loads
–
–
–
–
Takt time
Heijunka
Mixed-model assembly
Lot size of one
139
Two Ways Quality Improves
Profitability
Sales Gains via
• Improved response
• Flexible pricing
• Improved reputation
Improved
Quality
Reduced Costs via
Increased
Profits
• Increased productivity
• Lower rework and scrap costs
• Lower warranty costs
140
Resource Planning
• At the heart of any organization
• Starts with sales and operation plans which
helps when planning input requirements
• A process relative to the firm’s competitive
priorities and an important part of managing
supply chains
141
Enterprise Resource Planning
(ERP)
• An ERP system:
– Integrates a firm’s functional areas
– Is used by many different types of organizations
• How an ERP is designed:
– Single comprehensive database
– Mangers monitor all of the company’s products at all locations
and at all times
– Information is automatically updated in the applications when
transactions occur
– Streamlines data flows throughout the organization
– Requires a careful analysis of major processes
– Significant changes in ERP systems - interoperability
142
Conclusion
143