CIMA P2

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CIMA Paper P2

Management Performance

For exams in 2012

Notes

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CHAPTER 1

Pricing and Product Decisions

START

The Big Picture

This chapter examines the key concepts of costs and revenue relevant to product and pricing decisions.

KEY KNOWLEDGE

Relevant Decision-making

One of management’s responsibilities involves making decisions affecting the firm in the short- and long-run based on relevant costs.

Such decisions typically take the form of: • Accept-Reject

• Costing projects • Make-Buy • Shut down

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What is “Relevance”?

Each of the above will be illustrated by practical exercises. But first it is necessary to establish the meaning of a relevant cost.

Cash & Incremental

A relevant cost is a cash cost which is uniquely incurred (or avoided) as a consequence of taking a decision; cash, because it is the main determinant of value (unlike accounting profit); and unique in the sense that is not common to the alternative choices that are under consideration.

EXAMPLE

A company seeking to determine whether to continue to transport its products by truck or to switch to the railroad, discovers that insurance costs are identical in both choices; it that case, insurance costs are not relevant to the decision.

If, however, there is a difference in the two insurance costs, then one can speak as the difference between the two choices as being “incremental”; this difference (referred to in some places as the “differential”) is relevant to the decision under consideration.

Future

Relevant costs refer to the future, i.e. they can be influenced prospectively by choice. It follows that:

• Sunk costs are not relevant: They have already taken place and cannot be reversed. • Committed costs, if they cannot be avoided, are likewise not relevant, even if the

timing of their occurrence is in the future. Their “unavoidability” has already been established in the past (making them effectively the equivalent of sunk costs). In keeping with the above logic, relevant costs therefore involve cash, are incremental and relate to the future.

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EXAMPLE

A company considers building a storage facility on the site of a parking lot. If the parking lot had been generating parking fees which will now be lost, then this foregone revenue is an opportunity cost.

Accept-Reject decisions

EXERCISE

A company currently produces fire hydrants with the following per unit data:

Selling Price 100

Direct materials 50

Direct labour 1 h 15

Fixed overheads 25

This company has been asked to supply a one-time contract supplying garden ornaments with the following conditions:

• Contract revenue is 750 • 10 hours of labor are required

• Materials specific to this contract are valued at 200

Required

1. Should the company accept or reject the order?

2. What would be the impact on your decision if labor was at full capacity?

Learning Points

The relevant cost for labor depends on the capacity utilization of labor: • If there is spare labor capacity, then the relevant cost is zero; • If labor is at full capacity, then the relevant cost is either:

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o its variable market cost, if additional labor can be hired, or

o the value sacrificed as a result of diverting labor from another activity already performed within the firm

Costing projects

It is a standard management accounting practice to determine the relevant costs of a new project in order to come up with a price quotation. Setting a price without having an accurate understanding of costs can put a company at a competitive disadvantage, particularly if there is intense competition.

EXERCISE

A proposed contract calls for the use of 200 liters of Agent Q and 50 kg. of Compound P. Additional data:

In stock Historical price Current price Scrap value

Agent Q 150 liters USD 7 USD 5 USD 1

Compound P 100 kg USD 12 USD 15 USD 2

Agent Q is no longer in use.

Compound P is in regular use at the company.

Required

1. What are the relevant costs of the two materials for the proposed contract? 2. The company discovers that as the result of a change in environmental laws, the

residual value of Agent Q has actually become negative, i.e. there is a net cost of USD 1.50/liter disposal cost. How does this affect the relevant cost?

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Learning Points

The relevant cost for materials depends on the following:

• If the material is not owned, then it must be bought at the current replacement (market) price;

• If the material is already in stock, then the relevant cost is either:

o its current replacement cost, if it is to be replaced in the regular course of business, or

o its current scrap (resale) value, if it is no longer in use, or its value (if greater than scrap) if it can be applied as a substitute for another product.

• If the material is scarce (i.e. cannot be purchased externally) and must be diverted from another activity already performed at the company, then its opportunity cost must be ascertained in order to arrive at an accurate relevant cost.

Make-Buy

An automotive components producer can buy car heaters from an outside supplier for USD 165 per unit. In considering whether to make these internally, the company calculates that an equivalent unit can be made in 2 labour hours using USD 100 worth of materials.

Labor is currently at full capacity producing carburetors which generate contribution of USD 90. A carburetor takes 3 hours to produce. Labor costs USD 6 per hour. The carburetor also absorbs fixed overhead costs at the rate of USD 20 per labour hour.

Should the company make or buy the heaters?

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Shut Down decisions

EXERCISE

Assume car factory with three locations:

Erie Huron Superior

Revenues (m) 25 30 40

Costs (m)* (15) (26) (44)

Profits (m) 10 4 (4)

* 25% of the costs are fixed costs allocated by H.O.

Required

Management is considering shutting down the Superior plant. Please advise management. Even if we take allocated costs out of the equation, it is necessary to examine the structure of the costs to determine whether a plant generating a positive contribution should stay open.

The dilemma of short-term decisions and fixed costs

Beware of allocated costs; but don’t forget: In the long-run, all costs are variable. In the cases above, we focused on Contribution (Revenue minus Variable Costs). In the short-run, contribution is relevant in decision-making.

However, one must not forget that fixed costs have to be covered – they don’t simply vanish!

In the long-run, a company’s “business model” must include how fixed costs are to be covered, otherwise the business model lacks long-run viability.

Non-financial factors for investment appraisal

Although the financial case for making an investment is a vital part of the decision-making process, non-financial factors can also be important.

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EXERCISE

How does one assess non-financial criteria?

KEY KNOWLEDGE

Cost-Volume-Profit Analysis (CVP)

The breakeven formula

Total Costs = Fixed Costs + Unit Variable Cost x Number of Units Total Revenue = Sales Price x Number of Units

If

TC = Total Costs, FC = Fixed Costs, V = Unit Variable Cost, X = Number of Units, TR = Total Revenue, SP = Selling Price,

C = SP – V = Unit Contribution and CM%= C/SP = Contribution Margin,

Then the break-even point (the output level at which TR=TC) is: • In units sold: X = FC/C

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• Safety Margin = Budgeted Sales – Break-even point (units/dollars)

• C is an important indicator, as it shows the contribution of each unit sold towards covering fixed costs. Therefore, in the short run, the firm may prefer to produce/sell below break-even in order to recover some of its fixed costs.

Break-even Analysis

Marginal costing is useful in calculating the “break-even” level of sales.

The break-even point is the level where the company achieves zero profit (neither gain nor loss). It just manages to cover its fixed costs.

• Contribution per sale – C/S ratio

This is understood as the amount of contribution generated by every dollar sold.

KEY KNOWLEDGE

Limiting factors

When a single limiting factor is present in a production plan, then it is necessary to identify it and to plan production around it.

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Take the following example:

Selling price 30 40 50

Product X Y Z

Labour cost per unit ($) 10 16 20

Material cost per unit ($) 5 8 10

Contribution 15 16 20

It appears that in the face of unlimited demand for all three products, Product Z would be given priority as it maximizes the contribution per unit.

Now, assume that labour hours are limited to 500 and that labour costs $2 per hour (demand remains unlimited for all three products).

In the above case,

Labour cost per unit ($) 10 8 20

Product X Y Z

No. of hours per unit 5 8 10

Contribution per hour 3 2 2

Now it becomes clear that Product X is favoured for the full number of hours available (500). 100 units of X can be produced.

If demand for X were limited to, say, 80 units (requiring 400 labour hours), then the

remaining available hours (100) could be used to produce either Y or Z (in this case there is indifference between the two).

The steps to be followed in working out the optimal production plan are: (1) Calculate the contribution per unit of product;

(2) Calculate the contribution per unit of limited resource; (3) Rank the products according to Step 2;

(4) Produce according to the priority established in Step 3, up to the demand limit of each product or until the limited resource is exhausted

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KEY KNOWLEDGE

Multi-limiting factors and the use of linear

programming and shadow pricing.

When resources are scarce, or other limiting factors are present in a given situation, then management is concerned with achieving the most efficient allocation of available resources. Whereas planning with one limiting factor involves the use of “key factor analysis” (in which typically one seeks to maximize the contribution per unit of the limited, or bottleneck, resource), the presence of several limiting factors requires the use of linear programming. In such cases, linear programming is typically used to either maximise contribution or to minimize costs. The usual steps to be followed are:

1) Define the variables

2) Define the “objective function” 3) Express the constraints as equations

4) Solve the equations simultaneously as well as feasible values corresponding to the corner points;

5) Determine the combination of specific values that satisfies the objective function. The answer can also be graphed and Step 5 determined visually. A graph also shows the “feasible region” of value combinations that are consistent with the constraints.

Shadow (dual) price

A shadow price is the additional value to be obtained (usually an increase in contribution) by having available one more unit of a scarce resource.

Slack

This represents the amount of a resource that has not been exhausted (i.e. its availability does not act as a constraint or limiting factor in a given set of circumstances).

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KEY KNOWLEDGE

Linear Programming – Simplex Method

Concept: A linear programming algorithm capable of solving optimization problems involving several output variables. The steps involve:

• Formulating the initial tableau; • Interpreting the final tableau; • Applying tableau information

EXAMPLE

Assume a company produces two products (A and B) which pass through three departments (X, Y and Z). Process constraints (S1, S2 and S3) are represented by the number of hours of

processing time available in each department.

A final tableau could look as follows:

Variable A B S1(x) S2(y) S3(z) Solution expression

A 1 0 0.3 -0.3 0 200 units (output)

B 0 1 -0.2 0.1 0 300 units (output)

S3

Contribution 0 0 0.5 0.4 0 5,500 monetary ($)

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KEY KNOWLEDGE

Pricing strategies

External pricing considerations

Good businesses do not compete on price alone, but seek to differentiate their products and services.

Intelligent pricing nevertheless is a key component of strategy. This is especially true in recessionary economic climates.

Price-Quality Relationship

A priori one would expect a positive correlation between price and quality.

The four principal pricing strategies are shown in the above quadrants. The more interesting ones involve High-Low and Low-High combinations.

There are a variety of pricing strategies with which one should be familiar:

Cost plus: A markup is added to a given cost base (which can be variable or full production cost). Skimming Premium Economy Penetration High Low High

Price

Quality

Low

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Skimming: Enter the market at a high price to catch customers willing and able to pay the price; pricing can subsequently be reduced to expand market.

Penetration pricing: Go in at a very low price to win market share; pricing can subsequently be increased once share is won.

Premium pricing: Maintain a high price due to the nature of the product.

Target pricing: Determining the price at which a product will be competitive and working back through required profit to determine the cost limits; this is the “flip side” of the target cost approach.

Economy (pricing): This is a no frills low price.

Promotional Pricing: These are in support of campaigns to raise customer awareness of a product.

Perceived value pricing: Plays on perception of value and what the market is willing to pay.

MR = MC: Marginal revenue = Marginal cost.

Value Pricing: Increasing the value content of the product so as to defend market share (in times of difficult economic conditions or competition).

Product-line pricing: Determining the pricing of particular items in a line of products which are closely linked with one another so as to maximize overall gain.

Product range pricing: Sell a “core” product cheaply and price high related products.

Volume-discounting pricing: The bigger the order, the lower the price per unit.

Discriminatory pricing: Pricing the same product at different levels in different markets (geographical) or market segments (customers).

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Geographical Pricing: Similar to price “differentiation”.

Psychological Pricing: Plays on the emotion of the consumer.

Product Bundle Pricing: Combining products into one pack and pricing it overall.

Complementary product pricing: This refers to products that are used in conjunction with other products (e.g. printers and cartridges, razor grips and blades, staplers and staples, automobiles and spare parts). The approach to pricing may be low for the main product and more expensive for the “re-fills”; alternatively, the approach may be a high initial price and cheaper for subsequent products/services.

Relevant cost pricing: Basing the price on a keen (accurate) understanding of the real costs of the product or service.

Captive Product Pricing: Similar to “product range” but product is more closely tied to the initial product.

Competitive pricing: Using competitors as a benchmark.

Product Line Pricing: The overall price reflects the benefits provided by the constituent parts.

Optional Product Pricing: The pricing of additional products and services once the customer

has made the initial purchase.

It is important not to fixate on pricing. It is only one of the four components in the marketing mix of a company, the famous 4 P’s of marketing:

• Price • Product • Place • Promotion

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KEY KNOWLEDGE

Joint Products / By-products

Joint products are two or more products that share a common processing path until the point of separation. Until they go their own (separate) ways, the costs of production during the joint processing cannot be physically distinguished.

There are different methods used to apportion common costs to such products at the point of separation:

• Market value (based on expected sales price)

• Number of units (litres, tons, or some other objective physical measurement) • Net realizable value = Final sales value – Incremental processing costs

By-products are goods which are incidental to the production process and which generate cash from sales, though the amount is modest in comparison to the overall revenues of the firm. The cash received for by-products can be viewed as a bonus that reduces production costs.

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CHAPTER 2

Cost planning and analysis

START

The Big Picture

This section looks at cost analysis techniques related to achieving competitive advantage.

KEY KNOWLEDGE

Just-In-Time (JIT)

• JIT is more than an inventory management model; it is a manufacturing philosophy which puts at its core minimization of inventories on the basis that most of inventory-related activities are non-value-added.

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KEY KNOWLEDGE

Total Quality Management (TQM)

Basic objectives are: Customer satisfaction, “get it right first time” and continuous quality improvement, cost savings mainly through complete elimination of waste, promotion of teamwork.

KEY KNOWLEDGE

Theory of Constraints (TOC)

An “optimised production technology” (OPT) approach to short-term management of

“bottlenecks” (sub-processes or operations which restrict the output from the whole process to less than the amount demanded)

• Bottlenecks generate idleness of both prior sub-processes – as soon as waiting line for current sub-process is full - and next sub-process, for which there is shortage of input.

Basic principle

• Costs incurred in the business process are all categorized as fixed, except for direct material costs, which are categorized as variable.

• Throughput contribution is defined as sales minus variable costs

• TOC/OPT states that

, that is, at the level of each sub-process, outputs minus direct material inputs.

• In a production process managed using a Drum-Buffer-Rope (DBR) system, the bottleneck operation is the “drum”, the minimal amount of work units in drum’s waiting line so that the drum never stops is the “buffer”, and the sequence of operations (including the drum) that must be co-ordinated in order not to build-up inventories is the “rope”.

short-term profits are maximized when throughput contribution by the bottleneck operation is maximized

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KEY KNOWLEDGE

Kaizen

Kaizen refers to the idea of continuous improvement in company operations. It is: • Consistent with TQM philosophy

• Requires building-in of costs to improve and improvement effects

• Budgeted targets cannot be reached if budgeted improvements do not occur

KEY KNOWLEDGE

Learning Curves

Learning curve effects can be applied to variance analysis, as they allow standards to be adapted to a dynamic situation, i.e. one where the time to produce units declines with the increase in output.

EXAMPLE

A product requires 20 hrs of labour per unit at a cost of $6 per hr.

A traditional labour standard would expect 4 units to be produced in 80 hrs at a labour cost of $480.

If a 90% learning curve effect applies, then one would expect the 4 units to be completed in less time. How long will they require?

Utilizing the formula: y = axb

Where:

y = cumulative time required per unit

a = time to produce the first unit (in the example above = 20) x = cumulative number of units produced ( = 4 units)

b = log r/log2

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We solve for: y = 20 X 4-.1522

= 16 (remember: this is the cumulative time per unit) Therefore, 4 units will require 64 hrs (16x4)

Conclusion: Based on the above, 64 hrs define the standard against which the time required to produce 4 units should be compared when calculating the labour efficiency variance.

KEY KNOWLEDGE

Activity-based Management (ABM)

Definition

ABM is a management system using ABC information to analyse relationships between costs and activities carried out, and to base decisions aimed at (a) reducing costs, (b) improve quality, (c) reduce idle time and eliminate bottlenecks, and (d) enhance process flexibility and promote innovation.

ABM approach to cost measurement

• Focus on activity costs (whether cross-departmental or not) rather than department costs

• Focus on indirect costs (overheads) and overhead generating areas, given their significance and the fact that their degree of controllability is higher

• Focus on individual customer profitability

NB that running an ABM programme does not necessarily need an underlying ABC system implemented.

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KEY KNOWLEDGE

Target Costing

This is a market-oriented approach to costing which starts by identifying the likely price that a product can fetch in the market, deducts the profit that the product is expected to earn, and arrives at the maximum (target) cost of manufacturing the product.

Such a method usually requires successive iterations in order to close a “cost gap”, i.e. where the costs are above the targeted level. Product re-design, alternative materials and production processes are examined in order to achieve the desired level of costs.

KEY KNOWLEDGE

Product Life Cycle

A company’s long term survival is influenced by its ability to bring new products to market. In some cases, such as pharmaceuticals, the lead time (R&D) can be lengthy. Moreover, the financial (and other resource) requirements of a product varies over its life, which will typically extend beyond the next accounting/budgeting period. Consider the following:

The conditions in which a product is sold change over its life.

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Characteristics of each stage

Introduction Growth Maturity Decline

Product Potentially unique product. Quality still being “tested”. New entrants arrive. Design improvements. Products start to become similar with few differences. Product may have minor enhancements to try to “extend the tail” of the lifecycle. Price Could be high for “skim pricing” or low for penetration pricing. Price can be maintained but pressure on pricing arising due to increased competition Possibly reduced prices due to increased competition. Possible further reductions to stimulate sales. Place Limited, specialist locations. Distribution channels increase as demand rises. Widespread distribution channels. Reduced number of distribution channels.

Promotion Aimed at the “early adopters”. Expands to the larger market. Focus on any differentiating products. Limited amount of promotion.

KEY KNOWLEDGE

Porter’s Value Chain

Support Activities

Primary Activities

Technological Development Human Resource Management

Firm Infrastructure Procurement Inb ound Lo gi st ic s Ope ra tio ns O utb ound Lo gi st ic s M ar ke tin g & S al es Se rvi ce

Strategic Choice to Purchase Some Activities From Outside Suppliers

Su ppo rt Pri m ary

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The value chain was introduced by Porter and represents an approach to looking at the development of competitive advantage within an organisation. All organisations consist of activities which “link” together to develop the value of a business. Together these activities represent the value chain.

The value chain represents a series of activities that both create and build value. Combined they represent the total value delivered by an organisation. The “margin” in the diagram is the added value (the difference between the total value of the activities and the cost of performing them).

Primary activities: related with production.

Support activities: provide the background for the effectiveness of the organisation (e.g.

HRM)

KEY KNOWLEDGE

Gain-Sharing

The Concept: The process of reviewing and adjusting contracts in a manner that benefits both parties.

It is primarily relationship-based, implying that there is a mutual endeavour to achieve cost savings or other benefits which can be shared between the parties.

Gain sharing is the antithesis of a zero-sum game or an approach whereby one party leverages its negotiating power to press the other into a corner (“winner take all”).

KEY KNOWLEDGE

Activity-Based Costing (ABC)

ABC is a method that seeks to group overhead costs according to the activities causing those costs. The activities giving rise to the costs are called “cost drivers”. By linking costs to activities (cost drivers), it becomes possible to charge costs to the agents undertaking those activities.

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ABC -- EXAMPLE

A factory clinic with total annual costs of $500,000 serves two Workshops A and B. Workshop A has 200 employees and Workshop B has 300 employees.

A conventional way of apportioning the cost would be on the basis of employees: Workshop A: (200/500) x 500,000 = 200,000

Workshop B: (300/500) x 500,000 =

500,000 300,000

An ABC approach might look at the number of visits to the clinic by the employees of A and B.

Workshop A: 150 visits p.a. Workshop B: 70 visits p.a. In this case, the apportionment could be:

Workshop A: (150/220) x 500,000 = 340,909 Workshop B: ( 70/220) x 500,000 =

500,000 159,091

The different levels of usage may reflect different degrees of occupational hazard present in the two workshops.

ABC advantages: provides a more precise way to determine costs per unit of output, especially since not all overhead costs are driven by production volumes.

Budgetary planning, pricing decisions and managing performance are all facilitated by ABC. ABC disadvantages: it can be complex and costly to implement. It is not a “plug-in-and-go” system! It is therefore imperative that management carefully weigh the costs against the (expected) benefits from ABC before deciding to implement it.

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The following is a manufacturing illustration which demonstrates the importance of accurate product costing.

Activity classification

According to Cooper (1990), product-related overhead costs can be grouped into four categories. They are:

• Unit-level activities; • Batch-level activities;

• Product-sustaining activities; and • Facility-sustaining costs

Pareto analysis

Pareto analysis is perhaps more popularly known as the “80/20 rule”, whereby (in many cases), a large number of problems can be explained by a small number of causes (in the rough ratio of 80:20. The origin of the theory comes from Pareto’s observation that 80% of the income in Italy (in the ) was earned by 20% of the population.

The applications are extensive:

• 20% of one’s clients accounting for 80% of the profit; • 20% of one’s sales staff generating 80% of the revenues;

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CHAPTER 3

Budgeting and Management Control

START

The Big Picture

Responsibility accounting

A system of accounting that attributes costs and/or revenues to individual business units (responsibility centres) for which a particular manager is held responsible.

KEY KNOWLEDGE

Alternative budgeting models

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Fixed

• A fixed budget is not adjusted to the actual volume of output (activity level)

Flexible vs. Flexed

The distinction is sometimes overlooked:

• Flexible: designed to change according to actual volumes of output; usually done before the start of the budgetary period as a sort of scenario planning;

• Flexed: This is done “after the fact” and is based on the actual level of activity achieved.

Rolling

A rolling budget is one which is revised on an on-going basis by comparing actual results with the original budget when one period has expired, while simultaneously adding a new period to the budget period.

EXAMPLE

An annual budget which is kept rolling on a quarterly basis, for example, may start with an (original) January – December forecast. At the end of March, the entire budget is revised on the basis of the first quarter, and a new set of forecasts relating to April (current year) – March (next year) are prepared, i.e. always with a 12 month range into the future.

Zero-based (ZBB)

• Each year, budget owners must justify the entire budget (build it from zero) • At odds with incremental budgeting (where only changes need justification, hence

encouraging the “spend it or lose it” mentality) • A three-step approach to ZBB:

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o Define “decision packages” (i.e. activities that result in costs or revenues), distinguishing between “mutually exclusive packages” (alternative activities to achieve the same result) and “incremental packages” (base level of input needed + additional inputs)

o Evaluate and rank packages (based on the benefit to the organisation) o Allocate resources across packages, considering ranking and seniority of

responsible managers

Activity-based (ABB)

• No budget owners (departments, functions), but budgeted activity cost (ABC costing) • Budgeted activity cost = demand for activity * unit cost of activity

• More detailed and accurate than traditional budgets, especially regarding indirect costs

Incremental

Such budgets are based on what went on during the period before. Typically, this approach results in modest changes and adjustments to the earlier budget. At worst, they retain and perpetuate inefficiencies and old assumptions. This might be termed the “lazy man’s budget”.

Behavioral aspects of budgeting

Budgetary control systems seek to monitor performance against the budget in a timely way so that deviations can be identified and rectified. The system can only work as well as the care and thought that went into defining performance targets to be measured, and the incentives (and sanctions) that follow from achievement (or not) of those targets. Budgets are prepared, implemented/managed and reviewed by people. The following aspects concerning human behavior need to be borne in mind:

• Goal congruence at all levels of the organization – corporate, divisional and individual

– must exist for a budget, and its attendant control systems, to be effective. A lack of congruence leads to organizational dysfunctionality.

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• To be motivating, budgets/targets should be set at a challenging – but not an

impossible – level. If they are too easy to achieve, then organizational/individual complacency result.

• Participation in the preparation of a budget can be motivating and secure the “buy-in” (i.e. commitment) of the employee.

Problems frequently encountered when using conventional budgets:

• They invite “gaming” of the system; • They can be inflexible;

• They are often imposed from the top – “Top Down”;

• There is an indirect connection with the company’s strategy; • They are used for too many different purposes;

• They reinforce a centralizing tendencies in the company

• There is a lack of goal congruence between corporate, divisional and individual goals

Key metrics

The traditional financial measures used in tracking performance should be familiar; these include:

• Profitability ratios, • Liquidity ratios; and • asset turnover ratios.

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What-if analysis

This refers to the process of testing different scenarios regarding volumes, prices and cost structures within a financial model in order to observe the financial consequences of alternative strategies.

The use of excel spreadsheets is indispensable in facilitating such analyses and their use is considered a basic working tool for all management professionals.

The scope of performance measurement

KEY KNOWLEDGE

Balanced Scorecard

The balance scorecard addresses a number of parameters (or “perspectives”) in monitoring business performance by asking the following questions:

• Financial perspective: “To succeed financially how should we appear to our shareholders?”

• Customer perspective: “To achieve our vision how should we appear to our customers?”

• Internal business processes: “To satisfy our shareholders and customers what business processes must we excel at?”

• Learning and growth: “To achieve our vision how will we sustain our ability to change and improve?”

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KEY KNOWLEDGE

Beyond Budgeting

“Beyond” budgeting: The future of budgets and alternatives to budgeting

Can you imagine a budget process that takes up to six months and 20 percent of management's time?

Numerous proposals have been offered to make budgeting more meaningful. Prof. Bourne (of Cranfield) is one proponent of the sort of measures below:

1. Sever the link between fulfilling budget and compensation

Otherwise managers are inclined to set budget targets too low. Some companies link bonuses to the results of competitors.

2. Separate the budgeting from forecasting

Budgets are linked to the allocation of resources, while forecasts are subject to more frequent changes, due to external influences (market, etc.)

3. External benchmarking to control costs

This offers a better way to control costs and helps avoid the bargaining process that goes on within the company when establishing the budget.

4. Implement financial and non-financial performance measures

Some companies are remarkably numbers-obsessed. Perhaps it gives the illusion of control!

5. Understand the connection between major non-financial activities and their financial

consequences

The above connection has to be managed more directly rather than via the numbers. 6. Make a distinction between operating costs and investments

This is a reminder to non-accountants and is frequently overlooked or not appreciated.

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CHAPTER 4

Control/Performance Measurement

of Responsibility Centres

START

The Big Picture

The concept of responsibility accounting introduced earlier is applied and examined in the context of organisational structure.

KEY KNOWLEDGE

Responsibility Centres

Ensuring goal congruence

The system should encourage managers to make the effort to reach common goals, which (a) should be consistent with organization’s objectives and (b) should be specific, objective and verifiable.

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Critical requirements

Classification

Cost centres

• Responsible for current expenses only

• Performance measures: standard costs, variance reports, efficiency measures o Efficiency = Productivity = [Output : Input]

o Support/service centres are common examples of cost centres

Revenue centres

• Responsible for revenues, but not current expenses other than marketing expenses

Profit centres

• Responsible for revenues and current expenses

• Performance measures: revenues, costs, output levels, profit

Investment centres

• Responsible for revenues, current expenses and capital expenditure Responsibility •Assign responsibility (obligation to perform) for activities to be performed within the responsibility centre Authority •Delegate authority to direct and exact performance of assigned activities Accountability •Establish duty to report performance and accountability for failure to meet obligation Controllability •Evaluate performance (with consequent feed-back ensuring controllability of the responsibility system)

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• Performance measures (refer to sub-section III.6. for more details): ROI, RI, EVA o ROI = ROCE = [Profit / Capital Employed]

o RI = PBIT – Capital Employed * Imputed Interest Cost

o EVA = Adjusted NOPAT – Adjusted Capital Employed Weighted Average Capital Cost

Behavioral aspects of system design

Management accounting systems must be designed to take into account the natural

tendency of people to “game” the system, i.e. manipulate it so that they can extract results which are most favourable to themselves in terms of recognition, bonuses and career development.

Controllable vs. Uncontrollable costs

The distinction above between “controllable” and “uncontrollable” costs is critical insofar as it relates to the idea of “responsibility accounting”, i.e. expecting people who have delegated authority to take responsibility for decisions within their area of control.

Changes in business structure and management accounting

Management accounting systems must be appropriate to the structure of the businesses they serve.

We have seen that that “beyond budgeting” is based on a recognition of the limitations of traditional management accounting techniques, particularly in rapidly changing business environments.

The way in which a business is organized – e.g. a functional, divisional or network form – has implications for the way in which performance is managed and measured.

Functional structures

The traditional form of company follows functional lines, these being generally production, marketing, human resources, etc. Specific skills are located within relevant departments and reporting lines and responsibilities rather straightforward. At the same time, this gives rise to

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inflexibility of structure and therefore limited ability to respond and adapt to external circumstances that require inter-disciplinary skills and responses.

Divisional organizations

Companies reaching a certain size, with a diversity of product lines and geographic coverage, often find that breaking themselves up along divisional lines enhances their ability to cope with changes in the market. This is because the divisions themselves replicate the original company, this time on a more decentralized basis and with specialization by product or region (meaning domestic regions for a national company, or supra-national regions in the case of a multi-national).

The divisional structure motivates division managers to practice more autonomy in decision-making across the range of functions located within their business unit.

Naturally, a division structure may lose some of the benefits provided by centralization, as for example, global purchasing (and the negotiation power it makes possible). Some organizations decentralize their treasury functions, while others maintain it at the parent company (corporate level).

Networks

In an effort to keep fixed costs low, some firms deliberately out-source most of their non-core functions, and even some that are vital to the functioning of their business. A training company, for example, may rely on free-lance tutors so as to minimize the impact of seasonal downswings in demand. In this way, companies may work in alliance with other professionals who can be mobilized according to specialist skill sets and specific client demand when periods of intense activity arise.

Virtual organizations are an extreme firm of networks possessing a kind of flexibility that was not possible before the advent of modern communications and transportation.

Modern approaches to business structure are “integrative” in nature, as they explicitly take into account the linkages between people, operations, strategy and technology.

CIMA P2

CIMA Paper P2

Management Performance

For exams in 2012

Notes

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Contents

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START

About ExPress Notes

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How to get the most from these ExPress notes

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Notes

Notes

Notes

START

About The ExP Group

As well as courses for CIMA and other professional qualifications, o

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Pricing and Product Decisions

START

The Big Picture

KEY KNOWLEDGE

Relevant Decision-making

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EXAMPLE

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EXAMPLE

EXERCISE

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EXERCISE

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EXERCISE

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EXERCISE

KEY KNOWLEDGE

Cost-Volume-Profit Analysis (CVP)

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KEY KNOWLEDGE

Limiting factors

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KEY KNOWLEDGE

Multi-limiting factors and the use of linear

programming and shadow pricing.

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