ACCT2522 Final Notes

INPUTS OUTPUTSTRANSFORMATIONAL PROCESS

(inter-related activities)

Understanding Processes and Value Creation

Management FinancialUsers Internal (middle to top level management) ExternalUses - Planning (strategy – LT v ST)

- Controlling (monitor things going to plan)- Facilitating decision making- Evaluation (qualitative & quantitative)

- Investment- Tax- Borrowing - Regulation

Reporting Standards

No mandatory rules- Only, benefits > costs to provide data

GAAP, IFRS, IAS, AASB

Emphasis Relevance, Timeliness, Flexibility Objectivity, Reliability, Precision Information Financial & Non-financial (subjective possible) Financial only Content/detail Broad & multidisciplinary but decision specific More self-contained and aggregatedOrientation Future Past

Management Accounting: the processes and techniques that focus on the effective and efficient use of organizational resources, to support managers in their tasks of enhancing both customer value and shareholder value.

- Resources: financial (debt/equity) and non-financial (factors of production) means of an organisation - Customer value: difference between what a customer receives (customer realisation) and what the customer

gives up (customer sacrifice) Customer realisation: tangible and intangible benefits received from products services

- Shareholder value: the value that shareholders place on a business E.g. dividends, share price, profits

Process AnalysisProcess analysis seeks to realign task performance and resource use to realise desired strategic goals and enhanced customer value i.e. the link between strategic goals and resourcing to achieve those goals

Objective of Process Analysis- Understanding (Business process map)

Understand the interrelationships, as well as the linkages with resources and strategy- Monitoring (Statistical process map)

Establishing key process attributes; and having these variables measured and compared, and taking correction action if required

- Prioritising(Pareto diagram) Identifies critical business processes and to differentiate between value adding and non-value adding; in

order to rank improvement of these first. - Problem Solving

Recognises where and why a problem occurs and by suggesting approaches to correct these problems

Identify the ProcessProcess: group of interdependent activities which, when performed, utilise the resources of a business to produce a definite product i.e. ordered activities to convert inputs into outputs

The activities are related because a specific event initiates the first activity in the process, which in turns triggers subsequent activities. An output or information flow occurs where two activities interact.

Value Chain: sequence of activities that creates a good or service in which each step of the sequence should provide attributes of the product that the customer values:

- Primary activities: those that involve the physical creation of the product, its sale and transfer to the customer and after-sale service i.e. inbound logistics, operations, outbound logistics, marketing & sales, after-sale services

- Support activities: activities that support primary activities and each other i.e. HR, technology, procurement, firms infrastructure

Note: the configuration of activities within the value chain and the co-ordination/optimization of linkages between activities differ between organisations, resulting in competitive advantages or disadvantages

Chart the ProcessProcess mapping involves decomposing the process to be analysed into its component activities and arranging them in a logical or sensible sequence

Can be multiple ends

Flow

Requires a verb at the start Answer is either Y/N

Note: Don’t include any unimportant activities as this will lead to an overload! Also, make sure to look at activities performed by the firm only

Evaluate the Process

Value Adding v Non-Value Adding ActivitiesValue adding activity: is a necessary activity, either because it:

- Increases customer satisfaction Willingness to pay for that activity If activity is removed, is service potential reduced? Does the activity bring the process closer to completion?

- Critical to remain in business

Non-value adding activity: don’t add value to the customer (i.e. customer would not be willing to pay for it) or can be eliminated without detriment to the business.

Note: activity improvements are not restricted to non-value adding activities i.e. value adding activities can be improved via activity sharing, reduction, selection or elimination

Effectiveness v EfficiencyEfficiency: ability of activities or processes to use the fewest possible resources to meet customer needs

- Measured by resource usage i.e. amount of resources being consumed relative to the quantity of outputs produced by a process

- Determined by the process and activity design and how they operate

Effectiveness: ability of a process or activity to meet customer needs

Start/End Activity Decisio

PRIMARY PROBLEM

MACHINERY METHOD

MATERIALS LABOUR

- Determined by activity design and measured by the degree of goal attainment

Note: there is a traditional trade-off between the efficiency and effectiveness

Effectiveness Measures- Customer satisfaction/complaints- % of sub-components accepted by subsequent processes- % of on-time deliveries- % of problems-free deliveries- Number of returned goods/sold goods

Efficiency Measures- Material yield and productivity- Manufacturing cycle time- Machine set-up time- Number of invoices processed per hour- Chargeable hours per employees

Note: Measures are not an action, need to be specific – generic is not good enough and proportions are better

Value ParametersCustomer/Process value parameters:

- Time → 2 dimensions: duration (how long does it take?) and timeliness (when do you get it?)- Cost: amount of resources consumed in a process

Improvement isachieved ifthe same process is carried out with lower levels of resource consumption Eliminate non-value added costs and reduce value-added costs

- Quality → should not be compromised when improving time and cost i.e. defect rate and variability

Process Attributes that support or constrain its ability to meet customer value parameters:

- Responsiveness: processes need to flexibly and efficiently cope with changing patterns of demand- Productivity: increased efficiency and consistency (reduced variability) enhances productivity - Linkages: interdependencies between activities i.e. change in one functional area may be adverse for others - Empowerment: employee empowerment is the key to innovativeness, which is critical to the long-term success

Useful ToolsUseful analytical tools that can be applied to process analysis as well as a range of managerial situations

1. Root Cause/Driver AnalysisRoot cause: most fundamental reason why something happens

Root cause analysis: the identification of the reasons for activity costs (choose one!)

- The most important question to ask is why? Why is the activity carried out this way or performed at all? Why do we spend so much time and resources moving raw materials around

2. Fishbone Diagrams Fishbone diagrams: are cause-and-effect diagrams, used to assist root cause analysis

1. The horizontal line (‘spine’) represents the primary problem to be solved.

2. The main potential causes are then added as the major ‘ribs’ of the fish

3. Smaller ‘bones’ are attached to each of the ribs to identify the possible causes of the ribs/main causes.

- In process analysis, a fishbone diagram allows us to identify the reasons for poor performance of processes, and opportunities to improve the efficiency and effectiveness of processes.

3. Statistical Process ControlStatistical Process Control (SPC): a technique that relies on the use of statistical analysis and control charts to understand, monitor and reduce variability in a process.

- Used to pinpoint uncommon variances (a result of assignable causes) that need to be addressed Those above or below the upper and control limits

4. Pareto Diagrams Pareto Diagram: a graphical bar chart representation used to plot the cause of problems in a process according to the frequency of their occurrences.

- Allows managers to prioritise improvements by focusing on the problem that occurs most frequently- Based on the idea that a small number of causes are responsible for a large percentage of quality problems; and

that the majority of problems in process management can be traced to only a few parts of the process

Process Improvement - Continuous Improvement or Business Re-engineering

Business Process Re-engineering (BPR) Continuous Improvement (CI)Scale of Change Radical IncrementalPersonnel Involvement Cross-functional teams EveryoneTiming One-off Ongoing

Note: BPR and CI are not mutually exclusive. Look at the change relative to the process to determine whether it is continuous improvement or business re-engineering

Four ways to reduce activity costs, accomplished by changes in product or process design:

- Activity Elimination: aims to save organisation resources by eliminating activities, which reduces resource usage- Activity selection: choosing an activity with the lowest cost that matches the chosen strategy, all other things

being equal i.e. if you have choices, choose the cheapest- Activity reduction: reduction of the resources consumed by an activity i.e. increase efficiency- Activity sharing: choosing or designing an activity that permits sharing between different products (economies

of scale)

The horizontal view allows you to determine which activities are value & non-value adding:

Cost Dimension

Resources

Process Dimension

Driver Analysis

Why?

Activities

What?

Performance Analysis

How Well?

Product

Cost BasicsCost: cash or cash equivalent value sacrificed for goods and services that is expected to bring a current or future benefit to the organisation i.e. dollar measure of the resources used to achieve a given benefit.

- Costs should be managed strategically and reduced (efficiency) whilst providing the same or greater customer value

- Expenses/Expired Costs: actual costs incurred for a current benefit i.e. to generate revenue Costs incurred for a future benefit e.g. WIP, unsold inventory

- Opportunity cost: benefit given up or sacrificed when one alternative is chosen over another

Cost Object: any item for which costs are measured and assigned

- Activity: basic unit of work performed within an organisation and can also be described as an aggregation of actions within an organisation useful to managers for purposes of planning, controlling and decision making

Note: an activity is described by an action verb joined with an object that receives the action

Cost ClassificationProduct Costs: cost assignment that supports a well-specified managerial objective

- Different cost classifications occur due to different information requirements- Managers should only be responsible and evaluated on the costs they can control or significantly influence

Value ChainInternal value chain: set of all activities required to design, develop produce, market, distribute and service a product. It provides a more complete picture by showing the costs assigned to both upstream (supplier) and downstream (customer) activities, then assigning the cost of these activities to products

TraceabilityAbility to assign a cost to a cost object in an economically feasible way by means of a cause-and-effect relationship

Note: If this is done easily and accurately, then it is a direct cost; otherwise it is an indirect cost. The more costs that can be traced to the object, the greater the accuracy of the cost assignments.

FunctionProduction Costs: associated with the manufacture of goods or the provision of services

- Direct Materials: materials directly traceable to the goods and services being produced because physical observation can be used to measure the quantity consumed by each product

- Direct Labour: labour that is directly traceable to goods and services being produced because physical observation can be used to measure the quantity of labour used to produce a product or service

- Manufacturing Overhead: costs that cannot be directly traced to the cost object or it is not economically feasible to or it is more appropriate to treat this cost as a cost of all output

Overtime premium is treated as OH unless, it is incurred when a special order is taken at 100% capacity, where then it is treated as a direct labour cost

Non-production Costs: associated with the functions of design, development, marketing, distribution, customer service and general administration

- Selling: costs necessary to market, distribute and service a product or service - Administrative: research and development and general administrative costs

Note: prime costs are the sum of direct materials and direct labour costs and conversion costs are the sum of direct labour and overhead costs

Cost Behaviour MethodsCost Behaviour: relationship between the change in costs incurred and the change in volume of output/activity

- Variable Costs: varies in direct proportion to output changes Cost per unit is constant

- Fixed Costs: Within the relevant range, costs in total remain constant despite changes in the activity output (over the short-term)

Relevant range: range of output over which the assumed cost/output relationship is valid Unit fixed costs decrease as output increases In the long run, all fixed costs become variable

- Step Costs: Costs fixed over a certain range i.e. volume of outputs and then jumps to another level, where it remains for a similar range of output.

Items that display this kind of behaviour must be purchased in chunks - Mixed Costs: cost that has both a fixed and variable component - Curvilinear Costs: there is no linear relationship between cost and activity output

Can be estimated with a straight line IF a relevant range is specified

Other considerations to be taken into account:

- Time horizon – short or long term?- Resources available = resources used + unused capacity

Flexible: supplied as used and needed through acquisition from outside sources with no long-term commitment for any given amount of the resource (i.e. QD = QS) e.g. raw materials

Variable Activity rate = total cost of flexible resources / capacity used Committed: supplied in advance of usage and are acquired through a contract to obtain a given quantity

of resource regardless of whether the amount is fully used or not Committed Fixed Expense: independent of actual resource usage and provide long-term activity

capacity Discretionary Fixed Expense: independent of the quantity used in the short run

Note: Fixed ActivityRate=totalcommittedcost

totalcapacityavailable Note: resource spending changes lag behind changes in permanent activity/output demands

- Sufficient Capacity: ability to do something Maximum Engineering Capacity: maximum volume of quantities able to be produced under ideal

conditions Practical Capacity: maximum capacity that can be produced while also operating efficiently Idle/Un-used Practical Capacity: extent to which production could be increased without incurring

additional fixed costs i.e. buffer

Understanding cost behaviour increases the accuracy of costing. This is important as it enhances cost prediction enabling more effective and efficient planning, control and decision-making.

Cost DriversCost Drivers: observable causal factors and activities that drives and measures a cost object’s resource consumption (i.e. incurred costs). Generally, there is either a cause-and-effect relationship or very strong correlation

Able to measurethe costs incurred by each activity from each product

- the accuracy of driver tracing depends on the quality of the causal relationship described by the driver - Production (Unit-Level) drivers explain changes in cost as units produced change - Non-unit level drivers explain changes in cost as factors others than units change i.e. costs are incurred no

matter how many units are produced

Activity HierarchyBased on concept that activities cause resources to be consumed. Each level has activities costs, which respond to different types of cost drivers (so, see if it is a unit level cost first, and work your way up):

- Unit Level Costs: costs incurred by performing an activity each time a unit of product is produced Costs vary with the number of units produced

- Batch Level Costs: costs incurred by performing an activity each time a batch or group of units is produced Costs vary with the number of batches but are fixed with respect to the number of units in each e.g. production scheduling, materials handling, set-ups

- Product Level Costs: costs incurred by performing an activity needed to supportspecific products or product families produced i.e. consumes inputs that develop products or allow products to be produced and sold

Rises as the number of different products increase e.g. engineering changes, development of product-testing procedures, marketing a product, process

engineering and expediting- Facility Level Costs: costs incurred by performing activities that sustain a firm’s general manufacturing process

i.e. benefit the organisation at some level but do not provide a direct benefit for any specific product Costs are fixed and are not driven by any of the cost drivers in any of the first three levels Technically, not included as it is difficult to trace costs to product

Not included in activity based-costing e.g. factory management, landscaping, community support programs, security, property taxes and

building depreciation

Note: if production facilities are organised around product lines, then it can be argued that space drivers measure the consumption of facility level costs

Cost EstimationThe process of determining the cost behaviour of a particular cost item; there are 3 approaches:

- Managerial Judgment: using judgment based on knowledge and experience to classify costs Advantages: simple and cost effective i.e. no additional data or formal analysis required, able to foresee

the future and possible ‘absurdity’ behind statistical results Disadvantages: relies on manager’s abilities, so you need a good one

- Engineering Approach: studies the processes that result in the incurrence of a cost; including time and motion studies.

Advantages: past data does not exist or is irrelevant, cost effective when you can trace the costs to the object

Disadvantages: costly, accuracy is dependent on worker’s behaviour- Quantitative Analysis

Note: Qualitative methods may be chosen over quantitative because there is a lack of knowledge on how to use quantitative methods, there are problems with the data, time shortages prevent the collection and collation of data and a low priority is given to high accuracy i.e. subjective cost estimates are good enough.

Cost FormulaAssumes there is a linear relationship between the cost of an activity and its associated driver.

Total Cost = fixed cost + variable rate outputNote: the independent variable measures output and explains changes in cost i.e. it is the activity driver. The choice of an independent variable is related to its economic plausibility.

High-Low MethodUse the highest and lowest level of output/activity and their corresponding cost levels to calculate the cost function.

- Advantages: objective, easy computation, requires little data (two data points only!)- Disadvantages: Not necessarily an accurate model as outliers are used in the computation (distortion) and it will

differ depending on the specified relevant range

Scatter-Plot MethodPlot the data on a graph and draw a line of best fit

- Advantages: enables a visual assessment as to whether a linear assumption is reasonable, highlights the outliers, incorporates all the data points and is thus more representative

- Disadvantages: subjective determination of line of best fit, only reflects a relationship between the one driver i.e. cost and activity usage

Regression Analysis Uses the least squares method to come up with an objective best-fitting line.

- Advantages: objective, accurate/complete, enables the consideration of more than one cost driver, allows for statistical evaluation

- Disadvantages: may be costly, there is more than one relevant range

Assumptions:

- Cost behaviour depends on a single activity- Cost behaviours are linear within a relevant range

Evaluating a Regression Model

1. Is it economically plausible to impose such a relationship? i.e. does it make sense?2. Look at adjusted R Square- Coefficient of Determination (R2): percentage of variability in the dependent variable that is explained by an

independent variable i.e. % is a goodness-of-fit measure - Adjusted R Square is used to compensate for a small sample size and in multiple regression, since another

degree of freedom is taken away, the increase in R2 does not necessarily mean a better fit3. Look at p-values (<0.05 is significant, independent variables do account for some variance in the dependent

variable)a. F-statistic = relationship between costs and all cost drivers – Has it occurred by chance?b. T-statistic = relationship between costs and that particular cost driver

Cost AssignmentHow do we measure and associate the costs involved with the units produced? (involves a relative concept of reasonableness and logic in choosing a method)

- Key to creating a reasonably accurate cost assignment is establishing a cause-and-effect relationship between the cost to be assigned and the cost object

Direct Tracing: identifying and assigning costs that are exclusively and physically associated with the cost object

Driver Tracing: using observable causal factors to measure a cost object’s resource consumption

Allocation: allocate indirect costs based on convenience and assumed linkage

- Reduces overall accuracy but is simple and cheap!

Managing Costs I: Overhead Costs

Cost MeasurementCost measurement: the dollar value amounts of direct materials, direct labour and overheads used in production.

Total Cost: prime costs (direct materials + direct labour) + overhead costs

Unit Cost: totalcostsassociatedwit h t heunitsproduced

numberofunitsproduced- Accuracy is essential in order to make decisions about product & service design, whether to keep, introduce or

scrap a product/service, submit meaningful competitive bids (i.e. specify the price, knowing the cost to get a preferable margin)

Actual Costing: assigns the actual cost of direct materials, direct labour and overheads to products

- Rarely used, as it cannot provide accurate unit cost information on a timely basis

Normal Costing: assigns the actual cost of direct materials and direct labour but a predetermined/budged cost for overhead.

OH Costs = manufacturing OH + non-production costs + responsibility centres costs (i.e. support departments)

Overhead AssignmentUnit-Level Activity Drivers: factors that cause changes in cost as the units produced change i.e. assumes overhead consumed are highly correlated with the number of units produced

- E.g. units produced, direct labour hours, direct labour dollars, machine hours, direct material dollars

Activity Capacity Measures for measuring cost drivers:

- Expected Activity Capacity: output firm expects to attain for the coming year- Normal Activity Capacity: average activity output that the firm experiences in the long term- Theoretical/Engineered Activity Capacity: absolute maximum output if everything works perfectly- Practical Activity Capacity: maximum output if everything operates efficiently

Cost Pool: aggregate of costs to be allocated to cost objects that have only one allocation base

Cost of Resources DM and DL Manufacturing Overhead

Direct Tracing

Driver Tracing

Allocation

Physical Observation

Causal Relationship

Assumed Relationship

Cost Object: Product

- Cost Allocation base: some factor or variable that is used to allocate costs in a cost pool to cost object. Ideally but rarely, it is also a cost driver. Generally, it has a high correlation or causal relationship.

Volume based – input (how much do you put in?) v. output (how much do you get out?) Is it common to all products? How easy is it to measure the cost driver?

Factorywide MethodA single overhead rate is calculated for the entire production plant i.e. there is one cost pool, the production plant

1. Identify the OH cost driver2. Calculate the OH rate

i.e. predetermined MOH = budgeted (manufacturing) OH / expected activity3. Apply the manufacturing OH cost to the product based on the predetermined OH rate

i.e. applied OH = predetermined OH actual activity

Note: OH variance = actual – applied OH i.e. overapplied if actual < applied

Department MethodFactorywide overhead cost are divided up and assigned to individual production departments, creating departmental overhead cost pools, because:

- Some producing departments are more overhead-intensive than others and therefore should be assigned more overhead costs

- Departments are affected by different unit-based cost drivers

Steps:

1. Departmentalise the firm2. Classify each department as a support or a producing department3. Assign all OH costs in the firm to a support or producing department4. Allocate support-department costs to the producing department costs to the producing departments5. Calculate predetermined OH rates for the producing departments- Adding the allocated support costs to the overhead costs that are directly traceable to the producing

department / total activity 6. Allocate OH costs to the units of individual products through the predetermined overhead rates

a. i.e. OH is assigned by budgetedover headcosts

estimatedactivity×actualactivity

Note: budgeted variable costs are calculated using the charging rate and the actual activity, whereas budgeted fixed costs are calculated using the charging rate and the expected activity

Activity Based Costing 1. Measure the cost of resources consumed by activities

a. Identify resources, resource drivers and then, cost per resource driverb. Identify activities and resource drivers consumed by activity

2. Allocate activities to cost objectsa. Identify activity drivers and calculate cost per activity driverb. Identify activities consumed by product and allocate activity costs to product

Homogenous Cost PoolsGrouping activities into homogenous sets reduces the number of overhead rates, but homogenous cost pools must be based on both these similar characteristics:

1. Must be logically related e.g. same activity level 2. Must have the same consumption ratio i.e. the same proportion of each activity consumed by a product

Steps to put activities into homogenous cost pools:

1. Classify overhead into cost hierarchies – unit, batch, product or facility2. Create homogenous cost pools and identify activities that belong to each pool3. Identify the activity driver for each pool (it doesn’t matter which one is used) and calculate the pool rate

Allocating Support Department Costs to Producing Department (Department Method!)Common (mutually beneficial) Costs: same resource is used in the output of two or more services or products

Producing Departments: directly responsible for creating the products or services sold to customers

Support Departments: provide essential support services for producing departments e.g. maintenance, engineering, personnel and storage

Note: OH costs must be assigned to only one department

Objectives1. To obtain a mutually agreeable price – ensure that you’ll make a profit, whilst competitively pricing 2. To compute product-line profitability – how much profit is generated by each product line?3. To predict the economic effects of planning and control – appropriate product mix & resource reallocation 4. To value inventory5. To motivate managers – encourage efficiency

Principles of allocation:

- Causal relationship: activities within a producing department that provoke the incurrence of support service costs i.e. how much resources are consumed by each department; uses a single charging rate

- Benefits received – how much benefit does department receive? How do we quantify this? Uses a multiple charging rate

- Ability to bear: the more profits, the more costs assigned to you i.e. uses a multiple charging rate

Budgeted rather than actual costs should be allocated because:

1. Timeliness – needed to cost the units produced before the end of the accounting period to set price, etc.2. Performance evaluation – used as a benchmark

a. Using budgeted means no efficiencies or inefficiencies from support departments are transferred

Note: Actual usage should be used instead of budgetedto assist with performance evaluation and so that departments, which make more use of the support service, pay more.

Direct MethodAllocates support-development costs only to the producing departments i.e. ignores the fact that support departments provide services to each other.

- Variable service costs are allocated directly to producing departments in proportion to each department’s usage of the service

- Fixed costs are allocated directly to the producing department but in proportion to the producing department’s normal or practical capacity

Sequential MethodPartially accounts for the provision of services between support departments. Cost allocations are performed in a step-down fashion, following a predetermined ranking procedure

- Allocation in one direction, from greatest amount of services provided (highest budgeted cost) i.e. A B C

Steps:

1. Calculate the Allocation Ratios2. Allocate the Support-department costs using the allocation ratios calculated in the first step

Reciprocal MethodFully accounts for the provision of services between support departments i.e. budgeted amount + that used by other support services

Steps:

1. Specify a set of equations that express the relationship between the departmentsi.e. Total cost = direct costs + allocated costs , where allocated costs = % received from other support

2. Solve the simultaneous equations (note: pronumerals represent total costs)3. Allocate the total cost of operating each support department to various departments that use its services

Managing Costs II: Activity Based Costing Activity-Based Costing: a methodology that can be used to measure both the cost of cost objects and the performance of activities i.e. it addresses the issues relating to non-unit related overhead costs and product diversity

- Resources: inputs required to produce an output- Activity: a unit of work performed i.e. something that you do- Activity dictionary: list of activities performed in an organisation and their critical activity attributes

Conduct interviews with departments and draw a process map to find the list- Activity attributes: financial and non-financial information describing activities - Cost Driver: a factor or activity that causes cost to be incurred

Resource driver: factors that measure the consumption of resources by activities Activity driver: factors that measure the consumption of activities by cost objects

Methodology1. Assigning resources to activities (resource drivers)

a. Assign cost of resources to activity centresb. Identify and cost the activities performed in each activity centre

2. Assigning activities to cost objects (activity drivers) a. Prepare a dictionary of activities for each cost objectb. Calculate the activity cost per unit of activity driver

Symptoms of outdated cost accounting system1. The outcome of bids is difficult to explain2. Competitors’ prices appear unrealistically low3. Products that are difficult to produce show high profits4. Operational managers want to drop products that appear profitable5. Profit margins are difficult to explain6. The company has a highly profitable niche all to itself7. Customers do not complain about price increases8. The accounting department spends a lot of time supplying cost data for special projects9. Some departments are using their own cost accounting system10. Product costs change because of changes in financial reporting regulations

Functional-Based Costing v. Activity-Based Costing

Functional-Based Costing (FBC) Activity-Based Costing (ABC)Cost drivers Assumes OH costs are consumed the same

way - based on the number of units produced- Volume unit-level drivers

Recognises that activities have different consumption ratios- Unit & non-unit level drivers used

Cost Assignment Allocation intensive (assign to departments) Tracing intensive (assign costs to activities)Product Costing Narrow & Rigid Broad & FlexibleActivity Information Sparse DetailedFocus Managing costs Managing activitiesAims Maximization of individual unit performance Maximisation of system-wide performanceMost Beneficial 1. OH costs are a small proportion of total

costs2. OH costs are driven by unit-level drivers

1. OH costs are a significant portion of total costs and a large part is not directly related to unit-level activities

2. Products consume support resources at diverse rates; not by volume-based drivers

Limitations 1. Existence of non-unit level drivers related to OH costs

- Activities aren’t performed each time a unit of product is produced

- Increases in upstream & downstream activities are not driven by volume

- Arbitrary allocation of a lot of facility level costs may distort product costs

2. Product Diversity – products consume overhead activities at different rates

1. Complexity- Detailed data collection

Map out process- Constant updating

Must re-map after CI- Very expensive

Cost v benefit analysis2. Facility level costs not included- Not allocated as there is no relationship with

the product, but how do we recover cost?

Standard Costs and Variance AnalysisPlanning and control ensure that plan and objectives are achieved. Control systems provide regular information to assist in control, which is an essential part of effective resource management.

Necessary Requirements for Control:

1. A predetermined or standard performance level2. A measure of actual performance3. A comparison between standard performance and actual performance4. Investigate causes of significant variances

StandardsStandard Cost: a budgeted cost of one unit of product i.e.StandardCost=quantitystandard× pricestandard

- Product costing: costs are assigned to products using standards for all 3 manufacturing costs – DM, DL, OH provides readily available unit cost information that can be used for pricing decisions

- Performance evaluation: comparing actual cost with budgeted costs by calculating variances provides specific signals regarding the need for corrective action and where that action should be focused.

Helps to distinguish between controllable and non-controllable costs

To determine the unit standard cost, 2 decisions must be made:

1. Quantity decision: the amount of input that should be used per unit of output2. Pricing decision: the amount that should be paid for the quantity of input to be used

Source / Responsibility What / Why? CautionQuantity Standard

Historical Evidence Provide a good basis for predicting future costs May include past operating inefficiencies

Engineering Studies Determines the most efficient way to operate May be too rigorousParticipative Standard Setting

Significant input from operating personnel as they are responsible for achieving the standards

Budgetary slack i.e. may under-report

Price Standard

Operations Determines the quality of the inputs requiredPurchasing Acquiring the input quality requested at the lowest

price (market conditions but can be negotiated)PersonnelAccounting Recording the price standards and preparing reports

that compare actual performance of the standard

Types of StandardsIdeal Standards Currently Attainable Standards

What is it? Demands maximum efficiency and can be achieved only if everything operates perfectly; reflects minimum attainable costs

Attainable performance under efficient operating conditions, with allowances made for normal breakdowns, downtime and wastage

Positive Impacts Encourages further training, capital investment and innovation i.e. process improvement

Motivated because goals are demanding but achievable

Negative Impacts Encourages dysfunctional behaviour Imperfection allowance encourages slack

Standard Cost Sheet: provides the details underlying the standard unit cost – description, standard price, usage, cost

- Direct Materials Standards Standard material quantity: total amount of direct material required to produce one unit of product Standard material price: total delivered cost of the material less quantity discounts

Quantity discounts are based on ordering a certain quality of material in specific order quantities from a specified supplier

- Direct Labour Standards Standard direct labour: number of labour hours normally needed to manufacture one unit of products Standard labour rate: total hourly cost of wages, including on-costs

On-costs: extra salary-related costs that all Australian companies have to pay

Note: a process map helps in determining what resources are used where and beware of defect rates (imperfections), which potentially affect both the standard cost of direct materials and direct labour.

Variance AnalysisVariance Analysis: comparing actual with standard is about management control

- Unfavourable variances: whenever actual prices or usage of inputs are greater than standard prices or usage- Favourable variances: actual prices/actual quantity < standard prices/standard quantity

Total Variance = price variance + usage variance Total Variance = AQ(AP - SP) + SP(AQ-SQ)Total Variance = AP × AQ – AQ × SP + SP × AQ – SP × SQTotal Variance = (AP × AQ) – (SP × SQ)

Direct Materials Price VarianceMeasures the effect on cost of purchasing at a price that is different from the standard.

MPV = (AP × AQ) – (SP × AQ)

MPV = AQ(AP – SP)

, where AQ = actual quantity of material used, where AP = actual price per unit, where SP = standard price per unit

The responsibility for controlling the materials price variance usually belongs to the purchasing (procurement) departments. Although, prices are generally beyond their control, they can reduce prices by their negotiating skills, quantity discounts, differing the quality purchased. However, pressure to generate favourable variances could result in lower quality materials being purchased or too much inventory to take advantage of quantity discounts.

Note: calculating the price variance at the point of purchase is preferable as corrective action can be taken then.

Direct Materials Quantity VarianceMeasures the effect on cost of the direct materials actually used compared with the direct materials that should have been used for the actual output.

MUV = (SP × AQ) – (SP × SQ)

MUV = SP(AQ – SQ)

, where AQ = actual quantity of material used, where SQ = standard quantity used, given actual output, where SP = standard price per unit

The production manger is generally responsible for materials usage – minimising scrap, waste and rework to ensure that the standard is met. Pressure can be problematic as they might allow a defective unit to be transferred to finished goods, which will create customer relations problems.

Direct Labour Rate VarianceMeasure of the effect on cost of paying a different labour rate than what should have been paid

LRV = (AR × AH) – (SR × AH)

LRV = AH(AR – SR)

, where AH = actual DLH used, where SR = standard rate per hour, whereAR = actual rate per hour

Labour rates are largely determined by external forces – labour markets and union contracts. Variances are generally assigned to individuals who decide how the labour will be used, asunexpected overtime, using the average wage rate as the standard rate or using more skilled and highly paid labourers for less skilled tasks creates variances.

Direct Labour Efficiency VarianceMeasure of the effect on cost of using a different number of direct labour hours, compared with what should have been used for the actual output

LEV = (AH × SR) – (SH × SR)

LEV = SR(AH – SH)

, where AH = actual DLH used, where SH = standard hours allowed given actual output , where SR = standard rate per hour

Production managers are responsible for the productive use of direct labour. Pressure poses a risk of dysfunctional behaviour, where defective units could be deliberately transferred to finished goods to prevent using additional hours

Investigating Significant Variances and Taking Corrective Action Investigations should be undertaken if anticipated benefits exceed the expected costs

- Benefits: reduced costs if cause of variance is eliminated, causes of favourable variances may improve work practices

- Costs: time & resources spent investigating the problem, disruption to the production process as the investigation is conducted, corrective actions (revision of standards)

Possible causes of variance – performance, standard or uncontrollable factor

Control limits are arbitrarily set, where variances falling outside the acceptable range are reported if significant:

- Size of variance- Recurring variance – reveal inefficiencies/efficiencies that should be abandoned/used elsewhere- Trends- Controllability – non-controllable derivations should result in a revising of standards

Note: interactions make it difficult to assign responsibility for particular variances and thus you need to track down the root cause, so that responsibility may be assigned elsewhere

Costing and Tactical Decisions

Life-Cycle CostingProduct life cycle: time a product exists, from conception to abandonment

Life Cycle costs: all the costs associated with the product for its entire life cycle, including:

- Development (planning, design, testing) 90% of costs are committed at this stage!!!- Production (conversion activities)- Logistics Support (advertising, distribution, warranty)

Note: If a cost reduction objective exists, it is important to redesign processes, products and marketing i.e. simplify it, BEFORE manufacturing takes place so that whole-life costs can be reduced.

Whole-life cost: life cycle cost + postpurchase costs incurred e.g. operation, support, maintenance, disposal

- If post-purchase cost is a significant % of whole-life costs, then it becomes an important decision in the purchasing decision; and if reduced, can create a competitive advantage.

Product Cost is made up of:

1. Non-recurring costs (planning, designing and testing)2. Manufacturing costs3. Logistic costs4. Customer’s postpurchase cost

- Allows managers to be better assess the effectiveness of life cycle planning and build more effective and sophisticated marketing strategies

- Increases managers’ ability to make sound pricing decisions and improve assessment of product profitability

Life cycle cost management: focuses on managing value-chain activities to create a long-term competitive advantage

- Value-chain activities: set of activities required to design, develop, produce, market and service a product- Must balance a product’s whole life cost, method of delivery, innovativeness and various product attributes

including performance, features offered, reliability, conformance, durability, aesthetics and perceived quality - Activity based costing can be used to encourage good life cycle planning by careful selection of cost drivers

Target CostingTarget Costing: a system of profit planning and cost management that determines the life cycle cost at which a proposed product must be produced to generate the desired level of profit i.e. price = profit margin + cost

- Works backwards from a price acceptable to consumers to find the cost necessary to manufacture the product- Focuses on the customer and customer expectations, ensuring that it is value adding- Powerful when used with life cycle costs, as it provides the guidelines on where to reduce the costs- Externally driven, generated by analysis of markets and competitors

Target Cost = Target Selling Price – Target Profit Margin

- Target Selling Price – shaped by desired market share and market conditions- Target Profit Margin = required rate of return on sales

Cost Reduction Objective = Current Cost – Target Cost

Cost Reduction Methods used:

1. Reverse engineering: tears down competitors’ products with the objective of discovering more design features that create cost reductions

2. Value Analysis: assess the value placed on various functions by customers, if the price they’re willing to pay is less than the cost, the function should be eliminated i.e. value engineering and cost-gap analysis

3. Process Improvement: redesign processes to improve their efficiency

Note: you NEVER reduce costs at the cost of the functionality of the product

Activity Analysis: process of identifying, describing and evaluating the activities that an organisation performs to suggest what activities are undertaken, how many people perform the activities, the time and resources required to perform the activities and an

Tactical Decisions Tactical Decision Making: choosing among alternatives with an immediate or limited end in view – short term decisions that generally have a long term strategic impact e.g. cumulative tactical decisions

1. Define the problem2. Identify alternative feasible courses of action3. Identify relevant costs and benefits of each alternative4. Total the relevant costs5. Compare cost and benefits of each possible course of action (including qualitative figures)6. Select a course of action

Relevant InformationRelevant Costs: future costs that differ across alternatives i.e. variable costs, not allocations of costs already incurred

- Costs that relate to future actions (sunk costs and allocations e.g. depreciation are irrelevant) Change in demand across activities changes resource supply changing activity costs

Demand for resource exceeds current supply Demand drops permanently and excess supply can be cut from activity capacity

- Costs (rev) that differ across alternative actions (incremental costs/rev, non-avoidable, opportunity costs)- Qualitative Factors

Note: Avoidable costs are those not incurred if a particular decision is made. However, long term committed resource costs are often fixed; and treating them as such requires assuming that you can drop them without any penalty.

Accept/reject a special orderQ. Supply a customer with a single one-off order for goods or services at a special price?

A. Accept special order if, incremental revenue > incremental costs

Excess Capacity No or Limited Excess Capacity$

Incremental Revenue- Price × special order quantity xxx

Incremental Costs- DL/DM/VOH (xx)- Commissions/one-off costs (xx)

Contribution from special order xxx

$Incremental Revenue

- Price × special order quantity xxxLost Revenue

- Opportunity cost of forgoing (xx)Incremental Costs

- DL/DM/VOH (xx)- Commissions/one-off costs (xx)

Contribution from special order xxxNote: ABC costing improves ability to recognise relevant information as it makes more costs variable

Qualitative Considerations1. Is this really one-off? Could be a strategic change2. Find alternative capacity if no excess e.g. cheaper to rent some excess capacity or forgo production?3. Existing customers reaction to this ‘special price’ especially if we can’t deliver their regular order4. Is this new customer likely to become a repeat customer?

Make or buy a product/serviceQ. Produce or purchase from an external supplier a particular good or service?

A. Whichever is cheaper!

Total Cost Approach Incremental Cost ApproachMake ($) Buy ($)

Cost of purchasing xxxxVariable Costs

- DM/DL/VOH xxxFixed Costs

- Unavoidable xxx- Avoidable xxx

Opportunity Cost- Use Spare Capacity xxx

xxxx xxxx

Make ($) Buy ($)Cost of purchasing xxxxAvoidable Costs

- DM/DL/VOH xxx- Avoidable FOH xxx (xxx)

Opportunity Cost- Use Spare Capacity xxx (xxx)

Additional costs from buying xxx

Note: Consider whether we increase our level of excess capacity if we outsource and can we reduce resources supplied?

Total Joint Costs

Split-off point

Qualitative Considerations1. Outsourcing decisions are difficult to reverse and can have strategic implications2. Quality of product & degree of customisation required 3. Responsiveness of supplier4. Ability of the supplier to respect confidential information 5. Capabilities of producing the product/service, require use of core resources?

Add or delete a product, service or departmentKey considerations are still incremental revenue and costs; if differential is positive take the action.

Keep Drop Drop and Replace DifferentialSales xxx xxx xxx xxxLess:

- Variable expenses- Direct avoidable fixed expenses

(xx)(xx)

(xx)(xx)

(xx)(xx)

(xx)(xx)

Total Relevant Benefit/(Loss) xxx xxx xxx xxx

Qualitative Considerations1. Customers may prefer ‘full service’ suppliers and leave 2. Deleting a department lowers morale3. Removing a product can lead to excess idle capacities in the short term 4. Costs do not immediately disappear as a product is removed

Joint product: sell or process furtherJoint Products: two or more products produced simultaneously from the one production process.

Q. Sell the joint product or process it further?A. If the Profit of processing further > profit of selling and not

Note: Costs prior to split-off (total joint costs) are not relevant

Steps:

1. Profit of Product B (πB)$

Revenue xxxLess:

- Packaging Costs- Delivery Costs

(xx)(xx)

Profit xxx

2. Profit of Product C (πC) i.e. processing further $

Incremental Revenues xxxLess: Incremental Costs

- Processing Costs- Packaging/Delivery Costs

(xx)(xx)

Incremental Profits from Processing Further xxx

3. Calculate Difference in Profits i.e. πB - πC

Qualitative Considerations1. Do we have the capabilities to process further?2. Is this a long term or one-off decision?3. Do we have problems with existing customers who want to purchase product B?4. Potential competition?

Transfer Pricing

Responsibility Accounting Responsibility Accounting: assigns responsibility and accountability to managers to run sub-units of an organisation

- Reinforces the advantages of decentralisation

Responsibility Centre: sub-unit manager is held accountable for the sub-unit’s activities and performance

Cost Centre – responsible for costs only Revenue Centre – responsible for sales and direct costs only Profit Centre – responsible for both revenues and costs Investment Centre - responsible for revenues, costs and investments

Objective is to influence behaviour so individual and organisational initiatives are aligned to achieve a common goal, by:

1. Assigning Responsibility2. Establishing Performance Measures or Benchmarks3. Evaluating Performance4. Assigning Rewards

i.e. delegation of responsibility for performance, and then accounting for performance

Functional-based accounting Activity-based accountingSuited Operating Environment

Stable:- Maintain status quo- Low competitive pressures- Standardised products & processes

Dynamic:- Competitive- Increasing organisational complexity- Change and continuous improvement

Responsibility Assigned to?

Individual in charge Cross-functional Teams- Emphasises value chain activities

Responsibility defined in?

Financial outcomes i.e. operating efficiency e.g. costs

Financial outcomes – continuously enhancing revenues, reducing costs and improving asset utilisation

Establishing Performance Measures or Benchmarks

- Determined by budgeting and standard costing i.e. unit costing

- Objective financial measures- Support the status quo and are currently

attainable- relatively stable i.e. static

- Process orientated financial & non-financial measures e.g. quality, time, efficiency

- Optimal standards provide ideal targets and identify potential for improvement

- Dynamic – reflect new goals & conditions- Standard reflects value-added by processes

Measuring Performance

- Compare actual v standard outcomes- Accountable for controllable costs only- Focus on financial efficiency

- Focus on quality improvement, cost & time reduction indicative of improved process

- Progress to achieving optimal standardsIndividuals rewarded based on

Financial performance i.e. manage costs to achieve or beat budgetary standards

multidimensional performance i.e. accountable for individual and team performance

Nature of Rewards Profit Sharing: global incentive to contribute to overall financial wellbeing of the firm

Gainsharing: share in gains related to specific improvement projects

Decentralisation Decentralisation: restructuring of the organisation into smaller sub-units, such as divisions and departments, each with specific operations and decision making responsibilities i.e. delegating decision-making authority to lower levels

- Obtaining goal congruence (consistency between managers’ personal goals and organisational goals) helps to ensure the effectiveness of decentralised organisations

Benefits1. Ease of gathering and using local information – more effective management of sub-unit markets and operations- Removes information overload, misinterpretation, transmission times better decision making 2. Focusing on central management – allows more time for considering strategic issues 3. Training and motivating segment managers – greater motivation, job satisfaction & managerial training 4. Enhanced competition, exposing segments to market forces – more responsive to opportunities and problems

Costs1. Managers focus on their own sub-unit performance rather than attaining the organisation’s overall goals2. Some tasks and services may be duplicated unnecessarily 3. Goal Congruence may be difficult to achieve (ameliorated by correctly set reward systems)

Transfer PricingTransfer Price: internal selling price used when goods and services are transferred between profit centres and investment centres in a decentralised organisation.

- Becomes the revenue of the selling division and the cost of the buying division i.e. allows the selling division to record revenue and earn profit to reflect their effort in producing the product

Matches revenue when finished good is sold to external customers to expenses incurred to obtain intermediate goods

- Consequently, divisional profits should be reliable and accurate measure of divisional performance- Preserves and encourage divisional autonomy- If you set an appropriate transfer price, everyone will be motivated to do the right thing i.e. goal congruence - Used to transfer profits between business units in different countries for tax considerations – ethical?

Transfer Pricing Methods Corporate management may set a general policy for transfer pricing but divisions have the autonomy to set and accept transfer prices. Qualitative considerations should be taken into account and this transfer price only affects the units being sold/purchased.

Note: fixed costs are only considered when considering profitability!

Market-based PriceIf a perfectly competitive, external market exists, then:

Transfer Price = market price – avoidable sales expenses It reflects all the opportunity costs of both the buying and selling division; and thus no division can benefit at the expense of another i.e. division actions simultaneously optimise divisional and organizational profits.

Opportunity Cost ApproachProvides a bargaining range for the transfer price of a good, where the opportunity cost (minimum price) of the selling division is less than the opportunity cost (maximum price) of the buying division. Consequently, total divisional profits will not decrease by this internal transfer.

Minimum Transfer Pricing = additional outlay costs (variable costs) + opportunity costs

Maximum transfer price = external market price ALWAYS

Maximum External Market - Excess Capacity – no opportunity cost but - Limited Capacity – opportunity cost (external price – variable costs) needs to be calculated on units affected are

added to determine the average transfer price - No Excess – opportunity cost of lost profits on external sales need to be accounted for in the transfer price

No External Market- Excess Capacity – no opportunity cost associated with the transfer; transfer price may be based on cost-plus - No Excess – transfer will need to account for opportunity cost of lost sales due to the transfer - Alternative use of committed resources prolong negotiation and possible dysfunctional behaviour

Negotiated PricePractical alternative to market price, where opportunity costs of both sides set the boundaries. It involves internal negotiation amongst divisional managers.

Advantages

1. Means to achieving goal congruence throughout entire firm2. Reflects autonomy3. Training for divisional managers

Disadvantages

1. Information asymmetry – divisional manager with private information may take advantage2. Negotiation can consume considerable time and resources 3. Performance measures may be distorted by negotiating skills of managers – potential conflict of interest

Do the managers possess required negotiation skills?

Service Level Agreement: contract between 2 sub-units that establish the nature of the service that will be provided; its price, quality and time of delivery, problem-solving arrangements, ways it can changed or terminated.

Cost-plus priceAppropriate if there is no external market for the intermediate product i.e. no external market price; particularly if the formula is set during negotiation. Also, its simplicity and objectivity are suitable when transfers have a small impact on the profitability of either.

Transfer Price = Standard Variable Cost + Mark-Up- Allows supplying division to show a contribution margin on the transferred product- Standard costs should always be used instead of actual, to prevent cost inefficiencies being passed on- Avoid standard absorption cost i.e. full cost as it leads to overpricing and possible dysfunctional behaviour

Managing QualityQuality: total features and characteristics of a product or service that enable it to satisfy stated or implied needs i.e. extent to which customer expectations are met or exceeded.

- Quality of Design = Customer Expectations + Design Specifications- Quality of Conformance = Design Specifications + Final Products

Best operational definition, as product specification should implicitly incorporate many quality dimensions i.e. reliability, durability, fitness for use, performance

Quality Dimensions 1. Performance – consistent functionality of product

Dimensions for services are responsiveness (willingness/prompt), assurance (trust/confidence), empathy 2. Aesthetics – appearance 3. Serviceability – ease of maintaining and/or repairing the product4. Features (quality of design) – differentiating characteristics ‘features’ + performance 5. Reliability – probability that products or service will perform its intended function for a specified time6. Durability – length of time a product functions7. Quality of Conformance – measure of how well finished product matches product design specifications8. Fitness for Use - suitability of carrying out what it is supposed to do. 9. Perceived Quality

Quality ViewsDefective product: one that does not conform to specifications

View Traditional (AQL) Zero Defects Robust (World Class)Optimal Quality

Occurs where total cost of quality is minimised, some defects are allowed and encouraged

No defects No defects, no variation from target even in specification limits

Trade-Off Increasing Control Costs reduce Failure Costs (should balance out)

None, increase in control cost will reduce failure costs and ultimately total cost of quality

Variability As long as attribute value falls within specification limits, it is acceptable and not costly

QLF – any variation from target value is unacceptable as it causes hidden quality costs

Quality Inspect for quality and rework if necessary

Quality should be designed and built in

Quantity Quantity is as important as quality

Without quality, quantity is irrelevant

Note: Spending more on conformance costs although non-value adding in the short term will be less costly in the future. QLF further suggests that by building quality into business processes, in the long term, these costs will disappear.

Cost of QualityCost of Quality: financial measures suggesting costs exist because poor quality may or does exist. 2 sub-categories:

- Control Costs: incurred to ensure products/services conform to quality standard – prevent & detect Preventative Costs: prevent poor quality products being produced in the first place

E.g. recruiting skilled workers, quality engineering, quality training programs, quality audits Appraisal Costs: detects any non-conformance after an activity is performed e.g. inspection and testing

Process acceptance: sampling goods while in the process to assess the process Product acceptance: sampling from batches of finished goods

- Failure Costs: incurred because product/services have not conformed to standard Internal Failure Costs: cost of non-conforming products detected by appraisal and corrective costs

E.g. scrap, rework, downtime due to defects, re-inspection, retesting, design changes External Failure Costs: costs associated with poor quality products delivered to, reaching customers

E.g. product recalls, returns, warranties, repairs, loss market share, complaint adjustment

Note: In assessing where the cost falls ask, why am I performing this activity and why is the cost incurred?

Measuring Quality CostsObservable Quality Costs: those available from an organisation’s accounting records

Hidden Quality Costs: opportunity costs resulting from poor quality leading to loss of reputation. Arises from external failure and are significant. Estimated by:

1. Multiplier MethodAssumes total failure cost is a multiple of measured failure costs. The multiplier is determined by research and experience. i.e. Total external failure cost = k × measured external failure costs

2. Market Research MethodUse formal market research (customer surveys and interviews with company’s sales force) to assess the effect of poor quality on sales and market shares, where results are used to project future profit losses attributable to poor quality.

3. Taguchi Quality Loss Function The QLF assumes any variation from the target value of a quality characteristic causes hidden quality costs i.e. the customer expects a level of quality, if they don’t or can’t expect that level as it deviates, then their perception of the company is affected.

- Hidden costs increase quadratically as the actual value deviates from the target value

L = k(y-T)2 , where L = unit lossy = actual value of the characteristicT= target value of the characteristick = proportionality constant k = c/d2 , where c = loss associated with a unit produced at the specification limit d = distance from the target value to the specification limit

Note: if you’re willing to accept a larger distance, it means you don’t value quality that much.

Therefore, to calculate total hidden costs:

1. Use QLF to calculate the loss for each sample unit2. Average these losses out3. Multiply this average with the number of units

Quality Cost Reporting Important as the information is used to improve and facilitate managerial planning, control and decision making

- e.g. quality, program implementation- evaluating effectiveness of quality programs (monitoring)s- strategic pricing – quality cost information and total quality control programs contribute to a significant decision - new product analysis

COQ DMOQ- Associate quality with $- Rank Problems- Highlight trade off between conformity and non-

conformity costs- Allows aggregation - Focuses on consequences- Assists in understanding, monitoring, prioritising

- Identify root cause of problems- Understandable/acceptable- Timely- Disaggregated - Focus on processes- Facilitates direct solutions and feedback- Assists in understanding, monitoring and problem

solving

Quality Cost Report (COQ)Reveals magnitude of quality costs and their distribution among the four categories, revealing opportunities for improvement. Also, useful as a measure of performance and impact on bottom line.

<Company Name>Quality Cost Report for the year ending <Date>

Quality Costs ($) % of SalesPrevention Costs:Appraisal Costs:Internal Failure Costs:External Failure CostsTotal Quality Costs

Note: long and costly to compute this report

Non conformance to conformance ratio

= Failure Costs Ideally, close to 0Control Costs

Report directs attention and assists in evaluating performance. Steps to take:

1. Look at failure costs2. Identify where the problem comes from3. Identify root cause4. Take corrective action

Trend Analysis Used to assess the change in quality costs through time, by plotting the percentage of sales of each of the 4 categories.

Direct Measure of Quality (DMOQ)Direct Measure of Quality: non-financial measure of a correctable physical attribute that customers value

- helps you to pinpoint where the problem is, often depicted in a SPC or Pareto charts- Good measures are specific, you’re able to put a number on it (not $ amount) and time comparable

External: customer response time, % of on time delivery, etc. Internal: looks at process e.g. defect rates, cycle times, equipment downtime

Total Quality Management Emphasis on continuous improvement on processes undertaken to provide products and services as good quality costs less than poor quality.

- anticipating, meeting and exceeding customer needs and experiences is important match spending to customer requirements i.e. spend on design parameters that customers value

- holistic approach, where all members are committed to TQM employees need full support in efforts to improve quality requires cross-functional approach

- variability should be analysed as it adversely affects customer perceptions, multiplies and makes processes harder to manage

often monitored using statistical process control (SPC) charts

Role of Management Accountants 1. Encourage quality awareness – reduce costs by increasing customer demand or decreasing costs i.e. wastage

eliminating/reducing non-value adding activities improving efficiency and effectiveness optimal use of human capital

2. Evaluate quality performance3. Identify and prioritise quality problems4. Ascertain causes of poor quality

5. Monitor quality improvements

Managing Time: The Theory of ConstraintsTime-based management: compresses the time required to undertake processes to enhance customer value and reduce costs i.e. how do we manage constraining resources in order to generate revenue at an increased rate?

- Dictates the rate at which products are produced and revenue generated - Determines how time resources are tied up in processes:

delays lead to inventory build up new products/services i.e. first-in advantage

Time to market Break-even time

Time taken to fill customer orders

Order Receipt Time (NVA) Production Cycle (Lead) Time (VA) Delivery Time (NVA)Order Receipt Time (NVA) Waiting Time (NVA) Production Time (VA) Delivery Time (NVA)

Aggregated, would give you an indication of the customer’s experience.

The time taken is reduced by:

- Involving suppliers- Efficient design process- Using cross-functional teams and decentralisation – make use of specialisation

ConstraintsConstraint: any element that prevents the organisation from making more money. It can be either:

- external/internal- tangible/intangible

AVOID treating all constraints as capacity constraints because getting to the root cause will often identify behavioural, managerial and/or logistical factors, which when addressed will make the constraint disappear

Binding constraint/bottleneck: weakest link in the organisation’s value chain i.e. most harmful constraint

External Constraints (Capacity > Demand)- Market constraint: when production capacity exceeds customer demand

Find ways to retain existing customers whilst seeking additional markets i.e. simultaneously provide greater customer value at lower cost

value engineering: effective in differentiating the product in cost-effective ways Overproduction leads to obsolete inventory that clogs warehouses and makes it less responsive to

changing customer requirements. Implementing a reliable JIT system also decreases the customer’s need to hold inventories, thus reducing total costs and increasing the acceptable price for the product.

- Supply Constraint:insufficient raw materials i.e. NO access to labour, raw materials poor planning unreliable suppliers managing supplier relationships is important

Order Order Order Order Order

Measures to assess product development

Preferable to have internal and intangible constraints i.e. more easier to control and change

material shortage in the market place

Internal Constraints (Demand > Capacity)- Materials: production processes are starved of materials i.e. got the materials but something is wrong,

preventing them from flowing through e.g. poor scheduling, breakdown of preceding process synchronisation & inventory buffers important

- Capacity: total demand exceeds total capacity i.e. different machine/people capacities labour and machines capacities directly influence the ability to maintain the required production flow

- Logistical: resources alternate between insufficient capacity and excess capacity as waves of production hit them planning and control issues i.e. variability

e.g. batch order entry system causes demand to come in waves that adversely affect the synchronous operation of the system

- Managerial: strategies and policies which adversely affect synchronous operations i.e. lead to the suboptimisation of the system limit the firm’s capacity

e.g. decisions about batch sizes and order quantities may be based on policies and procedures that have failed to keep up with changes in the manufacturing environment

e.g. no overtime working, only one shift per day, no new product development- Behavioural: managerial policies and procedures affects the habits, practices & attitudes of employees as they

are entrenched in the evaluation and reward systems: e.g. large amounts of raw materials inventory i.e. buy in bulk cheaper e.g. keep-busy approach work being done that is not required or scheduled

Theory of Constraints (TOC)Theory of Constraints: focuses on the time element, concentrating on reducing the time taken to generate profits and the rate at which direct materials are turned into sales i.e. rate at which a system generates money.

- Identifies selling price, sales volume and material cost as the three key values determining profitability and focuses on product flow by treating overhead and labour costs as fixed in the short term

- Somewhat simplistic, linear view of the production chain - Global goal of an enterprise is to make more money now and in the future. i.e. any action that moves the

organisation toward making money is productive Organisations have sought to simultaneously reduce cost, improve quality, respond faster and be

innovative due to increased competition & more stringent customer requirements - Emphasises the generation of revenue rather than the minimisation of costs

increasing the rate the system generates money through sales through increasing customer value manage resources according to ability to achieve goal i.e. focus on constraints before cost reduction

(only so much you can cut)

Throughput Inventory Operating ExpensesDefinition rate at which the system

generates money through sales

all the money that the system has invested in purchasing things that it intends to sell i.e. money tied up in the system

All costs other than direct materials incurred to turn inventory into throughput

Measured by sales – unit-level variable costs i.e. sales – direct materials

Direct materials + PPE + R&Di.e. carrying value of plant, property and equipment + inventories valued at direct materials costs only

Labour costs + overheadsalaries, utilities, supplies, marketing expenses, insurance, tax, etc

Notes Very short term focus: if you produce something, but don’t

Excess inventories can get in the way and make it difficult to find what is needed

Net Profit = throughput – operating expenses

sell it, it’s not throughput i.e. no value until you sell it

Inventoryturnover= t hroug h putinventory

Increase throughput whilst reducing inventory and operating expenses i.e. T↑ I↓ OE↓

Note: only the sale of finished goods contributes to making money i.e. accumulating inventory incurs additional costs (cost of warehouse, insurance, risk of obsolescence, etc.) where the buildup of WIP inventory will choke the production flow and tie up excessive amounts of capital (raw materials have to be purchased and investment cannot be recouped until finished product is sold)

Returnon inventory= t h roug h put – operating expensesinventory

Return on inventory is maximised by improving throughput, reducing operating expenses or reducing inventory:

- Increasing yields, reducing downtime and/or reducing product changeover time on the binding constraint increases throughput but may also decrease operating expense

- Improving the processing time on the binding constraint increases T but may also decrease OE

Measures to promote maximum throughput at bottlenecks

- Continually measuring workforce productivity and direct material yields at the binding constraint- Monitoring pre-biding constraint buffer stocks of WIP- Providing constraint capacity measures for different product lines in order to prioritise work at constraints- Report on lead times, setup times, wait times- Measure schedule adherence- Being aware of, and providing a measurement system for all factors that affect performance - Monitoring of stock by location, idle time and wait time throughout the production processes can be valuable as

indicators of the existence of constraints

Managing Constraining ResourcesConstraint management: tool that seeks to ensure a flow of products through the plant that matches market demand in a timely manner i.e. least capacity will determine the rate of production – managing this capacity constraint is critical to the organisation’s ability to generate revenue.

- Remove the constraint by purchasing additional resources BUT this is a longer term decision for potentially a short term and perhaps avoidable reason

If demand for that resource declines because the root cause is addressed, it may be difficult to cut back- Constraint determines the throughput contribution of the whole organisation

Drum: bottleneck sets rhythm or rate of production for organization Rope: crucial to communicate what is happening with the constraint at all times

Critical to ensure upstream operations produce the appropriate amount Prevent inventory from continually building up in front of the binding constraint

Buffer: shield binding constraint from variability by maintaining inventory in front of it Ensure it is operating at all times as constraint cannot catch-up

Steps:1. Identify the system’s binding constraint2. Exploit the binding constraint3. Subordinate all other activities along the production line to the constraint

4. Elevate/Eliminate the binding constraint5. Repeat the process

Identify the binding constraintThe actual flow of materials through the production plant will differ from the planned flow because:

1. Unpredictable disruptions E.g. machine breakdowns – know machine will breakdown but no idea of when

2. Inaccurate/indeterminate information E.g. time standards – precise set up/ batch processing time varies but on average may match standard

3. Large number of variables Too many variables to be considered in the planning process

Therefore, the identification of a binding constraint is particularly difficult when there is process variability, operations are synchronized and inventory levels are minimal i.e. bottleneck appears to be constantly moving between resources.

- Important to distinguish between day-to-day firefighting where production can catch-up and those constraints that have a long term impact i.e. as the latter is where the binding constraint is

- The binding constraint can be identified by: Informal measures

Observation: resources with a large quantity of inventory waiting to be worked on Extracting knowledge from staff: asking questions or conducting interviews

Formal measures Gantt Charts Capacity usage: If production capacity is known and not variable, the binding constraint can be

identified by determining the capacity of each resource.

Note: if there are two constraining resources, the greater deficiency would be the binding. However, the effect of the other constraint must be considered to ensure the proposed optimal product mix is feasible.

Exploit the binding constraint (How do we make the most of it in the short term?)Do everything possible to ensure the production process (and particularly the binding constraint) is operating as efficiently and effectively as possible. i.e. Ensure that the binding constraint keeps working at maximum capacity.

1. Determine Optimal Product Mix – maximises revenue by prioritising greatest throughput per unit of bottleneck i. Calculate the throughput contribution for each product i.e. Price – DM

ii. Calculate throughput contribution with respect to constraint time i.e. throughput/bottleneck time needed

iii. Use this throughput per unit of the binding constraint to priorities the production of each product subject to market demand

Note: If a person has to perform 2 processes to complete a product, the time she performs both is in the ratio of the time taken for each process.

2. Provide Quality Inputs - if the binding constraint receives poor quality inputs, it will be slowed down even more (require rework) or result in wastage loss of sales i.e. throughput ↓

Prevented by supplier management or inspection of incoming materials3. Eliminate idle time -binding constraint does not have excess capacity to ‘catch-up’; and if idle due to variability,

interrupted flow of work in process from proceeding steps, throughput is lost forever

Inventory buffers:held in front of the binding constraint to ensure that the binding constraint can keep working, if production breaks before it.

the size of the buffer will be determined by the variability of the preceding processes and the rate at which the constraint consumes the work in process/raw material

Reduce set-up times4. Preventative maintenance – unscheduled down time will result in lost throughput

preventative maintenance should minimise the amount of down time

Subordinate all other activitiesNon-binding resources should produce at the rate dictated by the effective use of the binding constraint, even if it means working below capacity the alternative is to build up work-in-process inventories which can be disruptive

- TOC assumes that direct labour is a fixed cost, therefore idle time does not increase costs but reducing inventories will decrease costs (opportunity costs + cost of physically holding inventory):

RationaleProduct Quality TOC emphasizes the TQM principle of building quality into process,

rather than inspecting the finished productEngineering The product can incorporate the latest technology

Price Higher Margins Lower operating costs e.g. overtime and lower inventory-carrying costsLower investment per unit Avoid investment in additional unnecessary capacity to deal with

bottlenecks caused by poor schedulingResponsiveness Due-date performance Lower inventories and increase the rate of every part of its operation

help to increase the rate of throughput Shorter quoted lead time

Elevate the binding constraint if necessarySpend money to reduce or change the nature of the constraint i.e. take actions to alleviate or eliminate the constraint

- Outsourcing- Process/product redesign

Cross-training Hire more workers, more experienced workers

- Capital investment Invest in ergonomic equipment, purchase faster machines

Note: look how long it takes to break even when trying to justify i.e. benefits > costs

Repeat the processThe process of identifying and eliminating constraints is never-ending. As each constraint is identified and brought under control, another constraint will emerge.

- The binding constraint should be the focus point for continuous improvement endeavours- It is imperative to review the applicable rules and policies implemented to address the constraint or else the

system may end up wallowing in a sea of policy constraints, causing inertia

ImplicationsAn important message of the theory of constraints is that resources need to be managed according to their effect on throughput. There will always be a constraint that limits the throughput of the organization. That constraint must be identified and carefully managed to ensure that it operates at maximum capacity i.e. other non-binding resources will often be operating at less than maximum capacity (idle time).

- Resource management Short term – do not divert resources to non-binding constraints Long term – reducing WIP and finished good inventories will benefit the organisation

- Inventory/products Mix - optimise throughput relative to the binding constraint Quality – poor quality inputs represent an opportunity cost of the lost throughput

- Performance measures KPIs and reward systems need to be re-evaluated Mentality of employees: produce as much as you can need to be retrained Should be evaluated on the basis of deviations from planned performance

Concepts conventional cost accounting New principles of throughput accountingRole of Direct & Indirect Costs

Direct costs are variable and indirect costs are fixed

Distinguishing between indirect and direct costs is not useful

Inventory Inventory is an asset and working on material increases its value

Not an asset, it is the outcome of unsynchronised manufacturing and hinders the organisation in achieving the global goal

Profit - Summing component costs to derive a product cost and subtracting the result from the sales price is a good way to determine relative product profitability

- Reducing component costs directly increases profits

- It is the rate at which the factory earns money that determines ultimate profitability, not the contribution of each product

- Profit is a function of material cost, total factory cost and throughput

Limitations- Distortions if assumptions don’t hold:

If direct labour and VOH are not fixed in the short-term- Difficulty in identifying the constraint if processes are subject to variability- Constraints are not easily controlled or addressed if external or intangible- Suggests that orders should be accepted as long as short run marginal pricing exceeds cost of raw materials BUT

fixed costs need to be recovered!

Capital Expenditure DecisionsCapital Investment decisions are concerned with expenditure on non-current assets or long term resources that usually involve a significant outlay of funds and require long-term commitment.

- Undertaken for: Strategy: further organisation’s long term goals for success (enhancement of quality, expansion)

i. cement market position or gain market share Profitability: revenue generation, cost reduction Regulation: environmental/OH&S requirements Infrastructure – IT

Note: each reason may have a different return i.e. profit not in terms of dollars but intangible like community benefit

Organisations can only carry out value adding activities if they have the necessary resources to support them!

Two types of capital investment projects:

1. Independent projects: if accepted or rejected, do not affect cash flows of other projects2. Mutually exclusive projects: if accepted, preclude the acceptance of all other competing projects

Investment/Approval Process i.e. Capital Budgeting1. Project generation2. Estimation & analysis of projected cash flows3. Progress to approval4. Analysis and selection of projects5. Implementation of projects6. Post-audit of process

Incremental Cash Flows Consider incremental costs and benefits – when estimating, we must consider (inflation, working capital (CA – CL), opportunity costs, disposal of equipment, relevant inflows/outflows after tax)

Note: when given tax rate, always use after-tax cash flows

Incremental cash outflows Incremental cash inflows1. Initial cost2. Operating cost over project life

1. Cost savings (savings from a cash outflow)2. Additional revenues

Tax Implications on Cash FlowsIncrease in taxable income greater cash outflow Decrease in taxable income lesser cash outflow

1. Gain on sale2. Increased revenues3. If government gives you an investment allowance,

and you make a capital investment, the allowance will be taxed

1. Loss on sale2. Increased expenses 3. Depreciation may reduce tax paid (indirectly). Unless told

otherwise, assume: a. depreciation for tax purposes = depreciation for

accounting purposes b. straightline depreciation

Analysis and Selection of Projects - Investment Analysis TechniquesManagers make capital investment decisions by using formal models to decide whether to accept or reject proposed projects. Depending on whether they address the time value of money, these decision models are classified as:

Non-Discounting Payback Accounting Rate of Return

Definitions

Payback period: time required for a firm to recover its initial investment (shorter time preferred)

Measures the return on a project in terms of profit

Calculations

- For even cash flows,

EvenCas h Flow= initialoutflowAnnualafter−taxcas hinflow

- For uneven cash flows, cash flows are summed until investment is recovered

- If only a fraction of the year is needed, then it is assumed that cash flows occur evenly

Accountingrateofreturn=avergeannualafter−taxprofitoriginaloraverageinvestment

Acceptance criteria

payback period < required time for payback

Advantages

- Easy to understand simple- Provides a measure of the liquidity

and risk (obsolescence + uncertain CF) of a project

- Ensures certain accounting ratios are not adversely affected e.g. debt-restrictions

- Relatively simple and easy to understand - Considers profitability of the project after payback i.e.

returns throughout asset life- Consistent with performance evaluation- Screening with respect to accounting ratios- Used for debt covenants, contracts with the bank

Limitations

- Ignores time value of money- Ignores cash flows beyond payback

period i.e. ignores the profitability of the project

- Ignores cash flows- Ignores time value of money - Accrual accounting distorts

Discounting1. Required rate of return/discount rate/hurdle rate/cost of capital2. Adjusted for risk of particular project i.e. higher risk, higher rate3. Minimal acceptable rate of return

Assumes:

1. Year-end timing of cash flows – cash flows comes in at the end of the year2. Certainty of cash flows

Net Present Value Internal Rate of Returndifference between the present value of future cash flows and the initial investment outlay i.e. measures the true economic return of the project, the productivity of capital, and the change in wealth of shareholders

Finding the interest rate that equates the present value of a project’s cash inflows with the present value of its cash outflows. Measures the true rate of return of the project and productivity of capital invested

Calculation present value of all project cash flows – initial investment

NPV=∑ CFt

¿¿

assumes discount rate at which NPV of cash flow is zero

Acceptance Criteria

NPV > 0 - present value of the inflows is greater than the present value of the outflows, the project is viable i.e. it generates sufficient returns to justify the investment and risk involved.

IRR > required rate of return

Notes: Two present value tables to simplify calculations:1. PV of $1 – works out the discount factor2. PV of annuity – used if you have a constant cash

flow (think summing of a geometric series, where a is the constant cash flow)

Provide same decision outcome as NPV for independent project analysis

Advantages - Considers time value of money- Considers size of the investment- use firm discount rate (can adjust for risk)

- Considers time value of money- Managers are accustomed to working

with rates of return Limitations - Assumes all cash flows are reinvested at the required

rate of return - Stated as a percentage rather than a

dollar amount- Assumes cash flows are reinvested at the

IRR of the project- May not select the project that maximizes

firm value

, where I = initial investment,

Small firms use DCF less, because of:

1. Liquidity issues2. Unfamilarity with the techniques3. Small project sizes don’t worry extensive analysis

Limitations- Heavy reliance on estimation- Use of unrealistic status quo – assumes market conditions stay the same regardless of investment decision- Hurdle rates too high – want to be sure that it’ll be a profitable project i.e. remove the risk by increasing rates- Time horizons too short – distortion of what is best – people don’t stay at the firm forever, are motivated by

incentive rewards for their generation of returns, now!- Difficulty in gaining approval for large projects- Strategic and competitive concerns may be overlooked – doesn’t take into account what the other firms will do- High potential for exclusion of benefits that are difficult to quantify or put into financial terms:

Financial outcomes: lower direct labour costs, less scrap and rework, lower stock costs, increase in software

Non-financial outcomes (how do you quantify these?) Reduction in manufacturing cycle time, increase in manufacturing flexibility, increase in business

risk due to higher fixed cost structure, improved product delivery and service

Dealing with Limitations - Try to quantify the benefits- Consider market conditions and economic trends- Include strategic and competitive concerns- Match required rate of return to uncertainty- Conduct sensitivity analysis – determine how much estimates can change before an investment looks bad- Conduct multiple scenario analysis – the risk and uncertainty can be incorporated by identifying multiple

scenarios and calculating expected NPV and assigning a relevant probability

Management of InvestmentCapital investment in the advanced manufacturing environment is affected by the way in which inputs are determined. Much greater attention must be paid to the investment outlays because peripheral items can require substantial resources.

- In assessing benefits, intangible items such as quality and maintaining competitive position can be deciding factors – choice of the required rate of return is also critical.

- Tendency of firms to use required rates of return that are much greater than the cost of capital should be discontinued.

- Salvage value of an automated system can be considerable, it should be estimated and included in the analysis.

Post-audit of processPost auditing evaluate the actual performance of a project in relation to the expected performance

- Post-implementation and/or post-completion audits: compare actual with estimated cash flow - May lead to corrective action to improve the performance of the project or to abandon it- Control mechanism – employees will be a bit more careful - Serves as an incentive for managers to make capital

investment decisions prudently which projects should be reviewed?- Provides feedback on accuracy of initial estimates i.e. hopefully benefits future decisions

Behavioural Implications Performance evaluation

- Performance measures- Investment proposal generation if you know that the company would like to, but you don’t because it’s bad

for your figures- Escalation of commitment you know it’s wrong, but you don’t get rid of it, because you’ve already committed

resources

3 qualitative considerations that should generally be considered in capital budgeting evaluations include:

- Quicker responses to market changes and flexibility in production capacity- Strategic fit and long-term competitive improvement from the project, or the negative impact to the company’s

competitiveness or image if it does not make the investment- Risks inherent in the project, business, or country for the investment

Performance Evaluation and Control

Role of Accounting Information in Organisational ControlThe Accounting Information System is an integral part of the organisation’s control system, as it provides:

- Decision-facilitating information (Planning) Budgeting, standard setting

- Decision-influencing information (Controlling) Assessing someone’s performance influencing your opinion of person’s effort Variance analysis, cost of quality report

MotivationMotivation: an individual’s intensity, direction and persistence of effort toward attaining goals

- Energises and guides behaviour toward obtaining a particular outcome - 2 types; and incentive system must strike a balance between them

Intrinsic: generated internally within the individual e.g. satisfactionMake work interesting improves opportunities for intrinsic rewards

Extrinsic: granted externally by the organisation e.g. recognition, praise, remuneration, prizes Effective incentive system if extrinsic rewards reinforce intrinsic rewards

Factors affecting motivation:

- Individual Characteristics e.g. specific to the person Interests, attitudes & needs that people bring to the work place controlled through recruitment

- Job-related Characteristics Content & context of task environment – autonomy, variety, difficulty

- Work Situation Characteristics Immediate work environment – policies, culture

intended to provide motivation for organisational members to take actions and make decisions consistent with the organisaiton’s objectives

What motivates people?

Efficient and effective use of organisational resources

Function of ability, uncertainty, effort, resources, etc.

Motivation Theories

1. Goal Setting Theory Setting a specific, difficult but attainable goal improves performance by motivating employees to put more effort (direct attention, increase persistence, stimulate effort) in.

Limitations:

1. Employee ability and task complexity (consider feedback)2. Degree of goal acceptance and commitment (ameliorated by participation in goal setting)3. Tunnel vision: person focuses on goal but forgets everything else (avoid by setting a number of goals and

focusing on effectiveness and efficiency)

2. Expectancy TheoryEmployees are motivated by an incentive plan that provides expectancy that desirable behaviour leads to rewards i.e. must provide a:

1. Desirable outcome (desirable reward/undesirable penalties); and2. High probability that behaving consistently with organizational objectives will lead to the outcome

Effort --- EXPECTANCY LINK -->Performance --- INSTRUMENTALITY LINK -->Outcomes --- VALENCE LINK -->Satisfaction

- Expectancy link: Does effort result in performance? Can I achieve the target? Is my effort reflected in performance?

- Instrumentality link: Does performance result in the reward? i.e. how certain are you that you’ll get the reward? How do outcomes reflect measured performance? Do outcomes reflect all facets of my performance?

- Valence link: Is the reward desirable? What outcomes do I value/want? How much do I value them?

Note: If any of these linkages are weak, the reward system is lousy. The stronger the linkages (relationships), the more motivated employees will be.

3. Agency TheoryInterdependent relationship exists between principals (employers) and agents (employees) who want to maximize their rewards at minimum costs.

- Agents are motivated by self-interest and have more information i.e. information asymmetry. Therefore, goal incongruence can lead to dysfunctional behaviour.

- Monitoring and incentives becomes important i.e. if you reward people properly, they’ll do the right thing Total agency costs = opportunity cost of misbehaviour + incentive & monitoring expenses

Incentive SystemsThe best incentive plans trades off the cost of administering alternative incentive plans against the cost of misbehaviour

- i.e. must attract and motivate qualified employees to behave according to the organisation goals, reward them if they do; and requires monitoring to ensure the performance measures are reasonable

- require reliable, objective and verifiable performance measures and clear guidance for evaluating trade-offs

Theory Theoretical Principle ImplicationsAgency Most individuals are motivated by

self-interestPerformance based rewards must be greater than alternative rewards from non-performance

Agency Organisations get the behaviour they reward

Performance measures and related rewards must reflect organizational goals

Expectancy Effort follows rewards Employees must believe that their efforts influence performance and will be rewarded.

Goal Setting Difficult but attainable goals motivate best

Impossible and easy goals are demotivators. Make goals difficult but not impossible

Expectancy Fairness is a basis for sustained motivation

Rewards must be linked to desired performance in a fair and consistent manner

Agency/Expectancy Manipulation undermines fairness and effort

Performance measures must be observable and verifiable

Expectancy Different rewards can motivate effort

Rewards must meet market conditions and be available

Agency Incentive systems involve trade-offs Minimizing the overall costs of aligning goals and monitoring behaviour is a goal of incentive system design

Balanced Scorecard: model of cause and effect relations among leading and lagging indicators of performance. Useful for measuring and communicating the effects of activities on organizational performance as it is looks at 4 areas of performance:

1. Learning and Growth 2. Internal Business Process3. Customer – satisfaction & loyalty4. Financial

Assign overall scorecard incentives to managers at higher levels to reinforce the goal to ensure subordinates are working to improve the measures they directly control. Use of a balanced scorecard in an incentive system is contentious.

Principles of Incentive System Design The key to designing incentive systems is to understand as well as possible which behaviours are desired and how incentives and rewards are likely to influence behaviours.

1. Use Multiple Measures Financial – levels & growths of revenues, costs, cash flows, operating income, ROI, stock price non-financial e.g. customer and employee satisfaction, social responsibility

2. Employees must believe that the reward is a result of something they can control3. Measure output v. input

Absolute or relative? Avoid rewarding output if:

Output cannot be measured consistently Output is affected by uncontrollable factors Output is expensive to measure i.e. cost prohibitive & difficult to measure

4. Link to critical success factors – what is crucial to the firm?5. Clear standards that employees can accept i.e. goal

Specific Measurable: quantifiable

Achievable: Realistic: Time bound:

6. Measures must accurately assess performance accurate, reliable and verifiable otherwise, conflict and cheating opportunities created

7. Group performance (relationship between action’s and company performance) v individual performance

Choices of Incentive System - Absolute or Relative measures- Reward formula-based (meeting targets + %) or subjective performance (take into account circumstances and

other desirable things about performance)? Effect on effort-performance linkage? Potential for “playing” the system?

- Financial or non-financial measures - Narrow or broad responsibility of performance - Current or deferred rewards

Salary, bonus, or stock Consider risks, alignment of interest

Current Rewards Deferred RewardsWhat is it? Cash or stock that can be cashed immediately

or soon after the awardDefer payment or payment is restricted until a future date

Advantages - closely linked to current performance i.e. strong motivation to improve current performance

- incentives to stay with the company- focus attention on long term performance- capture the lag effect of non-financial

performanceDisadvantages induce employees to manipulate performance

measures without concern for future performance or with the expectation of ‘cashing out’ and leaving the company

too far in the time horizon to be motivational