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Management Accounting Control

Philippe Smans

Manon Cuylits

Management Accounting Control 2012-‐2013 Manon Cuylits

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TABLE OF CONTENTS

Exam ....................................................................................................................................... 3

Chapter 1: Introduction ................................................................................................... 4 Some history ................................................................................................................................. 4 1. Classical approach ........................................................................................................................... 4 2. Cybernetic approach ...................................................................................................................... 5 3. Systemic approach .......................................................................................................................... 6 SUMMARY .................................................................................................................................................... 8

the management controller .................................................................................................... 8 The role of Finance is changing ....................................................................................................... 11 The role of the Management Controller is changing .............................................................. 12 Operational and strategic feedback ............................................................................................... 14 What might be part of the Management Control Function ................................................. 16 Required skills ........................................................................................................................................ 19

Chapter 2: Management accounting control ......................................................... 22 LINK WITH FINANCIAL MANAGEMENT ............................................................................ 22 LINK WITH MARKETING MANAGEMENT ......................................................................... 25 Controlling the sales force .................................................................................................... 25 Forecasting sales ................................................................................................................................... 26 Establishing sales territories and quotas .................................................................................... 28 Analysing expenses .............................................................................................................................. 29

THE LINK WITH HR MANAGEMENT ................................................................................... 31

Chapter 3: budgetting ................................................................................................... 32 Successive steps for a budgeting process: .................................................................................. 35

Operational budgets ............................................................................................................... 37 Financial budgets .................................................................................................................................. 38

Budget Process ......................................................................................................................... 42 Incremental method ............................................................................................................................. 42 Percentage method ............................................................................................................................... 43 « Zero based » budget .......................................................................................................................... 43

Chapter 4: Capital budgeting ...................................................................................... 45 Key motives for making capital expenditures .......................................................................... 45

Steps in the capital budgeting process ............................................................................. 46 Basic Terminology ................................................................................................................... 47

Chapter 5: cash flow ....................................................................................................... 49 The relevant Cash Flows ........................................................................................................ 49 Main components .................................................................................................................................. 50 Terminology ............................................................................................................................................ 51 What are the key elements of the recent business evolution? .......................................... 65 Parallel Business tools evolution: .................................................................................................. 66 But… ............................................................................................................................................................ 67 “Balances” ................................................................................................................................................. 69 Linkage between causes and strategic activities ..................................................................... 75

Perspective measurement .................................................................................................... 79 Financial perspective ........................................................................................................................... 80 Customer perspective .......................................................................................................................... 82


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Internal process perspective ............................................................................................................ 86 Learning and Growth perspective .................................................................................................. 87

Chapter 7: Technique of cost accounting ................................................................ 97

Allocation of costs .......................................................................................................... 97 producing department overhead ................................................................................................. 100

Allocation of service department costs to producing department ....................... 103 partial overhead absorption ........................................................................................................... 120 Activity-‐based costing (ABC) .......................................................................................................... 124 Activity-‐based Costing system ....................................................................................................... 134

CONCLUSION ................................................................................................................... 138

EXAM

Case study: 19 pages to read, there will be questions about it. We can bring it to the exam, and he will test our understanding. We can bring the case study with some notes on it.

Other questions: Mix of several types of questions: QCM – basic calculations (CF, Cost allocation, etc.) – questions aiming an understanding of the basic subjects (ex: explain the job of a MC) – close questions, etc.

We don’t have to know the presentations but we have to know one or two messages per presentation.


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CHAPTER 1: INTRODUCTION

This course is designed for students with a Bachelor Degree in Management or Business Administration who want to develop their abilities to work more effectively within large and/or well-‐structured companies and to deal with questions of management control in any type of company. Therefore, the course is developed from a company / business point of view. Theoretical concepts on Management Control will be reviewed, and will constantly be illustrated through real-‐life examples and case studies, in order to have the students familiarized with the main aspects of Management Control and especially to apply the methods of Management Accounting Control.

Basic concepts:

ð What is Management control? ð Why is it necessary? ð What are the basic tools?

SOME HISTORY

If we look back we can see that over time 3 types of management control:

-‐ Classical approach -‐ Cybernetic approach -‐ Systemic approach

1. CLASSICAL APPROACH

Fayol (theoretician): “management means a couple of things:

-‐ Planning, -‐ Organizing, -‐ Commanding, -‐ Coordinating activities, -‐ Controlling performances (NB: first time we see the word control)

Most of these activities are task management oriented rather than people management oriented. This was typical of Taylor and the Scientific Management.


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Contrôler (French) = to check something. (E.g.: to check the speed of a car)

To control something (English) = Make sure that things “happens” correctly ≠ to check. The “control” was perceived narrowly (“surveillance”) and not very explicit.

ð Management controller: not somebody who’s just checking the management, it’s something broader.

This looks like something mechanic, really systematic, but the experience shows that you might not be efficient; you could fail even If you make many efforts to plan, organize, …

Nowadays, things are moving really quickly. You have to be able to adapt to those changes. A better ability to adapt to a changing environment is needed. That leads to the cybernetic approach. After a while, if the output is not right in the case of the classical approach, you will change your approach to the cybernetic approach.

2. CYBERNETIC APPROACH

Without the right input it’s really difficult to have a good output. If my outputs seem not to be all right, it might be because of the inputs, or because of the system itself.

Output = It’s something you want to reach, an objective. Every company has objectives. They will put a system in place and chose inputs.

Examples:


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Profit is a typical output of the company, but not the only one. Another example of output could be customers, market shares, customer satisfaction, and so on. But it’s never limited to profit.

Most of the time they will first discover that the output is not good and they will make changes. It’s better than the previous approach but still no question about the relevance of the goals and objectives. “Is this the right output that I want to achieve?” or “Is there another output which would be better?”

If you start to question the relevance of your objectives, you arrive in the systemic approach.

3. SYSTEMIC APPROACH

You will consider any company as a system. That’s much more sophisticated, and closer to the reality, because nowadays, running a business is becoming more and more complex: (The following reasons bring problems but also opportunities)

-‐ More competitors on the market, globalization in the last decade, etc. -‐ Regulation is increasing; environment of regulation is becoming tougher and

tougher. The speed of change is increasing. -‐ The economic situation (crisis), it’s currently not easy. But it also creates

opportunities. -‐ Technologies. Some companies are very successful thanks to their ability to adapt

themselves really quickly to new technologies.

In this model, a company is defined as a system with goals and able to adapt itself (continuously)

The management control is no longer a process of “a posteriori” verification. “Control” means actually “keep control in order to adapt to the environment evolution”.

Therefore the role of the control is:

-‐ To ensure the relevance of the system’s goal and objectives -‐ To ensure that the relationships between subsystems allow to move towards the

objectives

Systemic control covers the 2 points of view:

-‐ External: the control system must ensure the relevance of the strategic choices and of the behaviors

-‐ Internal: the choice of control system is clearly linked to the organizational system


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Analytic approach Systemic approach

AA isolates and then concentrates on the elements SA unifies and concentrates on the interaction between elements.

Studies the nature of interactions Studies the effects of interactions

Emphasizes the precision of details Emphasize global perception

Modifies one variable at a time Modifies groups of variables simultaneously

Remains independent of duration of time, the phenomena considered irreversible

Integrates duration of time and irreversibility

Validates facts by means of experimental proof within the body of a theory

Validates facts through comparison of the behavior of the model with reality

Uses precise and detailed models that are less useful in actual operation (example: econometric model)

Uses models that are insufficiently rigorous to be used as bases of knowledge but are useful in decision and action

Has an efficient approach when interactions are linear and weak

Has an efficient approach when interaction are nonlinear and strong

Leads to discipline-‐oriented (juxtadisciplinary) education Leads to multidisciplinary education

Leads to action programmed in detail Leads to action through objectives

Possesses knowledge of details poorly defined goals Possesses knowledge of goals, fuzzy details

1ST ELEMENT

Analytic approach = “AA isolates and then concentrates on the elements”

Systemic approach = “SA unifies and concentrates on the interaction between elements.”

A company is a system (// human body: sum of different elements interacting a lot with each others).

In this approach you will define a company by a series of elements. è Different parts, and for each part: one specialist. That’s typical of many companies. What may happen if you concentrate on those elements?

Ex: You may have a purchasing department: the job of the purchasing manager is buying. If he’s a real specialist, he will be champion in bargaining for the minimum price. Sometimes it raises problems. Ex: I buy a car at the minimum purchasing price => lower quality, so much more reparations, and the total cost of the car could be higher than it was supposed to. Sometimes it’s not a good idea to buy a car at the minimum-‐purchasing price.

Systemic approach: It’s much more powerful than the analytic approach.

Here you look at several elements and at their interactions! You never look just at the purchasing price but also at the quality etc. You concentrate on the interactions between the elements in this approach.

Ex: as human resource manager, what do you expect? You want your people to be productive, so you want them to be motivated, and what drives motivation? Training possibilities, coaching, etc.


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Good managers have to look at the interactions between human resources, finance department, purchasing department, etc. It’s necessary for the company to succeed

SUMMARY

Classical approach: You focus on the output.è The only things you need to do are check, surveillance, look at the output.

Cybernetic approach: Focus on the process that produces the output. If my output is wrong, it’s probably because something is wrong with the process.è Process audit. How does the process work?

Systemic approach: Focus on the system1 that produces the output. è System audit. I’m going to look at the system (//computer system).

THE MANAGEMENT CONTROLLER

In front of increasing business complexity, there are often too many activities for a single person. More and more activities are delegated to a management controller, who must keep the CEO informed about things like:

-‐ The various department’s performances -‐ Sales -‐ Costs, benefits -‐ Control issues related to systems that operates transactions -‐ The impact of new taxes and other national or international trade regulations -‐ Etc.

As a CEO you don’t have time to do that, so you ask someone to do it for you and to keep you informed, and then you take decisions, because it’s your job. That someone is the management controller.

1 System = a collection of processes. Of course it’s much more complicated than a process because


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A management controller may be compared to a ship navigator, who keeps the captain aware of current or potential problems (icebergs, etc.)

The job of the management controller is to get the relevant data, to work them out, to translate them into useful information in order to give it to the CEO. He collects the information and summarizes it to give it to the CEO. The CEO will interpret those data and then use it to make decisions.

Therefore, the Management Controller needs to be aware of the company’s strategy. His job is to get the relevant figures; therefore he needs to know the objectives, strategy, etc. of the company.

Example: If the strategy of the company is to grow, the Management Controller knows some figures that are more important for the company to know. He can then select the relevant data depending on the direction that the company wants to take (its final destination, its strategy).

Traditionally, in most companies, the Management controller reports to the financial manager and in many cases his job is not named management controller but financial controller.

Summary: Get information è Analyze information è Provide, based on that information, a message to the CEO

It might be financial data, but it could also be other types of data. It’s absolutely not only related to financial data, that’s why the name “financial controller” isn’t that good for this function. Life of a company is not limited to financial data. They also need customer satisfaction, company reputation, etc. you don’t get that sort of data as easily accessible as financial data. Financial data are the most easily accessible data for a company.

SUMMARY OF EVERYTHING


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OPERATIONS MANAGEMENT

Operations management = Day-‐to-‐day management

In a company there is a difference between the people defining the strategies and the one applying them. Operations management is one type of management. Those managers are going to be concerned by what’s going to happen in the next days.

E.g.: A project manager is an operational manager. A production manager too (you have to produce, not only to sell), same for logistic managers, etc. è Those are operational activities. You realize the day-‐to-‐day life of a company.

STRATEGIC MANAGEMENT

Strategic management = To ensure relevance of the long-‐term objectives.

Time horizon is longer for this type of management. What do I want to achieve within 3 years/ 5 years. Etc. è But it’s not only related to the time horizon: The aim is to define a strategy and to make sure that the strategy is going to happen, to manage the strategy in other words.

Strategy: I want to achieve one goal, and this goal isn’t specific to one part of the company (e.g. not specific to sales).


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There are 2 ways of communications between the strategy management and the operations management even if their job has a completely different nature.

MANAGEMENT CONTROL

Management control è allows the definition of short-‐term objectives, relevant feedback, and a (usually) one-‐year time horizon management.

Feedback is really important. Once you’ve defined the strategy, you’ll need regular feedbacks.

There is another part in the job that we haven’t seen so far.

Basic tool used by the management controller to translate the strategy into shorter objectives: a budget! The budgeting process that is one of the most painful processes in companies; it’s the responsibility of the management controller. And if he isn’t the main responsible, he will be strongly involved in the budgeting process.

Budget is a tool, which is used to go from red to green. The dashboard also is a basic tool.

The purpose of a management controller is to help the good communication between operational and strategic management.

THE ROLE OF FINANCE IS CHANGING

PAST


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The first triangle was in the past. Most of the time spent by the people was in transaction processing, a little bit on reporting and control and a very little amount in decision support.

CURRENT

Transaction processing takes less time (almost zero). It gives much more time to Decision Support. It’s the role of management accounting controller. è The management controller doesn’t take the decisions but collects data, etc. and it helps the CEO to take decisions.

ERP Systems: Huge software (SAP for ex), basically they automate all that’s transaction processing. We enter one data in the system and it is going to check if there is enough raw materials for example, and if not, it will book some raw materials automatically, etc. Series of transactions are automatically performed. That’s why that part is really going down; which is a good new because it leaves more time for the other activities. Moreover, it’s a boring task. The finance people are no longer doing an accountancy job, but more and more decision support.

THE ROLE OF THE MANAGEMENT CONTROLLER IS CHANGING

ð Originally nothing more than a bookkeeper ð The function changed with the advent of computers ð In the 1970s and 1980s, CEOs became more concerned with the efficiency of all

company departments, including the accounting function ð Used a great deal of process and financial analysis skill to assist all parts of the

corporation in many ways. This is probably the most important skill for a management controller. Analysis: that’s what it is about.

ð Over the course of one century, the controller’s function has risen from one of senior clerk to one of the most advanced, highly educated, and useful positions in the entire corporate structure.


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FROM CHECKING TO CONTROLLING

Checking Controlling è Bureaucratic & Standard-‐based

It’s based on standards: e.g.: if I check the speed of a car that’s because there’s a speed limit.

è Reactive & flexible

Exactly like when you drive a car. The worst thing to do would be to be bureaucratic and standard-‐obsessed, that wouldn’t be very effective.

e.g. There are always going to be idiots that are not going to stop at a STOP panel, that are going to cross the streets when they are not supposed to. You have to be reactive and flexible.

è “Surveillance” è “Cause-‐and-‐effects” relationships

è No focus on relevance

The policeman doesn’t address the relevance.

è Focus on relevance

The Management Controller focuses on relevance. It’s good for him to ask himself “does it make sense? Does that objective make sense?”

è Resources management & allocation è Processes and competencies management

è “Single-‐loop” è “Double-‐loop”

è Reactive

React to what’s happening. That’s not a good way to manage a company.

è Proactive

Think to WHAT COULD HAPPEN, that’s the good way to manage a company

è Optimization è Adaptation

They successfully adapt, and they do it quickly!!!

è Use of theoretical models è Use of adequate behaviors

è Failure trigger sanctions è Failure allow learning and development

Failures are accepted, and they are necessary. It doesn’t mean that we like failure, but it is important because it allows learning.

E.g.: it’s impossible to learn riding a bicycle without falling.

There is nothing wrong at making mistakes, but you have to learn thanks to your mistakes.

In most of the American Companies, failures are accepted, but you’re not allowed to make 4 times the same mistake. Anyway it’s obvious that nobody like failure.


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OPERATIONAL AND STRATEGIC FEEDBACK

REALLY IMPORTANT SLIDE

What it means to be between strategic management and operation management.

OPERATIONAL FEEDBACK

When you’re in the operational world, you’ll often:

è Start with an operational plan (what are you going to produce, how much do I have to sell, etc.) èTranslate that into an operational budget è Translate/use the budget into operational activities (sell, buy, etc.). è At the end I have some outputs (number of units produced, bought, number of projects completed, new products developed, etc.). è I’m going to measure that (metrics) to close the loop, and è Compare that to my initial operational plan.

E.g.: At the end of the first week you only have 90 cars (you were supposed to have 100).

If metrics show that your outputs are not as they were supposed to be in the initial plans, there are 2 options: Both are good, it depends of the circumstances, etc.

-‐ Change your plan (maybe it wasn’t appropriate) -‐ Keep the plan but change something else (hire more people, etc.)


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STRATEGIC FEEDBACK

Strategic plan that I translate in a strategic budget that’s going to be used for strategic actions.

The difference I can do here is strategic actions (ex: mergers and acquisition, to launch a new product, … ) è they’re not routine decisions. The purpose of those strategic actions is to impact the operational activities.

Example: Mergers and acquisition: I buy a competitor and his activity becomes mine, and it’s going to impact the day-‐to-‐day activities. Same if I decide to launch a new product.

I will select the outputs that are interesting, in relation with the plan.

Outcome: by nature it’s nothing more than an output with a strategic, specific importance. I can measure those outcomes thanks to metrics and close the loop by returning to the strategic plan.

EXAMPLE

I run my business in BENELUX, I decide to take a strategic action, before I already had operational activities in place. I want to get more sales.

ð Outputs could be things like the unit sold in Belgium, Netherlands or Luxemburg ð The sales expressed in Euro ð The market shares in Belgium/Netherlands/Luxemburg ð Etc.

I can compare those outputs to your plan è what was my plan in relation with the market shares? è Strategic plan: to sell in Germany also!

BASIC DIFFERENCES BETWEEN THE STRATEGIC LOOP AND THE OPERATIONAL LOOP

The timing is very different between both loops.

Ø Operational loop: It’s going very fast, day-‐to-‐day activities. Done on a daily basis. Ø Strategic loop: That’s not something that you can do quickly basically! It takes

months.

Budget is in Strategic actions. Budget is expressing into operation figures some strategic decisions that I took.


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Operation è strategic (job of the management controller): The management controller will pick up some figures from the operational world and I will use them to provide information to the CEO.

è He will measure some of the outputs and provide information that are going to help the dashboard to take decisions. Therefore, a management controller needs to be perfectly aware of the strategic intent!

We can see that it isn’t an easy job. It’s not always easy to translate something into a figure. Ex: customer loyalty is not really easy to translate into a figure (I can count the number of customers lost). Sometimes it’s easy; sometimes it’s less easy.

“Strategically I want to have a better reputation”. Reputation is possible to measure but not that easy. Not easy to translate into figures.

WHAT MIGHT BE PART OF THE MANAGEMENT CONTROL FUNCTION

Might = in some companies it’s not part of the job, in other it is

AUDITING

Ø The scheduling and management of periodic internal audits, as well as the preparation of resulting audit reports and the communication of findings and recommendations to management and the board of directors.

Ø The preparation of work papers for the external auditors and the rendering of any additional assistance needed by them to complete the annual audit

NB: In some companies audit and management control are separated functions

BUDGETING

The coordination of the annual budgeting process, including maintenance of the company budget, and the transfer of final budget information into the financial statements.

CONTROL SYSTEMS

The establishment of a sufficiently broad set of controls to give management assurance that transactions are processed properly.

COST ACCOUNTING

(= comptabilité analytique) It’s almost systematically a part of the job ! You have to have a good understanding of the figures.


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Ø The coordination of periodic physical inventory counts Ø The periodic analysis and allocation of costs based on activity-‐based costing pools

and allocation methods. Ø The continual cost review of products currently under development, using the

principles of target costing. Ø The periodic compilation and evaluation of inventory costs.

FINANCIAL ANALYSIS

Ø The periodic comparison of actual to budgeted results and the communication of variances to management, along with recommendations for improvement.

Ø The continuing review of revenue and expense trends and the communication of adverse trends results to management, along with recommendations for improvement

Ø The periodic compilation of business cycle forecasting statistics and the communication of this information to management, along with predictions related to the impact on company operations.

Ø The periodic calculation of a standard set of ratios for corporate financial performance and the formulation of management recommendations based on the results.

FINANCIAL STATEMENTS

Ø The preparation of all periodic financial statements, as well as their accompanying footnotes.

Ø The preparation of an interpretive analysis of the financial statements. Ø The preparation and distribution of recurring and one-‐time

FIXED ASSETS

Ø The annual audit of fixed assets to ensure that all recorded assets are present. Ø The periodic recording of fixed assets in the financial records and their proper

recording under the correct asset categories and depreciation methods. Ø The proper analysis of all capital expenditure requests.

POLICIES AND PROCEDURES

Ø The creation and maintenance of all policies and procedures related to the control of company assets and the proper completion of financial transactions.

Ø The training of department personnel in the use of accounting policies and procedures

Ø The modification of existing policies and procedures to match the requirements of government regulations.


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PROCESS ANALYSIS

Ø The periodic review of all processes involving financial analysis, to see if they can be completed with better controls, lower costs, or greater speed.

RECORD KEEPING

Ø The proper indexing, storage, and retrieval of all accounting documents. Ø The orderly planning for and scheduling of document destruction, in accordance

with the corporate document retention policy.

TAX PREPARATION

Ø The timely preparation and filing of tax returns, as well as the supervision of all matters relating to corporate taxation, such as conducting an effective tax management program, and both providing and enforcing policies and procedures related to the compliance of all corporate personnel with applicable government tax laws.

TRANSACTION PROCESSING

Ø The timely completion of all accounting transactions at the intervals and in the manner specified in the accounting policies and procedures manual.

Ø The proper completion of all transactions authorized by the board of directors or in accordance with the terms of all authorized contracts.

Ø The proper approval of those transactions requiring them, in accordance with company policy.

This list may appear overwhelming, but just because the controller is responsible for all of the listed areas does not mean that this person must actually do each one.

In other words, the controller primarily manages the work of other people and ensures that they complete most of the tasks just listed. In particular, a controller can rely on the services of assistant controllers who are responsible for smaller portions of the accounting department.


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REQUIRED SKILLS

ANALYSIS OF INFORMATION

The controller must be sufficiently comfortable with financial information to readily understand the meaning of a variety of ratios and trends and what they portend for a company.è The figures and information: You don’t need to be a financial expert but a really good ability to analyze is required.

COMMUNICATION ABILITY

A key component of the controller’s function is compiling information and communicating it to management. If the compiling part of the job goes well, but management does not understand its implications, then the controller must improve his or her communication skills in order to better impart financial information to the management team

Ø Those two are the most important skills

COMPANY AND INDUSTRY KNOWLEDGE.

No accounting system is completely “plain vanilla”, because the companies and industries in which it operates have a sufficient number of quirks to require some variation from the typical accounting system. Accordingly, the controller must have a good knowledge of both company and industry operations in order to know how they impact the operations of the accounting department

Ø It’s better if you have some knowledge but not absolutely mandatory.

MANAGEMENT SKILL.

The controller presumably will have a staff and, if so, will have considerable control over the productivity of that group. Accordingly, the controller must have an excellent knowledge of the planning, organizational, directing, and measurement functions needed to manage the accounting department.

PROVISION OF TIMELY AND COST-‐EFFECTIVE SERVICES.

The controller must run the accounting department as if it were a profit center, so that the most efficient methods are used to complete each task and the attention of the department is focused squarely on the most urgent tasks

Ø A typical Management controller will have to create budget and dashboard. There’s a timing therefore (ex: budget needs to be ready on the first December). It’s important to be able to provide services on time.


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TECHNICAL KNOWLEDGE.

Creating an accurate financial statement, especially one for a publicly held company, requires a considerable knowledge of accounting rules and regulations. Accordingly, a controller should be thoroughly versed in all generally accepted accounting principles (GAAP2, IAS3, IFRS4 è Extremely technical standards.)

Ø Not always mandatory.

LET’S LOOK AT A VERY BASIC EXAMPLE OF IMC ISSUE

Compared profitability of 4 subsidiaries:

NB: figures between brackets = negative.

è Key message: I am loosing money with one country (Country A). When I’m selling something, I throw money through the window. We’ve a problem.

è Main reason: I’ve a problem because of customer delivery. WHY?

Let’s make the ratio between customer delivery and sales, for the good companies and for the bad company. For nice looking company, customer delivery cost must be around 5% of the sales. In country A, the cost is already a percentage of the sales. It’s 10 times more than for the good companies. Customer delivery costs are 10 times higher than in good working countries.

2 GAAP: Generally Accepted Accounting Principles

3 IAS: International Accounting Standards

4 IFRS: International Financial and Reporting Standards


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è Why are those costs so high? We can’t now thanks to the figures. There’s a limit. Those figures give information up to a certain limit. There’s a limit to the job of management controller. You have to talk with other people to have a better understanding of the problem.

Role of the Management Controller:

-‐ Interface between strategic management and operational management -‐ Getting data and being able to deliver those data as a message


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CHAPTER 2: MANAGEMENT ACCOUNTING CONTROL

LINK WITH FINANCIAL MANAGEMENT

OPERATIONAL CYCLE

When you start a company, you need first some money. You get that money thanks to Equity and LT Debts (Bank). LT debt means that you’ll have to pay it back within more than 1 year. That money is cash!

I can use this cash to buy LT assets (car, truck, etc.).

After that, you can start to operate. You find suppliers; you buy raw materials, etc. And you work to turn those raw materials into finished products. You sell those finished products in order to win cash. The aim of the game is to have CASH thanks to this operational cycle.

Most of the bankruptcies start because companies don’t have money to pay the salaries. They borrow then money to the bank but with an interest rate, and when they have to refund the bank, they face a problem.

The Management controller needs to reach a balance (both in amount and timing), and they reach it when they have a really low working capital requirement (or even negative, because it’s possible).


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Let’s have a look at the balance sheet:

Ø WC = Working Capital Ø WCR = Working Capital Requirement

Ø Left column: Assets (Actif) Ø Right column: Liabilities (Passif)

LT Assets: (>1 year): It’s an asset used for the production. It’s supposed to stay within the company more than 1 year. >< ST assets.


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Difference between depreciation and the other categories of costs:

Depreciation: That’s not money physically going out of the company. It’s something that you take into account as if it was a cost but actually there’s no money going out of the company physically.

Cash flow = net income + depreciation.

You may perfectly have situations with a positive cash flow but a negative profit.

EXAMPLE

NB: between brackets: negative figures

You use raw materials, workers (that you will have to pay) to produce during a period of time. It means you’ll face cost for this production. At the end of the month, you have to add 9450.

The difference between the inventory at the end of the period and the beginning of the period is what has been sold.

è Explanation in an easier way:

I have 1000. I produce 3000. I can sell 4000 then. If at the end of the period I have 2000, it means that I have sold for 2000. (It’s exactly the same than previously but with easier figures).


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LINK WITH MARKETING MANAGEMENT

All the rates have to be high in order to have a high market share. This is due to the fact that if awareness rate, contact rate and hit rate are high but consideration rate is low, your market share is going to be low.

CONTROLLING THE SALES FORCE

Two reasons for the control in the sales force:

-‐ Personal selling can be a large marketing expense component in the final price of the product or service. It’s worth to be controlled

-‐ It’s related to the efficiency. Sales force efficiency can’t be maximized unless it’s directed, motivated and audited on a continual basis.


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In order to have good results, there’s a need of controlling the sales force (directing them, motivating them, etc.)

Controlling the sales force involves 4 key functions:

1. Forecasting sales: It’s always the starting point 2. Establishing sales territories and quotas. 3. Analyzing expenses: Sales involve expenses. (E.g.: restaurants with prospects,

clients, etc.). 4. Motivating and compensating performance.

FORECASTING SALES

The sales forecast is an estimate of how much of the company’s output (€ or units) can be sold during a specified future period, under:

It lies in sales planning for the next year or in the future. There’s always a forecast long term and short term:

-‐ Short Term: It’s basically a managing of the sales force. It’s the starting point of the budget process. The period of time is maximum 1 year.

-‐ Long Term: To make sure you have a capital to finance the business development and to have enough production capacity. It’s focused on financing, production and development.

The sales forecast is an estimate of what we are going to sell next year. In other words, it’s how much of the company’s output can be sold during a specified future period. It’s not easy to calculate it and in order to minimize the risks we have to go through some steps:

1. An assumed set of economic conditions: it’s the way the economy is going to be next year. About the global economic environment.

2. A proposed marketing plan: what you plan to do in the future. Each marketing plan will deliver a specific impact on the product.


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Ø Used to establish sales quotas Ø Used to plan personal selling efforts and other types of promotional activities in

the marketing mix. Ø Used to budget selling expenses Ø Used to plan and coordinate production, logistics, inventories, personnel, etc.

SOME FORECASTING TECHNIQUES

JURY OF EXECUTIVE OPINION METHOD

I may ask to the top management what’s their opinion. “Next year, what do you think is going to happen?” The CEO and the operational management meet to discuss the decision of the company.

Inconvenient: the top management is not in contact with the customers. So, their decision is not based on relevant decision or at least not concrete enough. So, they may not do the right choice.

SALES FORCE COMPOSITE METHOD

Ask the sales people. The sales force is directly involved with the customers. They can bring a good approach for the future decisions related to the performance of the company.

Inconvenient: Not a secure method. If they know they are going to sell 20% more they will never say that to their boss, cause something might happen. It’s better to say that they are going to sell 10% more cause then we’ll give them that as an objective and if they sell more than 10% more, the boss might give them a bonus. They underestimate what they think they will need for the future. The salesman is going to be careful in his statement concerning his objectives. He’s not going to tell the truth. It’s always an estimation; there is a filter of information

As a boss you might say: “Instead of asking my sales people, why don’t I bypass them?”

CUSTOMER EXPECTATIONS METHOD

This method is used in case of the company doesn’t trust the salesman and suspects he filters the information he let the company know. Another solution is to ask directly the customer about his satisfaction. It concerns the raw information, untreated.

Inconvenient: number of customer is too large to be analyzed. There is a need of samples, and as a result, a limitation of the information. Moreover, customers are not always willing to answer the questions. Customers are not always going to tell the truth. If we ask them how much they are going to buy next year, they might not give the good answer.


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è Those 3 first techniques are necessary for a good forecast even if they suffer from imperfections and give truncated information. It’s always better to run them because those techniques bring a direct input from direct contact with important actors of the business. The 3 next techniques are more technical and mathematic.

TIME-‐SERIES ANALYSIS

You try to use the past to prevail the future. You look at the past evolution and try to extrapolate. Ex: during the last 10 years my sales have been increasing by 2% every year… It’s not silly to extrapolate then.

CORRELATION ANALYSIS

You correlate something with another forecast. You correlate your forecast to other forecasts. A forecast can never be something 100% accurate; it’s not possible to predict the future.

OTHER QUANTITATIVE TECHNIQUES

è Techniques: Statistical, mathematical, simulation models, etc.

The forecasting techniques can become highly sophisticated, but they are never a substitute to sound business judgment. We have to take into consideration both means: techniques and business judgement. No single method provides uniformly accurate results with infallible precision

ESTABLISHING SALES TERRITORIES AND QUOTAS

SALES TERRITORY

Represent the management’s need to match personal selling effort with the sales potential (or opportunity).

Example: A first salesman contacts a customer to offer a special package. Afterwards, another salesman from the same company contacts the same customer but he’s more aggressive and wants to sell the same offer. There’s going to be a big problem: the image of the company will be affected because there is a bad management and control inside the company to make such a mistake.


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QUOTA

It represents goals assigned to salespeople. As a result, it gives benefits to the company: it’s an incentive for salespeople, it allows to evaluate and control salespeople’s efforts and goals leads to quantitative standard different from the standards to measure performance. It means that it’s an additional way to measure performance. Nevertheless, it’s never easy to fix goals. There is always a discussion to define the goals.

What is an objective? It requires those conditions “SMART”.

- S: it has to be specific = a clear objective - M: It has to be measurable - A: the manager or the person in charge must agree it. - R: it has to be relevant and realistic (=réaliste). It has to be aggressive enough,

but realistic. - T: it must be an objective defined in terms of time

I want to measure a performance in the area of sales. I want to judge that performance. The list: different ways to measure that performance. They are some signs of good performance but you won’t use all those tools, you will have to select the best ones depending on your case.

ANALYSING EXPENSES


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Selling cost, expenses. You have to look at that, compare data between columns/lines… and then you can capture something. It’s important to take the time to have a look at that.

MOTIVATING AND COMPENSATING PERFORMANCE

2 basic types of compensation:

Ø Salary: In main company, the base salary is known… (?) Ø Commission: Commonly used for the sales people => the more you sell, the more

money you will have.

But numerous other forms of incentives:

• Positive feedback on salesperson performance evaluation • Company praise (ex: recognition in a newsletter) • Bonus (ex: cash, merchandise, or travel allowances) • Salary increase • Pay for performance for specific new product idea • Paid educational allowance • Earned time off • Fringe benefits • Stock options • Vested retirement plan • Profit sharing


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è The incentive system is important in the motivation and the compensation in order to boost the workforce.

In international business, we have to think about an international customer present in different countries. So the limitation of territory tends to disappear and multinational companies are growing.

THE LINK WITH HR MANAGEMENT

The idea is to make sure that the customer will receive what he asked for. Let’s remember that the simple aim of Management Control is to make sure that results conform to intentions. I want to make sure that what’s going to happen is what I expected. I want to have the measurement telling me whether I’m on the right track è do I have to change something or keep on doing like that?

Applied to HR Management, this implies 4 steps:

1) Deciding which behaviors or outcomes are desired. I have to decide what is the outcome that I expect, what do I want. The typical outcome expected when it comes to HR is “I expect the people to behave like that, to be creative/productive/able to work in team/customer focused/etc.”. You expect some specifics behaviors in the HR department. Another thing you could expect are the competences. You expect your people to be good at using computer.

2) Establishing ways to measure behaviors or outcome. You need to have ways to measure in order to reach your objectives. If you don’t measure there’s no chance that you’ll achieve your objectives! Some measurement are easy to make, some others are not. How can we measure behaviors? Ex: thanks to feedback, or by asking people.

3) Measuring what happens

4) Allocating rewards based on achievement


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CHAPTER 3: BUDGETING

DEFINITION

- A budget is a set of figures expressing money income and outcome, which shows whether a financial plan will help reaching organizational objectives.

- Budgeting is the process of budget preparation. - The various Budgets provide a tool to communicate short-‐term objectives. It is the

way to communicate the budget inside the company

BUDGETING TECHNIQUES

Initially I have a strategy. I will translate that strategy into figures.

Regardless of the business sector, the size of the company, etc. There are always three steps in every budgeting technique:

1. Forecast 2. Budget: I need to translate the forecast into figures 3. Control: I need to follow that budget => control activities/budget control. It doesn’t

make sense to make a budget if you don’t follow it after. And you need to follow it on a regular basis. “On a regular basis” is different depending on the business.

Every planning-‐control system is based on the willingness to control the future, and therefore to accept the idea of forecasting


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This attitude must be team-‐based, and active rather than passive. è If you take more than one point of view you will reduce the uncertainty! If you only take one point of view, the person could be wrong…

Forecasting is more than just extrapolating the past on a predictable trajectory as if nothing was changed in the behaviors.

Forecasting is necessary, since it is the starting point of many management tools. è Forecasting is the starting point of many things, that’s why it’s absolutely necessary! Knowing the future is impossible, you may describe what you think the future is going to look like but nothing’s sure.

To know the future is impossible; however, the experience shows that available forecast data, even far from perfection, are always better than no forecast data at all

Short term forecasting

Mid and long term forecasting

Prospective

Time Horizon Close Far Very far Purpose Precise: sales

forecast, raw materials pricing, salaries evolution, etc.

Global capacities: production, distribution, etc.

Future trends

Degree of certainty High Medium Low Variables Based on current

economic environment

Based on economic trends

Qualitatives

Different times perspective for forecasts:

Ø Short term forecasting: forecast for next year (1 year) Ø Mid and long term forecasting: (3 to 5 years) Ø Prospective: really long term (over 5 years)

Short term forecasting: precise: how much

• I need to be ready this year for what’s going to happen next year. I need to have some very precise information because based on that I will have to take some actions.

• Very high degree of certainty • I am going to have a look at the current economic environment.

Mid and long term forecasting:

Ø Here we talk about global capacities. I have to think in term of global capacities, production capacities, etc. (strategic decision)

Ø Medium degree of certainty Ø I will take a look at the economic trends


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EFFECTIVENESS OF TECHNIQUE

1st basic technique: Extrapolations:

I look at the past data’s and I extrapolate. I see that I’ve a 2% increase in sales every year, I can extrapolate and prevail a 2% increase in sales for next year. It’s very effective in the short term, less effective in the mid term and almost not effective on the long term.

2nd technique: Models:

Ex: Mathematical models, etc.

Models are not effective for the short term but are most effective for the mid term (and not effective for the long term). They are only effective for the mid term then. It’s done through programs.

3rd technique: Prospection:

Prospections techniques are good for the long term but not for the short and mid term.

You may have some simple prospection techniques like: get together a group of experts. This is the most common technique. You have some much more sophisticated prospection techniques like econometric methods.


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SUCCESSIVE STEPS FOR A BUDGETING PROCESS:

PLANNING PHASE OF THE BUDGET

è Long-‐term plan: What do I expect in 3 to 5 years from now? That’s my long-‐term plan. A company wants to know what are the long-‐term objectives. It’ll reflect in the budget process. The purpose is to influence the future. It’s more active, than passive in order to make the business grow. è Functional periodic budgets: It concerns budgets established by function for a period of time. Ex: Marketing Budget, Financial Budget, R&D budget, etc. NB: Periodic implies a part of year: term, months, etc.

è I split the budget into quarterly or monthly budgets: The budget has to be split into more precise framework of time for short-‐term forecast.

CONTROL ACTIVITIES

è Once the planning set, the budget is available and departments will run their projects. Months by months the management controller will receive the results, real data. Once all data are available, a comparison with the actual-‐forecast can be made. If results are not good, 2 options:

Ø I’ve been far too optimistic with my budgets


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Ø My forecast was really good but…

è Gap analysis: I will look at the gap (between forecast and real data’s), sometimes it’s not really big, and then I’ll just say that the gap is meaningless/not significant. That’s very tricky, not easy to do, but I need to do it for the next step

è Assessment of gap relevance: Is the gap relevant or not? If it’s not relevant, no problem but if it is relevant that’s difficult. The results of the gap analysis will make place to an assessment of the gap relevance. The purpose is to know if the gap could have been forecast or if it depends on external variables. The origin of the problem is addressed. Ex: quality problems, problem of communication, crisis on the market. The origin of the problem is maybe not inclusively in the sales, but it can come from another department

è Common understanding of the gap: You have to understand the reason of the gap. You may have many reasons combined together or one single reason difficult to find, etc. I have to understand what’s the gap. Only 20% of the reasons will explain 80% of the gap => “80-‐20 rule”! I want to know the main reasons. E.g.: Because my customers are not happy

è Corrective actions: Actions that I need to take to correct the situation. It may be:

Ø “I will change my plans for the following period” => I will train my sales people; I will change something for the next period of time. It’s an action that’s supposed to have an effect on the next period.

Ø “I will change my budget” which means: I will change my objectives Ø “I will change my long-‐term plan” è it means you really change your strategy, you

have to be careful with that!

Once the reasons of the gap are known, measures can be taken to handle the problem. They are likely to be made in the planning: long-‐term plan of functional periodic budget or the split of budgets.

And so, we close the loop!

Another way to look at that:


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PLANNING: To identify short-‐term objectives è To develop short-‐term plans è To develop the budget

CONTROL: To measure and assess the performance è Reassess objectives, goals, strategy, and plans.

PLANNING AND CONTROL, ROLE OF BUDGETS

Balance sheet expected at the end of the next year for example, cash flows, …è financial figures

OPERATIONAL BUDGETS

Usually 6 operational budgets:

1. Sales budget: how much am I going to sell next year (1st month, 2nd month… 1st quarter, etc.) How many units am I going to sell? I may split the sales budget into more detailed budget. (per categories,…). It’s a forecast; it doesn’t need to be very précised.

2. Investments: What’s the amount of money I’ll have to invest next year in order to be able to run my business…

3. Production budget: taking into account what I plan to sell next year, and what I plan to invest, How much will I have to produce myself? It depends on the sales forecast and on the investment.

4. Purchasing budget: taking into account all the previous element, how much will I have to purchase next year

5. Personal and training: How much will I have to pay?


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6. Administration and other (advertising, R and D,etc.): basket where you put all the rest.

You define those operational budgets in the order above, because some of them depend on the previous ones.

FINANCIAL BUDGETS

3 usual financial budgets:

Ø Projected cash flows Ø Projected (pro forma) balance sheet Ø Projected (pro forma) profit-‐and-‐loss statement

A budget is a set of figures expressing money income and outcome, which shows whether a financial plan will help reaching organizational objectives.

Ø If a budget doesn’t contain any figures, it’s not a budget: it’s something else. Most of the time it’s expressed in “money” => Money income and outcome (but not always). The figures are not necessarily financial figures. E.g.: a company usually wants to achieve a very high reputation/ brand reputation/… it would make sense to put that into the budget, even if it’s not easy to measure and it’s not a financial figure. Other objectives you could have: You want to reach a certain number of market shares/ you want to have “happy” customers/ you want to have a given level of competencies/ you want to launch a certain amount of new products (innovation aim).

Budgeting is the process of budget preparation

The various Budgets provide a tool to communicate short-‐term objectives

Ø There are several budgets (sales budget, purchasing budget, etc.) Ø May be a motivational tool: it can motivate to know that you have to sell a certain

number of products.

BUDGETS FLOW-‐CHART FOR SALES


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CLASSICAL FLOW-‐CHART

Sales forecast: I start here.

ð Long term forecast: 3 to 5 years ð Mid & Short term forecast: next year

Starting with a sales forecast is always an obligation. It’s really difficult unless you are in a really stable business, but that happens less and less. You have to take plenty of things into account.

Based on the mid & short term forecast, I will look at what I have to produce (production). That’s not necessarily the same amount as the number of products I have to sell. Why? BMW plans to sell 100.000 cars next year; do they have to produce 100.000 cars next year? No because they might have cars in the inventory. It depends on the amount in inventory then. Maybe they will subcontract; it means they don’t have to produce themselves.

Ø Sales è Estimation Ø Production èCalculation based on the estimation.


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è Purchasing: If I know what I have to produce, I know what I will have to buy (raw materials and so on). If BMW knows they have to produce 70.000 cars, they know how much steel they have to buy therefore.

è Investment and financing: There’s an investment budget (see above), it depends on 2 elements: Long-‐term sales forecast & mid-‐ & short-‐term sales forecast.

Investment means I will invest in assets that are going to stay more than 1 year in the company (Long-‐term assets). If I look at my long-‐term sales forecast, I might see that within 3 years I won’t be able to produce enough, and I can then decide to invest in something to improve the production.

è Sales means there’s money coming in => cash flow

è Production, purchasing, investment means there’s money going out

è Every part means there’s an influence on my cash flow.

If I have a good idea of my forecast, I can deduct my cash budget, what’s going to be my cash production over time. Once I have that, I can derive to “what’s my P&L Statement forecast going to look like month by month and at the end of the year, and same for the balance sheet forecast, I will know what it’s going to look like month by month and at the end of the year.

On the long-‐term : The investment and finance of the company are also affected by the long-‐term sales forecast. Indeed, as the long-‐term concerns the future, the company can plan the new investments they’ll have to make/buy in order to support the future activities of the company.

All the upper part of the chart allows defining the budget and the balance sheet.

COMPLEX FLOW-‐CHART


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Based on the slide above, I may decide on an Investment project. I will translate my investment projects into investment budgets (a budget is a set of figures). This has an impact on the cash budget, some cash money is going out. I will also decide my short-‐term objectives => Sales budget, production budget

Production budget: In some case you may have to precise the purchasing budget, the direct labor budget and the production overhead budget. Those are the elements that impacts on the cash budget. I divide the production budget into those 3 elements. I may derive a budgeted product cost. è Direct impact on the cash budget: It helps me to define the budgeted P&L.

The difference with the classical flow-‐chart concerns the beginning: we first start with the objectives and the strategic plans instead of the forecast on a long and short term like before. This first step will impact two dimensions.

- First dimension: The objectives and strategic plans will be reflected in the investment projects that will directly define the investment budget leading to a specific cash budget.

- Second dimension: The objectives and plans will lead to the short-‐term objectives defining the sales and production budgets.


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We always have to read the graph from top to bottom to see the relations and the consequences. You get the bottom level if you fulfil the bottom level. We’ll know analyse in details one budget through an example.

You may divide your budget into variable expenses.

Ø Variable expenses = commission on sales. The more I sell, the more I get. Ø Fixed expenses = salaries, depreciation, advertising.

BUDGET PROCESS

Starting point: always a sales forecast. The budget process lies in 3 steps:

1) Estimate projected sales revenue level è ESTIMATION

Ø Historical data (You may try to forecast the sales looking at the historical sales), Current factors, Economic variables, Other factors, Specific points of focus

2) Determine profit requirements è DETERMINATION

3) Calculate projected expenses values è CALCULATION based on the elements above. There are several ways to calculate that:

Ø Incremental method Ø Method based on a percentage Ø « Zero-‐based » budget

INCREMENTAL METHOD


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Ø Estimate future expenses based on current expenses: I take every expenses and I increase/decrease them by 5% for example (always same percentage); which means that the various expenses remain the same proportion. I keep the same costs like they were last year and I will just adapt them.

Ø Current expenses levels are incremented/decremented for the new budget Ø Based on the assumption that past year’s cost were justified and reasonable Ø Any inefficiency may be reproduced in the new budget! If an expense wasn’t

necessary, it will still be there next year. The problem with that method is that I base it on the assumption that every expense was necessary; which may be false. If I lost money last year because of inefficiency, I will still loose money this year.

Example of the incremental method:

- For the sales: If we want to increase our sales by 10%, we have to increase all the elements in the chain by 10% to reach the decision. And, we’ll have the increase in the future

- For the expenses: If last year, there were excessive expenses, the new budget will take on this charge. The expenses can’t be deleted. They are transferred to the next year. It’ll be less efficient and it’s going to be wrong in the future.

PERCENTAGE METHOD

This method is similar to the previous one, but we increment/decrement a percentage of the expenses each year.

Ø Based on the current % of each expense compared to total expenses Ø Uses the same % for next year. I keep the cost structure identical for the next year. Ø Based on the assumption that past year’s costs were justified and reasonable. Ø Any inefficiency may be reproduced in the new budget!

« ZERO BASED » BUDGET

Ø Build the expenses of the new budget « from scratch » Ø Previous year’s % are ignored Ø Each expense must be justified Ø Don’t produce inefficiencies in the new budget Ø But is really time and energy demanding

Idea: I don’t want to look at what was happening last year, I want to start with a blank paper, I start from scratch. I don’t look at the figures from last year and increase/decrease


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them. Each expense has to be justified then (>< 2 previous methods). Here I don’t reproduce inefficiencies. It takes a lot of time and a lot of energy to proceed like this.

What would you recommend? Starting from scratch again might not be a bad idea from time to time. Zero based-‐budget every year is not the good solution, but you might do it every couple of year or every 3 years. Every year is a bit too much. During 2 or 3 years, use then the easiest method: percentage method or incremental method.

How many years? It depends from the business and from the volatility of the budget.


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CHAPTER 4: CAPITAL BUDGETING

In the Management Control function you will have to make the good decisions and one of the usual decisions is an investment decision. Is it a good idea to invest in that machine? To invest in that company? To invest money there…?

I will have to help the top management to take the right decision, the right investment decision. Whenever I need to invest money, not as current expenses, it’s going to be called capital budgeting.

Capital Budgeting is the process of identifying, evaluating, and implementing a firm’s investment opportunities.

It seeks to identify investments that will enhance a firm’s competitive advantage and increase shareholder wealth. You don’t invest in something if you don’t get a “payment” (?)

The typical capital budgeting decision involves a large up-‐front investment followed by a series of smaller cash inflows. If I want to use a robot in a factory, that’s a huge up-‐front investment. Purchasing price + installation + training and so on, but why do I want to use a robot in a company? Because I will save some money, I want to automate some activities. Those smaller benefits I will get them on a long period of time. During 10 years for example I will save an amount of money, and that amount of money is the profit that I’ll get from that investment. I will then compare. In some cases the total profits are going to be higher but not always. If they are going to be higher, it’s a good idea to invest.

Poor capital budgeting decisions can ultimately result in company bankruptcy. If I don’t look carefully enough to the figures, I might have problems.

KEY MOTIVES FOR MAKING CAPITAL EXPENDITURES

Expansion, Replacement, Renewal, Other purposes:

- Replacing worn out or obsolete assets : machines, investments, equipment. - Improving business efficiency: new products up to date. - Acquiring assets for expansion into new products or market: most of the time, we

need additional assets to enter into a new market. - Buying a new business - Comply with legal requirements: less emission, more ecological, trade union. - Satisfying workforce demands - Environmental requirements


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EXAMPLES OF MOTIVES FOR CAPITAL EXPENDITURES

STEPS IN THE CAPITAL BUDGETING PROCESS


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Overall process:

I will ask people (everybody/the managers/etc.) to make proposals: “would you need some specific investments?” “Is there something you need?” They will then generate proposals. Those proposals are not always going to be accepted.

They will review and analyze those proposals in order to make a decision: which one am I going to accept/decline. They will then implement the investment and there’s going to be a follow-‐up.

BASIC TERMINOLOGY

MUTUALLY EXCLUSIVE VS INDEPENDENT

Ø Mutually Exclusive Projects are investments that compete in some way for a company’s resources. A firm can select one or another but not both.

Ø Independent Projects, on the other hand, do not compete with the firm’s resources. A company can select one, or the other, or both -‐ so long as they meet minimum profitability thresholds.

UNLIMITED FUNDS VS CAPITAL

Ø If the firm has unlimited funds for making investments, then all independent projects that provide returns greater than some specified level can be accepted and implemented.

Ø However, in most cases firms face capital rationing restrictions since they only have a given amount of funds to invest in potential investment projects at any given time. You know that next year you will have to invest up to 1.000.000 euros… The total may not go beyond…

ACCEPT-‐REJECT VS RANKING


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Ø The accept-‐reject approach involves the evaluation of capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criteria. I may decide to look at every project with very specific acceptance criteria! My investment has to be profitable.

Ø The ranking approach involves the ranking of capital expenditures on the basis of some predetermined measure, such as the rate of return. I could decide to keep the top 3, or top 5. If I accept to keep the top 3, the 3rd one might only have a 3% return on investment, and I have to accept that.

JUSKICI


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CHAPTER 5: CASH FLOW

Cash inflows: income specifically related to the project. In this case it’s always 2000 $, we don’t need to calculate to know if it’s profitable. The initial investment is 10.000 $ and we earn 2000 $ every year during 8 years.

If we only had cash inflows during 5 years, would it be an interesting investment? No I prefer to have 10.000 $ now than in 1 year.

Is it much profitable or not so much? If I want the answer I will have to make calculations.

It’s not an income, it’s not a profit: it’s a cash flow! It’s not the same.

In the example above we have cash flows every year. (Inflows and outflows)

THE RELEVANT CASH FLOWS

INCREMENTAL CASH FLOWS

Incremental cash flows are cash flows specifically associated with the investment, and their effect on the firms other investments (both positive and negative) must also be considered.


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IKEA: They have a store in Zaventem & want to open a new store in Anderlecht. They open a new store in order to attract new customers. Nevertheless they will also attract existing customers of Zaventem: Cannibalization.

ð It will have to be taken into account.

If I expect 1.000.000 euros sales, maybe in my calculation here that’s not 1.000.000 euros that I need to take into account. è Incremental cash flow.

Maybe 800.000 will come from existing customers from other stores.

Incremental = I decide to launch a project and because of that project, this cash flow shows up.

MAIN COMPONENTS

ð Initial Investment

For example, if a day-‐care center decides to open another facility, the impact of customers who decide to move from one facility to the new facility must be considered.


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ð Operating Cash inflows ð Terminal cash flow: I might have it the next year because some things could happen.

Typical way:

Outflow (= initial investment) then series of inflows (= operating cash inflows and terminal cash flow)

TERMINOLOGY

APD ICI NOTES A LA MAIN

EXPANSION VS REPLACEMENT CASH FLOWS

EXPANSION CASH FLOWS

è Ex: creating a new plant (a fourth one)

No problem: Estimating incremental cash flows is relatively straightforward in the case of expansion projects, but not so in the case of replacement projects. è Cash-‐flow specifically coming from the project/ specific to the project

REPLACEMENT CASH FLOWS

è Ex: you want to replace something (machine, pc, etc.)

With replacement projects, incremental cash flows must be computed by subtracting existing project cash flows from those expected from the new project. Incremental cash flows must be calculated by subtracting everything that’s coming from the old equipment because it might generate cash flows when existing.


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Those are the formulas that we are going to use.

SUNK COSTS VS OPPORTUNITY COSTS

• Note that cash outlays already made (sunk costs) are irrelevant to the decision process.

• However, opportunity costs, which are cash flows that could be realized from the best alternative use of the asset, are relevant.

INTERNATIONAL CAPITAL BUDGETING

• International capital budgeting analysis differs from purely domestic analysis because:

o Cash inflows and outflows occur in a foreign currency, and o Foreign investments potentially face significant political risks

• Despite these risk, the pace of foreign direct investment has accelerated significantly since the end of WWII.

EXAMPLES OF RELEVANT CASH FLOWS

ü Cash inflows, outflows, and opportunity costs ü Changes in working capital ü Installation, removal and training costs


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ü Terminal values ü Depreciation

CATEGORIES OF CASH FLOWS:

• Initial Cash Flows are cash flows resulting initially from the project. These are typically net negative outflows.

• Operating Cash Flows are the cash flows generated by the project during its operation. These cash flows typically net positive cash flows.

• Terminal Cash Flows result from the disposition of the project. These are typically positive net cash flows.

FINDING THE INITIAL INVESTMENT

The basic format for determining initial investment:

EXAMPLE: TAX TREATMENT ON SALES OF ASSETS


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Powell Corporation, a large diversified manufacturer of aircraft components, is trying to determine the initial investment required to replace an old machine with a new, more sophisticated model. The machine’s purchase price is $380,000 and an additional $20,000 will be necessary to install it. It will be depreciated under MACRS using a 6-‐year recovery period. The firm has found a buyer willing to pay $280,000 for the present machine and remove it at the buyers expense. The firm expects that a $35,000 increase in current assets and an $18,000 increase in current liabilities will accompany the replacement. Both ordinary income and capital gains are taxed at 40%.


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FINDING THE OPERATING CASH-‐FLOW


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Powell Corporation’s estimates of its revenues and expenses (excluding depreciation), with and without the new machine described in the preceding example, are given in next slide. Note that both the expected usable life of the proposed machine and the remaining usable life of the existing machine are 5 years. The amount to be depreciated with the proposed machine is calculated by summing the purchase price of $380,000 and the installation costs of $20,000.


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58


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FINDING THE TERMINAL CASH-‐FLOW

Continuing with the Powell Corporation example, assume that the firm expects to be able to liquidate the new machine at the end of its 5-‐year useable life to net $50,000 after paying removal and cleanup costs. The old machine can be liquidated at the end of the 5 years to


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net $0 because it will then be completely obsolete. The firm expects to recover its $17,000 net working capital investment upon termination of the project. Again, the tax rate is 40%.

SUMMARIZING THE RELEVANT CASH FLOWS

HOW TO HANDLE UNCERTAINTY

• Sensitivity Analysis -‐ Analysis of the effects of changes in sales, costs, etc. on a project.

• Scenario Analysis -‐ Project analysis given a particular combination of assumptions. • Simulation Analysis -‐ Estimation of the probabilities of different possible outcomes.


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• Break Even Analysis -‐ Analysis of the level of sales (or other variable) at which the company breaks even.

SENSITIVITY ANALYSIS

EXAMPLE

Given the expected cash flow forecasts listed on the next slide, determine the NPV of the project given changes in the cash flow components using an 8% cost of capital. Assume that all variables remain constant, except the one you are changing.

POSS IBLE OUTCOMES


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NPV calculations for pessimistic investment scenario

NPV Possibilities

SCENARIO ANALYSIS

EXAMPLE (CONTINUED)

Cash-‐flow (year 1-‐12)


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BREAK EVEN ANALYSIS

EXAMPLE

Given the forecasted data on the next slide, determine the number of planes that the company must produce in order to break even, on an NPV basis. The company’s cost of capital is 10%.

ANSWER

Ø The break even point, is the # of Planes Sold that generates a NPV=$0. Ø The present value annuity factor of a 6 year cash flow at 10% is 4.355

Thus,


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Solving for “Planes Sold”

Planes sold = 63


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CHAPTER 6: BUSINESS EVOLUTION

WHAT ARE THE KEY ELEMENTS OF THE RECENT BUSINESS EVOLUTION?

How can we collect info from operations?

It’s difficult to measure things especially in this environment.

ð More cross-‐functionality

Take large processes that analyze more process.

ð Stronger relationships with Customers & suppliers

Relationship with the customer is much stronger, same for the suppliers.

Today many automobile manufacturers say to the suppliers: we’ll five you access to all computer systems, you will look when we need raw materials and you will bring them to the manufacturing place, so that we don’t interfere with you. You enter the manufacturing place and you bring it to the place where it’s needed.

ð The market requirements

ð Globalization

ð More need for innovation: o Shorter life cycles (much shorter, especially in electronic equipment). o Time-‐to-‐market more critical: time it takes to bring to the market a new

product or service.

ð Competencies are enhanced


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Level of needed competencies is much higher

PARALLEL BUSINESS TOOLS EVOLUTION:

ð TQM

= Total Quality Management.

Focus on customer helps.

Way to secure the output of the process and not only it is good but it’s exactly what the customers expect to have. In many cases company from the apst were ready to accept ... the right output. TQM doesn’t accept that idea. 95% of the customers are good but it means that 5% that’s not good and that costs a lot of money.

ð JIT

Just In Time: work without intermediate inventories.

…

Whenever there’s a problem the full line has to stop, that’s what Toyota developed.

ð TBC

= Time Based Competition

All the tools that will help the company to shorten le life cycle, the production cycle, etc.

ð Lean production

A production with a minimum of overrates

Minimum production overate: minimum administration and so on.


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ð Customer-‐focused organization

No explanation

ð Re-‐engineering

Completely re-‐inventing an existing process because we are not happy with this process. Replace a process with a new one. Just a human improvement isn’t enough, there’s a need to change the process. Ex: manually => by computer.

Process have a cost, it takes a while and has some cost. In 90 to 95% of the cases, the process cost was higher than the repair cost. If it’s higher, that’s non-‐sense, something is wrong with that process, need to change this process, to use a new one.

ð ABC

Quite recent.

ð Empowerment

Giving authority to people.

BUT…

ð Results sporadic or disappointing. Results are not really good. Many companies are not happy with that. There has been some improvement but…

ð Weak cause-‐and-‐effect relationship with the strategy ð Limitations of finance and accounting tools and methods. For example, how to

measure the financial value of: (Standard accounting methods => very clear limitations)

o New products « in the pipe-‐line »?


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You have money you want to invest (?), let’s imagine you want to invest in pharmaceutical company, you hesitate between 2, the figures are the same for both companies (Balance Sheet, Profit and Loss statement, … everything based on the financial information is the same!) but you know that one company has 20 products under development, while the second one has only 10! Which of the two are you going to chose? Which one is more likely to succeed? The first one ! 20 products in the pipe-‐line.

o Process capability?

What’s the process is capable of doing or not?

When you take two identical production lines (same machines, process, etc.), you start one production line in Europe and the other in Japan. Systematically after a couple of years, one production line is doing better than the other. Its capability has been improved, but no investment has been made. Financially it’s impossible to detect that smth has been changed. Changing in some of the production steps, … something happened that’s not possible to detect from a financial point of view.

Better company but again, impossible to see that from a financial point of view.

o Personnel competency?

Not smth that you can measure based on the financial and accounting data? You can pay someone more, but it doesn’t mean he’s better or works better.

o Customer loyalty?

More able to invest if I see a better loyalty from customers.

o Quality of the databases?

ð No systematic feedback process on the effectiveness of the strategy.

MAC is about giving a good visibility to take good decisions.


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LIMITS OF FINANCIAL MEASUREMENTS OF PERFORMANCE

ð Focus on the short term, less on long-‐term investments ð The system favours tangible investments, with an easy-‐to-‐ measure return ð Too much emphasis on investments that can easily be valued ð Companies with high amounts of assets can operate unefficiently as long as short-‐

term results are good.

Investing in training, reputation of a company…

Whenever a company wants to invest in a huge machine or smth else, you will find a financial analysis with details…

A BALANCE IS NEEDED BETWEEN:

ð Traditional financial measurements: you need to complement them with other types of measurement:

ð The specific needs of the new business environnement

AND YOU ALSO NEED A BALANCE BETWEEN:

ð Short-‐term constraints ð Long-‐term goal

Complement traditional financial measurements (focused on the past) with measurements on « drivers » of future performance.

“BALANCES”


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Balance between the financial type of measurement and the non financial type of measurement. More and more, for a Management Controller, the reporting will be made by a mix of those 2 elements. A good reporting is not linked to … it’s a mix of financial information and non-‐financial information.

Cost, profitability, sales, amount of sales, … etc. all those examples are financial pieces of information.

Non-‐financial information: (necessary for business to take decisions) Customer loyalty, customer satisfaction, employee’s motivation, etc. are not financial! It’s crucial for the business but you don’t measure it financially.

Non-‐financial information are much more oriented towards the future. It doesn’t mean we can measure the future, that’s impossible.

Customer satisfaction: why do we pay attention to that? Probably because if you get satisfied customers you will get more sales. When I measure it, it’s because IN THE FUTURE I hope to have more sales. If I see an increase, I may expect, in the future, to have increased sales.

This is sometimes called a driver of financial reasons. And it’s good to pay attention to what’s the driver of financial reasons. Sometimes the driver is going to be non financial reason.

EXERCISE

ð Provide a definition of « strategy» ð Provide 3 attributes of a sound strategy


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ð Name 5 company’s areas that might be impacted by a strategy

4 categories of measurement:

-‐ CUSTOMERS: information related to customers: financial or not. But when it relates to customer, I put the measurements inot that category

-‐ FINANCIAL: that’s where I’ll put all my financial measurements (ROI, etc.). -‐ INTERNAL BUSINESS PROCESSES: production processes, logistic processes,

distribution processes, etc. whenever a measurement is related to that, I will put it into that category.

-‐ LEARNING & GROWTH: Where I will put any measurement related to the people, generally speaking. Personal development. Learning (training, etc.). Any measurement related to the development of the needed competencies. Things like measurement of the competencies needed, employee satisfaction/moral/retention/turnover etc., training level, training effort, training cost. All those things. It has to be related to personal.

Any important business measurement can be put into one of those 4 categories.

When you want to define and manage a strategy, you have to translate your strategy into those 4 categories. I can’t imagine that it’s possible to have a strategy that doesn’t have an impact on those 4 categories. A strategy impact on the categories!


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A very good reporting system will have to address at minimum measurement in those 4 categories. If not, bad.

In terms of finance, the basic question you have to answer to: “how do we look to shareholders?” => Maximum profit? Regular profit? Secured profit? What do they want? It might change from one shareholder to another! They don’t want necessarily the maximum. The answer to that question will tell you what you need to put in term of measurement. The measurement is going to provide the right visibility.

One I answered the previous question:

In a customer perspective: “how do customers see us?”. Ex: for Ryanair: they want to be seen as the cheapest flying company. It depends on who are your customers.

In an internal business process perspective: “what must we excel at?”. Where you need to be excellent, to perform really well? It may be a distribution process, a marketing process, a R&D process. It depends on the question above: how you want to be perceived. Not all your business processes need to be top, only some of them.

Given the processes where I need to be very good, I can ask me the following question.


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In an innovation & Learning perspective: “Can we continue to improve our employees skills and create value for our clients?”

…

We’ll start to look into each of those categories.

Measurements are not enough. Companies need a strategy management system, aiming at:

ð Clarify and translate vision and strategy ð Communicate strategic objectives and measurements, and make a clear link

between them. ð Plan and align strategic initiatives stratégiques, and assign them objectives. ð Improve the feedback and the learning process.

OPERATIONAL AND STRATEGIC FEEDBACK

Operational loop – strategic loop (cf. previous course).


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Strategic measurement => 4 categories: finance, customers, employees, internal processes. It’s going to help to translate strategy into measurement.

Measurement of outcome and Outcome = operational output.

A mix of financial and non-‐financial key indicators: is that enough to have a sound measurement system?

Is it enough?

NO !

Why? Because you need to have measurements but also objectives. When I see a measurement without an objective, … it doesn’t make sense. Do you achieve this objective? If a measurement not related to an objective: why do you measure that?

For example, a BSC (Balanced ScoreCard) is made out of a serie of objectives and measurements with a clear link between them, consistant and mutually reinforcing.

Think about flight simulator...

Focus on the cause-‐and-‐effect relationship:

ð A strategy is a set of assumptions about cause-‐ and-‐effect relationships. ð These relationships must be explicit, so that they can be managed...and validated. ð They must cover 4 perspectives.

The flow of cause and effect is always the same. Start from the top.

New definition of a strategy.


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LINKAGE BETWEEN CAUSES AND STRATEGIC ACTIVITIES


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An example of a cause and effect relationship can be outlined as follows:

ð IF we improve Leadership Capability AND give employees the Skills and Training they need to perform their jobs, THEN we will improve Employee Satisfaction & Motivation

ð Consequently, IF we improve Employee Satisfaction & Motivation, THEN Productivity will increase since Employee Satisfaction & Motivation is a driver of Productivity

ð IF we increase Productivity, THEN Cost will Decrease which will ultimately result in an Increased Return on Investment


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BSC = Balanced ScoreCard.

Are there positive aspects to that?

1 without 2: Lagging indicators without Leading indicators

ð Is silent about how to achieve results ð Does not provide early feedback on the success of strategy implementation

2 without 1: Leading indicators without Lagging indicators

ð May well provide short-‐term operational improvement ð But is silent about whether this is translated into sales increase, new customers,

market shares, financial results, ...


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It’s good to start with generic measurements:

First you will plan. When am I going to start? You don’t have to panic cause you can always start with generic measurement.

…

Generic measurement: you need to look at it when you start from scratch, when you start with a white sheet of paper.

Financial: Most of the time you will measure 2 or 3 financial elements, like ROI.

Customer


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Internal processes: you need to have an idea about the output. You need a quality measurement.

Those 3 elements are absolutely necessary. Why? If you only want a good quality, it might be really expensive (cost).

You should say “I want a good quality but not at any cost”.

…

Learning and growth: Important to have satisfied employees. You have to find a way to make your employees happy. Salary is not the best way, but empowerment, team spirit etc. are.

…

A balanced set of measurement will be set between a balance in those 4 categories???

…

High correlation between some of those elements: ex: difficult to ask a non-‐satisfied employee to be innovative.

Now we need to get more specific measurements, related to a given strategy.

Examples of strategic focus:

ð Business growth – one aspect may be the BG. My strategy is “I want to grow my business”. It can be growth through acquisition, or another type of growth. Not all strategies are growth-‐oriented.

ð To lower the risk for example through diversification. It can also be another strategic focus.

ð To increase the productivity or to lower the cost. ð Etc.

Most of the time the MC is not part of the team who’s going to decide on the strategy. He is in the middle management, not in the top management.

=> The clearer the strategic focus, the less measurement needed. <=

PERSPECTIVE MEASUREMENT


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FINANCIAL PERSPECTIVE

On which critical factors depend the relevant financial objectives?

ON THE LIFE CYCLE

Growth:

Example of the CD. It has been invented 25 years ago (+/-‐). Sales boomed for some years and then it became stable and now it’s decreasing because it’s the end of the CD’s life. It’s the same for any product.

ROCI = Return On Capital Investment.

Sustrain:

That’s where you really need to have a great profitability.

ROCE = Return On Capital Employed.

…

depending on where I am I will get more attention to some of the financial measurement & objectives (?)

MAIN STRATEGIC THEMES


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I may want to growth my revenue, to reduce my cost, or else.

E.g.: In some businesses, like the printing companies (newspapers), it’s quite impressive cause sales are huge, and one of the printers is a 100-‐meter long, and is really expensive. That asset has to run all the time; it may not stop, in such a business. Whenever it stops, I loose a lot of money. The asset HAS to work. (Asset usage).

Ryanair wants to minimize the time the plane is on the ground, that’s what they pay attention to! Planes are staying 25 minutes on the ground between two flights.


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I have all possible combinations. Depending on where you are, you will probably favour specific measurements.

CUSTOMER PERSPECTIVE

Represent the sources of the « revenues » that are part of the financial objectives.

Customers are going to bring me money => Sources of revenues. If they are happy to do business with me, first they will come back, and second they might be ready to pay some more money. If they are not happy they might leave to go to the competitor.

GENERIC MEASUREMENTS

Some generic measurement related to customers :

- Customer satisfaction : a company wants to have the answers to the question of satisfaction. If a product fulfills the customer needs and expectations. If a customer is highly satisfied, he’ll be loyal to the company and we’ll have a high level of customer retention. The way to measure it is to run a customer survey. The customer satisfaction is driver of the customer retention and customer profitability because customers will be ready to buy a product at a very high price.

- Customer acquisition : the mouth-‐to-‐mouth effect is an essential element to acquire new customers.

Rien suivi.

ð Measured by most of companies.

It’s not because it’s generic that it’s not good for us. It probably is.


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BEYOND GENERIC MEASUREMENTS

Measurements on attributes (factors)

Beyond generic measurement, there are measurements on attributes (factors) :

Value = product/Service attributes + image + relations

- Product/service attributes: it lies in functionality, quality, price and time. - Image: the image of a brand can influence customer’s choice (ex : Abercrombie,

Ferrari). It will pass a message. - Relation: the relations with the customer can play a role !

Each product of service represent a value …

It may come from the image or frome a specific relationship you have with a company.

Attributes:

-‐ Functionality -‐ Quality -‐ Price -‐ Time

E.g.: Ferrari: …

How to measure customer satisfaction? Best way = survey.

A customer survey is run to know the global satisfaction. It must be carefully realize because the answers are crucial for the company. So the questions must be specific and pertinent. Questions concern different element of the company strategy : product quality, delivery terms offered, on time delivery, ease of contact. All these elements help to measure global satisfaction. The answers will range between very unsatisfied, unsatisfied, neutral, satisfied


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and very satisfied. It’s important to ask the main question at the beginning of the survey : Are you globally satisfied ? Firstly, the customer will answer the question and then underline the reasons.

Survey where you ask a couple of question:

1) question about the global satisfaction a. About the Product quality b. About the delivery terms offered c. About the “on time delivery” d. … e. About the ease of contact

Ø Plenty of questions.

You don’t want to have twenty measurements, you only want one, If you have to choose one, which one would it be?

You have to take the measurements, analyze them and interpret them.

Interpretation of the survey

We can see that the global satisfaction is about 95% and the factor “ease of contact” is completely unsatisfied (98%). So, we can conclude that this factor plays no role and doesn’t have any incidence on the global satisfaction. As a result, a company can decide to focus on the three other factors : product quality, delivery terms and on time delivery which are more relevant. So, in a nutshell, we can increase our global satisfaction by focusing on a small series of factors instead of analyzing plenty factors.


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Ø 95% of the customers are unsatisfied. o 90% are satisfied with the product quality. o etc.

If you are a MC, your job is to interpret that and to deliver a message to the top management (?).

Interpretation: we’re not in a good situation. There might be a couple of reason therefore but the main reason obviously is the “on time delivery” here, because for all the other aspects don’t make the customers unsatisfied. So it means there’s a need to improve the on time delivery.


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Here the problem clearly is the ease of contact. However, it doesn’t seem to play a role in the global satisfaction (Very Satisfied). It’s not a driver. It’s not linked to the global satisfaction.

Trying to improve the ease of contact would be useless cause it wouldn’t improve anything else, even the global satisfaction because it’s not linked. It would only be a lost of time and money. That wouldn’t be a good management decision!

Looking at the relationship between the figures would lead to good management decisions. Looking at that is a must.

You might need to keep on calculating that (do I keep this question in the survey or not?).

INTERNAL PROCESS PERSPECTIVE

In this perspective, we identify the key processes (critical for customers and financial results) Ex: product equipment, R&D, billing processes. It typically comes in third logical steps

Generic measurements range from quality, cost, cycle time and “throughput”(don’t pay attention to this one).


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EXAMPLE OF MEASUREMENTS

The internal process starts with the customer need identified and ends with the customer need satisfied. Within this framework, other processes take place:

- Innovation process: it allows to identify the market and to create the Profit and Sale (P/S) offering. The measurements are It concerns % sales from new products, new production introduction vs. competition (are we going to introduce more products than the competitors), process capability and time to market (the time it takes between the identification and the operation process), BET metric (Break even time metric : it measures the time it takes to reach the break eve).

- Operation process : it allows to build and deliver the profit and sales. The product

will be produced and sold. The measurements are MCE (Manufacturing Cycle Efficiency -‐ it concerns the difference between the moment we start producing a product and the moment the product is finished), FPY (First Past Yield – it concerns the first control. After the realization fo the product, they are controlled and the amount of products controlled positive represent the first past yied. The faulties are returned. If after the first step in control, 80% of the products are OK, we don’t need to adjust it. 80% of FPY), ABC process cost.

- Postsale service process

LEARNING AND GROWTH PERSPECTIVE


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Are the people happy to work in my company? If yes it will probably improve the employee productivity and the employee retention. => Results…

Driver of employee satisfaction

- Competencies: two possible situations o You have a high degree of competencies and the company doesn’t use those

competencies. You don’t feel happy, even though the salary is really good. o You don’t have that much competencies and you have hard work to achieve.

Best way to measure competencies: …

- Technology & infrastructure Tools that are given to you to achieve your work

- Climate for action (am I part of a team, is my relationship with my boss… etc.)

Core measurements


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Concurrently with the customer satisfaction, employee satisfaction brings employee productivity and retention. Happy employee will be motivated to work and more productive. On the other hand, they’ll have no reason to leave the company. They gave good results.

How to measure these elements ? A good measure is a employee survey to get a right feedback and to take action. The purpose is to ask the main question (are you globally satisfied ?) and then move on to more detailed and precise questions to bring up the main reasons.

Enablers

- Competencies are important to know if employees fulfill the requirement for the job. The solution will be to offer training to employee in order to reach their self accomplishment. Measurement rely on strategic skills, training levels and skill leverage.

- Technology structure: this aspect can be relevant to know if the equipment employees have at their disposal are efficient. Measurement can concern strategic technologies (computers), strategic databases, experience capture and patent, copyrights.

- Climate for action : the company wants that its employees perform well in a good work sphere. If employees don’t have objecive, there is no action. Measurement consist in motivation, empowerment and alignment.

How to link measurements to the strategy?


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- Cause and effect relationships: Measurements has to be mixed to show their consequences and causes. Without cause and effect relationship, we’ll get a random sample of results unrelated with the relevant information.

- Use of performance drivers - Link with financial indicators

Group: assignment

- list all of the possible management control issues. And pick up the more relevant. - Rank the issues by importance the first one is the most important - For the top 3 issues, what are the solutions ? What are you going to do? - To outline what would be a good set of measurements based on the 4 perspectives. - Based on the information that we have, what would be a good example of effective

balance score. Be very specific.


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OTD is of critical importance, this is my top priority, if pressure, “please improve on time delivery, achieve a good level of OTD” that’s your objective, if you don’t reach it: consequences. Whenever one put a serious pressure on you, you’ll find a way to achieve your objective. That might be dangerous for the company. Why?

Not a good idea to have huge level of inventory. If I tell you my only priority is to improve OTD, you’ll find a way to achieve it, for example by having a huge inventory, but that’s not what I want. I want an improvement in OTD without having an inventory going to the roof !

My message must be a little bit more sophisticated than “improve the OTD”, it musts be: “improve the OTD without increasing the inventory”.

Time to market => objective = to decrease it.

The things I put pressure on (OTD & Time to market) are Strategic measurements: reflect what I want to achieve, part of my strategy. The reactions are not part of the strategy!

+ Diagnostic measurement (reactions).

SOME FIGURES

Results of survey:

• 59 % of top managers have a clear understanding of how to implement a vision. • ...and only 7 % of middle managers

o 74 % of top managers have bonuses linked to yearly objectives


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o < 33 % of top managers have bonuses linked to long-‐term strategic objectives

o < 10 % of middle managers have bonuses linked to long-‐term strategic objectives

Typical symptom: the use of different processes for:

• Long term strategic planning • Short-‐term annual budget

EXAMPLE

OBJECTIVE MEASUREMENT TARGET INITIATIVE

Value for money as perceived by Customers

Customer survey #1 by 75% of Customers

Focus Group

…

In a reporting system, just a figure is meaningless. If I know that net profit is 8%, I tells me something but not much… There’s a need for words.

“I want to be perceived by my customers like someone …”, once I know my objective, I have to decide how to measure it. Then I’ll define the target, with a figure. And then I may decide on a strategic initiative to achieve this objective.

In the previous system, deviations against established plans were considered as defects, which is not an incentive to check whether:

• Objectives were relevant • The method used to reach them was appropriate

Strategy is a process, and strategic ideas may origin from the whole organization.


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Three basic elements for a strategic learning process:

• A shared strategic structure, that communicates strategy and allows everyone to see how his own activities contributes to strategy achievement.

• A feedback process that collects data and allows to test assumptions made on links between objectives and initiatives.

• A team-‐based problem solving process, that analyse the data, draw conclusions and, when necessary, adapt strategy.

§ Correlation analysis § Scenario analysis § Initiatives review § External review § Anecdotes reports

• Step 1: 3 months, a team of top managers • Step 2: 6 months, from n to n-‐2. • Step 3: 1 month: elimination of non-‐strategic investments and start of change

programs • Step 4: 3 months, review of various BSC’s


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• Step 5: « refine » the BSC • Step 6: after 1 year, communication to the whole organisation. n to n-‐3 have their

individual objectives linked to BSC • Step 7: 3-‐5 year objectives settings for each measurement in the BSC. Identification

of needed investments. The first year becomes the annual budget. • Step 8: Monthly & Quarterly reviews • Step 9: Annual strategic review with update • Step 10: Each employee must link his individual objectives to those in the BSC.

WHY IS THAT NOT SIMPLE?

• Structure defects (ex. only « lagging measurements ») • Organizational defects

o Unappropriate delegation o Copy-‐paste of « best-‐in-‐class » o Wait too long for the perfect BSC

3 CRITICAL ROLES

• Architect • Change agent • Communicator

IT SUPPORT TOOLS


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In many of the recent ERP systems, you have balanced scorecard tools.


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You may really double click on those sections and have the following screen :

This is a practical tool; balanced scorecard isn’t a theoretical tool. A company uses it.


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CHAPTER 7: TECHNIQUE OF COST ACCOUNTING

ALLOCATION OF COSTS

Why is that important? When we talk about cost allocation, we talk about allocation of indirect costs; we don’t allocate direct costs.

Remember that Indirect Costs of a particular cost object are costs that are related to that cost object but cannot be traced to it in an economically feasible (cost-‐effective) way. These costs often comprise a large percentage of the overall costs assigned to such cost objects as products, services, customers, and distribution channels. Why do managers allocate indirect costs to these cost objects?

Example of direct costs:

- Raw materials: I can link/trace it directly to a unit being produced, the cost of that raw material I can trace it to the unit produced.

Salary: can be direct or indirect, it depends on the cost object. I want to relate that cost to a given cost object.

Salary of a supervisor: if the cost object is the unit produced by the manufacturing plant, if that’s the cost object, is the cost direct or not? Indirect, because not easy to link to the production of 1 unit.

Salary of the plant manager, supervisor: how can you link it? On the basis of what are you going to allocate it? It’s not easy to allocate, so it’s indirect.

It’s never impossible to relate a cost, but it’s direct or indirect depending on the fact that it’s easy or difficult to relate to…

So DIRECT or INDIRECT is a first classification in COSTS.

Second classification: FIXED or VARIABLE.

You look at the behavior over time, is it fix or does it vary over time? No cost is really fixed over a long period of time. Ex: the rent of a building is going to change, but is typically going to be fixed for 1 year.

Costs problematic for a company are not the variable costs. If you only have variable costs in a company, you’re not going to go bankrupt. Running a company with only variable costs is really comfortable.

Fixed costs are staying the same. Management controller will like to look at fixed costs because they are dangerous, and they are going to look at the indirect costs (direct costs are never a problem).


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I want to have a real idea of my TOTAL COST. If I have a very precise idea, I can take the right decisions.

How do we compute that total cost? For direct cost it’s easy but what about indirect costs!

How do I distribute it to each unit, what are the rules? That’s what we are going to cover here.

It’s very often quite significant, 20-‐35% of the total cost of a company!

Why do we watch those costs?

May influence the total cost. If my cost allocation base doesn’t make sense, some of my products might be overcosted of undercosted (receive more or less costs in indirect costs that they should receive).

…

Some allocation rules make sense, some other don’t.

IT Costs: costs of the IT department: what would be a good cost allocation base? Distribution on the basis of what ? We don’t have to pay anything if we don’t use any PC for example. We should use the number of PC for example, as a basis. If no computer, no IT costs.

…

Problem in many companies: the reliability of the data. => using timesheet data. Once a month, use the timesheet and try to remember what they did 3 weeks ago… It’s not going to provide reliable data. …


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If I know the total cost and the income of that, I just look at the difference between that, and I know if it’s profitable. If it’s not I could think about deleting it.

Comparison between income and cost.

It’s not because it’s not profitable that you will directly stop the product line. You might keep it for strategic reasons. Sometimes you loose money on one part of the activity, but you earn money in another part, which compensates the loss.

I’m in a research company, and I work on 4 projects. One of them is subsidized.

…

Is the photocopy machine SPECIFICALLY allocated to the project? Justify !!!

This is my cost object (ex: a product which I produce and sell, a project, a customer, a department, anything about which you want to have information about the costs).

Direct costs: directly linked, traced to the cost object.

Indirect costs: 2 categories. They are not traced, they are allocated, and I need to define an allocation method/base.

- producing department indirect costs - supporting (service) department costs (HR, IT, General services department, etc.)


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I have to make a clear distinction between those department where action takes place.

PRODUCING DEPARTMENT OVERHEAD

The cost of direct labor and direct materials can easily be identified and charged to specific jobs. All other costs, such as indirect materials, indirect labor, and other entity expenses which cannot be identified with or charged directly to specific jobs, are called producing department overhead. These indirect costs are categorized as fixed, variable or semi-‐variable.

Direct material: used to build the car for example.

Indirect materials: paper for the photocopy machine, stitches, etc.

Direct labor: made out of the cost for the people working directly

Indirect labor: secretaries, supervisor, IT people, etc.

Other costs, not direct or indirect, we call that sometimes PDO (see title).

…

The name « factory overhead » (« factory » meaning actually « producing department ») is widely used instead of « producing department overhead ». We will also use it here, but please keep in mind it is not just for manufacturing: it is equally applicable to service businesses such as audit companies, research laboratories, project companies, etc....

…

No distinction between a company with a production department producing cars (tangible element) and for example an audit company, where they produce audit, which is a service (intangible element). => Producing department.

Factory department has the same meaning but it’s better to use producing department because it doesn’t make a distinction between tangible and intangible elements produced.

11/12/12:


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Direct cost + allocated indirect cost = TOTAL COST => Basic information that you need (but not the only one). Costs that are not direct are indirect.

Salary of the company’s boss is going to be spread … this is called the allocation of indirect cost. How is it possible to allocate those costs? I need to allocate it to know the total costs of the aircraft being produced.

Direct cost: no problem because direct link, easily traced.

Producing department and the other ones (the ones related to the support department).

APPLIED FACTORY OVERHEAD

An estimate of the next period's factory overhead costs is made which is then divided by a base, such as labor hours, machine hours, etc., and expressed as a predetermined rate. This predetermined rate helps management measure unit costs. If no predetermined rate is used, management would have to wait until the end of the period to know the amount of factory overhead costs and, therefore, the total cost per unit.

BASE TO BE USED

The base used to compute the predetermined factory overhead rate should be closely related to functions represented by the factory overhead cost being applied. The five bases generally used to calculate the factory overhead rate are:


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Generally: 5 bases.

I could allocate on the basis of units of production: if a given department produces 2 times more than an other or else…

I will take the total of indirect costs (factory overhead, producing department overhead) and divide it by the units of production. It gives me a ratio ???

Example: we have a car manufacturing, we assemble 2 models (A & B), and if I use the number of units produced, what I will do, the total of the units produced (of the 2) is for example 1000. I produce 1000 totally.

Total of my indirect cost for that factory: 1000 euros. Calculation is easy, I have to allocate 1000 euros to each of the models. It means whenever I produce 1 car, I have to put to the top of the indirect cost: 1 euro.

Whenever a car is being produced, I will put on that car 2 euros of indirect costs if indirect costs = 2000 euros.

On the basis of that, I can make any type of calculation.

Use the direct material cost.

Computation: total indirect cost (factoruy overhead) divided by the direct material cost x 100. If I multiply by 100, I can get it as a percentage. This is applicable purely to Manufacturing company. You don’t use it in a service company.


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…

Direct labor hours, we talk about labor hours and not labor costs!

…

Which of those 5 methods should we choose?

He’s going to describe a business situation and we’ll have to decide which method to use.

Company with a … it’s produced by a robot. There is almost no human working there. Which method should we use to allocate indirect costs? Machine hours. We’ll put more costs on the products requiring more working hours.

All the costs are going to be driven by the machine.

…

I need an engineer checking the quality of … => this is an indirect cost! …?

Above: Typical list of allocation base. You will allocate based on the models in the first column.

Ex: Maintenance cost: indirect cost, I may decide to allocate it based on the number of machines (???) It is because I need more machine hours that I need more maintenance costs (… ?)

Ex: Supervision costs: what’s the cost driver of supervision cost? Why do I need supervision? To supervise persons working on the product. Amount of direct labour hours. If a product requires 2 times more … for this product I will need more supervision and then more supervision costs.

ALLOCATION OF SERVICE DEPARTMENT COSTS TO PRODUCING DEPARTMENT

There are two basic types of departments in any company: producing departments and service departments. A producing department is one where the conversion or production


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takes place. A service department (e.g., personnel or maintenance) provides support to the producing departments. Since the producing departments are directly benefited by service departments, the expenses of a service department should be allocated to the appropriate producing departments (as part of factory overhead costs). One of the following methods may be used to allocate service department costs to producing departments:

(1) Direct method

(2) Step method

(3) Algebraic method

Other type of indirect cost. I talk about service department, support department (not production department !!!).

We’ll look at 3 methods.

DIRECT METHOD

This is the most common method of allocating service department costs to producing departments because of its mathematical simplicity and ease of application. It involves allocation of service department costs directly to producing departments and ignores any services provided by one service department to another. The problem is just to choose the most appropriate allocation base, as it was in the allocation of producing department overhead.

This is the most common method of allocating service department costs to producing departments because of its mathematical simplicity and ease of application. It involves allocation of service department costs directly to producing departments and ignores any services provided by one service department to another. The problem is just to choose the most appropriate allocation base, as it was in the allocation of producing department overhead.

Situation: a company works on different project (i.e building, …)and they have to classical supporting departments (i.e. HR department and IT department). The company may make the assumption that the IT costs will be allocate to the different projects based on something. What about the HR department, to allocate the costs, we have to allocate the costs on the basis of person. The cost object is the project, the cost driver (= it’s a variable which impacts the cost object) is the workforce (the more people we have, the more activities we’ll use from the HR department). The idea behind the direct cost is to say that HR people only work for the customer, the costs object. But, that’s not really true because the HR people also work for other department (i.e. IT, financial,….). But, in the direct


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method, we make here the assumption that the entire workforce is allocated to the HR department and the same thing for the IT department. As a result, it’s not close to the reality and it ignores the reciprocal element.

Most common method:

I take the total cost of a given support department (ex total cost of human resources). I record the costs and whenever there’s a cost I will put it in a department. I take the total cost of the department and I put it on the cost object directly.

Problem: allocation of the service cost is made directly to the … but I completely ignore the fact that support department may be working for each other’s.

HR dep works directly for the producing department, and idem for IT etc. IT’s an assumption but in the real life it’s not the case, because HR department also works for the IT department etc. for example!!! In this method I ignore that, it’s the limitation of the method.

Otherwise, this method is really easy. But it has limitations.

STEP METHOD

The idea is to take into account some reciprocal services among the department on a limited way. Based on the graph, we start with the building maintenance which provide services to all other department and will put this service on the top of the graph. Then, the other steps will concern the other department ranking by the decreasing importance of the allocation : facility management, other services, main cost pools.

For the step method, we’ll take the first step and allocate the costs to all the other steps. That’s the first allocation, under the step method, we make the assumption that nothing is going back. The other steps can give something to the firs step. The next step is to take the total costs of the facility management which the original total costs + what has been allocated and will be allocate to the lower steps. Actually, the first step become “facility management” and allocate the costs to the other costs.

This method is more accurate than the direct method when services are provided to other service departments. The allocation of service department costs is performed by a series of steps:

1. The costs of the service department that provides services to the greatest number of other service departments are usually allocated first.


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2. The costs of the service department that provides services to the next greatest number of service departments are then allocated. Any costs added to this department from step 1 are included. Note that under this method, the costs of subsequent service departments will not be allocated to the preceding service departments: thus any reciprocal services among service departments are ignored.

3. The sequence outlined above is continued. step by step, until all the service department costs have been allocated to producing departments.

Graphical example of the step method:

Second Method: Step method

You will list all the support department and you will put in the first position the one delivering services to the most of the others. Ex: building maintenance is offering serices to all the other department, it’s the most universal. I will then put the following one, facility management. And so on, I put that gradually.

I start wirth the one on the top position. I take the total of its cost. That amount of money I will allocate it to all the other departments.

I wil take an allocation base to allocate that cost to all the others.

I perform the allocation of the cost. One that step is completed, that bloc is empty cause all the costs have been allocated to other departments. I will then do exactly the same with the second one BUT I CAN’T GO BACK. I will empty that amount on money on the FOLLOWING one but won’t go back => I won’t allocate to the one backwards, on the top (here: building maintenance in comparison to facility management).

Assumption: In this case facility management doesn’t provide services to the building maintenances. Only downwards, not upwards. But in the real life it’s not the case, there are


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allocations between those departments. It’s better than the first method but there are still limitations.

I ignore that there are reciprocal departments.

If I want to take that into account I will need to use the 3rd method, the most accurate one.

ALGEBRAIC METHOD

This is the most accurate of the three methods when reciprocal services are provided among the service departments. With the algebraic method, simultaneous equations are used to allocate service department costs to service departments and producing departments. The number of simultaneous equations is proportional to the number of service departments. The use of a computer (excel sheet) facilitates the computations when many service departments exist.

It takes into consideration all the reciprocal services. (IT to HR and HR to IT). Based on the graph, we start with the cost by nature arriving in a company (i.e. material, labor, services, amortization costs). Those costs are standard for large categories in company = origin.

The purpose is to find the mechanism to allocate those costs to the cost object = destination.

Between there are different mechanism :

- direct cost : it goes directly from the origin to destination. They are traced directly to the cost object. Ex :

- indirect cost : We allocate them through (first step) cost pools (it’s a grouping of indirect costs before final allocation of the cost object). Normally, it’s just a department. It’s very easy for the department to collect all the indirect costs related to the department. We will identify some cost pools and we’ll first allocation the costs by nature to the cost pools which is the intermediate cost object. There are two ways to allocate indirect costs to the cost pools : o Measurement method : it’s easy to allocate costs if there is a measurement

(time sheet, electricy counter, …. ) we have a specific base to know at which we have to calculate the costs.

o Allocation base: in case of no measure method, for electricy, we can see that if an area is dubbled than another one, we can assume there will be a double consumption. We need to have a referencial data.

We don’t allocate directly to the cost object because we need to take into consideration the reciprocal services among (second step) service department. When it’s done, we can us the cost-‐allocation base to allocate pools of indirect costs to cost objects. Besides, cost pools can be allocated to other cost pools before ending in the cost object.


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Algebraic Method:

I’ll have to solve mathematical equations.

At the beginning I can identify some costs, I will identify the costs by nature. I will look at the bill and identify if it’s a cost for a service, a material bought to a supplyer etc.

4 types of cost nature:

- labour - service (bought to a supplier ex cleaning service) - material - amortization

Those cost I can identify them and the only thing I know is the nature of those costs. At the end I want those costd allocated to the final product or service.

Whenever you buy a PC a fraction of that cost is coming from the salary of the CEO of the company for example.

Process to go from origin (cost by nature) to destination (cost object).

If the cost is direct it goes directly to the cost object, no problem.

Indrect cost: cost which can’t be traced easily to the cost object, cost which is not direct.

1st I will group them in cost pools (= traditional department in a company ex: HR, IT, marketing, Sales, production,e tc.). We’ll have main cost pools and auxiliary cost pools …

Main cost Pools: where procution is made. Production deoartment

Auxiliary cost pool: support department. That’s not where the action takes place (that’s main cost ppols).

I group my costd into the right cost bools thanks to a MEASUREMENT METHOD (time sheet etc.) or using AN ALLOCATION BASE (number of square meters, of people, of PCs, etc.). It’s alxways one of those 2 methods. The best one is the first one, when you have a measurement tool available.

…

If I use more square meters I will have to heat (chauffer) more. Heating costs.

…


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Each room has its own calory meter. For each room you know the exact number of calories used. (possibility to work with pull overs etc.)

IT costs:

You may decide to allocate IT cost based on a number of PCs. It makes sense. We’ll allocate twice more IT when twice more PCs for example. We’ll ask technicians to use time sheet (fill them), whenever they repair a PC they need to write it on a time sheet.

Measurement = time sheet.

I have the information on which I can make my cost allocation.

If no measurement, find a way to allocate, based on an allocation method.

That was the first step. Put the costs in the right cost pool. (main and auxiliary).

I will solve the issue of reciprocal services. There are services from one service department to another one. Once that done, I will be able to…

All indirect cost will first be group into cost pools. After that: either transferred to other cost pools or allocated to the cost object. At a given moment I wan to have all the auxiliary cost pools exmpty (transfer to the main cost pools) and then from the main cost pools to the cost objects. Final destination: I want to have all the costs allocated to the cost object.

PRIMARY ALLOCATION and then SECONDARY ALLOCATION.

OVERVIEW OF THE FULL COSTING PROCESS


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All indirect costs will first be grouped in cost pools, and after that they will:

• Either be transferred to other cost pools; • Or allocated to cost objects, which is always the final destination.

In order to do this, two successive allocation steps will take place: primary allocation and secondary allocation.

PRIMARY ALLOCATION

All indirect costs to cost pools. The total of the costs regrouped in one cost pool is the cost of this cost pool. There are 2 categories of cost pool:

• Main cost pools : their costs will be almost fully transferred to cost objects; • Auxiliary cost pools: they provide services to other cost pools (main or auxiliary).

Auxiliary cost pools are sometimes called « service centers» or « support centers », because they don’t have direct link with what is being produced, but they contribute to the internal organization by providing services to other centers. Typical examples: payroll admin, IT, maintenance, HR.

Primary allocation : we allocate all the indirect costs to cost pools. These indirect costs come from supporting service and producing department that will be reflected in auxiliary and main pools. The auxiliary pools will still influence the department and still provide costs


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to other services. . That’s why we’ll need to allocate them in the main pools to cover all the indirect costs.

PUTIN INDIRECT COST AND PUT IT IN THE RIGHT POOL.

Main cost pool: cost pool whose cost will be almost fully transferred to the cost object.

…

I start with my indreict cost when they happen and I will put them in the right cost pool, main or auxiliary. This is the primary allocation. Any indirect cost will be transferred to one of the pools.

SECONDARY ALLOCATION

The purpose is to allocate the costs of the auxiliary pools to the main pools.

Secondary allocation : we’ll observe what happens inside the cost pools. The purpose is to allocate the auxiliary pools to the main pools. We want to have all the auxiliary costs empty.

Then I will have to perform a secondary allocation. The aim is to allocate the costs to the main pools. I take all my auxiliary cost and the aim is to empty them and put them in the main pools. That’s what I want by the end of the step: empty auxiliary pools and amounts transferred to the main pools. I do it USING AN ALLOCATION BASE that we’ll have to choose. Sometimes it’s going to be 3 times 1/3, it depends on the allocation base.


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REPROGICAL SERVICES

ALGEBRAIC METHOD

The reciprocal method allocates support-‐department costs to operating departments by fully recognizinng the mutual services provided among all support departments. This is of course contradictory with the step method, since there are services « simultaneously » provided between support departments.

Pool A provides services to pool B, and simultaneously pool B provides services to pool A.

We’ll use that method to deal with the reciprociacal method.


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We have Pool A and B, auxiliary pools, fulfilled with indreict costs and them made empty, transfer of the amounts to main pools?.

SIMULTANEOUSLY

Problem !

EXAMPLE

A research laboratory works on 4 projects, named P1 to P4.

The operations are supported by a HR department, and another department in charge of the IT equipment maintenance.

All the costs are allocated by using the table on the next slide.

Obviously the project is my cost object, I want to know what’s the total cost of the project (cost object). 4 projects then 4 costs objects. The operations, are supported by HR department and another one in charge with maintenance of the computers.

One department is in charge with work on the project P1, another one with project P2 etc. How many departments? At least 4, one per project. But on the top of that I have a human resource department and an IT maintenance department: 6 departments then. How many dep might be considered as main departments and how many as support? MAIN: 4, the 4 working on the projects and 2 support departments. That’s the basis for our analysis.

Different departments in the table.

Example :

A research laboratory works on 4 projects, named P1 to P4.The operations are supported by a HR department, and another department in charge of the IT equipment maintenance. All the costs are allocated by using the table on the next slide.


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Let’s assume that for a given period of time, I will record a total of 3 billion euros, total of all my costs. I will perform the primary allocation (allocating those costs to all the different cost pools, primary or auxiliary).

Why is it 10% ? No idea, that’s given. That’s a specifi allocation base.

2 basic ways to allocate that cost to the various cost pools:

- Measuremnt (time sheet, accounter) - Allocation base

Those are the results of the primary allocation. It might be the result of time sheets or anything else but now I’m just having a look at the results, not at the reasons.

After the primary allocation we need to go through the secondary allocation.

= What do I want to do with that allocation? Empty the auxiliary cost pools down to the main cost pools. At the end of that allocation I want to have HR and IT cost pools EMPTY and all the costs transferred to the 4 main cost pools. In order to do that I need an allocation base.

Here it’s given. TO allocate HR costs, you need an allocation base for example. 30% is for IT, 20% for P1, P2 and P3, and 10% for P4.

Etc.

People from HR management for 30% of their time (or spend 30% of their resources) for IT department (it”s the same rto say that).

I will do exactly the same for IT department.


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What do I want then? To empty the total cost of human resource.

What’s the problem with reciprocal services?

TOTAL OF HR Management: 164.000 + 10% of IT

TOTAL OF IT maintenance: 300.000 + 30% of the total amount of HR management.

It looks like I am turning around.

HR amount of money refers to IT and IT amount refers to HR !!!!! To know the amount of money in HR I need to know the one in IT and to know the amount of money in IT I need to know the amount of money in HR.

Mathematically it’s really easy to solve.

The total of all indirect costs is 3 000 000.

- The primary allocation : is to allocate the indirect costs to the other entities (P1,P2,P3,P4). How was it been allocated : either measurement method or allocation base or a combination of that.

- The secondary allocation : we’ll use an allocation base to express the percentage of costs related to each project for each department. The figures is calculated internally and are given for the table.

However, during the secondary allocation, we didn’t take into consideration the reciprocal services. The problem is that IT department is providing services to HR department and “inversément”. The total allocation for the HR management is 30% + costs allocated for the IT department and the same for the IT department. But we don’t know the amount of costs for the respective department (HR for IT management, and IT for HR management).

The solution so is to use “x” to be the unknown total of the HR department, and “y” the unknown total of the IT department. We have the following:

HR department : X = 164000 + 0.10Y

IT department : Y = 300 000+ 0.30X

leading to x =200 000 et y =360 000, which allows to finish the allocation table (see following slide).

Let’s go ahead with the secondary allocation. There are reciprocal services between HR and IT department.


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Let x be the unknown total of the HR department, and y the unknown total of the IT department.

We have the following:

Way to solve mathematically

X = 164.000 + 10% of Y

Y = 300.000 + 30% of X.

2 equations with two unknown variables. Easy to solve then.

Why 2 equations with two unknown variables? Because 2 auxiliary. If I had 3 auxiliaries, I would have 3 equations with 3 unknown values.

How are we going to solve that? We take the value “X =” and replace it in the second equation, and then we just solve.

Therefore, we have the equations systems:

• 164000 + 0,10 y = x • 300 000 + 0,30 x = y

Leading to x =200 000 et y =360 000, which allows to finish the allocation table (see following slide):


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There are no indirect costs left in the two departments, all the indirect costs have been allocated to the projects : P1,P2,P3 and P4. (for Hr department : 164.000 – 200.000 + 36.000 = 0).

In some case, highly different assumption can lead to minor difference in the calculation. So, the method is not sensitive to the assumption.

This methodology allows even further refinement:

BUT= HUMAN RESOURCES IS ALSO WORKING FOR ITSELF !!!


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here we see that HR work 10% of their time for itself, and IT 5% of their time for itself, so we put a percentage in the right case here.

Let’s go ahead again with the secondary allocation. There are reciprocal services between HR and IT department, and self-‐provided services.

Let x be the unknown total of the HR department, and y the unknown total of the IT department. We have now the following:

Exactly the same method to solve the equation

Therefore, we have the equations systems:

• 164000 + 0,05 y + 0,1 x = x • 300 000 + 0,20 x + 0,05 y = y

leading to x = 202 130 and y = 358 343, which allows to finish the allocation table (see following slide):

There’s no big difference after the refinement, we see that sometimes the refinement is worthless.


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Sometimes, subsidiaries can perfom better than other in th full costing method, but we need to take into consideration if there are over/undercosted and what kind of allocation method is used. It can change figures and cannot reflect the reality.

Differences in pourcentage. Using one allocation base and another one. The effect in percentage is almost not changing. Message: don’t over sophisticate the method, sometimes you won’t see the real result using a more sophisticated method. In this case, using one method or the other, there’s no big difference so no more effort needed.

As management controller you don’t look for the 100% accurate solution/ 100% visibility. You look for the good visibility (?). You have to be carefull with all those sophisticated method, you’re not looking for the PERFECT method.

PARTIAL OVERHEAD ABSORPTION


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You may look to some partial costs. We won’t cover this part, we should read it but no question at the exam.

The allocation, sometimes made on a more or less arbitrary basis, of the overhead and structure costs to the products or services sold during the time period is not always the most relevant method allowing to take sound decisions (pricing, etc...)

Actually, it is sometimes better to calculate a “margin” that simply measures the contribution of the different products and services to the common costs.

In this case, it is better to use partial overhead absorption method, that will absorb only a well defined portion of the total costs, rather than calculate the total cost.

The methods that are used in practice are :

• Margin on direct cost • Margin on variable cost • Margin on specific cost

The allocation, sometimes made on a more or less arbitrary basis, of the overhead and structure costs to the products or services sold during the time period is not always the most relevant method allowing to take sound decisions (pricing, etc...)

Actually, it is sometimes better to calculate a “margin” that simply measures the contribution of the different products and services to the common costs. In this case, it is better to use partial overhead absorption method, that will absorb only a well defined portion of the total costs, rather than calculate the total cost

The methods that are used in practice are :

- Margin on direct cost : is the opposite of variable costs - Margin on variable cost : is the opposite of direct costs - Margin on specific cost : the most used method in practice. It concerns all variable

costs (direct and indirect) + fixed direct costs. The four possible is fixed, variable, direct and indirect. Under that method, only the fixed indirect costs are not taken into account because it’s the most difficult to allocate. The other costs are easy to allocate.

MARGIN ON DIRECT COST


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MARGIN ON VARIABLE COSTS

MARGIN ON SPECIFIC COSTS

This method is much more used in practice.


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Applying this method allows therefore the separation of specific fixed costs from common fixed costs. It allows the calculation of a « margin on specific costs», also called «contribution».

The specific cost is not a full cost, but it is often very close, since the gap is only related to the common part of structure costs, which is often useless to allocate distinctly to every product.

Building the margin on specific cost is described the following way (for a company having 3 activities A, B et C) :

This method shows the same type of advantage as the margin on variable costs; it is a « natural » enhancement. In particular, all issues related to keeping or leaving an activity may be adressed through specific costs.

Compared to margin on variable costs, it shows more clearly the contribution of each product, service or activity to the structure costs. This allows to identify which portion would remain if the decision is taken to leave the product, service or activity.


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ACTIVITY-‐BASED COSTING (ABC)

Different approach.

ABC is an approach to costing that focuses on individual activities as the fundamental cost objects. It uses the costs of these activities as the basis for assigning costs to other costs objects such as the products or services.

An activity is an event, task or unit of work with a specified purpose (for example designing products, setting up machines, ...) More informally: activities are verbs; they are things that a company does.

We focus on activities as cost object. We just use the activities for the cost allocation. It’s another method of cost allocation and it’s more accurate.

The basis idea is to avoid any over or undercosting. A cost object can be overcosted or undercosted. If indirect cost is too high, we’ll talk about overcosted

Ex (1): We have three people going to the restaurant. The total bill is 60€. If we are good friends, we take the bill divided by three = 20. Who’s overcosted and undercosted ?Jose and Nancy are overcosted whereas Roberta is undercosted. In a business language, this situation can be translated by : we have a total cost we want to allocate to different cost objects (=three persons). The result of the cost allocation is 20 on each cost object. The allocation cost process is allocated equally to the cost objects. In this case, I perform an allocation of the total cost and we allocate a cost to the cost objects based on the allocation base. It’s far from the reality.

Ex (2): Kole corporation is manufacturing a normal lens and complex lens. I assume that the company uses a single indirect-‐cost rate job costing system. The cost objects are the lens: 80NL + 20CL. The normal lens includes direct materials and direct mfg labor. The direct cost per unit is 29€. For the complex lens, the direct cost per unit is 59€. For the indirect costs, we have 2.900. 000. We have to allocate that to the final cost objects in order to do that we’ll have to define an allocation base. Since it’s a manufacturing company, it’s a good idée to allocate that in function of the manufacturing labor-‐hours. Logic = if we need more lens, we’ll need more workforce. Per unit, it is 58€ per direct manufacturing labor-‐hours.


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Ex(3) : We have a total of 50 000 costs, and the division is : Kole uses 36,000 direct manufacturing labor-‐hours to make NL and 14,000 direct manufacturing labor-‐hours to make CL.

How much indirect cost are allocated ot each product ?

NL :36.000 x 58 = 2.088.000 (=indirect cost allocated)

CL : 14.000 x58€ = 812.000

The total costs of the normal lense is direct costs + allocated indirect costs (2.320.000 + 2.088.000) and th complexe lense is similar ((1.992.000).

è this is the traditional allocating method using the allocation method base = direct manufacturing labour hours.

ABC is an approach to costing that focuses on individual activities as the fundamental cost objects.

It uses the costs of these activities as the basis for assigning costs to other costs objects such as the products or services.

An activity is an event, task or unit of work with a specified purpose (for example designing products, setting up machines, ...)

More informally: activities are verbs; they are things that a company does.

Activity-‐Based Costing (ABC) is another method of allocating costs to products and services. It is generally used as a tool for planning and control. It was developed as an approach to address problems associated with traditional cost management systems, that tend to have the inability to accurately determine actual production and service costs, or provide useful information for operating decisions. With these deficiencies, managers can be exposed to making decisions based on inaccurate data. The higher exposure is for companies with multiple products or services.

ABC allows managers to attribute costs to activities and products more accurately than traditional cost accounting methods. The activities responsible for the costs can be identified and passed on to users only when the product or service uses the activity. Some of the advantages ABC offers is an improved means of identifying high overhead costs per unit and finding ways to reduce the costs.


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The way it works is:

• First major activities are identified in the process system. • Next cost pools are created for groups of activities that can be allocated together. • Following this cost drivers are identified. The number of cost drivers used vary

depending on the balance between accuracy and complexity. • After determining the cost drivers, rates are calculated. • The rates are then applied to the respective cost drivers for each product or service

that is being considered. • The overhead cost per unit is then derived by dividing the total cost for the product

by the total product units.

Learning Objective 1:

Explain undercosting and overcosting of products and services.

Undercosting and Overcosting Example

Undercosting and overcosting problematic (products and service)

There’s a risk of putting to much or not enough money when allocating, depending on the method I use.


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What’s likely to happens when you’re a good friend? You divide it by 3: 20. Everybody’s going to pay 20.

That person is obviously undercosted. (?)

One perso undercosted and 2 are overcosted. But no problem in this case cause we can assume that those eprsons are good friends. But it might be a problem in other problematics.

If it costs to much because of a mistake in my process and I decide to stop the production because It seems to be overciosted, it might be a bad decision.


Present guidelines for refining a costing system

EXISTING SINGLE INDIRECT-‐ COST POOL SYSTEM EXAMPLE

We have a company manufacturing lenses (for microscopes).


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2 types of lenses: normal and complex I will produce 80.000 normal lenses and 20.000 complex lenses.

Each normal lense produced has a direct cost of 29 euros.

Each complex lens produced has a direct cost of 59 euro.


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Now we are going to deal with the indirect costs. Total costs = indirect + direct (basic).

I will pool all the indirect cost in a cost pool. Total amount of 2.900.00 euros. I need to allocate that to the different lenses, normal and complexes. I decide to allocate it on the basis of direct hours. (see different methods above).

If I want to allocate 2.900.000 on the basis of 50.000 direct labor hours:

58 euros of indirect cost per direct manufacturing labor hour. (?)

In this case what’s the meaning of that amount of money? Whenever a lens is going to use 1 hour of direct labor hour, I will count on the top of that 58 euros of indirect cost. If a lens requires 10 direct labor hours, I will add 580 euros of indirect cost.

58 euros of indirect cost per direct manufacturing hour.

Now I can compute the total cost: direct and indirect costs.

Here I can compute the total costs. For a given lens I will look at the number of direct hours needed to produce it and then multipliate.

LET S WORK THAT OUT.


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CL = complex lenses

NL = normal lenses

That amount of money is spread between the 2 types of lenses.

I perform the allocation of the total indirect costs to my different cost objects. The allocation base (labor hours) is ok because the more hours I use, the more it costs (?).

Direct cost that has been computed earlier + the indirect = 4.408.000 euros.

The cost per unit = 55,10 euros.


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TOTAL UNIT COST of a complex lens = 99,60 euros.

Let’s imagine we can sell the normal lenses. We have a 8,2% margin.

We can see that complex lenses are more profitable than normal lenses.

REFINING A COSTING SYSTEM

We’ll look at one of the basis activities of the company.

1. Design of products and process : 2. Manufacturing operations 3. Shipping and distribution


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In ABC, we’ll start with the fundamental cost objects. The starting point inside the fundamental is the activities and their costs. That will lad to the assignments of other cost objects (cost of products, service, customer). The most complicated task is to define the most relevant activities. We have to find the right balance between the total list of activities and not enough activities. Inside the company, the corporation identified key activities :

§ Design products and processes. § Set up molding machine. § Operate machines to manufacture lenses. § Maintain and clean the molds. § Set up batches of finished lenses for shipment. § Distribute lenses to customers. § Administer and manage all processes.


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In order to refin I will look at my operation. I see that I have some important activities (shipping and distribution, manufacturing, etc.). Difference with the ABC method is that here I will look at the activities. I will look at my operations, my activities, and calculate the cost of my activities and based on that I will …

My Cost allocation base (CAB) is the cost of the basic activities of the company. I will allocate indirect cost based on the cost of the activities.


Distinguish between the traditional and the activity-based costing approaches to designing a costing system.


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ACTIVITY-‐BASED COSTING SYSTEM

All my company is summarized by describing those 7 activities. People have to agree on what are the key activities.

Find a right balance between not to many activities and 1 or 2 activities on the other hand might be not enough.

Example of 3 of those activities:


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Those are activities. Fundamental cost object = cost activities. I have activities. I will use those activities as cost pools. Indirect costs related to set up activities I will group them here, etc.

Allocation to the final cost object. But I need to find a way to allocate that.

For the shipment I will allocate the shipping indirect cost based on the number of shipment. If 1 Single lens requires more shipment, I will allocate more shipment (costs?)???.

Clear cause and effect relationship. The cause= fact that I have many shipment and effect = I need more indirect shipping costs.

Set up cost. Allocate indirect set up cost based on the number of set up hours. The more set up hours I need, the more set up indirect costs I will have.

Design: design indirect costs are going to be allocated on the basis of the number of parts per square feet (?).

…

I will probably avoir under and overcosting.

- Shipping : We want to assign the total costs of the shipping activities to the lense list : either NL, or CL or other. Which allocation method are we using ? On the number of lenses? On the number of shippers ? Yes, it makes sense. In other word, if the lenses NL require two times more shipping than lenses CL, it will require two times more shipping costs.

- Setup : For the setup of the machines, we’ll use an allocation base as the number of setup hours. If a lence NL needs two times more setup hours than lence CL, the cost will be dubbled.

Another example with the batch:

What I will do here: illustrate that method for indirect set up costs (1 category of indirect costs)

I will use the 2 methods for the same amount of money and we will compare.


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640 = 320 * 2hours

I will produce the NL in 320 batches of 250 units (?)

Whenever I start a batch I need 5 hours. Since I need 5 hours for any batch, it gives me a total of 640 setup hours (???)

Total set up costs = 409.200 euro that I will allocate to my 2 cost objects (NL and CL)

8.184 is the cost bear by each direct manufacturing labor-‐hour unit.

I can compute the cost of 1 single set up hour. Each set up hour cost me 155 euros.

/labour hour? (see previous method). 8.184 euros

We have 409200 amount of indirect costs that we want to allocate the final product using the first method, the biggest portion the costs is on the Normal lense. We have 36000 x 8184. Actually, the real situation is exactly the reverse. But, based on the ABC activity, the biggest portion is for the Complex lense. If a company would have based its decision on the first method, it would have been a wrong decision. If we allocate on the setu-‐hours, it


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reflects the good image of the reality. The second method, ABC, is the good method. The normal lenses are overcosting and the complex lense are undercosted for the first method. We’ll stop producing the overcosted products because less we produce, more we have profit.

Allocation using the direct labour hur: I will count 8,184euros allocated to …

We do it for each method.

One is the opposite of the other. In the first one I allocate 75% to the complex lenses and 25% to the normal lenses and here it’s the exact contrary, 75% to the NL and 25% to the CL !!

Obviously I have a serious overcosting or undercosting problem. Which method is the most accurate? (TYPICAL EXAM QUESTION) Which method would be the best one, which one would you recommend and why?

Allocating set up indirect cost: it make sense to allocate the set up indirect cost on the basis of the set up hours. If a product requires more set up hours I will put on that product more set up hours.

Does it make sense to allocate set up indirect costs based on the number of direct labour hours? No.

…

ALLOCATING USING SET UP HOURS:

which product would be overcosted? Normal Lenses


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We’re talking about 3 times more. Normal lenses are going to be overcosted and automatically the CL are going to be undercosted (if 2 products, if one is overcosted, automatically the other one is going to be undercosted).

If I decide to stop the NL because the cost is to high, it’s a bad decision because I base my decision on a bad number.

Benefit of Activity based costing = method providing the most accurate results.

CONCLUSION

Written exam:

- 10% for the presentation - 90%

1 question related to the case study (READ IT!!!!)

He wants to use it to test our understanding of some basic concepts. No shmet questions.

We have to understand the global environment of the case study, and then one question related to that case study

Ex: use it to show an example of what might be a measurement of something

Ok using the case study if I ask you to draft, give an example of a balance score card, what element would you put in it (?????)

That question has not ONE RIGHT ANSWER.

Multiple choice questions

One or two calculation questions

Ex: Indirect cost allocation exercice (see last course)


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One ore two general questions, open-‐ended questions (definition of a concept, or else). He expects from us to give our own perception of the concept. Let’s not copy paste the slides.

Ex: best definition of the job of a management controller.

We can take everything we want with us at the exam.

Our answers have to be PERSONALS!!! Copy pasting the slides isn’t the right choice. We need to show that we understood the basic concepts. Express it simply.

There’s going to be some very vague, general questions. Way to test wether we got a good understanding of the basic concepts and if we can go directly to what’s essential/crucial.

management accounting control

Economy & Finance